A general bankruptcy primer: What happens when your customers file?
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Editor's Note: Tyler J. Russell is a member of the Creditors' Rights, Financial Institutions, and Community Associations Practice Groups at Ward and Smith, P.A.
Imagine this scenario: You operate a business that sells goods and services to customers on credit. You do not take collateral to secure your customers' accounts. One customer in particular (referred to as "ABC, LLC" or "ABC" throughout this article) owes you a large amount from several jobs or one large project, or both. Although you fully expect the account to be paid, you check the daily mail and find an official notice informing you that ABC, LLC has filed a petition for relief under the United States Bankruptcy Code ("Bankruptcy Code"). After recovering from the initial shock and concern that might follow such a notice, do you know what you can and cannot do to recover the debt owing on ABC's account?
What Does the Bankruptcy Filing Mean?
The Bankruptcy Code serves three basic purposes. It provides creditors, such as you, with an organized forum to address payment issues with the insolvent ABC. It provides the honest, but unfortunate, ABC with a "fresh start." And, if ABC chooses to reorganize its debts, it provides a process for saving and preserving ABC's going-concern value and/or its business. Generally, in filing bankruptcy, ABC's end-goal is to restructure and/or obtain a "discharge" of the debts owed to you and others. Think of this as a cancellation of ABC's obligation to repay the pre-bankruptcy debt owed to you. With some limited exceptions, debts discharged in bankruptcy cannot later be pursued and collected.
There are several types of bankruptcy cases that ABC might file. Unfortunately, they cannot all be discussed in this article. However, your rights, remedies, and obligations may vary widely depending on the "Chapter" of the Bankruptcy Code under which ABC files. Since ABC is a business entity, it is most likely to file for bankruptcy protection under Chapter 7 or Chapter 11 of the Bankruptcy Code. As discussed below, only individual debtors can utilize the protections found in Chapter 13.
Chapter 7 bankruptcy is a liquidation action that can be utilized by both businesses and individuals. Only individuals will be granted a discharge in Chapter 7 bankruptcy. If ABC does not intend to reorganize its debts, it may choose to file a Chapter 7 case. The Bankruptcy Court will appoint an independent Chapter 7 Trustee and that Trustee will take control of and administer ABC's assets. Typically, ABC's assets will be surrendered to creditors in accordance with applicable law and/or, if not encumbered by a surviving lien, sold to generate proceeds that can be distributed to creditors as payment for the debts owed to them.
Chapter 11 bankruptcy is a reorganization action. Chapter 11 cases can be filed by business entities seeking to reorganize their debts and by individuals whose debt levels exceed the stringent requirements for Chapter 13 bankruptcy. Chapter 11 cases typically involve active participation by creditors. In Chapter 11 cases, the debtor can file a plan that outlines the debtor's proposal to modify and repay the debtor's debts. Once a plan has been "confirmed" (that is, approved by the Bankruptcy Court), payments are made according to the plan's terms. A confirmed plan determines how and when payments are made.
Chapter 13 bankruptcy is a reorganization action for debtors who are individuals with regular income and not business entities. Chapter 13 bankruptcy is sometimes called a "wage earner's case." In a Chapter 13 case, the debtor must file a "plan" that outlines the debtor's proposal to modify and repay his or her debts. The plan can propose payments over a period of up to five years from the date the case was filed and, in certain circumstances, can provide for little or no payment to unsecured creditors. The Bankruptcy Court will appoint an independent Chapter 13 Trustee, although the debtor will typically retain possession and control of the assets. Payments required by the plan are typically paid by the debtor to the Trustee who then distributes those funds to the creditors entitled to payment.
