You Receive Notice That a Client has Filed for Bankruptcy: What do you do?

You Receive Notice That a Client has Filed for Bankruptcy: What do you do?

By Gregory E. Scallon, DeWitt Ross & Stevens, S.C.

Past Legal Briefs have discussed best practices to avoid the situation of a non-paying client, and, if that failed, actions you could take to address collecting the outstanding balance from the non-paying client. However, no matter how well you manage your practice, sometimes you are faced with the client who is not only “slow or no pay,” but who files a petition in the US Bankruptcy Court to address, and perhaps seek to discharge, the debt owed to you.

This process will most often start with your receipt of an official looking legal notice from the bankruptcy court informing you that the debtor has filed for relief under the US Bankruptcy Code and has listed you as a creditor.

Upon receipt of notice of the bankruptcy filing, all collection efforts, other than through the bankruptcy court, must stop. If you are asked to provide any future services for the bankrupt client, you can require payment, in cash, in advance for the future services. You are not required to provide further services. However, you cannot continue to seek payment for pre-bankruptcy services.

A preliminary question is whether you have any basis to object to discharge of the debt. The most common ground is fraud (e.g., Did the client provide false financial information that induced you to extend credit?). The bankruptcy system is very much slanted in favor of the debtor, so you should consider this in only the most egregious situations (e.g., large sum due and clear evidence of fraud). In many instances, objecting to the discharge is just throwing good money after bad. If you feel you have a substantive basis to assert fraud, you should obtain legal counsel to evaluate the merits of your position and to assist in filing the objection to discharge.

It’s important to look at the chapter of the Bankruptcy Code under which the debtor has filed. The path forward differs greatly depending on the specifics of the bankruptcy filing.

If the client is an individual, they have most likely filed under either Chapter 7 or Chapter 13 of the Bankruptcy Code. Chapter 7 is a straight liquidation, the debtor has no assets from which to pay creditors even a partial payment, and no further action on your part is required, or merited. In the instance of a no-asset Chapter 7, the notice from the bankruptcy court will state that you should not file a proof of claim unless you receive a further notice.

An individual may also file under Chapter 13, which is sometimes referred to as a “wage earner’s plan.” Under a Chapter 13, the Debtor is proposing to pay the debts over a period of time. In that instance, you would want to file a proof of claim so that you receive payments under the Chapter 13 plan.

If the client is a business, either an entity or a sole proprietorship, they might file under Chapter 11 of the Bankruptcy Code, which is essentially the business equivalent of an individual Chapter 13 filing. Again, in the instance of a Chapter 11 filing, you would want to file a proof of claim to participate in any payment plan. Be aware, that a high percentage of Chapter 11 filings fail and turn into straight liquidations with some recovery for secured creditor and unsecured creditors frequently getting nothing.

There is a special section of the US Bankruptcy Code, Chapter 12, which relates to farmers (and to fishing operations). Chapter 12 for farmers is similar to Chapter 13 for individuals and Chapter 11 for other businesses. Under Chapter 12, the farm debtor submits a plan for payment of outstanding debts over a 3- to 5-year period. There is a Trustee appointed who oversees implementation of the plan.

In some instances, a bankruptcy is caused by a catastrophic event (e.g., high uninsured medical costs) and the debtor otherwise wants to pay creditors to maintain good relations. The debtor can voluntarily pay a debt which is otherwise discharged through bankruptcy, either through a formal reaffirmation or simply informally, and accepting such a payment is perfectly fine. You just need to be certain that the payment is voluntary and not the result of collection actions.

There is no better course of action than putting good credit policies in place up front, and monitoring and enforcing those policies. However, no matter how good the system, there will almost inevitably be exceptions, and, when those go bad, you need to know your rights, and also know those actions which are not allowed.