Retailer bankruptcies: what suppliers need to know
The U.S. economy has undergone significant financial and social upheaval over the past five years, with companies seemingly invincible to the vagaries of the financial markets disappearing overnight. Many companies have been forced to contract by closing unprofitable stores, laying off employees, reducing spending, deferring research and development, or have been acquired by more profitable companies. With few exceptions, those companies that have survived have done so by cutting costs to the bone.
In addition, there is little precedence for the Federal Reserve’s “quantitative easing” program, which unleashed an aggressive campaign of purchasing government bonds to keep interest rates artificially low. Only time will tell whether the U.S. economy will slip back into recession.
Given these uncertainties, it is vitally important for companies to understand and address financial stress before it becomes a problem, and to consider certain legal and operational strategies that can help mitigate such risks. This article summarizes some of the key issues and strategies that can be implemented by companies to protect themselves when suppliers and other trading partners suffer distress.
A. Monitoring Performance
Companies must regularly monitor performance, billings, and payments. When customers or vendors start to suffer financial distress, they will look for ways to cut costs to keep the lights on. Credit managers should be on the lookout for late payments, increasing receivables, requests for a change in payment terms, and decreased market share, among other things. Several services enable companies to monitor performance of their suppliers including Capital IQ and Dun & Bradstreet. Reports generated by these companies often reveal the financial health of a company or industry, and can be used as an early warning system to identity and prevent disruptions or other failures resulting from financial distress.
The first line of defense is to manage the risk of financial distress at the outset of the relationship. When properly written, vendor contracts should allow for flexible termination in distress situations to avoid having to do business with a troubled company. Legal counsel can assist in reviewing and suggesting modifications to contracts to maximize potential remedies, leverage and options available against troubled companies.
B. Early Warning Signs
Companies must be vigilant in order to maximize their leverage and options against customers or suppliers suffering financial distress. Early warning signs may include:
Deteriorating accounts receivable and accounts payable
Requests for a change in pricing terms, early payments, accelerated payment terms, or customer financing
Late deliveries
Deteriorating product quality
Deteriorating market position
Changes in key management positions
Delinquent taxes
Employment of turnaround consultants or financial advisors
Delayed issuance of financial statements or change in audit firms
The first opportunity to minimize risk when dealing with a troubled company is at the inception of the relationship when negotiating the contract. The second opportunity is at the first sign of financial distress, but before a default or bankruptcy. Each of these events is discussed below.
C. Making Your Contract Iron Clad
The relationship between a company and its suppliers is similar to a marriage. The key is to establish the rules of engagement at the outset of the relationship when times are good, so that the parties know what to expect should the relationship sour. Thus, a clear and unambiguous contract is the first line of defense.
A company should have its counsel analyze key contractual terms including what constitutes an event of default and the circumstances under which a supply contract can be terminated. Of course, the right to terminate or declare an event of default often depends on the relative bargaining positions between the parties. The greater the freedom to terminate, the greater the chance of mitigating damage resulting from a supplier’s financial distress.
In addition, certain contracts that are executory in nature (i.e., where material obligations remain unperformed on both sides such that the failure to perform constitutes a breach), can be assumed, assigned or rejected in bankruptcy. Many creditors are surprised to learn that certain bankruptcy default provisions are not enforceable in bankruptcy.
1. Adequate Assurance
When financial distress occurs, suppliers can demand adequate assurance of future performance from the customer under Uniform Commercial Code § 2-609, which has been adopted in most states. Adequate assurance may include change in payment terms, security interests, personal guaranties, letters of credit, or other financial protections. If the customer cannot provide adequate assurance, the supplier may exercise certain remedies including the withholding of performance under the contract.
a. Ensuring Continued Supply
Business operations may be negatively impacted or even grind to a halt when a critical supplier stops shipping goods. Oftentimes, the customer is unable to recover quickly enough to survive. It is not uncommon for a supplier to threaten to stop shipping prior to or during a bankruptcy case. Such threats are often used as leverage by the supplier to get what it wants. Manufacturers and other customers should have action plans to address these threats, including having counsel lined up at a moment’s notice to seek court approval to ensure continued supply.
b. Workouts
After the appearance of early warning signs of financial stress, companies will often attempt to negotiate an out-of-court workout to restructure their debt and capital structure. A workout may include a sale of the distressed company. The distressed company and key creditor constituencies may negotiate a variety of agreements to ensure that the company continues to operate during workout negotiations including forbearance or participation agreements, among others. As part of these negotiations, distressed companies may request that their lenders provide working capital financing and that their suppliers continue existing production, to ensure continuing cash flow. In exchange, suppliers often request accelerated payment terms.
2. Bankruptcy
If an out-of-court workout fails, it is likely that a distressed company will file a voluntary
