What to do When Your Customer Files Bankruptcy

Sooner or later virtually all businesses face the specter of a customer who owes them a significant amount of money filing for bankruptcy.  Many businesses face a customer’s bankruptcy proceeding with an attitude like that of a condemned soul in Dante’s Inferno, where the sign above the entrance reads:  “Abandon all hope ye who enter here.”  After the initial anger and frustration subside, however, the question arises:  “What do I do now?”  There are many potential answers to that question, depending on such things as the size and importance of the receivables to the company, whether the bankruptcy is a Chapter 11 reorganization or a Chapter 7 liquidation, whether the debt is secured or unsecured, and other considerations.  It is important for businesses facing this dilemma to bear in mind that the law provides creditors with substantial rights, and actions that a creditor takes or doesn’t take can make a significant difference to its ultimate recovery.

If the creditor company has recently shipped products to the bankrupt customer on credit, it should immediately consider whether to assert a right to reclaim the products.  The Bankruptcy Code and the Uniform Commercial Code preserve, under certain conditions, the right to reclaim goods sold to an insolvent buyer.  Under the Utah Uniform Commercial Code (section 70A-2-702(2)), the seller must ordinarily make a written demand within 10 days after the buyer has received the goods.  The goods must be in the possession of the buyer in their original form and have been sold in the ordinary course of business.  For example, if the goods are raw materials that have been converted into finished products they are not recoverable.  If a demand for reclamation is successful, it can reduce the seller’s exposure in the bankruptcy, or at a minimum give the seller a priority administrative claim that is entitled to payment ahead of general unsecured creditors.

Another concern is whether the creditor has potential exposure for a “preference” claim.  The Bankruptcy Code gives bankruptcy trustees the right to sue to recover certain types of payments made within 90 days of the bankruptcy filing (or one year in the case of payments to insiders), that result in preferential treatment to certain creditors over others.  It makes no difference that the creditor had earned the money and didn’t do anything wrong.  In fact, the preference statute presumes that the payment was made on a legitimate debt.  The objective of the law of preferences is to promote equal distribution to creditors.  To achieve equal treatment, some creditors who received payment within 90 days of the bankruptcy can be forced to return the money to the bankruptcy estate so it can be shared with other creditors.  In many bankruptcy cases the trustee will sue virtually every trade creditor who received a check that cleared within 90 days of the bankruptcy petition.  In large bankruptcy cases that can be hundreds of lawsuits.  Exposure for preference liability can be devastating, and in some instances even threaten the continued viability of the creditor who received the preference.

There are potential defenses to a preference claim, and creditors who face potential exposure should take care to preserve the accounting records that may become necessary to assert those defenses in the future.  Complaints to recover preferential transfers can sometimes be filed years after the bankruptcy case is filed, and creditors who do not maintain careful sales records can be frustrated when they try to reconstruct facts and assemble evidence to defend against the preference action.

Good records can help creditors, for example, in exercising the “subsequent new value defense.”  Preference liability is reduced dollar-for-dollar by new credit that the creditor extends to the debtor after receipt of an otherwise preferential transfer but before the debtor’s bankruptcy filing.  The theory is that by receiving the preference, the creditor has diminished the assets of the bankruptcy estate that would otherwise be available for distribution.  If that creditor subsequently extends new credit, however, the new credit replenishes the bankruptcy estate and offsets the receipt of the preference.  A creditor that received payment from a bankruptcy debtor within approximately 90 days of the filing of the bankruptcy petition should carefully preserve all records of subsequent credit that it extended to the debtor, so it can take advantage of the subsequent new value defense.

Another common defense to preference claims is referred to as the “ordinary course of business” defense.  Basically this means if there was nothing unusual about the allegedly preferential payment, the creditor may be able to defeat the trustee’s claim.  In order to assert the ordinary course of business defense it is important to show that the timing of the receipt of the payment in question was in line with the customary pattern that existed between the buyer and seller or in line with the customary payment cycle within the industry.  When faced with potential preference liability, a creditor should carefully preserve copies of invoices and all other documents that evidence its history of dealing with the bankrupt customer.  In addition, a creditor who may have received a preferential transfer may also want to consider establishing a reserve on its accounting records for the potential preference liability, so that it is prepared to take the financial hit that may come in the future.

An obvious but important step to take in the event of a customer bankruptcy is to file a proof of claim.  Ordinarily creditors will have months after receipt of the bankruptcy notice to file the proof of claim, but it is a good idea to file the claim promptly before it has a chance to slip between the cracks.

Initial care in preparing the proof of claim can avoid the subsequent expense and hassle of having to deal with an objection to the claim by the debtor or trustee.  Typically, the notice of bankruptcy will include a proof of claim form.  Otherwise, forms are readily available at the bankruptcy court’s Web site.  All applicable blanks should be filled in, and copies of invoices or other documentation evidencing the nature and amount of the claim should be attached.

It is important to calculate the proper amount of the claim.  This should include accrued interest and possibly other collection fees up to the date of the bankruptcy petition, and should be accompanied by a schedule showing how the interest computation was made.

