When involuntary bankruptcy follows an ABC

An ABC provides speed and flexibility, but, especially in non-judicial ABC states, there is less transparency into the process than in a public bankruptcy proceeding.

Creditors may challenge and disrupt an ABC by filing an involuntary bankruptcy petition, which brings the debtor under the jurisdiction of the bankruptcy court and results in the appointment of a neutral trustee upon the order for relief. 

Because an ABC and involuntary bankruptcies may be pending at the same time, bankruptcy courts are called upon to determine which process is in the best interest of creditors and will continue and which will be set aside. 

Filing an involuntary bankruptcy after an ABC begins

Under section 303 of the Bankruptcy Code, at least three creditors may join together to file an involuntary petition if they are owed at least USD 18,600 and the debtor is generally not paying its debts as they come due.

Creditors may do so if they believe that: (1) the ABC process disproportionately benefits insiders or secured creditors; (2) a bankruptcy trustee’s investigative and avoidance powers may uncover improper conduct or increase recoveries; and/or (3) greater transparency and formal oversight are necessary to protect creditor interests.

Assignees overseeing an ABC may seek to dismiss the involuntary bankruptcy or request that the court abstain from hearing the petition pursuant to section 305 of the Bankruptcy Code. Courts are more likely to rule in favour of the assignee when the ABC has already substantially progressed, the process is efficient and in the best interests of creditors, and there are no credible allegations of misconduct, mismanagement, or preferential treatment by the debtor. 

Courts may also consider the stage of the ABC, the nature and extent of secured claims, and whether the ABC is likely to result in a meaningful distribution to creditors without the added cost and complexity of bankruptcy.

Strategic takeaways

Timing is critical: Courts are more likely to defer to an ABC if it is already meaningfully underway, the assignee has taken steps to liquidate assets, and creditors have been informed of the ABC. Conversely, for unsecured creditors seeking to keep an involuntary filing under the jurisdiction of the bankruptcy court, it is important that they file an involuntary petition as soon as possible after the commencement of the ABC.

Substance over form: Courts will scrutinise whether the ABC is genuinely serving creditor interests or merely shielding insiders and benefiting secured lenders.

Cost efficiency and practicality: Courts may be more likely to allow the ABC to proceed if the bankruptcy process will add unnecessary expense without improving outcomes.

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Elizabeth (Lisa) Vandesteeg is a partner in the Financial Services and Restructuring Group at Levenfeld Pearlstein. She helps clients identify risk exposure and mitigate liability, with a concentration in the areas of bankruptcy, creditors’ rights, commercial litigation, and data security and privacy.

Sean P. Williams is a partner in the Financial Services and Restructuring Group at Levenfeld Pearlstein. He assists debtors, creditors, creditors’ committees, and purchasers of assets in bankruptcy courts throughout the nation.