The facts behind the recent Supreme Court case on whether a bankruptcy debtor engaged in actual fraud without a misrepresentation raises a question worth exploring: When is it worthwhile for creditors to initiate an involuntary bankruptcy against debtors as opposed to merely suing for breach of contract in state court? (It wasn’t an issue in the case, which was voluntary.)
Most of the time when debtors fall behind on their debts, creditors hoping to recover simply sue them. They don’t go out of their way to file an involuntary bankruptcy petition against them, and creditors almost never use involuntary bankruptcy in consumer-debt situations. The rarely used process is directed almost solely against business debtors. Indeed, once debtors are sued for breach, they often file bankruptcy themselves, saving creditors the trouble of filing involuntary bankruptcy against alleged debtors—as well as the risks to creditors of filing in bad faith.
One way to examine the involuntary bankruptcy versus breach of contract conundrum is to look at who benefits most from the respective processes.
Breach of contract claims mainly serve individual creditors rather than groups of them. Secured creditors determine that foreclosing on the collateral property serves their long-term interests better than allowing the debtor to retain it. Unsecured creditors often don’t even bother at all and just sell bad debts to debt collectors who hope to recover a fraction of the debts they purchase. The closest alternative to involuntary bankruptcy for creditors is to convince a state court judge to place the alleged debtor’s assets into receivership. This process might be more time consuming, and bankruptcy offers more options, like forced liquidation.
Bankruptcy is designed to benefit debtors, not creditors. Most of the time, however, creditors don’t want debtors in bankruptcy anyway or at best it doesn’t affect them. Unsecured creditors know they won’t be paid, and secured creditors will either be paid by the money that’s not directed to the unsecured creditors or they’ll just start foreclosure proceedings.
It’s when there are substantial assets at stake—and usually more than a couple creditors as well—that involuntary bankruptcy becomes a viable option for creditors. Good examples of involuntary bankruptcies are when the alleged debtor is frittering away assets or losing money, motivating the creditors to put a stop to it. It can also occur when a business is falling apart, but a minority of the owners (even if it’s just a two-person partnership) can’t compel the business to repay them before the assets are depleted. Involuntary bankruptcy can help them recover their money and dissolve the company.
Involuntary bankruptcy is rare and usually only appears in business contexts, but it overlaps with other state-court options creditors should be aware of. Strategizing these options requires the help of an experienced New York bankruptcy lawyer.
For answers to more questions about involuntary bankruptcy, the automatic stay, effective strategies for dealing with foreclosure, and protecting your assets in bankruptcy please feel free to contact experienced Brooklyn bankruptcy attorney Bruce Weiner for a free initial consultation.