CREDIT CORNER

Facts About Business Bankruptcy

By:  Michael C. Dennis, coveringcredit.com

(Reprint of May 2003 edition of “Business Credit Magazine”)

 

Disclaimer:  This article is not legal advice.  It is not intended to be legal advice, nor is it a substitute for competent legal advice on bankruptcy.

 

 

If you thought 2002 was a bad year for bankruptcy filings, you were right.  Five of the ten largest bankruptcy filings in US history occurred in 2002. More than 180 publicly traded companies filed for Chapter 7 or Chapter 11 in 2002, with debts of more than $360 billion.

 

Some of the more common causes for these bankruptcies included:

 

·        Accounting irregularities [and in some instances accounting fraud]

·        A weakening US economy

·        Bursting of the high-tech bubble, and

·        Crisis of confidence resulting in investors and banks pulling bank when corporations ask either for “help” or possibly even a financial bailout

 

In connection with their risk management responsibilities, credit managers need to know if the worst if over. It seems likely that more companies will step forward in 2003 and admit to the “accounting irregularities” but it seems unlikely that any bankruptcies that may result from these revelations will match the size and scope of the bankruptcies in 2002 – which included Enron, Encompass and WorldCom bankruptcy filings.

 

Here are a few interesting facts about business bankruptcies:

·        There are approximately 40,000 business bankruptcies filed each year in the US

·        Contrary to popular misconceptions, a bankruptcy filing by a customer resulting in a bad debt loss to a creditor company is not necessarily an indication that the credit department made a mistake in extending credit to that company. Bad debt losses are a cost of doing business and a consequence of selling to customers on open account terms

·        Automatic stay protects companies that file for bankruptcy. The automatic stay stops any lawsuit filed against the debtor as well as all actions against the debtor by a creditor or collection agency

·        Contrary to popular misconception, there is no guarantee that a creditor selling on open account terms to a debtor in possession in a Chapter 11 bankruptcy will be paid in full. The “administrative priority” that post petition creditors receive as an inducement to extend credit to the DIP is, to some extent, illusory to the extent that it purports to guarantee payment to post-petition creditors

·        Less than half the companies that enter Chapter 11 bankruptcy [reorganization] successfully emerge with a confirmed Plan of Reorganization

·        A company in Chapter 11 may continue to sell goods and to employ workers

·        A company exits Chapter 11 when the US Bankruptcy Court has approved a Chapter 11 Plan of Reorganization, and the transactions and payments proposed in the Plan are consummated

·        This Plan is usually developed by the debtor in possession [the DIP] in conjunction with its pre-petition secured and unsecured creditors, and in consultation with the official unsecured creditor’s committee

 

Following a bankruptcy filing, trade creditors can lawfully:

1.     Place the account on credit hold

2.     Stop shipments in transit

3.     Arrange for the return of merchandise in transit

4.     File a reclamation claim for any shipments received by the bankrupt debtor within a specific time frame prior to the bankruptcy filing date

5.     Refuse to extend credit to the bankrupt debtor

6.     Ask the Court to appoint a Trustee to run and manage the business if the debtor’s management is incompetent, or is involved in some form of theft or fraud

7.     Ask to be made a part of the official unsecured creditor’s committee

8.     Refuse an invitation from the US Trustee to join the official unsecured creditor’s committee

9.     Petition the Court to convert a reorganization bankruptcy into a liquidation

10. Demand immediate payment against any personal guarantee or inter-corporate guarantee that a pre-petition creditor may have on file. The creditor company can also sue the guarantor [if necessary] to collect against a guarantee

 

 

A Bankruptcy Checklist

Managing the credit department’s activities following a bankruptcy filing using a preprinted Checklist can save time and money, and more importantly doing so can prevent mistakes.

 

Important activities that should be included on the Checklist include:

·        Promptly sending a reclamation notice on shipments sent within the reclamation period

·        Reviewing payments received from the bankrupt debtor within 90 days of the bankruptcy filing date to determine the potential amount of reclamation claims [if any]

·        Calculating how much product was shipped to this customer in the 90 days prior to the filing date

·        Reprinting copies of all invoices, debits and credits open on the filing date, along with at least two copies of the entire account statement

·        Ordering proof of delivery on all open invoices

·        Promptly reviewing every document received from the Court to determine what action, if any, is required

·        Filing a Proof of Claim before the Bar Date

o       Including the required supporting documentation with the Proof of Claim

o       Completing the Claim in its entirety

o       Signing the Claim

o       Send the Claim to the Court by registered letter

o       Confirming your Claim was received and was filed by the Court

o       Keeping a copy of every document sent to the Court

 

 

Preference Claims

Any payment received within 90 days prior to the bankruptcy filing date may be subject to a preference action. Preference avoidance power is granted to “ensure an equitable distribution of the debtor’s assets”.

 

You should know that there are numerous defenses that can be raised by a creditor to preference action. A creditor often needs the help of an attorney to evaluate possible defenses against preference action, and/or to represent the creditor in Bankruptcy Court when hearings are held on the preference claims.

 

 

Selling to a Bankrupt Debtor

Since less than half of the companies that go into bankruptcy successfully emerge from it, unsecured creditors need to think carefully before agreeing to sell to a debtor in possession. Before doing so, creditors should be certain that:

·        Debtor acknowledges receipt of your reclamation notice/demand

·        Court has issued an order authorizing the use of cash collateral

·        Debtor has secured DIP financing [if such financing is necessary]

·        Creditor’s records and the debtor’s records match with regard to the amount of the pre-petition debt

 

 

Reclamation

Bankruptcy reclamation rights are often misunderstood. Reclamation involves the right of pre-petition creditors to reclaim goods shipped to an insolvent [bankrupt] customer shortly before the bankruptcy filing date.

 

The reclamation process begins when a creditor sends a letter to the bankrupt debtor demanding the return of goods. This letter/demand should be faxed, sent by overnight delivery, and sent by mail with return receipt requested. This letter should be sent as soon as possible. It should instruct the debtor to set aside, safeguard and not sell any of the items that are the subject of the reclamation demand. A seller generally has only ten (10) days to make its written reclamation demand, but if the ten-day period expires after the bankruptcy has been filed, the seller can make its reclamation demand within twenty (20) days of the buyer’s receipt of the goods.

 

A seller can reclaim goods delivered to a buyer if the seller satisfies all of these conditions

1.     Seller delivered the goods to the buyer

2.     Goods were sold to the buyer n the ordinary course of business

3.     Buyer must have possession of the goods at the time of the demand; and

4.     Buyer was insolvent when it received the goods

 

A creditor cannot require or demand that the debtor allow them to access to inspect and count inventory, but a creditor can request permission to do so. Also, a creditor’s reclamation rights are subordinate to the rights of a prior secured creditor with a security interest in inventory. Thus, the existence of a creditor with a blanket security interest in all the buyer’s assets [or just in inventory] will result in the denial of a reclamation claim.

 

 

The Advantages of a Bankruptcy for Pre-Petition Creditors

If you think nothing good comes from a bankruptcy filing, you are wrong. From the creditor’s perspective, the advantages of a bankruptcy filing include:

·        The fact that a bankruptcy filing forces the debtor to treat all “like” creditors the same way, rather than offering preferential treatment to some at the expense of others

·        The debtor is required to questions about its financial dealings under oath – and this may uncover certain transactions that can be “unwound” under the US Bankruptcy Code resulting in a larger payout to unsecured creditors.

·        A bankruptcy filing can prevent a dishonest or incompetent debtor or management teams from draining the company’s assets and enriching themselves at the expense of the company’s creditors