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Creditors and Standing to Object to Chapter 11 Petitions

By Rudolph J. Di Massa, Jr. and Sommer L. Ross
December 1, 2006
The Legal Intelligencer

Creditors and Standing to Object to Chapter 11 Petitions

By Rudolph J. Di Massa, Jr. and Sommer L. Ross
December 1, 2006
The Legal Intelligencer

Read below

In In re Orchard at Hansen Park, the U.S. Bankruptcy Court for the Northern District of Texas was faced with the issue of whether a creditor has standing to raise the issue of authority to file a bankruptcy petition and to pursue a motion to dismiss when a limited liability company files for bankruptcy without obtaining the approval of all its members, as required by the company's operating agreement. On July 7, Bankruptcy Judge Harlin D. Hale issued an opinion holding that, in such an instance, a creditor did have standing to bring such a claim.


The Orchard at Hansen Park is a limited liability company organized and existing under the laws of the state of Washington. Orchard was created to acquire, own, hold, maintain and operate a 212-unit apartment complex located in Kennewick, Wa. HSM-Kennewick and WO Kenneywick (WOK) comprise the entire membership of Orchard, with HSM controlling 90 percent and WOK controlling 10 percent of the equity interests. Under Orchard's operating agreement, the consent of all members and managers of Orchard must be obtained before Orchard may file for bankruptcy protection.

On May 19, (the petition date), Orchard, by and through an attorney hired by HSM, filed a voluntary petition for relief under Chapter 11 of the U.S. Bankruptcy Code with the U.S. Bankruptcy Court for the Northern District of Texas. The petition was filed without WOK's consent.

Shortly after the petition date, GDW Capital Partners, a creditor of Orchard, together with the purported manager of Orchard, filed motions to dismiss Orchard's Chapter 11 bankruptcy petition arguing, in part, that Orchard's operating agreement requires the consent of all members of Orchard to validly file a voluntary petition. At the time the petition was filed, Orchard's obligations to GDW included unsecured mezzanine debt of approximately $2.4 million.

HSM filed a motion to strike GDW's motion to dismiss. In its motion to strike, HSM argued that GDW, as a creditor of Orchard, did not have standing to raise the issue of HSM's authority to file a bankruptcy petition on behalf of Orchard.

After an expedited hearing on the matter, the bankruptcy court found that GDW, as a creditor of Orchard, had standing to raise the issue of HSM's authority to file a petition for bankruptcy protection on behalf of Orchard. In addition, the bankruptcy court granted GDW's motion to dismiss, finding that HSM had filed the petition without the unanimous consent of Orchard's members, as required by Orchard's operating agreement.

The Court's Analysis

In support of its decision that GDW had standing to raise the issue of authority to file a bankruptcy petition and that GDW could legally prosecute a motion to dismiss HSM's bankruptcy petition, the bankruptcy court relied on precedent from other jurisdictions, as well as express language contained within the Bankruptcy Code.

The bankruptcy court first pointed out that several other courts have held that a creditor to a chapter 11 bankruptcy may have standing to challenge a bankruptcy filing. These include the 1st U.S. Circuit Court of Appeals in In re Abijoe Realty Corp; the Bankruptcy Court for the District of Maine in In re Consol. Auto Recyclers, Inc. (citing In re Cmty. Book Co., from the district of Minnesota, upholding a creditor's challenge to filing, even though dismissal benefited the petitioning creditor); the Bankruptcy Court of the Western District of Texas in In re Memphis-Friday's Assocs. (holding a creditor may challenge a filing on the basis that it was effected without consent of general partners); and the Bankruptcy Court of the District of Maine in In re AT of Main, Inc. (allowing a creditor to object to Chapter 11 filing).

The bankruptcy court then turned to the relevant provisions of the Bankruptcy Code, including sections 1109 and 1112. Pursuant to Section 1109(b) of the code, any party in interest - including a creditor - may raise and appear and be heard on any issue in a case under Chapter 11. The term "party in interest" is not explicitly defined in the code, however, the definition does explicitly include a "creditor," and the term has been generally interpreted to include all entities whose pecuniary interests are directly affected by the bankruptcy proceedings. Accordingly, the bankruptcy court concluded that Section 1109(b) allows any party "with a financial interest in the outcome of the case to participate in the proceedings in order to protect that interest."

