Bankruptcy Court May Not Second Guess State Court Judgments When Evaluating the Merits of an Involuntary Petition

Contributed by Elizabeth Hendee
In a recent decision, Marciano v. Chapnick (In re Marciano), the United States Court of Appeals for the Ninth Circuit held that the holder of an unstayed state court judgment could be a petitioning creditor for the purposes of commencing an involuntary case  under section 303(b)(1) of the Bankruptcy Code.  Even though the judgment was the subject of an ongoing appeal, the Ninth Circuit found that the claim was neither contingent nor disputed.  This holding, which is contrary to the Fourth Circuit’s holding in Platinum Financial Services Corporation v. Byrd (In re Byrd), has created a circuit split regarding whether unstayed state judgments can ever be contingent or the subject of a bona fide dispute under the Bankruptcy Code.
The courtroom battle that led to the recent Ninth Circuit decision began over five years ago.  In 2007, Georges Marciano, a co-founder of Guess, Inc., former designer for Guess and one-time candidate for California governor, sued five of his former employees in California Superior Court, alleging theft of artwork and company funds and fraud.  In response to the lawsuit, three of the former employees filed cross-complaints against Marciano, alleging defamation and intentional infliction of emotional distress.  The trial court struck Marciano’s answers to the cross-claims as a sanction for multiple discovery abuses.  Following a jury trial on damages, the trial court entered judgments in favor of the three employees for a total of approximately $100 million.  Marciano appealed the three judgments to the California Court of Appeal, but the judgments were never stayed.  While the appeals were pending, five other individuals who held judgments against Marciano totaling almost $200 million began collection efforts.  The three employees, evidently nervous that Marciano’s assets would be gone before the appeals process was complete, filed an involuntary petition under section 303(b)(1) against Marciano in the United States Bankruptcy Court for the Central District of California.  Marciano moved to dismiss the filing on multiple grounds, but the bankruptcy court, as well as the United States Bankruptcy Appellate Panel for the Ninth Circuit, sided with the employees and allowed the involuntary petition to stand.  The appeal to the Ninth Circuit followed.
Section 303(b)(1) requires that a petitioning creditor in an involuntary case hold a claim against the potential debtor that is “not contingent as to liability or the subject of a bona fide dispute as to liability or amount.”  Marciano argued to the Ninth Circuit that the requirements of section 303(b)(1) were not satisfied in this case because the three judgments obtained by his former employees, the petitioning creditors, were on appeal at the time that the involuntary petition was filed and, accordingly, were the subject of a bona fide dispute.
Courts have adopted two primary views when determining whether nonstayed judgments on appeal are the subject of bona fide disputes for the purpose of section 303(b)(1).  According to the majority view, the “Drexler rule,” which has been adopted by multiple bankruptcy courts, including in the Southern District of New York and Delaware, as well as the Fifth Circuit in an unpublished decision, unstayed non-default state judgments on appeal are never the subject of bona fide disputes.  Under the minority view, the Fourth Circuit’s “Byrd rule,” an unstayed judgment on appeal may be the subject of a bona fide dispute if the debtor is able to demonstrate the existence of such a dispute.  The Ninth Circuit adopted the Drexler rule because, according to the court, that rule is correct as a matter of statutory interpretation and federalism.
Section 303(b)(1) requires that a petitioning creditor hold a claim against the potential debtor.  “Claim” is defined in section 101(5)(A) of the Bankruptcy Code as a “right to payment, whether or not such right is reduced to judgment.”  According to the Ninth Circuit, the reference to “judgment” in section 101(5)(A) means that a right to payment, or claim, includes judgments themselves and not the disputes that resulted in those judgments.  Under this reading of the Bankruptcy Code, a judgment would only be the subject of a bona fide dispute if the judgment itself, not the related cause of action, was in dispute.  Here, no one questioned the validity of the state judgments.  The petitioning creditors had fully vested property interests in the claims, and, because the judgments were not stayed, were entitled to payment of the claims at the time they filed the involuntary petition against Marciano.  According to the Ninth Circuit, allowing a bankruptcy court to inquire into the validity of the underlying litigation claims would turn bankruptcy courts into “odds maker[s]” and inevitably result in inconsistent decision making.  A per se rule would lead to more objective and equitable decisions.
The Ninth Circuit also claimed that a per se rule would be consistent with the principles of federalism by affording state court judgments “full faith and credit” in the context of involuntary bankruptcy filings.  Here, the petitioning creditors were able, under California law, to collect on the judgments at the time the petition was filed.  If the bankruptcy court treated these same liabilities as contingent or subject to a bona fide dispute, it would not be affording the judgments true “full faith and credit.”  Accordingly, the Ninth Circuit held that the judgments were not the subject of a bona fide dispute, and, thus, the petitioning creditors satisfied the requirements of section 303(b)(1).
This decision, however, was not unanimous.  Circuit Judge Ikuta dissented.  Judge Ikuta would have adopted the Byrd rule, which requires a case by case analysis of the relevant claims.  Judge Ikuta disagreed with the majority’s statutory interpretation of section 303(b)(1) and federalism arguments.  According to Judge Ikuta, the Bankruptcy Code’s definition of “claim” does not include “judgment” but instead only includes rights to payment.  Accordingly, the relevant inquiry is whether or not the right to payment is subject to a bona fide dispute, not whether or not the judgment is subject to a bona fide dispute.  The dissent also argued that in this case, the fact that the petitioning creditors were able to immediately collect on their judgments was irrelevant because, under California law, if Marciano’s appeal were to succeed, the petitioning creditors’ collection efforts would have been unwound.  Accordingly, the creditors’ right to payment was not set in stone.  Further, according to the dissent, the Byrd approach would be consistent with the principles of federalism because, contrary to the majority’s assertions, the rule would not require a bankruptcy court to relitigate the claim but would only require the bankruptcy court to determine the genuineness of the appeal.  Judge Ikuta stressed that bankruptcy cases can have substantial consequences for debtors so a bankruptcy court’s decision to place a debtor into bankruptcy against his will cannot be made lightly.  Interestingly, on appeal, the three judgments were reduced substantially to $10 million a piece.
Whether section 303(b)(1) creates a per se rule about whether an unstayed state court judgment may be the subject of a bona fide dispute has divided the circuits.  It will be interesting to see what side of the debate the next court to take on this hotly contested issue will fall on.