One of my favorite pastimes(?) is watching the behemoth that is the US economy.  I have been fascinated by it since my Intro to Economics class in college way back when (supply and demand baby!).  It’s a pretty incredible engine; dynamic and resilient over the course of hundreds of years.  But it does have some down periods, big ones on occasion, and I have lived through several of these.  And despite clamoring from the left and the right, whether the US economy is good or bad, up or down, really doesn’t depend on who is President.  Our economy has a mind of its own – like a four-year-old or a cranky grandparent.  Regardless, for the past couple of years, we have all been wondering if the USA will fall into a recession or not.  So far, the answer has been “not.”  Which is great.  Gen Z deserves a break or two.  If our economy does go into a recession one thing all in-house lawyers will see is an increase in the number of bankruptcy filings.  It’s never a great day when a major customer of a company files for bankruptcy protection.[1]  Most in-house lawyers know, intuitively, that getting paid amounts owed by that customer will now be a challenge.  But there is so much more that in-house counsel must be aware of when dealing with a debtor in bankruptcy if they expect to properly advise the business on the next steps (or recognize an issue that requires the expertise of outside counsel).  On the other hand, while most in-house lawyers will experience bankruptcy from the viewpoint of a creditor of the bankrupt company (my experience), some will have the unenviable task of seeing it up close and personal as counsel to the debtor filing for bankruptcy protection.  Albert Einstein said it best when he noted, “That’s a bummer, dude.”  He was, as usual, correct (and succinct).  Consequently, in-house lawyers also need a basic understanding of the bankruptcy process in case such a filing becomes a realistic possibility, and they are called upon to provide some initial advice to the business or bring in the experts if necessary (which you will do if the company is on the verge of going under).  Sound painful? Never fear, I got your back.  This edition of “Ten Things” deals with bankruptcy basics for in-house counsel:

1.  What is bankruptcy?  When a company’s debts are greater than its assets it becomes “insolvent” and can file for bankruptcy protection.  In reality, many companies work hard to fix any imbalance between debts and assets and view bankruptcy only as a last resort.  If, however, bankruptcy is the only (or best) option for the company, then it will engage bankruptcy counsel to help guide the process (this is critical – bankruptcy is not a process for the uninitiated).  One key thing to remember about bankruptcy is that it is designed to either get the bankrupt company back in business or ensure it is liquidated in an orderly manner.  Regardless of which path the debtor chooses, the bankruptcy process treats similarly situated creditors the same in terms of a share of the proceeds of a sale of assets or as to the plan for reorganization and payment or discharge of past debts.  Depending on where you sit in that creditor pecking order, you may get a big chunk of dough or a few pennies on the dollar.  And you may even get jack shit, which is Latin for “nothing.”  Where you are in the pecking order is something in-house lawyers can have a hand in before there is a problem.  More on that below.

2.  What is bankruptcy law?  Bankruptcy law in the U.S. is part of a well-defined process set out in the US Bankruptcy Code (Title 11 of the U.S. Code) and special rules of bankruptcy procedure (including local rules), all of which both preempt and rely on state law.  Bankruptcies are filed and decided in special federal bankruptcy courts before bankruptcy court judges.  There are several different bankruptcy chapters each covering different types of debtors and situations, but the most common are Chapter 7, Chapter 11, and Chapter 13.

• Chapter 7: In this type of bankruptcy, also known as “liquidation” bankruptcy, the debtor’s non-exempt assets, if any, are sold by a trustee to repay creditors, and any remaining eligible debts are discharged. It is typically suitable for companies with no realistic prospects for reorganization.  Generally, a trustee is appointed, and her job is to manage the process on behalf of the bankrupt company, gather assets, and ensure an equitable payout to creditors.
• Chapter 11: Chapter 11 bankruptcy allows businesses to restructure their debts while continuing operations, known as debtors-in-possession (yes, the people who managed the company into bankruptcy are usually put back in charge).[2] It involves creating a reorganization plan that outlines how the debtor will reorganize and repay creditors over time.  Sometimes the bankruptcy court decides (on its own or at the urging of creditors) that the folks who mismanaged the company do not deserve to be in charge any longer and a trustee is appointed to manage the process.  There are, of course, pros and cons to doing so (another thing for in-house counsel to understand).
• Chapter 13: This type of bankruptcy is primarily designed for individuals but may be used by sole proprietorship businesses. It involves the debtor creating a repayment plan to pay off their debts over a specified period (usually 3 – 5 years).

