When an involuntary bankruptcy petition is dismissed, section 303(i) of the Bankruptcy Code permits a debtor to seek reasonable attorneys’ fees and costs from the petitioners, and, if the petition was filed in bad faith, damages proximately caused by the bad-faith filing and punitive damages. 11 U.S.C. § 303(i). What if the petitioner is a state—say, a state taxing authority, which may seek an involuntary petition to recover allegedly unpaid taxes? Under Supreme Court precedent, states have sovereign immunity shielding them from most lawsuits without their consent. But Congress also has the constitutional power to set bankruptcy law, and the Supreme Court has held that sovereign immunity does not shield states from at least some claims grounded in laws enacted pursuant to that power. Central Va. Cmty. Coll. v. Katz, 546 U.S. 356 (2006). The application of these principles to claims under section 303(i) is discussed in a recent Ninth Circuit decision, Montana Dep’t of Revenue v. Blixseth (In re Blixseth), 2024 U.S. App. LEXIS 20462, 112 F.4th 837 (9th Cir. Aug. 14, 2024).
We have blogged previously about the involuntary petition filed against Timothy Blixseth. The Montana Department of Revenue (“MDOR”) and three other creditors filed an involuntary petition that Blixseth sought to dismiss on the ground that the creditors’ claims were subject to bona fide disputes. In a 2019 decision, the Ninth Circuit agreed. The case returned to the bankruptcy court, which dismissed the petition. Blixseth then brought an adversary proceeding against MDOR under section 303(i) seeking attorneys’ fees and costs, proximate and punitive damages, and sanctions against counsel. MDOR sought dismissal on grounds of sovereign immunity. The bankruptcy court rejected the sovereign immunity defense, on the grounds that (1) MDOR had voluntarily invoked the court’s jurisdiction with the involuntary petition, (2) MDOR’s counsel had waived sovereign immunity based on an earlier colloquy with the court while the involuntary petition was pending, and (3) a 303(i) action is ancillary to the bankruptcy court’s in rem jurisdiction and therefore is not subject to sovereign immunity. MDOR appealed to the Ninth Circuit’s Bankruptcy Appellate Panel, which dismissed the appeal on the ground that the bankruptcy court’s decision was not a final order. MDOR appealed to the Ninth Circuit.
The Ninth Circuit reversed. As an initial matter, it noted that denials of sovereign immunity are immediately appealable, contrary to the decision of the Bankruptcy Appellate Panel. The court then proceeded to address the bankruptcy court’s three grounds for rejecting MDOR’s sovereign immunity defense. On the first ground, the bankruptcy court had relied on the principle that when a state files a proof of claim in a bankruptcy case, it waives sovereign immunity as to any claim by the bankruptcy estate that arises out of the same transaction or occurrence as the state’s claim. The Ninth Circuit rejected this reasoning. The Ninth Circuit explained that a section 303(i) claim does not arise out of the same transaction or occurrence underlying the involuntary petition, because it arises from the fact of the petition itself. The Ninth Circuit also rejected an analogy to Rule 11 sanctions, noting that it had previously distinguished between Rule 11, a sanctions statute pertaining to specific filings, and section 303(i), a fee-shifting statute pertaining to the merits of the litigation as a whole. On the second ground, that MDOR’s counsel had waived sovereign immunity, the Ninth Circuit noted that a waiver of sovereign immunity had to be “unequivocal” and concluded that MDOR’s counsel could not and did not effect an unequivocal waiver of sovereign immunity.
The Ninth Circuit’s most extended analysis concerned Katz. The Ninth Circuit explained that Katz held that the bankruptcy clause in the Constitution manifested state consent to subordinate sovereign immunity to the in rem jurisdiction of a bankruptcy court and orders ancillary to that jurisdiction. In Katz, the Supreme Court held that this consent extended to the avoidance of preferential transfers, since avoidance and recovery of preferential transfers was a core longstanding aspect of the administration of bankrupt estates. The Ninth Circuit analyzed whether Blixseth’s 303(i) claim fell under Katz by looking to three core functions of bankruptcy proceedings referenced in Katz: “[1] the exercise of exclusive jurisdiction over all of the debtor’s property, [2] the equitable distribution of that property among the debtor’s creditors, and [3] the ultimate discharge that gives the debtor a ‘fresh start’ by releasing him, or her, or it from further liability for old debts.” Blixseth, 2024 U.S. App. LEXIS 20462, at *16 (quoting Katz, 546 U.S at 363‑64). The Ninth Circuit held that none of these functions were implicated by the 303(i) action. Section 303(i) is a remedial scheme for dismissed involuntary petitions and has no relation to exercising jurisdiction over a debtor’s property or equitably distributing that property among creditors. Nor is it related to affording debtors a fresh start—Blixseth, the Ninth Circuit reasoned, did not seek a fresh start with respect to old debts but rather reimbursement of his costs for the involuntary petition.
As such, the Ninth Circuit concluded that sovereign immunity applied, and remanded the case to the bankruptcy court with instructions to dismiss the 303(i) claim as barred by sovereign immunity.
