A Basic Guide to Bankruptcy Laws for Trade Creditors

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A Basic Guide to Bankruptcy Laws

for Trade Creditors

Pia N. Thompson

312.899.1630

pthompson@gouldratner.com

222 North LaSalle Street, Suite 800

Chicago, Illinois 60601

Tel:

312.236.3003

Fax:

312.236.3241

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Introduction

This outline describes bankruptcy and insolvency issues which frequently arise for (i) trade vendors 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 you spot some key items that may be of concern, but it is not a substitute for seeking legal advice on how to address a particular situation. This outline focuses on entities that file for Chapter 11 reorganization, rather than Chapter 7 straight liquidation (which often involve no ongoing operations and no prospect for recovery for unsecured creditors) or individual bankruptcy cases under Chapters 13 (wage earners), 11 or 7.

Involuntary Bankruptcy

How to File: If there are more than 12 creditors, an involuntary bankruptcy filing requires three or 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 creditors so 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 proper grounds 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 an involuntary 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. An involuntary case can only be dismissed on notice to all creditors (i.e., the debtor cannot make the case 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 the petitioning creditors want them to do so.

Gap Period: While the automatic stay against collection efforts begins with an involuntary filing, many other protections in the Bankruptcy Code do not begin until the bankruptcy court approves the involuntary petition or the debtor consents to the bankruptcy. For instance, the debtor is free to use or sell its assets as it pleases, although these transactions may be undone later. 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 still doing 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.

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Preferences

What is a Preference? A preference cause of action arises under the Bankruptcy Code. The basic 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 the debtor in property (i) to or for the benefit of a creditor, (ii) for or on account of an antecedent debt 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. There are some affirmative defenses to preference actions that are set forth below.

Pre-Bankruptcy Preference Protection Planning: When a customer is not paying current and seems to be having financial difficulties that could lead to a bankruptcy, you will want to think carefully 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 if you do continue to ship on credit, you will be entitled to claim any unpaid invoices after the 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 of business defense by applying the payment to the unpaid invoice which best fits the prior payment pattern (rather than the oldest invoice, because such an application may often be the worst choice for preference purposes). To determine this pattern, it is best to run a billing 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 otherwise they may designate other invoices for payment in the remittance information.

• Promptly Cash the Check/Do Not Change Method of Payment: Some cases hold that the transfer occurs not when you receive the check, but when the check is cashed. Some other cases hold that where payments were previously generally made by check, a change in 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 course is payment on a valid debt). It is always possible that the customer will not file bankruptcy until 91 days or more after the payment, in which case you should be outside the preference window. Even if the customer does file within that window, there may be defenses or at least the leverage that the bankruptcy estate has to sue you to recover the transfer.

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Preferences Continued…

• Preference Demand Letters: Bankruptcy estates often send preference demand letters prior 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 all of the transfers are subject to a valid defense. A little time with a bankruptcy attorney at this stage may avoid more substantial time and fees in defending a filed complaint later.

• Preferences Other than Payments of Money: While most preference actions involve payment of money, they can also involve other transfers such as (i) the granting or perfecting of a lien, (ii) the return of goods or (iii) other transfers of an interest in property of the customer. Note, however, that a draw under a letter of credit is generally not considered to be a preference.

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

Collateral

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 not geared towards doing business on this basis, customers sometime place a deposit with the vendor representing the anticipated amount of orders for the upcoming period (week, month, etc.) and then 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 its filing, you generally are not required to do so after the bankruptcy is filed. Indeed, you can generally 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. The profits 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) if the 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, you must be careful to distinguish pre-petition from post-petition obligations of the customers in your correspondence and billing statements and apply post-petition payments to post-petition obligations. Unsecured claims generally do not get paid until a Chapter 11 or 13 plan is confirmed or a Chapter 7 final report is filed. Payment then is only pro rata, to the extent that there 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 for approval of interim debtor-in-possession financing or usage of cash collateral with a final hearing scheduled shortly thereafter (often 15 to 30 days later). The lender in these situations typically 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 a bankruptcy or notice of a financing/cash collateral motion or order, it is important to have internal procedures in place to make the appropriate officers within the company aware of the bankruptcy and to make a prompt determination whether the company's stake is big enough to consult 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-petition extension of trade credit and recite the fact that they have a sizeable DIP loan or permission to use 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 and remedies, any special priority for post-petition trade credit and the total duration and size of the facility), 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 the case. 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, which is an adjunct of the bankruptcy court. The U.S. Trustee generally mails a questionnaire to the 20 largest unsecured creditors as listed in the debtor's petition and sets a date for an organizational meeting for the committee. If you are interested in serving, you should promptly complete and mail back the questionnaire. If you cannot attend the formation meeting, it is a good idea to call the U.S. Trustee's office to reinforce your interest. It is common that counsel and any financial advisors for the committee are selected immediately after or within a few days of the organizational meeting, especially if there is a lot happening in the bankruptcy case. Many potential committee members already have one or more candidates in mind to serve as committee professionals and discuss their candidates with other potential members of the committee in advance. These professionals are paid from the bankruptcy estate.

