Chapter 11

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Business Bankruptcy Issues Recent Developments

Do Hedge Funds Have To Disclose Their Trades If They Form A Bankruptcy Committee?

In recent years, hedge funds and other investors in distressed debt or the equity securities of bankrupt companies have taken active roles in Chapter 11 bankruptcy cases. Often, these investors form unofficial or "ad hoc" committees. This post reports on a recent decision by a New York bankruptcy court in the Northwest Airlines case which, if ultimately enforced, could have a major impact on hedge funds, ad hoc committees, and Chapter 11 cases.

Ad Hoc Committees. Unofficial or ad hoc committees, much like official committees of unsecured creditors, equity security holders, retirees, or other constituencies, typically hire counsel and file motions and other pleadings during the course of a bankruptcy case. By acting as a group, the committee’s members not only share the costs of participating in the bankruptcy case but also have the ability to wield greater influence by acting collectively instead of on an individual basis.

The Rule 2019(a) Statement. After making an appearance in a bankruptcy case, these committees, their counsel, or both will typically file what’s known as a "Rule 2019(a) Statement." This is a public filing required by Rule 2019(a) of the Federal Rules of Bankruptcy Procedure, the set of procedural rules which, together with the United States Bankruptcy Code itself, govern the conduct of bankruptcy cases. Rule 2019(a) provides, in part, as follows:

[E]very entity or committee representing more than one creditor or equity security holder . . .  shall file a verified statement setting forth (1) the name and address of the creditor or equity security holder; (2) the nature and amount of the claim or interest and the time of acquisition thereof unless it is alleged to have been acquired more than one year prior to the filing of the petition; (3) a recital of the pertinent facts and circumstances in connection with the employment of the entity . . . ; and (4) . . . the amounts of claims or interests owned by the entity, the members of the committee or the indenture trustee, the times when acquired, the amounts paid therefor, and any sales or other disposition thereof.

The Ad Hoc Committee In Northwest Airlines. While seemingly a dry and arcane bankruptcy rule, it has recently become anything but in the Northwest Airlines Corporation Chapter 11 case. In January 2007, an Ad Hoc Committee Of Equity Security Holders first made an appearance in the case. Its thirteen members include hedge funds and other investment entities that collectively own more than 19 million shares of Northwest Airlines stock and approximately $265 million in claims. The Ad Hoc Committee sought discovery in the case and asked that an official committee of equity security holders be appointed (a request it recently withdrew). 

The Debtors Seek Additional Disclosure. In the course of litigating certain disputes, Northwest Airlines filed a motion seeking, among other relief, an order under Rule 2019 requiring the Ad Hoc Committee to disclose more detailed information about the amounts of claims or stock owned by the Committee’s members, when they acquired it, how much they paid for it, and when they sold or otherwise disposed of any of their holdings. In support, Northwest Airlines made this argument:

The Ad Hoc Committee remains a mystery to the Debtors and to all the other constituencies in the Debtors’ cases, yet it seeks to make an impact at this late stage of the Debtors’ reorganization. Without the proper disclosures, the Court should refuse to allow the Ad Hoc Committee to continue to cause serious delays to the Debtors’ reorganization efforts, and operate outside of the Bankruptcy Code and the Bankruptcy Rules.

The Ad Hoc Committee Opposes The Motion. The Ad Hoc Committee opposed the motion on several grounds, including that its Rule 2019 statement was proper in form, that the purpose of the rule is only to ensure that plans of reorganization are negotiated and voted on by those authorized to act for the real parties in interest, and that this purpose was satisfied by the form of the statement already filed.

The Northwest Airlines Court’s Rule 2019 Decision. On February 26, 2007, Judge Gropper issued his decision requiring the Ad Hoc Committee to file a Rule 2019 statement that provided the detailed information the Debtors had sought in their motion. The Court ruled that Rule 2019 applies to ad hoc or unofficial committees and rejected the Ad Hoc Committee’s argument that the prior Rule 2019(a) statement, which did not give detailed information about dates of trades and prices paid, was adequate.

