Six Questions to Ask When Your Vendor, Supplier, or Customer Files Bankruptcy

October 28, 2020 - Mary M. Caskey
After almost eighth months of dealing with the severe economic impact of COVID-19, it is not surprising that more and more businesses are turning to bankruptcy for relief. Commercial filings continue to rise as many government-backed programs expire and the lasting effects of COVID-19 take hold. For many corporate counsel, interactions with bankruptcy may be limited, but how you respond to a vendor, supplier, or customer bankruptcy after a filing can have a significant impact on your company’s ability to mitigate its losses and avoid liability.

So, what should you do when you get notice of a customer’s or vendor’s bankruptcy filing? Here are a few key questions that may arise. 

1. Your company just delivered product to a customer, right before it filed for bankruptcy. What can you do?

If you delivered goods to a debtor in the 20 days before the debtor filed bankruptcy, and those goods were delivered in the ordinary course of business, then you can get administrative claim status of the amount of the goods delivered. See 11 U.S.C. § 503(b)(9). If your claim for administrative expenses is allowed, you jump ahead of all the other unsecured creditors, and in a Chapter 11 case, generally you get paid in full. (Note that the administrative claim is only for the value of the goods, and does not include add ones like taxes, shipping fees, or claims for surcharges. You can still make a claim for those amounts, but they will be an unsecured claim, and not entitled to administrative claim status.) Usually, there is a deadline set early in the case for filing a 503(b)(9) claim, so keep an eye out for notices concerning any “claim bar dates.” 

In many cases, you may just want to get your goods back. The Bankruptcy Code gives a seller certain reclamation rights in goods that were delivered within 45 days prior to the bankruptcy filing, or within 20 days of the bankruptcy filing if the 45 day period expires after the date of the filing. See 11 U.S.C. § 546(c). A reclamation demand can only be made if (1) the goods are still in the debtor’s possession (i.e., they haven’t been sold to the debtor’s customer), and (2) if they have not changed form or been incorporated into another product (i.e., flour baked into bread, or made as components of an engine). Additionally, if there is a secured creditor who has a lien on the debtor’s inventory, the goods are subject to the secured creditor’s lien and cannot be reclaimed. Timing for a reclamation demand is key—reclamation demands must be served within 20 days of the bankruptcy filing.

How do you decide whether to assert a 503(b)(9) claim or reclaim the goods? In the early days of a case, it can often be difficult to decide which option is better. For all you know, the bankruptcy case could end up being insolvent and unable to pay a 503(b)(9) claim, and you would have been better off reclaiming the goods. However, if you exercise your reclamation rights only to have them rejected, but fail to timely file a 503(b)(9) claim, you can get stuck with a general unsecured claim. Generally, if you believe you may want the goods back, it is better to timely serve the reclamation demand and timely make a 503(b)(9) claim, but you will want to monitor the case to determine which option provides you the best recovery.

2. Can I stop goods in transit to a customer if I learn it filed for bankruptcy?

Generally, a seller has the right under the Uniform Commercial Code to stop goods in transit to a buyer if the seller determines that the buyer is insolvent or learns that the buyer has filed for bankruptcy protection. However, this right is only available if the buyer who filed has not yet received the goods. If a seller stops a shipment, the seller effectively forces the buyer/debtor to choose whether to “assume” the sale contract, which, as explained below, requires the buyer to pay for the goods in order to receive them and the benefits under the sale contract. If the buyer “rejects’ the sale contract, then the seller takes the goods back to inventory and can file a claim for any losses suffered by the rejection. 

3. What happens to my contracts with the debtor?

If you have an executory contract or a lease with a debtor, the debtor has the right to “assume” or “reject” the contract. If a debtor assumes the contract, then the debtor must cure any defaults under the contract, (including paying all past due amounts owed), and provide assurances to you that it can continue to perform after the contract is assumed. If a debtor “rejects” a contract, then the contract is deemed terminated as of the date that the debtor filed for bankruptcy protection, and you have a general unsecured claim for any damages that result from the termination.

