Involuntary Bankruptcy Proceedings

by Andrew K. Alper September/October 2011
The filing of an involuntary bankruptcy petition by a creditor can be a very useful tool for a creditor to collect money from its recalcitrant debtor. But given some new cases, maybe a creditor should give the filing of an involuntary bankruptcy proceeding a second thought.

Part one of this two-part article, which was in the 2011 Monitor 100 issue, focused on the reasons why a creditor should file an involuntary bankruptcy petition and why it is a very useful tool for a creditor to collect money from its debtor. This part will discuss why a creditor should not file an involuntary bankruptcy petition and the dangers in filing the involuntary petition.

The Issue of Whether There is a Bona Fide Dispute With the Involuntary Petitioner(s)
When the Bankruptcy Code was amended by the BAPCPA it changed 11 USC §303 (b)(1) and (h)(1) amending the language from simply “bona fide dispute” to “bona fide dispute as to liability or amount.” Prior case law almost always focused on bona fide disputes as to liability but not bona fide disputes as to amount. Therefore, suppose that there is no dispute as to liability but there is a dispute over late charges, or the present value discount rate, or default interest, or as to the value of unliquidated collateral, or the debtor contends it has a setoff, does this mean that there is a bona fide dispute because there is a bona fide dispute as to the amount due to the petitioning creditor? If there is a bona fide dispute, then that creditor cannot file an involuntary bankruptcy petition.

Assume, for example, that the creditor is owed $1 million, but the debtor contends that it has a bona fide dispute over $500,000. Does this mean that the petitioning creditor could not file an involuntary bankruptcy petition because there is a bona fide dispute as to amount even though that amount exceeded the $14,425 necessary to file an involuntary petition? Does this mean that the only way a creditor is assured of not running into this bona fide dispute issue as to amount, the creditor must either have judicial admissions as to not having a bona fide dispute as to liability and amount or otherwise reduce its claim to a judgment before it can file an involuntary petition?

The issue as to whether there is a bona fide dispute because the amount is in dispute but is over the threshold amount, which is currently $14,425 has a split in authority. See In re Demrico Holdings, Inc. 2006 Bankr. LEXIS 1131 (Bankr. CD Ill. June 9, 2006); In re Dilley 331 B.R. 1 (Bankr. D. Me 2005) Rev’d Sub Nom. In re Dilley 339 B.R. 1 (B.A.P. 1st Circuit 2006; In re ELRS Loss Mitigation, LLC 325 B.R. 604,626-27 Bankr. N.D. Oklahoma 2005), which held that bona fide dispute regarding a portion of a creditor’s claim does not disqualify a creditor so long as the amount in dispute is not below the statutory threshold, as contrasted with, for example, In re Mountain Dairies, Inc. 372 B.R. 623 (Bkrtcy S.D.N.Y. 2007); and In re Bimini Island Air 370 B.R. 408 (Bankr. S.D. Fla. 2007), which holds that even a dispute as to amount create a bona fide dispute even if it is over the statutory threshold.

Disputes as to Number of Creditors
Another area of dispute that is common in involuntary bankruptcy petitions where a single creditor files an involuntary bankruptcy petition against a debtor that contends that it has 12 or more unsecured creditors not contingent as to liability or the subject of a bona fide dispute as to liability or amount. It is the petitioning creditor’s burden of proof as to the main elements of 11 USC §303; however, if only one creditor files the involuntary petition, then the debtor bears the burden of proof showing the debtor has more than 12 creditors. (See In re Rothery 143 F. 3d 546 9th Circuit 1998). Section 303(c) permits joinder in the petition and it has been held that if the debtor makes the contention that the debtor has more than 12 such undisputed noncontingent unsecured creditors, the creditor must be allowed discretion to see if the other named creditors wanted to join in a petition. [See In re Kidwell 158 B.R. 203 (Bankr. E.D. Cal 1993)].

Is the Debtor Insolvent on the Petition Date?
Another issue, although not typically common, is where the debtor contends it is paying its debts as they become due and therefore should not be in bankruptcy. The Ninth Circuit, for example, has adopted a “totality of the circumstances” test for determining whether a debtor is generally not paying its debts under §303(h).