For our purposes, today we will focus on Chapter 7 and Chapter 11.[3]

3.  What happens when a company files for bankruptcy?  Once a petition (claim) for bankruptcy is filed, several things happen automatically:

• Automatic Stay:  An automatic stay goes into effect with no further action needed on the part of the debtor.  The stay halts virtually all collection activities by creditors, including lawsuits, foreclosure proceedings, and collection calls. There are steep penalties for creditors that violate the stay, i.e., file a lawsuit against the bankrupt company.[4]  The stay gives the debtor a chance to catch its breath and work to reorganize the business – without the hassle of creditor collections, lawsuits, or other actions – so that it can continue as a going concern, if under Chapter 11, or liquidate the assets if Chapter 7 is invoked.
• Priority of Debts:  Bankruptcy law establishes a hierarchy for the payment of debts. Secured debts, for example, debts secured by collateral or an Article 9 UCC filing are generally given priority, followed by certain priority debts, such as tax obligations and employee wages. Unsecured debts, such as those typically owed to company vendors, may be paid if there are sufficient assets or funds available prior to discharge or liquidation.  Your job as in-house counsel (working with your buddies in finance) is to help the company recognize when collateral or other security may be needed in advance to deal with credit risk and then to ensure the correct steps are taken to perfect any security interest so that if bankruptcy is the end game, your company is near the top of the pecking order in terms of getting their money.  If you are asleep at the switch, learn Latin, i.e., jackus shitoris.
• Executory Contracts:  In Chapter 11, the debtor has the option to assume or reject certain contracts.[5]  These are known as executory contracts (contracts where the parties still have duties to perform) or unexpired leases.  Creditors must continue to perform under contracts regardless and until the debtor assumes or rejects.  Whether the debtor assumes or rejects the contract can take months (yet another point of frustration for the business).  If the debtor rejects a contract, it is terminated then and there, and no further performance is due by either party.  Payment for amounts owed to the creditor under the contract prior to rejection is determined by the priority of debts, i.e., the pecking order.  If the debtor assumes the contract, then it must cure any default, including payment (pre and post-filing for bankruptcy).  If the debtor fails to do that, the creditor will have a claim in bankruptcy with a higher priority than basic unsecured claims.
• Preferences:  To ensure that all creditors are treated as evenly and fairly as possible, bankruptcy law will prevent debtors from favoring certain creditors over others by paying them shortly before filing for bankruptcy. These are called “preferences.”  Any such preference must be paid back by the creditor.
• Warren Zevon:  Not really a legal term, but I just like one of the most brilliant lines in music, i.e., “Send lawyers, guns, and money.  The shit has hit the fan.”  This is an excellent summary of where most unsecured creditors find themselves in bankruptcy proceedings – knee-deep in lawyers, guns, and shit.

4.  Preferences. The next to last bullet above is pretty important for in-house lawyers and drives a lot of confusion on the part of the business (which you will need to be prepared to manage).  So, I am going to go deeper into preferences here.  Simply put, having to give money back to a bankrupt customer is a tough pill to swallow.  If you are the messenger of such news, wear a bulletproof vest and bulletproof underwear because you will likely be shot (or shot at).  In Texas, where I live, we call this “Tuesday.”  So, what’s going on, you ask?  Well, to ensure that all creditors are treated as evenly and fairly as possible, bankruptcy law prevents debtors from favoring certain creditors over others shortly before filing for bankruptcy. Hence the term “preference.”  Preferences must be paid back to the bankruptcy estate, i.e., you must give back money the debtor already paid you.  To qualify as a preference there must:

• be a transfer of the debtor’s property, either money or assets.
• for the benefit of a specific creditor.
• on account of an existing debt.
• made within a certain period before the bankruptcy filing, usually 90 days.
• that allows the creditor to receive more than they would have received through the bankruptcy distribution process.

