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.