The Ad Hoc Committee’s Further Motion. On March 1, 2007, the Ad Hoc Committee filed a motion for an order allowing the additional Rule 2019 statement to be filed under seal but asking that the Court stay its prior order pending further hearing. The Ad Hoc Committee argued that the trading information required under the Court’s order represented trade secrets and confidential commercial information and that, to its knowledge, no other committee or party had been required to file such information publicly in any other Chapter 11 case. The Ad Hoc Committee contended that requiring its members to make that disclosure would irreparably damage them, as other investors were not required to make such disclosures but some might use that information to inform their own trades.

The Court Grants The Ad Hoc Committee’s Motion. Later that same day, the Court granted the Ad Hoc Committee’s motion. The Court set a fast briefing schedule and a further hearing for March 7, 2007. I will plan to report on the resolution of that motion after the Court makes its decision.

Why This Matters. While disputes over disclosure are not always worthy of motions, multiple hearings, and blog postings, this case is different. Hedge funds and other buyers of distressed debt or stock in bankrupt companies carefully guard their trading information, especially the price they’ve paid. If ad hoc committee members will be required to disclose this information publicly, or perhaps even privately, they may choose not to participate in unofficial committees or generally may be dissuaded from becoming active participants in Chapter 11 cases. Hedge funds and other distressed debt traders have been deploying enormous amounts of money through second lien lending in distressed situations and directly in bankruptcy cases through the purchase of claims and stock. They have also regularly taken very active roles in major Chapter 11 cases. Any ruling with the potential to reverse or impact this trend would be big news indeed.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

The New Section 503(b)(9) Administrative Claim: The Latest On What Courts And Debtors Have Been Doing

A couple of months ago I posted on the new "20 day goods" administrative claim enacted as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA"). BAPCPA, which took effect in October 2005, added Section 503(b)(9) to the Bankruptcy Code giving vendors an administrative priority claim for "the value of any goods received by the debtor within 20 days before" the date the bankruptcy petition was filed, as long as "the goods have been sold to the debtor in the ordinary course of such debtor’s business." 

In my earlier post, I posed a number of unresolved questions about this new section and predicted that courts would soon start to address those issues. Well, in the past couple of months we have in fact seen decisions answering at least a few of the questions raised by Section 503(b)(9).

The First Court Decisions. In late December 2006, bankruptcy courts in the District of Delaware and the Eastern District of Pennsylvania issued what appear to be the first two decisions on when and under what circumstances Section 503(b)(9) administrative claims must or should be paid. As explained below, in both decisions the bankruptcy court held that the administrative claimant was not necessarily entitled to payment prior to, in a Chapter 11 case, confirmation of a plan of reorganization.

  • In the first decision, issued December 21, 2006, Judge Kevin Gross of the U.S. Bankruptcy Court for the District of Delaware denied a creditor’s motion for payment of a Section 503(b)(9) administrative claim in the In re Global Home Products, LLC Chapter 11 bankruptcy case. The court held that the timing of payment of administrative claims is left to the discretion of the court. In so doing the court quoted with approval from an article that described Section 503(b)(9) as a "rule of priority, rather than payment." The court relied on a non-Section 503(b)(9) decision for the three factors to assess when considering when an administrative claim should be paid, chiefly, (a) the prejudice to the debtor, (b) hardship to the claimant, and (c) potential detriment to other creditors. The court applied those factors and denied the creditor’s request for immediate payment.
  • In the second decision, issued a week later on December 28, 2006, Judge Eric Frank of the U.S. Bankruptcy Court for the Eastern District of Pennsylvania denied a motion for immediate payment of Section 503(b)(9) claims filed by several creditors in the In re Bookbinders’ Restaurant, Inc. Chapter 11 bankruptcy case. Although the debtor agreed that the creditors were entitled to allowance of a "20 day goods" administrative claim, it opposed the immediate payment of those claims. The court held that the timing of payment was a matter of the court’s discretion but agreed to hold an evidentiary hearing to consider evidence to guide the exercise of that discretion.

