Where do I go from here? A primer on common bankruptcy issues facing molders

Whether it’s your customer or supplier that goes belly-up, there are steps you can take to protect yourself from sinking with the ship.

With signs of an economic slowdown mounting, injection molders face an increased risk that more of their customers or suppliers may seek bankruptcy protection or suffer financial distress. While many molders have dealt with such issues during recent bankruptcies in the automobile industry, others may be unprepared to deal with substantial changes to the nation’s bankruptcy laws.

This article provides an overview of some of the common issues facing molders impacted by bankruptcy filings. In addition, we’ll address how to structure transactions with potentially insolvent companies to minimize losses and avoid lawsuits. (Disclaimer: This article is not intended as legal advice.)

Effect of bankruptcy filing on claims

Once a company files a petition for relief under the Bankruptcy Code, a distinction is made between “prepetition” and “postpetition” claims against the debtor. Any prepetition claims that are not secured and not entitled to priority under the Bankruptcy Code are general unsecured claims that will be paid pursuant to a plan of reorganization or liquidation, and paid after all secured and priority claims.

On the other hand, a creditor’s postpetition claims—claims relating to goods and services provided to the debtor postpetition—are likely to fare better than prepetition claims. Under the Bankruptcy Code, creditors are entitled to “administrative claims” for goods and services provided to a debtor postpetition so long as they are “actual, necessary costs and expenses” used to preserve the debtor’s estate. Since administrative claims must be paid in full under plans of reorganization, these claims are usually paid in full.

As a creditor, if you become aware of a pending bankruptcy case, you should monitor the bankruptcy court’s docket to determine if the court has established a “bar date” by which creditors must file their claims. Failing to file a claim by the bar date can result in the claim’s disallowance.

Common issues facing creditors postpetition

Once your customer or supplier files for bankruptcy, you should consider a range of issues that may affect your claims against, liability to, and future business dealings with the debtor:

Lawsuits to recover preferential transfers. Companies that have dealt with bankrupt customers have likely already fallen victim to lawsuits filed by debtors to avoid and recover “preferential transfers.” A “preference” is any transfer (including a payment) made by a debtor to a creditor on a debt within 90 days before the date of the debtor’s bankruptcy petition. A preference may be avoided even though there was no wrongdoing on the part of the creditor or the debtor.

The good news is that the Bankruptcy Code permits a number of defenses to preference claims. Although a detailed discussion of these defenses is beyond the scope of this article, transfers made in the ordinary course of the business of the debtors and the creditor are exempt from avoidance, as are transfers to creditors who provide additional unsecured credit to the debtor after a transfer. In many circumstances, once a preference claim has arisen, the most prudent response is to assert a number of affirmative defenses and negotiate a favorable settlement with the debtor. In other situations, it may make sense to litigate the case.

Creditors can prevent preference claims from arising by placing distressed customers on a cash-only basis or obtaining purchase money security interests in the goods they sell. Moreover, companies facing possible exposure to preference claims are better able to assert and prevail on the possible defenses by taking the following measures:

1. Maintain records and documentation. Companies should maintain complete records regarding transactions with the debtor in order to assert the statutory defenses.

2. Enforce payment terms. Strictly enforce the terms of payment. The closer a payment is to the due date, the better the ordinary-course-of-business defense.

3. Confront the claim. Don’t ignore a debtor’s demand letter or lawsuit regarding preferences. Failing to respond may result in a default judgment against the creditor that it will have to pay in full.

Treatment of contracts with debtors. After a debtor files for bankruptcy, an automatic stay immediately goes into effect that, among other things, prevents creditors from unilaterally canceling or terminating an executory contract (one in which material performance remains on both sides). Instead, a party must continue to perform under the contract until either the debtor assumes or rejects the contract, or the contract expires on its own terms.

If the debtor rejects the contract, then such rejection is treated as a breach of contract immediately before the date of filing and may entitle the nondebtor party to a prepetition claim. If, however, a debtor assumes the contract, it must cure all payments under the contract. This is a very favorable result for creditors who wish to continue doing business with the debtor since such creditors will receive full payment for both prepetition and postpetition payments.

For most contracts, a debtor has until the confirmation of a plan of reorganization to determine whether it wishes to assume or reject an executory contract. A frequent issue for creditors under a long-term contract with a debtor, therefore, is whether or not the debtor will assume or reject the contract. One option is for a creditor to move the court to compel the debtor to assume or reject the contract in a shorter timeframe. Courts have broad discretion to order a debtor to assume or reject an executory contract within a specified period of time if the court determines that such an acceleration is prudent based on: the nature of the interests at stake; a balancing of the benefit and loss to each of the parties; and whether such an acceleration is consistent with the broad purpose of the Bankruptcy Code to permit the rehabilitation of debtors.

