How to Protect Yourself When Doing Business with Financially Distressed Entities
 
March 29, 2004
 
Adam August - Northern Virginia
Richard E. Lear- Washington
James Lewis - Northern Virginia

Whether you are a trade creditor, supplier, service provider, customer, employee, general contractor, subcontractor, landlord, tenant, licensor or licensee, it is not uncommon today to find yourself doing business with entities that are prime candidates for bankruptcy protection. Sometimes signs of their financial distress are obvious: a customer fails to pay for goods delivered or services rendered as timely as it has in the past, or a petition for protection is filed under the U.S. Bankruptcy Code.[1] Quite often, however, it is more difficult to determine whether changed habits are a result of short-term financial woes or operational concerns. Of course, it is important to begin planning for the possibility of bankruptcy before you formally enter into business transactions with anyone.

The Bankruptcy Code gives debtors in bankruptcy certain rights and remedies unavailable to entities that are not in bankruptcy. For example, with limited exceptions, creditors are prohibited from taking any action to enforce their rights against a bankruptcy debtor without court permission. This prohibition is referred to as the “automatic stay,”[2] which goes into effect immediately upon the filing of a bankruptcy petition.[3] The stay is binding whether or not the creditor has actual notice of the bankruptcy filing.

Bankruptcy also allows a Chapter 11 debtor to select which of its assets it thinks will be useful in a reorganization[4] of the debtor’s business (if one is contemplated), and which should be abandoned or returned to you [5] (for example, if an agreement is “executory”[6]) or transferred to a third party even without your consent.[7] What is worse, these decisions often take place after substantial delays[8] and are based on the same business judgment that may have caused the debtor to be the subject of a bankruptcy case in the first place!

This article suggests how best to position yourself with respect to financially distressed entities, and what to consider in the event the entity becomes the subject of a bankruptcy filing. Of course there are many potential variables that affect any decision; these variables inevitably will alter any one or more of the suggestions provided below.

Prepetition Measures

If you find yourself in the unfortunate position of doing business with an entity you suspect is having financial difficulties, consider these suggestions to improve your position before the entity files for bankruptcy protection (known as “prepetition”):

1. Create contract provisions that allow you to quickly terminate an agreement. If you suspect that there may be problems with the other party’s performance, you will be able to cancel the contract before the other party files for bankruptcy protection. If you do not terminate quickly and the other party becomes the subject of a bankruptcy case, termination may be subject to bankruptcy court review and nullification. Be careful, however; contract provisions that automatically terminate the agreement when one party files for bankruptcy protection are unenforceable provisions referred to as “ipso facto clauses.”[9]

2. Do business with distressed entities on a “cash-on-delivery” basis, if allowed by contract. Payment terms such as cash-on-delivery, letters of credit and security deposits provide assurance not only that you will be paid for goods and services you provide to the buyer, but also that the payments will be made without risk that the debtor can recover the payments as “preferences.”[10] If an entity is already the subject of a bankruptcy case and you do not demand cash payment upon delivery, to receive payment you may be required to file pleadings with the bankruptcy court as an administrative creditor. [11] When you negotiate a commercial contract, structure the payment so that you can shift the payment terms to cash-on-delivery under specified circumstances, such as failure to make timely payments or any other breach of the agreement.

3. Understand your state law rights under the applicable commercial code to determine whether you can reclaim goods shipped to the buyer.[12] The Uniform Commercial Code allows a seller to “reclaim” goods it ships within 10 days under certain circumstances where the seller discovers that the buyer is insolvent.[13]  It may be important to quickly and efficiently enforce your rights when you discover that the buyer is experiencing financial troubles. Even if the entity becomes the subject of a bankruptcy case before the 10 days expire, you may have the right to reclaim the goods in the bankruptcy case.[14]

4. Try to obtain payment on outstanding invoices in the ordinary course of business. It goes without saying that a prudent business does not allow accounts receivable to age. If it does, the creditor may find itself in a very bad position. Payments made within 90 days[15] (or within one year in the case of “insiders” of the debtor[16]) prior to the filing of a bankruptcy petition can sometimes be recovered by the debtor or bankruptcy trustee as “preferences.” Because it is a basic premise of U.S. bankruptcy law that all creditors of the same class be treated equally, payments to an unsecured creditor may not exceed on a pro rata basis those made to other unsecured creditors.[17] In that event, the creditor will have to return the payment dollar for dollar, file a proof of claim for the amount, and be treated as a general unsecured creditor. There are several ways, however, to protect yourself from having to return an alleged preferential payment; one defense is based on whether the payment was made by the entity in the ordinary course of its business.[18] (See the discussion on preference litigation below).

