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Distressed Vendors: Legal Implications for Business Partners

Assessing and Exercising Contractual Rights and UCC Remediespresents

Today's panel features:

Timothy W. Brink, Partner, DLA Piper, Chicago

Eric S. Prezant, Partner, Bryan Cave, Chicago

Michael J. Viscount, Partner, Fox Rothschild, Atlantic City, N.J.

Wednesday, May 20, 2009

The conference begins at:1 pm Eastern12 pm Central

11 am Mountain10 am Pacific

The audio portion of this conference will be accessible by telephone only. Please refer to the dial in instructions emailed to registrants to access the audio portion of the conference.

A Live 90-Minute Audio Conference with Interactive Q&A

TRADE VENDOR STRATEGIES FOR DEALING WITH A DISTRESSED BUYER

Timothy W. BrinkDLA Piper LLP (US)

203 North LaSalle Street, Suite 1900Chicago, Illinois 60601

(312) [email protected]

May 20, 2009

1

EARLY WARNING SIGNS OF A BUYER’S FINANCIAL DISTRESS

Bounced checks

“Lock box” payment instructions

Payment delays

Management/employee turnover

Lawsuits/liens against buyer

Credit inquiries

Industry rumors

2

STRATEGIES FOR DEALING WITH A DISTRESSED BUYER

Before resorting to contract and commercial law remedies, a trade vendor should consider whether it can obtain:• Price increases

• Accelerated payment terms

• Liens, guarantees, or other credit support

• Standby and commercial letters of credit

• Purchase money security interest

• Credit insurance

3


A trade vendor’s pre-bankruptcy rights generally will be governed by the terms of the parties’ contract and by Article 2 of the Uniform Commercial Code (the “UCC”).

4


Withhold delivery of goodsUnder UCC Section 2-703(2)(a), a trade vendor may withhold delivery of goods until the buyer provides adequate assurance of performance.

5


Stop delivery of goodsEven if the goods already are in transit, under UCC Section 2-703(2)(b), a trade vendor may stop delivery of goods until the buyer provides adequate assurance of performance.

6


Resell goodsUnder UCC Section 2-703(2)(c) and (g), a trade vendor may identify both finished and unfinished goods to the contract, use its reasonable judgment to resell the goods in a commercially reasonable manner, and recover damages from the buyer.

7


Reclaim goodsUnder UCC Section 2-703(2)(d), a trade vendor may reclaim goods from the buyer by demand made within a reasonable time after the trade vendor discovers that payment was not made.

8


Cancel the contract• Under UCC Section 2-703(2)(f), a trade

vendor may cancel the contract by giving the buyer reasonable notice of cancellation.

• Upon cancellation, a trade vendor may pursue its other remedies.

9


Recover damages and lost profitsA trade vendor has a number of damage remedies available to it under UCC Sections 2-703(2)(g) (h), (i), (j) and (l), including the right to recover the difference between the contract price and the resale price of any identified goods sold to third parties.

10

STRATEGIES TO PROTECT AGAINST A POSSIBLE BANKRUPTCY FILING

Limit exposure to preferences• Section 547 of the Bankruptcy Code

generally permits a debtor to avoid and recover certain payments – known as “preferences” – made to creditors within 90 days before its bankruptcy filing.

• To reduce preference exposure, a trade vendor should attempt to maintain payment terms, or move the buyer to C.O.D. or advance payment terms.

11


Reduce potential for fraudulent transfersSection 548 of the Bankruptcy Code generally permits a debtor to avoid and recover certain transfers of property or interests – known as “fraudulent transfers” – made for less than “reasonably equivalent value” during the two-year period before its bankruptcy filing and while the debtor was insolvent.

12


Maximize future setoff rights• Because setoff rights are treated as secured claims

in bankruptcy, a trade vendor may maximize the portion of its claim that will be treated as a secured claim by delaying payments to a distressed buyer.

• This strategy has its limits, however, as a trade vendor cannot acquire claims against the debtor (or incur debt to the debtor) within 90 days of the bankruptcy for the purpose of enhancing its setoff rights.

13

POST-BANKRUPTCY STRATEGIES

Make a reclamation demand• Under Section 546(c) of the Bankruptcy

Code, a trade vendor may demand reclamation of goods that were received by the debtor, in the ordinary course of the trade vendor’s business, within 45 days before the bankruptcy.

• Note, however, that reclamation claims are subject to prior perfected liens on the debtor’s assets.

14


Assert a Section 503(b)(9) administrative expense claim

• Under Section 503(b)(9) of the Bankruptcy Code, added to the Bankruptcy Code in 2005, a trade vendor may assert an administrative expense priority claim for the value of goods that were received by the debtor in the ordinary course of business within 20 days before the bankruptcy.

