Welcome to the second of Straight & Narrow's three-part series on ethical issues in involuntary bankruptcy proceedings. As noted in the previous installment in the series, "Involuntary Fee Slaughter: The Perils of Professional Fees for Representing a Debtor During the Gap Period,"¹ April 2002, there was a trend of creditors using involuntary bankruptcy filings to resolve their disputes with debtors. This installment addresses ethical issues faced by counsel for petitioning creditors in involuntary bankruptcy proceedings.

Unlike the ethical problems facing counsel for the alleged debtor, which primarily could lead to the disqualification of the debtor's counsel or disallowance of fees, the ethical problems that petitioning creditor's counsel face involve the small but genuine risk² of the imposition of significant monetary sanctions under 11 U.S.C. §303(i), Bankruptcy Rule of Procedure 9011 and/or state court lawsuits related to the involuntary petition.

Well, How Bad Can It Be? Oh—That Bad!

Under 11 U.S.C. §303,³ there are two separate grounds under which a debtor, against whom an involuntary bankruptcy petition has been dismissed, can be awarded sanctions.⁴

Under 11 U.S.C. §303(i)(1), a court may grant a judgment against petitioning creditors⁵ for costs or reasonable attorney's fees if the involuntary petition is dismissed. Courts have broad discretion in determining whether such costs and attorneys' fees should be awarded under 11 U.S.C. §303(i).⁶ Awards of attorneys' fees and costs under 11 U.S.C. §303(i) are generally calculated under the same lodestar standards as are used in calculating the debtor's and unsecured creditors' committee's attorneys' fees in bankruptcy cases.⁷ No actual finding of bad faith is required for a bankruptcy court to award costs and attorneys' fees under 11 U.S.C. §303(i)(1).

However, if a court determines that the petitioners acted in "bad faith," then the bankruptcy court may, in its discretion, award not only attorney's fees and costs,⁸ but any damages "proximately caused by such filing, and punitive damages."⁹ The term "bad faith" as used in 11 U.S.C. §303 is not defined in the Bankruptcy Code, but it is an issue that must be determined on a case-by-case basis. There are also a wide range of tests and standards that the court can use to determine whether an involuntary petition has been filed in bad faith.¹⁰ Examples of cases where attorneys have been found liable for some or all of the damages arising from a bad faith involuntary filing include (1) an attorney who filed an involuntary petition in an attempt to relitigate disallowed partnership claims arising from the dissolution of a law partnership she had with her former husband,¹¹ (2) an attorney who filed an involuntary bankruptcy to prevent the foreclosure of property rented by the petitioning creditor tenants, who had failed to pay rent for several months,¹² and (3) an attorney who orchestrated an involuntary bankruptcy against his former clients using confidential information he obtained from them during his course of representation.¹³

In the event bad faith is found in the filing of an involuntary bankruptcy, an award of compensatory and punitive damages can be quite substantial. In one of the most famous involuntary petition damage cases, In re Landmark Distributors Inc.,¹⁴ the bankruptcy court, after finding that the petitioners filed an involuntary petition in bad faith and caused the destruction of the debtors' business, awarded the debtors' attorney's fees, which were estimated at $1.5 million; compensatory damages in the amount of $3.2 million; and punitive damages of $500,000.¹⁵ While the facts of this case are particularly egregious, they do illustrate a court's willingness to sanction parties who improperly use involuntary bankruptcy proceedings for their own purposes.¹⁶

But I Am Not a Petitioner, Right?

The initial issue facing a petitioner's counsel, should a court determine it is appropriate to award sanctions under 11 U.S.C. §303(i), is whether counsel for a petitioning creditor is a party against whom 11 U.S.C. §303(i) sanctions can be awarded. As noted above, the precise language of §303(i) does not directly permit an award of damages against the petitioner's counsel.¹⁷ However, several courts, including three published decisions from Colorado,¹⁸ have held that counsel for petitioners can be sanctioned under §303(i) if their conduct is sufficiently egregious to otherwise support liability under 11 U.S.C. §303(i). These courts note that there is no express prohibition against awarding §303(i) damages against counsel for petitioners and have held that §303(i) damages can be awarded against attorneys for petitioners in appropriate circumstances. These courts have held that under their inherent judicial powers, they may award sanctions under §303(i) cases without the need for the express statutory language authorizing such awards.

