Federal Bankruptcy Jurisdiction and Procedure

7/30/2019 Federal Bankruptcy Jurisdiction and Procedure

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Bankruptcy - Federal Bankruptcy Jurisdiction

And Procedure

Regardless of the type of bankruptcy and the parties involved, basic key jurisdictional

and procedural issues affect every bankruptcy case. Procedural uniformity makes

bankruptcies more consistent, predictable, efficient, and fair.

Judges and Trustees Pursuant to federal statute, U.S. COURTS OF APPEALS appoint

bankruptcy judges to preside over bankruptcy cases (28 U.S.C.A. 152 [1995]).

Bankruptcy judges make up a unit of the federal district courts called bankruptcy court.

Actual jurisdiction over bankruptcy matters lies with the district court judges, who thenrefer the matters to the bankruptcy court unit and to the bankruptcy judges.

A trustee is appointed to conduct an impartial administration of the bankrupt's

nonexempt assets, known as the bankruptcy estate. The trustee represents the

bankruptcy estate, which upon the filing of bankruptcy becomes a legal entity separate

from the debtor. The trustee may sue or be sued on behalf of the estate. Other trustee

powers vary depending on the type of bankruptcy, and can include challenging transfers

of estate assets, selling or liquidating assets, objecting to the claims of creditors, and

objecting

A sample involuntary petition for bankruptcyto the discharge of debts. All bankruptcy cases except chapter 11 cases require trustees,

who are most commonly private citizens elected by creditors or appointed by the U.S.

trustee.

The office of the U.S. trustee, permanently established in 1986, is responsible for

overseeing the administration of bankruptcy cases. The U.S. Attorney General appoints

a U.S. trustee to each bankruptcy region. It is the job of the U.S. trustee in some cases to

appoint trustees, and in all cases to ensure that trustees administer bankruptcy estates
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competently and honestly. U.S. trustees also monitor and report debtor abuse and

FRAUD, and oversee certain debtor activity such as the filing of fees and reports.

Procedures Today, debtors file the vast majority of bankruptcy cases. A bankruptcy

filing by a debtor is known as voluntary bankruptcy. The mere filing of a voluntary

petition for bankruptcy operates as a judicial order for relief, and allows the debtor

immediate protection from creditors without the necessity of a hearing or other formal

adjudication.

Chapters 7 and 11 of the Bankruptcy Code allow creditors the option of filing for relief

against the debtor, also known as involuntary bankruptcy. The law requires that before a

debtor can be subjected to involuntary bankruptcy, there must be a minimum number ofcreditors or a minimum amount of debt. Further protecting the debtor is the right to file

a response, or answer, to the allegations in the creditors' petition for involuntary

bankruptcy. Unlike voluntary bankruptcies, which allow relief immediately upon the

filing of the petition, involuntary bankruptcies do not provide creditors with relief until

the debtor has had an opportunity to respond and the court has determined that relief is

appropriate.

When the debtor timely responds to an involuntary bankruptcy filing, the court willgrant relief to the creditors and formally place the debtor in bankruptcy only under

certain circumstances, such as when the debtor generally is failing to pay debts on time.

When, after litigation, the court dismisses an involuntary bankruptcy filing, it may order

the creditors to pay the debtor's attorney fees, COMPENSATORY DAMAGES for loss of

property or loss of business, or PUNITIVE DAMAGES. This reduces the likelihood that

creditors will file involuntary bankruptcy petitions frivolously or abusively.

One of the most important rights that a debtor in bankruptcy receives is called the

automatic stay. The automatic stay essentially freezes all debt-collection activity,

forcing creditors and other interested parties to wait for the bankruptcy court to resolve

the case equitably and evenhandedly. The relief is automatic, taking effect as soon as a

party files a bankruptcy petition. In a voluntary chapter 7 case, the automatic stay gives

the trustee time to collect, and then distribute to creditors, property in the bankruptcy
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estate. In voluntary chapter 11 and chapter 13 cases, the automatic stay gives the debtor

time to establish a plan of financial reorganization. In involuntary bankruptcy cases, the

automatic stay gives the debtor time to respond to the petition. The automatic stay

terminates once the bankruptcy court dismisses, discharges, or otherwise terminates the

bankruptcy case, but aparty in interest(a party with a valid claim against the

bankruptcy estate) may petition the court for relief from the automatic stay by showing

good cause.

