Picture the scene: You have just received word that your customer has filed Chapter 11. You had followed my ad-vice (see article Reducing a Customer’s Accounts Receiva-ble in the Zone of Insolvency), and put the customer on a cash-before-delivery basis and demanded assurances of performance. You were successful in reducing the ac-counts receivable owed, and avoiding preference liability in doing so.

The customer, now a Chapter 11 debtor, calls and de-mands that you continue to ship, and resume credit terms.

The customer tells you its lawyers have advised you are required under provisions of the U.S. Bankruptcy Code to continue to ship goods and to extend credit terms set forth in the contract. The problem is there is still a prepetition accounts receivable balance and you are not certain the debtor will survive in Chapter 11. You are certainly aware that in recent years many Chapter 11 debtors don’t suc-cessfully restructure their business. Rather, “success” in Chapter 11 often means a Section 363 sale, where the as-sets are sold as a going concern. Many view Section 363 sales as a tool for lenders to liquidate collateral using the efficiency of the Chapter 11 process. All too often the strike price for the assets is very close to the prepetition secured debt. Understandably, secured lenders’ goals are to recover their loan, and minimize their “transactional” costs in doing so. To lenders, “transactional costs” in-clude Chapter 11 professional fees, post-petition adminis-trative claims and whatever they are compelled to pay on general unsecured claims. The latter may be in the form of critical vendor payments, Section 503(b)(9) claims (so-called “20 day administrative claims”), and a carve-out for dividends on unsecured claims.

Analyzing the risk of extending credit terms outside of Chapter 11 is difficult, but analyzing the credit risk of a Chapter 11 debtor is a complex calculus at best. Is there DIP financing? Is it sufficient? Is the budget realistic? Is the financing short-term, largely discretionary and termi-nable at will by the lender? Can the debtor pay as it goes in Chapter 11, or will it become administratively insol-vent? Is there a critical vendor order? Will the buyer in the Section 363 sale assume the contract? What “outs” does the buyer have on its proposed purchase? Chapter 11 is the ultimate “fluid” situation requiring the consensus of multiple parties. Without certainty on these issues, it is nearly impossible to gauge the risk of post-petition credit extensions. After all, the debtors’ professionals obtained retainers to secure payment of their post-petition services, rather than accept the risk of administrative insolvency.

Despite this uncertainty, debtors insist you ship goods and extend credit terms … because there is a prepetition con-tract that so provides.

The Basis for the Debtor’s Demand

Section 365 of the Bankruptcy Code is the basis of the de-mand. Section 365 provides a debtor the right to assume or reject any executory contract, which is a Bankruptcy Code term meaning simply a contract where both sides owe material performance to the other. A sales or supply contract is clearly an executory contract. Moreover, Sec-tion 365 provides:

(e)(1) Notwithstanding a provision in an executory contract … or in applicable law, an executory con-tract … may not be terminated or modified, and any … obligation under such contract … may not be terminated or modified, at any time after the commencement of the case solely because of a pro-vision in such contract … that is conditioned on –

(A) the insolvency or financial condition of the debtor at any time before the closing of the case;

(B) the commencement of a case under this ti-tle ....

(2) Paragraph (1) … does not apply to an executory contract …, if –

(A)

(i) applicable law excuses a party, other than the debtor … from … rendering per-formance … and

(ii) such party does not consent to such as-sumption or assignment ….

Translated, if a contract contains terms that provide for termination of or cash-before-delivery credit terms, upon the insolvency of the customer or upon the filing of Chap-ter 11, such terms (referred to as “ipso facto” clauses) are not enforceable. However, this provision does not abro-gate rights that exist under non-bankruptcy law, such as the Uniform Commercial Code, in this instance Article 2 relating to the sale of goods.

There is no provision in Section 365 that provides the non-debtor party (the vendor) must perform while the debtor decides whether to assume or reject. In addition, there is no provision in Section 365 that actually compels the ven-dor to perform. Rather, debtors rely on the language above that the contract cannot be terminated or modified after the commencement of the case.

But, this is limited to contract provisions that terminate or modify a contract based on insolvency or based on a Chap-ter 11 filing, not applicable non-bankruptcy law, Article 2 of the Uniform Commercial Code for example.

If the debtor’s position were correct (which it’s not), then any non-bankruptcy law on the subject would be inappli-cable.

The Uniform Commercial Code Article 2 Remedies for Vendors

Vendors have two powerful tools in Article 2 of the Uni-form Commercial Code governing the sale of goods:

Section 2-609 Anticipatory Breach

When reasonable grounds for insecurity arise with re-spect to the performance of either party, the other may in writing demand adequate assurances of due perfor-mance and if commercially reasonable, suspend any performance pending such assurances.

