“Special Circumstances” did not Save a 12 Year Old Involuntary Case
In Popular Auto, Inc. v. Reyes-Colon (In re Reyes-Colon), Nos. 17-1971, 17-1972, 2019 WL 1785039 (1st Cir. April 24, 2019), the First Circuit recently ruled that “special circumstances” does not authorize a bankruptcy court to use its equitable powers to contravene the numerosity requirement for an involuntary petition under section 303(b)(1) of the Code. This twelve year dispute did not end well for the petitioning creditors.
In November 2006, Banco Popular, an unsecured lender, commenced an involuntary petition against Debtor Edgar Reyes-Colon (“Debtor“), a plastic surgeon, when the Debtor failed to pay his debts. Popular Auto, another unsecured lender, joined the involuntary petition shortly after, but no other unsecured creditor joined.
In early 2007, the bankruptcy court dismissed the involuntary case, concluding that the petitioning creditors failed to meet the numerosity requirement under section 303(b)(1), because they had failed to join a third petitioning creditor.
A year and a half later, the bankruptcy appellate panel reversed and remanded, finding that all creditors should have been given notice of the dismissal hearing, thereby giving them an opportunity to join the petition before dismissal. The parties then returned to the bankruptcy court for another 3+ years of proceedings.
In March 2011, the Debtor moved for summary judgment, arguing that he had at least 15 creditors at the commencement of the case. While the bankruptcy court granted partial summary judgment on this ground, it also allowed the parties to conduct discovery on whether “special circumstances” excused compliance with section 303(b)(1)’s numerosity requirement.
In September 2016, four years later, the bankruptcy court dismissed the petition, concluding that, while it appeared that the Debtor had schemed to defraud creditors, the court did not have equitable powers to override the numerosity requirement in section 303(b)(1).
The appellate process, again, ensued, eventually ending in the First Circuit Court of Appeals.
Section 303(b) of the Bankruptcy Code requires that an involuntary petition against a debtor have at least three petitioning creditors if, at the time the petition is filed, the debtor has twelve or more eligible creditors. 11 U.S.C. § 303(b)(1)-(2). If the debtor has less than twelve eligible creditors, only one petitioning creditor is required to commence the case. Id.
The First Circuit found that, once a debtor answers an involuntary petition and provides a list of creditors under Bankruptcy Rule 1003(b), the petitioning creditors then bear the burden of proving that the debtor has less than 12 creditors. Here, the Banks failed to disqualify enough creditors to lower the numerosity requirement under section 303(b)(1).
But, the Banks further agued that special circumstances warranted an equitable exception to the numerosity requirement. This equitable exception is derived from section 105(a) of the Code and the bankruptcy court’s inherent powers under common law.
However, the Supreme Court has previously stated that “bankruptcy courts may not contravene specific statutory provisions’ when they exercise their statutory and inherent powers.” Law v. Siegel, 571 U.S. 415, 421 (2014). Here, the First Circuit found that the bankruptcy court would have plainly contravened section 303(b) if it had bypassed the numerosity requirement based on “special circumstances.” According to the First Circuit:
Allowing the case to proceed with only two petitioning creditors would have flown in the face of the Code’s directive that there be three petitioning creditors when a debtor has more than twelve creditors at the time the involuntary petition was filed.
Reyes-Colon, at 2019 WL 1785039, at *6. Thus, Siegel forecloses employing equity to waive the plain statutory language in the Code. Id. at *6. The bankruptcy court’s second dismissal was ulimately affirmed, ending the 12-year struggle.
Takeaway-Because the Bankruptcy Code defines the term “claim” so broadly, it is often not difficult for most putative debtors to claim to have more than 12 creditors. Thus, it is rarely safe to proceed with an involuntary petition without, at least, 3 petitioning creditors and often more, in the event 1 of the petitioning creditors is disqualified. It’s a shame it took 12+ years for the parties to figure this out in the Reyes-Colon case.