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A Creditors’ Guide for Claims Against Bankrupt Customers: Getting Claims Paid and Preventing Claw-Back of Payments Received

You recently shipped goods to a U.S. customer on credit.  Now the customer is insolvent and evidently sliding into bankruptcy.  As in baseball, at the close of the slide, the customer may be safe, continuing in business or sold as a going concern, or out, and facing liquidation. What to do?

Included among the concerns shaping your future dealings with the distressed customer are:

  • The maximization of return on goods shipped on credit pre-bankruptcy by means of reclamation, 20-day claims, critical vendor status, and contract assumption;
  • The opportunity for further returns by continuing to do business during the bankruptcy case; and
  • The minimization of risk from a later preference avoidance and claw-back suit.

Let us first address the last concern, because it may determine how you seek payment from your troubled customer in the months before a bankruptcy case.

How to Minimize Avoidance and Claw-Back of Payments Received

Any payment that is not a pre-payment or cash on delivery received during the 90 day period before the customer’s bankruptcy filing date could result in an avoidance and claw-back lawsuit against you for the benefit of the debtor’s bankruptcy estate. Preference avoidance and recovery provisions under the Bankruptcy Code were enacted to reduce unequal treatment of creditors and to discourage creditors to racing to pursue legal collection remedies from the struggling debtor.  Those policies are cold comfort when you are later sued by the debtor’s estate to pay back the funds you received for goods you delivered.  That the creditor did nothing wrong by getting paid for services previously rendered is not a defense to a preference avoidance and claw-back suit.

Here are two ways to minimize preference liability for future payments you receive:

  • Get the customer to agree to pay Cash on Delivery a/k/a COD for future deliveries.  If the parties agree to exchange goods or services contemporaneously with payment therefor, and then in fact do so, the payments should qualify for the “contemporaneous exchange” for new value defense.  While courts differ on how much time can elapse between the delivery of goods and payment under this defense, almost all courts agree that COD is contemporaneous and immune from preference liability.
  • Get the customer to pay in advance for future deliveries.  If a payment is made in advance, it is not on account of an “antecedent debt” (which is required for a payment to be avoided as a preference).  Seeking payment in advance may not go over well with your customer (who has many needs for precious cash), so you will need to consider what leverage, if any, you have with the customer. Further, you will need to document that cash received is not applied to older unpaid invoices.

If neither COD nor pre-payment terms are possible, a supplier can limit its preference exposure by continuing to work with the customer on the same terms it was before the bankruptcy filing. Upon proving such facts, a preference defendant may prevail on an “ordinary course of business” defense.

This defense is effective when the customer’s payment pattern, for example method and timing of payment after delivery of goods, is consistent between the periods before and after the bankruptcy filing. The defense may be weakened if the supplier exerts special collection pressure on the customer or changes payment terms, including method of payment (to a tighter days-to-pay requirement, but short of COD or prepayment), or mode of payment (requiring wire transfers instead of checks).  A related defense, the “ordinary business terms defense,” may apply if the length of time it takes for a debtor to pay an invoice in the preference period accords with industry norms.

Creditors should also be cautious of fraudulent transfer claims.  While the name suggests devious intent, you can be the target of a fraudulent conveyance avoidance and claw-back action even where you lack such intent; for example, if you receive more from an insolvent customer than you give.  This can occur where the debtor pre-pays for goods that are not delivered (e.g., where a supplier cuts off all deliveries because the customer filed a bankruptcy case).

Thus, perhaps counter-intuitively, how you get paid and on what terms by a struggling customer are issues to be discussed with counsel knowledgeable about bankruptcy.

How To Maximize the Value of Your Bankruptcy Claims

The filing of a bankruptcy petition automatically puts in place an injunction-like automatic stay.  Thus, creditors are barred from taking any action to collect a pre-petition debt except through the claims process within the bankruptcy case. Violating the automatic stay is serious business and can result in punitive damages.  For more on the automatic stay, see this article.

One of the requirements for getting payment on your claim is (most often) the filing of a proof of claim before any bar date is set in the bankruptcy case.  Failure to file a valid and adequate proof of claim before the bar date can result in your claim being disallowed – whereupon you would lose your right to a cash distribution from the bankruptcy estate on the claim.

