California Creditor's Rights & Business Bankruptcy Lawyer & Attorney : Robert Eisenbach : Business Bankruptcy Blog

An issue that comes up for creditors when a customer files bankruptcy is whether to keep doing business or end the relationship. Since debtors usually cannot survive without at least some level of trade support, generally they reach out to suppliers in an attempt to obtain trade terms, or at least a steady supply of goods, after a Chapter 11 bankruptcy is filed.  Often they put information about doing business in light of the bankruptcy (see this example from Delta Airlines) on a restructuring website or send out written communications to suppliers.

This post looks at the issue from the creditor's perspective. When a smaller customer files bankruptcy the "keep doing business" question is less critical, and the bankruptcy filing may just be the final straw that leads you to want to stop selling or providing services to the customer.  When one of your bigger customers files bankruptcy, the stakes go up -- often way up.  In either case, it's important to know the ground rules about doing business with a bankrupt customer.

Administrative claim for post-bankruptcy sales. In general, if the bankrupt customer is a Chapter 11 debtor in possession, it is legally permitted to pay for post-petition (post-bankruptcy filing) purchases of goods and services in the ordinary course of business. Such amounts are generally accorded administrative claim status, with priority over unsecured and certain other claims, and the debtor is authorized to pay them currently. (Chapter 7 trustees usually close a business down and do not place further orders.)

Make sure you have an administrative claim. The standard for allowance of administrative claims requires proof of the necessity and the value to the estate of the goods or services.  While this usually is the amount set forth in a contract or purchase order, to avoid any dispute it's best to reach a clear understanding with the debtor (or a bankruptcy trustee in the rarer instances when a Chapter 11 or Chapter 7 trustee is purchasing goods or services) before providing post-petition goods or services. Moreover, if there's any chance that your transaction would not be considered an "ordinary course" transaction, for example if it's an unusually large purchase or on unusual terms, you should consider seeking bankruptcy court approval to make sure the transaction is authorized and that your rights are protected.

Be careful of the executory contract twist. Your dealings with the debtor post-petition may also depend on the nature of your pre-petition relationship. 

• If you have sold products through separate purchase orders or individual transactions without an overarching contract (see earlier post for a fuller discussion of such executory contracts) governing the relationship, generally you may choose whether to continue dealing with the debtor post-petition and on what terms you do so (e.g., whether to require cash in advance or continue with trade credit terms). If you have unpaid amounts based on your pre-petition transactions with the debtor, that claim would be treated like other unsecured claims separate from any post-petition claim. 
• If you and the debtor are parties to a pre-petition contract that is executory (meaning both you and the debtor have material obligations to continue to perform), you cannot automatically stop performing post-petition unless the debtor has officially rejected the contract. Rejection means that the debtor has decided to stop performing and the bankruptcy court has approved that decision. Alternatively, if the debtor has decided to continue to perform (assume) the contract, and the bankruptcy court has approved this assumption decision, the debtor will have to cure, in cash, any pre-petition amounts owed.
• Until the debtor has made a decision about your contract, the debtor may be willing to make current post-petition payments under the contract. You should consider confirming this understanding with the debtor or its counsel in writing to protect your rights.
• If you're concerned that you won't be paid for your post-petition performance or if you don't want to continue to perform for other reasons, you may need an attorney to file a motion to compel the debtor or trustee to assume or reject the contract, or to seek “adequate protection” payments pending that decision. Bankruptcy courts often give a Chapter 11 debtor a long time to make this decision, even until a plan of reorganization is confirmed.  However, the court may be willing to order that you be paid currently for post-petition amounts and/or clarify that you have an administrative priority claim for your post-petition performance.

Is the debtor creditworthy? While these legal issues are important, it's equally critical to assess the debtor's financial condition after bankruptcy.  A bankruptcy filing relieves a debtor from the obligation to pay pre-petition unsecured creditor claims, and this can make a substantial difference to a debtor's cash flow. Still, the debtor has to have sufficient liquidity to pay its post-petition administrative claims.

• Many debtors obtain post-petition financing from lenders -- known as debtor in possession or DIP financing -- and this can provide the necessary liquidity to pay administrative claims. DIP financings are usually secured by a blanket security interest on all of the debtor's assets, however, putting the DIP lender ahead of even administrative claims in the event of default.  
• While not common, debtors do sometimes default under DIP financings. When that happens, the DIP lender will often foreclose on the debtor's assets and the bankruptcy case will be converted to Chapter 7 liquidation. If so, not only will the DIP lender's debt be paid first from the estate's assets, but the administrative claims generated during the Chapter 11 case will become second in line to Chapter 7 administrative claims, such as the Chapter 7 trustee's fees and expenses and those of his or her counsel. 
• For these reasons, it's still very important to be comfortable with a Chapter 11 debtor's financial condition and its wherewithal to pay for post-petition sales before extending post-petition credit. Most debtors are required to file post-petition monthly financial reports (here's an example from Delphi's bankruptcy case), and they can serve as one source of financial information.

