When Your Large Customer Files a Chapter 11: Common Supplier Pitfalls
22 Nov 2017
Chapter 11 bankruptcy filings are down anywhere from 60 to 80 percent from the last peak in 2010, but that doesn’t mean there haven’t been some pretty significant cases filed in recent memory. A respectable number of large, publicly held companies in retail, energy and a hodgepodge of other sectors have entered Chapter 11 in the last year or so, bringing with them a commensurate volume of impacted suppliers (or what we call “trade creditors” in the Chapter 11 world).
If your customer has just filed a Chapter 11, and has left you holding the bag on open invoices on Net-30 or other standard terms (i.e., you don’t have the benefit of any purchase money security interests (PMSIs), third-party guarantees or other credit enhancements), your first instinct may be to say “well, this is a bummer, but it’s pretty straightforward: I just need to file a proof of claim for my AR and see what shakes out.” And maybe you have been pressured by the debtor-customer or its law firm under some vaguely articulated legal compulsion to continue to ship new orders on terms without any paydown of your AR balance, go-forward COD/CIA, or any other security/accommodation. Or maybe you’ve heard rumors that Chapter 11s have “critical vendor” programs and there may be some way to petition your way onto it.
Unfortunately, these are all well-travelled paths to suboptimal recoveries and, in many cases, ballooning (and further aging) accounts receivable. Well-travelled paths that are, in many cases, avoidable.
Large Chapter 11 cases typically have enormous trade creditor pools and are well financed, which means that the debtor’s professionals have a substantial budget to implement different types of elaborate procedures (replete with layers of deadlines, forms, special hearing/notice requirements, and other obstacles for creditors to negotiate). These can include intricate rules and protocols for prosecuting reclamation claims, post-bankruptcy “administrative” claims, 20-day priority claims (also called “503(b)(9)” claims), lease and contract assumptions, and objections to various debtor motions. These added complexities are always by design: the more difficult the procedure is for the creditor, the more likely creditors will miss deadlines, balk at retaining bankruptcy counsel, and clear the path for the debtor to get what it wants.
In my experience, suppliers most often face these bureaucratic perils in two areas/scenarios, both of which tend to arise very soon after the bankruptcy filing:
1. Reclamation and 503(b)(9) claims procedures; and
2. Critical vendor programs
Let’s consider these items in that order.
Reclamation and 503(b)(9) Claims Procedures: Layers of Red Tape and Deadlines
The Bankruptcy Code (section 546(c)) preserves the state-law (U.C.C.) rights of sellers of goods to “reclaim” goods shipped to a non-paying customer if they were shipped “within 45 days of” the bankruptcy filing. But this preservation comes with a big caveat: the Bankruptcy Code also recognizes the superior rights of the lenders with a “floating lien” on the debtor/customer’s inventory; i.e., if you “ship into the floating lien,” the debtor’s senior secured lender(s) will have first rights in the goods you are trying to reclaim. But hold that thought for now.
The onus is on you, the trade creditor with unpaid shipments in the 45-day pre-bankruptcy window, to make a timely reclamation demand. If you don’t send a written demand within 20 days after the bankruptcy filing date, you waive your right to reclaim the goods under 546(c).
But many large Chapter 11 debtors make this requirement even more difficult and complicated to meet. Consider the pending Toshiba/Westinghouse case in the Southern District of New York (In re Westinghouse Electric Company LLC), in which the debtors implemented court-ordered “Exclusive and Global Procedures for Treatment of Reclamation Claims” that imposed additional bureaucratic procedures on reclamation vendors well beyond the basic 20-day notice requirement. There are up to five different interim deadlines for claimants to meet, including a requirement that claimants amend or resend their reclamation demand letter if it doesn’t meet a carefully composed four-part list of technical requirements (i.e., it is very difficult for most vendors to comply with these rules without involving bankruptcy counsel).
Large debtors may also impose similar layers of procedures for 503(b)(9) claims. A 503(b)(9) claim (also known as a 20-day claim) is a priority “administrative expense” claim afforded vendors who ship product that is delivered (received by the debtor) in the 20 days prior to the filing date. Since many reclamation claims are negated by the floating lien superiority problem, 503(b)(9) claims are often vendors’ only path to anything approaching 100% recovery on their prepetition open invoices (but bear in mind an “allowed” administrative expense does not mean automatic 100% recovery—some cases are “administratively insolvent” and even “first priority” administrative creditors take a bath!).
The Bankruptcy Code does not specify any particular mode of prosecuting a 503(b)(9) claim and does not impose a deadline for doing so, so the default procedure is to file a motion asking for allowance and payment, with invoices, bills of lading and other evidence of delivery within the 20-day window as backup. But some large debtors implement procedures that deviate from this norm. In some cases, deadlines are established and trade creditors are required to complete forms and/or meet a specific set of criteria for proving delivery and the value of the goods shipped. Debtors may also seek an upfront order permitting “allowance” of 503(b)(9) claims, but also deferring any payment of the claims until a plan of reorganization or other significant liquidity event occurs.
Critical Vendor Programs: A Reality Check
As for critical vendor programs, there are two important things to understand: (i) the Bankruptcy Code does not per se authorize “critical vendor” payments and (ii) there’s no way to force your way on to a critical vendor list.
The Bankruptcy Code generally prohibits post-petition payments on prepetition debt. There is no statutory exception to this rule for vendors who are sole-source or otherwise “critical” to the debtor’s go-forward operations. This is how the concept of a “critical vendor order” was born: it was conceived by creative bankruptcy professionals and theoretically authorized by the vague, catch-all language of Bankruptcy Code section 105(a), which permits bankruptcy courts to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of [the Bankruptcy Code.]”
Over the course of many large cases over many years, some basic ground rules for critical vendor programs have evolved. First, the debtor must demonstrate that whatever vendors they propose to designate as “critical” are, in fact, critical. Senior lenders and official committees of unsecured creditors will scrutinize critical vendor motions to make sure the debtor isn’t squandering its cash on claims that might otherwise receive little or nothing in the way of distributions.
Second, if the debtor is going to pay good money to vendors who hold nothing other than nonpriority unsecured claims, the debtor will need to get something of value in return—something better than CIA or COD terms that will squeeze the debtor’s already constrained liquidity. In other words, you should expect that your participation in a critical vendor program will almost certainly obligate you to extend terms to the debtor going forward—terms that will often be longer or riskier than those you extended prepetition. In
some cases, for example, critical vendors are required to sign a master contract that binds the vendor to ship on buyer-friendly terms for an extended period of time.
Third, there is really no way to petition yourself on to a critical vendor list. There is no motion to file and no coercion to apply, at least as a legal matter. Of course, it is sometimes possible that the debtor has not truly taken stock as to which of its vendors are sole-source or otherwise truly critical (because of lead times or market pricing, etc.), and you may get a late invitation to the list. Caveat vendor!Tags: Business Law, Capital and Finance