Creditors Should Prepare Now For Increase In Customer Bankruptcies

Monday, December 1, 2008 - 00:00

With the decreased availability of capital and the resulting likely increase of bankruptcies, trade vendors should revisit their own credit practices and, in particular, the means for securing payment from their customers that eventually file for bankruptcy. With the knowledge that some of their credit customers are likely to face financial distress in the near future, vendors should realize that there are a number of protections afforded them by state and federal law that will decrease their exposure to a failed customer. While the United States Bankruptcy Code is intended to provide a moratorium period to those filing bankruptcy from the collection efforts of creditors, it recognizes many important state law remedies available to creditors and also contains several protections for creditors. Creditors should expect that the customer preparing to file for bankruptcy is being advised by competent counsel and is doing those things that will increase the chances of a successful bankruptcy and certainly do little that will benefit the creditor.

Warning Signs And Best Protections

For example, it has become common practice for a customer that knows it's going into bankruptcy to "stock up" on inventory just before filing for bankruptcy. This leaves the debtor with more inventory to sell during and after bankruptcy and more unencumbered cash to fund a reorganization. Of course, this leaves an unsuspecting and unprepared trade seller holding a larger claim against the debtor that is merely unsecured. The news can be even worse. If vendors are able to collect accounts from customers on their way into bankruptcy, those creditors should recognize and plan for the possibility that they may have to give some or all of those monies back to a bankruptcy trustee. In our practice, we have counseled clients on effective ways to collect their accounts from bankrupt debtors and, just as importantly, avoid having to return any monies they've already received.

It is vitally important that the trade vendor do what is necessary to avoid finding itself an unsecured creditor in a bankruptcy. Depending on the financial condition of the debtor, its forecasts of future performance and other factors, the Bankruptcy Code permits a bankrupt debtor to pay very little to an unsecured creditor to extinguish its debt. Distributions of less than 10 percent are common and these can have disastrous effects on the trade creditor that may be overextended itself. In the past, bankruptcy courts permitted debtors to pay unsecured creditors for pre-petition debt if they were deemed to be "critical vendors" but courts widely disfavor this practice today. To say the least, the unsecured creditor in any bankruptcy is not in an enviable position.

The most obvious and best type of protection is the letter of credit, prepayment, deposit, personal guaranty or other means of securing other funds or other sources of payment in advance of the credit transaction. The Bankruptcy Code permits the creditor to draw on a debtor's letter of credit or collect against non-debtor third parties, even without first obtaining court authority. However, these are difficult to obtain even in favorable economic conditions and may place the vendor at a competitive disadvantage in the marketplace. If they can be obtained, they should be obtained at the inception of the business relationship rather than obtained on the eve of bankruptcy where they are vulnerable to objection.

In the absence of prepayment or other source of payment, the most common means of obtaining protection for repayment is obtaining a lien to secure the obligation. The Bankruptcy Code protects creditors that have been able to obtain a lien to secure their debt. Typically, a debtor must either return the collateral to the secured creditor or pay the secured creditor the value of the secured claim. The secured creditor is in a far better position than the unsecured creditor in a bankruptcy case. However, the trade creditor must take those steps early since it will be too late to obtain security for prepetition debt once the customer files for bankruptcy or even within 90 days of a bankruptcy filing.

Liens To Secure Debt

There are a number of ways to obtain a lien to secure debt, but generally liens can be extended by agreement, by statute or by state constitution. The creation and perfection of liens is governed largely by state statutes, so a full discussion of each is beyond the scope of this article, but some generalizations can be made.

Consensual liens are the most typical liens, and there has been a focus in the recent past on strict interpretation of security agreements and filing statements. Bankruptcy courts will rely on the applicable state's version of the Uniform Commercial Code and recent changes to the UCC make it extremely important to adhere to the filing requirements. Strict care must be taken in properly identifying the exact name of the debtor, properly completing the UCC Financing Statement, and properly and timely filing it in the appropriate location. The trade creditor should not rely on identifying information given by the debtor on applications but should do its own investigation. For example, the trade creditor should review the Secretary of State records to identify proper names and learn of other primary lenders. The trade creditor should be certain that its security agreements and financial statements are in order because savvy counsel for debtors, trustees and competing creditors - who stand to benefit most from the failure of the trade creditor's lien - will be reviewing these documents closely to determine the validity of the lien.

Liens may, of course, arise by state statute and most creditors are aware of these. However, it is surprising how many trade creditors have failed to update their practices to comply with some of the more recent filing requirements under the UCC. Given the present economic climate, now is the time for trade creditors to make certain that they are complying with the requirements of state statutes. There are limited assets in any bankruptcy and it is important to recognize that the inventory vendor is competing not only against the debtor but against the debtor's primary or other lienholders. For example, inventory vendors may have valid purchase money liens if they've complied with the filing requirements but that lien will be of no use against a senior creditor to whom the vendor failed to give notice.

