Clark & Trevithick | Risky Business -- Credit Sales in 2009 and 2010

August 10 , 2009 Volume 1, No. 5

This edition of Currents is brought to you by our Creditors' Rights & Remedies Team which is comprised of attorneys John A. Lapinski, Leslie R. Horowitz, Kimberly S. Winick, Joel A. Goldman and Stephen E. Hyam. To learn more, visit us at ClarkTrev.com.

Risky Business—Credit Sales in 2009 and 2010

During the next few years more and more frequently you will find yourself facing the prospect of doing business with a customer which is operating in a bankruptcy as a Chapter 11, Debtor-in-Possession (DIP). The following is a brief summary of what this means: the risks, the benefits, and what you need to know in order to make well-informed business decisions.

Look For Early Signs of Trouble
As your customer starts to show a longer and longer turn around period on your open invoices, you need to be aware of this early indicator that a possible bankruptcy may be just around the corner. Outside of bankruptcy, sellers on an unsecured basis have a limited number of options available to them to reduce the risk of loss. Everything starts with your credit manager maintaining a vigilant eye on your receivables, watching for any sign that the customer is having problems with timely paying for your goods. If your systems or personnel are not properly equipped for this task, now is the time to make necessary changes and investments.

The California Uniform Commercial Code (UCC) provides important protections for vendors on open credit: section 2609 permits you, when you reasonably believe that payment may not be made, to demand adequate assurance of performance. In such circumstances you might request some form of credit enhancement such as a letter of credit or other collateral to reduce your exposure to loss. If you are taking a lien on the goods sold as collateral, you should get legal assistance to assure that you correctly create and perfect that lien, so that you get the full benefit of the bargained-for protection. If you request a new signed financial statement from your customer, you may be able to increase your leverage later on should the customer have to file bankruptcy.

Know How to Protect Your Interests
Additional vendor protection is provided by UCC section 2702, which allows sellers who discover, after shipping goods, that their customer is insolvent, to reclaim goods sold on open credit within 10 days after receipt. As an added protection, if that insolvent customer gave the seller a signed financial statement that contained misrepresentations of insolvency, within three months before the seller learns of the customer’s insolvency, the seller may be entitled to reclaim all goods sold to the customer after delivery of the false financial statement.

If you can identify your goods you may be able to reclaim and resell them to other customers and mitigate a portion of your damages. If a bankruptcy petition is filed and your customer operates as a Chapter 11 DIP, you will still have an opportunity to compel some agreement under the Bankruptcy Code provisions of section 546(c). Upon timely demand, you can seek to recover the goods sold up to 45 days before the bankruptcy petition was filed. The key is to act immediately upon learning of the bankruptcy filing.

Avoid Common Pitfalls
The common misperception has been that insolvency risks are of no concern once your customer is operating as a Chapter 11 DIP. This is not true and it is imperative to understand your risks and how they may be mitigated. Debtor’s counsel will argue there is no risk because doing business with the DIP will give rise to administrative claims that will have priority over general prepetition creditors. This is true as far as it goes, but leaves lots of room for bad things to happen. Is buying from you ordinary course, or are you possibly making sales that will not qualify for administrative claim protection? Is there a secured creditor with a prior claim to and lien on virtually all assets? Does the DIP have the authority and ability to use funds to pay you? What other administrative claims will be competing with yours for payment? Should you structure a secured or non-credit relationship with the DIP?

We have seen DIPs do many things to jeopardize administrative claim recoveries: stop restructuring efforts midstream and abruptly liquidate operations; reject goods in transit so that the seller had to mitigate damages before it could establish an administrative claim; fail to budget all purchases, so that DIP couldn’t use encumbered cash to pay vendors; incur so much postpetition debt that the estate could not pay all administrative claims in full. Many other things can go wrong, in each case leaving creditors that continued to trade with the customer on open account when it became a DIP to become victims of additional losses, on top of the amounts they lost for prebankruptcy sales to the debtor.

There are many ways to fashion sales arrangements, before and during bankruptcy, to reduce your exposure. Our attorneys have broad experience and enjoy structuring and enhancing these transactions, and look forward to assisting you in this hazardous marketplace.

Currents is intended to be educational only. It is designed to provide our clients and friends with the discussion of current topics and legal authorities as applied to those topics. Currents is not intended to constitute legal advice or provide any opinion about the application of such legal authorities to a particular circumstance, set of facts or situation. In addition, that you have received transmission of Currents does not create any relationship of attorney and client between Clark & Trevithick, PLC and you.

Clark & Trevithick, PLC is a full service law firm representing clients throughout California and western states for more than three decades. Our practice includes specialization in federal and state taxation law and tax reporting compliance, as well as estate planning for owners of closely-held businesses and other high net worth individuals. We also counsel on the sale of closely-held businesses. We develop methods for transferring wealth to surviving spouses and descendants by the most efficient and tax-advantaged methods available. Our practice profile also includes corporate, real estate, litigation, creditors' rights and remedies and employment law matters.

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