The Financially Troubled Company

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Business Bankruptcy Issues The Financially Troubled Company

20 Day Goods: New Administrative Claim For Goods Sold Just Before Bankruptcy

In a recent post about a vendor’s reclamation rights, I discussed how the 2005 amendments to the bankruptcy laws, known as the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (called "BAPCPA"), extended a vendor’s right to reclaim goods once a bankruptcy petition has been filed. This post focuses on another of BAPCPA’s important changes affecting vendors, specifically, the new provision giving vendors an administrative claim for certain pre-petition goods sold.

Expanded Reclamation Right. As mentioned in my earlier post, a new 45 day bankruptcy reclamation right was added to Section 546(c) of the Bankruptcy Code. Prior to this change, the Bankruptcy Code had merely incorporated the Uniform Commercial Code’s 10-day reclamation period. Now, once a bankruptcy is filed, a vendor can assert a reclamation demand for goods received within 45 days of the bankruptcy filing. However, in some cases a vendor may not be able to reclaim its goods. The reasons can include a failure to make a timely reclamation demand, the existence of a secured lender with a lien on the goods in question, or the debtor’s prior sale of the goods. 

A Brand New Administrative Claim For Vendors, Even If Reclamation Fails. If a vendor’s reclamation claim fails, another new Bankruptcy Code section, Section 503(b)(9), gives vendors an important additional right: an administrative priority claim for "the value of any goods received by the debtor within 20 days before" the date a bankruptcy petition was filed "in which the goods have been sold to the debtor in the ordinary course of such debtor’s business." 

In most cases, administrative claims are paid in full instead of only cents on the dollar as with general unsecured claims. This new administrative claim is therefore a significant benefit, in effect putting vendors selling goods to a debtor in the 20 days before the bankruptcy filing on par with vendors selling goods after the bankruptcy filing.

  • Section 546(c)(2) of the Bankruptcy Code expressly provides that even if a seller of goods fails to provide the required notice to have a post-bankruptcy reclamation claim, the vendor may still assert this special Section 503(b)(9) administrative claim. 
  • This administrative claim applies in all types of bankruptcy cases, including Chapter 11 reorganization cases, Chapter 7 liquidation cases, and Chapter 13 cases.
  • Vendors who sold goods during the 21 to 45 day period before the bankruptcy filing will have to rely on reclamation alone as to those goods.
  • In either case, vendors and debtors should keep good records of shipments and deliveries of all goods received during the 45 days before the bankruptcy filing.

Unresolved Issues. This provision has been in effect for only a year and there are still a number of unanswered questions about how it will actually work in bankruptcy cases. Reviewing these questions may give you a sense of some of the issues to keep in mind when considering whether you (if you’re a vendor) or your vendors (if you’re a debtor) will have an administrative claim for "20 day goods." These issues include:

  • Since the vendor is entitled to an administrative claim for the "value of any goods received by the debtor," does that mean the invoice price or some other amount?
  • Does the term "goods" include services bundled with the goods?
  • Does the term "goods" include intellectual property-based products, such as boxed software or other similar items, which the debtor resells or sublicenses?
  • Does the "received by the debtor" requirement exclude goods that have been drop-shipped to a debtor’s customer at the debtor’s direction?
  • What does the requirement that the goods have been "sold to the debtor in the ordinary course of such debtor’s business" really mean?
  • Does the vendor have to file a pleading to be paid on this administrative claim, given that this new section requires "notice and a hearing"?
  • Can the debtor pay for the goods at the beginning of the case, much as it would for goods purchased after the bankruptcy filing, as a way of treating qualifying vendors as "critical vendors"?
  • Can the debtor wait to pay for these "20 day goods" until a plan of reorganization goes effective, as it can for certain other administrative claims?
  • If a Chapter 11 case converts to a Chapter 7 case, will this "20 day goods" administrative claim be treated as a Chapter 7 administrative claim, ahead of all unpaid Chapter 11 administrative claims, including those for goods sold during the Chapter 11 case?
  • Will the existence of this administrative claim provision give vendors who actually got paid before the bankruptcy for "20 day goods" a new defense to a claim that the payment was preferential? 