Industry-Specific Statutes

Trade vendors should also be aware of statutory liens that may have some particular application to their own business model. As an example, a vendor that provides special manufacturing processes to a customer's products on credit in a state granting possessory liens may have a lien in the customer's products that are in the vendor's possession. That vendor may claim a lien in those goods when the customer files for bankruptcy.

Vendors in certain industries are sometimes given special statutory protections that can be very effective in a bankruptcy. In some situations, statutes may elevate an otherwise unsecured trade creditor to a creditor with a lien in its goods and, furthermore, impose burdens on the debtor to hold those goods and any proceeds in trust. This is particularly effective as principals of the debtor who use those trust proceeds for other means can be personally responsible. Debtors in the restaurant industry, for example, now typically make special accommodations for payment of the vendors of their perishable agricultural products. Similar protections are afforded those creditors in the livestock industry. Consequently, it is important for the vendor to know of any special protections available to its industry.

Even if a creditor fails to obtain security, there are other limited situations where it can protect itself. An often overlooked remedy to the trade creditor is the state law right to reclaim goods delivered to the debtor, which is recognized and expanded in the Bankruptcy Code. A creditor who sells goods in the ordinary course to an insolvent customer can reclaim those goods within 45 days of delivery or, if the 45 days expires after the customer's bankruptcy filing, then 20 days after the bankruptcy filing. The creditor's rights are limited, however, if the debtor has already sold those goods or if the debtor's primary lenders have senior liens in those goods. There are also special provisions now in the Bankruptcy Code where the vendor can elevate its otherwise unsecured claim to an administrative priority claim if it has sold goods to the debtor within 20 days prior to a bankruptcy filing.

A lien is not infallible; even the properly perfected lien can be "crammed down" in a bankruptcy. In the situation where the amount of debt secured by the lien is more than the value of the underlying collateral, the debtor can "cram down" the amount of the secured claim. Any deficiency is classified and paid as an unsecured claim. A once fully secured creditor can quickly find itself with only a partially secured claim. If the trade creditor's collateral is depreciable, that vendor should consider additional means to secure payment. However, this usually occurs only in a Chapter 11 in which the debtor expects to emerge as a viable business and may still be a customer of the vendor and a better credit risk.

Going Forward

Beyond collection of one's debt, there are other advantages to having security when a customer files for bankruptcy. In most bankruptcies where distributions on claims to creditors are less than 100 percent, a trustee or creditors' trust can be expected to seek a return of preferential payments. These are payments made by the debtor to a creditor within 90 days prior to filing bankruptcy (or one year for an insider). Unsecured creditors are often surprised to find that not only are they getting paid little or nothing on their unsecured claims, but they may have to return to the trustee all of the payments they received on invoices in the 90 days prior to filing. However, one of the elements of the trustee's prima facie case is that the creditor must have received more than they would have received in a hypothetical Chapter 7 case. This means that the secured creditor, who should have received full payment in the hypothetical Chapter 7 on account of its collateral, is not liable to return payments received in the 90 days. Of course, if the value of the collateral underlying the debt is less than the amount of the debt at the time of the payment, then the creditor is partially unsecured and may have to return some of the payments received.

The trade vendor that is contractually obligated to sell to a customer is not relieved from its obligations just because the customer files for bankruptcy. Since contractual provisions that declare a default based on a customer's bankruptcy filing are void, the vendor should consult with counsel on how to deal with the bankrupt debtor and how to protect any collateral in the bankruptcy.

Should the trade creditor on open account continue to deal with a bankrupt debtor? It is difficult for any vendor to turn away any business and a customer's bankruptcy should not necessarily disqualify it from credit. In the absence of a contract, the vendor has no obligation to sell to a creditor, so the vendor can demand whatever protection it deems necessary including any of those mentioned above. The vendor's leverage is, of course, determined by the marketplace. In other words, the lucky vendor that offers limited or specialized products in a limited or specialized market can and should drive a hard bargain with a bankrupt debtor. Otherwise, the trade vendor should exercise caution in extending unsecured credit to a debtor. For example, the trade vendor should review proposals for interim funding of the debtor to determine the availability of funds for repayment. The Bankruptcy Code provides some protection to those vendors that extend credit to a debtor by giving them "administrative claims" or claims that are paid above other creditors. Keep in mind that an administrative claim is of limited use if the debtor has no money to pay them. Also keep in mind that an administrative claim against a Chapter 11 debtor has less priority if that debtor eventually goes into Chapter 7.

Russell W. Mills and Gerald P. Urbach are Shareholders in the Dallas-based firm of Hiersche, Hayward, Drakeley & Urbach, P.C. and have more than 55 years of combined experience in bankruptcy and business litigation. More information about the authors and firm is available by calling (866) 240-5197 or by visiting www.hhdulaw.com.

Please email the authors at rmills@hhdulaw.com or gurbach@hhdulaw.com with questions about this article.