12: Involuntary Bankruptcy
© Charles Tabb 2010
What is it?
• Bankruptcy case is commenced by CREDITORS,
not the Dr
• Thus is “involuntary” from the perspective of
the DR
History
• Involuntary bk was the norm for 300 years
• Indeed was part and parcel of the meaning of
“bankruptcy” – the whole idea was that CRs
commenced the proceeding
challenge
• Put into BK all DRs for whom the collective bk
remedy is needed, but no more
• Thus need to recall the reasons we have BK in
the 1st place
• From Crs viewpoint, that reason is to solve the
collective action problem when multiple CRs
and insufficient assets
Balance
• Can’t make it too HARD for Crs to put Dr in, or
will lose chance for efficacious relief
• At same time, can’t make it too EASY
– Would give CRs huge leverage agst DRs prior to bk,
knowing that threat of involuntary existed
– Major financial calamity for DR – a big deal
Invol. Bk = 3 bears porridge
• Not too hot, not too cold, but just right
Was too hard before 1978
• Until 1978 Code, was too hard to put DR in
• Had to prove “act of bankruptcy”
• In 1978, Congress tried to make involuntary
relief more available
importance
• Might think involuntary bk rules not important
because so few cases filed
• Not so
• Importance is that frames the out-ofbankruptcy negotiations
“fleet in being”
• The right to pull the involuntary bk trigger is
for CRs akin to a “fleet in being”
• Don’t necessarily have to use fleet to get what
you want from enemy, because they know
that you COULD
Which chapters?
• ONLY
– Chapter 7
– Chapter 11
• NOT
– Chapter 13
– Chapter 12
Why not chapter 13?
• Why do you think Congress has refused
to permit involuntary chapter 13 cases?
No ch 13
• “involuntary servitude”?
• Debt peonage violates 13th Amendment
13th amendment?
• What about garnishment of wages?
• How is an involuntary ch 13 any
different?
New involuntary ch 11 rules?
• 2005 – new rules on ch 11 for individual DRs
• Now capture DR’s post-petition earnings as
property of the bk estate, § 1115
• And can file involuntary ch 11 vs individual
so same legal effect as involuntary ch 13
Does this violate 13th Amendment?
Not “compulsory”
• Probably not a 13th amendment violation
• Not “compulsory”
– Can just quit working
Other reasons not have invol. Ch 13?
• Would it WORK to try to compel a person
to work for her CRs?
• Especially since has to pay 100% of
projected disposable income to Crs
Eligible DRs
• Two exclusions:
– 1. Farmers
– 2. “corporation that is not a
moneyed, business,
or commercial corporation”
Why not against farmers?
• why do you think Congress refused to
permit involuntary bk against farmers?
Why not against nonprofits?
• Why do you think Congress prohibited
involuntary bk against nonprofits?
Petitioning creditors: claims
• “creditor” or an indenture trustee
• claim must be “not contingent as to liability”
• claim must be “not the subject of a bona fide
dispute as to liability or amount.”
• the petitioners as a group must hold unsecured
claims totaling at least $13,475
Unsecured only
• Why do you think Congress precluded secured
creditors from serving as petitioning
creditors?
Not contingent
• What does it mean for a claim to be “not
contingent as to liability”?
No bona fide dispute - liability
• Why do you think Congress excludes as
eligible petitioning Crs those whose claims are
subject to a bona fide dispute as to liability?
No Bona fide dispute – “amount”?
• CR has claim that it asserts to be $5,000, while
the DR disputes that amount and concedes only
that it owes $4,000.
• Does the BAPCPA amendment really mean that
this creditor is totally disqualified from serving as
a petitioning creditor, since there is a “bona fide
dispute as to ... amount,” or
• Does it rather mean that this creditor’s claim can
only be counted for $4,000 of the necessary
$13,475 in unsecured amount?
Petitioning Crs – how many?
• Rule:
– If 12+ Crs 
need 3 petitioners
1
2
3
– If < 12 CRs  only need 1 petitioner
1
Counting to 12 is
harder than you think
CR-1
CR-2
CR-3
Cr-4
• Exclude:
–
–
–
–
insiders
employees
recipients of voidable transfers
assignees
 WHY exclude these people from the count??
CR-5
What if < 3 file?
• What if have 12+ total Crs (who count), but
involuntary petition is filed by < 3 Crs??
Creditors
Petitioner
Joinder?
• Statute and Rules say can just
add 2 more pet. Crs before dismiss
Bar to joinder?
• Some courts have created a “bar to joinder”
rule if initial petitioner in bad faith
– i.e., if KNEW Dr had 12+ qualifying Crs but filed as
a sole petitioner anyway
Q  would rationale of Marrama support bar
to joinder?
Grounds for relief
Two alternative tests in § 303(h):
• First, the debtor is generally not paying its
debts as they come due. § 303(h)(1)
• Second, a custodian has been appointed for
substantially all of the debtor’s assets within
the past 120 days. § 303(h)(2)
Custodian ground
• How does proof of the appointment of a
custodian indicate the need for bankruptcy
relief?
Equity insolvency test
“Generally not paying debts as they come due”
 Why is this an appropriate indicator of the
need for bankruptcy relief?
Which unpaid debts count?
• Crucial Q -> which unpaid debts count against
the Dr in the “generally not paying” calculus?
• BIG ISSUE: what if Dr disputes the debt –
does it still count?
Disputed debt – not count
• In 1978, Congress did count disputed debts
against the DR
• Changed in 1984 – NOT count disputed debts
• Amended again 2005 – not count if disputed
as to liability OR AMOUNT
Why not count disputed?
