Protecting yourself from customer bankruptcies

QUESTION: I just had two large customers file bankruptcy. One of them was making payments on a rental that included an informal purchase option — just some notes written on the face of a rental contract; the other owes me more than $50,000 on a job I did not lien. Now, I’m wondering what to do. Any advice you can provide would be appreciated.

Answer: Unfortunately, as a result of the raft of coronavirus (COVID-19)-driven shutdowns, which were unforeseeable just a year ago, you are not the only one in this predicament. Businesses, large and small, throughout the country are struggling to survive. A number already have closed their doors and/or filed for bankruptcy protection, including 24 Hour Fitness, J.C. Penney, J.Crew, Neiman Marcus, Gold’s Gym, Chesapeake Energy and Hertz Rent-a-Car.

Among other things, depending on the type of filing — typically for businesses, either Chapter 11 (reorganization) or Chapter 7 (liquidation), the effects of bankruptcy filings can include:

  1. Allowing debtors to delay, restructure (require “payment plans”), and in some cases, wipe out altogether, certain debts.
  2. Requiring immediate cessation of all collection activities, the “Automatic Stay.”
  3. Retention and, often sales, by bankruptcy trustees of any assets in which the bankrupt debtor held an “Ownership Interest” — including in some cases, and problematically here, rented assets subject to purchase options.

Chapter 11. In a Chapter 11 bankruptcy, the customer’s debts can be reorganized, meaning the customer may be permitted to cram down the throats of its creditors a payment plan calling for reduction of the amount owed to a creditor to reflect the fair market value of the collateral that was used to secure the original debt, and/or payment of the bankrupt customer’s debts, in whole or in part, in installments. With respect to leases, the debtor is required to make the lease payments during the Chapter 11 case and is required to assume or reject the lease no later than confirmation of a Chapter 11 plan by the Bankruptcy Court. If the lease is assumed, the bankrupt debtor must cure all defaults and will be bound by the terms of the lease going forward. If the lease is rejected, the property subject to the lease typically is turned over to the lessor, and the lease is terminated. All of this may occur while the owners of a bankrupt business entity remain in charge — a debtorin-possession (DIP) bankruptcy — while being overseen by a U.S. Trustee, or, in some instances, through the appointment of a separate Bankruptcy Trustee who effectively acts as the bankrupt entity’s CEO.

Chapter 7. A Chapter 7 bankruptcy, by contrast, is a winding up and liquidation of the bankrupt customer’s operations, in which its assets are collected and sold off by a Bankruptcy Trustee, with the sale proceeds used to pay creditors in the order precedence dictated by the U.S. Bankruptcy Code. As with Chapter 11 bankruptcies, the treatment of a lease claim turns on whether the lease is assumed or rejected. In a Chapter 7 case, the lease is only assumed if it is to be assigned to a third party, which is a rarity. However, if the lease is assumed, all defaults must be cured, and the third-party assignee will be required to thereafter continue to comply with and make all remaining payments due under the lease. If the lease is rejected, the Bankruptcy Trustee typically will consent to the lessor’s retaking of possession of its equipment, and the lessor can file a Proof of Claim for its losses arising from the rejection. Importantly, most Chapter 7 bankruptcies result in limited or no distributions to unsecured creditors that have not taken liens on specific items of collateral.

Equipment lessors, being the owners of the property they rent or lease, typically don’t face permanent forfeiture of that property in bankruptcy, except in cases where they’ve improperly documented a purchase option. But with respect to the amounts they’re owed, they are typically deemed unsecured, which significantly reduces the likelihood that they will be able to collect any accrued rent and/or other amounts due. Worse, if they’ve entered into an improperly documented rental purchase option (RPO) or if their lease/rental agreement somehow allows a Bankruptcy Trustee to validly portray the lessee’s interest as an ownership interest, the lessor (rental company) may actually lose the equipment made the subject of the RPO or lease. This fact motivates many lessors to aggressively file UCC-1 financing statements whenever possible.

As indicated above, however, the conversation starts with whether your lease/rental is accepted or rejected by the bankruptcy estate under Section 365 of the Bankruptcy Code. If it is accepted, then as noted above, the bankruptcy estate in a Chapter 11 case, or the thirdparty assignee in a Chapter 7 case, must cure all defaults; give the lessor adequate assurance of future performance; and actually continue to comply with the requirements of the lease/rental agreement going forward. If the lease is rejected, in most cases, the lessor will then have the option to retrieve its property and file a Proof of Claim with the Court seeking to recover its damages arising from the rejection.

