A customer’s impending bankruptcy is one of the most stressful experiences a supplier can face in the course of running their business. You are confronted not only with the potential loss of a major customer but also the possibility of a significant financial loss due to unpaid accounts receivable. Following a US customer’s bankruptcy, Canadian-based manufacturers will invariably ask themselves if they could have seen this coming. They will wonder what signs they missed and the obvious red flags that should have alerted them to their customer’s financial distress. Often, there are early warning signs that can signal a US customer is experiencing problems or is in financial distress—and there are steps you can take as a creditor to proactively prevent or minimize your risk of loss. To help guide you, this three-part series of articles outlines some of the more common signs of financial trouble as well as protective measures creditors can take to prevent financial loss both prior to and after a customer’s US bankruptcy filing.
The Right to Demand Adequate Assurance
Upon learning of a retailer’s financial distress, the first steps a supplier should take are to demand adequate assurance of performance under the party’s existing contract and to suspend performance of its contractual obligations until that assurance is received. Uniform Commercial Code (UCC) Section 2-609 permits a seller to suspend performance due under a contract temporarily where the seller has an objective belief that the buyer cannot fulfill its contractual obligations.
Specifically, UCC Section 2-609(1) provides:
“[W]hen reasonable grounds for insecurity arise with respect to . . . performance [by the buyer] . . . the [supplier] may in writing demand adequate assurance of due performance and until he receives such assurance may if commercially reasonable suspend any performance for which he has not already received the agreed return.”
If a retailer then fails to provide that assurance “within a reasonable time not exceeding thirty days,” the retailer is deemed to be in “repudiation of the contract” such that the supplier is no longer obligated to perform.i
Most importantly, a supplier can demand adequate assurance even where it is uncertain whether the retailer will ultimately file for bankruptcy; only “reasonable grounds for insecurity” is necessary. This standard is a flexible one, as “what constitutes reasonable grounds for insecurity . . . is determined according to commercial standards.”ii
That said, under the relevant United States case law “[t]o find a reasonable ground of insecurity, ‘there must be an objective factual basis for the insecurity, rather than a purely subjective fear that the party will not perform.’”iii Thus, while the specific events that give rise to “reasonable grounds for insecurity” may vary from industry to industry, at a minimum, a supplier’s right to demand adequate assurance may be appropriate when a supplier has actual or market-based knowledge that a retail customer is in significant financial distress.
To invoke UCC Section 2-609, the supplier must make the demand for adequate assurance in writing.iv While this written demand need not be lengthy, US courts have required that it must be sufficiently clear to ensure that “all parties are aware that, absent assurances, the demanding party will withhold performance.”v At least one court has held that “[t]o invoke UCC Section 2-609, a party’s written communication must ‘mention 2-609 of the code or demand assurances.’”vi Therefore when making a demand for adequate assurance to a retailer, the supplier should make its demand in writing and explicitly invoke UCC Section 2-609 (or its state law equivalent).
Once a concerned supplier makes a proper demand for adequate assurance, UCC Section 2-609(1) permits the supplier to “suspend any performance for which he has not already received the agreed return.” In other words, the supplier is not required to ship any additional goods to the retailer while its demand remains unanswered, nor must the supplier abide by any other contractual obligation in the interim. This is true even if the retailer makes a partial payment on outstanding invoices; Section 2-609(3) explicitly provides that “[a]cceptance of any improper delivery or payment does not prejudice the aggrieved party’s right to demand adequate assurance of future performance.” The ability to suspend performance pending receipt of adequate assurance from a distressed retailer thus provides a supplier with the ability to be proactive when it is concerned its counterparty may be unable to pay for goods delivered.
Finally, if a retailer, “[a]fter receipt of a justified demand” fails to provide “within a reasonable time not exceeding thirty days such assurance of due performance as is adequate under the circumstances of the particular case,” the retailer is deemed to have repudiated the contract.vii Importantly, courts have recognized that this provision “does not automatically mean that [the buyer] ha[s] 30 days in which to respond.”viii To the contrary, considering all of the circumstances, US courts have agreed that a buyer’s response can be required in “something less than 30 days.”ix Accordingly, a supplier may be able to deem its contract with a distressed retailer rescinded altogether if the retailer is unable to provide adequate assurance within a relatively short period of time.