A Few Early Take-Aways. In both of these decisions, the courts held that they have discretion to defer payment until the end of a Chapter 11 bankruptcy case, when a plan of reorganization is confirmed.

  • Creditors who can establish that failing to pay their Section 503(b)(9) claim would cause them hardship, but not prejudice the debtor or other creditors, may still be able to obtain immediate payment. As these cases show, however, creditors will find it challenging to meet that standard.
  • Interestingly, the Bookbinders court rejected what it called an "equal protection" argument by the creditors, who asserted that they should be paid immediately because vendors delivering goods to the debtor post-petition were being paid on their administrative claims. The court drew a distinction between the two claims, explaining that the creditors delivering goods post-petition were paid not under Section 503(b) but instead under Section 363(c)(1) of the Bankruptcy Code. That latter section allows a debtor in possession or trustee to enter into post-petition ordinary course of business transactions, and to pay for them, without court approval.
  • Finally, DIP financing orders can impact the timing of paying Section 503(b)(9) claims. In some cases the DIP budget may not include funds to pay these claims and in others the DIP order may expressly prohibit their payment. Section 503(b)(9) creditors may want to review proposed DIP financing motions carefully with this in mind.

What Debtors Have Been Doing. In an attempt to exert a degree of control over Section 503(b)(9) claims, some debtors have filed motions seeking to establish procedures to handle these claims, not unlike the procedures used in past cases for reclamation claims. In the Seattle case of In re Brown & Cole Stores, LLC, for example, the debtor filed a motion for an order establishing procedures for Section 503(b)(9) claims. The court granted the motion and entered a Section 503(b)(9) procedures order which, among other things:

  • Required creditors to file Section 503(b)(9) claims by a special bar date;
  • Required the debtor to file a report evaluating such claims 21 days after the special bar date;
  • Gave creditors 15 days thereafter to file a reply to the debtor’s position;
  • Made the debtor’s position binding in the event a creditor did not timely respond; and 
  • Reserved to the court the right to resolve any disputes. 

The order effectively reserved the issue of when valid Section 503(b)(9) claims would be paid but made the procedures the exclusive method for determining the validity and amount of such claims. I expect that other debtors will pursue similar procedures for handling these "20 day goods" claims.

Don’t Touch That Dial. These early decisions are the first in what should be many future rulings on the questions posed by Section 503(b)(9). I’ll continue to update you on how courts are interpreting this new administrative claim and, over time, we should begin to see more clarity on how debtors, vendors, and courts will address this new BAPCPA provision.

Business Bankruptcy Issues Recent Developments

Delaware Bankruptcy Court Denies Reclamation Claimant’s TRO Request To Stop Sale Of Goods

In a recent post, I discussed how Section 546(c) of the Bankruptcy Code, as revised by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA"), gives vendors the ability to assert a reclamation claim for goods received by a debtor in the 45 days prior to the bankruptcy filing. In addition to extending the reclamation period to 45 days, BAPCPA also added a provision in Section 546(c) making reclamation claims "subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof." This quoted language refers to a secured creditor with a senior lien in the same goods.

The Advanced Marketing Services case. Section 546(c)’s expanded reclamation rights, and how they may be impacted by the "prior rights" of a secured creditor, recently played out in the Chapter 11 bankruptcy case of In re Advanced Marketing Services, Inc. pending in the United States Bankruptcy Court in Delaware.

Simon & Schuster, Inc., a reclamation claimant, filed a complaint against the debtor, Advanced Marketing Services, Inc. ("AMS"), seeking to reclaim more than $5 million worth of goods that the debtor allegedly received in the 45 days prior to the bankruptcy filing. (You can access the pleadings from the Simon & Schuster litigation by clicking on the appropriate links in this post.)

