What To Do When Your Customer Files For Bankruptcy

This is the fifth in a series of brief articles that Moye White is sending to its clients and friends to provide practical advice about the opportunities and challenges presented by today's economy.

With the current state of the economy, many businesses are experiencing the effects of a bankruptcy filing by a customer. Regardless of the type of bankruptcy filing (e.g., Chapter 7 or Chapter 11), you first should consult with your attorney and determine your rights and exposure as a result of the filing. Your customer’s bankruptcy filing results in the imposition of the “automatic stay,” which is an injunction that prohibits you from beginning or continuing any action against the customer based on your claim. Instead, you will need to file a proof of claim to evidence the amount and basis of your claim as well as any security interest applicable to your claim.

If the customer continues its business operations after filing under Chapter 11, you then should determine whether it is prudent to continue to do business with the customer. If you continue to do business with a customer after it has filed Chapter 11, it is critical to properly structure your business and financial arrangements with that customer to mitigate any potential post-bankruptcy losses.

If there is credible debtor-in-possession financing in place, you may feel comfortable extending a modest level of credit to your customer. If there is not, you may require your customer to go COD or even to prepay its orders. However you decide to structure your business relationship after a bankruptcy filing, post-bankruptcy transactions receive an “administrative priority” in the case. This does not guarantee that you will be paid, but means that your post-bankruptcy claims will be paid ahead of all pre-bankruptcy unsecured claims if there is not enough money to go around. Occasionally, however, Chapter 11 cases end up “administratively insolvent,” such that not all administrative priority claims can be paid. Thus, it is important to remain well-informed about the customer’s business and its prospects for reorganization during the Chapter 11 process.

If you shipped goods to your customer prior to the bankruptcy filing, there are avenues under the Bankruptcy Code to get your goods back and/or be entitled to an administrative claim. Prompt action after the case begins is required to preserve your rights.

If you have an uncompleted (“executory”) contract or a lease with your customer, there are some rather complicated provisions under the Bankruptcy Code that need to be carefully understood and applied to protect your rights to the maximum extent possible.

You may have a right of setoff or recoupment if you owe your customer money and your customer owes you money as of the beginning of the bankruptcy case, but this right is subject to the automatic stay described above and must be carefully utilized. Under certain circumstances, you may be able to reduce or offset the amount of your liability to your customer with the amount of your customer’s liability to you.

While every bankruptcy scenario has unique elements, effective communication with your attorney can allow your company to maximize its opportunity to recover on its claims in the bankruptcy case, and preserve a business relationship if you choose to do so.

For more information contact: Jim Burghardt, David Laird or Bo Anderson at (303) 292- 2900.

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Moye White LLP has prepared this bulletin to provide general information, however this bulletin does not provide legal advice and does not create an attorney-client relationship between the reader and Moye White. No legal or business decision should be based solely on the content of this bulletin.