New England Biz Law Update
In-house counsel can play a critical role in making sure their companies get paid by financially distressed customers before a bankruptcy filing.
The key? Act quickly and decisively at the first whiff of trouble.
Some preventative actions include:
- negotiating a “wish list” of remedies incorporated into sales agreements;
- seizing goods delivered but not yet sold; and
- threatening or obtaining collection remedies such as attachments, reach and apply and trustee process.
If a customer or competitor goes into bankruptcy, buying assets at a bargain price is another strategy in-house counsel can implement for their companies.
In-house lawyers must arm company personnel with the necessary knowledge and procedures to immediately spot and act upon warning signs of customers and suppliers in financial trouble.
Persuading senior management to buy into the philosophy of “preventative credit collection” is essential, says creditor rights attorney William S. Rogers Jr., because “that gives in-house counsel the platform to educate the company’s workforce and to implement the necessary procedures.”
What Rogers calls “total quality management” — that is, all levels of a company committed to effective credit collection — puts in-house lawyers at the center of enhancing profits.
“In-house lawyers are in the best position to develop systems that make information on customers readily available so their companies can act quickly,” says Rogers, a Worcester, Mass. trial lawyer. “Encourage rapid recognition of problems and have systems in place to facilitate the sounding of alarms right away. Don’t wait until problem occurs.”
Boston commercial litigator Richard L. Levine agrees.
“Speed is of the essence,” Levine cautions. “Don’t wait. Get an attachment or some security interest right away. The faster you act, the sooner you can breathe a sigh of relief when the 90-day voidable preference period passes.”
Transactions out of the ordinary course of business within 90 days of a bankruptcy filing can be undone later as a “preferential” payment.
Delays can mean other creditors get paid first, and, worse, the financially distressed company could file for bankruptcy, severely hamstringing collection efforts.
“In-house counsel needs to ensure the paper trail is in order. You should be able to yank the file and be ready to go,” Levine says. “A common problem is that agreements aren’t complete, or important signatures are missing, or purchase orders can’t be found.”
Fears over having payments voided in bankruptcy as a “preference” should not deter collection efforts, Levine stresses.
“Tried to get paid as soon as possible,” he says. “That reduces the risk that the payment is out of the ordinary course of business [one of the hallmarks of a voidable preference]. Pursue, pursue, pursue; don’t wait for other creditors to get in the way.”
Paul W. Carey, a Worcester, Mass. bankruptcy attorney, adds: “On the eve of bankruptcy, you want to get paid. Don’t avoid payments solely because of the risk of a voidable preference action. If you have a good credit collection policy in place, that will limit your exposure to voidable preference claims.”
Think Collection, All The Time
Rogers observes: “From day one, you have to be focused on collection, not just sales revenue. There is a common disconnect between contract signing and credit worthiness and collection. Do your due diligence. Can a company pay its bill? If not, don’t do business with them. If maybe, then do a thorough credit evaluation, watch that company carefully, and do business on a provisional basis. If yes, then push the sales force to get more sales [from that company].”
Rogers and Carey were panelists on an April 22 seminar co-sponsored by their firm, Mirick, O’Connell, Demallie & Lougee and the Northeast Chapter of the American Corporate Counsel Association. The program was entitled “Dealing With Distressed Businesses: Effective Corporate Counsel Strategies For Minimizing Risk And Maximizing Value.”
In-house counsel should try to include provisions in written sales agreements that maximize financial protection.
One example is a short “cure” period, where a customer has a certain period of time to pay overdue bills. Otherwise, your company can terminate the agreement.
“The shorter the cure period, the better it is for the creditor,” says Levine, a veteran bankruptcy law expert. “For example, the cure period could be 30 days, or you get back your license. Short triggers means you have the chance to pounce, and you’re not helplessly watching the clock tick away.”
Overall, Levine suggests that in-house counsel view written agreements as an opportunity to create a “wish list” in the event of a default.
Rogers says: “Go for provisions entitling you to recover attorneys’ fees and costs in the event of a default, plus all costs of collection. Massachusetts has favorable remedies for creditors, so you might want to include a forum selection clause of Massachusetts.”
Creditors should not hesitate to aggressively pursue bad accounts, even when the sales force is pressuring in-house counsel to ease up, according to Rogers.
