A recent appellate decision addresses the availability of damages when an involuntary bankruptcy petition is filed in bad faith.  See Stursberg v. Morrison Sund PLLC, No. 23-1186, 2024 U.S. App. LEXIS 20286 (8th Cir. Aug. 13, 2024).

The decision discusses both the interplay between Bankruptcy Code sections 303 and 305 and federal preemption of state law.

The debtor owned a firm that financed mobile home parks.  In 2018, he sued a co-owner of two parks for alleged misconduct. The debtor’s counsel’s fees totaled $300,000. The debtor thought the amount was too high and didn’t pay.  He said the lawyer “accomplished basically nothing” and looked to retain a new lawyer.  The lawyer said if they couldn’t settle the matter, “I am going to commence collection steps.” 

The lawyer then filed the involuntary bankruptcy case against the debtor in the United States Bankruptcy Court for the District of Minnesota under Bankruptcy Code section 303.  After an involuntary petition is filed, a debtor can contest the petition and seek to dismiss the case.  If a petition is contested and the petitioner loses, the court can award the debtor costs, reasonable attorneys’ fees and, for a filing in bad faith, “damages proximately caused by such filing” and punitive damages.  11 U.S.C. § 303(i). 

After the case here was filed, the debtor moved to dismiss it.  He didn’t rely on Bankruptcy Code section 303 but rather section 305(a)(1), which enables a court to abstain from jurisdiction “when so doing better serves the interests of creditor and the debtor.”  In re Kujawa, 270 F.3d 578, 581 (8^th Cir. 2001).  The debtor sidestepped section 303 because a motion under that section would require notice to all creditors and a hearing.  He thought additional notice would increase “the financial and reputational harm caused by the involuntary petition . . . .”  2024 U.S. App. LEXIS 20286, at *13. 

The bankruptcy court found cause to dismiss the case and did so under section 305.  The judge said the lawyer filed the involuntary petition to collect his own debt rather than to benefit all creditors, which the judge noted is what “an involuntary is to do. . . .”  2024 U.S. App. LEXIS 20286, at *5.  The judge added that the involuntary proceeding “was being used as a hammer . . . . [W]hen I look at this whole case . . . quite frankly, it smells bad.”  Id.

Given the bad faith filing, the debtor sought damages. This time he cited section 303.  But the bankruptcy court denied that request, holding that dismissal under section 305 barred recovery under section 303(i).

The debtor didn’t appeal, but still wanted to pursue damages against the lawyer for the bad faith filing.  The debtor filed a separate lawsuit in the Eastern District of Pennsylvania, citing state tort law and using the court’s diversity jurisdiction.

After various motions, including a motion to remove the case to the District of Minnesota, the court proceedings ended up before the U.S. Court of Appeals for the Eighth Circuit.  The decision it issued is straightforward. 

First, the court held that section 303(i) provides exclusive relief for a bad faith bankruptcy filing.  Although determining the existence of bad faith is grounded in state tort law, the remedy for a bad faith filing is found in federal bankruptcy law.  Therefore, the court ruled, the remedy under federal law preempts state tort law.  As a result, the lawyer couldn’t seek redress under state law.

Second, the appellate court disagreed with the bankruptcy court that a dismissal under section 305 precludes damages under section 303(i).  Following another court’s analysis, In re Macke Int’l Trade Inc., 370 B.R. 236, 248-53 (B.A.P 9^th Cir. 2007), the Eighth Circuit stated that section 303(i) “applies to all involuntary case dismissals, including ‘abstention’ dismissals under § 305(a)(1).”  2024 U.S. App. LEXIS 20286, at *11.

But after years of litigation, the debtor couldn’t benefit from the ruling.  As the Eighth Circuit said, the bankruptcy court’s order “was a final order . . . [the debtor] did not appeal.  It therefore governs this subsequent proceeding between the same parties arising out of the same operative facts.”  2024 U.S. App. LEXIS 20286, at *16.  Thus, the debtor couldn’t seek damages for the bad faith filing under section 303(i).