The changes to "individual chapter 11" wrought by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), which essentially grafted the chapter 13 structure onto chapter 11 for individuals, have been controversial. Issues and problems remain concerning, among others, the application of the absolute priority rule, income taxation, plan modification standards and, in the case of involuntary cases, the constitutionality of the new scheme. However, while these issues are resolved in the courts, creditors seeking to recover from individuals may have a potentially powerful weapon in their arsenal: the involuntary chapter 11 petition.

The involuntary bankruptcy petition is not often used as a collection device against an individual. An individual cannot be the subject of an involuntary chapter 13 case.¹ An involuntary chapter 7 may be useful where the debtor has significant nonexempt assets, although that situation is somewhat uncommon and may become even more uncommon in light of the expanded exemptions for common retirement assets.² Moreover, the involuntary chapter 7 does not capture a debtor's future income, such as post-petition wages or salary.³ So that leaves chapter 11. Does it hold any promise for the creditor trying to collect a debt from an individual? It does now.

Commencing the Case

An individual may the subject of an involuntary chapter 11 case. The involuntary case is commenced in the same way that an involuntary is commenced against a business entity. Three or more creditors holding noncontingent claims that are not disputed as to amount or liability can commence an involuntary chapter 11 case against an individual by filing and serving a petition if the aggregate amount of their claims is greater than $12,300.⁴ If there are fewer than 12 holders of noncontingent, undisputed claims, then a single creditor can file the involuntary petition. In determining whether there are more than 12 creditors, most courts hold that insiders and employees of the debtors are excluded.⁵ A creditor that acquires its claim for the purpose of joining an involuntary petition is not eligible to join an involuntary petition.⁶

A petitioning creditor bears the burden of making a prima facie case that its claim is not contingent as to liability or subject to a bona fide dispute as to amount or liability.⁷ Once the creditor makes that prima facie showing, the burden shifts to the putative debtor to demonstrate the existence of a contingency or a bona fide dispute.⁸

What is the test for whether a putative debtor is subject to the entry of an order for relief in an involuntary case? In general, if the putative debtor is not generally paying its undisputed debts as they become due, then an order for relief will issue.⁹ There is no requirement of technical, or "balance sheet," insolvency, and there is no bright-line test for determining when a debtor is not generally paying his debts as they became due. Courts examine the totality of circumstances and examine a wide range of factors, including:

• the total amount of the debt;
• the percentage of debts not being paid within terms;
• the extent of the delinquency;
• the extent of the debtor's ongoing business operations;
• the likelihood that there will be sufficient assets to pay the debts;
• whether records were being preserved;
• whether the petitioning creditors had adequate remedies under nonbankruptcy law; and
• whether the bankruptcy is in the best interests of the debtor and all of its creditors.¹⁰

The existence of a few unpaid debts may not be sufficient.¹¹ Because there is no clear test for determining whether a debtor is generally not paying its debts as they become due, creditors should proceed with caution if there is any question. As there is no right to a jury trial on contested issues under §303, those issues will be decided by judges, most often bankruptcy judges.¹²

A creditor should not sign an involuntary petition without understanding the attendant risks. Chief among those is the risk of a damages award under §303(i) for an improper petition. That section provides:

(i) If the court dismisses a petition under this section other than on consent of all petitioners and the debtor, and if the debtor does not waive the right to judgment under this subsection, the court may grant judgment—

(1) against the petitioners and in favor of the debtor for—
(A) costs; or
(B) a reasonable attorney's fee; or
(2) against any petitioner that filed the petition in bad faith, for—
(A) any damages proximately caused by such filing; or
(B) punitive damages.¹³

If an order for relief is not entered in an involuntary case, the court will typically award costs and attorneys' fees whether or not the petition was filed in bad faith.¹⁴ However, a petition filed in bad faith exposes the creditor or creditors to awards of compensatory and punitive damages. Courts have interpreted §303(i) as providing authority for some or all of the enumerated remedies despite that section's use of the term "or."¹⁵ In KP Enters., the court examined several tests for determining whether a petition was filed in bad faith.¹⁶ Ultimately, the court held that the test was similar to the test under Rule 9011 of the Federal Rules of Bankruptcy Procedure.¹⁷

