Blakeley & Blakeley LLP - Trade Vendor Monthly News Flash

Vendors are well aware of the costs of vendor allowances taken by retail customers. Vendor allowances generally consist of money given by vendors to retailers in exchange for guarantees for advertising, prime display space, and other benefits. Vendor allowances may not be clearly accounted for, or even acknowledged in the accounts.

Kmart recently attributed that a factor causing its Chapter 11 was its accounting of vendor credits and allowances. Kmart records vendor allowances, discounts or rebates that it receives from vendors at the end of its fiscal year, on a quarterly basis. However, some of the vendor allowances required Kmart to achieve certain sales goals. The decline of Kmart's sales during the fourth quarter caused vendors to withhold some of the allowances that Kmart had already recorded.

By recording partial allowances throughout the year, Kmart reported lower costs, boosting the income reported on its earnings statement for earlier quarters. Kmart stated that it is evaluating its methods for handling vendor allowances and may restate last year's earnings. Kmart has not yet reported its fourth-quarter results and has delayed filing its annual 10-K report with the SEC.

Efforts to collect on delinquent account are stayed even with filing of an involuntary bankruptcy petition -- or risk violating the automatic stay

In evaluating various collection remedies, vendors collectively may find the commencement of an involuntary chapter 7 or chapter 11 bankruptcy petition (the Bankruptcy Code excludes chapters 9, 12 and 13 involuntary proceedings) to be one of the most effective tools they have against a debtor to collect on their delinquent open account in appropriate circumstances, as an involuntary bankruptcy may be viewed as the ultimate prejudgment attachment since it freezes the debtor's assets for the benefit of all creditors.

But vendors must be mindful that with an involuntary bankruptcy filing, the automatic stay is imposed. The automatic stay is an injunction which automatically and immediately goes into effect as soon as a bankruptcy case is field, whether the bankruptcy filing is one under Chapter 7, 11 or 13, whether the case was commenced as an involuntary bankruptcy. The stay is automatic in the sense that it arises automatically upon filing the bankruptcy case by operation of law, without the bankruptcy court having to enter an order stating that it exists. The stay is in effect even where the creditor has not been given notice that the bankruptcy case has been filed.

Creditor Fleet Financial found itself with a bankruptcy court order disgorging $2.4 million for violating the automatic stay. Fleet, a creditor of the debtor, had collected money owed it during pendancy of the involuntary bankruptcy petition. The bankruptcy judge rejected the creditor's argument that because the debtor operated its business in the ordinary course during the pending involuntary petition, the collections were appropriate. The collections violated the automatic stay.

The essential vendor doctrine is a more common request of Chapter 11 debtors. Under the essential vendor doctrine, a vendor may find that the product or service it provides a Chapter 11 debtor is essential to continued operations. The uniqueness of the product or service may give the vendor leverage in negotiating post-bankruptcy sales. Under the doctrine, a vendor may be deemed an essential vendor and have its claim paid in exchange for postpetition credit sales. For a vendor that is not deemed an essential vendor, yet, perhaps a competitor is, the question is asked "how do I qualify"?

In In re Coserv LLC, 273 B.R. 487 (Bankr. N.D.Tx 2002)
the court devised a standard for the necessity doctrine. The court found: (1) it must be critical that the debtor deal with the claimant; (2) unless it deals with the claimant, the debtor risks the probability of harm, or, alternatively, loss of economic advantage to the estate or the debtor's going concern value, which is disproportionate to the amount of the claimant's prepetition claim; (3) there is no practical or legal alternative by which the debtor can deal with the claimant other than by payment of the claim.

The court also noted the importance of continued operations of the debtor: "In any case, it appears that Debtors' businesses will continue in the future. Thus it is in the interests of unsecured creditors, so far as it is consistent with the prudent business practices, to facilitate Debtors' maintenance of their businesses. Not only will this make payment of unsecured claims more likely; it will in many cases preserve an ongoing customer." In re Coserve, 273 B.R. at 491.

Your customer can't pay your credit sale but can afford to make officer loans (which are forgiven): What's up with that?

Business bankruptcies and out-of-court insolvencies are at record levels. Notwithstanding these companies inability to pay creditors because of their poor financial condition, there are more reports of companies making loans to their management - and then forgiving these loans. What's up with that? For example, telecommunications company Worldcom forgave its $400 million loan to its CEO; Conseco forgave $162 million; Enron forgave millions; Kmart forgave $5 million to its former CEO.

