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The journal of INSOL EuropeAutumn 2018

€30 Issue 73

Greece:CorporateRescue

Historic debt-deal

Also inside this edition:• France is catching up• Legal framework in Croatia• Consumer insolvency in Poland• Brexit and cross-border insolvencies• Conferences, books and more...

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US CoLUmN

A rose by another name has its thorns1

David Conaway advises not to get stuck in Chapter 11 when a sales contract is deemed to be an executory contract

In 2017, the U.S.’s largesttrading partner was theEuropean Union at $717

billion.2 Also in 2017, EUcountries representedapproximately 43% of foreigndirect investment in the U.S.

This trade is memorialised bya variety of contracts includingsales contracts, joint ventureagreements, technology andlicensing agreements, financingagreements, agency anddistribution agreements, and realand personal property leases. Withthe growth of cross-borderinsolvencies by companies withoperations and assets in multiplecountries, and acknowledging thatthe U.S.’s Chapter 11 is an oftenutilised as a strategic business tool,it is likely that such contracts willbe impacted by Chapter 11.

Foreign companies doingbusiness in the U.S. shouldunderstand the legal andeconomic impact of Chapter 11.This impact on sales and supplycontracts allows proactive advanceplanning to avoid or minimise riskof loss. The following insights arebased on advising numerousclients regarding multi-year andmulti-million or billion dollar salesand supply agreements that havebeen subjected to the Chapter 11process.

Companies sell goods orprovide services to customersusually on two bases: (1) purchase orders and invoices

with references to terms andconditions, or

(2) a written sales or supplyagreement.

A formal sales or supplyagreement is normally indicativeof a more material and longerterm commitment by the parties.

Beyond the parties’ performanceobligations set forth in thecontract, agreements are theculmination of significantnegotiation of the terms andconditions of the contract, and abusiness decision to dedicatecapacity and providecommitments on pricing, terms ofpayment and customer service, allof which are significant economicinvestments. In the event of aproblem, the risk of loss is fargreater than unpaid invoices.

Executory contractsSales and supply agreements aretreated as “executory contracts”under the Bankruptcy Code,which is the statutory frameworkfor Chapter 11 cases.

Debtors are provided theright to decide to assume, toassume and assign, or to rejectexecutory contracts. This decisionis required as part of the plan ofreorganisation process, whichnormally occurs at the end of theChapter 11 process. Pending adebtor’s decision, the parties aregenerally obligated to continueperforming.

In Chapter 11 cases wherethe “main event” is a Section 363sale of all of the assets of thedebtor to a third party, theoutcome for material contracts isusually resolved as part of the saleprocess. The relevant pleadingsand documents regarding the saleinclude a sale motion, the stalkinghorse asset purchase agreement(addressing assumed obligationsand contracts), the proposedbidding procedures for a saleauction, and a proposed saleorder, all of which are subject toobjection by any stakeholder. Assuch, a Section 363 sale is both a

“contested matter” (litigation) anda complex M&A transaction.Accordingly, suppliers mustengage in the nuances of theSection 363 process to protecttheir contract rights.

If a debtor seeks to assume,or to assume and assign, thecontract, he or she is obligated to:(1) Cure pre-petition arrearages,

meaning paying outstandingpre-petition accountsreceivable balances, and

(2) Provide to the supplier“adequate assurances offuture performance.”

In the case of an assumption andassignment, the debtor as apractical matter delegates theadequate assurances obligation tothe buyer.

If a contract is assumed, andarrearages are paid and adequateassurances are provided, thesupplier should have successfullyavoided the risk of economic loss.

If the debtor elects to reject acontract, any outstanding pre-petition balances will likely not bepaid. Rejection is deemed a pre-petition breach of the contract,and the breach of contractdamage claim (under Article 2 ofthe Uniform Commercial Code) isa pre-petition general unsecuredclaim. Such claims unfortunatelyrarely receive any meaningfulvalue. Clearly, rejection of amaterial contract results in lossesregarding the current obligationsowed under the contract andregarding damages for breach offuture performance.

