Download Controlling Your Destiny - Protecting Your Interests From

CONTROLLING YOUR DESTINY-PROTECTING YOUR INTERESTS FROM
DEMANDING DEBTORS
BY: SCHUYLER G. CARROLL &
JEFFREY N. ROTHLEDER
Abstract
It has become common for chapter 11 debtors to demand that creditors continue to supply them
with goods on agreed upon credit terms after the filing of their bankruptcy cases. This demand
places a creditor in a precarious position because the debtor can usually provide no significant
assurance that it will be able to pay for the goods. Indeed, creditors are often left with
substantial administrative claims that are either not satisfied or are satisfied only upon the
effectuation of a plan of reorganization, which can be months if not years after the goods are
shipped. Congress attempted to rectify this troubling situation in the 2005 amendments to the
Bankruptcy Code; however, courts interpreting the added section 503(b)(9) have decided that
creditors must still wait for payment through a plan of reorganization because Congress did not
provide a deadline by which a debtor must satisfy this allowed administrative claim. Thus,
creditors face the dilemma – do they succumb to the debtor’s demand and risk receiving no
payment or significantly delayed payment or do they sever the relationship. Of course, severing
the relationship may not be so simple either as debtors may threaten to sue for breach of
contract or for violation of the automatic stay. This article, through the hypothetical situation
below, provides the credit professional with an understanding of the issues involved and
potential strategies for dealing with demanding debtors.
Acme and Build-It – A Detrimental Relationship
Acme, Inc. manufactures furniture and sells its product to a variety of companies. One of the
companies that Acme supplies is Build-It-Yourself Furniture, Inc., a chain of low-priced
furniture stores catering to the college market. Acme sells its lowest quality product to Build-It,
which adds a mark-up above the cost and sells to its customers. The products sold to Build-It are
made to Build-It’s specific requirements. As low as this quality is, Acme has few other
customers for these products.
Build-It has been experiencing financial difficulty due to its reputation for selling low-quality
products and poor customer service. Recently, Build-It closed 50 of its 200 national stores and
rumors in the industry say it is seeking to sell at least half of the remaining stores. Build-It,
however, believes that it can successfully continue operations selling Acme products with minor
modifications to its business plan. In order to accomplish this turnaround, Build-It files a
voluntary chapter 11 petition.
After filing for chapter 11, Build-It requests, in fact demands, that Acme continue selling its
products to Build-It. Worse yet, Build-It demands that Acme continue providing credit on the
same terms as it did prior to the bankruptcy filing. Acme is reluctant for several reasons. First,
Build-It is in arrears in paying Acme for amounts due from prior shipments. Acme is presently
owed approximately $2,000,000 from Build-It. Second, Acme has had several disagreements
with Build-It’s current management and has no confidence that Build-It can successfully
complete its ambitious turnaround plans. Acme, concerned about Build-It’s ability to pay, does
not wish to continue providing its products or credit. Essentially, Acme is concerned about
providing further shipments of its products when it is unsure Build-It will be able to make the
required payments or pay the outstanding amounts due. Acme is not even comfortable continuing
doing business with Build-It on a C.O.D. basis since doing so requires Acme to produce
identifiable goods long before receiving payment and, of course, there is the risk of whether
Acme will even get paid. Thus, even C.O.D. terms leave Acme in the position of having
expended the full cost of production and shipment before receiving payment and without any
certainty of payment. This is a particular concern for Acme in this situation because Acme has
few other customers that it can sell these goods to. The question becomes what are Acme’s
options in light of Build-It’s demand for continued delivery of its products. Acme’s options are
discussed in this article.
Reclaiming Shipped Goods
Acme may wish to completely sever ties with Build-It and attempt to reclaim the products which
were recently shipped despite the demand for continued deliveries. Section 546(c) of the
Bankruptcy Code grants a creditor, such as Acme, the right, known as reclamation, to obtain the
return of goods shipped to a debtor within 45 days of the petition date under certain
circumstances. The creditor must (i) demonstrate that the buyer was insolvent when the goods
were received, (ii) make a timely written demand for the goods, and (iii) send that demand within
45 days of the debtor’s receipt of the goods. In addition, the creditor may only recover the goods
which the debtor has in its possession when the demand is made. If Acme were able to demand
Build-It’s return of goods prior to the petition date, Acme may be able to remove the majority of
its goods from Build-It’s possession. There are several defenses to reclamation that limit the
usefulness of this remedy. These defenses are not discussed in more detail, but are addressed in a
prior article. See Reclamation Rights in Bankruptcy: What Every Credit Manager Needs to
Know, The Credit and Financial Management Review; first quarter, 2007 (Vol. 13, No. 1).
