Dealing with Counterparties and Companies in Financial Distress

INTRODUCTION

In times of unprecedented market uncertainty, assessing financial exposure to your counterparties is essential.  Volatility in the commodities markets and a public health crisis create the perfect storm for financial distress for companies in nearly every industry.  Risk is inherent in business and that risk is heightened when you are dealing with a company in financial distress.  Managing these risks begins with knowing your counterparties and understanding your legal position with respect to those counterparties.

KNOWING YOUR COUNTERPARTY

A proper assessment of financial exposure to your contract counterparty requires knowing your counterparty. Identifying all of your company’s relationships with your counterparty’s corporate family is a key first step.

Once all of those relationships are identified, you are then able to assess your counterparty:  the nature of its business and the market conditions affecting it; how critical your goods/services are to your counterparty; its capital structure; maturity of its business; its correct name, legal form and state/country of formation; where the counterparty fits into the corporate family; whose creditworthiness upon which you are really relying; past relationship history; and its litigiousness.

Gaining this knowledge about your counterparties may provide opportunities to review and analyze business relationships, understand and quantify exposure, clarify existing agreements, enhance your competitive position, and acquire strategic assets.

UNDERSTANDING YOUR LEGAL POSITION

An assessment of your counterparties will be enhanced by understanding your contractual and other legal rights, as well as the effect of a potential bankruptcy by your counterparties.  Financial distress often leads to bankruptcy where a whole new set of rules come into play.  Familiarizing yourself with the tools that will be available to a debtor if it files bankruptcy can often assist you in managing and minimizing those risks. 

The Contract Outside of Bankruptcy. Uniform Commercial Code § 2-609 addresses your right to demand adequate assurance of your counterparty’s future performance in connection with the sale of goods.

What triggers the right to demand adequate assurance? Many contracts include specific grounds, such as a material drop in stock price, a downward trend or a negative outlook by a rating agency, a restatement of prior financial statements, or a default by the counterparty under its debt instruments. Other contracts are silent on the subject. If, for example, your counterparty is giving discounts for cash payment, you hear rumors of covenant defaults or that a “market player” has suspended trading activity, or Moody’s has given your counterparty a “negative outlook,” you may have reasonable grounds to demand adequate assurance.

Well-drafted contracts will include triggers for demanding adequate assurance, specify when performance may be suspended and define what constitutes “adequate assurance” (i.e., prepayment or a letter of credit). A pre-bankruptcy demand for adequate assurance is key. “Adequate assurance” of future performance established pre-bankruptcy can survive in bankruptcy while contracts terminated prior to bankruptcy will not be revived. Contractual provisions on adequate assurance are critical for contracts NOT involving the sale of goods, because there is no implied right under the UCC.

The Contract in Bankruptcy. Most actions against a debtor are immediately and automatically stayed upon the filing of a bankruptcy petition.  The automatic stay prevents a counterparty from suspending performance under a contract or terminating a contract.  These “ipso facto” provisions are not enforceable in bankruptcy. Exceptions are limited and include certain protected financial contracts (e.g., securities contracts, commodities contracts, forward contracts, swaps, repos, master netting agreements), contracts to make loans, or financial accommodations and contracts where applicable law excuses a party (other than the debtor) from accepting performance from (or rendering performance to) the debtor. Creditors are also typically barred from creating or enforcing liens against property of the bankruptcy estate without court approval with the exception of timely filing of M&M liens under state law.

Assumption or Rejection. The debtor has two options for treatment of executory contracts.  Rejection of your contract gives rise to a claim by you for rejection damages, which will likely be unsecured. To assume a contract, the debtor must cure existing defaults. If the debtor seeks to assume and assign a contract to a third party, you may require proof of ability to perform from the assignee. Contracts terminated prior to the bankruptcy filing cannot be assumed in bankruptcy.

Critical Vendor.  If your service/commodity is critical to your counterparty’s business, it is likely that your contract will be assumed and your claim paid in full, but this may take time. Courts have historically allowed “critical vendor” payments on an emergency basis where a debtor has a critical need to deal with the vendor or risk the loss of some economic benefit to the estate’s going concern value that is disproportionate to the payment. No practical or legal solution other than payment of the claim must exist.

Contractual Obligations. In a bankruptcy, creditors are paid according to priority. A bare contractual obligation, including indemnification obligations, typically gives you only an unsecured claim.  Holdbacks, third-party escrows, bonds, letters of credit, statutory liens and set-off rights increase your likelihood of payment. Contractual obligations to third parties undertaken for affiliates of the debtor can be attacked in bankruptcy. All parties to the contract should be giving and receiving consideration. Allocate the purchase price or calculation of the benefit to each subsidiary. Also consider obtaining a valuation or solvency opinion.

