The Jurisdiction Debate In Involuntary Bankruptcy Cases

The Jurisdiction Debate in Involuntary Bankruptcy Cases: Are the Section 303(b) Requirements Jurisdictional in Nature?

Written By: Akiva Leeder [email protected]

Introduction

A split between the circuits has developed regarding whether the requirements for commencing an involuntary bankruptcy case set forth in section 303(b) of the Bankruptcy Code are subject matter jurisdictional in nature. While there are arguments supporting both views, the stronger position is that these requirements are not subject matter jurisdictional and therefore can be waived. Though voluntary bankruptcy filings vastly outnumber involuntary filings,1 the ability of creditors to force or at least threaten to force an alleged debtor into bankruptcy is still an important concern. As Thomas H. Jackson noted in The Logic and Limits of Bankruptcy Law,2 while bankruptcy law can be viewed on the one hand as a tool that allows debtors to discharge their debts, “Most of bankruptcy law is concerned with … providing a compulsory and collective                                                          1

See David S. Kennedy, James E. Bailey, III & R. Spencer Clift, III, The Involuntary Bankruptcy Process: A Study of the Relevant Statutory and Procedural Provisions and Related Matters, 31 U. MEM. L. REV. 1, 3 (2000) (noting that in 1998 less than 1/1000 of one percent of all bankruptcy cases filed were involuntary). 2 Thomas H. Jackson, The Logic and Limits of Bankruptcy Law (1986), reprinted in FOUNDATIONS OF BANKRUPTCY LAW, 77, 78 (Barry E. Adler ed., 2005).

 

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forum for satisfying the claims of creditors.” Recognizing the dual aims of bankruptcy, the Bankruptcy Code seeks to establish a balance between the interests of an alleged debtor in avoiding the demands of bankruptcy with the interests of creditors whose debts are not being paid by allowing such creditors to force an insolvent debtor into bankruptcy. A creditor may find it necessary to file an involuntary petition when, for example, the creditor seeks to avoid a preferential transfer made by the alleged debtor to another creditor. The ability to file an involuntary petition can also provide strategic advantages for the petitioning creditor, not least of which is the ability to select the bankruptcy forum. However, a creditor’s right to file an involuntary petition must be used with caution. In addition to stringent filing prerequisites,3 petitioning creditors in an involuntary bankruptcy action may be subjected to penalties, including attorneys’ fees, if the petition is dismissed without the consent of all parties and the debtor does not waive its right to judgment.4 The debtor in an involuntary bankruptcy petition case may contest the petition within twenty-days,5 which will cause the court to hold a hearing where the creditors must establish that relief is warranted.6 However, should the alleged debtor fail to contest the petition within twenty-days, the bankruptcy court will enter an order of relief by granting the petition.7 While seemingly straightforward, debtors have attempted to avoid this limited window of reply by attacking the subject matter jurisdiction of the bankruptcy court. Since an attack on a federal court’s subject matter jurisdiction can be made at any time,8 forcing the court to dismiss

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See 11 U.S.C. §§303 (a) – (c) (2006). See 11 U.S.C. §303 (i) (2006). 5 See FED. R. BANKR. P. 1011. 6 See FED. R. BANKR. P. 1013(a). 7 See FED. R. BANKR. P. 1013(b). 8 See FED. R. CIV. P. 12(h)(3). 4

 

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the action if successful, this presents a powerful tool for an alleged debtor who failed to timely contest a petition. Specifically, some alleged debtors have argued that the requirements for commencing an involuntary bankruptcy laid out in §303(b) of the Bankruptcy Code are jurisdictional in nature.9 By framing these requirements as jurisdictional, an alleged debtor may attack the authority of the bankruptcy court to adjudicate the matter. If true, this would mean that the §303(b) requirements cannot be waived, such as by a failure to contest, and thus may be attacked at any time. This question of subject matter jurisdiction has created a circuit split primarily between the Eleventh10 and Ninth11 Circuits, which hold that the §303(b) requirements are not subject matter jurisdictional in nature, and the Second Circuit,12 which holds that they are. To determine which Circuit has the better position, it is important to understand the purpose and uses of the involuntary bankruptcy proceeding, the underpinnings of bankruptcy court jurisdiction, the relation between subject matter jurisdiction and a substantive element of a claim, as well as the practical effects each view would have in the market.

