Academic journal article Journal of Accountancy

When Your Customer Goes Belly-Up

Academic journal article Journal of Accountancy

When Your Customer Goes Belly-Up

Article excerpt

How to protect an unsecured creditor's interests when its customer is in financial straits.

In fat times it's easy to miss the signs that a valued customer may have financially overextended itself. Alas, inevitably someone's customer does declare bankruptcy. Even such high-profile companies as Boston Chicken, Crown Books, Grand Union Co., L.A. Gear, Montgomery Ward, Pan Am Corp. and J. Peterman have stumbled in the last few years.

To protect a creditor's interests, CPAs in business and industry and those in public practice who advise business clients need to understand that bankruptcy law is full of traps. If a creditor doesn't tread carefully, it may find that its prior notion of who has a right to what claims can turn to dust. The CPA can help creditors bolster their claims.


Bankruptcy law can seem mysterious to the uninitiated. CPAs should be aware of many circumstances that can cause complications. In some cases, assets that a debtor has in its possession can end up as property of the bankruptcy estate (see glossary, page 78) even though the supplier's management believes its company owns them.

For example, depending on the circumstances, the bankruptcy court may treat

* Consigned inventory as the debtor's property.

* The creditor's property as an extension of unsecured credit, even if the transaction is not styled as a sale, if it is used in the debtor's manufacturing process or is entrusted to the debtor for processing and return.

* Equipment leases as sales rather than true leases.

To recover such assets or their value, CPAs should be aware that the creditor must prove its ownership interest. In any of the situations described, a clear, written agreement will help the creditor make its case. The agreement should require the debtor's books and records to reflect the creditor's property interest. Filing a financing statement called a UCC-1, under a provision of the Uniform Commercial Code, can put other parties on notice that such an agreement exists. Normally, a UCC-1 is filed to "perfect" a security interest granted in personal property; however, unsecured creditors may file a UCC-1 proclaiming an interest in specified assets even if there isn't any security interest. For example, when the owner of artwork consigns it to a gallery for sale, she can file a UCC-1 to protect herself in case the gallery's finances wobble.


Commercial law does leave some wiggle room for unsecured creditors. Accordingly, CPAs should advise creditors to take full advantage of their rights.

For example, goods in transit may be recalled after a bankruptcy petition is filed. Depending on the shipping terms, it may be possible for a seller/creditor to recall shipments in transit to the purchaser/debtor. For instance, goods shipped FOB destination remain the property of the seller until delivery. In such cases, the seller should be able to direct the carrier to return the goods if it learns of the buyer's insolvency or bankruptcy filing prior to completed delivery. That would give the creditor a chance to reassess the buyer's creditworthiness before extending more unsecured credit. If the seller neglects to stop delivery, the goods will become the property of the bankruptcy estate, and the creditor may not get paid for them.

Most states have laws granting sellers the right to reclaim some goods shipped on open account even after delivery is made. This is called the right of reclamation. Only identifiable goods that the debtor has not processed or shipped qualify. Usually the seller must exercise this right on discovery of the buyer's insolvency and within 10 days of when the buyer received the goods. If bankruptcy intervenes, the period is extended. The creditor must make the demand for the specific goods it reclaims in writing.

A secured creditor's prior lien supersedes reclamation rights. …

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