Exceptions to Involuntary Petition Requirements Are You Pushing Your Luck
Involuntary Petitions Under the Bankruptcy Code
Pursuant to 11 U.S.C. §303, an involuntary bankruptcy case under chapter 7 or 11 may be commenced against an individual or entity that may be a debtor under the chapter under which such case is commenced. Generally, an involuntary case is commenced by the filing of a petition:
- by three or more entities, that hold claims that are not contingent or subject to bona fide dispute if the claims of such entities aggregate at least $10,775 more than the value of any lien on property securing such claims; or
- if there are fewer than 12 claim holders, by one or more of such holders that hold in the aggregate at least $10,775 of such claims.
Section 303 further states that the court shall order relief against the debtor only if:
- the debtor is generally not paying its debts as such debts become due, unless such debts are the subject of a bona fide dispute; or
- within 120 days before the petition date, a custodian was appointed or took possession of substantially all of the debtors' property.
Thus, §303 provides for the specific circumstances and requirements for filing an involuntary bankruptcy case. Considering the express language of §303, one would think that under no other circumstances could a creditor file an involuntary bankruptcy case. It is easy to imagine circumstances under which a debtor could avoid an involuntary bankruptcy by careful "anti-involuntary" planning—i.e., fraudulent transfers and other schemes. In fact, such circumstances have occurred, and courts have held that such special circumstances may justify the filing of an involuntary bankruptcy case regardless of §303's express requirements.
Special Circumstances Deviating from the Requirements of §303
An involuntary bankruptcy case may be filed without the petitioning creditors meeting the specific requirements of §303. For example, if a sole creditor would be without adequate remedy of law, or special circumstances amounting to fraud, trick, artifice or scam exist, then a single creditor with only proof of a default may file an involuntary petition. See In the Matter of 7H Land & Cattle Co., 6 B.R. 29 (Bankr. D. Nev. 1980).
[S]ection 303 provides for the specific circumstances and requirements for filing an involuntary bankruptcy case.
In 7H Land & Cattle, the petitioning creditor was the only creditor of the alleged debtors. The creditor filed an involuntary petition based on the debtors' default on a promissory note to the creditor. The debtors asserted, however, that the default upon the promissory note did not constitute a finding that they were not generally paying their debts as they became due.
In its determination, the court reviewed the reasoning of certain cases under Canadian insolvency law, which addressed similar circumstances. In doing such, the court held that despite the express language of the Code, special circumstances may exist that justify the filing of an involuntary bankruptcy petition. See 7H Land & Cattle, 6 B.R. at 32. These special circumstances include when "a sole creditor cannot possibly obtain adequate relief in the ordinary courts without resorting to the bankruptcy court," and when "the debtors, by some scam, artifice, trick or fraud, were using uncollectible deposits to pay other creditors." See Id., 6 B.R. at 32-3.
Similarly, the Sixth Circuit has approved the "fraud, artifice or scam" exception. See Concrete Pumping Services Inc. v. King Construction Co. Inc., 943 F.2d 627 (6th Cir. 1991). In Concrete Pumping, the single petitioning creditor obtained a state court judgment against the debtor. The debtor had allegedly received numerous loans from its president, who collateralized such loans after entry of the judgment. The debtor subsequently "defaulted" on these loans and all of the debtor's assets were surrendered to the debtor's president.
The debtor's president then started a new company that performed the same service as the debtor, using the same equipment and trade vendors. In fact, the new company paid all of the debtor's creditors, except for the petitioning creditor. Thus, the debtor had no remaining creditors, except for the petitioning creditor, which filed an involuntary bankruptcy petition.
The bankruptcy court denied the debtor's motion to dismiss and entered an order for relief, which the district court affirmed. The Sixth Circuit observed that courts "have developed an almost per se rule against granting a petition for involuntary bankruptcy where there is only a single creditor." See Concrete Pumping, 943 F.2d at 629; citing In re Smith, 123 B.R. 423, 425 (Bankr. M.D. Fla. 1990). The Sixth Circuit then noted that courts applying the "single creditor rule" also developed an exception where evidence of "fraud, artifice or scam" exists. See Concrete Pumping, 943 F.2d at 630; citing In re Smith, 123 B.R. at 426.
