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November 27, 2017

 

By: Erin N. Brady & James M. Gross

The impending bankruptcy of a retailer is one of the most stressful experiences that a supplier may face. The supplier is confronted not only with the potential loss of a major customer, but also with the possibility of significant financial losses on account of unpaid accounts receivable. A supplier often finds itself scrambling to mitigate its exposure. The logistics around this can be confusing. For instance, does a supplier have the right to suspend shipments of goods due under a contract if it believes the retailer may be unable to pay for those goods? Likewise, can a supplier stop shipments of goods already in transit to the retailer, but which have not yet been delivered? And if the goods are delivered without payment, can the supplier somehow recover those goods—or the value of those goods—if the retailer ultimately files for bankruptcy?

Fortunately, many states have adopted provisions of the Uniform Commercial Code (UCC) that provide options to suppliers dealing with these complex issues. Two of these provisions are particularly useful to suppliers when faced with the potential bankruptcy of a significant customer: the right to demand adequate assurance from the distressed retailer (UCC Section 2-609) and the right to withhold delivery due to insolvency (UCC Section 2-702). Additionally, Sections 546(c), 503(b)(9) and 553(a) of the Bankruptcy Code may also afford additional rights and remedies if a retailer does ultimately file for bankruptcy. While these statutes do not completely immunize suppliers from risk, they do afford suppliers with tools which, if exercised promptly and correctly, can go a long way in mitigating financial losses.

The Right to Demand Adequate Assurance and Suspend Delivery

Upon learning of a retailer’s financial distress, the first step that any supplier should take is to demand adequate assurance of performance under the parties’ existing contract, and to suspend performance of its contractual obligations until such assurance is received. UCC Section 2-609 permits a seller to suspend performance due under a contract temporarily where the seller has an objective belief that the buyer cannot fulfill its contractual obligations. Specifically, UCC Section 2609(1) provides that “[w]hen reasonable grounds for insecurity arise with respect to . . . performance [by the buyer] . . . the [supplier] may in writing demand adequate assurance of due performance and until he receives such assurance may if commercially reasonable suspend any performance for which he has not already received the agreed return.” If a retailer then fails to provide such assurance “within a reasonable time not exceeding thirty days,” the retailer is deemed to be in “repudiation of the contract,” such that the supplier is no longer obligated to perform. UCC Section 2-609(4).

Importantly, a supplier can demand adequate assurance even where it is uncertain whether the retailer will ultimately file for bankruptcy; only a “reasonable grounds for insecurity” is necessary. This standard is a flexible one, as “what constitutes reasonable grounds for insecurity . . . is determined according to commercial standards.” UCC Section 2-609(2). That said, “[t]o find a reasonable ground of insecurity, ‘there must be an objective factual basis for the insecurity, rather than a purely subjective fear that the party will not perform.’” Koursa, Inc. v. Manroland, Inc., 971 F. Supp. 2d 765, 789 (N.D. Ill. 2013) (quoting Puget Sound Energy, Inc. v. Pac. Gas & Elec. Co., 271 B.R. 626, 640 (N.D. Cal. 2002)). Thus, while the specific events that give rise to “reasonable grounds for insecurity” may vary from industry to industry, at a minimum, a supplier’s right to demand adequate assurance may be appropriate when a supplier has actual or market-based knowledge that a retailer is in significant financial distress.

To invoke UCC Section 2-609, the supplier must make the demand for adequate assurance in writing. UCC Section 2-609(1). While this written demand need not be lengthy, it must be sufficiently clear to ensure that “all parties are aware that, absent assurances, the demanding party will withhold performance.” Koursa, Inc., 971 F. Supp. at 792. At least one court has held that “[t]o invoke UCC Section 2-609, a party’s written communication must ‘mention 2-609 of the code or demand assurances.’” Id. (quoting Canteen Corp. v. Former Foods, Inc., 238 Ill. App. 3d 167 (1992)). Thus, when making a demand for adequate assurance to a retailer, the supplier should make its demand in writing and explicitly invoke UCC Section 2-609 (or its state law equivalent).

Once a concerned supplier makes a proper demand for adequate assurance, UCC Section 2-609(1) permits the supplier to “suspend any performance for which he has not already received the agreed return.” In other words, the supplier is not required to ship any additional goods to the retailer while its demand remains unanswered, nor must the supplier abide by any other contractual obligation in the interim. This is true even if the retailer makes a partial payment on outstanding invoices: Section 2-609(3) explicitly provides that “[a]cceptance of any improper delivery or payment does not prejudice the aggrieved party’s right to demand adequate assurance of future performance.” The ability to suspend performance pending receipt of adequate assurance from a distressed retailer thus provides a supplier with the ability to be proactive when it is concerned its counterparty may be unable to pay for goods delivered.

Finally, if a retailer, “[a]fter receipt of a justified demand” fails to provide “within a reasonable time not exceeding thirty days such assurance of due performance as is adequate under the circumstances of the particular case,” the retailer is deemed to have repudiated the contract. UCC Section  2-609(4)(1); see also Norcon Power Partners, L.P. v. Niagara Mohawk Power Corp., 92 N.Y.2d 458, 464 (N.Y. 1998) (explaining that “[w]hen adequate assurance is not forthcoming, repudiation is deemed confirmed, and the nonbreaching party is allowed to take reasonable actions as though a repudiation had occurred”). Importantly, courts have recognized that this provision “does not automatically mean that [the buyer] ha[s] 30 days in which to respond.” Hitachi Zosen Clearing, Inc. v. Liberty Mut. Ins. Co., No. 92 C 5363, 1996 WL 388432, at *7 (N.D. Ill. July 1996). To the contrary, considering all of the circumstances, courts have agreed that a buyer’s response can be required in “something less than 30 days.” Id. Accordingly, a supplier may be able to deem its contract with a distressed retailer rescinded altogether if the retailer is unable to provide adequate assurance within a relatively short period of time.