  • In an effort to gain control over the goods at issue, Simon & Schuster filed an application for a temporary restraining order (known as a "TRO") seeking a court order to prevent AMS from selling the goods. 
  • The debtor opposed the TRO, challenging whether Simon & Schuster had the right to reclaim the goods.
  • The debtor’s secured creditor, Wells Fargo Foothill, Inc., also filed an opposition to the TRO, arguing that the reclamation claim was subject to its prior rights as a prepetition secured creditor and as a debtor in possession ("DIP") lender. In this case, the DIP loan has been structured as a "creeping roll up" in which prepetition obligations are to be satisfied by the use of cash collateral and the DIP lender in turn receives a postpetition lien as that cash collateral is used.
  • Simon & Schuster filed a reply brief responding to the opposition papers filed by the debtor and the secured creditor.

The Court’s Decision. In a decision issued by the Bankruptcy Court yesterday, Judge Sontchi denied Simon & Schuster’s application for a TRO without prejudice, holding that Section 546(c) made Simon & Schuster’s reclamation rights subject to the prior rights of the secured creditors. (The Bankruptcy Court also noted that it would have reached the same result under pre-BAPCPA bankruptcy and UCC law.)

  • The Bankruptcy Court held that the secured creditors had superior prepetition and postpetition liens in the goods Simon & Schuster sought to reclaim and that Simon & Schuster therefore could not establish that it was likely to prevail on the merits of its reclamation claim.
  • The Bankruptcy Court also rejected any attempt to require "marshaling" by the secured creditor, which if ordered could have required the secured creditor to satisfy its claim first from collateral other than the goods that Simon & Schuster sought to reclaim.

Stay Tuned. As one of the first decisions on this reclamation issue under BAPCPA, the Advanced Marketing Services decision is an important one. However, it’s not the last word on how the respective rights of reclaiming vendors and secured creditors will be decided in Chapter 11 cases. Reclamation issues are often fact dependent and results may vary in different cases. Also, vendors unable to prevail on a reclamation claim may still have a "20 day goods" administrative claim, and this fact may influence how debtors treat vendors in future cases.  

Business Bankruptcy Issues Recent Developments

Second Liens and Intercreditor Agreements: Are Those Bankruptcy Voting Provisions Really Enforceable?

In this post I look at the second lien phenomenon and then discuss an interesting new case addressing whether a fairly common intercreditor agreement provision — giving a senior lender the right to vote a second lien lender’s claim in bankruptcy — will actually be enforced.

Senior Debt And Mezzanine Financing. When a company borrows from a bank, it typically grants the bank a first priority, blanket security interest in all of its assets to secure this senior debt. In the past, when a company needed additional capital, whether to grow the business or to fund an acquisition, it often turned to unsecured "mezzanine" financing, so named to reflect its middle position between senior debt and equity. This type of unsecured debt typically is subject to complete payment subordination in favor of the senior lender and is considerably more expensive than bank debt. 

The Second Lien Market. One of the biggest financing trends in recent years has been the move away from unsecured mezzanine credit to debt secured by a second priority security interest on all of the company’s assets. Much of this "second lien" debt is coming from hedge funds and other private equity funds, although more traditional lenders have also become active in the market. According to CFO.com, the second lien market has grown dramatically over the past several years, from $570 million in 2002 to more than $16 billion in 2005. Some reports suggest it approached $30 billion in 2006. 

Why the attraction to second lien financing? The main reasons are price, terms, and availability. Healthy companies generally find the pricing on second lien credit to be lower than unsecured mezzanine debt (although a bit more expensive than on senior debt) and often comes with few covenants. For distressed companies, if they can obtain additional credit at all, many times it’s as part of a restructuring in which a new lender requires a second lien to protect it from an increased risk of default. 

Subordination and Intercreditor Agreements. Most second liens are blanket security interests and cover the same collateral against which the senior lender has a first lien. Traditionally, senior lenders include provisions in their loan documents prohibiting borrowers from granting security interests or liens to any other lender without the consent of the senior lender. When a lender proposes to make a second lien (also known as a "junior" or "tranche B" loan), it must negotiate not only with the borrower but also with the senior or "tranche A" lender. As the size of the second lien market suggests, senior lenders have been willing to consent to second lien loans, often to help the borrower make an acquisition or to bring in additional liquidity.

