3 Issues for Vendors to Consider When Their Customer Files For Bankruptcy

Trade Creditors Still Have Options In the Event of a Customer Bankruptcy

When a customer files bankruptcy, vendors can be exposed to considerable losses if they have debts owed by the customer that arose before the commencement of the case (the “Petition Date”). Once the case is filed, the vendor becomes a creditor, or trade creditor, with a claim against the debtor. The claim against the debtor may take years to be paid and may not be paid in full. To protect themselves in the days and weeks after the customer’s bankruptcy filing, creditors must assess how to maximize their distribution on claims and prepare for potential avoidance litigation later in the case.

There are also steps a creditor can take before the case is filed to protect their interests in the event of a financially troubled debtor. Considerations for trade creditors include:

• Filing 503(b)(9) or reclamation claims
• Critical vendor status
• Potential avoidance actions

Section 503(b)(9) and Reclamation Claims

The 2005 amendments to the Bankruptcy Code provided numerous new protections to creditors in the event of a customer bankruptcy. Among these added safeguards is section 503(b)(9) of the Bankruptcy Code, which provides that “[a]fter notice and a hearing, there shall be allowed administrative expenses … including—the value of any goods received by the debtor within twenty days before the date of commencement of a case under this title in which the goods have been sold to the debtor in the ordinary course of such debtor’s business.”

“Administrative expenses,” which support the administration of the debtor’s estate and usually are incurred during the case, are paid in full (in any reorganization plan) ahead of unsecured claims. In order for a vendor to obtain this administrative priority status, the vendor must prove:

• That it sold goods (and not services) to the debtor;
• That these goods were received by the debtor within the twenty days prior to the Petition Date;
• That the goods were sold to the debtor in the ordinary course of the debtor’s business; and
• The actual value of the goods, for the purpose of establishing the amount of the claim.

The Section 503(b)(9) claim provides a safe harbor for the trade creditor in the event that their customer files bankruptcy. Prior to the 2005 Amendments to the Bankruptcy Code, vendors seeking something more than an unsecured claim were entitled only to file claims for the reclamation of goods advanced to the debtor in the forty-five days just before the Petition Date under both the Uniform Commercial Code and section 546(c) of the Bankruptcy Code.

The reclamation process was (and continues to be) quite onerous and includes the making of a reclamation demand in writing before the Petition Date. The timely written demand requirement requires vendors to monitor their customer’s financial state. And, even among those who do, many vendors are unaware of their reclamation right and thus unable to exercise it.¹

In recognizing such difficulties, Congress intended that section 503(b)(9) claims provide an additional remedy to vendors.² Contacting counsel immediately upon the receipt of notice of a customer bankruptcy can help you protect your section 503(b)(9) and reclamation rights.

In addition, vendors, like all other creditors, must watch for the establishment of a claims bar date by the bankruptcy court, which sets the date on or before in which a creditor must file a proof of claim—usually including claims under section 503(b)(9)—or have such claims forever barred.

Critical Vendors and the Doctrine of Necessity

A debtor in possession (“DIP”) in a case under chapter 11 of the Bankruptcy Code may not make any distributions on account of pre-petition claims outside of a plan of reorganization. A DIP may not ordinarily pay this or that creditor earlier than it pays all such creditors in a plan. However, in certain bankruptcy circumstances, the goods or services provided by particular vendors are essential to the viability of the debtor’s enterprise, and reorganization would be impossible without reaffirming those vendor-credit relationships.³ These providers of essential goods or services are referred to as “critical vendors” or “essential vendors.”

A trade creditor that provides an essential good or service, and who is also stuck with a considerable pre-petition claim, may have certain leverage if their customer files bankruptcy. In some cases, the vendor can use their leverage to get the debtor to seek court approval of immediate payment of the creditor’s pre-petition claim as a condition of the creditor’s continued delivery of goods or services to the debtor. No section of the Bankruptcy Code specifically provides for such payments of pre-petition claims to critical vendors. Thus, obtaining this relief can be controversial or even impossible in some venues. Which jurisdiction the case is filed in may determine whether a debtor can pay off critical vendors.

Avoidance Actions

Under chapter 5 of the Bankruptcy Code, the DIP or trustee (or a successor to their powers under a plan) can file lawsuits to avoid (de-legitimate) and recover (clawback) certain transfers made by the debtor either before or after the Petition Date.

Under sections 544 and 548 of the Bankruptcy Code, transfers that are found to be fraudulent, either due to the intent of the parties or because they were made in exchange for less than reasonably equivalent value while the debtor was insolvent, can be avoided and clawed back from the creditor that received them. Under section 547 of the Bankruptcy Code, the DIP or trustee can sue to avoid and recover certain “preferential” transfers made in the ninety days leading up to the Petition Date (the “Preference Period”).⁴

Creditors that have already suffered from unpaid invoices experience avoidance lawsuits as afflictions. Given the technical aspects of avoidance actions, counsel can lessen the affliction both by litigation defense and, at an earlier stage, by advising on the vendor’s payment arrangements with distressed customers.

After entering bankruptcy, the DIP is authorized to make transfers (i.e., pay vendors) in the ordinary course of business under section 363 of the Bankruptcy Code without a court order. The debtor can continue its normal vendor-credit relationships during the case. That is to say, the creditor can sell goods to the debtor throughout the bankruptcy proceeding and receive payments from the debtor. However, section 549 of the Bankruptcy Code provides that unauthorized post-petition transfers (including transfers that are not in the ordinary course) can be avoided and recovered by the DIP. For example, a vendor may wish to have additional payments to continue the relationship or to change the payment terms. In that case, those payments may not be seen as in the ordinary course.

A vendor may well desire some assurance that its transactions with the debtor will be deemed to be ordinary course or otherwise exempt from recovery through section 549. To protect itself, a vendor can ask the debtor to seek a “comfort order” from the court providing that payment to the vendor is authorized under section 363 and cannot be recovered under section 549. Alas, courts are increasingly reluctant to grant such orders. While a debtor may agree to seek such an order, it is no sure bet that it will be granted.

Take Prompt Action When Your Customer Files Bankruptcy

In the event of a customer bankruptcy, creditors need to be on their toes. Section 503(b)(9) claims, reclamation claims, and critical vendor issues present themselves in the early days of a bankruptcy case. Because cases can move quickly, creditors help themselves by reviewing all relevant pleadings and taking prompt action to protect their rights.

We think you’ll also like:

1. Who Gets Paid First (and Second, Third, etc.) in Bankruptcy
2. The Order of Claims in Bankruptcy: Absolute Priority Rule, Structured Dismissals, and More
3. Commercial Real Estate Tenant Bankruptcy — What To Do

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can watch at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Defending Against Bankruptcy Avoidance Actions
2. The Nuts & Bolts of a Chapter 11 Plan

This is an updated version of an article originally published in May 2013 and previously updated on July 2, 2021.]

©2023. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.

1. See Brendan M. Gage, Should Congress Repeal Bankruptcy Code Section 503(b)(9)?, 19 Am. Bankr. Inst. L. Rev. 215, 235-36 (Spring 2011).
2. Id. At 233.
3. See Mark A. McDermott, Critical Vendor and Related Orders: Kmart and the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, 14 Am. Bankr. Inst. L. Rev. 409, 413-14 (Winter 2006).
4. See 11 U.S.C. § 547(b) (The transfer must be: (1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt owed by the debtor before such transfer was made; (3) made while the debtor was insolvent; (4) during the Preference Period; and (5) enable the creditor to receive more than it would have received if the bankruptcy case were a chapter 7 liquidation and the transfer at issue had not been made).