Southern California Bankruptcy Law Blog

Involuntary Bankruptcy: What Is It, And Why Would Anyone File One?

Posted in Chapter 11, Chapter 11 for Individuals & Married Couples, Chapter 7, Debt, Small Business Bankruptcy, Small Business Chapter 7

A fellow attorney, but not a bankruptcy attorney, recently asked me this question because he had a business client who wanted to use an involuntary bankruptcy filing to collect money from a judgment debtor.  To answer my colleague’s question we need a little background.  Let’s start with the concept of a voluntary bankruptcy.

I.          Voluntary Bankruptcy

Almost all bankruptcies filed today are voluntary bankruptcies.  Regardless of the underlying chapter at the heart of the bankruptcy, a voluntary bankruptcy is filed either under 11 U.S.C. § 301(a), or § 302(a).  § 301(a) provides (with emphasis added):

A voluntary case under a chapter of this title is commenced by the filing with the bankruptcy court of a petition under such chapter by an entity that may be a debtor under such chapter.

The phrase, “by an entity that may be a debtor under such chapter,” appears because a business can file under § 301(a).  However, if the debtor is not a business, then the entity in question is one individual.  Section 301(a) cannot be used by a married couple.  Why?  The answer is found in § 302(a) (with emphasis added):

A joint case under a chapter of this title is commenced by the filing with the bankruptcy court of a single petition under such chapter by an individual that may be a debtor under such chapter and such individual’s spouse.

Notice the common thread in these two sections:  it is the debtor who files the bankruptcy petition.  The reason such bankruptcies are called voluntary bankruptcies is that the debtor voluntarily enters into bankruptcy.  Contrast this with the statutory language authorizing involuntary bankruptcies.

II.        Involuntary Bankruptcy

Section 303(b) provides (with emphasis added):

An involuntary case against a person is commenced by the filing with the bankruptcy court of a petition under chapter 7 or 11 of this title—

(1) by three or more entities, each of which is either a holder of a claim against such person that is not contingent as to liability or the subject of a bona fide dispute as to liability or amount, or an indenture trustee representing such a holder, if such noncontingent, undisputed claims aggregate at least $10,000 more than the value of any lien on property of the debtor securing such claims held by the holders of such claims;

(2) if there are fewer than 12 such holders, excluding any employee or insider of such person and any transferee of a transfer that is voidable under section 544, 545, 547, 548, 549, or 724 (a) of this title, by one or more of such holders that hold in the aggregate at least $10,000 of such claims;

(3) if such person is a partnership—

(A) by fewer than all of the general partners in such partnership; or

(B) if relief has been ordered under this title with respect to all of the general partners in such partnership, by a general partner in such partnership, the trustee of such a general partner, or a holder of a claim against such partnership; or

(4) by a foreign representative of the estate in a foreign proceeding concerning such person.

The subsection is a bit long, and if you’re not used to reading statutory language it may be a bit daunting.  For our purpose the key point to get is that an involuntary bankruptcy is filed by someone other than the debtor, against the debtor.  It is for that reason that such a bankruptcy is called an involuntary bankruptcy.

Although almost all bankruptcies filed today are voluntary, there was a time in American history when a significant number of bankruptcy filings were involuntary.  The reason for the decline reflects the current understanding of the main purpose of bankruptcy:

The principal purpose of the Bankruptcy Code is to grant a fresh start to the honest but unfortunate debtor.

Marrama v. Citizens Bank of Massachusetts, 127 S. Ct. 1105, 1107 (2007) (internal quotes omitted).

In other words, the primary focus of current bankruptcy law is on giving the debtor, rather than the creditors, relief.  Why then is there a provision for involuntary bankruptcy?  And more to the point of my colleague’s question, why would creditors file an involuntary bankruptcy against a debtor? 

Linguistic triviality:  an involuntary debtor is sometimes referred to as an “alleged debtor” because of the involuntary nature of the case.

