You have just learned that a key customer or supplier is in financial distress. A Chapter 11 bankruptcy petition may be imminent, or perhaps already filed. What should you do?
While recognizing the severity of the problem, do not hit the panic button. Terminating your relationship with the troubled company may not be in your best interest. Nevertheless, act quickly. Some remedies (such as reclamation of goods under Article 2 of the Uniform Commercial Code) have legal deadlines, and some strategies you might wish to pursue (for example, seeking to attach funds in a bank account) may, as a practical matter, require speed in order to be effective.
If the troubled company is not in Chapter 11, here are some approaches to consider:
- Do your own due diligence. Rumors of financial distress are sometimes false. You do not want to destroy a valuable relationship by jumping to conclusions. If you have a reliable way to find out what’s really going on with the allegedly distressed company, that should be your first step.
- Did you recently ship goods to the distressed company? If the goods are still in transit, consider exercising the right of stoppage of delivery under Section 2-705 of the Uniform Commercial Code. If the distressed company has received delivery of the goods within the last ten days, or if you received a representation of the buyer’s solvency within the last three months, you may have a right to reclaim the goods pursuant to Section 2-702 of the Uniform Commercial Code. Of course, it would be preferable to get paid, including your profit margin, rather than to get back the goods. But unless the buyer can provide assurance of payment before you lose your rights under the U.C.C., you may be better off trying to get back the goods than hoping that the financially distressed buyer will pay.
- Have you recently received a payment? If the distressed company goes into bankruptcy, any payment within 90 days before the bankruptcy petition (one year in the case of an “insider” as defined in the Bankruptcy Code) may be a “preferential transfer,” which will have to be disgorged. Fear of having a payment avoided should not deter collection efforts, and payments should always be accepted. However, the timing and size of received payments may be a reason not to pursue aggressive collection activity on outstanding debts that could push the debtor into bankruptcy within that critical 90-day period. Numerous defenses exist under the Bankruptcy Code to avoidance of preferential transfers, so you should consult with legal counsel upon receipt of any preference demand letter from a debtor or other estate representative.
- Should you file a lawsuit immediately? If you do not mind jeopardizing your relationship with the debtor or possibly pushing the debtor into bankruptcy, you should consider a prompt lawsuit. The debtor may be trying to stall for time, and may be willing to pay you rather than have you obtain a judgment. In some states, you may be able to obtain pre-judgment remedies that could provide powerful leverage to collect your debt.
- Should you keep selling to the debtor? There are ways to continue selling to a distressed company without increasing your potential credit exposure. You could require payment in advance, making sure to deliver the goods only once the debtor’s check has cleared. You could sell on a C.O.D. basis, but unless you receive wired funds, certified check, bank cashier’s check or the like, you could get burned if the debtor’s payment was dishonored or even if there were a delay in clearing the check (the payment could be a preferential transfer, subject to disgorgement as described above, if clearing of the check is not “substantially contemporaneous” with delivery of the goods). You might wish to deliver new goods only after first receiving payment for the same amount of old goods. Another alternative is to create a “purchase money security interest” in the goods. So long as the interest is properly perfected, the risk of preference liability will be reduced significantly. Be aware of a credit-risky customer that suddenly places an unusually large order. This may be a signal that the customer is gearing up for a bankruptcy filing.
- What if you have a long-term contract with the buyer? If you have good reason to believe that the buyer will not perform, you may have the right under the Uniform Commercial Code to demand adequate assurance of the buyer’s performance (such as cash in advance or a letter of credit) or you may be able to break the contract without penalty. If the debtor files a Chapter 11 petition and the contract has not been terminated, the debtor will typically have the right to assume or reject the contract. But this is not necessarily disadvantageous to you, as discussed below.
After the Chapter 11 Filing
If your customer files a Chapter 11 petition, the rules change. The petition triggers the automatic stay, which bars most types of collection activity. However, you still may have a right of reclamation or stoppage in transit (see above), but you should consult counsel immediately because timing is critical. Some further considerations:
- Should you keep selling to the debtor? Ironically, a Chapter 11 debtor may be a better credit risk than a company outside of Chapter 11. That’s because obligations incurred by the debtor after filing under Chapter 11 are “administrative expenses” entitled to priority over all other unsecured obligations, including the debtor’s prepetition obligations to you and your fellow trade creditors. However, in most cases your priority claim will be junior to the debtor’s secured obligations and to postpetition bank financing, whether or not secured. If you wish to consider extending unsecured credit on a postpetition basis, legal counsel familiar with Chapter 11 can help you assess the credit risk.
- Can you be designated a Critical Vendor? In certain instances, a debtor will seek to designate certain of its suppliers as “critical vendors.” Obtaining critical vendor status may provide a unique opportunity to obtain payments on account of prepetition debts that you otherwise may not be entitled to receive.
- Can you collect for goods recently shipped? An amendment to the Bankruptcy Code in 2005 provides administrative-expense treatment for unpaid goods received by the debtor within 20 days before the bankruptcy filing. Congress also expanded the period for asserting reclamation claims, although reclamation rights of trade creditors may still (as in the past) be trumped by existing liens on inventory.
- What if you have a long-term contract with the debtor? The debtor will probably have the right to assume or reject the contract. If the contract is assumed, the debtor typically may choose to perform the contract itself or to assign the contract to a third party. If the contract is rejected, then it will not need to be performed and you will likely have a general unsecured claim for whatever damages you suffer because of the debtor’s breach. If the contract is assumed, however, both sides will be required to perform the contract, including payment in full of all monetary obligations. You may have the right to compel the debtor to make a prompt decision, which could have the effect (if the debtor assumes the contract) of you receiving payment in full. During the period before the debtor makes its decision, you may be obligated to perform your side of the contract, but you may have the right to require C.O.D. payment for any goods that you deliver after the Chapter 11 filing.
- What if you are invited to serve on the Creditors’ Committee? If you are one of the largest unsecured creditors of the debtor, you may be invited to serve on the Official Creditors’ Committee, which represents the interests of all unsecured creditors in the Chapter 11 case. The creditors’ committee can play a critical role in a Chapter 11 reorganization. The goals identified by the committee, and the manner in which it pursues them, can have a great influence on the ultimate outcome of a Chapter 11 case.
Doing business with a financially distressed customer is not without its challenges and risks. However, if those challenges and risks are properly managed, you may be the beneficiary of a continued and stronger business relationship with your customer. But if the warning signs of your customer’s financial trouble are mounting and past being able to be managed without reasonable comfort of getting paid, swift action must be taken to protect against a possible bankruptcy filing and the attendant losses that are likely to follow.