“In-house counsel has to be the watchdog and make decisive, tough decisions,” he says. “Sometimes you have to have a no-nonsense, firm conversation with the business people. Just deal with the problem on a pragmatic, business basis. You want cost-effective solutions, and not just put it into suit and let it languish.”
Rogers suggests companies should constantly look for signs that a customer is having financial troubles, such as progressive delays in payments or erratic payment patterns.
“Your company needs to see the warning signs, be on alert, and know when to act,” Rogers says. “In-house counsel has to get the facts and assess the situation, and know when it’s appropriate to simply send a demand letter, or get expedited judicial relief.”
‘It’s All About Leverage’
Once a company decides to go after a bad account, creditors have plenty of “tools to gain leverage to change the equation in the mind of the debtor,” Rogers says. “One month they pay Peter, but rob Paul. You have to get in their heads.”
Some judicial remedies include attaching property of the debtor, or physically seizing goods delivered to a customer but not yet sold, Rogers says.
Other methods include a court order requiring a third party owing money to your debtor to instead pay your company, he notes.
“Just the threat of that remedy can be very powerful because it causes your customer to be concerned about its reputation with its customers,” Rogers observes.
Your company’s sales force should systematically gather and retain information about which companies their clients are doing business with, he says. “In normal conversations with sales clients, they should talk about contracts, job sites and the like. It’s very simple information to get.”
And, Rogers adds, make sure your company keeps copies of checks of customers to determine their banking relationships and account numbers, which will help in getting a court-ordered trustee process, where the bank makes payments to your company directly.
“All of these remedies are geared toward leverage,” he says. “It’s all about leverage. The squeaky wheel gets the grease.”
Beating Back Bankruptcy
Should a customer file bankruptcy, experts tell New England In-House that speedy action remains paramount for creditors.
“In-house counsel might have the impression that bankruptcy is a big, lumbering thing playing itself out,” says Carey. “You don’t want to wait around until a Chapter 11 reorganization plan is filed [before participating in a case]. Key battles and rights are decided in the opening days.”
One such action in-house attorneys should consider is dashing off a reclamation letter to the debtor-customer, which does not violate the Bankruptcy Code’s automatic stay against creditor actions, Carey says.
In the reclamation letter, a creditor demands a return of goods delivered, or a security interest in other property, or a priority claim against the bankruptcy estate, Carey says.
And, he notes, your company could also try to stop goods in transit before the customer receives them. Once a debtor receives goods they become property of the bankruptcy estate.
But it’s important for in-house attorneys to be wary of violating the powerful automatic stay rights of the debtor.
“All actions to collect money from a bankruptcy debtor, or to grab property of the estate, is prohibited,” Carey says. “If you’ve [just] delivered goods to a debtor, and they’re sitting on the factory floor in unopened boxes, you still are prohibited from taking them back.”
He also warned that all pending litigation should come to a standstill, and that a creditor can’t simply stop performing on a contract since a debtor in a Chapter 11 reorganization has the right to accept or reject a contract.
Debtors at the immediate outset of a Chapter 11 reorganization bankruptcy case file so-called “first-day” motions seeking court approval of anything from new financing to “critical vendor” lists.
Indeed, gaining “critical vendor” status carries Bankruptcy Court approval of continued payments in full.
But Carey cautions that judges are increasingly more skeptical of critical vendor requests. And some debtors are “attaching strings” that may be detrimental to a creditor, such as guaranteed deliveries for extended periods of time, he adds.
Voidable preference actions typically emerge as a bankruptcy case proceeds over time.
In-house counsel can respond to a demand letter sent by the debtor-in-possession or bankruptcy trustee without having to hire an outside lawyer, Carey notes.
“You can raise a number of defenses in a well-reasoned response,” he says, “including that your company hasn’t received all payments, or that the payments were made in the ordinary course of business, or that payment was on c.o.d. basis, or that your company gave ‘new value’ to the debtor after receiving payment.”
Carey said voidable preference litigation can be expensive, and a strong response letter can often lead to settlements in most cases. Hiring outside counsel may be necessary to seal the deal though, he says.
The ‘Stalking Horse’
In-house counsel can also play an essential role in acquiring bargain-rate assets in bankruptcy, either from a current customer or a competitor that hits the skids.
