Customer Bankruptcies: Protect Your Right to Get Paid

Customer Bankruptcies: Protect Your Right to Get Paid

We are going to take a break from our series on how to construct an SMS system to look at ways to protect your right to get paid.

There are valuable strategies for protecting your right to get paid for your work. These strategies become especially important in tough economic times. Several air carriers filed for bankruptcy or insolvency protection at the beginning of the Covid-19 pandemic, and it looks like another wave of bankruptcies could be around the corner, especially among smaller airlines in certain markets.

This article examines bankruptcy priorities, and offers several strategies for increasing your potential to get paid when you are selling articles or providing services to a company that subsequently becomes insolvent. If you are intrigued by what you see here, then further investigation with an attorney may be appropriate.

What is Bankruptcy/Insolvency?

There are typically two main types of bankruptcy filings for aviation businesses – liquidation and reorganization. We will refer to the businesses that are seeking this sort of legal process as “firms.”

In the United States, liquidation is commonly known as a “chapter 7” filing, based on the chapter in the U.S. Bankruptcy Code. Firms who are entering a liquidation will sell off their assets in order to pay creditors. The firm may continue operation for a short time if continued operation will benefit the creditors.

When a firm thinks it can emerge from bankruptcy with the court’s help, it can file for a reorganization, or Chapter 11. In such an event, the firm would use its bankruptcy trustee to help reorganize its debts. The trustee is an administrator who is appointed to protect the creditors’ interests, and who typically has powers to help liquidate or reorganize the firm. The firm may operate as a debtor-in-possession and essentially serve as its own trustee, under close court monitoring.

One of the key powers of a Bankruptcy Court in the United States is the power to decide whether a contract shall be assumed, rejected, or otherwise terminated (note that the U.S. Bankruptcy Code gives courts the power to continue executory contracts even when the contract says that it is terminated for bankruptcy). If you have an outstanding contractual obligation and your partner files for bankruptcy protection, then the court could terminate the contract or it could order you to continue performing under the contract.

Outside the United States, the bankruptcy proceeding is often called “Insolvency,” and it may vary from the United States norms that are described in this article. For instance, some countries permit liquidation but do not have a corollary to the reorganization portion of the U.S. Bankruptcy Code.

Bankruptcy Priorities – Who Gets Paid?

When a firm files for bankruptcy protection, any efforts to collect on outstanding debt owed by the firm immediately cease and all claims against the firm must go through the Bankruptcy Court.

The outstanding debts of the firm are typically paid according to “priority.” The first priority is for the administrative expenses of the bankruptcy trustee. This encourages trustees to work actively for the firm, because the trustee knows that he or she will get paid. The second priority is for certain claims made by a Federal reserve bank related to certain loans. The third priority is for certain claims that arise in an involuntary filing (most aviation bankruptcy filings tend to be voluntary).

The fourth priority is claim is for claims for employee wages and sales commissions, followed by the fifth which is for contributions to an employee benefit plan.

In all, there are ten priorities that get paid before any secured creditors are paid. And the secured creditors will then be paid from their security before the unsecured creditors. The unsecured creditors are paid last, and they typically get a pro rata share of anything that is left (which can be pennies on the dollar or can be nothing). The difference between unsecured and secured creditors is explained in the next section, where we also explain how one can become “secured.”

There is usually a difference between debts from before the filing and debts incurred afterwards, especially in reorganization cases. In a reorganization case, the court wants to encourage companies to do business with the bankrupt firm in order to make the reorganization successful. As a consequence, it is normal for the court to order a priority for essential vendors. Those who are providing a good or service that is essential to continued operation will get paid for their post-filing transactions, and in some cases (where the good or service is sufficiently critical and cannot be obtained elsewhere) they may be able to negotiate the payment of pre-filing debt as a condition of continued business.

Normally, an independent repair station that performed work for an operator (that is now in bankruptcy) cannot find its way into the first ten priorities, but it can take steps to improve its ability to get paid in the event of a bankruptcy by taking steps to be able to reclaim unpaid property, or by seeking to become a secured creditor.

What Can I Do to Protect My Right to Get Paid?

One way to protect your right to get paid is to be able to assert ownership of an asset that appeared to be a part of the bankruptcy estate (but it was not because you owned it). If you sell parts to an air carrier, your contract could specify that they are placed in the air carrier’s inventory as a loan but that they are not purchased until they are paid-for. This does create certain additional liabilities (including tort liabilities that may arise related to the goods that you own) and those liabilities need to be considered and addressed in a written document before this approach is used.

A related approach is one in which goods are sold and then can be claimed if they remain unpaid in the event of an insolvency (pre-filing). This is a short-time period right that arises under the Uniform Commercial Code – the right is only good for ten days, and demand for return has to be made (in writing) within ten days of delivery. Ten days is a very short time period, and most vendors will not be able to ascertain an insolvency within ten days of a delivery. If the insolvent customer misrepresented its solvency – in writing – during the three months before the delivery of the goods in question, though, then this waives the ten-day limit and you may be able to reclaim the goods more than ten days after delivery. With this in mind, it may make sense to ask some customers to make a written assertion of solvency: either on a periodic basis, or before certain key deliveries.

It is also possible in some cases to reclaim unpaid goods after a bankruptcy filing. The bankruptcy code establishes timelines for post-filing reclamation and key dates arise at the 20-day and 45-day marks after filing, so this is something that you should investigate quickly if your customer files for bankruptcy, while owing you money for deliveries.

Reclaiming unpaid goods is just one possible remedy when you customer is insolvent. Another option is to establish a security interest in the goods. A security interest doesn’t give you the right to reclaim the goods, but it does give you a priority during the bankruptcy that makes your claims superior to those of the unsecured creditors.

When you have a security interest in good, then you get paid first out of the sales proceeds. Let’s say that you sell a serialized article worth $100,000 to customer X and secure the transaction with a security interest in the article. You are owed $100,000 and that amount is currently secured by the serialized article. If the bankruptcy trustee sells the article for $60,000 in an auction, then you would get the $60,000 and this would satisfy your secured interest. You would end up with $60,000 plus a 40,000 unsecured claim. While this is not as good as your original $100,000 expectation, it is better than a $100,000 unsecured claim that might yield only $1,000 after years of litigation.

One of the issues with securing a transaction is that you typically have to plan for the security interest. This means that it is something that you ought to plan with your legal consultants before it becomes necessary.

For repair stations, there are typically two different ways to secure a transaction. The first is that you can secure an interest by “contract” using a security agreement and a financing statement. This is often the way that a sale is secured. This requires the buyer (debtor) to sign certain documents related to the transaction, so it usually requires up-front negotiation to effect this ort of relationship, and it also typically requires documents to be filed in order to be effective against third parties (this is known as “perfection” of an interest).

The second way to secure an interest is that you can rely on a law that offers a specific path to assert a lien against property. In the United States, the specifics of this process will vary based on state law, but there is often a mechanism that allows a repair station to assert a lien against an asset on which it has performed work. Some states have aviation-specific laws and some states have laws that more generally apply to all sort of maintenance. A repair or alteration performed on an aircraft may permit the repair station to assert a lien against the entire aircraft.

Look at the laws in your state carefully! A common mistake is to try to rely on the “mechanics’ lien” law (which in many states applies to real estate contractors and not to aviation mechanics). Because these laws are different in every state, it is important for a repair station to work with a lawyer to examine its own state laws to assess (1) when such a lien may be asserted, (2) against what sort of assets it may be asserted (e.g. just aircraft or can you assert the lien against a component), and (3) how it must be asserted (what is the technical process to follow to make the lien enforceable).

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