A petitioning creditor may be ordered to post a bond for amounts that may be awarded under §303(i).¹⁸ The putative debtor must demonstrate "cause" before creditors may be required to obtain a bond.¹⁹

The Gap Period

The period between the filing of an involuntary petition and the entry of an order for relief is known as the "gap period," or simply the "gap." During the gap, a putative debtor does not have the rights, power and duties of a trustee.²⁰ The general rule is that during the gap, the debtor may continue to operate its business and to use, acquire and dispose of property as if there had been no bankruptcy.²¹ Although certain post-petition transfers during the gap may be avoidable, see 11 U.S.C. §§549(a)(2) and (b), debtors are generally free to deal with their assets and properties as if there had been no filing. The unsuspecting creditor may find that assets have been diverted during the gap, leaving the possibility for expensive and time consuming litigation under §549. Moreover, some courts have held that a debtor may convert nonexempt property to exempt property during the gap.²²

Notwithstanding this general rule, the court may limit the debtor's ability to operate its business, or to use, acquire or dispose of property during the gap.²³ The legislative history of §303(f) shows that the court should grant relief where the alleged debtor "may attempt to abscond with assets, dispose of them at less than their fair market value, or dismantle his business, all to the detriment of [his] creditors."²⁴ Although the case law on §303(f) is relatively sparse, some courts are reluctant to utilize the authority to limit a debtor's freedom to deal with its business or assets under §303(f).²⁵

Even though a putative debtor may continue using its assets and operating its business during the gap, creditor activity is limited by the automatic stay.²⁶ This prevents the proverbial "race to the courthouse" by competing creditors seeking to obtain attachments, judgment liens or other remedies.

There may be other ways for a creditor to control the debtor's conduct during the gap. Section 303(g) allows the court to appoint a trustee before the entry of an order for relief in a chapter 7 case.²⁷ By its terms, §303(g) does not apply in a chapter 11 case and one court has held that it lacked the ability to appoint a chapter 11 trustee in the gap.²⁸ Most courts do not subscribe to this view, holding instead the §§1104 and 105 provide a sufficient basis for the appointment of a trustee in an involuntary chapter 11 case.²⁹ If there is no reasonable likelihood that an order for relief will enter, then the court may decline to appoint a trustee even if the creditor can establish the requisite "cause" under §1104.³⁰

A creditor that seeks to use an involuntary petition as a collection device should recognize that the payment of its debt by the debtor during the gap may not result in the dismissal of the petition. Some courts have held that the payment of a debt during the gap, such that after the payment there are less than the requisite number of petitioning creditors, does not deprive the court of jurisdiction or compel the dismissal of the petition.³¹ Joining an involuntary petition to coerce payment of a debt is a risky strategy, particularly if there are reasons why the entry of an order for relief may not be in the creditor's interests, such as the existence of transfers to the creditor that might be avoidable as preferences or fraudulent transfers.

Getting a Look under the Hood

If a creditor suspects that assets have been diverted, an involuntary case may help provide information about where those assets went. Once the order for relief has been entered, the debtor is subject to a number of reporting requirements, all designed to increase the transparency of the process. The debtor must file a schedule of assets and liabilities, as well as a "statement of financial affairs," which lists information about the debtor's sources of income, transfers to or for creditors including insiders, and about the debtor's books and records. The debtor must file monthly operating reports with the U.S. Trustee. Unjustified failure to file these schedules and reports may be cause for appointment of a chapter 11 trustee.³² In the post-BAPCPA world, if there are grounds for conversion or dismissal of a chapter 11 case—and the enumerated list of "cause" has been expanded—then the court should appoint a chapter 11 trustee if such appointment is in the best interests of creditors and the estate.³³

Creditors are entitled to examine the debtor under oath about a wide range of topics, including its assets, liabilities, financial condition and "any other matter which may affect the administration of the debtor's estate...."³⁴ A debtor's diversion of assets and the existence of potential recoveries, whether as preferences, fraudulent transfers or otherwise, are within the permissible scope of a Rule 2004 examination.

