Trade creditors often face the issue of whether they are required to continue providing goods or services on credit to a customer that has filed chapter 11 bankruptcy. Unfortunately, the Bankruptcy Code fails to specifically address the rights and obligations of a trade creditor facing this dilemma, resulting in a tug-of-war created by the debtor’s need for continued goods and services and the creditor’s need for assurance of payment. Further complicating the problem is that the case law is relatively undeveloped in this arena.
As a precursor, trade creditors must understand the interplay between their supply agreement and the immediate consequences arising from the debtor’s bankruptcy filing. The supply agreement is likely an “executory contract” under the Bankruptcy Code, which has generally been interpreted by courts as a contract under which material performance remains due from both parties. Section 365 of the Bankruptcy Code governs executory contracts and provides the debtor with the option of either (i) “assuming” the contract, which requires the debtor’s payment of any arrearages as a precondition to assumption, or (ii) “rejecting” the contract, which results in an unsecured claim for the trade creditor. The problem, however, is that under Section 365, the debtor has until confirmation of the chapter 11 plan to assume or reject the contract, which in complex chapter 11 cases could equate to several months or even years after the bankruptcy filing. Compounding the problem is the fact that the Bankruptcy Code does not address the parties’ respective rights and obligations under the contract during this time period. And, to make matters worse, the “automatic stay” arises under Section 362 of the Bankruptcy Code on the date of the bankruptcy filing and generally prohibits the trade creditor from unilaterally canceling or modifying the contract after the petition date. Accordingly, if the trade creditor suspends performance or attempts to modify the terms of the supply agreement so as to require cash-on-delivery in response to the debtor’s bankruptcy, the debtor may threaten to sue the trade creditor for breach of contract or for violation of the automatic stay.
This is certainly not the situation the trade creditor envisioned when it originally entered into its supply agreement. However, as discussed herein, all is not lost as the trade creditor does have options under both the Bankruptcy Code and applicable state law.
First, if the debtor is in default as of the bankruptcy filing, the trade creditor’s leverage is vastly improved as courts have held that the defaulted debtor cannot compel the creditor to continue to provide goods or services on credit. These courts have relied on basic contract law, which prevents the defaulting party from enforcing a contract against the non-defaulting party. Thus, if the debtor wants the trade creditor to continue to supply goods or services, the debtor will be required to assume the trade creditor’s contract early in the case, which, as noted above, requires the debtor to cure the pre-petition default and provide adequate assurance of future performance. Similarly, a trade creditor who distinguishes itself as a “critical vendor” is often included by the court early in the bankruptcy as part of a designated group of vendors whose pre-petition claims are paid in full in return for their continued services.
But what if the debtor is not in default as of the bankruptcy filing, and yet the trade creditor still has grave concerns as to its now-bankrupt customer’s ability to make its payments moving forward? While the creditor does not have the same leverage as discussed in the preceding paragraph, the creditor is not without options.
First, the trade creditor always has the option of filing a motion under Section 362(d) of the Bankruptcy Code requesting relief from the automatic stay to either cancel the supply agreement or modify the terms of the supply agreement (such as from net 30 days to cash-on-delivery). In order to obtain stay relief, the trade creditor must show “cause” which includes, without limitation, a showing of lack of “adequate protection” — i.e. that the debtor lacks adequate financing to pay for the goods or services in the future and/or is administratively insolvent. Similarly, Section 363(e) of the Bankruptcy Code allows a creditor with an interest in property used, sold or leased by the debtor to file a motion requesting that such use, sale or lease be conditioned upon the debtor providing the creditor with adequate protection. Accordingly, both Section 362(d) and Section 363(e) provide the trade creditor with potential means of forcing the debtor to provide adequate protection, such as cash-on-delivery, as a precondition to the trade creditor’s obligation to continue supplying goods or services. Moreover, the filing of the motion alone often creates leverage for negotiating cash-on-delivery terms with the debtor.
In addition to these options provided by the Bankruptcy Code, a trade creditor that providesgoods (but not services) under its supply agreement also has state law remedies available under Article 2 of the Uniform Commercial Code. First, UCC § 2-609 allows a trade vendor who has “reasonable grounds” for questioning its customer’s ability to pay for the goods to send a written demand to its customer to provide “adequate assurance” of its ability to perform under the contract. If the customer does not timely respond within 30 days or provide adequate assurance of its ability to perform, the trade creditor can treat the contract as repudiated. Second, the trade creditor has the right to suspend performance under the contract where the requirements of UCC §§ 2-702, 2-703, and 2-705 are satisfied. Generally speaking, the trade creditor can stop delivery where its customer is insolvent (satisfied by a showing that the debtor’s liabilities exceed its assets or that the debtor cannot pay its debts as they become due) and demand cash-on-delivery in exchange for continued performance.
These options hopefully provide trade creditors with ideas of how to obtain cash-on-delivery terms with a bankrupt customer. However, as a final note, trade creditors must make sure that the debtor has obtained approval to use its cash collateral to make such payments, otherwise the trade creditor runs the risk of having to disgorge unauthorized payments. Accordingly, in addition to monitoring the debtor’s ability to pay for future deliveries, the trade creditor must also confirm that the debtor has obtained approval to use its cash collateral for such payments.Republished with permission. This article first appeared in Inside Counsel on August 11, 2015.