Remember, as much as it hurts to give the money back, the process is designed to reclaim the assets for the bankruptcy estate to distribute them more equitably among all the creditors. So, yes, Karl Marx did apparently write the bankruptcy code.  And while it may seem pretty harsh if you are one of the companies getting a letter from a trustee about paying back the money, just keep in mind that if you happen to be one of the creditors who did not get such a payment you will be pretty grateful for the preference process, and can even start the process yourself if you think something shady has gone down.[6]

The good news is that all is not lost if you get a letter from the trustee attempting to recover an alleged preferential payment.  There are several defenses to a preference claim that you can assert to prevent having to pay money back over.  These defenses recognize that there are legitimate transactions that occurred before the bankruptcy and they should be allowed to stand:

• Contemporaneous exchange for new value: If you can demonstrate that the payment was made in exchange for new value given to the debtor at or around the same time (e.g., payment for goods delivered to the debtor right before the payment), it may not be considered a preferential transfer.
• Subsequent new value: A creditor can argue that, even if a preferential payment was made, they later provided the debtor with new value (goods or services) after that payment and did not receive any further payment for this new value. You can use this to offset any preference claim.
• Ordinary course of business: This defense applies if the payments were made in a manner consistent with the terms and conditions of past transactions between the debtor and the creditor. The idea here is that routine transactions made in the ordinary course of business are not considered preferential.  If you think you may want to rely on this with a shaky customer, document it in writing before the 90 days and be sure that the new pattern, e.g., payment every 10 days goes off like clockwork.
• Secured creditor: Payments made to a secured creditor, to the extent of the value of the collateral securing the debt, is generally not a preference.
• Floating lien: Payments made in the ordinary course of business that are secured by a floating lien on assets or inventory are sometimes exempt from preference actions.

5.  Debtor-In-Possession. If you are in-house counsel to the bankrupt company, Chapter 11 provides for a “debtor-in-possession” whereby the current management is responsible for managing day-to-day business operations, making business decisions, obtaining financing, and seeking opportunities to maximize value for the creditors.  Major decisions, such as the sale of assets or entering into new contracts, may require court approval. The debtor-in-possession must propose a reorganization plan outlining how they intend to repay creditors over time and restore the business’s financial stability. The plan must be approved by the bankruptcy court and accepted by the creditors. The debtor must also provide regular financial reports to the bankruptcy court and the creditors.

6.  Proof of claim.  If the debtor owes you money, to collect anything you must file a proof of claim setting out the amount owed and, importantly, whether or not the money owed is secured by collateral of some type or, more commonly, is “unsecured” meaning there is no particular asset of the debtor tied to the repayment of the money owed.  As you can tell by now, being an unsecured creditor in bankruptcy is not an envious position.  It usually means you can expect to get about ten cents of every dollar owed to the company.  For small debts, i.e., where you expect to get a small amount back from the debtor based on the “ten cents” rule of thumb, you are better off filing the proof of claim yourself and not paying outside counsel to do it for you.  It’s a pretty simple process and one I did myself several times as an in-house lawyer.  It’s a form and then attaching some proof of the debt owed.  You file it and then sit back and wait because it will take a while to get paid, if you get paid out at all.