• Like other administrative claims, a Section 503(b)(9) claim must be paid on confirmation of a plan.

15


File a proof of claim• A trade vendor should file a proof of claim as

soon as possible after the debtor’s bankruptcy filing – even if a bar date has not yet been established.

• Once a proof of claim is filed, the claim is deemed allowed unless a party objects.

16


Seek critical vendor treatmentConsider creditors’ committee membershipPursue contract assumption

17

QUESTIONS?

Stuck in the Middle with You

Dealing with Distressed Suppliers

Presented by:

Eric S. Prezant, Partner Bryan Cave LLP 161 North Clark Street Suite 4300 Chicago, Illinois 60601 (312) 602-5033 [email protected]

2

Introduction• Protecting your business from distressed buyers is

only half of the battle, you must also ensure the continuity of critical supplies.

• Loss of a key supplier of goods or services can be just as devastating as losing a key customer.

• Many businesses find that they are stuck in the middle of a bad situation.

3

“Well I don't know why I came here tonight, I got the feeling that something ain't right, I'm so scared in case I fall off my chair,

And I'm wondering how I'll get down the stairs, Clowns to the left of me,

Jokers to the right, here I am, Stuck in the middle with you.”

-- Stealers Wheel - Stuck in the Middle with You (1972)

4

Early Identification and Action is Key

• Identifying and addressing possible risks early is the legal and business equivalent of eating healthy and exercising -- identifying possible issues late is the legal and business equivalent of triage.

5

The Three Big Questions• If Supplier X were to close its doors, how would it

harm our business?• How immediate would that harm be?• How quickly can we obtain comparable products or

services from another supplier and at what cost?

6

Formulate Your Strategy• Find another supplier (or backup supplier).• Increase inventory of critical supplies.• Obtain financial information from supplier.• Take possession of finished goods or arrange for

third party warehousing.• Purchase raw materials and obtain Article 9 Security

Interest on raw materials, WIP and finished goods.

7

Formulate Your Strategy (continued)

• Lien waivers from tool makers or artisans.• Performance bonds. • Protection of intellectual property and operations-

critical software – escrows for source code.• Clarify ownership issues.

8

Early Warning Signs of Distress

• Unusual shipping delays.• Requests for price increases, reduced credit terms or advance

payments.• Change in components or materials to cheaper grade.• Abrupt change in key management/personnel.• Layoffs.• “News alerts” and industry speculation about company.• Engagement of management consultants.• Supplier’s employees, consultants, accountants, or bank confirming

purchase orders and work flow.• Vendors seeking information or references relating to the supplier.

9

Post-Distress Quagmire (PDQ)• Purely legal remedies are largely ineffective to

protect continuity of supply if your supplier is experiencing severe financial distress.

• Timing constraints and business realities trump most contractual and Uniform Commercial Code (Article 2 of UCC) remedies.

10

PDQ Legal Remedies• Cancel contract and “cover” under Article 2 of the UCC.• Can sue for damages under the contract and under Article 2 of

the UCC – difference between contract price and cover price, plus incidental and consequential damages.

• Specific performance is available only under highly limited circumstances (i.e., unique goods or other proper circumstances) – you may need to file emergency lawsuit.

• Valid liquidated damages under contract.• Other possible contractual remedies.• Can’t get blood from a stone!

11

The Intersection of Law and Business – Creative PDQ

Solutions• Consignment agreements for raw materials, components, or

finished goods. • Consider price increases, prepayments or short term working

capital loans to supplier (need to properly document all of these to mitigate risk).

• Article 9 security interest on goods, M&E and specialty tooling used to make the goods.

• Secure manufacturing rights from third party manufacturer or for your own company.

• Considering purchasing assets/business of the distressed supplier.

12

Pre-Bankruptcy Considerations

• Understand contractual rights and obligations.• Take permitted setoffs against any amounts owed for

goods previously supplied.• Examine title and possession issues.• Assess monetary exposure.• Be realistic about your options and risk to your

business.

13

Pre-Bankruptcy Considerations (continued)

• There is no substitute for a face-to-face meeting.

14

Questions or Discussion Points?

Stuck in the Middle with You

Dealing with Distressed Suppliers

Presented by:

Eric S. Prezant, Partner Bryan Cave LLP 161 North Clark Street Suite 4300 Chicago, Illinois 60601 (312) 602-5033 [email protected]

Fox Rothschild LLPATTORNEYS AT LAW

RIGHTS OF SUPPLIERS IN AN ECONOMIC DOWNTURNby Michael J. Viscount, Jr.