In larger bankruptcy cases it is not uncommon for several related companies to file bankruptcy petitions simultaneously, and for the bankruptcy cases to be jointly administered.  In such circumstances, it is important to be sure the proof of claim is filed in the correct case, using the appropriate debtor’s name and case number.

Ordinarily, proofs of claim are filed with the bankruptcy court.  However, in larger cases they are sometimes filed with special servicing companies.  Creditors should take care to be sure they send their completed proofs of claim to the right place and do so by the claims filing deadline.  Creditors should also submit an extra copy of the proof of claim with a self-addressed stamped envelope, with a request that the file clerk stamp the copy and return it to the creditor, so it will have evidence of filing.  Creditors can also confirm filing by checking the bankruptcy court’s electronic docket to assure the proof of claim was received.

There are investment funds that specialize in buying bankruptcy claims at a discount.  Particularly in larger bankruptcy cases it is not unusual for creditors who have filed proofs of claim to receive solicitations to buy their claims.  A good rule of thumb to remember in those instances is that the companies who offer to buy the claim have conducted a thorough study of the anticipated payment to creditors, and the price they are willing to pay for the claim factors in a hefty return on their investment.  Creditors who sell their claims give up the possibility of receiving more value later for cash now.  Also, if the claim later faces objection and is ultimately disallowed for any reason, the creditor may have to buy back its claim and cover the purchaser’s expenses incurred in connection with the transaction.

In Chapter 11 reorganization cases, major creditors will sometimes be invited to serve on a creditors committee.  This presents both potential advantages and disadvantages.  Members of the creditors committee have enhanced access to information regarding the bankruptcy case and can have a voice in influencing the reorganization process.  Committee members owe legal duties to all creditors whom they represent, and they may not use their position on the committee to advance their own interests at the expense of other creditors.  Service on the committee can sometimes require travel to distant cities to attend committee meetings, but the creditor’s expenses can ordinarily be paid out of the bankruptcy estate on a priority basis.  Committees often hire attorneys and accountants to represent the committee at the expense of the estate, but a committee member who is separately represented by counsel will need to bear its own attorneys’ fees.  Committees try to work with the debtor in formulating a plan of reorganization.  Committees (or other creditors) also sometimes prepare and file their own reorganization plans.

Creditors often receive periodic notices of hearings and other pleadings filed in the bankruptcy case.  To business people not familiar with the bankruptcy process (and that is nearly everyone), it can be confusing to try to figure out whether to attend hearings or otherwise take action in response to those notices.  Depending on the size of the claim involved, it may be cost effective to have an attorney monitor the case and alert the creditor of important events.  If a creditor’s claim is small, the creditor may not want to do anything more than file a proof of claim and wait to see if the debtor objects.

Companies that have entered into leases with bankruptcy debtors, either of real or personal property, enjoy special protection under the Bankruptcy Code.  Generally speaking, the debtor will have to make lease payments during the bankruptcy case so long as it retains the leased property.  At some point, the debtor lessor will be required either to assume or reject the lease.  If the lease is assumed, the debtor will have to cure defaults.  If the lease is rejected, the debtor will have to surrender the leased property.  Rejection is treated as a breach of the lease, and the lessor can file a proof of claim for its rejection damages.

Creditors holding secured claims should confirm that they have properly perfected their security interests, and contact an attorney immediately if there is any question about perfection.  Evidence of the perfection, such as a UCC-1 financing statement, should be attached to the proof of claim.

The filing of a bankruptcy automatically stays, or prohibits, creditors from foreclosing, sending demand letters, or taking other steps to collect their debts.  Secured creditors may, however, under various circumstances, be able to seek relief from the automatic stay or receive “adequate protection” payments to offset depreciation of the collateral or other erosion of the secured position during the progress of the bankruptcy proceedings.

Secured creditors in particular should consider attending the creditors meeting held shortly after the commencement of a bankruptcy case.  This meeting is typically held at the offices of the United States Trustee and is relatively informal.  Creditors are given an opportunity to ask questions of the debtor.  This is a good opportunity to confirm that the collateral is being well maintained and insured.  The meeting of creditors is also a good opportunity to address questions of relief from stay and adequate protection payments.

The Bankruptcy Code provides that some types of claims are not entitled to a discharge in bankruptcy.  This includes claims based on fraud or other dishonest behavior by the debtor.  There are strict time limits and technical requirements for challenging the dischargeability of a claim, so creditors who believe their claim may not be entitled to a discharge should act promptly to protect their interests.  This requires filing a complaint in the bankruptcy court, which initiates what is referred to as an adversary proceeding.

Lastly, it is important to remember that the bankruptcy filing by a debtor company does not prevent a creditor from pursuing any personal guarantees it may have obtained from the owners of the company or from pursuing collection efforts from non-debtor parties.  The threat of exposure on a personal guarantee will often motivate the owner of a debtor company to negotiate adequate protection payments or other favorable treatment of the creditor as part of the bankruptcy.

A customer’s bankruptcy does not have to be a black hole with no hope for repayment.  There are actions a creditor can take to maximize its chances for recovery, and to minimize its potential preference exposure.  It is important for a business to maintain complete records of its dealings with the bankrupt customer and to file timely documentation with the court to preserve its rights within the bankruptcy proceedings.