Feb 23, 2017

Creditors force March Madness icon into settlement using involuntary bankruptcy

We will soon face the daunting challenge of completing our brackets for the NCAA tournament. This requires predicting which teams will advance through each round, based on a combination of loyalty to alma maters, blind guessing and deciding which team has the superior mascot. The completion of one’s bracket is closely followed by moments of joy, heartbreak and shock, as underdogs prevail, Goliaths fall and games are decided in the final seconds. Tournament coverage will undoubtedly include a flashback to Christian Laettner’s 1992 iconic buzzer-beater that catapulted Duke into the Final Four. From there, Laettner went on to play in the NBA and earned over $60 million. By June 2016, however, Laettner’s creditors were forcing him into a Chapter 7 bankruptcy after he failed to repay $14 million in soured real estate loans. Just four months later, Laettner reached a settlement with his creditors and the parties agreed to dismiss the bankruptcy. The success of Laettner’s creditors illustrates how involuntary bankruptcy can be a valuable tool. This article briefly explores the requirements for filing an involuntary bankruptcy, the ensuing process, the advantages of doing so and the circumstances that may warrant such an action.

There are three general requirements for filing an involuntary bankruptcy. First, at least three creditors must petition and the amount owed in the aggregate must total $10,000 over the value of the creditors’ secured liens. However, if the debtor has fewer than 12 creditors, only a single creditor is required, but certain parties, such as employees, are ineligible. Secondly, the debts must be undisputed and non-contingent. In Laettner’s case, the amounts owed were reduced to judgments, such that the debts were clearly existing and past due, and therefore could not be contested. Lastly, the debtor must be failing to pay debts as they come due. 

Creditors have the option of bringing the case under Chapter 7 (for liquidation) or Chapters 11 or 13 (for reorganization). After the petition is filed, the debtor has 21 days to respond and, until the court grants relief, the debtor may operate in the same manner as if the bankruptcy had not been filed. The debtor can opt to proceed as bankrupt or, if the debtor objects, the case then proceeds towards trial, with the ultimate issue typically being whether the debtor is paying debts as they come due. The debtor can also convert the case to another chapter if the debtor is otherwise eligible.  

If the court finds in favor of the creditors, the court places the debtor into whichever bankruptcy was requested, and the case then proceeds as a typical Chapter 7, 11 or 13 case. If the court finds in favor of the debtor, the judge dismisses the case and may enter a judgment against the creditors for costs or attorneys’ fees. Importantly, in the case of a bad-faith filing, the court may award the debtor any damages caused by the filing or punitive damages. These sanctions must be paid by the creditor acting in bad faith and the amount can be significant. 

There are at least three advantages of involuntary bankruptcy over customary collection techniques. First, creditors can request that a bankruptcy trustee be appointed to take control of the business. While receivers may be appointed in state court, bankruptcy trustees often possess a heightened expertise in financial analysis, fraud detection and legal knowledge. Secondly, creditors or the trustee have the right to “avoid” certain payments by the debtor that occurred prior to the petition, including monies paid to insiders, fraudulent transfers and even payments to innocent third parties. This brings money into the estate that would otherwise be unrecoverable. Finally, if the creditors prevail in forcing the debtor into bankruptcy, the creditors can submit a claim for their expenses, including attorneys’ fees, which will be given priority over all other classes of claims. Given these features, creditors should consider involuntary bankruptcy for a debtor that is: (1) being grossly mismanaged and whose assets are being rapidly depleted; (2) unjustly favoring insiders or certain creditors to the detriment of other creditors; and/or (3) engaging in fraudulent transfers or conducting a Ponzi scheme.

While it is unclear what prompted Laettner’s creditors to initiate an involuntary bankruptcy, the quick resolution indicates the strategy was effective. If your organization is not being paid and the debtor is acting erratically or suspiciously, an involuntary bankruptcy may be the best solution. Conventional litigation is time-consuming and often results in a judgment against a defunct and uncollectable party.

As with all collection issues, you should speak with one of Chuhak & Tecson’s experienced banking attorneys to determine the best course of action.  

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

Client alert authored by:
Michael W. Debre, Associate

This alert originally appeared in the Spring 2017 Banking Focus newsletter.