Whether you are a supplier of goods, or an operator trying to manage cash flow and payyour creditors in these times of tight credit throughout the domestic and global economy,understanding the rights of suppliers in bankruptcy and other insolvency situations isimportant for your business. This article will address a number of the basic rights andremedies that suppliers have when operators are unable to pay in a timely manner and resortto filing for bankruptcy or other available relief from the credit crunch. Before getting intothe supplier’s rights and remedies, some bankruptcy basics will be addressed.

I. BANKRUPTCY PRIMERBankruptcy is generally understood as a mechanism by which business operators can seekrelief through the courts from the pressures of day to day stress placed upon the businessby demands of creditors and others to be paid. Bankruptcy is a remedy for “debtors” (thosewho owe money to others called “creditors”), which is governed by a federal law know asthe United States Bankruptcy Code or simply the “Bankruptcy Code.” This law can be foundat 11 U.S.C. §§ 101 et seq. Bankruptcy relief is available in three (3) basic scenarios: (1)those who wish to simply liquidate can do so under Chapter 7 of the Bankruptcy Code, (2)businesses and certain individuals who wish to restructure their debts and try to stay inbusiness can reorganize under Chapter 11 of the Bankruptcy Code and (3) individualswith jobs can restructure and repay their debts over time through a wage earner plan underChapter 13 of the Bankruptcy Code.

The Bankruptcy Code supersedes all other law when it comes to the relationship among adebtor and its creditors. However, the Bankruptcy Code is and must be interpreted andapplied in the context of the broader relationship among parties to commercial transactions.When the Bankruptcy Code is silent regarding an issue, as it often is, the parties must look to“otherwise applicable non-bankruptcy law” for guidance. This means that other state andfederal laws often play major roles in the outcome of matters that are influenced, but notnecessarily determined, by the Bankruptcy Code. In the context of the relationship betweensuppliers and customers in the commercial context, the otherwise applicable non-bankruptcylaw generally consulted is the Uniform Commercial Code of the various states in whichparties transact their business.

II. AUTOMATIC STAYThe basic objective of bankruptcy is to allow the debtor to have some breathing room fora time while the business seeks professional advice to first determine the best and most

appropriate course of action to exit bankruptcy, and then to develop and implement a plan todo just that. The mechanism that allows this breathing room to happen is the automatic stay,which goes into effect immediately upon the filing of a bankruptcy petition without anyfurther action by the Bankruptcy Court.

Typically, in the law, action by a party is not stayed unless a court orders such after specificnotice and an opportunity to be heard is afforded to the affected parties. Not so in bankruptcy.Under § 362(a) of the Bankruptcy Code, once a bankruptcy petition is filed with the Clerk ofthe Bankruptcy Court, no action may be taken by any creditor against the debtor or its assetsto collect on a debt that arose prior in time. There are some limited exceptions that are beyondthe scope of this article, but the general principle stands that once the business operator filesbankruptcy, the suppliers and other creditors must cease all efforts to collect on sums due forgoods and services supplied prior to the time of filing, which is called the filing date. Thereare a number of steps suppliers can take to protect their rights and enhance their prospects toultimately get paid for amounts due for goods and services provided prior to the filing date,or pre petition.

III. SUPPLIER REMEDIESIn all 50 United States, the relationship between sellers and buyers of goods and servicesin the commercial setting is generally governed by the Uniform Commercial Code which iscommonly referred to as the “UCC.” The UCC in one form or another has been adopted byall 50 states. The basic rights and remedies of sellers, including suppliers of goods andservices, and their customers generally can be found in Article 2 of the UCC. The remediesfor suppliers when a customer is bankrupt or otherwise insolvent can be found in Subchapter7 of Article 2. These UCC remedies are recall of goods in transit and reclamation of goodsreceived. The Bankruptcy Code expands on these rights by providing special treatmentfor 20-day claims - sums due for goods and services provided within 20 days prior to abankruptcy filing and by allowing setoff and recoupment against sums due by the supplierto the customer.

Recall of Goods

UCC § 2-705 provides suppliers with the right to stop delivery of goods in the possession of acarrier if he discovers the buyer to be insolvent. This right applies to delivery of all sizes, nomatter how small or large. A second and related right to recall goods in transit under the sameprovision of the UCC allows for the stoppage of the delivery by carload, truckload, planeloador larger shipments in the additional situations where the buyer repudiates or fails to makepayment due before delivery or if for any other reason, the supplier has the right to withholdor reclaim the goods. In either case, the goods must not yet have been received by the


buyer. Thus, once a supplier becomes aware of a buyer’s insolvency, the prudent action is todetermine immediately whether there are goods in transit that one may wish to recall. Recallunder UCC § 2-705 is generally not a violation of the automatic stay for the simple reasonthat the goods have not yet become the property of the debtor/buyer.

