Effective seller remedies when confronting a financially distressed buyer prior to bankruptcy.
So what are the options for trade creditors who are obligated to sell on credit to a financially distressed company that is on the verge of, but has not yet filed for, bankruptcy? Article 2 of the Uniform Commercial Code ("UCC") contains two remedies (in addition to reclamation) that, a trade creditor can utilize, in the right circumstances, to enhance the likelihood of payment of its claim.
The first remedy is a seller's state law right to stop delivery of goods to a customer that is either insolvent or is in default of its obligations to the seller. However, what if the seller has a financially troubled customer that is current in payment of its obligations and/or the seller has no proof of the customer's insolvency, and, therefore, cannot exercise any stoppage of delivery rights? The trade creditor may still have concerns about the customer's ability to pay for goods sold on credit based upon the customer's perilous financial condition and/or the threat of the customer's imminent bankruptcy filing.
The answer is an alternative, less widely-known, UCC Article 2 remedy where the seller can demand adequate assurance of due performance from a financially shaky customer that the seller has reasonable grounds to believe will not be able to pay for goods sold or otherwise perform under their contract. Pending receipt of such assurance, and if commercially reasonable, the seller can suspend performance under the contract, including selling only on cash terms to the financially distressed customer.
There's a lot to chew on here. Let's flesh out some of these trade creditor remedies.
A Seller's Stoppage of Delivery Rights
According to UCC [section][section] 2-702, 2-703 and 2-705, an unpaid seller can stop delivery of goods not yet received by a buyer that is either insolvent or has failed to timely pay its obligations to the seller. A seller seeking to prove the insolvency of its financially troubled buyer can rely on the UCC definition of insolvency. The UCC defines insolvency on either an equity or balance sheet basis. Under the easier to prove equity definition, a buyer is insolvent when it is unable to pay its debts in the ordinary course of business or as they come due. Under the far more restrictive and harder to prove balance sheet definition, a buyer is insolvent when its liabilities exceed its assets.
According to UCC [section] 2-702(1), a seller can refuse to deliver goods to an insolvent buyer other than on cash terms. This remedy allows a seller to stop delivery of goods in its possession and condition further deliveries on a change from credit to cash terms.
An unpaid seller can also stop goods in transit, goods in the possession of a common carrier, warehouse or other third party bailee, where the buyer is insolvent or in default of its obligations to the seller. A seller that seeks to stop delivery of goods in transit must instruct the carrier, warehouse or other third party not to release any goods they are holding to the buyer. While there is no requirement for a written instruction to stop delivery, the seller would be wise to deliver a written demand to stop delivery to the carrier, warehouse or other bailee, and also send a copy of the demand to the buyer.
A carrier, warehouse or other bailee that receives a seller's notice to stop delivery of goods in transit, must hold and deliver the goods according to the seller's instruction. The seller is liable for all charges and damages that the carrier or other third party incurred from honoring the seller's stoppage of delivery instruction.
A seller loses its right to stop delivery of goods in transit when (a) the buyer received the goods; (b) a bailee, other than a carrier, acknowledges to the buyer that it is holding the goods for the buyer; (c) a carrier transporting the goods acknowledges to the buyer that the carrier is holding the goods for the buyer by either reshipping them according to the buyer's instruction or holding them as the buyer's warehouse; or (d) a negotiable document of title for the goods has been issued or negotiated to the buyer, or a non-negotiable document has been issued to someone other than the seller.
An unpaid seller can stop delivery even after passage to the buyer of title or risk of loss with respect to the goods. Additionally, a seller's stoppage of delivery rights remain intact even where the buyer had engaged the carrier that picked up the goods or where the buyer is responsible for insuring the goods and/or paying the shipping charges. An unpaid seller that is considering exercising its stoppage of delivery rights should carefully review its contract with the buyer to determine whether there are any limitations on these rights.