The Bankruptcy Code allows bankruptcy judges to dismiss bankruptcy cases when

certain conditions exist. The debtor, the creditor, or another interested party may ask

the court to dismiss the case. Petitionersdebtors in a voluntary case, or creditors in an

involuntary casemay seek to withdraw their petitions. In some types of bankruptcycases, a petitioner's right to dismissal is absolute; other types of bankruptcy cases

require a hearing and judicial approval before the case is dismissed. Particularly with

voluntary bankruptcies, creditors, the court, or the U.S. trustee has the power to

terminate bankruptcy cases when the debtor engages in dilatory or uncooperative

behavior, or when the debtor substantially abuses the rights granted under bankruptcy

laws.

Compensatory Damages

A sum of money awarded in a civil action by a court to indemnify a person for the

particular loss, detriment, or injury suffered as a result of the unlawful conduct of

another.

Compensatory damages provide a plaintiff with the monetary amount necessary to

replace what was lost, and nothing more. They differ from PUNITIVE DAMAGES, which

punish a defendant for his or her conduct as a deterrent to the future commission ofsuch acts. In order to be awarded compensatory damages, the plaintiff must prove that

he or she has suffered a legally recognizable harm that is compensable by a certain

amount of money that can be objectively determined by a judge or jury.
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One of the more heated issues facing the U.S. legal system during the past quarter

century has been the call for reform of states' TORT LAWS. HEALTH CARE providers and

other organizations have sought to limit the amount of damages a plaintiff can receive

for pain and suffering because they claim that large jury awards in MEDICAL

MALPRACTICE cases cause premiums on medical insurance policies to rise, thus raising

the overall costs of medical services. California took the lead in addressing concerns

with rising medical costs when it enacted the Medical Injury Compensation Reform Act,

Cal. Civ. Code 3333.2 (1997). The act limits the recoverable amount for non-economic

loss, such as pain and suffering, to $250,000 in actions based on professional

NEGLIGENCE against certain health care providers. Although the statute has been the

subject of numerous court challenges, it remains the primary example of a state's efforts

to curb medical costs through tort reform.

Other states have sought to follow California's lead, though efforts to limit

compensatory damages have met with considerable resistance. Opponents claim that

because these limitations greatly restrict the ability of juries and courts to analyze the

true damage that plaintiffs have suffered, defendants avoid paying an amount equal to

the harm inflicted upon the plaintiffs. Medical organizations, such as theAMERICAN

MEDICAL ASSOCIATION, continue to advocate for limitations on damages, however, and

they have sought to encourage state legislatures to enact such provisions.

Damages.

Punitive Damages - Sending A Message Or A

Plaintiff's Windfall?, Further Readings

Monetary compensation awarded to an injured party that goes beyond that which is

necessary to compensate the individual for losses and that is intended to punish the

wrongdoer.

Punitive damages, also known as exemplary damages, may be awarded by the trier of

fact (a jury or a judge, if a jury trial was waived) in addition to actual damages, which

compensate a plaintiff for the losses suffered due to the harm caused by the defendant.
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Punitive damages are a way of punishing the defendant in a civil lawsuit and are based

on the theory that the interests of society and the individual harmed can be met by

imposing additional damages on the defendant. Since the 1970s, punitive damages have

been criticized by U.S. business and insurance groups which allege that exorbitant

punitive damage awards have driven up the cost of doing business.

Punitive damages have been characterized as "quasi-criminal" because they stand

halfway between the criminal and CIVIL LAW. Though they are awarded to a plaintiff in

a private civil lawsuit, they are noncompensatory and in the nature of a criminal fine.

Punitive damages were first recognized in England in 1763 and were recognized by the

American colonies almost immediately. By 1850, punitive damages had become a well-established part of civil law.

The purposes of punitive damages are to punish the defendant for outrageous

misconduct and to deter the defendant and others from similar misbehavior in the

future. The nature of the wrongdoing that justifies punitive damages is variable and

imprecise. The usual terms that characterize conduct justifying these damages include

bad faith, fraud, malice, oppression, outrageous, violent, wanton, wicked, and

reckless. These aggravating circumstances typically refer to situations in which thedefendant acted intentionally, maliciously, or with utter disregard for the rights and

interests of the plaintiff.