Reclamation

UCC § 2-702 provides a supplier with two very important remedies once it is discoveredthat a buyer in receipt of goods is insolvent. The basic remedy is that the supplier may refusedelivery, except for cash, or may stop future delivery altogether. Thus, it is common practicefor suppliers in a bankruptcy setting to refuse to continue providing goods or servicesother than on a C.O.D. basis. This right under UCC § 2-702 also serves as the basis forrenegotiation of trade terms after a bankruptcy filing. The other right provided to suppliersunder UCC § 2-702 is the right to reclaim goods that are already received.

The UCC provides that where a seller discovers that the buyer has received goods on creditwhile insolvent, he may reclaim the goods upon demand made within 10 days after thereceipt. Additionally, if there is a misrepresentation of solvency made to the supplier inwriting within three months before the delivery, the 10-day limitation does not apply at all.The Bankruptcy Code was recently amended to extend this 10-day period to 45 days.Bankruptcy Code § 546(c)(1) expands the reach back to 45 days, and also provides additionaltime - up to 20 days after the filing date - to make a reclamation demand for goods shippedwithin the 45 days prior to the bankruptcy filing.

On its face, it appears that the reclamation benefits under the Bankruptcy Code substantiallyimproved the position of suppliers in the bankruptcy context. However, recent court decisionshighlight a number of very substantial hurdles confronting a supplier seeking to assert theright to reclaim goods already received. In order to recover, the supplier must make a detailedwritten demand within the required time frame, which is 10 days after receipt outside ofbankruptcy and 20 days if the buyer has filed bankruptcy. In addition, the supplier mustbe able to establish that he did not become aware of the insolvency until after receipt of thegoods. This would apply to each particular shipment at issue. Most significantly are a numberof cases recently decided that tend to establish that the right of reclamation is subject to therights of other creditors who have obtained liens on the buyer’s inventory and that extend tothe supplier’s goods upon receipt by the debtor. Essentially, where the supplier has aninventory finance arrangement by a bank or other financial source, the right to reclamationhas proven to be essentially illusory.



20-Day Claims

In 2005, Congress dramatically improved the rights of suppliers by amending the BankruptcyCode with the insertion of § 503(b)(9) to enhance the standing of suppliers with respect tosums due for goods shipped within 20 days prior to the filing of the bankruptcy. Even thoughthe so-called “20-day claims” continue as pre-petition unsecured claims in the bankruptcycase, § 503(b)(9) elevated the status of these unsecured claims and assigned a priority to theseclaims in the bankruptcy payment scheme equal to that of all other administrative claims. Thisspecial claim status is provided with respect to “the value of any goods received by the debtorwithin 20 days before the date of the commencement of a case . . . in which the goods havebeen sold to the debtor in the ordinary course of the debtor’s business.”

The elevated priority for a supplier’s 20-day claims under § 503(b)(9) is certainly a welcomedbenefit. However, the suppliers need to temper the expectations for prompt payment. Courtdecisions since the enactment of § 503(b)(9) have resulted in delays and other roadblocks tothe receipt of timely payment by suppliers with 20-day claims. For example, the priority forpayment matters only if the customer is successful in reorganizing or is liquidating in chapter11. If the customer does not exit from bankruptcy, or is sold and the case converted to achapter 7 liquidation, this benefit may be difficult to realize.

Setoff and Recoupment

Generally speaking, if at the time of the filing of bankruptcy there are mutual debts due byboth supplier and customer to the other, the supplier can offset the amount it owes to thecustomer against what the customer owes to the supplier, thereby relieving the supplier’sobligation the customer to that extent. The operative provision of the Bankruptcy Code is §543(a). Before the supplier can take this step, it must give the customer notice and get thecourt’s permission to act. Failure to get permission from the court is a violation of theautomatic stay.

If the debt of the supplier to the customer does not arise until after the bankruptcy filing, theright of set off under § 543 does not help the supplier, because it applies only to mutual debtswere both arose prior to bankruptcy. However, the supplier whose mutual debt arises postbankruptcy may be able to set off that debt against the money due by the customer using aremedy called “recoupment.” Recoupment is not found in the Bankruptcy Code, but is oneof those “otherwise applicable non-bankruptcy law” concepts that apply in the bankruptcysetting, because it is not prohibited by the Bankruptcy Code. To enforce a right to recoup amutual debt, the law requires that both debts arise out of the same transaction. Recoupment

is a useful remedy for a franchisor or other supplier seeking to avoid payment of rebates andother incentive obligations when continuing to do business with a franchisee-buyer whilein bankruptcy.