Liens and Priority. You may benefit from a contractual or statutory lien on your counterparty’s assets. If you are in possession of your counterparty’s product, you should hold it and immediately ask the court to allow you to set off against it or request adequate protection. Beware as possessory liens typically secure only amounts currently owing under the contract, not damages for rejection of the contract.

Set Off. Set off exists under common law and is allowed in bankruptcy. It applies to debts owed by the same parties (i.e., same legal entities) in the same capacity (both pre-petition/both post-petition).  Affiliated companies which are separate legal entities are not the “same party” for set off purposes.  Never turn over funds to a debtor unless you confirm you have no right to set off against them.

Letters of Credit. Bankruptcy does not prevent you from drawing on a letter of credit issued by a third party on behalf of your counterparty.  However, there is a preferential transfer risk if the letter of credit is received within 90 days (or one year for insiders) of your counterparty’s bankruptcy filing – another reason to request adequate assurance at the first sign of trouble.  Bankruptcy courts seldom stop a draw.  In these rare circumstances, the debtor must show the following: the debtor is likely to prevail in litigation against the beneficiary asserting that the beneficiary had no right to draw (i.e., the debtor did not breach the underlying agreement); the beneficiary will not be irreparably harmed; and public policy favors an injunction  (which it seldom does).  Stated differently, in order for a bankruptcy court to order the return of the letter of credit proceeds to the debtor’s estate, the debtor must show that you were not entitled to draw under the underlying contract, you breached the underlying agreement or the letter of credit was issued during the preference period. 

Fraudulent Transfers.  A pre-bankruptcy transaction with the debtor may later be attacked as a fraudulent transfer.  Anytime a debtor files bankruptcy, any sale or other transfer of its assets is subject to review under certain provisions of the Bankruptcy Code providing for recovery of fraudulent conveyances. The debtor may avoid a transfer of the debtor’s property, or an obligation incurred by the debtor, if the debtor received less than “reasonably equivalent value” in exchange and the debtor (i) was or became insolvent as a result of the transfer; or (ii) was engaged in business, and was left with unreasonably small capital after the transfer; or (iii) intended to incur debts after the transfer, or believed it would incur debts after the transfer, that would be beyond its ability to pay as they matured. The Bankruptcy Code allows avoidance of fraudulent transfers within two years prior to the bankruptcy filing.  This is referred to as the lookback period.  State Uniform Fraudulent Transfer Acts may provide for longer lookback periods allowing debtors to avoid transfer occurring more than two years before the bankruptcy filing.

Preferential Transfers.  A pre-bankruptcy payment from your debtor counterparty may later be attacked as a preferential transfer.  The debtor may avoid any transfer of property of the debtor if the following five elements are present and no statutory defense is available: (i) the transfer is to or for the benefit of a creditor (transfer includes granting a lien or issuing a letter of credit); (ii) the transfer is made for or on account of an antecedent debt; (iii) the debtor was insolvent; (iv) the transfer was made on or within 90 days before the date that the debtor filed its petition (one year for insiders); and (v) the transfer enabled the creditor to receive more than it would have received if the transfer had not been made.

Protection for Financial Contracts. Financial contracts are protected from fraudulent transfer and preference attack (except in case of actual fraud) and the effect of the automatic stay. A financial contract carries with it a right to liquidate, terminate, accelerate or offset, and if under a master netting agreement, these rights run across contracts.

Reclamation. Under the UCC, you have a right to reclaim goods from an insolvent buyer within ten days. The Bankruptcy Code extends that time to 45 days but act promptly. If goods have been resold, used or cannot be identified, your right is inferior to the lender with a lien on the goods. While the Bankruptcy Code allows an administrative claim for the value of goods received by the debtor within 20 days of the petition date, the claim is usually inferior to a Debtor-in-Possession lender.

Contract Litigation.  Litigation over provisions of corporate agreements occurs most often with ambiguous provisions, poorly drafted definitions, careless use of forms from previous transactions, inclusion of provisions that appear unfair or inequitable, and failure to take into account the larger implications. Be mindful of some of the most common terms used to finesse language for the sake of getting a deal done: commercially reasonable, material, good faith, related, and best efforts. Though these terms may have proven useful on the front end of a deal, the ambiguity of these terms increases the likelihood, duration, and complexity of litigation.  You and your counterparty may know the exact details of the negotiation and the agreement, but keep in mind when drafting or amending your contracts that the judge will only see what is in the document. 

 CONCLUSION

Knowing your counterparties and their financial condition and understanding your legal rights will better prepare you for mitigating risk and maximizing opportunities.  Becoming and remaining informed about key aspects of your contractual relationships, including priority, security/collateral, offset options, statutory liens and reclamation rights, allows you to move quickly if your counterparty files bankruptcy.