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A client's bankruptcy has surprise costs to creditors
By Bankrate.com

Bankruptcy filings are up dramatically, so don't be surprised if a trip to the mailbox yields a letter from an attorney or federal court telling you that one of your customers is seeking court help to solve his financial troubles.

That's when his bad news becomes your problem. The bankruptcy process is full of rules that the filer and creditors must follow. Ignoring them could cost you more than just missed payment from your client.

Surprise letter, lots of info
Chances are quite good that the letter will be the first you've heard about a client's financial problem. If you recently got a check from them, you might not even have noticed the letters DIP, short for Debtor in Protection, following the company name.

"It's not like wearing the scarlet letter but it's the closest thing to it," says Keith Costa, a former U.S. trustee for bankruptcy court and now a practicing bankruptcy attorney with Cummings and Lockwood in Stamford, Conn.

The extent of your client's troubles are more clearly revealed in the letter. This first communication includes a good deal of important information for you, the creditor, including:

  • the type of bankruptcy for which the debtor has filed,
  • the legal and DBA name of the company and its taxpayer ID number,
  • the date the case of was filed,
  • the court in which the case is being heard and the name of the judge,
  • deadline to file a proof of claim
  • the time, date and place of the first meeting of creditors, and
  • rules on collecting what's owed to you.

Of those, pay closest attention to the type of bankruptcy, the date the case was filed, the deadline to file a proof of claim and rules on collecting what's owed.

Three bankruptcy types
The case will be either a Chapter 7, 11 or 13 bankruptcy.

Chapter 7 is liquidation -- the company has determined its debts outweigh the value of the assets and it's liquidating what's left to split up among the creditors. Those cases can drag on for years, with the creditors paid at the end of the case.

Chapter 11 and 13 filings are marginally more encouraging.

Chapter 11 is for corporations and 13 is for individuals. If your client is a sole proprietor operating as a DBA, he would file in Chapter 13 as an individual.

In these cases, the debtor gets a breather from creditors while he attempts to reorganize and come up with a better (that is, profitable) way of doing business.

Law looks for ways to pay debts
Eventually paying creditors some money is a goal of restructuring, although it may not always seem that way during the bankruptcy process.

"Congress presumed the assets of the debtor are more value if they're used in a rehabilitated business than if they're sold for scrap," Costa says. "It's a safety net. They're trying to pay creditors and save the business. You try to maximize the value and then allocate those assets."

The strategy under Chapter 11 is to speed things along as quickly as possible, with the average case taking four to seven months to submit a plan for the new and improved version of the company. The bad news is that only about 30 percent of the plans are approved. The rest proceed from Chapter 11 into a Chapter 7 liquidation.

In either case, the experts say you can reasonably expect to recoup about 10 cents on the dollar -- in about four years. (We warned you. This is not a happy story.)

Get in line and wait
Bankruptcy court, as with most things in life, has a definite pecking order. Where you fall in the order will determine how likely you are to get any of what you're owed.

The ranks, from top to bottom, are:

  1. Administrative expenses and professional services. These are the people who do the work of filing the bankruptcy, such as the lawyers. (Are you surprised?)
  2. Secured claims, including mortgage holders.
  3. Priority claims, including wages and taxes.
  4. Unsecured claims. Most likely, that's you, trying to collect for goods sold or services rendered.
  5. Equity claims. These are stockholders. If it is any consolation, they will probably get even less than you do.

Then come the consequences of the date the claim was filed. This determines whether your invoices were submitted pre- or post-petition.

If they were submitted before the bankruptcy filing, you can't do anything to try to collect those debts. The day the case was filed, an automatic stay went into effect. That means no phone calls to the accounting department, no nasty letters to the company president and no filing liens or you -- yes, you -- will face penalties.

Giving money back
Another reason to look at the claim date is a provision in the bankruptcy code called preferential transfer, says Ed Bond, managing partner of the West Orange, N.J. certified public accounting firm Bederson and Co.

What it means is that if you got paid in the 90-day period before the case was filed, you may get a letter from an attorney demanding that you give the money back to put into the pot for distribution to all the creditors. And they'll want it a whole lot sooner than it took you to get it out of your cash-strapped client.

While not as common in Chapter 11, preferential transfer is a given in a Chapter 7 case, says Luis Salazar, a bankruptcy attorney with Greenberg Traurig in Miami, Fla.

"When you're the subject of the letter, it seems outrageous," Salazar says. "I can't tell you how many times I've had to call people and say, 'You have to give it back.'"

