Being an unsecured creditor in a distressed business situation is not enviable. Unsecured creditors don’t have collateral to which they can look to make themselves whole in the same way as a secured creditor; most unsecured claims are frequently at the bottom of the heap in terms of creditor priorities. Not to mention that, if an unsecured creditor is dealing with a customer in distress, the creditor runs further risks of litigation for any transfers it receives from the customer in the days leading up to the customer filing for chapter 11.
Armed with this knowledge, we can examine how unsecured creditors can (and in many cases should) conduct themselves with respect to dealing with customers generally, with a view toward mitigating the risks associated with distressed business situations.
Nearly all trade vendors work with their customers on unsecured business credit terms. As a business generates sales to customers, customers rarely pay for goods or services up front. Instead, a trade vendor will typically take an order from a customer, fulfill the order, and issue an invoice for the goods or services provided (creating an account receivable), with payment to be made by the customer under the terms it agrees to with its vendor. The people tasked with managing and collecting accounts receivable typically hold the title “credit manager.”
There is an inherent push-pull relationship for trade vendors who deal with customers on an unsecured basis. On one hand, a vendor must generate sales (i.e., revenues) to create new accounts receivable and keep its business running. On the other hand, the same vendor has to ensure that new and existing customers can timely pay their accounts to avoid business disruptions and potential losses.
One general best practice to manage customer relationships is to perform up-front diligence on new customers, asking (or requiring) that prospective customers provide financial information and reporting, usually by completing a credit application to show that the customer is creditworthy and that the vendor’s risk of loss will be acceptably low. If a credit department determines that a new customer is not creditworthy after conducting initial diligence, it may not be the end of the process. Instead, a trade vendor may propose alternative payment terms to the customer (cash in advance, cash on delivery, etc.) under which it is comfortable entering into a new customer relationship, or may require that an individual (usually the owner of the customer-business) personally guarantee payment of any amounts the customer fails to pay. For existing customers, regular communications and management of accounts receivable will ensure that a business relationship is successful, and risks are kept low.
But we aren’t here to discuss the successful business credit relationship. There are additional specific steps that can be taken to ensure that, if a customer ends up in distress (and may be headed towards bankruptcy), the vendor has done what it can to properly protect itself and its claims against the customer-turned-debtor.
One means by which a vendor can keep tabs on customers is to monitor their solvency, especially in the case of a large customer whose accounts represent a concentration of the vendor’s receivables. Numerous financial services firms provide credit opinions regarding commercial companies and their ability to pay debts as they come due, making this monitoring process more manageable.
When a debtor files for bankruptcy relief, unsecured creditors will be left waiting to see whether their unpaid prepetition claims will be paid after the automatic stay is triggered. What many unsecured creditors don’t realize, however is that when a debtor files for bankruptcy relief, creditors may also be liable to the debtor’s estate for receiving payments (referred to as “preferences”) from the debtor during the 90-day window preceding the bankruptcy filing. The Bankruptcy Code permits a debtor to sue creditors to recover payments made during this 90-day period before the bankruptcy filing where the creditor receiving the payment(s) was paid more than it would have been entitled to in a liquidation scenario.
It’s important to know, however, that vendors have defenses to these preference actions. For example, payments are safe from being clawed back by a debtor if (1) they constitute a contemporaneous exchange; (2) the payments were made in the “ordinary course of business”; or (3) the creditor being sued provided “new value” to the debtor after receiving payments during this time period.1
The Bankruptcy Code was recently amended in an effort to cut down on the number of preference cases by limiting the scope of preferences a debtor can clawback. Under the Small Business Reorganization Act of 2019, a plaintiff asserting a preference claim must now (1) consider the preference recipient’s potential affirmative defenses under § 547(c) before filing a preference lawsuit; and (2) cannot pursue a preference recipient who was paid less than $25,000 during the 90 days before the bankruptcy case was filed.
Regardless of statutory defenses and congressional efforts to limit preference lawsuits, the risks that they’ll be brought is still alive and well. By keeping accounts current and following ordinary billing practices, vendors can limit their exposure to these risks, making it critical for credit managers to avoid allowing accounts to slip beyond customary payment terms.