Expenses of Serving as Committee Member: The out-of-pocket costs of committee members are generally paid as an administrative expense of the Chapter 11 case. This includes travel to any in-person committee meetings, telephone calls, postage for packages, etc. It generally does not include any imputed or other hourly rate for your time or the time of other persons who may assist you in the process. Many committee meetings are held telephonically, especially if the members 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 than most other unsecured creditors; and

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

Possible Disadvantages of Serving: Disadvantages of serving on a creditors' committee can arise from the fact that (i) you will likely be required to sign a confidentiality agreement and (ii) you will have a duty to consider the interests of all unsecured creditors generally (which is not exclusive 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 employees or 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 for unfinished machines or unmixed product where you have largely paid for the service to be rendered but the work is not yet completed. Even if you ultimately succeed in getting your goods or other property returned to you, the delay in doing so may cause you to breach obligations to any intended end-purchaser and result in claims for damages against you. There can also be substantial litigation in any bankruptcy to establish that the property belongs to you and 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 is financially troubled but you still want to do business with them, there are precautions you can take to improve your position. These include:

• Legal documents with the other party acknowledging that the goods/equipment belong to you;

• Segregation and/or marking of your property on-site; and

• An acknowledgment from the party’s working capital lender and other potential lienholders that the property belongs to and can be removed by you at any time and that they have no lien or other rights regarding your property.

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

Problems After Relationship has Begun: In situations where you do not know about the company's financial troubles until after the relationship is in place, there are still protections which 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 is promptly 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 the product elsewhere gives the bankrupt party and its creditors leverage to seek to extract more than the agreed purchase price from you. If some of the property is proprietary, you will want to make sure that the information (including any molds or formulas) is kept confidential and assert possible restrictions on the ability of the other party or its foreclosing lender to sell that property or product to others.

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Reclamation: Section 546(c) of the Bankruptcy Code preserves the rights of a "seller of goods that has sold goods to the debtor, in the ordinary course of such seller's business, to reclaim such goods if the debtor has received such goods while insolvent, within 45 days before the date of the commencement 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 the date of receipt of such goods by the debtor; or (B) not later than 20 days after the date of commencement 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 a reclamation procedures order at the beginning of the bankruptcy case. Any such demands must comply with the terms of any order setting forth a uniform reclamation procedure in order to preserve the creditor's claim. In these instances it is often best to contact bankruptcy counsel as debtors often attempt to catch reclamation creditors asleep at the wheel and subsuently deny such reclamation claims and demands.

§ 503(b)(9) Claims – Section 546(c) provides that if a seller fails to comply with its terms that a creditor may still assert its rights under § 503(b)(9). This provision of the Bankruptcy Code provides that a creditor will be granted an administrative claim (which usually means the creditor will be paid 100% of its claim) for "the value of any goods received by the debtor within 20 days before the date of commencement of a case under [Chapter 11] in which the goods have been sold 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) claims bar 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 bar date 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 a bar date has been set, which generally can be done through phone calls or checking electronic dockets in the case. Upon emergence from bankruptcy, a bar date for administrative claims which 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 in the 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 do file 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 whether there are any contingent or unliquidated claims (indemnities, product warranties, etc.) which should be preserved in the proof of claim, as well as any basis for asserting that at least a portion of the claim is secured or entitled to priority. Counterclaims giving rise to setoff rights may be the basis for asserting a secured claim. Contract based claims generally should be reviewed with counsel.

Multiple Debtors: Often, there are two or more related entities who file bankruptcy. The prospects for recovery by their respective unsecured creditors may be quite different. You will want to understand each of these entities, their available assets and how they relate to the business 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 have material assets.

Logistics: In some larger cases, proofs of claim must be logged at a post office box and therefore, facsimile or timely overnight courier delivery of the proof of claim may not be possible. In such cases, it is a good idea to allow some lead time before the bar date for filing the claim. 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 is a sufficient showing of excusable neglect. While it is always more desirable to timely file a proof of claim, you should discuss any late filed claim issues with counsel as soon as you are aware of the situation.

Claims Purchasers: In an increasing number of cases, claims arbitrageurs mail general offers to buy unsecured claims. These may allow you immediate liquidity but also generally involve some discount from the ultimate expected recovery for unsecured creditors. Claims arbitrageurs often request that you represent that your proof of claim will be allowed in the amount asserted by 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. Not all 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 may provide a first rough glimpse of what the prospects for recovery by unsecured creditors are 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 of Reorganization and Going Concern Sale Exit Strategies

• If Exit Strategy Negotiations are not progressing well, you may see (i) Motions to Lift the Automatic Stay by Secured Creditors, (ii) Motions to Terminate the Debtor's Exclusive Periods to Propose and Solicit Acceptances of a Plan, (iii) Motions to Appoint a Trustee or Examiner or (iv) Motions to Dismiss the Bankruptcy Case or Convert the Case to a Chapter 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

A Basic Guide to Bankruptcy Laws for Trade Creditors