When It Counts: Fully Secured and Paid-Off Creditors Can Count as Petitioning Creditors for Involuntary Bankruptcy Petitions

BACKGROUND

Applicable Statutory Provisions
Filing an involuntary petition under Section 303 of the Bankruptcy Code to force an individual or entity into a court-supervised bankruptcy proceeding can serve as a powerful tool for creditors seeking recovery. Section 303(b)(1) sets forth requirements to commence an involuntary proceeding. The statute provides that if an alleged debtor has 12 or more total creditors, then at least three creditors holding claims that (1) are “not contingent as to liability or the subject of a bona fide dispute as to liability or amount,” and (2) aggregate at least $18,600 more than the value of any security held by those creditors, are required to prosecute an involuntary case. In contrast, Section 303(b)(2) provides that if there are fewer than 12 total creditors holding such claims against the alleged debtor, only one creditor is required to commence an involuntary proceeding—provided that creditor holds a fixed unsecured claim, not subject to a bona fide dispute, of at least $18,600. It is important to ensure accuracy on these issues when filing an involuntary petition because improper petitions dismissed by the court, including petitions that fail to meet the numerosity requirement, may subject the petitioning creditors to costs and sanctions under Section 303(i). Indeed, while not addressed in this alert, sanctions were sought by the alleged debtors in the King bankruptcy proceedings.

Treatment of the Involuntary Petitions by the Bankruptcy Court
On August 31, 2022, Wolverine Endeavors VIII LLC (Wolverine) filed separate single-creditor involuntary chapter 7 bankruptcy petitions in the bankruptcy court for the Central District of California against John E. King and Carole D. King pursuant to Section 303(b)(2). The Kings opposed the involuntary petitions, arguing that Section 303(b)(1), which requires at least three eligible petitioning creditors where the alleged debtor has 12 or more holders of eligible debts, applied rather than Section 303(b)(2). On May 12, 2023, joinders to both involuntary petitions were filed by Insurance Company of the West (ICW) and Fence Factory Inc. (Fence Factory), the latter of which was purportedly withdrawn on September 7, 2023. East West Bank (the “Bank”) filed a joinder on September 14, 2023.

The bankruptcy court conducted an evidentiary hearing on October 3, 2023, and dismissed both involuntary petitions on January 8, 2024. In both cases, it found the existence of 13 holders of eligible debts, including three holders of fully secured claims, thus necessitating three petitioning creditors for each involuntary petition. In Mrs. King’s involuntary case, the Court found that Fence Factory was not her creditor, and that Wolverine and the Bank constituted a single creditor. Left with only two qualifying petitioning creditors (i.e., Wolverine and ICW), the bankruptcy court dismissed the involuntary petition that was filed against Mrs. King.

In the case of Mr. King, the bankruptcy court found the existence of at least 13 holders of eligible debts, thus also necessitating three petitioning creditors. As it did in Mrs. King’s case, the court treated Wolverine and the Bank as a single creditor. However, rather than disregarding Fence Factory as a petitioning creditor because it did not have a claim, the court disregarded Fence Factory as a qualifying petitioning creditor because it had been fully paid by a third party after the filing of the involuntary petition and before trial. Left with only two eligible petitioning creditors, the bankruptcy court likewise dismissed the involuntary petition that was filed against Mr. King.

Wolverine Appeals the Dismissals to the Ninth Circuit BAP
Wolverine appealed the dismissals to the Ninth Circuit BAP. In the appeal from the dismissal of Mrs. King’s case, Wolverine argued that the Bankruptcy Court improperly included the three fully secured nonrecourse debt holders in determining whether she had 12 or more creditors. Had these fully secured creditors not been included, Mrs. King would only have had 10 creditors, and only a single qualifying creditor, rather than three qualifying creditors, would have been required to commence the involuntary case.

In the appeal from the dismissal of Mr. King’s case, Wolverine did not appeal the bankruptcy court’s ruling that the petition was supported by only two qualifying claim holders. It did, however, challenge the bankruptcy court’s decision to exclude Fence Factory as an eligible petitioner because it was paid in full after the initial petition date. Had Fence Factory not been excluded, even with more than 12 creditors, the involuntary petition would have been filed by a sufficient number of creditors—three.

