When Your Customer Goes Under

By Tom Mullinix

Economic growth hasn’t been able to slow the surge in bankruptcies since 2007.
When a corporate client becomes insolvent, what options do you have?

There are several types of bankruptcy, and the options available to a creditor vary with the type of relief sought by a debtor. In general, Chapter 7 cases seeking liquidation of assets are unlikely to yield distributions to unsecured creditors, whose claims are generally discharged—creditors have a very difficult time collecting assets from an entity that has none. And a Chapter 13 bankruptcy is filed by individuals and some individually owned small businesses with the ability to pay creditors on the debtor’s terms.

For purposes of this article, we’ll focus on Chapter 11 reorganizations, primarily filed by corporations or other types of entities. Individuals, however, may file a Chapter 11 if their unsecured debts exceed $383,175 and secured debts exceed $1,149,525, as there are monetary jurisdictional limits for filing under Chapter 13. The treatment of secured and unsecured claims is not much different from that in a Chapter 13—secured creditors normally retain their rights in the collateral and unsecured creditors may receive a pro rata distribution of the unsecured assets and future cash flow or profits.

Unsecured creditors should monitor a Chapter 11 case closely, as they have the most to lose. They are dependent on the value of the
debtor’s unencumbered assets and profitability, and are the last to be paid after the costs of administration, secured claims, tax claims and other senior debts. Since significant decisions require notice to creditors pursuant to Bankruptcy Rule 2002, one of the best methods to monitor a case is to file a request to be added to the service list and receive a copy of all of the filings in the case. Additionally, the Chapter 11 debtor is required to file monthly operating reports. A review of these reports, which must be provided upon request, can provide pertinent information concerning the debtor’s financial health during the bankruptcy.

It is also prudent to review the “first day motions and hearings” filed in a Chapter 11 case. Often, these motions include a request to treat some creditors’ claims preferentially if those creditors are inherently necessary to the success of the debtor’s business. First day motions are generally granted and may also include a determination of utility deposits. Thus, utilities should not overlook these motions when received.

Within 30 days after the filing of a Chapter 11, the United States Trustee conducts a First Meeting of Creditors. Sometimes, attending this meeting can educate the creditor concerning the reason for the filing and the debtor’s general intentions. If the case is large enough, the creditors with the largest unsecured claims may be invited to create an unsecured creditors’ committee, which can play a meaningful role in directing the course of the reorganization efforts and protecting unsecured creditors’ rights.

In a Chapter 11 case, vendors may have the right to reclaim goods sold to a debtor in the ordinary course of business and while the debtor was insolvent if (1) the debtor, while insolvent, received those goods not later than 45 days prior to the commencement of the case and (2) written demand for reclamation of the goods is made not later than 45 days after the receipt of such goods by the debtor or not later than 20 days after the commencement of the case, if the 45-day period expires after the commencement of the case. A seller may make a reclamation demand but the bankruptcy court may grant the seller a priority claim in the goods rather than requiring a surrender of the goods.

During a Chapter 11 former management is authorized to operate the business and incur unsecured debt in the ordinary course of business and without court approval; however, the debtor is required to pay these debts as they come due, and failure to do so creates an administrative expense claim for that debt. Nevertheless, creditors providing goods to a Chapter 11 debtor are not required to offer payment terms and, if they do, should not do so if the debtor falls behind in its payments.

A debtor may also elect to liquidate through the Chapter 11, especially if it has a going concern business, or the Chapter 11 may be converted to a Chapter 7 if the debtor proves unable to effectively reorganize. The decision to convert may be voluntary or may occur upon request of creditors or the United States Trustee. The assets are then typically sold to the highest bidder, with general unsecured claims receiving nothing.

In general, for the first four months after the Chapter 11 case is filed only the debtor is allowed to propose a Plan of Reorganization. Unless that time is extended, if a Plan is not filed any party in interest, such as a creditor or even a competitor, may file a Plan. The debtor or the party who proposes the Plan files a Disclosure Statement, which describes the debtor’s financial condition, and the Plan to present how the claims of all creditors would be paid. Most creditors have the right to vote on the Plan and their votes may determine whether the Plan can be confirmed.

It is possible for three creditors to petition the court to put an individual or corporation into an involuntary Chapter 7 or Chapter 11 bankruptcy. These creditors must have non-contingent, undisputed claims of at least $15,325.00. If the potential debtor objects, the bankruptcy court will determine whether the debtor should be placed in an involuntary bankruptcy. Until a decision is made and unless a trustee is appointed, the debtor continues to operate its business. Involuntary bankruptcy petitions are not usually filed, as the petitioning creditors may have to pay legal costs or fees in the event the court determines that the involuntary petition should not have been filed. In general, an involuntary petition is appropriate if there is fraud, gross mismanagement or management is “cherry picking” the payment of creditors.

In all cases, a creditor will receive a notice of bankruptcy, which, in a Chapter 13 and an asset Chapter 7, provides a deadline for filing a Proof of Claim. The Proof of Claim should be filed before the deadline, as failure to file a Proof of Claim may prevent the creditor from receiving payment. A separate pleading is filed in a Chapter 11 to set the deadline. The filing of the Proof of Claim enables the creditor to (1) be added to the mailing list; (2) receive notices which are mailed to all creditors; and (3) provide an address to send payments and notices. The Proof of Claim should identify all security for the debt and all obligations which are owed by the debtor and provide copies of all documents which support the claim. Creditors must mail the Claim so it is received prior to the deadline and should include at least one additional copy with a self-addressed, stamped envelope to receive a filed copy from the court, which is proof that the Claim was filed.

While a Proof of Claim is not complex to prepare, it may be wise to employ an attorney to assist in filing the Claim. This is particularly so for creditors who are owed a large sum of money, have claims arising from a breach of a contract or lease, secured creditors and those with a Mechanic’s Lien or equitable claim. An improperly filed Proof of Claim may result in its disallowance, which precludes the creditor from participating in distributions.  

About the author

Tom Mullinix is a partner in the Shawnee law firm of Evans & Mullinix.