Creditors Take Aim at Bankruptcy
It appears that my February article, “Turning Lemons Into Lemonade,” which discussed benefits of bankruptcy from a debtor’s perspective, made some readers’ blood boil. No doubt, those readers were creditors, who likely experienced firsthand how bankruptcy can wipe out any hope of being paid on your accounts receivable. Companies can—and do—use bankruptcy as a means to eviscerate your accounts receivable and walk away owing you nothing.
As I previously explained, debtors also can use bankruptcy to get out of otherwise binding contracts, thereby depriving you—the other party to the contract—of the benefit of your bargain. Bankruptcy is a process that inherently favors the debtor and looks out for its best interest. Folks, that’s reality, so don’t shoot the messenger for delivering this news. But, for this month’s article, here are some pointers to assist creditors in handling deadbeat accounts who are in, or on the verge of, bankruptcy.
If you are a creditor (someone owes you money), and you find out that a debtor (the company who owes you money) has filed for bankruptcy, your initial reaction is probably to feel sucker-punched in the stomach. As we all know, when a company files for bankruptcy, the likelihood of recovering the entire amount owed to you is nil. After all, a primary purpose for debtors in bankruptcy is to have their debt discharged. However, don’t despair. As a creditor, there are a few measures you can take to protect yourself.
• Some of the debt will get paid. If the debtor is seeking to reorganize and remain a growing concern (as opposed to liquidate), some of the outstanding debt owed to you likely will be repaid. Without bankruptcy, the debtor is unlikely to pay you on its own. While you may get repaid pennies on the dollar, some repayment is better than nothing at all. And, if you have a security interest in the debtor’s property (see number 2), you will get more (and maybe all) of your money.
• You can have control over the debtor’s property. Bankruptcy gives you, the creditor, indirect control over the debtor’s assets and money. Outside of bankruptcy, the debtor unilaterally can sell off its assets and pick and choose which creditors it wishes to pay while leaving others unpaid. In bankruptcy, the bankruptcy court and trustee have control over the debtor’s property to make sure creditors are repaid.
• You will have access to the debtor’s financial information. With bankruptcy, you, the creditor, will have access to the debtor’s financial information. The debtor is required to provide detailed information about its financial affairs to the court, under oath. You also get to examine the debtor, under oath, regarding the debtor’s assets. Without bankruptcy (or a lawsuit), you would not be entitled to such information. This information is helpful for the creditor to determine the debtor’s ability to pay the debt and any concealment of assets.
This information also is helpful to determine whether the debtor has filed a “bad faith” bankruptcy proceeding. Courts can dismiss (i.e., throw out) the debtor’s bankruptcy filing if it was filed in “bad faith.” In other words, debtor’s bankruptcy petitions are subject to dismissal under the Bankruptcy Code unless they are filed in good faith. The requirement that bankruptcy cases be filed in good faith has long been the policing mechanism of courts to make certain those who invoke bankruptcy do so only to accomplish legitimate aims and objectives and for no other purpose.
One requirement to establish good faith is the debtor be in financial distress. While a debtor may claim to be in financial distress, its financial information may indicate otherwise. Therefore, having access to the debtor’s financial information and having an opportunity to question the debtor under oath can help determine whether the filing was made in good faith.
As mentioned in my February 2009 article, the Bankruptcy Code is complex and contains many requirements. However, here are some guidelines to help you deal with bankrupt (or purported bankrupt) debtors:
1. Monitor your customers’ payments. Don’t let your customers fall too far behind in their payments to you. If you think a customer is having financial difficulty and is late on payments, do not extend any further credit to him or her. Extending further credit will just increase the amount of debt that will get discharged (and unpaid to you) if the customer files bankruptcy.
2. Get a security interest. If a customer owes you money, ask him or her to give you a security interest in his or her assets. A security interest is an interest (such as a mortgage or lien filed of record) in the debtor’s collateral, such as equipment, accounts receivable, real estate and inventory. A security interest is important because secured creditors get paid in bankruptcy first—before all others—and get paid a larger portion (and, if there is enough equity in the property) of the debt.
For example, let’s say your bankrupt customer, Deadbeat Diner, Inc., owns only one asset—a piece of real estate. Deadbeat owes you $100,000. Deadbeat owes the rest of its creditors, who are unsecured (i.e., they have no security interest in any of Deadbeat’s asset), $500,000. The real estate has a market value of $300,000. In bankruptcy, if Deadbeat gives you a security interest in the property for the amount of its debt to you ($100,000), you will be paid before all other (unsecured) creditors. In other words, upon sale of the real estate, you will receive the full $100,000. Thus, having a security interest in the debtor’s property will allow you to maximize amounts you can receive from bankrupt debtors. Keep in mind that you can only take a security interest before the debtor files for bankruptcy.
3. File a proof of claim. If you receive notice that a customer has filed for bankruptcy and they owe you money, file a proof of claim with the bankruptcy court as soon as possible. If a creditor does not file a proof of claim, it will not receive any payment. There are certain time limitations for when proofs of claims must be filed.
4. Watch for bad faith bankruptcy filings and attack them. You can seek to have a debtor’s bankruptcy filing dismissed if the filing was made in bad faith. If the bankruptcy matter gets dismissed, the debtor’s debt to you will not get discharged. Don’t let debtors who owe you money abuse the bankruptcy process to wipe out your accounts receivable. Be proactive! PPR
By Lisa A. Lori, Esq.
Lisa A. Lori, Esq., is a partner in the litigation department at Klehr, Harrison, Harvey, Branzburg & Ellers, LLP. Lori represents clients in a full-range of complex commercial litigation matters, including employment, intellectual property and general business torts. She also counsels clients on a variety of issues, including advertising, marketing, branding and regulatory compliance.