Seven Factors to Consider BEFORE Filing an Involuntary Bankruptcy Petition

To many, the thought of filing an involuntary bankruptcy against a debtor appears to be a legitimate debt collection practice, with certain vengeful qualities. However, while the threat of an involuntary petition might compel a debtor to pay up or work out its debt, you might just as easily find yourself in the defensive role of needing to justify the validity of the involuntary petition. Thus, before filing an involuntary petition, you should become familiar with some of the strategic considerations involved.

There are a number of legitimate reasons to file an involuntary bankruptcy petition. The most significant reasons are discussed below.

One: Prevent the Removal of Property from the Estate
At times, debtors take steps to transfer their property, or otherwise reduce their non-exempt assets, in order to reduce the size of the bankruptcy estate available for distribution to creditors. By filing an involuntary petition, you can cut off any further transfers outside the ordinary course of business and recapture transfers made for less than reasonably equivalent value under the avoidance provisions set forth in the Bankruptcy Code.

Two: Halt Payments of Debts Guaranteed by Insiders
Another situation that calls for an involuntary petition occurs when a debtor directs its payments towards those creditors whose debts are guaranteed by principals of the debtor. The debtor’s obvious intent here is to minimize the amounts for which its principals will be "on the hook" in the event the debtor later files voluntary bankruptcy petition. The filing of an involuntary petition and the subsequent entry of an order for relief subjects future transfers of this nature to increased scrutiny and subjects prior transfers that benefit insiders to avoidance as preferential transfers.

Three: Obtain Avoidance of Preferential Payments
Similarly, by filing an involuntary petition and obtaining an order for relief, you can "trap" preferential payments made by the debtor prior to the petition date. For example, if the debtor has paid an affiliate, an insider or one of its creditors, an involuntary bankruptcy may be employed to trap the significant payment within 90 days of the preferential transfer time period. That time period is extended to one year if the creditor at the time of such transfer is an insider.

Four: Eliminate Improper Lender Control
An involuntary petition might be worthwhile when the debtor is being controlled by its lenders, or is otherwise taking actions that benefit its lenders, to the detriment of other creditors. The filing of an involuntary petition opens all such transactions to increased scrutiny and, potentially, subjects an overzealous lender to subordination under 11U.S.C. 510(C).

Five: Preserve Unencumbered Assets
As a financially troubled debtor slides closer to bankruptcy, its lenders will frequently seek additional collateral, or cross-collateralization of its assets, in an effort to better secure their position. To preserve unencumbered assets for later distribution to creditors, an involuntary petition might be filed. The filing "traps" any new liens given within the 90-day preference period or, alternatively, within the one-year period for avoiding fraudulent conveyances.

Six: Replace Incompetent Management
If a debtor’s management is grossly incompetent, mounting losses may reduce or even eliminate any potential distribution to creditors by the time a voluntary bankruptcy petition is filed. After the filing of an involuntary petition and the entry of an order for relief, creditors can move to appoint a trustee for the bankruptcy estate or, alternatively, seek to replace existing management with more competent individuals.

Seven: Control Jurisdiction of the Bankruptcy
A debtor that does business in Texas and has most of creditors in Texas, but whose home office is in Bangor, Maine may file bankruptcy in Maine to make it cost-prohibitive for unsecured creditors to meaningfully participate. If a bankruptcy is imminent, you may want to commence the bankruptcy in the jurisdiction of your choice.

The above article is being provided by the publisher of the Weekly Summary of Financially-Challenged U.S. Companies. Published since 1988, this time-saving summary provides credit managers with the very latest information on companies that are experiencing some form of financial difficulty. To obtain a sample of the Summary call 1-800-407-9044 or visit the insideARM bookstore.