Sometimes You Just Get Lucky (or, What to Do if Your Customer Files for Bankruptcy)

Although the recession officially may have ended, bankruptcy filings – a lagging indicator – continue to rise. Consequently, companies need to be extra vigilant when they decide how far to extend credit to their customers. A recent development for one of my clients (“Client”) illustrates this point.

Client sells its products exclusively through resellers. Over the course of 18 months, one of them (“Reseller”) had become Client’s largest customer based on the volume of goods purchased. Throughout that period, Reseller had paid every bill on time.

Unexpected Call

Then Client received an unexpected call from Reseller’s CFO. Reseller was having financial problems because its bank had withdrawn a line of credit. If Reseller did not find a buyer for its business within a week, Reseller likely would be forced into bankruptcy.

Client was concerned. Reseller had $165,000 of Client’s products in inventory plus another $220,000 of unpaid receivables. As a small company, Client could ill afford to lose most, let alone all, of the revenue it was owed.

Client’s President called me to ask what he should do. The first task was to find out whether Client had a right of reclamation with respect to some or all of its products in Reseller’s inventory.

Right of Reclamation

The right of reclamation is a right that a supplier may have under the U.S. Bankruptcy Code to reclaim goods from a customer that was insolvent at the time the goods were shipped. For Client to have had a right of reclamation in this instance, all of the following would have had to be true:

1. Client sold the goods to Reseller on credit.
2. The sale was in the ordinary course of business for both parties.
3. The goods were shipped when Reseller was insolvent. Here, “insolvent” means that Reseller had stopped paying debts in the ordinary course of business, or would be unable to pay debts as they become due, or had a negative net worth if all assets and liabilities were considered at fair market value.
4. Client made a written demand for return of the goods within 45 days of their receipt by Reseller.
5. Reseller had possession of the goods when the demand was received.

Unfortunately, Client’s right of reclamation was limited to less than ten percent of the inventory then in Reseller’s possession.

Bankruptcy

The following week passed quickly. Reseller filed for reorganization under Chapter 11 of the Bankruptcy Code and entered into a Purchase Agreement with a buyer that was willing to extend Debtor in Possession financing so Reseller could remain in business. If this transaction closed, Client would receive only a fraction of what it was owed.

Meanwhile, Client replied promptly to all notices and participated in every meeting of Reseller’s creditors. Client resumed shipping products to reseller, though now on a cash, rather than credit, basis.

Then Client got lucky. The court held an auction for substantially all of Reseller’s assets. The successful bidder agreed to a price that was three times what the initial buyer agreed to pay. As a result, it is likely that all creditors to be paid in full. After just two months, but with quite a bit of uncertainty and anxiety, the matter came to a resolution that pleased Client.

If you provide products or services to customers on credit, the following tips always are appropriate, but they are especially important during tougher economic times:

• Be careful about which customers receive credit and how much credit you extend.
• Keep in touch with customers so you can learn about any financial problems as quickly as possible.
• If a customer files under the Bankruptcy Code or takes other legal action, carefully read every document that you receive.
• If you don’t understand a document or are not sure how to proceed, obtain legal advice to make sure that you are pointed in the right direction.

This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact an attorney directly.