7.  Priority of Debts.  As noted above, and to the surprise of many on the business side, there is a hierarchy for the payment of debts in bankruptcy.  Most in-house counsel know that “secured” debts are generally at the top of the repayment list.  But what follows can be a real eye-opener and one you must prepare your client for.  Above simple unsecured creditors come certain priority debts, such as tax obligations, tort victims, employee wages, attorneys’ fees,[7] trustee fees, and so-called “critical vendor” payments. Unsecured debts are literally at the bottom of the barrel – so far down they have pierced the earth’s crust and are approaching molten magma.   Sometimes there is nothing left at all for unsecured creditors, and they go home empty-handed, not even with the home edition bankruptcy board game.  Remember your Latin…

8.  Rejection of contracts.  In Chapter 11, the debtor has the option to assume or reject certain contracts.  As already mentioned, these are known as executory contracts (contracts where the parties still have duties to perform) or unexpired leases.  Here’s the kicker: your company, however, must continue to perform under contracts regardless and until the debtor assumes or rejects the agreement.  If the debtor rejects a contract, it is terminated and no further performance is due by either party.  Payment for amounts owed to the creditor under the contract is determined by the priority of debts, meaning you may be performing services for pennies on the dollar.  Fortunately, if the debtor assumes the contract, it must cure any default (pre and post-filing for bankruptcy).  But having your contract rejected after several months of waiting and having to perform can be another nasty surprise and yet another thing you need to warn the business about (or if counsel to the bankrupt company a potential strategy to gain negotiating leverage for a new contract).

Sadly, the rejection of contracts is not the only surprise you may have coming.  Last on our list of horribles is what is known as a “Free and Clear” sale, i.e., a sale by the debtor of property you may have an interest in.  To gather money for the bankruptcy estate, the trustee or debtor in possession may try to sell certain assets free and clear of any liens, claims, or encumbrances.  This can be land, buildings, patents, machines, vehicles, etc.  In-house counsel must know how to ensure you are notified if a debtor is going to sell something you have an interest in, e.g., selling your proprietary information to a competitor.  This is an area where you want experienced outside counsel engaged.  If you, or your outside counsel, are not on the ball you can end up with some real problems.

9.  The end game.  The point of the bankruptcy process is for the debtor to reorganize or liquidate.  In Chapter 7, the trustee attempts to recover the largest amount of cash possible through preference claims or the sale of debtor assets and distributes the proceeds to the creditors (after the trustee and lawyers get their cut).  In Chapter 11, the debtor must propose a reorganization plan.  The plan typically includes provisions for renegotiating contracts, reducing debts, and modifying payment terms. The plan must be approved by the bankruptcy court and the affected creditors – who, among the unsecured creditors, have typically formed a creditors’ committee to help ensure the highest distribution possible to its members.  In-house lawyers will be heavily involved in drafting the plan.

Ultimately, bankruptcy will result in the discharge of eligible debts, relieving the debtor from the legal obligation to repay them. However, not all business debts are dischargeable, such as certain tax obligations and debts arising from fraud or illegal activities. Lastly, when emerging from bankruptcy, the debtor will usually take steps to rebuild its credit and implement improved financial practices to reduce the stigma of filing and to encourage creditors and vendors to resume doing business the with “new” company. The legal department will likely have a role in all of this.

10.  “What do I do?” checklist.  When a customer files for bankruptcy, here is a short checklist of things to do to help ensure you put the company in the best position possible and so that you can educate the business on what to expect with regard to discussion above:

• Review and verify the bankruptcy filing (confirm that the customer has indeed filed for bankruptcy) and the chapter, e.g., Chapter 7 or Chapter 11.
• Gather relevant documentation (collect and organize all relevant documents related to the debt, including invoices, contracts, purchase orders, etc.).
• Determine your creditor status (are you secured or unsecured).
• Consult bankruptcy counsel (depending on the size of your claim or if you find yourself in a preference action).
• Consider attending creditors’ meetings (stay informed about the progress of the bankruptcy case).  If your claim is small, no need to waste time attending.
• File a proof of claim (you cannot get paid anything unless you file a proof of claim form).
• Monitor docket to ensure no “free and clear” sales impact your company.
• Observe automatic stay (take care to comply with the stay and refrain from any further collection actions until instructed by the court).
• Keep this business updated on where things stand (including a primer on bankruptcy rules so they understand preferences, the automatic stay, rejection of contracts, etc.).
• Learn the words to “Lawyers, Guns, and Money” – you’ll be using it a lot.