  • The negotiations between the first and second lien lenders usually address their respective rights to the collateral and various provisions regarding repayment of their loans. Sometimes the second lien debt will be subordinated to repayment of the senior debt, as with traditional mezzanine financing, but more often only the security interest in the common collateral will be subordinated to that of the senior lender.
  • The senior lender generally insists that the junior lender be a "silent second" and waive rights to object to actions taken by the senior lender in a default or bankruptcy. The junior lender instead wants to have the ability to protect its own interests. The end result often comes out somewhere in between, but restrictions on the second lien lender are common.
  • The arrangements between the senior and second lien lenders are documented in a separate agreement, usually called an intercreditor agreement or a subordination agreement.

Key Intercreditor Agreement Provisions. If everything goes well and the borrower repays its loans on time, the provisions of the intercreditor agreement won’t be all that important. However, if the borrower defaults on the loans, or files for bankruptcy, the terms of the agreement can become critical.

  • With bankruptcy in mind, key provisions negotiated in intercreditor agreements often include waivers or consents by the second lien lender relating to debtor in possession (DIP) financing, use of cash collateral, rights to adequate protection, conduct of a Section 363 sale of the debtor’s assets (i.e., the lenders’ collateral), and the extent to which the senior lender will have the right to vote the second lien lender’s claim on any Chapter 11 bankruptcy plan of reorganization.
  • Section 510(a) of the Bankruptcy Code provides that a "subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law." Bankruptcy courts routinely enforce payment subordination provisions in which the junior lender agrees not to receive any payments (or to turn over any that it does receive) until the senior lender is paid in full.

Bankruptcy Voting Provisions. Bankruptcy voting provisions, however, have not always been enforced. Most notably, the court in In re 203 North LaSalle Street Partnership, 246 B.R. 325 (Bankr. N.D. Ill. 2000), held that Section 1126(a) of the Bankruptcy Code, which provides that the "holder of a claim or interest allowed under section 502 of this title may accept or reject a plan," means that only the actual holder of the claim may vote and that an agreement giving that right to the senior lender is not enforceable. Other courts have been more willing to enforce voting provisions in subordination agreements. Still, the issue has not come up very often. Voting provisions have been the subject of reported decisions in only a handful of cases over the past 25 years.

The Aerosol Packaging Decision.  That dearth of authority makes the decision in In re Aerosol Packaging, LLC, issued by a bankruptcy court in Atlanta in late December 2006, of keen interest. (Thanks go to Scott Riddle of the Georgia Bankruptcy Law Blog for first posting on the decision.) In that case, Wachovia Bank was the senior lender under a subordination agreement entered into with Blue Ridge Investors, II, L.P., a second lien lender to the debtor, Aerosol Packaging. In its Chapter 11 bankruptcy, the debtor filed a plan of reorganization acceptable to Wachovia. When votes were solicited, both Wachovia and Blue Ridge submitted competing ballots voting Blue Ridge’s claim, with Wachovia’s ballot accepting the plan’s primary treatment of Blue Ridge’s claim and Blue Ridge’s ballot rejecting that proposed treatment.

  • Blue Ridge then filed a motion seeking a determination of its voting rights and allowance of its ballot instead of the one Wachovia submitted. (For reference, the subordination agreement attached as an exhibit to that motion designates Blue Ridge as the "Subordinated Creditor" and Wachovia, as successor to SouthTrust Bank, as the "Lender.")
  • Wachovia opposed the motion, relying on a section in the subordination agreement that made it, as the Lender, "irrevocably authorized and empowered (in its own name or in the name of the Subordinated Creditor)" to "take such other action (including without limitation voting the Subordinated Debt. . . " as it "deemed necessary or advisable." Wachovia also argued that the In re 203 North LaSalle Street Partnership case, relied on by Blue Ridge, was wrongly decided and that the bankruptcy rules allowed agents to vote another party’s claim. 
  • To complete the picture, the debtor itself also filed a response supporting Wachovia’s position.

