Legal Strategies for Vendors Coping With Financially Challenged and Insolvent Customers

COVID-19
April 22, 2020
 

Economic metrics show that the U.S. has entered into a recession (with the potential to become a depression), the global economy has ground to a halt as a result of the rampant global COVID-19 pandemic, and numerous countries are experiencing mass hospitalizations and deaths despite stay-at-home orders. Unfortunately, these circumstances bode ill for the survival of businesses in a broad swath of industries.

Brick-and-mortar retailers, sporting and other entertainment venues, restaurants, lodging, transportation and healthcare providers are struggling to endure this extended shutdown of their physical locations or events and the attendant, unprecedented loss of revenues. Similarly, the oil industry is experiencing negative oil prices per barrel, many manufacturers and other service providers are experiencing significant drops in orders and revenues, and many are struggling to pay their employees, their lenders and other obligations.

Companies that serve as vendors to these struggling businesses are experiencing their own financial challenges. In addition to assessing the credit risk of their buyers and monitoring the amount of receivables, vendors also must be conversant with and employ tactical remedies necessary to maximize the likelihood of receiving payment for goods and services sold.

Payment terms of cash-in-advance or cash-on-delivery would eliminate the risk of nonpayment, but the standard for many industries and sale transactions contemplates credit terms under which a seller begins and often completes performance well before a buyer’s obligation to pay becomes due and owing. In the current pandemic economy, vendors must exercise heightened vigilance and diligence as to the financial condition of their customers or risk suffering losses that might otherwise be avoidable. As an initial matter, upon discovering that a customer to whom goods have been shipped has fallen into insolvency or has filed for bankruptcy, sellers of unpaid goods must understand that taking immediate, informed action to enforce their remedies may result in assuring themselves payment in full.

Sellers of goods must take actions to the extent practicable to qualify as administrative creditors to receive 100% payment on claims in bankruptcy cases and to thus avoid the status of mere general unsecured creditors, junior to claims of secured lenders and on equal footing with other unsecured creditors. Lamentably, in most bankruptcy cases, sellers with mere general unsecured claims recover typically only pennies on the dollar. However, there are steps that sellers may take to avoid the certain losses associated with holding a general unsecured claim and to preserve their ability to claim entitlement to a higher priority and 100% recovery.

Stoppage and Recalling Goods in Transit

Sellers whose goods remain in transit to, and not yet received by, a buyer have game-changing recovery rights, which if timely exercised, would prevent the completion of the sale and the attendant losses associated with a general unsecured claim. Upon discovering a buyer’s insolvency, both state law (the Uniform Commercial Code as enacted by the states) and international law (the United Nations Convention on Contracts for the International Sale of Goods or CISG) enable a seller to stop goods that are in transit before their physical receipt by the buyer. Critically, a seller that knows and exercises this right can reclaim the goods or demand immediate payment or adequate assurance of performance prior to completing the delivery into the physical possession of the buyer.

Once the goods are received by a buyer, the goods are likely covered by a buyer’s secured lender’s blanket liens, and the ability to reclaim those goods may be severely limited. On the discovery of a buyer’s insolvency, regardless of whether it has commenced a bankruptcy case, an astute seller must exercise the right to stop goods in transit and refuse to complete delivery absent receipt from the buyer of satisfactory assurance of payment for those goods. If the buyer has filed a bankruptcy case, a seller may exercise its right to stop goods in transit and proceed to leverage that stoppage to confirm allowance of a 100% administrative expense claim for release of the stopped goods.

Vendor Entitlement to Administrative Expense Priority for Goods Received by a Debtor in the 20 Days Before Bankruptcy and Thereafter

The uninterrupted flow of goods necessary to a buyer’s business operations, be it a retailer’s store merchandise or parts integral to a manufacturer’s continued production of its own goods, has been recognized as critical to a distressed business’s efforts to survive and potentially reorganize. Accordingly, to encourage sellers to continue to do business with a financially distressed company and to not exercise rights to stop goods in transit, the U.S. Bankruptcy Code elevates the priority of claims for goods received by a financially distressed buyer both in the 20 days immediately prior to a bankruptcy filing and thereafter.