Get Good Advice. These issues, and the potential for a valuable administrative claim, are yet another reason for vendors to get good legal advice as soon as they learn of a bankruptcy filing. Debtors also need to get good advice, both legal and financial, so they can factor in how the requirement to pay for these pre-petition goods as an administrative claim will impact their cash needs.

Stay Tuned. This provision has been in effect for only one year, and applies only to cases filed after BAPCPA took effect on October 17, 2005. No formal court decisions have addressed, much less answered, these open questions. I expect bankruptcy courts will start to answer some of these questions in the coming months, and I’ll keep you updated on those developments. 

Business Bankruptcy Issues The Financially Troubled Company

Reclamation: Can A Vendor “Get The Goods” From An Insolvent Customer?

Although vendors sell goods to get paid, it doesn’t always work out that way. If the customer is insolvent or files bankruptcy, the vendor may be stuck with an unpaid account. To make matters worse, some customers (especially those with limited prospects for financing) may even "load up" on inventory and then file bankruptcy without paying. Regardless of why it happens, no one wants to ship goods and not get paid.

Some vendors, however, may be able to take advantage of a special, although limited, right to get back or "reclaim" certain of the goods. This reclamation right is part of both the Uniform Commercial Code and the Bankruptcy Code. The recent 2005 amendments to the bankruptcy laws, known as the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (called "BAPCPA"), made some significant changes that have enhanced a vendor’s rights in a bankruptcy. This post discusses how reclamation rights play out both before and after bankruptcy.

Reclamation before bankruptcy. If the customer has not filed for bankruptcy, a vendor’s reclamation rights are governed by the Uniform Commercial Code (known as the "UCC"). UCC Section 2-702 is the UCC"s reclamation statute. It provides a seller with the right to reclaim goods that a customer received on credit "while insolvent" if the seller makes a demand within ten days after the customer received the goods. This 10-day period means that, absent a bankruptcy, a vendor’s reclamation right will be limited to reclaiming only those goods received by the customer in the ten days prior to the demand.

  • Under the UCC, "insolvent" means (A) having generally ceased to pay debts in the ordinary course of business other than as a result of good faith dispute; (B) being unable to pay debts as they become due; or (C) being insolvent within the meaning of federal bankruptcy law.
  • Under the federal Bankruptcy Code, insolvent means that the entity’s debts exceed the value of its assets at a fair valuation. This is essentially a balance sheet test but, importantly, one using market value and not financial reporting standards such as GAAP. Because they are prepared for a different purpose, GAAP balance sheets tend to overstate asset values and understate actual liabilities compared to the bankruptcy balance sheet test. Companies that might seem solvent under GAAP could be insolvent under the UCC or the Bankruptcy Code.
  • If the customer misrepresented its solvency in writing during the three months before the delivery of the goods in question, then the 10-day limitation does not apply.

The UCC reclamation demand. To exercise a reclamation right before bankruptcy, the vendor must make a demand. The demand should be in writing, directed to the customer, identify which goods are being reclaimed to the extent that information is available, include a general statement reclaiming all goods received by the customer from the vendor during the applicable time period, and demand that the goods be segregated. Vendors should consult with counsel to be sure the demand adequately protects their reclamation rights.

Reclamation after bankruptcy. Because of changes made in the 2005 amendments to the Bankruptcy Code, applicable to all bankruptcy cases filed on or after October 17, 2005, the filing of a bankruptcy now actually expands a vendor’s reclamation rights. These new provisions apply in both Chapter 11 reorganization cases and Chapter 7 liquidation cases. Some of the key changes include:

  • A new, 45-day bankruptcy reclamation right has been added to Section 546(c) of the Bankruptcy Code. Prior to this change, the Bankruptcy Code had merely incorporated the UCC’s 10-day period. Now, once a bankruptcy is filed, a vendor can assert a reclamation demand for goods received within 45 days of the bankruptcy filing.
  • The goods must have been sold in the "ordinary course" of the vendor’s business and the debtor must have received the goods while insolvent (using the Bankruptcy Code’s definition of insolvent discussed above).
  • The reclamation demand must be in writing and made within 45 days of the receipt of the goods by the customer (now the debtor in bankruptcy).
  • If the 45-day period expires after the bankruptcy case is filed, the vendor must make the reclamation demand within 20 days after the bankruptcy filing.
  • As with pre-bankruptcy demands under the UCC, the demand should identify the goods being reclaimed, include a general statement reclaiming all goods received by the debtor from the vendor during the 45-day period, and demand that the goods be segregated. Vendors may also want to file a notice of reclamation with the bankruptcy court.