Constitutional (and Other) Concerns

A creditor that is considering the use of an involuntary chapter 11 case against an individual should understand that there are serious questions regarding the extent to which a debtor's future wages can be "seized" by a chapter 11 plan. Some commentators have suggested that an involuntary chapter 11 case against an individual, in light of the changes to the Code made by BAPCPA, would violate the Thirteenth Amendment's proscription against involuntary servitude.³⁵ Other commentators have suggested that no more than 25 percent of a debtor's "disposable earnings" could be captured by a chapter 11 plan in light of federal consumer protection restrictions on wage garnishment.³⁶ The answers to these questions are not clear, and like almost all legal issues, getting the answers will take time and cost money. The Thirteenth Amendment issue is explored in greater detail below.

Prior to the enactment of BAPCPA, the conventional wisdom was that an involuntary chapter 11 case against an individual did not run afoul of the Thirteenth Amendment because the debtor could not be forced to devote his or her future earnings to the payment of claims under his or her plan. This was the result of the "earnings exception" to §541, which defines the scope of a debtor's bankruptcy estate.³⁷ Although an individual could be forced into a chapter 11 case with no absolute right to convert to a chapter 7 case and with the prospect of a creditor-filed plan, the exclusion of post-petition income from personal services was viewed by many as steering the statute clear of the Thirteenth Amendment.³⁸ Chapter 13 does not raise Thirteenth Amendment concerns. First, there cannot be an involuntary chapter 13 case. Second, only the debtor can file a chapter 13 plan. Third, the debtor has an absolute, or nearly absolute, right to convert a chapter 13 case to one under a chapter 7. Taken together, these demonstrate that a creditor could not effectively "capture" a chapter 13 debtor's future earnings without the debtor's consent.

With respect to individual chapter 11 cases, BAPCPA changed things in a couple of important respects. First, an individual chapter 11 debtor's estate now includes post-petition earnings.³⁹ Section 1115 provides:

(a) In a case in which the debtor is an individual, property of the estate includes, in addition to the property specified in §541—

(1) all property of the kind specified in §541 that the debtor acquires after the commencement of the case but before the case is closed, dismissed or converted to a case under chapter 7, 12 or 13, whichever occurs first; and
(2) earnings from services performed by the debtor after the commencement of the case but before the case is closed, dismissed, or converted to a case under chapter 7, 12 or 13, whichever occurs first.⁴⁰

Second, a chapter 11 plan may not be confirmed over the objection of an unsecured creditor unless the debtor has devoted all of his projected disposable income over at least five years to the payment of claims under the plan.⁴¹ These changes, combined with the absence of an absolute right to convert an involuntary chapter 11 case, mean that a plan devoting five years of a debtor's projected disposable income could be confirmed without the debtor's consent. Does that violate the Thirteenth Amendment? One observer has framed the issue as follows:

The critical issue is whether the service is compelled. If our debtor can simply quit, and suffer no sanction other than a suit for damages or the economic dislocation brought upon by the absence of debt relief, then the Thirteenth Amendment is not implicated.⁴²

But quitting may, according to Keach, expose the debtor to contempt sanctions or even incarceration.⁴³

Without question, the court has the statutory authority to enter an order requiring the debtor to devote its future income to payment of claims under a plan.⁴⁴ In addition, it is clear that a bankruptcy court has the power to impose sanctions for civil contempt.⁴⁵ The issue is whether contempt is an available remedy for an individual debtor's failure or refusal to perform its obligations under a confirmed plan. There are statutorily prescribed remedies for a debtor's failure to comply with the terms of a confirmed plan, namely, conversion or dismissal.⁴⁶ And the "penalty" for an individual debtor's failure to complete all of the payments described in a confirmed chapter 11 plan is, in most circumstances, the denial of a discharge.⁴⁷ The existence of these statutory "remedies" has caused at least one commentator to argue that contempt should not be available as an additional remedy:

The failure to make chapter 11 plan payments would result only in denial of the discharge and dismissal of the case. Perhaps the payments could be compelled by a wage assignment, but there is no sanction other than loss of the discharge if the debtor quits the job. The peonage challenge to involuntary chapter 11 proceedings will present a fascinating issue to the bankruptcy courts and ultimately to the Supreme Court. But it has to be remembered that rarely have the courts found practices to be unconstitutional peonage in violation of the Thirteenth Amendment. The challenge is made especially difficult because there is no possibility of contempt or imprisonment for those who fail to make the required payments.⁴⁸

