ANTICIPATING AND ADDRESSING CUSTOMER FINANCIAL DISTRESS, DEFAULT, AND BANKRUPTCY The financial distress rippling through the economy has roiled the supply chain and left sellers of goods to face the significant business and legal challenges engendered by the financial distress of their traditional customer base. This alert identifies a number of such business and legal challenges. We then suggest a variety of strategies to address such challenges. Identifying Risks. First and foremost, vendors will be well served if they take steps to identify the early warning signs of a customer s financial distress. By being proactive, vendors should be able to take measures to mitigate such risk. Early warning signs of customer financial distress may include: Bounced checks; Frozen bank accounts; Receipt of lock box payment instructions; Increased payment delays; Reduced communication in response to inquiries; Suits by other parties against the counterparty; Employee reductions; Upper management turnover; The hiring of a Chief Restructuring Officer and other advisory professionals; An attempt to obtain better credit terms to aid the party with liquidity issues; Industry rumors; General industry distress likely to impact the counterparty; Sudden attempt to resolve open issues, perhaps as preparation for a refinancing, forced sale, or bankruptcy filing; An unexpected lump-sum payment, as a possible indicator of a possible bankruptcy filing; Public filings concerning adverse financial results or a going concern opinion in a 10-K or 10-Q, etc.; Negative disclosures regarding the finances of a parent or affiliate; and Sale of a profitable division or business to generate cash. Action Items Business and Legal. When a specific customer appears for the first time as a blip on a vendor s financial distress radar screen, such vendor would be well advised to take immediate action to address the situation rather than waiting for the occurrence of a payment or other monetary default. The best practice for the vendor, in our view, is for the responsible 1
officers of such vendor to coordinate an internal response to the nascent problem on the business side and consult with legal counsel knowledgeable in supply chain/vendor issues and creditors rights matters. By doing so, a seller of goods will position itself to identify and evaluate the rights, remedies, and obligations of the buyer and the seller under the existing agreement of the parties and applicable commercial law. Such law may include the Uniform Commercial Code (the UCC ), the statute governing virtually all domestic sales transactions, the laws and rules applicable to cross-border transactions, and where applicable, the Bankruptcy Code. By addressing certain action items with all due deliberate speed, a seller of goods should be able to better position itself vis a vis its increased credit risk. Some of the action items requiring immediate attention include: Identifying the documents that constitute the agreement between the parties, including supply agreements, correspondence, amendments, purchase orders, invoices, shipping documents, and the like; Reviewing the operative documents and focusing on provisions setting forth the rights and remedies available to the parties in case of a counterparty default or other credit event; Evaluating the credit risk; Negotiating and preparing revised contract provisions, including, by way of example, contractual affiliate offset rights, where appropriate; Crafting purchase order protocols; Negotiating security agreements; Identifying potential preference and fraudulent transfer exposure and adopting a strategy to minimize such risk; Preparing guaranties and other documentation providing for enhanced vendor/creditor protections; and Pursuing litigation remedies, if necessary, to protect a vendor s interests. Domestic sellers with foreign operations (for example, in Mexico or Brazil) will have additional issues to consider, including: Reviewing agreements and understanding the rights and remedies of the parties under the applicable foreign law; Determining the legal title to assets, with a focus on assets subject to special customs arrangements (such as bonded maquila operations); and Preparing documents for authentication so they can be produced timely. Remedies and Workout Strategies. The best practice for a vendor facing the challenges posed by a customer s financial distress will be for the vendor to take action on a proactive basis, rather than to wait and react to a payment, volume purchase, or other default that may occur during a 2
