Business Law Group

Author:  Mason C. Simpson, Esq.

Business Law Attorney

Oh No! Our Customer Just Filed For Bankruptcy!

It is all too common for financially distressed entities or individuals to seek the refuge of the Bankruptcy Code in an effort to avoid paying outstanding bills and other debts, including loans and other credit vehicles.  Indeed, bankruptcy is a significant credit risk to businesses and individuals who do not collect payment immediately from their customers, clients, or debtors. And if you have ever been on the creditor side of a bankruptcy proceeding, you likely know that once a bankruptcy petition is filed, all litigation against the filing party stops until the bankruptcy case is concluded or the bankruptcy judge enters an order stating otherwise. That cessation of litigation and debt collection is called an “automatic stay,” and violating that automatic stay (by suing or otherwise trying to collect a debt) has very harsh consequences. Even if one manages to squeeze money out of a debtor after or close to a bankruptcy filing, such money would likely be subject to a “claw-back” action by other creditors or a bankruptcy trustee.  Claw-back actions unwind the debtor’s transfers of money or property that occur close in time to the bankruptcy filing and bring such money or property back into the “bankruptcy estate” for a later distribution to creditors—if there is any money left at the conclusion of the bankruptcy proceeding.

Does that mean that if someone or some entity who owes a large amount of money files for bankruptcy, the creditors are relegated to stand by and, at best, receive pennies on the dollar for outstanding debts pursuant to the debtor’s bankruptcy plan?  Not necessarily. 

The Bankruptcy Code’s “automatic stay” prevents a creditor from suing an entity or person who has sought the protection of the Bankruptcy Code, but a creditor can bring what is called an “adversary proceeding” in the bankruptcy court where the bankrupt person or entity filed. An adversary proceeding is a lawsuit within a bankruptcy proceeding and is presided over by the bankruptcy judge.  Some common examples of issues that can be decided in an adversary proceeding include creditor objections to the discharge of a specific debt, general objections to granting the filer a discharge, and determinations of whether a secured creditor has a valid lien on the filer’s property.  Even a contract dispute regarding a debt listed in the bankruptcy can be the subject of an adversary proceeding.  Often allegations of fraud against the debtor provide the basis for an objection to the discharge of a debt in a bankruptcy, which can be raised in an adversary proceeding. If you believe a debtor who has filed for bankruptcy has committed fraud, you may well have a substantial basis to stop the discharge of a debt connected to a fraud or even increase the amount of money you are ultimately able to receive in a bankruptcy liquidation or reorganization plan.  But facts and circumstances vary wildly, and there is no one-size-fits-all approach to almost anything having to do with bankruptcy.  One unvarying fact, however, about bankruptcy from the perspective of creditors is that time is always of the essence! If you do not act quickly when you learn a debtor has filed for bankruptcy, you will lose your right to object to how your debt is treated or to otherwise mitigate a loss. In other words, if you sit on rights as a creditor in a bankruptcy proceeding, you lose them. 

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