Collateral Damage: Non-debtor Recovery for Bad Faith Involuntary Bankruptcy Petitions

• Publication year: 2019

Collateral Damage: Non-Debtor Recovery for Bad Faith Involuntary Bankruptcy Petitions

Seth Webster

COLLATERAL DAMAGE: NON-DEBTOR RECOVERY FOR BAD FAITH INVOLUNTARY BANKRUPTCY PETITIONS

ABSTRACT

Involuntary bankruptcy is a powerful tool that creditors can use as a last resort in attempting to collect a debt. Because this option is inherently dangerous to undeserving debtors, the Bankruptcy Code provides for extensive damages if creditors pursue involuntary bankruptcy in bad faith. Unsurprisingly, this danger extends to non-debtor third parties tied to the economic wellbeing of the debtors, but a recent circuit split creates a question as to whether protection extends to these non-debtors as well.

While no court found that the collaterally harmed third parties had standing under the damages provision of the Bankruptcy Code, in August 2016 the Third Circuit split from Ninth Circuit precedent by finding that non-debtor third parties could pursue recovery in state court. The Ninth Circuit had previously relied on complete preemption to foreclose these opportunities.

This Comment argues the Third Circuit's approach is moving in the right direction and ultimately proposes a hybrid approach that attempts to solve the flaws in both circuit decisions.

INTRODUCTION

An August 2016 decision by the Third Circuit created a circuit split on an issue of importance for creditors contemplating filing and parties harmed by an involuntary bankruptcy petition.¹ The split concerns whether, under § 303 of the Bankruptcy Code (the "Code"), a non-debtor third party is preempted by the Code from pursuing a claim under state law resulting from an involuntary bankruptcy petition filed in bad faith.² The Third Circuit ultimately ruled in favor of the injured non-debtor third parties, ruling against preemption.³ This decision set the Third Circuit in conflict with the Ninth Circuit, which previously interpreted the Code to completely preempt state law claims and prevent non-debtor third parties from having standing to pursue damages for an involuntary bankruptcy petition filed in bad faith.⁴ This circuit split involves interpretive

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differences of statutory construction, competing jurisdictional doctrines, congressional intent, and the ultimate purpose of the Code within the realm of involuntary bankruptcy law in the United States.⁵

This Comment argues that the Third Circuit's interpretation is more consistent with the Supreme Court's presumption against preemption and reduces tension within the Code created by the Ninth Circuit's prior ruling. Additionally, this Comment suggests a third, hybrid approach to how the courts could interpret the Code in order to achieve the goals set forth by both Circuits.

First, this Comment explores the history, purpose, and current trends of involuntary bankruptcy within the U.S. Bankruptcy system. There are three central building blocks inherent in any of these situations, and thus this Comment next provides important background information of each in turn: (1) the relevant Code provisions; (2) the complex and often overlapping preemption and removal doctrines; and (3) the situations in which a non-debtor third party might be damaged in an involuntary bankruptcy filing.

This Comment then proceeds in three parts by (1) detailing the recent Third and Ninth Circuit cases and the resulting split between them; (2) arguing that the Third Circuit result is preferable; and (3) examining the potential impact of this ruling on the current involuntary bankruptcy trends. Finally, this Comment suggests a potential third option for courts to interpret the Code in these situations and concludes with a call to Congress to clarify its intent.

I. BACKGROUND

A. History and Purpose of Involuntary Bankruptcy

Involuntary bankruptcy, as its name suggests, is a tool that creditors can use to force unwilling debtors into a chapter 7 or chapter 11 bankruptcy.⁶ The concept has existed since bankruptcy laws were first enacted in 16th century England.⁷ In fact, involuntary bankruptcy was the only type of bankruptcy available in the United States until the United States Bankruptcy Act of 1841.⁸ The dominant purpose of the original bankruptcy system was to help creditors collect debts, not to aid debtors in finding relief from creditors, and as such only

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creditors could commence the bankruptcy proceeding.⁹ Bankruptcy was thus premised only on "debtor misconduct" and involuntary bankruptcy continued its reliance on this concept all the way until the Bankruptcy Reform Act of 1978,¹⁰ at which point bankruptcy policy began to shift from debtor misconduct to debtor relief. As this Comment discusses below, the broad theme of bankruptcy law in the United States has shifted almost completely to the other side of the pendulum, but the tension between the competing objectives still exists today and permeates through the Code and case law.¹¹

Thus, the purpose of involuntary bankruptcy in the current Code system is still to provide creditors with a tool to "compel a reorganization or liquidation of the debtor's estate."¹² This tool is especially useful if the creditor suspects the debtor is wasting or concealing assets, or to prevent other creditors from seizing the debtor's property.¹³ However, Congress has recognized this tool inherently opens the door for creditor abuse and thus included significant debtor protection provisions in the Code as well.