The BAP Affirms With Respect to Counting Secured Creditors for Determining Whether an Alleged Debtor Has 12 or More Eligible Creditors Thus Necessitating Three or More Petitioning Creditors
In connection with Mrs. King’s involuntary case, the BAP focused on whether secured creditors must be counted to determine the number of required petitioning creditors (three versus one) by examining the plain language of Section 303(b). The statute refers to such creditors as “a holder of a claim,” not differentiating between petitioning creditors and creditors counted to determine whether one or three petitioning creditors are required for the involuntary case. The BAP stated that “[w]hether a creditor is a nonrecourse creditor has no bearing on whether the creditor is fully or partially secured.” In re King, 2024 WL 4600043, at *9.

The BAP noted that a fully secured creditor with a recourse or nonrecourse claim can be counted in determining whether an alleged debtor has 12 or more creditors to determine if one or three creditors are required to commence an involuntary petition. A secured creditor cannot qualify as the sole petitioning creditor under Section 303(b)(2) because they would not hold a claim alone that “aggregate[s] at least $18,600 more than the value of any lien on property of the debtor securing such claims held by the holders of such claims” under Section 303(b)(1). The language of the statute, however, does not prevent secured creditors from being one of the three required petitioning creditors under Section 303(b)(1) when there are 12 or more total creditors, and the aggregate is met by unsecured creditors.

To illustrate how the numbers work in the King decisions, consider the following two examples. In the first, assume the alleged debtor has 13 creditors: (a) one $18,000 GUC, (b) one $600 GUC, (c) one $100,000 fully secured, and (d) 10 creditors at $100 apiece. Here, the $18,600 threshold is met, and the petition requires at least three creditors to prosecute an involuntary petition. Moreover, creditor (c) is both counted and qualifies as a petitioning creditor.

In a second example, assume an alleged debtor with three creditors: (a) one $18,000 GUC, (b) one $600 GUC, and (c) one $100,000 fully secured. The $18,600 unsecured threshold is met, and creditor (a) or (b) must commence an involuntary petition. Creditor (c) is counted, but does not qualify as, and cannot be, the sole petitioning creditor since its claim alone does not meet the unsecured $18,600 threshold.

Paid-Off Creditors
Section 303(c) states that “a creditor holding an unsecured claim” who later joins an involuntary petition shall be assessed “with the same effect” as a petitioning creditor under Section 303(b). The BAP’s opinion in the appeal from Mr. King’s bankruptcy case reasoned that the plain meaning of the word “holding” in Section 303(c) determined that paid-off creditors are counted for purposes of involuntary petitions. The bankruptcy court relied on the present tense meaning of “holding” to disallow Fence Factory from joining the petition since it no longer held a claim on the date it filed its joinder. See In re King, 2024 WL 4599982, at *2. The BAP, however, reasoned that Congress used “holding” to require an assessment of whether the joining creditor held an eligible claim as of the petition date. See id. at *18. Since petitioning creditors are evaluated on the petition date, the same standard will apply to joining creditors. Consequently, under the BAP’s ruling, the petition date is the appropriate point for evaluating whether a joining creditor holds a qualifying claim for purposes of the involuntary petition.

Furthermore, the BAP relied on Liberty Tool, & Mfg. v. Vortex Fishing Sys., Inc. (In re Vortex Fishing Sys., Inc.) and stated that “it is a ‘rather obvious proposition’ that alleged debtors cannot defeat an involuntary petition by paying off petitioning creditors.” Id. at *14 (quoting Liberty Tool, & Mfg. v. Vortex Fishing Sys., Inc. (In re Vortex Fishing Sys., Inc.), 277 F.3d 1057, 1065 (9th Cir. 2002)). Thus, if an alleged debtor cannot defeat an involuntary petition by paying off a petitioning creditor, then, the BAP reasoned, the alleged debtor cannot defeat an involuntary petition by paying off a subsequently joined creditor.

Conclusion
Properly counting qualifying creditors for the purpose of meeting the required number of petitioning creditors to file an involuntary petition is imperative, since improper petitions may be subject to costs and sanctions under Section 303(i). The Ninth Circuit BAP’s rulings in the King cases provide important assistance and clarity regarding which creditors are counted for purposes of determining whether an alleged debtor has 12 or more creditors under Section 303(b) of the Bankruptcy Code, thus necessitating at least three petitioning creditors for involuntary petitions. Fully secured creditors, recourse or not, are counted under both Section 303(b)(1) and Section 303(b)(2), and may join as one of the required three petitioning creditors under Section 303(b)(1) when the aggregate is met by unsecured creditors. Additionally, joining creditors are counted if they hold a claim on the filing date, even if the claim is later paid off. Gamesmanship regarding paying off creditors to defeat an involuntary petition will not work in the Ninth Circuit.