A Dispute over Bona Fide Disputes in Involuntary Bankruptcy Proceedings

The world of federal bankruptcy law is divided into two realms: voluntary bankruptcy proceedings and involuntary bankruptcy proceedings. Section 303 of the Bankruptcy Code governs involuntary bankruptcy proceedings. Under § 303(b)(1), a set of creditors can force a debtor into involuntary bankruptcy provided that, among other things, each creditor possesses a claim against the debtor that is not “the subject of a bona fide dispute.” Despite the importance of this seemingly simple requirement, the Bankruptcy Code does not define the term “bona fide dispute.” Parties commonly use involuntary bankruptcy to collect money judgments issued in prior proceedings by nonbankruptcy state courts. In the typical case, a set of plaintiffs brings suit against a defendant in state court and ultimately secures a money judgment. The judgment constitutes a claim against a debtor within the meaning of the Bankruptcy Code. Assuming that the defendant does not dispute the money judgment, the victorious plaintiffs (now creditors) can use their claims against the defendant (now debtor) to file an involuntary bankruptcy petition in federal bankruptcy court. However, when the creditors’ claims against the debtor include an unstayed state court judgment, a dilemma arises when the debtor appeals the underlying state court judgment before the creditors file their involuntary bankruptcy petition. On the one hand, the court could find, as debtors in these types of cases often advocate, that the appeal of the state court judgment creates a bona fide dispute within the meaning of § 303, thereby rendering the creditors ineligible to proceed with their involuntary bankruptcy petition. On the other hand, the court could find, as creditors often advocate, that the appeal can never create a bona fide dispute over an otherwise enforceable judgment. The dilemma appears intractable for at least two reasons. First, although the legislative history of § 303 expresses a general purpose of the bona fide dispute requirement, that purpose, in conjunction with a relatively sparse legislative record, provides little interpretive guidance. Second, the question implicates significant federalism concerns. It is unclear whether federal bankruptcy courts should apply state or federal law to determine whether an appeal creates a bona fide dispute. While federal bankruptcy law creates the bona fide dispute requirement, federal courts—including federal bankruptcy courts— generally must look to state law to determine what effect to give state court judgments. Thus, a federal bankruptcy court’s determination that the appeal of a state court judgment can create a bona fide dispute under federal law potentially fails to respect a state court’s determination of state law.

Because of these difficulties, courts have struggled to determine whether the appeal of an unstayed state court judgment can create a bona fide dispute within the meaning of § 303. Federal bankruptcy courts have offered competing answers for nearly three decades. More recently, a circuit split has developed. The Fourth Circuit adheres to the view that the appeal of an unstayed state court judgment can, under appropriate circumstances, create a bona fide dispute within the meaning of § 303. The Ninth Circuit, to the contrary, follows the per se rule that the appeal of an unstayed state court judgment can never create a bona fide dispute within the meaning of § 303. The resulting circuit split has created significant confusion among bankruptcy courts and practitioners alike. This Comment seeks to resolve this issue. Specifically, it aims to show that existing judicial approaches fashion uniform federal rules that go against well-established Supreme Court precedent favoring the adoption of state law as the federal rule of decision. Relying on these observations, this Comment argues that federal bankruptcy courts should adopt state issue preclusion law as the federal rule of decision to determine whether an appeal creates a bona fide dispute. If, under the applicable state issue preclusion law, an appeal does not affect the finality of judgments for the purpose of issue preclusion, then the appeal cannot create a bona fide dispute. But if an appeal renders a judgment nonfinal for the purpose of issue preclusion, then the appeal can create a bona fide dispute. By looking to state law to determine whether an appeal can create a bona fide dispute, the proposed approach avoids the federalism concerns noted above, renders the interpretation of § 303 consistent with other bankruptcy and nonbankruptcy legal doctrines, and potentially reconciles conflicting judicial interpretations.