One assumes that the decision to file a bankruptcy case is made by the debtor. However, a bankruptcy case can be commenced “against” the debtor by creditors. Given the serious implications for the debtor and its business of being forced into bankruptcy, the Bankruptcy Code limits who can attempt to place a debtor into bankruptcy. One of the requirements is the petitioning creditors must hold claims that are not subject to a “bona fide dispute.” What constitutes a bona fide dispute has been the subject of significant litigation when the debtor contests the involuntary bankruptcy filing and requests that the court dismiss the case. The issue was recently analyzed by the U.S. Bankruptcy Court for the Central District of California, in In re QDOS, Case No. 8:18-bk-11997-MW. In an opinion issued on Oct. 31,Bankruptcy Judge Mark S. Wallace dismissed an involuntary bankruptcy case after disqualifying two of the four petitioning creditors. The opinion reviews conflicting case law on the issue of what constitutes a “bona fide dispute.”
The Petitioning Creditors’ Procedural Maneuvers
According to the opinion, three creditors filed an involuntary Chapter 11 petition against QDOS, Inc. (the debtor). The petitioning creditors were Carl Wiese, as trustee of the Wiese Family Trust, Felice Terrigno and Matthew Hayden. The debtor filed a motion seeking dismissal of the bankruptcy petition on the grounds that the creditors did not qualify as creditors entitled to file an involuntary bankruptcy petition and the petition was filed in bad faith. The Bankruptcy Court issued a tentative ruling that it intended to grant the motion because Terrigno was not qualified, leaving less than the three creditors required to support the involuntary petition against the debtor. Another alleged creditor, Jim Maddox, filed a joinder in support of the involuntary petition prior to the hearing on the motion.
The court recounted how the hearing on the dismissal motion had been repeatedly rescheduled. In several instances, the court ordered the petitioning creditors to appear in person at the hearing so they could be cross-examined by the debtor regarding their claims. The alleged creditors advised the court that they would not appear. Ultimately, neither Terrigno nor Maddox appeared when an evidentiary hearing was held on Oct. 17, despite the court’s order that if a petitioning creditor failed to appear at the hearing, any and all declarations filed by such creditor would be stricken. Prior to the hearing, Maddox filed a proof of claim in what the court called “a transparent effort to avoid the effect of the striking of Maddox’s declarations.” The “cagily-drafted” proof of claim did not assert how much Maddox was owed, but instead stated the debt was “not less than $220,000,” without interest. The court found that Maddox’s absence from the evidentiary hearing prejudiced the debtor because there was no opportunity to cross-examine Maddox.
Petitioning Creditors Disqualified
The court began its analysis by stating the requirements to file an involuntary bankruptcy petition against a debtor with more than twelve creditors. The Bankruptcy Code requires, among other things, the petition to be filed by at least three creditors holding claims that “… are not contingent as to liability or the subject of a bona fide dispute as to liability or amount …” See 11 U.S.C. Section 303(b)(1). In the case at hand, the eligibility of two of the four petitioning creditors was contested.
The court started with Terrigno. He had provided funds to the debtor under a subscription document that provided him common stock in exchange for his investment. While the opinion notes he also received subscription documents in the form of a loan, he only executed the common stock subscription agreement, and received only common stock in exchange for his funds. Terrigno testified that he thought he was making a loan. The court did not find his testimony credible in light of his status as “a West Point graduate” who also had a business degree from Rice University. The court concluded that Terrigno was not a creditor because he held an equity interest.
The court then turned to Maddox and noted Maddox was a creditor because he held a promissory note issued by the debtor. The debtor argued the interest on the loan was usurious and the interest could not be lawfully collected. The petitioning creditors argued that even if the loan was usurious, only the interest would be cancelled, leaving the principal undisputed as to liability or amount. As such, the issue was whether a creditor with a partially disputed claim as to amount is disqualified under Section 303(b)(1).