As mentioned briefly above, when a vendor becomes aware that a particular customer is or has become a credit risk and may potentially seek bankruptcy protection, it can significantly reduce its risk exposure by initiating certain payment alternatives that will protect its interests in the event of a filing. These alternatives may include (1) obtaining advance payment or cash on delivery (COD) for shipments; (2) establishing an evergreen retainer or cash deposit against which the vendor will draw to pay down outstanding accounts; (3) obtaining letters of credit; or (4) obtaining a payment guaranty from a third party.
So what should a trade vendor do when its customer files for chapter 11, and it’s left holding a general unsecured claim for prepetition receivables that stands to be paid last in terms of priority? Since general unsecured creditors stand to lose out most in a failed chapter 11 reorganization, they are often the parties who will be most benefited by a thorough monitoring of the debtor’s affairs during the chapter 11 case.
As we discuss in Installments 4 and 6, the first days of a chapter 11 case are immensely important to setting the stage for how a debtor’s chapter 11 case will proceed. In almost all cases, a debtor’s first day motions will include requests to treat certain creditors’ claims differently than they might otherwise be treated by the Bankruptcy Code’s priority scheme.
Notably, first day motions often include requests for the Court to give the debtor authority to immediately pay certain types of unsecured claims in advance of other unsecured claims. These may include motions to pay prepetition wages and benefits, critical vendor claims, sales and use taxes, customer obligations, and other obligations, depending on the nature of the debtor’s business. In most cases, the bankruptcy judge will grant these motions, if the debtor can show that paying these such claims is critical to maintaining the debtor’s ongoing operations and going concern value.
Unsecured creditors will also want to pay close attention to a debtor’s first day motion seeking authority to use cash collateral or obtain DIP financing, because orders granting these first day motions will often have a significant impact on the priority scheme for recoveries in the case, as they usually involve priming and replacement liens, intricate debt service requirements, and carveouts for specific types of claims.
Unsecured creditors and their advisors should read a debtor’s first day motions to consider the potential impact on their rights. If appropriate, they should file an objection (or if there isn’t enough time to file something, show up at the hearing and object) to ensure they don’t lose rights unnecessarily.
Beyond monitoring a debtor’s first day motions and activities, general unsecured creditors should keep themselves apprised of the actions going on in a chapter 11 case. Debtors are required to give all creditors notice of their initial bankruptcy filing, but beyond this there are very few matters about which a debtor must affirmatively notify all creditors of activity taking place in its chapter 11 case.
Thus, individual creditors must take their own affirmative steps to gather additional information about the case and the treatment of their claims. One way to stay in the loop is to file and serve a request under Bankruptcy Rule 2002 to be added to this general service list and receive copies of all filings in the bankruptcy case. And while this may open a floodgate of mail, it is traditionally the best way to monitor a case. To cut down on document costs, some courts permit service by email and electronic document retrieval.
Another good source of information for creditors will be the U.S. Trustee’s office. As we discuss in Installment 2, the U.S. Trustee acts as a government watchdog over the chapter 11 process. In many cases, the attorneys for the debtor will meet with attorneys for the U.S. Trustee just before or just after a chapter 11 filing to brief the U.S. Trustee on the background of the case, and how the debtor plans to navigate its way through chapter 11. The U.S. Trustee also conducts the meeting of creditors under § 341 of the Bankruptcy Code, and is also charged with appointing a committee of unsecured creditors in the event enough interest is expressed to form an official committee.
Speaking of committees in bankruptcy, unsecured creditors should consider whether to sit on an official committee of unsecured creditors in the debtor’s chapter 11 case (provided that the case is not proceeding under subchapter V of chapter 11, where committees are not required), especially if the creditor holds one of the largest unsecured claims against the debtor, as we discuss in Installment 35.
An additional important monitoring function for unsecured creditors in chapter 11 is to take note of when the debtor files a chapter 11 plan, and to specifically understand how the chapter 11 plan proposes to treat the creditor’s claim, including projected distribution amounts, estimated timing for payment of the claim, and any other relevant information affecting creditor recoveries under the plan.
