Bankruptcy Bounties

American bankruptcy law allows unsecured creditors to drag a debtor into bankruptcy by filing an involuntary petition, but they almost never do.  Using data from the Federal Judicial Center, we find and discuss in a recent paper that involuntary petitions account for less than 0.05% of all bankruptcy petitions. Even this meager number may overstate involuntary bankruptcy’s role because most involuntary petitions are dismissed without a court even issuing an order for relief to formally begin a bankruptcy case.  These cases generally are dismissed because petitioning creditors failed to prosecute their case or consented to dismissal, not because they tried and failed to demonstrate that the requirements for an involuntary petition were satisfied. One should not expect creditors to use involuntary petitions to drag individuals into bankruptcy because individuals rarely have non-exempt assets.  However, involuntary petitions still account for less than 2.5% of petitions filed against corporate debtors, and nearly half of these corporate involuntary petitions are dismissed without an order for relief. 

We further show that involuntary petitions played a much larger role in the past.  Involuntary petitions accounted for more than 10% of all filings between 1898 and 1933, and courts received eighteen times the number of involuntary petitions in 1933 as they did in 2016.  These aggregate filing statistics actually understate the historic importance of involuntary bankruptcy.  From the passage of the 1898 Bankruptcy Act until the government stopped recording the relevant statistics in 1933, more than twice as much money was returned to general creditors through involuntary cases as through voluntary cases.  Petitions filed by creditors were not supporting actors in the early twentieth century.  Rather, they played the leading role.  The rate of involuntary petitions began a sharp decline in the mid 1930s, falling to under five percent of all filings in 1940 and under one percent by 1970.  Among the many changes that led to this decline, we focus on one: the end of a practice in which some districts implicitly (and probably unintentionally) rewarded attorneys who brought involuntary petitions with lucrative post-petition work. 

We argue that Congress should consider borrowing a page from bankruptcy’s past and pay bankruptcy bounties to the attorneys or creditors who file involuntary petitions.  More specifically, we argue that bankruptcy should grant the petitioning creditors a monetary reward that varies with the amount recovered for general creditors.  Creditors have long complained that businesses wait too long to voluntarily file for bankruptcy; by the time the debtor files, its assets are dissipated or of negligible value.  Theory suggests that they are right.  If the business is a corporation and can remain outside of bankruptcy, there is a chance that its assets will appreciate sufficiently to allow equity to retain some value after debt is fully repaid.  If the value of the assets falls to zero, limited liability allows shareholders to walk away.  Thus, rational shareholders have an incentive to delay filing even when bankruptcy would maximize the value of the firm.  A collective action problem may prevent creditors from filing involuntary petitions in a timely manner.  The petitioning creditor must incur the costs of monitoring the debtor and bear the risk of liability for filing an improper petition.  However, current law requires the petitioning creditor to share the benefits of bankruptcy pro rata with all others similarly situated.  Even worse, a creditor who has learned of the debtor’s true financial status can profit by filing a debt collection suit in state court or by demanding a side payment from the debtor instead of filing an involuntary petition.  A sufficiently generous reward system would attract socially valuable involuntary petitions that would not otherwise have been filed.  The possibility should be taken seriously.

Richard Hynes is the John Allan Love Professor of Law at the University of Virginia School of Law

Steven D. Walt is the Percy Brown, Jr. Professor of Law at the University of Virginia School of Law