Your Customer Filed for Bankruptcy: Now What?

Most Everything You Wanted to Know About Commercial Bankruptcies but Was Afraid to Ask

By John Salek and David Schmidt

Even though the economic headwinds are moderating, now is not the time to become less vigilant from a customer credit perspective. Commercial bankruptcies began rising earlier this year after an unprecedented lull during the Covid crisis. Historically, bankruptcies have tended to peak after an economic crisis has passed and that appears to be what is happening now.

During Covid, we also saw an unprecedented number of new business formations. According to decades worth of US Department of Census data, just over 30 percent of new businesses never see their second anniversary. Right now there are nearly a million new businesses beating the odds. When the pendulum swings back, as we believe it is beginning to do, there is likely to be a rising flood tide of business failures.

If you are extending credit to business customers, prudence dictates that you be prepared to deal with customer bankruptcies. When a customer files bankruptcy, it immediately stops any payments coming from them to you. There are ways to obtain payments for money they owe you through the bankruptcy court, but this usually entails:

• You follow bankruptcy-law-mandated procedures precisely
• A long period of time — months if it is a prepackaged reorganization or years if the bankruptcy was not planned
• Recovery of less than the full amount owed you — very infrequently an unsecured creditor will receive a 100% settlement, but more often the distribution will be a small fraction of the total owed or nothing at all when it is a no asset case

Adding insult to injury, pursuing a claim in bankruptcy court may also require a significant labor cost filing and documenting your claim and in some cases legal fees. Concurrent with filing your claim with the bankruptcy court is to decide how much effort you will expend on this bankruptcy — effort that may or may not increase your recovery. A cost/benefit analysis will help you determine if you should cut your losses or spend good money chasing after bad.

Initial Steps Upon Learning a Customer is Bankrupt

These are the critically important actions you should take as soon as you learn of a purported customer bankruptcy.

1. Confirm that the bankruptcy has actually been filed with the bankruptcy court, and which type (usually Chapter 7 liquidation, Chapter 11 reorganization, or Chapter 13 if an individual is operating as a sole proprietor).
2. Once the bankruptcy filing has been confirmed, halt all collection efforts and contacts immediately.
3. Notify everybody at your firm that has dealings with the customer (including all members of the executive team), of the customer’s bankrupt status, and that for now your firm is no longer accepting and fulfilling orders for this account.
4. Put all of this customer’s existing orders on hold.
5. Contact your freight carriers to have all undelivered shipments returned
6. File a 503(b)(9) claim for any goods that may have been delivered within 20 days of the bankruptcy filing — this can be the difference between receiving nothing as an unsecured creditor and being paid 100% of the value of the goods via this administrative claim process
7. Document all unpaid amounts (Purchase Order, Bill of Lading, Invoice, etc.) and then file your claim for your outstanding receivables with the bankruptcy court
8. Ensure you are listed as a creditor (secured or unsecured) for the correct amount by the bankruptcy court — if the customers payables do not match your receivables the documentation will be need to be filed with the bankruptcy trustee to substantiate your claim
9. Charge to your provision for bad debts (aka: bad debt reserve) or current period bad debt expense, the full amount of the amount claimed. Absorb the impact up front and be done with it. Forecasting recovery is difficult and it will be an accounting issue you’ll need to revisit every quarter.

Once your claim is filed, you will eventually receive a payout or notice that no funds are available. In Chapter 7 (liquidation) bankruptcy filings, the initial notice may indicate there are no assets and no need to file a claim. We recommend you file one anyway because sometimes assets are found.

If you have engaged an attorney, you should periodically evaluate the cost /benefit of continuing to pursue these receivables. The cost (attorney and court fees and your time) can be considerable, and the return (i.e., bankruptcy distribution) can be very small. Ultimate resolution of bankruptcy claims can take years. Usually, you will only need an attorney if there are complicating issues relating to preferences, fraud, disputed balances and so forth.

Other Bankruptcy Situations

Other issues may crop up in a bankruptcy case of which you should be aware. Most of the time filing a bankruptcy claim is routine. However, these situations often come into play and complicate matters:

• Preference Claims — the bankruptcy court can require you to pay back all funds you received from the bankrupt company during the 90 days prior to filing on the grounds that you were paid on a “preferential” basis as opposed to during the “normal course of business.” If the debtor is making consistent payments to your company, albeit late (for example, regularly ranging from 45 to 75 days slow), they will usually be considered “normal course.” However, if you require the debtor to pay an old debt before you release a current order, that could be considered a preference. If you accept returned merchandise to reduce old debts, that also can be considered a preference. If the customer paid you regularly until 120 days before they filed bankruptcy and sent you a single payment 30 days before the filing date, that too would be considered a preference payment. Bankruptcy trustees will try to recover as many payments made to creditors during the 90-day pre-filing window as they can. As a result, you should only expect to recover a small percentage of any funds you have to give back as a preference (these funds increase the amount of your claim), when the final bankruptcy distribution is made.
• Critical Vendor – if your products are important to the debtor (the bankrupt company) and their ability to generate revenue during their protected “reorganization” period, you may be designated a “Critical Vendor.” This will enable you to start over with the bankrupt company with a new accounts receivable account for your post-bankruptcy shipments. You can price your products to a level acceptable to the customer, and negotiate payment terms to mitigate your risk. Serving as a critical vendor to a company filing for Chapter 11 bankruptcy elevates your status above other creditors and means that you will likely get paid for any outstanding balances as a condition for continuing to provide critical goods or services. This is another area where a bankruptcy attorney can be of assistance.
• Creditors’ Committee – the bankruptcy court will create a Creditors’ Committee to represent the interest of all the creditors of the bankrupt company. Usually, it is only a few large creditors who are named to this committee. If you are one of the larger creditors, you can try to get on this committee. It will position you to protect your company’s interests better, but can require a very large commitment of your time. Another cost/benefit decision.
• Secured Creditor – if you are a secured creditor due to your filing a UCC Security agreement or a Purchase Money Security Interest (PMSI) your position will be very different from the unsecured creditors. Secured creditors get paid after any administrative claims but before the unsecured creditors. However, this is something that has to be set up prior to a customer entering bankruptcy.

Final Thoughts . . .

Unless you are a critical vendor, you should not sell to a bankrupt entity (aka: debtor in possession, or DIP) on open terms. Stick with cash only until after their reorganization has been approved and executed. Even then, you should be very careful before granting them credit, and only with some sort of security or guarantee.

In addition, while a company is a debtor in possession, they should be set up with a different account than your pre-bankruptcy customer. This is necessary so there is no mix-up in what was and is owed pre- and post-bankruptcy. In fact, the specter of a customer filing bankruptcy is a excellent argument for implementing both good system of record and credit policy controls.

Editor’s Note:  This article was initially published August 1, 2023, in The Virtual Credit Manager and is reprinted in Credit Today with the permission of the authors.

About the Authors:

• John Salek has over 33 years of experience and has helped over 250 companies improve their AR management. He ispresident of Revenue Management Associates and the author of "Accounts Receivable Management Best Practices" (John Wiley & Sons, 2005).
• David Schmidt is Managing Director of A2 Resources (a consultancy focused on credit, collections and AR automation), Editor of Credit Today, and co-author of “Power Collecting: Automation for Efficient Asset Management” (John Wiley & Sons, 1998).