A Key Customer Filed for Bankruptcy: Should You Keep Doing Business With Them?

by Cooley LLP

When a key customer files bankruptcy, one of the first questions you will face is whether to keep doing business or end the relationship. (Another key question is making sure your pre-bankruptcy claim gets on file or otherwise acknowledged.) Since companies in bankruptcy (called debtors or debtors in possession) usually cannot survive without trade support, they often reach out to suppliers to ask for trade terms, or at least a steady supply of goods, after a Chapter 11 reorganization bankruptcy is filed. They may put bankruptcy information on a restructuring website or send out written communications to suppliers. Note that if a customer files for Chapter 7 bankruptcy, the business typically will be closed with no further orders placed.

When a smaller customer files bankruptcy the “keep doing business” question is less critical, and the bankruptcy may just be the final straw that leads you to stop taking orders for new products or services. When one of your bigger customers files bankruptcy, the stakes go up — often way up. In either case, it is important to know the ground rules about doing business with a bankrupt customer. A distressed customer might use a non-bankruptcy state procedure, like an assignment for the benefit of creditors, but here the discussion is focused on what happens in a formal bankruptcy under federal law.

Getting paid for post-bankruptcy sales

In general, if the bankrupt customer is a Chapter 11 debtor in possession, the customer is legally permitted to pay for post-petition (post-bankruptcy filing) purchases of goods and services in the ordinary course of business. Even better, such amounts are generally accorded administrative claim status, meaning they have priority over unsecured and certain other claims, and the debtor is authorized to pay them currently.

Claims get administrative claims status if the debtor needs the goods or services and the cost is reasonable. Usually the amount in the contract or purchase order governs, but it is best to get a clear understanding with the debtor (or a bankruptcy trustee in the rarer instance when a bankruptcy trustee is purchasing goods or services) before providing post-petition goods or services.

If your transaction would not be considered an “ordinary course” transaction, for example if it is an unusually large purchase or on unusual terms, consider getting bankruptcy court approval for the transaction so your rights are protected.

Regardless of whether you continue to do business with the customer, any amounts the customer owed you from before the bankruptcy filing can now only be paid, if at all, with the approval of the bankruptcy court.

Be careful of the executory contract twist

Your dealings with the customer after its bankruptcy may also depend on the nature of your pre-petition relationship.

  • If you have sold products through separate purchase orders or individual transactions without an overarching contract governing the relationship, generally you may choose whether to continue dealing with the debtor post-petition and on what terms you do so (e.g., whether to require cash in advance or continue with trade credit terms).
  • If you and the debtor are parties to a pre-bankruptcy contract that is executory (meaning both you and the customer have material obligations to continue to perform), you cannot automatically stop performing post-petition unless the debtor has officially rejected the contract. Rejection means that the debtor has decided to stop performing and the bankruptcy court has approved that decision. Alternatively, if the debtor has made a formal decision to continue to perform the contract, and the bankruptcy court has approved this assumption decision, the debtor will have to cure, in cash, any pre-petition amounts owed.
  • Until a decision has been made, the debtor may be willing to make current post-petition payments under the contract. You should confirm this understanding with the debtor or its counsel in writing to protect your rights.
  • If you are concerned about getting paid or do not want to continue to perform for other reasons, you may need an attorney to file a motion to compel the debtor or trustee to assume or reject the contract, or to seek “adequate protection” payments pending that decision. Chapter 11 debtors get a long time to make decisions about executory contracts, often until a plan of reorganization is confirmed. However, the bankruptcy court may be willing to order that you be paid currently for post-petition amounts and/or clarify that you have an administrative claim for your post-petition performance.

Is the customer creditworthy?

Be sure to assess the debtor’s financial condition after bankruptcy. A bankruptcy filing relieves a debtor from the obligation to pay pre-petition unsecured creditor claims, and this can make a big difference to a debtor’s cash flow. Still, the customer has to have sufficient liquidity to pay its post-petition administrative claims.

  • To get the liquidity, debtors often obtain debtor in possession or DIP financing from lenders. DIP financings are usually secured by a blanket security interest on all of the debtor’s assets, putting the DIP lender ahead of even administrative claims in the event of default.
  • Although uncommon, debtors do sometimes default on DIP financings. If so, the DIP lender may foreclose on the debtor’s assets and the bankruptcy case may be converted to a Chapter 7 liquidation. If that happens, the DIP lender’s debt will be paid first from the estate’s assets. The administrative claims generated during the Chapter 11 case fall behind Chapter 7 administrative claims, such as the Chapter 7 trustee’s fees and expenses and those of his or her counsel, lowering their chance of being paid in full.
  • It is still very important to be comfortable with a Chapter 11 debtor’s financial condition and ability to pay for post-petition goods or services before extending post-petition credit. Most debtors are required to file post-petition monthly financial reports with the bankruptcy court; they can serve as one source of financial information.

Consult with bankruptcy counsel

These general rules govern many scenarios, but dealing with a debtor post-petition can be complicated and raise issues unique to your situation. Consider getting advice from a bankruptcy attorney before engaging in any significant transactions with a bankrupt customer.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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