The U.S. economy has undergone significant financial and social upheaval over the past five years, with companies seemingly invincible to the vagaries of the financial markets disappearing overnight. Many companies have been forced to contract by closing unprofitable stores, laying off employees, reducing spending, deferring research and development, or have been acquired by more profitable companies. With few exceptions, those companies that have survived have done so by cutting costs to the bone.
In addition, there is little precedence for the Federal Reserve’s “quantitative easing” program, which unleashed an aggressive campaign of purchasing government bonds to keep interest rates artificially low. Only time will tell whether the U.S. economy will slip back into recession.
Given these uncertainties, it is vitally important for companies to understand and address financial stress before it becomes a problem, and to consider certain legal and operational strategies that can help mitigate such risks. This article summarizes some of the key issues and strategies that can be implemented by companies to protect themselves when suppliers and other trading partners suffer distress.
A. Monitoring Performance
Companies must regularly monitor performance, billings, and payments. When customers or vendors start to suffer financial distress, they will look for ways to cut costs to keep the lights on. Credit managers should be on the lookout for late payments, increasing receivables, requests for a change in payment terms, and decreased market share, among other things. Several services enable companies to monitor performance of their suppliers including Capital IQ and Dun & Bradstreet. Reports generated by these companies often reveal the financial health of a company or industry, and can be used as an early warning system to identity and prevent disruptions or other failures resulting from financial distress.
The first line of defense is to manage the risk of financial distress at the outset of the relationship. When properly written, vendor contracts should allow for flexible termination in distress situations to avoid having to do business with a troubled company. Legal counsel can assist in reviewing and suggesting modifications to contracts to maximize potential remedies, leverage and options available against troubled companies.
B. Early Warning Signs
Companies must be vigilant in order to maximize their leverage and options against customers or suppliers suffering financial distress. Early warning signs may include:
- Deteriorating accounts receivable and accounts payable
- Requests for a change in pricing terms, early payments, accelerated payment terms, or customer financing
- Late deliveries
- Deteriorating product quality
- Deteriorating market position
- Changes in key management positions
- Delinquent taxes
- Employment of turnaround consultants or financial advisors
- Delayed issuance of financial statements or change in audit firms
The first opportunity to minimize risk when dealing with a troubled company is at the inception of the relationship when negotiating the contract. The second opportunity is at the first sign of financial distress, but before a default or bankruptcy. Each of these events is discussed below.
C. Making Your Contract Iron Clad
The relationship between a company and its suppliers is similar to a marriage. The key is to establish the rules of engagement at the outset of the relationship when times are good, so that the parties know what to expect should the relationship sour. Thus, a clear and unambiguous contract is the first line of defense.
A company should have its counsel analyze key contractual terms including what constitutes an event of default and the circumstances under which a supply contract can be terminated. Of course, the right to terminate or declare an event of default often depends on the relative bargaining positions between the parties. The greater the freedom to terminate, the greater the chance of mitigating damage resulting from a supplier’s financial distress.
In addition, certain contracts that are executory in nature (i.e., where material obligations remain unperformed on both sides such that the failure to perform constitutes a breach), can be assumed, assigned or rejected in bankruptcy. Many creditors are surprised to learn that certain bankruptcy default provisions are not enforceable in bankruptcy.
1. Adequate Assurance
When financial distress occurs, suppliers can demand adequate assurance of future performance from the customer under Uniform Commercial Code § 2-609, which has been adopted in most states. Adequate assurance may include change in payment terms, security interests, personal guaranties, letters of credit, or other financial protections. If the customer cannot provide adequate assurance, the supplier may exercise certain remedies including the withholding of performance under the contract.
a. Ensuring Continued Supply
Business operations may be negatively impacted or even grind to a halt when a critical supplier stops shipping goods. Oftentimes, the customer is unable to recover quickly enough to survive. It is not uncommon for a supplier to threaten to stop shipping prior to or during a bankruptcy case. Such threats are often used as leverage by the supplier to get what it wants. Manufacturers and other customers should have action plans to address these threats, including having counsel lined up at a moment’s notice to seek court approval to ensure continued supply.
After the appearance of early warning signs of financial stress, companies will often attempt to negotiate an out-of-court workout to restructure their debt and capital structure. A workout may include a sale of the distressed company. The distressed company and key creditor constituencies may negotiate a variety of agreements to ensure that the company continues to operate during workout negotiations including forbearance or participation agreements, among others. As part of these negotiations, distressed companies may request that their lenders provide working capital financing and that their suppliers continue existing production, to ensure continuing cash flow. In exchange, suppliers often request accelerated payment terms.
If an out-of-court workout fails, it is likely that a distressed company will file a voluntary bankruptcy petition or be placed into an involuntary bankruptcy or receivership. It is therefore important that customers and suppliers remain vigilant and are able to act promptly to enforce their legal rights and remedies. Key issues to be addressed in a Chapter 11 bankruptcy include the following:
a. Executory Contracts
Most contracts, including supply agreements, can be assumed, assumed and assigned, or rejected in bankruptcy. If an executory contract is assumed, the debtor must promptly cure all pre-petition defaults. Some debtors may be willing to assume the contract if the terms are modified. If an executory contract is rejected, the non-debtor party is simply left with an unsecured, breach of contract damages claim.
