A Basic Guide to Bankruptcy Laws for Trade Creditors

7/30/2019 A Basic Guide to Bankruptcy Laws for Trade Creditors

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A Basic Guide to Bankruptcy Laws

for Trade Creditors

Pia N. [email protected]

222 North LaSalle Street, Suite 800Chicago, Illinois 60601

Tel: 312.236.3003Fax: 312.236.3241

www.gouldratner.com


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Introduction

This outline describes bankruptcy and insolvency issues which frequently arise for (i) tradevendors and other unsecured creditors, (ii) parties who outsource certain manufacturing, mixing,

fabrication or storage functions and (iii) similar entities. This outline is designed to help youspot some key items that may be of concern, but it is not a substitute for seeking legal advice onhow to address a particular situation. This outline focuses on entities that file for Chapter 11reorganization, rather than Chapter 7 straight liquidation (which often involve no ongoingoperations and no prospect for recovery for unsecured creditors) or individual bankruptcy casesunder Chapters 13 (wage earners), 11 or 7.

Table of Contents

Involuntary Bankruptcy.................................................................................................................2

Preferences....................................................................................................................................3

Doing Business with a Chapter 11 Company/DIP Financing-Cash Collateral.............................5

Creditors Committees...................................................................................................................6

Property in Possession of a Bankrupt; Reclamation & 503(b)(9) Claims.................................7

Proofs of Claim..............................................................................................................................8

Timeline of Major Events in a Typical Chapter 11 Case..............................................................9

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Involuntary Bankruptcy

How to File: If there are more than 12 creditors, an involuntary bankruptcy filing requires threeor more creditors owed at least $14,4251 (subject to annual inflation adjustment) whose claims

are not the subject of a bona fide dispute. A secured creditor may count as one of these creditorsso long as the unsecured petitioning creditors hold at least $14,425 of unsecured undisputed debt.Note that there can be significant penalties for filing an involuntary petition without propergrounds to do so. You can also request an interim trustee if you suspect wrongdoing.

Debtor's Response: A debtor must generally respond within 15 days. The only valid defenses,assuming you have an unsecured undisputed debt against the debtor that you seek to file aninvoluntary against, are that (i) the debtor is generally paying its debts as they become due or (ii)a receiver for substantially all of the debtor's property has been in place more than 120 days. Aninvoluntary case can only be dismissed on notice to all creditors (i.e., the debtor cannot make thecase go away merely by paying off or otherwise striking a deal with the petitioning creditors).

Other creditors can join in the involuntary petition after it is filed regardless of whether thepetitioning creditors want them to do so.

Gap Period: While the automatic stay against collection efforts begins with an involuntaryfiling, many other protections in the Bankruptcy Code do not begin until the bankruptcy courtapproves the involuntary petition or the debtor consents to the bankruptcy. For instance, thedebtor is free to use or sell its assets as it pleases, although these transactions may be undonelater. Supplying goods or services to the debtor on credit during this Gap period is risky.

Major Reasons to Consider Filing an Involuntary Bankruptcy:

Suspect debtor is wasting, giving away or hiding assets;

Debtor is suspiciously unresponsive; Statutes of limitation on debtor's causes of action against others (such as its lenders or

insiders) are running, especially causes of action arising under the Bankruptcy Code;

Someone else is about to foreclose lien or otherwise dismantle the debtor; or Suspect debtor is considering filing bankruptcy in a venue inconvenient to creditors.

Major Reasons to Consider Not Filing an Involuntary Bankruptcy:

You still have realistic hope of receiving some payments on existing debt or you are stilldoing profitable business on a cash-in-advance basis;

You have recently obtained or are close to obtaining a judgment or consensual lien on

some or all of the debtor's assets to secure your debt; You may have preference or other exposure;

Your claim or other possible petitioners' claims are subject of bona fide dispute; or

Out of court restructuring offers better prospects for recovery/future business.

1 11 U.S.C. 303(b)(1) as amended December 1, 2010.

