In today’s economic climate, it is not uncommon for law firms to encounter trouble collecting outstanding legal fees. Although not preferred, law firms may ultimately have no choice but to commence collection actions against former clients. It is uncommon, however, for law firms to commence involuntary bankruptcies against former clients to recover unpaid fees.
Involuntary bankruptcy petitions remain quite rare, mainly because there are potentially serious risks and penalties associated with the filing of such. The recent case of In re Skyworks Ventures Inc.[1] provides a cutting example for when those risks are ignored. The Skyworks court dismissed an involuntary petition filed by the debtor’s former law firm and ruled that the debtor company was entitled to its reasonable attorneys’ fees and costs, as well as punitive damages. The Skyworks decision provides a sobering lesson that a creditor, including a law firm, should thoroughly examine the risks associated with filing an involuntary bankruptcy petition before using it to collect an outstanding debt.
Background
Scarola Ellis LLP had an attorney-client relationship with Skyworks Ventures Inc. (Ventures) for about two years. Despite paying more than $900,000 in legal fees to Scarola during the approximately two-year period, Ventures continually complained about Scarola’s high legal fees. At the moment Scarola terminated the relationship, Scarola alleged that roughly $200,000 remained unpaid in legal fees.
To recover those fees, Scarola filed suit against Ventures in the District Court for the Southern District of New York. Scarola’s complaint also named Ventures’s subsidiary, Skyworks Interactive Inc. (Interactive), as a defendant. In response, Ventures mailed to Scarola—but did not file—a draft answer, which included several counterclaims directly against Ventures's claims. Thereafter, with settlement discussions having failed, Scarola voluntarily dismissed the action, only to re-file a similar suit some six days later (the “second action”). Scarola, though, failed to ever serve the summons and complaint for the second action on Venures.
Meanwhile, Interactive itself was facing financial difficulties, which culminated when seven of its creditors filed an involuntary petition against it in March 2010 (the “Interactive involuntary bankruptcy”). Notably, Scarola was not a petitioning creditor, but believing that it was a true creditor, Scarola filed a notice of joinder to the Interactive involuntary bankruptcy.
Scarola’s joinder proved futile because Interactive reached a settlement with the original petitioning creditors. Scarola was not a party to this settlement. Despite Scarola’s objection, U.S. Hon. Raymond T. Lyons approved the settlement and permitted the Interactive involuntary bankruptcy to be dismissed. Dissatisfied with this result and notwithstanding the pending second action, Scarola filed an involuntary bankruptcy against Ventures (the “Ventures involuntary bankruptcy”).
The Holding
Section 303(b) of the Bankruptcy Code provides, in part, that an involuntary petition may be filed by either (1) three or more creditors with claims that are not the "subject of a bona fide dispute as to liability or amount,"[2] or (2) one or more creditors holding a minimum amount in claims, if fewer than 12 creditors exist.[3]
In its motion to dismiss the Ventures involuntary bankruptcy, Ventures argued that Scarola satisfied neither condition. Judge Lyons dismissed the Ventures involuntary bankruptcy. Pursuant to § 303(i)(1), if an involuntary petition is dismissed, the court has discretion to award costs and attorneys’ fees against a petitioning creditor. If a finding of bad faith is made, compensatory and punitive damages may also be awarded pursuant to § 303(i)(2). Thus, Judge Lyons considered the application of§ 303(i) to the facts presented.
Attorneys’ Fees and Costs
Judge Lyons observed that the “historical policy of bankruptcy law is to serve as a collective debt-collection device for the benefit of creditors as a group.”[4] As the sole petitioning creditor and with the second action pending, Scarola did not conform to that policy. Instead, Judge Lyons found that Scarola’s motive for filing was a “litigation tactic” to “shortcut” the second action and force settlement.
Judge Lyons additionally recognized the nexus between Scarola’s exclusion in the Interactive involuntary bankruptcy and its filing of the Ventures involuntary bankruptcy. As such, Judge Lyons “infer[red]” that Scarola improperly filed the Ventures involuntary bankruptcy, hoping to induce a payment on its disputed claim. Therefore, adopting the majority rule that fees and costs are awarded upon the dismissal of an involuntary petition, Judge Lyons awarded Ventures its attorneys’ fees and costs.
