When bankruptcy papers arrive in your mailbox, they often signal the beginning of a formal legal process that will determine how much, if anything, you will recover from your customer’s debt. Bankruptcy laws can be overwhelming. Still, understanding the basics of creditor rights, proof of claim requirements and recovery priorities can help you make strategic decisions about your involvement in the case.
Immediate steps when a debtor files for bankruptcy
When you learn a customer has filed for bankruptcy, acting quickly and correctly can preserve your claim:
- Understand the automatic stay: The moment a bankruptcy petition is filed, an “automatic stay” goes into effect. This powerful federal injunction stops almost all collection activities against the debtor. You cannot call them, send collection letters, repossess property or continue any lawsuits.
- File a Proof of Claim: To recover any money from the bankruptcy estate, you must file a “Proof of Claim” form with the bankruptcy court. This document officially states how much the debtor owes you. The court sets a deadline for filing these claims, called the “bar date.”
- Distinguish between secured and unsecured claims: A “secured claim” means you have a legal right to specific collateral, such as equipment or real estate, if the debtor defaults. An “unsecured claim” does not have such collateral backing it, such as unpaid invoices for services or goods. Secured creditors generally have a better chance of recovery than unsecured creditors.
Federal bankruptcy law dictates many of these first steps, which apply across all states, including California.
Types of bankruptcy chapters and their impact
Different types of bankruptcy affect commercial creditors in distinct ways. The two most common types for businesses are Chapter 7 and Chapter 11:
- Chapter 7 bankruptcy (liquidation): A trustee sells the debtor’s non-exempt assets to pay creditors. This is a liquidation process, and businesses typically cease operations. Unsecured creditors often receive little to no recovery in Chapter 7 cases because secured creditors and administrative expenses get paid first.
- Chapter 11 bankruptcy (reorganization): Chapter 11 allows a business to reorganize its debts while continuing operations. The debtor proposes a “plan of reorganization” outlining how it will pay creditors over time, and creditors vote on this plan. Chapter 11 can offer a better chance of recovery for unsecured creditors than Chapter 7, but the process is longer and more involved.
Large cases sometimes form creditors’ committees to monitor the proceedings and negotiate with debtors. Joining these committees can give you a voice in important decisions affecting your recovery.
Chapter 7 cases can be resolved more quickly, often within a year. Chapter 11 cases, especially for larger businesses, can take several years to conclude. Patience is essential, but vigilance in the process is equally important.
Preference payments and fraudulent transfers
Bankruptcy law allows trustees to recover certain payments made before filing. If your customer paid you within 90 days of bankruptcy (or one year for insider payments), the trustee might demand the return of those funds as “preference payments.”
You can defend against preference claims by proving the payments were made in the ordinary course of business. Fraudulent transfer claims target payments made to defraud creditors or for less than fair value. These recovery actions can benefit creditors if the trustee collects money that is distributed to all creditors.
Objecting to discharge and adversary proceedings
Sometimes, you might want to object to a debtor’s discharge. A discharge frees the debtor from certain debts, and you can object if the debtor committed fraud or hid assets.
An adversary proceeding, meanwhile, is a lawsuit within the bankruptcy case. You might file one to prove fraud or to argue your debt should not be discharged.
Protecting assets and claims before bankruptcy
The best defense is often a good offense. Consider these steps:
- Security agreements and UCC filings: When extending credit, consider obtaining a security interest in the customer’s assets. File a Uniform Commercial Code (UCC-1) financing statement to perfect your security interest. This makes your claim secured and gives you priority over unsecured creditors.
- Guarantees: For business customers, consider seeking personal guarantees from the business owners. This provides an additional source of recovery if the business files for bankruptcy.
- Monitoring financial health: Pay attention to early warning signs of financial distress in your customers, such as delayed payments or requests for extended credit terms. This allows you to take protective measures before a bankruptcy filing occurs.
Taking steps to secure your claims before a customer files for bankruptcy can significantly improve your recovery prospects.
Seeking legal guidance is key
Bankruptcy law contains numerous traps for unwary creditors. Deadlines are strict, procedures are technical and mistakes can be costly. An experienced debt collection attorney can help you recover what you have earned and protect your business interests.