Using Preference and Involuntary Bankruptcy Laws to Your Advantage

Article excerpt

Creditors tend to view bankruptcy as a shield used by debtors to avoid paying valid debts. However, when your insolvent debtor has made significant payments or transfers of security to other creditors, you may be in a position to increase your recovery from the debtor. By putting the debtor into involuntary bankruptcy, you can trigger preference laws which will pull assets back into the bankruptcy estate for redistribution, in part, to you.

Involuntary Bankruptcy

Creditors can invoke the trustee's power to pull back preferential transfers under Section 303 of the Bankruptcy Code. Section 303 provides that creditors who meet certain requirements have the right to put a debtor into bankruptcy without the debtor's consent. One creditor can put a debtor into bankruptcy if the creditor is owed at least $5,000 and there are fewer than 12 creditors. If there are 12 or more creditors, then it takes three creditors with unsecured claims totalling $5,000 or more.

Invoking Preference Laws

I once was involved in a situation in which a creditor could have increased its recovery by invoking preference laws through an involuntary bankruptcy but failed to do so. Creditor A and Creditor B were the Debtor's major suppliers and were the Debtor's only significant creditors. The Debtor had no secured creditors and fewer than 12 total creditors. The Debtor began to experience financial problems and had generated past-due debt of about $100,000 to each of the two creditors. It had about $100,000 of assets consisting of inventory and receivables. The Debtor granted to A a security interest in all the Debtor's assets to secure A's debt in turn for forbearance from collection action for a period of time.

The Debtor's granting of the security interest to A greatly increased B's exposure. Because of the security interest, the Debtor suddenly had no equity in its assets in which B could execute. Now in the event of bankruptcy or liquidation, A would be paid its entire debt and B would be paid nothing. This increased exposure alone would be a reason for B to consider putting the debtor into involuntary bankruptcy. If the involuntary bankruptcy petition were filed within 9O days after the security interest was granted, the security interest would be void and B's position would be restored. …