I. Statutory Framework for Involuntary Cases

Section 303 of the Bankruptcy Code lays out several requirements regarding who may file an involuntary bankruptcy petition and who may be the target of such a petition.13 Section 303(a) provides that “an involuntary case may be commenced only under chapter 7 or 11,” and                                                          9

See In re Trusted Net Media Holdings, LLC, 550 F.3d 1035 (11th Cir. 2008). See Id. 11 See In re Rubin, 769 F.2d 611 (9th Cir. 1985).  12 See In re BDC 56 LLC, 330 F.3d 111 (2d Cir. 2003). 13 See 11 U.S.C. §303 (2006). 10

 

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forbids the involuntary filing against a farmer, non-commercial corporation, and by definition any party ineligible for a voluntary chapter 7 or 11 filing.14 Section 303(b) lays out specific requirements for the creditors filing involuntary petitions, which are often referred to as the “Petitioning Creditors.”15 Specifically, the pertinent part of §303(b)16 states that: An involuntary case against a person is commenced by the filing with the bankruptcy court of a petition under chapter 7 or 11 of this title – (1) by three or more entities, each of which is either a holder of a claim against such person that is not contingent as to liability or amount, or an indenture trustee representing such a holder, if such noncontingent, undisputed claims aggregate at least $13,475 more than the value of any lien on property of the debtor securing such claims held by the holders of such claims; (2) if there are fewer than 12 such holders, excluding any employee or insider of such person and any transferee of a transfer that is voidable under section 544, 545, 547, 548, 549, or 724(a) of this title, by one or more of such holders that hold in the aggregate at least $13,475 of such claims While much litigation has addressed what is required to establish the elements of §303(b) (e.g., what a “bona fide dispute” is), few reported Court of Appeals decisions have addressed the jurisdictional threshold question of §303(b). Specifically, only the Second, Ninth, and Eleventh Circuits have addressed whether a petitioning creditor’s failure to establish the requirements of §303(b)(1) and/or (2) denies the bankruptcy court subject matter jurisdiction over the matter. Though rarely the subject of academic debate, the position that these elements must be established for subject matter jurisdiction to exist has been offered by at least one                                                          14

See Id. §303(a). 2 ALAN N. RESNIK & HENRY J. SOMMER, COLLIER ON BANKRUPTCY ¶ 303.03[1] (15th rev. ed. 2008) (noting that “‘petitioning creditor’ [may] refer to those who commence an involuntary case, whether the statute authorizes then to do so or not”). 16 11 U.S.C. §303(b)(2006). 15

 

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commentator.17 However, this same commentator in a different publication would seem to support the opposite conclusion by stating that the requirements of §303 “are not jurisdictional in the sense of subject matter jurisdiction, but are substantive matters which may be waived, and which must be proved if put in issue.”18 The confused state of the law on this question is evidenced by the contradictory positions taken in different treatises published by the Norton family.

II. The Second Circuit Position

The Second Circuit addressed the issue in In re BDC 56 LLC,19 a case involving the construction of a hotel owned and managed by alleged debtor, BDC.20 After the general contractor, HRH, suspended work during construction, the subcontracts, including that of the petitioning creditor Key, were assigned to BDC.21 Key claimed that it had substantially performed and was owed $231,938, while BDC claimed “Key’s work was defective and incomplete and insisted that Key complete performance.”22 BDC ultimately hired another contractor to complete the work, after which Key joined with other subcontractors in filing an involuntary petition.23 After the bankruptcy court found there to be a bona fide dispute between BDC and Key, it granted BDC’s motion for summary judgment and dismissed the petitioning                                                          17

WILLIAM L. NORTON JR. & WILLIAM L NORTON III, NORTON BANKRUPTCY RULES, FED. R. BANKR. P. 1011 cmt. (d) (2008) (noting that whether a debtor is “amenable to an involuntary petition, is a question of subject matter jurisdiction, and therefore, may be raised at anytime”). 18 See WILLIAM L. NORTON JR. & WILLIAM L NORTON III, NORTON BANKRUPTCY LAW AND PRACTICE §22:1 (3d ed. 2008). 19 330 F.3d 111 (2d Cir 2003). 20 See Id. at 114.  21  Id.  22 Id. 23 Id. at 115.

