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Involuntary Bankruptcy: the Pros and Cons

Originally published: February 2012

What You Need to Know Before Filing an Involuntary Bankruptcy Petition Against Your U.S. Debtor

Under the U.S. Federal Bankruptcy Code Title 11, creditors may file an involuntary petition for Chapter 7 or Chapter 11 against any debtor entity excluding banks, credit unions, insurance companies, farmsteads and non-profit organizations.

At first glance, this may appear an attractive option once you've exhausted your standard arsenal of collection tools to no effect. While the threat or actual filing of a petition for involuntary bankruptcy may help in recovering at least some of your money, you shouldn't be too quick to go down this path. There are a number of pitfalls within the law you need to be aware of. These are concerning enough to make this action a creditor’s last resort.

Requirements of an Involuntary Petition

The legal requirements for filing an involuntary bankruptcy petition are outlined in Section 303(b) of U.S. Title 11:
  1. The creditors filing the petition must have total outstanding, unsecured debt of at least $14,425. Where there are 12 or more creditors, three unsecured creditors claims totaling at least $14,425 that do not involve any bona fide disputes must participate in the involuntary petition. Where there are fewer than 12 creditors, a single unsecured creditor may file as long as the claim has no bona fide disputes and is an amount of $14,425 or more. The rules regarding partnerships are somewhat different (see Section 303(b)(3) of the Bankruptcy Code).
  2. The debts must not be contingent or involve bona fide disputes. “Bona fide disputes” were defined in the 2005 BAPCPA amendment to Section 303(b) as disputes relating to liability for or the amount of the claim.

Involuntary Bankruptcy Process

The process for filing an Involuntary Bankruptcy Petition is as follows:
  1. Filing the Documents. The creditor/s first determine whether to file as a Chapter 7 (liquidation) or a Chapter 11 (reorganization). They then file Form B5 and a summons with the U.S. Bankruptcy Court clerk in the debtor’s locale. The B5 form must be completed, accurate and signed by the petitioning creditor/s or their attorneys. The filing fee is paid by the creditors, who are also responsible for ensuring that the petition is filed on the debtor in a timely manner. A process server is generally hired to accomplish this.
  2. Debtor Objection. The debtor has 20 days from the date of filing to object to the Petition. If the objection is not filed, then the petitioning creditors automatically win and the Bankruptcy 7 or 11 proceeds in the normal manner.
  3. Court Hearing. If an objection is filed, both sides are granted a hearing to present their cases.
  4. Court Decision. For the court to find in favor of the creditors and issue an order of relief against the debtor, it must find that:
    1. the debtor is not generally paying its debts as they come due; and
    2. the creditor’s petition was made in good faith.
    • If the creditor wins, the debtor is forced into bankruptcy and the case proceeds as a normal Chapter 7 or Chapter 11. If the debtor wins, the petition for bankruptcy is denied and the petitioning creditors may have to pay the debtor’s legal costs and damages.
    • The court can also abstain from the matter or, if it feels the best interests of the creditors and the debtor would be better served by a dismissal or suspension, dismiss the case out of hand.

Benefits of Filing an Involuntary Petition

A primary benefit of forcing an involuntary bankruptcy is the ability to recover back into the debtor’s estate “avoidable transfers” (called preferences), as well as insider and fraudulent transfers. The filing of the involuntary bankruptcy stops the clock, allowing the avoidance of:
  • insider transfers made within 2 years prior to filing.
  • fraudulent transfers made within 1 year prior to filing under the Federal Code, but up to 4 to 7 years under certain state Codes.
  • non-insider preferences made within 90 days prior to filing.
Another benefit is that the bankruptcy provides the opportunity for the automatic appointment of a Chapter 7 Trustee, or, for cause, the appointment of a Chapter 11 Trustee. Thus focusing attention on the conduct of the debtor – whether it be illegal or inadequate.

A secondary benefit: If the petition is accepted by the Court, the creditors involved in the filing can submit an administrative claim for “actual, necessary expenses” incurred up to the time of the order for relief. These expenses include what are termed “administrative fees” under Title 11. They include attorney’s and accountant’s fees and costs, costs for preparing and filing the petition, time involved in contacting other creditors to join the filing, and any litigation directly related to the petition. These claims receive first priority under U.S. bankruptcy law and are paid before any other claims.

