Compass Newsletter - Articles

Now What? Understanding the Process After Your Customer Files Bankruptcy

By Daniel J. Rice
(Summer 2012)

If you have a business with accounts receivable, chances are good that you have or will receive a notice that a client or customer who owes money on an account has filed bankruptcy. The notice can lead to many questions.

What steps should the business take? Is there any issue with any payments that have already been received? Does the bankruptcy mean that the account will never get paid?

Bankruptcy often presents a complex maze, and the answers to these and other questions depend on the particular facts surrounding a debtor’s situation. With that caveat in mind, this article summarizes the bankruptcy process from a business creditor’s perspective and broadly outlines the steps a creditor can take and factors it should consider upon receiving a bankruptcy notice.

Step 1: Heed the Automatic Stay

The first step any business should take when receiving a bankruptcy notice or otherwise learning of the bankruptcy is to stop all efforts to collect on the account. The bankruptcy code provides debtors with an “automatic stay” against almost all collection efforts as soon as they file a bankruptcy petition. The automatic stay serves both to provide the debtor immediate relief from collection activity and to freeze the debtor’s financial situation to ensure that all creditors receive fair treatment and that the debts are addressed in an orderly fashion according to the bankruptcy laws.

Creditors who willfully violate the automatic stay through continuing to pursue collection risk having the court order sanctions, which can include payment of any damages incurred by the debtor and attorney fees. Creditors can violate the automatic stay through both formal actions, such as initiating or continuing a lawsuit, or through informal actions such as making phone calls or sending correspondence demanding payment.

In a few cases, courts have imposed sanctions on businesses for simply continuing to send monthly invoices generated by their accounting software after learning of the bankruptcy and receiving requests from the debtor to stop. To avoid any potential for sanctions, a business should ensure that a customer who has filed bankruptcy does not receive invoices for goods or services provided prior to the bankruptcy petition.

Step 2: File a Claim in Most Circumstances

A customer’s bankruptcy does not necessarily mean all hope of ever receiving payment on the debt is lost. In many situations, a business creditor may receive at least partial payment from the bankruptcy estate. For example, an individual debtor who files a chapter 7 petition to discharge all debts might have assets with equity, in which case the trustee could sell the assets and distribute the proceeds to creditors. In a chapter 11, 12, or 13 bankruptcy to reorganize debts, the bankruptcy court will approve a plan by which the debtor’s future disposable income for a specified period of time (usually three to five years) is committed to paying creditors.

In many cases, a creditor will need to timely file a proof of claim to receive payment from the bankruptcy estate. The proof of claim is a simple form that outlines the basic details of the debt and should typically be accompanied by a copy of an invoice, contract, or other document evidencing the debt.

The bankruptcy notice will typically indicate whether a creditor needs to file a proof of claim and provide the deadline. In a chapter 7 liquidation case, the notice will state whether the trustee has determined that the debtor has equity in assets to apply toward payment of creditors, in which case a proof of claim is required.

In a chapter 11, 12, or 13 reorganization case, a proof of claim is a prerequisite to receiving payment from any reorganization plan approved by the court, and all creditors, whether secured or unsecured, should consider filing a claim.

Step 3: Receiving Payment on Claims

Submitting a claim, of course, does not guarantee a creditor any payment. Claims will receive different treatment depending on the nature of the debt and whether it is secured by a lien against a debtor’s asset. Certain debts, including spousal and child support obligations and administrative expenses in the bankruptcy, are given “priority” status by the bankruptcy code and will be paid before other debts.

In a Chapter 7 case, whether any creditors receive payment in the bankruptcy depends on whether the trustee determines that the debtor has sufficient equity in assets to administer them. The sales proceeds will first pay off the liens on the sold assets and then be applied to the priority claims. General unsecured creditors get anything that remains.

In a reorganization case, payment will depend on the reorganization plan ultimately approved by the court. In a Chapter 13 case, one of the limitations on a reorganization plan is that the plan cannot treat unsecured creditors any worse than they would have fared in a Chapter 7 liquidation case. For this reason and others, the valuation of assets and collateral, which determines how creditors would fare in a Chapter 7 bankruptcy, becomes a critical issue in a reorganization case.

Whether their debt is secured or unsecured, creditors should pay careful attention to the proposed reorganization plan submitted by the debtor. Creditors have the opportunity to object to a plan before the court confirms it.

Step 4: Assessing Other Options

For many creditors, timely submitting a proof of claim may as a practical matter represent the only step worth taking, especially when the debt is unsecured and the amount owed is relatively small. For other creditors, however, many other considerations may come into pay.

