New England Biz Law Update
Your slow-paying customer has now become a non-paying customer, and its CFO tells you that if your company presses too hard for payment a bankruptcy filing is likely to follow.
You are further told that a secured creditor is ahead of you with an all-asset perfected security interest. In essence, you are told that you cannot get blood from a stone.
Do you have recourse, or are you throwing good money after bad?
It is possible to get blood from a stone by being aggressive, and by looking “outside the box.” If your company is reluctant about throwing “good money after bad” in light of the size of its claim, thought should be given to joining up with other creditors so that resources may be pooled to accomplish the desired result.
Business Leverage
If the customer needs additional goods or services from you, there is certainly reason for optimism, but only if you take appropriate precautions. Ongoing deliveries should be made on a pre-paid or C.O.D. basis. If credit must be given, it should be secured by way of a purchase money security interest placing you ahead of other secured creditors, or by a letter of credit or guaranty.
In order to work down the outstanding balance, ongoing deliveries should be conditioned upon partial payments of the past debt. If the customer needs your product or service and can’t find a suitable replacement, you have leverage to impose this requirement.
Legal Actions
If the customer no longer needs you, your leverage is not as great, but you are not without recourse. Have a demand letter written, and if the response is less than satisfactory, sue. Take advantage of the many vehicles for pre-judgment attachment available in Massachusetts and in other New England states, including trustee process (typically attachment of bank accounts), personal property and real estate attachments.
A very effective remedy is the reach-and-apply attachment, permitting you to attach sums due to your customer from its customers. No entity wishes to have its customers brought into a lawsuit, and no entity wishes to have an important payment stream attached. Your attachment may be subordinate to a secured creditor’s lien, but the secured creditor might be forced to enter into a three-way negotiation involving you and your customer.
If payment is still not forthcoming, consider the possibility of other deep pockets. Obviously, if there is a guarantor, there is no reason to forbear from pursuing action on the guaranty.
In the absence of a guaranty, there may well be recourse against a principal of your corporate customer. For example, if a corporate principal engaged in deception to induce you to advance credit to the entity, you have recourse against the principal. If you were provided fraudulent financials on which you relied to advance credit, you may well have a cause of action against the individual(s) responsible for the preparation and distribution of the financials.
In addition, you could sue the accountants for negligence in their review or auditing of the financials, assuming it was actually foreseeable on their part that you fell within a class of entities that would receive the financials.
If your customer diverted assets, you may well have recourse against the individuals responsible for effectuating the diversions as well as the persons and entities that were the recipients of the assets.
If distributions were made to shareholders when the corporation was not paying its creditors, you may well have rights to pursue the individual shareholders who receive the distributions and/or the directors and officers who authorized such dividends.
By invoking the doctrine of piercing the corporate veil, a creditor may directly sue individual controlling shareholders or a parent entity in select cases.
Courts have established a multi-part test. The most important factors are whether the corporate-debtor was simply an instrumentality for the shareholders or parent corporation, allowing them to take undue advantage of creditors through diversions of corporate assets or intermingling with other assets.
Where the debtor-entity is entirely defunct but has not filed a bankruptcy petition, a creditor may have a court appoint a receiver. The receiver is authorized to take control of the debtor’s assets, books and records. The records may demonstrate that the corporate principals have diverted assets, in which case the receiver may have a duty to pursue a cause of action against the principals and any transferees of assets.
Bankruptcy Rights
In the event of a bankruptcy, your chances for recovery may be significantly reduced, but you are not altogether without hope.
For example, the automatic stay provisions of the Bankruptcy Code do not protect the guarantor unless he/she has also filed.
In the absence of a guaranty, there are options to consider in the bankruptcy context. In a Chapter 11 reorganization case, you may be eligible to sit on a creditors’ committee and influence the negotiation of the debtor’s plan of reorganization.
You may have a basis for obtaining an exception to the debtor’s discharge, typically by demonstrating that the underlying indebtedness is the result of fraud or false pretenses. You may also be able to deny the debtor an overall discharge by demonstrating that records were not properly kept, debts were not properly explained or the debtor did not follow Bankruptcy Code requirements.
The Bankruptcy Court may be used for a counterattack against the debtor’s principals. If the principals received preferential payments, for example in the form of repayment of loans, the Bankruptcy Code allows for the potential recovery of those payments for the benefit of the creditors. Indeed, the exposure of the principals to a preference claim is greater than that of normal creditors, as the preference period goes back a full year prior to the bankruptcy petition rather than the usual 90-day period.
In addition, the debtor’s shareholders, directors and officers may be subject to a suit brought by a trustee in bankruptcy or on behalf of a creditors’ committee for diversions of assets, excessive payments of salaries and dividends and corporate mismanagement.
If the corporate principal is claiming to be a creditor, for example on the argument that he/she lent money to the corporation, there may well be grounds for having the Bankruptcy Court re-characterize the loan as an equity contribution and thus defeating the claim of the principal, or by equitably subordinating the claim to the claims of the other shareholders.
Lawrence G. Green is managing partner of the Boston law firm Perkins Smith & Cohen LLP and is chair of the firm’s creditors rights practice group.