However, even if a court follows the majority view that 11 U.S.C. §303(i) does not directly permit the imposition of sanctions against counsel for a petitioning creditor, this does not prevent a court from finding another way to indirectly assess those sanctions against a petitioning creditor's counsel. In the case of In re Grossinger,¹⁹ the court found that it could sanction an attorney, who filed what it characterized as "sham" involuntary petitions, under the provisions of 11 U.S.C. §303(i) through 11 U.S.C. §105(a).²⁰ The Grossinger court held that it had the power under its general authority to prevent abuse of process before the court to apply 11 U.S.C. §303(i) sanctions against the petitioner's counsel.

But I Was Only Following Orders: Rule 9011 As a Tool to Sanction Counsel for Petitioning Creditors Who File Improper Involuntary Bankruptcy Petitions

By far, the most common tool used by courts in sanctioning attorneys for their participation in the filing of improper bankruptcy petitions comes from Rule 9011 and 28 U.S.C. §1927.²¹

While there are numerous factors that courts consider in determining whether an attorney has violated Bankruptcy Rule of Procedure 9011²² or run afoul of the provisions of 28 U.S.C. §1927,²³ in cases where bankruptcy courts have found that where there was a bad faith filing of an involuntary bankruptcy, the requirements for sanctions under either Rule 9011 or 28 U.S.C. §1927 are generally met.

While there is a variety of factual situations that may lead to the imposition of sanctions under Bankruptcy Rule of Procedure 9011 and 28 U.S.C. §1927, sanctions are most generally imposed on petitioning creditors' counsel where (1) counsel for the petitioning creditors does no or a totally inadequate investigation of the facts prior to filing an involuntary bankruptcy petition;²⁴ (2) counsel for the petitioning creditors files the involuntary bankruptcy petition for an improper purpose;²⁵ and (3) counsel for the petitioning creditor engages in improper actions during litigation of the involuntary bankruptcy petition.²⁶ A bad-faith involuntary filing that unfortunately combines all three of these typical grounds for imposition of sanctions under Rule 9011 is the case of In re Computer Dynamics Inc.²⁷ from the Eastern District of Virginia.

In Computer Dynamics, counsel for the petitioning creditors filed an involuntary bankruptcy proceeding in an effort to have his primary client regain control of the company he once owned and operated as CEO.²⁸ Counsel for the petitioners gained additional petitioning creditors by using his primary client, the primary petitioning creditor, to "recruit" additional petitioning creditors, who were told by counsel that they have no chance of collecting their debts from the debtor unless an involuntary bankruptcy was filed against the debtor corporation and a trustee was appointed to operate the debtor's affairs. In developing the factual allegations in support of his trustee motion in this involuntary case, counsel for the debtor almost exclusively relied on the investigations done by his primary client concerning the affairs of the debtor. The court found that the attorney for the petitioning creditors in this case had failed to make a reasonable investigation prior to the filing of the involuntary bankruptcy petition and accompanying trustee motion, and therefore was subject to Rule 9011 sanctions.

Further, the court found that the involuntary bankruptcy and the accompanying motion for the appointment of the trustee were filed for improper purposes because they constituted a bad-faith attempt by the attorney's primary client to regain control of Computer Dynamics and to continue a vendetta against the current operator of Computer Dynamics. Not surprisingly, the court found that these objectives constituted a bad-faith use of the involuntary bankruptcy process and a violation of Rule 9011.

Finally, the bankruptcy court found that the attorney's use of improper, defamatory and irrelevant evidence in his pleadings and the presentation of evidence at the hearing on the trustee motion constituted improper actions by the attorney pursuing the involuntary bankruptcy filing. Particularly, the bankruptcy court found that counsel's attempt to interject unsubstantiated allegations of sexual harassment against the debtor's current CEO, which the court found had no relevance to the involuntary bankruptcy filing or the accompanying motion for a trustee, constituted a violation of the Virginia Code of Professional Responsibility, as well as a violation of Rule 9011. In light of all these various violations of Rule 9011, the court awarded sanctions of $20,000 against counsel for the petitioning creditors due to his actions in this case.

