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Bankruptcy Involuntary bankruptcy: A creditor’s last resort

What is an involuntary bankruptcy petition?

Since the days of the Twelve Tables in ancient Rome, laws have been enacted to regulate the liquidation of property of bankrupts for the benefits of their creditors.

Most people agree the history of English bankruptcy law starts with the statutes passed by Henry VIII in 1542 and his daughter, Elizabeth I, in 1570.

These early English statutes allowed only for involuntary bankruptcy proceedings initiated by creditors. Voluntary bankruptcy was an American invention that didn’t appear until 1721.

England and the United States currently have both voluntary and involuntary bankruptcy petitions, each with the common aim of reducing the debtor’s assets, or estate, to money for the benefit of creditors.

How is an involuntary bankruptcy case initiated? In the United States, an involuntary bankruptcy case is initiated by a requisite number of creditors filing a petition and a summons with the clerk of the U.S. Bankruptcy Court.

The petition requests that an order for relief be entered making an individual or entity a “debtor” under a specified chapter of the U.S. Bankruptcy Code of 1978, as amended.

When the petition and summons are filed, the petitioning creditors pay the appropriate filing fee. Currently, the fee to initiate an involuntary Chapter 7 case is $200 and the fee for an involuntary Chapter 11 case, other than for railroads, is $830.


– Forms Available To File Petitions

The involuntary petition used by a creditor is designated as Official Form No. 11. The involuntary petition used by a general partner of a partnership is Official Form No. 12. The summons to the debtor has been designated as Official Form No. 13.

All of these forms can be found under Title 11 of the U.S. Code Annotated at local law libraries. They may also be available in legal bookstores or at a local bankruptcy court.

After the clerk of the court issues the summons, the petitioning creditors serve the summons and the involuntary petition on the alleged debtor. This has to be done personally or by first-class mail within 10 days of its issuance. A proof of this service must be filed with the clerk of the court.

The Bankruptcy Code states that unless the involuntary petition is “timely controverted,” an order for relief shall be entered and the bankruptcy case shall proceed.

What types of involuntary cases may be initiated? An involuntary case may be commenced only under Chapter 7, liquidation case, or Chapter 11, reorganization case, of the Bankruptcy Code.

It may not be commenced under Chapter 9, debt adjustment involving municipalities, Chapter 12, bankruptcies involving family farmers, or Chapter 13, adjustment of debts of an individual with regular income.


– Debtors May Continue Business

In a Chapter 11 case, the debtor is allowed to stay in business by a reorganization plan that meets statutory criteria. Creditors are paid from the ongoing cash flow of the business. A Chapter 7 case involves a termination of operations and a quick liquidation of the debtor’s assets.

In either a Chapter 7 or 11 case, only the creditors with claims allowed by the bankruptcy court will be paid a dividend from the debtor’s estate.

Whom may an involuntary petition be filed against? A Chapter 7 or a Chapter 11 petition can be filed against anyone, or anything, that is considered a debtor under the chapter in which the case is commenced.

In general, a “person,” such as an individual, corporation, or partnership, who resides, or has a domicile, a place of business, or property in the United States may be a debtor.

There are a few exceptions: a bank, insurance company, credit union or savings and loan may not be a debtor under either chapter, a railroad may not be a debtor under Chapter 7 and a stockbroker or commodity broker may not be a debtor under Chapter 11.

Convicts, dissolved corporations, entities no longer doing business and insane individuals , if the subject’s debts were incurred during a lucid period , have all been held to be eligible for an involuntary petition.

But, a golf club and a Masonic lodge have both been held to be nonprofit entities against which an involuntary petition may not be filed.


– Spouses Considered Two Separate Debtors

An involuntary petition may not be filed against a husband and a wife; separate petitions must be filed for each. Although a husband and wife are specifically allowed to file a joint voluntary petition under the Bankruptcy Code, they are two separate debtors.

What conduct makes one eligible to be an involuntary debtor? There are two situations where a debtor may become the subject of an involuntary bankruptcy.

In the first situation “the debtor is generally not paying such debtor’s debts as such debts become due unless such debts are the subject of a bona fide dispute.”

Secondly, if within 120 days before the filing date 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 of the alleged debtor’s assets, such as an assignee for the benefit of creditors, that individual or entity is also eligible for involuntary relief under the Bankruptcy Code.