An effective way to get a leg up on buying the assets is to act as the “stalking horse,” which is the initial bidder for assets. The stalking horse essentially sets the base price with its initial bid that other bidders have to exceed in order to purchase the assets in question.
Purchasing property from a debtor’s bankruptcy estate has the huge advantage of shedding preexisting liens, which are paid from the bid price.
The stalking horse bidder negotiates terms with a debtor, subject to notice to other creditors and other interested parties, and ultimately approval by the bankruptcy judge.
“The stalking horse does have advantages, such as setting the basic terms of the proposed sale,” Carey notes. And they can protect themselves against losing a bid by including an “overbid protection” clause that pays for out-of-pocket expenses, and a “break-up” fee that’s built in to the bid, so that another bidder has to offer a percentage amount higher than the original bid to get the assets.
In-house counsel can lead the negotiations or work with outside counsel, he adds.
A. Davis Whitesell, a veteran business bankruptcy specialist in Boston, emphasizes that negotiations with a debtor “are not that dissimilar to deals outside of bankruptcy. There’s a little bit of a dance going on. The terms are subject to the give and take between a debtor and creditors. Cash talks in bankruptcy.”
Whitesell, who usually represents debtors, says he typically will seek a sale “as is,” noting, “as debtor’s counsel, I try to get rid of representations, warranties and covenants. Why sell assets if the buyer can make a claim against the sale proceeds?”
He says a middle ground is to set aside money in escrow to indemnify the buyer in the event of an environmental claim, for example.
“A buyer tries to be aggressive in getting an indemnification clause,” Whitesell says, “and to stand fast on the representations and warranties. It says to the debtor: ‘You need us, or we’ll shut your doors.'”
Should a company not be the stalking horse and is interested in purchasing assets, in-house counsel should immediately contact the debtor to get a copy of the bid package, Carey says.
He notes that a stalking horse bidder can sometimes “impose unreasonable restrictions on the information. You should insist on your right to get all of it. It can be complicated, with financial disclosures and confidentiality agreements. You need to understand all the rules of the game before the hearing.”
In-house attorneys should always be on the lookout for bankruptcy filings of competitors, or of businesses in industries their companies are seeking an increased presence, Carey says.
Better yet, he adds, they can look for financially troubled, “diamond-in-the-rough” companies pre-bankruptcy and negotiate asset-purchase deals as the stalking horse.
Helping The Troubled Company: In-House Counsel’s Role
In-house counsel working for a financially weakened company can be vitally important in reducing liabilities and maximizing leverage with creditors, experts tell New England In-House.
When a company slips into financial trouble, in-house attorneys often are at the center of working with creditors on restructuring loans, modifying payments, reworking shipment terms and the like, according to attorney Michael O’Hara.
He should know. O’Hara is overseeing the liquidation of retail conglomerate Casual Male Corp., which filed for bankruptcy in May 2001.
“It’s important to realize that today’s creditor may be a member of the creditor’s committee [tomorrow] in bankruptcy,” O’Hara notes. “Be fair with them and have foresight when dealing with their problems. That will be remembered and be potentially meaningful as your company attempts to reorganize its business in Chapter 11.”
Of the utmost importance, according to O’Hara, is to focus on the interaction of all creditor groups, such as lenders, bondholders, landlords and trade creditors.
As a company faces greater financial distress, a senior lender may seek greater control over operations, which could impact other creditors.
“You need to be completely versed in the instruments governing creditor rights, including loan documents and bond indentures,” O’Hara says. “If you propose an action, will that be acceptable to the senior lender or bondholders?”
It’s critically important for in-house lawyers to regularly communicate with creditor groups, particularly as to what they believe their rights are and how flexible they’re willing to be in enforcing those rights.
“Talk with them. Work with them,” O’Hara advises. “Give them early advance notice of possible modifications with other creditors and how that might affect them. They’ll be more likely to work with you and be flexible.”
Another important role for in-house counsel is to help arrange a “pre-packaged” bankruptcy where a major creditor agrees to a restructured deal and is willing to avail itself of the power of the Bankruptcy Code in helping a debtor company reorganize its finances and payoff other existing creditors.
It’s probably advisable to consult with outside counsel early on, O’Hara says.