Unless otherwise required by statute, the award of punitive damages is left to the

discretion of the trier of fact. A small number of states refuse to award punitive damages

in any action, and the remaining states have instituted various ways of determining

when and how they are to be awarded. In some states, an award of nominal damages,

which acknowledges that a legal right has been violated but little harm has been done, is

an adequate foundation for the recovery of punitive damages. In other states, the

plaintiff must be awarded COMPENSATORY DAMAGESbefore punitive damages are

allowed.
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In the absence of statutory authorization, punitive damages usually cannot be recovered

in breach-of-contract actions. Punitive damages are sometimes recoverable in TORT

actions in which breach of contract is tangentially involved.

Punitive damages will not be awarded in tort actions based on the defendant's

NEGLIGENCE alone. The conduct must have been willful, wanton, or reckless to

constitute an intentional offense. Willfulness implies a plan, purpose, or intent to

commit a wrongdoing and cause an injury. For example, if an automobile manufacturer

knows that the gas tank in its car will likely explode on impact but does not change the

design because it does not wish to incur additional costs, the behavior could be classified

as willful. Conduct is considered wanton if the individual performing the act is cognizant

that it is likely to cause an injury, even though SPECIFIC INTENT to harm someone doesnot exist, such as when an individual shoots a gun into a crowd. Although the individual

does not have the intent to injure anyone in particular, injury is a natural and probable

consequence of the act. Recklessness is an act performed with total disregard of its

foreseeable harmful consequences. Punitive damages can be awarded on the basis of an

injurious act done with ill will, a wrongful or illegal motive, or without any legal

justification, but a wrongful act performed in GOOD FAITH is an inadequate basis for

such an award. For example, if a grocery sold canned goods that later turned out to be

tainted, and the store did not know of the problem before selling the canned goods, it

would be liable for compensatory damages to the victims who ate the food but would not

be liable for punitive damages.

The measurement of punitive damages has been controversial because, traditionally, the

amount to be awarded is, for the most part, within the discretion of the trier of fact. To

determine the amount, the jury or court must consider the nature of the wrongdoer's

behavior, the extent of the plaintiff's loss or injury, and the degree to which the

defendant's conduct is repugnant to a societal sense of justice and decency. In some

states, the financial worth of the defendant can properly be considered.

Ordinarily, an award of punitive damages by a jury will not be upset as excessive or

inadequate. If the trial court believes that the jury award is excessive or unwarranted by
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the facts, it can remove punitive damages from the final judgment, or it can reduce the

amount through a procedural process called remittitur.

Since the 1980s, appellate courts have been called on to review punitive damage awards

and to assess the procedural fairness involved in awarding such damages. State

legislatures and the courts have attempted to craft ways of ensuring reasonable punitive

damage awards, but there is no uniform approach.

The U.S. Supreme Court, inPacific Mutual Life Insurance v. Haslip, 499 U.S. 1, 111 S.

Ct. 1032, 113 L. Ed. 2d 1 (1991), upheld a large punitive damage award on the grounds

that the Alabama jury had received adequate jury instructions and the Alabama

Supreme Court had applied a seven-factor test to assess the reasonableness of theaward.

Two years later, the U.S. Supreme Court shifted its stance on how it would assess

whether a punitive damage award was excessive. In TXO Productions Corp. v. Alliance

Resources Corp., 509 U.S. 443, 113 S. Ct. 2711, 125 L. Ed. 2d 366 (1993), the Court

stated that the DUE PROCESS CLAUSE of the FOURTEENTH AMENDMENT to the U.S.

Constitution prohibits a state from imposing a "grossly excessive" punishment on a

person held liable in tort. Whether a verdict is grossly excessive must be based on anidentification of the state interests that a punitive award is designed to serve. If the

award is disproportionate to the interests served, it violates due process.

The Court further defined the issues surrounding excessive awards inBMW of North

America v. Gore, 517 U.S. 559, 116 S. Ct. 1589, 134 L. Ed. 2d 809 (1996). In this case, the

plaintiff, Ira Gore, was sold a purportedly new automobile. In fact, the car had been

repainted because of damage during shipping. When Gore found out, he sued BMW.