5. Structure contracts such as technology licenses under which you are the licensor so that you can force the debtor-licensee to “assume or reject” the contract within a certain time period. Do not allow the debtor to “assume and assign” the contract. An “executory contract,” generally speaking, is an agreement under which performance remains due to some extent on both sides. [19] Almost all license agreements will be executory contracts. A debtor in bankruptcy has the option to assume an executory contract by (1) curing any default, (2) compensating any third party for any monetary loss caused by a default, and (3) providing adequate assurance of future performance.[20] Under certain circumstances, the debtor may be able to assume a license and then transfer it to a competitor or potential customer of yours, even though transfer is expressly prohibited by the license agreement itself.[21] This outcome may be financially devastating to you. Properly structuring the terms of technology license agreements is critical due to the possibility that the debtor-licensee may become a debtor in bankruptcy and gain rights that it would not have under non-bankruptcy law.

6. Structure technology licenses under which you are the licensee so that you can retain the license if the debtor/licensor files for bankruptcy protection. A debtor-licensor may terminate a technology license if the license agreement is found to be executory. This may result in a complete loss to you as licensee of the benefits of the license. Depending upon the circumstances, the debtor-licensor may not be able to perform its obligations under the license, and the documentation and support so critical to the license (such as the source code) may be unavailable to you as the licensee. In the case of an executory technology license, the Bankruptcy Code provides the non-debtor licensee certain rights to maintain the license in its pre-bankruptcy petition state.[22] Properly structured license agreements may assist the non-debtor licensee to gain access to other methods for proper use of the license. It is, therefore, vital to the licensee to structure the license agreement adequately in order to provide certain rights to the licensee that are enforceable under the Bankruptcy Code.

7. Terminate commercial real property leases before a tenant files for bankruptcy protection. A debtor may not assume or assign a real property lease if the lease has been terminated prior to the entry of an “order for relief.”[23] If the lease is not terminated beforehand, however, the landlord must ask the bankruptcy court to lift the automatic stay before the landlord can enforce its eviction or other rights,[24] or compel the tenant to assume or reject the lease in a timely manner.[25] Even then, the landlord may face the prospect of capped damages[26] and other potential pitfalls. Additionally, the debtor-tenant may assume and assign the lease to tenants with which the landlord might not otherwise agree to contract.[27]

Post-Petition Recourse

Once an entity becomes a debtor in bankruptcy (referred to as “post-petition”), there are additional measures that you can take to maximize your potential for recovery.

1. Hire an attorney who is competent in handling bankruptcy matters.[28] Even experienced non-bankruptcy lawyers admit that for bankruptcy matters, you need a skilled attorney who is knowledgeable about bankruptcy issues. Although no one wants “to throw good money after bad,” consider this: attorneys competent in bankruptcy matters handle these situations for a living. Experienced bankruptcy practitioners should be able to determine (relatively quickly and efficiently) whether or not you can expect to receive payment from a debtor. It is not in the attorney’s interest to generate a lot of fees without consulting with you regularly and addressing the probability of your receiving any payment from the debtor.

2. In a Chapter 11 reorganization case, consider sitting on the official committee of unsecured creditors.[29] As a member of the unsecured creditors’ committee, you will have access to the debtor’s financial information and to the services of court-appointed counsel for the creditors’ committee, who can give you insight into the case and into the debtor’s ability to emerge from bankruptcy. Also, the debtor’s bankruptcy estate pays, at no direct cost to you, for the services of counsel to the unsecured creditors’ committee as an administrative expense.

