Protecting Suppliers and Customers of Insolvent or Bankrupt Companies

August 14. 2020 Articles
The Recorder

Some 3,600 companies having already filed for Chapter 11 protection in the first half of 2020—more than in any year since 2012—and many are bracing for an even greater surge of bankruptcy filings before the COVID-19 pandemic ends. For those doing business with financially troubled companies, questions regarding whether and how to continue doing business with them will necessarily arise.

Ensuring Payment for Goods and Services Provided

There are several ways a seller of goods can protect itself when it learns its buyer is or may be insolvent. For example, it may seek a security interest in the goods being sold or demand payment in advance or on a cash-on-delivery (COD) basis. A seller may also seek a guaranty from the buyer’s parent or an affiliated company. In addition, the Uniform Commercial Code (UCC), which has been adopted in some form in every state of the United States, allows a seller to suspend performance until it receives “adequate assurance” of performance (i.e., ability to pay) by a buyer if there are reasonable grounds for insecurity regarding their performance.

Stopping Goods in Transit and Reclaiming Goods

The UCC also provides protections for sellers that have sold goods on credit to an insolvent buyer. For goods not yet shipped, a seller can “refuse delivery except for cash including payment for all goods theretofore delivered under the contract, and [to] stop delivery,” or “withhold delivery” of goods where the buyer fails to make payment due on or before delivery. If goods are still in transit, the seller may also stop them from being delivered if the buyer has not taken actual or constructive possession of the goods.

For goods already delivered, a seller can reclaim goods from the insolvent buyer within 10 days after delivery, but there is no time limitation if the buyer misrepresents its solvency in writing to the seller within three months before delivery of the goods. Importantly, the seller’s right to reclaim is subject to the rights of a subsequent “buyer in the ordinary course” or another “good faith purchaser.”

Initial Steps When Customer Files for Bankruptcy

A bankruptcy filing triggers an “automatic stay” that prohibits collection action for pre-petition debts. A company dealing with a debtor in bankruptcy should consider filing a notice of appearance/request for notice to receive documents filed in the case, as well as attending the “meeting of creditors” to learn about the debtor’s finances and ask questions of the debtor company’s representative under oath. A creditor must file a proof of claim to preserve its right to payment on any pre-bankruptcy debt or obligations.

Reclaiming Goods Sold Before Bankruptcy and Related Priority Claims in Bankruptcy

In a buyer’s bankruptcy case, a seller can demand to reclaim goods sold in the ordinary course of business and delivered to an insolvent debtor within 45 days (or within 20 days after the petition date, if bankruptcy was filed within such 45-day period). However, these rights are subject to any prior security interest in the goods, such as a lender with “blanket lien” on the debtor’s assets. Bankruptcy courts often establish universal procedures for resolving such reclamation claims.

Alternatively, a seller that delivers goods to a debtor in the ordinary course of business within 20 days prior to the bankruptcy filing has a priority (administrative expense) claim, which is generally entitled to payment before other unsecured pre-bankruptcy claims.

Continued Dealings With Debtor in Bankruptcy

A debtor in bankruptcy is permitted to pay for goods and services received after the bankruptcy filing in the ordinary course of business. If not paid, such debts generally give rise to administrative expense claims, with payment priority over unsecured pre-bankruptcy debt. By contrast, debts arising prior to the bankruptcy filing generally can only be paid through a confirmed Chapter 11 reorganization plan or a bankruptcy trustee’s liquidation of the debtor’s assets. However, some bankruptcy courts have carved out an exception to this rule, by allowing payment of pre-bankruptcy debts owed to designated “critical vendors” of the debtor that agree to continue extending credit for goods and services supplied during the bankruptcy case.

Despite their payment priority, administrative expense claimants are not assured of full payment for the goods and services provided to a debtor. Thus, it is important for a supplier to assess the debtor’s financial condition before extending additional credit, including the debtor’s access to continued funding for its operations, which often requires debtor-in-possession financing.

Executory Contract Considerations in Bankruptcy

There are special rules in bankruptcy for executory contracts—i.e., agreements as to which material performance remains on both sides. For such contracts, a debtor has the option (subject to the bankruptcy court’s approval) of: “assuming” (ratifying, by curing all pre- and post-bankruptcy defaults and providing adequate assurance of future performance); “rejecting” (repudiating and ceasing performance, with the counterparty entitled to claim damages resulting from such breach); or assuming and assigning (which does not require a counterparty’s consent notwithstanding contractual provisions to the contrary, although the assignee must provide adequate assurance of future performance).

Unless the debtor rejects the contract, the automatic stay prohibits a counterparty from terminating a contract with the debtor or ceasing performance without the bankruptcy court’s permission, even if the agreement contains such rights. However, a contract counterparty can seek “adequate protection” of its financial interests if the debtor’s ongoing performance is uncertain pending its decision to assume or reject the agreement.

Need for Bankruptcy Counsel

Because many of the matters discussed above involve technical issues of bankruptcy law, it is often prudent to engage an attorney with bankruptcy expertise to provide guidance and assistance.

Reprinted with permission from the August 17, 2020 issue of The Recorder. © 2020 ALM Media Properties, LLC. Further duplication without permission is prohibited.  All rights reserved.

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