Incentive Primer: Award Suppliers and Bankruptcy
July 07, 2008
By Dan Beederman
What do a well known Las Vegas casino, an airline, a national home builder, a leading housewares retailer and a leading furniture showroom share in common? Each of them, like so many other manufacturers, distributors, retailers and individuals, is a victim of our current economic climate, having recently filed for bankruptcy. All too often, bankrupt companies are more than just headlines in the financial news. Rather, they happen to be your customers, your suppliers and, if you are an independent sales representative, your principals (the company whose products you sell). What impact will such a bankruptcy have upon your business? What can you do and not do? Will you be paid and, if so, how much and when? More importantly, is there anything you can do now to prepare for this contingency, so that another’s bankruptcy will not be the cause of your own? Here is a brief summary of some things to consider and, if appropriate, to discuss with your company's legal counsel.
There are no simple answers to these questions, for bankruptcy cases involve many variables and technical legal issues that are controlled by the United States Bankruptcy Code (referred to in this article as the "Code"), which, in turn, is subject to varying judicial interpretation and enforcement by the United States Bankruptcy Courts. Also, the answers to these questions often are dependent on whether the "Debtor" (the person or company that has filed for bankruptcy) has filed a Chapter 7 or Chapter 11 bankruptcy action.
Chapter 7 Proceedings
Generally, under a Chapter 7 proceeding, which is often referred to as a "straight bankruptcy" or "liquidation bankruptcy," the Debtor has ceased its business operation and its assets will be liquidated in an orderly manner under court supervision for the benefit of its creditors. A court-appointed "Trustee" will collect the Debtor's accounts receivable (by filing lawsuits, if necessary) and will sell the Debtor's assets, such as its inventory, equipment and real estate, to the extent that such property is not pledged as security to the Debtor's bank or other "secured" or "lien" creditor. Only after all of the Debtor's assets have been liquidated (and after secured creditors have recovered their property or been paid), will any remaining funds be distributed to the Debtor's unsecured creditors in order of their "priority" as set forth in the Code. Typically, the majority of a Debtor's creditors are unsecured, meaning they do not have liens on or security interests in any of the Debtor’s property. For the most part, unsecured creditors have the lowest priority rights and usually will only receive a proportionate share of what is left after secured creditors and priority claims (such as administrative costs incurred by the Trustee and others) have been paid. Regrettably, that amount often is only a small fraction of what is due, if anything.
Chapter 11 Proceedings
Another type of bankruptcy that companies may file is under Chapter 11 of the Bankruptcy Code, and is referred to as a "reorganization bankruptcy." In a Chapter 11 bankruptcy proceeding, the Debtor (often referred to as the "Debtor in Possession") continues to operate its business in an effort to work out its financial difficulties, with the ultimate goal of proposing a "Plan of Reorganization" under which its creditors will receive more than they would have received under a Chapter 7 liquidation. In this scenario, many of the Debtor's various creditors may very well be asked to continue to sell products or provide services to the Debtor in Possession. Depending on your bargaining position (such as whether your products or services are vital to the success of the Debtor's reorganization), you may have the ability to negotiate payment of amounts that were due and owing prior to the commencement of the bankruptcy proceeding. However, you will need to be careful, because many Chapter 11 proceedings are not successful and ultimately may be converted to a Chapter 7 liquidation. In that event, you could find yourself deeper in the hole for sales made and services rendered to the Debtor while it was trying to reorganize. The best way to avoid that possibility is to limit the amount of credit extended to the Debtor, and to be prepared to terminate the relationship if you are not being paid in a timely manner during the reorganization process.
Reclamation Rights (The Code giveth…)
Immediately upon the filing of a bankruptcy petition, there exists an "automatic stay" which limits the actions that a creditor can take against the Debtor or its property. Absent the Bankruptcy Court's approval, all pending lawsuits and other legal actions, such as those seeking to enforce a judgment order, are "stayed"—meaning put on hold. However, there are exceptions to this. Under Bankruptcy Code Section 546(c), a seller has the right to reclaim goods it sold to a Debtor within 45 days prior to the commencement of the Debtor's bankruptcy case. In other words, a "buy/sell" sales representative, or a manufacturer or distributor has the right to repossess goods it sold and delivered to a Debtor prior to bankruptcy. To do so, a seller must make a written demand for the reclamation of goods not later than 20 days after the commencement of the bankruptcy case. Moreover, each of the following conditions must be satisfied:
• The goods must have been sold to the Debtor in the ordinary course of seller's business.
• The Debtor must have been insolvent when the goods were received.
• The Debtor must have received the goods within the 45 day period prior to the commencement of the bankruptcy case.
• The goods must still be in the Debtor’s possession and identifiable (if not, the seller may be entitled to "priority" treatment of its claim).
It is important to note that you need not wait for a customer's bankruptcy to seek such relief, for a similar remedy is provided to creditors under the Uniform Commercial Code (or UCC) which, with certain variations, has been adopted in every state. Article Two of the UCC codifies commercial transactions and governs the business relationship between a buyer and seller of goods. The UCC provides a seller of goods with a number of statutory remedies, including the right to reclaim goods sold to an insolvent customer.