The court began by noting that, despite the plain language of the statute and the legislative history being “… about as clear as it can possibly be…”, courts disagree on whether a claim that is partially disputed as to amount, such as Maddox’s claim, is or is not subject to bona fide dispute. The opinion notes that the Colliers treatise agrees with the position that if only part of the amount is disputed, the creditor is still qualified to be a petitioning creditor. The court reasoned that if in order to be disputed as to amount the entire amount must be in dispute, the word “amount” would be redundant because it would mean the same thing as “liability.” As such, a dispute as to liability is a dispute as to the entirety of the claim, and a dispute as to amount can be a dispute to only a portion of the claim.
The court found this conclusion supported by the legislative history of Section 303. Specifically, debtors were being forced into involuntary bankruptcy even though they legitimately disputed either the liability or amount of the claims against them. The code was amended to prevent creditors from using the bankruptcy system as a “tool of coercion.” The opinion states as follows: The proposition “a partially disputed claim is a disputed claim” is not only true, it is necessarily true. Its truth is not contingent on anything, and it would be contradictory to deny that a partially disputed claim is nonetheless a disputed claim. The word “dispute” includes within it various degrees, just like the term “bald.” If a creditor sent a debtor an invoice for $1,000, and the debtor wrote back that he owed only $600, it is properly said that the invoice is in dispute. Equally true, it would be palpably false to state under these circumstances that the invoice is not in dispute.
The court concluded that a dispute as to a portion of a claim can be a bona fide dispute as to liability or amount. Turning to whether the dispute here was “bona fide,” the court noted that a debtor must do more than disagree with the amount of the claim. The opinion cites a U.S. Court of Appeals for the Ninth Circuit decision for the rule that there must be “an objective basis for either a factual dispute or legal dispute as the validity of the debt.” The Maddox claim was based on a promissory note in the principal amount of $250,000, and a “loan fee” of $25,000. The loan’s term was six months, so the effective per annum interest rate was 20 percent. California’s Constitution prohibits commercial loans with rates in excess of 10 percent. The petitioning creditors argued that the loan fee was not interest, and permitted under California law. The debtors countered that California case law provides that loan fees must be reasonable, among other things. The court held that the petitioning creditors had failed to show that a $25,000 loan fee on a $250,000 six-month loan was reasonable.
As a result, the court concluded that the Maddox claim was the subject of a bona fide dispute. Alternatively, the court ruled that neither Maddox’s filed declarations nor his proof of claim would be taken into account in determining whether he had a claim for purposes of qualifying as a petitioning creditor. In so ruling, the court wrote, “Mr. Maddox cannot be permitted to disobey multiple court orders requiring his appearance at an evidentiary hearing, consistently dodge cross-examination on pleadings he filed in support of the contention that he is a qualified creditor and still qualify as a petitioning creditor.”
Without Terrigno or Maddox, there were only two remaining petitioning creditors, an insufficient number to support an involuntary bankruptcy petition against a debtor with more than 12 creditors such as the debtor. The court granted the debtor’s motion to dismiss the bankruptcy case, and scheduled a hearing for January 2019 on the issue of whether judgment should be entered against the petitioning creditors in favor of the debtor for reasonable attorney fees and costs in connection with the involuntary bankruptcy petition.
This case, and the conflicting case law on what constitutes a bona fide dispute, reminds us that practitioners must be cautious in advising clients about filing an involuntary petition and what may be involved. The filing of an involuntary petition is the commencement of litigation. Petitioning creditors must be apprised that litigation over the filing can be expensive, and if a court determines the creditors were not qualified to file, the court may award fees and costs, as well as damages, to the debtor.
Andrew C. Kassner is the chairman and chief executive officer of Drinker Biddle & Reath, a national law firm with more than 635 lawyers in 12 offices. He chaired the corporate restructuring group for almost 20 years. He can be reached at firstname.lastname@example.org or 215-988-2554.
Joseph N. Argentina Jr. is an associate in the firm’s corporate restructuring practice group in the Philadelphia and Wilmington, Delaware, offices. He can be reached at email@example.com or 215-988-2541.