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MCLE Self Study
Involuntary Bankruptcy
By Wesley H. Avery

Edited by Barbara Kate Repa
Category: Bankruptcy
        
        By dint of a new law, bankruptcy courts now have the authority to prohibit consumer credit reporting agencies from circulating details of individual involuntary cases that have been dismissed. The law, the Involuntary Bankruptcy Improvement Act of 2003 (H.R. 1529), was passed soon after its introduction, just as the public outcry over the growing problem of fraudulent involuntary bankruptcy petitions is reaching a fever pitch.
        
        As one egregious example, a tax protestor in Wisconsin filed involuntary bankruptcy petitions last year against numerous local officials in an attempt to turn the civil legal system against the government itself. Those cases were dismissed but not without a great deal of inconvenience on the part of the targeted public officials whose credit ratings were severely damaged in the interim.
        
        Involuntary cases have traditionally made up a small percentage of the bankruptcy filings each year, as they offer an imperfect remedy for creditors; the debtor's assets that are liquidated to pay claims are paid to all creditors, not just those who signed the involuntary petition. And it is a costly process for the debtor. If the court allows the petition, the subject may have to give up some or all nonexempt property and will be under the jurisdiction of the bankruptcy court for a period ranging from six months to several years.
        
        On the other hand, involuntary bankruptcy preserves the assets of an account debtor from further dissipation and provides for their orderly liquidation. Furthermore, the threat of forcing individuals or businesses into bankruptcy involuntarily may also encourage them to work out solutions out of court.
        
        A Look at History
        Since the Twelve Tables in ancient Rome, laws have been enacted to regulate the liquidation of bankrupts' property for the benefit of their creditors. Most commentators, including Blackstone, agree that the history of English bankruptcy law starts with the statutes passed by Henry VIII in 1542 and his daughter Elizabeth I in 1570.
        
        Those early English statutes allowed only for involuntary bankruptcy proceedings initiated by creditors; voluntary bankruptcy was an American invention that did not appear until 1721. Eventually both England and the United States adopted comprehensive statutory schemes featuring both voluntary and involuntary bankruptcy petitions-a common aim of which is to reduce a debtor's assets, known in this country as the debtor's estate, to money for creditors' benefits.
        
        Chapters 7 and 11 Only
        An involuntary case may be commenced only in Chapter 11 reorganization or Chapter 7 liquidation bankruptcies. It may not be commenced under Chapter 9 (debt adjustments involving municipalities), Chapter 12 (bankruptcies involving family farmers), or Chapter 13 (adjustment of debts of an individual with regular income).
        
        In a Chapter 11 case, the debtor is typically allowed to stay in business by following a reorganization plan that meets statutory criteria, such as satisfying the creditors' debts before any payment is made to equity holders. Creditors are paid from the ongoing cash flow of the business. A Chapter 7 case, on the other hand, involves terminating operations and quickly liquidating the debtor's assets. In both cases, only creditors with claims allowed by the bankruptcy court are paid from the debtor's estate.
        
        Included Debtors
        A Chapter 7 or Chapter 11 petition may be filed against any debtor-an individual, corporation, or partnership-with a residence, domicile, place of business, or property in the United States. But banks, insurance companies, credit unions, and savings and loans may not be debtors under Chapter 7 or 11; a railroad may not be a debtor under Chapter 7; and a stockbroker or commodities broker may not be a debtor under Chapter 11.
        
        An involuntary petition may not be filed against a farmer or eleemosynary institution. In addition, membership organizations such as a golf club (In re Elmsford Country Club, 50 F.2d 238, 239 (D.C.N.Y. 1931)) and a Masonic lodge functioning as an insurance corporation (In re Supreme Lodge of the Masons Annuity, 286 F. 180, 188 (N.D. Ga. 1923)) have been held to be nonprofit entities against which an involuntary petition may not be filed. The reasoning: Congress has determined that a beneficial organization doing public good should not be the subject of bankruptcy proceedings against its will.
        
        And finally, an involuntary petition may not be filed against a husband and a wife; separate individual involuntary petitions must be filed for each. The legal basis is that although a husband and wife are specifically allowed to file a joint voluntary petition under the bankruptcy code (11 U.S.C. § 302(a)), they are in fact two separate debtors.
        
