Petitioning Creditors Beware: No Right To Setoff For Punitive Damages From Bad Faith Involuntary Bankruptcy Filings

Creditors often think that an involuntary bankruptcy petition is a great bargaining chip when faced with a recalcitrant debtor. However, the actual filing of an involuntary bankruptcy petition (when that petition is filed in “bad faith”) confers a considerable risk to the petitioning creditors.  Recently, the United States Court of Appeals for the Third Circuit issued an opinion that re-emphasizes just how risky bad faith involuntary petitions can be for creditors.

In that non-precedential opinion authored by Circuit Judge Rendell, the Third Circuit weighed in on whether a creditor can set off damages imposed against it due to a bad faith involuntary bankruptcy petition against its claims against the debtor.  U.S. Bank, N.A. v. Maury Rosenberg, No. 18-1249, 2018 WL 3640987 (3d Cir. July 31, 2018).

Although this case has extensive procedural history the basic facts and procedural history are as follows: Maury Rosenberg established and owned a group of companies and partnerships operating as National Medical Imaging (“NMI”). NMI entered into equipment leases with U.S. Bank’s predecessors-in-interest. After NMI defaulted, U.S. Bank sued NMI and Rosenberg, which eventually settled (resulting in modified lease agreements under which NMI would continue to lease the equipment). As part of the settlement, Rosenberg would be personally liable if NMI again defaulted, which NMI did after twenty-one months.

After the default, entities related to U.S. Bank filed an involuntary bankruptcy petition against Rosenberg in the Eastern District of Pennsylvania, which was transferred to the Southern District of Florida (where Rosenberg lived).  The involuntary bankruptcy petition was subsequently dismissed.  After the dismissal, Rosenberg filed an adversary proceeding against U.S. Bank under 11 U.S.C. § 303(i) seeking the recovery of costs, attorney’s fees, and damages resulting from a bad faith filing of an involuntary bankruptcy petition.  That adversary proceeding was removed to the District Court, and tried before a jury. The jury awarded Rosenberg over $6 million, including $5 million in punitive damages, which are only warranted when the evidence shows that a defendant acted “with intentional malice” or that its conduct was “particularly egregious”.  After an appeal to the Eleventh Circuit (which reinstated the jury’s punitive damage award that had been vacated by the District Court in Florida), a final judgment of $6,120,000 (including the $5 million punitive damage award) was entered against U.S. Bank and its related entities for filing a bad faith involuntary petition against Rosenberg (the “Florida Judgment”).

At the same time, U.S. Bank proceeded with an action in the Eastern District of Pennsylvania for breach of contract against Rosenberg.  The District Court found in favor of U.S. Bank and awarded U.S. Bank approximately $6.5 million in damages, fees, and costs (the “Pennsylvania Judgment”).

Thereafter, U.S. Bank filed a motion with the Eastern District of Pennsylvania requesting that the District Court offset the Florida Judgment against the Pennsylvania Judgment. If such motion were granted, U.S. Bank would owe Rosenberg nothing and, importantly, would not have been required to come out of pocket for the Florida Judgment.  Reasoning that (i) the judgments lacked mutuality (because, among other things, the parties involved were not identical) and (ii) “equitable principles embodied in § 303 of the United States Bankruptcy Code preclude setoff”, the District Court, exercising its discretion consistent with Pennsylvania state law, denied the motion.  U.S. Bank appealed.

Determining that it need not reach the question of whether there was a lack of mutuality, the Third Circuit determined that the District Court did not abuse its discretion in denying U.S. Bank’s motion for mutual judgment satisfaction based on equitable principles.  Rosenberg, 2018 WL 3640987 at *2.  Accordingly, the Third Circuit affirmed the District Court.  In so doing, the Third Circuit cited with approval several other courts that have concluded that § 303(i)’s equitable purpose would be frustrated if bad faith filers were allowed to offset a § 303(i) judgment.  Citing In re Macke Int’l Trade, Inc., 370 B.R. 236, 255 (B.A.P. 9th Cir. 2007); In re Diloreto, 442 B.R. 373, 377 (E.D. Pa. 2010); In re Forever Green Athletic Fields, Inc., Bankr. No. 12-13888-MDC, 2017 WL 1753104, at *7 (Bankr. E.D. Pa. May 4, 2017); In re K.P. Enter., 135 B.R. 174, 185-86 (Bankr. D. Me. 1992); In re Schiliro, 72 B.R. 147, 149 (Bankr. E.D. Pa. 1987).

Setoff rights are an important remedy for creditors especially when a debtor becomes insolvent or files for bankruptcy. Frequently, it may be the only way a creditor can collect on such debt. However, under Pennsylvania law, “[s]etoff is an equitable right to be permitted solely within the sound discretion of the court.” Foster v. Mut. Fire, Marine & Inland Ins. Co., 531 Pa. 598, 614 A.2d 1086, 1095 (Pa. 1992). Therefore, courts may weigh whether setoff is equitable or if other equitable concerns are tantamount. Sanctions under § 303(i) seek to deter the improper filing of involuntary petitions. These sanctions play “a key role in deterring bad faith filing and remedying the negative effects of improperly-filed petitions.” Rosenberg, 2018 WL 3640987 at *2. The Third Circuit’s decision recognizes that permitting U.S. Bank to set off the § 303(i) award would severely undermine § 303(i)’s equitable purpose. Thus, it held that in light of U.S. Bank’s conduct and the equitable principles underlying § 303(i), the District Court did not abuse its discretion in denying U.S. Bank the equitable remedy of setoff.

This case is but another warning to creditors considering the use of an involuntary petition for a bad faith purpose.  In this case, U.S. Bank’s decision to commence an involuntary petition exposed it to a substantial award that made a bad situation worse – it must now write a large check and only hope that it can collect against a judgment debtor that may be judgment proof.   This is the quintessential lose/lose situation for any creditor.