For goods received by a debtor after the bankruptcy filing, section 503(b)(1)(A) of the U.S. Bankruptcy Code mandates that “[a]fter notice and a hearing, there shall be allowed administrative expenses,” including “the actual, necessary costs and expenses of preserving the estate.” Such a claim arises when there is a postpetition transaction (one between the debtor-in-possession and the creditor) from which the bankruptcy estate receives a benefit. A seller of goods that are ordered by a debtor after the bankruptcy filing is entitled to payment for those postpetition-ordered goods in the ordinary course as administrative expenses. Similarly, claims for goods under prepetition purchase orders that are delivered into the physical possession of a debtor after the bankruptcy filing are entitled to administrative expense priority treatment under section 503(b)(1)(A) because a debtor’s acceptance and use of those goods in its postpetition operations evidences that those goods were an actual, necessary expense. In fact, it is common that Chapter 11 debtors request that a bankruptcy court enter orders confirming the administrative expense priority of claims for goods received postpetition, even if the orders were placed and shipped prepetition.

For goods received by a debtor in the 20 days immediately prior to the bankruptcy filing, section 503(b)(9) of the U.S. Bankruptcy Code provides that: “[a]fter notice and a hearing, there shall be allowed, administrative expenses . . . including – (9) the value of any goods received by the debtor within 20 days before the date of commencement of a case under this title in which the goods have been sold to the debtor in the ordinary course of such debtor’s business.” In response to a debtor that claimed goods were “received” when title and risk of loss transferred at the time the goods were placed with a shipper in China, the Third Circuit, in In re World Imports, Ltd, determined that goods are not “received” for purposes of section 503(b)(9) until debtors or their agents take physical possession of the goods and rejected the argument that delivery to common carriers qualifies as a debtor’s agents

Read in concert, these two subsections confirm that goods received by debtors within 20 days before, or at any time after, the petition date on account of prepetition orders are entitled to priority as administrative expenses.

A Word of Caution

Notwithstanding the decades-old, common practice of courts confirming administrative expense priority for goods under prepetition orders that are received and accepted by the debtor after the filing date and the clarity of the Third Circuit’s World Imports decision, certain debtors have attempted to argue that the date of title transfer when goods are placed with a common carrier (often when that date is more than 20 days before a bankruptcy filing) is the relevant date for determining when a debtor has received goods. Because of the extended time of shipping from point origin to a debtor’s physical possession, foreign vendors who ship goods from overseas are most likely to get caught in this type of dispute. The best protection for a vendor with goods in transit is threatening to exercise (and if needed exercising) its right to stop those goods prior to physical receipt by the buyer to obtain clarity and certainty from the debtor with respect to the priority of a claim for those goods prior to turning them over to a distressed and insolvent buyer.¹

Still other opportunities may exist in favor of vendors to protect themselves and maximize the likelihood of their obtaining a meaningful recovery from an insolvent buyer. In the Chapter 11 context, this includes seeking treatment as a critical vendor, if appropriate, and timely completing and filing a correct proof of claim. If a vendor finds itself with a large unsecured claim, it should consider serving on an official committee of unsecured creditors, where it can have direct participation in the Chapter 11 case, receive full information about the debtor as it advances its common interests within the collective unsecured creditor body, and benefit without cost to itself from the advice of counsel and financial advisers retained by the committee and paid for by the debtors.

Vendors facing an insolvent buyer may benefit from speaking with their attorney or with one of Calfee's Business Restructuring and Insolvency attorneys in order to protect their interests and maximize their recovery.
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¹Calfee has been litigating, including filing an appeal to the United States District Court for the Southern District of New York, these very issues in the Chapter 11 cases of retailer Sears on behalf of a Hong Kong-based vendor that placed goods with common carriers prior to the bankruptcy case but had those goods delivered in both the 20 days prior to and after the bankruptcy filing. In representing global vendors in the Sears mega Chapter 11 cases (among other bankruptcy cases), Calfee attorneys have been privileged to gain state-of-the-art knowledge and expertise in the legal rights and remedies of vendors of distressed and bankruptcy buyers and have had an active hand in shaping vendor law. Calfee’s Business Restructuring and Insolvency practice group, which includes a former General Counsel to two national retailers, has more than 100 years of collective experience advising clients on bankruptcy and insolvency matters. With this depth of experience and an office in New York City, where many large retail and other major cases are filed, Calfee is uniquely positioned to assist its clients in all aspects of business restructuring and insolvency.


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