During the litigation, he discovered that for many years BMW had routinely repainted

cars and sold them as new. The jury awarded Gore $4,000 in compensatory damages

and punitive damages of $4 million. The Alabama Supreme Court reduced the punitive

damages to $2 million but upheld the reduced award.
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On appeal, the U.S. Supreme Court overturned the punitive damage award. First, the

Court identified the "degree of reprehensibility of defendant's conduct" as the most

important indication of reasonableness in measuring a punitive damage award under

the Due Process Clause. In the Court's view, the damages imposed should reflect the

enormity of the defendant's offense and may not be grossly out of proportion to the

severity of the offense. In Gore's case, the award was excessive because BMW's conduct

did not demonstrate indifference or reckless disregard for the health and safety of

others. The minor repairs it made to the cars did not affect their performance, safety

features, or appearance.

Second, the Court applied the most commonly used indicator of excessiveness, the ratio

between the plaintiff's compensatory damages and the amount of the punitive damages.Even though the state court reduced the punitive damages by half, the Court found the

ratio of 500 to 1 to be outside the acceptable range.

Finally, the Court examined the difference between the punitive damage award and the

civil or criminal sanctions that Alabama could impose for comparable misconduct. The

fact that the $2 million verdict was substantially greater than Alabama's $2,000 civil

fine for deceptive trade practices was another ground for finding the punitive damages

excessive, according to the Court.

This decision had important consequences in civil litigation. The decision "sent a

message" about punitive damages to the lower courts, strongly implying that they

should do more to rein in juries that award excessive amounts. Courts have the power to

reduce or throw out punitive damages. In the wake ofBMW, many federal courts

carefully applied the Supreme Court's standards and reduced punitive damages awards.

State courts have been less uniform in following these standards, with some courts

distinguishing the decision in order to sustain large punitive awards. However, in 2003,

the Supreme Court reaffirmed theBMWdecision and three-part analysis inState Farm

Mut. Auto. Ins. Co. v. Campbell, 538 U.S. 408, 123 S. Ct. 1513, 155 L. Ed. 2d 585. The

court made clear that state courts must employ this analysis or risk reversal.


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Though the decision reassured some in the insurance industry, the industry has

continued to pursue "tort reform" legislation at the state and federal level. President

GEORGE W. BUSH proposed his own tort reform package in 2002, which included a

limit on punitive damages. This proposal would cap punitive damages at whichever is

less: $250,000 or twice the economic damages.

When filing an involuntary bankruptcy petition makes

sense.

Involuntary bankruptcy is the ultimate and most deadly weapon in the creditor's arsenal. It sends a

dire warning to the debtor: no more business as usual. A successful involuntary petition can

transform creditors from grumbling passengers to copilots of the debtor's business.

Credit managers are nonetheless plagued by a great deal of uncertainty in determining whether this

remedy should be used. Their questions are repeated in case after case with predictable familiarity:

Does the debtor qualify for involuntary bankruptcy? Do I need the help of other creditors and, if so,

how do I enlist it? What benefit will my company get out of the process? Who bears the cost? And,

isn't there liability if we're wrong about doing this?

Involuntary bankruptcy is indeed a drastic remedy and should be approached with care and

deliberation. Filing an involuntary petition in the wrong case may be, at best, no more than a waste

of money, even if the petition is ultimately granted. In the right case, however, creditors can speed up

the collection of their claims by bringing the debtor under judicial control and taking advantage of a

bankruptcy trustee's extraordinary powers to gather assets and recover transfers of property.

Fortunately, several guiding principles are available to help credit managers distinguish the right

cases from the wrong ones. When used in conjunction with the advice of an experienced bankruptcy

attorney, these principles will help you avoid costly blunders.

Is the Debtor Eligible for an Involuntary Bankruptcy?

The requirements for placing a debtor into an involuntary bankruptcy are spelled out in Section 303

of the federal Bankruptcy Code. Virtually any debtor is eligible - whether an individual, partnership,

corporation, or trust - except farmers and non-business corporations. A debtor is eligible if it meets

either of two tests: (1) it is generally not paying its debts (other than those that are the subject of a

bona fide dispute) as they become due, or (2) a custodian has been appointed during the last 120
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days to take charge of substantially all of the debtor's property. Once proof of either of these two

circumstances is made, the bankruptcy court must place the debtor into bankruptcy for liquidation of

its assets (Chapter 7) or court-supervised reorganization (Chapter 11).

