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What should you do when a customer files bankruptcy?

What's your best course of action if a customer files bankruptcy? First, consider the size of the debt. If it's a small amount, it may not be worth the trouble to do much other than make sure your claim is listed. If it's a large amount, more action may be warranted. Here are some guidelines for dealing with a bankrupt customer.

Stop all collection activity immediately
Probably the most important thing to do when a customer files bankruptcy is to cease all collection activity immediately. This holds true even if you just hear about the bankruptcy or read about it in the paper. You do not need to receive formal notice. By law, you cannot ask for payment of any pre-bankruptcy-petition debts of a company. If you do, you will run afoul of the bankruptcy court and may end up having your entire debt disallowed. If the client owes you a large amount, contact someone knowledgeable in bankruptcy, such as Blackman's turnaround management consultants or an attorney specializing in bankruptcy.

All creditors are not created equal
The likelihood of recovering what you are owed will depend greatly on the nature of the debt, which determines where you stand in the line of creditors. Understanding this can help you decide whether to expend resources to pursue payment.

• The highest-priority creditor is the senior secured creditor; there may also be junior secured creditors. Taxing authorities may fall into one of these categories, depending on the circumstances.
• Administrative claims such as consultants approved by the bankruptcy court and vendors who continue to sell to the company during the bankruptcy have very high priority.
• Executory contracts where performance remains to be completed, such as leases, give the debtor the right to accept or reject the contract. If he accepts it, the debtor has to cure the default; if the debtor rejects the contract, the debt becomes unsecured.
• Unsecured debts, such as most trade payables, have lowest priority.

Look at the market value of the company's assets if sold in liquidation, or how much money the company might generate in a reorganization. Does the company have any hope of paying something to the creditors in your class?

Develop an action plan
Consider the impact of your client's bankruptcy on your business. If the loss of this receivable and customer will have a material impact on your business, develop an action plan; aggressively pursuing new business, temporary layoffs, etc., so you do not become the next bankruptcy. Begin with the assumption that you will not collect anything from your client in bankruptcy, or you will at least not receive anything for a long time.

Be sure you're on the schedule
When a company files for bankruptcy, it files a schedule of all its creditors and the amount owed, which is almost always inaccurate. When you receive a client's notice of bankruptcy, check to see if you are on the schedule, and for what amount and status. Whether you are or not, you may still need to file a proof of claim to put the court on notice, letting them know what your company is owed. If the amount is small, it is easy to fill out the proof-of-claim form yourself; you may obtain the form from the court clerk.  If your claim agrees with the schedule, there's not a problem; if it doesn't, you'll need documentation to prove your claim.

Attend the 341 meeting
When a company files bankruptcy, a U. S. trustee holds a 341 meeting to which all the creditors are invited. At the meeting, the trustee asks questions of the debtor under oath and opens the floor for anyone who wants to ask questions. A 341 meeting can be a non-event where nobody shows up, or it can be very contentious. If you have a large claim, you need to have a bankruptcy attorney represent you at the 341 hearing; that's where a creditors committee will be formed, and you want to be sure your interests are represented. Some bankruptcy cases can drag on for years; be prepared to wait. Continue to monitor the situation until it's resolved.

Move quickly
It's important to move quickly if you sell something to a company and then find out if it is in financial trouble. You have a right of reclamation allowing you 10 days to demand your goods back if the debtor is insolvent.

What can't you do?
As stated earlier, it is illegal to try to collect debts from a company in bankruptcy,even if you have not received formal notice of the bankruptcy filing. You also cannot refuse to ship to a company in bankruptcy until the previous debt is paid; that's technically trying to collect the old debt, and it can get you in deep trouble. However, you can refuse to ship new materials unless you're paid in advance.

When are sales to a bankrupt firm secure?
Doing business with a company in bankruptcy is not always a bad idea. After a company has petitioned for bankruptcy protection, its operating expenses have priority over unsecured pre-petition expenses, the only creditor with a higher security interest may be the bank with a secured loan. Once a company files for bankruptcy, its cash flow suddenly improves because it is not paying old debts, making it easier to pay its current operating expenses. If the debtor does not pay you for post-petition goods in a timely manner, you have a lot of leverage in court. If the debtor doesn't pay, it may wind up with a trustee appointed, or with its bankruptcy case converted from a Chapter 11, a reorganization to try to save the business, to a Chapter 7 liquidation.

Be careful of "preferences"
A "preference" is generally any money a debtor pays to you outside of the normal course of business in the 90 days preceding a bankruptcy filing, such as payment on an old trade payable. The court can order you to return those preferences to the debtor. If you are deemed an insider, the look-back period is one year.

• If you've received a large payment from a debtor in the 90 days before the company files bankruptcy, talk with someone knowledgeable in bankruptcy to help you determine whether or not you have a preference.
• What constitutes a preference? Amounts paid off in the normal course of business may not be considered preferences, unlike paying off old debts.
• Some debtors (bankruptcy attorneys) claim that if a company is insolvent, any amount it paid in the 90 days before filing bankruptcy is a preference. These attorneys will sue every creditor receiving a payment during that time, claiming that the amounts couldn't have been paid in the normal course of business due to the insolvency.
• If the company is a debtor in possession, its attorney can go to court and sue for the preferences. If a trustee is appointed to take the place of the debtor in possession, he can also sue for preferences.
• How many companies survive Chapter 11? Some statistics say only 15% survive more than a couple of years.

Know when to cut your losses
Be careful not to spend good money to chase after bad; realize that you may already have lost the amount owed you, and being actively involved in the bankruptcy may not do a thing to help you to collect it.

Take stock of your situation and choose the best course of action based on where you are today. For more information, please contact Patrick F. McNally, Partner in Charge of Corporate Finance Consulting, Blackman Kallick at 312-980-2934 or pmcnally@BlackmanKallick.com.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.