It happens at least once a year. I find out after the fact that a customer that owes me money has been placed into involuntary bankruptcy (Chapter 7 bankruptcy) by its creditors. Trade creditors not involved in the filing often learn of the Chapter 7 filing long after the fact almost by accident. They may be having a conversation with another credit manager who mentions the bankruptcy filing in this way: "I guess you heard that XYZ Company was forced into Chapter 7 bankruptcy last week. How much did they get you for?"

When a bulk sale takes place, under the Uniform Commercial Code there is a requirement of notice to creditors. When a company is forced into involuntary bankruptcy protection, there is no such notice requirement. And because notice is not required, many trade creditors continue to ship to the debtor on open account terms even after the involuntary petition is filed. This can dramatically increase the credit risks they face--and the amount they eventually write off--especially if the business is liquidated.

Editor's Note: This article originally appeared in the Credit & Collection Manager's Letter, which Credit Today purchased in 2006.

Once creditors have filed an involuntary bankruptcy petition against a debtor, the debtor has three options and 30 days to decide which option to choose among them. Those options are:

• Do nothing. In this case, at the end of the grace period the Bankruptcy Court will appoint a trustee to liquidate the assets of the company and then distribute the proceeds of that liquidation to creditors based on the absolute priority for distribution of proceeds as described in the U.S. Bankruptcy Code.

• The debtor can request a hearing before the Court and present evidence in support of its request that the involuntary bankruptcy filing be dismissed. That evidence must show the customer is not insolvent according to the Balance Sheet test contained in the Bankruptcy Code. The debtor must also demonstrate to the Court that it has been paying creditors' bills as they came due. [Note: If the debtor can prove to the Court that the bankruptcy filing was made in bad faith, the debtor may recover both actual and punitive damages from the petitioning creditors.]

• The debtor can ask the U.S. Bankruptcy Court to convert the Chapter 7 liquidation to a Chapter 11 reorganization. Once the Court has granted this request, the debtor [now the Debtor in Possession] has 120 days in which to formulate and to present a plan or reorganization to its creditors.

The problem lies not with the three options listed above. The problem is the fact that many creditors are unaware that an involuntary bankruptcy petition has been filed. As a result, they continue to ship to the debtor--increasing their risk of loss. Technically, creditors that ship after the bankruptcy filing date and before the debtor avails itself of one of the three options listed above will enjoy a super-priority as a "gap" creditor (a post-petition creditor). Unfortunately, there is no guaranty that a gap creditor will be paid in full in the event of liquidation. In case anyone is listening, I recommend the Bankruptcy Code be changed to require debtors to notify creditors whenever a voluntary or involuntary bankruptcy petition is filed.

Editor's Note: The above article originally appeared in the Credit & Collection Manager's Letter, a newsletter purchased by Credit Today in 2006. This article originally appeared prior to 2000.