When a Client Files for Bankruptcy

The subsidiary that should have paid you filed for Chapter 7, but the parent company wants you to continue to work as a contractor

My small computer consultancy does work for a very large company that requires all its contractors to be hired through one of its subsidiaries. This is so the large company will be insulated from lawsuits and limit its risk exposure. Unfortunately, the intermediary filed for Chapter 7 bankruptcy protection recently. The large company would like me to continue working for them, but they owe me two months' back pay. They told me they paid the subsidiary, but that firm has not paid me. What legal recourse do I have in this situation, and what can I do in the future to protect my company? —J.A., Fairfax, Va.

Unfortunately, a Chapter 7 bankruptcy filing means the company—in this case, the subsidiary that contracted with you on behalf of the larger firm—is shutting its doors. Unlike Chapter 11 or Chapter 13, where reorganization is the goal, Chapter 7 effectively closes the company, says attorney M. Jonathan Hayes, a certified bankruptcy specialist in Woodland Hills, Calif.

If the larger corporation wants you to continue your work with it, it obviously will have to make you whole in terms of the two months' back pay you are owed despite the fact it already paid its subsidiary. You should not do any more work for the larger corporation until you've got a payment for the outstanding amount and a new contract directly with the big firm, says Donald King, a bankruptcy attorney with Odin, Feldman, Pittleman in Fairfax, Va. You should also ask for administrative priority in the subsidiary's bankruptcy case, meaning your claim will get higher priority for repayment.

Get Paid Early to Avoid Danger

If you get no remedy from the larger corporation, file what's called a "proof of claim" with the bankruptcy court detailing what you are owed and why. If there is any money left after the bankruptcy proceeding, the trustee appointed by the court will be charged with repaying various creditors. "Of course, if there is $1 million in proof of claims and $100,000 to send out, everybody would get 10%," Hayes noted.

You might also want to talk to an attorney (BusinessWeek.com, 8/23/06) about whether your contract with the subsidiary firm was valid in the first place. There may be a possibility of suing the subsidiary despite the bankruptcy, he said, and you won't know whether there is money available to recover unless you try.

In general, small businesses should not be 60 days in arrears on a major contract, Hayes says. "Get a deposit, get collateral, or get a third-party guarantee from your clients," he advises. "Having a client declare bankruptcy is a risk you take in business, but if you get paid earlier, there won't be so much money outstanding if they do."