The longer you are in business, the greater the chance that one of your customers becomes delinquent. While you have many options to collect a debt in normal circumstances, if your customer files for bankruptcy, you have a minefield of issues to maneuver through. Don’t panic and proceed with caution.

FIRST. Stop all goods in transit and arrange for their return to your facility.

Once you learn that your customer has filed for bankruptcy, you should stop all goods in transit, so long as your customer has not prepaid for the goods or the goods have not already been delivered to your customer or their agent.

SECOND. Stop all collection efforts.

The filing of a bankruptcy petition triggers the automatic stay. 11 U.S.C. 362. It stops most legal actions against the debtor and property of the bankruptcy estate. Unlike other types of cases, no court order is required. Upon learning a customer has filed for bankruptcy, you should stop sending invoices for debts owed as of the date of the bankruptcy filing; making collection calls for goods and services provided; initiating or continuing with a lawsuit, wage garnishment, or foreclosure; and any other collection efforts. There are some exceptions to the automatic stay, such as some actions by the government to collect taxes, criminal proceedings, and some family law proceedings, among others. Creditors can ask the bankruptcy court to lift the automatic stay in certain circumstances, such as if the debtor is not making their mortgage payments or if the creditor has a valid lien on the debtor's property. You should consult counsel before taking any action against the debtor or their property because violating the automatic stay could land you in court.

THIRD. Gather your documentation.

Gather and preserve all documentation regarding your relationship with the bankrupt customer. Be sure to review your records to determine the amount that the customer owes you and the terms of your agreement with the customer. Also, maintain all records of supplied products or services, returned goods, and received payments. You may need to prove a claim that you have against your customer or protect yourself from future litigation. Debtors and trustees have two years to bring claims against creditors over pre-bankruptcy transactions.

You may need your records to protect against preference payments. 11 U.S.C. 547. The Bankruptcy Code gives bankruptcy trustees the right to sue to recover certain types of payments made within 90 days of the bankruptcy filing (or one year in the case of payments to insiders), that result in preferential treatment to certain creditors over others. It does not matter if you earned the money or did nothing wrong. You may be forced to return money that you received within 90 days of the bankruptcy to the bankruptcy estate for distribution to creditors.

You have defenses to a preference payment action: the “subsequent new value defense” and “ordinary course of business” defense. Basically, if you provided something new in exchange for the payment, like more products or credit, or there was nothing unusual about the payment, you may be able to defeat the trustee’s claim. You have to be able to show that the timing of the receipt of the payment was in line with the customary pattern that existed between the buyer and seller or the customary payment cycle within the industry.

FOURTH. Consult a bankruptcy attorney.

Once you have stopped all actions between you and your customer and gathered your documentation, you will need to take action to preserve your rights as a creditor, assess the viability of any future relationship with your customer, and ensure compliance with bankruptcy laws, rules, and procedures. Missteps have consequences, such as losing your right to collect payment, losing property, or even being sued yourself.

FIFTH. File a proof of claim, if necessary.

If your claim is not listed on the schedule of debts filed by the debtor; is listed incorrectly; or is designated as disputed, unliquidated, or contingent, you will need to file a written proof of claim to preserve your right to payment. Typically, the proof of claim is only filed in Chapter 7 cases if assets are distributed, and in Chapter 11 and Chapter 13 cases. Failure to file a claim correctly and timely could result in the court denying your claim. Therefore, you must determine whether the bankruptcy is a Chapter 7 liquidation or a Chapter 11 reorganization (though Chapter 11 could be used to liquidate a business) or a Chapter 13 reorganization (though only individuals can file a case under Chapter 13). You also need to determine whether the debt is secured or unsecured, and whether it is liquidated or unliquidated. Filing a proof of claim correctly and timely will enable you to participate in any distribution of assets that occurs.

The purpose of Chapter 11 and 13 bankruptcy cases is the confirmation of a plan of reorganization. The plan lays out, among other things, the proposed treatment of creditor claims. You should review the plan closely with legal counsel to make sure that your claim is treated correctly. In Chapter 11 cases, you may have the opportunity to vote on the plan by casting your ballot or lodging an objection to the plan, as appropriate.

SIXTH. Determine whether you have to continue doing business with the bankrupt customer.

If you have an executory contract, a contract under which each party still owes the other significant performance, so that one party's failure to perform will excuse the other party's performance, other rules apply. If the bankruptcy court approves, a debtor can assume or reject an executory contract. 11 U.S.C. 365. To assume the contract, a debtor must cure all existing defaults and provide adequate assurance that it can perform all of its future obligations. If a debtor assumes such a contract, both parties must continue to perform. However, if a debtor rejects an executory contract, the rejection is treated as a breach of the contract just prior to the bankruptcy filing and possibly a termination of the contract. When that happens, you are entitled to file a claim for pre-petition damages. Pending assumption or rejection, you must continue to perform your obligations, unless you make a demand for adequate assurance.

In a Chapter 7 case, the trustee has the right to decide whether to assume or reject. If not assumed or rejected earlier, executory contracts in Chapter 7 cases are deemed rejected 60 days after the bankruptcy case is filed, unless the bankruptcy court extends the deadline. In a Chapter 11 or 13 case, the debtor ordinarily will have until confirmation of a Chapter 11 or 13 plan to assume or reject executory contracts. In either event, a vendor may seek an order from the bankruptcy court to force the debtor to decide more quickly whether to assume or reject, but will need to show extraordinary circumstances that require a quick decision.

SEVENTH. Monitor the case.

If there are assets to distribute, certain debts will be paid first. Secured debt (such as mortgages and car loans for the purchase price) and administrative and trustee fees get paid before unsecured debt. Post-petition claims for goods or services critical to the survival of the business are also given higher priority status as long as the costs are reasonable. Some debts may qualify for a discharge, meaning the debtor is no longer legally required to pay the debt, and you, as the creditor, are barred from taking any form of collection action. As the case continues, stay informed of any important developments, such as changes in the debtor's bankruptcy status, the potential for a distribution of asset, or changes in the distribution of assets.

Is your debt discharged after the case concludes? The Bankruptcy Code provides that some types of claims are not entitled to a discharge in bankruptcy. 11 U.S.C. 523. This includes claims based on fraud or other dishonest behavior by the debtor, certain taxes, and damages for willful and malicious injury. There are strict time limits and technical requirements for challenging the dischargeability of a claim, so if you believe your claim may not be subject to discharge, you must act quickly to protect your interests by filing a complaint (adversary proceeding) in the bankruptcy court.

If one of your customers files for bankruptcy, it can have a significant impact on your business.

Overall, dealing with a customer who has filed for bankruptcy can be a complex and challenging process. It is important to act quickly and consult with a bankruptcy attorney who can help you navigate the process and protect your interests.

Has your customer filed for bankruptcy? Do you have questions about this article or want more information on bankruptcy issues in general? Please contact Mitchell Goldstein (mgoldstein@setlifflaw.com) at (804) 377-1269, or Steve Setliff (ssetliff@setlifflaw.com) at (804) 377-1261.