On the other hand, not every creditor is eligible to act as a petitioner for involuntary relief against a

debtor. Section 303 requires that a petitioning creditor have a claim against the debtor that is "not

contingent as to liability or the subject of a bona fide dispute." Creditors with undisputed trade debts

or unsecured loans typically qualify, while tort creditors or litigants await a court judgment to resolve

a disputed claim usually do not. Even secured creditors are eligible to petition for involuntary

bankruptcy, provided they are undersecured to some extent.

Section 303 also specifies the necessary number of petitioning creditors. If you are lucky enough to

have a debtor with fewer than 12 creditors with non-contingent, undisputed claims, a single creditorcan file a petition for involuntary bankruptcy. In the more usual case where there are 12 or more

creditors, at least three eligible creditors must join together in signing the petition. Sometimes it is

easy to find the three creditors necessary to sign the petition, such as when the trade creditors are

part of an association or when the debtor's financial condition has brought them into informal

contact. At other times, the prospective petitioner must locate other creditors through a review of

financial statements, credit reports

, litigation, and judgment records, by informal discussions with the debtor's officers or employees, or

simply by guesswork based upon the debtor's known commodity and service needs. Trade creditors

with long overdue bills are usually eager to discuss their situation and to share information.

Whether the debtor is generally paying its debts as they become due requires a judgment call that the

credit manager should make with the advice of a bankruptcy attorney. When the debtor's financial

default is a matter of public information or has been conceded by the debtor in public statements or

correspondence, this requirement becomes a non-issue. In cases where the debtor has elected to

keep certain essential creditors current while "riding" others, a potential petitioner must reach a

conclusion based upon the proportionality of the unpaid debts. In other words, when the amount of

overdue debts would lead a reasonable person to conclude that the debtor is "generally" not paying

its debts as they become due, this test has been met.

A hostile debtor will often respond to an involuntary petition by contacting each of the petitioners in

an effort to persuade them to drop out of the fight. Several inducements are commonly offered.
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Debtors will sometimes use the "carrot" approach, offering to promptly pay off a creditor's particular

debt or promising that it will receive a continuing share of business if the petition is dropped.

Equally common is the threat of a damages action or a total cut-off of future purchases from the

petitioning creditors. These efforts are often quite effective with wavering or inexperienced creditors

with little or no stomach for a fight. Courts have generally held, however, that a creditor's withdrawal

from a petition after it is filed will not defeat the petition as to the other petitioning creditors.

Nevertheless, it is a wise practice to enlist four or five petitioners when possible, instead of the

minimum of three.

Successful petitioning creditors are entitled by statute to recover the reasonable and necessary

expenses of their effort. This includes attorneys' fees, court costs, and travel expenses incurred by

creditors in connection with the involuntary bankruptcy petition. The petitioners' attorney may apply

to the bankruptcy court for reimbursement of these expenses shortly after an "order for relief" is

signed by the judge. Once the bankruptcy judge determines that all criteria have been met for

involuntary bankruptcy - and the procedural rules require that trial be held "at the earliest practical

time" - he will appoint a trustee or may designate the debtor as "debtor in possession" to act

henceforth for the benefit of creditors in reorganization cases.

Beyond Legalities Conducting a review of the legal requirements is only part of an informed decision

whether involuntary bankruptcy should be used. Creditors must also conduct a business analysis,

which boils down to the risk (including cost) versus the reward. Despite their efforts and expense,

petitioners must bear in mind that they are still only general, unsecured creditors. The debts owing

to involuntary petitioners are entitled to no priority over those of nonparticipating unsecured

creditors. Experience shows that the following situations are likely to produce an ultimate net benefit

for involuntary petitioners:

The debtor has made a significant transfer of assets otherwise available to unsecured creditors. A

debtor's financial default may be preceded or accompanied by a large transfer of its assets to a third

party. Often, the transferee is a person or entity who is closely related to the persons in control of the

debtor. Such transactions may either be fraudulent, i.e., made with actual intent to hinder, delay or

defraud creditors, or for less than reasonably equivalent value while the debtor is insolvent, or

preferential, i.e., favoring one antecedent debt over others of equal priority. Both types of

transactions are potentially avoidable by a bankruptcy trustee.


