Defending Involuntary Bankruptcies Part II: Defenses, Strategies and Remedies

By: Charles B. Jimerson, Esq., Austin B. Calhoun, Esq., and Hana Eldick, J.D. Candidate

Involuntary bankruptcy is a legal proceeding creditors may use to force a debtor into bankruptcy, rather than a debtor voluntarily seeking bankruptcy protection on his or her own behalf. Creditors seeking involuntary bankruptcy must file a petition in the bankruptcy court, and the debtor has the opportunity to defend against being forced into bankruptcy.

Involuntary petitions, even if ultimately dismissed, can have a powerfully negative impact on an alleged debtor. See In re Reid, 773 F.2d 945, 946 (7th Cir. 1985); In re Gills Creek Parkway Assocs., L.P., 194 B.R. 59, 64 (Bankr. D.S.C. 1995). Fortunately, alleged debtors are not without defense and remedy, and involuntary petitions can be just as harmful to creditors as they are to alleged debtors. See In re Global Energies, LLC, 763 F.3d 1341, 1350 (11th Cir. 2014). This is especially true in instances where courts grant damages and attorneys’ fees upon dismissal of an involuntary petition. This blog is Part 2 in a two-part series on defending against involuntary bankruptcies. Part 1 set forth the basics of an involuntary bankruptcy. This part expands on the arsenal of remedies and strategies for defending against an involuntary bankruptcy petition.

Statutory Defenses

An alleged debtor can raise any number of defenses found in 11 U.S.C. § 303 to contest the involuntary petition. The following are the most common statutory defenses:

  1. The existence of twelve (12) or more eligible creditors (the “Numerosity Requirement”).
  2. Petitioning creditor’s claim is contingent or disputed as to liability or amount.
  3. Debtor is generally paying debts as they become due.

All of the above are available as defenses to defeat the petition and must be asserted in an appropriate responsive pleading, such as a motion to dismiss or answer. Fed. R. Bankr. P. 1011(d). Failure to do so will result in an immediate order of relief for the petitioning creditor(s).

Numerosity

When fewer than three (3) creditors file an involuntary petition, and the alleged debtor alleges the existence of at least twelve (12) qualifying creditors, alleged debtor has the burden to raise the issue that it has twelve (12) or more creditors by filing a list pursuant to Bankruptcy Rule 1003(b). The burden then shifts to the single petitioning creditor to prove that an alleged debtor has less than 12 eligible creditors. Atlas Mach. & Iron Works, Inc. v. Bethlehem Steel Corp., 986 F2d. 709 (4th Cir. 1993). An involuntary petition that does not meet the 12-creditor numerosity requirement must be dismissed. In re MacDonald Const. Co., 379 F. Supp. 385, 386 (E.D. Mo. 1974) aff’d sub nom. Hydromechaniki, S. A. v. MacDonald Const. Co., 511 F.2d 475 (8th Cir. 1975).

Section 303(b)(2) provides that for purposes of the numerosity requirement, eligible creditors are those who are not an employee or insider of the alleged debtor, which hold a claim that is: (1) not contingent as to liability; (2) not the subject of a bona fide dispute as to liability or amount; and (3) not voidable under section 544, 545, 547, 548, 549, or 724(a) of the Bankruptcy Code. The legal nuances as to whether a creditor counts for numerosity are vast and filled with traps for the unwary, and in a single petitioner case these issues will be hotly contested by the petitioner. Of particular concern is the prospect of disqualifying a creditor by making post-petition payments. An alleged debtor would be wise to study all facets of the numerosity requirements and take immediate, affirmative steps to avoid disqualifying any of its creditors from the numerosity count. Experienced legal guidance will be needed.

Petitioning Creditor Is Not Qualified

The petitioner must prove that it is qualified under the Code to file an involuntary petition—that is, petitioner must demonstrate that it holds a claim that is: (1) not contingent as to liability; (2) not the subject of a bona fide dispute as to liability or amount; and (3) at least $15,325 more than the value of any lien on property of the debtor securing its claim. 11 U.S.C. § 303(b).

