Benjamin Franklin is credited with once saying, “An ounce of prevention is worth a pound of cure.” That is, it is better to try to keep a bad thing from happening than it is to correct the bad thing after the fact. The same could be said of preparations and due diligence prior to the filing of an involuntary bankruptcy claim.
Among the various collection remedies available to creditors, the commencement of an involuntary bankruptcy proceeding may be one of the most powerful tools creditors have to realize upon delinquent debt. More often than not, however, creditors choose to pursue state law collection remedies over involuntary bankruptcy proceedings in large part because of the risks associated with the wrongful commencement of such proceedings.
Should a court determine that an involuntary bankruptcy petition is without merit, creditors and their counsel may be exposed to substantial liability for damages caused to the involuntary debtor, including attorneys’ fees. Accordingly, creditors and their counsel are well advised to conduct preliminary financial and legal due diligence prior to commencing an involuntary bankruptcy case. This article provides an introduction to assist creditors and their counsel in navigating the potential pitfalls of the involuntary bankruptcy process so that this powerful collection remedy can be evaluated and utilized.
Overview of § 303
As a general rule, the objective of an involuntary bankruptcy proceeding is to protect against the dissipation and diminution in value of a debtor’s assets. This is particularly true where creditors are concerned that the debtor may be improperly transferring assets or where management has proven to be incompetent or dishonest. In this regard, bankruptcy provides a forum in which the debtor’s management may be replaced, further dissipation of assets can be prevented, and the Bankruptcy Code’s avoidance powers may be utilized to claw back avoidable pre-petition transfers.
Bankrutpcy Code § 303 governs the commencement of involuntary bankruptcy cases and provides, in pertinent part, as follows:
(b) 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 $[15,325] 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[n avoidable] transfer, by one or more of such holders that hold in the aggregate at least $[15,325] 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.
The Requirements of § 303(h)
If the involuntary petition is timely contested by the debtor, the court will enter an order for relief against the debtor only if (i) 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 (ii) 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
A debtor is “generally not paying” debts when the debtor is “regularly missing a significant number of payments which are significant in amount and in relation to the size of the debtor's operation.”2 Note that “generally,” “regularly” and “significant” are all not well-defined and leave open the opportunity for analysis to assist the court in demonstrating whether the debtor is generally not paying debts as they come due.
Legal Due Diligence Checklist
Determining whether the commencement of an involuntary proceeding is appropriate is typically a team effort among the petitioning creditors, their counsel and their financial advisors. The following checklist provides an overview of the preliminary legal due diligence that could be conducted:
Financial Due Diligence of Debtor Payments
As mentioned above, one of the requirements considered by the court in entering an order for relief against the debtor is whether 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.3 As described below, a creditor may be well-served to conduct an analysis of the debtor’s payment practices prior to the filing of the involuntary bankruptcy in working with counsel to assess the risks of such a filing.
Assessing whether a debtor is paying its debts as they become due can seem to be a relatively simplistic task: Merely evaluate whether the debtor is paying before the invoice due date or after. In fact, in certain circumstances this may suffice for demonstrating that the debtor was generally not paying its debts as they became due. In other cases, the sheer magnitude of late payments for multiple creditors is sufficient to demonstrate that the debtor is not paying its debts as they become due. However, in many circumstances, particularly in sophisticated commercial relationships, the analysis could be much more complex. For example, in many industries it is typical or ordinary for customers to pay after the invoice due date. In other circumstances, a debtor may have established a history of taking advantage of early-payment discounts such that paying debts “as they become due” represents a significant deviation from prior experiences.
The extent of the analysis that could be completed in advance of an involuntary bankruptcy proceeding is well beyond the scope of this article. However, we highlight below certain analyses or considerations that may assist creditors in evaluating the extent to which a debtors is “generally” not paying its debts as they become due. As a point of reference, courts have noted that whether a debtor is generally not paying its debts as they become due should not necessarily be a simple exercise. Instead, courts have considered several factors, depending on the facts of case, including, but not limited to:4
While each of the above factors can be important in assessing whether the debtor is generally paying its debts as they become due, the timeliness of payments of past-due obligations and the materiality of these debts may involve certain additional considerations, as discussed below. Further, there are two considerations for which the creditor may be well suited to perform significant analysis, without the receipt of additional documents from the debtor.
Timeliness of Payments and Materiality of Past-Due Amounts
An assessment of the timeliness of payments can involve significant complexity in certain circumstances. Considerations may include the duration of time that is applicable, the terms of payment obligations (and any changes thereto), standard industry practices, prepayment incentives, etc. Bearing in mind these considerations, an analysis of the timeliness of payment will typically consider the duration of time between due date and payment date of an invoice. While this analysis has a simple foundation, in complex commercial relationships this analysis can be quite involved. Provided below are examples of certain factors that may be important to consider in this analysis:
Further, with respect to the materiality of past-due amounts, the following metrics and ratios provide measures of materiality that may assist the court in understanding that the issue of the debtor’s untimely payment trends is not immaterial:
In In re Petro Fill Inc. the court noted, “The scope and meaning of ‘generally unable’ and ‘generally failed’ are left to the courts. It is not possible to lay down guidelines that will fit all cases.”5 However, a creditor may benefit from proactively assessing these guidelines prior to attempting to demonstrate that the debtor is “generally not paying debts as they become due.” The challenge faced by the creditor is the limitations of available information regarding the debtor’s general financial condition and broad payment history with other creditors. As such, it can be important for creditors to understand the risks of this presentation to the court as well as the benefit of preparing an analysis in an effort to demonstrate the nature and extent of late payments from the debtor. Further, such analyses may also be helpful post-petition in response to the debtor’s response.
Involuntary bankruptcy should be a carefully considered maneuver and can involve collaboration from multiple parties and substantial risk if proceedings are not properly planned. However, there are many benefits to an involuntary bankruptcy, and several factors exist that can be assessed by creditors prior to filing a petition that can be used to evaluate a potential bankruptcy. With the proper preparation, the analyses and due diligence conducted pre-petition will likely be useful in demonstrating the merits of the proceeding to ensure a successful outcome. On the other hand, these analyses may reveal that other collection efforts might be more appropriate.
1 11 U.S.C. §303(h) (emphasis added).
2 In re All Media Props. Inc., 5 B.R. 126, 143 (Bankr. S.D. Tex. 1980); In re Einhorn, 59 B.R. 179, 186 (Bankr. E.D.N.Y. 1986).
3 11 U.S.C. §303(h) (emphasis added).
5 In re Petro Fill Inc., 144 B.R. 26 (Bankr. W.D. Pa. 1992).