Creditors Beware

Involuntary bankruptcies are not common because they can be difficult and risky for the filing creditors. Therefore, creditors should fully evaluate their risks prior to taking this action. Also note that, once the petition is filed, the creditors cannot withdraw it, even if the debtor agrees to withdrawal.

Other Risks

  • The debtor can resist the involuntary petition by filing, within 20 days, an objection that disputes the issues of whether or not he is paying his debts as they become due and/or that the debts are subject to a bona fide dispute. The burden of proof is on the creditors and defeating the debtor’s challenges can often be a difficult and expensive undertaking.
  • The court may, for cause, require the creditor/s to file a bond to indemnify the debtor for potential damages. Should it rule in the debtor’s favor, dismissing the involuntary petition, the creditor/s involved may be subject to:
    1. A judgment for costs and attorneys’ fees incurred by the debtor.
    2. Punitive damages if the Court feels the action was not brought in “good faith”. 
  • The petitioning creditors have the burden of proving that the debtor has generally not been paying its debts as they come due. Therefore, they should conduct careful due diligence. The fact that a few creditors are not being paid is not enough to satisfy the requirement. To make a determination, courts have used factors such as the amount of debts that are long overdue, the age of the past-due accounts, and the debtor’s liquidity.  “Generally not been paying” has been defined by some courts to mean that the debtor is regularly missing a significant number of payments that are significant in relation to the debtor’s overall financial situation.  In the case of bona fide disputes, if the debtor can allege any legitimate defense, whether the defense has any merit or not, the court can disqualify the claim.
  • The purpose of involuntary bankruptcy is to prevent unfair practices against creditors as a group, referred to as the “good faith” requirement. Therefore, if the Court determines that the petition was filed to favor specific creditors, or for reasons of malice or harassment, or as a substitute for state-law remedies, it will dismiss the petition.
  • Involuntary bankruptcies filed by a single creditor have an additional risk of being denied as the Bankruptcy Court might consider them two-party disputes that should be adjudicated in a forum other than the bankruptcy court. In this case, the filing of the petition will be found unwarranted and the creditor will lose its petition.

Other Considerations Before Filing an Involuntary Bankruptcy Petition

  1. Until an order for relief is filed by the court, the debtor can continue to operate as if an involuntary petition had never been filed. The Bankruptcy Code does contain provisions whereby a trustee can be appointed on an interim basis. However, the creditors have to prove “gross mismanagement”, which is difficult.
  2. The bankruptcy may result in further barriers to collecting the debt as the filing triggers an automatic stay, which precludes creditors from taking any other course of action to collect.
  3. During the “gap period” between filing the petition and the court’s order for relief, the debtor does not have the rights of a debtor-in-possession. Thus, while creditors may need to extend credit during this period to keep the debtor afloat, they cannot secure this credit by super-priority liens (liens that take priority over other liens).

7 Reasons to Consider Filing an Involuntary Bankruptcy Petition

Despite the risks, there are still instances where the creditors should consider forcing an involuntary bankruptcy. It’s a foregone conclusion that you don’t consider filing an involuntary bankruptcy petition unless the debtor is not paying its debts. Beyond that, consider this remedy if:
  1. The debtor is squandering assets or is grossly incompetent.
  2. The debtor is transferring unsecured assets to a third party for less than reasonably equivalent values.
  3. The debtor is transferring assets to a creditor for forgiveness of a debt, and thus leaving insufficient funds to pay other creditors.
  4. The debtor is transferring assets to a related company or a successor company.
  5. The debtor is only paying debts that have been guaranteed by its principals, or is only paying debts owed to other “insiders”.
  6. Actions are being taken that benefit the debtor’s lenders at the detriment of other creditors, for instance, lenders are seeking additional collateral to better secure their positions.
  7. A bankruptcy filing is imminent, but in a jurisdiction that will make it cost-prohibitive for unsecured creditors to participate.

To File or Not to File

The involuntary bankruptcy provisions of the U.S. Title 11 Bankruptcy Code offer creditors a powerful remedy when utilized appropriately. However, the risks involved should not be taken lightly, nor should creditors institute such an action without the advice of competent legal counsel.