11 Key Strategies To Protect Your Company's Supply Chain And Mitigate Risks Against Financially Distressed Customers And Suppliers

• Published date: 08 July 2022
• Subject Matter: Corporate/Commercial Law, Insolvency/Bankruptcy/Re-structuring, Corporate and Company Law, Insolvency/Bankruptcy, Contracts and Commercial Law
• Law Firm: Foley & Lardner
• Author: Mr John Simon and Sharon M. Beausoleil

As we pass the midpoint of 2022 and the world expresses a collective sigh of relief that the worst of the COVID-19 pandemic seems to be behind us, a perfect storm of extraordinary factors is creating conditions for financial distress throughout many supply chains. In short, there is a substantial risk that companies obligated to pay you for goods or services or to supply goods or services to you might become unable to do so.

In this article, we provide you with a toolkit to mitigate your supply chain risks in the face of this expected economic turmoil.

Note: Because these situations are fluid, complex, risky, and involve various potential legal risks in their analysis and implementation, it is important that you engage with bankruptcy/creditors' rights counsel early in addressing them.

Understanding the Impact of a Possible Bankruptcy

To prepare for insolvency-related non-performance by a customer or supplier, it is critical to know the effects of a possible bankruptcy on the obligations owed to you under your contracts or other arrangements with the customer or supplier that would be a "Debtor" in bankruptcy.

What Type of Bankruptcy: Chapter 11 bankruptcies allow a Debtor's management to stay in control, continue operating and providing goods and services, restructure debts, sell some or all company assets, and confirm a reorganization plan. In contrast, in Chapter 7 bankruptcy cases the Debtor's management is removed and replaced by a bankruptcy trustee, who is responsible for liquidating the Debtor's assets and generally stops operating the business.

Section 362 Automatic Stay: Once a bankruptcy is filed, the automatic stay arises and acts as an injunction against any efforts, including continuation of pending litigation, to collect on any prepetition claim, debt, or other obligation owed by the Debtor, any action to possess or control the Debtor's property (e.g., foreclosure, perfection of liens subject to limited exceptions, seizure of the Debtor's assets), and most unilateral attempts to terminate contracts or execute setoffs. Unless court approval is obtained, acts taken in violation of the automatic stay are void or voidable. Creditors that violate the automatic stay can be liable to the Debtor for damages. Due to the automatic stay, many of your rights as a creditor or contract party will be stronger before a bankruptcy is filed, rather than after.

Priority Payment Scheme: Under the Bankruptcy Code there is a priority payment scheme, which identifies which claims are paid first and requires that the higher level claim must be paid in full prior to any lower level claim receiving a payment. Think of a waterfall: At the top of the waterfall are secured claims (amounts secured by security interests, liens, or mortgages, such as most bank loans), followed by administrative priority claims (including expenses incurred by the Debtor during the bankruptcy such as its professional fees or amounts for postpetition goods or services), then priority claims (including certain tax claims), followed by general unsecured claims (including most ordinary trade debts), and finally equity interests (see chart below.)

There are a few exceptions to this scheme, including: (a) claims for goods actually received by the Debtor within 20 days prior to the bankruptcy, referred to as "503(b)(9) Claims"¹ that are given administrative priority treatment; (b) prepetition amounts due under assumed contracts and leases that are treated as cure claims which are entitled to be paid in full in cash; and (c) prepetition general unsecured claims that the Debtor obtains Court approval to pay, for instance pursuant to an order authorizing the Debtor to pay vendors critical to its continuing operations.

Executory Contracts:² As of a bankruptcy filing, a Debtor obtains significant leverage and additional rights regarding contracts with you pursuant to the Bankruptcy Code. Notwithstanding anti-assignment clauses, a bankrupt Debtor can assume (i.e., agree to perform), and then assign to a third party (subject to demonstrating adequate assurance of future performance), or reject (refuse to perform) any executory contract³ (subject to limitations for certain personal service, IP and license, and loan or financial commitment agreements). A Debtor must assume⁴ or reject⁵ executory contracts no later than confirmation of the Chapter 11 plan.

Preference and Fraudulent Transfer Risks: To complicate matters, payments, liens, or obligations made in your favor while the Debtor was insolvent prior to a bankruptcy can potentially be recovered or "avoided" (although it is generally better to receive such a payment and fight about possible avoidance of it with a Debtor or bankruptcy trustee rather than not be paid at all).⁶

Given the foregoing and possible negative aspects of contract rejection (i.e., non-payment/non-performance, little recovery of damages, potential assignment to unknown third parties) and possible positives (cure payment of any outstanding arrearages required for assumption and assignment), you should carefully evaluate with bankruptcy counsel the contract and claim strategy that...