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 1 st 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-of- bankruptcy 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 13 th Amendment

13 th 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 13 th Amendment?

Not “compulsory” Probably not a 13 th 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 – If < 12 CRs  only need 1 petitioner

Counting to 12 is harder than you think CR-1CR-2CR-3Cr-4CR-5 Exclude : – insiders – employees – recipients of voidable transfers – assignees  WHY exclude these people from the count??

What if < 3 file? What if have 12+ total Crs (who count), but involuntary petition is filed by < 3 Crs?? CreditorsPetitioner

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 De lta 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!) badgood

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” – 2 nd priority 2.During involuntary gap – 3 rd priority -- this is for Dec. 20 to Jan 1 period in problem days before bk – 4 th priority -- this is for Dec 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 ) – 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