Post-Petition Shipments

Contrary to popular belief, there is no guaranty for payment of post bankruptcy extensions ofcredit. Suppliers who ship on credit during the chapter 11 do get paid on a priority basis, overthe suppliers with pre-bankruptcy claims, but there still has to be money to pay and the banks,which are likely providing revolving credit to fund the operations in bankruptcy, generallyhave a super priority claim so that in the event of a post-bankruptcy insolvency, the supplierscould still get stuck. Suppliers are advised to limit the credit balance and watch the paymentcycle closely to make sure they do not get extended beyond normal terms during the courseof the bankruptcy.

V. CONCLUSIONSuppliers of goods are cautioned to exercise diligence in these difficult economic timesfor franchisees and other buyers of their goods on credit. If a customer becomes insolvent,prompt action is required to take advantage of a few basic remedies available to the supplier.By diligently paying attention to trends and patterns of payment, a supplier can stay inposition to take advantage of rights to (1) recall goods in transit not yet received by aninsolvent buyer, (2) reclaim goods received by an insolvent buyer within 10 days of deliveryoutside of bankruptcy and 45 days of delivery to a buyer who has filed bankruptcy, (3) assertan unsecured claim with administrative priority and enhanced prospects for payment onaccount of goods received by an insolvent buyer within 20 days prior to the filing ofbankruptcy, (4) setoff or recoup mutual debts owed to the buyer who has received goods orservices without payment, and (5) stop deliveries altogether or demand COD or other paymentterm modifications when a buyer is found to be insolvent or as a condition for provision ofgoods or services after a bankruptcy is filed.There are issues with all of these remedies and a thorough review of all options withcompetent bankruptcy counsel is recommended before action is taken. Nonetheless, the priceof inaction can be dramatic so the watch word for suppliers is to remain ever diligent indealings with customers in an economically distressed economy.

About the Author Michael J. Viscount, Jr. is a partner in the Atlantic City office of FoxRothschild LLP. He is a commercial lawyer with 27 years of experience representing publicand private businesses and creditors' groups on corporate debt restructuring, workouts,bankruptcies, and other complex commercial matters. Michael can be reached at609.572.2227 or [email protected].



ATLANTIC CITY, NJ phone 609.348.4515 fax 609.348.6834

Let our experience be your guide®

Michael Viscount is a commercial lawyer with extensive experience representingpublic and private businesses and creditors' groups on corporate debt restructuring,workouts, bankruptcies and other complex commercial matters. From manufacturers,suppliers and service providers to public and private funding sources, Michael hasa long track record of developing creative solutions to meet the needs of financiallydistressed companies and creditors.

Michael J. Viscount, Jr., [email protected]

MICHAEL J. VISCOUNT, JR. | FOX ROTHSCHILD LLP | ATLANTIC CITY, NEW JERSEY

IMPLICATIONS OF THE BANKRUPTCYCODE ON VENDOR WORKOUTS

A. Interplay with the UCC. In all 50 of the UnitedStates, the relationship between sellers and buyers ofgoods and services in the commercial setting isgenerally governed by the Uniform Commercial Codewhich is commonly referred to as the “UCC.” TheUCC in one form or another has been adopted by all50 states. The basic rights and remedies of sellers,including suppliers of goods and services, and theircustomers can generally be found in Article 2 of theUCC. The remedies for suppliers when a customer isbankrupt or otherwise insolvent can be found inSubchapter 7 of Article 2. These UCC remedies arerecall of goods in transit and reclamation of goodsreceived.

(1) Recall of Goods. UCC § 2-705 providessuppliers with the right to stop delivery of goodsin the possession of a carrier if he discovers thebuyer to be insolvent. This right applies todelivery of all sizes, no matter how small or large.A second and related right to recall goods intransit under the same provision of the UCCallows for the stoppage of the delivery by carload,truckload, planeload or larger shipments in theadditional situations where the buyer repudiates orfails to make payment due before delivery or if forany other reason the supplier has the right towithhold or reclaim the goods. In either case, thegoods must not yet have been received by thebuyer. Thus, once a supplier becomes aware of abuyer’s insolvency, the prudent action is todetermine immediately whether there are goodsin transit that one may wish to recall. Recallunder UCC § 2-705 is generally not a violationof the automatic stay for the simple reason thatthe goods have not yet become the property ofthe debtor/buyer.