crisis. By staying ahead of the default curve and working with legal counsel, a vendor may be able to achieve a consensual agreement or avail itself of the applicable contractual and legal remedies in a thoughtful and deliberate fashion, rather than having to react to a critical event, such as a payment default or bankruptcy filing. The statutory remedies generally available to sellers of goods who are concerned about the financial condition of a buyer, before and after a monetary default, include: Adequate assurance (UCC 2-609) remedies; Anticipatory repudiation (UCC 2-610) remedies; Termination or modification of credit terms; Reclamation; Stoppage of goods in transit; Identification and salvage of goods; Resale of goods; Damages for non-acceptance of goods or repudiation of the contract, including loss of profit; Action for the price of the goods; and Possible cancellation of the contract. If there are discussions between the vendor and its financially distressed customer, either before or after a payment default, the vendor may consider the following forms of credit enhancement: Price increases and accelerated payment terms; Guaranties and other credit support; Payment of legal fees; Reporting requirements; and A purchase money security interest in the goods being sold by the vendor to the customer. Any workout agreement should be reduced to written form in consultation with counsel. A consensual outcome nearly always is preferable when compared to litigation. However, it is important for a vendor to properly understand the risks engendered by a consensual pre- or postdefault workout agreement, as benefits obtained by a vendor through a workout are likely to be subjected to creditor and/or judicial scrutiny or challenge in the event of a bankruptcy filing or similar proceeding. Courts and creditors may focus on issues including: Whether the transaction constitutes a fraudulent conveyance in favor of the vendor; Whether the transaction constitutes a preferential transfer to the vendor; and Whether the transaction constitutes some sort of overreaching or fraud by the vendor. 3
To avoid a subsequent unwinding of a consensual transaction, a vendor should consult with counsel when negotiating the terms of the governing documents. If a buyer is financially unable to make the concessions sought by the vendor, and the exercise of remedies is not a good option, third party credit support for the buyer s obligations to the seller may be the only answer. The concept of third party credit support refers to guaranties and other types of transactions where a third party agrees to be financially responsible for the obligations of the buyer. Forms of third party credit support include: Standby and commercial letters of credit; Performance bonds; Suretyship obligations; Credit insurance; and Guaranties (secured or unsecured). Guaranties may be provided by affiliates (such as a parent or a shareholder) or non-affiliates (such as a bank) of the buyer. Vendors must take care to carefully document any agreement providing for third party credit support to avoid the possible loss of the benefits provided in any such agreement, by virtue of a legal misstep and possible judicial and creditor scrutiny after the fact. Legal issues regarding third party credit support that must be of concern to sellers of goods include: The Statute of Frauds any guaranty must be in writing and signed by the guarantor; Ultra vires does the entity providing the credit support have the authority to do so under its governance documents; Failure of consideration, fraud, or duress; Fraudulent transfers did the guarantor receive fair value or reasonable equivalent value in exchange for a guaranty; Failure to satisfy conditions precedent to enforcement; Alteration of the debt or collateral; and Failure to notify the guarantor of the sale of personal property collateral, as required by the UCC or as otherwise required by the governing documents. Buyer s Bankruptcy. In the event of a bankruptcy filing, sellers of goods will need to consider an array of bankruptcy-specific issues and action items, including: Preparing and filing proofs of claims; Seeking critical vendor status; Focusing on financing and operational issues; 4
Defending preference and/or fraudulent transfer claims; Monitoring the bankruptcy case; Responding to claims objections; Prosecuting administrative, priority, and secured claims where such status is available; Effecting setoff rights; Considering creditor committee participation; Assessing any plan of reorganization or liquidation proposed by or on behalf of the buyer/debtor; and Considering the possibility that the financially distressed buyer may seek to obtain cross-border protection by invoking a reorganization statute in two or more countries. Supply agreements governing the continuing sale of goods generally will be executory contracts under the Bankruptcy Code. (11 U.S.C. 365). As an executory contract, the continuing agreement between the buyer and seller may be assumed or rejected by the customer/debtor during the administration of such customer s bankruptcy case. Assumption means, among other things, that (i) the contract continues in place, (ii) pre-bankruptcy defaults, including payment defaults, must be cured or waived, and (iii) the parties are left to their own devices almost as if there were no bankruptcy case. The foregoing is only a brief summary of this complex area of bankruptcy law. Any seller of goods involved with a buyer that has filed for bankruptcy relief should consult with counsel having the appropriate expertise in bankruptcy law and creditors rights matters. Most bankruptcy courts agree that, after the filing of a bankruptcy case