The vast majority of Chapter 11 bankruptcy cases today are voluntary, meaning that debtor voluntarily initiated the bankruptcy process by a filing a petition for bankruptcy protection. Most bankruptcy experts tend to agree that this is a positive reflection of our modern understanding of the true purpose of bankruptcy, which is to provide an opportunity for a debtor to discharge debts and begin afresh. However, there are certain circumstances under which other parties, most often creditors, can initiate what is known as an involuntary bankruptcy: a bankruptcy case that is filed against a debtor by someone other than the debtor. Though these cases are not often seen in today’s courts, they are worth a closer look, particularly in terms of how they differ from typical voluntary cases, and the potential risks and benefits to the parties who initiate them.
What are the requirements for an involuntary bankruptcy petition?
- Bankruptcy chapter—Involuntary petitions can only be filed under Chapters 7 or 11 of the Bankruptcy Code.
- Type of debtor—An involuntary bankruptcy can be filed against most individuals and businesses except for insurance companies, banks, credit unions, farmers, and corporations that are nonprofit or otherwise not commercial.
- Minimum number of creditors and minimum amount of debt—If the debtor’s total number of creditors is 12 or more, at least three creditors must participate in filing the involuntary bankruptcy. Only one creditor is needed where there are fewer than 12 creditors. In both these cases, the aggregated claims of the filing creditors must total at least $17,856 (this amount is adjusted every three years), and must not be contingent in any way or subject to any disputes.
- Non-payment by the debtor—In order for an involuntary petition to be accepted, the debtor must be generally not paying debts as they come due. In other words, the overall financial health of the debtor must be in question. This requirement is to prevent creditors whose specific claims have not been paid from inappropriately resorting to involuntary bankruptcy action.
How is an involuntary bankruptcy different from a voluntary case?
- No immediate placement into bankruptcy—When an involuntary petition is filed, the automatic stay takes effect to prevent creditor actions, but otherwise, a debtor’s business operations may remain relatively unchanged. The company may continue to conduct its normal business and may use, dispose of, or acquire property as if no bankruptcy case had been filed. In this way, an involuntary bankruptcy petition is more like a complaint. It only serves as an official request to the court to place the debtor into bankruptcy, and it is served to the debtor together with a summons.
- Debtor can consent to the bankruptcy—If an involuntary filing is made, a debtor can respond with their own voluntary Chapter 11 filing, thereby taking control of the case in the capacity of debtor-in-possession.
- Decision to place the debtor in bankruptcy—Litigation over whether the debtor should be put in bankruptcy may involve a variety of matters not always found in voluntary Chapter 11 cases. These include pleadings, status conferences, document and deposition discovery, motions for summary judgement, and evidentiary hearings and trials.
What are the usual reasons for filing an involuntary bankruptcy petition?
On the most practical level, creditors most often file an involuntary petition when they suspect fraud on the part of a debtor or fear that a debtor’s actions are causing creditors to lose value by rapidly depleting or otherwise squandering resources that should be use to pay creditor claims. Particular situations that can give rise to these fears include the following:
- Demonstration of gross incompetence on the part of the debtor
- Transfer of unsecured assets by the debtor to a third party at less than their equivalent values
- Transfer of assets by the debtor to a successor or related company
- Payment by the debtor of debt owed to “insiders” or payment only of those debts that have been guaranteed by the company’s principals
- Actions underway that benefit the debtor’s lenders at the expense of other creditors
What are the risks involved in filing an involuntary petition?
While the involuntary bankruptcy provisions of Chapter 11 can, in appropriate situations, offer creditors a powerful remedy against debtors, an involuntary filing is a serious undertaking that can involve the following potential risks for those launching the petition:
- No dismissal without a hearing—Once an involuntary position has been filed, certain proceedings must be accomplished, including a notice and an opportunity for a hearing. Even if the debtor and the petitioning creditors agree, they are obligated to carry through these initial steps of the bankruptcy process.
- Creditor liability—If an involuntary petition is dismissed by the court, the initiating creditors may be liable for the debtor’s attorney fees and other costs.
- Consequences of bad-faith filing—Petitioning creditors can face even more serious financial consequences if the bankruptcy court determines that the filing of the involuntary position took place in bad faith. Creditors can find themselves liable for damages caused by the filing, and possibly even for additional punitive damages.