(2) Refusal and Reclamation. UCC § 2-702provides a supplier with two very importantremedies once it is discovered that a buyer inreceipt of goods is insolvent. The basic remedy is

that the supplier may refuse delivery, except forcash, or may stop further delivery altogether.Thus, it is common practice for suppliers in abankruptcy setting to refuse to continue providinggoods or services other than on a C.O.D. basis.This right under UCC § 2-702 also serves as thebasis for renegotiation of trade terms after abankruptcy filing. The other right provided tosuppliers under UCC § 2-702 is the right toreclaim goods that are already received.

The UCC provides that where a seller discoversthat the buyer has received goods on credit whileinsolvent, he may reclaim the goods upon demandmade within 10 days after the receipt.Additionally, if there is a misrepresentation ofsolvency made to the supplier in writing withinthree months before the delivery, the 10-daylimitation does not apply at all.

B. Expansion of UCC Remedies in Bankruptcy. TheBankruptcy Code expands on supplier’s rights underthe UCC by enhancing reclamation remedies, byproviding special treatment for 20 day claims - sumsdue for goods and services provided within 20 daysprior to a bankruptcy filing and by allowing setoff andrecoupment against sums due by the supplier to thecustomer.

(1) Reclamation in Bankruptcy. The BankruptcyCode was recently amended to extend this 10-dayperiod to 45 days. Bankruptcy Code § 546(c)(1)expands the reach back to 45 days, and alsoprovides additional time - up to 20 days after thefiling date - to make a reclamation demand forgoods shipped within the 45 days prior to thebankruptcy filing. On its face, it appears that thereclamation benefits under the Bankruptcy Codesubstantially improved the position of suppliers inthe bankruptcy context. However, recent courtdecisions highlight a number of very substantialhurdles confronting a supplier seeking to assertthe right to reclaim goods already received. In


California Connecticut Delaware Florida Nevada New Jersey New York Pennsylvania

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order to recover, the supplier must make a detailedwritten demand within the required time frame,which is 10 days after receipt outside ofbankruptcy and 20 days if the buyer has filedbankruptcy. In addition, the supplier must be ableto establish that he did not become aware of theinsolvency until after receipt of the goods. Thiswould apply as to each particular shipment atissue. Most significantly are a number of casesrecently decided which tend to establish that theright of reclamation is subject to the rights ofother creditors who have obtained liens on thebuyer’s inventory and which extend to thesupplier’s goods upon receipt by the debtor.Essentially, where the supplier has an inventoryfinance arrangement by a bank or other financialsource, the right to reclamation has proven to beessentially illusory.

(2) 20 Day Claims. In 2005, Congressdramatically improved the rights of suppliers byamending the Bankruptcy Code with theinsertion of § 503(b)(9) to enhance the standingof suppliers with respect to sums due for goodsshipped within 20 days prior to the filing of thebankruptcy. Even though the so-called “20 dayclaims” continue as pre-petition unsecured claimsin the bankruptcy case, § 503(b)(9) elevated thestatus of these unsecured claims and assigned tothese claims a priority in the bankruptcy paymentscheme equal to that of all other administrativeclaims. This special claim status is provided withrespect to “the value of any goods received by thedebtor within 20 days before the date of thecommencement of a case . . . in which the goodshave been sold to the debtor in the ordinarycourse of the debtor’s business.” The elevatedpriority for a supplier’s 20 day claims under §503(b)(9) is certainly a welcomed benefit.However, the suppliers need to temper theexpectations for prompt payment. Courtdecisions since the enactment of § 503(b)(9) haveresulted in delays and other roadblocks to thereceipt of timely payment by suppliers with 20day claims. For example, the priority for paymentmatters only if the customer is successful inreorganizing, or is liquidating in chapter 11. If thecustomer ends up not exiting from bankruptcy, orgets sold and the case gets converted to a chapter7 liquidation, this benefit may be difficult torealize.

(3) Setoff and Recoupment. Generally speaking,if at the time of the filing of bankruptcy there aremutual debts due by both supplier and customerto the other, the supplier can offset the amount itowes to the customer against what the customerowes to the supplier, thereby relieving the

supplier’s obligation to the customer to thatextent. The operative provision of theBankruptcy Code is § 543(a). Before the suppliercan take this step, it must give the customer noticeand get the court’s permission to act. Failure toget permission from the court is a violation of theautomatic stay.

