Always Be Prepared: Forecasting a Business Partner's Financial Problems and How to Prepare

by BakerHostetler
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As the American economy continues to slog through the ongoing Great Recession, even financially sound companies face challenges due to the continued economic malaise. In particular, a company that works with suppliers, customers and other business partners facing financial troubles needs to be prepared to handle the consequences of others' fiscal problems. Being attuned to signs of distress and taking defensive actions early can help strong companies avoid problems and be better positioned in the case of a significant event, such as a business partner filing for bankruptcy. A working knowledge of a handful of key principles, particularly those that apply in bankruptcy, can go far toward effective strategic planning.

STAYING INFORMED

Being aware of a partner's financial problems is a critical first step to a company strategically protecting itself, especially when the partner's problems ultimately lead it into bankruptcy. Closely monitoring relationships with suppliers and customers -- particularly payment patterns from customers -- is essential. A company that has good reason to be concerned that a counterparty will not meet its obligations can employ certain state laws to require the struggling partner to show it has the ability to meet its commitments. Seeking alternative payment terms or security interests can be an opportunity for a financially sound company to better position itself. In addition to staying abreast of news and facts that are readily accessible to a company through both public and internal sources, outside counsel can provide valuable information. Many major law firms subscribe to and monitor data and news services providing information not just on legal developments that affect clients, but also on debt markets, restructurings and bankruptcy filings. These resources can provide vital clues and insights for companies on current conditions and anticipated future developments within their own industries.

SIGNS OF TROUBLE -- HOW TO REACT

After becoming aware of a business partner's financial troubles, a quick and strategic response can put a company in a strong position to protect its rights and interests. Demanding the partner provide assurances it will meet its obligations under an existing contract, shoring up unsecured debts by seeking pledges of collateral and understanding bankruptcy's effects on certain kinds of contracts are just some of the strategies available.

WORKING WITH AN INSOLVENT CUSTOMER OR INSOLVENT SUPPLIER: DEMANDING ADEQUATE ASSURANCES

When a company has a reason to feel insecure that a counterparty to a contract will not meet its obligations under a contract, one of the available options is to require the financially troubled party to demonstrate it will perform and, if it cannot, let the financially sound party terminate the contract early. More specifically, the financially sound party can make a so-called "demand for adequate assurances" under the relevant state's commercial laws adopting the Uniform Commercial Code.

The demand for adequate assurances can only be made under the right circumstances -- when there are "reasonable grounds" to believe the financially troubled party will not perform its obligations under the contract, and when there is an "objective factual basis" to feel insecure. That is to say, if there is an objective basis for concern that a supplier will not provide promised goods or services, or that a customer will not pay its bills, the financially sound company can make a demand for adequate assurances. Courts analyze these situations on a case-by-case basis; no single formula or easy checklist exists to help determine whether the financially sound company meets the requirements to demand assurances. Remember that a demand for adequate assurances is different from a dunning letter -- it's a right allowed by state law and is more than simply a demand to be paid.

If sufficient assurances are not provided, the financially sound company making the demand can deem the contract terminated. However, the demand must be done artfully. Otherwise, the financially sound company making a demand could be deemed to be anticipatorily breaching the very same contract it is trying to enforce.

A demand for adequate assurances, if done properly, can alert a financially sound company whether it can expect to be paid for its goods and services, or if it should end the contract and better allocate its resources. Similarly, forcing a struggling company to address its ability to continue meeting its obligations allows a financially sound partner to look to other sources to ensure its needs are met.

WORKING WITH AN INSOLVENT CUSTOMER OR INSOLVENT SUPPLIER: BANKRUPTCY'S EFFECTS ON CONTRACTS

Understanding the ramifications of a bankruptcy on existing contracts is also important when deciding how to proceed when facing a financially troubled business partner.

Bankruptcy courts will not enforce contract provisions that use bankruptcy as a triggering event. For example, a provision that terminates a contract if one party files for bankruptcy is an unenforceable ipso facto clause under the Bankruptcy Code. Similarly, provisions requiring one party to take certain actions after filing for bankruptcy (e.g., requiring it to continue performing under the contract) are similarly unenforceable. Though many commercial contracts contain these types of clauses, a bankruptcy court will not enforce them, and they should not be relied on to provide security.

