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 michele@cosenzalawfirm.com.

See this month's Quick Tip for steps to take if it looks like your customer may file for bankruptcy.