The justification for this restriction is to prevent creditors “from using the threat of an involuntary petition to extort payment of their disputed claim or coerce the alleged debtor into a favorable settlement of their disputed claim.” In re Ransome Grp. Investors I, LLLP, 424 B.R. 547, 511 (Bankr. M.D. Fla. 2009). The courts apply an objective rather than subjective test to determine whether the claim is disputed. Courts first analyze the petition to “determine whether there is an objective basis for either a legal or factual dispute as to the validity of the debt.” Id. Usually, an unappealed, unstayed final judgment is not subject to a bona fide dispute. In re Manhattan Industries, Inc., 224 B.R. 195, 200 (Bankr. M.D. Fla. 1997). Once a court determines that there is not an objective basis for a legal or factual dispute, the burden shifts to the alleged debtor to present evidence to the contrary. Bartmann v. Maverick Tube Corp., 853 F.2d 1540, 1544 (10th Cir. 1988). If successful, the alleged debtor will defeat the petition.

Generally Paying Debts as They Become Due

An order for relief can only be entered against a debtor if the petitioning creditor proves 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.” 11 U.S.C. § 303(h)(1). Congress has not yet given specific guidelines as to what this means. As a result, courts have crafted their own guidelines. E.g., Matter of Luftek, Inc., 6 B.R. 539 (Bankr. E.D.N.Y. 1980) (“[T]he test is met if the debtor is unable to pay its debts or simply is not paying its debts as they mature.”); 7H Land & Cattle Corp., 6 B.R. 29 (Bankr. D. Nev. 1980) (holding that the determination comes down to ability rather than merely not paying). An involuntary case must be dismissed if the alleged debtor is generally paying his or her debts as they become due. In re Brooklyn Resource Recovery, Inc., 216 B.R. 470, 485 (Bankr. E.D.N.Y. 1997). This determination is to be made at the time of the filing of the involuntary petition. In re J.B. Lovell Corp., 80 B.R. 254, 254-55 (Bankr. N.D. Ga. 1987).

The burden of proving that the alleged debtor was generally not paying his debts as they came due rests on the petitioning creditor. Id. at 482. Even though there is a significant adversarial nature to an involuntary filing, involuntary bankruptcy is not to be used as a forum for the trial and collection of an isolated claim. In re Murrin, 477 B.R. 99, 106 (D. Minn. 2012). Courts will dismiss petitions if they feel that the process is being invoked to supplicate the court to be a surrogate bill collector.

Petitioners trying to prove this element must do more than establish that the debtor “is not meeting its debts as they mature.” In re Trans-High Corp., 3 B.R. 1 (Bankr. S.D.N.Y. 1980). The failure to meet debts must be relevant to the debtor’s delinquency. In re Caucus Distributors, Inc., 106 B.R. 890 (Bankr. E.D. Va. 1989). Four commonly used factors in evaluating relevance are: (1) number of unpaid claims; (2) amount of such unpaid claims; (3) materiality of the nonpayment; and (4) the debtor’s overall conduct of its financial affairs. Id.; See also In re Reed, 11 B.R. 755 (Bankr. S.D. W. Va. 1981). Additionally, courts typically hold that creditors must prove the existence of more than one unpaid debt in order to meet this threshold burden. E.g., In re Blaine Richards & Co., 16 B.R. 362 (Bankr. E.D.N.Y. 1982). The failure to meet one debt, without more, is not considered “general” nonpayment. See In re Gold Bond Corp., 98 B.R. 128, 129 (Bankr. D.R.I. 1989).

Burden of Proof

Once these statutory defenses are raised by the alleged debtor, the burden is placed on the petitioner to establish that it is qualified to act as a petitioning creditor under § 303(b)(1). In re DSC, Ltd., 486 F.3d 940, 944 (6th Cir. 2007). And ultimately, it is the petitioner’s burden to demonstrate—by the preponderance of the evidence—that all statutory requirements of § 303 have been met. In re Palace Oriental Rugs, Inc., 193 B.R. 126, 128 (Bankr. D. Conn. 1996) (“Petitioning creditors bear the ultimate burden of proving that all statutory requirements of Bankruptcy Code Section 303 have been met. 2 Collier on Bankruptcy ¶ 303.15[7], at p. 303–80 (15th ed. 1995). Specifically, they bear the burden of establishing the ‘jurisdictional’ prerequisites of Section 303(b). See, e.g., In re Charon, 94 B.R. 403, 405–406 (Bankr.E.D.Va.1988). Likewise, they bear the ultimate burden of proving by a preponderance of the evidence that the Alleged Debtor is generally not paying its debts as such debts become due.”) An alleged debtor needs to guide the court to not lose focus that these burdens rest on the petitioner. This is a nuanced point that often gets lost in complicated involuntary filings.

