Chapter 11's on the Rise
Red Flags and Steps to Protect Your Credit Sales
By Scott Blakeley

A record number of bankruptcies for businesses are being reported. Enron filed the largest Chapter 11 ever, with billions in assets and liabilities. Kmart followed, being the largest retailer to file, with assets and liabilities in the billions and 2,100 stores. The notion that a company is simply too large to file Chapter 11, as the company would be rescued by creditors or the government, is gone.

Whether a local business suffering a downturn in business, or public company with a billion dollars in assets, Chapter 11, the reorganization chapter of the Bankruptcy Code, is on the rise. The causes for the spike in Chapter 11 filings are varied. Sept. 11 has been cited by companies as both a direct and indirect factor. Bank financing, bond offerings and IPO's are significantly down, making it difficult for customers to borrow. Commercial insurance premiums are soaring. Revenues for many companies are significantly down, resulting in missed payments to vendors.

A credit professional must pay close attention to existing customers and scrutinize the financial ability of new customers to spot red flags of insolvency. To the credit professional never exposed to an economic downturn, a customer's bankruptcy may seem to appear with little or no warning, especially with the long-term customer that paid within credit terms. What are red flags that a credit professional may identify that a bankruptcy may be in the offing? What steps can a credit executive take to protect open account sales in this environment, more than simply restricting credit or insisting on COD or CIA?

Many Reasons for Filing Chapter 11

A customer may file Chapter 11 for a variety of reasons, such as to stay creditor collection actions, pare down pre-bankruptcy vendor debts, dispose of certain assets, renegotiate or reject leases, and reposition itself in the marketplace.

Insolvency not a Condition to Filing Chapter 11

The credit professional finds that the corporate customer unable to meet its debts seeks refuge with a Chapter 11 filing to stay creditors from collecting on their delinquent accounts. However, the Bankruptcy Code does not require a customer be insolvent to file bankruptcy. Indeed, Chapter 11 has been used by companies to shed burdensome leases, sell assets and deal with mass litigation, such as asbestos claims. The stigma of Chapter 11 seems to have disappeared, and companies that file for Chapter 11 view it as another tool to achieve a business objective.

Where the Debtor Files: The Delaware Train

A credit professional may be surprised to find that a large, local corporate customer located, say, in Portland Oregon, files for Chapter 11 in Delaware (or New York).

Major companies often can choose to file for Chapter 11 in a number of jurisdictions, most commonly where they are incorporated, have their headquarters or have major operations. This allows for the company with operations primarily in Oregon, but incorporated in Delaware, to file in that state. Of course, local vendors sense that the Delaware locale is chosen, in part, to make it inconvenient for them to be active in the proceeding. It also allows the company to find a forum more favorable to their interests. In recent years, Delaware's caseload was so heavy that it started imported bankruptcy judges to help out.

Some creditors have objected to the forum shopping, complaining to the bankruptcy judge that Chapter 11 should proceed where the majority of creditors are located. In the Enron Chapter 11's, creditors located in Houston file a motion to have the bankruptcy cases transferred from New York to Houston as the majority of the creditors are located in Houston. The bankruptcy judge in New York handling the cases declined the creditors' request to change venue.

Liquidation Versus Reorganization

As the number of bankruptcies of public companies increase, these companies are increasingly forced to liquidate and sell to the highest bidder instead of reorganize. The reasons companies are being forced to liquidate rather than reorganize includes difficulty in obtaining debtor financing, fewer unencumbered assets and impatient creditors pushing for a bankruptcy sale in hopes of maximizing value and belief that assets are slipping away through continued operations. Liquidations can be in the form of company selling off its assets in a piece meal, as seen with LTV, to companies that sell to the highest bidder as a going concern, such as TWA.

Red Flags Indicating Bankruptcy Looming

Given the spike in bankruptcy filings and uncertain economy, a credit professional's skill to identify red flags that may predict a customer's bankruptcy filing is invaluable. The following warning signs may be of assistance:

Tapped-out with bank. If a customer has drawn down on its bank line of credit, it may not have cash flow to meet its operating obligations. This may also mean that the customer may be not be able to find an alternative source of financing, as it does not have assets to offer as collateral. If the customer is struggling and tapped with its lender it is unlikely to additional funding from the bank or bondholders. With the source of financing stalled, more companies are running out of cash and faced with either shutting their doors, finding a buyer, or securing cash at an extraordinary price.

Bond debt value depreciates. A customer's publicly traded bond debt may be a measurement of impending bankruptcy. Where a customer's bond debt value drops, bondholders are fleeing the investment, perhaps fearing bankruptcy. A customer bond payment that is due may elect to file Chapter 11 rather than make the bond payment.

