Creditors often consider filing an involuntary bankruptcy petition against their financially distressed debtors. Before using this extraordinary remedy, a creditor should evaluate whether it will achieve a valid business objective. Additionally, each creditor should evaluate whether there is a valid basis to support the filing. When the debtor's bankruptcy is appropriate, it can be a valuable step in maximizing a creditor's recovery. But the stakes are high. If the involuntary petition is dismissed, the bankruptcy court can direct each petitioning creditor to pay the debtor’s legal fees and can award damages. We identify here some of the critical issues that should be considered when deciding whether to commence an involuntary bankruptcy case.
Valid Business Objective
An involuntary petition is appropriate when there is a strong reason to replace the debtor’s management with a court-appointed trustee or to place the debtor's assets under court control and supervision. An involuntary bankruptcy filing will also stay another creditor from foreclosing on the debtor's assets and will facilitate the recovery of preferences and fraudulent transfers.
An involuntary petition ordinarily requires at least three unsecured creditors with aggregate claims exceeding $13,475.1 The claims must be non-contingent and undisputed.2 A secured creditor can join in the petition if it has an unsecured deficiency claim.3 Affiliated entities (i.e., domestic and offshore funds acting as lenders under a single loan agreement) should constitute separate creditors if their separate existence is recognized under applicable non-bankruptcy law.4
Ch. 7 or 11?
Petitioning creditors may file the involuntary petition either under Bankruptcy Code Chapter 7 (liquidation) or Chapter 11 (reorganization).5 If the goal is to replace management and force a liquidation, then Chapter 7 is more appropriate. The debtor, however, may convert an involuntary Chapter 7 case to a Chapter 11 case.6 Thus, unless the debtor is prepared to consent to a liquidation, the creditor should expect the debtor's conversion of the case to Chapter 11.
The United States Trustee ("UST") will, if the court orders bankruptcy relief, appoint an interim Chapter 7 trustee with no creditor input in the selection.7 Unsecured creditors (excluding insiders) can later elect a permanent trustee.8 In a Chapter 11 case, the debtor’s management remains in control,9 but the court on a showing of cause, including fraud, dishonesty, incompetence or gross mismanagement, can order the appointment of a trustee (selected by the UST or elected by creditors, if they request).10
The debtor has 20 days to contest the involuntary petition.11 From the time the petition is filed until the court's ruling on the petition (the so-called “gap period”), the debtor remains in control and may continue to use, acquire or dispose of property without any court oversight.12 The petitioning creditors can, however, move for the appointment of a trustee during the gap period in order to preserve property of the estate or to prevent loss.13 A bond must be posted by the petitioning creditors,14 and the petitioning creditors can seek to limit the debtor’s powers.15
Only the Debtor May Contest the Petition
If the debtor contests the petition, the petitioning creditors must prove that the debtor is generally not paying its debts as they become due.16 Not paying one debt out of many is generally insufficient. Courts typically consider (i) the number of unpaid claims; (ii) the amount of unpaid claims; (iii) the materiality of the non-payment; and (iv) the debtor’s overall financial condition.17 Prior to filing the petition, creditors should obtain a recent accounts payable aging report and determine the debtor’s cash position. If the petitioning creditors prevail, the court will enter an "order for relief," and the case will proceed. Other creditors may not support the debtor's opposition, for Congress long ago recognized that creditors or insiders who received preferences, for example, would readily oppose an involuntary bankruptcy.18
Withdrawing the Petition
The involuntary petition can be dismissed by the court only after a hearing on notice to all creditors.19 This requirement is intended to prevent collusive settlements among the debtor and petitioning creditors.20
Fees and Damages Available for Improper Petition
If the court dismisses the petition, the petitioning creditors may be directed to pay the borrower’s legal fees.21 Moreover, if the court finds that the creditors filed the petition in “bad faith,” it may hold the petitioning creditors liable for any damages caused by the filing plus punitive damages.22 On the other hand, if the petition is granted, the petitioning creditors’ legal fees are recoverable as a priority administrative expense.23