Exceptions to Involuntary Petition Requirements Are You Pushing Your Luck

The Bankruptcy Code provides a vehicle of relief for creditors whose debtor refuses
to face reality: the ability to file an involuntary bankruptcy petition under 11
U.S.C. §303. While the Code sets forth the circumstances and requirements for
filing an involuntary petition, certain courts have deviated from the express requirements
of the Code and created a "special circumstances" judicial exception. As demonstrated
below, not all courts recognize this exception in all its forms, and the wise
practitioner should examine the local case law carefully.

Involuntary Petitions Under the Bankruptcy Code

Pursuant to 11 U.S.C. §303, an involuntary bankruptcy case under chapter 7
or 11 may be commenced against an individual or entity that may be a debtor under
the chapter under which such case is commenced. Generally, an involuntary case is
commenced by the filing of a petition:

1. by three or more entities, that hold claims that are not contingent or subject
   to bona fide dispute if the claims of such entities aggregate at least
   $10,775 more than the value of any lien on property securing such claims;
   or
2. if there are fewer than 12 claim holders, by one or more of such holders
   that hold in the aggregate at least $10,775 of such claims.

See 11 U.S.C. §303(b).

Section 303 further states that the court shall order relief against the debtor
only if:

1. the debtor is generally not paying its debts as such debts become due, unless
   such debts are the subject of a bona fide dispute; or
2. within 120 days before the petition date, a custodian was appointed or took
   possession of substantially all of the debtors' property.

See 11 U.S.C. §303(h).

Thus, §303 provides for the specific circumstances and requirements for filing an
involuntary bankruptcy case. Considering the express language of §303, one would
think that under no other circumstances could a creditor file an involuntary bankruptcy
case. It is easy to imagine circumstances under which a debtor could avoid an
involuntary bankruptcy by careful "anti-involuntary" planning—i.e., fraudulent transfers
and other schemes. In fact, such circumstances have occurred, and courts have held
that such special circumstances may justify the filing of an involuntary bankruptcy case
regardless of §303's express requirements.

Special Circumstances Deviating from the Requirements of §303

An involuntary bankruptcy case may be filed without the petitioning creditors meeting
the specific requirements of §303. For example, if a sole creditor would be
without adequate remedy of law, or special circumstances amounting to fraud, trick,
artifice or scam exist, then a single creditor with only proof of a default may file
an involuntary petition. See In the Matter of 7H Land & Cattle Co., 6
B.R. 29 (Bankr. D. Nev. 1980).

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[S]ection 303 provides for the specific
circumstances and requirements for filing an
involuntary bankruptcy case.

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In 7H Land & Cattle, the petitioning creditor was the only creditor of the
alleged debtors. The creditor filed an involuntary petition based on the debtors'
default on a promissory note to the creditor. The debtors asserted, however, that
the default upon the promissory note did not constitute a finding that they were not
generally paying their debts as they became due.

In its determination, the court reviewed the reasoning of certain cases under
Canadian insolvency law, which addressed similar circumstances. In doing such, the
court held that despite the express language of the Code, special circumstances may
exist that justify the filing of an involuntary bankruptcy petition. See 7H Land &
Cattle, 6 B.R. at 32. These special circumstances include when "a sole creditor
cannot possibly obtain adequate relief in the ordinary courts without resorting to the
bankruptcy court," and when "the debtors, by some scam, artifice, trick or fraud,
were using uncollectible deposits to pay other creditors." See Id., 6 B.R. at
32-3.

Similarly, the Sixth Circuit has approved the "fraud, artifice or scam" exception.
See Concrete Pumping Services Inc. v. King Construction Co. Inc., 943
F.2d 627 (6th Cir. 1991). In Concrete Pumping, the single petitioning
creditor obtained a state court judgment against the debtor. The debtor had allegedly
received numerous loans from its president, who collateralized such loans after entry
of the judgment. The debtor subsequently "defaulted" on these loans and all of the
debtor's assets were surrendered to the debtor's president.

The debtor's president then started a new company that performed the same service
as the debtor, using the same equipment and trade vendors. In fact, the new company
paid all of the debtor's creditors, except for the petitioning creditor. Thus, the
debtor had no remaining creditors, except for the petitioning creditor, which filed
an involuntary bankruptcy petition.

The bankruptcy court denied the debtor's motion to dismiss and entered an order
for relief, which the district court affirmed. The Sixth Circuit observed that
courts "have developed an almost per se rule against granting a petition for
involuntary bankruptcy where there is only a single creditor." See Concrete Pumping,
943 F.2d at 629; citing In re Smith, 123 B.R. 423, 425
(Bankr. M.D. Fla. 1990). The Sixth Circuit then noted that courts
applying the "single creditor rule" also developed an exception where evidence of
"fraud, artifice or scam" exists. See Concrete Pumping, 943 F.2d at 630;

citing In re Smith, 123 B.R. at 426.

