Facing Involuntary Bankruptcy

Most entrepreneurs are all too aware of the dark cloud of bankruptcy. What many don't realize, however, is that their creditors can force them into involuntary bankruptcy.

Creditors initiate an involuntary bankruptcy for several reasons, such as:

• It forces a debtor to confront all his creditors at once, instead of forking over money only to those who press the hardest
• It also keeps a debtor from draining all his assets before finally giving up and filing for bankruptcy

But woe to aggressive creditors when the bankruptcy court denies their petition for involuntary bankruptcy.

Beginning an Involuntary Bankruptcy

Creditors begin an involuntary bankruptcy case by filing a petition and a summons with the clerk of the U.S. Bankruptcy Court. The debtor has 20 days to file objections. If that happens, the case can go to trial. If not, the bankruptcy proceeds.

But an involuntary case can be initiated only under Chapter 7 or Chapter 11 of the Bankruptcy Code.

Under Chapter 11, the debtor can stay in business with a plan of reorganization. Creditors get paid from the cash flow of the business. A Chapter 7 case, however, involves closing shop and liquidating the debtor's assets. In both cases, only creditors with claims allowed by the bankruptcy court get money from the debtor's estate.

A Chapter 7 or Chapter 11 petition can be filed against anyone or any entity that owes money, except for:

• Farmers
• Nonprofit groups
• Banks
• Insurance companies
• Credit unions
• Savings-and-loan institutions

Additionally, railroads can't be debtors under chapter 7, and stockbrokers and commodity brokers can't be debtors under Chapter 11.

Paying Up

There are two ways a debtor can become the target of an involuntary bankruptcy.

The first arises when a debtor isn't paying up, aside from any disputed arrears. This includes regularly missing a significant number of payments or regularly missing sizable payments. The other is if a custodian was appointed or took possession of the debtor's property within 120 days before the petition was filed.

Not a Sure Bet

If a debtor has 12 or more creditors, an involuntary petition needs at least three creditors who are owed a minimum of $10,775 in total. If there are fewer than 12 creditors - aside from employees, insiders and anyone getting preferences - only one creditor owed at least $10,775 is needed.

Creditors take a risk. If a trial finds a debtor is fair game for an involuntary bankruptcy petition, the bankruptcy court enters an order for relief. The petitioning creditors can then collect their expenses and attorney's fees right away.

But if the court finds the petition was filed in bad faith, then it can award monetary damages and attorneys' fees to the debtor, leaving the creditor out even more money.

Because of this risk, creditors use involuntary bankruptcy petitions as a last resort, and only when they feel confident of winning.

Wesley H. Avery, an attorney 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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