Contributed by Abigail Lerner
While commencing a bankruptcy case is most commonly undertaken voluntarily by the debtor itself, the Bankruptcy Code gives certain creditors authority to force certain entities into chapter 11 or 7 bankruptcy. Unfortunately for the unwilling chapter 11 or 7 debtor, so long as petitioning creditors meet the statutory requirements to commence an involuntary case, the would be debtor will have no choice but to resolve itself under the Bankruptcy Code. This was the fate of the debtor in In re The District at McAllen, L.P. where the United States Bankruptcy Court for the Southern District of Texas ruled that involuntary bankruptcy relief against the debtor, The District at McAllen, L.P., was appropriately commenced by one of the debtor’s creditors notwithstanding the debtor’s argument that three creditors – not one – were necessary to file the involuntary petition.
Involuntary Bankruptcy Cases Generally
As noted above, although most bankruptcy cases are initiated by the filing of a voluntary petition by a debtor, the Bankruptcy Code allows for creditors to file an involuntary petition against a person, excluding a farmer and an eleemosynary institution. The debtor must be eligible to be a debtor under either chapter 7 or 11, the only chapters under which an involuntary petition may be filed.
Section 303 of Bankruptcy Code governs the commencement of involuntary bankruptcy cases. A court will enter an order for relief in an involuntary case if (1) the requisite number of eligible petitioning creditors file a petition and (2) the debtor is generally not paying such debtor’s debts as they become due unless such debts are the subject of a bona fide dispute as to liability and amount. If a debtor has twelve or more eligible creditors holding claims that are not contingent as to liability and not subject to a bona fide dispute as to liability or amount, three or more petitioning creditors holding noncontingent, undisputed claims aggregating at least $15,325 are needed to commence the involuntary case. If the debtor has fewer than twelve creditors, one petitioning entity holding a noncontingent, undisputed claim of at least $15,325 is sufficient. If there are fewer than three petitioning creditors that filed the involuntary petition and the involuntary debtor alleges that he or she has more than twelve creditors, then the debtor has the burden to raise this issue by filing a list of its creditors.
Despite the filing of the involuntary petition, the business of the debtor may continue to operate and the debtor may use, acquire or dispose of property until the court orders otherwise. The debtor may file an answer to the involuntary petition. If the debtor does not file an answer within 21 days after the involuntary petition, the court will order relief against the debtor (essentially commencing a bankruptcy case). If the petition is contested, the court will hold a trial and will order relief against the debtor only if (i) the debtor is generally not paying its debts as they become due, unless such debts are the subject of a bona fide dispute as to liability or amount, or (ii) a custodian over the debtor’s property was appointed within 120 days.
The time between the filing of an involuntary petition and the entry of an order for relief, which formally places the debtor into bankruptcy, is referred to as the “gap period.” Gap periods can vary from a few days to a couple of years, depending on the circumstances. Generally speaking, the Bankruptcy Code allows an alleged debtor to conduct its business during the gap period as if the filing never occurred. During the gap period, potential debtors are not prohibited from making payments on invoices that arose prior to the filing of the involuntary petition. However, certain payments may be recouped by the estate if value is not received for such payments. Additionally, during this period the automatic stay under section 362 of the Bankruptcy Code applies, thus, creditors are prohibited from taking any action to collect their debt. The Bankruptcy Code also provides for prepetition priority status to extensions of credit made during the gap period. An allowed claim related to unsecured credit extended during the gap period will be afforded priority status, so long as the credit is extended in the ordinary course of the debtor’s business and equal value is provided.
Involuntary Bankruptcy Case Against The District at McAllen, L.P.
As noted, the number of petitioning creditors needed to commence an involuntary case against a debtor depends on the number of the debtor’s qualifying creditors. Determining how many qualifying creditors a debtor has, however, is not as easy as it may appear. In District at McAllen two creditors petitioned for an involuntary chapter 11 case against The District at McAllen on the eve of foreclosure when the debtor was both insolvent and not paying its debts as they became due. In its answer to the petition, the debtor alleged that a total of twenty-three creditors held claims against it and, therefore, the number of petitioning creditors was insufficient to commence the involuntary case against The District at McAllen.
Turning to whether The District at McAllen had twelve or more creditors, the bankruptcy court noted that only those creditors holding claims that were, among other things, (i) not contingent, (ii) not subject to a bona fide dispute as to liability, (iii) not subject to a bona fide dispute as to amount, (iv) not held by insiders of the debtor, (v) at least $15,325 in the aggregate, and (vi) unsecured (or undersecured by more than $15,325 in the aggregate) could be included in counting to twelve under section 303(b)(1) and 303(b)(2) of the Bankruptcy Code. After combing through the debtor’s list of creditors, the bankruptcy court determined that The District at McAllen had included creditors that “do not count” as eligible creditors. These included taxing authorities with fully secured claims, insiders, persons who owed more to the debtor than they were owed by the debtor, and tenants of the debtor who held contingent claims.
In addition to the claims held by the creditors listed above, the petitioning creditors argued that de minimus claims should not be included in the count. The bankruptcy court disagreed, holding that unless the debtor is manufacturing small, recurring claims in contemplation of an involuntary case to increase the number of required petitioning creditors, then small, recurring claims should be included in the count. The court reasoned that section 303(b)(2) is very explicit in enumerating excluded creditors and de minimus claims do not appear within that section. Much to the relief of the petitioning creditors, however, even with the inclusion of de minimus claims, the number of The District at McAllen’s eligible creditors did not bring the total to twelve.
The bankruptcy court concluded that because the debtor had fewer than twelve creditors, one sole qualifying creditor was sufficient to commence the involuntary chapter 11 case.
Because chapter 11 is usually considered a proactive tool to be used by a debtor who seeks to gain the protections of the Bankruptcy Code, it may seem counterintuitive that the Bankruptcy Code also allows creditors to force a debtor into bankruptcy. As The District at McAllen demonstrates, however, there is no avoiding an involuntary case if the requisite number of petitioning creditors, based on the number of qualified creditors, takes the required actions. Therefore, when counseling creditors interested in commencing an involuntary case, practitioners should be sure, when advising their clients on the number of petitioning creditors necessary to institute the action, that they exclude those creditors that “do not count.” So long as the tally is correct and the other section 303 requirements are met, The District at McAllen teaches us that the Bankruptcy Code leaves little room for creative arguments that the debtor can successfully assert to prevent entry of the order for relief.