Ninth Circuit joins majority, holds unstayed judgments not ‘bona fide dispute’ — In re Georges Marciano, No. 11-60070 (9th Cir., Feb. 27, 2013)

In re Georges Marciano, No. 11-60070 (9th Cir., Feb. 27, 2013)

CASE SNAPSHOT

Judgment creditors of Georges Marciano filed an involuntary chapter 11 petition against Marciano, who appealed the state judgments before the petition was filed. The Ninth Circuit ruled, in a case of first impression, that unstayed state court judgments on appeal were not “the subject of a bona fide dispute,” and thus the Bankruptcy Court did not err when it entered an order for relief under chapter 11 against Marciano, notwithstanding the pending appeals.

FACTUAL BACKGROUND

Guess Jeans founder, Georges Marciano, sued multiple former employees in California Superior Court, alleging theft, and some of these employees cross-complained against Marciano for defamation and intentional infliction of emotional distress. The California court entered separate judgments against Marciano in favor of the employees in amounts as high as $55 million. Three of the former employees and judgment holders filed an involuntary chapter 11 petition against Marciano, while the judgments were being appealed by Marciano to the California Court of Appeal. Marciano did not post a bond to stay the judgments.

Marciano filed a motion to dismiss the involuntary petition based on lack of service, and sought discovery against his petitioning creditors to determine whether the involuntary petition was filed in bad faith. The petitioning creditors filed a motion for summary judgment seeking an order for relief under Bankruptcy Code section 303, and Marciano opposed summary judgment on the grounds that the involuntary petition should not have been filed because the three petitioning creditors’ claims were on appeal and, thus, subject to a bona fide dispute or contingent as to liability pursuant to Bankruptcy Code section 303(b)(1). Marciano’s motion to dismiss was denied, his discovery was quashed, and the Bankruptcy Court entered an order for relief under chapter 11 against Marciano.

Upon granting the order for relief, the Bankruptcy Court ruled that an unstayed non-default state judgment was not a bona fide dispute under Bankruptcy Code section 303(b)(1), and on appeal, the Bankruptcy Appellate Panel affirmed. Marciano appealed to the Ninth Circuit.

COURT ANALYSIS

The Ninth Circuit began its discussion by addressing the fact that Bankruptcy Code section 303(b)(1) does not define “bona fide” dispute for purposes of the propriety of involuntary bankruptcy petitions. Bankruptcy courts have split in their interpretation of the code section. The majority “Drexler Rule” provides that unstayed non-default judgments on appeal are not the subject of a bona fide dispute under section 303(b)(1) – and thus may per se form the basis for an involuntary petition. The minority “Byrd Rule” provides that although such unstayed non-default judgments are normally not the subject of a bona fide dispute under section 303(b)(1), the petitioning creditor must make a prima facie case under section 303(b)(1), and after considering the debtor’s dispute, a bankruptcy court must make the determination of whether a “bona fide dispute” exists.

The Ninth Circuit reasoned that the majority Drexler Rule was the better-reasoned rule, and that it was “difficult to imagine a more ‘objective’ measure of the validity of a claim than an unstayed judgment entered by a court of competent jurisdiction.” The Ninth Circuit determined that the Byrd Rule turned the bankruptcy court into an “odds maker on appellate decision-making,” and that the more bright-line Drexler Rule better served the purposes of the Bankruptcy Code of promoting an orderly distribution of a debtor’s assets to creditors.

DISSENT

In a dissenting opinion, Circuit Judge Ikuta argued that the Fourth Circuit Byrd Rule was better-reasoned because “the filing of an involuntary petition should not be lightly undertaken,” and that a bankruptcy court should be “at least bound to consider whether there were legitimate questions” regarding a state judgment on appeal. The dissent argued that the majority Drexler Rule was a “shortcut solution that skips over the safeguard of scrutinizing claims carefully before placing a debtor in involuntary bankruptcy.”

PRACTICAL CONSIDERATIONS

The Ninth Circuit has established a bright-line per se rule that unstayed state court judgments may form the basis for an involuntary bankruptcy petition. Other circuits, most notably the Fourth Circuit, subject such claims to further analysis by the bankruptcy court. The Ninth Circuit has not yet spoken on the issue of unstayed default judgments, although some bankruptcy courts applying the per se rule have indicated that closer scrutiny may be given to such default judgments.