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With the nationwide increase in bankruptcy filings, it is not unusual for a business to be faced with the question: Should I do business with a business in bankruptcy?
Many businesses with financial difficulties attempt to reorganize their affairs by filing a bankruptcy petition under Chapter 11 of the United States Bankruptcy Code. The filing of a Chapter 11 bankruptcy petition has two immediate and automatic consequences. First, all efforts by creditors to collect pre-bankruptcy indebtedness must cease. Second, notwithstanding the bankruptcy filing, the bankrupt business is entitled to keep its assets and continue operating its business. Under these circumstances, the bankrupt business is referred to as "Debtor-in-Possession."
How, then, should your business deal with a Debtor-in-Possession, if at all? Here are some of the questions most often asked:
1. Should my business continue to deliver goods or supply services to the Debtor-in-Possession on open account?
The answer to this question will depend upon the particular circumstances. Legally, the Debtor is required to make timely payment in full for all goods and services received after the filing of the bankruptcy. Practically, the Debtor-in-Possession may or may not have the ability to do so. In many instances, the simple filing of the Chapter 11 bankruptcy petition stabilizes the financial condition of the Debtor-in-Possession, enhancing, at least for the short term, the Debtor's creditworthiness. If the Debtor-in-Possession was reasonably current up until filing for bankruptcy, and the additional credit to be extended by your business is relatively small, you might consider extending the same payment terms after the filing of the bankruptcy. Obviously, the account should be closely monitored. The best practice, in any case, is to proceed cautiously. If a large extension of credit is under consideration, consider personal guaranties from the owners of the bankrupt business as a credit enhancement. Shipping C.O.D. or, in the alternative, obtaining a letter of credit from a bank, are the safest bets. A final word of caution: If the Debtor-in-Possession offers you any sort of collateral to secure payment for goods and services to be rendered during the bankruptcy, you cannot rely upon that offer until the U.S. Bankruptcy Court approves the arrangement. The Debtor-in-Possession has no power or authority to incur additional secured debt without Court approval.
2. Can I require payment on a past-due account as a condition of doing further business with the Debtor-in-Possession?
No. The Debtor-in-Possession is generally not permitted to pay pre-bankruptcy indebtedness. Pre-bankruptcy indebtedness must, instead, be repaid by the Debtor pursuant to the terms of a "Plan of Reorganization" which is approved by the Bankruptcy Court. One of the legal requirements for a Plan of Reorganization is that the Plan treat creditors in a fair, equitable and non-discriminatory manner. A "side deal" for payment of pre-bankruptcy debt in exchange for favorable treatment during the bankruptcy may, in fact, be a violation of federal criminal laws.
3. Does my business have to complete performance under a contract with the Debtor-in-Possession?
This is often a concern for businesses which have a contract pending with a Debtor-in-Possession at the time the bankruptcy case is filed. The contract may require you to provide additional goods or services and, of course, you will be concerned about getting paid. The right of a bankrupt business to assume or reject a contract is a complicated area of our bankruptcy laws, one which is beyond the scope of this article. However, two fundamental concepts should be kept in mind:
First, the filing of the bankruptcy by the Debtor-in-Possession does not automatically excuse your business from future performance of existing contractual obligations. This is true even if the contract states you can terminate the contract in the event of a bankruptcy filing--these "bankruptcy clauses" are generally not enforceable. Accordingly, your refusal to complete performance of the contract may result in your breach of the contract and result in liability.
Second, by taking certain legal action with the assistance of your attorney, the risk of either performing the contract and not getting paid or refusing to perform and being liable for breaching the contract can be minimized or eliminated all together. At your request, the Bankruptcy Court may require the Debtor-in-Possession to demonstrate its ability to pay your business for completion of the contract, or the Court may excuse your business from future performance altogether.
Chapter 11 bankruptcies are an economic fact of life. Good business judgment may require you to do business with a bankrupt business. On the other hand, there are certain risks and pitfalls associated with the Chapter 11 process. Given the complexity of our bankruptcy laws, when significant credit or contractual obligations are at stake, seek legal advice from an attorney experienced in bankruptcy law.
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For more information on bankruptcy, creditor-debtor and loan workout issues, contact Frederick Dudderar, fad@hanftlaw.com or 218-722-4766.
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The information provided in this article is general in nature and should not be used as a substitute for professional services and advice. The communication and receipt of this information is not intended to create an attorney-client relationship. Readers should consult with their legal counsel before taking any action on matters covered in this article.
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Copyright 2001 by Hanft Fride, P.A. All rights reserved. Hanft Fride, A Professional Association, 1000 U.S. Bank Place, 130 W. Superior Street, Duluth, MN 55802. Phone 218-722-4766; fax 218-529-2401.
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