Regardless of the path chosen in chapter 11, general unsecured creditors will do well to monitor a debtor’s chapter 11 case to ensure they are staying informed of major developments that may affect their rights and distributions down the road.
It is also of paramount importance to understand, once a chapter 11 case has been filed, how to protect a general unsecured claim and prevent any loss of rights postpetition. General unsecured creditors must absolutely be aware of any claims bar dates established in the chapter 11 case to ensure they timely file a proof of claim, because, as we discuss in Installment 11, missing a bar date can cause a claim to be disallowed (meaning the claim is never going to be paid) or subordinated (meaning the claim is booted to the end of the priority line).
In addition to monitoring a chapter 11 case and protecting their claims, unsecured creditors should understand that the Bankruptcy Code does accord relief to otherwise-unsecured creditors in limited contexts. Claims for reclamation under Bankruptcy Code § 546, and administrative expenses under § 503(b)(9) are two of the most important to know about and understand.
“Reclamation” refers to the right of seller to reclaim goods sold to a debtor while the debtor was insolvent. Bankruptcy Code § 546(c) focuses on this right in the context of a sale that took place immediately before a debtor files for bankruptcy. In such cases, timing is a critical factor. There is a narrow window within which the seller must act to protect its rights. Specifically, the seller must make a written reclamation demand:
(i) within 45 days of receipt of the goods by the debtor; or
(ii) if the 45-day period expires after the commencement of the bankruptcy case, within 20 days after the debtor received the goods.
11 U.S.C. § 546(c). This right applies to goods received by the debtor, while insolvent, within 45 days before its petition date—though the seller may have little interest in reclaiming goods sold within the 20 days immediately preceding the Petition Date, since the creditor it is likely to receive full payment for such goods as an administrative expense of the debtor’s chapter 11 estate under § 503(b)(9).
While the provisions of § 546(c) mirror state-law-based reclamation rights, it is not derivative of or dependent upon a state’s law. Section 546 represents a federal right of reclamation. This reclamation right is subject to the rights of senior secured lenders, so it may be illusory in cases where a lender has an undersecured floating lien covering a debtor’s inventory. Some large commercial debtors will seek to streamline the reclamation process by filing a “reclamation procedures motion,” in the chapter 11 case, requesting that a claim substitution process occur automatically, without the need to make individual requests for each reclamation claim.
Managing unsecured credit outside of a distressed business situation is a tall task on its own, much less in the context of distress and chapter 11. Having a playbook ready to mitigate risk (while maximizing revenues) is therefore a key consideration for trade vendors entering into and managing relationships with their customers.
The authors are corporate restructuring and insolvency attorneys. Read more about three of them at the end of Installment 1.
Understanding all this stuff in the context of bankruptcy is important, but not every distressed company winds up in bankruptcy. So, you also need to understand how it works outside of bankruptcy. Read Installment 14 to get the rest of the story.
To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):
©2022. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Jonathan Friedland is a principal at Much Shelist. He is ranked AV® Preeminent™ by Martindale.com, has been repeatedly recognized as a “SuperLawyer” by Leading Lawyers Magazine, is rated 10/10 by AVVO, and has received numerous other accolades. He has been profiled, interviewed, and/or quoted in publications such as Buyouts Magazine; Smart Business Magazine; The M&A…
Jack is a corporate and restructuring partner in the Chicago office of Sugar Felsenthal Grais & Helsinger LLP. Jack’s practice covers a range of healthy and distressed business engagements. He is widely recognized for his excellent work as a restructuring attorney including recognition by various organizations for his strategic thinking and tactical expertise, including SuperLawyers…
Hajar is an associate with Much Shelist in both its Business Transactions Group and its Restructuring & Insolvency Group.
How to Save Your Business from Financial Distress: The Potency of Subchapter V of Chapter 11
Chapter 15 Bankruptcy: A Concise Overview
Dealing with Corporate Distress 15: Digging into DIP Financing & Cash Collateral Motions in Bankruptcy
Dealing with Corporate Distress 14: The Secured Creditor’s Perspective About its Debtors
An Introduction to Bankruptcy Claims Trading Part 2: Sale of a Claim
An Introduction to Bankruptcy Claims Trading
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