Insolvency Trend among Retailers Makes for Wary Suppliers: Economic Crisis Extends beyond Financial Markets

With gas and food prices what they are, how many of us can afford shopping sprees anymore? Besides financial institutions, retail stores have been among the hardest hit this year as consumer confidence has faltered. And that means suppliers of merchandise to retailers also have suffered. Recent large-scale insolvencies in the retail sector—Linens 'n Things, Sharper Image and Mervyns are just a few companies that have filed for Chapter 11 this year—have made suppliers very nervous. In the midst of this storm, insolvency and credit professionals can impart a few observations and suggestions.

Warning Signs: Taking Pre-Bankruptcy Precautions

A victimized supplier often waits until after a bankruptcy is filed by a retailer to look back at accounts receivable aging reports and pinpoint where the customer began having trouble meeting terms. By then, however, it is too late because the bankruptcy filing prevents the supplier from recovering a pre-bankruptcy debt. Wary suppliers can protect their interests and potentially save money by proactively monitoring customer behavior to spot negative trends and take precautionary action before a bankruptcy is ever filed. For starters, a supplier can put in place cash-on-delivery (COD) or cash-in-advance (CIA) mechanisms. Taking a more creative approach, a supplier can also ask for personal guaranties from the customer's principals.

One of the newest trends is credit insurance. This type of protection features a high up-front fee but provides valuable coverage in the event of a troubling financial event. For instance, your credit insurance policy might cover 90% of invoices for a particular retail customer. If that customer fails to pay you $100,000 within terms, you will be entitled to $90,000 from your insurance company. As with other insurance policies, there is generally a coverage limit beyond which the insurer will not pay (for instance, $500,000 per customer). In the end, receiving 90% of what you are owed is far better than the expense and effort associated with collections, judgments and insolvencies. Clearly, suppliers are wise to investigate credit insurance.

After the Filing: Observations from Retail Bankruptcies

Once a bankruptcy has been filed, suppliers typically face a number of issues in attempting to collect on open invoices and in deciding whether to continue doing business with the troubled customer, known in bankruptcy terms as the "debtor."

Payment for Post-Bankruptcy Shipments. Debtors frequently obtain new financing and count on their suppliers to continue to provide credit terms. Unless the bankruptcy court rules otherwise, a debtor trying to reorganize in Chapter 11 is authorized to continue operating its business in the ordinary course, which includes buying goods from its suppliers. By law, a supplier's claim for unpaid post-bankruptcy deliveries has administrative priority and entitles the supplier to immediate payment. In practice, however, this claim is difficult to monetize.

Should the debtor fail to pay, the supplier can make a motion to the bankruptcy court to have its claim for payment approved and paid. But even if that claim is allowed (and it should be, barring dispute by the debtor), the debtor may lack the financial resources to pay. If and when the debtor confirms a plan of reorganization, that particular supplier will be paid first and in cash. Depending on the success of the debtor's bankruptcy case, however, this may take a while. In the ongoing Sharper Image bankruptcy case, for example, many of the debtor's suppliers hold agreed-upon administrative claims and are still awaiting payment. The better option, even after a customer has already filed for bankruptcy, is to put the buyer on COD or CIA terms, or obtain credit insurance.

Even with agreed-upon COD or CIA terms in place, a debtor may still refuse to pay. In the Linens 'n Things bankruptcy case, for example, many suppliers became so insecure about receiving payment for post-bankruptcy shipments that they stopped giving credit terms. But the debtor needed their goods to stay in business and, with its lenders' consent, was forced to come up with a creative solution. Essentially, the lenders backed a letter of credit, and the debtor promised that its aggregate account balance to the suppliers would not exceed twice the amount of the letter of credit. A neutral "trustee" was appointed to act on behalf of the suppliers if a default occurred and if Linens 'n Things had to draw upon the letter of credit. In order to participate in the credit protection program, suppliers were required to give the debtor 45-day payment terms—much longer than most of them previously had required of the debtor. In the Linens 'n Things case, these suppliers could have refused to do business with the debtor, but the credit protection program proved to be better than no protection at all. Some participating suppliers also obtained credit insurance as an added layer of protection.

Going-Out-of-Business Sales. The "going-out-of-business" sale is one method by which the debtor can quickly sell inventory at an underperforming retail location. Under this scenario, a liquidator purchases the inventory from the debtor at its underperforming stores and then attempts to sell the merchandise at a profit. The debtor is paid a guaranteed amount but can receive more if the liquidator nets above a certain threshold. Naturally, the lender will be the first party actually to see a portion of this money. Suppliers are affected by store closing and going-out-of-business sales in that purchase orders typically fall, and brands can be tainted by this "fire sale" atmosphere.

Reclamation Claims. Under the Uniform Commercial Code, suppliers can exercise what is known as "reclamation rights." In other words, when a buyer fails to pay for the product and becomes insolvent, the supplier may be allowed to identify and reclaim the specific goods (in lieu of payment). But during bankruptcy, a supplier cannot simply arrive at the debtor's warehouse and reclaim the goods. Instead, the supplier can assert a reclamation claim for the value of those goods. Reclamation claims are difficult to monetize, however, because the debtor's lender almost always has a superior lien on all inventory coming in. Having COD or CIA systems in place before bankruptcy can help avoid the headache of asserting a reclamation claim, only to have it placed behind the lender in line for payment.

Lessons Learned

Recent retail bankruptcies have proven that there are no easy answers in the current economic environment. However, there are a number of strategies that suppliers can consider as a means of protecting their interests and avoiding financial loss. Whether you are anticipating problems from a buyer or a key customer has already filed for bankruptcy protection, being proactive and seeking the advice of experienced professionals at the earliest signs of trouble can save a great deal of money and stress.

Editor's note: Members of the firm's Creditors' Rights, Insolvency & Bankruptcy group have created a timely and informative seminar for commercial lenders that addresses troubled loans. The presentation covers a range of issues facing lenders in today's economic environment, including signs of trouble, pre-workout steps, out-of-court workout agreements, bankruptcy from the viewpoint of the secured creditor, foreclosures and non-bankruptcy insolvency. For more information, please contact Norman B. Newman at 312.521.2492 or nnewman@muchshelist.com.