What Is Involuntary Bankruptcy?
An involuntary bankruptcy has several steps. First, each filing creditor must prove that their claim is not subject to a bona fide dispute. If the debtor can allege any legitimate defense, whether or not the defense is meritorious, the debtor can disqualify the claim as a basis for involuntary bankruptcy.
Most courts adopt the test of whether there is a genuine issue of material fact that bears upon the debtor’s liability as the criteria of a bona fide dispute. A debtor’s challenge to liability or the amount of damages may constitute a bona fide dispute. The purpose of the bona fide dispute criteria is to prevent creditors from forcing bankruptcy upon debtors who have legitimate defenses.
A second filing requirement is that the debtor must be shown to be not paying his non-disputed debts as they become due. That a debtor is not paying one or two creditors, regardless of how upset these creditors may be, does in itself not mean that the debtor generally is not paying his debts. Courts have used several factors to evaluate “generally not paying” tests, such as the amount of debt not being paid, the length of time of the debtor’s non-payment, and the debtor’s liquidity. Some courts have defined “generally not paying” to mean that the debtor is regularly missing a number of payments that is significant in relation to the debtor’s overall financial situation. The creditor has the burden of proving the debtor is generally not paying debts.
A discussion of involuntary bankruptcy begins with recognizing that bankruptcy law (the Bankruptcy Reform Act of 2005) makes bankruptcy court an inhospitable environment for Florida debtors. The law deprives Florida debtors of many powerful asset protections previously available in bankruptcy, including much of their most important: homestead protection. The new bankruptcy law only affects debtors who are under the jurisdiction of the bankruptcy court. Outside of bankruptcy, Florida debtors retain their full homestead protection and other Florida exemptions from creditors. The new bankruptcy law creates a substantial divergence between liberal asset protections, including homestead, in Florida’s state court collection proceedings and a federal bankruptcy system that is much more creditor-oriented. Because of creditors’ advantages created in the Bankruptcy Reform Act, many debtors are worried about their creditors forcing them into involuntary bankruptcy.
Many debtors understand that a single creditor with a claim of more than approximately $12,000 can file a petition for involuntary bankruptcy. When a debtor has 12 or more creditors, any three creditors together may petition for involuntary bankruptcy. Alone, these requirements make an involuntary bankruptcy filing seem easy for unsatisfied creditors. In fact, involuntary bankruptcy is uncommon because other legal requirements make it difficult and risky for a creditor to pursue forcing a debtor into bankruptcy involuntarily.
Another basis for involuntary bankruptcy is the debtor’s transfer of substantially all of its assets to a third party, such as a trustee or receiver. A voluntary assignment of assets for the benefit of creditors in a state court proceeding or an out-of-court settlement triggers the right to involuntary bankruptcy if filed within 120 days of the debtor’s transfer. A debtor who makes an assignment for the benefit of creditors under Florida Chapter 727 invites a petition for involuntary bankruptcy. Perhaps the most important requirement for a creditor’s involuntary bankruptcy petition is that the petition be filed in good faith. A court will dismiss a petition upon a determination that the creditor’s motives were in bad faith.
The historical purpose of involuntary bankruptcy is to prevent unfairness to creditors as a group caused by ensuring fair and proportionate distribution of a debtor’s non-exempt assets. Involuntary bankruptcy is properly imposed to prevent a debtor from fraudulently conveying assets or from giving preferential payments to favored creditors. Courts will dismiss involuntary bankruptcy petitions filed for an improper purpose such as malice, harassment, or other improper use of bankruptcy procedures.
Applying this standard, courts have dismissed involuntary bankruptcy petitions which were designed to shut down a debtor corporation’s business, to gain settlement leverage, or which were used as a substitute for customary state court collection. Most bankruptcy courts will not allow involuntary bankruptcy to be used as a creditor collection tool employed by an aggressive creditor. The appropriate use of involuntary bankruptcy is preserving assets and enforcement of fairness among a group of creditors.
The main reason involuntary bankruptcy petitions are rare is the creditor’s liability for filing an unsuccessful petition. It is usually difficult for a creditor to determine prior to filing an involuntary petition whether claims are subject to a debtor’s bona fide dispute and therefore unable to support the petition or whether a court will find that the petition was not filed in good faith in furtherance of a valid bankruptcy purpose. Suppose a court dismisses an involuntary bankruptcy petition. In that case, the court may sanction the petitioner (the filing creditor) with a judgment for the debtor’s costs, attorneys fees, compensatory damages, and, where appropriate, punitive damages. In most cases, damages and fees may be awarded even in the absence of bad faith.