What Is a “Bona Fide Dispute”?

Two provisions of the Bankruptcy Code turn on the existence of a “bona fide dispute.” An involuntary petition may not be filed by an alleged creditor against the alleged debtor if the creditor’s claim is “the subject of a bona fide dispute as to liability or amount.”[1] A trustee may sell property free and clear of an interest that is “in bona fide dispute.”[2] These disparate statutory provisions share a unique phrase.

What is a “bona fide dispute”? Two recent court decisions address this question.

Consistent with canons of statutory construction,[3] the definition of the term “bona fide dispute” is the same in both § 303, where its absence is one of the requirements for a creditor to be eligible to file an involuntary bankruptcy petition, and § 363, where it is one of the five circumstances in which a trustee (or debtor in possession) may sell assets free and clear of liabilities. The majority of courts have adopted the “objective standard,” which “requires the bankruptcy court to ‘determine whether there is an objective basis for either a factual or a legal dispute as to the validity of the debt.’”[4]

In a recent decision, the U.S. Bankruptcy Court for the Middle District of Pennsylvania examined the standing of creditors to file an involuntary bankruptcy petition against an alleged debtor.[5] Chief Bankruptcy Judge Henry W. Van Eck analyzed whether the petitioning creditors’ claims were the subject of a “bona fide dispute” under applicable Third Circuit precedent. Under such precedent, a petitioning creditor’s claim “is the subject of a bona fide dispute if ‘there is a genuine issue of a material fact that bears upon the debtor’s liability, or a meritorious contention as to the application of law to undisputed facts.’”[6]

Applying this standard, the court evaluated each of the petitioning creditors’ claims. The court noted a number of evidentiary deficiencies in the alleged claims, particularly insufficient evidence establishing the validity of the claims or rebutting the alleged debtor’s defenses. Thus, a number of the petitioning creditors’ claims were disqualified. However, since the court declined to find the existence of bad faith, additional creditors were not disqualified from joining in the petition, and the court set further proceedings to determine whether including joining creditors in the petition would satisfy the requirements for an involuntary petition.

In another recent decision, the U.S. District Court for the Central District of California addressed whether the bankruptcy court erred when it approved a sale of property over the objections of a secured creditor.[7] The appellant creditor had obtained a state court judgment against the debtor appellee, the creditor’s former business partner. The debtor filed for chapter 11 protection after the creditor recorded abstracts of judgments against the debtor’s properties. The case was later converted to chapter 7.

The chapter 7 trustee sold a parcel of real property of the debtor. The bankruptcy court authorized the trustee’s sale free and clear of the creditor’s liens on the basis that those interests were the subjects of a “bona fide dispute” within the meaning of § 363(f)(4) of the Bankruptcy Code. On appeal to the district court, the creditor challenged the bankruptcy court’s determination that there was a bona fide dispute. The creditor argued that the interests were not the subject of a bona fide dispute because the bankruptcy court had previously ruled that the creditors’ liens were not avoided.

In that earlier adversary proceeding, the bankruptcy court had entered summary judgment in favor of the debtor ruling that the liens were subject to mandatory subordination under § 510(b), although the liens were not avoided.[8] The creditor appealed that decision, and that prior appeal was still pending while the sale motion was before the bankruptcy court.[9] District Court Judge Dolly M. Gee ruled that a dispute as to the priority of an interest is a bona fide dispute within the meaning of § 363(f)(4).[10] Ultimately, the court found the bankruptcy court’s ruling “consistent with the purpose of § 363(f)(4), which seeks to prevent the delay of liquidation of the estate’s assets while disputes regarding interests in the estate are litigated.”[11]

While these two cases involve very different facts and requests for relief, the meaning of “bona fide dispute” is consistent, and courts should be able to rely on the standard established in precedent when addressing a “bona fide dispute,” whether under § 303 or 363 of the Bankruptcy Code.