Restructuring

Article Contributed by Christopher Linden
At a time when more and more creditors are opting to file involuntary petitions against recalcitrant borrowers, the precise meaning and import of section 303 of the Bankruptcy Code is becoming increasingly important.  Pursuant to section 303(b)(1), an involuntary case can be commenced “by three or more entities, each of which is [] a holder of a claim . . . that is not contingent as to liability or the subject of a bona fide dispute as to liability or amount.” (emphasis added).  As is often the case, the Bankruptcy Code does not elaborate on what it means for a debt to be “the subject of a bona fide dispute.”  In re Hicks, No. 11-32263, 2011 WL 6000861 (Bankr. E.D. Tenn. Nov. 30, 2011), a recent decision by the Bankruptcy Court for the Eastern District of Tennessee, provides a rather comprehensive definition.
Hicks involved an involuntary petition filed against an individual by five different banks (only four of which are the subject of this dispute) from which the debtor had borrowed several million dollars to finance various real estate projects.  After the debtor defaulted, each of the banks exercised its state law remedies and foreclosed on the properties pledged as security for the loans.  Three of the four banks completed the foreclosure process, while the fourth bank’s foreclosure process was stayed by the filing of the involuntary petition.  All of the sales consummated prior to the bankruptcy filing resulted in deficiency balances, which became the basis for the banks’ claims against the debtor.  As of the bankruptcy filing, the validity and amount of the deficiency claims were all the subject of state court litigation.
After a full-blown trial on the issue, in which the parties submitted almost 40 exhibits and the court heard testimony from eight witnesses, the bankruptcy court determined that none of the banks’ claims were the subject of a bona fide dispute.  Recognizing that the Bankruptcy Code fails to define “bona fide dispute,” the bankruptcy court relied on Sixth Circuit BAP (Marketing & Creative Solutions, Inc. v. Scripps Howard Broadcasting Co. (In re Marketing & Creative Solutions, Inc.), 338 B.R. 300, 305 (B.A.P. 6th Cir. 2006)) precedent outlining the generally accepted definition: “a claim is subject to a bona fide dispute if there is either a genuine issue of material fact that bears upon the debtor’s liability, or a meritorious contention as to the application of law to undisputed facts.”  Put another way, a bona fide dispute exists where there is a “legitimate basis for the debtor not paying the debt, whether that basis is factual or legal.”  The court made it clear that its duty was not to resolve any issues of material fact or law, but, instead, simply to identify the existence of any such issues.  In determining whether a claim is subject to a legitimate dispute of law, however, the court may be required (and is permitted) to conduct a cursory analysis of the legal issues to ascertain whether an “objective legal basis for the dispute exists.”  Although the court did not elaborate on what an “objective legal basis” is, the court made clear that no such basis will be found where the “applicable law is well-established and not subject to legitimate dispute.”  In terms of burden of proof, it is initially on the petitioning creditor to make a prima facie showing that no bona fide dispute exists, after which the burden shifts to the debtor to establish the opposite.
The debtor argued that, because the deficiency claims were the subject to a bona fide dispute (i.e., state-court litigation), the petitioning creditors were not permitted to file the involuntary petition under section 303(a) of the Bankruptcy Code.  Analyzing the debtor’s claim under the foregoing analysis required the court to examine closely Tennessee law regarding deficiency judgments to determine whether the debtor’s claim had an “objective legal basis.”  The bankruptcy court performed a painstaking analysis of the foreclosure proceedings conducted by the various lenders and found no procedural or substantive defect.  Thus, the bankruptcy court held that, even though the deficiency claims were the subject of state court litigations, the banks’ claims were not the subject of bona fide dispute vis á vis section 303(a) of the Bankruptcy Code.  According to the court’s holding, it is not enough for a claim to be simply the subject of litigation; such litigation must be evaluated further to determine whether a “legitimate question exists about the application of the law to the undisputed facts presented.”  In this way, the bankruptcy court must – without actually deciding the underlying litigation – engage in a quasi summary judgment analysis to ascertain whether there is any genuine basis for challenging the claim.  Although Hicks involves an individual debtor, the court’s holding provides a useful and increasingly relevant explanation of what it means for a claim to be the subject of bona fide dispute.