In siding with Wachovia, the bankruptcy court held that Wachovia was the agent of Blue Ridge, that under the subordination agreement Blue Ridge assigned its right to vote to Wachovia, and that Section 1126(a) of the Bankruptcy Code does not prohibit the enforcement of such provisions. The court therefore accepted Wachovia’s ballot and rejected the one submitted by Blue Ridge. The court also pointed out that Blue Ridge is not without a remedy: it "may free itself from the ongoing effect of the Subordination Agreement by paying the Wachovia claim in full in cash." Blue Ridge has appealed the decision, so a higher court may have a chance to rule on the issue.

Uncertainty Remains. As only one bankruptcy court ruling, the Aerosol Packaging decision does not settle the issue of whether bankruptcy voting provisions will be enforced. Still, it’s interesting that the court considered and rejected the reasoning of the In re 203 North LaSalle Street Partnership decision. Given that this subordination agreement involved both lien and payment subordination, it’s unclear whether the voting provision would have been enforced if the lenders’ agreement had involved only lien and not payment subordination, which is the more typical second lien arrangement. The answer to that question will have to wait for the next case.

Recent Developments

New Bankruptcy Resource: The Absolute Priority Newsletter

As a member of the Bankruptcy & Restructuring Group at Cooley Godward Kronish LLP, I wanted to let you know that we have just launched a new quarterly newsletter called Absolute Priority. The newsletter give updates on current developments in bankruptcies and workouts with the goal of keeping you "ahead of the curve" on these issues. You can access a copy of the first edition here and can register to receive future editions.

The inaugural edition is focused on the first year of experience under the October 2005 Bankruptcy Abuse Prevention and Consumer Protection Act (known as BAPCPA). It includes articles on:

A two-page chart on M&A transactions involving Chapter 11 cases and an update on some of the bankruptcy and workout matters we have handled recently are also included. The newsletter starts with a welcome from my partner, Lawrence Gottlieb, the Chair of our Bankruptcy & Restructuring Group, and a note from another of my partners, Adam Rogoff, the editor of Absolute Priority.

I hope you find Absolute Priority informative and helpful.

Business Bankruptcy Issues The Financially Troubled Company

20 Day Goods: New Administrative Claim For Goods Sold Just Before Bankruptcy

In a recent post about a vendor’s reclamation rights, I discussed how the 2005 amendments to the bankruptcy laws, known as the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (called "BAPCPA"), extended a vendor’s right to reclaim goods once a bankruptcy petition has been filed. This post focuses on another of BAPCPA’s important changes affecting vendors, specifically, the new provision giving vendors an administrative claim for certain pre-petition goods sold.

Expanded Reclamation Right. As mentioned in my earlier post, a new 45 day bankruptcy reclamation right was added to Section 546(c) of the Bankruptcy Code. Prior to this change, the Bankruptcy Code had merely incorporated the Uniform Commercial Code’s 10-day reclamation period. Now, once a bankruptcy is filed, a vendor can assert a reclamation demand for goods received within 45 days of the bankruptcy filing. However, in some cases a vendor may not be able to reclaim its goods. The reasons can include a failure to make a timely reclamation demand, the existence of a secured lender with a lien on the goods in question, or the debtor’s prior sale of the goods. 

A Brand New Administrative Claim For Vendors, Even If Reclamation Fails. If a vendor’s reclamation claim fails, another new Bankruptcy Code section, Section 503(b)(9), gives vendors an important additional right: an administrative priority claim for "the value of any goods received by the debtor within 20 days before" the date a bankruptcy petition was filed "in which the goods have been sold to the debtor in the ordinary course of such debtor’s business." 

In most cases, administrative claims are paid in full instead of only cents on the dollar as with general unsecured claims. This new administrative claim is therefore a significant benefit, in effect putting vendors selling goods to a debtor in the 20 days before the bankruptcy filing on par with vendors selling goods after the bankruptcy filing.