The Right to Withhold Delivery

While a demand for adequate assurance allows a supplier to suspend performance of future shipments due under the contract, the supplier may also have shipments in transit to the retailer. For such goods, the supplier may consider issuing a “stop delivery” order to the appropriate common carrier(s) pursuant to UCC Section 2-702(1).

UCC Section 2-702(1) allows a seller to “stop delivery”—except for cash paid on or before delivery—when the seller “discovers the buyer to be insolvent.” In addition to requiring cash for future deliveries, UCC Section 2-702(1) provides that delivery need not to be resumed until an insolvent buyer has paid for all previously delivered goods.

The key question under UCC Section 2-702(1) is whether the retailer is, in fact, “insolvent.” UCC Section 1-201(23) defines “insolvent” as:

(A) having generally ceased to pay debts in the ordinary course of business other than as a result of a bona fide dispute; (B) being unable to pay debts as they become due [known as “equitable insolvency”]; or (C) being insolvent within the meaning of the federal bankruptcy law [known as “balance sheet insolvency”].

Courts have recognized that “‘[b]alance sheet’ insolvency is undoubtedly more difficult to prove than equitable insolvency,” as the former imposes a “heavy burden” on a seller trying to prove that a buyer is insolvent. See, e.g., In re Storage Tech. Corp., 48 B.R. 862, 867 (Bankr. D. Colo. 1985). While case law is scarce on this topic, the UCC’s incorporation of both equitable and balance sheet insolvency into its definition of “insolvent” suggests that a supplier may be able to stop delivery under UCC Section 2-702 even where the distressed entity has not yet filed a bankruptcy petition, but the supplier otherwise has knowledge that the retailer cannot pay its debts.

If a retailer is, in fact, insolvent, UCC Section 702-1 entitles the supplier to stop shipment of any goods that are currently en route to the distressed entity. UCC Section 702-5 sets forth the procedures by which such a stoppage would occur. In order to stop delivery, a supplier must first “so notify the bailee by reasonable diligence to prevent the delivery of goods.” UCC Section 2-705(3)(a). Any stop delivery orders to carriers and bailees should (a) invoke UCC Section 2-702(1) and (b) reference any relevant provisions in agreements with those third parties.

“After such notification the bailee must hold and deliver the goods according to the directions of the seller.” UCC Section 2-705(3)(b). It should be noted, however, that when a stop shipment order is issued, “the seller is liable to the bailee for any ensuing charges or damages” that the supplier may incur due to complying with the request. Id. These charges or damages can be substantial, particularly if the bailee is transporting goods for other entities. Thus, a stop shipment order does not mitigate a supplier’s risk altogether, and a supplier should be sure to communicate with its bailees or carriers to assess the costs involved in stopping shipments. Nonetheless, a stop delivery order provides suppliers with a useful tool in preventing goods from reaching an insolvent entity.

Post-Bankruptcy Rights and Remedies

Finally, even if goods are delivered to a retailer that subsequently declares bankruptcy, a supplier may have a right (1) to reclaim these goods pursuant to Section 546(c) of the Bankruptcy Code, (2) to assert an administrative expense claim for goods the retailer received within 20 days of the retailer’s bankruptcy filing pursuant to Section 503(b)(9) and/or (3) to assert a claim for mutual prepetition setoff.

Section 546(c)(1) provides that, with some limitations, “a seller of goods that has sold goods to the debtor, in the ordinary course of such seller’s business, [may] reclaim such goods if the debtor has received such goods while insolvent” within 45 days of the petition date. A demand for reclamation must be made “not later than 45 days after the receipt of such goods by the debtor, or not later than 20 days after the commencement of the [bankruptcy case], if the 45-day period expires after the commencement of the” bankruptcy proceeding. 11 U.S.C. § 546(c)(1)(A), (B). While the statue appears to afford broad relief, in practice its application is often limited. Many courts require that the retailer still possess any goods the supplier seeks to reclaim. And Section 546(c) specifically provides that reclamation rights are “subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof,” such that if a retailer’s secured lenders have a floating lien on inventory, the lenders’ security interest will be senior to any reclamation rights a supplier may have. Thus, while Section 546(c) provides sellers with some protections, it does not eliminate altogether the risk associated with providing goods to distressed entities.

In addition to the rights afforded under Section 546(c) of the Bankruptcy Code, suppliers may also have remedies under Bankruptcy Code Sections 503(b)(9) and 553(a). Section 503(b)(9) provides creditors with an administrative expense claim for goods (not services) that a debtor receives in the 20 days before bankruptcy. Section 503(b)(9)—which is not dependent on a retailer’s continued possession of goods and which often results in a dollar for dollar recovery—is generally recognized as an alternative (and more desirable) remedy to reclamation rights. Additionally, Section 553(a) of the Bankruptcy Code preserves a creditors’ rights to offset mutual pre-bankruptcy debts under non-bankruptcy law. Offset claims are essentially secured claims and—like Section 503(b)(9) claims—often result in a dollar-for-dollar recovery.

Conclusion

When a supplier learns that a customer may be contemplating bankruptcy, it is well advised to explore options for mitigating losses. The rights afforded under the UCC and the Bankruptcy Code may provide suppliers meaningful mechanisms by which to do so. Because the mechanics for invoking these provisions can be complex, a supplier should always consult with counsel before taking any action. Doing so ensures that these rights are exercised correctly, and maximizes the supplier’s ability to mitigate losses.