The Right to Withhold Delivery
While a demand for adequate assurance allows a supplier to suspend performance of future shipments due under the contract, the supplier may also have shipments in transit to the retailer. For those goods, the supplier may consider issuing a “stop delivery” order to the appropriate common carrier(s) under UCC Section 2-702(1).
UCC Section 2-702(1) allows a seller to stop delivery—except for cash paid on or before delivery—when the seller “discovers the buyer to be insolvent.” In addition to requiring cash for future deliveries, UCC Section 2-702(1) provides that delivery need not to be resumed until an insolvent buyer has paid for all previously delivered goods.
The key question under UCC Section 2-702(1) is whether the retailer is, in fact, insolvent. According to UCC Section 1-201(23), a retailer is insolvent if they:
- Have generally ceased to pay debts in the ordinary course of business other than as a result of a bona fide dispute;
- Are unable to pay debts as they become due (i.e., equitable insolvency) or
- Are insolvent within the meaning of the federal bankruptcy law (i.e., balance sheet insolvency).
Courts have recognized that “‘[b]alance sheet’ insolvency is undoubtedly more difficult to prove than equitable insolvency,” as the former imposes a “heavy burden” on a seller trying to prove that a buyer is insolvent. While case law is scarce on this topic, the UCC’s incorporation of both equitable and balance sheet insolvency into its definition of insolvent suggests that a supplier may be able to stop delivery under UCC Section 2-702 even where the distressed entity has not yet filed a bankruptcy petition, but the supplier otherwise has knowledge that the retailer cannot pay its debts.
If a retailer is indeed insolvent, UCC Section 2-702 entitles the supplier to stop shipment of any goods that are currently en route to the distressed entity. UCC Section 2-705 sets forth the procedures by which this stoppage would occur. In order to stop delivery, a supplier must first “so notify the bailee by reasonable diligence to prevent the delivery of goods.”x Any stop delivery orders to carriers and bailees should: (a) invoke UCC Section 2-702(1) and (b) reference any relevant provisions in agreements with those third parties. UCC Section 2-705(3)(b) states: “After such notification the bailee must hold and deliver the goods according to the directions of the seller.”
It should be noted, however, that when a stop shipment order is issued, “the seller is liable to the bailee for any ensuing charges or damages” that the supplier may incur due to complying with the request. These charges or damages can be substantial, particularly if the bailee is transporting goods for other entities. So, a stop shipment order does not mitigate a supplier’s risk altogether, and a supplier should communicate with its bailees or carriers to assess the costs involved in stopping shipments. Nonetheless, a stop delivery order provides suppliers with a useful tool in preventing goods from reaching an insolvent entity.
Once your US customer actually files bankruptcy, the first thing you might ask yourself is what can be done now? Rather than facing a total loss, you still have important creditors’ rights whenever your customer seeks bankruptcy protection by filing, in most business cases, a Chapter 11 petition. Luckily, US Bankruptcy Sections 546(c), 503(b)(9), and 553(a) provide you with specific rights and remedies as a creditor. All the statutory provisions described above under the UCC and described as follows under the Bankruptcy Code do not completely immunize you from risk; however, they do give suppliers some tools that, when exercised promptly and correctly, can go a long way in mitigating any potential financial loss.
In the third part of this three-part series, we will specifically address how to protect your creditor rights once your US customer files bankruptcy.
iUCC Section 609-4.
iiUCC Section 609-2.
iiiKoursa, Inc. v. Manroland, Inc., 971 F. Supp. 2d 765, 790 (N.D. Ill. 2013).
ivUCC Section 2-609(1).
vKoursa, Inc. v. Manroland, Inc., 971 F. Supp. 2d 765, 792 (N.D. Ill. 2013) (quoting Puget Sound Energy, Inc. v. Pac. Gas & Elec. Co., 271 B.R. 626, 640 (N.D. Cal. 2002)).
viKoursa, Inc. v. Manroland, Inc., 971 F. Supp. 2d 765, 792 (N.D. Ill. 2013) (quoting Canteen Corp. v. Former Foods, Inc., 238 Ill. App. 3d 167, 606 N.E.2d 174, 184, 179 Ill. Dec. 342 (Ill. App. Ct. 1st Dist. 1992)).
viiUCC Section 2-609(4).
viiiHitachi Zosen Clearing v. Liberty Mut. Ins. Co., 1996 U.S. Dist. LEXIS 9562, at *20 (N.D. Ill. 1996).
ixId.
xUCC Section 2-705(3).