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Assuming that the transferred assets, once recovered, will provide a meaningful distribution to

unsecured creditors after deduction for the trustee's costs of litigation, such cases are good

candidates for involuntary bankruptcy.

Timing is crucial, however. A trustee will not be permitted to recover a preference unless the

involuntary petition is filed within 90 days of the transfer (one year for transfers to or for the benefit

of insiders), or a fraudulent transfer unless the petition is filed within the period allowed by state

fraudulent transfer law (most commonly four years).

Some courts will waive the three-creditor requirement in cases where the debtor has made a

particularly large fraudulent transfer. In such extraordinary cases, even a single creditor will

sometimes be allowed to force a debtor into bankruptcy upon the requisite showing that it has not

generally been paying its debts as they become due.

The debtor's assets are being rapidly depleted. This is a case of here today, gone tomorrow. The

debtor has sufficient assets now to make an involuntary petition worthwhile, but is experiencing

severe operating losses. An involuntary petition filed soon enough will bring the debtor under the

bankruptcy court's control and staunch the flow of red ink, preserving a distribution to creditors.

Creditors have begun a race to the courthouse. In this scenario, one or more other creditors have

filed suit against the debtor and are about to take judgments against it. Once a creditor obtains a

judgment and levies on assets, its status advances to that of a lien creditor, with a right to specific

assets of the debtor. The race to the courthouse by other creditors may quickly remove the debtor's

most valuable assets from the reach of its unsecured trade creditors. The filing of an involuntary

petition immediately stays litigation and collection efforts. It also allows judgment liens taken within

90 days of filing to be attacked as preferences.

The debtor's management is irreparably tainted by fraud or misconduct. Poor financial performance

caused by the miscalculations of management is often correctable. However, revelations that the

company's officers have engaged in fraud, dishonesty, or serious misconduct usually signal that poor

performance has been no miscalculation - and things are headed south quickly. Dishonest

management may rapidly deplete a company's assets through fraudulent transfers, asset diversions,

excessive compensation, or similar schemes.

Discoveries of prior diversions of assets usually follow initial revelations of fraud. In cases where

deteriorating financial performance is accompanied by substantial misconduct, involuntary


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bankruptcy may be the only means of wresting control of the company from dishonest management

and preserving what remains for creditors.

The debtor has suffered a financially fatal blow. The circumstances will vary by industry, but the

meaning is clear: the debtor has suffered a knockout blow from which recovery will be next to

impossible. Examples include the collapse of the market for the debtor's goods or services, the loss of

its principal customers, the resignation en masse of its management, the death of its owner-operator,

default with its principal secured creditor, the refusal of other trade creditors to extend further

credit, or a protracted strike. In such cases, efforts by the debtor to continue its business are likely to

be both futile and financially wasteful. Creditors may do well to staunch the bleeding quickly and

recover what they can on their claims.

Throwing Good Money After Bad

The ability to spot sure losers in bankruptcy is as helpful as recognizing the best candidates. These

are the cases which flunk the risk/reward analysis, even though the debtor technically qualifies for

bankruptcy. Remember, the name of the game is ultimate financial recovery by creditors, not

retribution. Here are some examples to avoid:

The debtor's remaining assets are insignificant or unavailable. This is a case of closing the barn door

after the horse is gone. The debtor has been permitted to financially hemorrhage for so long that

there is almost nothing left to distribute to unsecured creditors. A check for voidable preferences or

fraudulent transfers likewise yields nothing of consequence. Equally as futile is the situation where

the debtor has substantial assets but they are fully subject to a secured lender's liens (unless there is

clear evidence of inequitable conduct on the lender's part). It is pointless to invest the time and

expense of an involuntary petition in such cases.

You're not being paid, but most others are. A financially strapped debtor typically allocates cash to

the most essential trade creditors, leaving a number of others unpaid. If most creditors are being

paid current but you are not, an involuntary petition is an invitation to protracted litigation.

