Supplier Rights and Remedies When Dealing with Financially Troubled Customers

Various rights and remedies exist for suppliers of goods that are not often utilized and frequently not even known to suppliers. If used and done properly, these rights and remedies are an excellent tool to help suppliers minimize risk and maximize recovery when selling to financially troubled customers. While these options are helpful under normal circumstances, the current COVID-19 environment will present exceptional challenges throughout the supply chain, including to customers, both large and small, that warrant extra attention from suppliers to options for addressing relationships with troubled customers in order to protect the suppliers’ own financial health.

Article 2 of the Uniform Commercial Code (UCC), which applies in nearly identical form across all states, offers certain rights and remedies for sellers of goods. These protections are available even if they are not written into the supplier’s contract, purchase order or terms and conditions; they apply automatically to all contracts involving the sale of goods. Several of these useful rights and remedies are discussed below.

Adequate Assurance of Future Performance

Upon reasonable grounds for insecurity, a seller can demand adequate assurance of performance from a financially distressed buyer. Let’s break this down into its parts.
 
What constitutes “reasonable grounds for insecurity?”
 
The supplier must be “reasonable” in making its determination that it is insecure about the customer’s ability to pay for goods shipped. This is determined by commercial standards as between merchants. In other words, other merchants standing in your shoes would feel just as insecure as you feel about the customer’s ability to pay. This standard can be satisfied, for instance, by:
 

• the customer being past due with the supplier making the adequate assurance request;
• the customer being past due with other suppliers (which can be determined by comparing notes with other suppliers to the same customer, being careful to avoid violating antitrust rules); or
• warning signs of future customer bankruptcy, such as:
  • missed interest payments on long-term debt; or
  • hiring of restructuring advisers.

What constitutes adequate assurance of performance?
 
Adequate assurance can come in a number of different forms, including, but not limited to:
 

• revoke credit terms and switch to cash in advance / COD;
• shorten credit terms;
• partial advance payment with balance due on delivery or on shortened terms;
• letter of credit;
• guaranty;
• obtaining collateral;
• cash deposit; or
• obtain financials.

 
Pending receipt of the requested form of adequate assurance, the supplier can suspend performance or switch to cash in advance / COD. If the requested adequate assurance is not provided within 30 days, the supplier can deem the contract to be repudiated by the customer, which excuses the supplier from any further performance obligations under the contract. (However, a supplier bears some risk if it refuses to continue to ship on the basis of an unreasonable adequate assurance demand. For example, it would be unreasonable for a supplier to demand a $1 million letter of credit from a customer to which it averages $100,000 of business per year. This type of demand is likely to be viewed as unreasonable and made solely as an improper attempt by the supplier to extricate itself from the contract.)
 
Stoppage of Delivery of Goods in Transit
 
Article 2 of the UCC permits a seller of goods, upon discovering that its buyer is insolvent while the goods are in transit, to instruct the carrier to stop delivery of those goods. Unlike the adequate assurance remedy discussed above, the stoppage of delivery remedy has a more stringent test: the buyer must be insolvent. The buyer’s insolvency can be determined in one of two ways:
 

• balance sheet test: liabilities exceed assets; or
• buyer’s failure to pay debts as they come due.

 
How to Stop Delivery
 
To exercise this right, a supplier must inform the carrier to stop delivery in a manner that is intended to actually cause the carrier to stop delivery. In other words, do not send a letter by regular mail. Timing is critical; the carrier must know of the supplier’s request to be able to act upon it before the goods are actually delivered. Therefore, we recommend sending notice to several people at the carrier (dispatcher, manager, CFO, CEO) by e-mail, fax and overnight delivery (every method available in order to ensure receipt in some form). In addition, pick up the phone and call the carrier to make the request known.
 
The supplier is responsible for additional charges the carrier incurs to turn around the goods or to store them pending a decision where they should ultimately be delivered. Once a proper stoppage request is issued by the supplier, the carrier ignores it at its own peril; a carrier can be liable for damages to the supplier if it ignores a proper stoppage notice. While the stoppage is pending, the supplier may revoke credit terms and ship only on a cash-in-advance basis for future orders.
 
When Are Stoppage of Delivery Rights Cut Off?
 
Stoppage of delivery rights are cut off primarily by the customer receiving physical possession of the goods (which can include a warehouseman or bailee that receives the goods and acknowledges it is holding the goods for the customer). Title transfer is irrelevant. So, for example, if goods a supplier sold to a customer are coming from overseas on FOB point-of-origin terms, even though the customer has legal title to the goods while they are on a container ship traveling across the ocean to a port in the United States, the supplier still has the right to stop delivery if it discovers the buyer is insolvent because the buyer is not yet in physical possession of the goods.
 
Benefit of Exercise Stoppage of Delivery Rights
 
The stoppage of delivery remedy is a potent tool to maximize recovery for a supplier to a financially troubled customer. Consider the following two scenarios involving a supplier who has goods in transit to a customer it discovers to be insolvent while the goods are in transit:
 

• Scenario 1: The supplier does not exercise its stoppage of delivery rights, and the goods are delivered. Shortly thereafter, and before the supplier is paid for those goods, the customer files bankruptcy. The supplier is now an unsecured creditor in the customer’s bankruptcy, standing in line with other unsecured creditors to be paid some cents on the dollar at some point in the future.
• Scenario 2: The supplier does exercise its stoppage of delivery rights, and the goods are stopped before delivery. The supplier now has leverage:
  • The supplier can demand cash payment in full from the customer before the goods will be released.
    • This results in immediate payment in full for the goods versus cents on the dollar at some point down the road in the customer’s bankruptcy.
  • If the customer no longer wants the goods or cannot pay for them, the supplier can resell the goods to another customer for full payment (assuming the goods are not unique to the original customer’s specifications or bear a trademark that cannot easily be removed before resale).