The phrase “generally not paying such debtor’s debts as such debts become due” includes regularly missing a significant number of payments to creditors. It may also mean regularly missing payments that are significant in amount to the size of the alleged debtor’s operation.

The determination that an alleged debtor is not paying his debts is made as of the date the involuntary petition is filed.

Once a petitioning creditor establishes a prima facie case that no bona fide dispute exists, the burden shifts to the alleged debtor to present evidence demonstrating that a bona fide dispute does exist.


– At Least Three Creditors Petition

Who may be petitioning creditors? If an alleged debtor has 12 or more creditors, an involuntary petition must be initiated by no less than three of those creditors. Each must be a holder of an unsecured claim against the alleged debtor that is not contingent as to liability or the subject of a bona fide dispute, and they must total at least $10,775 as of the petition date.

If an alleged debtor has fewer than 12 creditors, excluding the debtor’s employees or insiders and recipients of preferences or fraudulent transfers, then only one creditor with an unsecured claim of at least $10,775 is needed.

A special exception occurs where an alleged debtor has only one creditor. An involuntary petition probably may not be filed as the creditor will be unable to prove that the alleged debtor is not paying its debts as they become due.

Some courts have held that relatives of the alleged debtor may be petitioning creditors. Chapter 11 debtors are eligible to be petitioning creditors against others. Even states can be petitioning creditors.

It has been determined that limited partners are not eligible by virtue of their partnerships to bring an involuntary petition against a partnership. Only one general partner is needed to file an involuntary petition against a partnership, whatever the amount of the partnership debts.

If all of the general partners of a partnership are each in bankruptcy, the holder of a claim of any amount may file an involuntary petition against that partnership.

At least one court has held that creditors of the alleged debtor who are insiders are ineligible to file an involuntary petition.

While fully secured creditors cannot commence involuntary insolvency proceedings, partially secured creditors are not disqualified as a petitioning creditor to the extent that their claims are unsecured.

The fact that a petitioning creditor is owed something other than a cash payment does not qualify that creditor from acting as a petitioning creditor.


– Amount Of Claim Can Be Undetermined

It is also unnecessary to determine the exact amount of the claim of a petitioning creditor as this can be left for future determination. Nor does a failure to send a bill or a failure to demand payment affect one’s status as a creditor.

What happens if an alleged debtor contests the involuntary petition? Before trial, both the petitioning creditors and the alleged debtor may take discovery of the other. The alleged debtor may also make a motion that the petitioning creditors post a bond to indemnify the alleged debtor for damages proximately caused by the filing.

If an alleged debtor is found to be the proper subject for an involuntary bankruptcy petition, an order for relief is entered. The petitioning creditors may then collect their expenses and their attorney’s fees from the debtor’s estate as a first priority administrative expense.

If the court finds the alleged debtor not subject to relief under the Bankruptcy Code and dismisses the involuntary petition, it may grant a judgment against the petitioning creditors for reasonable attorney’s fees. It may also award damages “proximately caused by such filing” or even punitive damages if the court finds that the petition was filed in bad faith.

If the involuntary petition is contested, what happens in the interim? In the so-called “gap period” before the entry of an order for relief, the alleged debtor may continue its business in the ordinary course.

However, an alleged debtor may not dispose of assets in a manner detrimental to creditors. During this interim period, the petitioning creditors my file a motion to appoint an interim trustee to take control of the alleged debtor’s affairs to preserve the property of the estate.


– Gap Claims Have Priority Payment

Claims against an alleged debtor that arise postpetition but prior to the entry of the order for relief are known as “gap claims” which are entitled to a special priority for payment ahead of most other unsecured claims.

Conclusion: Involuntary bankruptcy should be a creditor’s last resort. Assets of the debtor will be used to pay all creditors who have allowed claims against the debtor’s estate, not just the allowed claims of the petitioning creditors.

Further information on the filing of involuntary bankruptcy petitions can be obtained by consulting the applicable provisions of the Bankruptcy Code, the Federal Bankruptcy Rules, and the rules of your local bankruptcy court.

Because petitioning creditors may be liable for actual or punitive damages if the case is dismissed, it may be prudent to confer with an experienced bankruptcy attorney before relief is sought under the involuntary provisions of Title 11 of the U.S. Code.

Avery, a Partner at the Los Angeles office of Sulmeyer, Kupetz, Baumann & Rothman, is a certified specialist in both personal and business bankruptcy law.

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