Despite its acknowledgement of the "special circumstances" exception, the Sixth Circuit also considered the factual determination of whether the debtor was generally not paying its debts as they became due using the totality of the circumstances test. In doing so, the court held that the debtor was 100 percent in default upon 100 percent of its creditors. Id. Thus, while certain decisions purport to adopt the "special circumstances" exception, none contain findings that would otherwise prevent the entry of an order for relief. Indeed, in both 7H Land and Cattle and Concrete Pumping, the single creditor had debts exceeding $10,000 from debtors with less than 12 creditors. See 11 U.S.C. §303(b)(2).
Other courts, however, have developed the "special circumstances" exception, even where the debtor was generally paying its debts as they became due. See In re Moss, 249 B.R. 411, 424 (Bankr. N.D. Tex. 2000); citing In re Norriss Brothers Lumber Co. Inc., 133 B.R. 599 (Bankr. N.D. Tex. 1991). In Moss, the court found that the debtor had 12 or more creditors, but that the petitioning creditors held only two claims. Therefore, the involuntary petition was defective. The court did not dismiss the involuntary petition, however, because of the existence of special circumstances in the form of preferential and fraudulent transfers. Id. at 424; citing In re Norriss Brothers Lumber Co. Inc., 133 B.R. 599, 608-09 (Bankr. N.D. Tex. 1991) (where the court held that arguable fraudulent conveyances and arguable preferential transfers constituted special circumstances that justified the lack of three creditors).
The debtor asserted that the special-circumstances exception was not applicable because courts developing the exception only applied it to single-creditor cases when analyzing whether the debtor generally failed to pay debts, and that expansion to the three-creditor rule of §303(b)(1) was unwarranted. Citing In re Rothery, 211 B.R. 929, 934-35 (9th Cir. BAP 1997), rev'd. on other grounds, 143 F.3d 546 (9th Cir. 1998) (which refused to follow Norriss). The court held, however, that if one exception to the technical requirements of §303 existed, then that exception applied to the other technical requirements as well. Moss, 249 B.R. at 424.
Despite the early development of the special-circumstances exception, where its application was questionable, the later applications have truly developed the exception. As demonstrated, however, the special-circumstances exception is not recognized by all courts. Nonetheless, the special-circumstances exception is developing a growing body of support. See Matter of Wagner, 53 B.R. 93 (Bankr. W.D. Wis. 1985); In re H.I.J.R. Properties Denver, 115 B.R. 275 (D. Colo. 1990); In re Blain Richards & Co., 16 B.R. 362, 365-66 n. 4 (Bankr. E.D.N.Y. 1982). The cases add to the arsenal creditors have in forcing reluctant debtors into facing their own insolvency.
To further complicate the involuntary arena, the court in In re Fales, 73 B.R. 44 (Bankr. S.D. Ohio 1987) placed an interesting twist on the Bankruptcy Code's abstention provisions. In Fales, the court determined that even though the basis for an involuntary case was established, §305 required consideration of whether dismissal would better serve the interests of creditors and the debtor. Id. at 46; citing In re Tarletz, 27 B.R. 787, 793 (Bankr. D. Colo. 1983). Due to the existence of state law remedies that were unavailable in a bankruptcy proceeding, the court therefore dismissed the involuntary petition. Id. at 47; see, also, In re Arker, 6 B.R. 632 (Bankr. E.D.N.Y. 1980); rev'd., Crown Heights Jewish Community Council Inc. v. Fischer, 202 B.R. 341 (Bankr. E.D.N.Y. 1996) (stating that an order for relief should be granted in the exceptional case of an alleged debtor with a sole creditor who would otherwise be without an adequate remedy under non-bankruptcy law).
While the Fales decision seems lacking in codified support, equity does support such a conclusion. Further, when considering that the "special circumstances" arguments are equally lacking in codified support, the Fales holding makes sense.
The special-circumstances exception is judicially created with no codified support. One should take further notice that many courts addressing the special-circumstances exception also made findings that supported the filing of an involuntary petition.
Practitioners must also remember the consequences of filing an involuntary petition that is later dismissed. Particularly when bad faith is found, the results can be harsh. They include recovering actual and punitive damages as well as attorney's fees. Research into the applicable circuit and/or district's precedent on this issue is not only advisable, but a must.