Despite its acknowledgement of the "special circumstances" exception, the Sixth
Circuit also considered the factual determination of whether the debtor was generally
not paying its debts as they became due using the totality of the circumstances test.
In doing so, the court held that the debtor was 100 percent in default upon
100 percent of its creditors. Id. Thus, while certain decisions purport to adopt
the "special circumstances" exception, none contain findings that would otherwise prevent
the entry of an order for relief. Indeed, in both 7H Land and Cattle and
Concrete Pumping, the single creditor had debts exceeding $10,000 from debtors
with less than 12 creditors. See 11 U.S.C. §303(b)(2).

Other courts, however, have developed the "special circumstances" exception, even
where the debtor was generally paying its debts as they became due. See In re Moss,
249 B.R. 411, 424 (Bankr. N.D. Tex. 2000); citing In re
Norriss Brothers Lumber Co. Inc., 133 B.R. 599 (Bankr. N.D. Tex.
1991). In Moss, the court found that the debtor had 12 or more creditors,
but that the petitioning creditors held only two claims. Therefore, the involuntary
petition was defective. The court did not dismiss the involuntary petition, however,
because of the existence of special circumstances in the form of preferential and
fraudulent transfers. Id. at 424; citing In re Norriss Brothers Lumber Co.
Inc., 133 B.R. 599, 608-09 (Bankr. N.D. Tex. 1991) (where
the court held that arguable fraudulent conveyances and arguable preferential transfers
constituted special circumstances that justified the lack of three creditors).

The debtor asserted that the special-circumstances exception was not applicable because
courts developing the exception only applied it to single-creditor cases when analyzing
whether the debtor generally failed to pay debts, and that expansion to the
three-creditor rule of §303(b)(1) was unwarranted. Citing In re Rothery,
211 B.R. 929, 934-35 (9th Cir. BAP 1997), rev'd. on other
grounds, 143 F.3d 546 (9th Cir. 1998) (which refused to follow
Norriss). The court held, however, that if one exception to the technical
requirements of §303 existed, then that exception applied to the other technical
requirements as well. Moss, 249 B.R. at 424.

Despite the early development of the special-circumstances exception, where its
application was questionable, the later applications have truly developed the exception.
As demonstrated, however, the special-circumstances exception is not recognized by all
courts. Nonetheless, the special-circumstances exception is developing a growing body
of support. See Matter of Wagner, 53 B.R. 93 (Bankr. W.D. Wis.
1985); In re H.I.J.R. Properties Denver, 115 B.R. 275 (D.
Colo. 1990); In re Blain Richards & Co., 16 B.R. 362,
365-66 n. 4 (Bankr. E.D.N.Y. 1982). The cases add to the arsenal
creditors have in forcing reluctant debtors into facing their own insolvency.

To further complicate the involuntary arena, the court in In re Fales, 73
B.R. 44 (Bankr. S.D. Ohio 1987) placed an interesting twist on the
Bankruptcy Code's abstention provisions. In Fales, the court determined that even
though the basis for an involuntary case was established, §305 required consideration
of whether dismissal would better serve the interests of creditors and the debtor.
Id. at 46; citing In re Tarletz, 27 B.R. 787, 793 (Bankr. D.
Colo. 1983). Due to the existence of state law remedies that were unavailable
in a bankruptcy proceeding, the court therefore dismissed the involuntary petition.

Id. at 47; see, also, In re Arker, 6 B.R. 632 (Bankr. E.D.N.Y.
1980); rev'd., Crown Heights Jewish Community Council Inc. v. Fischer,
202 B.R. 341 (Bankr. E.D.N.Y. 1996) (stating that an order for
relief should be granted in the exceptional case of an alleged debtor with a sole
creditor who would otherwise be without an adequate remedy under non-bankruptcy law).

While the Fales decision seems lacking in codified support, equity does support such
a conclusion. Further, when considering that the "special circumstances" arguments are
equally lacking in codified support, the Fales holding makes sense.

Conclusion

The special-circumstances exception is judicially created with no codified support.
One should take further notice that many courts addressing the special-circumstances
exception also made findings that supported the filing of an involuntary petition.

Practitioners must also remember the consequences of filing an involuntary petition
that is later dismissed. Particularly when bad faith is found, the results can be
harsh. They include recovering actual and punitive damages as well as attorney's fees.
Research into the applicable circuit and/or district's precedent on this issue is not
only advisable, but a must.