1. Trends in Involuntary Bankruptcy

In order to examine when a creditor might be liable for a dismissed involuntary bankruptcy petition, it is important to first briefly inspect when, why, and how often creditors pursue this path. This section highlights the trends in involuntary bankruptcy law in the U.S. as well as reasons why creditors might not be choosing this option for collecting on a debt.

Despite the prevalence of involuntary bankruptcy proceedings in the early stages of bankruptcy law and Congress' continued support of their use, in modern history, the number of involuntary bankruptcy proceedings filed each year is surprisingly low, both in total and in comparison to the number of voluntary bankruptcy cases filed each year, as seen in Figure 1 below.

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Year	Total Bankruptcies	Total Involuntary	% Involuntary
1970	194,399	1,099	0.57%
1975	254,484	1,286	0.51%
1980	210,364	936	0.44%
1985	364,536	1,597	0.44%
1990	749,981	1,637	0.22%
1995	883,457	1,142	0.13%
2000	1,262,102	730	0.06%
2005	1,782,643	563	0.03%
2010	1,596,355	1,054	0.07%
2015	860,182	351	0.04%

Figure 1: Involuntary Bankruptcy Cases Filed by Year¹⁴

Congress enacted the Bankruptcy Reform Act of 1978 in part to encourage involuntary bankruptcies by relaxing the standard that creditors must prove to successfully place a debtor into involuntary bankruptcy.¹⁵ Notwithstanding these efforts, involuntary bankruptcies have remained few and continued to decline.¹⁶ The significant risks a creditor faces when filing an involuntary bankruptcy,

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combined with the variety of alternative options for collecting on a debt, have left involuntary bankruptcies as a last resort, a view supported by the bankruptcy courts.¹⁷

It is important to note, however, that "these statistics do not present a clear picture of the extent to which debtors are coerced into bankruptcy. The line between voluntary and involuntary filings is an ambiguous one because debtors often file voluntary petitions in reaction to creditors' collection efforts."¹⁸ Elizabeth Warren accentuates this by stating "[a] very real issue-and one often ignored-is whether the barriers to involuntary filings discourage too many creditors who should force a defaulting creditor into the bankruptcy process."¹⁹ If Congress were to takes steps to combat these overly coerced voluntary bankruptcies, involuntary bankruptcy could see increased usage and significance.

Overall, involuntary bankruptcies are likely here to stay, even as an infrequently used last resort.²⁰ Despite the seemingly inconsequential number of involuntary bankruptcies relative to the entire bankruptcy scheme, this process remains an important aspect of both the Code and creditor collection options and thus warrants continued analysis.

2. Requirements For Filing an Involuntary Bankruptcy Petition Under § 303

Involuntary bankruptcy cases are governed by § 303 of the Code, which sets forth the requirements for a creditor to be able to file an involuntary bankruptcy petition.²¹ As previously mentioned, creditors may initiate involuntary bankruptcy proceedings under either chapter 7 or chapter 11.²² However, there

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are more than five times as many chapter 7 involuntary bankruptcy petitions as chapter 11.²³ This reflects the fact that involuntary bankruptcy proceedings do not usually occur until it is too late for an optimistic outlook towards restructuring and reorganization of the debtor—the goals of chapter 11—and the creditor is hoping to recover whatever it can through the liquidation that results from a chapter 11 case.²⁴ This highlights the recurring theme in involuntary bankruptcy that creditors must balance the risks of forcing debtors into bankruptcy and the potential serious penalties, if incorrect, against their goal of recovering at least some of the debt.

Under either chapter there are several requirements that must be met for a debtor to be eligible for an involuntary bankruptcy proceeding.²⁵ First, the aggregate amount of eligible unsecured claims held by the debtors must be at least $15,775.²⁶ If the debtor has twelve or more creditors, then at least three of the creditors must participate in the filing.²⁷ If there are fewer than twelve creditors, only one creditor must file for the petition to qualify.²⁸ Finally, a claim is only considered eligible for involuntary bankruptcy if there is no legitimate reason that the...