Filing for bankruptcy gives debtors the choice to either "assume" or "reject" certain kinds of contracts. An unexpired lease or other kind of contract that is "executory" (i.e., both sides still have unperformed obligations) must be assumed or rejected by the debtor, sometimes within a limited time period. For example, a debtor must assume or reject a non-residential lease within 120 days of the debtor filing for bankruptcy. Assuming a contract means the parties must continue performing under that contract. Rejecting a contract is the equivalent of the debtor opting to stop performing under, and therefore breaching, the contract.

Before a debtor can assume a contract, however, it must remedy any arrearages or defaults and demonstrate it can continue meeting its obligations under the contract. There are also special rules governing executory contracts, including those for intellectual property rights and real property transfers. But beware: certain kinds of executory contracts cannot be assumed at all. For example, neither a contract to make loans or extend debt financing, nor a contract involving personal services may be assumed.

If a contract is rejected, the non-debtor contract party is generally entitled to breach of contract damages. However, it is treated as if the debtor breached the contract immediately before filing for bankruptcy, which leaves the unfortunate creditor with only a general unsecured claim for damages. But be aware that the Bankruptcy Code contains certain statutory limits on damages for rejection of certain executory contracts, including for rejection of an unexpired, non-residential lease of real property and employment contracts.

WORKING WITH AN INSOLVENT COMPANY THAT LICENSES ITS INTELLECTUAL PROPERTY

As mentioned above, special rules in the Bankruptcy Code govern executory contracts involving the use of intellectual property. Specifically, when a company that owns intellectual property (IP) and grants licenses to use that IP files for bankruptcy, the debtor-licensor can reject the license agreement. When that occurs, the licensee has the option of continuing to use the licensed IP (as long as the licensee meets certain obligations) or treating the license as having been terminated. But beware: different rules apply for the license of trademarks. Certain jurisdictions will not allow a trademark licensee to continue using a trademark if the licensor rejects the license.

WORKING WITH AN INSOLVENT CUSTOMER: PREPARING FOR BANKRUPTCY BY BEING A STRATEGICALLY-POSITIONED CREDITOR, EVEN IF AN UNSECURED CREDITOR

Addressing a partner seeking a change in payment terms should be done with an eye towards potential effects in the event of a bankruptcy. Forbearance agreements and restructuring payment terms can and should be done with an understanding of how revised terms will affect the financially sound company's position in a bankruptcy. Positioning a company ahead of other creditors through the proper use of security instruments (e.g., getting a lien on the struggling company's receivables) can help ensure a better outcome in the event of a bankruptcy.

If properly perfected, fully-secured liens generally survive a bankruptcy. An undersecured lien is less valuable, and a creditor holding a lien that is fully unsecured will typically be in the same position as a general unsecured creditor.

Further, caution should be given to obtaining a security interest in the collateral within 90 days of bankruptcy. Under such circumstances, the lien can be avoided by a debtor, leaving the party in the same unsecured position it was before receiving the lien. General unsecured creditors often receive just pennies on the dollar on their claims -- if anything at all -- though an unsecured creditor holding a sizable claim can help steer the course of the bankruptcy through the actions of a committee of unsecured creditors.

In certain chapter 11 bankruptcies, a committee of unsecured creditors will be appointed to represent all unsecured creditors. A creditors' committee is a win-win for unsecured creditors; not only does it allow unsecured creditors to speak with a single voice, but counsel for the committee is paid by the debtor rather than by the creditors themselves.

WORKING WITH AN INSOLVENT CUSTOMER: RECLAIMING GOODS BEFORE AND AFTER BANKRUPTCY FILED

A seller who knows a buyer is insolvent may be able to reclaim goods it supplied while the buyer was insolvent by asserting its right of reclamation under the applicable state's commercial laws adopting the Uniform Commercial Code. In general, the seller can demand return of the items that were sold on credit where the buyer received the goods while it is insolvent. The seller must still have title to the goods, and the demand must be made within 10 days of the buyer receiving the goods. That 10-day window can be expanded if the buyer misrepresents to the seller in writing that it is solvent.

