Getting Over the Scariness of Filing an Involuntary Bankruptcy Petition

The Notorious Case of the Involuntary Bankruptcy

Mention involuntary bankruptcy to many in the credit industry, and you often get a sharp response: no way. Decisions that awarded punitive damages to debtors have received broad attention. Trying to collect on a bad loan is challenging 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 commercial creditors. Instead they can provide tools much more effective at realizing the value of a debtor’s assets than pursuing a collection action in state court.

Outrageous Facts Lead to Big Punitive Damage Awards

A new homebuyer 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 sue the 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. Instead they were based on broad allegations of harm resulting from breach of a contract and tort claims. Whether or not such claims might be found valid in a state court proceeding did not matter. Speculative and unresolved claims cannot form 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 typically 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 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 and compensatory and punitive damages, almost eight times the amount the buyer claimed was owed him. The Sixth Circuit Court of Appeals upheld the bankruptcy court’s award. [ii]

A case from Chicago, [iii] 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. The other was the former boyfriend of the tenant who had no direct claim against the landlord. The bankruptcy court had little trouble finding 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 quickly determined that the landlord was entitled to an award of punitive damages of $180,000 against the tenant and her former boyfriend (as the purported Hong Kong corporation did not exist, it could not be sanctioned).

In a recent New York case, [iv] a party sought to enjoin a draw on a letter of credit in state court. When unsuccessful, that party filed an involuntary bankruptcy petition against the party holding the LC and several affiliates. The involuntary bankruptcy fell apart for several reasons. There was no dispute at all, let alone one that might be called bona fide, and the petition had not been authorized by two of the three petitioning creditors. Sanctions were deservedly and easily awarded.

What do these cases, whose outcomes seem reasonable, mean to the holder of a past due or defaulted debt instrument or a trade creditor considering joining an involuntary petition? They mean nothing. These cases and other cases where courts have awarded punitive damages, 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.

The Requirements for a Valid Petition

There are three basic requirements for a valid, non-sanctionable involuntary bankruptcy petition:

Must Be an Individual or a Commercial Entity

The debtor must be an individual (not a farmer) or a commercial entity. Generally, involuntary petitions may not be filed against not-for-profit organizations.

Debt Must Not Be Contingent or Disputed

The debt of the petitioning creditor must not be contingent or disputed. This requirement excludes any claim or debt 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. Commercial tort claims, such as for infringement of an intellectual property right or to impose successor liability on a party, should never be the basis of an involuntary filing. [v]

Claims based on promissory notes and trade debt must be ‘liquidated’ 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 damages have not yet been determined, even though the party in breach has not denied the violation, 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 minor disagreement 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 if 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. [vi] 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. [vii] 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. [viii]

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 note’s principal amount 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). Still, the creditor may see that as a small price to pay compared to other benefits of bankruptcy.

What about guaranties? If the guaranteed debt has not yet 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.

Debtor Must Not Be Paying Its Debts

The third requirement of an involuntary bankruptcy filing is that the debtor must not be paying its debts as they come due. This requirement is easily met when the debtor is out of business and not paying anyone or when the debtor defaults on its principal credit facility. Otherwise, the debtor’s failure to pay its debts in a timely manner 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 has lawsuits filed 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 some acknowledgment from the debtor (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.

A word of caution for the lawyer filing an involuntary petition: you must directly obtain from each petitioning creditor written authority to file the petition on that creditor’s behalf, and confirmation from the creditor of the amount owed and that the debt is not disputed. It is dangerous to rely on one creditor’s assurance that the other two creditors consent to being included in the petition. And a further word of caution: check for involuntary cases in your circuit and district. There remain isolated decisions that are hostile to involuntary cases. [ix] Although those decisions cannot be squared with recent cases of the Supreme Court on interpretation and application of the Bankruptcy Code, they exist and pose a risk the lawyer must appreciate before filing a case.

What Are the Benefits of a Bankruptcy?

You may now be satisfied that joining an involuntary bankruptcy petition is not very risky if you hold 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, by guarantying the fees of the trustee’s litigation counsel (without such guarantee, 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 an ‘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.

Some involuntary cases have resulted in large recoveries for creditors that could not have been imagined before the filing. Often, 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.

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We think you’ll also like:

1. I’ve Been Asked to Sign an Involuntary Bankruptcy Petition. Should I?
2. Dealing with Corporate Distress 14: The Secured Creditor’s Perspective About its Debtors
3. Dealing with Corporate Distress 07: Chapter 11 is Not Always the Answer: Strategic Alternatives For and Against Distressed Businesses

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can watch at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Bad Debtor Owes Me Money!
2. Defending Against Bankruptcy Avoidance Actions
3. Bankruptcy Claims Trading

This article originally published on March 30, 2020 and was last updated on December 4, 2023.]

©2025. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.

References

[i] In re John Richards Homes Building Co., L.L.C.,291 B.R. 727 (Bankr. E.D. Mich. 2003)

[ii] In re John Richards Homes Bldg. Co., L.L.C, 439 F.3d 248 (6th Cir. 2006).

[iii] In re Meltzer, 516 B.R. 504 Bankr. N.D. Ill. 2014).

[iv] Anmuth Holdings 600 B.R. 168 (Bankr. E.D.N.Y. 2019)

[v] See Crest One Spa v. TPG Troy, LLC, 793 F.3d 228 (2d Cir. 2015) (case dismissed and fees awarded where petitioning creditors alleged that the debtors were liable for another party’s debt on an alter ego theory).

[vi] See, e.g., In re General Aeronautics Corporation, 594 B.R. 442 (Bankr.D.Utah 2018); In re Demirco Holdings, Inc., 2006 Bankr. LEXIS 1131, at *9-10 (Bankr. C.D. Ill. June 9, 2006).

[vii] In re Green Hills Dev. Co., LLC, 741 F.3d 651, 658 (5th Cir. 2014).

[viii] See, e.g., In re Hentges, 351 B.R. 758 (Bankr. N.D. Okla. 2006); See also In re Manolo Blahnik USA, Ltd., 2020 WL 4793973 (Bankr.S.D.N.Y. August 18, 2020).

[ix] See Wilk Auslander LLP v. Murray (In re Murray), 900 F.3d 53 (2d Cir. 2018) (an involuntary filing that meets the requirements of Section 303 can still be dismissed under Section 707, although there would be no basis to sanction the petitioning creditors).