In summary, the Computer Dynamics opinion sets forth an "excellent" primer of the various issues and causes of action that can be raised against counsel for petitioning creditors under the provisions of Bankruptcy Rule 9011 if the attorney participates knowingly in the filing of a bad-faith involuntary bankruptcy petition.

State Courts? What Do State Courts Have to Do with Involuntary Bankruptcies?

Finally, even if a petitioning creditor's attorney in a bad-faith involuntary case somehow escapes the sanctioning power of the federal courts, there still remains the possibility that the debtor or the attorney's own petitioning creditor clients may take action against him in state court proceedings.

Currently, there is a serious split of authority as to whether the provisions of 11 U.S.C. §303(i), 28 U.S.C. §1927 and Bankruptcy Rule of Procedure 9011 "pre-empt" state court jurisdiction over malicious prosecution and other actions brought by a debtor subject to an involuntary bankruptcy proceeding against counsel for the petitioning creditors.

One line of cases, typified by Koffman v. Osteoimplant Technology Inc.,²⁹ holds that, given that bankruptcy law and bankruptcy petitions are matters of exclusive federal jurisdiction, permitting state courts to develop standards as to when parties can seek relief in the federal court for claims based on alleged abuse of the Bankruptcy Code would violate both the Supremacy Clause of the U.S. Constitution and the constitutional preemption doctrine.³⁰ These courts hold that the only appropriate forum where sanctions for an improper involuntary bankruptcy case may be brought is the bankruptcy court where the underlying bankruptcy action was filed.³¹

However, decisions finding a pre-emption of state law remedies are by no means universal. There is a very strong minority position that holds that there is no federal preemption over state law-based causes of action under theories of civil conspiracy, abuse of process and malicious prosecution.³² These courts have held that since causes of actions being filed against petitioners and their counsel are based on state common law theories and not Bankruptcy Code remedies, that federal bankruptcy law therefore does not preempt these causes of action. The courts that adopt the "no preemption" line of reasoning generally stress that there is no conflict with bankruptcy liquidation and/or reorganization proceedings by allowing state courts to punish people who abuse the Bankruptcy Code under state law causes of action.

Further, there is an additional form of state law action that should concern counsel for petitioners in involuntary bankruptcy proceedings: the ever-popular legal malpractice suit.³³ This possibility is illustrated by the twin cases of In re Better Care Ltd.,³⁴ decided by the Bankruptcy Court for the Northern District of Illinois, and Sarno v. Akkeron,³⁵ the Better Care malpractice case, decided by the Illinois appellate court. In the Better Care case, the bankruptcy court determined that the involuntary bankruptcy proceeding was filed in bad faith and that the advice of counsel defense offered by the petitioning accounting firm did not excuse them from liability; the bankruptcy court also noted that this faulty advice of counsel could give rise to a malpractice suit in the state courts.³⁶ As part of determining that the involuntary bankruptcy petition was filed in bad faith, the bankruptcy court awarded the debtor compensatory and punitive damages of more than $55,000 against their former accounting firm, which was one of the petitioning creditors in the case, and also sanctioned the accounting firm's law firm for gross violations of Bankruptcy Rule 9011.