How are a seller's stoppage of delivery rights affected by the buyer's bankruptcy filing? Bankruptcy courts have ruled that a seller can stop delivery of its goods despite the buyer's bankruptcy filing and the resulting automatic stay that would otherwise halt a creditor's collection efforts. Courts have also ruled that a seller's stoppage of delivery of its goods is not an avoidable preference. In many cases, following a seller's exercise of stoppage of delivery rights, the buyer obtains delivery of the goods by paying for them.
The seller should proceed carefully when exercising its stoppage of delivery rights following a buyer's bankruptcy filing. The seller should review the court docket in the buyer's bankruptcy case to make sure that no order has been entered that bars the exercise of its stoppage of delivery rights. And, except for notifying the carrier or other bailee to stop delivery of its goods, the seller should take no further action to recover its goods without first moving for relief in the bankruptcy court.
A Seller's Adequate Assurance of Due Performance Rights
The UCC also provides relief to a seller that has concerns about a buyer's financial viability where the seller cannot satisfy the UCC's stoppage of delivery requirements. UCC [section] 2-609 provides that when a party to a sales contract has reasonable grounds to be insecure about the other party's ability to perform under the contract, the insecure party may send a written demand for the other party to provide adequate assurance of that party's ability to perform its obligations under the contract. The other party must then respond with adequate assurance of its ability to perform in a reasonable time not to exceed thirty (30) days. In the meantime, the insecure party can suspend its own performance under the contract (such as by switching from credit to cash terms), until it receives such assurance as long as its suspension of performance is "commercially reasonable." In the event the other party fails to respond or does not provide adequate assurance of its ability to perform under the contract in a timely manner, the insecure party can treat the contract as repudiated and sue for breach of contract.
A seller's right to adequate assurance under UCC [section] 2-609 is premised on the fact that each party to a sales contract cannot impair the other party's expectation of receiving full performance under the contract. That includes the buyer's timely payment of the purchase price for the goods. The seller should be protected from the risk of nonpayment by a financially shaky buyer once the seller learns of the uncertainty of the buyer's ability to pay for the goods.
The UCC [section] 2-609 adequate assurance of performance remedy contains many poorly defined terms and is very fact-based. When does a seller have reasonable grounds to be insecure about a financially shaky buyer's ability to pay for goods? The seller must be "reasonably" insecure to exercise this remedy, not absolutely certain of the worst. A seller can demand adequate assurance of performance where the buyer becomes past due on its indebtedness to the seller or other creditors. A seller would also have reason to be insecure in response to a buyer's sudden increase in requests for credit or the buyer's decision to discontinue an early payment discount. Even a seller's suspicion of the buyer's insolvency that turns out to be untrue could trigger the seller's right to adequate assurance in the right circumstances.
UCC [section] 2-609 also lays out a very fact-based amorphous standard for what constitutes adequate assurance of due performance by the buyer. The buyer's assurance must satisfy undefined "commercial standards." The buyer must prove the likelihood of its ability to perform under the contract that would convince a reasonable merchant. The courts have been left with fleshing out the meaning of these terms. For instance, courts have ruled that a financially shaky buyer's offer of a letter of credit in favor of the seller was adequate assurance of the buyer's ability to perform under its contract with the seller. Other courts have ruled that a buyer had provided adequate assurance by providing financial information, including cash flow projections and financial statements, or proof of the availability of credit under the buyer's lending arrangements, that confirmed the buyer's ability to pay for the goods. On the other hand, a financially shaky buyer's mere unsubstantiated assurance of its ability to pay for goods or obtain adequate financing or other third-party support may not be adequate assurance of its ability to pay for the goods.
Trade creditors should proceed carefully and consult with counsel prior to exercising this remedy. A creditor that lacks reasonable grounds for insecurity, made an improper demand for adequate assurance of due performance by the buyer, improperly rejected assurances offered by the buyer and improperly halted performance under the contract could be in breach of contract and subject to damage claims by the buyer. The creditor should also review the terms of its contract with the buyer which may waive or determine adequate assurance rights, specify the grounds for insecurity that would give rise to these rights or specify the assurances a buyer could offer.
