Defending Involuntary Bankruptcies Part I: The Basics of an Involuntary Bankruptcy

Involuntary bankruptcy is a legal proceeding creditors may use to force a debtor into bankruptcy, rather than a debtor voluntarily seeking bankruptcy protection on its own behalf. Creditors seeking involuntary bankruptcy must file a petition in the bankruptcy court, and the debtor has the opportunity to defend against being forced into bankruptcy. This blog is Part 1 in a two-part series, and will set forth the basics of an involuntary bankruptcy. Part 2 provides tips and strategies for defending against an involuntary bankruptcy petition.

Who can file an involuntary petition?

Involuntary bankruptcies are typically brought by three or more petitioning creditors. However, a single petitioning creditor may pursue an involuntary bankruptcy when the debtor has eleven (11) or less creditors. 11 U.S.C. § 303(b). This is commonly known as the “numerosity” requirement. If the debtor has twelve (12) or more creditors, §303(b) requires that three qualified creditors file the petition. The burden is on the petitioning creditor(s) to prove that the numerosity requirement has been satisfied. Additional petitioning creditors can join in the petition during the “gap period,” or the time in-between the filing of petition and the order of relief, and are treated as if they had been a petitioner from the date of filing. 11 U.S.C. §303(c).

Not just any creditor can file a petition. A petitioning creditor must be a holder of a claim against the alleged debtor that is (i) not contingent as to liability or (ii) the subject of a bona fide dispute as to liability or amount. 11 U.S.C. § 303(b)(1). The petitioning creditors must hold unsecured claims that aggregate at least $15,325.00. Furthermore, a qualifying creditor’s claim cannot be barred by a statute of limitations. See Bartmann v. Maverick Tube Corp., 853 F.2d 1540, 1544-45 (10th Cir. 1988).

“An entity that has transferred or acquired a claim for the purpose of commencing a case for liquidation…or for reorganization…may not be a petitioner for purposes of commencing an involuntary case.” Fed R. Bankr. P. 1003(a). If the petitioner petitions a claim that was transferred, “the transferor or transferee must annex to the original and each copy of the petition a copy of all documents evidencing the transfer,” regardless of the purpose of the transfer, as well as “a signed statement averring that the claim was not transferred for the purpose of commencing the case and setting forth the consideration and terms of the transfer.” Id.

What happens after the petition is filed?

The alleged debtor has twenty-one (21) days to file an answer or other responsive pleading. Fed. R. Bankr. P. 1011(b). In the event that the debtor fails to timely oppose the involuntary petition, “the court, on the next day, or as soon thereafter as practicable, shall enter an order for the relief requested in the petition.” Fed. R. Bankr. P. 1013(b). However, if the alleged debtor contests the petition, the court shall make determinations “at the earliest practicable time.” Fed. R. Bankr. P. 1013(a). Until the court enters an order for relief, the parties are in what is commonly referred to as the “gap period.”

Gap Period

Similar to a voluntary bankruptcy proceeding, an automatic stay goes into effect during the gap period. 11 U.S.C. § 362(a). Therefore, the alleged debtor can choose not to pay its creditors during the gap period because the creditors are barred from collecting on the debts. Importantly however, and this is a critical difference from a voluntary bankruptcy, the alleged debtor “may continue to use, acquire, or dispose of property as if an involuntary case concerning the debtor had not been commenced.” 11 U.S.C. § 303(f). An alleged debtor can choose to pay its creditors without seeking approval from the court. For these reasons, some refer to the gap period as the “best of both worlds” and the gap period may last as long as two years while the petitioning creditors and debtor litigate over whether an order for relief should be entered. E.g., In re Wynn, 889 F.2d 644 (5th Cir. 1989). Still, the court has authority to restrict the alleged debtor’s operations during the gap period. 11 U.S.C. § 303(f). This may manifest in the appointment of an interim trustee. 11 U.S.C. § 303(g).

What do the petitioning creditors have to prove?

To succeed in putting the alleged debtor into bankruptcy, the petitioning creditor(s) must prove at trial that “the debtor is generally not paying such debtors debts as such debts become due unless such debts are the subject of a bona fide dispute as to liability or amount.” 11 U.S.C. § 303(h). This is known as the insolvency requirement.

There is no brightline test set forth in the Bankruptcy Code for courts to employ in determining whether an alleged debtor is generally not paying his or her debts as they become due. Rather, the bankruptcy court looks to various factors and will take into consideration: the number of unpaid claims; amount of claims; materiality of nonpayment; overall conduct of debtor’s financial affairs; amount of delinquencies; and number of delinquencies, just to name a few.

Similarly, “bona fide dispute” is also not defined in the Bankruptcy Code. A majority of federal circuits have adopted an objective test. This test requires a determination of whether there is an “objective basis for either a legal or factual dispute as to the validity of debt.” In re Ransome Group Investors I, LLP, 424 B.R. 547 (Bankr. M.D. Fla. 2009). In other words, “if the defense of the alleged debtor to the claim of the petitioning creditor raises material issues of fact or law so that a summary judgment could not be rendered as a matter of law in favor of the creditor on a trial of the claim, the claim is subject to a bona fide dispute.” In re Stroop, 51 B.R. 210, 212 (Bankr. D. Colo. 1985). After the petitioning creditor(s) prove that their claim is not the subject of a bona fide dispute, the burden shifts to the alleged debtor to prove otherwise.

Additional Considerations

An involuntary petition is extreme in nature and carries with it serious consequences to the alleged debtor, examples of which include loss of credit standing, interference with general business affairs and public embarrassment. Because of the harshness, and to prevent frivolous filings, the Bankruptcy Code provides an alleged debtor with an arsenal of defenses and remedies. For instance, an alleged debtor may ask the court to require the petitioners to post a bond under 11 U.S.C. § 303(e). If the alleged debtor successfully defends against the involuntary petition and gets it dismissed, the court should award alleged debtor a judgment against the petitioners for costs and attorney’s fees under §303(i). If the alleged debtor proves that the petitioners filed in bad faith, the debtor is additionally entitled to damages caused by the filing and possibly even punitive damages. These remedies and other defenses available for alleged debtors are explored in more detail in Part 2 of this blog series.