What to Do When Your Customer Files Bankruptcy

If your factor assumed 100 percent of the credit risk, you can stop reading this article and go to the beach. However, if any part of the credit risk is yours, there are several issues you might want to consider and take appropriate action. Although your customer’s bankruptcy may involve numerous issues and activities that may have an effect on what action you might consider, here are 10 things, at a minimum, to look at:1. Reclamation The reclamation provision of the Bankruptcy Code (“Code”) traces its origins to the common law under which an unpaid seller of goods who was defrauded into extending unsecured credit to a buyer had the right to rescind the sale and recover the goods. This common-law right was eventually codified by the Uniform Commercial Code (“UCC”). The Code adopted the UCC provision in part, and the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) extended the UCC reclamation period to goods delivered within 45 days prior to the commencement of the bankruptcy case.

The Code contains several hoops through which a creditor must jump in order to obtain the return of the goods—and the unpaid seller’s rights are subject to the superior rights of a secured creditor holding a perfected security interest in inventory.

2. Administrative Expense BAPCPA added a new provision to the Code that gives an unpaid unsecured creditor a priority expense claim for goods received by the debtor within 20 days before the commencement of the case. Priority claims are paid before those of general unsecured creditors. However, the claim must be asserted in a timely manner, and other restrictions may apply.

3. Request for Notice A great deal of court activity takes place in the early stages of a Chapter 11 bankruptcy case: financing motions, motions for authority to pay employee wages, honoring gift certificates, paying critical vendors and paying to retain professionals, to name a few activities that might affect the outcome of the case. Although you may be one of the 20 largest creditors ordinarily included on the list to receive notice of all court filings, consider filing a “Request for Notice.” It’s a good idea to consult with a bankruptcy attorney to prepare the request in proper form and have it be served on all of the individuals and entities shown on the master mailing list that the debtor had to file with the court.

4. Creditors’ Committee If you are eligible to do so, consider serving on the Unsecured Creditors’ Committee. The debtor is required to file with the court a list of its 20 largest unsecured creditors. From that list, a committee of five to seven creditors is appointed by the United States Trustee serving the court where the bankruptcy is pending. Those creditors who are on the “top 20” list and wish to serve are invited to complete a simple questionnaire.

Service on the committee can be an enlightening experience. The committee may consult with the debtor concerning the administration of the case to investigate the acts, conduct, assets, liabilities and financial condition of the debtor; the operation of the debtor’s business; the desirability of the continuance of such business; and any other matter relevant to the case or to the formulation of a plan of reorganization. The committee may participate in the formulation of a plan of reorganization, advise those represented by the committee of the committee’s determinations as to any plan that is formulated, and collect and file with the court acceptances or rejections of the plan. The committee can also request the appointment of an examiner or a trustee to take over the operation of the debtor’s business.The Code gives the committee very broad powers to perform “such other services as are in the interest of those represented.”

The committee can retain the services of attorneys, accountants and other professionals at the expense of the bankruptcy estate. Although committee members are not paid for their services, they can be reimbursed for reasonable and necessary expenses incurred in carrying out their duties. These usually include transportation, meals and lodging expenses.

5. Proof of Claim Consider filing a proof of claim as soon as possible, unless you have a reason not to subject yourself to the jurisdiction of the court. Even when a reclamation demand has been made, a separate reclamation proof of claim should be prepared and filed with the clerk of the Bankruptcy Court. If money is owed because of prior unpaid shipments that were not shipped with factor approval, a separate proof of claim should also be filed. Although most factors will be diligent in filing proofs of claim on their own behalf, it doesn’t hurt to gently remind the factor to file a proof of claim to include whatever money is owed to you by the debtor. When filing a proof of claim, the approved form should be used. The advice and assistance of a bankruptcy attorney is helpful to be certain that all of the required supporting documentation and information is included.