3. File a proof of claim for the debts owed to you by the debtor. [30] Although not always required, it is often recommended that you file a proof of claim to put the world on notice that you claim an interest in the bankruptcy estate. If not set by the Bankruptcy Rules,[31] the bankruptcy court will establish a “bar date” by which all creditors must file their proofs of claims.[32] It is important that you correctly complete the proof of claim and that you monitor the bankruptcy case in order to receive payment, if at all, on the debt owed to you. If a bankruptcy case is an “asset case,” meaning that after liquidation there will be net proceeds available to distribute to creditors, you will probably want to file a proof of claim. Depending on the nature of your claims against the debtor, and vice versa, you may strategically decide not to file a proof of claim.[33]

4. Maintain complete books and records of payments made to you by an entity that becomes a bankruptcy debtor and be prepared to defend preference actions to recover those payments. [34]
As noted above, payments made to creditors within 90 days (one year in the case of “insiders” of the debtor) of the filing of a bankruptcy petition may be recoverable as “preferences.” Payments made contemporaneously in exchange for “new value”[35] are not recoverable, however, nor are payments made in the ordinary course of the distressed entity’s business^.[36] An experienced creditor’s rights attorney will be able to evaluate your legal position and potential defenses, negotiate a settlement with the debtor or bankruptcy trustee and, if appropriate, work with you to defend your receipt of the payments.

5. Consider filing for bankruptcy court approval to employ you as an “administrative professional.”[37] In the list of priorities for payment from the bankruptcy estate, administrative priority is near the top.[38] This means that as an administrative professional you will be entitled to payment before most other creditors and, unless the debtor is “administratively insolvent,” you will receive 100 percent of your bankruptcy court-approved expenses. Some creditors that do business with debtors are considered administrative professionals who may be retained by the debtor, subject to bankruptcy court approval. Some of these professionals may be obvious, including lawyers and accountants. But there are other administrative professionals who are not as obvious, including investment bankers, financial consultants, business brokers and appraisers. It is often suggested to administrative professionals seeking employment by the debtor that the terms of their relationship include a waiver of any preference claims the debtor may otherwise bring against the professional. Depending on the circumstances, a court may or may not approve a waiver, but it may be appropriate to seek it anyway, eliminating the creditor’s concern that it may be faced with a preference lawsuit later on. Additionally, some non-professional creditors may be so vital to the successful reorganization of a debtor that they can use that leverage to gain advantageous terms of their engagement post-petition, such as the payment of prepetition debt. These entities are sometimes referred to as “critical vendors.”

6. File an administrative claim for goods and services provided to the debtor post-petition.[39] If you are not able to arrange for cash-on-delivery or similar payment terms with a debtor, you may be entitled to administrative priority status as a creditor that will enable you to receive payment for the goods you deliver and services you render post-petition. If you have entered into a post-petition contract with a debtor and the debtor has failed to pay you, you should be vigilant in protecting your rights: Be alert to deadlines for filing proofs of administrative claims and assert your rights as an administrative claimant.

7. Consider utilizing the rights of recoupment and setoff.[40] Suppose you owe the debtor $100,000 and the debtor owes you $50,000. Under certain circumstances referred to as “recoupment” (where both liabilities were incurred in the same transaction), you may be able to reduce the amount of your liability to the debtor to $50,000 without seeking bankruptcy court approval. Under certain circumstances referred to as “setoff” (where the liabilities were not incurred in the same transaction), you may be able to offset the amount of your liability to the debtor with the amount of the debtor’s liability to you, but only upon bankruptcy court approval. If you do not utilize recoupment and setoff rights, you may be required to pay the debtor the full amount of your liability ($100,000) and retain only an unsecured claim for the amount of the debtor’s liability to you ($50,000), for which it is unlikely you will receive 100 cents on the dollar.

8. When dealing with a debtor-landlord, make sure maintenance, utilities and janitorial services are available from sources other than the lessor. The Bankruptcy Code gives the tenant of a debtor-landlord options in how the tenant treats a lease that its debtor-landlord rejects, including the right either to treat the lease as rejected or to remain as a tenant and offset against the rent obligation any damages incurred as a result of the landlord’s rejection of the lease.[41] Be aware, however, that the debtor-landlord may not be required to provide ancillary services to the holdover tenant and, as a result, the tenant will likely face operational problems in obtaining those services elsewhere.

9. Consider whether the debtor’s business may be an acquisition target. Often, an entity looking to acquire a target seeks to run that target through a bankruptcy case in order to “cleanse” the debtor’s assets of liens, claims and encumbrances. Since sales of a debtor’s assets are outside the ordinary course of its business, any such sale is subject to bankruptcy court approval. The good news for an acquiror is that it is very difficult for the debtor-target’s creditors to later contest such a sale once it has been “blessed” by the bankruptcy court and authorized by federal statute.[42] While the acquiror runs the risk that competing bidders will come forward at a bankruptcy court auction and force up the purchase price, usually the acquiror has the strategic advantage, having already done its due diligence and having a jump on its competitors. As a result, it often can acquire the assets at a “liquidation value,” which may be far below the “going concern value.”