III.       Reasons For Filing An Involuntary Bankruptcy

            A.        The Practical Reason

On a practical level, the most compelling reason for filing an involuntary bankruptcy against a debtor is the fear that the debtor is rapidly depleting the resources available to pay its creditors. 

For example, suppose a business debtor owes its five creditors $100,000 each, and it has only $400,000 in assets.  Suppose further that the debtor is losing $50,000 a month, meaning that it will run out of money in eight months.  If one of the creditors becomes aware of the debtor’s rapidly depleting assets and alerts the other creditors of the situation, the group may feel that the only way to prevent any further hemorrhaging of money and preserve the remainder for distribution to them is to take legal action via an involuntary bankruptcy.

            B.        The Technical And Legal Reasons

On a more technical and legal level, § 303(h) gives the only two grounds on which the Court can grant an order for relief in an involuntary bankruptcy:

(1) the debtor is generally not paying such debtor’s debts as such debts become due unless such debts are the subject of a bona fide dispute as to liability or amount; or

(2) within 120 days before the date of the filing of the petition, a custodian, other than a trustee, receiver, or agent appointed or authorized to take charge of less than substantially all of the property of the debtor for the purpose of enforcing a lien against such property, was appointed or took possession.

                        1.        The First Ground

The first ground includes:

. . . regularly missing a significant number of payments to creditors or regularly missing payments which are significant in amount in relation to the size of the Alleged Debtor’s operation.  

In re West Side Community Hosp., Inc., 112 B.R. 243, 256-57 (Bankr. N.D. Ill. 1990).  

As for the chronology of the first ground:

To grant an involuntary petition, the bankruptcy court must determine whether the creditors met their burden of proving that the debtor was not paying his debts once due. . . . This determination should be made as of the date that the involuntary petition was filed.

Bartmann v. Maverick Tube Corp., 853 F.2d 1540, 1546 (10th Cir. 1988) (emphasis added).

The question of whether there is a bona fide dispute over the legitimacy of the debts must, of course, also be resolved before the Court can issue an order for relief. 

In applying this standard, the petitioning creditor must establish a prima facie case that no bona fide dispute exists. Once this is done, the burden shifts to the debtor to present evidence demonstrating that a bona fide dispute does exist

In re Rimell, 946 F.2d 1363, 1365 (8th Cir. 1991).

                        2.        The Second Ground

The second ground arises if a custodian has been appointed to take possession of the debtor’s assets.  The custodian, who cannot be a trustee or receiver, serves as an assignee for the benefit of creditors.  If such a custodian was appointed or took possession of the debtor’s assets within 120 days before a petition was filed, then the second ground for relief has been satisfied.

            C.        A Nonbankruptcy Approach

A nonbankruptcy approach available to creditors who are dealing with a debtor who is wasting assets, or just not paying its debts, is to ask a state court judge to appoint a receiver to take control of the debtor’s assets until the court can sort things out.  However, this approach lacks the teeth of bankruptcy, and could take a very long time to complete.  Therefore, the creditors might elect to file an involuntary bankruptcy instead.  However, there are several important limitations to involuntary bankruptcy that are designed to prevent creditor abuse.

IV.       Limitation #1:  Some Chapters Are Unavailable

According to the beginning of § 303(a):  “An involuntary case may be commenced only under chapter 7 or 11 of this title . . .”  Thus, there can be no involuntary Chapter 12 or 13.  Why?

This may be the only time you will see a modern day application of the thirteenth amendment to the U.S. Constitution:

Neither slavery nor involuntary servitude, except as a punishment for crime whereof the party shall have been duly convicted, shall exist within the United States, or any place subject to their jurisdiction.

Since slavery and involuntary servitude have been prohibited by the supreme law of the land, no individual (as opposed to a business) can be forced into a multi-year repayment plan because the individual would then be involuntarily working for the recipients of the payments.  Since Chapter 12 and 13 cases involve such plans to be paid by individuals using postpetition earnings, involuntary cases cannot be filed under these chapters.  For the same reason, an involuntary Chapter 11 filed against an individual, that requires the individual to make payments through the Chapter 11 plan, would violate the thirteenth amendment.