  • Section 546(c)(2) of the Bankruptcy Code expressly provides that even if a seller of goods fails to provide the required notice to have a post-bankruptcy reclamation claim, the vendor may still assert this special Section 503(b)(9) administrative claim. 
  • This administrative claim applies in all types of bankruptcy cases, including Chapter 11 reorganization cases, Chapter 7 liquidation cases, and Chapter 13 cases.
  • Vendors who sold goods during the 21 to 45 day period before the bankruptcy filing will have to rely on reclamation alone as to those goods.
  • In either case, vendors and debtors should keep good records of shipments and deliveries of all goods received during the 45 days before the bankruptcy filing.

Unresolved Issues. This provision has been in effect for only a year and there are still a number of unanswered questions about how it will actually work in bankruptcy cases. Reviewing these questions may give you a sense of some of the issues to keep in mind when considering whether you (if you’re a vendor) or your vendors (if you’re a debtor) will have an administrative claim for "20 day goods." These issues include:

  • Since the vendor is entitled to an administrative claim for the "value of any goods received by the debtor," does that mean the invoice price or some other amount?
  • Does the term "goods" include services bundled with the goods?
  • Does the term "goods" include intellectual property-based products, such as boxed software or other similar items, which the debtor resells or sublicenses?
  • Does the "received by the debtor" requirement exclude goods that have been drop-shipped to a debtor’s customer at the debtor’s direction?
  • What does the requirement that the goods have been "sold to the debtor in the ordinary course of such debtor’s business" really mean?
  • Does the vendor have to file a pleading to be paid on this administrative claim, given that this new section requires "notice and a hearing"?
  • Can the debtor pay for the goods at the beginning of the case, much as it would for goods purchased after the bankruptcy filing, as a way of treating qualifying vendors as "critical vendors"?
  • Can the debtor wait to pay for these "20 day goods" until a plan of reorganization goes effective, as it can for certain other administrative claims?
  • If a Chapter 11 case converts to a Chapter 7 case, will this "20 day goods" administrative claim be treated as a Chapter 7 administrative claim, ahead of all unpaid Chapter 11 administrative claims, including those for goods sold during the Chapter 11 case?
  • Will the existence of this administrative claim provision give vendors who actually got paid before the bankruptcy for "20 day goods" a new defense to a claim that the payment was preferential? 

Get Good Advice. These issues, and the potential for a valuable administrative claim, are yet another reason for vendors to get good legal advice as soon as they learn of a bankruptcy filing. Debtors also need to get good advice, both legal and financial, so they can factor in how the requirement to pay for these pre-petition goods as an administrative claim will impact their cash needs.

Stay Tuned. This provision has been in effect for only one year, and applies only to cases filed after BAPCPA took effect on October 17, 2005. No formal court decisions have addressed, much less answered, these open questions. I expect bankruptcy courts will start to answer some of these questions in the coming months, and I’ll keep you updated on those developments. 

Business Bankruptcy Issues

Doing Business With A Customer In Bankruptcy: What You Need To Know

An issue that comes up for creditors when a customer files bankruptcy is whether to keep doing business or end the relationship. Since debtors usually cannot survive without at least some level of trade support, generally they reach out to suppliers in an attempt to obtain trade terms, or at least a steady supply of goods, after a Chapter 11 bankruptcy is filed.  Often they put information about doing business in light of the bankruptcy (see this example from Delta Airlines) on a restructuring website or send out written communications to suppliers.

This post looks at the issue from the creditor’s perspective. When a smaller customer files bankruptcy the "keep doing business" question is less critical, and the bankruptcy filing may just be the final straw that leads you to want to stop selling or providing services to the customer.  When one of your bigger customers files bankruptcy, the stakes go up — often way up.  In either case, it’s important to know the ground rules about doing business with a bankrupt customer.

Administrative claim for post-bankruptcy sales. In general, if the bankrupt customer is a Chapter 11 debtor in possession, it is legally permitted to pay for post-petition (post-bankruptcy filing) purchases of goods and services in the ordinary course of business. Such amounts are generally accorded administrative claim status, with priority over unsecured and certain other claims, and the debtor is authorized to pay them currently. (Chapter 7 trustees usually close a business down and do not place further orders.)

