The volatility of commodity prices is not news to those in the industry, but the recent unprecedented swing in prices has resulted in numerous bankruptcies, and increased the financial risks to parties associated with grain contracts. The extent of the bankruptcy risk will depend on the terms of your contract, the financial condition of the debtor, and the actions that you take both before and after a bankruptcy filing.
Grain contracts take a variety of forms, but most have similar essential terms. They usually are written in the form of a confirmation, which may or may not be signed by all parties. The fact that it has not been signed by both parties does not necessarily affect the enforceability of the parties’ agreement. The contracts specify the price, quality, quantity and delivery terms. How a bankruptcy of a party (the “debtor”) affects this contract depends in large part on whether the contract has value to the debtor and whether delivery of the commodity has occurred at the time the bankruptcy petition is filed.
Assumption or Rejection. The Bankruptcy Code gives a debtor the right to either accept or reject executory contracts. In most instances, unperformed grain contracts are considered executory contracts, thus the Bankruptcy Code allows a debtor to accept or reject these contracts. The debtor’s decision whether to accept or reject a grain purchase contract no doubt depends on if the debtor is “in” or “out” of the money on the contract.
If the debtor is “in” the money, the debtor may assume the contract and demand performance by the other party (the “counterparty”). In this instance, the counterparty is entitled to demand adequate assurances of the debtor’s performance before it is required to perform under the contract. Adequate assurances usually require the debtor to show it has the ability to pay under the terms of the contract.
If the debtor is “out” of the money, it can reject the contract, which is a breach of the contract. If this occurs, the counterparty does not have to perform and is generally left with a pre-petition unsecured claim for the breach. The counterparty has a duty to mitigate these damages in a commercially reasonable manner and should act prudently to obtain the best price for the commodity upon learning of the breach.
Delivery. If you deliver product more than 20 days prior to the filing of a bankruptcy and have not been paid for such product, you are likely left with an unsecured claim for the price of the commodity. Unsecured claims may share in some payment/dividend at the conclusion of the bankruptcy. If you deliver the product within 20 days of the date of the bankruptcy filing, you may be entitled to an administrative claim under 11 U.S.C. 503(b)(9), which generally means you hold a priority position above unsecured creditors. There is no certainty that the amount of the administrative claim will be equal to the contract price for the commodity. The Bankruptcy Code states a 503(b)(9) administrative claim is equal to the value of the goods received by the debtor. Accordingly, you can anticipate a debtor may try to reduce such a claim to the current market price for the commodities at the time of delivery. Any difference between the current value of the commodity and the contract price would then be treated as an unsecured claim in the bankruptcy.
Preferences. If you received payment from the debtor within 90 days prior to the filing of the bankruptcy petition and the payment was not according to the terms of the contract or prior payment history with the debtor, your payment may be subject to a preference/avoidance attack by the debtor. If this occurs, it is important you know there are numerous defenses to a preference claim and you should consult with an attorney to see what defenses may be available to you.
Doing Business With the Debtor Post Petition—Practical Considerations.
Can You Get Paid? This is the most important consideration that you should evaluate prior to entering into any contracts with anyone that has already filed for bankruptcy. You need to determine if the debtor has the authority to operate its business and has obtained sufficient financing that will allow it to pay its creditors in the ordinary course of its business. Unless both of these minimal conditions are met, you may be exposed to great risk in any post petition transactions with the debtor.
Sales Post Petition. A seller who delivers product post petition (i.e. following a bankruptcy filing) is entitled to an administrative claim which has priority over an unsecured claim. While this is better than being unsecured, it is not a guarantee of payment. The value of an administrative claim is often over sold by the debtor and may not be sufficient to justify doing business with the debtor post petition. An administrative claim, although ahead of an unsecured claim, still ranks in priority behind the claim of a secured lender and unless the debtor has sufficient assets to satisfy the secured claims, the administrative claimant will receive nothing in a bankruptcy. In addition, while a debtor may be able to operate temporarily post petition, there is no guarantee that the debtor will continue to operate and pay its creditors. Also, if the debtor defaults on its financing, the lender’s faucet can be quickly turned off and the post petition seller of commodities is left with little or no recourse. The lesson is this: before engaging in business with a post petition debtor, you must conduct thorough due diligence and the assistance of a bankruptcy professional is advised.
Changing Your Commercial Terms. A common tactic of a debtor is to demand that the counterparty provide contract terms and credit on similar terms as were done prior to the bankruptcy. They often package the demand as “critical trade vendor” treatment which they ask the bankruptcy court to authorize, and then offer to pay you on a go forward basis, but only if you provide “the most favorable terms” that they enjoyed for some period prior to the bankruptcy. You should be very cautious of such offers. There is no legal requirement which forces a counterparty to sell to the debtor on credit nor provide favorable terms. The fact of the matter is, the risk associated with doing business with the debtor has significantly changed due to the bankruptcy. While a counterparty may have felt comfortable selling on open terms prior to the bankruptcy, there is nothing to prevent a counterparty from demanding adequate assurances of payment, including pre-payment or other collateral to ensure that it will be paid for property delivered to the debtor. Counterparties are cautioned to be careful in cashing any checks received from the debtor prior to the bankruptcy or signing any letter agreements that attempt to trap the counterparty into agreeing to provide continuing credit to the debtor post petition, and we strongly suggest any proposed agreements or pleadings you receive relating to such treatment be reviewed by legal counsel.
Safe Harbor. The Bankruptcy Code provides certain protections and remedies for forward contract merchants dealing in forward contracts, which may be applicable to counterparties. These are referred to as the “Safe Harbor” provisions of the Code. The Safe Harbor provisions allow parties to enforce provisions in a forward contract, which terminate the contract upon a bankruptcy filing and provide that settlement payments made under the terms of such contracts are not recoverable by the usual preference/avoidance provisions of the Code. The key in determining if a grain contract is subject to the Safe Harbor provisions is whether the contract is actually a “forward contract” between “forward contract merchants” as opposed to a standard grain delivery contract. This is a highly technical area of the law and consultation with legal counsel is recommended.
Pick and Choose. We are often asked if a debtor who has multiple contracts with the counterparty will be allowed to pick and choose which agreements it wants to accept and which agreements it wants to reject. This can be a difficult issue and will likely depend on the contracts at issue and the course of dealings between the parties. As long as the agreements are truly separate agreements, the debtor may have the ability to accept certain agreements and reject others. On the other hand, if multiple contracts are tied to a master agreement or were treated in that fashion by the parties, the debtor’s ability to pick and choose may be limited.
The law concerning the enforceability of a grain contract is usually created during times of great variations in commodity prices. We believe this year is no different, and the recent changes in commodity prices coupled with the emergence of the ethanol industry present a multitude of unique legal issues. There are numerous stumbling blocks that can be avoided by careful contract drafting and taking quick and prudent action upon learning of a bankruptcy or otherwise dealing with a financially distressed buyer or seller.