Abstention

Alleged debtors should not overlook the use of the Court’s abstention powers when responding to the petition. Even when an involuntary petition is properly brought, a court may nonetheless abstain and dismiss under 11 U.S.C. § 305 if doing so would better serve the interests of the creditor(s) and the debtor. Courts consider various factors when determining to abstain, including:

  1. Efficiency and economy of administration and avoiding an unnecessary duplication of efforts and a waste of time and resources;
  2. Whether an alternative means is available for achieving an equitable distribution of the assets;
  3. Whether a nonfederal insolvency has advanced so far in those proceedings that it would be costly and time consuming to start afresh with the federal bankruptcy process;
  4. Whether federal proceedings are necessary to reach a just and equitable solution;
  5. The lack of advantage to creditors by invoking federal bankruptcy jurisdiction and/ or the lack of prejudice to parties resulting from abstention and dismissal;
  6. The existence of minimal assets to administer; and
  7. The motivation and/or purpose of the parties seeking to invoke federal bankruptcy jurisdiction.

See In re Spade, 258 B.R. 221 (Bankr. D. Colo. 2001). An alleged debtor would be wise to investigate these factors and consider including §305 abstention in its motion to dismiss or affirmative defenses.

Bad Faith

The purpose in allowing for involuntary bankruptcy is to provide creditors with a remedy in instances where obtaining a remedy is impracticable outside of bankruptcy. An involuntary bankruptcy case is not meant to be used as “means of pressuring a debtor to pay a legitimately disputed debt.” In re TPG Troy, LLC, 793 F.3d 228 (2d Cir. 2015). Filing an involuntary petition as a collection tactic is considered a bad faith filing, which is a basis for dismissing the petition. Creditors can meet all of the statutory requirements for an involuntary petition and still have their petition dismissed upon a finding of bad faith. See In re Forever Green Athletic Fields, Inc., 804 F.3d 328 (3d Cir. 2015). Alleged debtors have the burden of proving bad faith by a preponderance of the evidence. In re Petralex Stainless Ltd., 78 B.R. 738, 743 (Bankr. E.D. Pa. 1987). Furthermore, evidence of bad faith is grounds for punitive damages under 11 U.S.C. § 303(i)(2)(B). A dismissal for bad faith is a proverbial ‘can of worms’ for a petitioning creditor. There are serious consequences for bad faith filings.

How Quickly Can the Petition Be Dismissed?

While some alleged debtors may enjoy the “best of both worlds” during the “gap period,” other alleged debtors want the involuntary petition dismissed as soon as possible. For these alleged debtors there is support in the case law—some petitions have been dismissed within only a few days after filing. E.g. Draiman v. Multiut Corp., 04-C-5532, 2008 WL 904778, at *4 (N.D. Ill. Mar. 31, 2008)(upholding bankruptcy court’s dismissal of the case, pursuant to 11 USC 303(b), upon alleged debtor’s emergency motion to dismiss, at a hearing two days after the involuntary petition was filed); and In re Bank of Am., N.A, 11-24503 MER, 2011 WL 2493056, (Bankr. D. Colo. June 21, 2011) (dismissing involuntary petition, four days after the petition was filed, at the emergency hearing upon alleged debtor’s motion to dismiss). Furthermore, a court can dismiss an involuntary petition at a hearing prior to discovery commencing. See e.g. Key Mech. Inc. v. BDC 56 LLC., 01 CIV.10169(RWS), 2002 WL 449856, at *2 (S.D.N.Y. Mar. 22, 2002) aff’d sub nom. In re BDC 56 LLC, 330 F.3d 111 (2d Cir. 2003)(upholding bankruptcy court’s dismissal of involuntary petition at a hearing on alleged debtor’s motion to dismiss, less than one month after involuntary petition was filed, upon hearing argument and reviewing the documentation filed by the parties, before any discovery was taken); In re U. Millennium Park, LLC, 8:10-BK 29022-MGW, 2011 WL 4634028, at *1 (M.D. Fla. Oct. 5, 2011)(upholding bankruptcy court’s order granting alleged debtor’s emergency motion to dismiss the involuntary petition before discovery commenced). On the other hand, it is industry standard for contested involuntary filings to take between 6 months and a year to fully litigate whether the alleged debtor is a proper bankruptcy candidate. As you can imagine, this is a significant disruption for a company that is a going concern, such to the point where the filings at times become fait accompli.

11 USC §303(e) Indemnity Bond

An alleged debtor can move the court to require the petitioner(s) to post a bond pursuant to 11 USC §303(e) to indemnify the alleged debtor for such amounts as the court may later allow under 11 USC §303(i). A Court should require the petitioning creditor to post an indemnity bond when the Court finds “cause.” In re Ransome Group Investors I, LP, 423 B.R. 556, 558 (Bankr. M.D. Fla. 2009).

