The COVID-19 pandemic is a public health crisis unprecedented in modern history, and the resulting economic dislocation has caused financial distress across supply chains worldwide. In light of this extraordinary crisis—and in anticipation of a wave of defaults by businesses large and small in the months to come—shippers, vendors, and other suppliers are assessing their potential exposures in the event of a customer failure. And while suppliers will no doubt consider reasonable accommodations to assist their customers in weathering these challenging times, prudent actors may still be wondering what can be done to prepare for the worst. Although the suggestions outlined below are by no means exhaustive, suppliers of goods and services that take proactive steps such as these will often find themselves in a more favorable position in the event that a customer files for bankruptcy.
The first step is to monitor customers for early signs of potential distress, so that a supplier can take proactive steps before it is too late. The scope and frequency of this review will depend upon the size and importance of each customer to the supplier’s business. Larger customers, for instance, may be reviewed frequently or on an ongoing basis, while a less frequent, periodic review may suffice for smaller customers.
There are many ways to monitor customers’ financial health, and the exact means of doing so will largely depend upon whether they are publicly traded companies or are otherwise subject to regulations that mandate public disclosures.
The review process will be considerably easier for publicly traded companies, which are required under federal securities laws to file both annual and quarterly financial reports (SEC Forms 10-K and 10-Q, respectively) and to publicly disclose other material events on an ongoing basis (generally on a form 8-K). These documents are available free to the public on the Securities and Exchange Commission’s EDGAR page. To the extent that one does business with state or local government units, those entities might be required to make similar disclosures under municipal securities laws, which are also made publicly available on the Municipal Securities Rulemaking Board’s EMMA website. Companies based overseas may also be subject to financial disclosure requirements by the laws of their home jurisdiction.
Although it can be more challenging to obtain the same degree of information on privately held companies—which are generally not subject to public disclosure requirements—there are still ways to obtain valuable information in the public domain. For example, with respect to larger customers that have issued debt such as bonds or bank loans traded on the open market, that debt might be rated by one of the major credit rating agencies (Fitch, Moody’s, Kroll, or Standard & Poor’s). These agencies will often make certain reports available to the general public (with more detailed information available to paid subscribers). To the extent available, suppliers should review these reports for all of their customers, whether publicly traded or privately owned. However, these reports can be especially valuable for private companies, as they often contain information on such companies’ financial health (including compliance with debt covenants and other metrics) that private companies are not otherwise required to disclose publicly.
For smaller businesses or companies without widely traded debt, there are several credit bureaus that offer “business credit reports” similar in nature to the personal reports used in consumer lending (although these business credit reports may contain out-of-date or inaccurate information).
In addition to these sources of information, it may be worth considering whether to require periodic financial reporting from customers as a condition to providing trade terms or when negotiating the next supply contract.
In reviewing a customer’s financial disclosures, credit reports, and other relevant documents, a supplier should be on the lookout for anything that suggests a customer’s inability to continue to operate or otherwise pay its obligations in full when due. Some of these indicators are obvious—for instance, a missed interest payment—while others are less intuitive. Although the below list is far from exhaustive, some common signs of distress include the following:
Of course, one of the most important signs of distress can be identified without any diligence on the supplier’s part at all: when a customer requests an extension of (or other deviation from) their customary payment terms. For example, a customer that had been paying cash upon delivery may seek to pay 30 days in arrears; similarly, customers currently paying in arrears may seek to extend the payment time to 45 or 60 days (or seek alternative payment arrangements such as consignment). Other times customers do not request an extension, but instead begin to “stretch” payments of their own accord, either because they are planning to file for bankruptcy or because they simply need to triage payments. In either case, this is a key sign of distress; although there are a number of reasons a customer may seek to alter payment terms—many of which are benign—this is often an early sign of more serious financial difficulties down the road. Accordingly, suppliers should develop and implement internal mechanisms to alert them when payments are being made outside of normal trade terms. And to the extent that a customer affirmatively requests an alteration of payment terms, such a request provides a supplier with the opportunity to obtain some of the protections described below.
Once the signs of potential distress have been identified, there are a number of actions that can be taken to minimize (or at least mitigate) exposure in the event of a more serious adverse event down the road, such as a bankruptcy filing, foreclosure, or similar scenario.
Some of the most common protective actions are identified below; these actions are not mutually exclusive, and may be more effective when combined. Conversely, not all of these will be available or appropriate to address a given scenario. A vendor or supplier considering taking action should consult with counsel to determine which of these will be most effective to suit its specific needs. In addition, this list is geared towards customers that, while experiencing financial distress, have not filed for bankruptcy. Once a customer has filed for bankruptcy (which is discussed briefly below), one should not do anything without consulting with counsel first, as there may be significant penalties for taking certain actions with respect to a debtor in bankruptcy absent leave of the bankruptcy court.
A supplier that takes one or more of the steps outlined above should (hopefully) be well positioned in the event that a customer ends up filing for bankruptcy. However, there are additional protections that may be available once the bankruptcy has commenced.
Many debtors, for instance, seek approval via “first day motion” to pay the prepetition claims of so-called “critical vendors” at the outset of the case; to the extent that a supplier provides a good or service that is crucial to the customer’s operations, it is possible that the debtor will grant such supplier critical vendor status. To the extent one has shipped goods to the debtor within 20 days prior to the bankruptcy filing (and has not yet received payment), those claims are generally entitled to priority of payment ahead of other unsecured claims. In addition, mechanics’ or materialmen’s liens that could be asserted by a supplier under state law will generally be enforceable in the bankruptcy (increasing the chance that associated claims will be paid).
Suppliers should consult with counsel to determine whether one or more of these are available and appropriate for the particular situation.
Although the failure of a key customer or other contractual counterparty may be out of a supplier’s control, the proactive measures outlined above may help to mitigate the negative impact of such a failure on the supplier’s business. These tips are to an extent evergreen, and are prudent actions to take at any stage of the business cycle. They are made all the more important, however, in light of the extraordinary economic dislocation that has occurred as a result of the ongoing COVID-19 pandemic.
Also published in Pratt's Journal of Bankruptcy Law.