A Customer in Bankruptcy

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Bankruptcy is a common phenomenon in our country; it’s even written into the U.S. Constitution. Financial trouble can surprise anyone, from toy makers to hospitals.

It shouldn’t come as a bombshell, then, if one of your customers — even the Steady Eddie — quits paying his bills and files for bankruptcy.

In 2006, for example, 20,000 businesses filed for bankruptcy, according to the United States judiciary system (www.uscourts.gov). Business bankruptcy filings are a function of both the economy and specific industry troubles, says Professor Dan Schechter, a lawyer who has taught courses in bankruptcy and commercial finance at Loyola Law School in Los Angeles for nearly 30 years. The concern is not just for those who are affected by the subprime mortgage crisis.

"If you are in a dying industry, like buggy whips or rotary dial telephones, that industry is going to see a spike in filings. If the economy in general is hurting — think oil crisis or credit crunch — the filings will be across the board," he says.

Accounts receivable personnel play an important role in recovering money from companies in trouble. From before the filing through the liquidation and distribution of funds, AR has to track the process and make sure their company recovers as much of the cash they’re owed as possible. In fact, accounts receivable may actually be among the first to sense a problem. If a company begins to regularly make late payments, or short pays, it’s time to wonder if something larger is wrong.

But don’t worry, you don’t have to play detective for too long. Chances are the first notification of the bankruptcy will be from the company itself. A company petitioning for bankruptcy is required to mail notices to all of its creditors and list the amount of money owed.

If a customer actually files for bankruptcy, AR’s course of action depends on whether the customer has filed for Chapter 11, in which it is trying to reorganize and stay open, or Chapter 7, in which it’s closing down the business and liquidating its assets.

What to do if your customer files Chapter 11

Chapter 11 filings are more complicated than Chapter 7. The customer is required to notify you of its petition (filing Chapter 11) and the amount of money it owes you. If the amount it reports matches your receivables, then you typically don’t have to take any action. However, if you dispute the amount (they say they owe you $100, you say they owe $250), then you have to file a proof of claim in the bankruptcy court. You must specify and document exactly how much the customer owes you.

If you have a dispute, pay attention to the bar date. This is the date by which you are required to file a proof of claim. In large cases, it can be one or two years after the petition (the official date the bankruptcy is filed in the court). If you fail to file a proof of claim before the bar date, your claim is tardy and most likely won’t be counted. The customer will mail to you most of the forms and the crucial information you need. However, you can also check local court Web sites for additional forms and protocols. Most bankruptcy courts are on the PACER system.

After you’ve filed the proof of claim, look back at the transactions between your company and the customer that occurred within the 90-day period prior to the bankruptcy. This is called the preference period. Here’s where AR’s actions really matter. The court wants to see that your transactions were consistent with your normal course of business; otherwise you may have to return some payments.

Here’s how to prevent returning money paid to you by the customer during the preference period: If you suspect a customer might file bankruptcy soon, don’t suddenly raise your prices or start billing more frequently. For example, if you normally ship out 100 toothbrushes for $200 every month, continue to do so. Any shipments or payments outside of what’s normal for your relationship with that customer — or what’s normal for that industry — can be considered a preferential treatment, and the court may order you to repay the money.

"Preference actions are brought to the court to attempt to get money back for redistribution to creditors," explains Joel Helmrich, a bankruptcy lawyer with the firm Meyer, Unkovic & Scott in Pittsburgh. "Business as usual is No. 1," he says. "Just because you got a payment within 90 days doesn’t mean you have to return it. If the payment is in the ordinary course of business, that payment could be defended and retained."

In 2005 changes in the bankruptcy codes were made to protect small businesses. Before 2005, if a preferential payment was suspected, the court would send the business a letter and they would have to return the payment, hire a lawyer in the customer’s state and hope to get it back when all of the funds were redistributed; or they could keep 20 percent of the payment and be done with it. Now, a preferential payment has to be at least $5,000 to be pursued by the bankruptcy lawyers. If the amount is under $10,000, and the two companies are in different states, the bankrupt company has to pursue the preferential payment in the creditor’s home state. This protects small businesses from having to hire an out of state lawyer.

The reason for preference actions is this: there’s a pecking order in Chapter 11 bankruptcy that determines which creditors get paid first. You can’t try to collect your money outside of the court’s proceedings, like an AR vigilante.