Conclusion

This article contains some suggestions for dealing with financially distressed entities, both pre- and post-bankruptcy. Since every situation and every debtor is unique, any action you take must be evaluated in light of the facts and circumstances of that case. An attorney who specializes in bankruptcy matters can be an invaluable resource in evaluating your risks, advising how best to position yourself, and pursuing your remedies.

For more information, e-mail Richard E. Lear at richard.lear@hklaw.com, James M. Lewis at james.lewis@hklaw.com, or Adam J. August at adam.august@hklaw.com, or call toll free, 1-888-688-8500.

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1. 11 U.S.C. § 101, et seq., is commonly referred to as the “Bankruptcy Code.” Note that it is also possible for an involuntary bankruptcy petition to be filed against most entities pursuant to 11 U.S.C. § 303.

2. See 11 U.S.C. § 362.

3. See 11 U.S.C. §§ 301-303.

4. Usually, a reorganization of the debtor’s affairs will be accomplished under Chapters 11 and 13 of the Bankruptcy Code.

5. See 11 U.S.C. § 365 regarding the treatment of “executory contracts” and see 11 U.S.C. § 554 regarding abandonment of property.

6. See discussion of executory contracts below.

7. See 11 U.S.C. § 363 regarding the sale of the debtor’s assets. See 11 U.S.C. § 365 regarding the assumption and assignment of “executory contracts.”

8. Although 11 U.S.C. § 365(d) provides deadlines for the assumption of executory contracts, these time periods may be extended “for cause.”

9. See 11 U.S.C. §§ 363(l) (use, sale or lease of property), 365(e) (executory contracts) and 541(c)(1).

10. See 11 U.S.C. §§ 547(a)(2) and (c).

11. Under these circumstances, you would likely be considered an administrative claimant. See Merry-Go-Round Enterprises, Inc. v. Simon DeBartolo Group, L.P., 180 F.3d 149, 155-157 (4th Cir. 1999) (citing In re Klein Sleep Products, Inc., 78 F.3d 18 (2d Cir. 1996); Lamparter Organization, Inc. v. Pergament, 207 B.R. 48 (E.D.N.Y. 1997); In re Chugiak Boat Works, Inc., 18 B.R. 292 (D. Alaska 1982)). See discussion below regarding administrative claims.

12. This appears to be allowed, at least in part, pursuant to UCC § 2-702(1), which provides:

(1) Where the seller discovers the buyer to be insolvent he may refuse delivery except for cash including payment for all goods theretofore delivered under the contract … .

13. UCC § 2-702, “Seller’s Remedies on Discovery of Buyer’s Insolvency,” provides:

(1) Where the seller discovers the buyer to be insolvent he may … stop delivery under this Article.

(2) Where the seller discovers that the buyer has received goods on credit while insolvent he may reclaim the goods upon demand made within ten days after the receipt … .

14. See 11 U.S.C. § 546(c).

15. See 11 U.S.C. § 547(b)(4)(A).

16. See 11 U.S.C. § 547(b)(4)(B).

17. Bankruptcy permits the avoidance of preferences to discourage creditors “from racing to the courthouse to dismember the debtor during his slide into bankruptcy,” and in order to “facilitate the prime bankruptcy policy of equality of distribution among creditors of the debtor. Any creditor that received a greater payment than others of his class is required to disgorge so that all may share equally.” H.R.Rep.No. 595, 95th Cong., 1st Sess. 177-78 (1977).

18. See 11 U.S.C. § 547(c)(2).

19. See N.L.R.B. v. Bildisco & Bildisco, 465 U.S. 513, 522, n.6 (1984)(interpreting legislative intent as to the meaning of the term “executory contract”); Vern Countryman, Executory Contracts in Bankruptcy, Part I, 57 Minn. L. Rev. 439, 460 (1973)(“[T]he obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance could constitute a material breach excusing the performance of the other.”).

20. See 11 U.S.C. § 365(b)(1). As an added benefit to having an executory contract assumed by the debtor, there is encouraging recent case law holding that the assumption of an executory contract waives preference actions that the debtor may otherwise file against the creditor who is the contracting party. See, e.g., In re Superior Toy & Mfg. Co., Inc., 78 F.3d 1169 (7th Cir. 1996); In re Philip Services (Delaware) Inc., 284 B.R. 541 (Bankr. D. Del. 2002).