Sold goods and other issues. Whether before or after a bankruptcy filing, a vendor will lose its right to reclaim any goods that the customer sells before or after receiving the vendor’s reclamation demand. 

  • Absent an agreement with the customer or a reclamation program approved by the bankruptcy court (see this example from the Delphi case, which was filed before the new BAPCPA rules took effect), a vendor may be forced to seek and obtain a court order preventing further sales of goods while its reclamation claim is pending. 
  • This "sold goods" problem has probably become more important because BAPCPA removed language from the prior version of Section 546(c) that had allowed a bankruptcy court to give a reclaiming vendor an administrative claim (with priority over unsecured claims and certain other claims) in lieu of a return of the goods.
  • Both the UCC and the Bankruptcy Code require that the debtor itself must have received the goods for them to be reclaimed. Thus, goods that are drop shipped or otherwise delivered first to the debtor’s own customer likely will not be able to be reclaimed.
  • If the debtor made a misrepresentation of its solvency and then filed bankruptcy, it’s unclear whether the 45-day rule in bankruptcy will govern or whether, like under the UCC, no time limit will apply. Keep in mind, however, that often goods shipped as far back as 45 days or longer, and sometimes even as few as 10 days for debtors with fast inventory turns, may already have been sold and thus will not be subject to reclamation. 

Rights of secured creditors. A vendor’s reclamation right is further limited by the possibility that the debtor may have granted a bank or other creditor a security interest in the goods, which will be senior to the reclamation right.  As amended in 2005, Section 546(c) now expressly makes reclamation rights subject to the prior rights of a secured creditor with a security interest in goods or their proceeds.

New administrative claim for 20-day goods. Even if a vendor fails to make a reclamation demand, all may not be lost. A new Bankruptcy Code section, Section 503(b)(9), added by BAPCPA, gives vendors an administrative priority claim for the value of any goods received by the debtor within 20 days prior to the bankruptcy filing if the goods were sold in the ordinary course of the debtor’s business. (I intend to discuss this new provision in a future post.) For now, note that it may be an important "fall back" right for vendors who fail to make a reclamation demand or who are unable to reclaim goods for other reasons.

Impact of new reclamation right on debtors and other creditors. With every new right also comes new burdens. Vendors certainly have greeted as good news the ability to reclaim goods received by a debtor as far back as 45 days. The impact of these changes on debtors, however, remains unclear. Some bankruptcy attorneys wonder whether this expanded reclamation right, together with the administrative claim for 20-day goods and certain other changes made by BAPCPA, will make it more difficult for debtors to reorganize or otherwise to pay unsecured creditors.

As always, get good legal advice. Reclamation can involve a number of twists and turns. Vendors who think they may have reclamation rights should be sure to get legal advice immediately upon learning of a customer’s insolvency or bankruptcy to protect their interests, just as debtors should to know their own rights in response to reclamation demands.

Recent Developments The Financially Troubled Company

New Delaware Decision Limits Direct Creditor Claims Against Directors In The “Zone Of Insolvency”

The Delaware Court of Chancery has issued another decision involving creditor claims against directors of a financially troubled corporation. In North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 2006 WL 2588971 (Del. Ch. Sept. 1, 2006), Vice Chancellor Noble made two important holdings:

  • First, although derivative claims can be brought, creditors may not assert direct claims against directors of a Delaware corporation for alleged breaches of fiduciary duty that occur while the corporation is in the "zone of insolvency." 
  • Second, assuming Delaware law would allow any creditor to bring a direct, non-derivative claim against directors of an actually insolvent corporation (still an unresolved question), the suing creditor’s right to payment would have to be "clearly and immediately due." Thus, creditors with disputed or contingent claims likely will not be able to assert a direct claim for breach of fiduciary duty, even if the corporation is in fact insolvent.

