Contributed by Debra McElligott
Section 303(b)(1) of the Bankruptcy Code allows an involuntary petition to be filed by three or more creditors who hold non-contingent claims totaling at least $15,325 more than the liens on the debtor’s property. Those creditors then must prove that the debtor was generally not paying its debts as they came due within the guidelines of section 303(h)(1) or that a custodian had been appointed or had taken possession under section 303(h)(2). But what happens when all the requirements of an involuntary filing are met, but the petitioning creditors have ulterior motives that may harm the debtor and other creditors? The Third Circuit recently considered this question in In re Forever Green Athletic Fields, Inc., holding that bad faith provides an independent basis for dismissing an involuntary petition.
Forever Green and Pro Green were competitors in the artificial turf playing field business. In 2005, Forever Green filed a lawsuit in Pennsylvania against Pro Green for $5 million, which the parties agreed to arbitrate. In a separate action in Louisiana, Charles Dawson, the owner of Pro Green, and his wife obtained a consent judgment against Forever Green totaling more than $300,000. Pro Green then filed a motion to terminate the arbitration in Pennsylvania, arguing that Forever Green was insolvent and could not pay the arbitrator’s fees. The Dawsons also obtained a writ of execution to garnish the arbitrator’s fees in satisfaction of their $300,000 judgment. The arbitrator suspended the arbitration pending resolution of the fee issue. When Forever Green moved to reinstate the arbitration, the Dawsons threatened to keep the arbitration suspended indefinitely until their judgment was paid and to force the company into bankruptcy unless it abandoned its lawsuit. Shortly thereafter, the Dawsons, along with a third creditor, filed an involuntary petition against Forever Green.
Forever Green moved to dismiss the involuntary petition as a bad faith filing. The United States Bankruptcy Court for the Eastern District of Pennsylvania granted the motion, finding that Charles Dawson acted in bad faith by using the involuntary petition as a litigation tactic and an attempt to collect on a debt. The United States District Court for the Eastern District of Pennsylvania affirmed, and the Dawsons appealed to the Third Circuit.
Finding “Bad Faith” in Section 303
Although good faith is not among the requirements outlined in Section 303(b)(1), the Bankruptcy Code does provide, in section 303(i)(2), that when the bankruptcy court dismisses an involuntary petition, it may award damages against any creditor that filed the petition in bad faith. The Third Circuit noted that parties litigating the issue of bad faith generally do so in the damages context. In a typical case, the creditors have not met their burden of proving the requirements of section 303 in the first instance. Forever Green, however, presented a different question: whether an involuntary petition may be dismissed as a bad faith filing even when, as here, the relevant creditors have met the requirements of section 303(b)(1) and 303(h)(1).
The Dawsons argued that the court should not be able to engage in a bad faith inquiry when the requirements of section 303(b)(1) are met because the statute contains objective criteria. They also argued that the court is obligated to order relief under section 303(h)(1) of the Bankruptcy Code if section 303(b)(1) is satisfied and the debtor is failing to pay its debts within the meaning of section 303(h)(1). The Third Circuit disagreed, stating that meeting the criteria under section 303(b)(1) is “just the first hurdle,” and that the criteria have no bearing on any defense or other grounds for dismissal that may exist. The court noted that the express reference to “bad faith” in section 303(i)(2) also supported its holding, as there is no reason the Bankruptcy Code would allow damages for bad faith filings, but prohibit dismissal for the same conduct. Furthermore, the court rejected the argument regarding section 303(h)(1), as it does not require relief, but simply provides that the court shall order relief “only if” the debtor is not paying its debts. In other words, the debtor’s nonpayment is necessary, but not sufficient, to obtain relief.
In addition to its analysis of the statutory language, the court also highlighted several policy considerations. One, which the Dawsons failed to address in their argument, is that the bankruptcy court has broad equitable power. The good faith doctrine allows the bankruptcy court to “patrol the border between good- and bad-faith filings,” and the majority of courts, including the Fourth Circuit and the United States Bankruptcy Appellate Panel for the Eighth Circuit, agree that bad faith is cause for dismissal of an involuntary petition. Another concern the Third Circuit highlighted is that an involuntary petition is an “extreme remedy with serious consequences to the alleged debtor.” For that reason, the bankruptcy court must have the power to protect debtors from creditors with retributive motives and ensure that only creditors who file petitions for proper reasons will be allowed to commence a case.
Finally, the Third Circuit held that the bankruptcy court did not abuse its discretion by dismissing the petition in this case. The court, acknowledging the variety of standards that may be used to evaluate bad faith, found the “totality of the circumstances” test most appropriate to encompass the ways a creditor may act in bad faith. The test is fact-intensive and allows courts to consider a multitude of factors, such as whether a creditor used the petition as a litigation tactic or to obtain a disproportionate advantage. Examining Charles Dawson’s behavior, the court emphasized that it is improper for creditors to use bankruptcy as a debt collection device or a means to gain a personal advantage against a debtor. The court also highlighted that Forever Green’s largest asset was its claim against Pro Green, which totaled $5 million and could have been used to pay the company’s creditors. The court found that Mr. Dawson’s conduct thus “ran counter to the spirit of collective creditor action that should animate an involuntary filing.”
Although the Forever Green opinion clearly states that bad faith is a basis for dismissing a voluntary petition, the court explicitly did not reach the question of whether a good faith creditor could cure such a petition, as none stepped forward before dismissal in this case. Additionally, the fact-based nature of the bad faith inquiry makes the reach of the ruling unclear, especially because the facts in Forever Green constitute an extreme case of bad faith. It remains to be seen whether courts will limit the Third Circuit’s holding to its facts or expand the opinion to apply to less egregious conduct.