The determination of whether to require a bond should not be turned into a de facto hearing on the merits. In re Secured Equip. Trust of E. Airlines, Inc., 91 CIV. 5049 (MBM), 1992 WL 295943, at *6 (S.D.N.Y. Oct. 8, 1992). Rather, the court must merely find evidence that makes the involuntary petition’s lack of merit relatively clear. Id. In considering a request for an indemnity bond, the court must carefully scrutinize the filing of an involuntary petition by a creditor because such action is extreme in nature and carries with it serious consequences to the alleged debtor, examples of which include loss of credit standing, interference with general business affairs and public embarrassment. In re McDonald Trucking Co., Inc., 76 B.R. 513, 516 (Bankr.W.D.Pa.1987).

One purpose of the provision regarding the posting of a bond is to discourage frivolous petitions. In re Antar, 12-13288-AJC, 2012 WL 6200366, at *2 (Bankr. S.D. Fla. Dec. 12, 2012). The filing of an involuntary petition is not something which should be lightly undertaken. In re Advance Press & Litho, Inc., 46 B.R. 700, 702 (D.Colo.1984). The Bankruptcy Code was created by Congress to act as a shield for debtors, rather than as a sword for creditors. In re R.N. Salem Corporation, 29 B.R. 424 (S.D.Ohio 1983). Another purpose of § 303(e) is to insure that if an award is made under § 303(i) the debtor had a ready means of recovery for its losses. In re Apollo Health St., Inc., 11-22970 NLW, 2011 WL 2118230, at *3 (Bankr. D.N.J. May 23, 2011).

11 USC §303(i)(1) – Attorney’s Fees and Costs

If a petition is dismissed, the Court may grant judgment against the petitioners and in favor of the debtor for costs or reasonable attorney’s fee. 11 USC 303(i)(1). Petitioners should generally anticipate that an award of costs and fees will be granted upon the dismissal of an involuntary petition. Patraka v. Orlinsky, No. 09-21903-CMA, slip op. at 6 (S. D. Fla. Dec. 8, 2009) (affirming the bankruptcy court’s award of $96,500 in attorney’s fees and $4,454.32 in costs where the court found no bad faith on the part of the petitioning creditor) aff’d, 417 Fed. Appx. 852 (11th Cir. 2011). As one bankruptcy court explained, “Congress intended for the ‘losing creditors to pay for the burden they…created.’” In re Atwood, 1993 WL 13005093 at *5 (Bankr. S.D. Ga. April 20, 1993).

The court may grant judgment against unsuccessful petitioners for costs and attorney’s fees, regardless of bad faith. In re Landmark Distributors, Inc., 189 B.R. 290, 306 (Bankr. D.N.J. 1995). Further, it is not necessary that the involuntary petition be frivolous or meritless to award costs and fees under this subsection, as that is not a stated condition. In re Advance Press and Litho, Inc., 46 B.R. 700, 703 (D.Colo.1984).

While the general rule is that fees and costs should be awarded upon dismissal, the court should still exercise discretion and employ a totality of the circumstances test. In re Miller, 11-CV-130-GKF-FHM, 2012 WL 1029534, at *10 (N.D. Okla. Mar. 26, 2012). Relevant circumstances 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 petitioning creditors; (4) the motivation and objectives behind filing the petition; and (5) other material factors the court deems relevant. Id. The merits of the involuntary petition refers to whether the decision to dismiss the petition was straightforward. The closer the question of dismissal, the less likely it may be appropriate to award counsel fees. In re Atwood, 88-41165, 1993 WL 13005093, at *6 (Bankr. S.D. Ga. Apr. 20, 1993).

Once the alleged debtor demonstrates that the involuntary case was dismissed, the burden shifts to the petitioning creditors to present evidence to disallow an award of fees. In re Ross, 135 B.R. 230, 238 (Bankr. E.D. Pa. 1991).

An award for attorney’s fees under 11 USC 303(i)(1) includes the fees and costs incurred during all proceedings arising from the petition. In re Rosenberg, 779 F.3d 1254, 1267 (11th Cir. Feb. 27, 2015). For instance, an award should include fees and costs incurred during the defensive phase, in securing dismissal, or in the offensive phase, when alleged debtor brings an adversary proceeding to determine that petitioning creditor filed in bad faith, and to determine the amount of compensatory and punitive damages (regardless of which party prevails in the adversary proceeding). Id. Attorney’s fees and costs incurred at the appellate level are also included in the award. Id.