*****

There is much more to the bankruptcy process than outlined above.  But this will get you started if faced with bankruptcy as counsel for the debtor or a creditor.  As a creditor, you are generally in a tough spot and it pays to understand the process and, if necessary, seek the help of experienced counsel.  If you are aware a customer may be a credit risk before a contract is signed, you can add a lot of value by trying to get collateral in place or create a process of more frequent ordinary course payments to avoid a preference claim down the road.  Regardless, if there is only a small amount owing to the company, you can file a proof of claim easily and at least avoid having to pay someone to get you pennies on the debt owed.  You can collect those pennies yourself.  If you are an in-house lawyer for a company that is on the verge of filing for bankruptcy, the best things you can do are 1) engage experienced counsel (and listen to them), 2) avoid paying out any preferences or engaging in fraudulent transfers, and 3)  keep the business educated and informed.

Sterling Miller

March 28, 2024

Book number six is in the hands of the ABA.  The working title is The Productive In-House Lawyer: Tips, Hacks, and the Art of Getting Things Done.  It should be available this summer.  So, stay tuned for more details! My fifth book, Showing the Value of the Legal Department: More Than Just a Cost Center is available now, including as an eBook!  You can buy a copy HERE.

Two of my books, Ten Things You Need to Know as In-House Counsel – Practical Advice and Successful Strategies and Ten (More) Things You Need to Know as In-House Counsel – Practical Advice and Successful Strategies Volume 2, are on sale now at the ABA website (including as e-books).

I have published two other books: The Evolution of Professional Football, and The Slow-Cooker Savant.  I am also available for speaking engagements, webinars/CLEs, coaching, training, and consulting.

Connect with me on Twitter @10ThingsLegal and on LinkedIn where I post articles and stories of interest to in-house counsel frequently.  

“Ten Things” is not legal advice nor legal opinion and represents my views only.  It is intended to provide practical tips and references to the busy in-house practitioner and other readers.  If you have questions or comments, or ideas for a post, please contact me at sterling.miller@sbcglobal.net, or if you would like a CLE for your in-house legal team on this or any topic in the blog, contact me at smiller@hilgersgraben.com.

[1] This blog will focus on the U.S. bankruptcy system.  But there is a similar process in most countries so a lot of the concepts discussed here will apply regardless of where you may practice.  See, e.g., Foreign Bankruptcy Law – Emory Law School.

[2] You got to love this country.  What a system!  If you are in-house counsel for a bankrupt company, becoming a debtor-in-possession is one of your key goals.

[3] If you feel like you’re missing out on all the good Chapter 13 stuff, check out Chapter 13 – Bankruptcy Basics.  You’ll quickly realize you are not missing out on anything.  We now return to the rest of the blog post.

[4] This can be a tough area for in-house counsel to manage as the business will want you to go get their money, terminate contracts, or take other actions against the debtor.  Essentially, any such actions are prohibited without permission from the bankruptcy court and any action to the contrary can land the company in hot water with the bankruptcy judge.

[5] Yet another hard truth in-house lawyers must explain to the business about bankruptcy, i.e., the bankrupt company can simply walk away from the contract if it so chooses.

[6] In addition to preferences, keep your eyes open for potential fraudulent conveyances, i.e., trying to hide assets from creditors or the bankruptcy court.  Such converyances are something you will advise against as in-house counsel for a debtor.

[7] No shock here but the debtor’s lawyers will get paid before most other creditors.  And, if the bankruptcy is big enough, it can be a pretty lucrative engagement, much to the dismay of the unsecured creditors.