Facing Involuntary Bankruptcy

Finances are always a concern for a business of any size, and the threat of bankruptcy when times are tough. While it's a daunting thought to face bankruptcy, most businesses don't consider the possibility of involuntary bankruptcy started by creditors.

While only a small number of cases start with an involuntary petition, know the basics about this type of case. Whether you're a creditor or business owner, gain perspective on how and when involuntary bankruptcy may factor into your finances.

Starting Involuntary Bankruptcy

Who Can File

Creditors can file a petition and start the bankruptcy process. Creditors carry the burden to show they meet filing requirements. The number of creditors is a threshold issue:

  • Three creditors are needed to start a case when a debtor has 12 or more creditors
  • One creditor can start a case when there are less than 12 creditors

Some creditors aren't included in the count. Employees or insiders with claims who have some interest in not seeing a business go bankrupt don't count.

Bankruptcy Options Available

Involuntary bankruptcy is limited to two types of cases: Chapter 7 or Chapter 11. In Chapter 7, or liquidation, the business closes, its assets are sold, and creditors are paid. In Chapter 11, the debtor stays in business and follows a reorganization plan. Creditors are paid from the business's cash flow.

Not All Debtors Are Eligible

Generally, involuntary bankruptcy can be used against any person. A person may be an individual or business entity that owes creditors money. Involuntary cases almost always involve a business.

However, the law contains exceptions and involuntary Chapter 7 or 11 can't be used against:

  • Farmers
  • Banks
  • Nonprofit groups
  • Insurance companies
  • Credit unions and savings and loans institutions

Railroads can't be involuntary debtors under Chapter 7. Stock and commodity brokers can't be the subject of a Chapter 11 case.

Creditors Must Meet Claim Thresholds

Whether one or several creditors start a case, they must show the debtor owes at least $14,425. The claims must be unsecured, meaning there's no lien or collateral backing up the debt.

Claims must also be undisputed. A debt can't be contingent, and there can't be a disagreement on the debt, such as an ongoing lawsuit.

Sometimes debtors challenge creditors on the issues of the amount of undisputed claims and defeat an involuntary filing. A debtor could try to show part of the claims are secured, or some are in dispute, so creditors fail to meet the filing thresholds.

Filing Strategy and Failure to Pay

Creditors can use involuntary bankruptcy when a debtor isn't paying on its debts, or if a custodian or receiver took possession of the debtor-business within 120 days of the petition filing date.

Creditor Strategy and Filing

The strategy for using involuntary bankruptcy once there's a payment issue includes:

  • Forcing a person or business to face all debt issues with all creditors at once, so no single creditor is preferred
  • Preserving assets before the situation grows worse, and the person or business gives up and files for bankruptcy on its own

At this point, both sides may decide working out a solution outside of bankruptcy court is best.

When Is a Debtor Not Paying?

Creditors need to show that a debtor is generally not paying its debts to support an involuntary petition. The law doesn't draw a clear line on this issue, so the court decides. Factors include:

  • Amounts involved
  • The number of debts, and how many aren't paid
  • Which creditors are or aren't being paid, for example, is a chief creditor not paid?
  • The type and nature of the business involved

Courts look at the facts of each case, and often look at the big picture of a debtor's finances.

Risks for Creditors

Involuntary bankruptcy isn't a sure thing for creditors. The debtor may object, and may raise the issue of bad faith in filing the petition. A court can award a debtor money damages and attorneys' fees when bad faith is found.

The end result is involuntary bankruptcy involves strategic decisions, and is often a last resort to collect payment.

Questions for Your Attorney

  • If I provided financing to a business, and I have an ownership interest, can I still file an involuntary bankruptcy petition? Does it help if other creditors join my effort?
  • How do time limits factor into involuntary bankruptcy? Do I risk my position as a creditor if I try to work with a debtor without filing bankruptcy?
  • Once an involuntary case is filed and the debtor responds, does it proceed like any other case?
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