11 USC §303(i)(2) – Bad Faith Damages

If a petition is dismissed, the court may grant judgment against any petitioner that filed the petition in bad faith for (A) any damages proximately caused by such filing, or (B) punitive damages. 11 USC 303(i)(2).

In determining whether the petitioning creditor has exercised bad faith in filing an involuntary petition, inquiry may be made in to whether the petition was ill advised or improperly motivated, whether the petitioner took affirmative steps to ensure that the petition was proper, and whether the petitioner made sufficient inquiry into the facts and law surrounding the case to determine the total number of claim holders. In re Landmark Distributors, Inc., 189 B.R. 290, 309 (Bankr. D.N.J. 1995). The bankruptcy court, in examining the conduct of the petitioning creditor must consider whether a reasonable person in the position of the petitioning creditor would have filed the petition. Id. The Court must also ascertain the subjective motivations of a petitioning creditor, which is analogous to the consideration of the ulterior motives of petitioning debtors in voluntary bankruptcy proceedings. Id. The Court must look at the totality of the circumstances when determining bad faith. In re John Richards Homes Bldg. Co., L.L.C., 439 F.3d 248, 254 (6th Cir. 2006).

Courts have developed various bad faith tests to make this determination. The Eleventh Circuit has specifically referenced three tests, although it has not adopted or endorsed one to the exclusion of the others. General Trading, Inc. v. Yale Materials Handling Corp., 119 F.3d 1485, 1501-02 (11th Cir.1997). These tests include: (i) the “improper purpose” test, under which bad faith exists if the petitioning creditors were motivated to file the petition out of ill will or malice, or in order to harass or embarrass the debtor; (ii) the “improper use” test, under which bad faith exists if it is demonstrated that the petitioning creditors were motivated by an improper bankruptcy purpose (e.g., using the bankruptcy court as a substitute for customary collection procedures) in filing the petition; and (iii) the “Rule 9011” test, which requires both an objective and subjective evaluation of the petitioning creditors’ conduct in filing the petition. Id.; In re Basil St. Partners, LLC, 477 B.R. 846, 852 (Bankr. M.D. Fla. 2012).

In determining the compensatory damages amount, the alleged debtor has to establish with “reasonable certainty” that the bad faith involuntary filing directly produced or substantially contributed to his injuries. Rosenberg v. DVI Receivables, XIV, LLC, 2014 WL 4810348, Slip copy (S.D.Fla. September 29, 2014). Compensatory damages award should include lost future profits if the negative publicity surrounding the involuntary filing damaged the alleged debtor’s business, and the lost future profits must be calculable with a reasonable degree of certainty. Id. at 261-62 (finding that alleged debtor’s lost future profits were calculable with a reasonable degree of certainty and “totaled $4,100,000.00, based on an estimated loss of 20 home sales over the next five years (a 50% decline in sales) at an average sales price of $1.9 million and an incremental profit of 17%”).

The Court has discretion in awarding punitive damages under 11 USC 303(i)(2). In re Landmark Distributors, Inc., 189 B.R. 290, 316 (Bankr. D.N.J. 1995). The remedies under § 303(i)(2) are not exclusive. Id. In other words, the Court can award both compensatory and punitive damages. Id. Further, § 303(i)(2) specifically authorizes punitive damages even in the absence of or in addition to actual damages. Id. at 317.

Punitive damages should generally be awarded when there is a showing that the wrongful act was intentionally done without just cause or excuse, or to punish for outrageous conduct, or to deter similar conduct in the future. Id. The Court should examine the totality of the facts and circumstances surrounding the filing of the involuntary petition. Id. “As stated in In re Atlas Machinery & Iron Works, Inc., 190 B.R. 796, 804 (BC E.D. Va.1995), ‘[a]n award of punitive damages under 303(i)(2)(B) is intended to discourage unprincipled creditors from invoking the use of involuntary bankruptcy to serve a purpose at odds with core bankruptcy policy.’ This case is another demonstration of the proposition that the resolution of a two-party dispute is not a permissible purpose of an involuntary filing.” In re Lai Di Zhu, No. 10-19901PM, 2010 WL 4259553, at *3 (Bankr. D. Md. Oct. 21, 2010).

As stated above, an involuntary bankruptcy can have a powerfully negative impact on an alleged debtor. Courts want to provide relief for creditors, but even more so, courts want to achieve this by way of means that are best for all parties involved. An experienced legal team will arm an alleged debtor facing an involuntary petition—and those who expect to face the same—with a potent arsenal of defenses, strategies, and remedies.

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