 

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creditors’ subsequent motion for reconsideration.24 As the lack of a bona fide dispute is an element of §303(b), the Second Circuit took the opportunity to address whether this requirement was jurisdictional in nature.25 The Second Circuit held that “the requirement that a petitioning creditor’s claim not be subject to a bona fide dispute” is subject matter jurisdictional.26 The court went on to state that determining “whether an alleged debtor is properly before the bankruptcy court in an involuntary case is a threshold determination,” and “any creditor wishing to invoke the bankruptcy court’s jurisdiction in an involuntary case should be required to demonstrate” that its claims “are free from bona fide dispute.”27 The court also noted that this is a “threshold determination that should be made at the earliest possible stage of the proceedings.”28 From this it could be reasoned that a petitioning creditor’s failure to demonstrate other requirements of §303(b), such as the satisfaction of a contingency, would also strip the bankruptcy court of subject matter jurisdiction. The Second Circuit’s opinion relied primarily on preventing petitioning creditors from abusing the ability to file an involuntary petition. The court gave as an example the hypothetical situation of a creditor hauling a “solvent debtor with whom they have legitimate disputes into bankruptcy court, [forcing the debtor] to defend an involuntary proceeding,” while leaving until later the determination of whether the debtor is properly before the court.29 Since the opinion did

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Id. at 116. See Id. at 118. 26 See Id. 27 Id. 28 Id. at 118 (quoting In re Elsa Designs, Ltd., 155 B.R. 859, 863 (Bankr. S.D.N.Y 1993)). 29 Id. at 119. 25

 

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not offer further justifications, nor explain why the Ninth Circuit’s view was flawed,30 it would seem the Second Circuit’s main concern is in preventing petitioning creditors from using claims which may have legitimate disputes as the basis for coming under the jurisdiction of a bankruptcy court.

III. The Eleventh Circuit Position

Several years later in In re Trusted Net Media Holdings, LLC,31 the Eleventh Circuit, sitting en banc, took the opposite approach from the Second Circuit in holding that the requirements of §303(b) are not subject matter jurisdictional.32 In doing so, the Eleventh Circuit sided with the Ninth Circuit which held that although “petitioning creditors cannot prevail unless they show that their claims are not subject to bona fide disputes, . . . the bankruptcy court is not without jurisdiction prior to this determination.”33 The case involved an involuntary filing by The Morrison Agency, Inc. (“Morrison”), a creditor of Trusted Net Media Holdings, LLC (“Trusted Net”), and the subsequent denial of Trusted Net’s motion to dismiss.34 After Morrison filed the involuntary petition and Trusted Net failed to file a response, the bankruptcy court entered an order for relief and appointed a Chapter 7 trustee.35 About two years later, an officer and controlling member of Trusted Net, David W. Huffman, who was himself a creditor of Trusted Net as to his deferred salary, filed a motion to                                                          30

See Id. at 118 (noting that the Ninth Circuit found the bona fide dispute requirement of to be an element to sustain an involuntary proceeding as opposed to a jurisdictional requirement, but failing to address why that view in untenable) 31 550 F.3d 1035 (11th Cir. 2008). 32 See Id. at 1046. 33 Id. at 1041 (citing In re Rubin, 769 F.2d 611 (9th Cir. 1985)). 34 Id. at 1037-38. 35 Id. at 1037.