If the debt of the supplier to the customer doesnot arise until after the bankruptcy filing, theright of set off under § 543 does not help thesupplier, because it applies only to mutual debtswere both arose prior to bankruptcy. However,the supplier whose mutual debt arises postbankruptcy may be able to set that debt off againstthe money due by the customer using a remedycalled “recoupment”. Recoupment is not foundin the Bankruptcy Code, but is one of those“otherwise applicable non-bankruptcy law”concepts that apply in the bankruptcy setting,because it is not prohibited by the BankruptcyCode.To enforce a right to recoup a mutual debt,the law requires that both debts arise out of thesame transaction. Recoupment is a useful remedyfor a franchisor or other supplier seeking to avoidpayment of rebates and other incentive obligationswhen continuing to do business with a franchisee-buyer while in bankruptcy.

C. Post Petition Considerations. Once thecustomer/vendee is in Chapter 11, the supplier isimmediately confronted with the dilemma of whetherto continue to supply on credit. This is obviously adifficult decision that is to be made after carefulconsideration of the known risks and potential rewards.The bankruptcy issues center on questions ofadministrative priority, the availability of a criticalvendor’s program, and exposure to preference claims andother avoidance actions available to the Chapter 11debtors.

(1) Administrative Priority. Suppliers who shipon credit during the Chapter 11 case get paid ona priority basis over the suppliers with prebankruptcy claims, under § 503(b)(1) of theBankruptcy Code, which provides for payment ofthe “actual and necessary cost and expenses ofpreserving the estate.” Moreover, in some, but notall, reorganization cases, vendors do better in theshort term, because they often get better terms ofpayment post petition, which shortens the timefor conversion of receivables to cash. However,contrary to popular belief, there is no guaranty forpayment of post bankruptcy extensions of credit.There still has to be money to pay and the banks,which are likely providing revolving credit tofund the operations in bankruptcy, generally havea super-priority claim so that in the event of a



post-bankruptcy insolvency, the suppliers couldstill get stuck. Suppliers are advised to limit thecredit balance and watch the payment cycleclosely to make sure they do not get extendedbeyond normal terms during the course of thebankruptcy.

(2) CriticalVendor Programs. It has becomevogue in recent years for some vendee’s inbankruptcy to seek to induce favorable post-petition trade terms through the application ofwhat is commonly referred to as a critical vendorsprogram. Drawing from pre-code cases under thedoctrine of necessity, some courts allow debtors topay pre-petition obligations of those supplierswith whom the debtor can not operate without.The more common practice lately is for thedebtor to agree to designate a supplier as a criticalvendor and pay open invoices for pre-bankruptcyshipments, if the supplier will extend favorableterms going forward and just continue to ship inthe ordinary course as if nothing had changes.The benefits are obvious and the risks to thesupplier are numerous. Rarely does criticalvendor treatment come without strings attached.The supplier will have to agree not to tightentrade terms, and the debtor will reserve the entirepanoply of debtor’s rights in bankruptcy, includingthe right to recharacterize the payment of pre-petition invoices to payment of post-petitioninvoices under § 503(b), and reservation of allavoidance actions in case the situation developsthat the debtor is not able to reorganize and exitfrom bankruptcy. The so-called critical vendor iswell advised to enter with eyes open and obtainthe assistance of competent counsel before signingoff on any of these programs. The supplier shouldtake no consolation that the critical vendorprogram has been approve by a judge, and alwaysunderstand that the plans are worded to protectthe vendee/debtor not the supplier.

(3) Avoidance Actions/Preference Claims.Suppliers who expose themselves to recapture ofpayments and other transfers made outside of theordinary course of business when dealing inworkout situations with customers who areinsolvent or rendered insolvent by deals madewith creditors in the lead up to bankruptcy.Avoidance actions under Chapter 5 of theBankruptcy Code are available to debtors inpossession, bankruptcy trustees in Chapter 11 andChapter 7 cases, liquating agents under Chapter11 plans and sometimes unsecured creditors’committees, all in the quest to bring back into theestate money and other assets to be redistributedin accordance with the Bankruptcy Code’sdistribution priorities. The most common of

these co-called “strong-arm” threats confrontingsuppliers of goods and services is a “preference”action under § 547 of the Bankruptcy Code,which reads, in pertinent part, as follows (italicsare not in the original text, and are for emphasisonly):

§ 547. Preferences

(a) In this section—

…

(2) "new value" means money or money's worth in goods,services, or new credit, or release by a transferee ofproperty previously transferred to such transferee in atransaction that is neither void nor voidable by thedebtor or the trustee under any applicable law, includingproceeds of such property, but does not include anobligation substituted for an existing obligation;