  1. Secured Creditor Options

    Secured creditors will need to pay close attention to what the debtor intends to do with their collateral. In a chapter 7 case, debtors must file a statement of intent with respect to secured assets indicating whether they intend to surrender or keep the collateral.

    If the debtor surrenders the collateral, it remains part of the bankruptcy estate. The collateral will be sold in the event the trustee determines the debtor has sufficient equity in assets, and the creditor will receive the sale proceeds, up to the total amount of the debt, remaining after payment of sale expenses. If the trustee determines that the debtor lacks sufficient equity in assets to administer the collateral – the situation in most Chapter 7 bankruptcies – the creditor’s lien will simply “ride through” the bankruptcy. The creditor can foreclose following the debtor’s discharge, but, because the underlying debt has been discharged, the creditor cannot recover a deficiency judgment.

    If a Chapter 7 debtor intends to keep the collateral, the debtor generally must either (1) redeem the collateral by paying the creditor a lump-sum amount equal to the collateral’s value; or (2) reaffirm the debt by reaching an agreement with the creditor to gradually pay all or some of the debt under the original or modified terms.

    In a Chapter 13 reorganization case, collateral held by the debtor is not subject to being administered at the trustee’s discretion like in a Chapter 7 case. While a Chapter 13 debtor may choose to surrender collateral, the debtor can also choose to keep the collateral by continuing to pay the secured creditor through the reorganization plan. When the debtor owes more on collateral than it is worth, the debtor can in many circumstances “cram down” the amount owed to the value of the collateral and then keep the collateral free and clear after paying this amount.

    Regardless of what chapter a debtor files under, a secured creditor should take special note of what a debtor or trustee plans to do with collateral. Secured creditors will generally fare better than unsecured creditors in a bankruptcy but may need to take appropriate steps to protect their rights.

  2. Objecting to Discharge

    Creditors should not automatically presume that their debt is subject to discharge. The code gives creditors the ability to object to the dischargeability of a debt if the debtor is an individual and engaged in certain types of misconduct in incurring the debt. A debtor, for instance, may not discharge a debt that arises from false representations or fraud or is incurred with a false written financial statement reasonably relied on by the creditor.

    Creditors and the bankruptcy trustee can also object to the debtor’s receiving a discharge of any debts at all. The grounds for objecting to discharge center on the debtor’s conduct with respect to the bankruptcy process. The bankruptcy court, for instance, will deny a discharge of any debts when the debtor fraudulently conceals or transfers assets, loses, destroys, or falsifies records, or knowingly or fraudulently provides false information in the bankruptcy.

    To assert an objection to dischargeability of a specific debt or to a debtor’s discharge of any debts, a creditor must file a complaint against the debtor to initiate an adversary proceeding, which proceeds in much the same manner as a general civil lawsuit.

    Creditors that suspect cause to object to dischargeability or discharge should closely monitor the schedules of assets and liabilities the debtor submits with the bankruptcy petition. Creditors may also want to attend or obtain a recording of the “first meeting of creditors,” a hearing all debtors must appear for to answer questions under oath about their financial dealings and assets and liabilities. The sworn information the debtor provides in the early stages of the bankruptcy process can often help determine whether to object to discharge or dischargeability.

  3. Treatment of Payments Already Received

    In certain scenarios, creditors who have received payments from a debtor prior to a bankruptcy can suddenly find themselves on the defensive. The bankruptcy code gives the trustee the ability to bring a “preference” action against creditors that received payments within 90 days of the debtor’s petition to return the payment for distribution to all creditors. The 90-day window is extended to one-year when the creditor qualifies as an “insider” of the debtor because of a familial relationship or other close affiliation.

    A preference action presents the creditor with the prospect of not only failing to recovery what is still owed but also having to pay back what has already been received. A number of potential defenses to a preference action exist. The most common is when the creditor received the payment in the ordinary course of the debtor’s business.

    While not all payments made within the preference period will lead to a preference claim, creditors that received payments soon before the bankruptcy petition should recognize that they could find themselves fighting for what they already received in addition to what they are still owed.1


Receiving a customer’s bankruptcy notice in the mail may not be an ideal occurrence for a business. The bankruptcy laws, nevertheless, do provide an organized process to address a debtor’s obligations and give creditors rights to best protect their chances for at least partial recovery. Creditors who receive bankruptcy notices should assess their options early and act promptly to ensure all deadlines are met and that their rights are best protected.

1 For a thorough discussion of preferences, see Eric Yandell’s article, “Preferences in Bankruptcy – the Double Whammy,” published in the Spring 2002 Compass newsletter. The article is available at