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Preferences

What is a Preference? A preference cause of action arises under the Bankruptcy Code. Thebasic concept of a preference is a payment or other transfer which causes one creditor to be

better off than similarly situated creditors. The key elements are a transfer of an interest of thedebtor in property (i) to or for the benefit of a creditor, (ii) for or on account of an antecedentdebt owed by the debtor before such transfer was made, (iii) made while the debtor was insolvent(rebuttable presumption), (iv) made within 90 days of the petition date (for non-insiders), and (v)that enables such creditor to receive more than it would have in a Chapter 7 liquidation. Thereare some affirmative defenses to preference actions that are set forth below.

Pre-Bankruptcy Preference Protection Planning: When a customer is not paying current andseems to be having financial difficulties that could lead to a bankruptcy, you will want to thinkcarefully about how incoming payments are being applied to minimize your preference exposure.For instance, you may want to:

CIA/COD/Subsequent New Value: Require that all future orders be paid on a cash-in-advance or cash-on-delivery basis, to avoid increasing your preference exposure. Even ifyou do continue to ship on credit, you will be entitled to claim any unpaid invoices afterthe date of the payment under the subsequent new value defense to a preference action.

Ordinary Course of Business Defense: Bolster your position under the ordinary course ofbusiness defense by applying the payment to the unpaid invoice which best fits the priorpayment pattern (rather than the oldest invoice, because such an application may often bethe worst choice for preference purposes). To determine this pattern, it is best to run abilling and payment history for at least the past year. You may want to talk with the

customer in advance about which invoice you want to be paid first because otherwisethey may designate other invoices for payment in the remittance information.

Promptly Cash the Check/Do Not Change Method of Payment: Some cases hold that thetransfer occurs not when you receive the check, but when the check is cashed. Someother cases hold that where payments were previously generally made by check, a changein the method of payment (e.g. by wire transfer) may be preferential.

Take the Payment: There is nothing wrong with receiving a preference (which of courseis payment on a valid debt). It is always possible that the customer will not filebankruptcy until 91 days or more after the payment, in which case you should be outsidethe preference window. Even if the customer does file within that window, there may bedefenses or at least the leverage that the bankruptcy estate has to sue you to recover thetransfer.

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Preferences Continued

Preference Demand Letters: Bankruptcy estates often send preference demand lettersprior to filing a complaint as a method to try to collect funds. This may be an opportunity

for you to settle any preference exposure cheaply or convince the trustee that most or allof the transfers are subject to a valid defense. A little time with a bankruptcy attorney atthis stage may avoid more substantial time and fees in defending a filed complaint later.

Preferences Other than Payments of Money: While most preference actions involvepayment of money, they can also involve other transfers such as (i) the granting orperfecting of a lien, (ii) the return of goods or (iii) other transfers of an interest inproperty of the customer. Note, however, that a draw under a letter of credit is generallynot considered to be a preference.

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Doing Business with a Chapter 11 Company/DIP Financing-CashCollateral

CIA/COD/Cash Deposit: After a filing, most vendors place a customer in Chapter 11 on a cash-

in-advance or cash-on-delivery basis. Given that many vendors' and customers' systems are notgeared towards doing business on this basis, customers sometime place a deposit with the vendorrepresenting the anticipated amount of orders for the upcoming period (week, month, etc.) andthen the vendor can ship until the deposit is exhausted.

Must I Continue to Do Business?: Even if you were giving trade credit to a company prior to itsfiling, you generally are not required to do so after the bankruptcy is filed. Indeed, you cangenerally choose not to do business at all with the customer after its bankruptcy. If, however,you have a contract or lease with the customer, you generally cannot simply cut them off. Theprofits from continuing to do business post-petition, especially if you are getting paid current,may take some of the sting out of the probable loss on at least a portion of the pre-petition debts

owed to you and may preserve a long-term customer for you (as opposed to your competitors) ifthe business is successfully reorganized or sold as a going concern in the bankruptcy case.

