Creditors’ Strategic Use of Involuntary Bankruptcy
The purpose of an involuntary bankruptcy, where a company is forced into bankruptcy by its creditors, is to invoke the broad jurisdiction of the Bankruptcy Code over the company’s assets and liabilities. The benefits include, among other things:
- Marshalling and preserving the company’s assets;
- Controlling the use and disposition of the company’s property, through court supervision;
- Resolving disputes arising under, arising in, or related to the company’s bankruptcy case;
- Enjoining creditor actions or claims against the debtor;
- Scrutinizing, and potentially avoiding, transactions between the company and third parties, including preferential and fraudulent transfers; and
- Participating in the plan of reorganization process in chapter 11 cases.
An involuntary case differs substantially from a voluntary petition. Foremost, in a voluntary bankruptcy filing, the bankruptcy petition is equivalent to an adjudication that the company is bankrupt. Due process concerns, however, prevent the same approach in an involuntary case. See In re Arriola Energy Corp., 74 B.R. 784 (S.D. Tex. 1987). Instead, the filing of an involuntary petition is similar to the filing of a complaint in a federal lawsuit, where the plaintiff merely makes refuttable allegations against the company that are often challenged.
An involuntary bankruptcy petition can be filed against a person or an entity by three unsecured creditors whose claims aggregate $14,425 and are not subject to bona fide dispute. See11 U.S.C. s. 303(b). If the company has less than 12 creditors, an involuntary petition can be filed by a single creditor with an undisputed, noncontingent claim equal to or exceeding $14,425. If the company is a partnership, an involuntary petition can be commenced by fewer than all the general partners.
In order for the bankruptcy court to adjudicate a company bankrupt, the petitioning creditors must demonstrate that the company is not paying its debts as they come due, as of the date the involuntary petition is filed. See In re Harmsen, 320 B.R. 188 (10th Cir. BAP 2005). The petitioning creditors must do more than establish the existence of a few unpaid debts in order to satisfy this standard. See In re St. Marie Dev. Corp. of Montana, Inc., 334 B.R. 663 (Bankr. D. Mont. 2005).
Generally, courts have held that the “not paying debts” standard is flexible, considering the totality of the circumstances. See In re Concrete Pumping Service, Inc., 941 F.2d 627 (6th Cir. 1991). In In re Moss, 249 B.R. 411 (Bankr. N.D. Tex. 2000), the bankruptcy court for the Northern District of Texas demonstrated the flexibility of this standard, focusing on the following factors:
- the number of unpaid claims;
- the amount of such claims;
- the materiality of the nonpayments; and
- the debtor’s overall conduct in its financial affairs.
Only persons or entities that reside or have a domocile, place of business, or property in the U.S. may be a debtor in bankruptcy. See 11 U.S.C. s. 109(a). An involuntary case can be commenced under chapters 7 and 11 of the Bankruptcy Code. A chapter 7 case is a liquidation case, where a trustee is appointed to sell all the assets of the company and make distribution to creditors. A chapter 11 case is a reorganization case, where the company proposes a plan that reduces, modifies or restructures all of its debts and obligations.
A person or entity may generally qualify for chapter 7 relief if such person or entity is not a railroad, a domestic insurance company, banks, savings bank, cooperative bank, savings and loan association, homestead association, small business investment company, credit union, industrial bank or similar institution. A person or entity entitled to chapter 7 relief generally can also be entitled to chapter 11 relief.
An involuntary case cannot be commenced against entities that are not moneyed, business or commercial corporations. 11 U.S.C. s. 303(a). This exception has been consistently construed to mean that nonprofit organizations such as schools, churches, charitable organizations are not subject to involuntary bankruptcy. See In re Mem. Medical Ctr., Inc., 337 B.R. 388 (Bankr. D. N.M. 2005); H.R. Rep. No. 95-595, 95t Cong., 1st Sess. 321 (1977); S. Rep. No. 95-989, 95th Cong., 2d. Sess. 33 (1978), U.S. Code Cong. & Admin. News 1978, pp 5963, 6277, 6278, 5785, 5819.
Due Process Concerns
After the filing of an involuntary petition, the clerk of the bankruptcy court issues a summons to be delivered by the petitioning creditors upon the company within 10 days. See Fed. R. Bankr. P. 1010. The petitioning creditors must then deliver the summons, along with a copy of the involuntary petition, to the company, in accordance with Federal Rules of Bankruptcy Procedure. The company has 20 days after receipt to challenge the involuntary petition, by filing and serving a responsive pleading or motion to dismiss, pursuant to Federal Rule of Civil Procedure 12(b).
The company essentially has the options of contesting the involuntary petition, consenting to the bankruptcy relief or converting the case to a different chapter. Section 303(j) of the Bankruptcy Code also provides that an involuntary petition may be dismissed (a) on motion by a petitioning creditor, (b) consent of all petitioners and the company or (c) for lack of prosecution. It has been a long-standing rule that a non-petitioning creditor lacks standing to contest an involuntary petition. See Carlson Plywood Co. v. Vytex Plastics Corp., 519 F.2d 556, 557-58 (7th Cir. 1975)
If the company constests the involuntary petition, possible defenses include:
- lack of jurisdiction;
- improper venue;
- amount of debt of petitioning creditors is below threshold;
- insufficient number of petitioning creditors;
- nonqualifying petitioning creditors (e.g., claims are secured);
- petitioning creditors’ claims raise issues of duress, estoppel, fraud or falsity; or
- a single petitioning creditor situation involves essentially a two-party dispute.
If the company does nothing, however, the bankruptcy court must adjudicate the company bankrupt. See 11 U.S.C. s. 303(h).
If the company challenges the involuntary petition and the matter proceeds to trial on the mertis, any party is entitled to conduct discovery regarding the merits and may file a dispositive motion, based on undisputed facts or law, that allows the bankruptcy court to rule without a trial.
Petitioning Creditors’ Reimbursement
Pursuant to sections 503(b)(3)(A) and 503(b)(4) of the Bankruptcy Code, petitioning creditors can be reimbursed costs incurred in connection with filing an involuntary petition, including all reasonable legal fees and costs. See In re On Tour LLC, 276 B.R. 407, 415 (Bankr. D. Md. 2002); In re Crazy Eddie Inc., 120 B.R. 273, 278 (Bankr. S.D.N.Y. 1990).
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