Even if Acme can overcome Build-It’s defenses to reclamation, it will not solve all of Acme’s
problems because reclamation only relates to shipments that pre-date the petition date. Moreover,
if Build-It disposes of any of the goods before receipt of the written demand from Acme, Acme
will not be able to reclaim those goods. Nor does reclamation require Build-It to pay for any
products. Rather, reclamation only relates to recovery of goods. Therefore, Acme may receive its
product back but may still not be able to re-sell or otherwise use that product in its business
operations and, thus, lose most or all the costs associated with those goods. Thus, reclamation
often has limited utility to a creditor.
Taking Advantage of the New Administrative Priority
Acme may be able to minimize its loss as a result of recent amendments to the Bankruptcy Code.
In 2005, Congress added section 503(b)(9). Essentially, this section of the Bankruptcy Code
grants a creditor, like Acme, a priority claim for those goods sold to and received by a debtor
within 20 days of the petition date, as long as they are sold in the ordinary course of business.
This section, however, does not provide a deadline for Build-It to make payment to Acme.
Indeed, Acme could be required to wait for confirmation and effectuation of a plan of
reorganization before actually receiving payment. This may mean waiting several months, if not
years, after the date of shipment. Moreover, if a plan is never confirmed, Acme may never
receive payment despite having an allowed administrative priority claim.
Recently, a creditor in Acme’s position tried to compel a debtor to pay a similar administrative
priority claim before waiting for confirmation of a plan and the United States Bankruptcy Court
in Delaware denied the creditor’s request. In this case, In re Global Home Products LLC, the
Court stated that the creditor’s administrative claim would be paid on the effective date of a plan
of reorganization but did not have to be paid before. The Court reasoned that the debtor could not
be compelled to make such a payment because the budget approved in connection with the
debtor-in-possession financing did not provide for payment of such administrative claims and the
Court stated the statute does not specify a time for payment to a creditor. Thus, Acme must wait
until Build-It confirms a plan of reorganization and accept the treatment provided therein for its
allowed administrative claim. As a result, rights of trade creditors, such as Acme, under this
section of the Bankruptcy Code are severely limited despite Congress’ attempt to provide them
additional rights. Accordingly, Acme must look to other means to protect itself and assure
payment when Build-It demands delivery of goods.
Negotiating with the DIP Lender
Some courts have suggested that creditors in Acme’s position may protect themselves by
negotiating a carve-out with the lender providing the debtor-in-possession financing (the “DIP
Lender”), similar to the type of carve-out which debtor’s professionals usually negotiate in such
financing arrangements. If Acme can do so, it would be able to negate the reasoning set forth in
the Global Homes decision by having its administrative expense claim agreed to and provided
for in the budget associated with the court-approved financing. Moreover, if this claim was
provided for in Build-It’s court-approved DIP or cash collateral budget, Build-It would have no
justifiable reason for delaying payment to Acme. As a result, Acme would not be forced to wait
until the end of the case before it can be paid.
One might ask how could Acme negotiate such a carve-out given that a DIP Lender usually
wields substantial leverage over debtors and trade creditors. Acme could accomplish its goal if
its goods were so essential to the debtor’s operations that without them the debtor would have no
possibility for reorganization. This might be the case if Acme was Build-It’s sole source of
products. Advancing this argument, however, could be detrimental to a creditor’s reclamation
claim because Build-It would assert these goods are required for continued operations. If Acme
pursues this argument, it could be successful as a DIP Lender generally does not wish to see the
case fail if it becomes unlikely that the DIP Lender will get repaid. Thus, if Build-It cannot
reorganize without Acme’s furniture, the DIP Lender might agree to a carve-out to ensure that
Acme receives payment for goods shipped post-petition, and Acme will have obtained protection
for goods demanded by Build-It.
Strength in Numbers – Forming a Committee
If the DIP Lender does not agree to a carve-out for Acme, Acme may consider contacting other
trade creditors and forming a committee under section 1102 of the Bankruptcy Code. If many
creditors band together and form such a committee, they can increase their negotiating power
over the debtor and DIP Lender. In addition, creditors can limit their costs in teaming up and
joining together under certain circumstances. Indeed, the costs may be entirely borne by the
debtor if the creditors are successful in persuading the United States Trustee that the committee
represents an interest so vital to the conduct of the case which is not otherwise represented that it
deserves recognition as an official committee. To a lesser extent, creditors may also obtain
similar benefit by serving on the Official Committee of Unsecured Creditors. Acme and the other
trade creditors can increase their collective role in the case and have a greater ability to protect
their interests and those of similarly situated creditors. Moreover, if a committee is formed, the
creditors can exercise the rights granted under section 1103 of the Bankruptcy Code, which
include investigating the financial condition of Build-It and the conduct of its officers and
directors. Such investigations can result in the pursuit of causes of action such as breach of
fiduciary duty claims and other similar claims against Build-It and its principals. Having the
ability to pursue these claims can provide Acme and its fellow committee members with
significant leverage from which to negotiate payment terms or other concessions from Build-It in
exchange for the continued supply of goods.
