Startups: What to Do if One of Your Customers Goes Bankrupt

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Bankruptcy.

It’s a pretty scary thought but not an uncommon one to most starters who stare down financial ruin every day.

For a minute, forget about your own business or personal bankruptcy and the related specter of ramen noodles and urban foraging.  Instead, think about this: what if one of your customers goes bankrupt? It’s intuitive that a startup whose customers go bankrupt might suffer the same fate at some point.  But remember that “bankruptcy” isn’t equivalent to “going out of business.”  Many companies have gone into bankruptcy and later emerged to fight again.

So what happens if a large customer of your startup files for bankruptcy?

To learn more, I sat down with Jordan Litwin, a bankruptcy attorney in Chicago.

Let’s say a large customer of a startup goes bankrupt.  Assuming that the bankrupt customer has money, but just has problems paying its bills on time and is going into bankruptcy to reorganize, what are the risks to the startup?

The main risk to the startup of a customer’s bankruptcy relates to getting paid or keeping payments for services already performed or goods already furnished.  In legalese, the startup becomes subject to the “preference” and “automatic stay” provisions of the bankruptcy code which could stop the startup from getting paid for work it’s already done or even having to return payments that could be deemed a “preference.”

What is a preference?

One of the primary principles of the Bankruptcy Code is to ensure equal treatment of similarly situated creditors.  The theory behind “preferences” is that for a period of time prior to filing bankruptcy, a company may know that a bankruptcy is inevitable and may start paying certain creditors over others.  If one company received payment and another company did not, this violates the equal treatment spirit of the Bankruptcy Code.

To help avoid that outcome, bankrupt companies (or trustees overseeing them) can actually recover payments made to third parties, like suppliers and vendors, made within 90 days prior to the bankruptcy filing.

In other words, a service provider could get paid by its customer but be required to give back the money it was paid if it was paid during that 90-day period leading up to the bankruptcy filing.

What is an automatic stay?

When a company (or individual) files bankruptcy, it is instantly protected by a statutorily imposed stay against taking any action against the company or its assets.  In other words, the bankrupt company cannot be sued, its assets cannot be repossessed, and anyone to whom the bankrupt company owes money cannot even send the bankrupt company an invoice or call and ask that a balance be paid without risking sanctions by the Bankruptcy Court.

So a startup that does work for a company that later files bankruptcy could end up being forced to give back payments it received?

Yes, that’s right, if the payment was made within 90 days before the bankruptcy filing.  But realize that companies that are reorganizing in bankruptcy will often want to maintain relationships with suppliers and vendors, and are therefore unlikely to aggressively pursue preference actions.  Think about it: if I go into bankruptcy and force you to give me back money I paid you for services you actually rendered, that necessarily creates an adversarial relationship.  Once I emerge from bankruptcy, you may not want to do business with me again.

Contrast this with liquidating companies, however, that have little motivation to maintain relationships and are much more likely to pursue preference actions.  Liquidations in a chapter 7 bankruptcy are also run by a trustee who is incentivized to pursue preference actions.

So how can a startup protect itself from having to give back payments it receives, which qualify as preferences?

First, there are some important dollar limits to take into account.  Any payment less than about $6,000 is going to be safe.

Any payment between $6,000 and $12,000 can theoretically be recovered, but is often unlikely because of certain procedural barriers required under the Bankruptcy Code.

If the payment is large enough, then a bankrupt company might try to reclaim it as a preference.  The easiest way for a startup to protect against further litigation is to simply settle.  Generally speaking, the quicker a startup settles in this circumstance, the less it will have to give back.

Certain planning can reduce the likelihood that a preference action is brought against a startup or successful if brought, and negotiating a smaller settlement amount is aided by a strong defense.  Two of the primary defenses are:

  • COD: Setting up a COD payment arrangement with customers will typically allow those payments to avoid preference demands;
  • Ordinary Course: Ensuring that customers make payments in the same manner every time (same time after invoiced, same manner, same percentage of amount owed, etc.) will help establish a defense to preference demands.

Needless to say, this area is hyper-technical and a startup is well served to involve a bankruptcy specialist early on in the process if it believes a large customer is on shaky financial ground.

What about the automatic stay you described?  What should startups do if they are made aware of a customer’s bankruptcy?

The startup should immediately implement procedures to ensure that no collection efforts are made against the bankrupt customer.  This includes invoices, phone calls and obviously lawsuits.  If a startup has an ongoing legal proceeding involving the bankrupt customer, it should let its attorney know about this development immediately.

Knowing that a customer has filed bankruptcy is also a startup’s first sign that it may have preference exposure.  A startup would be well advised to understand the extent of that exposure (the payments received from the bankrupt company within the 90 days prior to the bankruptcy filing), and collect and maintain all evidence related to that customer to aid later defenses.  Startups should preserve all records related to the bankrupt company and maintain them until the closure of the bankruptcy case.  A bankruptcy case may last years and preference demands may not be made until late in the case.

With these basics in mind, startups should be able to fare better if a big customer files for bankrtupcy protection. 

Jordan Litwin is with the Chicago law firm of Meltzer, Purtill and Stelle, LLC.  Jordan focuses his practice in the areas of bankruptcy, business reorganizations and workouts, including related litigation. His practice has included the representation of debtors in Chapter 7 and Chapter 11 cases, secured and unsecured creditors, purchasers of assets in bankruptcy cases, official and ad hoc committees and out-of-court restructurings.  Jordan can be reached at (312) 461-4313 or by email at jlitwin@mpslaw.com

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