Creditors may have grounds to recapture the "loans", which some view as disguised compensation. The fraudulent conveyance laws or corporate duty laws may be triggered with the loans.

Selling your claim when your customer files Chapter 11: a vulture investor may be interested

Billion dollar companies such as Enron, Kmart and Global Crossing have changed the notion that a customer is simply too big to be forced to file Chapter 11. The perception that lenders, vendors, even the federal government, may step in and rescue a financially struggling company is no longer. Vendors of these mega-companies find themselves with a surprise Chapter 11 customer, and trapped with a delinquent account which is treated as an unsecured claim in the bankruptcy.

Of course, with the Chapter 11, the vendor is looking at uncertain payment over, perhaps, years delay. Is the vendor stuck? If the vendor does not qualify as an essential vendor, perhaps a third party will purchase the vendor's claim, at a discount, by a distressed-debt investor, sometimes referred to as vulture capitalist (VC). A VC may be either purchase the trade claim for its own account, or serve as a broker or trader. Mutual funds have also entered the market of buying debt at a discount, sometimes referred to as vulture funds. VC's are often viewed as targeting bond claims, but that has changed. An example of the strength of VC buying power, one investor in the Enron bankruptcy has purchased over $11 billion of Enron's debt.

With the rising number of multi-billion-dollar bankruptcies, VC's are increasingly offering to purchase a vendor's unsecured claim, in hopes that a Chapter 11 company's trade debt will be worth more after reorganization, sale or liquidation than while the company is tied-up in bankruptcy. The VC's may offer to purchase claim both in and out of bankruptcy.

While VC's may wait years for their investments to pay off, a vendor may prefer to sell their unsecured claim early because they either don't want to battle a debtor who may remain a customer post bankruptcy, or they expect the bankruptcy to drag on for years and prefer to turn their trade claim into immediate cash rather than speculative on a greater return perhaps years later. Turning the delinquent account into immediate cash through a sale of the claim may be especially important where a vendor's delinquent account may be sizeable and may have a dramatic impact on its cash flow. The vendor can't afford to wait and must sell the claim at a discount.

A VC may try to accumulate a mass of trade claims because the more claims, the better return and the more influence in the debtor's reorganization. However, VC's face significant risks, as there is no regulations framework to govern transactions. Buying and selling claims is not governed by the Bankruptcy Code. VC's must take into account the claim's likely validity, whether a court will accept their offer, the value of the debtor's estate and the length of the bankruptcy when making an offer to a vendor.

Once a deal is done, the VC becomes the creditor. They then file a transfer of claim with the bankruptcy court, pursuant to Bankruptcy Rule 3001. If a money distribution occurs, it goes to the VC instead of the vendor. Preference risk usually sticks with the vendor.

No can of soup: failure to provide proper notice will have you throwing tomatoes at your buyer

In King v. Hartford Packing Co., Inc., 2002 WL 416386 (N.D.Ill.2002), Plaintiffs sought to enforce a claim under the Perishable Agricultural Commodities Act ("PACA"). In King, the Plaintiffs owned farms that supplied tomatoes to a Buyer that processed the tomatoes into a variety of uses for consumption. In 1999, a bear market depressed the price of tomatoes and the Buyer defaulted on its payments. The Plaintiffs made oral agreements with the Buyer to permit the Buyer to make payment beyond 30-days from the date of delivery. In addition, Plaintiffs sent letters to the Buyer seeking to enforce their rights under PACA more than 30-days after the delivery of the shipment. In the interim the Bank, a secured creditor, liquidated the Buyer's remaining assets. The Plaintiffs sought recovery against the Bank alleging, among other things, that a PACA trust preserved the Plaintiffs rights to payment under PACA.

PACA requires buyers of certain perishable goods to promptly pay for shipments of produce. Congress enacted PACA to promote fair trading practices in the produce industry. In particular, Congress intended to protect small farmers and growers who were vulnerable to the practices of financially irresponsible buyers. In 1984, Congress amended PACA to further protect unpaid suppliers by creating a floating statutory trust on a seller's produce and all products and proceeds derived from that produce. Prior to the statutory trust, a seller of produce was an unsecured creditor. The benefit of the floating trust provided unpaid sellers an interest in the trust assets superior to that of a perfected, secured creditor.

