Pay, or else Featured

8:00pm EDT May 26, 2008

Having a hard time collecting money from one of your customers? Don’t want to subject yourself to a long, complicated and sometimes expensive lawsuit?

Depending on the situation, you may have an interesting, little-known option: Force your customer into involuntary bankruptcy and collect when the assets of your customer are liquidated.

“This is a very aggressive maneuver and an alternative to the garden-variety breach-of-contract collection action,” says Leonard M. Shulman, managing partner, Shulman Hodges & Bastian LLP. “Frankly, it is also less expensive. The legal fees involved in preparing and prosecuting an involuntary bankruptcy petition are a fraction of what a breach-of-contract action and post-judgment collection activity can cost.”

Smart Business talked to Shulman about using involuntary bankruptcy as a collection strategy.

How can an involuntary bankruptcy petition result in getting money that is owed to you?

An involuntary bankruptcy is placing a company or an individual into a potential Chapter 7 [bankruptcy]. The involuntary petition is filed by one creditor if the ‘alleged debtor’ has 12 or fewer total creditors or by three creditors if the debtor has more than 12 creditors.

In order to petition the court in such a manner, the money owed by the alleged debtor must not be disputed (subject to a bona fide dispute by the debtor), unliquidated (amount owed is unknown or subject to a future event) or contingent (much like a guaranteed debt that is not yet owed).

When the petition is filed, the company or individual in question becomes an ‘alleged debtor’ and has 30 days to respond by asserting either (1) that the involuntary petitioners are not true creditors or (2) that the alleged debtor is generally paying debts as they become due.

The alleged debtor does have one other strategic option: namely, agree that it should be in bankruptcy. Instead of a Chapter 7 liquidation, the alleged debtor can consent to an order for relief and elect to attempt a Chapter 11 reorganization. Chapter 11 of the U.S. Bankruptcy Code provides a breathing spell for the debtor, during which negotiations can take place to try to resolve creditor difficulties. The debtor can terminate burdensome contracts and leases, recover assets and rescale its operations in order to return to profitability and pay its debts over time.

Why should a company use the involuntary bankruptcy strategy?

It is an extremely powerful tool that is often overlooked because it is not well known.

Let’s say a company does not pay what is owed to you. Assuming you find out that it has more than 12 creditors, you have a choice. You can file a collection lawsuit in state court and try to collect upon that judgment, or you can locate two other creditors who have not been paid and the three of you could place your common debtor into involuntary bankruptcy. If the debtor does not have a defense, its assets will be liquidated and your debt may be paid, along with the debts of other creditors. Note that the debt will be paid to the extent that there are unencumbered assets with which to pay creditors.

However, this strategy does not come without risks. If your claim is subject to a real dispute by your debtor — which ultimately shows the court that the involuntary petition was wrongful — you can be assessed significant sanctions. So creditors have to be extremely certain that their claims and the claims of any other petitioners are valid — not disputed, unliquidated or contingent.

How difficult might it be to locate other creditors?

The process of finding other creditors is easy in this day of the Internet. You could do an online credit search, a search through the Better Business Bureau or use a variety of other means, including the use of third-party services or investigators to locate other outstanding creditors.

What role do bankruptcy trustees play in the involuntary bankruptcy process?

If the alleged debtor does not have a defense to the involuntary bankruptcy petition and the alleged debtor does not voluntarily opt for a Chapter 11, then a trustee is appointed to liquidate all its assets. If value of the assets in liquidation is less than what is owed to all creditors, the creditors will share pro rata in whatever money the trustee generates when the trustee liquidates the assets. The trustee has other powers to recover assets transferred prior to bankruptcy, a discussion of which is beyond the scope of this interview.

How common is this strategy? Isn’t it fairly unusual?

It is becoming more acceptable as it is becoming more known. Creditors are getting very frustrated with the garden-variety breach-of-contract process, which includes waiting up to a year for a judgment, trying to collect on the judgment, and perhaps getting delayed or stonewalled by the debtor.

Involuntary bankruptcy is a very quick process. The alleged debtor has to respond to the petition filing within 30 days, and within 60 to 90 days, it can be adjudicated a debtor, ultimately to be liquidated by a court-appointed trustee.

LEONARD M. SHULMAN is a managing partner with Shulman Hodges & Bastian LLP. Reach him at lshulman@shbllp.com or (949) 340-3400.