As the temperature started to swell during the heat wave we had this past April, the owner of a large commercial office building in Manhattan needed the building's main air conditioning unit serviced in order for it to work. One of our clients, an HVAC specialist, was the contracted service provider. Problem was, the building owner was behind on his account by a fairly wide margin.

It seems that few businesses have better leverage over non-paying customers than a HVAC service company when the mercury climbs past 90 degrees. Our client's request to its customer: bring the account current and get your AC fixed.

On its face, this seemed like a simple, yet effective, collection policy--that is, until the customer filed a petition for bankruptcy.

Our client, who had little interest in performing services for an account that was past due, was surprised to learn that the bankruptcy court would require them to continue to perform the contracted services. They did so, without knowing when the customer's account would be brought current, if at all.

As the economy teeters and fuel prices surge, in entrepreneurial circles, bankruptcy has become a frequent topic of conversation. According to Todd Duffy, a bankruptcy attorney with the New York firm Duffy & Atkins LLP, "we're definitely seeing an up-tick in business bankruptcy filings, especially in small businesses." "In particular, businesses that heavily rely on fuel consumption, like trucking or distribution companies, have been proportionally affected by recent increases in oil prices."

Unless you're a bankruptcy lawyer, most likely when you think about bankruptcy it's from the perspective of the person or company who owes money--the debtors--and how they use the bankruptcy laws to seek protection from the people they owe money to-the creditors. However, in our firm, most often when we come in contact with a bankruptcy situation, we see stable companies that have been affected by their customers' financial problems.

Frequently, we see situations like the HVAC company, where our client is a party to an "executory contract", an agreement where one party agrees to deliver a service or good and another party agrees to pay for such service or good. Once a debtor customer initiates a bankruptcy, a creditor service provider cannot terminate an executory contract. Even worse, the court will obligate the creditor to continue to perform under the terms of agreement.

In the case of our HVAC client, they were forced to service their customer's AC unit under the terms of the service agreement.

"The bankruptcy code is very slanted towards protecting debtors," says Duffy, "initially, when a debtor files for bankruptcy the debtor is not required to perform under the contract, but the creditor is." A good example would be a creditor who is a landlord. Even though a tenant may be six months behind in rent payments, the landlord has to continue to provide the leased space and services until advised by the court that it can stop doing so.

According to Duffy, it's extremely important that the creditor does not stop performing services under an executory contract. Bankruptcy courts will view the creditor's unilateral termination of the agreement as an attempt to try to force the debtor to pay, a tactic that is absolutely prohibited in bankruptcy.

The good news is that once a debtor files for bankruptcy, any money due to a creditor for services performed post petition is paid as it comes due in the ordinary course of business. "A classic example is a landlord who will receive rent payments by the first of every month post petition," says Duffy.

In terms of the debtor's past due account, the news isn't so good. "It's extremely difficult to know how much and how quickly you may get paid," says Duffy.

Under the bankruptcy code, a debtor has up to 180 days to either assume or reject an executory contract. If the debtor assumes the contract, it's as if the bankruptcy never happened. Monies due and owed pre-petition will eventually be paid by the debtor in full.

If the debtor assumes a contract, they must prove to the court that they can perform (pay fees) under the terms of the contract. Says Duffy, "we see the assumption of contracts by debtors most often when there is an assignment of the contract to a third party in exchange for money, for instance to the buyer in the sale of the debtor's assets or where there is a below market lease that can be assigned."

For pointers on how you may be able to get below market prices by purchasing assets from debtors in bankruptcy, listen to my interview of Todd Duffy at: www.alternativefundingstrategies.com/bankruptcy.

If the debtor rejects the contract, the creditor is no longer obligated to perform and it will be aggregated with all other creditors to wait for payment from the debtors remaining assets. This is where there is a wide margin of uncertainty about what will happen next.

According to Duffy, their firm always looks for ways to "restructure" the company rather than liquidate the company. "In a liquidation scenario, the company is essentially terminated and its assets are sold for pennies on the dollar," what Duffy calls "Bankruptcy Dollars." "What we try to do is find a way for the debtor to pay creditors as much as possible, even if it's a structured payment over time." However, even if the debtor agrees to a payment plan, the amount a creditor will be paid depends on the amount of the debtor's liquid assets. Additionally, the payment may be less than what is owed or it may be non-cash consideration, like equity in the post-bankruptcy company.

During the 180-day period when a debtor is deciding whether it will assume or reject a contract, the only remedy a creditor has to get out of the contract is to make a motion to the bankruptcy court to reject the contract.

"This is a very difficult fight for creditors," says Duffy. "The creditor must prove that the debtor violated its business judgment when it entered into the contract-a very difficult standard to meet because courts are generally reluctant to question business judgment." Even if the creditor wins, their financial remedy is to collect on a breach of contract claim alongside all the other creditors.

When it comes to creditors getting tangled in a customer's bankruptcy, lawyers often get involved when the creditor gets paid by the debtor just prior to the filing of a bankruptcy petition. In bankruptcy, this type of payment is called a "preference", which is prohibited under the bankruptcy code.

"Under the bankruptcy code, all creditors are entitled to a pro rata share of the debtor's assets," says Duffy. "The bankruptcy code was designed to prevent all of the company's creditors from scrambling to get a hold of the company's assets, which would create a situation where some creditors get more than others. It also prevents a company from paying a preferred creditor a greater percentage of the estate."

The Bankruptcy code allows the court to examine any payment that was made to a creditor within 90 days of filing and up to one year for payments made to management and other insiders. Payments made during this period, especially payments of past due accounts can be deemed preferential. In this case, the debtor would sue these creditors in a "preference action," in which case, creditors may be forces to return payments back into the debtor.

There are several defenses that a creditor can use to prove a payment was not a preferential. Three of the most common are:

• where the creditor has exchanged new value in exchange for payment, like a COD payment for the delivery of goods;

• where creditor is paid and delivers new value, for example, the creditor performs new services, that is in excess of the payment made by the debtor; and

• where a payment is made in the ordinary course of business, for example payments made under a service contract or rent paid to a landlord.

Some clever entrepreneurs have tried to contract their way out of getting tangled up in a customer's bankruptcy. You will frequently see a clause in a contract where the debtor's filing of a bankruptcy petition is considered a default under the agreement and grounds for termination. However, according to Duffy, once a debtor is in bankruptcy, these clauses are unenforceable.

In terms of our HVAC client, after their customer filed for bankruptcy they were notified by their customer's attorney that a buyer of the customer's assets wanted to assume the service contract. Post petition, our client continues to perform services and get paid from the debtor pursuant to the terms of their agreement. They expect to be paid the past due balance on the debtor's account upon the closing of the buyer's purchase of the assets.

See this month's Quick Tip for steps to take if it looks like your customer may file for bankruptcy.