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Distressed Debt - How Can an Unsecured Creditor Ensure Payment?

With chapter 11 bankruptcy filings on the rise, all vendors should use this opportunity to evaluate the credit risks that their customers present. Short of terminating the relationship for nonpayment, there are some actions that vendors can take to minimize the risk of continuing to do business with a struggling customer. Below we discuss a variety of possibilities, including some that are not often used but can be very helpful in protecting a vendor’s position.

Revised Payment Terms – In distressed situations, vendors may need to modify the payment terms offered to a customer to avoid exposing themselves to further credit risk. Shortening the terms or moving to cash in advance or cash on delivery are effective ways to lessen the risk as to future shipments in order to maintain a relationship with the customer. This, of course, would not help with recovering on past due amounts.

Credit in Exchange for Payments on Past Due AmountsIn lieu of, or perhaps in conjunction with, a modification of a customer’s payment terms, vendors might offer to continue shipping on credit if the customer makes payments on past due invoices. For example, a creditor could require payments on past due invoices commensurate with the amount of new purchase orders it ships. Alternatively, the vendor might offer to put the past-due invoices into a promissory note that is to be paid on a fixed schedule, such as weekly or monthly payments, and offer to continue shipping so long as the customer makes the required payments.

Trade-Credit Insurance – An underused vehicle for obtaining payment on trade debt is trade-credit insurance. Trade credit insurance protects sellers from buyers who do not or cannot pay, whether due to bankruptcy, insolvency, or other delinquency. A trade-credit insurance policy could cover single invoices or an entire portfolio of accounts receivable. Ordinarily, such policies provide for payment of 75% to 95% of the invoice amounts in the event of default by the customer. A trade-credit insurance policy is one that a vendor would obtain directly from an insurer, without involvement of the customer. If the customer were to file for bankruptcy, the policy and proceeds would not be property of the bankruptcy estate, so collection on the policy would not be subject to the automatic stay. Vendors would need to plan ahead, however, because trade-credit insurance is not likely to be available in the moment of a customer’s greatest financial distress.

Standby Letter of Credit Another tool that a creditor can use to minimize its risk is a standby letter of credit (“LOC”). LOCs, like trade-credit insurance, effectively shift the risk of loss to a third party. Unlike trade-credit insurance, LOCs require the cooperation of the customer. Indeed, the customer would need to request a letter of credit from an issuer, which in most cases would be a bank or other financial institution. The issuer, after receiving payment of a fee or other collateral from the debtor, would then issue a written letter of credit ensuring payment to the vendor. The letter of credit would typically allow the creditor to draw against it upon presentation of certain documents. Because an LOC is considered an independent obligation of the issuer to the vendor, the LOC and its proceeds are not generally considered property of the bankruptcy estate and are not subject to the automatic stay. As such, the vendor would generally be able to draw against the LOC immediately in the event of the customer’s bankruptcy.

Guaranties – Guaranties obligate a third party to pay an amount that a debtor is primarily obligated to pay. Debtors often provide guaranties in an effort to persuade vendors to continue the parties’ business relationship in distressed situations. In the event that a debtor were to file bankruptcy under chapter 11, guaranties can be particularly useful, because the automatic stay usually does not apply to enforcement actions against non-debtor guarantors. Vendors would be well advised, of course, to verify the financial worthiness of any guarantor prior to accepting a guaranty. Oftentimes guarantors are so closely related to the debtor that their financial condition is dependent on, or inextricably bound to, the financial condition of the debtor. Accordingly, a vendor would want to make sure that the guaranty it receives has value independent of the debtor’s financial performance.

Surety BondsAn additional form of protection a creditor may be able to obtain from a struggling customer is a surety bond, which is common in industrial, construction, and international-trade contexts. Surety bonds function much like insurance policies in that if the creditor incurs a loss as a result of the customer’s default, then by virtue of holding the surety bond, the creditor may demand payment from the surety. Similar to the other forms of protection discussed above, a creditor is generally entitled to demand payment from surety without the need to seek relief from the automatic stay in the event of the customer’s bankruptcy. While surety bonds can be costly, they may be far less costly or disruptive for the customer than losing the relationship with the vendor. Surety bonds, however, generally require that certain notice procedures be followed and often allow the surety to conduct an investigation of the debt and circumstances of the debtor’s default. Accordingly, creditors are best advised to review the terms of the surety bond carefully to avoid any unnecessary complications when they attempt to enforce the bond against the surety.

If you have questions about any of these solutions or their application in specific circumstances, please contact Lauren R. Goodman and Michael T. Eversden of McGrath North’s Insolvency, Restructuring and Bankruptcy Group.