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Your Customer Goes Bankrupt – What's Next?

You receive a notice in the mail that one of your customers has filed for bankruptcy. They owe you a lot of money. Is it a total loss? Not necessarily. Or perhaps, through diligent collection efforts, you have recently received a large payment or have been paid in full. Can you keep the payments? Not necessarily.

There are extensive rules governing the law and procedure when a business or an individual files for bankruptcy. There are libraries full of materials on bankruptcy issues. Obviously, an extensive discussion of bankruptcy law goes beyond the scope of Legal Briefs. However, there are a few tips you should know.

There are two types of creditors in bankruptcy, secured creditors that have a lien on real estate, accounts receivable, inventory or other assets and unsecured creditors without liens. Secured creditors that are owed more than the value of their collateral are partially secured and partially unsecured.

When a debtor files for bankruptcy, the court appoints a bankruptcy trustee to investigate the debtor's affairs and to administer the bankruptcy estate. In certain bankruptcies, the court allows the debtor to operate as the trustee as a "debtor in possession."

The Bankruptcy Code allows certain transactions to be set aside or avoided by the bankruptcy trustee. Setting aside or avoiding a transfer means a creditor will be required to pay money to the trustee. The most likely reason why a bankruptcy trustee may demand money from you is for alleged "preferential transfers."

The Bankruptcy Code provides that if a debtor pays an unsecured creditor on an old debt, the creditor must repay that money to the bankruptcy estate so that it can be divided pro rata between all unsecured creditors. As a practical matter, money received from avoided transfers are often used to pay the expenses of administering the bankruptcy.

Notice of Customer's Bankruptcy. If you receive notice of a customer's bankruptcy, you should do the following:

1) Stop Goods & Services. Do not ship any new goods or provide any new services to the debtor. If goods are in transit, do everything you can to stop delivery. If services are currently being provided, discontinue those services immediately.

2) Stop All Collection Efforts. Do not attempt to collect the debt you are owed. Upon filing, the Bankruptcy Code provides for an "automatic stay." This means that all collection efforts must stop. If you violate the automatic stay, you can be liable for contempt. Anything you collect will need to be repaid. You can even be punished with jail time (not likely, but theoretically possible).

3) Gather Documents. Assemble documents evidencing the debt owed to you by your customer. This can include purchase orders, invoices, contracts, sales documents, promissory notes, billing statements, account histories, security documents, etc. . . .

4) First Meeting of Creditors. You will receive notice of a first meeting of creditors. Also known as a §341(a) hearing. If you have information regarding assets the debtor may be hiding, want to ask questions of the debtor or are a secured creditor and want to locate your collateral, this is your chance to do so.

5) Proof of Claim. Fill out a proof of claim form, attach all of the documents you gathered evidencing the debt you are owed and file with the court before the deadline set by the court. You may recover some portion of the money that you are owed. Some creditors do not bother to file completed proofs of claim. As a result, they receive nothing and their share is divided between the creditors that do file.

Trustee's Demand Letter. If you receive payments within 90 days prior to the filing of the bankruptcy on an old unsecured or partially secured debt, you may receive a demand letter from the trustee. There are defenses to a trustee's preferential transfer claim. If one or more of the defenses apply in your case, you may get to keep some or all of the money that the trustee demands. If you receive such a letter, you should do the following:

6) New Value. Perform a new value analysis. If a customer pays on an old debt but you have shipped new products for which you have not yet received payment, this can be a defense to a preferential claim. Make a list of the dates of invoices and payments so that new value can be properly analyzed.

7) Contemporaneous Exchange. Determine if any payments were received in exchange for new goods or services (such as COD or cash and carry). Contemporaneous exchanges are another defense to a preferential transfer claim.

8) Payments in Ordinary Course. Analyze how long it normally took the bankrupt customer to pay your invoices. Bankruptcy trustees take the position that any payment made more than 30 days after the date of delivery or the date of invoice is a preferential transfer. However, I was able to show in at least one case, that throughout the history of the account, payments averaged 63 days after the date of invoice. For this debtor and this creditor, 63 days were the "ordinary course of business."

9) Combine Defenses. Remember that even if one defense is not adequate to allow you to keep all of the payments the trustee seeks to avoid, you might be able to layer or combine defenses. There have been a number of cases where I have been able to show that a portion of the payments qualified for the new value defense and other payments qualified for the contemporaneous exchange or payments in the ordinary course defense. As a result, our clients were able to keep more of the money they had previously collected from their bankrupt customer.

10) Negotiate. Even if you do not have any defense to a preferential transfer claim or your defenses do not allow you to keep all the payments you received, negotiate with the bankruptcy trustee. He or she will want you to write a check. They know it is better to settle with you than it is to file a separate adversary proceeding against you, conduct discovery and present evidence at a hearing before the bankruptcy court to obtain an order compelling you to pay. Trustees will negotiate in order to avoid the time, expense and uncertainty of litigation.

11) Don't Assume Defeat. Don't automatically conclude that because you receive a letter from a bankruptcy trustee, you must pay the amount demanded. I recently worked on a case for a manufacturer where a large law firm made that very mistake. Fortunately, we were able to do a new value analysis and calculate the ordinary course of business between the parties to protect a large portion of the amount that had been previously collected. We then negotiated the difference. If this manufacturer had simply responded to the trustee's demand letter or even relied on the advice from the large law firm, they would have paid money to the bankruptcy trustee that they were not obligated to pay.

Customers will go bankrupt. That is a fact of business life. If you require personal guarantees as a condition of granting credit (put the guarantees right on your credit applications), age and monitor your receivables, work your receivables and cut off past-due clients, you can avoid large losses when a customer goes bankrupt. Even then, remember, it may not be a total loss if you document the debt and file a proof of claim. You may even be able to keep some or all of the money you previously collected notwithstanding demand letters from bankruptcy trustees.

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