Risk Mitigation in Supply Chain Contracts: Critical Vendor, Reclamation and Pipeline Claims

COVID-19 Update

Date: May 26, 2020

Key Notes:

  • As COVID-19 continues to cripple the U.S. and world economies, many businesses question whether those within their supply chain will file for bankruptcy and how that will affect their claims for sold goods.
  • A fundamental bankruptcy principle is that similarly situated creditors should be treated equally. Creditors who hold prepetition unsecured non-priority claims generally do not receive favorable treatment and will be paid pro-rata at the end of the case.
  • However, holders of certain prepetition unsecured claims may be entitled to receive special treatment and may be paid or receive value that is more than just bankruptcy dollars.
  • Some may be able to assert that they are “critical vendors” who should be paid at the start of the case, as they help a debtor reorganize under chapter 11; some may be able to reclaim certain goods that were shipped prior to the bankruptcy filing or otherwise ensure immediate or priority payment for those goods.

As the pandemic’s economic consequences continue to ripple through supply chains worldwide, including an uptick in bankruptcy filings, many companies that sell goods to other businesses wonder what recourse they have to seek payment for or return of goods they have shipped to a customer who has filed for bankruptcy.

Imagine the following scenario: Your business just sold goods to a customer and the latest shipment is on the way. But then you receive notice that the customer has filed for bankruptcy. Most sellers in this situation are understandably concerned that they will no longer be paid and may not be able to reclaim delivered goods.

Fortunately, the Bankruptcy Code provides several options for suppliers who have shipped goods to a debtor-customer and have not been paid. While they are usually considered general unsecured creditors who will not be paid until the end of the bankruptcy case, some can assert that they are “critical vendors” who should be paid at the start of the case, as they help a debtor reorganize under chapter 11. In some cases, the supplier may be able to reclaim the goods it shipped prior to the bankruptcy filing or otherwise ensure immediate or priority payment for those goods.

Is your company considered a “critical vendor” that can potentially receive payment for goods delivered to the debtor prior to the bankruptcy filing?

In some situations, the debtor cannot obtain the goods a vendor sells from any other supplier, making the creditor a “critical vendor” that the debtor needs to rehabilitate and reorganize its business under chapter 11 of the Bankruptcy Code. For example, a critical vendor might be a pre-approved sole supplier of essential, specially fabricated components it sells to a debtor that manufactures parts, which the debtor then sells to automobile manufacturers. Essential creditors like this should determine whether the debtor filed a “critical vendor motion” at the commencement of the bankruptcy case, seeking court authorization for payment on account of goods delivered prepetition.

Under the “doctrine of necessity,” also known as the “necessity of payment” rule, a bankruptcy court may allow a debtor to pay certain prepetition claims early in the case if it can show that payment will help rehabilitate or reorganize its business without harming other parties in interest. The debtor pays the critical vendor all or part of its prepetition claim in exchange for the vendor’s promise to provide essential goods and services to the debtor post-petition. Under a typical critical vendor order, the supplier must continue to do post-petition business with the debtor or refund any prepetition payments it has received under the critical vendor order (except to the extent that the payments relate to post-petition goods and services).

When authorizing critical vendor payments, bankruptcy courts usually rely on section 105 of the Bankruptcy Code, which allows a court to “issue any order, process, or judgment that is necessary or appropriate[.]” Note that some courts are more willing to use this power than others. Bankruptcy judges sometimes express concern that critical vendor payments are considered a form of subordination – the procedure by which a court reorganizes the distribution of claims. Without any kind of inappropriate conduct by other creditors, the subordination of certain general unsecured claims to others may be considered inappropriate.

Is your company entitled to a priority administrative claim as a post-petition supplier?

