All three judges on an Eighth Circuit panel agreed that a debtor who wins dismissal of an involuntary petition under Section 305(a)(1) may obtain damages under Section 303(i), even though Section 305(a)(1) has no provisions for damages.

The majority on the circuit panel did not reach the question of whether federal law preempts state law claims for dismissal of an involuntary petition. The dissenter would have ruled that preemption bars claims of the sort under state law.

Before bankruptcy, the debtor had hired a law firm to sue two of his customers. After the law firm ran up $300,000 in fees and allegedly “accomplished almost nothing,” the debtor fired the law firm and hired someone else.

Rather than sue to collect unpaid fees, the law firm filed an involuntary bankruptcy petition against the debtor. Instead of filing a motion to dismiss under Section 303(i), the debtor moved to dismiss under Section 305(a)(1), which is titled “Abstention.” The debtor contended that dismissal would better serve “the interests of creditors and the debtor,” the standard under Section 305(a)(1).

When asked by the bankruptcy court why the debtor was moving under Section 305 rather than Section 303, the debtor’s counsel said that a Section 303 dismissal would require notice to all creditors under Section 303(j), while Section 305 does not require broad notice. The debtor believed that broad notice would entail reputational damage.

The bankruptcy court dismissed the involuntary petition under Section 305. Later, the debtor moved in bankruptcy court for the imposition of attorneys’ fees and costs under Section 303(i)(1), but the bankruptcy court dismissed, ruling that dismissal under Section 305 does not permit damages under Section 303(i).

Around the same time, the (former) debtor sued the law firm in federal district court on diversity jurisdiction, raising state law tort claims, like abuse of process, for filing a frivolous involuntary bankruptcy petition. The district court dismissed the suit, believing that federal law preempted the state law claims.

The debtor appealed the district court’s dismissal to the Eighth Circuit. [Note to readers: We have truncated the procedural history.]

Section 303 Damages Ok Under Section 305

In his August 13 opinion, Circuit Judge James B. Loken ducked the question of preemption. Instead, he said:

[I]t [is] obvious from the structure and purpose of § 303 that Congress intended that the federal court that dismisses an involuntary case has exclusive jurisdiction to enforce the debtor remedies provided in § 303, including remedies for bad faith filings under § 303(i), and for fraudulent filings under § 303(k)(1).

However, Judge Loken saw “no reason why state tort law is irrelevant in determining whether a petitioning creditor’s harassing involuntary petition was a ‘bad faith’ filing.”

Judge Loken went on to hold “that a dismissal in the best interests of creditors under § 305(a)(1) does not preclude an involuntary debtor’s subsequent damages claim under § 303(i)(2).” He then said that federal courts “will look to state tort law principles in determining an issue such as bad faith.”

In short, Judge Loken found exclusive federal jurisdiction, not federal preemption.

Judge Loken upheld dismissal in the district court, because the debtor had not appealed the bankruptcy court’s decision that damages under Section 303 are not available when dismissal was granted under Section 305.

The Concurrence

Chief Circuit Judge Steven M. Colloton concurred in the judgment, but he had different ideas about some of the underlying issues.

Judge Colloton would have agreed with the district court and would have dismissed by holding that the state law claims were preempted.

However, Judge Colloton agreed with the majority that damages under Section 303 are available if there is a Section 305 dismissal.