Under the U.S. Federal Bankruptcy Code Title 11, creditors are allowed to file an involuntary petition for Chapter 7 or Chapter 11 against any debtor entity except for farmsteads and non-profit organizations. With debtors that have not responded to any other forms of encouragement to pay their debts, the threat or actual filing of a petition for involuntary bankruptcy may appear to be a good collection tool for recovering at least some of your money. However, there are a number of pitfalls within the law to watch for that should make this a last resort in any creditor’s collection arsenal.

7 Reasons to Consider Filing an Involuntary Bankruptcy Petition

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:

The debtor is squandering assets or is grossly incompetent.
The debtor is transferring unsecured assets to a third party for less than reasonably equivalent values.
The debtor is transferring assets to a creditor for forgiveness of a debt, and thus leaving insufficient funds to pay other creditors.
The debtor is transferring assets to a related company or a successor company.
The debtor is only paying debts that have been guaranteed by its principals, or is only paying debts owed to other “insiders”.
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.
A bankruptcy filing is imminent, but in a jurisdiction that will make it cost-prohibitive for unsecured creditors to participate.

Requirements of an Involuntary Petition

The legal requirements for filing an involuntary bankruptcy petition are straight-forward and outlined in Section 303(b) of U.S. Title 11:

The creditors filing the petition must have total outstanding, unsecured debt of at least $10,000. Where there are 12 or more total creditors, three must participate in the involuntary petition. Where there are fewer than 12 creditors, a single creditor may file. The rules regarding partnerships are somewhat different (see Section 303(b)(3) of the Bankruptcy Code).
The debts must not be contingent or involve bona fide disputes.

For the court to find in favor of the creditors (order relief against the debtor), it must find that:

the debtor is not generally paying its debts as they become due; and
the creditor’s petition was made in good faith.

Benefits of Filing an Involuntary Petition

A primary benefit of forcing an involuntary bankruptcy is the ability to recover “avoidable transfers” (called preferences), as well as insider and fraudulent transfers, back into the debtor’s estate. 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 attorney’s and accountant’s fees and costs, legal fees and costs for preparation and filing of the petition, time involved in contacting other creditors to join the filing, and any litigation directly related to the petition. Administrative claims receive first priority under U.S. bankruptcy law and, thus, are paid before any other claims.

Creditors Beware

Involuntary bankruptcies are not common because they can be difficult and risky for the filing creditors.

The debtor can resist the involuntary petition by filing, within 20 days, an opposition 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 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:

A judgment for costs and attorneys’ fees incurred by the debtor.
Punitive damages if the Court feels the action was not brought in good faith.

Generally Not Paying Debts as They Come Due. The creditor has the burden of proving this point, and therefore, 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 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.

Bona Fide Disputes. 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.

“Good Faith” Requirement. The purpose of involuntary bankruptcy is to prevent unfair practices against creditors as a group. 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.

Other Considerations Before Filing an Involuntary Bankruptcy Petition

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.
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.
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).

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.

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Disclaimer: This information is provided by ABC-Amega Inc. for informational purposes only and is not intended to be legal advice and is not a substitute for competent legal advice on the referenced subject.

This information is provided by ABC-Amega Inc. -- providing commercial debt collection services in more than 200 countries worldwide, For further information, contact info@abc-amega.com.