Protecting Your Business as Your Customer/Client May be Approaching Bankruptcy

Apr 12, 2021 | Blog

The Warning Signs

The warning signs can be both subtle as well as more obvious. One or more of your previously payment-reliable customers/clients start to stretch their payment terms. Less than 30 days becomes closer to 60 days, then moves steadily towards 90 days, 120 days, and onward. Customers/clients may also start to pay less than the outstanding amounts due, making them fall even further behind.

Then, the “excuses” start. It is not them; it is those that they rely on in business who are reportedly falling behind. You are told that your customer’s/client’s business is fine—they just need to lean more on their own suppliers or lender. Or the circumstances are just temporary and, with a little more time, they will be caught up with what they owe you. The list of rationalizations goes on and on.

These scenarios are frequently followed by the hearing of “rumors” that these customers/clients are in financial trouble. Word gets out that key management or employees are leaving, cash flow has become ever-tighter, other debt obligations (such as loan and lease payments) are falling behind, and it is becoming harder and harder to get these customers/clients to return your calls or emails.

Given what the economy has gone through with the pandemic, and as stimulus money dries up and forbearances (private or government-mandated) run their course, reality may quickly cause a number of struggling companies to have little recourse other than to file for bankruptcy during the year ahead. Case in fact, a new report from retail analysts at UBS indicates that as many as 80,000 retail stores in the U.S. may close during the next few years. In the past year alone, 17 major retailers filed for bankruptcy, including: Ann Taylor and several other retailers under the umbrella of the former Ascena Retail Group; Century 21; Brooks Brothers; and Lord & Taylor, resulting in the jettisoning of thousands of store locations and related liquidations.

In short, challenging times may not be far off for some business sectors. However, there are times when (for various business reasons) you may want to continue working with your company’s struggling customers/clients, while at the same time trying to minimize your potential risk and exposures. To that end, any business finding themselves in such circumstances with significant unsecured debt should consider steps to take both before and after the commencement of a bankruptcy to limit their exposure, while seeking to maximize their future recovery from the debtor’s bankruptcy estate.

Pre-Bankruptcy Collection Efforts and Limiting Preference Exposure

An all-too-familiar knee jerk reaction when customers/clients are falling behind on their payments and other obligations is to “apply pressure” on them to fulfill these obligations as soon as possible. Some companies will become fervent collection agencies and start corresponding with their struggling customer/client repeatedly, possibly “threatening” to impose various collection actions or to cut off the customer/client completely. Payment periods may be suddenly shortened, interest added, payment terms changed, or demands made to “secure” the creditor’s position. This may also be captured in written correspondence and/or emails leaving a lengthening paper trail as to what transpired.

Depending on just how critical the creditor is to the debtor, the debtor may agree to alternative terms in order to maintain the business relationship. However, if the debtor still ends up filing for bankruptcy, it may be months or even years into the case when you find your business in the unenviable position of having a large, unsatisfied claim against the debtor that might only receive, at best, a small partial payment through the bankruptcy. At the same time, your company could be served with a complaint seeking to cause your business to reimburse the debtor, in full, some or all of the payments your business received in the 90 days preceding the bankruptcy filing (or during the prior one year as to “insiders”). Obviously, this is not a position any company wants to find itself in, and there are several steps that can be taken pre-bankruptcy that may limit such avoidance exposure.

First, a bit of brief background on what these “preferential transfers” are comprised of. Under Section 547 of the Bankruptcy Code, certain transfers—usually payments, though they can come in other forms too such as causing the debtor to secure previously unsecured obligations—made by the debtor prior to its bankruptcy may be “avoided” and “recovered” on behalf of the debtor’s bankruptcy estate (whether by the debtor, a trustee, an assigned-to creditor, a liquidation specialist, or otherwise). In order for this to occur, it must first be proven that the transfers:

(1) were of the debtor’s property;
(2) were made to or for the benefit of the creditor;
(3) were made for or on account of an antecedent debt;
(4) were made while the debtor was insolvent;
(5) were made within 90 days before the bankruptcy was filed (or, again, one year in the case of transfers to an “insider”); and
(6) allowed the creditor to receive more than it would receive in the bankruptcy had it not received the challenged transfers.