A copy of the decision is available here. Thanks to the Delaware Business Litigation Report blog for reporting on it first. 

No direct claim in the "zone of insolvency." The court’s refusal to permit a creditor to assert a direct claim — as opposed to a derivative claim — against corporate directors for breach of fiduciary duty in the zone or vicinity of insolvency was based on its careful analysis of the arguments for and against such claims. The court summed up its reasoning:

Indeed, it would appear that creditors’ existing protections—among which are the protections afforded by their negotiated agreements, their security instruments, the implied covenant of good faith and fair dealing, fraudulent conveyance law, and bankruptcy law—render the imposition of an additional, unique layer of protection through direct claims for breach of fiduciary duty unnecessary. Moreover, any benefit to be derived by the recognition of such additional direct claims appears minimal, at best, and significantly outweighed by the costs to economic efficiency. One might argue that an otherwise solvent corporation operating in the ‘zone of insolvency’ is one in most need of effective and proactive leadership—as well as the ability to negotiate in good faith with its creditors—goals which would likely be significantly undermined by the prospect of individual liability arising from the pursuit of direct claims by creditors.

Unclear if direct claims can be brought at all, even in a case of actual insolvency. The court engaged in a different analysis, focused more on the deficiency of the actual allegations in the complaint, in dismissing direct claims against the directors during the corporation’s alleged actual insolvency. However, the court commented that, to the extent Delaware law would permit a creditor to have a direct claim against directors of an insolvent corporation for breach of fiduciary duty, the claim would have to involve invidious conduct directed at that creditor. In so holding, the court relied heavily on two earlier decisions of the Court of Chancery, one by Vice Chancellor Strine in Production Resources Group v. NCT Group, Inc., 863 A.2d 772 (Del. Ch. 2004) (discussed in an earlier post) and the other by Vice Chancellor Lamb in Big Lot Stores, Inc. v. Bain Capital Fund VII LLC, et al., 2006 WL 846121 (Del. Ch. March 28, 2006) (available here). These decisions, taken together, suggest that most if not all creditor claims for breach of fiduciary duty against directors of insolvent Delaware corporations will be characterized as derivative and not direct claims.

Developing trend against expanding a director’s exposure to creditor claims. The Production Resources, Big Lot Stores, and now North American Catholic Educational Programming decisions, together with the recent Trenwick America Litigation Trust case refusing to recognize a cause of action for deepening insolvency (discussed in an earlier post), reflect the Delaware Court of Chancery’s resistance to attempts by creditors to expand the liability of directors when a corporation is insolvent or in the zone of insolvency. Although well-stated derivative claims by creditors for breach of fiduciary duty may be recognized by the courts in some cases, a direct claim by a creditor — if such a claim exists at all under Delaware law — seems to be limited to the rare circumstance in which that particular creditor was the only creditor harmed by an alleged breach of fiduciary duty. The Delaware Supreme Court has yet to weigh in, but these four decisions from three different Vice Chancellors indicate that the Court of Chancery is developing a consistent view on these issues.

Recent Developments The Financially Troubled Company

Deepening Insolvency: New Delaware Decision Holds That No Such Cause Of Action Exists

Over the past few years, a number of bankruptcy and other federal courts have held that plaintiffs, often bankruptcy trustees or other bankruptcy estate representatives, could pursue a cause of action against a corporation’s directors and others for "deepening insolvency."  What has made a deepening insolvency claim so attractive to plaintiffs and troubling to defendants is the lack of clarity about what conduct might give rise to such a claim, how damages for it might be calculated, and whether it would allow for expanded recoveries under other causes of action. 

What is deepening insolvency? Courts have described deepening insolvency as the "fraudulent prolongation of a corporation’s life beyond insolvency," resulting in "damage to the corporation caused by increased debt" and similarly as the “fraudulent expansion of corporate debt and prolongation of corporate life.”  A more colorful way of putting it might be, under some circumstances, "better dead than (deeper in the) red." 