“You need expertise to figure out the legal alternatives to maximize the chances of having them be successful,” he says. “And in the event of a bankruptcy, you’ll need advice on how best to approach a lender to arrange financing in a Chapter 11.”
And a bankruptcy law expert will help in-house attorneys work their way through the thicket of fraudulent conveyances and voidable preferences under the Bankruptcy Code, where transactions on the eve of bankruptcy can be later undone as being unfair to other creditors.
Beware The ‘Zone Of Insolvency’
A body of case law has emerged across the country where a company that enters the “zone of insolvency” has a fiduciary duty not only to shareholders, but to creditors as well. That fiduciary responsibility extends to officers and directors.
If a company goes belly up, creditors may sue, claiming corporate officers and directors made decisions to enhance the equity of a company, rather than pay off creditors when they had the chance to do so.
A Delaware Chancery Court created this “dual” fiduciary duty and other lower courts have adopted it. But no appellate court has ruled either way on its legitimacy, according to Boston bankruptcy lawyer Richard L. Levine.
“It’s controversial,” Levine said. “When the fiduciary duty begins to shift toward creditors, how can a corporation have competing fiduciary duties? How do you know when a company has even passed into the zone of insolvency?”
Either way, in-house counsel has to pay keen attention to the possibility of direct claims against a company’s officers and directors under the zone of insolvency theory, O’Hara said.
“You have to weigh the interests of the financial viability of an enterprise as a going concern against the interests of shareholders,” he explained.
For example, he said, if a holding company with bondholders agrees with a trade creditor to the shipment of goods on the condition of issuing a letter of credit, in-house counsel has to be aware of the ramifications of going forward with that deal.
“The duty requires a company not to waste resources with respect to prior creditors, but maybe a deal is ultimately harmful to shareholders in the company,” he noted.
“In-house counsel has to pay attention to this extremely seriously,” O’Hara stresses. “A guiding principle, when a creditor proposes improving its position because it’s willing to ship widgets knowing your company is in financial distress, is to ask whether giving a guarantee of a parent company to ensure delivery is reducing assets to the detriment of preexisting creditors.”
Determining whether your company is in the zone of insolvency can be “esoteric,” according to O’Hara, and may require the assistance of outside counsel. It boils down to whether state law defines it as a company being in the red, or whether it is unable to pay debts when due, he says.
Potential Liabilities
In-house counsel working for a financially troubled company can help avoid personal liability for themselves and other high-ranking corporate officers, according to Levine, by making sure that all withholding taxes and wages are paid. Failure to do so can trigger criminal and civil liability.
And it’s equally important to make sure health insurance of employees has been paid.
“If you haven’t covered that, you’re in trouble,” he warns. “There’s nothing wrong with pre-paying critical debt. Once you’re in bankruptcy, you lose control over how to spend money. If you need Bankruptcy Court approval to pay a health insurance carrier, that may take weeks. In the interval, some employee may need benefits right away. You don’t want any delays.”
Levine suggests creating a separate payroll account in the event a creditor seeks to attach bank accounts.
“It’s critical to make sure there is a separate payroll account identified as such, because those cannot be attached,” he explains. “There’s no rule on how far in advance you need to fund the payroll account, but a month at minimum is a good idea in the event of a financial cataclysm. You want to have the wherewithal to pay wages.”
And prior to bankruptcy it might make sense to pay critical employees an advance on salaries as a way to keep them from jumping ship.
“A Bankruptcy Court judge may require you to give the money back, but so what,” Levine says.
He also explains that it’s dangerous for a company in financial trouble to consider shifting assets to subsidiaries or affiliates “because the odds are high the company that did the transferring may get sued for aiding and abetting a fraudulent transfer. That means personal liability for everyone involved in the transaction, including in-house counsel.”
Another potential landmine is criminal liability awaiting those officers who “knowingly” make fraudulent transfers pre-bankruptcy, Levine says.
He also notes that it’s important to revise loan documents when your company’s finances change.
“It’s a criminal offense to make misrepresentations on loan applications from a federally insured bank,” he explains. “These documents represent the financial strength of a company. There’s a continuing obligation to represent the accuracy of the numbers. And a company is reasserting all the covenants when it seeks a new loan or new interest rate. A bank may not mind nods and winks. But if it gets angry enough, it may want to enforce those covenants. Officers may forget that.”