The supplier’s claim will most often be a general unsecured claim. It would be rare for a supplier to have another type of claim, such as a lien on the customer’s property in order to secure payment of invoices.

Under the payment priority scheme established by the Bankruptcy Code, there are types of claims that are prioritized over general unsecured claims and which, therefore, get paid in full before general unsecured claims get paid at all (for more on the priority scheme, see this article and this article).  We discuss four such claims that may be available to a supplier of goods.

  • Make a reclamation demand. If you deliver goods to an insolvent debtor who received the goods within 45 days before the bankruptcy filing and you were not paid, you may send a written demand for the return of the goods.  This demand is known as a “reclamation claim.”  Under the Bankruptcy Code, a reclamation claim must be made within 45 days after delivery of the goods or, if the 45- day period expires after the bankruptcy filing date, within 20 days after the bankruptcy filing.  Usually, you can reclaim goods only if they are both (x) still in the debtor’s possession and (y) not subject to a lien in favor of a secured creditor (alas, normally they are!).  For more about the relative priority of reclamation and secured creditor claims, see this recent article.
  • File a 20-day claim (aka “Section 503(b)(9) claim”).  If you deliver goods that are received by the debtor within the 20 days before the bankruptcy filing, you may be entitled to a priority claim from the bankruptcy estate, per section 503(b)(9) of the Bankruptcy Code.  This kind of claim can provide full recovery even when payments to general unsecured creditors are pennies on the dollar.  Such deliveries must have been made in the ordinary course of the debtor’s business to qualify for the priority of payment.  There may be special procedures established in a bankruptcy case for asserting 20-Day Claims.
  • Become a Critical Vendor.  If what you supply is “critical” to a debtor’s operations – perhaps because you are the only supplier and the debtor cannot operate without your goods – the debtor may successfully ask the court to approve paying your pre-petition claim immediately and in cash in order to keep you supplying.  As a practical matter, courts allow payment of some or all of the prepetition debt to a critical vendor while also binding it to continuing to do business with the debtor post-petition on specific terms (because nothing is free).
  • Get Your Contract Assumed. Pre-petition debts can be paid in full if you have a contract with the debtor that the debtor “assumes.”  In bankruptcy, a debtor can either assume or reject most pre-petition contracts on which both parties have continuing material obligations, i.e., executory contracts (by contrast, for example, to a one-off sales contract on which you supplied and did not get paid).  If the debtor rejects your executory contract, it no longer needs to perform and you are left with a general unsecured claim for damages. If the debtor assumes your executory contract (in order to enjoy your performance or to assign the contract to a third party), the debtor must “cure” all amounts owed to you.  Sometimes it makes sense to take a discount on the “cure” claim in return for the debtor assuming your executory contract.   The discounted cure may greatly exceed the likely return on your general unsecured claim.

Doing Business With A Debtor- A Good Idea?

Some bankrupt debtors liquidate (i.e., are “out” after the slide) or get sold as a going concern early in a bankruptcy case.  Others continue to operate in bankruptcy with hope of reorganizing.  Vendors who continue to do business with a bankrupt debtor are usually rewarded with an “administrative expense” priority on claims for payment for all goods or services delivered after the case began.  Administrative expenses are paid in full before general unsecured claims are paid anything (for more on administrative expense claims, see this article).  However, it is possible that a given debtor’s estate will lack funds to pay administrative expense claims in full. In doing business with a debtor in bankruptcy, a supplier should pay close attention to the debtor’s financial condition and should timely exercise rights to request payment of administrative expense claims (and to be sure to comply with any administrative expense claims bar date).

For an earlier article covering some of the ground above, see here.

Editor’s Note: The content of this article is intended to provide a general guide to the subject matter and neither constitutes legal advice nor forms an attorney-client relationship. Specialist advice should be sought about your specific circumstances.

About Christopher M. Cahill

Mr. Cahill is counsel with Lowis & Gellen LLP, in Chicago, Illinois.   He guides secured lenders, creditors, debtors, creditors’ committees, potential purchasers and others through bankruptcy cases, out-of-court workouts, assignments for the benefit of creditors, and receiverships.  Mr. Cahill has substantial mega-case experience at national law firms representing very large debtors, and has counseled and…

Read Full Bio »   •   View all articles by Christopher M. »

Christopher M. Cahill

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