||What Happens When Your Customer
Files for Bankruptcy
by Stephen Furnari
As the temperature started to swell during an early Spring heat wave, the owner of a large commercial office building in Manhattan needed the building's main air conditioning unit serviced in order for it to work. One of our clients, an HVAC specialist, was the contracted service provider. Problem was, the building owner was behind on his account by a fairly wide margin.
It seems that few businesses have better leverage over non-paying customers than a HVAC service company when the mercury climbs past 90 degrees. Our client's request to its customer: bring the account current and get your AC fixed.
On its face, this seemed like a simple, yet effective, collection policy--that is, until the customer filed a petition for bankruptcy.
Our client, who had little interest in performing services for an account that was past due, was surprised to learn that the bankruptcy court would require them to continue to perform the contracted services. They did so, without knowing when the customer's account would be brought current, if at all.
As the economy continues to falter, in entrepreneurial circles, bankruptcy has become a frequent topic of conversation. According to Michele Cosenza, a bankruptcy attorney in New York City, "we're seeing an up-tick in business bankruptcy filings, especially in small businesses which are typically burdened with debt and are experiencing a real drop in demand for their products or services."
Unless you're a bankruptcy lawyer, most likely when you think about bankruptcy it's from the perspective of the person or company who owes money--the debtors--and how they use the bankruptcy laws to seek protection from the people they owe money to-the creditors. However, in our firm, most often when we come in contact with a bankruptcy situation, we see stable companies that have been affected by their customers' financial problems.
Frequently, we see situations like the HVAC company, where our client is a party to an "executory contract", an agreement where one party agrees to deliver a service or good and another party agrees to pay for such service or good. Once a debtor customer initiates a bankruptcy, a creditor service provider may expose itself to breach of contract claim if it terminates the contract. In addition, a creditor's termination of an agreement may be viewed as an attempt to try to force the debtor to pay its pre-bankruptcy obligations, a tactic that is prohibited under bankruptcy law.
Generally, a court will require the creditor to continue to perform under the terms of the agreement. In the case of our HVAC client, they were forced to service their customer's AC unit.
According to Cosenza, once in bankruptcy, a debtor has a grace period to decide whether it will reject the contract, assume it and continue to perform under the agreement (pay post-bankruptcy fees), or assign it to a third party, such as an acquirer of the business. However, says Cosenza, "during that grace period, the creditor is generally required to continue performing services under the contract unless it receives permission from the bankruptcy court.”
According to Cosenza, if the debtor rejects the contract, the outstanding debt (or a portion thereof) will be paid at the end of the bankruptcy with any remaining assets, and according to a court approved payment schedule.
If the debtor assumes the contract, both parties are obligated to perform and are liable for any obligations based upon the original contract terms; however, the debtor must prove to the court that they are able to perform (pay fees) and cure any defaults under the contract.
The good news is that once a debtor files for bankruptcy, any money due to a creditor for new services is paid as it comes due in the ordinary course of business. "A classic example is a landlord who will receive rent payments by the first of every month," says Cosenza.
In terms of the debtor's past due pre-bankruptcy obligations, the news is less certain. “These claims are generally paid at the end of the bankruptcy case with any remaining assets, and according to a court approved payment schedule," says Cosenza.
When it comes to creditors getting tangled in a customer's bankruptcy, lawyers often get involved when the creditor gets paid by the debtor just prior to the filing of a bankruptcy petition. In bankruptcy, this type of payment is called a "preferential payment", which is prohibited under the bankruptcy code.
According to Cosenza, the bankruptcy code was designed to provide the debtor with some breathing room by preventing its creditors from scrambling to reach its assets. The law is also designed to protect creditors from each other. Says Cosenza, “the law prevents some creditors from unduly receiving a larger slice of the pie while others are left with only crumbs."
However, creditors do have several defenses they can use to prove a payment was not preferential. Three of the most common defenses are:
• where a payment is made in the ordinary course of business, for example payments made under a service contract or rent paid to a landlord;
• where the creditor has made an exchange for new value, like a COD payment for the delivery of goods; and
• where creditor performs new services, that is in excess of the payment made by the debtor.
Some clever entrepreneurs have tried to contract their way out of getting tangled up in a customer's bankruptcy. You will frequently see a clause in a contract where the debtor's filing of a bankruptcy petition is considered a default under the agreement and grounds for termination. However, according to Cosenza, once a debtor is in bankruptcy, these clauses are generally unenforceable.
In terms of our HVAC client, after their customer filed for bankruptcy they were notified by their customer's attorney that a buyer of the customer's assets wanted to assume the service contract. Post petition, our client continues to perform services and got paid from the debtor pursuant to the terms of their agreement. They expect to be paid the past due balance on the debtor's account upon the closing of the buyer's purchase of the assets.
If your company needs assistance with a bankruptcy issue, contact Michele Cosenza at email@example.com.
See this month's Quick Tip for steps to take if it looks like your customer may file for bankruptcy.
Firm Name Gets an Update
We're excited to announce that, effective as of today, the name of the firm will be Furnari Scher LLP.
Eric Scher joined the firm as a partner last September. In light of his contributions over the past year, we felt it was appropriate to make him a name partner of the firm. You can read more about Eric on the firm's website, which will now be located at www.FurnariScher.com.
Gregory Levine will continue to advise certain of the firm's financial services clients as Of Counsel.
Our contact information remains the same, except that the domain portion of all email addresses for the firm will be "@furnarischer.com".
|PUBLISHED ARTICLE IN:
What's Your Company Worth?
The art and science behind early-stage company valuation
If you plan on raising investment capital, issuing options to employees, buying out a partner or selling assets, you need to get a handle on the basics of corporate valuation.
A number of our clients have struggled with issues regarding valuation, so we interviewed valuation expert and friend of the firm, Michael Pellegrino, and wrote an article that was published by Entrepreneur.com on June 24, 2008.
We'd like to thank Mike, our client, David Lindsay of Confluentia Group, Inc., and Tom Dickerson of the VC firm Tullis Dickerson & Co., Inc.,for helping us out with the article.
For useful tips on valuation and to receive a free copy of a 35 minute interview with valuation expert Michale Pellegrino, visit www.ValuationInfo.com.
Staying out of hot water as a creditor in bankruptcy
• Require COD or advance payment or retainers for client projects.
• Keep open communications with your customers about their ability to pay. Terminate service as far in advance of filing as possible if they get too far behind on payments.
• Call a lawyer immediately. Set up a consult, which is usually free, and assess your options.
• Cease all collection activity.
• Consider setting aside any of the debtor's "past due" payments received within 90 days of their filing.
• If you are a party to an executory contract, continue to perform until advised otherwise by counsel.
• File your "Proof of Claim", the document that proves that the debtor owes you money. If you don't file timely, you will be barred from collecting what's owed to you.
• Legal representation can cost $10,000+ for creditors. To save on legal fees, consider teaming up with one or more other creditors to retain counsel jointly.
|ABOUT THE FIRM:
Furnari Scher's attorneys are entrepreneurs, so we understand what business owners need from a law firm.
At Furnari Scher, our expert team of corporate and securities lawyers specializes in helping business owners with the legal aspects of raising capital, buying and selling businesses, structuring corporations and partnerships, protecting intellectual property, and reviewing and negotiating contracts.
Our business-oriented approach to the law is why we take a special interest in startups and emerging growth companies and the needs of their investors, broker-dealers, investment advisors and investment funds. In short, we work with the kind of people who make things happen.
It's also why we're proud to stand behind this one simple pledge:
- Your money will not be wasted.
- Your time will be respected.
- We will add real value to your business.
- You will always get superior service.