ACC 543 Week 5 Debtor-Creditor Relationships, Property and Insurance Example

When the Biggest Customer Files Chapter 11: A Composite Packaging Supplier's Rights as a Creditor, Its Preference Exposure and the Property and Insurance Questions It Should Have Asked Sooner

[Student Name]

University of Phoenix

ACC/543: Managerial Accounting & Legal Aspects of Business

Week 5 Assignment

[Instructor Name]

[Date]

The supplier, its customer and all figures are composites written for a model paper; the law is stated generally from the sources listed and applies to US federal bankruptcy law.

A composite company makes corrugated boxes and trays for food producers. Its largest customer, a frozen food producer that bought about 14% of its output, filed a Chapter 11 petition on a Monday in March after losing a national grocery contract. At the filing, the producer owed the supplier $1.24 million for boxes delivered over the previous 60 days. The supplier's controller had to decide what to do that week and what to record at quarter end. A creditor's recovery in bankruptcy depends less on how much it is owed than on what kind of claim it holds and what it does in the first few weeks. This paper analyzes the supplier's position.

The Automatic Stay

The petition triggered the automatic stay, which stops most collection efforts against the debtor. The supplier's sales staff could no longer call the producer demanding payment, and the supplier could not set off amounts or take back goods without court permission. The stay gives the debtor breathing room to reorganize and prevents creditors from racing to seize assets (Cheeseman, 2019).

The Proof of Claim

Creditors file proofs of claim to participate in any distribution. The supplier filed a claim for $1.24 million with supporting invoices and delivery records. Most of this amount is a general unsecured claim, which in Chapter 11 is paid under the plan, often at a fraction of face value.

Priority for Recent Deliveries

Boxes delivered in the 20 days before the petition receive special treatment. The value of goods received by the debtor within 20 days before the filing, sold in the ordinary course of business, is allowed as an administrative expense (11 U.S.C. § 503). Administrative expenses must be paid in full for a Chapter 11 plan to be confirmed. The supplier's records show $310,000 of deliveries in that window, so it filed a request for administrative priority for that amount, leaving $930,000 as a general unsecured claim.

Reclamation

A seller may seek to reclaim goods delivered to an insolvent buyer within 45 days before the filing if it makes a timely written demand. The supplier sent a demand, but reclamation is of little value here: most of the boxes had already been folded, filled with frozen pizza and shipped to stores, and the producer's lender holds a security interest in its inventory that may have priority. The controller treated reclamation as a backup rather than a source of recovery.

Estimating Recovery for the Accounts

For its quarterly statements, the supplier must estimate what it will collect. It expects the $310,000 administrative claim to be paid if the reorganization succeeds, since the producer obtained debtor-in-possession financing. For the $930,000 unsecured claim, recoveries in similar food industry cases have ranged from 10 to 40 cents on the dollar. The controller recorded an allowance of $744,000, reflecting an expected 20% recovery on the unsecured portion and full recovery of the administrative claim, and disclosed the concentration of credit risk.

The Preference Demand

Six months later, the producer's estate sent a demand letter seeking return of $720,000 the supplier had received in the 90 days before the filing. A trustee or debtor in possession can recover a transfer made to a creditor on an antecedent debt, while the debtor was insolvent, within 90 days before filing, that let the creditor receive more than it would in a liquidation (11 U.S.C. § 547). The payments meet those elements on their face.

The supplier has defenses. Payments made in the ordinary course of business between the parties, or according to ordinary business terms, are protected. The producer had paid the supplier's invoices in 38 to 45 days for three years, and the payments in the 90 days fell in the same range, supporting the ordinary course defense. The supplier also delivered $260,000 of new boxes after receiving some of the payments, which may reduce exposure under the subsequent new value defense. Counsel estimates the likely exposure, if any, at under $150,000. The supplier disclosed the claim as a reasonably possible loss rather than accruing it.

Continuing to Sell to the Debtor

The producer asked the supplier to keep shipping during the case. Sales to a debtor in possession after the filing are administrative expenses, paid ahead of prepetition unsecured claims, and the producer's debtor-in-possession financing budget included payments to key suppliers. The supplier agreed to ship on terms of cash in advance for the first month, then 15 days, and it monitored the producer's reports to the court each month. Some debtors also ask the court for authority to pay critical vendors' prepetition claims in exchange for continued supply; the supplier raised the possibility, but the producer had other box sources, so the request was not made.

Why Reorganization Is Costly

Bris et al. (2006) studied Chapter 7 and Chapter 11 cases and found that bankruptcy costs, including legal fees and the loss of asset value, varied widely and that Chapter 11 was often not more costly than liquidation and preserved more value for creditors in many cases. For the supplier, a successful reorganization means continued sales to a restructured customer, which is worth more than a small liquidation dividend.

Property and Risk of Loss

The supplier also reviewed its property and shipping arrangements. Its boxes ship on its own trucks under delivered terms, so it bears the risk of loss until delivery and has an insurable interest in goods in transit. Its manufacturing equipment bolted to the plant floor is treated as fixtures, part of the leased real property for some purposes, which matters to its landlord's lien rights under the lease. The controller confirmed that the equipment is listed as tenant property in the lease so the supplier can remove it.

Insurance That Would Have Helped

Trade credit insurance covers losses when customers fail to pay because of insolvency. The supplier had declined it two years earlier to save about $60,000 a year in premiums. With a policy covering 90% of approved limits, its unsecured loss would have been largely covered. The supplier has now purchased coverage for its ten largest customers and set internal credit limits based on the insurer's assessments. It also reviewed its commercial property and business income policies to confirm coverage for a fire at its plant, which would halt deliveries to all customers.

Conclusion

The customer's Chapter 11 turned the supplier's $1.24 million receivable into a $310,000 administrative claim likely to be paid and a $930,000 unsecured claim worth perhaps 20 cents on the dollar, followed by a preference demand the supplier can likely defeat with its payment history. The legal steps it took, filing the claim, seeking administrative priority and documenting ordinary course payments, set its recovery, and the accounting followed. Trade credit insurance, now in place, would have reduced the loss considerably.

References

Bris, A., Welch, I., & Zhu, N. (2006). The costs of bankruptcy: Chapter 7 liquidation versus Chapter 11 reorganization. The Journal of Finance, 61(3), 1253-1303. https://doi.org/10.1111/j.1540-6261.2006.00872.x

Cheeseman, H. R. (2019). Business law: Legal environment, online commerce, business ethics, and international issues (10th ed.). Pearson.

11 U.S.C. § 503 (2018).

11 U.S.C. § 547 (2018).