Managing Risk Under Supply Contracts in Extraordinary Times

April 20, 2020

By: Caroline C. Fuller

Virtually every industry is suffering due to mandated business shut-downs while our country addresses the coronavirus pandemic.  Even businesses that are permitted to continue operations are likely struggling with declining revenues, payment delays and deferrals, and delays or cancellations of various projects.  This summary highlights some key issues suppliers should consider in supplying customers who are in default or are slow-paying their payables.  

Written Contracts
If you don’t have a written contract with your customer, your options are simple.  You have no obligation to accept additional orders from the customer; you can require cash on delivery or cash in advance before shipping additional supplies.  You can sue to collect on your outstanding invoices.

If you have a written supply contract, your options are more limited.  Review its terms carefully to understand your rights.  You may have the right to refuse to ship until current invoices are paid. You may have the right to terminate the contract, probably after written notice of default and an opportunity to cure.  Sending a notice of termination may give you the leverage to negotiate some form of credit enhancement – such as a letter of credit, collateral, or personal guaranty – to secure payment of outstanding invoices or before shipping additional goods on credit. 

State Law Rights
In addition to whatever is provided in your contract, state law creates certain additional protections.  Under the Uniform Commercial Code, adopted in some form in all 50 states, if you have reason to believe that your customer is in financial trouble, even though it is not currently in default under your contract, you have the right to demand “adequate assurance of due performance” – proof that the customer is able to pay your bills -- before shipping additional goods under the contract.  Adequate assurance may take the form of a sworn financial statement confirming the customer’s solvency, or some form of additional payment protection, such as a deposit or letter of credit.  

If you learn that your customer is insolvent after you have shipped goods, you have the right to stop goods in transit.  You also have the right to reclaim goods within ten days of delivery, butt this right of reclamation is more limited.  If the goods have already been resold to a good faith purchaser, there is nothing left to reclaim.  And, if the customer has a secured lender with a lien on its inventory, that lender’s rights will take priority over your reclamation demand.  But, there is no harm in sending the reclamation demand, as it may create leverage to secure payment or additional credit projection from the customer.

Bankruptcy Filing
If your customer files Chapter 11 bankruptcy, you are obligated to continue to perform under your written contract with your customer during the bankruptcy case, while it determines its bankruptcy exit strategy, including whether to assume or reject your contract.   The automatic stay of a bankruptcy case stops you from terminating your contract, and stops any collection actions you’ve taken to collect pre-bankruptcy receivables. 

If, however, you effectively terminated your contract pre-bankruptcy, or if you never had a written contract at all, there is no contract to assume or reject, and the customer cannot compel you to continue to ship.   In that case, you can insist upon COD or other terms as a condition of continuing to supply the customer, if you choose to do so at all.  

Administrative Claims
The bankruptcy filing freezes the customer’s pre-bankruptcy obligations to you, but you hold an “administrative claim” for post-bankruptcy shipments.  An administrative claim is a first priority obligation in the bankruptcy case, but it still generally falls behind a secured lender’s claims.  Normally, the customer will enter into an agreement with is lender securing permission to continue to pay bills in the ordinary course, and may also secure additional financing to funds its operations during bankruptcy.  But if the reorganization fails, and the company ends up liquidating, it may have insufficient funds to pay everyone.  Thus, there is always some risk in a bankruptcy case that you may not be paid even for post-bankruptcy shipments.   You may want to monitor the customer’s financing arrangements and budgets during the course of the bankruptcy case to make sure that sufficient funds are budgeted to pay suppliers.  If the customer falls behind on payment of your post-bankruptcy invoices, you can go to court to compel payment, or for some form of adequate assurance of future payment as a condition of continuing to supply the customer.  

In addition to the administrative claim for post-bankruptcy shipments, you are also entitled to an administrative claim for goods received by the customer within 20 days prior to its bankruptcy filing.  Courts generally hold that these claims need not be paid until a plan is confirmed, but this provides you additional protection for some goods shipped shortly prior to the bankruptcy.

Critical Vendor Status
If you are a key supplier, you may be able to negotiate “critical vendor” status.  Some courts will permit special treatment for those creditors whose products are so essential that, without an assured source of supply, the customer’s business would fail.  If you have a written supply contract, that special treatment may be assumption of your contract and cure of existing defaults.  If you don’t have a written contract, critical vendors are typically granted some payment of pre-bankruptcy invoices in exchange for continuing to supply product post-bankruptcy on credit terms.

Assumption or Rejection of Contract
If you have a written contract with the customer, the customer will have to decide whether to assume or reject that contract in connection with its reorganization plan.  If the customer’s exit strategy is to sell its business, the buyer will decide whether it wants to take assignment of your contract.  In either case, if your contract is assumed, and possibly assigned to a buyer, you are entitled to immediate payment of all the pre-bankruptcy obligations under it, and any unpaid post-bankruptcy obligations.  You are also entitled to “adequate assurance of future performance” under your contract.  If you have doubts about the customer’s or buyer’s ability to continue to perform under your contract, you can object to the proposed assumption, and seek some form of credit enhancement or improved credit terms.    

If your contract is rejected, you still hold an administrative claim for all post-bankruptcy shipments.  Your claim for pre-bankruptcy shipments, and any other damages you may have for breach of your contract, will be paid under the terms of the plan, which can range from no recovery to full payment.  The courts generally defer to the customer’s business judgment and will rarely second-guess a decision to assume or reject your contract.  

The customer has no legal right to force you to renegotiate your contract as a condition of assumption.  Nevertheless, it may use the threatened rejection of your contract in order to try to secure more favorable terms.  It’s up to you whether you would prefer to let your contract be rejected, or to retain the customer by making some concessions in your contract terms.