        However, convicts, dissolved corporations, entities no longer actively doing business, and insane individuals-if the subject's debts were incurred during a lucid period-have all been held to be eligible for relief (11 U.S.C.§ 303(a)). Such is the case even though liquidating their estates would probably yield no dividends for creditors, as one aim of the bankruptcy code is to provide relief to all honest debtors unless there is a contrary congressional mandate.
        
        Covered Conduct
        Debtors are subject to involuntary bankruptcy in two situations.
        
        The first is when the debtor is generally not paying debts as they become due, unless they are the subject of a bona fide dispute. 11 U.S.C. § 303(h)(1). That includes regularly missing a significant number of payments to creditors or regularly missing payments that are large in relationship to the size of an alleged debtor's operation. In re West Side Community Hosp., Inc., 112 B.R. 243, 256-57 (Bankr. N.D. Ill. 1990). The determination that an alleged debtor is not paying due debts is made when the involuntary petition is filed. Bartmann v. Maverick Tube Corp., 853 F.2d 1540, 1546 (10th Cir. 1988).
        
        As a matter of proof, once a petitioning creditor establishes that no bona fide dispute exists, the burden shifts to the alleged debtor to present evidence demonstrating that it does exist. In re Rimell, 946 F.2d 1363, 1365 (8th Cir. 1991), cert. denied, 504 U.S. 941 (1992). For example, it has been held that an involuntary petition could not be maintained by attorneys against a former client when their claim for legal services was subject to a substantiated counterclaim for legal malpractice. In re Ferri, 59 B.R. 656, 657 (Bankr. E.D.N.Y. 1986).
        
        Also eligible for involuntary relief is an alleged debtor whose assets are in the hands of a custodian-such as an assignee for the benefit of a creditor-who was appointed or took possession of the alleged debtor's assets within 120 days before a petition was filed. 11 U.S.C. § 303(h)(2).
        
        Who May Petition
        If an alleged debtor has twelve or more creditors, excluding employees or insiders and those who receive preferences or fraudulent transfers, an involuntary petition may be initiated by at least three of them as long as each holds an unsecured debt that is not contingent as to liability or the subject of a bona fide dispute. In addition, their claims must total at least $11,625. If an alleged debtor has fewer than twelve such creditors, only one who holds an unsecured claim of at least $11,625 is needed. 11 U.S.C. § 303(b).
        
        A single creditor with a claim subject to bona fide dispute probably cannot file an involuntary petition, as that creditor will be unable to prove that the alleged debtor is not paying debts as they become due. A second rationale for that result is that the bankruptcy court is not the appropriate forum "for the trial and collection of an isolated disputed claim." In re Nordbrock, 772 F.2d 397, 399-400 (8th Cir. 1985). Some courts have held that the alleged debtor's relatives may qualify as petitioning creditors. Chapter 11 debtors are eligible to be petitioning creditors against others. Even states can qualify.
        
        However, limited partners may not bring an involuntary petition against a partnership. In re Royal Gate Assoc., Ltd., 81 B.R. 165, 167 (Bankr. M.D. Ga. 1988). On the other hand, only one general partner is needed to file an involuntary petition against a partnership, whatever the amount of the partnership debt. 11 U.S.C. § 303(b)(3)(A). And if all of the general partners are in bankruptcy, the holder of a claim of any amount may file an involuntary petition against that partnership. 11 U.S.C. § 303(b)(3)(B).
        
        At least one court has held that creditors of the alleged debtor who are corporate insiders are ineligible to file an involuntary petition. In re Runaway II, Inc., 168 B.R. 193, 198 (Bankr. W.D. Mo. 1994). Though fully secured creditors cannot commence involuntary insolvency proceedings, those who are partially secured are not disqualified from filing on their unsecured claims.
        
        In addition, the fact that a petitioning creditor who holds a promissory note, for example, and is owed something other than a cash payment does not disqualify that creditor from petitioning. In re All Media Properties, Inc., 5 B.R. 126, 137 (Bankr. S.D. Tex. 1980), aff'd, 646 F.2d 193 (5th Cir. 1981). It is also unnecessary to determine the exact amount of a petitioning creditor's claim, as bankruptcy judges routinely estimate the amount of a creditor's claim if necessary to resolve a contested matter before the court. In re Gleason Bros., Inc., 3 F. Supp. 224 (D. Mass. 1932). Nor does a failure to send a bill (In re Rimell, 111 B.R. 250, 253 (Bankr. E.D. Mo. 1990), aff'd 946 F.2d 1363 (8th Cir. 1992), cert. denied, 504 U.S. 941 (1992)) or a failure to demand payment (In re First Energy Leasing Corp., 38 B.R. 577, 584 (Bankr. E.D.N.Y. 1984)) affect status as a creditor.
        