There are a variety of potential defenses to such an action set forth primarily in Section 547(c) of the Bankruptcy Code. If one or more of the steps outlined below were taken by the creditor pre-bankruptcy, either the action itself may not exist or the creditor’s defense would be enhanced before the case was commenced.

Avoiding Extraordinary Collection Activity

As noted above, there are times where creditor-companies will engage in what can only be referred to as “extraordinary” steps to compel their debtors to satisfy outstanding debts or other obligations. Simply put, any atypical steps taken between a creditor and its debtor that allow the creditor to be paid or further secured in the months immediately preceding a bankruptcy filing can become fair game for establishing an avoidable transfer, especially if a paper trail was left behind them. Avoiding engaging in such steps, including leaving such a paper trail, is a first prong to limiting exposure to preferential transfer avoidance. Payments made in conformity with the parties’ historical practices and on accounts that conform with the parties’ usual practices will, instead, usually qualify for what is referred to as the “ordinary course of business” defense.

Pursuing Cash on Delivery (COD) Terms

When parties agree to contemporaneously exchange goods or services for payment, and they in fact do so, the payment may be protected by the “contemporaneous exchange of new value defense.” Critical to this defense is that the parties had the “intent” to engage in a contemporaneous exchange, as for instance pursuant to COD terms, and such exchange was substantially contemporaneous (with the possibility of some gap being allowed between the goods/services provided and the payment made based on the facts of the case).

Requiring Payments in Advance

Since one of the elements of a preferential payment is that it must be on account of an “antecedent debt,” your company could insist upon payment in advance and, thereby, arguably cause this prerequisite to go unfulfilled.

Using Critical Vendor Status

This will be discussed further below but, from a preference standpoint, if your business is approached as being a possible “critical vendor” to the debtor’s post-bankruptcy operations, one element of negotiation for your business to be willing to continue to supply goods or services post-petition pursuant on ordinary business terms is that your business not only receive payment for some or all of what it was due pre-bankruptcy, but also with the understanding that any potential preferential transfer liability your company might have is waived. Additionally, you will want to make sure this new relationship is captured in a Critical Vendor Agreement executed on behalf of your company.

Considering Litigation Settlements

Of course, the longer payments and other obligations go unfulfilled by a debtor pre-bankruptcy, the greater the possibility that a lawsuit may need to be filed to compel the debtor to meet its obligations. As the action progresses, the parties may determine to settle it rather than bring it to trial. The payments made (or liens granted) pursuant to a settlement, however, may raise their own possibility of being challenged as preferential if the debtor ultimately files for bankruptcy. Additionally, certain protective provisions of the agreement, such as stipulating that the debt would be non-dischargeable in a subsequently filed bankruptcy, could be deemed preferential and/or in violation of public policy. While beyond the scope of this overview, there are possible “bankruptcy-proofing” considerations to such settlements that Barton counsel will be able to advise you on before the settlement is finalized and executed.

Utilizing Letters of Credit and Guarantees

Additionally, under appropriate circumstances, insisting upon letters of credit and/or the execution of third-party guarantees of the debtor’s outstanding (and future) debts can add further levels of protection.

Are the above steps effective? They have been in representing this author’s clients for over three decades. While there are no complete guarantees, with the advice of counsel, Barton has had clients whose frustrating preference actions have been resolved with zero or significantly reduced liability.

