Documenting Your Credit Sale to the Financially Distressed Customer: Can A Supply Contract Get You Paid And Avoid Preference Risk If Your Customer Files Chapter 11?
September 24, 2009, By Scott E. Blakeley
A vendor may sell its customer on an invoice by invoice basis, or commit to a supply of its product or service over a period of time or duration of a project under a supply contract. The method in which the vendor is selling the customer has particular significance during the recession, especially given the number of customers resorting to chapter 11 to attempt to resolve their financial difficulties, and in particular using the asset sale provision of the Bankruptcy Code for an early exit from chapter 11.Headlines of major companies rushing to sell their assets while discarding liabilities in the opening weeks of chapter 11 (Chrysler selling to Fiat in 42 days and GM selling itself to "new GM" in 60 days), as well as prepackaged plans are now common for these customers to attempt to exit Chapter 11 in record time. What do these recent developments mean to the vendor in evaluating credit risk and sale alternatives, especially during a recession?
The Sales Mantra: Maintain Market Share in a Down Market
With the downturn in the economy, vendors are struggling to meet their sales objectives. From the credit professional's perspective, credit evaluation requires a more flexible approach as management is likely willing to increase credit risk to attempt to achieve market share. The credit professional is much more a relationship builder in this marketplace, attempting to accommodate sale's objectives, rather than merely serving as a gatekeeper to the vendor's unsecured credit. In this setting, may the method in which the vendor sells the customer, whether invoice by invoice vs. supply contract, better achieve management's objectives Selling Invoice by Invoice vs. A Supply Contract
Under an invoice by invoice trade relationship with the customer, the vendor does not have a commitment to the customer to provide additional goods or services, other than what was provided under the purchase order honored by the vendor. In contrast, under a supply contract, the vendor is committing its product or service for a period of time or duration of a project, for example. Under a supply contact, the customer may be attempting to lock in uninterrupted supply of the vendor's product or service, and perhaps a range of pricing. The customer may also need a longer term commitment from the vendor to plan sufficiently with its own customers. The credit professional must consider the terms and conditions contained in the supply contract to give the vendor special protections to hold orders or terminate the contract should the credit professional believe that the customer may be insolvent or otherwise cannot perform. This type of provision may be especially important in today's economy. Chapter 11 Trend: Selling Assets vs. Earnout Plan
Customers struggling financially are getting cues from General Motors and Chrysler that they may resolve their financial difficulties through a chapter 11 filing, followed by a prompt sale of their assets pursuant to section 363 of the Bankruptcy Code. Assets sales are being used in more creative ways from the view of the customer party buying the assets. For example, institutional shareholders, such as hedge funds, of customers are capitalizing a new company for the purchase of the customer's assets in chapter 11, rather than the customer selling its assets to a competitor or an unrelated third party financial investor. This development of potentially more buyers of assets in chapter 11 may lead to more customers that are struggling financially to opt for a sale of assets, especially given a more flexible approach being adopted by bankruptcy courts in authorizing early sales. Special Treatment for Supply Contracts Under the Bankruptcy Code
When a customer files chapter 11, treatment of a vendor's claim is often dependent on whether the trade relationship in one where the vendor sold on an invoice by invoice basis or by a supply contract. With the invoice by invoice trade relationship, the vendor is not obligated to continue to sell the debtor postpetition. In contrast, with a supply contract that is deemed executory, the vendor may be required to sell to the buyer based on the terms set forth in the contract. Not until the supply contract has been assumed or rejected may the vendor be able to evade selling post-petition. Besides the difference of a vendor's obligation to sell the debtor postpetition based on invoice by invoice trade relationship or a supply contract, is the significant distinction of whether the vendor's prepetition invoices will be paid. This is highlighted in the Chrysler and General Motors bankruptcy cases, where the buyer of these companies' assets (Fiat and the "new" GM) elected to assume scores of executory contracts. Vendors with supply contracts ended up receiving a full assumption of their claims as they were assumed by third parties. Bankruptcy Code section 365 gives special payment protections to a vendor whose supply contract is deemed executory: payment in full on the prepetition balance where the debtor assumes the supply contract and possibly assigns the contract to a buyer. In addition, a majority of courts recognize that where the supply contract is assumed, the vendor has a preference defense to payments received during the preference period. Further, for the vendor there is less risk with credit sales after the supply contract has been assumed and assigned to a third party as the third party must provide financial assurance that it can perform under the contract. Generally, a buyer's balance sheet is much less leveraged and their ability to honor payment on the credit purchases should be much greater. Therefore, the sales force and management's objectives of maintaining market share in a recession can be better achieved with a supply contract as it provides the opportunity for sales and the vendor's prepetition debt is paid through the cure. By contrast, a vendor that has sold invoice by invoice is not entitled to payment in full on the prepetition debt unless the bankruptcy court authorizes a critical vendor payment. From a debtor's view, the legal standard for having one vendor's contract assumed is much easier for creditors to support, and the bankruptcy court to approve, then to have a critical vendor motion approved. Thus, for the vendor having sold on an invoice basis, it is more difficult to have its prepetition claim paid. Working With Sales Yet Managing Credit Risk
In a recession, the credit professional must work more closely with sales to make the sale, yet manage credit risk. This may mean selling to customers that have a higher likelihood of filing chapter 11, especially given the Chrysler and General Motor early sale examples. In this economic climate, the credit professional may need to reevaluate the trade relationship and consider documenting the sale via a supply contract, with an eye towards managing credit and bankruptcy preference risk. The above article originally appeared in the Fall 2009 issue of Blakeley & Blakeley's Trade Credit Quarterly. Scott Blakeley, Esq. can be reached at seb @ blakeleyllp.com.
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