Looking Forward, Early Protection
One point about the importance of early planning: constant diligence and monitoring of your
customer should be made here. If Acme were able to address Build-It’s rising delinquencies
early on, i.e. before the chapter 11 filing, Acme may be able to negotiate changes in credit terms
or other protections that would provide benefit to Acme. First, Acme could have limits on its
credit exposure at the time of Build-It’s chapter 11 filing. Second, Acme might still be able to
require that Build-It post a letter of credit to guaranty payment to Acme should Build-It fail to
make timely payment. The letter of credit would be drawn-down should Build-It fail to pay,
which can be accomplished regardless of Build-It’s chapter 11 petition. Case law has determined
that letters of credit are not property of a debtor’s bankruptcy estate. Even though the Bankruptcy
Code provides that almost every type of property is included in what the debtor owns, courts
have held that a debtor does not have any interest in a letter of credit. Therefore, if Acme has the
foresight to require Build-It to post a letter of credit in the amount equal to the requested
shipment or even a greater amount to cover future payments, Acme’s payment on that shipment
would be guaranteed by drawing-down the letter of credit. Another potential avenue that could
be pursued by Acme would be to demand a security interest in the goods being shipped and,
thus, elevating itself and the priority of its claim for those goods.
Dealing with Demanding Debtors
Absent these protections, however, after a chapter 11 filing, Acme may not be protected against
Build-It’s demand for continued shipments and Acme’s concerns regarding payment. If Acme
provided its goods on an individual purchase order basis, Acme can simply refuse to continue to
provide goods because it has no on-going contractual obligation to do so. In this instance, if,
prior to the petition date, Acme understood the financial dangers in Build-It’s business plan and
determined that Build-It was not a financially sound company, Acme could proceed to do
business with it but should refrain from entering into a long-term multi-sale contract so that
Acme would maintain control of the relationship and be able to refuse Build-It’s demand for
additional goods without serious risk of legal ramifications. If Acme did enter into a blanket or
long-term purchase sales contract, before the filing of the petition, Acme could be compelled to
perform under that contract by the debtor. Acme would be placing itself at great risk as the
debtor could continue to compel Acme to perform under that contract. Build-It, however, would
assume very little risk as it could continue to demand and receive goods under that contract but
not satisfy its obligations thereunder. Ultimately, Build-It may reject the contract under section
365 of the Bankruptcy Code. Acme would have the administrative expense claim, as discussed
above, plus an unsecured claim for rejection of the contract and the pre-petition amounts owed
but most likely would only receive a fraction of those amounts. This situation would leave Acme
in the same situation as described above that is, relying on payment of its claims upon the
effectuation of a plan of reorganization.
Aggressively Protecting Your Interests
In order to mitigate this possibility, Acme could decline to enter into a long-term contract but
could only operate on a purchase order or C.O.D. basis. A better alternative would be to be paid
in advance of shipment or even in advance of producing the goods. Unfortunately, however, it is
rare that it is possible to obtain either of these protections. In the typical case where cash in
advance is not possible, it would be difficult for Build-It to compel Acme to continue to provide
goods on credit to Build-It, if the relationship is one of only individual purchase orders, without
any long term contract. If there is a long term contract, however, and the Debtor seeks to compel
Acme to provide goods on credit, Acme might seek a temporary restraining order preventing
Build-It from demanding shipment or denying Acme’s reclamation claim because of the history
of non-payment and Acme’s well-founded fear that non-payment will re-occur. This option also
is not without risk. Succeeding in obtaining a temporary restraining order is often difficult as
Acme would need to demonstrate to a court, among other things, that it would likely be
successful in proceeding against Build-It.
Recently, the United States Bankruptcy Court for the District of Delaware in In re Advanced
Marketing Services, Inc., denied a creditor’s motion for a temporary restraining order because
the creditor could not establish it would likely succeed on its underlying reclamation claim since
the goods were subject to the lien of the debtor’s pre-petition and post-petition lender. This court
also denied the creditor’s request for a temporary restraining order because it found that the
creditor could not establish that it would be irreparably harmed because the harm done to the
creditor can be remedied by monetary compensation. While the Advanced Marketing case dealt
with a creditor attempting to reclaim its goods, Acme would face similar difficulties in
attempting to block Build-It’s attempts to compel delivery. A court could find that, absent a
significant breach of contract by Build-It or Build-It’s failure to pay amounts owed to Acme
would cause irreparable harm thereto, Acme could be awarded monetary compensation, i.e. a
claim in Build-It’s bankruptcy case and denied the motion for temporary restraining order. Thus,
attempting to seek a temporary restraining order is a difficult (and probably very expensive)
route.