If a debtor seeks to reorganize its business, it may also enter into new relationships with vendors post-petition. Since these creditors provide goods and services on credit terms to the debtor or trustee during the course of the bankruptcy case, they are provided priority and typically paid before prepetition unsecured claims. Section 364(a) of the Code permits a bankruptcy trustee to obtain unsecured credit and incur unsecured debt “in the ordinary course of business.” The debt incurred from these transactions is then given priority as an administrative expense claim under section 503 of the Bankruptcy Code as the “actual and necessary costs and expenses” of preserving the bankruptcy estate. This priority status induces creditors to do business with a debtor or trustee during the bankruptcy case, thus increasing the likelihood that the debtor will rehabilitate its business.

In addition, section 364(b) of the Code allows the trustee to obtain unsecured credit or incur unsecured debt outside of the ordinary course of business. Such debt will also receive administrative priority, but it must be approved by the court first. Although not explicitly required, the trustee will likely need to show why they are seeking this transaction, and if the terms are less favorable than what the debtor could have obtained within the case, the court will likely deny the request and find that it’s not a prudent exercise of the trustee’s business judgment.

Can your company reclaim goods sold to the debtor before the bankruptcy filing?

In certain situations, a creditor may be able to reclaim goods that it sold to a debtor before the debtor filed for bankruptcy. Section 546(c) of the Code gives a seller the right to reclamation if the debtor received the goods while “insolvent” and within 45 days before the case was filed. To exercise this remedy, a seller must make a written demand no later than 20 days after the case was commenced. The goods must be identifiable (i.e., not commingled with other goods), and the seller’s rights are still subject to the prior rights of a holder of a security interest in the goods. Note that a debtor or trustee may be able to defeat the creditor’s right to reclamation through state fraudulent transfer law or fraudulent transfer law under section 548 of the Code.

If a seller fails to timely provide a reclamation notice, it may still assert a right to allowance of an administrative expense claim under section 503(b)(9) of the Bankruptcy Code, which grants priority for the value of any goods sold to, and received by, the debtor within 20 days before the case was filed, so long as the goods were sold in the ordinary course of the debtor’s business. This priority claim is a statutory departure from most of the other claims under section 503(b), since it provides administrative expense status to a prepetition debt.

Can your company get paid for “pipeline” claims?

When a debtor files for bankruptcy, there may be goods that are still in transit on the petition date and scheduled to be delivered post-petition (i.e., the goods are still in the delivery “pipeline”). Surprisingly, there is no specific provision in the Bankruptcy Code that directly addresses how these goods should be treated in the bankruptcy case. While section 546(c) provides a seller the right to reclaim goods under certain conditions, it does not provide the seller with the right to pursue other non-bankruptcy remedies (such as the right to stop goods in transit). Since the debtor did not receive the goods 20 days before the petition date, the vendor is also not entitled to recover value of the goods as part of a 20-day reclamation claim. Furthermore, the automatic stay limits a vendor’s ability to refuse to deliver post-petition goods.

To resolve this unique issue, debtors often file a motion at the start of the case seeking an order that will enable them to pay vendors the full value of any goods in the pipeline. But if the motion is not filed and granted, a vendor may seek confirmation from the debtor that either the cost for accepted goods will be treated as an administrative claim or the shipment will be considered part of an executory contract between the debtor and vendor, which may be assumed or rejected later on in the case.

FOR MORE INFORMATION

For more information, please contact:

Connie Boland
212.908.3950
Connie.Boland@ThompsonHine.com

David S. Forsh
212.908.3913
David.Forsh@ThompsonHine.com

Sean A. Gordon
404.407.3678
216.566.5626
Sean.Gordon@ThompsonHine.com

Matthew Kerschner
216.566.5834
Matthew.Kerschner@ThompsonHine.com

Jessica Kincaid
216.566.5683
Jessica.Kincaid@ThompsonHine.com

Laura Watson Schultz
216.566.5824
Laura.Schultz@ThompsonHine.com

Louis F. Solimine
513.352.6784
Louis.Solimine@ThompsonHine.com

Additional Resources

We have assembled a firmwide multidisciplinary task force to address clients’ business and legal concerns and needs related to the COVID-19 pandemic. Please see our COVID-19 Task Force page for additional information and resources.

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