In a prior post, we explored the risks of utilizing an involuntary bankruptcy petition as a litigation tactic.  That post examined a July 2015 decision from the Second Circuit Court of Appeals in the TPG Troy LLCbankruptcy case, in which the court held 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 Third Circuit Court of Appeals recently addressed the intersection of bad faith and involuntary bankruptcy in In re Forever Green Athletic Fields, Inc., No. 14-3905 (3d Cir. Oct. 16, 2015).  Taken together, these two opinions serve as a warning to creditors of both the risks inherent in filing involuntary bankruptcy petitions and of the necessity of having a legally proper purpose for the involuntary filing.

Underlying the Forever Green decision was a tortured history of pre-petition litigation.  In 2005, Forever Green sued one of its competitors, ProGreen, for $5 million for diversion of corporate assets.  Forever Green and ProGreen subsequently agreed to arbitrate those claims.  That same year, ProGreen’s principal, Charles Dawson, and his wife sued Forever Green for unpaid commissions and wages.  In 2011, the Dawsons obtained a $300,000 judgment against Forever Green, and based upon the judgment, ProGreen filed a motion to terminate the arbitration.  In response, Forever Green filed a lawsuit against the Dawsons trying to reinstate the arbitration.  Instead of responding to that complaint, the Dawsons and a law firm that was owed over $200,000 from Forever Green filed an involuntary Chapter 7 bankruptcy petition against Forever Green.

Section 303(b)(1) of the Bankruptcy Code contains three objective requirements for commencing an involuntary proceeding where an alleged debtor has more than twelve creditors: (1) there must be three or more petitioning creditors; (2) none of the petitioning creditors’ claims are contingent or subject to a bona fide dispute; and (3) the unsecured portion of the claims must be in excess of $15,325.  It was undisputed that the Dawsons and the law firm satisfied all of these requirements.  Nonetheless, the bankruptcy court dismissed the involuntary petition on the basis that the petition was filed in bad faith.  In support of this conclusion, the court found that the petition was filed for two improper purposes: (1) to frustrate Forever Green’s efforts to litigate its claim against ProGreen; and (2) to collect on the judgment.  The district court affirmed the dismissal and the Dawsons appealed (the law firm did not join in the appeal).

It is a basic tenet of bankruptcy law that a debtor’s bankruptcy petition may be dismissed if the court finds that it was filed in bad faith.  Less clear, however, is whether an involuntary petition may be dismissed as a bad faith filing where the petitioning creditors satisfy the statutory requirements for an involuntary petition under section 303.  Here, there was no dispute that the Dawsons and the law firm satisfied the three objective criteria under section 303(b)(1).  The Dawsons argued that their purported subjective bad faith was irrelevant and that as long as section 303(b)(1)’s criteria are satisfied, the court is required to enter an order for relief as long as Forever Green was not paying its debts.  Because there was no dispute that Forever Green was not paying its debts, the Dawsons argued that the involuntary petition should not have been dismissed.

The Third Circuit rejected the Dawsons’ argument and held instead that involuntary filings may be dismissed if the court finds that they were filed in bad faith.  The court held that the Dawsons’ reading of section 303(b) ignored the equitable nature of bankruptcy and the requirement of good faith that underlies the Bankruptcy Code.  In so doing, the court aligned itself with the majority of courts that have held that involuntary petitions that satisfied section 303(b)’s objective criteria can nonetheless be dismissed if they were subjectively filed in bad faith.

Turning to the issue of whether the petition was filed in bad faith, the court adopted the “totality of the circumstances” standard for determining bad faith under section 303.  Under this test, the court examines both subjective and objective evidence of bad faith.  Looking at the totality of the circumstances, the court held that the bankruptcy court did not abuse its discretion in finding that the Dawsons had filed the involuntary petition in bad faith.

According to the bankruptcy court, the petition was filed in bad faith because it was filed to force Forever Green to pay the judgment entered in favor of the Dawsons and to get Forever Green to abandon its claims against ProGreen.  The appellate court held that this ran counter to the “spirit of collective creditor action that should animate an involuntary filing.”  Opinion, p. 16.

Also crucial to the court’s decision was the absence of evidence that the Dawsons had engaged in “the type of due diligence and sober decision-making process that should precede any involuntary filing.”  Opinion, p. 17.  Had the Dawsons done an investigation prior to filing the petition, they would have discovered that Forever Green was not making preferential payments to creditors or dissipating its assets.  Preventing preferential payments and depletion of assets are both appropriate rationales for filing an involuntary petition, and their absence solidified the court’s conclusion that the petition was filed in bad faith.

Forever Green is the second court of appeals decision in the last few months addressing involuntary bankruptcy petitions.  In the TPG Troy decision, the Second Circuit analyzed the risks to petitioning creditors if the involuntary case is dismissed, and held that when an involuntary case is dismissed there is a presumption that the petitioning creditors will be assessed fees and costs even without a bad faith showing.  In Forever Green, the Third Circuit makes clear that the subjective intent of the petitioning creditors will be considered as a basis for dismissal even if section 303(b)’s objective criteria are met.  Both of these cases underscore the importance of creditors thinking twice, if not three times, before filing an involuntary petition.  The principal purpose of an involuntary filing is to install a trustee for the benefit of all creditors and not to leverage a creditor’s position in ongoing litigation.  Creditors who ignore this may ultimately have to pay their alleged debtors.