A question of state law. Since federal courts apply state law to many substantive issues, those federal courts that have recognized a deepening insolvency cause of action have done so by predicting how state courts would rule on the question.  With so many companies incorporated there, Delaware’s view on deepening insolvency may be the most important.  For that reason, many attorneys took note when in the past few years bankruptcy courts in Delaware allowed deepening insolvency claims to go forward, based on their prediction that Delaware state courts would also recognize the cause of action.

The new Delaware decision.  Although federal courts had issued rulings, no Delaware state court had decided whether a cause of action for deepening insolvency exists under Delaware law.  Well, that changed on August 10, 2006, when Delaware’s corporate law court, the Court of Chancery, issued a decision in a case called Trenwick America Litigation Trust v. Ernst & Young LLP, et al.  Click here to read the court’s decision.

In Trenwick America, Vice Chancellor Strine squarely held, in unusually strong language, that no cause of action for deepening insolvency exists under Delaware law. The court also elaborated on how the business judgment rule can protect directors when a corporation is insolvent or in the zone of insolvency. Since the decision is almost 90 pages long, I’ve quoted below from the key deepening insolvency discussion (although I left out the extensive footnotes). It makes for interesting reading — even if you’re not a lawyer. 

Delaware law does not recognize this catchy term as a cause of action, because catchy though the term may be, it does not express a coherent concept. Even when a firm is insolvent, its directors may, in the appropriate exercise of their business judgment, take action that might, if it does not pan out, result in the firm being painted in a deeper hue of red. The fact that the residual claimants of the firm at that time are creditors does not mean that the directors cannot choose to continue the firm’s operations in the hope that they can expand the inadequate pie such that the firm’s creditors get a greater recovery. By doing so, the directors do not become a guarantor of success.  Put simply, under Delaware law, ‘deepening insolvency’ is no more of a cause of action when a firm is insolvent than a cause of action for ‘shallowing profitability’ would be when a firm is solvent. Existing equitable causes of action for breach of fiduciary duty, and existing legal causes of action for fraud, fraudulent conveyance, and breach of contract are the appropriate means by which to challenge the actions of boards of insolvent corporations.

Refusal to embrace deepening insolvency as a cause of action is required by settled principles of Delaware law. So, too, is a refusal to extend to creditors a solicitude not given to equityholders. Creditors are better placed than equityholders and other corporate constituencies (think employees) to protect themselves against the risk of firm failure.

The incantation of the word insolvency, or even more amorphously, the words zone of insolvency should not declare open season on corporate fiduciaries. Directors are expected to seek profit for stockholders, even at risk of failure.  With the prospect of profit often comes the potential for defeat.

The general rule embraced by Delaware is the sound one.  So long as directors are respectful of the corporation’s obligation to honor the legal rights of its creditors, they should be free to pursue in good faith profit for the corporation’s equityholders.  Even when the firm is insolvent, directors are free to pursue value maximizing strategies, while recognizing that the firm’s creditors have become its residual claimants and the advancement of their best interests has become the firm’s principal objective.

Delaware law imposes no absolute obligation on the board of a company that is unable to pay its bills to cease operations and to liquidate. Even when the company is insolvent, the board may pursue, in good faith, strategies to maximize the value of the firm. As a thoughtful federal decision recognizes, Chapter 11 of the Bankruptcy Code expresses a societal recognition that an insolvent corporation’s creditors (and society as a whole) may benefit if the corporation continues to conduct operations in the hope of turning things around.

If the board of an insolvent corporation, acting with due diligence and good faith, pursues a business strategy that it believes will increase the corporation’s value, but that also involves the incurrence of additional debt, it does not become a guarantor of that strategy’s success. That the strategy results in continued insolvency and an even more insolvent entity does not in itself give rise to a cause of action. Rather, in such a scenario the directors are protected by the business judgment rule. To conclude otherwise would fundamentally transform Delaware law.