There are, however, no reported decisions holding that contempt is not an available remedy to address an individual debtor who fails to fund his plan, for whatever reason. Moreover, if, as suggested in Toibb, the individual debtor can achieve conversion by not cooperating (i.e., ceasing work), then the benefits of the involuntary chapter 11 would be lost; thus, the remedy that saves the case from constitutional infirmity would result in the loss of the goal the creditor is trying to achieve. This issue will surely be resolved by the courts in due course.

The Absolute Priority Rule

Problems have existed with respect to confirmation of individual chapter 11 plans for quite some time. BAPCPA did not rectify those problems and, in fact, may have exacerbated them. If an impaired class of unsecured creditors does not accept a plan, the plan may still be confirmed pursuant to §1129(b), known as "cramdown."⁴⁹ In general, if a nonconsenting class of unsecured creditors is not being paid in full, then a plan may not be confirmed if the holder of any claim or interest junior to the nonconsenting class receives or retains any property on account of such junior interest.⁵⁰ In the context of an individual chapter 11 debtor, BAPCPA relaxed the prohibition on the receipt or retention of property by the junior class of claims or interests: "In a case in which the debtor is an individual, the debtor may retain property included in the estate under §1115, subject to the requirements of subsection (a)(14) of this section."⁵¹ In addition, §1129 now provides that, in an individual chapter 11 case, if a single unsecured creditor objects to confirmation, the plan must provide for the distribution of property having a value equal to or greater than the debtor's projected disposable income, as defined in 11 U.S.C. §1325(b)(2), for at least five years.⁵²

Accordingly, creditors may be able to force a debtor to devote the value of five years of projected disposable income and his nonexempt assets to the payment of claims under a plan. In addition, some courts have held that an individual chapter 11 debtor's retention of any property, including exempt property, violates the absolute priority rule.⁵³ Other courts have disagreed.⁵⁴ BAPCPA's change to §1129 does not resolve the question, however, as it only permits the individual debtor to retain post-petition earnings property brought into the estate pursuant to §1115; §1129(b)(2)(B)(ii) does not address the retention of exempt assets in the context of the absolute priority rule.

Conclusion

Until the issues described above are sorted out by the courts—at the expense of the litigants—the new, involuntary individual chapter 11 case may provide an effective collection device for creditors in appropriate circumstances. In the majority of cases, there will be no dispute about the debtor's financial circumstances or the bona fides of the relevant petitioners' debts. In those cases, and assuming the constitutional and federal garnishment issues are resolved favorably to creditors, access to detailed disclosures, the value of nonexempt and possibly exempt property, and five years of projected disposable income may be too hard for some creditors to pass up.

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Footnotes

1 See 11 U.S.C. §303(a)(providing for involuntary cases under chapters 7 and 11, but not chapter 13).

2 See, e.g., 11 U.S.C. §522(b)(3)(C).

3 See 11 U.S.C. §541(a)(6).

4 See 11 U.S.C. §303(b)(1).

5 See 11 U.S.C. §303(b)(2). Some courts have construed §303(b)(2)'s exclusion of insiders, employees and certain transferees of the alleged debtor differently. These courts hold that insiders, employees and certain transferees are ineligible to join an involuntary petition where there are fewer than 12 creditors, not simply that they are excluded from determining the number of creditors (which is important in determining how many creditors must join the petition). See, e.g., In re Gills Creek Parkway Assocs. LP, 194 B.R. 59 (Bankr. D. S.C. 1995); In re Runaway II Inc., 168 B.R. 193 (Bankr. W.D. Mo. 1994); In re Kreidler Import Corp., 4 B.R. 256 (Bankr. D. Md. 1980).

6 See Fed. R. Bankr. P. 1003(a) ("An entity that has transferred or acquired a claim for the purpose of commencing a case for liquidation under chapter 7 or for reorganization under chapter 11 shall not be a qualified petitioner").