With the exception of leases of commercial real estate, in a Chapter 11, the debtor has until the time a plan of reorganization is approved to decide whether to assume or reject a contract. (The deadline can get moved up if the non-debtor party to a contract makes a request and the bankruptcy court issues an order.) The timing of payment is within the bankruptcy court’s discretion. So, if you have a contract at the time the bankruptcy is filed, and you cannot get the debtor to agree to alter the terms, then you are stuck with the terms of the contract until the court decides otherwise. Any amendments proposed to an executory contract to be assumed by the debtor are subject to court approval. 

4. I’ve been pushing to get past due amounts paid by the customer, and I got it paid before the bankruptcy. Why am I being asked to pay the money back as a “preference?”   

Creditors that are paid within the 90 days before a bankruptcy filing on account of a pre-existing debt may be liable to return the payment as a “preference.” A debtor or trustee can seek the return of the preference payment even if the payment was warranted, due under a contract, and even if you had absolutely no reason to suspect that the debtor would later enter bankruptcy. Intent is not a factor. Instead, the purpose behind allowing debtors and trustees to claw back preferential payments is to increase equality among all unsecured creditors.

However, just because you get a preference demand does not mean that you are out of luck and forced to return the entire payment. One common defense to a preference claim is that the payment was received in the ordinary course of business between your company and the debtor. A second defense is that payments received were according to what is considered ordinary course terms in that customer’s industry. However, if your company has changed the manner in which you do business with the debtor during the preference period, (which often happens if you get wind of the debtor’s distress), then you can ruin or compromise your ability to use the ordinary course of business defense. If you change the method or timing of the debtor’s payments, then they may be able to argue that such payments were no longer in the ordinary course of business.

In addition to the ordinary course defenses, a creditor also has a defense to any payment to the extent it provides value to the debtor after the creditor receives the payment. In other words, imagine that you receive a payment of $1,000 on Day 1 for goods that the debtor has already received. Then, on Day 5, the creditor delivers another round of goods worth $2,000. That creditor would have $1,000 in preference exposure, and a new value defense of $2,000, meaning no preference liability at all.

Generally, creditors receive a demand letter for a preference, demanding all or a portion of the preference payments be returned to the debtor. If you get such a demand, you will want to have the billing and payment histories with the debtor carefully reviewed so that you can assess the defenses available to avoid liability.

5. I have a customer or vendor that I think is in distress and might file. What can I do?

If you become aware or suspect that a Chapter 11 filing is forthcoming and you want to extricate your company from the contract, you should consider taking steps to terminate it prior to the filing if there is a basis to do so.  Generally, a lease or contract that is validly terminated prior to a bankruptcy filing cannot be resurrected after the bankruptcy is filed. You should review the contract to determine if there are any notice requirements as a condition to termination. If so, the notice period must expire before the bankruptcy is filed in order for the contract to be validly terminated.

If you do not have a contract, you will still want to be careful in your dealings with distressed customers, particular when it comes to changing payment terms in methods, so that you can avoid potential preference liability or liability for a fraudulent transfer by the debtor. If a debtor files bankruptcy, a creditor’s correspondence and dealings with that debtor for period prior to the filing will come under careful scrutiny. To protect your company, keep good, orderly records, monitor the timing of payments, and avoid deviations in timing or method of payments. If unusual collection action becomes inevitable, consider contacting bankruptcy counsel for specific advice on options to mitigate any potential losses.
6. What should I do if a customer, vendor, or supplier tells me they have filed bankruptcy?

If a customer informs you of their bankruptcy filing, stop any further collection efforts, but ask for the following information:
            a. Date of the case filing
            b. Case number
            c. Court in which the case was filed
            d. Name and contact information for the debtor’s attorney

This information should then be provided to your own counsel if you retain counsel to assist you in the bankruptcy case.

If you have questions about this or related matters, please contact Mary.

This article was first published in the ACC South Carolina Chapter’s September 2020 newsletter.