The next chapter for some could be reorganization or liquidation

The bottom line is, unless you took protective steps few were taking prior to late 2019, a customer bankruptcy, whether Chapter 7 or Chapter 11, is likely to result in some measure of delay and legal expense, and it could result in a significant loss for an equipment lessor. However, you may yet have some options:

File a UCC-1 whenever possible — and always for RPOs. The most effective means of avoiding losing your equipment in a bankruptcy is to immediately file a UCC-1 financing statement for every lease/rental transaction as soon as it is entered into. Acknowledging that this will not be feasible in many, or most, cases for equipment lessors who rent equipment on a short-term basis, doing so at least with respect to long-term leases and RPOs can be a lifesaver. Longer leases — particularly, those with stated terms of more than a year — and RPOs create the danger that the customer will be deemed to have taken an ownership interest in the subject equipment. If that happens, and you didn’t timely file a UCC-1 financing statement, you could be deemed an unperfected secured creditor with respect to your own equipment. Unperfected secured creditors are junior in lien priority to the customer’s other perfected secured creditors. Thus, as an unperfected secured creditor, you would be entitled to payment only after all perfected secured creditors are paid, including the customer’s bank(s), most of which routinely file blanket liens on all of their borrowers’ assets in the course of providing lines of credit and/or perhaps other types of financing. Importantly, Bankruptcy Trustees’ fees include a percentage of any assets sold, which creates an incentive for them to accumulate and sell off as many assets as possible. Consequently, if for instance, an aggressive Bankruptcy Trustee were to seize your equipment and sell it off to pay the customer’s debts, the superior creditors — those who take priority under the Bankruptcy Code — first, meaning there may be nothing left to pay you. Among the more problematic potential outcomes is the prospect of losing your equipment and actually being paid nothing for it. See below, however, for some additional protective measures to consider. It may already be too late to recover the equipment subject to the RPO, but you may still have some alternatives.

The $50,000 debt. The customer’s debt for rent is unsecured, aside from, perhaps, a deposit, meaning that there are no specific assets that can be seized if the customer fails to pay you, which leaves you, as a lessor, with few options for recovery if a customer goes bankrupt. That is one reason many lessors take advantage of the growing number of state statutes that authorize the filing of liens on real estate improved through the customer’s use of rented equipment. As discussed in the “Legally Speaking” column in the April 2016 issue of Rental Management, mechanics’ liens can be powerful incentives for customers and others, including real property owners, to make sure you get paid — failing which, you may have the right to foreclose on and sell the subject real property in order to recover your unpaid rent. This is true regardless of whether your customer owns the real property itself, meaning the lien may significantly impact other parties, such as the actual owner(s) of the property and/or developers — which can make a lien filing extraordinarily valuable, particularly where upstream contractors have not been paid. That said, in better economic times, equipment lessors tend to be reluctant to file liens and/or send pre-lien notices for fear of offending their customers and/or other upstream parties. That day has passed. Liens and pre-lien notices are no longer considered especially unusual or offensive in most areas. But if, in the present case, you no longer have that option — statutory time limits being short and strictly enforced — you still may not be entirely out of luck.

Options to consider. The picture you have painted is not pretty, but equipment lessors sometimes have options they may not have realized were available. I would advise you and any other equipment lessor who finds him/her/itself in a similar situation to consider taking one or more of the following steps to protect your equipment and to give yourself the best possible chance of recovering the amounts you are owed:

File a Proof of Claim if permitted. As discussed earlier, when a customer goes bankrupt, you must immediately cease all collection activities. Filing a Proof of Claim may be an option, but many creditor meeting notices issued with respect to Chapter 7 bankruptcies, most of which stand little or no chance of having any assets available for distribution to creditors, will state that no Proof of Claim needs to be filed unless and until you, the creditor, receive a subsequent Notice of Possible Dividend or other similarly named document indicating that a Proof of Claim may be filed and setting forth a deadline for such filing. The reasoning behind this is that in the vast majority of Chapter 7 cases, no assets will be available for distribution, and Bankruptcy Courts do not want their systems being overloaded with needlessly filed Proof of Claim forms. If you do receive a Dividend Notice, consider immediately filing a Proof of Claim with the Bankruptcy Court in order to protect any claim(s) you might have to any funds that remain in the bankruptcy estate after payment of superior creditors. Many unsecured creditors still ultimately receive nothing, but some are surprised to learn that there actually will be assets sufficient to pay all or some portion(s) of their claims. In order to do so, however, you will need to have timely filed a Proof of Claim after you received the Dividend Notice.

