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Vendors Selling to a Bankrupt Debtor

By Nicholas Ortiz, Boston Bankruptcy Attorney

Vendors are often afraid to sell to a bankrupt debtor on normal credit terms. At first glance, this makes a lot of sense. A debtor who is liquidating in bankruptcy doesn’t seem like a very good credit risk. However, what about those businesses seeking to reorganize in Chapter 11? The bankruptcy laws provide incentives and protections for vendors to continue to give terms to these debtors.

Section 503(b)(1)(A) of the Bankruptcy Code gives administrative priority to the “actual, necessary costs and expenses of preserving the estate [....]” Examples are listed for expenses like post-petition salaries and wages, but inventories and other items sold to a debtor have uniformly been held by the courts to be included in this formulation. After all, the stuff a debtor needs to conduct business is essential and beneficial to a reorganizing debtor’s bankruptcy estate.

But it’s not all blue skies for the post-petition vendor. They will be entitled to an administrative priority above almost all other claims, but the exceptions matter when a debtor fails to reorganize and has to liquidate by converting to Chapter 7. In such a scenario, there may not be enough money to pay all administrative claims. This is known as administrative insolvency. If this happens, certain secured debts, the liquidation and trustee expenses, and any domestic support obligations get paid first. After that, the other administrative claimants (like post-petition vendors) share the remaining picked-over pie, getting less than 100 cents on the dollar and expending legal fees to get even that.

Administrative insolvency is not too common, and so it should not scare a vendor away from potentially profitable sales, but it is a risk and one that should be considered when selling to a bankrupt debtor on credit terms.

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Full post as published by Credit Law Network on February 23, 2011 (boomark / email).