April 3, 2020
Doing Business with Troubled Companies in the Age of COVID-19
April 3, 2020
This outline is intended to provide some basic considerations and tools to be used in connection with anticipating non-payment by customers during times of economic disruption, including the disruption we are anticipating and witnessing arising out of the current COVID-19 crisis. Anticipating non-payment rather than waiting for it to occur may give you time to minimize your exposure to a particular customer by obtaining credit enhancements from that customer or legally modifying terms of sale to improve your position.
The Uniform Commercial Code (“UCC”) provides several remedies when a seller has reason to believe that its customer may be unable to abide by the payment terms of the agreement. The ability to use those remedies is usually dependent on a seller having a commercially reasonable belief that a customer is insolvent.
WARNING SIGNS OF INSOLVENCY
Review your customer list and accounts receivable to identify which customers are likely to be affected by the COVID-19 crisis and look for the following warning signs of insolvency:
- Invoice aging creeping higher;
- Credit rating agencies issuing downgrade/credit watch;
- Disclosure of financial problems in the buyer’s industry or through trade journals;
- Credit insurance coverage being withdrawn;
- Delays or refusal to provide financial information that was routinely provided;
- CEO, CFO, and/or other financial personnel resigning or being terminated;
- Board members resigning; and
- Increased number of credit reference requests concerning the customer.
PROOF OF INSOLVENCY
Many of the remedies available under the UCC require either that a seller has “reasonable grounds for insecurity” concerning a customer’s ability to pay or that a customer be insolvent. Obviously, having evidence that a customer is insolvent also serves as a “reasonable ground” for feeling insecure about a customer’s ability to pay.
- Under the UCC, insolvency can be proven using one of two tests:
- Payment of debt test: a customer is not paying debts in the ordinary course of business as they become due, or
- Balance sheet test: a customer’s liabilities are greater than its assets.
- The first test is the one usually used based on information available in D&B reports and public filings.
- It can be difficult to use the balance sheet test since outcomes will vary depending on whether the valuation methodology used is going concern vs. fair market value vs. liquidation.
- The UCC gives a seller the right to demand “adequate assurance” from a customer that it can pay if the seller has “reasonable grounds for insecurity” concerning the customer’s ability to pay. (UCC Sec. 2-609). Accordingly, if you observe warning signs of insolvency (see above) and it is “commercially reasonable” to do so, you have the right to demand adequate assurance that the customer can perform its obligations. Include in your demand proof of ability to pay and current financial information.
As stated above, if a seller has reasonable grounds for insecurity, it can demand adequate assurance of performance.
- Until assurance is given by a customer, the seller can suspend performance.
- “Commercial standards” govern reasonableness of grounds for insecurity and reasonableness of assurance offered.
- If a customer does not deliver reasonable proof of its ability to pay within a reasonable period of time (not exceeding 30 days), the customer is deemed to have repudiated the agreement, which allows the seller to cease performing its obligations under the contract. The seller can seek damages for its expenditures, lost profits, and other provable damages arising from the customer’s breach.
- Several remedies are available to the seller upon a determination that a customer is insolvent (UCC Sec 2-702 through 2-705):
- The seller may withhold delivery of goods not yet shipped;
- The seller may stop delivery of goods already shipped; and
- The seller may seek “reclamation” of goods already delivered.
Reclamation is a remedy that allows a seller to take back goods already delivered to a customer if certain conditions are met.
- Timing is critical in using this remedy.
- A seller may reclaim only product received by a customer within 10 days prior to the seller delivering a written reclamation demand to the customer.
- However, that limitation does not apply if the customer has made any misrepresentations of solvency to the seller.
- The remedy of reclamation is also available under Bankruptcy Code Sec. §546(c).
- Under this section of the Bankruptcy Code, the seller may recapture deliveries made 45 days before bankruptcy.
- There are significant limitations to this remedy:
- The seller must be able to identify its goods and they must not have been incorporated into the customer’s product;
- If the seller’s goods are out of the customer’s hands already, the seller loses; and
- In most jurisdictions, this remedy can be “trumped” by a prior perfected lien in favor of another secured creditor.
- Reclaiming goods and stopping goods in transit under UCC Sec. 2-702 both require fast action.
- It is sometimes necessary for the seller to get in front of a judge quickly if the carrier or customer ignores the seller’s demand.
- The failure to “prosecute” these rights may waive them.
HOW TO ASSURE PAYMENT
Whether seeking adequate assurance of payment on a current order or an order placed by a customer but not yet accepted, consider obtaining the following credit enhancements:
- Cash on Delivery/Cash Before Delivery
- In addition to assuring that the seller is paid for the goods, payment that is COD or CBD provides the seller with a “contemporaneous exchange” defense against a preference claim if a customer files bankruptcy.
- Letter of Credit
- Find a third-party guarantor or provider of a credit enhancement
- Principal, equity sponsor, or other business stakeholder.
- A customer of your customer might need the product so badly that it will provide a guaranty or other credit enhancement.
- A customer’s bank – if the bank’s loan is at risk if your goods are not delivered, the bank may give a seller a “carve out” of its security interest or permit its borrower to pay the seller even if it represents an over-advance.
- Be creative in identifying potential guarantors – it might be any party that stands to suffer economic loss if the seller refuses to do business with the customer.
- Obtain a security interest in your product or other collateral.
- If a blanket lien – obtain subordination of the bank lien in your favor.
- Review financials – identify unliened collateral (e.g. IP, real estate, choses in action).
IF CUSTOMER FILES BANKRUPTCY
A recent change to the Bankruptcy Code permits businesses with debts up to $7.5 million to file a relatively inexpensive and speedy bankruptcy proceeding. Accordingly, it can be anticipated that more customers will make use of Chapter 11 than before. If your customer files a bankruptcy proceeding, be certain to take the following steps:
- A seller has reclamation rights with respect to any product delivered to a customer within 45 days prior to the commencement of the bankruptcy case.
- The written demand for reclamation of the goods must be made not later than 45 days after the date of the customer’s receipt of the goods or not later than 20 days after the commencement of the case if the 45-day period expires after the commencement of the case.
- Obtain and review any reclamation order that might have been issued by the bankruptcy judge – it might require you to send a separate notice.
- 503(b)(9) claim – a seller will have a priority claim for goods delivered 20 days before bankruptcy.
- Timely file a proof of claim in accordance with the notice received from the bankruptcy court.
- Your claim may be for more than simply the account receivable.
- Your claim may include raw materials purchased in anticipation of fulfilling a customer’s order, other costs incurred in connection with setting up for performance under the contract with the customer, or other damages identified in the invoice or MSA.
The information provided in this outline speaks only to the information and guidance we have available as of the date of publication and is subject to change. We will continue to follow further issued guidance and regulations and endeavor to post those updates via our website. Please continue to follow these updates at ulmer.com. This legal update was created by Ulmer & Berne LLP, and is not intended as a substitute for professional legal advice. For any questions, or for further information, please contact Richard G. Hardy at email@example.com.