7 See In re Dilley, 331 B.R. 1, 6-8 (Bankr. D. Me. 2005). The bankruptcy court's holding in Dilley, namely, that the debtor had established a bona fide dispute as to liability on the petitioning creditors' claims, was reversed on appeal. See In re Dilley, 339 B.R. 1 (1st Cir. B.A.P. 2006). However, the Bankruptcy Appellate Panel did not quarrel with the bankruptcy court's allocation of the burden of proof to the petitioning creditors.

8 See id. at 6.

9 See 11 U.S.C. §303(h)(1). Additionally, an order for relief will enter if a custodian was appointed or took possession of the debtor's assets within 120 days before the filing of the petition. See 11 U.S.C. §303(h)(2).

10 See In re Hentges, 2006 WL 2766060, *12 (Bankr. N.D. Okla. 2006); In re Harmsen, 320 B.R. 188 (10th Cir. B.A.P. 2005); In re Paper I Partners LP., 283 B.R. 661 (Bankr. S.D.N.Y. 2002); In re Molen Drilling Co. Inc., 68 B.R. 840 (Bankr. D. Mont. 1987).

11 See In re Focus Media Inc., 378 F.3d 916 (9th Cir. 2004).

12 See 28 U.S.C. §1411(b).

13 11 U.S.C. §303(i).

14 See, e.g., In re KP Enters., 135 B.R. 174 (Bankr. D. Me. 1992).

15 See id. at 177.

16 See id. at 179-80 and nn. 14-18 (discussing the "improper use test," the "improper purpose test," the "subjective test," the "objective test" and the "combined test").

17 See 135 B.R. at 180.

18 See 11 U.S.C. §303(e).

19 See id.; see also In re Dill, 13 B.R. 9 (Bankr. D. Nev. 1981) (declining to require bond where petitioners had sufficient assets to respond to damages award under §303(i) if one were made and where involuntary petition appeared to have been filed in good faith).

20 See In re Roxy Roller Rink Joint Venture, 73 B.R. 521 (Bankr. S.D.N.Y. 1987).

21 See 11 U.S.C. §303(f).

22 See In re Gaudreault, 315 B.R. 1 (Bankr. D. Mass. 2004).

23 See id.

24 H.R.Rep. 95-595, 95th Cong., 1st Sess. 323 (1977); Senate Rep. No. 95-989, 95th Cong., 2d Sess. 33 (1978), U.S.Code Cong. & Admin.News 1978, 5787, 6279, 5819.

25 See, e.g., In re DiLorenzo, 161 B.R. 752 (Bankr. S.D.N.Y. 1993) (denying §303(f) motion where there was no evidence that the debtor would "transfer assets from his estate if left to his own devices"); In re ROPT Limited Partnership, No. 96-15114 (Bankr. D. Mass. July 22, 1996) (denying mortgagee's §303(f) request to prohibit the debtor from using the cash collateral for any purposes other than paying essential post-petition expenses of operating, maintaining, repairing and insuring the real property).

26 See In re Bankvest Capital Corp., 276 B.R. 12 (Bankr. D. Mass. 2002), rev'd on other grounds, 2003 WL 1700978 (D. Mass 2003).

27 See 11 U.S.C. §303(g).

28 See In the Matter of Beaucrest Realty Assoc., 4 B.R. 164 (Bankr. E.D.N.Y. 1980).

29 See In re Professional Accountants Referral Servs. Inc., 142 B.R. 424 (Bankr. D. Colo. 1992); In re Colony Press Inc., 83 B.R. 862 (Bankr. D. Mass. 1988).

30 See Professional Accountants, 142 B.R. at 429.

31 See In re Faberge Restaurant of Florida Inc., 222 B.R. 385 (S.D. Fla. 1997); In re All Media Props. Inc., 5 B.R. 126 (Bankr. S.D. Tex. 1980).

32 See 11 U.S.C. §1112(b)(4)(F) (cause includes the "unexcused failure to satisfy timely any filing or reporting requirement" under the Code or the Federal Rules of Bankruptcy Procedure).