…

(b) Except as provided in subsections (c) and (i) of thissection, the trustee may avoid any transfer of an interest ofthe debtor in property--

(1) to or for the benefit of a creditor;

(2) for or on account of an antecedent debt owed by thedebtor before such transfer was made;

(3) made while the debtor was insolvent;

(4) made--

(A) on or within 90 days before the date of the filing ofthe petition; or

(B) between 90 days and one year before the date of thefiling of the petition, if such creditor at the time ofsuch transfer was an insider; and

(5) that enables such creditor to receive more than suchcreditor would receive if--

(A) the case were a case under chapter 7 of this title [11USCS §§ 701 et seq.];

(B) the transfer had not been made; and

(C) such creditor received payment of such debt to theextent provided by the provisions of this title [11USCS §§ 101 et seq.].

(c) The trustee may not avoid under this section atransfer--

(1) to the extent that such transfer was--

(A) intended by the debtor and the creditor to orfor whose benefit such transfer was made to be acontemporaneous exchange for new value given to thedebtor; and

(B) in fact a substantially contemporaneousexchange;



(2) to the extent that such transfer was in payment ofa debt incurred by the debtor in the ordinary courseof business or financial affairs of the debtor and thetransferee, and such transfer was--

(A) made in the ordinary course of business orfinancial affairs of the debtor and the transferee; or

(B) made according to ordinary business terms;

(3) that creates a security interest in propertyacquired by the debtor--

(A) to the extent such security interest securesnew value that was--

(i) given at or after the signing of a securityagreement that contains a description ofsuch property as collateral;

(ii) given by or on behalf of the secured partyunder such agreement;

(iii) given to enable the debtor to acquire suchproperty; and

(iv) in fact used by the debtor to acquire suchproperty; and

(B) that is perfected on or before 30 days after thedebtor receives possession of such property;

(4) to or for the benefit of a creditor, to the extentthat, after such transfer, such creditor gave new valueto or for the benefit of the debtor--

(A) not secured by an otherwise unavoidablesecurity interest; and

(B) on account of which new value the debtordid not make an otherwise unavoidabletransfer to or for the benefit of such creditor;

…

(f) For the purposes of this section, the debtor is presumedto have been insolvent on and during the 90 daysimmediately preceding the date of the filing of thepetition.

(g) For the purposes of this section, the trustee hasthe burden of proving the avoidability of atransfer under subsection (b) of this section, andthe creditor or party in interest against whomrecovery or avoidance is sought has the burden ofproving the nonavoidability of a transfer undersubsection (c) of this section.

D. Conclusion. Suppliers of goods and services arecautioned to exercise diligence in these difficulteconomic times for buyers of their goods and serviceson credit. If a customer becomes insolvent, promptaction is required to take advantage of a few basicremedies available to the supplier. By diligently payingattention to trends and patterns of payment, a suppliercan stay in position to take advantage of rights to (1)recall goods in transit not yet received by an insolventbuyer, (2) reclaim goods received by an insolvent buyerwithin 10 days of delivery outside of bankruptcy and45 days of delivery to a buyer who has filed bankruptcy,(3) assert an unsecured claim with administrativepriority and enhanced prospects for payment onaccount of goods received by an insolvent buyer within20 days prior to the filing of bankruptcy, (4) set off orrecoup mutual debts owed to the buyer who hasreceived goods or services without payment, and (5)stop deliveries altogether or demand COD or otherpayment term modifications when a buyer is found tobe insolvent or as a condition for provision of goods orservices after a bankruptcy is filed. There are issuesand risks with all of these remedies and a thoroughreview of all options with competent bankruptcycounsel is recommended before action is taken.Nonetheless, the price of inaction can be dramatic sothe watch word for suppliers is to remain ever diligentin dealings with customers in an economicallydistressed economy.

Attorney Advertisement© 2009 Fox Rothschild LLP.All rights reserved.This publication is intended for general information purposes only. It does not constitute legal advice.The reader should consult withknowledgeable legal counsel to determine how applicable laws apply to specific facts and situations.This publication is based on the most current information at the time it was written.Since it is possible that the laws or other circumstances may have changed since publication,please call us to discuss any action you may be considering as a result of reading this publication.

Michael J. Viscount, Jr.Partner, NJ, [email protected]

Michael Viscount is a commercial lawyer with 27 years ofexperience representing public and private businesses andcreditors' groups on corporate debt restructuring, workouts,bankruptcies, and other complex commercial matters. Frommanufacturers, suppliers, retailers, and service providers topublic and private funding sources, Michael has a long trackrecord of developing creative solutions to meet the needsof financially distressed companies and creditors.


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