To preserve benefits under a PACA trust, a supplier must strictly adhere to the statue's requirements, which includes providing notice to the buyer of the supplier's intent to preserve its PACA trust benefits within 30 days default. Alternatively, a supplier can give notice of its intent to preserve its trust benefits by including a statement referencing the trust on its invoices. Under PACA, payment is due within 10 days after delivery, or alternatively, up to 30-days if a written agreement is executed by the parties. PACA does not permit an extension beyond 30-days and any oral agreement for an extension beyond the 30-days is void.

The District Court for the Northern District of Illinois strictly construed PACA and concluded that the Plaintiffs failed to provide proper notice. Accordingly, the Plaintiffs lost their rights under PACA and will only receive unsecured creditor status.

Vendor loses against guarantor: make sure your guarantee contains essential terms as the law does not favor an incomplete guarantee

The concept of an unsecured personal guaranty with the commercial credit sale is seemingly straightforward. A party, usually a principal of the company purchasing the goods (the guarantor), states to the vendor that if the vendor will sell to the debtor on credit, the guarantor will guarantee the payment. This promise to pay by the guarantor is an inducement for the vendor to sell the debtor on open account. The guaranty creates a contract of secondary liability. However, in Kenby Oil Co. v. Lange, 42 P.3d 201 (2002), the vendor learned that its personal guarantee must contain essential terms or face being ruled unenforceable.

In Kenby Oil, the vendor insisted on a personal guarantee before it would extend credit to the business. However, the vendor's gurantee did not include the name of its company, but rather was blank. An owner of the business signed the guarantee. After the guarantor signed the guarantee, the credit department filled in the vendor's name. The business failed to pay and the vendor sued the guarantor for payment. The lower court ruled that the guarantee was unenforceable as it was incomplete: "the failure to provide the name of the guarantor's company in the guaranty agreement was an omission of a material term; thus, the agreement did not comply with the statute of frauds and was unenforceable." Kenby 42 P.3d at 204. To avoid this kind of challenge to your guaranty, ensure the essential terms of the guaranty are included.

Credit professionals are always looking for ways to minimize risk with commercial credit sales and boost cash flow. Business use of commercial credit cards is dramatically increasing; by 2004 it is projected that commercial credit card payments will be $112 billion. In the face of this increased use of credit cards to pay for commercial sales, does the credit professional reduce or eliminate credit risk by accepting credit card payment? What are the legal aspects of a credit card sale for the credit professional?

There are three types of commercial cards: corporate, purchasing and business. Corporate cards are mainly used for travel and entertainment purposes. They generally offer high credit limits, though they do not offer revolving credit lines. Purchasing cards are used for office equipment, supplies and services. These cards are generally used for purchases under $2,000.00 and also do not offer revolving credit lines. The business card is multi-purpose and does offer revolving credit terms.

The credit professional finds credit card payments attractive as the card payment provides for immediate cash, eliminates accounts receivable and deductions, and reduces DSO. However, the vendor faces the risk of charge back if the customer disputes the charge. Under the merchant agreement, the credit card company may be entitled to deduct the disputed balances from the vendor. One method to reduce the problem of charge backs is to have the customer agree in writing that the customer will report the disputed charge to you first and provide a time period to resolve the dispute before reporting to the credit card company.

One unique trend with credit card payments is to have the principal of the customer use the personal credit card to pay for the corporate sale. Why is this? Often it is the frequent flier miles given to the principal.

There are unique risks for credit card payments through the Internet. Fraud and identity theft have been reported with Internet credit card payments. Technology is emerging to reduce the risk of fraud.

Don't let an errant e-mail undermine dispute with customer

E-mail is revolutionizing how credit professionals communicate, be it with customers, sales and other credit professionals. Over a trillion e-mails are to be sent by businesses this year. However, with e-mail quickly replacing telephone communication, the credit professional must be mindful of the loose or errant e-mail about a customer. Merrill Lynch agreed to a $100 million settlement after e-mails from Merrill suggested misdeeds with its clients. Arthur Andersen is being questioned as to its internal e-mails regarding shredding documents.

Consider the situation where a customer refuses to pay for a credit sale, complaining your product is defective. Your sale's person makes a customer visit and acknowledges the products' defects in an e-mail to you. You are forced to sue to collect on the delinquent account. The customer serves discovery requesting the e-mails between the credit department and sales.

