When is a claim contingent? When is a claim subject to a bona fide dispute and who has the burden of proof? When is a claim against a person? When is a claim too small to count? When is an alleged debtor generally not paying his debts as they come due? Are we there yet?

All but the last represents a sample of the exhaustive litany of questions recently addressed by the Bankruptcy Court for the Northern District of Florida in an analysis of whether an involuntary case was properly commenced under section 303 of the Bankruptcy Code. In re Peter H. Bos, Jr. and Legendary Holding, Inc. Ultimately, though section 303 may have supported the involuntary petition, the court took a hard turn after 50 pages of the opinion and found that it should abstain and dismiss the involuntary proceedings under section 305 of the Bankruptcy Code.

Background (a/k/a when sophisticated parties dig in their heels and refuse to settle)

The economic downturn that began in 2007-2008 was a challenge for Bos and his wholly-owned subsidiary, Legendary Holding, Inc., whose subsidiaries and affiliates, since 1976, had built and managed hundreds of millions of dollars’ worth of real estate projects along Florida’s Gulf coast. During the recession and after, Bos and LHI struggled to service and repay 27 separate loans totaling $270 million. Bos and LHI were able, however, to reach forbearances, workout agreements, and loan restructurings with 13 of the 14 lenders holding those loans, leaving only one lender – SE Property Holdings, LLC (SEPH) – who did not come to terms with Bos and LHI.

SEPH, who was partially secured by a mortgage on property worth approximately $3 million, sued Bos and LHI in Florida state court after Bos and LHI failed to perform on a guaranty of a $7 million loan held by SEPH. After 4 years of contentious and expensive litigation, Bos and LHI lost, and SEPH was granted a judgment of more than $15 million – more than twice the amount of the original loan after accounting for attorneys’ fees and default interest accruing at a whopping 18%.

During its attempt to collect on the judgment, SEPH discovered Bos and LHI had granted, to the detriment of SEPH, additional security to two of their friendly, insider creditors in the form of stipulated charging orders on Bos’ and LHI’s ownership interests in most of their subsidiaries and affiliates. Accordingly, by the time SEPH filed a judgment lien certificate and received its own charging order, most of the assets of Bos and LHI were already fully encumbered. SEPH filed involuntary chapter 7 petitions against Bos and LHI, now the Alleged Debtors, shortly thereafter.

Qualified Petitioning Creditors and Numerosity under Section 303 of the Bankruptcy Code

Section 303 of the Bankruptcy Code provides that a single qualified petitioning creditor can commence an involuntary case by filing a petition if the alleged debtor has fewer than 12 qualified creditors, excluding insiders and employees of the alleged debtors, holding aggregate unsecured claims in an amount over $15,325. 11 U.S.C. § 303(b)(2). A qualified petitioning creditor is a holder of a claim against an alleged debtor that is “not contingent as to liability or the subject of a bona fide dispute as to liability or amount.” 11 U.S.C. § 303(b)(1). In various motions targeted at dismissing the involuntary petitions, the Alleged Debtors challenged SEPH’s status as a qualified petitioning creditor, and also argued that they each had more than 12 qualified creditors with aggregate unsecured claims over the threshold amount and, thus, SEPH was not permitted to commence the involuntary proceedings as the sole petitioning creditor.

With respect to SEPH’s status as a qualified petitioning creditor, the Alleged Debtors argued that SEPH had not met its burden of proof with respect to the amount of its unsecured claim. The Alleged Debtors argued that SEPH had a judgment lien claim, a charging order, and the ability to foreclose on the property subject to mortgage, and that SEPH failed to produce evidence as to the value of those interests. Analogizing the dispute over the value of the secured and unsecured portions of SEPH’s claim to a bona fide dispute as to liability or amount of claim under section 303, the court noted that, once a petitioning creditor establishes a prima facie case that its claim is not subject to a bona fide dispute, the burden of proof shifts to the alleged debtor to prove the existence of such a dispute. After holding that SEPH had proven it was the undisputed holder of a $15 million claim secured only by mortgaged property worth approximately $3 million and second or third liens with respect to other property, the court held that the burden of proof with respect to the value of SEPH’s secured claim shifted to the Alleged Debtors. The Alleged Debtors, however, failed to put on evidence regarding the value of the real or personal property subject to the judgment lien and charging order and, accordingly, failed to meet its burden of proof. As a result, the court found that SEPH was a qualified petitioning creditor.

After finding that SEPH was, in fact, a qualified petitioning creditor, the court turned its analysis to the Alleged Debtors’ lists of creditors to determine whether the Alleged Debtors each had more than 11 other qualified, non-insider and non-employee, creditors. Bos and LHI each filed lists of creditors and the court found that Bos had 42 creditors and LHI had 25. In painstaking detail, the court addressed each claim finding that (i) guaranty claims were contingent because amounts were not due thereunder before the date of the involuntary petitions, (ii) certain claims were held by insiders, (iii) claims held by various taxing authorities were also contingent because taxes had been assessed but were not yet payable before the date of the involuntary petitions, (iv) certain claims were fully secured, (v) certain claims were held by creditors who received avoidable transfers, and (vi) certain listed creditors did not, in fact, hold any claim against the Alleged Debtors – all reasons to exclude each of these persons from the list of qualified creditors.

Moreover, the court noted that small, or de minimus, and recurring claims, if any, against the Alleged Debtors would be excluded from the numerosity calculation under the contrarian, but still precedential, Fifth Circuit opinion in Denham v. Shellman Grain Elevator, Inc., 444 F.2d 1376 (5th Cir. 1971). In Denham, the Fifth Circuit held that Congress did not intend for small and recurring obligations such as utilities or phone bills to derail the commencement of involuntary cases by one or two more substantial creditors and, accordingly, such claims should be excluded from the numerosity calculation. Courts in the Eleventh Circuit (post-split with the Fifth Circuit) have continued to follow Denham even though section 303 contains no such exclusion. The issue here, though, was moot because the Alleged Debtors did not have any claims that the court found de minimus or recurring.

Tacitly acknowledging that the Alleged Debtors had fewer than 12 qualified creditors and to complete the analysis under section 303, the court turned to section 303(h) and whether the Alleged Debtors were generally not paying their debts as they came due – a finding required for a court, after a trial on the issue, to order relief against the alleged debtor in an involuntary case. The test for determining whether debts are being paid as they come due is subject to considerable judicial discretion and the court noted arguments supporting both sides. Though the Alleged Debtors were failing to pay the obligation undeniably owed to SEPH, the Alleged Debtors were paying everyone else. As Bos testified, the only creditor that was not being paid as agreed was SEPH, indicating this was little more than a two-party dispute.

For this reason, among others, the court did not ultimately rule on the section 303 issues and, instead, shifted focus to section 305 and whether the Alleged Debtors and all their creditors, not just SEPH, would be better served by dismissal of the involuntary proceedings. The court found that abstention was, in fact, the best route because it was the least disruptive to the Alleged Debtors, their employees, and other creditors and because, though not ideal for SEPH, SEPH could continue to pursue remedies against Bos and LHI outside of bankruptcy.

As always, where the law and the facts do not dictate a specific outcome, a court’s job is to balance the equities, as the court did here in deciding to abstain and put the two parties back where neither is punished or rewarded as a result of the involuntary cases and with full rights to pursue state law remedies and defenses – or a reasonable settlement.