Involuntary Petitions Under the Bankruptcy Reform Act of 1978

Publication year1984
CitationVol. 13 No. 8 Pg. 1367
13 Colo.Law. 1367
Colorado Lawyer

1984, August, Pg. 1367. Involuntary Petitions Under the Bankruptcy Reform Act of 1978


Vol. 13, No. 8, Pg. 1367
Involuntary Petitions Under the Bankruptcy Reform Act of 1978
by Joseph G. Rosania

Although the Bankruptcy Reform Act of 1978, embodied in Title 11 of the United States Code ("U.S.C.") and commonly known as the Bankruptcy Code, may be used by a debtor as a haven from levying creditors, it can also be an effective tool for a creditor to compel liquidation or reorganization of the debtor's estate. The Code contains a mechanism by which creditors can initiate bankruptcy proceedings against an unwilling debtor. In fact, bankruptcy began as a tool in the arsenal of creditors' remedies to force an orderly liquidation of the assets of a debtor.(fn1)

The Bankruptcy Code, recently amended by the Bankruptcy Amendments and Federal Judgeship Act of 1984, has instituted important changes in the substantive and procedural law relating to involuntary petitions. Under the Bankruptcy Act of 1898 ("1898 Act"), the law on involuntary petitions was spread through a number of sections. Code § 303 incorporates much of the prior law into one convenient section. In addition to § 303, there are other relevant Code sections and a myriad of federal Bankruptcy Rules (Federal Rules of Bankruptcy Procedure) to be consulted. Also, a substantial body of recent case law has evolved which applies and interprets the statute, and much of the pre-Code case law remains valid.

Due to the continuing economic woes of small businesses and the socioeconomic transition from an industrial society to an informational society, the general practitioner may be called upon to bring or defend against an involuntary bankruptcy petition. The purpose of this article is to offer general guidance with respect to the filing decision, including commentary on what to file, who may file, the form of the petition, trial on the involuntary petition, grounds for relief, post-filing activities and dismissal.


The imposition of an involuntary petition involves some risk for the petitioning creditors.(fn2) The 1898 Act required proof of technical "acts of bankruptcy" in order to initiate an involuntary petition. The Code has relaxed these requirements, but in return has exacted a toll from unsuccessful petitioning creditors. The filing of an involuntary petition is a serious action which should not be taken lightly or out of revenge or rage. If the court enters an order for relief under Chapter 7, the operation of the debtor's business will cease and a trustee will be appointed to liquidate and distribute non-exempt, unencumbered assets. Hence, prior to filing an involuntary petition, the creditor should carefully consider alternative remedies.

Speed is the overriding concern when pursuing a judgment debtor. The creditor must move quickly to preserve assets and documents and to prevent a bulk or forced sale. Before settling on any particular course of action, the creditor should obtain verifiable facts so that short- and long-term financial analyses can be performed. In the case of a debtor engaged in business, balance sheets, income statements, cash flow reports, SEC filings and security agreements must be considered. In the case of an individual not engaged in business, tax returns should be examined and title searches performed. In either case, the creditor should evaluate the extent of unencumbered, non-exempt assets.

The first alternative is for a creditor to do nothing. For an unsecured creditor, who is a victim of the operation of state grab law, this may be the wisest course in certain circumstances. Where the amount of the debt is relatively small, a cost-benefit analysis may indicate that the court costs, legal fees, time and frustration are too great to justify pursuit of any remedy. Further, possibilities for a return may be non-existent if the debtor does not own sufficient non-exempt assets where the operation of state grab law has exhausted such assets.