• Policy  why not count disputed debts?
“general” default
• When is DR’s failure to pay debts as they come
due “general”?
factors
When is failure “general”?
• # unpaid debts
• % unpaid debts numerically
• % unpaid debts in dollar terms
• $ unpaid debts
• age of unpaid debts
– compared to historical norms for debtor and industry
• the debtor’s overall conduct of its financial affairs
Problem 2.14
• May 1: involuntary bankruptcy petition filed against Debtor,
Inc. by three petitioning creditors: Alpha, Beta, and Gamma.
• Alpha was Debtor’s largest creditor, with an undisputed,
noncontingent, unsecured claim of $70,000. Alpha recently
won a judgment against DR for $70,000, concluding a bitter
court fight
• Beta and Gamma had unsecured, noncontingent, undisputed
claims of $100 each.
• Total debts of $100,000, owed to 30 different creditors
• Only 3 creditors Debtor is in default to are the three
petitioners.
 Is Debtor “generally not paying its debts as they come due”?
Answer 2.14
• Not paying:
$: $70,200 of $100K (over 70%)
#: 3 of 30 (10%)
• Paying:
$: $29,800 of $100K
#: 27 of 30
 Do we need a collective proceeding here?
Problem 2.15
• May 1: Involuntary bankruptcy petition filed against Debtor,
Inc. by three petitioning creditors; Beta, Gamma, and Delta
• Each of the petitioners held an unsecured, noncontingent,
undisputed claim of $5,000 against Debtor
• Total debts of $100,000, owed to 30 different creditors
• Only one of the 30 creditors to whom Debtor is not entirely in
default is Alpha. Debtor had owed Alpha $90,000 on a
judgment, but two weeks before the involuntary petition was
filed, Debtor paid Alpha $20,000 on the judgment and
entered into an agreement to pay the remaining $70,000
balance over a two-year period.
 Should the court find that Debtor is “generally not paying
its debts as they come due” and enter an order for relief?
Answer 2.15
• Not paying:
$: $30K of $100K (30%)
#: 29 of 30 (~ 97%!!)
• Paying:
$: $70K of $100K
#: 1 of 30
 Do we need a collective proceeding here?
Recapture preference?
• Might need bankruptcy to recapture the
possible $20K preference that Dr paid to Alpha
just before bankruptcy
Operations in the gap
• Voluntary bk:
– Dr’s filing of petition = “order for relief”
• Involuntary Bk:
– CRs’ filing of petition ≠ order for relief
 Have to prove a ground for relief
Gap between filing and order
• Thus inevitably have a time gap between the
filing of the involuntary petition and the ct’s
decision on the merits whether to enter an
order for relief
Petition filed
Order Relief
Gap Gap Gap Gap Gap
╩ ------------------------------------------------- ╩
Balancing rights in gap
Difficult during gap to balance need to:
1. Make sure Crs DO get effective relief if judge
does eventually enter order for relief
(i.e., not lock stable after horse is gone!)
bad
good
Gap balance
And yet
2. Preserve DR’s rights, considering that Crs
have proven nothing yet
Problem 2.16(a)
• How would the following problems that arise
during the gap period be resolved?
a. On December 20, an involuntary petition is
filed against Debtor, Inc., an airline. Debtor has
hundreds of flights scheduled for the holiday
season.
What happens to those flights?
Answer 2.16(a)
• Flights go on as scheduled, 303(f)
• Burden on CRs to either:
– Dispossess DR and appoint Trustee, 303(g)
– Get court order limiting business operations
Bottom line: “business as usual” UNLESS
court says otherwise
Problem 2.16(b)
• How would the following problems that arise
during the gap period be resolved?
b. On December 20, an involuntary petition is
filed against Debtor, Inc., an airline. On January 1
Debtor is scheduled to pay employees’ wages of
$1 million.
May Debtor pay the wages?
Answer 2.16(b)
• DR may pay the wages, 303(f)
• If ct enters order for relief, then what?
• Possible that employees may have to give
back some of $ that goes to pre-bk services
Wage priority
• Employees’ wages have different priority,
depending on when earned:
1. After order for relief (i.e., during bk) –
“administrative expense” – 2nd priority
2. During involuntary gap – 3rd priority
-- this is for Dec. 20 to Jan 1 period in problem
3. 180 days before bk – 4th priority
-- this is for Dec. 1-20 period in problem
4. Before 180 days – no priority
Problem 2.16(c)
• How would the following problems that arise during the
gap period be resolved?
c. On December 20, an involuntary petition is filed
against Debtor, Inc., an airline. Alpha, who is a
regular supplier of in-flight meals for Debtor,
submits an invoice on January 15 for $50,000 for
meals provided between December 15 and January
15.
May Debtor pay the invoice?
Answer 2.16(c)
• Dr may pay the invoice, 303(f)
• If Ct enters order for relief, then 549(a) & (b)
kick in
– Alpha has to return payment for portion of invoice
that represents value given PRIOR to involuntary
filing (i.e., for period Dec. 15-20)
– Alpha has good defense to extent gave value
during gap period (i.e, Dec. 20-Jan 15)
• Obviously necessary to induce CRs to do business with
DR in involuntary bk
dismissal
• Important – petitioning Crs do NOT have right
to dismiss case
• Ct must approve
• Like filing a class action
Risk to petitioners
• If case dismissed, other than with DR consent,
petitioning crs could be hit with costs,
damages, and fees