Consult with bankruptcy counsel. These general rules govern most scenarios, but dealing with a debtor post-petition can be complicated and raise many issues unique to your situation. For this reason, it's best to get an attorney’s advice before engaging in any significant transactions with a debtor.

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Much like executory contracts, commercial real estate leases are governed by special rules in bankruptcy. If a lease's term has not yet expired, it is known as an “unexpired lease” (yet more clever bankruptcy terminology). This post explores how landlords and tenants are treated in bankruptcy, first in the more common situation of a tenant's bankruptcy and then briefly in the context of a landlord's bankruptcy.

Assumption and rejection. If the debtor is the tenant under an unexpired commercial lease, it must either assume or reject the lease within 120 days of the filing of bankruptcy. The court can extend this time period without the landlord’s consent for 90 additional days, making a total of 210 days, but any further extensions require the landlord’s prior written consent. If the lease is not assumed (or assumed and assigned) within this period, the lease automatically will be deemed rejected and the debtor will have to move out. 

• Assumption of a lease requires the debtor to reaffirm the lease, cure all pre- and post-filing defaults, and show that it will be able to perform its obligations in the future. Additional restrictions must be met before a lease located in a shopping center can be assumed or assigned. 
• Rejection of a lease means that the lease is breached, the debtor tenant has to vacate the property, and the landlord can file a claim against the debtor’s estate for the amount of any past or future rent. 

Capping a landlord's claim. If a lease is rejected, the landlord's damage claim for termination of the lease will be treated as a pre-filing unsecured claim.  In addition, the claim for future rent under the lease will be capped at an amount equal to the greater of one year's rent or fifteen percent of the remaining lease term, up to a maximum of three years' worth of rent, calculated from the earlier of the date the bankruptcy petition was filed or the date when the landlord recovered possession of, or the tenant surrendered, the premises. This ability to cap a landlord's claim in bankruptcy is often a major benefit to a debtor tenant, especially when the lease rejected is a long-term lease with rent obligations higher than current market rates. Landlords with security deposits, either in the form of cash or letters of credit, generally will be able to retain or draw on that security at least up to the amount of their capped bankruptcy claim.

Assignments of leases in bankruptcy. Although some leases contain restrictions or outright prohibitions on the tenant’s ability to assign the lease, many of these provisions will be unenforceable in bankruptcy. This can allow a debtor to “assume and assign” a lease to a third party over the landlord's objection. Since third parties will often pay substantial sums to take over a lease with rent obligations below current market rates, these below-market leases can be valuable assets for debtors.   

The recent bankruptcy law changes. The 210 day maximum lease decision period represents one of the major changes enacted with the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA"), discussed in an earlier post. Before these amendments took effect in October 2005, although debtors initially had only 60 days to assume or reject leases, they were permitted to seek extensions of this period without any statutory limitation. Cumulative extensions of a year or more, over a landlord's objection, were not uncommon under the pre-BAPCPA version of the Bankruptcy Code. That is no longer possible under BAPCPA.

Impact on retailers. This change is particularly significant for retailers with dozens or even hundreds of leased stores. In the past, retailers usually evaluated sales at stores for at least one holiday shopping season, and sometimes two, before deciding whether to retain the store. Now a retailer has only seven months to make that decision. This shortened period also impacts a retailer's ability to sell off its unwanted leases, especially through a sale of "designation rights" (the right to designate the assignee of a lease), as the buyer of those rights now will have a limited time to find buyers for those leases.

Landlord as debtor. Sometimes the debtor is not a tenant but a landlord. In that situation, although the debtor can reject a lease and no longer perform any of its duties as landlord, it cannot use bankruptcy to evict a tenant that prefers to stay in possession of the premises. In Section 365(h)(1) of the Bankruptcy Code, a special provision reminiscent of the rights of a licensee of intellectual property under Section 365(n), a tenant may elect to remain in the premises for the remaining term of the lease, plus any renewal or extension of the term that may be provided in the lease if enforceable under applicable state law. If it so elects, the tenant must continue to pay the rent required under the lease but can offset against that rent any damages caused by the landlord's nonperformance. 

Sublandlord as debtor. When the debtor is a sublandlord (also known as a sublessor), these protections generally do not apply and the subtenant is at risk of losing possession of the premises.  Because a sublandlord is a tenant under a master lease (with the "real" landlord), if the debtor rejects the master lease it, and its subtenants, usually will not have any continuing rights to possession of the premises. Subtenants looking to protect themselves in such a situation often obtain, as part of their sublease, a non-disturbance agreement, direct lease right, or similar protection from the master landlord.

Get good advice. Whether the debtor is a tenant or a landlord (or both), bankruptcy can have a significant impact on commercial real estate leases and subleases. For this reason, it is important to get prompt legal advice on your particular lease, both at the time the lease is negotiated and in the event of bankruptcy, to protect your rights.

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