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Third Circuit Holds That Bad Faith Determined by the Totality of the Circumstances Provides an Independent Basis for Dismissing an Involuntary Petition

In re Forever Green Athletic Fields, Inc., No. 14-3906, 2015 WL 6080665 (3d Cir. Oct. 16, 2015)

Despite no dispute that the petitioning creditors satisfied the statutory requirements for commencing an involuntary chapter 7 proceeding under section 303(b)(1) of the Bankruptcy Code and that the putative debtor was not paying its debts as they came due, this precedential Opinion of the Third Circuit Court of Appeals adopted the “totality of the circumstances” standard for determining bad faith under section 303 and affirmed the decisions of the lower courts that dismissed the proceeding as a bad faith filing.

In ruling so, the Third Circuit considered the petitioning creditors’ argument that bad faith cannot serve as an independent basis for dismissal for two reasons.  First, the subjective intent of petitioning creditors cannot be considered in light of the objective criteria contained in section 303(b)(1) that serves as the basis for the entry of an order for relief if a putative debtor is not paying its debts as they come due (see 11 U.S.C. § 303(h)(1)).  And second, that section 303(i)(2), the only subsection of section 303 that mentions bad faith, only requires an assessment of bad faith when a court determines damages after an involuntary petition is dismissed.  Ultimately, the Court disagreed with both arguments.  Among other things, the Court does not believe that bad faith could serve as a basis for the issuance of damages but not the dismissal of an involuntary petition—a position supported by the language of section 303(h)(1), which makes the failure of a putative debtor to pay its debts a necessary but not only prerequisite for ordering relief.  Additionally, as courts of equity, the Court believes that bankruptcy courts are permitted to use the doctrine of bad faith to “patrol the border between good- and bad-faith filings”—a task often accomplished in voluntary chapter 11 proceedings and necessary to police an extreme remedy such as involuntary proceedings.  Op. at *4.

In affirming the lower courts’ bad-faith dismissal, the Third Circuit examined the totality of the circumstances (as opposed to the “improper use”, “improper purpose”, and objective tests adopted by other courts) and agreed that the bankruptcy court’s findings supported dismissal.  The petitioning creditors filed the involuntary chapter 7 petition to stop an action against their own company commenced by the putative debtor, which was the debtor’s largest asset that could be used to pay its creditors.  The bankruptcy process was intended by the petitioning creditors to pressure payment of their claims ahead of other priority creditors, was commenced with no due diligence or “sober decision-making”, and was suspicious in its timing.  Id. at *6-7.  As noted by the Court, “[i]nvoluntary Chapter 7 proceedings…are intended to protect creditors from debtors who are making preferential payments to other creditors or from the dissipation of the debtor’s assets.  Creditors who file petitions for other reasons—such as to collect on a personal debt, to gain an advantage in pending litigation, or to harass the debtor—act in bad faith.”  Id. at *2.