With stay at home orders mandating businesses to stay closed, and falling consumer demand, retailers have been devastated by the COVID-19 pandemic and its seemingly endless fallout.  It is no surprise that, as a result, a number of major retailers have filed for bankruptcy – such as Neiman Marcus, J. Crew, JCPenney and True Religion Apparel.  When a debtor files Chapter 11 bankruptcy, however, the issue is whether to end the relationship or continue doing business. As debtors need trade support in order to survive, they usually reach out to suppliers in an attempt to maintain a steady supply of goods to keep their business afloat.  The bankruptcy process may be explained on the debtor’s website or on a third party restructuring website (e.g. Stretto, for Neiman Marcus).

Companies can continue doing business with a debtor in bankruptcy, but there are risks inherent in doing so, including of course, the fact that the debtor may simply not pay for the goods sold after the bankruptcy proceeding has been filed.  There are ways to manage such risks including, for example, by requiring that the debtor pay a deposit or on delivery of the goods, or even in advance, or by shortening trade credit terms, or requiring a letter of credit as security.  These options can be fraught with peril for the unwary, as payment does not guarantee that the transaction will not be challenged in court.  Below is an outline of some of the issues that can arise in the context of doing business with a Chapter 11 debtor in bankruptcy.

Chapter 11 is a Reorganization Bankruptcy:

A case filed under Chapter 11 of the United States Bankruptcy Code is frequently referred to as a “reorganization” bankruptcy.  In other words, the debtor is not planning on liquidating its assets and going out of business.  On the contrary, it plans on reorganizing and continuing to do business.

A Chapter 11 case begins with the filing of a petition with the bankruptcy court serving the area where the debtor has a domicile or residence.  Unless the court orders otherwise, a debtor must file with the court: (1) schedules of assets and liabilities; (2) a schedule of current income and expenditures; (3) a schedule of executory contracts and unexpired leases; and (4) a statement of financial affairs.  The petition filed by the debtor will include standard information regarding the debtor, the debtor’s plan or intention to file a plan, and a request for relief under the Bankruptcy Code.  Upon filing of the petition, the debtor automatically assumes an additional identity as the “debtor in possession.”  In other words, the debtor is in possession and control of its assets while undergoing a reorganization under Chapter 11.

Ultimately, the debtor files a plan of reorganization with the court, which includes a classification of claims and specifies how each class of claims will be treated under the plan.  Creditors whose claims are impaired vote on the plan by ballot.  After the ballots are collected and tallied, the court conducts a confirmation hearing to determine whether to confirm the plan.

Post-Bankruptcy Sales are “Administrative Expense Claims”

Once the debtor is a Chapter 11 debtor in possession, it is legally permitted to pay for post-bankruptcy filing (“post-petition”) purchases of goods and services in the ordinary course of business.  Such purchases are accorded administrative claim status, which means they are given priority over unsecured and certain other claims – in other words, they have priority over certain pre-bankruptcy claims.  It also means that the debtor is permitted to pay them, even if the purchase was made post-filing.  The reason the Bankruptcy Code prioritizes such expenses is because it encourages vendors to continue doing business with debtors in possession.  Chapter 11 debtors are thus obligated to timely pay their bills in order to use the bankruptcy process to successfully restructure their company.  If the debtor fails to pay such post-petition bills, the court can step in and order payment.  It is thus not uncommon for vendors to feel payment is “guaranteed” when dealing with a debtor in possession.

Secured Creditors Trump “Administrative Expense Claims”

It is important to note, however, that there is no such guarantee.  Indeed, the Bankruptcy Code gives priority to a Chapter 11 debtor’s secured lenders.  The Bankruptcy Code forbids a debtor from using “cash collateral” (i.e. cash subject to a lender’s security interest) unless either (a) the lender consents, or (b) the court has entered an order authorizing such use.  Cash collateral is defined as “cash, negotiable instruments, documents of title, securities, deposit accounts, or other cash equivalents,” 11 USC 363(a), in which a creditor has a lien.    In other words, if the debtor in possession uses cash collateral to pay for post-petition purchase orders, the transaction can be challenged in court and the vendor can be ordered to pay back all of the money it received.

That is exactly what happened in In re Delco Oil, Inc., 599 F.3d 1255 (11th Cir. 2010) where the Eleventh Circuit Court of Appeals ordered a vendor to return more than $1.9 million that it had received from the debtor in bankruptcy.  The vendor in that case had provided petroleum products worth $1.9 million after the filing of the bankruptcy case.  The debtor, however, did not have a court order or stipulation allowing it to use cash collateral to pay for the goods.  The vendor was thus required to pay every single penny back, and this despite its lack of knowledge that the debtor was using the cash improperly.  In other words, the vendor was strictly liable to return the monies.

“Ordinary Course of Business” Transactions

Another important point is that these post-petition transactions must be done in the “ordinary course of business.”  Therefore if the order is an unusually large purchase, or on unusual terms, the transaction runs the risk of not being incurred in the ordinary course of business.  If that is the case, the vendor should consider getting bankruptcy court’s approval so that its rights are protected.

Conversion to Chapter 7 Liquidation

Finally, it is not uncommon for a Chapter 11 bankruptcy proceeding to turn into a Chapter 7 liquidation.  If that occurs, Chapter 7 administrative claims have priority over Chapter 11 claims.  The likelihood of recovering monies on post-petition purchases thus becomes cents on the dollar, rather than the full payment that was originally anticipated in the context of Chapter 11 proceedings.

Interaction with the UCC Article 9

It would similarly be futile for a vendor to seek to protect its interests under Article 9 of the Uniform Commercial Code (“UCC”).  UCC 9-317 provides that an unperfected security interest is subordinate to a judicial lien on the property.  Section 544 (a)(1) of the Bankruptcy Code, however, states that the trustee or debtor in possession steps into the shoes of a creditor and thus obtains “a judicial lien on all property on which a creditor on a simple contract could have obtained such a judicial lien, whether or not such a creditor exists.”  In other words, the debtor in possession, by virtue of filing the petition, is a lien creditor that benefits from UCC 9-317.

Therefore, if a secured creditor is perfected as of the petition date, its security interest trumps the debtor in possession.  If the secured creditor is not perfected as of the petition date, the debtor in possession trumps the creditor’s interest, and the creditor must share pro rata with other unsecured creditors.

Consult with Counsel

This post addresses some of the issues that may arise when a retailer files for Chapter 11 bankruptcy.  Each situation is unique and a Chapter 11 proceeding can be complicated.  Any contract negotiated with a retailer in Chapter 11 bankruptcy must be done carefully and requires thorough due diligence to determine whether the debtor is creditworthy.  Our team is available to guide you in this complex negotiation process.

Dunnington Bartholow & Miller LLP – Fashion Practice Group Chair, Olivera Medenica – OMedenica@dunnington.com