June 13, 2016
Creditors are often compelled to commence expensive and time consuming litigation to first prosecute their claims and then locate and seize a debtor's assets. During this lengthy and costly process, the debtor's assets are dissipated and the creditor may realize only a fraction of its claim. The Bankruptcy Code1 allows a trustee to liquidate a debtor's assets in a cost-effective, expeditious manner. Because of this, involuntary bankruptcy is a powerful tool that can expedite and maximize payments to affected creditors.
Filing an Involuntary Petition. An involuntary bankruptcy is commenced by the filing of an involuntary petition by a "petitioning" creditor.2 The petition sets forth requirements for the creditor to satisfy and can be filed against an individual or business entity, other than "a farmer, family farmer, or a corporation that is not a moneyed, business, or commercial corporation" and only under Chapters 7 or 11 of the Bankruptcy Code.3
A petitioning creditor is qualified to file an involuntary petition if it satisfies the following requirements: (1) it holds a claim against the debtor that (a) is "not contingent as to liability or the subject of a bona fide dispute as to liability or amount" and (b) equals at least $15,3254; and (2) it demonstrates that the debtor is "generally not paying such debtor's debts as such debts become due" (unless such debts are the subject of a bona fide dispute as to liability or amount).5 An involuntary petition may be filed by a single qualifying creditor (if the debtor has less than 12 qualifying creditors) and three or more qualifying creditors (if a debtor has 12 or more creditors).6
If an alleged debtor does not answer the petition or seek its dismissal within 21 days after service of the petition and summons, or, if there is a trial and the petitioning creditor has satisfied the statutory requirements, then the Bankruptcy Court shall "order relief … under the chapter under which the petition was filed … ."7 (This is the operative step resulting in the debtor being adjudicated a bankrupt and subject to Bankruptcy Court jurisdiction).
Creditors can expect debtors subject to involuntary bankruptcy to fight tooth-and-nail to avoid entry of an order for relief. Insiders of alleged debtors (officers, directors, shareholders, and family members) are very reluctant to "open their kimono" and expose their financial dealings to either the transparency required under the Bankruptcy Code or the tools a bankruptcy trustee can use to claw-back payments to these insiders made prior to the filing of the involuntary bankruptcy. Also, if the alleged debtor is operating, the filing of an involuntary bankruptcy proceeding will not only cause vendors to immediately, and drastically, change their credit terms, but will chill the debtor's ability to sell its goods and services to its customers. (The debtor's competitors know who these customers are and will gladly disclose the bankruptcy filing to them).
Alleged Debtor Defenses to Involuntary Petitions. The two most litigated8 potential defenses to an involuntary bankruptcy are whether (1) the claim is subject to "bona fide dispute"; or (2) the debtor is "generally not paying [its] debts as they become due." These terms are not defined in the Bankruptcy Code.
A claim is subject to a bona fide dispute if "there is an objective basis for either a factual or a legal dispute as to the validity of [the] debt."9 When making this determination, a court is not required to resolve the dispute; but only to ascertain whether a dispute exists. The petitioning creditor has the burden to establish a prima facie case that no bona fide dispute exists, after which the debtor must present evidence sufficient to rebut the prima facie case.10 Courts have found the existence of pending litigation or the filing of an answer, or counterclaim, standing alone, insufficient to establish the existence of a bona fide dispute.11 A debtor's previous recognition of a debt, such as listing the debt on a balance sheet or accounts payable ledger, has been found to be conclusive evidence that a debt is not in bona fide dispute.12 Importantly, judgments obtained by default or otherwise are not considered subject to bona fide dispute in the Second Circuit.13
Whether a debtor is "generally not paying such debtor's debts as such debts become due" calls for the consideration of four factors: "(1) the number of unpaid claims; (2) the amount of such claims; (3) the materiality of the non-payments; and (4) the debtor's overall conduct of its financial affairs."14 The failure to pay just one significant creditor can support a finding that the debtor is generally not paying its debts.15
An involuntary petition filed by a single qualified creditor draws greater scrutiny from the Bankruptcy Court out of concern that the courts will be used as "collection agencies."16 In those situations, alleged debtors can rely on additional defenses with varying degrees of success depending upon the jurisdiction.
