Receiving notice that a borrower or business customer has filed for bankruptcy creates immediate uncertainty for any creditor. The process is governed by a dense body of federal law, and missteps can result in sanctions, lost recovery opportunities, or unnecessary financial exposure. However, creditors who understand their rights and act strategically from the outset are positioned to maximize their recovery and protect their interests throughout the proceeding.
This guide outlines the key concepts every creditor should understand when a customer enters bankruptcy and the practical steps to take at each stage.
Identifying the Type of Bankruptcy Filing
The bankruptcy petition will specify which chapter of the Bankruptcy Code governs the case. The chapter determines the scope of the debtor’s obligations, the timeline of the proceeding, and the remedies available to creditors.
For business entities, the most common filings occur under the following chapters:
- Chapter 7 governs liquidation proceedings. A court-appointed trustee takes control of the debtor’s non-exempt assets, sells them, and distributes the proceeds to creditors according to a statutory priority scheme. Chapter 7 is the most frequently utilized business filing and typically results in the dissolution of the business entity.
- Chapter 11 governs reorganization proceedings. The debtor generally retains possession of its assets and continues operating while developing a restructuring plan to address outstanding obligations. Chapter 11 offers creditors more avenues for recovery but also involves a more complex and extended process.
- Chapter 13 applies to individual debtors (not businesses) and involves a court-supervised repayment plan, typically spanning three to five years.
The chapter under which your customer has filed fundamentally shapes your strategy. In a Chapter 7 liquidation where you hold no collateral, your options are largely limited to filing a proof of claim and awaiting distribution. Unsecured creditors frequently receive little or no recovery in these cases. Chapter 11 proceedings, however, present significantly more opportunity for creditors to influence the outcome, particularly for those holding secured claims or providing essential goods and services.
The Automatic Stay: What It Means for Your Collection Efforts
The moment a bankruptcy petition is filed, the automatic stay under 11 U.S.C. Section 362 takes effect. This federal injunction immediately halts virtually all collection activity against the debtor, including:
- Sending invoices, demand letters, or collection notices
- Initiating or continuing lawsuits related to pre-petition debts
- Repossessing collateral or foreclosing on property
- Setting off mutual debts without court authorization
Violations of the automatic stay can result in contempt sanctions, damages, and attorney fee awards against the offending creditor. Upon learning of a customer’s bankruptcy filing, cease all collection activity immediately and consult with experienced bankruptcy counsel before taking any further action. While certain narrow exceptions to the stay exist, navigating them without legal guidance creates substantial risk.
Continuing Business Relations During Bankruptcy
Creditors are not automatically prohibited from transacting with a debtor in Chapter 11. In fact, many business relationships continue throughout the reorganization process. However, the terms of that continued relationship shift meaningfully.
If an enforceable contract remains in place, you may be obligated to continue performing under its terms during the bankruptcy. Conversely, if no binding agreement governs the relationship, you retain considerable flexibility to modify your terms of trade. Common protective measures include:
- Requiring cash on delivery or advance payment rather than extending credit
- Shortening payment terms for post-petition transactions
- Reducing credit limits or requiring personal guarantees
Goods and services delivered to the debtor after the bankruptcy filing generate what are known as administrative expense claims under 11 U.S.C. Section 503(b)(1)(A). These claims carry priority over pre-petition unsecured debts and must represent “actual, necessary costs and expenses of preserving the estate.” In practice, routine operating expenses generally satisfy this standard, which means vendors who continue supplying a debtor during Chapter 11 typically receive payment ahead of general unsecured creditors.
Exercising Your Right to Reclaim Goods
The Bankruptcy Code preserves certain reclamation rights derived from the Uniform Commercial Code (UCC) that allow sellers to recover goods delivered to an insolvent buyer. To exercise these rights, creditors must act within strict deadlines:
- A written reclamation demand must be sent to the debtor within 45 days of the debtor’s receipt of the goods.
- If the bankruptcy petition was filed during that 45-day window, the reclamation demand must be made within 20 days of the filing date.
Additionally, creditors who delivered goods to the debtor in the ordinary course of business during the 20 days immediately preceding the bankruptcy petition may assert an administrative expense claim for the value of those goods. This provision offers an alternative path to recovery even when reclamation of the physical goods is impractical.
Pursuing Critical Vendor Status
In certain Chapter 11 cases, the bankruptcy court may authorize the debtor to establish a critical vendor program. Under these programs, the debtor identifies suppliers whose continued participation is essential to the reorganization and receives court approval to pay their pre-petition claims in full. In exchange, the designated critical vendors agree to maintain their pre-bankruptcy trade terms, including extending credit throughout the Chapter 11 process.
If you believe your customer’s reorganization depends on your continued supply of goods or services, positioning yourself for critical vendor designation should be an immediate priority. Factors that courts consider include:
- Whether your goods or services are available from alternative suppliers
- The volume and importance of your sales to the debtor’s operations
- Whether interruption of supply would jeopardize the reorganization
Securing critical vendor status effectively guarantees full payment of your pre-petition claim, making it one of the most favorable outcomes available to trade creditors in a Chapter 11 case. Work with legal counsel to build the strongest possible case for designation.
Filing Your Proof of Claim and Defending Against Preferences
Every creditor should file a proof of claim, a standardized court document that establishes the amount the debtor owes you as of the petition date. Even if the debtor’s schedules already list your claim and do not dispute the amount, filing your own proof of claim preserves your rights and ensures you are included in any distribution.
Be aware that the debtor or the bankruptcy trustee may seek to recover payments you received during the 90 days before the bankruptcy filing as preferential transfers under 11 U.S.C. Section 547. A preference action does not mean you did anything wrong; it simply reflects the Bankruptcy Code’s policy of ensuring equitable treatment among creditors of the same class.
If you receive a preference demand, do not assume the claim is valid on its face. Several well-established defenses are available, including:
- Ordinary course of business defense: Payments made according to ordinary business terms between the parties may be exempt.
- Subsequent new value defense: If you provided new goods or services after receiving the alleged preferential payment, the value of those deliveries can offset the preference claim.
- Contemporaneous exchange defense: If the payment was intended as and in fact was a substantially contemporaneous exchange for new value, it may be protected.
Prompt engagement with experienced bankruptcy counsel is essential to evaluating and asserting these defenses effectively.
Protecting Your Position as a Creditor
The most important step a creditor can take when a customer files for bankruptcy is to act promptly and deliberately. If you sense that a customer is experiencing financial distress before a filing occurs, consider tightening credit terms, securing additional collateral, or reducing your exposure.
Once a bankruptcy filing is made, the process involves multiple deadlines, strategic decisions, and legal technicalities that directly impact your recovery. Geraci LLP has extensive experience guiding creditors through every phase of the bankruptcy process, from initial filing response through plan confirmation and distribution. Contact us today at (949) 403-3488 to discuss your rights and develop a recovery strategy tailored to your situation.
Anthony Geraci is the founder of Geraci LLP, located at 90 Discovery, Irvine, CA 92618. Geraci LLP represents private lenders, fund managers, and financial institutions in bankruptcy, litigation, and transactional matters nationwide.
