Bankruptcies are Happening. What do you need to know to protect yourself?

It is no doubt that these are trying times. With air travel substantially curtailed the need for parts to support commercial fleets is significantly reduced. That means challenges for distributors. Adding to those challenges is a harsh reality: even when customers are buying parts,  they may have difficulty paying. And when a customer to whom you’ve extended payment terms becomes insolvent, you may be left holding the bag.  So far in 2020 we’ve already seen several operators enter bankruptcy, including Flybe (UK), Virgin Australia, Avianca, and LATAM.

Struggling operators still need parts to maintain their aircraft, and therein lies the rub. Distributors want and need to sell parts, and airlines want and need to buy them. With an airline that may be on the brink of bankruptcy, the question becomes how can a distributor make a much-needed sale, and protect itself against the risk that the customer may not be able to pay?

Obviously, the safest way to protect yourself is to require cash up front. If you and your customer are in a position to make such an arrangement, great! You can stop reading now. But the reality of our (and may others) industry is that goods are typically sold on Net 30 or similar terms. If you send goods to your customer and they declare bankruptcy before you get paid (or worse, have several outstanding invoices unpaid), you may be placed into a class with dozens of other unsecured creditors fighting for pennies on the dollar of what you were actually owed.

When cash is tight invoices can pile up. So, what steps should a distributor take to protect itself in the face of a struggling customer? In this series of articles, we’ll discuss the steps necessary to attach and perfect a security interest in goods, as well as mistakes to avoid to ensure payments your customer makes to you can’t be clawed back.

First, though, there are some things to know about bankruptcy filings. For the purpose of these articles we’ll be focusing on the US bankruptcy laws, which are found in Title 11 of the United States Code. The two types of bankruptcy filings most people are familiar with occur under Chapter 7 of the Bankruptcy Code (Liquidation) and Chapter 11 (Reorganization).

Under a Chapter 7 filing, an organization (like an airline) will cease operations and a trustee will be appointed to sell the company’s assets to satisfy creditors. Creditors are divided into classes with secured creditors being first in line to be paid, followed by unsecured creditors, and finally stockholders.

Secured creditors are those whose credit is backed by collateral. Unsecured creditors have extended credit but without the backing or security of collateral. Aircraft parts distributors can fall into either category depending upon whether they have taken the necessary steps to attach and perfect a security interest in the goods they’ve sold.

Secured creditors can sometimes have their collateral returned to them, though this process has some limitations and requires very quick action.  It also has very strict requirements that the debtor (customer) have been insolvent and the goods be delivered within 45 days before bankruptcy. A specific written demand for the goods must also be made within 45 days of delivery or within 20 days after bankruptcy if the 45 days expired after the declaration.  Chapter 2 of the the Uniform Commercial Code may also provide rights to reclaim goods. We’ll discuss these options in a future post.

It can often be difficult to reclaim specific goods, but a secured creditor still has a claim for the value secured by those goods if they are liquidated by the trustee in the course of the bankruptcy and in satisfaction of other secured debts. (If the value of secured collateral is insufficient to cover the amount owed, creditors become unsecured creditors for the balance due.) Because of the value of remaining assets when a company enters liquidation, unsecured creditors often receive only pennies on the dollar, if they receive anything at all.

Under a Chapter 11 filing the organization remains in operation and under management’s control, but major decisions must be approved by the Bankruptcy court. Rather than liquidate all assets in satisfaction of outstanding debts, a committee of unsecured creditors will be formed to develop a plan to allow the company to eliminate part of its debt to regain its financial footing. Committees representing secured creditors, stockholders, and other interested parties may also be formed. The plan the committees develop specify classes of claims and how those claims are to be treated, in addition to numerous other considerations to enable the company to continue to function.

Under Chapter 11, aircraft parts subject to a security interest may also be subject to special treatment. A customer filing under Chapter 11 may be preferable to Chapter 7 for a distributor who is unsecured because although the full amount owed may not be paid, partial payments may be made to encourage the distributor (and other suppliers) to continue selling to the company to allow it to operate. On the other hand, a distributor with a security interest in aircraft parts may have the right to take possession of the collateral or be assured of payment under the security agreement.

Being a secured creditor is always preferable to being unsecured. It puts the creditor in a position to reclaim its collateral or get paid to the greatest extent possible. Unsecured creditors are often left with significantly diminished claims if they receive anything at all.  In our next article, we’ll talk about the steps you need to take to attach a security interest to the parts you sell.

Bankruptcy is confusing and can be fast-moving, and we haven’t even scratched the surface here. Always be sure to consult a bankruptcy attorney if you have a customer file for bankruptcy that owes you a significant amount.

This post has been updated for clarity.