Editor’s Note: This is a new one for us at The Bankruptcy Cave. We are starting a series of primers, covering a narrow range of law but with more depth than just “here’s a recent case.” And also, we have our first edition of “The Bankruptcy Cave Embedded Briefs” – top quality briefs on a certain issue, feel free to download to your own form files or come back and grab ’em when you need ’em. Let us know what you think – we are always trying to improve things around here for our readers.

Involuntary bankruptcy is an underused but potentially powerful tool in the Bankruptcy playbook. Although the process to initiate an involuntary case is relatively straightforward (and has been largely unchanged for decades), the scarcity of involuntary petitions filed each year means few bankruptcy lawyers have any practical experience in this area of law. In 2012 (the last year for which we have good data) just over 500 involuntary bankruptcy petitions were filed, representing but .04% of total bankruptcy filings.[1]

Initiating the Involuntary Case

An involuntary case is commenced by the filing of an involuntary bankruptcy petition under Chapter 7 or 11 of the Bankruptcy Code.[2] With a few exceptions,[3] creditors holding “a claim … that is not contingent as to liability or the subject of a bona fide dispute as to liability or amount” have standing to file an involuntary bankruptcy petition. A bona fide dispute must be to the debt’s existence and validity, and not merely the amount of the debt owed.[4]

An involuntary petition requires three or more creditors with an aggregate claim of at least $15,325.[5] However, if the putative debtor has fewer than twelve total creditors (excluding employees and insiders), a single creditor may file an involuntary petition if its claim exceeds $15,325.

  • The Bankruptcy Cave Embedded Briefs: Can you have an involuntary case if the Debtor has just one creditor? Yes – so long as there is a “bankruptcy purpose” to the case – fraudulent transfers, the need for a trustee, or other relief that is somewhat unique to the Bankruptcy Code. Check out this imbedded brief [Imbedded Brief 1] on the issue (which won), and use for future reference. And see the posts cited below for more on the requirement that there be a “bankruptcy purpose” for an involuntary case, even where the statutory standards are met.

The requirements of Section 303 are determined at the moment the involuntary petition is filed; a putative debtor cannot defeat an involuntary petition by subsequently paying off the petitioning creditors to reduce their number or to generate a “bona fide dispute” as to a claim.[6] Additionally, Section 303(c) permits other creditors to join a petition after it is filed to cure a deficiency in the original petition.[7]

Unlike a voluntary petition under Chapter 7 or 11, the filing of an involuntary petition does not constitute an order for relief under Section 301(b) and, therefore, most provisions of the Bankruptcy Code do not yet apply. Until an order for relief is entered, a putative involuntary bankruptcy debtor may continue to operate under normal business conditions, as if the involuntary petition had never been filed.[8]

Challenging the Involuntary Bankruptcy Petition, Part I – The Statutory Standards

Filing an involuntary bankruptcy petition is akin to filing a lawsuit against the putative debtor. Upon the petition filing, the bankruptcy court clerk will issue a summons to be served on the debtor,[9] and the debtor generally has twenty-one days from the date of service to respond.[10] If contested, a bench trial on the petition will be held. The petitioning creditors must prove that the threshold elements of Section 303(b) were met and either:

  1. the debtor is generally not paying its debts as they become due, unless such debts are the subject of a bona fide dispute; or
  2. within 120 days before the date of the filing of the petition, a custodian, other than a trustee, receiver, or agent appointed or authorized to take charge of less than substantially all of the property of the debtor for the purpose of enforcing a lien against such property, was appointed or took possession.[11]

The “generally not paying debts” standard looks to the totality of the circumstanced at the time the involuntary petition was filed, and takes into consideration the following, non-exclusive factors: (i) the number and amount of unpaid claims; (ii) the materiality of the nonpayment; (iii) duration of nonpayment; (iv) total amount of indebtedness and financial situation; and (v) any reduction in the debtor’s assets.[12]

If the petitioning creditors can establish that the putative debtor is generally not paying debts, or that a custodian has been appointed over substantially all of the putative debtor’s property, an order for relief will be entered and the case will proceed in the same course as a voluntary Chapter 7 or Chapter 11 case.

Challenging the Involuntary Bankruptcy Petition, Part II – An Independent Requirement of Good Faith?

Recent Delaware caselaw indicated that even an involuntary petition that satisfies the statutory requirements of Section 303 can be dismissed, if there is an ulterior motive to the filing separate from the collection of a debt. In one case, the petitioners’ primary desire to effectuate a change in management, and not to collect their debts, rendered the filing in bad faith. Check out the analysis (and a link to the opinion) here, courtesy of John Bird of Fox Rothschild. In another recent case, the petitioning creditors were using the bankruptcy case to transfer venue of long-running litigation, resulting in another dismissal of the case due to bad faith. Check out this additional analysis (and a link to the opinion) here, from Ben Keenan of Ashby and Geddes. (By the way, Fox Rothschild’s Delaware Bankruptcy Litigation blog and Ashby and Geddes’s Delaware Bankruptcy Insider are really the two best Delaware-centric bankruptcy blogs out there – must-read stuff (in addition to The Bankruptcy Cave, of course) to stay abreast of DE happenings and DE’s influence in the restructuring world.)