Retrieve your property. An equipment owner or secured creditor whose lease is rejected will generally be permitted to retrieve its property with a simple call to the Bankruptcy Trustee. Because the timing requirements for assumptions and rejections differ between Chapters 7 and 11, you will need to be aware of which type of bankruptcy has been filed. Also, in some cases, you may need to consider filing a Motion for Relief from the Automatic Stay in order to retrieve your equipment and/ or pursue other collection activities. This is a written formal statement requesting relief from the Bankruptcy Court. In the motion, the party requesting the relief, the Movant (you) must include the legal basis, citing the applicable section(s) of the Bankruptcy Code and Bankruptcy Rules, for the relief requested. Each such motion must demonstrate cause for lifting the Automatic Stay and must be supported by admissible evidence. For example, if a creditor asserts a secured claim, the motion must contain admissible documents that assert a valid security interest and support an assertion of lack of adequate protection or a lack of the customer’s equity in the subject property. In your case, this may be necessary with respect to the equipment made the subject of the RPO, or perhaps even with respect to other equipment that has been leased to the bankrupt customer, depending on the terms of the lease and/or your RPO agreement. If the court agrees with you, it may issue an order lifting the Automatic Stay and allowing you to retrieve your equipment. Be careful here, however, as you may still need to comply with other laws, including state laws applicable to repossessions.

Require personal and/or corporate guarantors. If the bankrupt customer is a business entity, a personal guaranty by one or more of the customer’s individual owners and/or corporate affiliates — such as parent companies, joint venture partners or subsidiaries — may yet enable you to recover the amounts you are owed in full. By effectively side-stepping the customer’s corporate veil of limited liability, a guaranty can preserve your claims against others, including individuals and other businesses, who/which may not be subject to bankruptcy protection. Thus, even if your customer, as a business entity, is bankrupt, if you have a guarantee from one or more of the customer’s owners, shareholders, officers, directors, affiliates or others, then provided they have not individually filed bankruptcy, in most cases you will have the right to pursue your claims against them outside of your customer’s bankruptcy.

Investigate other possible guarantors. Aside from the individual owners of your customer, other parties that may have an interest in a given project include the project’s owner, an upstream contractor, a corporate parent, etc. One or more of these parties may have an interest in making certain the customer is able to lease the equipment necessary to complete a project. Any one or more of such parties might, therefore, also be willing, though they will rarely offer, to guarantee your customer’s debts to you in exchange for your agreement to rent, or continue to rent, your equipment to the customer

Pursue liens. As discussed earlier in this article, liens can be immensely valuable collection tools. A lien filing against real estate that is not owned by your customer generally will not be impaired by the customer’s bankruptcy filing or the resulting Automatic Stay. If the real estate is owned by the now-bankrupt customer, the Automatic Stay may prohibit filing suit to foreclose the lien, but Section 362(b)(3) of the Bankruptcy Code provides for an exception to the Automatic Stay for “any act to perfect, or to maintain or continue the perfection of, an interest in property to the extent that the trustee’s rights and powers are subject to such perfection under section 546(b) … or to the extent that such act is accomplished within the period provided under section 547(e) (2)(A) of this title.” Notably, Section 546(b) allows mechanics’ lienholders to file a notice of perfection of lien with the Bankruptcy Court as an alternative to filing a foreclosure action, provided the notice is timely filed. Be diligent about this, however. Deadlines are short and strict.

Credit reports. For new business customers, consider running a formal credit report or accessing one of the available informal business credit reporting options. Somewhat surprisingly, informal options often reveal more timely and/or granular information regarding a company’s continuing viability and ability to pay for equipment. In this environment, current and reliable customer information is especially important. The American Rental Association (ARA) has partnered with BizCreditReports to provide several discounted U.S. reports based on information obtained from Experian, a national credit bureau. Several commercial reports are available. To learn more, visit ARArental.org and click on “Manage Your Business” under the “Resources” tab and click on “Credit Report Services.

Credit applications. Make a practice of having customers complete credit applications that, among other things, request references, contain authorizations to access and retain the customer’s credit reporting information, and wherever possible, include guarantees. For existing/ long-term customers, telling them you merely are updating your credit file documents on the advice of your attorney, accountant, banker or insurer can soften the request and help avoid offending them.

Deposits. Do not be shy about requiring deposits, especially if a customer’s credit history, credit references, circumstances and/or general demeanor appear(s) suspect. Though many lessors were reluctant to require deposits in the past for fear of creating deal friction, these are different times. Telling customers that deposits are refundable — being careful to limit the circumstances in which they will be refunded — and/or offering to put deposits on credit cards also can help in some cases.

