5 considerations if your client files for bankruptcy

ARTICLE | September 14, 2020

Authored by RSM US LLP

In statistics recently published by the American Bankruptcy Institute, Chapter 11 filings have increased 35% in the first six months of 2020 over the last six months of 2019. We anticipate these numbers will continue to worsen in the coming months, and will affect a significant number of industry sectors.

So, how can a company minimize its financial exposure and maximize its potential recoveries should its clients or vendors face bankruptcy? RSM US LLP has outlined five key considerations:

1. How does a creditor file a claim and what is the structure of bankruptcy creditor classes?

The Bankruptcy Code defines a claim as: (1) a right to payment; (2) or a right to an equitable remedy for a failure of performance if the breach gives rise to a right to payment.¹ Shortly after filing for bankruptcy protection, the debtor company must file a schedule noting each of their creditors and the amount they believe is owed to that creditor. In the event a creditor disagrees with the amount listed, or disagrees with the debtor’s scheduling of the amount as disputed, contingent or unliquidated, the creditor must file a proof of claim with the bankruptcy court with documentation supporting their claim amount.²

Given that a company must be in financial trouble to declare bankruptcy and the administration of the bankruptcy process itself can be expensive, there is typically not enough cash available to satisfy each claimholder. Creditors’ claims are paid in a legal priority established by the Bankruptcy Code and case precedent. In general terms, major groupings of claims may encompass:

• Administrative claims represent amounts owed to those that provide court-approved goods or services to the bankruptcy estate, post-petition. Attorney and other professional fees associated with representing the bankruptcy estate are common examples. Other examples include post-petition vendors, post-petition debt obligations or other payments required by the court.  The amount of such claims is not known at the time of filing.
• Secured claims represent collateralized debt. Common examples include asset-based commercial lines of credit (collateralized against inventory, property, plant, equipment and/or receivables) and property mortgages.
• Priority unsecured claims are described in the Bankruptcy Code, section 507, and include certain taxes, employee wage claims, and debts related to goods and services provided to a debtor’s estate while the bankruptcy case was pending.
• Unsecured claims represent all other debt incurred and outstanding by the debtor business at the time of filing. Trade payables, such as unpaid amounts owed to suppliers and service providers, are the most common example of an unsecured claim.
• Equity claims, or claims of ownership interest such as common stock holders, are the lowest priority and rarely receive payment.

Each class of claims must be paid in full prior to the next subordinate class receiving payment. In certain circumstances, specific claims may be subordinated by court order (11 U.S.C. §?510). If funds are not sufficient to pay an entire class, the remaining funds are distributed pro rata among class members. For example, if unsecured claims total $100,000,000, but only $10,000,000 is available for the creditor class, each unsecured creditor would receive 10% of their claim amount.

Bankruptcy recoveries for lenders, creditors, equity holders and other parties in interest can be uncertain, and the facts and circumstances will vary in each case, so parties will need to inform themselves about their respective positions and potential outcomes in order to assess available strategies and responses.

2. What is an unsecured creditors committee and how can a creditor participate?

An unsecured creditors committee is appointed by the Office of the United States Trustee (the UST) and generally includes an odd-numbered group of unsecured creditors (typically three, five or seven) selected from the 20-largest unsecured claimholders.³ Shortly after the bankruptcy petition is filed, the UST will schedule a meeting of creditors to inquire about the status of the debtor’s business, reasons for filing bankruptcy and to form this committee. The committee will then organize and select professionals, such as lawyers and financial advisors, to represent the committee. The committee’s role is to monitor and scrutinize the debtor’s Chapter 11 process representing the interests of unsecured creditors. This committee and their representatives participate in meetings, court hearings and negotiations regarding the administration of the case and formulation of a plan of reorganization or liquidation.⁴

Participating on a creditors committee can be beneficial for those with a substantial stake in the matter and can help keep creditors informed and fairly represented. Professional fees for the creditors committee are paid for by the debtor’s estate, at no direct cost to the committee members.

3. What is a critical vendor and what are the benefits of becoming one?

The Bankruptcy Code provides an “automatic stay” which immediately halts many legal actions against the debtor, such as a creditor’s ability to collect outstanding debts from the debtor company. The stay commences at the moment the bankruptcy petition is filed and lasts until the debtor emerges from bankruptcy or liquidates, which can take years in some cases.⁵ The stay can be lifted by court order and actions against the debtor can be permitted to proceed depending on the issues involved.

