Creditor’s Rights: Capture a Debtor’s Value by Forcing an Involuntary Bankruptcy

The vast majority of bankruptcy cases begin when a debtor files a petition seeking relief from creditors. This document is known as a “Voluntary Petition” and usually results in the bankruptcy court assuming jurisdiction over a debtor’s assets and, in the case of an individual, entry of an order discharging pre-bankruptcy debts.

Debtors are not the only parties who have the power to enlist help from the bankruptcy courts. Under the right circumstances, creditors can file an Involuntary Petition and force the debtor to address issues of insolvency and the dissipation of assets. The following are the main threshold requirements to initiate an involuntary bankruptcy case:

  1. If the debtor has more than eleven creditors, three creditors can join together to file an involuntary bankruptcy petition. These creditors are known as the “petitioning creditors.” If the debtor has eleven or fewer creditors, only one creditor is required. In practice, between normal utility, cell phone, credit card, employee, mortgage and other claims most debtors will have more than eleven creditors.
  2. The debtor is generally not paying its debts as they become due, unless such debts are the subject of a bona fide dispute as to liability or amount. A bankruptcy court will examine the debtor’s overall financial health. If the debtor simply cannot keep up with its bills the court will be much more likely to approve an involuntary bankruptcy than if the petitioning creditors are disgruntled claimholders with whom the debtor is in litigation. .
  3. The three creditors must have noncontingent debts. These debts must not be personal guaranties or other claims that will not mature until some other event occurs to trigger liability.
  4. The debts of the petitioning creditors must not be subject to a bona fide dispute. Creditors cannot use the involuntary bankruptcy procedure as a litigation tactic.
  5. The aggregate amount of the unsecured claims of the petitioning creditors must be more than $14,425. Involuntary bankruptcy is a remedy for unsecured creditors, not secured creditors who may foreclose on or seize collateral to obtain repayment of their claims.

Creditors most commonly use the involuntary bankruptcy procedure when the debtor has transferred, or is likely to transfer, assets that will diminish the creditors’ likelihood of being paid. For example, if the Debtor has made substantial transfers to insiders without adequate consideration, a bankruptcy trustee may recover those transfers for up to four years, depending upon the law of the applicable state. Similarly, if a debtor has repaid creditors substantial sums within the prior 90 days, a trustee can recover those payments as preferences.

On the other hand, sometimes creditors have concerns that a debtor will transfer significant assets, or even the debtor’s entire business operation. If a creditor obtains this kind of information the creditor may seek similarly situated creditors and commence an involuntary bankruptcy case by filing a petition with the bankruptcy court.

Filing an involuntary petition is similar to filing a federal court complaint. The debtor has thirty days after service to contest the validity of the filing. As shown from the list above, debtors may have many grounds to resist the bankruptcy filing. However, if the creditors prevail at a trial on their petition, the court will enter an order for relief and appoint a Chapter 7 trustee to begin the process of administering the debtor’s assets. At that point, the debtor has the right to convert its case to Chapter 11 (or 13, if the debtor is an individual) in order to reorganize its affairs.

The filing of an involuntary petition is often a double edged sword for creditors. On the one hand, the filing creates an automatic stay that prevents creditors from taking any steps to collect on their claims. Thus no foreclosure, lawsuit or asset seizure may occur after filing an involuntary case.

On the other hand, until the bankruptcy court enters the order for relief the debtor’s activities are not restricted. Thus the debtor can continue to buy and sell assets and even transfer assets without consideration. However, if the court views these activities as severely prejudicial to creditors’ rights, or even if the petitioning creditors can establish that the debtor has committed fraud or other abusive acts, the court has the power to appoint an interim trustee even without entering an order for relief. Under those circumstances, the debtor will lose control of its assets.

It is not surprising that the filing of an involuntary bankruptcy may have disastrous effects on the debtor’s business. The adverse publicity of a bankruptcy case, along with the cost of contesting an involuntary petition, may cause significant damage to the debtor. In light of these potentially dire results, the bankruptcy code provides significant remedies for debtors who ultimately prevail against an involuntary petition. If the petition is dismissed debtors may obtain costs or a reasonable attorneys’ fee. If the court rules that the involuntary petition was filed in bad faith, the court may award the debtor any damages caused by the filing or punitive damages.

Under the right circumstances, when the debtor’s actions are causing creditors to lose significant value to repay their claims, the filing of an involuntary bankruptcy may result in a significant recovery and prevent years of costly and futile litigation. However, the prospect that a debtor may receive an award of its attorneys’ fees even against petitioning creditors who act in good faith should cause creditors to carefully analyze all the elements and likely defenses before filing that simple two page involuntary petition.

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