The rejection of an independent cause of action for deepening insolvency does not absolve directors of insolvent corporations of responsibility.  Rather, it remits plaintiffs to the contents of their traditional toolkit, which contains, among other things, causes of action for breach of fiduciary duty and for fraud.  The contours of these causes of action have been carefully shaped by generations of experience, in order to balance the societal interests in protecting investors and creditors against exploitation by directors and in providing directors with sufficient insulation so that they can seek to create wealth through the good faith pursuit of business strategies that involve a risk of failure.  If a plaintiff cannot state a claim that the directors of an insolvent corporation acted disloyally or without due care in implementing a business strategy, it may not cure that deficiency simply by alleging that the corporation became more insolvent as a result of the failed strategy.

Moreover, the fact of insolvency does not render the concept of “deepening insolvency” a more logical one than the concept of “shallowing profitability.”  That is, the mere fact that a business in the red gets redder when a business decision goes wrong and a business in the black gets paler does not explain why the law should recognize an independent cause of action based on the decline in enterprise value in the crimson setting and not in the darker one.  If in either setting the directors remain responsible to exercise their business judgment considering the company’s business context, then the appropriate tool to examine the conduct of the directors is the traditional fiduciary duty ruler.  No doubt the fact of insolvency might weigh heavily in a court’s analysis of, for example, whether the board acted with fidelity and care in deciding to undertake more debt to continue the company’s operations, but that is the proper role of insolvency, to act as an important contextual fact in the fiduciary duty metric. In that context, our law already requires the directors of an insolvent corporation to consider, as fiduciaries, the interests of the corporation’s creditors who, by definition, are owed more than the corporation has the wallet to repay.

In so ruling, I reach a result consistent with a growing body of federal jurisprudence, which has recognized that those federal courts that became infatuated with the concept, did not look closely enough at the object of their ardor.  Among the earlier federal decisions embracing the notion – by way of a hopeful prediction of state law – that deepening insolvency should be recognized as a cause of action admittedly were three decisions from within the federal Circuit of which Delaware is a part.  None of those decisions explains the rationale for concluding that deepening insolvency should be recognized as a cause of action or how such recognition would be consistent with traditional concepts of fiduciary responsibility.

You might find Professor Larry Ribstein’s discussion of the new decision interesting, as well as the comments made by Francis Pileggi, who publishes the Delaware Corporate and Commercial Litigation Blog.  They also discuss another aspect of the decision, the holding that directors of a wholly owned subsidiary corporation did not breach their fiduciary duties by taking on debt for the benefit of the parent corporation, even though both the parent and subsidiary ended up in bankruptcy.

Echoes of Production Resources. Some of you may recall that Vice Chancellor Strine was also the author of the November 2004 Production Resources decision, which interpreted Delaware law more favorably for directors of corporations that are insolvent or in the "zone of insolvency." The Production Resources decision was the subject of an earlier post. 

This new decision builds on Production Resources and, in so doing, follows an approach similar to one recently taken by a bankruptcy court in New York in In re Verestar, Inc.  The June 2006 Verestar decision cited to Production Resources and predicted that Delaware courts would reject deepening insolvency as a cause of action. Click here for a copy of the Verestar decision; its deepening insolvency discussion starts at page 41. 

Conclusion. With a clear voice from the Delaware Court of Chancery, the Trenwick America decision reinforces a recent trend among some federal courts to step away from recognizing deepening insolvency as a separate cause of action.  As with any new decision, however, the real test of its influence will be the extent to which other courts, including Delaware’s highest court, the Delaware Supreme Court, follow its holding and reasoning. 

 

Recent Developments The Financially Troubled Company

Directors Of Insolvent Corporations: Duties And Protections

The fiduciary duties that directors owe a Delaware corporation and its shareholders are generally held to expand to include the interests of creditors when the company is insolvent or in the "zone of insolvency."  A hot topic among directors, particularly those serving on boards of troubled companies, is how best to meet their fiduciary duties and avoid the potential for personal liability in these situations. 

One of the most important decisions in recent years on this issue came from the Delaware Court of Chancery, the corporate law court, in November 2004 in a case called Production Resources. Why is the case important?  In short, the Production Resources court interpreted the law in a way that gives directors more protection when they make business judgments for a troubled company. 

