Minimizing (some) of the Pain of a Customer’s Bankruptcy

The COVID-19 pandemic may be waning, but the damage and disruption to all sorts of businesses caused by it linger on. Although new bankruptcy petitions filed thus far in 2021 are substantially fewer than the record number filed in 2020, consumer-facing businesses remain vulnerable to external conditions beyond their control with a likely ripple effect throughout the economy.

A bankruptcy filing by a significant customer almost always carries painful consequences to a supplier or service provider. Those consequences are, in no particular order of pain –

• Uncollectible accounts receivable – A supplier’s accounts receivable are instantly transformed by the customer’s bankruptcy petition into “unsecured pre-petition claims,” none of which can be paid or collected until the debtor’s liquidation or its confirmed plan of reorganization (in the case of a Chapter 11 proceeding). In both the liquidation and reorganization scenarios, a distribution to unsecured pre-petition creditors is a rare and beautiful thing. It can only occur if the debtor has assets remaining after (1) all higher priority claims are satisfied in full, and (2) the allowed administrative costs of the bankruptcy proceeding are paid. Legal fees figure prominently in this category of claims superior to pre-petition receivables. I typically advise a client or its accountant to set up a 100% bad debt reserve when a customer goes bankrupt.
  
  
• Permanent loss of a customer – Businesses ordinarily file for bankruptcy when their economic situation is so dire that they have no alternative. Many – perhaps most – bankrupt businesses never resume operations after the conclusion of a bankruptcy proceeding. In those cases, the creditor that has written off its receivables will also have to face the fact that its customer has gone up in smoke.
  
  
• Avoidable Preferences – Finally, and the principal focus of this blog, is what I often call the “salt in the wounds” provision of bankruptcy law. Avoidable preferences (Section 547 of the Bankruptcy Code) are the enforced re-payments by the creditor of accounts receivable collected during the 90-day period preceding the filing of the bankruptcy petition (the “preference period”). Not only does the creditor lose its outstanding receivables and what may once have been a valuable customer, it usually gets hit by a claim that it “disgorge” (what an ugly word!) all payments made by the debtor during the preference period.

Statutory defenses available to a creditor
Enforcement of avoidable preferences, a true insult added to a previously absorbed injury, typically begins when the creditor receives a letter from the debtor’s attorney or its trustee demanding payment of all amounts paid by the debtor during the preference period in the amount as set forth in the letter. If the distraught creditor is my client, my immediate advice – made in blissful ignorance of the pertinent facts – is “please do not write out a check until we look at the possible statutory defenses.”

This is not frivolous advice. The Bankruptcy Code provides a number of defenses that often are available to the besieged creditor. It is not uncommon for one or more of these statutory defenses to fit the creditor’s circumstances, more or less comfortably. In many cases, the fit is close enough to provide the basis of a coherent argument that will lead to an economically tolerable settlement.

Now we’ve come to the hard part – the explanation of the Code’s principal statutory defenses. The statutory language itself and the many judicial opinions interpreting the statutes are convoluted and inconsistent. The unique facts of each case weigh heavily on the applicability of any defense. Hopefully, the below summary will be comprehensible to anyone reading this post:

• The “Contemporaneous Exchange for New Value” Defense – This defense can be used in a case where the payment to the creditor was made and intended to be in exchange for the delivery of something of equivalent value to the debtor. For example, think about a C.O.D. delivery of a part required by the debtor to complete the assembly of a product to enable its sale by the debtor. “Contemporaneous” does not necessarily mean “simultaneous” (as in the case of my C.O.D example), but it does mean close in time. The courts are all over the place as to how close the payment must be – 10 to 14 days seems to be the outer limit of “contemporaneous.”
  
  
• The “Ordinary Course of Business” Defense – The Bankruptcy Code provides that a payment is not a “preference” if (A) it is associated with a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the creditor, (B) payment is made in the ordinary course of business or financial affairs of the debtor and the creditor, and (C) made “according to ordinary business terms.”
  
  The financial records of both the creditor and the debtor must be consulted to determine whether clauses (A) and (B) apply. In the ideal case (which I have never actually seen in my many years of practice), the records will show that the creditor delivered product to the debtor on let’s say the first day of each month and that the debtor paid the invoices for such products within let’s say thirty days of delivery. Only a reasonable level of correspondence between the time of delivery or performance by the creditor and the time of payment by the debtor is necessary for this defense to work. The practical problem is that debtors typically fail to maintain their usual payment schedules as they spin into insolvency and bankruptcy and their payments become increasingly erratic. (By the way, I have never encountered clause (C) of the statute, which is intended to avoid payments made under idiosyncratic terms that are unusual in the industries of the parties. 

• The “Subsequent New Value Defense – This is, in my experience, the most useful of the statutory defenses. In the fewest possible words, this defense defeats the preference claim if the creditor provides “new value” after it has received the preferential payment (e.g. the creditor continues to sell and deliver product to the customer after receipt of the payment that is alleged to be preferential). Remember, the customer is in financial difficulty. Its current payment history is erratic. The creditor is incurring a risk that its customer will be unable to pay for the goods or services that it continues to provide. The prudent creditor/vendor will need to carefully weigh the risk of continuing to do business (and create new accounts receivable) with a financially stressed customer against the assurance that it will be legally entitled to retain the payments that it has received. It almost always makes sense for a creditor to accept whatever payment the customer can squeeze out and continue to do a low level of business with a financially distressed customer. Preferences are not illegal even if they may be avoidable.

To sum up, bankruptcy is a legally and commercially complex subject with outcomes depending on the unique characteristics of the relationship between the creditor and the debtor that winds up in bankruptcy. Every business entity that provides goods or services on open account is exposed to being dragged into the swamp of a bankruptcy proceeding. Unfortunately, the typical business entity cannot – as a practical matter – make the kind of credit evaluation of a prospective customer that a prudent commercial lender will make of a prospective borrower, nor can it obtain a security interest in the assets of a customer or erect other protections against the risks of a customer’s insolvency.

When a company finds itself a creditor of a bankrupt customer or client, and that happens to the best of us, it should understand that it is in dangerous territory. However, with the right help, minimizing losses may be possible. If you would like to learn more about the defenses available to creditors when a preference avoidance claim is raised, please contact Lew Segal at lsegal@outsidegc.com.

Lew Segal is a Member of Outside GC’s New England-based team with extensive experience as a business lawyer and senior business executive. His practice has focused on business entity formations, acquisitions and divestitures, complex contract negotiation and drafting, corporate and commercial financing, and advising senior corporate management teams and boards of directors on a wide range of issues, including bankruptcy filings by customers or clients. Lew can be reached at lsegal@outsidegc.com.