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Five Things You Need to Know About Your Customer in Bankruptcy

This year has presented unique challenges for business owners and management.  The economic crisis caused by the COVID-19 pandemic has driven people to work remotely, caused companies to curtail capital spending and hiring, and even led to reductions in force.  Additionally, the pandemic has pushed many distressed businesses over the edge and into bankruptcy, resulting in a sharp increase in Chapter 11 commercial bankruptcy filings. According to data compiled by Epiq Systems, Inc., the number of Chapter 11 commercial bankruptcy cases filed through October 2020 (6,081 cases) exceeded the total for all of 2019 (5,519 cases).  For many businesses, having a customer, client, or contract-counter party file for bankruptcy will be a reality if it hasn’t happened already.  This article will highlight various aspects of bankruptcy law and provide some practical pointers for a business dealing with a bankrupt business partner (“Customer”).

1. Don’t Keep the News to Yourself. 

When your Customer files for bankruptcy, it is important that you notify in-house counsel and your management team of the bankruptcy filing promptly so that they do not violate federal bankruptcy law by obtaining judgments, terminating contracts, sending demand letters, suspending service, or taking other prohibited action.  Additionally, bankruptcy gives rise to important deadlines for creditors, who seek payment from the Customer’s bankruptcy estate.  Failure to meet these deadlines will make it very difficult to obtain payments for amounts due.

2. The Customer is Now Protected by the Automatic Stay.

Once the Customer has filed for bankruptcy, all of its property vests in the bankruptcy “estate”.  The estate is, in essence, a new entity that holds all property interests of the Customer, including any product you shipped as well as your contract with the Customer.  For all practical purposes, you are doing business with a “new” Customer, which has significant legal ramifications. 

First, because of the bankruptcy filing, the Customer and its property are protected by the “automatic stay,” which prohibits you from taking certain collection actions against the Customer.   The stay makes it illegal for you to file a lawsuit to collect a pre-bankruptcy debt. In addition, you cannot continue pursuing an existing lawsuit and you must take steps to stop any ongoing collection action.  In most cases, the stay also prevents you from terminating your contract with the customer (e.g., supply contract, services contract).  Finally, you cannot take any action to obtain possession or control of the Customer’s property (e.g., repossession of consigned inventory).  It is imperative that you not violate the stay because doing so can result in severe monetary penalties, including an award of punitive damages in the most egregious cases.

3. Executory Contracts. 

In Chapter 11 bankruptcy cases, the Customer has an opportunity to evaluate whether to assume, or continue to be bound by, its “executory contracts,” i.e., those agreements where both you and your Customer have material obligations that are not yet performed.  The law recognizes many types of unperformed obligations, including, for example: 1) the requirement that one party provide workers to the other for installation, relocation, or removal of equipment that was sold under the contract, 2) the requirement that a party indemnify the other against certain claims or losses, 3) the requirement that either party maintain insurance against certain risks, and 4) the  requirement that the parties keep confidential certain information. 

If a contract is executory, you must honor it and perform your obligations thereunder until the Customer decides to assume or reject the contract.  Pending assumption or rejection, you may have certain rights to set-off, recoup, and/or suspend service, although you should consult counsel before exercising any remedy against the bankrupt Customer.

In order for your Customer to assume its contract with you, it must cure all defaults (including paying any undisputed amounts you are owed) and provide “adequate assurance” that it can perform (i.e., pay) under the contract in the future.  The Bankruptcy Code also permits your Customer to assign your contract to a third-party in certain situations (e.g., sale of the Customer’s assets).  Again, in order to accomplish this goal, the Customer, or the assignee, must cure defaults and must produce evidence that the assignee can perform all obligations under your agreement on a going-forward basis.  In certain limited situations, you may have a defense against assumption and assignment, depending on the circumstances of the case (e.g., state law prohibits assignment without your affirmative consent).  Importantly though, the Bankruptcy Code generally makes any contractual “anti-assignment” provision unenforceable.

Notably, if you terminated the contract with your Customer before the bankruptcy filing, that contract does not become property of the bankruptcy estate and the Customer has no right to assume or assign it.  For termination to be effective, you must have taken all necessary steps, and the Customer cannot have any remaining right of redemption, cure, or reversal either under the terms of the contract or under applicable law.  The language in the contract generally governs whether the default is curable.  Depending on the nature of the default, it is even possible for a court to permit the Customer to remedy the default even after the cure rights have expired.

4. Risks of Doing Business with a Customer in Bankruptcy. 

Now that your Customer is in Chapter 11 bankruptcy and you are performing under the contract, the Bankruptcy Code affords you certain protections for doing business with a company in bankruptcy.  First, any product you sell or services you provide to your bankrupt Customer on credit gives rise to an “administrative claim,” which the Customer is obligated to pay in the ordinary course of its operations in a timely manner.  If the Customer stops paying, you may seek an order from the Bankruptcy Court to compel payment.

Also, you must continue to supply product to the Customer under existing executory contracts and you cannot unilaterally change the payment terms of the agreement (e.g., you cannot impose “pre-pay” when contract requires “net-30”).  However, because your Customer has to provide you with some assurance that it can perform under the agreement while in Chapter 11 bankruptcy, including the ability to pay for purchased product, you may be able to negotiate shorter payment terms to reduce your risk.  This type of negotiation can be delicate so you must take extra care not to threaten to terminate the contract without first obtaining permission from the Bankruptcy Court.

5. Getting Paid for Pre-Bankruptcy Receivables.

Often when your Customer files for Chapter 11 bankruptcy, they will owe you money.  In order for you to get paid, you must file a proof of claim in the bankruptcy case.  The Court will set a deadline - the “claims bar date” - to file these claims.  You must timely file a proof of claim for any amount the Customer owes you as of the date they filed for bankruptcy.  If you fail to file a proof of claim by this date, you likely forfeit any right to payment for pre-bankruptcy receivables. 

If you are a supplier of goods, the Bankruptcy Code provides you increased protection by granting you an administrative expense claim for the goods you sold to the Customer that they received during the twenty days before they filed for bankruptcy.  Having such a claim is important in two ways.  First, an administrative claim is accorded higher priority in the payment scheme under the Bankruptcy Code, which means that you are much more likely to get paid for these amounts.  Second, in order to obtain court approval of a Chapter 11 plan of reorganization, the Customer must prove that it can pay these administrative expense claims when it emerges from bankruptcy (i.e., when the plan becomes “effective”). This requirement gives you significant leverage in any Chapter 11 case involving a Customer.

In light of the economic downturn, taking these steps will help you be better prepared if one of your Customers files for bankruptcy.

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The information contained here is not intended to provide legal advice or opinion and should not be acted upon without consulting an attorney. Counsel should not be selected based on advertising materials, and we recommend that you conduct further investigation when seeking legal representation.