Efforts to Collect Pre-petition Debt: Because the automatic stay prohibits collection efforts, youmust be careful to distinguish pre-petition from post-petition obligations of the customers in yourcorrespondence and billing statements and apply post-petition payments to post-petitionobligations. Unsecured claims generally do not get paid until a Chapter 11 or 13 plan isconfirmed or a Chapter 7 final report is filed. Payment then is only pro rata, to the extent thatthere are funds available for unsecured creditors, after payment of secured, administrative,priority and reclamation claims.

DIP Financing/Cash Collateral: In many Chapter 11 cases, there is a first day motion forapproval of interim debtor-in-possession financing or usage of cash collateral with a finalhearing scheduled shortly thereafter (often 15 to 30 days later). The lender in these situationstypically tries to encumber all of the assets of the debtor to maximize its prospects for recovery,including currently unencumbered assets which may be your best chance for recovery.Therefore, whenever someone in your company receives notice of the commencement of abankruptcy or notice of a financing/cash collateral motion or order, it is important to haveinternal procedures in place to make the appropriate officers within the company aware of thebankruptcy and to make a prompt determination whether the company's stake is big enough toconsult with counsel before prejudicial financing or other orders become final and non-appealable in the bankruptcy case.

Giving Credit Based on DIP Loan: Sometimes, bankrupt customers will ask for post-petitionextension of trade credit and recite the fact that they have a sizeable DIP loan or permission touse cash collateral as grounds for suggesting that you will be paid for such shipments or services.Without understanding more about the terms of the loan facility (including events of default andremedies, any special priority for post-petition trade credit and the total duration and size of thefacility), it is best to be cautious in these situations.

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Creditors' Committees

Purpose: In many Chapter 11 cases, an unsecured creditors' committee is formed early in thecase. Its role is to investigate, negotiate and, if appropriate, file pleadings which protect the

interests of unsecured creditors generally.

How is a Committee Formed?: A committee is formed by the Office of the U.S. Trustee, whichis an adjunct of the bankruptcy court. The U.S. Trustee generally mails a questionnaire to the 20largest unsecured creditors as listed in the debtor's petition and sets a date for an organizationalmeeting for the committee. If you are interested in serving, you should promptly complete andmail back the questionnaire. If you cannot attend the formation meeting, it is a good idea to callthe U.S. Trustee's office to reinforce your interest. It is common that counsel and any financialadvisors for the committee are selected immediately after or within a few days of theorganizational meeting, especially if there is a lot happening in the bankruptcy case. Manypotential committee members already have one or more candidates in mind to serve as

committee professionals and discuss their candidates with other potential members of thecommittee in advance. These professionals are paid from the bankruptcy estate.

Expenses of Serving as Committee Member: The out-of-pocket costs of committee members aregenerally paid as an administrative expense of the Chapter 11 case. This includes travel to anyin-person committee meetings, telephone calls, postage for packages, etc. It generally does notinclude any imputed or other hourly rate for your time or the time of other persons who mayassist you in the process. Many committee meetings are held telephonically, especially if themembers of the committee are based in diverse geographic locations.

Benefits of Serving: By serving on a creditors' committee, you will likely:

Receive better and more up-to-date information on what is happening in the case thanmost other unsecured creditors; and

Have an influence on whether the customer's business survives and the terms of any planof reorganization or going concern sale.

Possible Disadvantages of Serving: Disadvantages of serving on a creditors' committee can arisefrom the fact that (i) you will likely be required to sign a confidentiality agreement and (ii) youwill have a duty to consider the interests of all unsecured creditors generally (which is notexclusive of your ability to protect your own self-interest). This can be problematical when:

You want to buy certain assets of the bankrupt or solicit some of the debtor's employeesor customers away;

You want to sell your claim; or You have other issues which may put your interests at odds with the interests of other

unsecured creditors in general.

