On February 27, 2013, in a 2-1 decision, a three-judge panel of the Court of Appeals for the Ninth Circuit issued a published decision on an important issue fundamental to contested petitions in involuntary bankruptcy cases. The involuntary petition was filed against Georges Marciano, founder of the clothing retailer Guess, by three former employees who had obtained large state court judgments against Marciano. Marciano contested the involuntary petition and argued, among other claims, that the state court judgments held by the three petitioning creditors were on appeal and subject to a bona fide dispute, although the judgments were not stayed on appeal.

The Ninth Circuit decision in In re Marciano, ___ F. 3d ___, 2013 WL 703157 at *1 (9th Cir.), creates a per se rule that holds a state court judgment that is not a default judgment and that has not been stayed on appeal is not a claim that is subject to a bona fide dispute and properly qualifies the holder of the judgment as a petitioning creditor for the purposes of the involuntary bankruptcy petition. The In re Marciano decision creates a split among the circuits, contradicting the ruling in a published decision by the Court of Appeals for the Fourth Circuit that held that the unstayed state court judgment creates only a prima facie showing on the amount and validity of the claim and that the debtor contesting the involuntary petition can challenge the judgment to show that it is subject to a bona fide dispute. See In re Byrd, 357 F. 3d 433 (4th Cir. 2004).

The statute in question in the Marciano case is §303(b)(1) of the Bankruptcy Code. Section 303(b)(1) sets forth the requirements that must be met to commence an involuntary case where the person against whom the petition is to be filed has 12 or more creditors. Among other criteria, the statute requires that there be at least three petitioning creditors who each hold “a claim against such person that is not contingent as to liability or the subject of a bona fide dispute as to liability or amount.” The Bankruptcy Code does not define what constitutes a claim subject to a bona fide dispute, leaving it to case law to construe that requirement.

The judgment creditors in the Marciano case held judgments that in the aggregate totaled approximately $95 million. The judgments arose out of litigation brought by Marciano against five former employees for alleged theft. Three of the former employees filed cross-complaints alleging defamation and other tort claims. The state court struck Marciano’s answer to the cross-complaints as a sanction for discovery abuses, and a jury trial was held on damages, resulting in an award in favor of the three former employees who were the petitioning creditors. Marciano appealed the judgments but did not post a bond to stay the judgments. Despite Marciano’s motions to the trial court and the state appellate court for a stay pending appeal, no stay of the judgments was granted. Marciano was also facing significant judgments against him held by other persons totaling approximately $190 million.

Marciano contested the involuntary petition and sought to demonstrate that the petitioning creditors were acting in bad faith in filing the involuntary petition. Marciano asserted that he should be allowed to conduct discovery in connection with the contested petition to try to demonstrate the petitioning creditors’ bad faith, and Marciano also argued that the judgments were subject to a “bona fide dispute” and therefore the petitioning creditors did not meet the statutory requirements to file the involuntary petition under §303(b)(1). The bankruptcy court and later the bankruptcy appellate panel ruled against Marciano on both arguments, and Marciano appealed to the Ninth Circuit.

The issue before the Ninth Circuit was one of first impression for the court but is straightforward: can an unstayed, non-default judgment of the state court that is on appeal be subject to a bona fide dispute for the purposes of §303(b)(1)? The Ninth Circuit imposed a per se rule holding that such a judgment cannot be deemed subject to a bona fide dispute and therefore such a judgment qualifies the holder to be a petitioning creditor under §303(b)(1) so long as any other requirements of that provision, such as the dollar amount of the judgment and the status of any lien, securing the debt, are met.

The Ninth Circuit held that it was improper for the bankruptcy court to examine the merits of the underlying judgment and the pending appeal to try to assess the judgment and the likelihood that the judgment might be reversed or modified on appeal. Rejecting the position of the Fourth Circuit in In re Byrd, the Ninth Circuit followed what it cast as the “majority view” articulated by the Bankruptcy Court for the Southern District of New York in In re Drexler, 56 B.R. 960 (Bankr. S.D.N.Y. 1986) that an unstayed, non-default state judgment is not subject to dispute as not being a bona fide claim under §303(b)(1) based on judicial principles of respecting enforceable, final judgments and the “full faith and credit” federal courts are required generally to accord to state court judgments. The Ninth Circuit noted that allowing the bankruptcy court to assess the appeal of the unstayed, state court judgment would make the court an appellate odds-maker, divining how the state appellate court might rule on the appeal while the judgment under applicable state law was final, fully enforceable and subject to immediate payment. The court further found its bright line rule to be supported by the policies underlying involuntary petitions, which are to prevent the depletion of a debtor’s assets and the unequal distribution of assets among similarly situated creditors. The court also noted that the legislative history of §303(b)(1) suggested that its provisions were designed to make filing involuntary petitions easier rather than to raise the hurdles creditors had to overcome in petitioning the court for an order for relief.

The Ninth Circuit also distinguished its prior decision in In re Vortex Fishing Systems, 277 F. 3d 1057 (9th cir. 2001) relied on by the dissent. The claim in Vortex was a contract claim that had not been reduced to judgment, and the Ninth Circuit ruled in Vortex that the bankruptcy court was required to analyze the merits of the underlying contract claim held by the petitioning creditor to evaluate whether it was subject to a bona fide dispute. The absence of a litigated judgment on the claim in Vortex was found to be a clear, distinguishing factor from the facts presented in Marciano.

The Marciano decision is an important and noteworthy ruling for creditors that may be considering an involuntary petition. There is limited reported case law, particularly at the circuit level, addressing involuntary petitions, and this decision creates an easy-to-follow, bright-line test for determining whether a petitioning creditor with a judgment that is on appeal but not stayed has a claim that satisfies the requirements of §303(b)(1).

Lesley Anne Hawes, a partner in the Los Angeles office of McKenna Long & Aldridge, LLP, specializes in the representation of secured and unsecured creditors in bankruptcy proceedings and in the representation of federal equity receivers appointed in civil enforcement actions by federal agencies such as the Federal Trade Commission and Securities and Exchange Commission. Hawes is a regular contributor to the Monitor and other journals, and she has lectured for the National Business Institute and other organizations. She graduated Order of the Coif from University of Southern California law school and earned her undergraduate degree in political science magna cum laude from University of Southern California.