When customers and suppliers file bankruptcy

Although economic growth in recent years has resulted in fewer business bankruptcies, increasing signs of economic slowdown may mean that fabricators will soon see more of their customers or suppliers file for bankruptcy.

Effect of Bankruptcy Filing on Claims

Once a company files a petition for relief under the Bankruptcy Code, a distinction is made between prepetition and postpetition claims against the debtor.

Any prepetition claims that are not secured and not entitled to priority under the Bankruptcy Code are general unsecured claims that will be paid according to a plan of reorganization or liquidation, after all secured and priority claims. However, a creditor's postpetition claims are likely to fare better than prepetition claims.

Under the Bankruptcy Code, creditors are entitled to administrative claims for goods and services provided to a debtor postpetition, as long as they are "actual, necessary costs and expenses" used to preserve the debtor's estate. Since administrative claims must be paid in full under plans of reorganization, these claims usually are paid in full. In some cases, however, a debtor cannot pay administrative claims in full, so it is important to monitor a bankruptcy proceeding to determine if this result is likely.

Although some creditors are not required to file a proof of claim with the bankruptcy court in certain circumstances, most creditors need to do so. When a creditor becomes aware of a pending bankruptcy case, it should monitor the bankruptcy court's docket to determine if the court has established a bar date by which creditors must file their claims. Failing to file a claim by the bar date can result in the claim's disallowance.

Common Issues Facing Creditors' Postpetition

Once a customer or supplier files for bankruptcy, fabricators should consider a range of issues that might affect their claims against the debtor, liability to the debtor, and future business dealings with the debtor.

Lawsuits to Recover Preferential Transfers. The Bankruptcy Code allows a debtor to avoid and recover any payments it made which constitute a preference. A preference is any transfer (including a payment) made by a debtor to a creditor on a debt within 90 days before the date of the debtor's bankruptcy petition. A preference may be avoided even though there was no wrongdoing on the part of the creditor or the debtor. In fact, neither the debtor's intent nor the transferee's state of mind is relevant when analyzing the elements of a preference.

The good news is that the Bankruptcy Code permits a number of defenses to preference claims. Transfers made in the ordinary course of the business of the debtors and the creditor are exempt from avoidance, as are transfers to creditors who subsequently provide additional, unsecured credit to the debtor after a transfer. In many circumstances, once a preference claim has arisen, the best response is to assert a number of affirmative defenses and negotiate a favorable settlement with the debtor. In other situations, it may make sense to litigate the case.

Creditors can prevent preference claims from arising by placing distressed customers on a cash-only basis. Doing this allows a creditor to continue to supply a distressed customer while reducing the likelihood that the payment would not be considered preferential.

Creditors can also eliminate or reduce their preference exposure by obtaining purchase-money security interests in the goods they sell. A purchase-money security interest is a security interest created when a buyer uses a seller's money to make the purchase and immediately gives the seller security. To the extent a creditor maintains a security interest entitled to priority over other creditors, it is entitled to payment in full in a bankruptcy up to the value of the goods. Because payments to secured creditors do not allow creditors to receive more than they would otherwise receive, such payments are not preferences.

Companies facing possible exposure to preference claims are better able to assert and prevail on the possible defenses by taking the following measures:

1. Maintain records and documentation. Companies should maintain complete records regarding transactions with the debtor. Records are necessary to verify that the debtor's information regarding alleged preferential payments is correct, and to assert the ordinary course of business and new value defenses.

2. Enforce payment terms. The terms of payment must be strictly enforced. The closer a payment is to the due date, the better the ordinary course of business defense.

3. Confront the claim. Companies must not ignore a debtor's demand letter or lawsuit regarding preferences. Failing to respond to a lawsuit could result in a default judgment against the creditor that it will have to pay in full.

Treatment of Contracts With Debtors. After a debtor files for bankruptcy petition, an automatic stay immediately goes into effect which, among other things, prevents creditors from unilaterally canceling or terminating an executory contract (a contract in which material performance remains on both sides). Instead, a party must continue to perform under the contract until either the debtor assumes or rejects the contract or the contract expires on its own terms.

If the debtor rejects the contract, that is a breach of contract immediately before the date of filing and may entitle the nondebtor/creditor to a prepetition claim. If, however, a debtor assumes the contract, it must make all payments under the contract. This is a very favorable result for creditors who wish to continue doing business with the debtor, because such creditors will receive full payment for both prepetition and postpetition claims.

For most contracts, a debtor has until the confirmation of a reorganization plan to determine whether it wishes to assume or reject an executory contract. A frequent issue for creditors under a long-term contract with a debtor, therefore, is whether or not the debtor will assume or reject the contract.