        How It All Begins
        An involuntary bankruptcy case is initiated when creditors file a petition and summons with the clerk of the United States Bankruptcy Court. 11 U.S.C. § 101. The petitioning creditors must also pay the appropriate filing fee: $200 for a Chapter 7 case, $830 for a Chapter 11 case other than for railroads. 28 U.S.C. § 1930 as supplemented by additional fees mandated by the Judicial Council.
        
        Nonpetitioning creditors do not have the right to contest an involuntary petition, as they may receive prepetition preferential payments from the alleged debtor that will be recovered by the bankruptcy estate if an order for relief is entered. Abramson v. Boedeker, 379 F.2d 741, 746 (5th Cir. 1967), cert. denied, Boedeker v. Abramson, 389 U.S. 1006 (1967).
        
        An alleged debtor who contests the petition must present defenses and objections within 20 days of receiving the summons and petition. Fed. R. Bankr. Proc. 1011(b). A trial will then be necessary to determine their merits. Otherwise, an order for relief will be entered and the bankruptcy case will proceed. 11 U.S.C. § 303(h) and Fed. R. Bankr. Proc. 1013(b).
        
        Contests by Debtors
        Prior to a trial on the involuntary petition, the petitioning creditors and the alleged debtor may take discovery of one another. Fed. R. Bankr. Proc. 1018. And the alleged debtor may also request that the court order the petitioning creditors to post a bond to indemnify for damages caused by the filing. 11 U.S.C. § 303(e).
        
        If an alleged debtor is found at trial to be the proper subject for an involuntary bankruptcy petition, an order for relief will be entered. Fed. R. Bankr. Proc. 1013(a). The creditors may then collect their actual, necessary expenses and the attorneys fees incurred in filing the petition from the debtor's estate as a first priority administrative expense. 11 U.S.C. §§ 503(b)(3)(A) and (4) and 507(a)(1).
        
        If a court finds the alleged debtor is not subject to relief under the bankruptcy code and dismisses the involuntary petition, it may grant a judgment against the petitioning creditors for reasonable attorneys fees, damages proximately caused by filing, or even punitive damages if it finds that the petition was filed in bad faith. 11 U.S.C. § 303(i). And a creditor who is unsuccessful in an involuntary bankruptcy case and has been ordered to pay the alleged debtor's attorneys fees may not set off the fees against the original debt. In re Schiliro, 72 B.R. 147, 149 (Bankr. D. Pa. 1987).
        
        Minding the Gap
        In the gap period before an order for relief is entered, the alleged debtor may continue in the ordinary course of its business. In re Retail Stores Delivery Corp., 11 F. Supp. 658, 660 (S.D.N.Y. 1935). However, in this interim period an alleged debtor may not dispose of assets in any way that would be detrimental to creditors. In re Greenwalt, 48 B.R. 804, 808 (Bankr. D. Colo. 1985). For example, during the gap period a toy store could continue to sell merchandise to its retail customers but may not transfer all of its assets to a single creditor to satisfy a debt.
        
        If petitioning creditors believe that there is cause for an interim trustee to take control of the alleged debtor's affairs during the gap period-such as, to preserve the property of the estate-they must file a motion to get such relief. 11 U.S.C. § 303(g); In re James Plaza Joint Venture, 62 B.R. 959, 963 (Bankr. S.D. Tex. 1986) (cause existed for a grant of relief under section 303(g), where it was shown that an alleged debtor has possession of money subject to dissipation if an interim trustee was not appointed immediately).
        
        Creditors may hesitate to do business with an alleged debtor whose bankruptcy status has yet to be determined. Because of this, claims against an alleged debtor that arise after the petition but before the order for relief is entered-known as gap claims-are specially entitled to payment ahead of most other unsecured claims. 11 U.S.C. §§ 502(f) and 507(a)(2).
        
        Wesley H. Avery (wavery@sulmeyerlaw.com) is a partner at the Los Angeles office of SulmeyerKupetz and a certified specialist in personal and small business bankruptcy law.

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