The risk of e-mail is that its meaning can be misconstrued in the customer dispute. Unlike a phone conversation with the sale person that is temporary and not recorded, the e-mail is not. The meaning of an e-mail can be taken out of context and misread. The e-mail can be the smoking gun in the dispute. Moreover, the e-mail can be used to assist in the testimony of the author of the e-mail, compared where the conversation was by phone and the party has forgotten. If the vendor responds to the demand for turnover of e-mails by simply deleting them, they will face tough questioning from attorneys and speculation as to their contents. In the obstruction of justice trial of accounting firm Arthur Andersen, government prosecutors have made much of Andersen's deleting thousands of e-mails.

E-Mail notice in bankruptcy proceedings

The vendor that has ended up on a list of twenty largest unsecured creditors with a customer's Chapter 11 filing may be surprised as to the amount of paper a debtor serves on its largest creditors. Of course, to serve all of that paper is very expensive, and is borne by the creditors collectively.

As courts go electronic, the burdensome paper service may soon be obsolete, thanks to e-mail. Bankruptcy Rule 9036 allows for electronic notice, provided the creditor requests. From this Rule, vendors may soon be filing their proofs of claims electronically. This may eliminate the risk of the lost proof of claim.

Documenting your electronic credit sale: watch out for the "battle of the forms" trap as you go electronic

A customer e-mails a purchase order. You confirm the credit sale with an order acknowledgment via e-mail. Your terms and conditions for the credit sale are contained on the order acknowledgment. However, the customer's P.O. contains terms that are favorable to the customer and conflict with yours. To complicate things, the P.O. contains boiler plate: "Seller Accepts The Terms Stated Herein. Any Different Terms Proposed By The Seller Are Rejected". You have a battle of the forms.

As a starting point, Article 2 of the Uniform Commercial Code governs the rights and remedies of a buyer and seller with the sale of commercial goods. Article 2 provides that with the sale of goods over $500, there must be a signed writing. The P.O. and invoice satisfy the writing requirement of Article 2. But was there ever a sales contract formed between the parties, given the conflicting terms? If a sales contract was formed, what terms control, yours or the customer's? What is the impact that the documents were exchanged electronically?

Article 2 simplifies formation of a sales contract and generally recognizes that a sales contract may be formed with the exchange of a P.O. and order acknowledgment, even though terms may conflict. Article 2 provides that new terms, such as contained on the vendor's order acknowledgment, may become part of the sales contract, unless the customer's P.O. expressly limits acceptance to the customer's own terms, the vendor's terms materially alter the sales contract or the customer objects within a reasonable time.

For the vendor, this means that new terms that may materially alter the agreement may be thrown out by a court, and the court may provide terms. Given this risk, vendors may insist the customer agree in writing to its credit application or order acknowledgment which sets forth its terms. Given the arrival of the electronic credit department and documenting credit sales electronically, how does the credit professional reduce the risk of an electronic battle of the forms. What of the credit department that posts their credit application on their web site, or sends their order acknowledgment via e-mail?

As noted, Article 2 requires a signed writing with the sale of goods. An electronic version of the credit application has the same force as its paper counter part. But what of the signature to bind the customer to the terms? The Electronic Signatures in Global and National Commerce Act (The E-Sign Act) was enacted in 2000. The E-Sign Act makes e-signatures as legally binding as ink-and-paper signatures, and can be used in legal proceedings. An e-signature is generally defined as a form of technology, including fingerprint readers, stylus pads and encrypted "smart cards", used to verify a party's identity so as to certify contracts that are agreed to over the Internet.

The effect of the E-Sign Act is a uniform and nationwide legal recognition that a vendor may engage in e-credit transactions across state lines and the e-contract is valid with all states.

Some of the relevant provisions of The E-Sign Act for the credit professional are: (1) parties to the contract decide on the form of digital signature technology to validate the contract; (2) businesses may use e-signatures on checks; and (3) businesses require parties to the contract to make at least two clicks of a computer to complete a deal.

As the credit department goes electronic, how secure is your customer's financial information? Hackers reportedly steal 13,000 credit reports from Experian

As the credit department goes electronic, more and more sensitive customer information is stored and shared electronically, from confidential financial information provided by the customer, to credit card information provided by the customer. Security experts make much that companies need to have electronic firewalls to block hackers from accessing computer networks and stealing confidential information.

