The Bankruptcy Code1 offers several advantages for the creditors of financially distressed individuals and corporations, including federal court supervision of a possibly untrustworthy debtor and mitigation of the risk of potential or ongoing fraudulent transfers. It is therefore not surprising that creditors who are owed significant sums may consider filing an involuntary bankruptcy petition against those from whom they are owed money. Section 303 of the Bankruptcy Code establishes the process and requirements for filing an involuntary petition.

Perhaps more important, Section 303 also sets forth the risks associated with forcing a person or company into bankruptcy. Under 11 U.S.C. § 303(i), if the bankruptcy court dismisses the bankruptcy petition, it may order the petitioning creditor to pay the alleged debtor compensatory damages and, if the court determines the involuntary petition was filed in "bad faith," punitive damages as well. As a frightening example, in In re John Richards Homes Bldg. Co., L.L.C., 291 B.R. 727 (Bankr. E.D. Mich. 2003), the bankruptcy court awarded compensatory damages of $4,100,000 and punitive damages of $2,000,000 against the petitioning creditor, a purchaser of a luxury home, who filed an involuntary bankruptcy petition against the homebuilder even though the purchaser knew that his dispute with the homebuilder was subject to bona fide dispute, withheld critical information from his attorneys, and engaged in a public campaign of disparagement with the specific intent of destroying the homebuilder’s business.

Compensatory damages may be assessed against a petitioning creditor for damages "proximately caused" by the filing of the involuntary petition. Damages awarded include: (1) attorneys’ fees and expenses, accountants’ fees, documented travel expenses and other nominal damages,2 (2) lost income,3 (3) lost profits and harm to business reputation4 and (4) damages for emotional distress.5 As a general rule, the alleged debtor must establish competent proof of the amount of its compensatory damages. For example, it must present evidence of specific business losses resulting from the petitioners’ filing and a satisfactory method of quantifying any such damages identified.6

In determining whether to award punitive damages, courts consider whether the petitioning creditor demonstrated ill will or malice toward the alleged debtor.7 The petitioning creditor’s bad faith is an issue of fact. Courts around the country have developed no less than five tests for determining bad faith, some of which consider overlapping factors: (1) the subjective test, (2) the improper purpose test, (3) the objective test, (4) the improper use test and (5) the combined test.8

The "subjective test" looks to the subjective motivation of the petitioning creditor for the filing. An improper motive, such as harassing the debtor, is subjective evidence of bad faith.9 The "improper purpose" test similarly finds bad faith based upon the petitioner’s improper motivation for filing the petition. This test examines whether the filing was motivated by ill will, malice or for the purpose of harassing the debtor.10

The "objective test" questions whether a reasonable person would have filed the involuntary petition under the same circumstances.11 Under the “improper use” test, bad faith is found when a petitioning creditor uses involuntary bankruptcy proceedings in an attempt to obtain a disproportionate advantage for itself, rather than to protect against other creditors obtaining disproportionate advantages, particularly when the petitioner could have advanced its own interests in a different forum.12

Many jurisdictions find that a combination of the subjective and objective tests is the proper standard for determining bad faith.13 Some courts have even developed a sixth test called the "nose test." This test considers the totality of the circumstances, incorporating all of the above-referenced tests and operates on the premise that if it smells like bad faith, it must be bad faith. It is the broadest of all the tests and captures the amorphous and fact-specific nature of the bad faith inquiry. For example, the court in In re Apache Trading Group employed a totality of the circumstances analysis in holding that the petitioning creditor did not file the involuntary petition in bad faith, since it had conducted a prudent investigation of the debtors’ affairs before filing the petition, the investigation indicated that the debtors might be dissipating assets and were in substantial financial distress, and it was undisputed that the debtors had not paid a substantial debt to the petitioner.

The takeaway for creditors contemplating filing an involuntary bankruptcy petition is that they should carefully examine the possibility of being sanctioned if the petition is dismissed and determined to have been filed in bad faith. Although punitive damages are generally awarded only when the petitioning creditor has acted with ill will or malice toward the alleged debtor, the risk of being monetarily sanctioned is a significant one. Therefore, while bankruptcy court oversight of a debtor’s actions is certainly advantageous, a creditor may want to consider other collection alternatives, such as prosecution in state court, before enlisting the bankruptcy court’s assistance.

-----------------------------------------------------------------------------

111 U.S.C. § 101, et seq.
2See, e.g., In re Johnston Hawks, Ltd., 72 B.R. 361 (Bankr. D. Haw. 1987); In re McDonald Trucking Co., 76 B.R. 513 (Bankr. W.D. Pa. 1987); In re Camelot, Inc., 25 B.R. 861 (Bankr. E.D. Tenn. 1982).
3See, e.g., In re Johnston Hawks, 72 B.R. 361.
4See, e.g., In re Cadillac by Delorean & Delorean Cadillac, Inc., 265 B.R. 574 (Bankr. N.D. Ohio 2001).
5See, e.g., Rosenberg v. DVI Receivables, XIV, LLC, 2012 U.S. Dist. LEXIS 151001 (S.D. Fla. Oct. 19, 2012).
6See In re Cadillac, 265 B.R. 574.
7See In re Schloss, 262 B.R. 111 (Bankr. M.D. Fla. 2000).
8In re Ballato, 252 B.R. 553 (Bankr. M.D. Fla. 2000).
9In re Ballato, 252 B.R. 553; In re Apache Trading Group, 229 B.R. 891 (Bankr. S.D. Fla. 1999).
10In re Ballato, 252 B.R. 553; In re Landmark Distributors, Inc., 189 B.R. 290 (Bankr. NJ 1995).
11In re Ballato, 252 B.R. 553; In re Apache Trading Group, 229 B.R. 891; In re Caucus Distributors, Inc., 106 B.R. 890 (Bankr. E.D. VA 1989).
12In re Ballato, 252 B.R. 553; In re K.P. Enterprise, 135 B.R. 174 (Bankr. Me. 1992).
13See Matter of Sims, 994 F.2d 210 (5th Cir. 1993); Atlas Mach. & Iron Works, Inc. v. Bethlehem Steel Corp., 986 F.2d 709 (4th Cir. 1993); In re Wavelength, Inc., 61 B.R. 614 (9th Cir. BAP 1986); Camelot, Inc. v. Hayden, 30 B.R. 409 (E.D. TN 1983); In re Ballato, 252 B.R. 553; In re Elsub Corp., 66 B.R. 172, (Bankr. N.J. 1986).