COVID-19 has impacted an already shaky retail industry and pushed some of its participants into a rapid-fire series of bankruptcy filings. Although there was already a long list of prominent retail bankruptcies over the past several years prior to “shelter at home” orders – e.g. Toys “R” Us, Gymboree, Payless (twice), Forever 21, Barneys, Brookstone, Sears, Pier 1 (the list goes on) – it is unlikely that we have ever seen a single month like May 2020.
The following significant retail Chapter 11 cases were filed over a dizzying 23-day period:
- May 4 – J. Crew
- May 7 – Neiman Marcus and Aldo Shoes
- May 10 – Stage Stores (which operates Palais Royal, Beals and Goody’s department stores)
- May 15 – JC Penney
- May 27 – Tuesday Morning
- In June, GNC joined the party by filing Chapter 11 on the 23rd.
And there is reason to think that this is only the beginning. Balance sheets are upside down due to a lack of revenue, and it is unclear how retailers will be able to survive – even as the economy gradually opens with strict safety conditions.
As a result, many of our clients who supply merchandise to these companies and to others that might be future Chapter 11 candidates are asking questions about how they can best protect themselves. In many cases, there is a natural tug of war between the sales department and credit department. The sales department wants to sell as much as possible, even on unsecured credit terms, and the credit department wants to minimize exposure, i.e. lower the risk of non-payment. Usually, the sales department wins, which is why these clients have regularly been providing credit to retailers on 30-60 day unsecured credit terms. However, when the buyer veers closer to Chapter 11 or becomes a Chapter 11 debtor, this natural balancing act shifts toward the credit department.
This blog post discusses three frequently asked questions that arise in supplying customers whose creditworthiness becomes uncertain.
Question #1: Should I continue to ship product if I believe that my customer may soon file a bankruptcy?
Though not as satisfying as a yes or no answer, the correct answer is “it depends.” How important is this particular customer as a buyer? Is it one of the biggest customers? If so, then it is highly unlikely that the seller can afford to stop selling, and unless the seller is also one of the buyer’s biggest suppliers, the seller may not have the leverage to alter credit terms going forward. However, if the customer represents only a small percentage of the business, then the seller may be able to negotiate better credit terms because it can risk losing the sales.
If there is no existing supply agreement among the parties which requires the seller to sell a certain amount to the customer, then the seller is free to reject any purchase order if the buyer will not agree to the seller’s new credit terms. Even if a contract to sell exists or has been formed by the acceptance of a purchase order, if the seller has reasonable grounds to believe that it might not get paid, it can suspend performance under the contract and demand “adequate assurance” of the buyer’s ability to pay. Cal. Comm. Code §2609(1). For instance, the seller can seek payment on a C.O.D. basis, or require a guaranty or other credit enhancements. After the seller provides written notice that it is concerned about payment, the buyer has 30 days to provide such assurance. If it is unable or unwilling to do so, the seller is not required to deliver the product and is not at risk of being in breach of the contract. Cal. Comm. Code §2609(4).
Question # 2: Once my customer has filed Chapter 11, should I continue to ship merchandise, and if so, under what credit terms?
The general rule is that an unpaid pre-bankruptcy debt is entitled to a lower repayment priority than a post-bankruptcy debt. Post-bankruptcy sales are entitled to “administrative priority” status, meaning that payment to the client will have equal or greater priority to most every claim, EXCEPT that of the secured lender, i.e. the customer’s bank. Historically, a post-bankruptcy seller could be confident that it would be paid, even while its pre-bankruptcy claim remained at risk. This is because bankruptcy rules typically require a debtor to remain administratively solvent i.e. that it can pay its debts incurred during the bankruptcy, even if it cannot pay its pre-bankruptcy debts. However, during this recent flurry of retail bankruptcy cases over the past few years, administrative insolvency – the debtor’s inability to pay even these administrative priority claims in full – has unfortunately become a somewhat recurring feature. Toys “R” Us, Forever 21 and Gymboree are examples of this phenomenon.
Therefore, the client should no longer assume that post-bankruptcy sales are going to be paid in full. The client should utilize the same analysis as described above in connection with question #1. Is the customer a critical buyer to the client, or can the client afford to lose the customer?
Question # 3: After a bankruptcy is filed, how do I enhance my ability to get paid on my pre-bankruptcy debt?
In addition to filing a proof of claim for the pre-bankruptcy debt before the court-imposed deadline, there are two avenues for increasing the amount of payment on the pre-bankruptcy claim: (a) becoming a so-called “Critical Vendor" in the bankruptcy case, and (b) asserting a section 503(b)(9) priority claim.
Becoming a critical vendor is essentially a three-step process – and it is almost entirely outside of the seller’s control. If the debtor claims to have great difficulty reorganizing without access to the seller’s product, then the seller may be considered “critical”. Next, the court must authorize the debtor to make payments to critical vendors. And finally, the debtor must pay some or all of the pre-bankruptcy claim in order to induce the seller to continue to ship product post-bankruptcy.
Indeed, payment to critical vendors is conditioned upon a commitment to continue shipping to the debtor, usually on terms that are favorable to the debtor. The seller’s limited role in this process is usually to use whatever leverage it has to push for as large a payment as possible on the pre-bankruptcy debt, asserting that it will not sell further product without a significant payment on pre-bankruptcy debt. In exchange for a sufficiently significant payment on its pre-bankruptcy claim, a supplier will usually be willing to continue to sell product, even on debtor-favorable terms.
Goods which are received by the customer within 20 days of the bankruptcy filing give rise to a section 503(b)(9) administrative priority claim. These sales should be paid ahead of all other pre-bankruptcy claims. Of course, if the case becomes administratively insolvent (as discussed above), even these claims will not be paid in full.
The above analysis discusses three questions that a creditor might have when one of its customers enters or is poised to enter Chapter 11 bankruptcy. For further and case-specific recommendations, it is important to consult with counsel.