Section 1112(b)(1) of the Bankruptcy Code provides that a party in interest may object to a bankruptcy filing and request dismissal of the case for "cause." Section 1112(b)(4) reads as follows:

"For purposes of this subsection, the term 'cause' includes -

(A) substantial or continuing loss to or diminution of the estate and the absence of a reasonable likelihood of rehabilitation;

(B) gross mismanagement of the estate;

(C) failure to maintain appropriate insurance that poses a risk to the estate or to the public;

(D) unauthorized use of cash collateral substantially harmful to 1 or more creditors;

(E) failure to comply with an order of the court;

(F) unexcused failure to satisfy timely any filing or reporting requirement established by [the Bankruptcy Code] or by any applicable rule to a case under . . . chapter [11];

(G) failure to attend the meeting of creditors convened under section 341(a) or an examination ordered under Rule 2004 of the Federal Rules of Bankruptcy Procedure without good cause;

(H) failure timely to provide information or attend meetings reasonably requested by the United States Trustee (or the bankruptcy administrator, if any);

(I) failure timely to pay taxes owed after the date of the order for relief or to file tax returns due after the date of the order for relief;

(J) failure to file a disclosure statement, or to file or confirm a plan, within the time fixed by [the Bankruptcy Code] or by order of the court;

(K) failure to pay any fees or charges required under chapter 123 of title 28 [of the United States Code];

(L) revocation of an order of confirmation under section 1144;

(M) inability to effectuate substantial consummation of a confirmed plan;

(N) material default by the debtor with respect to a confirmed plan;

(O) termination of a confirmed plan by reason of the occurrence of a condition specified in the plan; and

(P) failure of the debtor to pay any domestic support obligation that first becomes payable after the date of the filing of the petition."

The reader will note that our federal legislators created an exhaustive list of the types of cause that would justify dismissal of a bankruptcy case. The reader will also note that "lack of corporate authority" is not included in Section 1112(b)(4) as one of the "causes" for dismissal of a bankruptcy case. Fortunately for GDW, though, the bankruptcy court found the aforementioned list to be nonexclusive.

The bankruptcy court also reasoned that before determining whether a creditor has standing to seek dismissal, the court must consider whether the creditor has a sufficient stake in the case. In addition, it determined courts should "take into account the policies underlying the principles" they invoke, together with "the scope of protections intended to be afforded by these policies."

Applying the relevant case law and statutory provisions, and despite the fact the bankruptcy court felt the debtor's situation "crie[d] out for bankruptcy relief," the bankruptcy court found that GDW had a sufficient stake and pecuniary interest in Orchard's bankruptcy case to give GDW standing to pursue the motion to dismiss. Specifically, GDW was Orchard's second largest creditor. In addition, although the mezzanine loan provided by GDW was unsecured as to the debtor, it was secured by the members' equity interests in the debtor. Accordingly, the bankruptcy court found that GDW was in a "far different position than a general creditor of the estate who is otherwise a stranger to the debtor['s] entities."


At first glance, this case appears to be relatively straightforward: The bankruptcy court relied on the rulings of other courts examining the same issue and reached the same conclusion. Moreover, it grounded its holding in Section 1112(b) and in its broad interpretation of "cause" as set forth in Section 1112(b)(4).

However, a closer examination of the 16 examples of "cause" reveals a common theme: Each example identifies a post-petition event, failure or action; not one of these 16 items addresses pre-petition events or activities. As such, we are left to muse upon whether the bankruptcy court crossed the relatively bright line drawn by Section 1112(b)(4). Conversely, it could be argued that we are raising a fuss over very little. After all, the bankruptcy court probably had the authority, under Section 105, to raise this issue on its own.

Under Section 105(a), bankruptcy courts may issue any order deemed necessary to carry out the provisions of the Bankruptcy Code, and "[n]o provision of [the Bankruptcy Code] providing for the raising of an issue by a party in interest shall be construed to preclude the court from, sua sponte, taking any action or making any determination necessary or appropriate to enforce or implement court orders or rules, or to prevent an abuse of process."

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors’ rights. He is a member of the American Bankruptcy Institute, the American Bar Association and its business law section, the Commercial Law League of America, the Pennsylvania Bar Association and the business law section of the Philadelphia Bar Association.

Sommer L. Ross practices in the area of business reorganization and financial restructuring. Admitted to practice in Delaware, Pennsylvania and New Jersey, Ross is a 2004 graduate of Rutgers University School of Law, where she was a member of the Rutgers Law Journal, and a graduate of the University of Delaware.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.