Under the totality of circumstances test, if the debtor is remaining current with its tax obligations, payroll, rent, utilities and operating expenses even though it was not paying one creditor, this may be sufficient grounds for dismissal of the involuntary petition on the ground that the debtor is paying its debts as they become due and is therefore not insolvent. [See In re Vortex Fishing Systems, Inc. 277 F. 3d 1057 (9th Circuit 2001)]. Other circuits may use different tests.

The Big Problem: Damages
If a creditor is not qualified to file the involuntary petition and the involuntary petition is dismissed, the creditor is going to be liable for damages. The only question is: How much and what damages? Pursuant to §303(i) the alleged debtor may be awarded costs, attorneys’ fees and, in an appropriate case, compensatory and punitive damages if the involuntary petition is dismissed without the consent of the petitioners and the alleged debtor. This section is designed to discourage persons holding doubtful claims from filing involuntary petitions.

It is also not unusual in single creditor disputes for a court to abstain from hearing the dispute pursuant to 11 USC §305(a) based on a determination that the case dismissal is in the best interest of creditors and the alleged debtor as the single creditor can go to state court to deal with the issues. A petitioning creditor may also be held liable for damages even when the court decides to abstain whether the creditor has the right to file the involuntary petition or not. [See In re Macke International Trade, Inc. 370 B.R. 236, (B.A.P. 9th Circuit 2007)].

If an involuntary bankruptcy petition is dismissed, and if the debtor does not waive the right to recover attorneys’ fees and costs as part of the dismissal, there is a presumption that the debtor is entitled to reasonable attorneys’ fees and costs pursuant to 11 USC §303(i). [See Higgins v. Vortex Fishing Systems, Inc. 379 F. 3d 701, 707 (9th Circuit 2004), and In the Matter of Maple-Whitworth, Inc. 556 F.3d 742, 746 (9th Circuit 2009)]. The presumption is rebuttable and is evaluated under a totality of the circumstances test. The factors that a court could consider include a.) the merits of the involuntary petition; b.) the role of any improper conduct on the part of the alleged debtor; c.) the reasonableness of the action taken by the petitioning creditors; and d.) the motivation and objectives behind filing the petition. (See In re Vortex Fishing Systems, Inc. supra at 707). The burden is on the petitioning creditors to establish that factors exist under the totality of circumstances, which overcome the presumption and support a disallowance of fees and costs. As stated above, attorneys’ fees may even be awarded based on dismissal under the abstention doctrine of §305(a).

Punitive and/or compensatory damages may be awarded if petitioners acted in bad faith. They may even be awarded in the absence of actual damages. [See Orange Blossom Ltd. P’ship v. S. Cal. Sublet Developers, Inc. (In re Southern California Sunbelt Developers, Inc.) 608 F.3d 456, 460 (9th Circuit 2010)]. The standard for awarding punitive damages is an objective one — that is what a reasonable person would have believed. [See In re Wavelength, Inc. 61 B.R. 614, 620 (9th Circuit B.A.P. 1986) and In re C&C Jewelry Mfg. Inc. 373 Fed. Appx. 775, 777, 2010 WL 1417858 (9th Circuit 2010)] (unpublished decision).

Other courts outside of the Ninth Circuit have used different approaches to determine whether an involuntary petition was filed in bad faith since the term is not defined in the Bankruptcy Code and there is no legislative history addressing the intent and meaning of the language. One of four tests is generally employed: 1.) the improper use test; 2.) the improper purpose test; 3.) the subjective test; and 4.) the Rule 9011 test. [See In re K.P. Enterprise 135 B.R. 174, 179-180 (Bankr. D. Me. 1992); Lubow Machine Co. Inc. v. Bayshore Wire Products Corp. (In re Bayshore Wire Products Corp.) 209 F. 3d 100. 105-106 (2nd Cir. 2000)].

A debtor may also recover fees incurred in even prosecuting their motion for fees and also on appeal. [See In re Southern California Sunbelt Developers, Inc., supra; Law Offices of David B. Bloom, APC v. Knupfer (In re Wind N’ Wave) 509 F.3d 938 (9th Circuit 2007)]. The Southern California Sunbelt Developers case is a particularly onerous case for the creditor whose petition was dismissed based on the court finding there was a bona fide dispute. Alleged debtors had incurred fees of approximately $170,000 in obtaining dismissal of the two involuntary petitions filed against them. This was the amount initially sought by the alleged debtors in their motion for fees under §303(i) plus punitive damages as determined by the court.