First, the Production Resources court rejected a trend among some courts and commentators that had sought to impose on directors of insolvent or potentially insolvent corporations a new set of fiduciary duties, beyond those owed to the corporation, in favor of creditors. That trend started back in 1991 with the Court of Chancery decision in the Credit Lyonnais case — the decision that helped coin the phrase “vicinity” or “zone” of insolvency.  

Second, it held that the common exculpatory provision found in the corporate charter of most Delaware corporations, protecting directors from liability for monetary damages for a breach of the fiduciary duty of care, applies to claims made by creditors as well as by shareholders or the corporation itself.

This analysis discusses the Production Resources decision in more detail. (A pdf of the analysis is available as well.)  A "zone of insolvency" conference last November also produced an interesting discussion reported by Professor Larry Ribstein.  If you want to read the 54-page Production Resources decision itself, click here.

The decision’s ultimate impact will depend on whether other courts (including bankruptcy courts where these issues are often litigated) decide to follow its approach — so stay tuned.

Business Bankruptcy Issues The Financially Troubled Company

Setoffs And Bankruptcy

Many businesses not only sell products or services to another company, they also buy products and services from that company.  If you do business with a customer or vendor and you each end up owing the other money, you may have the right to "set off" the amount the other company owes you against the amount you owe it.  

Setoff. When a complete setoff is made, no cash changes hands but each side’s debt to the other is canceled. In some business relationships, including in the telecommunications industry, these kinds of cross-debts occur frequently and setoffs can be an important part of the payment structure. In others, setoffs only come up if one side fails to pay what it owes.  The term is also used to describe a bank’s right to sweep or set off the amounts owed on a loan against amounts the borrower has on deposit at the bank. 

Recoupment. A related concept called "recoupment" is similar to a setoff but it applies only when the offsetting amount or other defense to payment arises from the same contract or transaction that gives rise to your debt to the other company.

Impact of bankruptcy. The U.S. Bankruptcy Code does not create any setoff rights, but with certain limitations it does recognize the rights that exist under other applicable law.  However, with a bankruptcy filing comes a new risk that is similar to the preference risk that arises when you receive a direct payment before a bankruptcy.

  • If you made a setoff within 90 days before the bankruptcy filing, the debtor company (or its bankruptcy trustee, if one has been appointed) may have a right to sue you to recover the amount of that pre-bankruptcy setoff.  
  • Be sure to maintain detailed records of any setoffs made, along with the amounts each side owed the other during the business relationship. These records can be very helpful to your defense if such a claim is ever brought.

Setoff after bankruptcy. Making a setoff after a bankruptcy is filed — also known as a "post-petition" setoff — is allowed only in narrow circumstances.  Among other technical requirements, the debts have to be mutual between you and the actual debtor (not with one of its subsidiaries, for example) and they have to have arisen before the bankruptcy was filed.  Another very important point to remember is that you cannot make a setoff unless the bankruptcy court first grants you relief from the automatic stay that arises as soon as a company files for bankruptcy.

Get legal advice. This is a complex area of bankruptcy law and neither setoffs nor recoupments should be attempted after a bankruptcy has been filed without the advice of a bankruptcy attorney.  The old adage “Don’t try this at home” definitely applies. 

 

Business Bankruptcy Issues The Financially Troubled Company

Buying Assets From An Insolvent Company — Balancing Risk And Reward

Insolvent or nearly insolvent companies can present an attractive opportunity to purchase assets on the cheap, or at least at a significantly reduced cost.  Of course, a buyer purchasing assets from a troubled company wants to be as sure as possible that it is buying only the target’s assets – and not also taking on all of the troubled company’s liabilities. This kind of specialized M&A deal raises issues that usually don’t come up when acquiring a solvent company and that aren’t always obvious at first. 

Several different strategies exist for balancing these risks with the potentially substantial rewards of a distressed asset acquisition.  Here is an overview of these issues.  A more extensive discussion focusing in particular on intellectual property assets, written by Cooley Godward intellectual property partner Gary Moore, can be found here.