but prior to assumption or rejection of a contract, such contract continues in effect, is binding on the non-debtor party, and the non-debtor party is required to continue providing performance even though the contract is not binding on the debtor during this so called limbo period. Thus, a debtor/buyer in a bankruptcy case often may compel a vendor to continue selling goods notwithstanding the existence of pre-bankruptcy payment defaults. In response to any attempt to compel performance, a seller s counsel should respond by seeking to compel the debtor/customer to demonstrate that (a) the debtor/customer has been and will continue to make timely postbankruptcy payments to the vendor pursuant to the terms of the governing supply contract and (b) the debtor/customer would suffer irreparable harm if the seller fails or refuses to make deliveries. As a corollary, where a seller of goods has a commercially valid reason to be concerned with the ability of a customer to perform and is concerned about a bankruptcy filing by such customer, the seller of goods can demand adequate assurance (UCC 2-609) to secure payment. Sellers often rely on a contract provision purporting to permit such vendor to terminate contracts or 5
modify terms upon the insolvency or bankruptcy of a customer. Unfortunately, such reliance is misplaced because such clauses, referred to as ipso facto bankruptcy default provisions, are not enforceable against a customer/debtor in bankruptcy (11 U.S.C. 365(e)(1)). More Bad Bankruptcy Law News for Sellers. The automatic stay, found in Section 362 of the Bankruptcy Code, prohibits the exercise of creditor remedies upon the filing of a bankruptcy petition by a debtor entity. Thus, absent any exception, a bankruptcy filing enjoins a vendor from protecting itself by pursuing its contract rights and non-bankruptcy law remedies otherwise available to a seller. The seller under a supply contract, unfortunately, can be left in a position where it may have to continue to supply its buyer, and the buyer may have to pay for current shipments, but the seller will be stayed from trying to collect for pre-bankruptcy sales or exercising other remedies normally available to sellers of goods, absent relief from the automatic stay pursuant to a court order. What can a seller do to protect its interests in a Chapter 11 situation where it is the non-debtor party to an executory contract? The seller s To Do List after bankruptcy filing may include the following items: Request an early assumption or rejection; Demand adequate assurance; Consider whether a safe harbor (e.g., 11 U.S.C. 556, forward contracts) may apply that would eliminate the applicability of the automatic stay; Renegotiate; Assert administrative priority status where appropriate (11U.S.C. 502(b)(9)); Assert secured claim status where appropriate; Monitor for assumption, which can occur via motion or through configuration of a plan of reorganization or liquidation; Watch for estoppel notices; and Watch for purported sale of the contract to a third party under Section 363 of the Bankruptcy Code. Conclusion. With the continuing financial distress roiling the markets and customer defaults becoming more and more commonplace, even historically strong vendors are being placed at risk. Vendors hoping to survive the current economic contraction and see the turnaround almost certainly will face the challenge of multiple customer defaults. A proactive and well-counseled seller of goods will be best positioned to survive and then thrive when the economy returns to better health. This client alert is sent for the information of our clients and friends. It is not intended as legal advice or an opinion on specific circumstances and is not intended or written to be used, and may not be used, by any person for the purpose of avoiding penalties that may be imposed under United States federal tax laws. The lawyers at Thompson & Knight LLP are available to assist you in working through any of these topics. Please contact the attorney with whom you regularly work or one of the following attorneys for assistance. 6
CONTACTS: Rhett G. Campbell Corporate Reorganization and Creditor s Rights Practice Leader Houston Office +1.713.653.8660 Rhett.Campbell@tklaw.com Mitchell E. Ayer +1.713.653.8638 Mitchell.Ayer@tklaw.com David M. Bennett Partner, Dallas Office +1.214.969.1486 David.Bennett@tklaw.com John S. Brannon Partner, Dallas Office +1.214.969.1505 John.Brannon@tklaw.com Jorge A. de la Garza Partner, Monterrey Office +1.52.81.8215.7730 Jdelagarza@tklaw.com Henry L. Hardwick +1.713.653.8602 Henry.Hardwick@tklaw.com Ira L. Herman Partner, New York Office +1.212.751.3045 Ira.Herman@tklaw.com Robert B. Jackson Of Counsel, Dallas Office +1.214.969.1199 Robert.Jackson@tklaw.com Robert L. Paddock +1.713.951.5878 Robert.Paddock@tklaw.com Millie Aponte Sall Counsel, Houston Office +1.713.951.5852 Millie.Sall@tklaw.com Carlos R. Valencia Partner, México City Office +52.55.5002.8101 Carlos.Valencia@tklaw.com Bruno Werneck Partner, São Paulo Office +55.11.2504.4245 Bruno.Werneck@tklaw.com Randy W. Williams +1.713.653.8645 Randy.Williams@tklaw.com 7