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All too often attorneys get inquiries from sales reps who have just received notice that one of their principals has filed for bankruptcy.
Invariably, their first question is whether they will get paid the commissions owed to them. Unfortunately, there is no simple answer, for bankruptcy cases involve many variables and technical issues that are controlled by the voluminous United States Bankruptcy Code (referred to in this article as the “Code”), which is subject to judicial interpretation and enforcement by the United States Bankruptcy Courts. As such, before answering that or any other of the rep’s questions, an attorney first will need to ascertain some initial information, including whether the principal (referred to in the Code as the “Debtor”) has filed a Chapter 7 or Chapter 11 bankruptcy action. This distinction will likely impact how much commission, if any, a rep may be able to recover.
Chapter 7 Proceedings
Generally, under a Chapter 7 proceeding, which is often referred to as a “straight bankruptcy” or “liquidation bankruptcy,” the principal has ceased its business operations and its assets will be liquidated in an orderly manner under court supervision for the benefit of its creditors. A court-appointed trustee will collect the Debtor’s receivables (by filing lawsuits, if necessary) and sell the Debtor’s other assets, such as its inventory, equipment and real estate, which are not pledged as security to the Debtor’s bank or other such “secured” or “lien” creditor. After all of the assets have been liquidated (and after the secured creditors have recovered their property or been paid), the remaining funds then will be distributed to the Debtor’s unsecured creditors in order of their “priority” as set forth in the Code. Since reps typically are unsecured creditors (meaning they don’t have liens on the Debtor’s assets), they usually will only receive a prorated share of what is left after unpaid taxes and secured and administrative creditors have been paid. However, in a Chapter 7 proceeding that often amounts to only a small fraction of what is due, if anything at all.
In all of this vision of gloom, there is one possible, but limited, glimmer of hope. In certain instances, the Code allows independent sales reps a “fourth priority” claim to recover up to $10,950 of commissions earned within 180 days prior to the date on which the bankruptcy case was filed or when the Debtor ceased its business operations, whichever occurred first. Of course, payment of this or any amount is entirely dependent upon the availability of funds. Unfortunately, the Code imposes strict conditions which make this type of relief generally unavailable to most multi-line independent sales representatives. Specifically, the Code provides fourth priority claim status only for:
“Sales commissions earned by an individual or by a corporation with only one employee, acting as an independent contractor in the sale of goods or services for the debtor in the ordinary course of the debtor’s business if, and only if, during the 12 months preceding that date, at least 75 percent of the amount that the individual or corporation earned by acting as an independent contractor in the sale of goods or services was earned from the debtor.”
In other words, this relief is only available either to an individual rep or a rep corporation with only one employee, provided that the principal was responsible for at least 75 percent of the rep’s income in the preceding year. In essence, the Code is granting this limited priority to a rep who has the typical attributes of an employee of the Debtor.
Chapter 11 Proceedings
The other type of bankruptcy proceeding is a case filed under Chapter 11 of the Bankruptcy Code, and which is often referred to as a “reorganization bankruptcy.” In this type of case, the principal (referred to as the “Debtor in Possession”) continues to operate its business in an effort to work out its financial difficulties, with the ultimate goal of proposing a Plan of Reorganization under which its creditors will receive more than they would under a Chapter 7 liquidation. In this scenario, a rep may be asked to continue to sell the same products for the Debtor in Possession, which is treated as a new entity. Should that happen, the rep, depending upon the strength of its bargaining position, may have an opportunity to negotiate terms that might allow it to recover commissions for sales made prior to the Chapter 11 bankruptcy action. Even then, the rep will need to be careful because many Chapter 11 proceedings are not successful and ultimately may be converted to a Chapter 7 liquidation. In that event, the rep could find itself owed commissions for sales it procured both prior to and during the Chapter 11 proceeding. Although the Code provides the rep with a priority claim for commissions earned during the Chapter 11 proceeding, that won’t be any help if the Debtor’s estate has no assets!
Of course, the best way for a rep to avoid such double exposure is for it to not extend too much credit to the Debtor in Possession and to be prepared to terminate the relationship if commissions are not being paid in a timely manner during the reorganization process. Also, whether a principal files a Chapter 7 or Chapter 11 bankruptcy case, a rep should always file a “Proof of Claim” form with the Clerk of the Bankruptcy Court where the case is filed. This form usually is sent to the Debtor’s creditors with the official notice that a bankruptcy proceeding has been filed. If a Proof of Claim form is not filed by the stated deadline, the rep will not be able to recover any amount in a Chapter 7 proceeding, and in a Chapter 11 case will only recover whatever amount the Debtor may have acknowledged is due in the documents it filed with the Bankruptcy Court (which amount is often incorrect).
Preference Payments to Reps
While most reps are justifiably concerned about recovering unpaid commissions, they also need to be aware of the possibility that they may be required to return all or a portion of commissions paid to them within 90 days prior to the filing of a principal’s bankruptcy, during what is referred to as the “preference period.” Specifically, the Code provides that the Trustee can demand repayment of such “preference payments” if they were made on account of “antecedent debt” — that is, for amounts already owed a creditor. Thus, while a rep may initially have felt lucky to have been paid long past due commissions by a failing principal, all too often the rep later (perhaps years later in the course of the bankruptcy proceeding) will receive a demand that it return such payments. Fortunately, not all payments received during the preference period are subject to preference claims, because the Code provides certain defenses which preclude the Trustee’s recovery of certain payments.
One such defense is available when the alleged preference payment was made in the “ordinary course of business.” This means a rep may have a defense to a preference claim if the commission payment received during the preference period either was made in accordance with the terms of the Rep Agreement or, even if not, at least in a manner consistent with how commissions were paid within the year preceding bankruptcy. A second possible defense to an alleged preference claim is available to a rep that continued to provide “new value” to the principal during the 90-day preference period. Such “new value” arguably would be based on the rep’s continued promotion and sale of the principal’s products for which no commissions were paid prior to bankruptcy. Essentially, this defense gives the rep a setoff against preference payments for commissions earned from its continuing efforts for the principal.
Since these are but general descriptions of many complex legal rules and issues, the facts of each case must be thoroughly analyzed by an attorney to determine if these or other defenses may be available to a rep in any given situation. However, it is important for reps be aware that such defenses do exist and that they have a fighting chance to defeat a preference claim and also to recover some unpaid commissions due from a bankrupt principal.