One line of attack is to assert that a sole creditor can never meet its burden of demonstrating that the alleged debtor is not generally paying its debts as they become due. This argument, referred to as the "almost per se" rule, while followed in a minority of jurisdictions, has been flatly rejected in the Second Circuit, in cases where the claim of a single creditor constitutes either all or the overwhelming amount of the debts.17
Another more successful line of attack for an alleged debtor in sole creditor cases is to seek abstention or dismissal of the petition under §305 of the Bankruptcy Code even though the creditor has technically satisfied the statute. Under §305, a bankruptcy court may dismiss a bankruptcy case (involuntary and voluntary) or suspend all proceedings if "the interests of creditors and the debtor would be better served by such dismissal."18 As set forth above, because bankruptcy courts do not wish to be perceived as collection agencies, an involuntary case which is essentially a two-party dispute may be dismissed for this reason under §305.19
An important exception that bankruptcy courts recognize to determine whether an involuntary petition should be dismissed either under §§303 or 305, is whether the petitioning creditor can demonstrate special circumstances, such as the ability to obtain relief in bankruptcy that it is not available under nonbankruptcy law. For example, under §547 of the Bankruptcy Code, a trustee may generally recover a transfer made to a creditor on account of an antecedent debt within 90 days of a bankruptcy filing, commonly referred to as a preferential transfer. This relief is unique to the Bankruptcy Code. As a result, bankruptcy courts have consistently entered orders for relief in involuntary bankruptcy proceedings when qualifying creditors, even a single one, seek the entry of an order for relief for these types of special circumstances as well as other bankruptcy related purposes.20
Until recently, the Bankruptcy Court applied the standards set forth in §§303 and 305 in an objective manner. However, a 2015 decision by the U.S. Court of Appeals for the Third Circuit injected additional hurdles for qualified creditors to satisfy in order to obtain an order for relief. In Forever Green, the court affirmed the dismissal of an involuntary petition even when the statutory requirements under §303 had been satisfied, based solely on a petitioning creditor's bad faith. By going outside the statute and grafting this additional requirement, the court in Forever Green not only made it significantly more difficult for creditors to file involuntary petitions, but created a deterrent for creditors seeking such relief in the future because dismissal of a petition on bad faith grounds may result in the imposition of stiff financial penalties.
Debtor Remedy Against Petitioning Creditor Upon Dismissal of an Involuntary Petition. When an involuntary petition is dismissed under §303, there is a presumption that costs and attorney fees will be awarded in favor of the debtor. Courts apply a totality of the circumstances test when considering whether to award a debtor its costs and attorney fees upon the dismissal of an involuntary petition. These factors include "(1) the merits of the involuntary petition; (2) the role of any improper conduct on the part of the alleged debtor; (3) the reasonableness of the actions taken by the petitioning creditors; and (4) the motivation and objectives behind the filing of the petition."21
If the court finds that the petitioning creditor(s) acted in bad faith, as the Third Circuit concluded in Forever Green, the petitioning creditor(s) may also be liable for damages proximately caused by the filing or punitive damages.22 The Second Circuit has endorsed the application of four separate tests to determine bad faith.23 These tests are the: (1) "improper use" test; (2) the "improper purpose" test; (3) an objective reasonableness test; (4) and the standard set forth in Bankruptcy Rule 9011 (a rule which is almost identical to Federal Rule of Civil Procedure 11).
The Third Circuit in Forever Green adopted a broader and arguably more discretionary "totality of the circumstances" test to determine bad faith. Significantly, this is the same standard used to determine an award of attorney fees and costs under §303(i)(1), which does not require a finding of bad faith. Courts in the Second Circuit are not required to analyze the petitioner's good faith to determine whether to dismiss a bankruptcy case. However, in light of Forever Green, even creditors who satisfy §303 may think twice before filing an involuntary petition because of the potential monetary penalties.
Under appropriate circumstances an involuntary petition gives creditors a forum to expedite and maximize collection of a debtor's assets and make distributions on a cost-effective basis. However, in light of the Forever Green decision, care should be given to all facts surrounding any potential filing to minimize the chance of dismissal or, even worse, a finding that the filing was made in bad faith.
Eric Snyder is a partner and chairman of Wilk Auslander's bankruptcy department. Eloy Peral is an associate at the firm.
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1. 11 U.S.C. §101 et seq.
2. 11 U.S.C. §303(b).
3. Chapter 7 is the liquidation chapter for individuals and businesses. Chapter 11 is the reorganization chapter of the Bankruptcy Code. Involuntary petitions cannot be filed against not-for profit entities. U.S. Code Cong. & Admin. News 1978, pp. 5963, 6277, 5787, 5819 ("schools, churches, charitable organizations and foundations" are protected from involuntary petitions).
4. 11 U.S.C. §303(b). Qualified unsecured claims include the undersecured portion of a secured debt. Paradise Hotel Corp. v. Bank of Nova Scotia, 842 F.2d 47, 50 (3d Cir. 1988).
5. 11 U.S.C. §303(h). This requirement is excused if a custodian is appointed within 120 days of the filing of the petition. Id.
6. 11 U.S.C. §303(b)(1), (2). When counting qualifying creditors, employees, insiders (related entities) and recipients of transfers that may be recovered under the Bankruptcy Code are not counted.