21. See 11 U.S.C. § 365(f).

22. See 11 U.S.C. § 365(n).

23. 11 U.S.C. § 365(c).

24. See 11 U.S.C. § 362(d).

25. See 11 U.S.C. § 365(d).

26..Under 11 U.S.C. § 502(b)(6), a landlord’s claim resulting from a tenant’s rejection of a real property lease is subject to a cap if an objection is filed to the lease rejection claim.

27. Although 11 U.S.C. § 365(f) requires the proposed assignee to provide adequate assurance of future performance, the new tenant may not otherwise be the kind of tenant the landlord desires in terms of tenant mix, creditworthiness and other considerations. See also Fed. R. Bankr. Proc. 6006. However, Section 365(b)(3) does include these factors as prerequisites for adequate assurance in the case of shopping center leases as a benefit to shopping center landlords.

28. It should be noted that the location of the bankruptcy case may impact who you decide to retain as counsel since, in order to enter an appearance and file pleadings, an attorney is required to be a member of the bankruptcy court where the case is pending or, alternatively, to seek admission pro hac vice (meaning “for this particular occasion”), in either case possibly being required to associate with local counsel.

29. See 11 U.S.C. §§ 1102 and 1103.

30. See 11 U.S.C. § 501 and Fed. R. Bankr. Proc. 3001 through 3003.

31. See Fed. R. Bankr. Proc. 3002(c) for cases not under Chapter 11 of the Bankruptcy Code.

 32. See Fed. R. Bankr. Proc. 3003(c)(3) for cases under Chapter 11 of the Bankruptcy Code. If this bar date has passed, a creditor may still file a claim upon motion and hearing by the bankruptcy court. See also 11 U.S.C. § 503(a). To determine the propriety of a late-filed proof of claim, the bankruptcy court uses the “excusable neglect” standard set forth by the U.S. Supreme Court in Pioneer Investment Services Co. v. Brunswick Assoc., 113 S.Ct. 1489 (1993).

33. When a creditor consents to the equitable jurisdiction of the bankruptcy court by filing a proof of claim, the creditor loses its right to trial by jury. For example, if you have a cause of action against the debtor or a defense to a cause of action by the debtor (e.g., an avoidance action under 11 U.S.C. § 547) in which you desire a trial by jury, then the filing of a proof of claim precludes your right to a trial by jury. Langenkamp v. Culp, 498 U.S. 42 (1990); Katchen v. Landy, 382 U.S. 323 (1966); but see 28 U.S.C. § 1411(a) for personal injury tort or wrongful death causes of action.

34. We have experience representing, among others, high-level employees of distressed entities in bankruptcy cases in which the trustee files a preference action against the employee for reimbursed expenses incurred by the employee during the retention. Often, the more detailed information the employee can provide to the trustee, the greater the likelihood that the trustee will dismiss the preference action without the employee having to incur significant legal expenses.

35. 11 U.S.C. § 547(c)(1).

36. 11 U.S.C. § 547(c)(2). Other defenses to preferences may also be asserted in appropriate circumstances. See 11 U.S.C. § 547(c)(3) – (8).

37. See 11 U.S.C. §§ 327 and 330.

38. See 11 U.S.C. § 507(a).

39. See 11 U.S.C. § 503. You should also consider how filing an administrative claim affects your right to a jury trial, as discussed above regarding the filing a proof of claim.

 40. The doctrine of recoupment refers to the circumstances by which a defendant is allowed to reduce the amount of the plaintiff’s claim by asserting a claim against the plaintiff that arose out of the same transaction as the plaintiff’s claim, in order to arrive at a just and proper liability on a plaintiff’s claim. 5 Collier on Bankruptcy ¶ 553.03 (15th ed. rev. 2003); see In re Holford, 896 F.2d 176 (5th Cir. 1990). A setoff involves a claim of a defendant against the plaintiff that arose out of a transaction different from the one on which plaintiff’s claim is based. In re Clowards, Inc., 42 B.R. 627, 628 (Bankr. D. Idaho 1984), quoted in In re Holford, 896 F.2d 176 (5th Cir. 1990). See 11 U.S.C. § 553 for the parameters of the application of setoff rights.

41. See 11 U.S.C. § 365(h).

42. See 11 U.S.C. § 363.