Shortly after the bankruptcy court awarded these damages to the debtor, the debtor and its principal owner filed suit against their petitioning creditors, including their former accounting firm, under state law, asserting various causes of action related to the petitioning creditor's attempt to destroy the debtor. The defendant accounting firm filed a "counterclaim"³⁷ against its law firm, alleging legal malpractice in this action. The law firm moved to dismiss the counterclaim, alleging the bad faith of its client in relation to its filing the bankruptcy petition. The trial court accepted the law firm's argument, holding that the accounting firm was collaterally estopped from suing its attorneys for malpractice by virtue of the bankruptcy court's findings in the involuntary bankruptcy proceeding and, in the alternative, the accounting firm was barred by the doctrine of "unclean hands" from maintaining a suit against its counsel for malpractice. On appeal, the Illinois appellate court reversed the decision of the trial court, holding that the accounting firm did not have a full and fair opportunity to litigate its claims against its law firm in the bankruptcy proceeding and that the "unclean hands" doctrine could not be used to dismiss the accounting firm's claim against the law firm. In overruling the trial court's unclean-hands decision, the appellate court found that the law firm's actions in representing the accounting firm in the involuntary bankruptcy petition may have given rise to the "bad-faith finding" on which the trial court based its decision and that the law firm should not be excused from possible liability due to its own malpractice in allowing an unfavorable judgment to be rendered against its client.³⁸ The Illinois appellate court remanded the case for further findings by the trial level court on the issues of the possible malpractice of the law firm and the alleged bad faith of the petitioning creditor.

Conclusion

While petitioning creditors' counsel do not face the myriad of technical and conflict-ridden ethical considerations that a debtor's counsel has in an involuntary bankruptcy proceeding, they do face very real and very significant ethical issues related to undertaking high-risk litigation. Courts have made it generally clear that improper use of an involuntary bankruptcy petition is something to be strongly discouraged and, in appropriate cases, severely sanctioned. Given the highly contentious nature of an involuntary bankruptcy petition to begin with, counsel for petitioning creditors should take care in making sure they properly investigate the underlying facts of their involuntary petitions so that they will not be blamed either by their clients or the debtors should an involuntary bankruptcy petition go awry.

Author's Note: Update—My Card Was Right. For that small but hardy band of regular readers of this column, I am here to give you an important update on my article, "But It Says on My Card...Unauthorized Practice of Law Issues in Bankruptcy," which was published in the March 2001 ABI Journal.³⁹ In that article, I discussed the issues that were raised by the bankruptcy court and district court's decisions in the case of In Re Desilets.⁴⁰ Recently, on June 3, 2002, the Sixth Circuit reversed the two lower-court Desilets decisions,⁴¹ holding that Allen Rittenhouse, the attorney whose fees were at issue, was properly admitted to the federal bar and did not engage in the unauthorized practice of law.⁴²

In Desilets, the Sixth Circuit adopted the Ninth Circuit's reasoning in the case of In re Poole,⁴³ where the Ninth Circuit ruled that admission to a federal bar was solely governed by federal law, not state-law consideration. In its decision, the Sixth Circuit disagreed with the lower courts' rulings in two critical respects. First, the Sixth Circuit found that the local rules of the U.S. District Court for the Western District of Michigan expressly permitted the type of activities in which Rittenhouse was engaged in representing his clients before a bankruptcy court and that state bar "approval" of his activities was not required.⁴⁴

Further, the Sixth Circuit found, unlike the lower courts, that Rittenhouse did have a valid state source of authority to practice law—his Texas law license. The Sixth Circuit noted that the Western District of Michigan rules only required that an attorney be licensed to practice law in any state in order to practice for the Western District of Michigan, not that they had to be licensed in the state of Michigan.⁴⁵

Finally, and most importantly for many readers of this argument, the Sixth Circuit further supported its decision in this matter, noting that:

The bankruptcy court's analysis also suffers from a practical failing; it did not realistically distinguish between Rittenhouse and those attorneys who have their offices across the border, but do all of their work before the Michigan federal courts. (footnote omitted). The bankruptcy court's analysis would equally extend to lawyers working for large New York firms who happened to do most of their legal work in Michigan for Michigan (or multistate, or multinational) clients. We do not believe that the Western District of Michigan Local Rules and 11 U.S.C. §101(4) can be read to prohibit Rittenhouse's practice, while permitting these other quotidian forms of practice.

This statement represents perhaps the highest level of judicial "approval" for the national type of chapter 11 practice that has been permitted by bankruptcy courts for the past several years. Not only is this a statement regarding general Sixth Circuit policy, but it is also a statement that indicates that in the Sixth Circuit, at least, federal courts would probably defend any out-of-state practitioner from charges of unauthorized practice of law arising from their representation of parties in bankruptcy proceedings.