Non-debtor parties to executory contracts are often surprised to learn that most executory contracts can be assigned without their consent so long as the debtor cures all monetary defaults, and the non-debtor party provides adequate assurance of future performance. There are several exceptions to this general rule including personal service contracts, financial accommodation contracts, or certain other agreements that are non-assignable as a matter of law without the consent of the non-debtor party (e.g., patents or trademarks). To reduce the risk of unauthorized assignment of a contract in bankruptcy, companies should consider negotiating language in the original contract to require performance of obligations that are akin to personal services or other non-delegable obligations that cannot be easily delegated.
In every bankruptcy case, creditors must file a proof of claim for pre-petition damages, including unpaid debts unless the claim is scheduled as undisputed, unliquidated, or not contingent, and the creditor agrees with the scheduled amount. It is always good practice to file a proof of claim even if the claim is properly scheduled. If a claim is not timely filed, it will be time barred and discharged.
c. Reclamation and Section 503(b)(9) Priority Claims
Suppliers may have limited rights to reclaim goods sold to debtors prior to bankruptcy or to obtain a priority claim in bankruptcy. However, the deadline to assert a reclamation demand is very short, and will be subject to a perfected security interest in the goods shipped. Suppliers must also be sure to timely make a request for allowance and payment of a Section 503(b)(9) claim for the value of goods received by the debtor within a 20-day period prior to the bankruptcy filing. The failure to timely make a request will result in disallowance of the claim.
d. Setoff and Recoupment
Creditors may have setoff or recoupment rights that could give them priority over other unsecured creditors. However, creditors must be careful not to violate the automatic stay as there are important nuances between exercising a right of recoupment (which is not a violation) with setoff (which requires relief from the automatic stay).
e. Post-Petition Financing
A Chapter 11 debtor must either obtain a lender’s consent or Bankruptcy Court order authorizing the debtor to use the lender’s cash collateral during the bankruptcy case. Oftentimes, lenders will not consent, requiring a debtor to provide the lender with adequate protection.
In the event that the debtor is not able to use cash collateral, the debtor’s key customers may be forced to increase prices or otherwise finance the debtor’s continuing operations pending the customer’s ability to find another supplier. The customer should engage experienced bankruptcy counsel to assist in maximizing repayment of post-petition financing in the event that the customer decides to do so.
f. Distressed Sales
Distressed companies often look for buyers to avoid bankruptcy. Sales can occur during a workout or bankruptcy. Because many supplier contracts permit termination upon notice by either party, an asset purchaser seeking to acquire key contracts should obtain customer approval as part of the sale process. Although buyers may typically assume executory contracts as part of a sale, such contracts typically include termination rights. Therefore, a proposed buyer must should consider obtaining customer approval to such assignment or renegotiate the terms of the contract during the sales process.
g. Critical Vendors
In some jurisdictions, a Chapter 11 debtor may be able to pay the pre-petition claims of critical vendors as consideration for the vendor’s agreement to continue to supply the debtor with goods or services. If the Bankruptcy Court approves a motion to pay critical vendors, the vendor may obtain payment of all of its pre-petition debt in contrast to other general unsecured claims that are frequently paid pennies on the dollar. However, some jurisdictions do not permit the payment of critical vendor claims while others restrict its applicability.
h. Avoidance Claims
The Bankruptcy Code gives a debtor the power to avoid and recover on behalf of the debtor’s bankruptcy estate amounts paid during the 90-day period (and a one-year period for insiders) prior to a bankruptcy filing on account of antecedent indebtedness. Experienced bankruptcy counsel can assist a creditor in evaluating various preference defenses including the “new value” and “ordinary course of business” defenses.
The key to avoiding preference liability is for the company to strictly manage its credit risk and payment. At the earliest signs of distress, a customer may want to insist on changing payment terms to require cash on delivery or prepayment.
i. Claims Purchasers
Claims purchasers frequently approach creditors with an offer to purchase the claims at some discount. These offers typically include representations and warranties, and clawback provisions. Creditors must carefully assess the purchase agreement to understand the risks and assess the likely recover in the bankruptcy case. Also, recent case law has called into question the ability of claim purchasers to credit bid the full amount of the claim, limiting the amount of the credit bid to the purchase price.
j. Creditors Committees
Creditors holding large unsecured claims (typically included on a list known as the “20 Largest Unsecured Creditors List,” may be asked to sit on a committee of unsecured creditors. Service on a creditors committee is often advantageous for a variety of reasons, and all fees incurred by Committee counsel must be paid by the debtor’s bankruptcy estate. The creditor, however, must understand the duties and commitments involved in serving on a committee, and how those duties will impact its own interests.
Keith C. Owens is a partner in the Los Angeles office of Venable LLP. He represents debtors-in-possession, creditors committees, secured and unsecured creditors, trustees and receivers, asset purchasers and other constituencies in bankruptcy, liquidation and workout matters around the United States