International Society of Primerus Law Firms

Stop, Look and Listen: How to Avoid Getting Hit by the Bankruptcy Train

Written By: David S. Schaffer, Esq. and Barry P. Kaltenbach, Esq.

Kubasiak, Fylstra, Thorpe & Rotunno, P.C.

Chicago, Illinois

For corporate counsel, the first several days following a bankruptcy of one of your company’s business partners can produce a flurry of activity and considerable confusion.  You often have to make quick decisions – both in responding to internal queries asking “what do we do now?” and in analyzing whether to engage outside creditor’s rights counsel to assert or defend claims.  Understanding the immediate implications of a bankruptcy filing can help you guide your company through what can become a very complex process.

1.  Effect of the Automatic Stay

While most attorneys understand the most common effect of the “automatic stay” that Section 362 of the Bankruptcy Code provides (i.e., freezing litigation against the debtor), there is often confusion regarding the scope and extent of the stay.  The automatic stay is just that – automatic.  It takes effect immediately upon the debtor filing bankruptcy.  Thereafter, almost any action that your company takes to collect from the debtor will violate the stay and expose your company (and potentially individuals within) to sanctions.  It applies not just to litigation, but to alternative dispute resolution and to informal collection efforts.  It also applies even if the debt is non-dischargeable in bankruptcy.  Formal notice of the bankruptcy is not necessary.  Upon having reason to believe a bankruptcy has been filed, you are “under a duty to seek further information which should reveal the applicability and scope of the automatic stay.”  In re Stewart, 190 B.R. 846, 850 (Bankr. C.D. Ill. 1996).  Failure to seek this “further information” can transform an inadvertent violation of the stay into a willful violation.  If your company improved its position by unintentionally violating the automatic stay, its continuing retention of that position also serves as a continuing violation of the stay.  In re Weatherford, 413 B.R. 273, 287 (Bankr. D.S.C. 2009).

2.  Reclamation

So what can you do?  One important action that is permissible is to promptly send a notice of reclamation.  Section 2-702 of the Uniform Commercial Code provides that once a seller of goods discovers the buyer is insolvent, the seller may refuse to ship further goods absent cash payment, even if an existing contract provides for credit.  The seller also has the right to reclaim goods already shipped, provided the notice of reclamation is sent within ten days after the debtor receives them.

Section 546 of the Bankruptcy Code modifies this time period in bankruptcy cases by extending the ten day period to forty-five days.  If the forty-five day period expires post-bankruptcy, the notice then must be sent within twenty days of the bankruptcy filing, so it is critical to move quickly.  If the debtor has already sold the goods in the ordinary course of its business, then the notice is ineffective.  This does not leave the seller without a remedy, however.  The seller will be able to assert a priority claim as to the value of goods received by the debtor up to twenty days pre-bankruptcy.  While this offers some protection, sellers of goods should nonetheless promptly send the notice of reclamation.

3.  Preferences

Another issue that may confront a creditor early in the bankruptcy process is avoidance of preferential payments, or “preferences.”  Section 547 of the Bankruptcy Code permits a debtor to “avoid” (i.e, recover) payments it made to creditors within the 90 days preceding its bankruptcy filing, if the payments were on account of an antecedent debt and they would permit the creditor to receive a greater distribution than the creditor would obtain upon liquidation.  Section 547 also provides a number of defenses to avoidance, including that the payment was made contemporaneously (as opposed to by credit), that the creditor subsequently provided new goods, and that the payment was made in the ordinary course of business.  Additionally, payments of less than $5,850 are not subject to avoidance at all.

4.  Critical Vendors: Be Careful

In reorganizations, the debtor may seek court approval to designate your company as a “critical vendor” in order to keep you doing business with it.  The theory behind the critical vendor doctrine is that paying certain vendors benefits all creditors by permitting the debtor to stay in business.  Motions seeking to approve critical vendor payments are often “first day” motions that a debtor presents to the presiding judge immediately after filing its petition.  Understanding the use and the implication of critical vendor orders is essential to successfully navigating the first few days of a debtor’s bankruptcy.

a.  Judicial Uncertainty

Many critical vendor orders authorize the debtor to pay those vendors that it deems critical for its continued operation.  Some courts have raised serious concern about the validity of this type of “blank check” critical vendor order.  See, e.g., In re Kmart Corp., 359 F. 3d 866 (7th Cir. 2004).  In Kmart, the Court of Appeals for the Seventh Circuit held that a bankruptcy court could only approve critical vendor payments if it first made factual findings that the vendor was truly critical, that the vendor refused to do business under any other terms (even cash on delivery) unless its pre-petition claims were paid, and that non-critical vendors would be better off if critical vendor payments were made.  As a result of this ruling, those Kmart vendors who had received critical vendor payments had to refund them.  More detailed factual findings by the bankruptcy court might have prevented this outcome.

In re Meridian Automotive Systems-Composites Operations, Inc., 372 B.R. 710 (Bankr. D. Del. 2004), provides another good example of a creditor believing erroneously that a critical vendor order afforded it protection.  The order provided that the debtor could make critical vendor payments in the exercise of its business judgment, but it did not identify the critical vendors by name, nor approve specific payment requests.  The bankruptcy court later questioned whether the payments were truly made pursuant to the critical vendor order (and thereby protected by it), since the order lacked any level of detail.  Moreover, the mere fact that the creditor received critical vendor payments did not afford it a defense to an avoidance claim.

b.  Need to Comply with the Order

Even a properly drafted critical vendor order affords no protection if a creditor fails to strictly comply with the order.  See, e.g., In re Hayes Lemmerz Int’l, Inc., 313 B.R. 189 (Bankr. D. Del. 2004).  In Hayes, the creditor accepted critical vendor payments after agreeing to continue to do business with the debtor under regular business terms.  Thereafter, the creditor attempted to negotiate a better deal and threatened to hold up delivery.  The bankruptcy court held that this violated the order and the creditor was required to disgorge the payments it had already received.

c.  Key Aspects of the Order

Because critical vendor orders have become a routine part of “first day” bankruptcy operations, corporate counsel may be called to negotiate or approve them before having a chance to fully consult with outside counsel.  While all orders are subject to reversal, and nothing is foolproof, when agreeing to continue to do business with debtors, certain basic safeguards can be put into place.  The order should identify your company as a critical vendor and require (not make optional) the payment of specific claims.  The order should also waive avoidance actions based on pre-petition payments.  When feasible, the order should contain detailed factual findings and make clear that, but for the critical vendor payment, your company will not do future business with the debtor.  Finally, make sure your company is aware that the order must be honored as-is and new terms cannot be negotiated without court approval.

Taken together, awareness of these issues can help you advise your company on how to avoid inadvertently stepping in front of the onrushing train that is the first few days of a bankruptcy filing.

For more information on Kubasiak, Fylstra, Thorpe & Rotunno, P.C., please visit or the International Society of Primerus Law Firms.

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