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.

1. 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.
2. 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.
3. 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.

1. 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.
2. 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.