Equity Can’t Alter the Three Petitioning Creditors Requirement, First Circuit Rules

Courts may not disregard the numerosity requirement for an involuntary petition based on “special circumstances,” even if the debtor has defrauded creditors, the First Circuit ruled.

Two bank lenders filed an involuntary petition against a doctor. At trial, the debtor established to the satisfaction of the bankruptcy court that he had 15 creditors. Rather than dismiss the petition for lack of at least three petitioning creditors as required by Section 303(b)(1), the bankruptcy court allowed the creditors to conduct discovery to establish whether there were “special circumstances” allowing the entry of an order for relief in the absence of a third petitioning creditor.

Bankruptcy Judge Enrique S. Lamoutte subsequently concluded there were “special circumstances” arising from the debtor’s “scheme to misrepresent his financial condition.” In re Reyes-Colon, 558 B.R. 563, 565 (Bankr. D.P.R. 2016). Still, Judge Lamoutte dismissed the petition for the lack of at least three petitioning creditors.

On the banks’ appeal, the district court determined that the debtor had fewer than 12 creditors. Because the bankruptcy court had found that the debtor was generally not paying his debts, the district court reversed and ordered the entry of an order for relief.

The debtor appealed to the First Circuit and won a reversal in an April 24 opinion by Circuit Judge William J. Kayatta, Jr.

With regard to numerosity, Judge Kayatta in substance concluded that the district court had misapplied the burden of proof.

The debtor had filed a motion for summary judgment in bankruptcy court, attaching an expert’s report listing 22 creditors. The banks argued that the debtor assumed the burden of proof to showing the existence of 12 or more creditors by having filed the motion for summary judgment.

To the contrary, Judge Kayatta said that filing the motion for summary judgment did not alter the burden of proof. By giving some evidence that he had more than 12 creditors, the burden fell on the creditors to prove that the debtor had fewer than 12. Because the banks presented no evidence in bankruptcy court to counter the debtor’s prima facie showing, the circuit court upheld the bankruptcy court’s finding that the debtor had at least 12 creditors.

To salvage the order for relief, the banks argued for an “equitable exception” to the numerosity requirement, because the debtor had schemed to defraud creditors. The lenders based their argument on Marrama v. Citizens Bank of Massachusetts, 549 U.S. 365, 375–76 (2007), where the Supreme Court said that bankruptcy courts have “inherent power” to sanction abusive litigation practices.

However, Judge Kayatta chose to follow the high court’s more recent authority,

Law v. Siegel, 571 U.S. 415 (2014). The Supreme Court, he said, held that “bankruptcy courts ‘may not contravene specific statutory provisions’ when they exercise their statutory and inherent powers.” More specifically, the Court ruled that the bankruptcy court could not invoke equitable powers to invade a debtor’s exempt property to pay an administrative claim.

Judge Kayatta cautioned that Law does not oust the bankruptcy court of discretion “in all circumstances.” Rather, he said, the bankruptcy court cannot override “‘specific mandates of other sections of the Bankruptcy Code.’” Id. at 421.

In the case on appeal, Judge Kayatta said the bankruptcy court “would have plainly contravened Section 303(b) if it bypassed the involuntary petition’s creditor numerosity deficiency via the ‘special circumstances’ doctrine.”

Reversing the district court and upholding the bankruptcy court’s dismissal of the involuntary petition, Judge Kayatta said that Law “provides no basis for simply deeming the creditor numerosity requirement to be inapplicable.”

N.B.: Appellate practice mavens should read the opinion in full text. Judge Kayatta discusses circumstances when a party may not have waived an issue on appeal by failing to discuss the topic in the intermediate appellate court or by relying on the opinion of the trial court.