Setoff rights. The right to set off debts is generally preserved in a bankruptcy proceeding. Setoff is an equitable right based on the presumption that if two entities are indebted to each other, one debt may be set off against the other. There are a number of limitations on the right of setoff under the provisions of the Bankruptcy Code. First, there must be mutual debts owed between the parties. In other words, the debts must be between the same parties in the same right or capacity. In addition, an obligation that is not a proper “claim” may not be set off.

Reclamation. Under the Uniform Commercial Code (UCC), if a seller discovers that a buyer has received goods on credit while the buyer was insolvent, the seller may reclaim the goods upon demand made within 10 days after the buyer’s receipt of the goods. The Bankruptcy Code recognizes the right of reclamation that exists under state law and provides a seller with an opportunity, with certain limitations, to avail itself of such rights.

Once your supplier or customer files for bankruptcy, you must meet the requirements of the Bankruptcy Code in order to take advantage of the right of reclamation. To establish a right of reclamation under the Bankruptcy Code, you must make a written demand for the goods either not later than 45 days after receipt of the goods by your supplier or customer, or not later than 20 days after receipt of the goods if the 45-day period expired after the case was commenced.

The right of reclamation, however, has some significant limitations. For example, the rights of secured creditors will be prior to the right of any reclaiming seller, since one who takes such a security interest is considered a good faith purchaser under the UCC.

Prebankruptcy strategies to minimize liability and loss

The Bankruptcy Code affords many protections to debtors that may prove troublesome for molders that provided the bankrupt company with goods or services prior to its bankruptcy filing. You can protect yourself by using the following strategies to minimize the adverse effects of a bankruptcy filing.

Obtain and perfect security interests. Although it’s not always possible to do so, obtaining a security interest from a customer will make the creditor’s claim a secured claim if the security interest is properly perfected, meaning correctly completed. Unfortunately, it’s not uncommon for a creditor to take a security interest and neglect to perfect it in a timely fashion. For preference purposes, if perfection occurs within 10 days following the time of the transfer, it is deemed to have occurred at the time of the transfer. If perfection takes place outside of this 10-day grace period, it is deemed to take place at the time of perfection. It is clearly in a creditor’s interest to perfect all security interests at the earliest possible time to decrease the likelihood that a bankruptcy trustee will be able to avoid the transfer.

Obtain letters of credit and surety bonds. Letters of credit and surety bonds are two types of accommodations creditors may seek as a way to secure payment when doing business with a financially troubled company. A letter of credit is a commitment to make a payment that involves three parties: (1) the issuer, generally a bank, on whose financial responsibility the transaction rests; (2) the beneficiary, for whom the letter of credit is issued; and (3) the account debtor, who causes the issuer to issue the letter of credit and is responsible for the payment of any money drawn on the letter of credit.

Most letter of credit transactions are protected from preference attack since a surety bond is not property of the account party’s estate. Typically, when the account debtor files for bankruptcy and the surety that issued the bond makes payment on the bond, the surety has only an unsecured claim against the bankruptcy estate, unless the surety has been able to bargain for collateral or a letter of credit in exchange for the issuance or renewal of a bond.

Obtain security deposits. If a debtor has paid you a security deposit, applying this deposit to amounts owed you will typically not be construed as a preference, even if such amounts are deducted from the security deposit during the 90-day preference period. You can apply it to invoices that are not being paid timely (or, as the case may be, to invoices that are not being paid according to the ordinary course of business between the creditor and the debtor).

Demand prepayment or require cash on delivery. Requiring customers to prepay for goods or services is another way to ensure a payment is not found to be a preferential transfer. By requiring customers to pay for goods or services in advance, sellers are able to take such payment outside of the statutory definition of a preference in that such payment is not “for or on account of an antecedent debt.”

Similarly, if you’re concerned that a debtor may file for bankruptcy protection in the near future, another option is to require the debtor to pay COD for all goods and services.

Dealing with the bankruptcy of a key supplier or customer can be a painful process. However, molders who are knowledgeable about their rights in bankruptcy and are prepared to assert those rights can minimize their losses. Legal counsel can provide meaningful assistance to molding companies struggling to understand the bankruptcy process. Particularly in cases in which claims are large or business dealings with a debtor or supplier are complex, molders and related creditors should consult counsel immediately upon a bankruptcy filing in order to preserve their rights and avoid costly pitfalls.

Author Timothy S. McFadden ([email protected]) is an attorney with Locke Lord Bissell & Liddell LLP (Chicago, IL). His practice focuses on commercial bankruptcy and related litigation, and he frequently represents secured and unsecured creditors in bankruptcy cases of all sizes.