August 24, 2022

How to Protect Your Business When a Key Customer Files Bankruptcy

EDITOR’S NOTE: This article is the second in a three-part series about how small and mid-sized businesses should deal with customers experiencing financial difficulties.

The first installment in this series focused on identifying customers that are in financial distress and taking steps to mitigate potential losses in the event a customer files bankruptcy. In this second installment, we discuss the impacts that a customer’s bankruptcy filing can have on a business and explore strategies that can be employed to maximize recovery in the bankruptcy process.

The Impacts of a Customer’s Bankruptcy Filing
A customer’s bankruptcy filing will affect different types of creditors in different ways. A secured lender or equipment financier may be treated very favorably on account of having liens on the customer’s assets. On the other hand, vendors, suppliers, and other unsecured creditors are generally afforded less favorable treatment under the Bankruptcy Code’s priority scheme, and their rights can be impaired by many of the Bankruptcy Code provisions that come into effect when a bankruptcy case is filed. Some of the most important of these provisions are highlighted below.

Every bankruptcy case is commenced by the filing of a petition by or against the debtor. Most business bankruptcy cases are filed as chapter 7 liquidations or chapter 11 reorganizations. In a chapter 7 case, the debtor ceases operations and a trustee is appointed to liquidate the debtor’s assets. In a chapter 11 case, the debtor in possession generally continues to operate its business.

The bankruptcy filing creates an estate, which consist of all interests of the debtor in property as of the petition date. It also gives rise to the automatic stay, which prohibits, among other things, litigation or any other acts to recover on a prepetition claim and enforcement of a prepetition judgment against or other acts to obtain possession of or control over property of the estate.

Claims against a debtor are treated according to the Bankruptcy Code’s priority scheme, with pre-bankruptcy trade creditors usually holding lowest priority general unsecured claims. However, trade creditors’ claims for goods or services sold to the debtor post-bankruptcy are treated as administrative expense claims, which rank below only secured claims in order of priority of payment.

If they are party to a supply contract at the time of the bankruptcy filing, the debtor may require a trade creditor to continue to perform under the contract until it decides whether to assume or reject it. To assume what is called an executory contract, the debtor must cure all defaults, which includes paying all unpaid pre- and post-bankruptcy amounts owed. Rejection absolves the debtor from liability and leaves the trade creditor with a pre-bankruptcy claim against the debtor.

Unless it can obtain payment sooner by employing one of the strategies discussed below, the amount and timing of a trade creditor’s recovery on its prepetition claim will depend on how the debtor’s chapter 11 plan treats its claim or, in a chapter 7 case, whether the case is an asset case and the trustee is able to make a distribution to creditors.

Strategies To Maximize Recovery in the Bankruptcy Process
It is a common misconception that once a customer files for bankruptcy there is little a trade creditor can do to protect its interests. In fact, by taking action early in the case a trade creditor may be able to increase its recovery substantially. While not every strategy discussed below will apply in every situation (and legal counsel should be consulted before proceeding), trade creditors should consider the following:

  1. Seek “critical vendor” treatment. A trade creditor may be able to recover some or all of its prepetition claim if the debtor obtains bankruptcy court approval to treat it as a critical vendor. In exchange for this favorable treatment, however, the trade creditor may be required to continue to supply the debtor on credit terms during the bankruptcy case.
  2. Make a reclamation demand. Section 546(c) of the Bankruptcy Code permits a trade creditor to demand return of goods sold to and received by the debtor within 45 days of the bankruptcy filing. While a trade creditor’s reclamation rights usually will be subordinated to claims secured by a lien on the debtor’s assets, a reclamation demand is easy to make and can result in an increased recovery in cases where a debtor’s assets are unencumbered.
  3. Assert a Section 503(b)(9) administrative expense claim. Under section 503(b)(9) of the Bankruptcy Code, a trade vendor is entitled to an administrative expense claim for goods sold to and received by a debtor within 20 days of the bankruptcy filing. To increase the chances of payment before plan confirmation, section 503(b)(9) claims should be filed early in the debtor’s bankruptcy case.
  4. Demand assumption of supply contract. A trade creditor supplying a debtor pursuant to a contract should consider asking the bankruptcy court to force the debtor to assume or reject the contract early in the case. While a debtor usually will be permitted to delay this decision until plan confirmation, the payoff for the trade creditor can be significant.
  5. File an administrative expense claim. If a trade creditor hasn’t been paid in full for goods sold or services provided to a debtor during the bankruptcy case, it should file an administrative expense claim. If an administrative expense claim is allowed before confirmation of the debtor’s chapter 11 plan, it must be paid in full upon confirmation; claims filed after plan confirmation usually will be paid as soon as they are allowed.
  6. File a proof of claim. A trade creditor also should file a proof of claim in the debtor’s case before any “claims bar date” that may be set. Even if it is unable to obtain an earlier recovery using the strategies discussed above, this will entitle the trade creditor to share in any distribution to creditors.
  7. Assert setoff and recoupment rights. Lastly, when preparing its proof of claim, a trade creditor should consider whether it owes any amounts to the debtor and, if so, assert its setoff or recoupment rights. By doing so, the trade creditor can convert its claim against the debtor into a secured claim to the extent of amount it owes to the debtor.

NEXT: What to do when you receive a pre-suit preference demand letter or are served with a preference complaint.

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