Creditors Beware Involuntary bankruptcies are not common

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.