It is a familiar issue for in-house counsel and credit managers: though you try to ensure that your key customers are stable, credit-worthy businesses, occasionally one of them will encounter financial trouble and you will hear rumors in the market that your customer is considering filing for bankruptcy protection. This is never good news, of course, but there are several steps you can take to minimize the adverse impact a customer’s bankruptcy filing may have on your business.

Exercise State Law Rights

Consider your rights as a seller or vendor under state law before your customer files any bankruptcy case. The Uniform Commercial Code provides several protections. For example, if your customer’s potential inability to pay for your goods or services establishes “reasonable grounds for insecurity,” you may demand adequate assurance of future performance and suspend your performance until you receive this assurance.

If you are a seller of goods, and you discover the buyer is insolvent, you have additional rights:

  • First, you may refuse future deliveries unless the buyer pays for the deliveries in advance and cures all arrearages for past deliveries.
  • Second, you may stop delivery of goods in transit if those goods have not been delivered to the buyer.
  • Third, if goods have been delivered to the buyer, you may reclaim them by making a written demand on the buyer within ten days after delivery (or longer if the buyer has misrepresented its solvency in writing in the past three months).

In some cases you may still assert these rights after your customer files for bankruptcy protection, but the bankruptcy filing triggers an “automatic stay” that prohibits many actions against a debtor-in-possession or its property, including penalties for taking unauthorized actions against the bankrupt company. It may be necessary to seek relief from the automatic stay in bankruptcy court in order to proceed against the debtor. Bankruptcy counsel can assist you to take the appropriate course of action and avoid making a bad situation worse.

Limit Preference Exposure

The Bankruptcy Code allows a bankruptcy trustee (or a customer, as “debtor-in-possession”) to recover certain payments (or “transfers”) made by the debtor to creditors within 90 days before the debtor files for bankruptcy protection, or within one year if the transfer is to an insider. The Bankruptcy Code refers to these transfers as “preferences,” based simply on the timing of the transfers, even though the debtor may not have actually intended to prefer one creditor over another.

Thus, if your customer files for bankruptcy protection, its ability to recover preferential transfers will be significant. There are, however, at least two ways that you can, prior to bankruptcy, limit your future exposure to such suits. First, require your customer to pay in advance or upon delivery. This is the most effective method to avoid preference liability because it eliminates one of the elements of a preference under the Bankruptcy Code—the existence of an “antecedent debt.” It may be unrealistic, however, if you lack negotiating leverage and your customer is already cash-strapped. Second, maintain regular payment terms with the customer to establish that any payments you receive are made in the “ordinary course of business.” As a practical matter, this generally requires a showing that the debtor’s payments to you have followed a reasonably defined pattern, and the payments in question conform to that pattern. In addition to these common bases for avoiding liability, other defenses exist. Consult counsel for advice tailored to your situation.

Strategies During a Bankruptcy Case

Your rights as a vendor change, but are not eliminated, following a customer’s bankruptcy filing. For example, the Bankruptcy Code recognizes suppliers’ reclamation rights, and allows them 45 days after delivery (or 20 days after the bankruptcy filing) to make a written demand upon the debtor to return the goods supplied during those periods. In addition, the Bankruptcy Code includes a special administrative claim for goods delivered within 20 days before the bankruptcy filing. In most cases, this administrative claim will be paid in full, but not until the end of the case, which could be months or years after the debtor files for bankruptcy. You should file a proof of claim against the debtor’s estate for any amount not eligible for administrative priority.

If you have a contract with the debtor that includes ongoing obligations on both sides, the debtor will likely have the option to assume or reject that contract. In a chapter 11 case, the debtor does not have to make that decision until it seeks confirmation of a chapter 11 plan, although creditors may ask the bankruptcy court to force an earlier decision.

Finally, some bankruptcy courts allow debtors to give preferred treatment to certain “critical vendors.” To be eligible for such treatment, you generally must show that your goods or services are so vital to the debtor that its business would cease without them, and that you will not continue to supply the debtor unless you are given special treatment. As a practical matter, you will not be considered a critical vendor if you can be replaced easily by another supplier.