The COVID-19 pandemic has left many companies unable to pay all their debts. Some of them will consider or file bankruptcy to reorganize their businesses or liquidate and close them. So, what questions should you, a supplier, contractor, or vendor, ask when you hear that your customer is in financial trouble or has filed for bankruptcy?
What is bankruptcy?
When a company files for bankruptcy, whether that’s under Chapter 11 (reorganization) or Chapter 7 (liquidation), it seeks the protection of a bankruptcy court from its existing debts. An automatic stay goes into effect to protect it from creditors while it sells its assets or comes up with a plan to repay its debts over time. The bankrupt company is called the “debtor,” and you, the person the debtor owes money to, are the “creditor.” The amount of money the debtor owes you is your “claim.” Unless the bankruptcy judge makes specific orders in the bankruptcy case, your claim will not be paid for a long time after the bankruptcy case is filed, perhaps even several years, perhaps only cents on the dollar, or perhaps not at all.
What can I do to reduce my exposure to a customer’s bankruptcy?
Reduce credit limits and terms, or ask for security. If your customer is pre-paying orders, posting letters of credit or guarantees, or paying invoices within a short period of time, then you may have a very small claim and little reason to worry about a bankruptcy. If your customer is paying you on much longer terms, your exposure could be much larger.
You can also ask your customer for a security interest by getting a cash deposit to hold against further charges or a state law lien on property of the debtor.
What does my customer’s bankruptcy mean for my operations?
The second that a debtor files a petition in bankruptcy court, it is protected by an “automatic stay.” The stay applies before it even gives notice to any of its creditors. The automatic stay is like a court order that prevents any creditors from trying to collect any debts the debtor owed them at the time it filed for bankruptcy. Violating the automatic stay is illegal and can subject you to fines and penalties.
Things that violate the automatic stay:
• Suing the debtor or moving forward with an existing lawsuit against the debtor. 2
• Sending the debtor a demand letter. • Asking the debtor to pay its pre-bankruptcy debts to you.
• Sending the debtor an invoice for pre-bankruptcy goods or services.
• Repossessing any property of the debtor.
• Locking the debtor out of its leased property.
• Terminating a contract with the debtor. You must continue to perform all of your contracts unless and until the debtor informs you that it has “rejected” your contract.
Things that do not violate the automatic stay:
• Calling the debtor and asking what its plan is to get out of bankruptcy and continue its business.
• Filing a claim in bankruptcy court for the money the debtor owes you.
• Suing the debtor’s guarantor or owner for money they owe you.
• If you do not have a contract with the debtor, you may refuse to do further business with it or sell it more goods or services.
What do I do when the debtor tells me it has filed for bankruptcy?
Ask the debtor which bankruptcy court it filed in. Some debtors confuse talking to a bankruptcy attorney for actually filing for bankruptcy, and the automatic stay only applies once the debtor has sent a petition to the bankruptcy court.
Tell your billing department to stop sending invoices or payment letters to the debtor if you think a debtor has filed for bankruptcy. You will only want to send invoices for goods or services you delivered 100% after the bankruptcy case was filed.
Figure out how much money you are owed before the bankruptcy case was filed. That is your “claim.”
You may wish to retain an attorney to assist you in filing your claim with the bankruptcy court and informing you of which priority your claim falls in. Usually, you must file a claim with the bankruptcy court to be paid by the debtor for any pre-bankruptcy debts.
Am I secured?
Most vendors and suppliers will be unsecured in a bankruptcy. Security interests are usually a matter of state law and contract, and in most states, you will only have a general unsecured claim for damages if you provided goods or services to a company and it failed to pay you as promised. You will not have a security interest even in the goods you sold unless the customer has previously agreed to give you a lien on its property to secure your right to payment. Some categories of service providers may be able to assert state law security interests without the consent of the debtor: warehousemen, mechanics, and materialmen for example. Having a security interest means you will be paid first from the sale of the specific assets your lien attaches to, rather than proportionately with all other creditors.
