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Article

Do You Have to Sell to an Insolvent Purchaser?

Date

June 30, 2008

AUTHOR(s)

James D. Gage
Larry B. Robinson
Sylvain A. Vauclair


Given the state of the economy, it will not be a rare occurrence in the short term for a supplier to receive a request to sell and deliver further goods to a purchaser who has filed proceedings under the Companies Creditors Arrangement Act (CCAA) or Chapter 11 of the United States Bankruptcy Code — and who is already indebted for unpaid pre-filing sales.

Can the supplier simply refuse to sell any further goods? Can the supplier impose the condition that some or all of its pre-filing invoices first be paid? And what assurances can the supplier obtain that new post-filing sales will in fact be paid?

In both CCAA and Chapter 11 proceedings, the answers to those questions depend on whether the supplier is bound at the time of the filing by an otherwise valid obligation to sell, for example, under a long-term supply contract.

In CCAA proceedings, the court would usually order that no supplier can modify or terminate existing supply contracts. Consequently, suppliers bound by such a contract would be obliged to sell further goods during the post-filing period.

Fortunately, the CCAA provides that in these circumstances, a supplier can request immediate payment for such post-filing sale of goods. This rule can lead to arrangements between the parties that provide for the payment of post-filing sales, typically the issuance of a letter of credit in favour of the supplier.

In those cases where the supplier is not at the time of the filing bound by an obligation to sell, it may be possible for the supplier to agree to sell post-filing in exchange for the payment of all or part of the pre-filing unpaid sales. This may be the case when the supplier is critical to the purchaser’s ability to continue to operate its business during the post-filing period. More on the critical supplier doctrine below when we discuss Chapter 11 proceedings.

Suppliers who choose to continue granting credit during the post-filing period should know that if a CCAA restructuring fails, and the purchaser must declare bankruptcy, their claims will in principle rank as unsecured claims with all other pre- and post-CCAA filing unsecured claims.

In Chapter 11 proceedings, the automatic stay imposed on creditors by the Code, which prohibits creditors from taking any action to enforce their rights against a debtor without specific court permission, will prevent suppliers from modifying or terminating their supply contracts.

US courts have held that a long-term supplier who refuses to continue supplying goods to the debtor violates the stay. They have issued injunctions forcing the supplier to continue conducting business with the debtor. However, the courts may impose payment conditions to ensure payment of post-filing sales.1

A supplier may find itself in a better situation if the debtor decides to assume the supply contract. Pursuant to the Code, a debtor may assume advantageous executory contracts while rejecting burdensome ones.2 As a condition of assumption, the Code requires the debtor to cure pre-filing defaults (or at least to give adequate assurances that these will be promptly cured) and to provide adequate assurances of future performance.

However, the debtor has until confirmation of its plan of reorganization to decide whether to assume or reject contracts. Although the Code allows a creditor to file a motion requiring the debtor to assume or reject earlier, such motions are not easily granted. Pending assumption, all creditors’ actions are frozen by the automatic stay. Creditors cannot enforce their rights or terminate their contracts, nor can they attempt to condition their future supplies on payment of pre-filing claims.

Significantly, the automatic stay and the debtor’s option to assume or reject contracts only apply to creditors bound by an executory contract. Hence, a supplier who has sold to a debtor on an order-by-order basis and who has no continuing obligation to sell goods to the debtor may attempt to condition future sales on the payment of pre-filing debt. The Bankruptcy Court must approve the payment of pre-filing debts and is requested to do so by a motion filed by the debtor. This is typically referred to as a "Critical Supplier Motion." If the debtor is able to convince the court that certain suppliers are in fact essential to the survival of its business, then the debtor may be able to convince the court to allow payment of that supplier’s pre-filing debt or at least part of it.

McCarthy Tétrault Notes:

Not all US courts recognize the Critical Supplier Motion, so some debtors will choose the jurisdiction in which to file their bankruptcy proceedings based partly on this issue.

In the Kmart3 case, the US Court of Appeal for the Seventh Circuit established that in order to successfully file a Critical Supplier Motion, the debtor must demonstrate that:

  1. the critical suppliers it wishes to pay are, in fact, "critical" to their reorganization;
  2. discrimination among unsecured creditors is the only way to facilitate a reorganization;
  3. non-critical suppliers will be at least as well off as they would otherwise be if the critical supplier order is not entered; and
  4. such payments will not diminish the amount of funds that ultimately will be available for payment to non-critical suppliers.

To demonstrate that a particular supplier is in fact critical, a debtor should be able to convince the court that the supplier in question is "virtually’ indispensable to profitable operations or preservation of the estate."4 A clear example would be a vendor that is the sole supplier of a product on which continued operation of the business depends.


1 See In re SportFame of Ohio Inc., 40 B.R. 47, 1984 Bankr. Lexis 5810, (Bankr. N.D. Ohio 1984), In re Ike Kempner &Bros. Inc, 4 B.R. 31; 1980 Bankr. Lexis 5716; In re:The Elder-Beerman Stores Corp., 195 B.R. 1019, 1996 Bankr. Lexis 543.

2 Title 11 U.S.C.§365.

3 In re Kmart Corp., 359 F.3d 866 (7th Cir.2004).

4 See, for instance, the test established in the decision In re CoServ L.L.C., 273 B.R. 487 (Bankr. N.D. Tex. 2002).

Expertise