Managing Relations with Insolvent Customers

How to get paid and keep the money


"Recoupment" refers to the supplier's right to set off mutual obligations arising from a single agreement with the customer. A right of setoff exists when the mutual obligations arise from independent agreements. However, pre-petition setoffs can sometimes be avoided by a bankruptcy trustee. Consequently, a supplier should consult counsel before exercising its right of setoff.

Getting Paid After a Customer Files for Bankruptcy

Once a customer seeks protection under the federal bankruptcy code (the "Code") by filing a bankruptcy petition, a supplier must consider how to maximize recovery of its pre-petition claim.

1. Immediate actions. A supplier that learns of a customer's bankruptcy should immediately exercise its right to stop any goods in-transit before title passes to the debtor. The supplier should also send the customer a reclamation demand that includes a demand that the debtor segregate and hold goods delivered by the supplier. Under the Code, a supplier can make a written demand for the return of any goods sold to the debtor in the ordinary course of the supplier's business, so long as the debtor received the goods while insolvent within 45 days before the bankruptcy filing. If that 45-day period expires post-petition, the supplier can make its reclamation demand not later than 20 days after commencement of the bankruptcy case. However, reclamation rights under the Code are subject to the rights of a creditor with a security interest in the goods or their proceeds.

If a supplier does not have a right of reclamation or if that right is trumped by a secured creditor's lien, the supplier may have one of four additional means of collecting its pre-petition debt.

2. Critical vendors. Many courts permit Chapter 11 debtors to pay the pre-petition claims of "critical vendors" at the beginning of a case. The definition of a "critical vendor" varies from case to case. It can be narrow, such as a sole supplier of goods without which the debtor cannot produce a product, or broad, such as any creditor with which the debtor would simply like to continue doing business.

However, achieving critical-vendor status typically comes at a price. In return for payment of its pre-petition debt, the critical vendor is usually required to provide trade credit to the debtor on terms no less favorable than the terms that were available pre-petition. Suppliers should consult counsel to determine whether critical vendor payments are available or advisable in a particular case.

3. Requesting assumption of executory contracts. If a supplier was providing goods or services to a debtor pursuant to an executory contract (a contract under which material performance is still due from each party) and is concerned about the debtor's ability to perform, the supplier can request a court order compelling the debtor to assume that contract. One of the requirements for a debtor's assumption of an executory contract is that the debtor cure any pre-petition defaults, i.e., pay any amounts due to the non-debtor party on the bankruptcy filing date. Unfortunately, bankruptcy courts are reluctant to compel assumption of executory contracts.

4. Adequate protection for secured claims. If a supplier obtained purchase money or other security interest in the debtor's goods, the supplier would be entitled to adequate protection for its security interest in those goods, i.e., compensation for value lost because of the debtor's use of the goods. The supplier's lien would also attach to the proceeds from any sale of the goods.

5. Administrative claim for goods shipped within 20 days of petition. The Code also gives suppliers an administrative claim for the value of any goods received by the debtor within 20 days prior to the petition date, so long as the goods were sold in the ordinary course of the debtor's business. Administrative claims have special value, because they have priority over pre-petition unsecured claims and must be paid in full, in cash, upon confirmation of a plan of reorganization. However, administrative claims are still unsecured claims, which means they are subordinate to pre- and post-petition secured claims. If the debtor's assets are worth less than the secured claims, there will be no money available to pay administrative claims.

Conclusion

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