CHAPTER 6 Bankruptcy of Troubled Suppliers and Customers in the United States

• Jurisdiction: United States

CHAPTER 6 Bankruptcy of Troubled Suppliers and Customers in the United States

Over the last two decades, manufacturing operations in North America and Europe have suffered from significant financial distress. In fact, the survival of several of the most prominent manufacturers, including General Motors Corporation and Chrysler, was recently called into doubt, and only after receiving government aid packages were these businesses able to continue. This financial distress has been attributed to a combination of several factors, including inferior product design and manufacturing processes, overseas competition, labor and legacy costs, an inability to access capital, general economic downturn, and an overall increase in the cost of raw materials as worldwide demand for these materials has increased. As a result, the manufacturing sector has experienced significant consolidation and, unfortunately in some instances, mass liquidation.

In the last several years, the vast majority of manufacturers who have resorted to bankruptcy in order to cleanse their operations and balance sheets in the U.S. have either sold substantially all of their assets as going concerns under § 363 of the Bankruptcy Code as part of a chapter 11 liquidation or simply liquidated in chapter 7. Meanwhile, the manufacturing sectors in other North American countries and Europe have experienced similar difficulties.

The discussions in Chapters 6-9 are intended to provide practitioners with an informative overview and analysis of the various themes and issues that arise in manufacturing insolvencies and bankruptcies in the U.S., Canada, Germany and Mexico.

A. Initial Considerations

In the U.S., there are two types of bankruptcy cases a troubled supplier can find itself in.

1. Voluntary vs. Involuntary Bankruptcy

In most cases, a debtor will unilaterally choose to file a petition for relief under either chapter 7 or chapter 11 of the Bankruptcy Code. As will be discussed, a chapter 7 proceeding is one in which the debtor has, or will in the near future, cease its business and a third-party trustee is appointed to liquidate the debtor's assets and distribute the cash proceeds to various types of creditors pursuant to the priority scheme established by the Bankruptcy Code. In a chapter 11 proceeding, the debtor itself will attempt to reorganize through the confirmation of a plan of reorganization, or wind down its operations in an orderly fashion and eventually liquidate through chapter 11 assets sales or a plan of liquidation.

The other way an entity can find itself in bankruptcy is involuntarily, through the actions of its creditors.²⁶³ As few as three creditors whose claims together amount to at least $14,425 or more than the value of any lien securing such claims can jointly file an involuntary petition against an entity. In rare instances, especially for the type of troubled supplier this treatise features, where the debtor has fewer than 12 creditors only one of those creditors is necessary in order for an involuntary petition to be filed. However, the burden would then be on the lone petitioning creditor to prove that the debtor has fewer than 12 creditors.²⁶⁴ Other creditors whose debts are not disputed can join in an involuntary petition or can even replace one or more of the original three petitioners, whose claim(s) may be subject to dispute, in order to maintain the requisite number of petitioning creditors.

An involuntary petition can be filed under either chapter 7 or chapter 11, but a chapter 7 can be converted by the putative debtor into a chapter 11 proceeding.²⁶⁵ Another option to the debtor is to contest the filing through a litigated process in the bankruptcy court. The court is required to enter an order for relief against the entity (i.e., making it a bankruptcy debtor) if it finds that the debtor is not generally paying its debts as they become due or that a custodian was appointed or took possession of the debtor's assets within 120 days of the involuntary filing.²⁶⁶

During the period frequently referred to as the "gap" period—from the time the bankruptcy is filed until the debtor either consents to or acquiesces in the bankruptcy or it is dismissed upon the putative debtor's challenge—the debtor continues to operate as if the bankruptcy had not been filed. In fact, many creditors may not even know of the involuntary filing during this period. Creditors who deal with the debtor during the gap period are also provided with special protection by being given administrative expense priority covering their transactions with the debtor.²⁶⁷

The filing of an involuntary petition can be an effective tool for creditors, especially when dealing with a debtor who refuses contact from its creditors, is being severely mismanaged or has been the subject of suspect transactions (e.g., where the owners may be absconding with the revenues). By placing the entity in bankruptcy, the creditors gain a degree of control over the debtor's situation, but more importantly, they gain access to information as a result of the disclosure of the debtor's financial condition and its past transactions—a disclosure that all debtors are required to make.