After an evidentiary hearing on the motion, which took a mere 28 court days over an 18-month period, the court entered judgment in favor of the alleged debtors for attorneys’ fees and costs totaling $745,318 and awarding $130,000 in punitive damages. All of the fees and costs including in the contested motion for attorneys fees and costs were also awarded plus the punitive damages.

How Some Damages Can Be Avoided
It is because of the potential damages for losing a contested involuntary petition, that if the creditor has any question as to whether the petition may be dismissed, it should think twice about filing an involuntary petition. In almost all cases, attorneys’ fees and costs will be awarded against the involuntary petitioner. But the involuntary petitioner runs the additional risk in a single party dispute that attorneys’ fees could be awarded even if the court believes the involuntary petition was properly filed but chooses to abstain. Punitive damages may also be awarded if the court finds the involuntary petitioner filed the petition in bad faith.

In addition, the court has inherent power to award sanctions against anyone signing or causing to be filed involuntary petition pursuant to Federal Rules of Bankruptcy Procedure 9011 and/or 28 USC §1927. Consequently, if the a creditor decides it wants to file an involuntary petition against the debtor to enforce its rights and collect its debts and avoid the potential for at least punitive damages, and assuming that the creditor has sufficient time to do so, it is suggested that the petitioning creditor(s) send a letter to the debtor stating the following:

  • that the creditor has a judgment or debt not subject to bona fide dispute;
  • that because of the debtor’s failure to pay the judgment or debt the creditor is contemplating the filing of an involuntary bankruptcy petition against the debtor;
  • that the creditor believes that the debtor is insolvent and is not paying its debts as they become due;
  • that the creditor does not know how many non contingent creditors not subject to bona fide dispute the debtor has and therefore the creditor does not know whether there are 12 or more of such creditors;
  • that in order to ascertain whether the creditor can properly file its involuntary bankruptcy petition by itself or whether it needs two other joining creditors, the debtor must provide the creditor with a statement of its assets and liabilities and income and expenses signed under penalty of perjury along with a list of its bona fide, undisputed and noncontingent creditors, the amount due to each such creditor, and the name, address, telephone number, contact and account number of each such creditor so that the involuntary petitioning creditor can ascertain whether the information is true;
  • that the creditor does not want to file the involuntary petition in bad faith and therefore needs this information in order to properly make its decision;
  • that all of such information requested would be the subject of a judgment debtor examination in any event or disclosed if there is a contested proceeding in the bankruptcy court;
  • that if the debtor fails to cooperate within ___ days (i.e., ten), then the debtor may leave the creditor no other choice than to file the involuntary petition; and
  • such other information as may be appropriate for the particular situation.

By sending such a letter, if the involuntary petition is dismissed by the court after a contested hearing, then this letter can be used to limit the damages to the creditor because it reflects that the creditor was acting in good faith by telling the debtor what it was going to do and the debtor could have avoided any damages by cooperating with the creditor and providing such information. In addition, this letter may get the debtor’s attention to resolve the matter with the creditor to avoid the bankruptcy proceeding.

The bottom line is that the involuntary bankruptcy petition should be one of the tools for collection of a debt that the creditor should consider but before doing so there should be a full discussion with the creditor’s counsel because the filing of the involuntary petition may have unintended results.


Andrew K. Alper is a partner with the law firm of Frandzel Robins Bloom & Csato, LC in Los Angeles. Alper has been representing equipment lessors, funding sources and other financial institutions since 1978. Alper obtained his Bachelor of Arts degree in Political Science, magna cum laude, from the University of California at Santa Barbara, and received his Juris Doctor from Loyola Marymount University School of Law making the Dean’s List. Alper’s practice emphasizes the representation of equipment lessors and funding sources in all aspects of equipment leasing including litigation, documentation, bankruptcy and transactional matters. Besides representing equipment lessors and funding sources, Alper represents banks and other financial institutions in the area of commercial litigation, insolvency, secured transactions, banking law, real estate and business litigation.

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