Make sure you have an administrative claim. The standard for allowance of administrative claims requires proof of the necessity and the value to the estate of the goods or services.  While this usually is the amount set forth in a contract or purchase order, to avoid any dispute it’s best to reach a clear understanding with the debtor (or a bankruptcy trustee in the rarer instances when a Chapter 11 or Chapter 7 trustee is purchasing goods or services) before providing post-petition goods or services. Moreover, if there’s any chance that your transaction would not be considered an "ordinary course" transaction, for example if it’s an unusually large purchase or on unusual terms, you should consider seeking bankruptcy court approval to make sure the transaction is authorized and that your rights are protected.

Be careful of the executory contract twist. Your dealings with the debtor post-petition may also depend on the nature of your pre-petition relationship. 

  • If you have sold products through separate purchase orders or individual transactions without an overarching contract (see earlier post for a fuller discussion of such executory contracts) governing the relationship, generally you may choose whether to continue dealing with the debtor post-petition and on what terms you do so (e.g., whether to require cash in advance or continue with trade credit terms). If you have unpaid amounts based on your pre-petition transactions with the debtor, that claim would be treated like other unsecured claims separate from any post-petition claim. 
  • If you and the debtor are parties to a pre-petition contract that is executory (meaning both you and the debtor have material obligations to continue to perform), you cannot automatically stop performing post-petition unless the debtor has officially rejected the contract. Rejection means that the debtor has decided to stop performing and the bankruptcy court has approved that decision. Alternatively, if the debtor has decided to continue to perform (assume) the contract, and the bankruptcy court has approved this assumption decision, the debtor will have to cure, in cash, any pre-petition amounts owed.
  • Until the debtor has made a decision about your contract, the debtor may be willing to make current post-petition payments under the contract. You should consider confirming this understanding with the debtor or its counsel in writing to protect your rights.
  • If you’re concerned that you won’t be paid for your post-petition performance or if you don’t want to continue to perform for other reasons, you may need an attorney to file a motion to compel the debtor or trustee to assume or reject the contract, or to seek “adequate protection” payments pending that decision. Bankruptcy courts often give a Chapter 11 debtor a long time to make this decision, even until a plan of reorganization is confirmed.  However, the court may be willing to order that you be paid currently for post-petition amounts and/or clarify that you have an administrative priority claim for your post-petition performance.

Is the debtor creditworthy? While these legal issues are important, it’s equally critical to assess the debtor’s financial condition after bankruptcy.  A bankruptcy filing relieves a debtor from the obligation to pay pre-petition unsecured creditor claims, and this can make a substantial difference to a debtor’s cash flow. Still, the debtor has to have sufficient liquidity to pay its post-petition administrative claims.

  • Many debtors obtain post-petition financing from lenders — known as debtor in possession or DIP financing — and this can provide the necessary liquidity to pay administrative claims. DIP financings are usually secured by a blanket security interest on all of the debtor’s assets, however, putting the DIP lender ahead of even administrative claims in the event of default.  
  • While not common, debtors do sometimes default under DIP financings. When that happens, the DIP lender will often foreclose on the debtor’s assets and the bankruptcy case will be converted to Chapter 7 liquidation. If so, not only will the DIP lender’s debt be paid first from the estate’s assets, but the administrative claims generated during the Chapter 11 case will become second in line to Chapter 7 administrative claims, such as the Chapter 7 trustee’s fees and expenses and those of his or her counsel. 
  • For these reasons, it’s still very important to be comfortable with a Chapter 11 debtor’s financial condition and its wherewithal to pay for post-petition sales before extending post-petition credit. Most debtors are required to file post-petition monthly financial reports (here’s an example from Delphi’s bankruptcy case), and they can serve as one source of financial information.

Consult with bankruptcy counsel. These general rules govern most scenarios, but dealing with a debtor post-petition can be complicated and raise many issues unique to your situation. For this reason, it’s best to get an attorney’s advice before engaging in any significant transactions with a debtor.