Last week, the Second Circuit Court of Appeals affirmed a decision by the Bankruptcy Court for the Southern District of New York in In re TPG Troy, LLC, 2015 U.S. App. LEXIS 12085 that awarded over a half-million dollars in legal fees and expenses to the subjects of an improper involuntary bankruptcy filing.  The Court’s decision in TPG Troyshould serve as a clear warning to all litigants who are thinking about using an involuntary bankruptcy petition as a litigation tactic.

The petitioning creditors were holders of promissory notes issued by Hellas Telecommunications (“Hellas”) and were pursuing an aggressive litigation strategy in several state, federal and foreign courts to collect after Hellas had defaulted on the notes.  The involuntary debtors (the “Troy Entities”) had partially owned Hellas at the time the notes were issued but did not actually issue or guarantee the notes and had sold their interests in Hellas years before the default.

As part of their litigation strategy, the petitioning creditors filed involuntary petitions against the Troy Entities.  Shortly after filing, counsel for the Troy Entities advised the petitioning creditors of the impact of their actions and the consequences of filing an improper involuntary bankruptcy—including the award of fees and costs pursuant to section  303(i)(1) of the Bankruptcy Code.  Counsel offered the petitioning creditors a safe-harbor in that if they immediately dismissed the involuntary petition, the alleged debtors would not seek an award of  fees and costs.  Rather than accept the offer, the petitioning creditors filed motions for the immediate examination of the Troy Entities and other non-parties pursuant to Bankruptcy Rule 2004.  In response, the Troy Entities moved to dismiss the involuntary proceeding and the bankruptcy court denied the Rule 2004 motions pending resolution of the motion to dismiss.  That did not stop the petitioning creditors from serving written discovery requests on the Troy Entities.  After briefing on the motion to dismiss and only two days before the hearing on the motion, the petitioning creditors continued their aggressive approach and filed an unauthorized sur-reply—attaching several declarations from other creditors who had not joined the involuntary proceeding.

The bankruptcy court dismissed the involuntary proceeding on two grounds:  (i) the petitioning creditors’ claims were subject to a bona fide dispute and they were therefore not eligible to act as petitioning creditors under section 303(b) of the Bankruptcy Code; and (ii) the principles of abstention under section 305 of the Bankruptcy Code warranted dismissal.  The Troy Entities then moved the bankruptcy court for sanctions in the form of attorneys’ fees and costs as well as punitive damages of two-times the fees and costs.  The bankruptcy court ruled that the Troy Entities were entitled to fees and costs based on the presumption that fees and costs should be awarded to an alleged debtor when an involuntary petition is dismissed.  The court rejected the petitioning creditors’ argument that bad faith is a prerequisite for awarding fees and costs.  However, the court denied the alleged debtor’s request for punitive damages.  The petitioning creditors appealed.

The Second Circuit first addressed a jurisdictional issue raised by the petitioning creditors and held that it did not, in fact, have jurisdiction to review the bankruptcy court’s abstention ruling.  Nonetheless, it held that it had jurisdiction to review the award of fees and costs.  The Second Circuit also quickly dispensed with the petitioning creditors’ assertion that, based on Stern v. Marshall, 131 S. Ct. 2594 (2011), they were entitled to a jury trial on the issue of fees and costs.  The appellate court held that, because counsel for the petitioning creditors had consented to adjudication by a bankruptcy judge on the record, they had waived any potential Stern argument.

The Second Circuit then turned its attention to the question of whether the petitioning creditors’ claims were subject to a bona fide dispute, since if they were, the petitioning creditors were not authorized to file the involuntary petition under section 303(b) of the Bankruptcy Code. This review was solely for determining whether there was a basis for the award under section 303(i) of the Bankruptcy Code.  In making such determination, the Second Circuit held that courts must “determine whether there is an objective basis for either a factual or legal dispute as to the validity of the debt.”  The Court clarified that such a test is satisfied if there is a genuine issue of material fact such that the debtor may have been justified in not paying its debts.  The court is not required to, as the petitioning creditors suggested, resolve such a dispute or even examine in detail the pending litigation.  The fact that there is pending litigation strongly suggests the existence of a bona fidedispute.  The Second Circuit held that the pending litigation as well as the Troy Entities’ vigorous dispute of the factual underpinnings of the claims (i.e., that the alter ego theory did not apply to foreign entities; the petitioning creditors had consented to the transactions at issue; there were no fraudulent redemption transactions) was sufficient to affirm the bankruptcy court’s ruling.  As such, the Second Circuit found no error in the court’s finding that the petitioning creditors’ claims were the subject of a bona fide dispute.

With regard to the fee award, the Second Circuit agreed with the bankruptcy court’s analysis and adopted the majority rule that when an involuntary bankruptcy petition is dismissed, there is a presumption that costs and fees will be awarded irrespective of a bad faith showing.  The Second Circuit engaged in the same analysis as the bankruptcy court, adopting a totality of the circumstances test, which includes the consideration of the following factors: (i) the merits of the involuntary petition; (ii) the role of any improper conduct on the part of the alleged debtor; (iii) the reasonableness of the actions taken by the petitioning creditors; and (iv) the motivation and objectives behind the filing of the petition.  The Court held that the bankruptcy court did not abuse its discretion in awarding fees and costs because (a) the petitioning creditors put forth no evidence to rebut the presumption, (b) the parties were embroiled in litigation, and (c) much of the work giving rise to the fees and costs arose from the conduct of the petitioning creditors.  The Second Circuit also opined that awarding fees and costs would discourage the future filing of involuntary petitions on disputed debts.

This case should serve as a serious warning to creditors—involuntary bankruptcies should not be used as a litigation tactic except in rare circumstances and never before first examining the risks attendant with filing an involuntary petition.  The standard for recognition of a bona fide dispute is such that creditors should be very wary of commencing an involuntary bankruptcy proceeding because dismissal will likely lead to a fee award.  The principal purpose of an involuntary bankruptcy filing is to install a trustee who will administer the estate under the Bankruptcy Code for the benefit of all unsecured creditors, not to leverage a creditor’s position in ongoing litigation.