 

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dismiss the bankruptcy case arguing that Morrison’s claim “was subject to a bona fide dispute,” and the “single-creditor petition was insufficient because Trusted Net had twelve or more creditors holding non-contingent, undisputed claims.”36 The bankruptcy court denied the motion after a hearing and no appeal was taken.37 About two years after that, the bankruptcy court approved, over Huffman’s objections, a settlement with five of Trusted Net’s creditors, one of which was Morrison.38 Thereafter, “Trusted Net (through counsel retained at Huffman’s behest) filed a motion to dismiss the entire bankruptcy case for lack of subject matter jurisdiction,”39 which made the same claims as Huffman’s original motion to dismiss. After the bankruptcy court denied this motion and the district court affirmed, the Eleventh Circuit took the opportunity to fully explain why the elements of §303(b) are not subject matter jurisdictional.40 After briefly acknowledging the Second Circuit’s position that the requirements of §303(b) are subject matter jurisdictional,41 the Eleventh Circuit conducted a more thorough analysis and ultimately concluded the opposite. The Eleventh Circuit reached its conclusion by comparing the Supreme Court’s treatment of subject matter jurisdiction with regard to Title VII to the Bankruptcy Code,42 analyzing the jurisdictional grant in Title 28, and exploring the Congressional intent behind §303(b). The Eleventh Circuit relied heavily on Arbaugh v. Y&H Corp.,43 in which the Supreme Court had to determine whether Title VII’s requirement that a company have fifteen employees

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Id. at 1037-38. Id. at 1038. 38 Id. 39 Id. 40 Id. 41 See Id. at 1041.  42 See Arbaugh v. Y&H Corp., 546 U.S. 500 (2006). 43 Id. 37

 

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in order to be deemed an “employer” under the statute44 was a jurisdictional question. The Supreme Court took the opportunity in deciding Arbaugh to announce a “bright line” rule of statutory interpretation: “when Congress does not rank a statutory limitation on coverage as jurisdictional, courts should treat the restriction as nonjurisdictional in character.”45 As applied to Title VII, the Supreme Court held that the “threshold number of employees for application of Title VII is an element of a plaintiff’s claim for relief, not a jurisdictional issue.”46 In reaching its decision, the Supreme Court noted that the text of the statute did not indicate that “Congress intended courts, on their own motion, to assure that the employeenumerosity requirement is met.”47 They also noted that the employee threshold appears in a separate provision of Title VII from the jurisdictional provision and interpreting the employeenumerosity requirement as subject matter jurisdictional would entail “unfairness” and a “waste of judicial resources.”48 Specifically, the Court relied on the district court’s reasoning that “it is unfair and a waste of judicial resources to permit the defendant to admit Arbaugh's allegations of jurisdiction, try the case for two days and then assert a lack of subject matter jurisdiction in response to an adverse jury verdict."49 In applying the Arbaugh test to the facts of In re Trusted Media Holdings, LLC, the Eleventh Circuit reasoned that like the employee-numerosity requirements in Title VII, §303(b) of the Bankruptcy Code does “not speak in jurisdictional terms,” and that there is a separate jurisdictional grant in Title 28,50 which “authoriz[es] bankruptcy courts to hear and determine

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42 U.S.C. §2000(e)(2)(B) (2006). 546 U.S. at 516. 46 Id. 47  Id. at 514.  48 Id. at 516 (citing Brief for the Petitioner). 49 Brief for the Petitioner at 33, Arbaugh v. Y & H Corporation, 546 U.S. 500 (2006) (04-944). 50 See 28 U.S.C. §§ 157, 1334 (2006). 45

 

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‘any or all cases under Title 11 … or arising in or related to a case under Title 11.’”51 Since involuntary bankruptcy cases “unquestionably arise” under Title 11, the Eleventh Circuit found that such cases “fall within the congressional grant of subject matter jurisdiction to the bankruptcy courts.”52 The court went on to state that there is “no indication from the text of §303 that Congress intended bankruptcy courts to consider sua sponte at any point in the proceedings whether the involuntary petition filing requirements have been met.”53 Finally, the court found that “§303(c) suggests that Congress did not intend the §303(b) requirements to be necessary to the bankruptcy court’s subject matter jurisdiction”54 since §303(c) allows creditors to join an involuntary petition “before the case is dismissed or relief is ordered.”55 As this section “grants the court power to permit one or more creditors to join a petition that may otherwise be dismissed,” the court found it “anomalous at best to conclude that a bankruptcy court . . . may create jurisdiction for itself by permitting additional creditors to join the petition.”56