Enhancing Your Company’s Payment Chances Once a Bankruptcy is Filed

As is generally well known, the filing of a bankruptcy gives the debtor the benefit of the “automatic stay.” In the absence of court-authorized relief from the stay, it bars the vast majority of attempts to continue to try and collect outstanding debts from the debtor, among other stayed actions. There are limited exceptions to the automatic stay, but you should consult counsel before trying to take any action against the debtor or its property during the bankruptcy. If a creditor violates that stay, they could be faced with not only having to pay the debtor actual damages, but also attorney fees and, in certain circumstances, punitive damages. But there are potential ways of enhancing your company’s chances of being paid on its claim(s) against the debtor:

Halting Goods in Transit and Insisting Upon Adequate Assurances

If your company provides goods to the debtor, it should consider halting or stopping goods in transit if they have not already been “delivered” to the debtor or an agent of it. Then, your company should make demand upon the debtor for proof that adequately assures you of the debtor’s ability for future performance (i.e., assurances that it can and will be able to pay going forward). Your counsel can also contemporaneously file a motion with the bankruptcy court seeking court-authorized adequate assurances and, in the absence of receiving the same, the ability to end your company’s obligations to continue to supply the debtor.

First-Day Motions and Gathering Ongoing Information About the Debtor

Particularly in Chapter 11 cases, a debtor will generally file a series of initial motions (i.e., first-day motions) seeking a variety of court authorizations for matters that it would not automatically be entitled to under the Bankruptcy Code. Some of the relief sought can include requests to treat certain creditor claims differently than what the Code generally provides. These requests may include seeking authority to promptly pay some or all of certain types of unsecured claims, such as pre-petition wages, critical vendor claims, certain customer obligations, and sales and use taxes. Additionally, the debtor may file motions for authority to use cash collateral and/or to obtain debtor-in-possession financing. Any of these motions could impact your company’s interests in the bankruptcy and, as a result, you may want your counsel to review and evaluate the same.

The filing also affords your company several different opportunities to obtain information about the debtor and its financial affairs that can prove beneficial as the case unfolds. After the case begins, the debtor will be required to make one or more presentations about what caused its filing and how it plans to reorganize during (1) the organizational meeting of creditors to form a Creditors Committee and/or (2) the 341 meeting of creditors administered through the Office of the United States Trustee. Creditors are generally allowed to ask questions of, and obtain information from, the debtor’s representatives during these early-in-the-case meetings.

Next, the debtor is required to file (generally within the first 30 days of the case) detailed schedules of its assets and liabilities as well as a statement of its pre-bankruptcy financial affairs. These pleadings usually contain significant information about the debtor’s financial status and financial affairs leading up to (and as of the date it commenced) its bankruptcy case. As the case progresses, the debtor is also required to file monthly operating reports that reflect the debtor’s financial position and cash distributions made during each monthly period of its ongoing case. Finally, under appropriate circumstances, Rule 2004 of the Federal Rule of Bankruptcy Procedure provides a mechanism for seeking document production(s) and deposition testimony of the debtor’s financial affairs that has been frequently described as allowing a “fishing expedition” of discovery.

Proofs of Claim

Either at the outset or during the course of a Chapter 7 bankruptcy, new Subchapter V small business bankruptcy, or more traditional Chapter 11 bankruptcy case, a date will be set (by notice and/or court order) by which most claims against the debtor for pre-bankruptcy debts must be filed or will otherwise be time-barred. This is especially true for creditors holding claims that the debtor has scheduled as either (1) contingent, unliquidated, or disputed or (2) in an amount that is less than that shown in the creditor’s books and records. Making sure that your company’s claim is timely filed is, therefore, a critical step to establishing its entitlement to be paid through the bankruptcy. Additionally, besides adequately documenting the support for your claim, you will need to understand the distinctions between having secured, unsecured, and/or administrative claims to be filed. Your company might also be able to secure a previously unsecured claim in certain limited circumstances, such as with the filing of a post-petition mechanics lien or assertion of a warehouseman’s lien where appropriate.

Creditors Committee Participation

In Chapter 11 cases, the Office of the United States Trustee frequently appoints a Committee comprised of creditors holding unsecured claims (the members typically number 3, 5, or 7). The members are normally selected from the creditors holding the 20 largest unsecured claims against the debtor, and the Committee is generally formed during the initial month of the case. The Committee typically handles such functions as investigating the debtor’s financial condition, conducting an analysis of its business affairs and other creditor classes, and participating in the formation and negotiation of the debtor’s bankruptcy plan, among other things. Should you be chosen to be a Committee member, you will likely become privy to a level of information that other creditors readily are not and can take an active role in seeking to maximize the recovery to unsecured creditors.