6. Preferences In proceedings under Chapter 11, as well as all other chapters, the debtor, through its financial advisers, may conduct an analysis of preferences and fraudulent transfers that may be recovered to increase the debtor’s estate. These activities require not only a thorough comprehension of the debtor’s bookkeeping systems and methods but also an in-depth knowledge of applicable bankruptcy law. The debtor’s bankruptcy professionals will be called upon to analyze insider preferences, non-insider preferences and fraudulent transfers.Insider preferences are those that occur within the one-year period prior to the filing of bankruptcy to those individuals and entities designated as “insiders” by the Bankruptcy Code. Non-insider preferences are those that occur within the 90 days preceding the filing of the bankruptcy. Fraudulent transfers under the Code are those that occur within the year preceding the filing of the bankruptcy. However, under California law, the Uniform Fraudulent Transfer Act, the bankruptcy trustee or the debtor in possession can recover fraudulent transfers that were made within four years and, in some cases, up to seven years prior to the time the bankruptcy petition is filed.

If your company received payment from the debtor on non-factored invoices within the 90 days preceding the commencement of the bankruptcy case, and such payment was for past-due amounts or meets other specified criteria, a claim against the company to recover the preferential amount may be brought. A bankruptcy attorney should be consulted if your company is the subject of such a claim.

7. Fraudulent Transfers A fraudulent-transfer claim against your company as a supplier, although highly unlikely, might also be brought under the appropriate circumstances. Consider a situation involving the sale of goods for $100 per garment and the buyer runs into financial difficulty. He asks the seller to take back the goods for full credit. The seller refuses to do so but will take them back for a credit of 30 cents on the dollar. The buyer agrees, returns the goods, gets the credit and files bankruptcy. The debtor or a trustee then sues the seller on a fraudulent-transfer theory, claiming that the buyer received less than the fair equivalent value on the return and demands the payment of the other 70 cents on the dollar. Yes, that could really happen! 8. Trademark Protection If your company, pursuant to a distribution or license agreement, provided to the debtor trademarked goods or rights to use your trademark, consideration should be given to the debtors’ intentions regarding the liquidation of its inventory bearing the mark.

Frequently, poor-performing stores in a retail chain are closed and the inventory is turned over to a liquidator and sold at greatly reduced prices. If you have trademarked goods in the stores being liquidated, consideration should be given to initiating appropriate actions in the bankruptcy court to prevent diminution of the value of the mark.

9. Disclosure Statement and Plan of Reorganization At some point in the Chapter 11 case, a plan of reorganization will be prepared. However, if the plan provides for anything other than full payment to all creditors, a disclosure statement must be prepared, and court approval of its provisions must be obtained before consents to the plan can be solicited. The disclosure statement must contain sufficient information to enable a creditor to determine whether or not to vote in favor of the plan. When you receive the disclosure statement, read it carefully and then decide whether to vote in favor of or against the plan. 10. Consult a Bankruptcy Attorney When your customer files bankruptcy, whether under the reorganization provisions of Chapter 11 or the liquidation provisions of Chapter 7 of the Code, various options are available. No two bankruptcy cases are alike, and each will present a different array of options. If your claim is of a significant amount, a bankruptcy attorney should be consulted prior to initiating any action.

Conclusion In spite of what you may hear to the contrary, there are Chapter 11 cases where unsecured creditors receive payment in full. There are other cases where unsecured creditors receive significant dividends because of the actions of creditors’ committees. Bankruptcy is complicated, expensive and confusing. If you want to do everything possible to maximize your recovery, consider the matters discussed in this article, and if you have any questions, ask a bankruptcy attorney.

Benjamin Seigel is a shareholder with the law firm Buchalter Nemer, practicing in the area of insolvency and financial solutions. He can be reached at bseigel@buchalter.com.

Buchalter Nemer is a full-service business law firm representing national and global clients in eight primary areas of practice: bank and finance, corporate, insolvency and financial solutions, litigation, labor and employment, intellectual property, real estate, and tax and estate planning. The firm has offices in Los Angeles; Orange County, Calif.; San Francisco; and Scottsdale, Ariz. For more information, visit www.buchalter.com.

This article is published as a service to clients and others. The material contained here is provided for informational purposes only and is not intended to constitute advertising, solicitation or legal advice.