IV. Resolution

In Arbaugh, the Supreme Court quoted a Second Circuit decision, Da Silva v. Kinsho International Corp.,57 for the proposition that judicial opinions “often obscure the issue by stating that the court is dismissing ‘for lack of jurisdiction’ when some threshold fact has not been established, without explicitly considering whether the dismissal should be for lack of                                                          51

Trusted Net, 550 F.3d at 1043-44. Id. at 1044. 53 Id. 54 Id. 55 11 U.S.C. §303(c). 56 550 F.3d at 1044-1045. 57 229 F.3d 358 (2d. Cir 2000). 52

 

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subject matter jurisdiction or for failure to state a claim.”58 Though the issue in Da Silva was the same issue presented in Arbaugh - whether Title VII’s employee-numerosity requirement is jurisdictional - it is interesting that the In re BDC 56 LLC court did not heed the warning laid out in Da Silva. The Supreme Court’s acknowledgement in Arbaugh that courts “have been less than meticulous” in distinguishing between these issues suggests that a cursory treatment of the matter may lead to an erroneous conclusion.59 While the concerns the Second Circuit relied on in In re BDC 56 LLC have some merit, they alone do not justify reading the requirements of §303(b) to be subject matter jurisdictional in nature. Even before considering the impact of the Arbaugh test on the Second Circuit’s position, it must be noted that the Bankruptcy Code already limits the ability of creditors to abuse the bankruptcy system by wrongly invoking its powers. The alleged debtor in an involuntary bankruptcy gets all the benefits of bankruptcy, such as the automatic stay,60 while the petitioning creditor’s advantages are likely limited to choice of venue and the ability to add certain pre-petition transfers to the property of the estate. Further, the creditor who does the legwork in filing the petition is no better off than the other unsecured creditors of the alleged debtor who get to participate in the ensuing bankruptcy case. In fact, a petitioning creditor runs the risk of paying fees if the bankruptcy court dismisses the involuntary petition in favor of the debtor,61 or punitive damages if the court finds that the petitioning creditor filed the petition in bad faith.62 These disincentives should prevent potential petitioning creditors from filing involuntary petitions against alleged debtors on “the basis of relatively                                                          58

Id. at 361. See 546 U.S. at 511. 60 See 11 U.S.C §362 (2006). 61 See id. §303(i)(1). 62 See id. §303(i)(2). 59

 

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untested claims,”63 and likely help account for the relatively low occurrence of involuntary filings. The Second Circuit’s position is even harder to justify in light of the Arbaugh decision. Critical to the Supreme Court’s analysis in Arbaugh was the fact that the employee-numerosity requirement in Title VII appears in a provision separate from that authorizing federal jurisdiction over Title VII claims.64 Similarly, the jurisdictional grant for bankruptcy related matters appears in separate provisions65 from the requirements for commencing an involuntary case.66 The Second Circuit’s failure to explain how the requirements of §303(b) can be jurisdictional despite the lack of jurisdictional language and the existence of separate provisions67 in the U.S. Code dealing with the jurisdiction of bankruptcy courts means it would likely fail the “bright line” rule delineated in Arbaugh.68 Once the Arbaugh decision is taken into account, it is hard to see how the Second Circuit would decide In re BDC 56 LLC the same way again. Should this question ever be litigated all the way to the Supreme Court, it is likely that the Court would endorse the Eleventh Circuit’s position and hold that the requirements of §303(b) are not subject matter jurisdictional in nature and therefore can be waived.

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330 F.3d at 118. See 546 U.S. at 515. 65 See 28 U.S.C. §§ 157, 1334 (2006). 66 11 U.S.C §303(b) (2006). 67 28 U.S.C. §§ 157, 1334 (2006). 68 See 546 U.S. at 516. 64

 

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