One option is for a creditor to move the court to compel the debtor to assume or reject the contract in a shorter time frame. Courts have broad discretion to order a debtor to assume or reject an executory contract within a specified period of time.

Setoff Rights. The right to setoff debts is generally preserved in a bankruptcy proceeding. Setoff is an equitable right based on the presumption that if two entities are indebted to each other, it is logical to apply one debt against the other.

The right of setoff has a number of limitations under the provisions of the Bankruptcy Code. First, there must be mutual debts owed between the parties. In other words, the debts must be between the same parties in the same right or capacity. In addition, an obligation that is not a proper claim may not be set off.

Reclamation. Under the Uniform Commercial Code (UCC), if a seller discovers that a buyer has received goods on credit while the buyer was insolvent, the seller may reclaim the goods upon demand made within 10 days after the buyer's receipt of the goods. The Bankruptcy Code recognizes the right of reclamation that exists under state law and provides a seller with an opportunity, with certain limitations, to avail itself of such rights.

Once a company files for bankruptcy, creditors must meet the requirements of the Bankruptcy Code to take advantage of the right of reclamation. To establish a right of reclamation under the Bankruptcy Code, the seller must make a written demand for the goods either not later than 45 days after receipt of the goods by the debtor or not later than 20 days after receipt of the goods if the 45-day period expired after the case started.

The right of reclamation, however, has some significant limitations. For example, the rights of secured creditors will take priority over the rights of reclaiming sellers, since one who takes such a security interest is considered a good-faith purchaser under the UCC.

Prebankruptcy Strategies to Minimize Liability and Economic Loss

The Bankruptcy Code affords many protections to a company that may prove troublesome for creditors that provided the bankrupt company with credit, goods, or services before the filing of its bankruptcy petition. Creditors can use some strategies to minimize the adverse effects of a bankruptcy filing on them.

Obtain and Perfect Security Interests. Although it is not always possible to do so, obtaining a security interest from a customer will make the creditor's claim a secured claim if the security interest is properly perfected (that is, for most types of collateral, perfection occurs when a financing statement is filed timely in the appropriate jurisdiction pursuant to the UCC). Unfortunately, it is not uncommon for a creditor to take a security interest and neglect to perfect it in a timely fashion.

For preference purposes, if perfection occurs within the 10 days after the transfer, it is deemed to have occurred at the time of the transfer. If perfection takes place after the 10-day grace period, it is deemed to take place at the time of perfection. It is clearly in a creditor's interest to perfect all security interests at the earliest possible time to decrease the likelihood that a bankruptcy trustee will be able to avoid the transfer.

Obtain Letters of Credit and Surety Bonds. Letters of credit and surety bonds are two types of accommodations creditors may seek as a way to secure payment when doing business with a financially troubled company. Most letter of credit transactions are protected from preference attack, since they are not property of the account party's (that is, the party at whose request a bank issues a letter of credit) estate if the account party files for bankruptcy.

Typically, when the account debtor files for bankruptcy and the surety that issued the bond makes payment on the bond, the surety has only an unsecured claim against the bankruptcy estate, unless the surety has been able to bargain for collateral or a letter of credit in exchange for the issuance or renewal of a bond.

Obtain Security Deposits. If a debtor pays a security deposit, the application of that deposit to amounts owed to a creditor will typically not be considered a preference, even if the deposit is made during the 90-day preference period. Creditors requiring the payment of a security deposit can apply it to invoices that are not being paid on time.

Demand Prepayment or Require Cash on Delivery. Requiring buyers to pay in advance is an effective way to ensure that such transfers are not recoverable by a debtor during bankruptcy. By requiring advanced payment, sellers are able to take such payment outside of the statutory definition of a preference, because the payment is not "for or on account of an antecedent debt." Similarly, requiring a debtor to pay cash on delivery for all goods and services will likely prevent a bankruptcy trustee from avoiding the particular payment as a preferential transfer.

Knowing and Asserting Creditors' Rights

Dealing with the bankruptcy of a key supplier or customer can be a painful process. However, creditors who know their rights in bankruptcy and are prepared to assert those rights can minimize their losses. Legal counsel can provide meaningful help to fabricating companies struggling to understand the bankruptcy process. Particularly in cases involving large claims or complex business dealings, creditors should get legal counsel immediately upon a bankruptcy filing to preserve their rights and avoid costly pitfalls.

Timothy S. McFadden is an attorney with Locke Lord Bissell & Liddell LLP, 111 S. Wacker Drive, Chicago, IL 60606, 312-443-0370, www.lockelord.com. This article is not intended as legal advice and is not legal advice. This article is intended to provide only general, nonspecific legal information.