Doing Business With a Distressed Company
© 2010 Cohn Whitesell & Goldberg
What should you do when you hear that a key customer or supplier is on the verge of Chapter 11? Or has already filed a Chapter 11 petition? Can you get back goods that you've shipped? Should you sue? Are you going to get sued? If you keep selling to the debtor company, how can you be sure of getting paid . . . and not later having to give the payment back to a bankruptcy trustee?
You have just learned that a key customer or supplier is in financial distress. A Chapter 11 petition may be imminent, or perhaps already filed. What should you do?
Do not hit the panic button. Terminating your relationship with the troubled company may not be in your best interest. But you should 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:
Try to find out what's really going on.
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. To learn more about your potential liability for receipt of preferential transfers, click here. It is not a crime to receive a preferential transfer; indeed, perhaps your credit manager deserves a promotion for squeezing funds out of a slow-paying customer. But receipt of a preferential transfer may be a reason not to pursue aggressive collection activity that could push the debtor into bankruptcy within that critical 90-day period.
Should you file a lawsuit at once?
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 (particularly in New England), 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 a certified check, bank cashier's check or the like, you could get burned if the debtor's check were 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.
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 of the road 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 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 administrative-expense 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 collect for goods recently shipped?
A new provision of the bankruptcy law, effective for cases filed after October 17, 2005, provides administrative-expense treatment for unpaid goods received by the debtor within 20 days before the bankruptcy filing. Congress has 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 your 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. To learn more about serving on a Creditors' Committee, click here.
This article provides general information concerning its topic. It is not intended to provide legal advice or to create an attorney-client relationship.