Debtors are required to file schedules of their assets and liabilities and a statement of their financial affairs. They are also required to attend a meeting wherein creditors are invited to ask questions of the debtor's management.²⁶⁸ The Bankruptcy Code provides a means for a more detailed deposition of sorts of the debtor's officers through a "2004 examination" on a broad array of topics.

Through these means, creditors may be able to establish whether there were any suspicious financial actions undertaken by the debtor and, if so, through other measures provided under chapter 5 of the Bankruptcy Code, investigate the full extent of those transactions and seek to avoid and recover mishandled funds for the benefit of all creditors. One weapon provided to creditors in this regard, where the debtor converts its involuntary chapter 7 to a chapter 11 proceeding, is to petition the court for the appointment of either a trustee who will displace or supplant the debtor's management and take over the debtor's operations, or seek to appoint an examiner to oversee and investigate the debtor's finances.²⁶⁹

There can also be substantial risk to the petitioning creditors who put an entity into an involuntary bankruptcy. The petitioning creditors can be liable for the costs and attorney's fees incurred by the putative debtor's successfully challenging an involuntary filing and any losses occasioned thereby, including additional sanctions and punitive damages appropriate under the circumstances, especially if the court finds that the filing was a tactical maneuver or was otherwise made in bad faith.²⁷⁰ For instance, putting a debtor into an involuntary bankruptcy in the hopes of gaining leverage to obtain payment of its claim has been held to be a filing made in bad faith.²⁷¹

A requirement of the petitioning creditor is that both the liability for, and the amount of, the debt be undisputed. In other words, there should be no issue regarding the debtor's liability for the debt, or that the amount owing is subject to a bona fide dispute. A frequent instance in which an involuntary petition is successfully challenged, and one or more of the petitioning creditors is sanctioned, is that the creditor uses the involuntary filing as a means to exact concessions from the debtor over a disputed debt. As noted, one such tactic is the filing of an involuntary petition as a means to force the debtor to pay the specific creditor's claim or to resolve a disputed debt. Another tactic is where the petitioning creditors intend to dismiss the involuntary petition if the involuntary debtor caves in to this pressure. Even though only a small fraction of the debtor's creditors can force a debtor into an involuntary bankruptcy case, allowing an involuntary bankruptcy is intended to be a mechanism to benefit all creditors by putting all creditors on an equal footing vis-à-vis the debtor. In cases where the filing of an involuntary bankruptcy is used as a device to benefit only one or a few creditors, it is considered improper and can lead to quite costly sanctions being inflicted on the petitioning creditors. Conversely, a legitimate filing tends to spread the costs of the bankruptcy case, the trustee's investigation, pursuit of the debtor's assets, and possible avoidance actions over the whole creditor body rather than those costs being borne by a few creditors whose actions might nonetheless serve to benefit all.

2. Chapter 7 Liquidation and Chapter 11 Reorganization

a. Chapter 7

One type of bankruptcy filing, and usually the most troublesome to creditors, is a chapter 7 liquidation. In the typical chapter 7 bankruptcy case, the debtor has ceased business (unless the chapter 7 trustee continues to operate the business pursuant to § 721), and a trustee is appointed to sell the debtor's assets and pay a dividend to creditors based on the priority scheme established by the Bankruptcy Code. Under this scheme, secured creditors are paid first out of the sale of their assets, or their collateral is given back to them.²⁷² The secured creditor can file an unsecured claim for the deficiency or unpaid portion of the claim.

Next on the priority list are priority unsecured creditors, which are entitled, on a pro rata basis in the order of their respective priority claim, to the next available funds. The Bankruptcy Code prescribes 10 levels of such priority creditors.²⁷³ The priorities cover a variety of special circumstances, including unpaid wages, benefits and costs incurred during the administration of the bankruptcy proceeding (this includes the fees and costs of the trustee and its counsel in liquidating assets and closing the bankruptcy case), and administrative expenses arising in connection with goods sold to the debtor within 20 days of the...