Will I get paid if my client files Chapter 11 bankruptcy?

What goes on with your clients goes on with you. At the beginning of 2020, business failures were projected to increase for the fourth year in a row, and some of your customers could file for bankruptcy this year. Just because everyone is smiling at your next trade show doesn’t mean that some of your customers aren’t facing Chapter 11.

Companies use Chapter 11 bankruptcy to reorganize and eventually pay back creditors under a plan. If a customer files for Chapter 11, the bankruptcy court has to approve the company’s big financial decisions. Your outstanding invoices could be paid in full, in part, or not at all. In the meantime, your own cash flow could suffer badly.

Your Chapter 11 Customer Continues to Do Business

Just because your customer files for bankruptcy doesn’t mean you can’t do business with them anymore. Your Chapter 11 customer continues to do business - under court supervision and following a plan the court approves. In many cases it’s your choice whether you continue to do business with them unless otherwise specified in a contract.

The debtor can continue to operate in the ordinary course of business, buying any essential goods they need after filing. Essential goods usually receive administrative claim status, meaning they must be paid. Pre-filing debts must wait for plan confirmation and court approval to be paid. Then they may or may not get paid.

Next time you sell something new to your Chapter 11 customer, confirm the sale qualifies for an administrative claim first. Then get approval from the court or trustee overseeing the case before you make the sale. Don’t wait and see if it gets paid.

Protect yourself against non-payment by tightening credit terms, or asking for COD (cash on delivery), or otherwise require a deposit or a letter of credit upfront.

Cash Collateral Account

The money the debtor earns from receivables, selling inventory or selling property is put into a cash collateral account. It can’t be touched without a court order.

Cash collateral often is subject to a lien. Any unauthorized payment can be challenged in court. Before accepting a payment, you should ask if the court has authorized your debtor to spend that cash - otherwise, you might have to give it all back.

Meanwhile, Chapter 11 “presses pause” on payments to creditors, while the company decides how to reorganize. Assets or the whole company may be sold. The debtor or creditors’ committee decide how to pay creditors with the proceeds. Not every creditor winds up whole. Or at all. If the business itself is sold, the buyer isn’t responsible for the seller’s old invoices.

Monthly Operating Reports

Chapter 11’s business-as-usual only goes so far. Customers’ cash flow often changes in unexpected ways. Operating reports are required and everything must be transparent to the court on a monthly basis: receipts, disbursements, balance sheets, cash flow, receivables, tangible assets like inventory and post-petition debts.

Read your customer’s monthly operating reports closely. Think of it as a monthly report card that tells you exactly where the business stands in terms of money (and merchandise) in versus money (and goods) out. You might find out just how strong or weak its credit really is. This helps safeguard your cash flow. Learn the creditworthiness of all of your clients, not just the one with a filing.

All this might sound like a reason to ditch the debtor entirely, but it doesn’t have to be. Sure, you might get paid for your new sales as an administrative claim, but it’s still your choice whether to keep the door open.