In these difficult economic times, many companies find themselves spending an inordinate amount of time chasing bad debts. The typical case presents a manufacturer selling goods to a distributor. The distributor stretches the credit terms until the manufacturer has had enough and demands full payment of outstanding invoices before it will ship more product. The distributor then informs the manufacturer that it does not have enough cash on hand to make the full payment, but agrees to make payments over time.
The payments never come. The distributor outlines another payment plan while it sells the manufacturer’s remaining inventory and pockets the proceeds. The distributor stops returning the manufacturer’s calls. And, the overdue receivable sits on the manufacturer’s books like a rotting tomato. The manufacturer reluctantly calls its attorneys, and the attorney files a lawsuit. The distributor throws up a litany of counterclaims and soon the manufacturer has spent more on legal fees than the amount of the invoices and is still no closer to receiving payment.
There has to be a better way.
An often-overlooked alternative to filing a lawsuit is to prepare an involuntary bankruptcy petition. Note that I did not say “file” an involuntary bankruptcy petition, but “prepare” one. Filing an involuntary bankruptcy against the trade debtor can initiate a bankruptcy case under Chapter 7 (liquidation) or Chapter 11 (reorganization), including the appointment of a bankruptcy trustee and notice to the debtor’s other creditors. Any recovery would be shared, first to the debtor’s secured lender, then to the taxing authorities, if there is anything left, pro rata by the debtor’s unsecured creditors. If the debtor truly is in financial distress, there is likely to be little left over for the creditor (the manufacturer, in this case) that spent the time and money to prepare the involuntary petition.
Preparing an involuntary bankruptcy proceeding, on the other hand, can lead to useful information about the debtor and its other creditors, may provide the impetus necessary to convince the debtor to reach a little deeper into its pocket. And, taking the steps necessary for preparing the petition will prepare you for that option, should it become desirable and necessary.
Step 1. Send the Demand Letter
If demand letters worked, you wouldn’t be reading this article. Debtors typically come in three forms: 1.) has money, but doesn’t want to pay; 2.) doesn’t have money, but wants to pay; and 3.) doesn’t have money, and doesn’t want to pay. If the debtor requires your services or products to operate its business (and it is continuing to operate its business), you likely have a motivated debtor that will pay its debt if it can. If the debtor has ceased operations, or it can operate without your services or products, recovery will be more difficult. One thing to keep in mind: the owner or owners of the business can pay the debt of the company either directly or by making a capital contribution to the company, if they are properly motivated.
Step 2. Gather Information
Filing an involuntary bankruptcy case requires the concerted action of three creditors with undisputed, liquidated claims against the debtor, except for the case of a debtor with fewer than 12 creditors, in which case a single creditor can file the involuntary case. Other potential petitioning creditors can usually be located by ordering a UCC lien search, or by simply reviewing the debtor’s website for its vendors, suppliers, etc., (i.e., any party that might also be encountering problems collecting from the debtor). Online services, such as Westlaw and Lexis, also have a variety of business research tools that can help identify other potential petitioning creditors.
Step 3. Follow Up
Contact the owner of the debtor after you have spoken with a fair number of its creditors. In many cases, the owner of the business will have learned about your investigation and will be eager to bring an end to any speculation that it has caused. You should be careful not to disparage the debtor or its principal during your investigation — stick to the facts and gather information. The creditors you speak with during your investigation may provide information that will inform your course of action or become needed allies if bankruptcy becomes an option.
A Word of Caution
A creditor should not prepare to file an involuntary petition unless it is prepared — and qualified — to use it. An involuntary bankruptcy petition can have a devastating effect on the putative debtor’s business, and the bankruptcy court will not be forgiving if a creditor uses its halls to force a settlement of a disputed claim. An involuntary debtor is typically allowed to continue to operate its business immediately after the petition is filed and before other relief has been granted. This is referred to as the “gap period.” If the case is filed under Chapter 7 of the Bankruptcy Code (liquidation), however, the United States trustee may appoint an interim trustee to manage the debtor’s property, including not just cash but also any inventory or other goods that it uses in its business operations.
The bankruptcy court may require a creditor to compensate a debtor for damages to its business, if the debtor can establish that the petition was filed in “bad faith.” Bad faith is most often found when the petitioning creditor or creditors failed to satisfy the requirements of an involuntary petition set forth in the Bankruptcy Code. An involuntary bankruptcy petition may be filed by a single creditor if the debtor has less than 12 creditors, or by three or more creditors if the debtor has 12 or more creditors. Each petitioning creditor’s claim cannot be contingent as to liability or amount or subject to a bona fide dispute. The petition creditors also must be prepared to demonstrate that the debtor was “generally not paying” its debts as they came due as of the petition date.
Examples of non-contingent claims are promissory notes in default, rent due and payable, overdue invoices and judgment claims. A claim of a guarantor, who has not yet been called to pay on the guaranty, is one example of a contingent claim.
A bankruptcy case will be initiated — complete with the automatic stay preventing the debtor from transferring any of its property — if the petitioning creditors can demonstrate that the debtor is either insolvent on a balance sheet basis or “generally not paying” its debts as they come due. In deciding whether the debtor is “generally not paying” his debts as they come due, within the meaning of Bankruptcy Code provision governing involuntary petitions, bankruptcy courts look to four factors: 1.) number of unpaid claims; 2.) amount of such claims; 3.) materiality of non-payments; and 4.) debtor’s overall conduct in his financial affairs.
The debtor will have an opportunity to move to dismiss the case if it can prove that the creditors have failed to prove any of the elements of an involuntary case. If the case is dismissed, the court may enter a judgment against the petitioning creditors for the debtor’s reasonable expenses, including attorneys’ fees. If the petition was filed in bad faith, the court also may enter a judgment against the petition creditors for any damages proximately caused by the filing of the petition and punitive damages in egregious cases.
Bad faith can be found if the debtor can prove that the petitioning creditor filed the involuntary petition to obtain an unfair and disproportionate advantage over the debtor, or if the filing was based on ill will, malice, or a desire to embarrass or harass the alleged debtor. Bad faith is often found where the petitioning creditor (or creditors) misstates the amount of the claim, asserts a claim that is disputed, or cannot demonstrate that the debtor is generally not paying its debts as they become due. It is not enough, for example, that the debtor has not paid the petitioning creditor; the petitioning creditor must provide evidence that the debtor is not paying its debts on a larger scale. Bad faith is rarely found when the involuntary petition was validly filed in compliance with the basic requirements of the Bankruptcy Code.
Filing an involuntary bankruptcy petition is a serious measure with serious consequences and associated risks. If the target company is truly in financial distress, however, an involuntary bankruptcy petition may be preferable to prosecuting a lawsuit only to receive a judgment worth less than the paper it is printed on. In most cases, the cost of an involuntary bankruptcy, although not insubstantial, will be less than the cost of protracted litigation. If done right, taking the steps necessary to prepare an involuntary petition is often all that is needed to motivate a debtor to take your demand seriously and make payment promptly, thus avoiding much of a risks and expenses associated with a bankruptcy case.
Patrick M. Jones is of counsel with the law firm of Golan & Christie LLP in Chicago, IL, where his practice focuses on commercial litigation and creditors’ rights. Jones is a graduate of the University of Oklahoma and the DePaul University College of Law, and was named a “Rising Star” by Illinois SuperLawyers magazine for 2010. Jones can be reached by e-mail at [email protected].