Some vendors may find that they in fact own a direct interest in property in the debtor’s possession, too. Categories of people who may be able to assert special trust or lien rights against the debtor, and avoid having an unsecured claim, include mineral royalty owners, vendors of perishable agricultural commodities, and contractors on construction jobs. If you think you fall into one of these categories, you should consult an attorney familiar with the specific industry as well as familiarity with bankruptcy.
What if the debtor just ordered inventory and it has filed for bankruptcy?
Generally, if you have a contract with the debtor, you must continue to perform on that contract as though the debtor had not filed bankruptcy. There is a special rule to prioritize payment to people who delivered goods to the debtor in the last 20 days before the debtor filed bankruptcy. If you ship goods or provide services to the debtor after it files for bankruptcy, you should be paid in the ordinary course of business, and at a higher level of priority than people who provided goods or services before the bankruptcy case.
Am I a critical vendor?
Larger debtors sometimes file motions to pay the pre-bankruptcy claims of “critical vendors” early in the bankruptcy case and avoid the strict priority scheme for payment of claims, which favors bankruptcy lawyers, secured lenders, employees, and taxing authorities before ordinary vendors are paid. If you have a good or important relationship with the debtor, it may be worth asking the debtor if you can be included in such a motion. Being deemed a “critical vendor” gets you paid sooner and at a higher percentage than other creditors. A debtor cannot promise to make you a critical vendor before it files; only a bankruptcy court can give that permission.
What is my preference exposure?
Many vendors worry that they will be sued for receiving preference payments after a company files for bankruptcy. A preference is a payment made by the debtor within the 90 days prior to its bankruptcy filing. The debtor or its trustee files preference lawsuits in bankruptcy court and can ask that you pay back such payments, even though you were legitimately owed the money, if you received relatively more than other creditors did. The typical defenses to preference claims are that you provided new value in the form of goods or services shipped or credit provided after receiving payment, or that you received payment in the ordinary course of business. This typically means that the debtor paid you on the same credit terms as it always had, and you did not start unusual collection activity. Red flags for a trustee include changes in payment terms or a threatening collection letter. Many vendors worry too much about preferences (which will usually not be filed until the tail end of a bankruptcy case) and not enough about just getting paid. If you are worried about preferences, you can switch to payment in cash on delivery for new orders or simply stop doing business with the debtor until after the bankruptcy filing. If you are paid cash at delivery or prepaid, you cannot be liable for preference.
Will I have an administrative claim?
Administrative claims are for goods and services that benefit the post-bankruptcy debtor. These claims are paid first (before unsecured creditors). You also can assert an administrative claim for goods you provided to the debtor within the 20 days before it filed for bankruptcy, or for goods and services you provided to the debtor after you filed for bankruptcy. Filing an administrative claim typically requires retaining a lawyer admitted to practice in that bankruptcy court to file a motion for payment.
Do I have an executory contract with the debtor?
If you have a contract that requires both you and the debtor to perform, or take some action, after the bankruptcy, then you have an “executory contract.” Examples of an executory contract would be an equipment lease, a 1-year contract for information technology services, or a 2-year requirements contract for raw materials. A debtor has the ability to accept or reject a contract by motion in bankruptcy court. Accepting it means that your contract with the debtor continues as though the debtor did not file for bankruptcy. Rejecting it means that the debtor will not perform under the contract. Until the debtor decides whether it will accept or reject the contract, you must continue to perform, even if the debtor is not paying you or performing. You can file an administrative claim for any services or goods provided post-bankruptcy. If the debtor accepts the contract, it must “cure” or make its payments and obligations current. If the debtor rejects the contract, you no longer need to perform, and you can assert a claim for damages for your expectancy under the contract.
Hedrick Kring, PLLC attorneys practice in bankruptcy courts nationwide. This memorandum is intended to provide general information and does not constitute legal advice regarding your specific situation. To consult with an attorney regarding your legal needs, you may contact Hedrick Kring, PLLC at 214-880-9600