Finding of Bad Faith Permits Compensatory and Punitive Damages
In addition to costs and fees, the Bankruptcy Code provides that the court may award compensatory and punitive damages against a petitioner who filed in bad faith.[5] As noted by Judge Lyons, “[t]he totality of circumstances should be considered in determining whether the petitioner acted in bad faith including whether the petition was filed for an improper use or purpose and the subjective and objective motives.” Judge Lyons concluded the Ventures involuntary bankruptcy was filed in bad faith for several reasons.
First, Scarola had reasons to know that its standing to file was “highly questionable.” Referencing a Second Circuit opinion, Judge Lyons agreed that “where a claim for offset arises out of the same transaction and is directly related to the creditor's underlying claim…a bona fide dispute exists.” Hence, Ventures’ debt was in dispute, because Scarola “knew that Ventures intended to vigorously defend [the second action] and would file counterclaims.”
Second, Scarola failed to sufficiently examine whether Ventures had fewer than 12 creditors, as required before a single creditor can file an involuntary petition. Before filing the Ventures petition, Scarola simply asked a former officer and director of Interactive whether other creditors existed besides Scarola. The former officer said “no,” and Scarola erroneously relied on this information, but had Scarola “pursue[d] the ordinary methods creditors use to assess their debtors,” it would have learned that Ventures had at least 21 creditors.
Third, as the sole petitioning creditor, Judge Lyons noted that the second action served as “an alternate forum…to resolve the dispute between Scarola Ellis and Ventures.” In this sense, it became clear to the court that Scarola’s filing was “an improper use of the bankruptcy process for an improper purpose.” Scarola should have resolved its fee dispute with Ventures in the second action.
Fourth, Scarola’s perfunctory inquiry about Ventures’ creditors suggested that it was the only creditor of Ventures. Consequently, Judge Lyons pointed to this as support for finding that the Ventures involuntary bankruptcy was a “litigation tactic,” as opposed to a filing “in the traditional spirit of collective creditor action.”
Judge Lyons concluded that Ventures could recover compensatory and punitive damages. Luckily for Scarola, Judge Lyons did not find that a basis for awarding compensatory damages had been established. At the hearing, Venture was unable to articulate any actual pecuniary loss. As for punitive damages, the court scheduled a further hearing.
Lessons Learned
First, do not file an involuntary bankruptcy petition unless you are certain that standing exists. In assessing standing, keep in mind that a court may scrutinize the merits of a claim that is subject to a bona fide dispute. Attorneys’ fees and costs may be awarded simply if the petition is dismissed without consent. A finding of bad faith is not required before awarding attorneys’ fees and costs.
Second, remember that bankruptcy serves as a collective debt-collection device. Therefore, unless certain that an involuntary case will benefit all creditors as a group, do not file an involuntary bankruptcy petition solely to collect your own legal fees. Also, if an alternate forum exists to resolve fee disputes with a former client, this fact may influence a bankruptcy court's finding of bad faith.
Third, be sure to perform a credit check, judgment search, lien search or similar inquiries against a debtor before filing the petition. The lack of such efforts may contribute to a finding of bad faith. If bad faith is ultimately found, punitive damages may be awarded even if actual damages do not exist.
1. In re Skyworks Ventures Inc., No. 10-24459, 2010 Bankr. LEXIS 2416 (Bankr. D. N.J. July 15, 2010),
2. The 2005 amendments to the Bankruptcy Code altered § 303(b)(1) by including the phrase “as to liability or amount" to qualify the original phrase "subject of a bona fide dispute." Pub. L. 109-08, 119 Stat. 23. This change in language has created a split in decisions between bankruptcy courts. However, Judge Lyons observed that the court need not resolve those issue to reach its holding.
3. 11 U.S.C. § 303(b).
4. See Thomas H. Jackson, The Logic and Limits of Bankruptcy Law, 3-4 (Beardbooks 1986).
5. 11 U.S.C. § 303(i)(2).