Every Rose Has Its Thorn: Involuntary Bankruptcy Petitions

On April 16, 2019 ruling in the U.S. Bankruptcy Court for the Northern District of Texas in the case of In re: Essential Financial Education, Inc. held that an involuntary bankruptcy petition filed under 11 U.S.C. §303 may not dismissed when it serves a legitimate purpose and is not merely an extension of a two-party dispute. The Essential Financial Education, Inc. decision gives creditors another factor to consider before filing an involuntary petition. Ultimately, Essential Financial Education, Inc. provides a reason why, with proper planning, filing an involuntary petition could be a good collection tool for creditors.

Involuntary Bankruptcy Petition requirements 

Under §303 of the Bankruptcy Code, creditors can file an involuntary bankruptcy petition under either Chapter 7 or 11 against a debtor who has more than 12 creditors if they meet three criteria:

1. there must be three or more petitioning creditors,
2. each petitioning creditor must hold a claim against the debtor that is neither contingent as to liability or the subject of a bona fide dispute, and
3. the claims must aggregate at least $15,325 more than the value of any liens held with respect to the debtor’s property.

If the petitioning creditors meet the threshold criteria and the court determines, after an evidentiary hearing, that the debtor is not generally paying its debts as they become due, the court will enter an order for relief and the bankruptcy case will proceed just as if a voluntary petition had been filed.

Creditors should know, however, that there is a significant caveat to this simple test. Pursuant to §303(i)(2) of the Code, if the court dismisses an involuntary petition after a determination that it was filed in bad faith, the court may impose sanctions on the petitioning creditors.

The Bankruptcy Court Ruling

Essential Financial claimed that its involuntary petition should be dismissed because it had been filed in bad faith. In essence, it claimed that the petition was nothing more than an extension of pre-bankruptcy litigation between Essential Financial and one of the petitioning creditors. The bankruptcy court disagreed.

After an evidentiary hearing, the bankruptcy court held that the bad faith necessary to support dismissal of an involuntary case rests on a finding that a petitioning creditor “acted with wrongful motives, wrongful objectives, or both”. The Fifth Circuit has characterized bad faith, for the purpose of evaluating involuntary petitions, as those “motivated by ill will, malice or for the purpose of embarrassing or harassing the debtor”. Further, many courts have adopted the presumption that a petitioning creditor “acted in good faith” in filing an involuntary petition. The court found that the petitioning creditors all had valid claims against the estate and that permitting the chapter 7 liquidating trustee to evaluate the scheduled and filed claims, along with the propriety of Essential Financial’s pre-petition transactions, was in the best interest of all creditors.

Implications 

The bottom line is that in the Fifth Circuit creditors must clearly and carefully examine their motives before filing an involuntary petition. Involuntary petitions serve a legitimate purpose – where the purported debtor is suspected of transferring assets or preferring other creditors – but using an involuntary petition for an improper purpose – such as, for example, attempting to gain an advantage in pre-petition litigation – may have carry severe consequences in the form of sanctions. Proper planning and a calculated, strategic approach is strongly recommended.