Risky Business: Selling to a Potentially Insolvent Customer

Kegler Brown Creditors' Rights + Bankruptcy Alert

Extending credit to a financially shaky customer is risky. When the customer files a chapter 11 bankruptcy case and continues to operate, the risks multiply. Properly understood, some of the inherent risks can be reduced.

Often a customer that has filed a chapter 11 bankruptcy case will contact a vendor with assurances of payment. Such assurances are certainly welcome, but keep in mind that the purchasing agent making the call probably does not have the legal authority to make any promises. A business in a chapter 11 proceeding is ordinarily not allowed to pay or promise to pay any invoices for goods shipped prior to the commencement of the bankruptcy.

A customer may also advise a vendor that unsecured credit will be entitled to priority in payment during the course of the chapter 11 proceeding. While this is technically true, a priority claim for an expense of operating the chapter 11 business is lower in priority than secured claims. Often chapter 11 debtors have substantial secured debt but insufficient assets to it. Secured debt is paid first in the event of failure of the reorganization, so creditors holding unsecured priority claims may be paid nothing. A vendor's priority claim for goods sold post-petition is often worthless.

Supply agreements or other ongoing contracts also troublesome. Unless a court orders otherwise, a vendor is usually required to continue to perform under a supply agreement, even if the customer has not paid all pre-petition invoices. Unilaterally stopping shipments to a customer in a chapter 11 case may be a violation of the automatic stay against collection activities. Vendors that have supply agreements in place are entitled to some protections under the Bankruptcy Code. Assistance of experienced counsel will be required to exercise these rights.

A large company in a chapter 11 proceeding may seek a court order allowing it to pay prepetition invoices to so-called "critical vendors." If allowed by the court, the customer will often be given the right to pick and choose vendors it believes to be critical to its operations. A vendor is not allowed to seek this designation. If critical vendor treatment is offered, a vendor should carefully review the court order approving the treatment and all fine print in any proposed critical vendor agreement. Ordinarily a participating critical vendor will be required to accept numerous changes in credit terms, often including prohibition of price increases. A vendor should carefully evaluate whether the proposed changes to credit terms out-weigh the benefit of payment of prepetition invoices.

Swift action is necessary when a customer files a chapter 11 bankruptcy. The vendor should determine whether there are pending contracts that may require continued sales on open account. Assurances of payment and of priority claim treatment must be viewed with skepticism, unless the court has entered a critical vendor order. Terms offered for critical vendor treatment and proposed changes in the credit relationship require careful consideration. Decisions to continue selling or to stop selling should be reviewed with experienced bankruptcy counsel if economic interest are substantial.