The Automatic Stay
Whether or not you are aware of the bankruptcy filing by ABC, LLC, it has an immediate and substantial impact on your rights. The "automatic stay" provision of the Bankruptcy Code acts as an injunction that stops lawsuits, foreclosures, garnishments, and all other collection activity against ABC or against property of ABC's bankruptcy estate. The automatic stay applies from the moment ABC files its bankruptcy case. Imagine ABC pressing a pause button that ceases all recovery efforts outside of the bankruptcy case itself. The automatic stay gives ABC a "breather" and allows it to liquidate its assets in an organized fashion for the benefit of all of its creditors or to reorganize its debts without threat of additional lawsuits, foreclosures, or other collection efforts by its creditors.
The automatic stay prevents the taking or continuing of any action to collect the balance of the money ABC owes you. It also prevents the enforcement of other rights you may have such as perfecting a lien ABC may have given you against its property. Further, if your debtor (1) is an individual and not a business entity like ABC, (2) files a Chapter 13 bankruptcy case, and (3) the debt owed to you qualifies as a "consumer debt" (i.e., a debt incurred for the debtor's personal, as opposed to business, needs), the automatic stay also prevents any action by you to collect from non-bankrupt individuals who may be jointly liable with the debtor on that debt. This is called a "co-debtor stay."
As stated above, the automatic stay applies to prevent these actions whether you know of the bankruptcy filing or not. Accordingly, you must proceed with caution to avoid violating the automatic stay. If you violate the automatic stay, ABC may have legal recourse against you and if your violation is found by the bankruptcy court to be willful, ABC may be awarded sanctions against you by the court. If ABC's request for sanctions is granted, you could be required to pay fines and/or ABC's attorneys' fees and/or you may lose certain of your rights in the bankruptcy case itself. If you receive notice that ABC is seeking sanctions for your violation of the automatic stay, act quickly and seek the assistance of knowledgeable legal counsel to minimize your exposure.
Payment Rights and Remedies
In limited instances, you may be entitled to have the stay lifted. If the stay is lifted, you can take any action that is allowed by the Bankruptcy Court. For example, in a Chapter 13 case, and despite an earlier prohibition on the action, you may be able to have the stay lifted and be allowed to file suit against a non-bankrupt individual who is jointly liable with the debtor for a consumer debt.
If you sell goods on credit in the normal course of your business, and if you sold goods to ABC within 45 days immediately preceding ABC's bankruptcy filing, you may be able to reclaim the goods from ABC. You may also be entitled to assert a priority claim for the value of any goods sold to ABC in the ordinary course of business during the 20-day period immediately preceding the bankruptcy filing. But, you need to act quickly to preserve these rights or they will be lost.
Certain debts cannot be discharged. Examples include debts caused by fraud, larceny, or embezzlement. In other words, a debt owed to you by ABC because it is responsible for a fraud, larceny, or an act of embezzlement will not be discharged in bankruptcy and ABC will remain obligated to you for its payment. The Bankruptcy Code defines situations in which a debt may be "non-dischargeable" and places strict burdens and time requirements on creditors seeking to prove non-dischargeability. The deadline for filing these claims must be closely monitored; once it expires, so will your right to seek the non-dischargeability of the debt owed to you.
You can also file a Proof of Claim with the Bankruptcy Court to evidence the debt owed to you by ABC. Doing so early is advisable to make sure your claim is recognized and that you are informed of the status of the bankruptcy proceeding. Filing a Proof of Claim does not guarantee repayment; instead, it merely preserves your right to share in a distribution of ABC's assets.
Every bankruptcy filing is different, and the underlying facts will impact your rights and influence your strategy in the case. Be proactive in seeking guidance on proper pre-bankruptcy loss mitigation efforts, but understand that all risk of loss cannot be avoided. And if a customer files bankruptcy, act quickly! It is up to you to seek out legal counsel or otherwise act promptly to protect your interests while remaining in compliance with all of the laws, rules, and procedures.
© 2014 Ward and Smith, P.A.
Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Tyler J. Russell practices in the Creditors' Rights, Financial Institutions, and Community Associations Practice Groups where he represents clients in a wide range of debt collection and bankruptcy matters. Comments or questions may be sent to email@example.com.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.
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