Dealing with customers headed for bankruptcy (Part I)

As the nation's economic "recovery" progresses, many business owners know that collecting receivables remains a challenge. In the last issue of Legal Insights, we discussed practical collection tools that vendors could consider to increase the chances of getting paid. In this issue, we discuss considerations and possible options if your customer is heading for, or has actually filed, a bankruptcy case. This discussion assumes that both parties are businesses; the law relating to personal bankruptcies is not considered.


    Creditors' rights in bankruptcy cases derive from the U. S. Bankruptcy Code and the Federal Rules of Bankruptcy Procedure, which alone occupy almost 1,000 pages of lawbook text, together with state commercial and property law. The proper application of the provisions of the Bankruptcy Code, the rules and state law requires a careful legal analysis and a thorough understanding of the facts involved in each transaction. This, plus the fact that many applicable deadlines occur very quickly after the filing of a bankruptcy, means there is no substitute for early consultation with experienced counsel.


    Your rights as a creditor in part depend on what kind of case your customer files.

    A "Chapter 7" is a liquidation case, in which a debtor's estate containing all of the debtor's assets is created as of the day of filing, and a third-party trustee is appointed to collect, liquidate and distribute, on an equitable basis, the assets of the estate.

    A "Chapter 11" is a reorganization case, under which a debtor company deals with its pre-petition liabilities under the terms of a written plan of reorganization. Although a Chapter 11 debtor may reorganize and emerge from the bankruptcy case to continue to do business, the large majority of Chapter 11 cases these days are "liquidating Chapter 11s" that use special provisions of the Bankruptcy Code to liquidate the debtor's assets and distribute those assets to creditors.


    Your success in your customer's bankruptcy case will depend largely on what happened before the case was filed. The following are suggested steps you should take now to put yourself in the best position should your customer file a bankruptcy case:

    • Review your contracts, purchase orders and other commercial documents so that they correctly identify your customer, establish definite payment terms and set forth collection, termination and repossession rights upon nonpayment.
    • Evaluate the extent to which you have or can create a security interest in the goods sold or other assets (discussed in more detail in the Spring 2012 issue of Legal Insights). Generally, secured claims have a higher priority of payment in bankruptcy.
    • Understand your rights under Article 2 of the Uniform Commercial Code (UCC), such as the right to demand adequate assurance, reclamation rights and the right to stop shipped goods in transit.

      In a little-known right under Ohio's UCC, a vendor that sold goods on credit may demand adequate assurance of performance from its customer if reasonable grounds exist for insecurity in the prospect of payment. A vendor thereafter may suspend its performance (e.g., withhold any additional shipments) until it receives adequate assurance that the customer is able to pay.
    • Understand your statutory lien rights (mechanic's lien, warehouseman's lien).


    The filing of a bankruptcy case, under any chapter of the Bankruptcy Code, triggers an immediate and wide-ranging injunction, called the automatic stay, against the commencement or continuation of any action by any creditor against the debtor or the debtor's property. The automatic stay protects the debtor and its assets from creditors, under the oversight of a bankruptcy judge, so that the assets may be collected, liquidated and distributed, or used in the reorganization, in an orderly and balanced way.

    Among other things, the automatic stay prohibits the following:

    • Collection calls.
    • Beginning or continuing lawsuits.
    • Enforcing a judgment.
    • Taking a set-off against a pre-filing claim.
    • Receiving a new assignment, lien or security interest.
    • Repossessions.
    • Foreclosure sales.
    • Garnishments or other levies.

    The automatic stay remains in effect until any one of these events occurs:

    • A judge lifts the stay at the request of a creditor.
    • A plan of reorganization is approved.
    • An item of property is no longer property of the estate.
    • The bankruptcy case is closed.

    The automatic stay does not stop the following:

    • Criminal proceedings.
    • An eviction by a commercial landlord under an expired lease.
    • A tax audit, a demand for tax returns or an assessment of tax.

    Under certain circumstances, a creditor with a first priority lien or a mortgage against specific property of the debtor may be released from the automatic stay to seek recovery of its claim from that property. This requires filing papers with the Bankruptcy Court and giving the debtor and the other creditors an opportunity to object.

    Otherwise, creditor actions taken after the stay is in place are generally void or voidable; that is, any action the creditor takes in violation of the stay has no legal effect and may be set aside. In addition, a creditor that willfully violates the stay may be held liable for actual damages caused by the violation and sometimes even punitive damages. Therefore, a creditor should ensure that all of its employees who have responsibility for collecting accounts receivable are aware of the importance of observing the automatic stay.


    A supplier should be aware of a number of possible actions available to maximize its recovery in the event of a customer's bankruptcy.

    One such action, contained in Section 503 of the Bankruptcy Code, provides administrative expense status for the value of any goods received by the debtor within 20 days before the commencement of the case in a transaction in which the goods have been sold to the debtor in the ordinary course of business. Under the Bankruptcy Code, holders of administrative expenses have priority over holders of general unsecured trade claims in receiving distributions. In other words, an administrative expense claimant gets paid 100 percent before a general unsecured creditor gets a penny. When a Section 503 claim is asserted, issues are often raised concerning when the particular goods were received for purposes of the statute and the value of the goods.

—Bruce L. Waterhouse Jr.