A rise in Chapter 11 bankruptcy—what this means for creditors

Geopolitical uncertainty, rising inflation and higher borrowing costs have pushed some businesses to the brink and, in many cases, beyond it. Earlier this year in April, Epiq AACER recorded a 42% surge in Chapter 11 bankruptcy filings from the previous year. In a recent eNews poll, credit professionals noted both slight (35%) and significant (15%) increases in Chapter 11 bankruptcy filings.  

Why it matters: Bankruptcy may come without warning, but that doesn’t mean creditors can’t prepare. Having a sound checklist and a clear understanding of what bankruptcy means for credit risk can help creditors avoid future losses—no matter how long the case.

The Automatic Stay: Complicating customer relationships  

One of the first significant consequences of a Chapter 11 filing is the automatic stay—a federal injunction that halts all creditor collection actions on pre-petition debts immediately upon filing—changing how creditors interact with their customers.

This makes maintaining customer relationships difficult, especially when the customer doesn’t understand how bankruptcy impacts credit risk. “You want to protect the company, but you also do not want to damage a relationship with a customer who may just be going through a rough patch,” said Eve Sahnow, CCE, director of credit at OrePac Building Products (Wilsonville, OR).

Creditors are also vulnerable to a preference claim, or preference action, which allows a trustee or debtor-in-possession to “claw back” or recover payments made to a creditor shortly before a bankruptcy filing.

Subchapter V: Weakening a creditor’s position

Customers may choose to file for a Subchapter V bankruptcy, a more efficient and less expensive alternative to a Chapter 11 filing that strips away certain elements beneficial to creditors. “There is an additional layer of risk with Subchapter V that does not exist in the traditional Chapter 11 route, and debt recovery might prove more challenging,” said Jason Torf, Esq., partner at Tucker Ellis LLP (Chicago, IL).  

For credit managers like Sahnow, a Chapter 11 bankruptcy surge is a reminder to stay close to customers and remain adaptable. “It usually means more account reviews, more conversations with sales and sometimes, tightening things up where needed,” said Sahnow.   

Your customer declared bankruptcy? Here’s what you can do

#1 Gather relevant claim information  

Once notified of bankruptcy, begin preserving all information related to the debtor, including credit files, invoices, bills of lading and delivery receipts for goods received by the debtor within 20 days of bankruptcy filing. This, along with any customer communication logs can help determine preference liability and potentially guide decisions in the case.

Documentation relevant to preference exposure is also important. This consists of payments received within 90 days of the bankruptcy filing, at least two years of payment history for the ordinary course of business defense and invoices or proof of delivery for the new value defense. 

#2 Exercise your reclamation rights  

Under the Uniform Commercial Code (UCC), creditors have the right of reclamation outside bankruptcy. This means that if the customer has received goods on credit while insolvent, creditors may reclaim the goods delivered to the customer within 45 days before a Chapter 11 bankruptcy filing (or 10 days under non-bankruptcy UCC rules) by making a written demand.  

However, the right of reclamation is subject to several limitations and conditions. “The seller should consider whether it would be better off pursuing recovery of the debt rather than reclaiming the goods, especially in those cases in which the goods are of questionable value or would be difficult to resell,” according to Hinckley Allen.  

#3 Secure critical vendor status  

Where a debtor relies heavily on the supplier, it may ask the court to permit the debtor to grant certain creditors ‘critical vendor’ status. This authorizes the debtor to pay pre-petition claims of creditors deemed critical or essential to the debtor’s ongoing business or reorganization. “We may continue under previously agreed credit terms only after we secure critical vendor status,” said Scott Woitas, CCE, CICP, senior manager, credit and collections at Donaldson Co Inc. (Minneapolis, MN). 

It’s important to note that a debtor’s proposed critical vendor agreement or “Trade Agreement” frequently includes extremely debtor-friendly terms. To protect a creditor’s interests, it is advised to negotiate such agreements under the guidance of bankruptcy counsel.  

#4 File a Proof of Claim  

At some point, a creditor may be required to file a Proof of Claim notifying the court and other parties that a debt is owed. Acting quickly is critical here, as missing the applicable bar date could eliminate a creditor’s right to recover anything. 

However, if a creditor can confirm that they weren’t properly notified of the date, the claim may be treated as timely filed so long as the estate’s funds have not yet been distributed. “You need to provide a reasonable excuse for having missed the bar date,” said Andrew Behlmann, Esq., partner at Lowenstein Sandler (Roseland, NJ). “Most often, it’s attributed to a failure of due process or failure of service, such as the debtor failing to send a notice or the debtor sending the notice to the wrong place.”  

#5 Understand executory contract obligations  

In bankruptcy, a debtor has the power to assume, reject or assign executory contracts, agreements where both the debtor and a third party have material performance obligations remaining. Until the debtor decides, both parties must continue to perform. If a contract is rejected, the creditor is left with the damages claim. If assumed, all pre-petition amounts owed must be cured.  

Creditors may file a motion to compel the debtor to make an earlier decision, though courts rarely grant this relief. Consulting with bankruptcy counsel is vital before deciding to decline extending credit, as doing so without proper guidance can have unintended legal and financial consequences.  

The bottom line: A bankruptcy filing by a customer might seem disheartening, but it is manageable with the right tools and processes. By using those tools and consulting with bankruptcy counsel, you can enhance your recoveries and effectively mitigate risk.

What’s next: NACM’s Legally Speaking Thought Leaders is meeting for the first time on July 22 to discuss legal challenges and explore legal topics in business credit. Hosted by the Lowenstein/Sandler LLP, meetings will be held on the fourth Wednesday of each month at 2 p.m. ET. Register today to secure your spot!