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Property in Possession of a Bankrupt;Reclamation & 503(b)(9) Claims

In General: Situations where your property is on-site at the location of another entity which is

going through foreclosure or bankruptcy can be quite difficult. This is especially of concern forunfinished machines or unmixed product where you have largely paid for the service to berendered but the work is not yet completed. Even if you ultimately succeed in getting yourgoods or other property returned to you, the delay in doing so may cause you to breachobligations to any intended end-purchaser and result in claims for damages against you. Therecan also be substantial litigation in any bankruptcy to establish that the property belongs to youand is not subject to the claims of the creditors of the other party.

Prior to Entering into Relationship: In situations where you suspect in advance that the party isfinancially troubled but you still want to do business with them, there are precautions you cantake to improve your position. These include:

Legal documents with the other party acknowledging that the goods/equipment belong toyou;

Segregation and/or marking of your property on-site; and An acknowledgment from the partys working capital lender and other potential

lienholders that the property belongs to and can be removed by you at any time and thatthey have no lien or other rights regarding your property.

Consignments and similar legal structures have strict requirements which must be met to havethem serve their intended purpose and therefore, the legal documents and notices must be doneproperly.

Problems After Relationship has Begun: In situations where you do not know about thecompany's financial troubles until after the relationship is in place, there are still protectionswhich may be available if you act promptly. These may include:

Any of the steps described above;

Making sure all finished goods are promptly shipped to you and all work in progress ispromptly finished;

Attempting to remove your property from the site; or

Changing the terms of any future orders/property you are going to place with them.

Specialized Products: In cases involving specialized property, you may be the only customer,which may give you leverage. On the other hand, any difficulties or delays in your sending theproduct elsewhere gives the bankrupt party and its creditors leverage to seek to extract more thanthe agreed purchase price from you. If some of the property is proprietary, you will want tomake sure that the information (including any molds or formulas) is kept confidential and assertpossible restrictions on the ability of the other party or its foreclosing lender to sell that propertyor product to others.

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Reclamation: Section 546(c) of the Bankruptcy Code preserves the rights of a "seller of goodsthat has sold goods to the debtor, in the ordinary course of such seller's business, to reclaim suchgoods if the debtor has received such goods while insolvent, within 45 days before the date of thecommencement of a case under this title, but such a seller may not reclaim such goods unless

such seller demands in writing reclamation of such goods l (A) not later than 45 days after thedate of receipt of such goods by the debtor; or (B) not later than 20 days after the date ofcommencement of the case, if the 45-day period expires after the commencement of the case."

Often times a debtor that is expecting to receive many reclamation demands will enter areclamation procedures order at the beginning of the bankruptcy case. Any such demands mustcomply with the terms of any order setting forth a uniform reclamation procedure in order topreserve the creditor's claim. In these instances it is often best to contact bankruptcy counsel asdebtors often attempt to catch reclamation creditors asleep at the wheel and subsuently deny suchreclamation claims and demands.

503(b)(9) Claims Section 546(c) provides that if a seller fails to comply with its terms that acreditor may still assert its rights under 503(b)(9). This provision of the Bankruptcy Codeprovides that a creditor will be granted an administrative claim (which usually means the creditorwill be paid 100% of its claim) for "the value of any goods received by the debtor within 20 daysbefore the date of commencement of a case under [Chapter 11] in which the goods have beensold to the debtor in the ordinary course of such debtor's business."

Again, creditors should be mindful of any 503(b)(9) procedures order and 503(b)(9) claimsbar date. Consult bankruptcy counsel if there is any uncertainty.

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Proofs of Claim

Bar Dates: In Chapter 11 cases, known creditors are supposed to be sent actual notice of the bardate for asserting pre-petition claims. If you are aware that any entity you may do business with

is in bankruptcy but have not received a bar date notice yet, it is prudent to determine whether abar date has been set, which generally can be done through phone calls or checking electronicdockets in the case. Upon emergence from bankruptcy, a bar date for administrative claimswhich arise during the bankruptcy case may sometimes be established as well.