Critical vendors are those deemed essential to the debtor’s immediate ongoing operations; this is a complicated area that has been extensively litigated, and the status and definition of the concept of critical vendors has evolved.  Designation as a critical vendor may allow the debtor to pay all (or a portion) of the pre-petition claim owed to such critical vendor during the bankruptcy process. Qualifying as a critical vendor can be challenging, with requirements varying by court district. A vendor could qualify if:

• Dealing with the creditor is virtually indispensable to the profitable operations of the debtor
• A failure to deal with the creditor risks probable harm or eliminates an economic advantage disproportional to the amount of the claim
• There is no practical or legal alternative to payment of the claim⁶

In many cases, there are negotiations between a debtor and its vendors preceding the filing of this motion, with a common sticking point being the vendors’ continued business relationship with the debtor during the bankruptcy process. The critical vendor motion is typically filed by the debtor on the first day or shortly after the commencement of a bankruptcy, highlighting the importance of proactive discussions between vendors and potentially insolvent customers.

4. What actions can a creditor take to reclaim or otherwise improve the chances of recovery on amounts owed for unpaid goods provided shortly before a bankruptcy filing?

Vendors may ship or deliver goods to a company shortly before the company files for bankruptcy protection. Goods may be in transit, or just delivered, and payments remain outstanding, or invoices may not have been issued yet, at the date of the bankruptcy filing.  This can result in vendors waiting for a significant amount of time for payment (months or years) and, depending on the outcome of the bankruptcy, vendors could ultimately receive only cents on the dollar for their sale. The Bankruptcy Code contains two provisions to aid creditors that find themselves in this position:

Reclamation – Section?546(c) allows creditors to reclaim (i.e., demand the return of) goods that were delivered prior to the bankruptcy filing while a debtor was insolvent. This statute has the following limitations:

• The reclamation demand must be in writing and made within 45 days of the receipt of the goods by the customer.
• The reclamation demand must be made within the 20-day period following the bankruptcy commencement date.

Administrative claim priority – Section 503(b)(9) allows the value of any goods received in the ordinary course of business by the debtor within 20 days before the date of commencement of a bankruptcy case to be treated as an administrative claim. This brings the claim to the “top of the pile” and significantly increases the chances it will be paid in full.

Companies should therefore act swiftly upon notification of a customer’s bankruptcy filing to determine what course they wish to follow and the necessary actions that may be required to meet the legal requirements of each option.

5. What are preference transfers and how can a creditor defend itself from litigation and clawbacks?

Chapter 5 of the Bankruptcy Code allows for a debtor estate to demand the return of certain transfers made in the months and years leading up to the bankruptcy filing.⁷ These are referred to in the Bankruptcy Code as avoidance actions. They are used to recover proceeds back into the bankrupt estate to reverse the impact of inequitable treatment and payments made to creditors prior to the bankruptcy filing. Preference actions are avoidance actions that seek to recover payments made by the debtor in the 90 days preceding the bankruptcy filing.

In general terms, defendants (e.g., vendors) who face a preference action for recovery of payments they received from the debtor have two primary defenses:

Ordinary course defense – this defense analyzes the nature of the business payment histories between the debtor and the vendor compared to others by using two tests:

• Subjective test – The subjective test analyzes the historical payment terms observed between the debtor and the transferee, both inside and outside of the 90-day preference period. If the transferee can prove the payments were made per the typical business arrangement between the parties, they may be able to avoid repaying the transfer to the bankruptcy estate.
• Objective test – The objective test analyzes applicable industry business standards as they relate to payment terms. If the transferee can prove the payments were reasonably in accordance with standard industry payment terms, they may be able to avoid repaying the transfer to the bankruptcy estate.

New value defense – This defense can apply when the transferee provided additional goods or services, subsequent to the payment in question that remained unpaid as of the bankruptcy petition date. In this case, the transferee could deduct the value of such transactions from the amount sought by the trustee.

In the event a company is served a complaint for preference transfers, they should consult with an attorney and financial advisor with industry and litigation consulting expertise.

In the coming months, wide-ranging economic troubles may have a profound impact on companies’ vendors and customers, which could in turn affect their business. Keeping these five things in mind will help companies to minimize their financial exposure and maximize their potential recoveries if their clients face the risk of bankruptcy.

<sub>¹ 11 U.S.C. § 101(5)

² Fed. R. Bankr. P. 3003(c)(2)

³  11 U.S.C. § 1102

⁴  11 U.S.C. § 1103

⁵  11 U.S.C. § 362

⁶  Binford, J. (2019, September 5). Not All Creditors Are Created Equal: Critical Vendors and Bankruptcy

⁷  11 U.S. Code Subchapter III—The Estate, notably sections 544, 545, 547, 548, 549, 550, 551, and 553(b)</sub>