Under UCC Section 2-702 (while each state has its own version of the UCC, most sections are consistent with each other), if a seller of goods discovers that its customer is insolvent (but may not yet have filed for bankruptcy), it may refuse to deliver goods except for cash and payment of any outstanding balance due for goods previously delivered under contract. A seller also can stop delivery of goods in transit. In addition, if a seller discovers that its customer received goods on credit while insolvent, the seller may reclaim the goods if written demand is made within 10 days following the customer's receipt of such goods. However, this 10 day limitation period will not apply if the customer made a misrepresentation of its solvency within 3 months prior to the delivery of goods to it. Therefore, if you are concerned that a customer is having financial difficulty, make sure to request updated financial statements or credit applications on a regular basis. If it turns out that information is false, you may be able to reclaim goods that are still in the customer's possession months after delivery. Of course, once the customer sells the goods in the ordinary course of its business to a good faith purchaser, all reclamation right as to those goods cease to exist.
Another way that the UCC allows you to avoid or at least minimize the effect of a customer's bankruptcy is through the creation of a “security interest” or lien upon a customer's assets, or, at a minimum, on goods sold to that customer. Typically, a security interest in all of the Debtor's assets, such as its inventory and accounts receivable, is taken by a bank or other entity which finances the Debtor's business operation. However, the UCC allows one who sells goods (referred to in the UCC as a "vendor") to obtain a type of security interest in goods it sells to its customers called a "purchase-money security interest" (a "PMSI"). Under UCC Section 9-324, a PMSI is superior to prior security interests taken in the customer's assets, which otherwise would include goods sold to the customer. While this is a highly technical legal area that requires strict compliance with the applicable UCC sections and should be discussed with your legal counsel, generally, to obtain a PMSI in goods that constitute inventory to the customer, you need to do the following:
• Obtain an agreement with the customer granting you a security interest in the goods sold. This agreement does not need to be a long or involved contract, but can be a provision included in your standard commercial documents.
• The PMSI is created and becomes effective (referred to as being "perfected" in the UCC) when the customer receives possession of the goods.
• File a UCC "Financing Statement" with the Secretary of State in the state where the customer is incorporated.
• Written notice of the PMSI must be sent to all holders of conflicting security interests (meaning you need to notify other creditors who have a pre-existing liens or security interests against the Debtor and its property).
• The notice to other secured or lien creditors must state that you expect to acquire a PMSI in goods you are selling your customer and describe such goods.
• The notice must be received within five years before the customer receives the goods. (This allows the PMSI to cover goods sold on an ongoing basis over a period of time.)
If you comply with all of the legal requirements to create the PMSI, you will have the right to recover goods sold to a customer either before or after the commencement of a bankruptcy proceeding.
Preference Claims (The Code taketh away…)
Perhaps the only thing worse than having a customer or principal file for bankruptcy owing you money, is having to repay amounts you received from a Debtor prior to its bankruptcy. But, under certain circumstances, this can happen. In fact, it happens quite often in bankruptcy cases. A Trustee or the Debtor in Possession has the right to seek to recover "preferential transfers" made within 90 days prior to the date of the Debtor's bankruptcy. The underlying objective for this policy is to create an equality of distribution among the Debtor's unsecured creditors. However, "equality" is the farthest thing from a creditor's mind, when it is sued by a Trustee (in what is called an "Adversary Proceeding") to recover amounts paid by a customer (or a principal) prior to bankruptcy. More likely, a creditor's immediate response is: "I have to give back what?!? I don't feel preferred." Yet, the Code provides that a Trustee can sue to recover amounts a Debtor paid within 90 days prior to filing for bankruptcy, during what is often referred to as the "preference period," if such payments were made on account of "antecedent debt"—that is, for amounts already owed a creditor. Thus, while you may initially have felt lucky to have been paid a long past due receivable just prior to a customer or principal's bankruptcy, all too often you will be required to return all or a portion of such payments months or even years later if the payments are found to be preference payments. Fortunately, not all payments received during the 90-day preference period are the proper subject of preference claims, because the Code does provide certain defenses.
One such defense is showing that the alleged preference payment was made in the "ordinary course of business." This requires evidence that the payment was made and received in a manner consistent with the parties’ prior business relation, provided that those practices were consistent with applicable industry standards. A second defense is showing that you provided "new value," in the form of additional goods sold to the customer (or services to a principal). In such case, you may be able to assert the value of such goods and services as a setoff against a prior preference payment. Still another defense is provided for payments that were received contemporaneously in exchange for goods sold or services provided, such as those paid on a COD basis. It is important to keep these defenses (and there are others) in mind when confronted by a preference claim against your company. While these are but general descriptions of many complex legal issues and corresponding Code sections, it is critical to be aware that such defenses exist and that you have a fighting chance to defeat a preference claim. Put simply: don't capitulate; analyze and assert all of your possible defenses. Your efforts may prompt a negotiated settlement.
Bankruptcy happens. Even your best customer or principal today, may have severe financial problems tomorrow. Therefore, your goal is to be prepared and, if possible, to take immediate action to lessen the impact that another's bankruptcy can have on your business. Whether or not you can reclaim goods or take advantage of other remedies provided under either the Bankruptcy Code or Uniform Commercial Code, perhaps the most important preventative measure is exercising sound fiscal and credit management. Don’t let your customer or principal get too far ahead of you! If necessary, don't be hesitant to reject an order, refuse to provide services or terminate a relationship. Sometimes, just saying "no", may help avoid a looming problem and actually strengthen your company.
Dan Beederman is an attorney in Chicago and a member of Schoenberg, Finkel, Newman & Rosenberg, LLC. For over 25 years, he has specialized in legal issues involving manufacturers' independent sales representatives and has served as legal counsel to numerous sales rep associations in various industries. Contact him at daniel.beederman@sfnr.com.
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