Let's make a deal
It's particularly frightening because most small businesses tend to cash and spend their checks pretty quickly. If you don't have the money any more, or even if you do, Salazar recommends "aggressive negotiation."

"Bankruptcy is a big 'Let's Make a Deal,'" he says. "You can always negotiate a resolution. Often times, you'll have to give back very little. You have to look at the statute, the money you have and the exposure you have."

There are several defenses under the law, including "ordinary course." That means that your client didn't show you any preference as a creditor; you just got paid the way you'd always been paid. A bankruptcy attorney can help you decide how to proceed.

Not surprisingly, no one wants to give the money back. As a result, lawsuits related to preferential transfer are a very common part of bankruptcy. That's one of the reasons they tend to drag on.

Filing a claim
The other major item to check on the court document is the deadline to file a claim. This is not a suggestion or an invitation to a party to which one arrives fashionably late. Meet the deadline or lose your right to submit a claim.

Costa recommends enclosing a self-addressed stamped envelope with a request that the clerk of the court file-stamp the claim and send it back to you.

"People send in the forms and that's it," he says. "With all the surge of filings, papers get lost and then you don't get paid. I've seen corporations lose millions by not doing it."

Creditors' committees
If the case is in Chapter 11, you should have a bit of strength in numbers.

The initial letter informing you of your client's filing also will provide you a date and place for the creditors' meeting. This is a meeting with the court-appointed trustee, the owner of the company and the people owed money. Here the company explains how things got so bad and what's going to be done about it, and the creditors get to ask questions.

If you're one of the 20 largest creditors, you'll receive a letter asking if you want to serve on the creditors' committee, Bond says. About half a dozen will be chosen to act on behalf of all the creditors, who get to vote on the debtor's plan to reorganize.

For the first 120 days, the debtor has the exclusive right to come up with a reorganization plan. If the court-appointed trustee decides the plan is workable, it's sent out to the creditors to review and vote on. For the plan to be approved, the debtor needs consent from more than 50 percent of the total number of creditors and from more than two-thirds of the debt owed.

Payment plans and debt-buy offers
You also want to look at the disclosures, which will tell you how much the bankruptcy filer plans on paying each of the creditors.

You need this information because you may be contacted by someone who wants to buy your claim. Typically, it will be from a company that is betting you'd rather get paid something now than wait months, if not years, for an uncertain return.

"Sometimes it's other creditors buying claims," Salazar says. "More often, it's companies that buy claims. If you receive something from them, chances are they think there's going to be a bigger payoff.

"If you get an offer, think it through very thoroughly. You may be able to get a better offer from them. These people are very smart and well-informed. Whatever they're offering you is very small compared to what they think they're going to make."

Bill Zewadski, a Tampa, Fla., bankruptcy attorney with Trenam, Kemker, Scharf, Barkin, Frye, O'Neill & Mullis, agrees. If you can wait for your money, it could make a big difference.

"There's a recognized mechanism to sell your claim in bankruptcy, but you need to investigate to see if you're being offered a fair price," he says. "Look at the filings in the case. The plan may offer far more than what you're being offered.

"I've seen a plan where the final payout to creditors was 120 cents on the dollar and they were being offered 105 cents. To have accepted the initial offer of 30 cents would have been ridiculous."

Glimmers of hope
While you're waiting for your client's bankruptcy to work through the process, there are a couple of important items to note and things you can do.

Since the cases tend to drag on, talk to your accountant about taking a deduction on your taxes for the bad debt. If you manage to recoup any portion of the debt down the road, you can claim it as income then.

Also, your debtor may ask you to continue working with him after he files for bankruptcy. While the immediate reaction might be to run in the opposite direction, it may actually be a way to recover some of what you've lost. Under Chapter 11 and 13, while the pre-petition debt is on hold, the debtor is supposed to stay current with his bills going forward.

"You can get better deals, tighter time frames, and you can add a premium to recover what you've lost," Salazar says. "Ask for COD or security deposit. A company can precipitously slide into a Chapter 7 and you're stuck. But if you keep up to date on it, you can make up some ground."

That may be true, Zewadski says, but keep in mind that there's nothing to keep a debtor from writing you a bad check.

"After bankruptcy," he says, "the only safe way to proceed is to get paid up front."

Pat Curry is a freelance writer based in Georgia.

-- Updated: Aug. 15, 2003


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See Also
Debt to a vendor could lead to default
Collecting from your customers
Fighting back against bouncing checks
Finding a lawyer for your business

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