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Getting Over the Scariness of Filing an Involuntary Bankruptcy Petition

Mention involuntary bankruptcy to many in the credit industry and you often get a sharp response:  no way.  Decisions that have awarded punitive damages to debtors have received broad attention.  Trying to collect on a bad loan is tough enough.  Why compound the struggle by giving the debtor the claim that an involuntary filing was made in bad faith, exposing the creditor to more delay and expenses if not substantial liability?

The truth is that joining an involuntary bankruptcy petition poses little risk to most creditors, and can provide tools much more effective at realizing on the value of a debtor’s assets than pursuing a collection action in state court. This article reviews the few notorious cases that have awarded debtors punitive damages where an involuntary petition failed, and discusses the circumstances that support an involuntary petition.   The article concludes by discussing benefits of bankruptcy that flow from a successful involuntary filing toward maximizing recovery on debt.

Outrageous Facts Lead to Big Punitive Damage Awards

A new home buyer in suburban Detroit is frustrated with the builder’s lack of progress in completing items on the punch list.  The builder has been in business for many years, has a good reputation in the community, and is not suffering from financial problems.  The unhappy buyer could complain to the state licensing board or even sue builder in state court.  But what does the buyer do instead?  He files an involuntary bankruptcy petition against the builder, and then pursues the petition with great zeal.

The bankruptcy court dismissed the petition because it found that the claims of the home buyer were subject to a bona fide dispute.[i]  The claims were not found in any written instrument, but instead were based on broad allegations of harm resulting from breach of a contract and torts.  Whether or not such claims might ultimately be found in a state court proceeding to have validity did not matter – speculative and unresolved claims cannot be the basis of an involuntary filing.

But the bankruptcy court did not stop there.  It did not believe that the buyer, when it filed the petition by itself when normally three creditors are required, could have ever believed that filing an involuntary bankruptcy petition was proper.  The court found that the buyer was not motivated by a desire to recover on a debt, but by a desire to harass and embarrass the builder.  With the petition pending, the builder had to explain the bankruptcy to prospective customers. Not surprisingly, the bankruptcy filing caused the builder to lose significant business.  The bankruptcy court awarded the builder $6.4 million in attorney fees, compensatory and punitive damages, almost eight times the amount the buyer claimed was owed him.  The bankruptcy court’s award was upheld by the Sixth Circuit Court of Appeals.

A recent case from Chicago, in which punitive damages were assessed against parties who filed an involuntary petition, also involved outrageous facts.  To forestall a lease eviction, an apartment tenant orchestrated the filing of an involuntary bankruptcy petition against her landlord.  Although three creditors joined the petition, one of the three was a phony Hong Kong corporation contrived by the tenant and the other was the former boyfriend of the tenant who had no direct claim against the landlord.  The bankruptcy court had little trouble finding both that the bankruptcy petition was filed for an improper purpose (to harass rather than to recover on a debt) and that the petition itself was fraudulent.

With these findings, the court easily determined that the landlord was entitled to an award of punitive damages against the tenant and her former boyfriend (as the purported Hong Kong corporation did not exist, it could not be sanctioned).  A separate trial has yet to be held on the size of the punitive award.

What do these cases, whose outcomes seem reasonable, mean to the holder of a past due or defaulted debt instrument or a trade creditor who is considering joining an involuntary petition?  They mean nothing.  These cases, and other cases where punitive damages have been awarded, do not cast doubt on the viability of cases filed by holders of legitimate commercial debt.  For a holder of such debt, the requirements of an involuntary filing are not difficult to meet.

What are the Requirements for a Valid, Non-Sanctionable Involuntary Petition?

There are three basic requirements.  First, the debtor must be either an individual (who is not a farmer) or a commercial entity.  Generally, involuntary petitions may not be filed against not for profit organizations.

Second, the debt of the petitioning creditor must not be contingent or disputed.  This requirement essentially excludes any claim or debt that is not either (i) evidenced by an instrument, such as a promissory note or (ii) an ordinary commercial trade debt that has not been disputed.  In other words, tort claims (such as for personal injury, or employment claims) cannot be used for an involuntary bankruptcy filing.

Even claims based on promissory notes and trade debt must be “liquidated” in order to be eligible for an involuntary petition.  This means that the amount of the claim must be settled or fixed.  It does not mean that the debt must be presently due – promissory notes that come due in the future may be included in an involuntary filing.  But it does mean that breach of contract claims where the amount of damages has not yet been determined, even though the party in breach has not denied the breach, cannot be included.

Sometimes there is a dispute over the interest due on a note, or credits that might be due on a trade account.  The question courts have faced is whether a small dispute over the exact amount of the debt renders the debt “unliquidated” and therefore not eligible for inclusion in an involuntary filing.  Some courts have said that as long as the undisputed portion of the debt exceeds the statutory minimum of $17,856, the debt is sufficiently liquidated and may be included in an involuntary petition.  Other courts have said that any good faith dispute over the amount of the debt asserted in the involuntary petition renders the entire debt unliquidated.  Even some of these courts, however, have suggested that the debt will be deemed liquidated if the creditor asserts in the involuntary petition only the undisputed portion of the debt.

