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Articles & White Papers
Doing Business with Troubled Companies
by Christy Myatt
Adams Kleemeier Hagan Hannah & Fouts
Doing business with troubled companies can result in significant
losses. This article addresses protecting against a customer's
bankruptcy, prebankruptcy remedies available upon a customer's
default, and the impact of bankruptcy on collection strategies.
I. Structuring credit transactions to protect
against bankruptcy impact.
Credit transactions with troubled companies can be structured
to minimize the future impact of a customer's bankruptcy. A creditor
can require a security deposit, third-party guaranty, security
interest in goods, or C.O.D. payment. If a transaction relates
to the sale of goods, Article 2 of the Uniform Commercial Code
allows a creditor to demand adequate assurance of performance;
stop goods in transit; or reserve to itself, under the terms of
shipping, a security interest in the goods. Article 2 also provides
that if a creditor becomes aware of a company's insolvency after
shipment of goods, the creditor can reclaim the goods understate
law, provided that written notice is given to the debtor within
10 days from the date of delivery. If the buyer has furnished
written representation of solvency, this 10-day period can be
extended for an additional 3 months.
Drafting of loan documents also is important. The Bankruptcy Code
eliminated the term "acts of bankruptcy' common in default
provisions of loan documents. Instead, specific acts which constitute
default, such as the making of a fraudulent or preferential transfer
or a general assignment for benefit of creditors should
be included. It also is recommended that loan documents set forth
a shortened "cure period" and provide for the automatic
acceleration or maturity of a debt in the event of bankruptcy.
Such provisions are significant to the enforcement
of a guaranty or a cross-default provision in another agreement.
Consideration should be given to requiring periodic reports on
the customer's payables along with other financial information
and covenants requiring the customer to maintain payables on a
current basis. These can provide early warnings that a customer
is in trouble and allow the creditor an opportunity to work out
the problem prior to a bankruptcy filing. Clauses which provide
for interest, prepayment or default premiums and attorneys'
fees should be included since they may be enforceable either before
or after bankruptcy or against the guarantors.
II. Available State Court Remedies.
A number of legal and "self help" remedies are available
prior to a customer's bankruptcy.
- Claim and delivery. This is an ancillary remedy to
a pending state court action to recover possession of specific
personal property. A creditor must establish that it is entitled
to possession of the property by reason of ownership or some other
contractual right.
- Pre-judgment Attachment. This procedure is generally
used where the defendant is either (1) a nonresident, (ii) a foreign
corporation, (iii) a domestic corporation whose officers cannot
be found, (iv) concealing himself with the intent to defraud creditors
or to avoid service of summons, or (v) concealing or removing
property with intent to defraud creditors. If any of these grounds
exist, the sheriff will seize property so that it may be used
to satisfy a judgment.
- Foreclosure. Foreclosure under a power of sale in a
deed of trust is the usual method of realizing a secured
creditor's interest in real property and extinguishing a debtor's
right of redemption. During the pendency of the foreclosure proceeding,
the debtor remains in possession of the property and is entitled
to the property's rents and profits unless the loan documents
provide otherwise or a receiver is appointed.
Receivership. A receiver may be appointed before a judgment
is entered to collect rents and profits or to take possession
of assets. Receivers may be appointed after judgment to recover
assets sufficient to satisfy the judgment. Receivers can be appointed
to liquidate or operate a business.
III. Workouts
Out-of-court settlements or workouts, frequently used for troubled
companies, have the advantage of speed and substantial flexibility
over bankruptcy. Typical types of workout agreements include composition
agreements. loan extension agreements, standby or moratorium agreements
with a creditors' committee, trade trustee. third-party trustee,
debtor as trustee, or any combination thereof.
If the company goes into bankruptcy, a workout arrangement may
become a plan of reorganization. Provisions which should be included
to ensure bankruptcy court ratification are (i) length of moratorium
and procedure for credit extension; (ii) percentage of creditors
(number and/or amount) required to validate the agreement; (iii)
proposed business terms and schedule of payment; (iv) treatment
of past and future debt, including new and extended trade credit;
(v) subordination of present debt to future trade creditors; (vi)
default provisions; (vii) inclusion and treatment of various classes
of creditors; (viii) treatment of advances by present secured
lender; (ix) creation and enforcement of liens; (x) treatment
of creditors holding insignificant amount of claims; (xi) selection
and compensation of directors, officers, attorneys, accountants,
etc.; (xii) validation of claims; and (xiii) mechanics for implementation
of the plan.
IV. Impact of Bankruptcy on Collection Strategies.
The Bankruptcy Code gives a debtor or bankruptcy trustee "strong-arm"
powers to recover pre-petition payments deemed to be preferential,
avoid pre-petition transfers or obligations which are fraudulent,
and reverse pre-petition setoffs in which a creditor has improved
its net position.
A. Avoiding Preferential Transfers. The Bankruptcy Code
defines "preference"' as a transfer made to or for the
benefit of a creditor on account of an old debt while the debtor
was insolvent, and which allowed the creditor to receive more
than it would have received if the debtor's assets had been liquidated.
A debtor is presumed to be insolvent with
respect to transfers made within ninety days prior to the filing
of the bankruptcy petition or one year if the creditor
is an insider. Preferential transfers may include payments of
money to a creditor, the granting of a security interest in
favor of a creditor, or the obtaining of a judgment by a creditor.
If a debtor or trustee succeeds in showing that the transfers
are preferences," the funds paid can be recovered or the
lien or judgment avoided.
The Bankruptcy Code provides creditors with some relief. A creditor
can defeat a preferential action or reduce the amount to be recovered
if the creditor can show that the transfer was made in the ordinary
course of business, the transfer was a contemporaneous exchange
of value (i.e. COD). or the creditor provided goods or "new
value" to the debtor for which the creditor has not been
paid after the creditor received the preferential transfer.
- Avoiding Fraudulent Conveyances. Transfers and obligations
which are deemed fraudulent are (i) those made by the debtor with
actual intent to hinder, delay or defraud his creditors, or (ii)
those in which the debtor received less than reasonably equivalent
value and was either (a) insolvent on the date that such transfer
was made or obligation incurred or became insolvent as a result
of such transfer obligation; (b) left with unreasonably small
capital; or (c) unlikely to pay future debts as they matured.
To recover a fraudulent transfer, the trustee must show that the
transfer or obligation was made or incurred within one year prior
to the filing of the bankruptcy petition or- such additional period
of time as allowed under state law. North Carolina has a 3-year
statute of limitations for fraudulent conveyance actions.
- Reversing Pre-Petition Setoffs. In situations where
a creditor has setoff a debt within ninety days of the bankruptcy,
the bankruptcy trustee is entitled to recover the amount by which
the creditor has improved its position during the ninety days
immediately preceding the bankruptcy.
V. Conclusion.
While it may be possible to minimize the impact of a customer's
bankruptcy, the "strong-arm" powers of a bankruptcy
trustee or debtor should be kept in mind as they can impact pre-bankruptcy
collection efforts.
Reprinted with permission from Legal Directions,
a publication of Adams Kleenheier Hagan Hannah & Fouts, a
Professional Limited Liability Company.
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