Critical Vendor Role

If your goods or services are deemed by the debtor to be essential or “critical” to its ongoing operations, the debtor may approach you—either as they are approaching their bankruptcy filing or not long thereafter—about being considered for critical vendor status. The quid pro quo expectation on the debtor’s side is that your company will continue to provide its goods and services as the case progresses under the normal business terms that the parties operated under pre-bankruptcy. In return, the expectation is that the debtor will pay your company all, or some portion (more likely), of what it was owed as of the date of the filing. In short, critical vendor status could get your company paid a notable portion of its pre-petition debt early in the case and well before any plan is developed. As noted above, you may also want to negotiate a waiver of any potential preference liability your company may have. Also, you will want to work through the terms of and execute a Critical Vendor Agreement before continuing the critical vendor relationship.

Reclamation Demands and/or 20-Day Administrative Claims

If your company has delivered goods to the debtor that it received within 45 days of filing for its bankruptcy petition, and your company did not receive payment for such goods before the filing, your counsel can help you prepare an appropriate written demand for return of those goods (commonly referred to as a “reclamation claim”). You must be diligent in doing so as such a demand must be made within 45 days of the debtor’s actual receipt of the goods or, if that date expires post-bankruptcy, within 20 days of the bankruptcy filing date. Failing to meet that time period results in a waiver of such a demand. Alternatively, instead of having the actual goods returned, your company could be granted a Bankruptcy Code Section 503(b)(9) higher priority administrative claim for the value of the goods supplied during the 20 days preceding the bankruptcy. In either case, you will have enhanced your debt collection chances post-bankruptcy as to the goods in question.

Pre-petition Contracts

If you have a pre-petition contract deemed “executory” (i.e., a contract under which one or both parties still have important duties to perform) and the debtor determines that this contract is still important to its ongoing operations and wants to continue to receive the benefits of it, the debtor may seek to “assume” that contract and, in certain instances, possibly “assign” it to a third party such as a buyer of certain of the debtor’s assets. To do this, however, the debtor must “cure” any outstanding defaults, including paying unpaid amounts due. As such, if your company is in such a contract with the debtor, you are entitled to be paid in full for any outstanding debts arising under the contract before it can be assumed or assigned by the debtor.

Administrative Claims

If your company continues to do business with the debtor during its bankruptcy filing, any goods or services your company provides to the debtor during this time are required to be paid for during the ordinary course of its post-petition business. To the extent the debtor falls behind in such payments, your company’s unpaid amounts should be treated as administrative expenses of the bankruptcy and entitled to a higher priority administrative claim for the amounts due when claims against the debtor’s bankruptcy estate are eventually paid. Your company can further protect its position by actively monitoring the debtor’s bankruptcy financial condition and making sure to file appropriate administrative proofs of claims.

Retention of Records

Your company should preserve all business records and other relevant documents (paper or digital) relating to its relationship with the debtor. These records could prove to be important in the long term as actions can be brought against creditors for transactions that predated the bankruptcy filing for up to two years after the date the bankruptcy was commenced. Your company may need this documentation to launch a successful defense in such actions.


Whenever your company is faced with a financially struggling customer/client, laying out an appropriate plan to temper your company’s risk and lower its exposure can be vital to the bottom line. Steps like those outlined above can minimize your company’s downside exposure, including potential preference liability, while maximizing the recovery on the debts owed by the debtor. Of course, the course of action will vary depending on the facts unique to the particular creditor-debtor relationship. However, being proactive, being diligent, avoiding reliance on extraordinary collection efforts, and working with your counsel are all likely to best protect your company’s interests and maximize its recoveries in any subsequently filed bankruptcy case.

If you have any further questions regarding protecting your business from exposure related to a financially distressed or bankrupt customer/client, please contact Eric Sleeper.