7. 11 USC §303(h); FED. R. BANK. P. 1013(b).
8. Only an alleged debtor can contest the petition under §303 either by filing an answer or moving to dismiss the petition with the 21-day period. 11 U.S.C. §303(d); FED. R. BANKR. P. 1011(a), (b) &(c). If an answer is filed, the "court shall determine the issues of a contested petition at the earliest practicable time and forthwith enter an order for relief, dismiss the petition, or enter any other appropriate order." FED. R. BANKR. P. 1013(a). Non-petitioning creditors may move to dismiss the petition pursuant to §707 of the Bankruptcy Code for "cause."
9. Key Mech. Inc. v. BDC 56 LLC (In re BDC 56 LLC), 330 F.3d 111, 118 (2d Cir. 2003) (abrogated on other grounds by In re Zarnel, 619 F.3d 156, 2010 WL 3341428 (2d Cir. Aug. 26, 2010)).
13. See In re Euro-Am. Lodging Corp., 357 B.R. 700, 712-13 (Bankr. S.D.N.Y. 2007) (citing cases); In re Amanat, 321 B.R. 30, 38 (Bankr. S.D.N.Y. 2005) (concluding that based on "the respect to be afforded State default judgments under Second Circuit law, there is support for a per se rule in this Circuit" but finding that even under the alternative "objective standard" the debtor failed to overcome the presumption of validity of the [default] judgment."). But see Platinum Fin. Servs. Corp. v. Byrd (In re Byrd), 357 F.3d 433, 438 (4th Cir. 2004) (holding that the existence of an unstayed final judgment does not necessarily end the bona fide dispute inquiry).
15. Id;. see In re Euro-Am. Lodging Corp., 357 B.R. at 713 (finding that the alleged debtor was not generally paying its debts as they became due where the petitioning creditor's claim represented 90 percent of alleged debtor's total debts); In re Amanat, 321 B.R. 30, 40 (Bankr. S.D.N.Y. 2005) (finding that the alleged debtor was not generally paying its debts as they became due where "the aggregate sum that [the alleged debtor] owes to [the petitioning creditors]) is more than 65% in amount of his total debt, including his $2.8 million mortgage, and over 87% of [the alleged debtor's] unsecured debt.").
16. See, e.g., In re Mountain Dairies, Inc., 372 B.R. 623, 636 (Bankr. S.D.N.Y. 2007) (dismissing the involuntary petition because the sole petitioning creditor's claim was in bona fide dispute, but concluding that even of the claim was not in dispute "this Court would be compelled to abstain pursuant to 11 U.S.C. §305 because this is essentially a two-party dispute for which the parties have adequate remedies in state court.").
17. In re Fischer, 202 B.R. 341 (E.D.N.Y. 1996) (rejecting the "almost per se" rule);In re Euro-American Lodging Corp., 357 B.R. 700, 728 (Bankr. S.D.N.Y. 2007); In re EM Equipment, LLC, 504 B.R. 8 (Bankr. D. Conn. 2013) (granting an involuntary petition filed by a sole creditor, rejecting the "almost per se" rule and citing Fischer with approval). But see In re Huggins, 380 B.R. 75, 83 (Bankr. M.D. Fla. 2007) (applying the "almost per se" rule).
18. See 11 U.S.C. §305(a); In re Monitor Single Lift I, Ltd., 381 B.R. 455, 465 (Bankr. S.D.N.Y. 2008) (setting out seven factor test for abstention).
19. In re Selectron Mgmt. Corp., No. 10-75320-DTE, 2010 WL 3811863, at *6 (Bankr. E.D.N.Y. Sept. 27, 2010); In re Mountain Dairies, Inc., 372 B.R. 623, 636 (Bankr. S.D.N.Y. 2007).
20. In re Forever Green Athletic Fields, Inc., 804 F.3d 328, 335 (3d Cir. 2015) (Forever Green); In re Concrete Pumping Serv., Inc., 943 F.2d 627, 629 (6th Cir. 1991) (affirming decisions of the bankruptcy court and district court in granting involuntary petition where petitioning creditor filed the petition for the purpose of avoiding a preferential transfer). See also In re Zais Inv. Grade Ltd. VII, 455 B.R. 839, 848 (Bankr. D.N.J. 2011) (involuntary bankruptcy proper in order to reject executory contract under Bankruptcy Code); In re B.D. Int'l Discount Corp., 13 B.R. 635, 638-39 (Bankr. S.D.N.Y. 1981) (transfer of substantial assets to insiders and third parties established special circumstances to allow bankruptcy by sole creditor).
21. 11 U.S.C. §303(i)(1); In re TPG Troy, LLC, 793 F.3d 228, 235 (2d Cir. 2015).
22. 11 U.S.C. §303(i)(2).