This post originally appeared on the Council of Fashion Designers of America website, CFDA.com.
You’ve worked so hard to get your foot in the door with that prized retailer, striving mightily to please them. They’ve finally supported your line and you just shipped them a big order for Fall 2020. But that same retailer has now filed Chapter 11. What can you do to protect your inventory in the bankruptcy proceeding? Should you continue to do business with the retailer during the bankruptcy? And what can you do to avoid these problems in the future with other retailers? This article will briefly address these questions and provide some basic strategies to help guide the designer/manufacturer in these difficult times.
Getting Paid Before A Bankruptcy Petition Is Filed
Purchasing goods on a wholesale basis with a purchase order does not by itself afford protections for a designer/manufacturer. As discussed below, certain protections are afforded by the Uniform Commercial Code (“UCC”), which applies to the sales of goods, with respect to reclaiming goods. Before any bankruptcy is filed, care should be taken to be in communication with the retailer to ensure that the designer/manufacturer’s level of exposure is limited by inserting closer to delivery or COD payment terms and limits on the size of orders. Care should also be taken to monitor the financial condition and credit conditions of the retailer and the timing of payments, the source of payments and any change in purchasing patterns.
Tools To Ensure Payment
A designer/manufacturer can minimize risk of non-payment by requesting a letter of credit, a third party guaranty, surety or security. A letter of credit is a written undertaking from a financial institution to pay upon certain terms such as shipment and delivery of conforming goods. This will ensure payment even if the retailer is unable to pay but letters of credit are difficult to obtain as part of a retail transaction. A third party guaranty represents a promise by another party to stand in for the retailer and to make payment if the retailer defaults on its obligation of payment. Guaranties must be in writing and the terms and conditions of the guaranty should be carefully drafted. A surety entails contracting with a third party, such as a bonding company to be responsible for payment much as a guarantor is liable.
Consignment Arrangement
A consignment arrangement generally involves a seller (“consignor”) delivering goods to a consignee under a bailment arrangement where the consignor retains ownership while the consignee holds the goods for sale to consumers and the consignee shares the proceeds with the consignor. Under common law, the consignee’s rights in the goods are limited and creditors typically cannot successfully assert claims against the goods and the proceeds. However, if the consignment falls under Article 9 of the UCC, which relates to secured transactions, creditors of the consignee can assert claims against the consigned goods, notwithstanding the fact that the consignor has legal title, and can claim priority based upon a perfected lien and pre-existing security interests if the consignor has not filed a UCC-1 financing statement for such goods and provided notice of the consignment to creditors. Where the retailer has received financing and the financing entity has filed security interests in the retailer’s inventory and proceeds of sales, it is probable that financiers have security agreements in place and have liens against pledged assets. The use of a consignment agreement can be problematic because of the need for a UCC-1 filing and notice of the consignment to financing entities and, if a security interest were perfected with respect to goods that are currently in inventory, it is likely that a pre-existing security interest has been filed as to the purchased goods. In addition, in certain circumstances, assets in a bankruptcy estate may become encumbered by a super priority lien that supersedes all previously-filed security interests. Given the need for UCC-1 filings and notice to creditors, consignment arrangements are generally used with respect to higher-priced goods as opposed to goods which are sold at a high volume and lower prices.
Shop-In-Shop/Lease Concession
One means of controlling possession of branded goods and limiting exposure to bankruptcy is to lease space within a retailer’s store and to sell the goods to the consumers directly. This method avoids putting the inventory in the hands of the retailer and therefore can protect goods from being deemed part of the bankruptcy estate. Suppliers should be mindful of the impact of relevant bankruptcy provisions and the written agreement should be very detailed. The lease concession agreement will likely be deemed an “executory contract” in the bankruptcy, meaning it that would be subject to the debtor’s assumption or rejection.
Reclamation Of Goods
Reclaiming Your Goods Before Bankruptcy
If the retailer has not yet filed for bankruptcy protection and you just shipped the goods within the past 10 days, a designer/manufacturer has the right under Section 2-702(2) of the UCC, which governs the sale of goods, to reclaim goods which were sold to a retailer on credit “while solvent” by demanding their return. However, the demand must be made within 10 days after the receipt and only those goods can be reclaimed. That limitation does not apply if a misrepresentation of solvency has been made to the seller in writing three months before delivery. In addition, the seller’s right to reclaim is subject to the rights of buyers in the ordinary course and so care should be taken to act quickly to protect one’s rights. The definition of “insolvent” under the UCC means: (i) having generally ceased to pay debts in the ordinary course of business other than the result of a good faith dispute; (ii) being unable to pay debts when they become due; or (iii) being insolvent as under the Bankruptcy Code. Insolvency under the Bankruptcy Code means an entity’s debts exceed the value of its assets at a fair valuation, using market value rather than financial reporting standards such as GAAP. The reclamation demand should be in writing and should identify clearly the goods being reclaimed, and demand that the goods being reclaimed be segregated. In order to protect your rights, it is generally prudent to consult with an attorney to make sure the demand properly protects your rights under Section 2-702(2).
Reclaiming Your Goods After A Bankruptcy Petition Has Been Filed
The Bankruptcy Code also provides reclamation rights to a designer/manufacturer under Section 546(c), which gives one the right to assert a written reclamation demand for goods received within 45 days of the filing of the bankruptcy for goods sold by it in the “ordinary course” and the debtor must have received the goods while insolvent as that term is defined by the Bankruptcy Code. If the 45-day period expires after the bankruptcy petition is filed, the designer/manufacturer must make the written reclamation demand within 20 days after the bankruptcy filing. The written demand, as with the demand under the UCC, needs to identify the goods being reclaimed, include a general statement reclaiming all goods received by the debtor from the vendor during the 45 day period and demand that the goods be segregated. Some courts have ruled that the designer/manufacturer must diligently assert its rights by seeking judicial intervention in the bankruptcy proceeding.
Administrative Claims For 20-Day Goods
Even if the designer/manufacturer fails to make a reclamation demand under Section 546(c), Section 503(b)(9) provides an administrative priority claim for the value of any goods received by the debtor within 20 days prior to the bankruptcy filing if the goods were sold “in the ordinary course of business.”
“Executory Contracts” – What Does It Mean And Can I Stop Performing If I Did Not Get Paid?
If the debtor retailer and you have entered into a contract pre-petition that requires performance on a continuing basis (an executory contract), you typically cannot just unilaterally cease performing unless the debtor has rejected the contract and the rejection has been approved by the bankruptcy court. If instead, the debtor seeks to assume the contract with bankruptcy court approval, the debtor will need to cure any outstanding defaults. It may be prudent to retain counsel given the complexities of navigating executory contracts issues.
Getting Paid For Post-Bankruptcy Sales
As a Chapter 11 debtor, the retailer may, with court authorization, purchase goods “in the ordinary course of business” after the bankruptcy filing. Payments for such purchases are accorded administrative claim status, which means these claims have priority over pre-petition unsecured claims and the debtor is typically authorized to pay these on a current basis. If in doubt about payment treatment of goods to be supplied post-petition, the designer/manufacturer should seek the bankruptcy court’s approval of the transaction in advance.