As the number of bankruptcies increase and are projected to keep increasing, it is important for creditors to think about how they can protect their interests before their debtor files for bankruptcy. In particular, the 90 day period preceding a bankruptcy filing is critical because, once in bankruptcy, a debtor may be able to claw back payments and other transfers made to its creditors within that 90 day period.
Steps a creditor should take when doing business with a distressed company include, among other things:
- Perfecting secured status: Creditors with a security interest should review loan agreements, security agreements and UCC-1 filings to confirm that any existing security interest is properly perfected. Unsecured judgment creditors should explore obtaining a lien on a potential debtor’s property or assets through the execution process;
- Consider protections in any settlement agreement: When settling a debt with a potential debtor, include language that delays releases until 91 days after full performance, and permits recovery of the full amount owed (rather than just the settlement amount) if bankruptcy is filed during settlement period or if the payments are clawed back in bankruptcy. Also consider third party guarantees and additional collateral to secure the settlement payments;
- Assess potential exposure to claw-back: Consider actions to take advantage of Bankruptcy Code defenses to the debtor’s ability to avoid prepetition payments, such as substantial contemporaneous exchange and payments in the ordinary course of business:
- Substantial contemporaneous exchange occurs when a transfer between the debtor and the creditor occurs at the same time. This can include cash-on-delivery (“COD”) payments or prepayments. Documentation indicating that the exchange was intended to occur contemporaneously can strengthen this defense.
- An ordinary course of business defense can succeed if a creditor establishes a course of conduct, including establishing consistent payment histories and standard default-notice procedures and adheres to this course of conduct during the customer’s financial distress.
- If the course of conduct has changed, consider changing payment terms to COD or prepayment to avoid any further exposure in the event of a debtor’s bankruptcy filing or to potentially eliminate exposure if a bankruptcy filing is not made within 90 days after changing payment terms to COD or prepayment.
Addressing these issues and consulting with legal counsel before a customer files for bankruptcy relief may greatly improve a creditor’s ability to recover payment of its prepetition claim during the bankruptcy and mitigates the risk to creditors that prepetition payments will be clawed back.
If you are doing business with a distressed customer, and have any questions or would like to discuss these issues, please contact Yonit A. Caplow, Anne M. Aaronson, Jennifer L. Maleski, or any of the attorneys in our Bankruptcy Group.