Consternation, concern and loss of control are usually what spring to mind for factors dealing with a client’s bankruptcy filing. There are valid reasons for this. Bankruptcy changes the normal way of operating. Everything changes on the petition date. The judge, the Bankruptcy Code and possibly a trustee or creditors’ committee are now involved. Business as usual has ended. Business according to the Bankruptcy Code has begun. But there is light at the end of the tunnel. The first few weeks can be difficult, but once the court sorts through the issues, bankruptcy can provide an orderly way for a debtor to either continue in business or liquidate. The key, however, is for factors to become aware of the bankruptcy filing as soon as possible and to work through the challenges with an understanding of the new normal — potentially averting problems.

Debtor/Factor Missteps

An example should help illustrate this. Assume that a factor has been purchasing accounts from a client for several years. Recently, however, the relationship has become bumpy. The client’s industry is suffering, and the client is developing serious cash-flow problems. The client may have even brought in a turnaround manager. In the meantime, the client desperately needs the factor’s help to stay in business. The factor fears losing significant funds if the client goes out of business, so the factor keeps funding. Eventually, the client files for Chapter 11 bankruptcy protection.

As often happens, when the debtor first files, it fails to immediately inform the factor. This means the factor has continued to make advances, collect funds and purchase accounts — in other words, business as usual — after the bankruptcy filing. Likewise, since the factoring agreement is with recourse, the factor maintains a reserve account. Frequently, reserve accounts attract unwanted attention from debtor’s attorneys and trustees hunting for money to feed a cash-starved debtor. In fact, although reserve accounts are wonderful tools, they are also often the source of many problems. And they can be a factor’s Achilles’ heel when disputes arise.

The problem is that too many times, factors do not understand their reserve accounts. In some cases, hundreds of transactions come into and go out of the reserve account, and the factor is at a loss to truly track what is happening. Personnel rely too heavily on software to tell them how much is owed without understanding why. Unfortunately, courts generally want people, not computers, to explain the reserve account. And the accounts usually do not function how courts expect them to function. Many judges simply expect collections from purchased accounts to go to the factor and everything else to go to the client. In reality, funds from both factored and nonfactored accounts and possibly even funds unrelated to any of the accounts go into the reserve. Then releases from the reserve need to be offset by short pays, no pays, misdirected payments, fees owed to the factor, and the list goes on. This creates a mishmash of debits and credits.

Pre-Petition Vs. Post-Petition

When bankruptcy courts start sorting all of this out, they begin by determining which issues are pre-petition issues and which are post-petition. As many of you know, bankruptcy is separated into what happened before the bankruptcy filing — pre-petition — and what happened after the bankruptcy filing — post-petition. Pre-petition debts can only be offset against pre-petition claims, not post-petition claims.¹ This is often where problems begin.

Pre-petition offsets can be complicated. Factors usually have outstanding and unpaid accounts receivable at the petition date. Factors may also owe the debtor funds net of offsets in the reserve. An aggressive trustee or creditors committee usually wants all of this. To justify this, trustees often argue that the factor does not own the accounts. Instead, the factor is simply lending against accounts receivable. Trustees may also argue that the factor needs to pay the full reserve amounts owed to the debtor without any allowance for setoffs or credits. Instead, they want the factor to send them everything and file proofs of claims for amounts owed.

The first question, then, is who owns the pre-petition accounts. This is often tricky to answer. Unfortunately, there are many examples in different situations where courts have found that a factor was not purchasing accounts but, in fact, lending against accounts.² Among the many facts that courts consider, the touchstone seems to be whether the factor has recourse against the client for unpaid or partially paid accounts. If so, many have found the factoring arrangement to be a loan rather than a sale. This is, however, a fact-specific inquiry and is influenced not only by the totality of the facts, but also by state-specific laws applicable to the transaction. Indeed, countervailing case law may be in the factor’s favor. For example, Texas is one state that is factor-friendly with regard to this issue.³

Offsets

Whether to allow offsets against the reserve is another fact-intensive issue. This inquiry often revolves around whether the factor is attempting a setoff or a recoupment. What distinguishes a recoupment from setoff is that the mutuality of obligations from a recoupment stems from the same transaction, as opposed to a setoff where the obligations stem from different transactions.⁴ Recoupments can be made without filing a motion for relief from stay. Setoffs, however, require an order from the court before setting off the obligations.

