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Now What? Issues a Small Business Faces When a Customer Files for Bankruptcy

The following was originally published in Lynchburg Business Magazine, January 2014 issue, and was written by David Cox.

For small businesses, receiving a notice of a customer’s bankruptcy can be confusing. While the best advice is always to contact an attorney to determine the exact impact of the bankruptcy, the analysis can be broken down into a few basic steps following the receipt of a bankruptcy notice.

Stop Collections and Gather Information

With very few exceptions, upon the filing of a bankruptcy by an individual, the automatic stay of the bankruptcy code generally prohibits further collection activities or legal actions against that individual and his or her property. The focus of a business that receives a bankruptcy notice should first be on identifying the debtor in its customer records, determining what, if any, collection actions it has pending, and ceasing those collection actions as well as the generation of further billing statements to the customer.

Most creditors will learn of the bankruptcy filing by receiving a written notice in the mail. This notice is the first document generated by the court upon the filing of a bankruptcy petition by an individual and it includes key information that the creditor should review. For example, the notice will indicate the full name and social security number of the debtor to aid in the creditor’s identification of the individual in its customer rolls. The bankruptcy case number will also be disclosed and should be referenced by the creditor in any correspondence it sends to the bankruptcy court related to the debtor.

The notice also includes the chapter that the debtor has filed, typically 7 or 13 for consumer debtors, and the date, time and location of the Meeting of Creditors. The chapter is particularly important because it will provide an early indication of whether funds might be available for the creditor in the case. Typically Chapter 13 bankruptcies provide some level of distribution to the creditor, albeit often just a small percentage for many general unsecured creditors. Chapter 7 bankruptcies may also produce dividends for the creditors, but whether funds will be available is typically not something that the creditor will be able to determine at such an early stage in the case.

Determine the Impact of the Bankruptcy

Many small business creditors mistakenly ask whether their debts are “included” in the bankruptcy. Technically this is not correct since all debts must be included, that is, listed and noticed, in the bankruptcy petition. The real question is whether a particular debt will be discharged or wiped out by the bankruptcy. The answer to that question depends in large part on whether the debt owed to the creditor satisfies one or more of the exceptions to discharge found in the Bankruptcy Code.

The Bankruptcy Code lists a number of types of debts that are not discharged in a bankruptcy. Examples include certain types of taxes, child and spousal support obligations and student loans that would not typically impact a small business creditor. Small business creditors often need to look more to the manner in which the debt was incurred. For example, such businesses may be able to assert that a debt should not be discharged because it was incurred by fraud or by the misrepresentations of the debtor.

Also, the receipt of a bankruptcy notice does not necessarily mean that the creditor will not receive further payments toward the debt. In Chapter 13 cases, the debtor’s proposed plan will be mailed to all creditors and provides information on what payments a creditor might expect. In Chapter 7 cases, the debtor files a Statement of Intention that indicates whether he or she will continue to make payments to certain creditors that have liens on the debtor’s property.

Consider Whether Further Action is Necessary

When faced with a customer’s bankruptcy filing, the creditor’s range of options extend from taking no action to becoming actively involved in the case, reviewing all filings and attending court hearings. Although much of the initial information gathering can be done without the assistance of an attorney, determining the effect of the bankruptcy filing and evaluating whether further action is necessary typically will require the expertise and advice of an attorney.

The bankruptcy process actually includes a fair amount of safeguards for creditors even if they do not participate in the case. Other parties, such as case trustees, are assigned to all consumer cases and oversee parts of the process. Although these trustees are not responsible for protecting the rights of any particular creditor, they will often bring to the attention of the court issues related to the debtor’s eligibility to seek bankruptcy relief.

Even if a creditor does not intend to become actively involved in a case, it should consider filing a proof of claim with the court if distributions are likely. A blank proof of claim form normally will accompany the initial bankruptcy notice from the court in all Chapter 13 filings since some level of distribution to creditors is anticipated in such cases. For Chapter 7 cases, the court generally only issues a notice to creditors to file a proof of claim in a case where distributions are expected. Timing is important, however, and a creditor needs to ensure its proof of claim is filed before the deadline noted for such claims.

A common misconception is that creditors must attend the Meeting of Creditors hearing or they will not be able to further participate in the bankruptcy. This is not true. The failure to attend the meeting of creditors by the creditor does not eliminate any of its rights with respect to the bankruptcy. It is an optional meeting that simply provides basic information about the case and the opportunity for questions to be asked of the debtor regarding his or her debts and property interests.

Depending on the circumstances of a particular case, some creditors may consider becoming more deeply involved in the proceedings. Creditors will want to consult with counsel before taking actions such as objecting to the debtor’s plan of reorganization, filing a special lawsuit to ask the court to determine that a debt is not discharged, seeking dismissal of the case or asking the court to lift the automatic stay in order for normal collections to proceed.

Hiring Counsel

Although small business creditors are understandably concerned with incurring more expenses and legal fees when faced with a customer’s bankruptcy filing, hiring counsel is always advisable when dealing with significant accounts. As with any legal matter, a business is best positioned to limit the impact of a bankruptcy when that business understands the process and its options.

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David Cox is a member of NACBA and serves as the Virginia State Co-Chair.
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