However, it is important to note that there was a spirited dissent to the Desilets case, which stated that the majority opinion represented a rejection of the concept of state and federal comity, and that under the majority's reasoning, admission to federal practice was now practically governed by the bar rules of the state with the easiest requirement for passing the bar.

This recent Desilets decision in the Sixth Circuit is critically important to the issue of unauthorized practice of law in federal bankruptcy cases and should provide great comfort to all attorneys who enter bankruptcy courts in states located other than where they have managed to pass the bar.

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Footnotes

¹ 21 Am. Bankr. Inst. J. 24 (April 2002). Return to article

² 2 Collier on Bankruptcy ?303.15[1] (noting the increased litigation under 11 U.S.C. §303(i) seeking damages for improper involuntary filings). Return to article

³ 11 U.S.C. §303(i) provides: If the court dismisses a petition under this section other than on consent of all petitioners and the debtor, and if the debtor does not waive the right to judgment under this submission, the court may grant judgment (1) against the petitions and in favor of the debtor for (A) costs or (B) a reasonable attorney's fee, or (2) against any petitioner that filed the petition in bad faith for (A) any damages proximately caused by such filing or (B) punitive damages. Return to article

⁴ For purposes of this article, we will assume there is no issue of debtor consent or waiver under 11 U.S.C. §303(i). Return to article

⁵ Although not directly covered in the statute, creditors that intervene in an involuntary bankruptcy petition may also be subject to damages under 11 U.S.C. §303(i). See Koffman v. Osteoimplant Technology Inc., 182 B.R. 115 (D. Md. 1995). Return to article

⁶ See, generally, In re Bayshore Wire Products Corp., 209 F.3d 100 (2nd Cir. 2000); In re Squillante, 259 B.R. 548 (Bankr. D. Conn. 2001) (discussing factors to be considered in awarding attorney's fees). Return to article

⁷ See In re Atlas Mechanical Iron Works Inc., 190 B.R. 796 (Bankr. E.D. Va. 1995) (discussing attorney's fees that can be awarded under 11 U.S.C. §303(i)). Return to article

⁸ 11 U.S.C. §303(i)(1) and 303(i)(2) damages are cumulative. See In re K.P. Enter., 135 B.R. 174 (Bankr. D. Maine 1992); 2 Collier on Bankruptcy. Return to article

⁹ See In re Landmark Distributors Inc., 189 B.R. 290 (Bankr. D. N.J. 1995) (awarding the debtor attorney's fees which were estimated at $1.5 million, compensatory damages of $3.2 million and punitive damages of $500,000). Return to article

¹⁰ See 2 Collier on Bankruptcy, ?303.06 (15th Ed. 1999) (discussing various ways to determine bad faith under 11 U.S.C. §303(i)). Return to article

¹¹ In re Law Center, 261 B.R. 607 (Bankr. M.D. Pa. 2001); aff'd., Shinko v. Miele, 29 Fed. Appx. 890 (3rd Cir. 2002) (unpublished decision). Return to article

¹² Keiter v. Stracka, 192 B.R. 150 (S.D. Tx. 1996). Return to article

¹³ In re Kujawa, 270 F.3d 578 (8th Cir. 2001). Return to article

¹⁴ 189 B.R. 290 (Bankr. D. N.J. 1995). Return to article

¹⁵ In the Landmark decision, the petitioner's bankruptcy counsel was not sanctioned due to the fact that the court found the petitioning creditors withheld important facts from their bankruptcy counsel. 189 B.R. at 318. Return to article

¹⁶ See Landmark, 189 B.R. at 319. The court noted the ancient wisdom of Robert Burton in his 1621 book, The Anatomy of Melancholy, where Burton stated "He that goes to law holds a wolf by the ear," in explaining its award of compensatory and punitive damages. Return to article

¹⁷ See In re Walden, 787 F.2d 174 (5th Cir. 1986) (sanctions not awardable against counsel for a petitioning creditor);