Credit Freeze

Once a factor becomes aware of a bankruptcy, I generally recommend freezing everything and not attempting any credits against the reserve without first seeking permission from the court. If the court determines that the factor offset the debt rather than recouped the debt, then the factor may be liable for violating the automatic stay, which can carry sanctions.⁵ By freezing everything first, you minimize the risk of violating the stay if the court later finds that you are not entitled to a setoff.

Collecting Funds

Another question is whether the factor can collect funds after the bankruptcy filing from accounts purchased pre-petition? Assuming that these are true purchases and the debtor has no legal or equitable interest in the accounts, courts generally hold that the factor is entitled to collect the funds. Once again, I suggest holding these funds in suspense until the court grants the factor permission to keep them. A bigger problem can be when the debtor keeps post-petition payments on pre-petition factored accounts. In that instance, the factor needs to immediately make the court aware of this and ask the court to order that the funds be turned over to the factor.

Purchasing Debtor Accounts Post-Petition

Post-petition purchases of debtors’ accounts are another problem. The accounts become assets of the bankruptcy estate at the petition date. Because of this, the factor needs permission from the court to purchase assets of the estate. That means that the court will have to approve the sale or the transaction has to be unwound. Debtors often do not have the resources to unwind the transaction. In those instances, they may cooperate with the factor in requesting the judge to confirm the order. If this happens, the factor should consider inserting language in the order requiring the debtor to provide replacement invoices if the post-petition accounts turn out to be uncollectible.

Also, if another creditor has a security interest against the accounts, this creates a whole host of other problems to be resolved.⁶ These other security interests may not only have arisen pre-petition, but also may have arisen post-petition by a debtor-in-possession financing order, cash collateral order or even an adequate protection order. Parties will need to sort through all of this.

Due Diligence

Blending of transactions across the petition date creates a myriad of problems that are time consuming and can become expensive. Being diligent about knowing what is in the reserve, stopping advances as soon as you become aware of a bankruptcy filing, holding all monies collected in suspense, monitoring all filings to avoid being primed by other creditors and quickly filing motions with the court to resolve the issues can help avoid problems down the line. In the end, bankruptcy court is another example where the most diligent party is usually the most successful.

Scot Pierce, partner at Whitaker Chalk Swindle & Schwartz, is an experienced business litigator and bankruptcy attorney. A large part of his practice is dedicated to representing businesses, financial entities and secured creditors.

Footnotes:

^{1.11 U.S.C. §553; U.S. v. Gerth, 991 F.2d 1428 (8th Cir. 1993).↩
2.See e.g., Fenway Financial, LLC v. Greater Columbus Realty, LLC, 995 N.E.2d 1225 (Ohio Ct. App. 2013) (holding that factoring a real estate commission was illegal under Ohio law because the transaction was not a true sale); In re: Qualia Clinical Service, Inc. 441 B.R. 325 (8th Cir. 2011) (holding that a factoring transaction was not a true sale but a loan for purposes of preference liability); Nickey Gregory Co., LLC v. Agricap, LLC, 597 F.3d 591 (4th Cir. 2010) (holding that a factoring transaction was a loan and not a true sale for purposes of the Perishable Agricultural Commodities Act).↩
3.See TEX. FIN. CODE 306.103; Korrody v. Miller, 126 S.W. 3d 224, (Tex. App.—San Antonio, 2003, no pet.); but see, Reaves Brokerage Co. v. Sunbelt Fruit & Vegetable Co., Inc., 336 F.3d 410 (5th Cir. 2003).↩
4.See e.g. In re: Southern Hosiery Mill, Inc.; Barrett L. Crawford, Trustee v. The CIT Group/Commercial Services, Inc. et al., 2011 WL 2651580 (Bankr. W.D.N.C., 2011) (holding that a factor could recoup a minimum fee from a bankrupt client’s credit balance without violating the automatic stay because the factor’s claim and client’s credit balance both arose out of the same factoring agreement)↩
5.See 11 U.S.C. § 362.↩
6.See e.g, In re Printz; CNH Capital America, LLC. V. Trainor Grain and Supply Co., 478 B.R. 876 (Bankr. C.D. Ill. 2012)↩}