Either way, by exercising its stoppage of delivery rights, the supplier has converted what would have been a cents-on-the-dollar recovery in the customer’s bankruptcy into a full recovery much sooner.
 
In addition, stoppage of delivery rights are superior to a lien on the goods. For example, assume the same scenario discussed above with a container ship coming from a foreign port on terms where title has already transferred to the buyer while the goods are in transit. If that customer has a secured lender with a blanket lien on assets, even though title has already transferred to the customer and the secured lender has a lien on those assets, the supplier’s right to stop delivery is superior to the secured lender’s lien and the remedy can be exercised regardless. This makes the stoppage of delivery right an incredibly powerful tool if exercised properly and fully before delivery. After the goods are delivered, the secured lender’s lien has priority in those goods over the supplier’s uncompleted stoppage of delivery right (including if the customer files bankruptcy after the goods are delivered and before the supplier is paid).
 
Reclamation
 
Once goods have been delivered, Article 2 of the UCC still affords a seller of goods, upon discovering that its buyer is insolvent, the right to reclaim goods. Reclamation is a seller’s right to recover possession of goods sold to a buyer:
 

• in the ordinary course of seller’s business;
• that the buyer received:
  • while insolvent; and
  • within the preceding 10 days.
    • After the buyer files bankruptcy:
      • this right to reclaim goods is expanded to a 45-day lookback prior to the buyer’s bankruptcy filing; and
      • a reclamation demand must be sent within 20 days after the buyer’s bankruptcy filing.

Unlike stoppage of delivery rights, which are superior to a lien on the goods, reclamation rights are subject to:
 

• a lien on those goods by a secured lender or other lienholder; and
• possession by the buyer (if the buyer has already disposed of the goods before the reclamation demand is issued, then the reclamation demand is invalid as to those goods).

Therefore, if a supplier can act before goods are delivered, stoppage of delivery rights are superior and more effective than reclamation rights, which often are deemed invalid due to the existence of a lien on the good sought to be reclaimed. This does not mean, however, that a reclamation demand should not be sent even where the supplier knows there is a secured lender with a blanket lien on the buyer’s assets. A reclamation demand is fairly easy to do and should be sent anyway. In the event an infirmity is later found to exist in the secured lender’s lien, reclamation rights that did not appear to be valid initially might later become valid and have significant value.
 
How to Issue a Reclamation Demand
 
To reclaim goods, a supplier must send a notice stating that it is exercising its right to reclaim goods delivered in the preceding 10 days due to the buyer’s insolvency. The notice must clearly identify the goods sought to be reclaimed. Proper identification of the goods is necessary to ensure a valid reclamation demand. For this reason, it is advisable not to try to list the goods in the body of the reclamation demand. Instead, it is better for the supplier to simply attach the invoices or purchase orders that identify the goods by description, item number and quantity. Trying to recreate that information in the body of the demand risks a transcription error, which could result in an ineffective reclamation demand.
 
The reclamation demand should be transmitted in a manner that can be tracked, such as overnight delivery via a reputable carrier, e-mail or fax. This ensures proof of delivery can be made if an evidentiary hearing becomes necessary. The demand should be sent to several people at the buyer (account manager and CFO, at a minimum) and to the buyer’s counsel, if known.
 
Additional Proactive Creditor Tip
 
Even if a supplier does not utilize the helpful remedies discussed above and continues to do business with a financially distressed customer, the supplier can minimize risk and maximize recovery by keeping the customer on relatively short terms. Outside of bankruptcy, this helps to keep exposure to a financially troubled customer to a minimum. It also helps in the event the customer files bankruptcy. Specifically, the Bankruptcy Code affords suppliers with a priority claim for goods delivered to the customer within 20 days before the customer’s bankruptcy filing. Therefore, if a supplier keeps the troubled customer on short terms and enforces those terms by not releasing new shipments if any prior shipment is not paid in full according to the stated terms, then most, if not all, of the supplier’s claim in the customer’s bankruptcy will be a priority claim because, given the short terms and the supplier’s strict enforcement of those short terms, most, if not all, of the unpaid amount will be for goods delivered within 20 days before the customer’s bankruptcy.
 
Practical Considerations
 
While the rights and remedies discussed above can be useful tools to minimize risk and maximize recovery when dealing with financially troubled customers, the current environment presents unique challenges affecting the entire supply chain. The leverage one supplier utilizes against its customers might similarly be used by the supplier’s own suppliers, and so forth, thus creating a potentially crippling impact across the entire supply chain. Therefore, given the incredibly novel circumstances that exist today, suppliers will be faced with a difficult business conundrum. While these rights and remedies are a valuable tool to mitigate risk, suppliers will have to balance risk mitigation with the desire to help the customer survive its current financial distress so a business relationship can be maintained going forward.
 
For more information or to discuss how Ice Miller attorneys can assist your business, please contact Nick Casto (312-726-8105 or nicholas.casto@icemiller.com).

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader’s specific circumstances.