Conversion or Dismissal – The Final Option
Since many of the above individual remedies likely will leave Acme leery of providing goods
demanded by Build-It, Acme could seek to convert or dismiss the chapter 11 case. This is a lastresort option as conversion or dismissal is extremely difficult to obtain absent other facts,
especially in the early stages of a chapter 11 case. Section 1112 provides grounds under which
Acme could move to dismiss or convert the case. Those grounds include, but are not limited to,
establishing that the debtor has no possibility for reorganization or rehabilitation within a
reasonable time or a continuing loss detrimental to creditors. To proceed under this ground,
Acme would need to establish that Build-It does not have sufficient liquidity to continue to
operate and cannot continue to operate profitably. Essentially, Acme would need to show that
Build-It cannot succeed and would not be able to pay for post-petition shipments.
Conversion or dismissal, however, comes with risk. First, it is often unsuccessful in the early
stages of a chapter 11 case because courts tend to give a debtor the benefit of the doubt,
especially when the debtor is within its exclusivity period, the first 120 days after the petition
date. In addition, if the case is converted, a trustee will be appointed increasing the
administrative costs to the estate and potentially lowering the amount ultimately distributed to
unsecured creditors, such as Acme. The threat of conversion, however, could spur negotiations
between all parties, and Acme may be able to protect its interests and avoid Build-It’s demand
for goods.
Conclusion
In the end, Acme and creditors in similar situations have numerous options for dealing with
demanding debtors, such as Build-It. Often, however, the option may not ultimately provide real
protection. Acme’s options include (i) avoiding long-term sales agreements and transacting
business on a purchase-order basis or C.O.D. basis; (ii) demanding that Build-It post letters of
credit so that if financial difficulties do arise, Acme can receive payment therefrom and avoid the
uncertainty of the bankruptcy process; (iii) seek to negotiate terms with a DIP financing lender or
the debtor’s existing secured creditors to carve-out payments for essential trade creditors and
have the budgets with those carve-outs approved by the bankruptcy court; (iv) seek the formation
of a trade creditor committee to increase negotiating powers; and (v) if all else fails, seek the
conversion or dismissal of the chapter 11 case. All of these options are subject to their own risks
and rewards and are very dependant on the specific facts of each case and the relationships
between the parties; however, in particular instances they provide creditors with the ability to
control their own destiny and not to rely on a debtor to protect their interests.
Schuyler G. Carroll is a partner in the Financial Restructuring and Bankruptcy Practice
Group in the New York office of Arent Fox. Schuyler most often represents creditors and
creditors committees in Chapter 11 cases, focusing on complex restructuring, transactional,
litigation and advisory work. Schuyler was recently ranked first for unsecured creditors’
lawyers and as the top legal advisor to trustees or examiners. He has represented a wide
variety of debtors, creditor committees, creditors, bondholders, indenture trustees, trustees,
landlords, investors and purchasers in Chapter 11 and 7 bankruptcy proceedings, out of court
workouts and non-judicial reorganizations and restructurings in such industries as financial
services, real estate, health care, manufacturing e-commerce, technology and
telecommunication and resort, hotel and hospitality. Schuyler is a 1992 graduate cum laude
of St. John’s University School of Law.
Jeffrey N. Rothleder is an associate in the Financial Restructuring and Bankruptcy Practice
Group in the Washington, DC office of Arent Fox. Jeffrey’s practice focuses on financial
restructuring and workout proceedings on behalf of financially distressed companies or their
creditors, including the representation of debtors, creditors, creditor committees, investors and
purchasers in in-court and out-of-court restructurings. Jeffrey is a 2002 graduate of the
University of Maryland School of Law where he graduated with honors and was elected to the
Order of the Coif. After graduation, Jeffrey served as judicial law clerk for the Honorable
Duncan W. Keir, Chief Judge of the United States Bankruptcy Court for the District of
Maryland.
Arent Fox (www.arentfox.com) – a full-service law firm with offices in Washington, New York
and Los Angeles – is a recognized leader in areas including intellectual property, real estate,
health care, life sciences and litigation. With more than 300 lawyers, Arent Fox has
significant experience in corporate securities and transactions, financial restructuring and
bankruptcy, government relations and regulation, labor and employment, finance, tax,
corporate compliance and the global business market. The firm provides services to Fortune
500 companies, government agencies, trade associations, foreign governments, long-term care
facilities, start-up companies and other entities.