Experian reportedly was the target of Internet hackers that stole 13,000 credit reports, posing as Ford Motor Credit employees. Experian reportedly has state of the art encryption technology. It is unclear how the hackers accessed Ford's identification.

The Federal Trade Commission (FTC) is the federal agency that regulates privacy issues. It has issued a final ruling on safeguarding customer information, in conjunction with the Gramm-Leach-Bliley Act (GLB). The FTC's ruling requires financial institutions, as defined under GLB, to have a security plan to protect customer information.

While the focus of GLB is to protect consumer financial information, the Experian/Ford Motor incident raises questions as to a vendor's responsibility and vigilance to safeguard customer financial information and Internet security in the commercial credit setting.

Fight or settle asbestos claims? The billion dollar question for companies facing mass asbestos litigation

There has been much press of companies whose affiliates are targets of asbestos litigation facing a significant swing in their stock prices, especially where the affiliate has been forced to file Chapter 11.

In an extraordinary development, PPG Industries agreed to fund, along with insurance companies, a $2.7 billion settlement of asbestos claims against its Chapter 11 affiliate, Pittsburg Corning (PC). PC filed Chapter 11 in April 2000 facing 400,000 asbestos claims. With the settlement, PPG, the, corporate parent, eliminates both known and future asbestos claims.

The question for the vendor selling on credit in this situation is whether customer will settle or litigate with asbestos claimants. Such companies as Halliburton and Corning are fighting asbestos claimants. The PPG settlement provides for a payout over 21 years, which may not jeopardize payment on credit sales.

Even if your customer never manufactured asbestos, it may be a target of asbestos litigation. The credit professional may question whether this litigation may create credit risk. Asbestos lawyers are targeting automakers and parts suppliers who used asbestos, as opposed to asbestos manufacturers. The automakers and parts suppliers claim that they used asbestos only after being reassured by the manufacturers and the government that it was safe for their particular application.

The Big Three automakers face billions of dollars in asbestos class-action lawsuits. In the fourth quarter of 2001, asbestos lawsuits against the Big Three grew to over 3,500 per month. Currently, more than 20,000 lawsuits are pending against the Big Three. The cost to defend such lawsuits is estimated at $2 billion.

Selling to an overseas customer has its own set of credit risk, including the customer's country's inability to honor its obligations. In an attempt to diminish defaults by developing countries, the U.S. and the Group of Seven allies (G-7) propose to modify the way governments borrow money. The G-7 proposes that bonds issued by governments include "contingency clauses", which provide a plan of action should the government borrower default, making the event less chaotic and less economically damaging.

Developing countries, however, feel that the inclusion of such clauses would brand them a higher risk. In addition, researchers state that interest rates on bonds that carry contingency clauses might be higher.

The U.S. suggests incentives, such as lower interest rates on IMF loans, to persuade borrowers to include the clauses. The U.S. sees the clauses as a quick fix while the International Monetary Fund proposal, which resembles a bankruptcy court for nations, is being contemplated.

In the 1980's developing countries borrowed from a few main banks. Today, however, most nations borrow by issuing bonds, which are then traded in secondary markets, making it difficult to come to an agreement among the highly diverse bondholders in the event of a default. Argentina, for example, has more than 120 different bond issues outstanding, subject to multiple jurisdictions and laws.

Proponents of the IMF proposal feel that while contingency clauses are helpful, a world bankruptcy court would serve to protect developing countries from collapse during financial crises and ensure the stability of the global economic system.

The U.S. congress is contemplating amending the bankruptcy laws to set universal procedures for global bankruptcies that would establish procedures for a corporate bankruptcy being handled in several nations. While the UN adopted the law in 1997 with a mandate that each member country adopt it separately, the legislation is tied up in the U.S. bankruptcy reform legislation.

The amendment will become Chapter 15 of the U.S. Bankruptcy Code. Chapter 15 will focus on assisting U.S. companies and their creditors deal with cross-border bankruptcies. In the interim, bankrupt companies with assets in the U.S. and other countries have set voluntary procedures that courts in two or more involved countries to cooperate during insolvency proceedings.

This information is not intended to constitute legal advice, nor a substitute for legal advice.

Scott Blakeley
Blakeley & Blakeley LLP
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