Against Your Will

Drowning in debt? If so, you should know about a legal maneuver creditors can use to force bankruptcy.
Magazine Contributor
3 min read

This story appears in the January 2004 issue of Entrepreneur. Subscribe »

Last June, the house of representatives passed a bill to amend the section of the Bankruptcy Code that governs a legal maneuver you may not know about-involuntary bankruptcy. The Bankruptcy Code allows two forms of bankruptcy for businesses in desperate financial straits. In Chapter 7 straight bankruptcy, a business is usually liquidated, and the creditors divide up the assets. In Chapter 11 reorganization, the bankruptcy court declares a moratorium on debt payments while the business realigns its financial obligations. The goal is for the business to work out a way to pay back as much as possible while still remaining alive.

Both forms are drastic measures. Chapter 11 reorganization isn't much easier to swallow than Chapter 7 liquidation, and the majority of businesses that go into it never successfully reemerge. Reorganization involves submitting your plan and every business decision to the scrutiny of a committee of creditors that has the right to second-guess your proposals. That's why businesses try every kind of negotiation and deal-making they can to stave off declaring bankruptcy.

What you might not know is that creditors can get together and petition the court to declare a business bankrupt under Chapter 7. Involuntary bankruptcy is a tool creditors can use when they fear the debtor will dissipate the remaining assets or pay certain creditors but not others. It forces the debtor to face all the creditors at once, paying debts in an orderly manner, according to the bankruptcy laws and under court supervision.

Creditors can initiate involuntary bankruptcy only if the debtor has regularly missed a significant number of payments, especially large ones, or if a custodian has been appointed or has taken possession of the debtor's assets within the previous 120 days. If there are 12 or more creditors, at least three of them have to sign the petition. Otherwise, it can be signed by any creditor owed at least $10,775.

The debtor has 20 days to respond. If the debtor objects, it turns into a lawsuit to determine whether the problems will be resolved through bankruptcy. Otherwise, the court may declare the business bankrupt-and require the debtor business to pay the legal expenses of the petitioning creditors. However, a judge who believes the creditors filed their petition in bad faith can require creditors to pay damages and the debtor's legal fees. That's why creditors typically file for involuntary bankruptcy only when they're confident of winning.

So why is Congress reforming the laws? Certain tax protestors and other extremists have been abusing the system to take vengeance on public officials and people who oppose them, filing a petition to force individuals into involuntary bankruptcy. Eventually, the court discovers it's fraudulent and dismisses it, but it stays in the court records and destroys victims' credit records.

The new law would direct courts to dismiss false, fictitious or fraudulent petitions and expunge all references to them from the court files.

If your business is being strangled by debt, the very existence of the bankruptcy laws can help you negotiate with creditors, because it's normally in the creditors' interest that your business not go bankrupt. Don't ignore debt problems, or your creditors might force you into a bankruptcy you might have otherwise avoided.

Jane Easter Bahls is a writer in Rock Island, Illinois, specializing in business and legal topics.

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