However, an involuntary Chapter 11 could be filed against an individual if the plan was a liquidation plan, i.e., the plan was restricted to liquidating nonexempt assets for the benefit of creditors.  And Chapter 7 bankruptcy, almost by definition, involves the liquidation of nonexempt assets for the benefit of creditors.  Therefore, an involuntary bankruptcy can be filed under either Chapter 7 or 11.

By the way, the thirteenth amendment does not protect businesses, only individuals.  Therefore, an involuntary Chapter 11 can be filed against a business, even if the plan is not a total liquidation plan.

Another by the way:  you might wonder why someone would file a Chapter 11 liquidation rather than file under Chapter 7.  In a Chapter 7 bankruptcy the Chapter 7 Trustee assigned to the case has complete control over the liquidation.  In most Chapter 11 cases there is no Chapter 11 Trustee, so the debtor has more flexibility in any liquidation that takes place – under Court supervision, of course.

V.        Limitation #2:  Some Entities Are Protected From Involuntary Bankruptcy

There is more to § 303(a) than I quoted above.  Here’s the entire subsection:

An involuntary case may be commenced only under chapter 7 or 11 of this title, and only against a person, except a farmer, family farmer, or a corporation that is not a moneyed, business, or commercial corporation, that may be a debtor under the chapter under which such case is commenced.

Since there is no such thing as an involuntary Chapter 12, you might wonder why farmers and family farmers (see § 101(18) for the definition – and no, it does not mean someone who grows families for a living) are explicitly excluded.  The reason is that they are protected from all involuntary bankruptcies, not just those filed under Chapter 12.  What about a corporation “that is not a moneyed, business, or commercial corporation”?  What kind of an entity is that?  The gist is a nonprofit charity.  I emphasize “charity” because some corporations end up being nonprofit because they’re poorly run rather than because of any eleemosynary mission.

VI.       Limitation #3:  Multiplicity Requirement

To reduce the likelihood that a single embittered creditor would file an involuntary bankruptcy out of spite, § 303(b) requires at least three or more creditors participate in the filing, unless there are fewer than a total of twelve creditors, and the creditors have to be owed at least $14,425.

VII.      Limitation #4:  A Bond May Be Required

Another protection afforded the debtor is found in § 303(e):

After notice and a hearing, and for cause, the court may require the petitioners under this section to file a bond to indemnify the debtor for such amounts as the court may later allow under subsection (i) of this section.

In other words, the filers may have to put up money so that if the filing is later found to be without merit, the debtor can be compensated for any harm experienced as a result of the filing.

VIII.    Limitation #5:  Abusive Filers May Have To Pay The Debtor

Yet another protection afforded the debtor is found in § 303(i):

If the court dismisses a petition under this section other than on consent of all petitioners and the debtor, and if the debtor does not waive the right to judgment under this subsection, the court may grant judgment—

(1) against the petitioners and in favor of the debtor for—

(A) costs; or

(B) a reasonable attorney’s fee; or

(2) against any petitioner that filed the petition in bad faith, for—

(A) any damages proximately caused by such filing; or

(B) punitive damages.

This means that if the involuntary bankruptcy was meritless, the Court can require the filers to cover the debtor’s costs and attorney’s fees, and award the debtor punitive damages.  Thus, creditors who file an involuntary bankruptcy out of spite, may find that that spite was a very expensive vice indeed.

IX.       Conclusion

Filing an involuntary bankruptcy against someone is very dangerous.  If you are a creditor who files an involuntary bankruptcy against a debtor, then if you can’t establish one of the two grounds for relief found in §303(h), you may find yourself paying the very entity from whom you’re trying to collect.  Therefore, absent compelling exigent circumstances it is probably safer to use some other approach to debt collection.