Cases Dealing With a Seller's Adequate Assurance Rights
In In re JW Aluminum Company, the United States Bankruptcy Court for the Middle District of Florida, in a 1996 decision, ruled that a seller was entitled to adequate assurance of a financially troubled buyer's ability to perform under their contract. The seller had agreed to supply aluminum on 30-day credit terms to the buyer under a long-term supply agreement. The court relied on the fact that the seller had become aware of the buyer's financial difficulties and of widespread rumors of the buyer's imminent Chapter 11 filing all while the buyer owed the seller $3,174,740 for aluminum the seller had previously sold and delivered to the buyer. The court also noted that the buyer's offer of an administrative priority claim in favor of the seller for postpetition credit sales following the buyer's bankruptcy filing was not adequate assurance of the buyer's ability to pay for the seller's goods. The court did note that the buyer could have satisfied the adequate assurance requirement by offering to post a letter of credit in favor of the seller or pay cash in advance or cash on delivery terms for the goods.
Similarly, in a 1976 decision, in Turntables, Inc. v. Gestetner, a New York State appellate court dismissed a buyer's lawsuit for breach of contract against the seller that had refused to continue selling goods on credit terms to the buyer based on the seller's suspicion of the buyer's insolvency. The court ruled that the seller had acted properly under New York's UCC [section] 2-609 in demanding adequate assurance of due performance by the buyer where the buyer was past due in payment of its obligations to the seller; the buyer's showroom was a telephone answering service; the buyer's factory was someone else's premises to which the buyer did not have access, the buyer had not leased space and had no employees, payroll, machinery or equipment in that facility; another supplier had told the seller that the supplier had been saddled with an unpaid bill owing by the buyer and the buyer had a reputation for not paying its obligations. The buyer's refusal to offer any assurances to the seller resulted in a cancellation of the contract, thereby defeating the buyer's breach of contract claim arising from the seller's refusal to continue delivering goods to the buyer.
Finally, in its 2007 decision in Precision Master, Inc. v. Mold Masters Company, the Michigan Court of Appeals rejected a seller's refusal to accept the buyer's offer to provide a letter of credit to assure payment of its obligations under its contract with a seller for the manufacture of pull ahead/production molds. The court rejected the seller's demand for C.O.D. payment terms, interest on the buyer's late payments and other requirements not contained in the parties' contract. The court viewed the seller's adequate assurance demands to be an improper attempt to alter and obtain more favorable terms under its contract with the buyer. The buyer's ability to obtain a letter of credit that would have assured the buyer's timely payment of its obligations to the seller was sufficient assurance of the buyer's ability to perform under the contract.
An unpaid seller's stoppage of delivery and adequate assurance of due performance rights are an effective means by which a seller, dealing with a financially troubled buyer, could enhance the likelihood of payment of its claim. At a minimum, a seller's exercise of these rights may open the door to a discussion with the buyer that could lead to reduced credit terms, and/or offers of third party support or other security for payment of the creditor's claim. Not a bad strategy for a trade creditor in these troubled times!
(1.) This author incorrectly believed the correct quote was "Fasten your seatbelts, it's going to be a bumpy ride," which sounds even more applicable to the current sorry state of the American economy.
Bruce Nathan, Esq.
Bruce will be speaking on these topics:
17041. Practical Bankruptcy Knowledge for Survival in Today's Troubled Economic Climate
17057. Hot and Emerging Legal Issues
17068. Creditors' Rights Forum
Bruce Nathan, Esq. is a partner in the New York City office of the law firm of Lowenstein Sandler PC. He is a member of NACM and is on the Board of Directors of the American Bankruptcy Institute and is a former co-chair of ABI's Unsecured Trade Creditors Committee. He can be reached via email at firstname.lastname@example.org.
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|Date:||Feb 1, 2009|
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