Stock price decline. When a customer's stock price declines significantly, a number of detrimental consequences result. A customer may find that a collapse of its stock price results in a cut-off of additional financing. Investors are more selective on who they will continue to finance, and are moving their money into investments that are less risky. When stock options are a major employment incentive, management may flee when the stock price drops. The customer may be unable to finance operations as it cannot return to the market for additional financing.

Management and key employee departures. Management, including the CFO, or key employees departs. Their departure may have a significant impact on the customer's continued operations, and thereby jeopardize repayment of a vendor's open account sale.

Post-dating and NSF checks. A customer post-dating checks shows that the customer has insufficient funds to meet vendor obligations, as does the NSF check. This may spur collection of lawsuits.

Withdrawal of vendor credit. While vendors act individually in their decision making for extending credit to a customer, news circulates amongst vendors when key suppliers refuse to continue to provide credit. This may spur the creation of an informal creditors' committee.

Using tax money to pay bills. Should a customer be tapped out of its financing, it may use money earmarked to pay taxing authorities.

Ignoring your e-mails and calls. When a customer begins its financial backslide, the vendor finds its e-mails and phone calls requesting payment are not returned. The customer may also refuse to provide financial information.

Hiring bankruptcy counsel or restructuring consultant. If the customer has retained bankruptcy counsel or investment banker or restructuring consultant, bankruptcy may be next, as the reorganization consultants may encourage an early bankruptcy filing to preserve value.

Personal Relations with Customer may be Key. To protect against unexpected bankruptcies, a credit professional may develop a personal relationship with the customer, which may include customer visits. The personal relationship may provide a better financial picture than the financial information provided. Credit professionals have found that not all financial information is contained on a credit report.

Steps to Protect the Credit Sale When Goods are out the Door

If your goods have been shipped to customer that is insolvent or files bankruptcy, what are your rights?

Stopping Goods in Transit

Under state law, UCC Sections 2- 702 (1) and 2-703, if the seller has not yet shipped goods that the buyer ordered on credit terms and the seller discovers that the buyer is insolvent or in bankruptcy, the seller may refuse to deliver the goods to the buyer unless the buyer pays for them. This converts the seller=s payment terms from credit to CBD/CIA or COD. The seller has the same right to withhold delivery of its goods until the buyer pays for them, whether or not the buyer is in bankruptcy.

Reclamation

Reclamation is the right of a seller to recover possession of goods delivered to an insolvent buyer. The right exists under both state law and the Bankruptcy Code. Under the Bankruptcy Code, a court generally does not allow a vendor to reclaim the goods. Rather, a vendor is given a priority claim for the value of the goods. The remedy of reclamation is needed when an unsecured vendor is unable to retrieve goods or stop them in transit. A reclaiming vendor need not prove fraud, although the premise of reclamation is that the vendor was defrauded. Under the common law and the old Uniform Sales Act, the seller could only exercise its reclamation rights if it proved the buyer obtained delivery by misrepresenting its solvency. However, the Uniform Commercial Code (UCC) has expanded this remedy where the buyer does not misrepresent solvency.

Essential Vendor Program

On occasion a vendor may find that the product or service it provides a Chapter 11 debtor is essential and is key to the debtor's continued operations. The uniqueness of the product or service may give such a vendor leverage in negotiating post-bankruptcy sales. In this situation, the debtor may request the bankruptcy court allow it immediately to pay the vendor's prepetition claim, in exchange for the vendor committing to sell on credit to the Debtor post-bankruptcy. The Doctrine of Necessity says that the debtor needs the vendor's product or service in order to reorganize its finances.

Steps to Reduce Credit Risk

Given the dramatic rise in bankruptcy filings and uncertain economic environment, the credit professional may consider alternatives to reduce credit risk, yet still make the sale. Those alternatives may include, a secured sale, either with a purchase money security interest or a security interest in all of the customer's assets, which is junior to the preexisting lender. The vendor may insist on a consignment sale, wherein title to the vendor's goods does not pass to the customer until sale of the goods. The vendor may also consider insisting on the customer providing either a corporate guarantee or a personal guarantee from the customer's principals. A letter of credit may also be considered to reduce risk. The vendor can obtain a standby L/C, which assures payment by a third party after the customer's default.

Commercial credit risk and customer defaults have increased significantly. The credit professional, especially one not experienced with an economic downturn, must be especially vigilant in identifying red flags that may signal a customer's bankruptcy or failure to pay the open account sale. Perhaps these steps will help the credit professional reduce risk of loss.

Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP Spring 02