Relying on Scheduled Amounts: In a Chapter 11 case, if you agree with the amount set forth inthe debtor's schedules for your claim and the debtor did not schedule such amount as contingent,unliquidated or disputed, you are not required to file a proof of claim, but many creditors still dofile a proof of claim as a matter of prudence.

Gathering Information: The better practice is for creditors to attach supporting documents

(invoices, contracts, etc.) to their proof of claim. You will also want to think through whetherthere are any contingent or unliquidated claims (indemnities, product warranties, etc.) whichshould be preserved in the proof of claim, as well as any basis for asserting that at least a portionof the claim is secured or entitled to priority. Counterclaims giving rise to setoff rights may bethe basis for asserting a secured claim. Contract based claims generally should be reviewed withcounsel.

Multiple Debtors: Often, there are two or more related entities who file bankruptcy. Theprospects for recovery by their respective unsecured creditors may be quite different. You willwant to understand each of these entities, their available assets and how they relate to thebusiness you conduct with them. For instance, your goods may have been sold to a subsidiary

with assets, but you may have sent your bills to the parent's headquarters which does not havematerial assets.

Logistics: In some larger cases, proofs of claim must be logged at a post office box andtherefore, facsimile or timely overnight courier delivery of the proof of claim may not bepossible. In such cases, it is a good idea to allow some lead time before the bar date for filing theclaim. It is also good practice to include a duplicate copy of the claim and a return self-addressed envelope so you can receive a file stamped copy of the claim for your records.

Late Claims: The Supreme Court has permitted filing of late claims after the bar date if there isa sufficient showing of excusable neglect. While it is always more desirable to timely file aproof of claim, you should discuss any late filed claim issues with counsel as soon as you areaware of the situation.

Claims Purchasers: In an increasing number of cases, claims arbitrageurs mail general offers tobuy unsecured claims. These may allow you immediate liquidity but also generally involvesome discount from the ultimate expected recovery for unsecured creditors. Claims arbitrageursoften request that you represent that your proof of claim will be allowed in the amount assertedby you and give them an indemnity if the ultimate face amount of your allowed claim is less.

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Timeline of Major Events in a Typical Chapter 11 Case

The following is a list of major events which commonly occur in a typical Chapter 11 case. Notall of these events occur in all cases, nor do they always occur in this order.

Reclamation Demands

Voluntary or Involuntary Bankruptcy Petition

Interim DIP Financing or Cash Collateral Motion and Other First Day Orders

Creditors' Committee Formation Meeting Convened by U.S. Trustee's Office

Creditors' Committee Forms and Selects Professionals

Final DIP Financing and Cash Collateral Order

Schedules of Assets and Liabilities and Statement of Financial Affairs Filed (which mayprovide a first rough glimpse of what the prospects for recovery by unsecured creditorsare and potential preference exposure)

Meeting of All Creditors (341 Meeting) and Opportunity to Question Debtor

Commercial Landlord Related Pleadings Going Out of Business Sale Motions/Rejection of Certain Unfavorable Leases and

Contracts

Creditors' Committee, Secured Creditors and Debtor Negotiate About Plan ofReorganization and Going Concern Sale Exit Strategies

If Exit Strategy Negotiations are not progressing well, you may see (i) Motions to Lift theAutomatic Stay by Secured Creditors, (ii) Motions to Terminate the Debtor's ExclusivePeriods to Propose and Solicit Acceptances of a Plan, (iii) Motions to Appoint a Trusteeor Examiner or (iv) Motions to Dismiss the Bankruptcy Case or Convert the Case to aChapter 7 Liquidation

Bar Date for Filing Pre-Petition Proofs of Claim Set

Going Concern Asset Sales

Claims Arbitrageur Solicitations

Plan Confirmation

Administrative Post-Petition Claims Bar Date

Claims Processing

Distributions to Creditors under Confirmed Plan

4835-8775-8345, v. 1

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A Basic Guide to Bankruptcy Laws for Trade Creditors

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