The better practice is to do as courts have suggested – assert only debt that is unchallengeable.  For instance, say a promissory note has a principal balance of $100,000 and accrued interest of $4,325.  If the interest calculation is disputable, the creditor might assert only the principal amount of the note in the involuntary petition.  This should block the debtor from arguing that the debt is not liquidated.  It may also have the consequence of limiting the creditor’s ultimate claim in the bankruptcy to $100,000 (whether it will have that effect has not been tested), but the creditor may see that as a small price to pay compared to other benefits of a bankruptcy.

What about guaranties?  So long as the debt being guarantied has not come due by default or maturity, a guaranty is a contingent obligation that cannot be used in an involuntary petition.  Once the underlying debt has become due and the holder of the guaranty has the right to demand full payment from the guarantor, the guaranty is no longer contingent, and the claim under the guaranty is liquidated to the same extent the underlying debt is liquidated.  In this case, a claim under a guaranty can be used in an involuntary petition, even where no judgment has been entered on the guaranty.

The third requirement of an involuntary filing is that the debtor must not be paying its debts as they come due.  This requirement is easily met where the debtor is out of business and not paying anyone, or where the debtor has defaulted on its principal credit facility.  Otherwise, the debtor’s failure to timely pay its debts must be pervasive – affecting most of its creditors, or at least affecting most true unsecured creditors.  Now if the debtor is paying only utilities and employees on time but is having lawsuits by trade creditors and tax liens filed against it, then it is not generally paying its debts as they come due.  On the other hand, if the debtor is struggling to pay only a few very large trade creditors but is otherwise avoiding lawsuits and liens, it might be risky to file an involuntary petition against it.

The upshot of this discussion is that the requirements of an involuntary filing are not difficult to meet if the petitioning creditors are holders of defaulted or post-maturity promissory notes, or guaranties of such notes.  The difficulty increases, but is still manageable, where the petitioning creditors are trade creditors who have long outstanding balances that have not been disputed by the debtor.  Before threatening or bringing an involuntary petition, a trade creditor might seek from the debtor some acknowledgment (an email will do) that the debt is not disputed.  Debtors are often willing to provide such an acknowledgment in exchange for a few more weeks of forbearance by the creditor.

So What Are the Benefits of a Bankruptcy?

You may now be convinced that joining an involuntary bankruptcy petition is not very risky if you are the holder of a defaulted or past due note or trade payable.  But that does not mean that you should join an involuntary petition.  It is not usually worthwhile to file a petition and then step away, hoping that the process will produce some distribution on your debt.  Without creditor involvement, the trustee, who may start the case with no money, often lacks the drive and resources to deeply search for assets and other sources of recovery.  Before filing, the petitioning creditors should have in mind an objective they hope to achieve through a bankruptcy case, such as avoiding preferences or fraudulent transfers, or bringing about a fair and open sale of the assets of the debtor.  They should also have in mind the means by which the objectives can be achieved, such as by electing a trustee, or by guarantying the fees of the trustee’s litigation counsel (without such guaranty competent counsel might not be found), or by serving on a creditors committee should the debtor convert the case to a chapter 11 case.

In fact, in the most successful cases that start as involuntary cases, the petitioning creditors drive the process from beginning to end.  They can arrange for counsel of their choice to serve as special litigation counsel to the trustee to pursue fraudulent transfer and shareholder and director liability claims.  They can work with the trustee to establish a sale process that maximizes the value of the assets.  In chapter 11 cases, they can propose a plan that advances the interests of general creditors.  To the extent these efforts are successful in creating a pool of money for creditors (referred to as “as estate”), the expenses of the petitioning creditors and the professionals they hire will be paid from the pool before anything is paid to general creditors.  This spreads the costs of their efforts to the entire creditor body.

The author of this article has filed a number of involuntary cases.  Some of those cases have resulted in large recoveries for creditors that could not have been imagined before the filing.  This has been because the trustee, using the broad, nationwide powers of the Bankruptcy Code, has been able to find assets, or realize on the value of known assets, that a single creditor enforcing a judgment in state court would probably never find or achieve.

[i]  The principal requirements for an involuntary bankruptcy case are set forth below and in an entry in this site’s Glossary.

About William Barrett

Mr. Barrett has 29 years of experience as a corporate restructuring lawyer, guiding companies and their constituents through financially challenging situations, including out-of-court workouts, bankruptcy cases, assignments for the benefit of creditors, and receiverships. Mr. Barrett has represented unsecured creditors and secured lenders in middle market chapter 11 cases, including negotiating cash collateral and DIP…

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