Credit card authorizations. As many know, Visa recently changed its chargeback processing rules, and many issuing banks now offer cardholders a means of easily disputing charges online. This, of course, spells more trouble for lessors, particularly those whose equipment is returned late, empty, partially cannibalized and/or damaged by subsequently bankrupt customers. A properly written charge authorization that, among other things, authorizes the taking of deposits, recurring charges and post-termination charges can help lessors avoid losses that other protective measures cannot.

Credit limits. Setting and monitoring credit limits for customers can be invaluable, particularly when coupled with the other measures described in this article. Options include using simple do-not-exceed amounts or separately, using triggers or thresholds, which require additional security — for example, guarantees, collateral and letters of credit — if and when a predetermined amount outstanding is reached. At the very least, a credit limit can work as an effective alarm bell for a lessor who may not otherwise realize a customer is becoming overextended.

Monitor receivables, limits and customers closely. Most customers know that appearances matter when it comes to credit. Consequently, it can be difficult to tell when a customer is approaching insolvency and/or bankruptcy. Indicators may include the appearance of late or reduced payments, approaching or exceeding credit limits, departures and/or sudden replacements of owners, partners, suppliers, employees and/or subcontractors, new lending relationships, etc. Paying close attention to customers who exhibit any of the above symptoms, as well as the word on the street, for better or worse, may provide you with critical advance notice of a looming financial collapse.

Consider discounts for early payments. When customers near insolvency, their payment streams tend to become more volatile and uneven. Consequently, they may periodically find themselves with small accumulations of available cash. Adopting discounts such as “2/10, Net 30” (2 percent discount if paid within 10 days, otherwise, the entire invoiced amount is due within 30 days), can motivate a customer with limited cash to pay you, or pay you more, first — and just before running out of cash completely. This may yield exposure to a preference claim under Section 547 of the Bankruptcy Code, in which a Bankruptcy Trustee seeks return of some or all of the funds, but if the customer strictly adheres to the stated payment terms, exposure to preference claims is largely eliminated and, in any event, in most cases, it’s better to argue the issue with money in your pocket than not. Contractual late fees, hefty interest charges that bear in mind the state usury limits, and guarantees may also be significant motivators.

Be careful with RPOs. If you have customers to whom you may be able to sell equipment on favorable terms through a rental purchase option or similar mechanism, it may be necessary to offer them a percentage of the rent paid as a discount against the ultimate purchase price. If you do that, however, remember that, if not done properly, a RPO can create an ownership interest in favor of the customer that can later be used by a Bankruptcy Trustee to justify retention and sale of your equipment without paying you — in short, you could wind up an unperfected secured creditor, for whom there is nothing left after paying off other creditors. If you intend to offer RPOs, do so only through an agreement that properly documents and limits them, and file UCC-1 financing statements immediately whenever possible. With potentially hundreds of thousands of dollars at stake in each transaction, this is not the place for learning through trial and error.

The picture you have painted is not pretty, but equipment lessors sometimes have options they may not have realized were available.

Include expansive default rights. All equipment leases should include expansive default rights in favor of equipment lessors. Among other things, such rights should include a broad right to seize equipment, except where prohibited by law, as well as rights to recover other amounts, such as unpaid rent, unreimbursed equipment losses and damage, interest, attorneys’ fees and other costs in the event of a default by a customer. Importantly, clauses that flatly enable lessors to deem bankruptcies defaults are technically void ipso facto provisions under the Bankruptcy Code. Consequently, even though most properly drafted default provisions include such clauses, a properly written default provision should also include other, often related, means of declaring defaults — such as late payments, non-payments, equipment damage, failure(s) to timely return, insecurity and more — in order to make certain their default-related rights are protected.

Act quickly. When customers go bankrupt, they tend to disappear, as does their cash, and in some cases, their property — which may include leased or rented property. If you hear or even have a reasonable suspicion that a customer might be insolvent or be preparing to make a formal bankruptcy filing, drop whatever you’re doing and move quickly to see if you can legally recover your property and any amounts you are owed. If and when an Automatic Stay takes effect, it may delay your ability to do any one or more of the foregoing, or worse, at a time when your cash and property are especially critical to the continued viability of your own business.

The most recent chapter in the continuing COVID-19 saga is the cascade of bankruptcies now reaching the courts, largely unforeseeable less than a year ago. For those who left themselves legally exposed, and even for some who didn’t, this could prove their undoing. If you suspect that one or more of your customers may be teetering on insolvency and/or bankruptcy, take steps to protect yourself and your business immediately