Help, a Customer Filed for Bankruptcy!

A vendor faces a thicket of decision points and pitfalls when a customer files for bankruptcy. Corporate counsel can more effectively navigate these situations by building a basic toolkit of rules to know, facts to gather and questions to ask. You will be better equipped to successfully advise your business teams and work with outside counsel to maximize payment and minimize exposure by focusing on three critical topics: dealing with existing orders and contracts, filing claims for debts owed and defending against preference claims.

The Bankruptcy Code automatically creates an "estate" generally composed of all the company's property owned as of the bankruptcy filing. It also imposes a sweeping "automatic stay" enjoining creditors from collection and enforcement activities against the company and its property. This injunction gives the bankrupt business "breathing room" to assess its operations and financial condition, and to develop a plan to exit bankruptcy through reorganizing as a going concern, a sale of assets or both. In most corporate bankruptcies, the company is a "debtor-in-possession," meaning that the company retains possession of its assets and continues operating while it formulates and implements a bankruptcy strategy.

Whether the business reorganizes or liquidates, creditors are typically paid at the end of the bankruptcy according to a waterfall based on each claim's relative priority. Generally, secured claims are paid first, administrative expense claims (including claims arising from the company's operations during bankruptcy, if not paid during the bankruptcy) are paid second and general unsecured claims arising from the company's prebankruptcy dealings are paid last. Administrative expense claims are usually paid in full in corporate bankruptcies. Creditors holding general unsecured claims, however, are paid pro rata and frequently don't receive more than pennies on the dollar. 

Knowing What's Yours

Upon learning of a customer's bankruptcy, corporate counsel should quickly take stock of the current status of orders and shipments with the customer. A vendor should stop shipment of any goods in transit, as permitted under UCC §2-705, as long as the goods have not been received by the customer or its agent. Using this remedy, a vendor may regain possession of in-transit goods without violating the automatic stay. If the customer still wants the goods, a vendor likely can be paid in cash for the postbankruptcy delivery of those goods under their agreed credit terms. Even if a vendor cannot stop goods in transit, all is not lost: As explained below, the vendor would likely have an administrative expense claim for the goods.

Generally, any supply contract with the customer, and sometimes an outstanding purchase order, will be an executory contract—meaning a contract under which each party has material performance obligations remaining as of the bankruptcy filing. The Bankruptcy Code allows a bankrupt company to keep or assign favorable executory contracts and reject its performance obligations under unfavorable ones. Until a decision is made (which often is not until the end of the bankruptcy), both parties must perform their postbankruptcy obligations under the contract. If the customer wants to keep or assign the supply contract, it must cure all prior defaults under the contract (including paying any open prebankruptcy invoices), provide adequate assurance of future performance and obtain court approval. If the customer rejects the contract, the rejection is treated as a breach of the contract as of the bankruptcy filing. In that case, a vendor would be left with a low-priority unsecured claim for any prebankruptcy invoices and damages arising from the rejection. While a vendor can ask the bankruptcy court to compel the customer to decide whether to keep or reject the contract sooner than the end of the bankruptcy, these requests are usually an uphill battle.

Claiming What's Yours

A vendor that supplies goods to a customer on credit will usually have only a low-priority unsecured claim for payments that were due prebankruptcy. By taking advantage of the following Bankruptcy Code and state law remedies, however, a vendor may improve its recovery:

Proof of Claim: Creditors must generally file a proof of claim identifying the prebankruptcy debts they are owed. A vendor should file its claim, a relatively straightforward process, before the court-approved "bar date" deadline to preserve its rights to a distribution in the bankruptcy.

503(b)(9) Claims: Bankruptcy Code §503(b)(9) gives a vendor an administrative expense claim for goods that the customer bought on credit in the ordinary course of business and received in the 20-day period before its bankruptcy filing. This claim will have a higher payment priority than a claim for goods received before the 20-day period. A vendor often must file this type of claim with the bankruptcy court as a condition to payment.

Reclamation Demands: The Bankruptcy Code expands a vendor's state law rights to reclaim possession of goods sold prebankruptcy to an insolvent customer. To avoid waiving these rights, a vendor must make a written demand to the customer within 45 days after the customer received the goods or within 20 days of a bankruptcy filing if the filing occurred within that 45-day period. This demand should be sent as quickly as possible, since a reclamation demand applies only to those goods that are identifiable and in the customer's possession. Reclamation rights often have limited value because, unlike a §503(b)(9) claim, they are subordinate to any prior perfected security interests in the customer's inventory. Nevertheless, a vendor should timely assert its reclamation rights to maximize its potential recovery.

Setoff: If a vendor and its customer are mutually indebted to each other, a vendor can seek court approval to offset the amount owed the vendor by the amount due the vendor. If approved, the vendor's claim would be reduced by the amount of the vendor's debt to the customer. Setoff essentially gives a vendor a secured claim in the amount of its debt due the customer and can vastly improve a vendor's outcome in the customer's bankruptcy.

Defending What's Yours

The Bankruptcy Code gives a debtor or bankruptcy trustee a claim to recover preferential payments made to creditors in the 90 days before the bankruptcy filing. These claims provide a remedy for any unequal treatment of creditors in the run-up to bankruptcy when a debtor typically pays favored creditors more or faster than other creditors. Preference claims usually are filed 18-24 months after the bankruptcy filing and often surprise creditors. After learning of the customer's bankruptcy, a vendor should assess its potential preference liability by examining whether it received any payments from the customer in the 90 days before the filing.

To counterbalance this broad "clawback" power for prebankruptcy payments and to protect vendors who continue doing business with a financially distressed company (and to encourage vendors to do so), the Bankruptcy Code establishes special defenses to preference claims. The "new value" and "ordinary course of business" defenses are most frequently used by a vendor. Under the new value defense, payments in the 90-day preference period are protected to the extent that, after the payment was made, a vendor extended "new value" to the customer, usually in the form of shipping new goods. The ordinary course of business defense protects payments that are made in the ordinary course of business to repay debts incurred in the ordinary course of business. Typically, a vendor can prove this defense by establishing that the customer's payment practices during the 90-day preference period—such as timing, method and terms—were consistent with how the customer paid the vendor previously. Because these defenses rely on a vendor's transaction history with the customer, a vendor should preserve all billing and payment documentation after learning of the bankruptcy. Also, the Bankruptcy Code gives a vendor a complete defense to preference liability if the aggregate value of all payments received in the preference period does not exceed $6,425. If properly asserted, these defenses often significantly reduce—or even entirely eliminate—a vendor's preference exposure.

When a customer files for bankruptcy, the Bankruptcy Code provides a complex set of new rules that can significantly affect whether and how a vendor is repaid. With a basic working knowledge of a vendor's important rights and remedies, corporate counsel often can improve the outcomes in this unfortunate scenario.

Reprinted with permission from the December 2016 edition of Corporate Counsel © 2016 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. ALMReprints.com – 877-257-3382 – reprints@alm.com.