Section 2-702(1) Cash Before Delivery Upon Buyer’s Insolvency

Where the seller discovers the buyer to be insolvent, the seller may refuse delivery except for cash.

Section 2-609 and 2-702(1) work well together. The seller’s performance obligations, which it may suspend under 2-609, are shipping goods and providing any credit terms agreed on between the parties. If reasonable grounds for insecurity exist, the seller may suspend its obligation to ship or to provide credit terms, or both. Section 2-702(1) likewise allows the seller to sell goods on a cash basis.

If these provisions control, the vendor has the right to sus-pend its obligation to “perform”, ship goods and extend terms, and demand assurances of future performance by the debtor, namely pay within terms.

In addition, a Chapter 11 filing presumes the customer is insolvent, in which case the vendor may insist on cash-before-delivery payment terms, regardless of what the contract provides.

The Collision of Chapter 11 and the Uniform Commer-cial Code

Debtors, and their lenders, want credit terms from vendors to reduce pressure on and costs of the DIP working capital facility, and to shift some of the working capital risk to vendors. To this end, Debtors seize on Section 365.

Vendors, already facing an accounts receivable write-off and possibly a preference claim down the road, are reluc-tant to increase the loss. The vendor may feel some pres-sure to “work with” the debtor. The same could be true for the debtor, who may need the support of vendors long-term.

This debate normally takes the form of brief, but intense, negotiations over the merits of the positions. Inevitably, debtors roll out the automatic stay violation angle. Specifi-cally, that the refusal to do business is a ruse to obtain pay-ment on the prepetition accounts receivable. Particularly when the vendor inquires about critical vendor status. Fair enough, stay violations can be serious, and should be avoided. There is a difference, however, in seeking pay-ment of the prepetition accounts receivable, and not in-creasing an already existing loss. The two are not neces-sarily linked. But expect debtors to up the ante to achieve a result.

When statutes are not clear, legal risk exists, and courts must decide based on cases before them. What have courts ruled?

  1. In JW Aluminum Co. (M.D. Florida), the Bankruptcy Court recognized the creditors’ 2-609 demand, and that the Debtor’s response that it would have an ad-ministrative claim was not sufficient as adequate assurances of performance.
  2. In National Sugar Refining Co. (S.D.N.Y.), the Bank-ruptcy Court ruled vendors may stop delivery of goods in transit, a UCC Article 2 remedy, without vio-lating the automatic stay, or Section 365.

It is illogical to suggest a seller could load a truck, commence delivery, then stop that delivery, all al-lowed under UCC Article 2, but cannot suspend deliv-ery in the first instance, also allowed under UCC Arti-cle 2 (Morrison Industries, L.P., W.D.N.Y.).

  1. Bankruptcy Courts have enjoined vendors from not providing goods or services, but only if the debtor could prove the debtor would be irreparably harmed, and the vendor was paid in advance.
  2. One Bankruptcy Court ruled that a contract termina-tion or modification by a vendor could violate the au-tomatic stay, but only in the situation where the con-tract was viewed as property of the estate, and the debtor had already filed a motion to assume the con-tract.

Also, as a practical matter, if a DIP facility extends for only 60 days, extended at the discretion of the lender, it is not reasonable to force a vendor into open-ended credit terms.

Bottom Line

The statutes and case law favor vendors’ ability to sus-pend performance until adequate assurances are provid-ed, and to utilize the UCC remedy of cash-before-delivery terms.

If debtors agree to cash-before-delivery terms, shipping goods poses little risk to the vendor and opens the door for a court to conclude that any refusal to ship on cash-before-delivery terms is designed to obtain payment of prepeti-tion accounts receivable, which is a stay violation.

Vendors should be prepared for the debtor’s position that critical vendor status is not appropriate for vendors with contracts. This is not accurate, and pre-supposes the cor-rectness of the position that vendors must ship and extend terms post-petition. If so, by definition, the vendor is not “critical”.

The interplay between the Uniform Commercial Code and the Bankruptcy Code can create uncertainty for vendors. To navigate this uncertainty it is important to understand the intricacies of the rules and how they apply to the cir-cumstances of the particular customer, and to also stand firm on the rights of vendors set forth in Article 2 of the UCC.

Given the specter of a stay violation, advice of counsel is prudent.

We hope you found this useful and informative, and feel free to share this with others in your company.