33 See 11 U.S.C. §§1104(a)(3).

34 Fed. R. Bankr. P. 2004(b).

35 See, e.g., Keach, Robert J., "Dead Man Filing Redux: Is the New Individual Chapter 11 Unconstitutional?," 13 Am. Bankr. Inst. L. Rev. 438, 500 (2005) [hereinafter "Redux"].

36 See Warner, G. Ray , "Garnishment Restrictions and the Involuntary Chapter 11: Rethinking Kokoszka in a Means Test World," 13 Am. Bankr. Inst. L. Rev. 733 (2005) (arguing that the wage garnishment limitation in 15 U.S.C. §1673(a)(1) should apply in individual chapter 11 cases). As Prof. Warner notes, the wage garnishment statute does not, by its own terms, apply in a chapter 13 case. See 15 U.S.C. §1673(b)(1)(B). There is no corresponding exclusion for a chapter 11 case.

37 See 11 U.S.C. §541(a)(6) (excluding "earnings from services performed by an individual debtor after the commencement of the case" from property of the estate).

38 See, e.g., Toibb v. Radloff, 501 U.S. 157, 165-66, 111 S. Ct. 2197, 2201, 115 L.Ed.2d 145 (1991).

39 See 11 U.S.C. §1115.

40 11 U.S.C. §1115(a) (emphasis added).

41 See 11 U.S.C. §1129(a)(15).

42 "Redux" at 500.

43 See id. at 500-01 ("Temporary confinement, as well as imposition of coercive fines, for civil contempt is within the bankruptcy court's arsenal of options to address willful violation of its orders").

44 See 11 U.S.C. §1142(b) ("The court may direct the debtor...to perform any other act...that is necessary for the consummation of the plan"); see also 11 U.S.C. §1142(a) ("the debtor...shall carry out the plan and shall comply with any orders of the court").

45 See, e.g., 1-3 Collier on Bankruptcy at ¶3.09 (15th ed. revised).

46 See 11 U.S.C. §1112(b)(4).

47 See 11 U.S.C. §1141(d)(5).

48 Chemerinsky, Erwin, "Constitutional Issues Posed in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005," 79 Am. Bankr. L.J. 571, 590 (2005) (emphasis added) (footnotes omitted); cf. Toibb v. Radloff, 501 U.S. at 165, 111 S. Ct. at 2201("If an involuntary chapter 11 debtor fails to cooperate, this likely will provide the requisite 'cause' for the court to convert the chapter 11 case to one under chapter 7"); In re Herberman, 122 B.R. 273, 284 (Bankr. W.D. Tex. 1990) ("The involuntary debtor could also justifiably argue that he simply does not desire to work for the estate, and that neither a trustee nor the court can make him, based on the Thirteenth Amendment, and the court could do little but accede") (emphasis added).

49 See 11 U.S.C. §1129(b).

50 See 11 U.S.C. §1129(b)(2)(B)(ii).

51 See id. The cross-reference to §1129(a)(14), which requires an individual debtor to be current on post-petition payments for domestic support obligations, is somewhat curious given that "cramdown" is only applicable where all requirements for confirmation except acceptance of the plan by all impaired classes are met. Section 1129(a)(14) is one of those requirements and, presumably, would need to be met before a plan proponent could resort to "cramdown."

52 See 11 U.S.C. §1129(a)(15)(B).

53 See, e.g., In re Gosman, 282 B.R. 45 (Bankr. S.D. Fla. 2002); In re Fross, 233 B.R. 176 (10th Cir. B.A.P. 1999) (unpublished opinion); In re Kovalchick, 1995 WL 118171 (Bankr. E.D. Pa.1995); In re Ashton, 107 B.R. 670, 674 (Bankr. D. N.D. 1989); In re Yasparro, 100 B.R. 91 (Bankr. M.D. Fla. 1989).

54 See In re Henderson, 321 B.R. 550 (Bankr. M.D. Fla. 2005) (rejecting Yasparro and reasoning that application of the absolute priority rule to retention of exempt property would be tantamount to requiring a debtor to forfeit its exemption rights, rights which apply in each chapter of the Code); In re Shin, 306 B.R. 397, 404 n.17 (Bankr. D. Colo. 2004).