Even though the Bankruptcy Code generally provides that creditors cannot enforce remedies against a debtor once the company is in bankruptcy, there is an exception for creditors who supply the debtor with goods shortly before it files for bankruptcy. A company that sells goods to a buyer that files for bankruptcy may be able to have those goods returned under certain circumstances. This may be a good business decision, as the bankruptcy filing severely jeopardizes the seller's ability to be paid for such goods and may limit the company's overall exposure to the bankrupt buyer. If goods are supplied 45 days before the bankruptcy, are sold in the ordinary course of the seller's business and the buyer received the goods when it was insolvent, the seller can seek reclamation of the goods. The demand for reclamation must be made in writing within 45 days after goods are received by the debtor. While there are exceptions to the right of reclamation, sellers should be aware that this remedy may be available.

WORKING WITH AN INSOLVENT CUSTOMER: AVOIDING "PREFERENTIAL" PAYMENTS

A debtor in bankruptcy can recover so-called "preference payments" -- payments made to creditors 90 days and sometimes up to a year before the bankruptcy filing. Pursuant to Section 547 of the Bankruptcy Code, payments made 90 days before the bankruptcy filing are considered preferential and subject to recovery if certain circumstances, such as existing debt and insolvency, exist. Payments made a full year in advance to the debtor's "insiders" -- a term of art -- may also be considered preferences that can be recovered by the debtor. The recipient can raise a variety of defenses in order to retain those payments, including that they were made in the "ordinary course of business." Other defenses include the creditor holding a security interest in the debtor's property, if the payment was part of a "contemporaneous exchange," and the creditor giving "new value" (e.g. new goods shipped on credit) to the debtor after the alleged preferential payment is received by the creditor.

Any unilateral change in the manner or pattern of payment -- late payments, a change in amount or the method of payment -- is a sign that should not be ignored. Indeed, it is these patterns that bankruptcy courts examine when deciding whether a payment is made in the ordinary course of business between the parties. Courts in different jurisdictions use somewhat different standards to make this determination. Some look at the entire payment history of the parties and compare it to how payments were made during the "preference period" (that is, 90 days before the bankruptcy filing) to determine if the pattern changed from the pre-preference period to the preference period. Other courts may only look to the year or two prior to the preference period to determine whether payments were received in the ordinary course of business. In short, monitoring payment trends can help a creditor protect those payments in the future.

Additional efforts to more aggressively collect bills can take payments outside the ordinary course of business. For example, sending dunning letters, or even emails and phone calls that are not routinely made, can support an argument that payments were made outside the ordinary course. This potential must be weighed against seeking adequate assurances as discussed above. Taking a strategic approach to collecting overdue debts can go a long way towards helping creditors keep payments received during the preference period.

WORKING WITH AN INSOLVENT CUSTOMER: AVOIDING "CONSTRUCTIVELY FRAUDULENT" PAYMENTS

A debtor can also recover payments that are "constructively fraudulent" if it did not receive something of equivalent value in exchange for the payments. A debtor can use the Bankruptcy Code's fraudulent conveyance provisions or applicable state fraudulent conveyance laws to recover such payments. The "look back" period for fraudulent transfers is two years under the Bankruptcy Code and varies under state law; for example, California has a four-year look back period and New York has a six-year period. Companies supplying goods or services to financially troubled customers should keep a close watch on the identity of the party actually paying bills and invoices, especially when dealing with large, multi-tiered corporations.

Receiving a payment from a corporate entity that does not exactly match the company that entered into the agreement, or that is receiving the goods or services, can result in a fraudulent transfer claim by a debtor many years after the payment was made. For example, some debtors have recently been employing creative arguments that payments made by a parent holding company on behalf of a wholly-owned subsidiary -- particularly through the use of a centralized cash management system -- are "constructively fraudulent" and must be returned because the parent holding company did not directly receive anything of value for the payment. Ensuring payments are received from the entity directly receiving the goods or services, or that is contractually obligated to pay for them, can help avoid headaches in the future.

TAKE-AWAY

Continued economic distress can mean continued headaches for companies seeking to navigate an ever-changing business landscape. After detecting signs of trouble, companies are well-advised to consult with counsel to best position themselves and protect their rights. But simply being aware of potential problems and having a basic understanding of the framework of possible options can go a long way to being prepared.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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