If application of the cost-benefit analysis yields a positive result, further action is dictated. If the creditor has a judgment, it may procure a judicial lien and levy upon non-exempt property, move to have a receiver appointed or attempt to force the debtor into a state law liquidation proceeding.(fn3) The creditor may also execute a contractual liquidation or seek appointment of an assignee for the benefit of creditors.(fn4) These processes are typically cheaper, more flexible and less formal than proceeding in the Bankruptcy Court. Once a judgment is obtained, post-judgment discovery may be pursued to locate assets.(fn5) Moreover, in light of the anticipated jurisdictional quagmire created by the Bankruptcy Amendments and Federal Judgeship Act of 1984 ("1984 Act"), litigants may find themselves debating jurisdiction to the exclusion of substantive issues.(fn6)

Occasionally, it may be in the best interest of all parties to rehabilitate the debtor. The decision to reorganize is


reached only after consultation and negotiation with the debtor, lenders, key suppliers and trade creditors. Liquidation of an insolvent debtor under state or federal law usually produces a minuscule recovery for creditors. Alternatively, rehabilitation of a going concern could enable the debtor to turn the financial corner, retain a workforce, utilize resources in an optimal fashion and become a viable enterprise.

When a concern suffers transient periods of insolvency, reorganization may be worth a try. Reorganization could be feasible where an entity that is hard-asset rich and cash poor attempted to expand too rapidly or into unprofitable markets, or both, or experienced difficulties from unpredictable market conditions, lack of diversification or mis-management. Other candidates are businesses with valuable pieces of property or with promising new services or products which have yet to establish themselves.

The parties also may attempt to effectuate what is, in effect, a rehabilitation by entering into a composition or extension agreement. A composition is a private agreement between and among the creditors and a debtor for immediate repayment of a smaller sum than what is owing. An extension is a private agreement between and among the debtor and creditors whereby creditors will be paid in full over an extended period of time. Often, the threat of involuntary bankruptcy is an important bargaining tool when negotiating out-of-court workouts.

These arrangements allow the debtor to avoid the stigma of bankruptcy, and the debtor still receives at least a partial, contractual discharge of debt. Creditors are assured of some repayment and may still resort to bankruptcy later if necessary.


In addition to facilitating economic revitalization and orderly liquidation of assets, the Bankruptcy Code provides four identifiable benefits to creditors. The foremost goal, particularly in a liquidation, is equal distribution of a debtor's non-exempt property, without preferential treatment. Numerous involuntary cases are begun by disgruntled unsecured creditors who have witnessed preferential payments to other creditors of the same rank. Voidable preferences, fraudulent conveyances, acquisition and perfection of liens and improper bulk sales are all preferential in nature. A secured creditor in a senior position may resort to collateral rather than be subjected to the automatic stay.(fn7)

Second, the value of the debtor's estate can be maximized for the benefit of all creditors by virtue of Code provisions that authorize turnover of estate property which is in the hands of third parties, even where a creditor seized the property pre-petition.(fn8) Also, the trustee has a range of avoidance powers which can be employed to recover property fraudulently or improvidently transferred or to void certain liens and encumbrances.(fn9)

Third, the vast investigative powers of the Bankruptcy Code and Rules assist in the discovery of assets, preservation of assets and evaluation of the debtor's pre-petition conduct.(fn10) Sanctions are appropriate for failure to produce books and records and otherwise respond to discovery requests, with the harshest sanction being the denial of the discharge of the debtor.(fn11)

Finally, an impartial trustee, armed with extraordinary turnover and avoidance weapons, is appointed. The trustee's fiduciary duties include recovery of assets, preservation of assets, examination of claimed exemptions, examination of the validity of security interests, examinations of the affairs of the debtor and distribution of the proceeds of non-exempt assets in accordance with the priority rules of the Code.(fn12) If a receiver or assignee for the benefit of creditors is biased or incompetent, the creditors may desire an impartial trustee whose activities are, at least indirectly, under court supervision. Although assignees for the benefit of creditors have some statutory powers,(fn13) they pale in comparison with those conferred upon a bankruptcy trustee.


Pursuant to Code § 301, the filing of a voluntary petition constitutes an order for relief. The aim of the petitioning creditor is to obtain an order for relief from the Bankruptcy Court against the subject debtor. The central governing Code section for involuntary cases is § 303. Pursuant to subsection (a), an involuntary case may only be commenced under Chapter 7 or 11 of the Code and only against a person(fn14) who is not a farmer or non-profit organization. A farmer is defined by the Code as a person who received more than 80 percent of his gross income in the year preceding the year in which the petition is filed from a farming operation owned or operated by such person. Where an involuntary petition is filed against a debtor who...

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