Likewise, creditors should avoid this remedy when the reason for nonpayment is a private dispute

with the debtor. An individual lawsuit is far more likely to bring successful results in such

circumstances.


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You've gained more to lose in bankruptcy. Preference and fraudulent transfer suits are powerful tools

to recover lost assets for the bankruptcy estate. However, these remedies may also be used by the

trustee or debtor-in-possession against petitioning creditors. Those considering placing the debtor

into involuntary bankruptcy would do well to conduct their own risk analysis to ensure they won't

have to return more to the estate than they will receive. It makes little sense to trigger bankruptcy to

recover a $100,000 debt when you received $175,000 in preferential payments during the past few

months. A bankruptcy court also has the power to bar any distributions to a creditor until it has

repaid all voidable transfers. Creditors may cure their preference problems in most cases by timing

the filing of the involuntary petition more than 90 days after they received any large preferential

payments.

The use of involuntary bankruptcy requires both a legal analysis and a cost-benefit assessment.

There are a number of clear cases when this remedy either makes economic sense or should be

avoided as futile. Credit managers who are able to recognize such cases can avoid costly blunders and

score well in recovering on their debts.

Larry Chek is a shareholder with the Dallas law firm of Jenkens & Gilchrist, P.C., practicing in the

areas of bankruptcy, creditors' rights, and commercial lending.

"Bad faith" and involuntary bankruptcy filings.

In evaluating various collection remedies, creditors collectively may find the commencement of an

involuntary bankruptcy petition to be one of the most effective tools they have against a debtor,

because an involuntarybankruptcy

can be viewed as the ultimate prejudgment attachment--it freezes the debtor's assets for the benefit

of allcreditors. The historic purpose of involuntary bankruptcy is to provide creditors with a means

of assuring equal distribution of a debtor's assets. An involuntary bankruptcy may be an appealing

alternative to an out-of-court workout in a number of situations, including those where a debtor is

unwilling to disclose financial information, a debtor is engaged in fraudulent activity, a debtor is

unable to obtain credit as a result of the unwillingness of the trade and banks to extend credit, and

the petitioning creditors seek to utilize the trustee's right to reject or assume and assign leases under

the Bankruptcy Code. Timing is an important element when considering whether to file an
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involuntary petition. The longer a creditor waits, the more difficult it may be to recapture property of

the estate.

There are a number of criteria that petitioning creditors must meet for a valid involuntary

bankruptcy filing: The petitioning creditors' unsecured claims total $10,000; the petitioning

creditor's claim may not be subject to a bona fide dispute nor contingent; the debtor is generally

failing to pay its non-disputed debts as they come due; and, if the debtor has 12 or more creditors, at

least three creditors must join in the petition.

The Legal Procedures

The procedure for an involuntary petition is that petitioning creditors file an involuntary petition

with the Bankruptcy Court in the district where the debtor has primarily conducted its business for

the last six months. Petitioning creditors may select either Chapter 11 of the Bankruptcy Code (the

reorganization chapter) or Chapter 7 (the liquidation chapter). The petition should allege that the

debtor has generally failed to pay its debts as they come due and that the petitioning creditors"

claims are neither subject to a bona fide dispute nor contingent. The "alleged" debtor may respond to

the petition by consenting to it.

Alternatively, the "alleged" debtor may dispute the basis for the involuntary petition, contending, for

example, that it is generally paying its debts as they come due or that one or more of the petitioning

creditors is not an eligible creditor. The debtor will request that the involuntary petition be

dismissed. If the Bankruptcy Court dismissed for failing to meet the involuntary petition criteria, the

debtor may request damages for the loss of business it suffers as a consequence of the petition being

filed, including attorneys' fees for defending the involuntary petition and punitive damages.

