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The 2nd U.S. Circuit Court of Appeals has clarified the procedure for determining whether a petition for involuntary bankruptcy should be dismissed when a debt is in dispute. Addressing the question for the first time, the circuit found a bankruptcy court’s determination that a debt is the subject of a “bona fide dispute” under the Bankruptcy Code should be made as soon as possible in the proceeding. The code, 11 U.S.C. � 303(b), states that an involuntary case against a debtor is commenced when three or more entities have a claim “that is not contingent as to liability or the subject of a bone fide dispute.” But the point at which a bankruptcy judge should make that determination has divided courts, with some judges finding the question should be decided immediately, and others allowing the question to be resolved later in the proceedings. The 2nd Circuit decided to adopt the former standard in Key Mechanical Inc. v. BDC, 56 LLC, 02-5029. “We believe the more sound view is that the requirement is subject matter jurisdictional, and now so hold,” Judge Barrington D. Parker Jr. said. “Whether an alleged debtor is properly before the bankruptcy court in an involuntary case is a threshold determination that should be made at the earliest possible stage of the proceedings.” Key Mechanical had appealed a judgment of Southern District Judge Robert W. Sweet affirming an order by Bankruptcy Court Judge Richard L. Bohanon, who dismissed an involuntary bankruptcy petition. Key Mechanical and two other construction companies that worked on the Chambers Hotel beginning in 1999 had sought payment for their services. In their application under � 303(b), the contractors claimed that the hotel owner, BDC 56, was insolvent. But BDC 56 argued it was solvent and that it had not paid the contractors in full only because it disputed the quality of the work. Judge Bohanon found the petition seeking to force BDC 56 into bankruptcy must be dismissed because there was a real dispute over the debts. Judge Parker noted that the Bankruptcy Code does not define the phrase “bone fide dispute.” “It has been left to the courts to give content to the term, although our Circuit has not spoken on the issue,” he said. Many courts, he said, had adopted a test along the lines of the 7th Circuit, which stated in In re Busick, 831 F.2d 745 (1987), that a “bankruptcy court must determine whether there is an objective basis for either a factual or a legal dispute as to the validity of the debt.” “We now adopt the Seventh Circuit’s objective test, as well as the burden-shifting framework developed by other courts for its application, which requires, first, that the petitioning creditor establish a prima facie case that no bona fide dispute exists,” Parker said. “Once a prima facie case has been established, the burden shifts to the debtor to demonstrate the existence of a bone fide dispute.” Creditors, he said, must be required to show that the debt is not in dispute “at the earliest practical point.” “Otherwise, creditors could, on the basis of relatively untested claims, haul a solvent debtor with whom they have legitimate disputes into bankruptcy court and force it to defend an involuntary proceeding while the bankruptcy court leaves for a later merits determination whether the debtor is even properly before it,” he said. The parties had also disputed the standard of review for a ruling on a bona fide dispute. Where a decision finding a bona fide dispute is based on findings of fact, Judge Parker said, the finding is reversed only where the reviewing court considers it in “clear error.” But “to the extent it involves conclusions of law,” he said, “we review it de novo.” Key Mechanical had claimed that the failure of Judge Bohanon to hold an evidentiary hearing required “de novo” review by the court: a fresh look at whether the ruling on the disputed debt was proper. “We disagree,” Parker said. “The nature of a bankruptcy court’s findings is not altered by whether it holds an evidentiary hearing.” Judges Guido Calabresi and Rosemary S. Pooler joined in the opinion. John H. Hall, Jr. and Adam Levy of Shaw, Licitra, Bohner, Esernio, Schwartz & Pfluger represented Key Mechanical Inc. Andrew P. Brozman, Jennifer DeMarco and Seven Rivera of Chadbourne & Parke represented BDC 56.

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