In a recent matter wehandled, the supplier invested inthe development of plant capacityto support a customer’s newproduct. The customer wasunable to contribute to the

32 | Autumn 2018

DAVID H. CoNAWAYAttorney at Law, Shumaker,

Loop & Kendrick, LLP

SALES ANDSUPPLYAGREEMENTS ARE TREATED AS “EXECUTORYCONTRACTS”UNDER THEBANKRUPTCYCODE

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investment. Instead, the contractprovided for minimum purchases,and for a payment to the suppliercalculated on the basis ofpurchasing shortfalls, meant tocompensate for the customer’sshare of the investment.Generally, such investment lossesare greater than the loss arisingfrom non-payment of currentinvoices.

There are also a number ofcomplexities of the assumption orrejection process that impact thesupplier’s risk.

1. Post-petition sales to an at-risk customer/debtor.

Generally, the parties mustcontinue performing post-petition,and debtors (and lenders and/orbuyers behind the scenes)certainly seek to enforceperformance through the terms ofthe contract, which usuallyrequires additional shipments ofgoods and credit extensions. Suchobligations may well increase thesupplier’s risk due to the financialcondition of the customer and theuncertainty of outcome inChapter 11.

Suppliers should be aware ofsignificant protections thatmitigate this risk, under Article 2of the U.C.C., particularly U.C.C.Sections 2-609 and 2-702regarding anticipatory breach andcash before delivery shipments,which can relieve obligations toship or to extend credit. Supplierscan anticipate that debtors willassert that the Bankruptcy Codetrumps Article 2, but case lawsupports Article 2 as “applicablenon-bankruptcy law” that governsthe parties’ rights and obligations.

Often the most importantrisk-assessment factor is thesufficiency and the terms andconditions of post-petition (DIP)financing. For example, DIPfinancing orders usually requiremodification (or objection) tocarve-out any ownership orsecurity interests of a supplier, aswell as protect any intellectualproperty rights.

2. Critical vendor

Depending on the particularChapter 11 case, essential vendorsdoing business on a purchase

order and invoice basis canreceive payment of some or all oftheir pre-petition claims inexchange for an agreement bythat vendor to continueuninterrupted shipments andextensions of credit. Suppliersshould be aware that performanceobligations required by theBankruptcy Code under a sales orsupply agreement may limit this“remedy”.

3. Anti-assignment clauses

Provisions in sales and supplyagreements that require consentas a condition of an assignmentare generally not enforceable inChapter 11. However, courts haveheld that assignment provisionsthat are “material andeconomically significant” areenforceable. Suppliers are well-advised to include in the materialcontracts specific economicrequirements of any assignee,rather than defer this analysis to ageneral “consent” provision.

4. Integration of related agreements

Often in the context of sales andsupply agreements, there arerelated agreements such assecurity or other creditenhancement agreements orintellectual property agreements.Such agreements should be clearthat they are integrated andinterdependent contracts thatmust be assumed (or rejected) intoto. Otherwise, there is the riskthat a debtor could attempt toassume a favourable supplyagreement, but reject a security

agreement that was essential tothe supplier when entering intothe sales contract.

5. Cure of pre-petitionarrearages

In cases of related or integratedcontracts, there may be pre-petition obligations owed undermore than one contract. It isprudent for the obligations owedunder integrated contracts to be“cross-defaulted” in order toachieve maximum benefit of thecure requirement.

A sales and supply agreementgenerally indicates a materialeconomic commitment orinvestment by the parties. Toavoid or manage the risk ofeconomic loss, companies shouldunderstand the impact of Chapter11 on such contracts and thepreventative measures that can beimplemented at the outset, thusavoiding the uncertainties of theChapter 11 process. �

Footnotes:1 Likely the first fused “quote” of

Shakespeare and the rock group Poison.2 2017 U.S. Census Bureau.

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Autumn 2018 | 33

PROVISIONS IN SALES ANDSUPPLYAGREEMENTSTHAT REQUIRECONSENT AS ACONDITION OFAN ASSIGNMENTARE GENERALLYNOTENFORCEABLE IN CHAPTER 11

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