Courts generally limit damage awards to those instances where the petitioning creditors filed for an

improper purpose, that is, in "bad faith". Thus, petitioning creditors must carefully examine whether

the debtor is an eligible debtor and whether they are eligible petitioning creditors before they

contemplate joining an involuntary petition. In addition, petitioning creditors must also carefullyexamine their purpose for filing an involuntary petition to avoid a determination that the petition

was a bad faith filing. But what is bad faith? How does a credit manager with a delinquent open

account balance determine whether the involuntary petition he is contemplating joining may be for

an improper purpose, and, thus, in bad faith? Unfortunately, there are no crystal-clear legal

guidelines. The Bankruptcy Code does not define bad faith. Nor have courts crafted a bright-line test
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for what actions will be construed as acting in bad faith. However, courts have held that an

involuntary petition is filed in bad faith where the sole purpose for filing the involuntary petition is to

shut down the debtor's business, force the debtor into labor negotiations, gain settlement leverage

over the debtor or take over a corporation. Yet, courts have determined that petitions filed to resolve

inter-creditor disputes, to effect an orderly workout of claims without preference to creditor, and to

obtain financial information were not filed in bad faith.

Examine Involuntary Petition Criteria Carefully

The bankruptcy court's recent ruling in In re Landmark Distributors (189 B.R. 290 (Bankr. D. New

Jersey 1995)) is a powerful reminder for trade creditors to carefully examine the involuntary petition

criteria, including the purpose for filing an involuntary bankruptcy petition to avoid a bad faith

holding. In Landmark Distributors, the debtor distributed records wholesale. Three trade creditorsfiled an involuntary Chapter 7 petition, and the debtor responded by disputing that it was generally

not paying its debts as they came due and contending that the petitioning creditors' claims were

subject to dispute. The court agreed with the debtor and dismissed the involuntary petition. In

addition, the court found the petition was filed for an improper purpose, and, thus, in bad faith.

Because the petition was filed in bad faith, the petitioning creditors were ordered to pay the debtor

$3.7 million in compensatory and punitive damages as a consequence of filing the involuntary

petition. The court determined that the involuntary petition caused the debtor to shut down its

operations.

Errors by Petitioning Creditors Can be Costly

The court found a number of badges of bad faith by petitioning creditors. The sole purpose of the

filing was to punish the debtor when negotiations with the petitioning creditors to acquire an

affiliated entity collapsed. The creditors filed the petition even though they knew the debtor had

resumed paying some creditors. The debtor had a legitimate dispute about one of the petitioning

creditor's claims, which disqualified the petitioning creditor. The petitioning creditors also claimed

to fear that the debtor's assets were being dissipated, yet they failed to seek an interim trustee to

protect the debtor's assets and waited nearly two weeks from the date they signed the petition to file

the petition. The petitioning creditors also faxed a copy of the petition to a national trade publication

immediately after the filing to ensure wide dissemination of the filing, an action which had a severe

impact on the debtor's relationship with its customers.


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The Landmark Distributors decision is a reminder that a real risk of liability exists for trade creditors

who file an involuntary petition without confirming that the involuntary petition criteria are met and

that the petition is filed for a proper purpose. An involuntary petition can cause the alleged debtor to

lose credit standing, interfere with its operations and result in public embarrassment.

Questions You Should Consider

A credit manager contemplating filing an involuntary petition, or joining with other creditors, must

consider a number of questions. Is the debtor generally not paying its debts as they come due? The

credit manager should discuss the account with other vendors of the debtor, especially principal

suppliers. If the debtor is a publicly held company, a petitioning creditor may review recent press

releases or the debtor's 10-Q or 10-K filings with the Securities and Exchange Commission.

Is the claim subject to a bona fide dispute? A bona fide dispute is most commonly found where the

creditor has sued to collect on the debt, the debtor disputes the collection action, and the creditor has

not yet obtained a judgment.

Is the claim contingent? This is usually found where payment is conditioned on an extrinsic event.

Finally, does the debtor have 12 or more creditors?

As the Landmark Distributors case makes clear, the credit manager must also reflect on the purpose

for the involuntary filing. Is the filing to force the debtor out of business, or properly, to ensure a

ratable distribution to creditors? Is the filing to gain leverage on the debtor? Is the filing made out of

spite? An involuntary petition can be a powerful tool for collecting assets and preserving the status

quo, so long as credit managers diligently confirm that proper grounds exist for filing the involuntary

petition.

Scott Blakeley is a partner in the law firm of Blakeley & Brinkman, Los Angeles, where he specializes

in bankruptcy and creditors' rights law.

Federal Bankruptcy Jurisdiction and Procedure

Documents

Transcript of Federal Bankruptcy Jurisdiction and Procedure