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When is Involuntary Bankruptcy an Option?

Bankruptcy

10/12/2015

By: Stewart Peck

As uncertainty continues in the national and global economies, the business world should expect to see a growing number of creditors that try to force borrowers into paying their debts, especially through involuntary bankruptcy. Though usually complicated and perhaps not preferable, involuntary bankruptcy serves a purpose in protecting both creditors and debtors.

Creditors who petition for involuntary bankruptcy are effectively trying to force a debtor into liquidating or reorganizing. The relevant part of the U.S. bankruptcy code is Section 303, which establishes the standards for determining whether bankruptcy relief is truly needed to protect the interests of a debtor or its creditors. It also includes a mechanism for shifting legal fees in an effort to prevent creditors from abusing the process.

Creditors that petition for involuntary bankruptcy must meet two general requirements. The petition must have a sufficient number of creditors holding undisputed claims, and petitioners must prove that the debtor is generally not paying its debts. If a debtor has less than 12 creditors, one creditor is all that’s needed to file an involuntary petition. Otherwise, a petition requires at least three creditors with claims totaling at least $15,325 more than the value of any security for the claims.

The term “undisputed claims” is key for creditors that initiate a petition. Claims cannot be contingent – they have to actually exist at the time the petition is made without depending on some other future variable like the outcome of a pending lawsuit, for example.

Moreover, claims used for involuntary petitions cannot be involved in a legal dispute over the liability or amount. This is often the biggest burden for petitioners. The Fifth Circuit has adopted an objective standard in making such determinations, meaning that the bankruptcy courts in the Fifth Circuit look at the facts of each claim individually.

Creditors can file an involuntary petition under Chapter 7 or 11, depending on whether they expect a liquidation of the debtor’s assets by a court-appointed trustee, which would usually be Chapter 7, or a reorganization, which would fall under Chapter 11. The creditors’ choice is not final, because the debtor usually has an opportunity to accept the involuntary petition, convert the case to Chapter 11 and retain control as debtor in possession.

After the petition is filed, the putative debtor has 21 days to answer the creditors’ allegations, including whether its debts are being paid as they come due. If the debtor doesn’t respond on time, the court enters an order for relief against the debtor.

If the debtor denies the petition’s allegations, an evidentiary hearing is held. Courts make a determination by examining the elements under Section 303, which will include the number of unpaid claims, the amount of unpaid claims, the materiality of nonpayments and the debtor’s overall conduct in its financial affairs.

Involuntary petitions are not without risk. If creditors are unsuccessful, they could be liable for the debtor’s attorney fees and damages, including punitive damages. If courts find that petitioning creditors act in bad faith, significant damages can be awarded to the alleged debtor. Even if a settlement is reached, the alleged debtor can, in certain cases, reserve its claim for recovering attorney costs and fees.

Creditors, therefore, should not overlook several remedies allowed under Louisiana law, such as writs of attachment, sequestration, involuntary dissolution and receivership. A writ of attachment, for example, can be an effective alternative in cases where creditors fear that debtors will try to unfairly dispose of property.

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Lugenbuhl’s bankruptcy and creditors’/debtors’ rights team is headed by Stewart Peck, a founding shareholder and attorney with more than 30 years of experience and who has served as lead trial and appellate counsel in dozens of bankruptcy cases. Mr. Peck has argued cases before the Fourth and Fifth Circuit courts, as well as the Louisiana Supreme Court, and the Louisiana Courts of Appeal. He has experience acting as counsel for both debtors and creditors in a number of Chapter 11 bankruptcies. Shareholders Benjamin Kadden and Christopher Caplinger also focus heavily on bankruptcy law and Chapter 11 reorganization. Joseph Briggett and Erin Rosenberg, associates in Lugenbuhl’s commercial litigation and bankruptcy practices, have both worked on a variety of bankruptcy proceedings, including involuntary proceedings. More information about Lugenbuhl’s bankruptcy practice is available here.

The content of this article is not intended to serve as an exhaustive review of the laws, statutes or issues related involuntary bankruptcy and is not intended to provide legal advice. The opinions expressed through this article may not reflect the opinions of the firm, individual attorneys or clients.