Spencer Fane LLP Logo

Manufacturer’s Corner: Dealing With Your Insolvent Buyer

It’s unfortunate, but it happens: you reach a deal with your customer and prepare to perform your side of the agreement, only to discover that your buyer is insolvent or close to it.  It is essential that you having a working knowledge your rights in this situation, because time is of the essence.

I have written elsewhere about the importance of recognizing the signals that a customer may be facing financial troubles, but I think it will be useful to consider here some remedies that are of particular importance to manufacturers.  Let’s begin by considering what you can do before your product is delivered to the customer.[1]

First, if you discover that your buyer is insolvent[2] before delivery of the goods, you may refuse delivery except for cash payment.  This is especially useful, because it allows you to tee up strong defenses in the event your customer files a bankruptcy petition and you become the potential target of a preference action.[3]

The Uniform Commercial Code also provides that parties to a contract for the sale of goods may demand, in writing, adequate assurance of due performance in the event they sense “reasonable grounds for insecurity.”  For our purposes here, it is important to understand that “reasonable grounds for insecurity” has been held to include a reasonable belief of insolvency or, more broadly, the failure of the buyer to make timely payments on its account or its sudden reliance on credit terms it did not previously use.

Upon discovering reasonable grounds for insecurity, you may notify your buyer, in writing, that you demand adequate assurance of payment.  Your notice should specifically reference Section 2-609 of the UCC,[4] make a specific demand (e.g. cash or wire payment, or a guaranty of payment by a principal or parent company),[5] and state that failure to comply with the demand will be deemed a repudiation of the contract that obviates your obligation to perform.  If you do not receive adequate assurance within thirty days of the demand,[6] you may suspend your performance.  Notably, if you have not yet completed manufacture of the goods when the buyer’s time to furnish adequate assurance has passed, you have the option of completing the goods and suing on the contract (not a great idea if your buyer is insolvent) or cease manufacturing and mitigate your damages by, for instance, scrapping the material.

But what if you have already shipped the goods?  Provided that the goods have not reached the buyer,[7] you may notify the carrier of the goods to stop delivery.  Unless certain exceptions apply, the carrier (or bailee) must hold and deliver the goods according to your instruction, though you bear any costs that result from that.

If the goods have already been delivered when you discover your buyer to be insolvent, time becomes critical.  Assuming your customer has not yet filed for bankruptcy protection, you have ten days from delivery to reclaim the goods.[8]  Conversely, if your buyer has filed for bankruptcy protection, you can demand reclamation within 45 days of delivery.[9]  In either event, your reclamation notice should specify the goods to which it refers, and demand that they be segregated from other goods in the buyer’s possession.

If you miss your reclamation deadline and your buyer has filed for bankruptcy, you are not entirely out of luck.  If the goods were delivered within the 20 days preceding the bankruptcy filing, you may seek an administrative priority claim for their value.  Although this will not protect you in all instances, it greatly enhances your chances of payment.

If this all sounds like a huge pain, you’re right, it is.  Please refer back to the opening paragraph, and remember the importance of recognizing financial distress in your customers.  But, in the event you miss the signs and sell to an insolvent buyer, understand that time is of the essence and that you must take quick and decisive action to protect your interests.

[1] One of the best things you can do is to obtain a purchase money security interest in the goods sold.  In the interest of space, however, that is not addressed in this post.  We’ll get to it.

[2] Note that “insolvent” under the UCC does not necessarily line up with “insolvent” in the accounting sense.  A buyer can be GAAP-solvent while still being UCC-insolvent.

[3] Certain payments to creditors can be clawed back by a bankruptcy trustee or debtor-in-possession.  These clawback actions typically take the form of preference actions, but there are other variants.  We can talk about that another time.

[4] As enacted by the legislature of the state whose law governs your transaction.

[5] Remember that you may only request reasonable adequate assurance.  In the context of merchant-to-merchant sales, that is governed by industry standards.  In other words, don’t be greedy; Section 2-609 isn’t an excuse to turn a credit transaction into a cash transaction in every instance.

[6] The UCC requires only a “reasonable time,” but sets an outside limit of thirty days.  Your industry, or the nature of the assurance you seek, may not require thirty days.

[7] The text oversimplifies this.  Your right to stop delivery ceases upon receipt by the buyer; acknowledgement to the buyer by a bailee of the goods that the bailee holds the goods for the buyer; if a carrier by reshipment or as warehouseman makes a similar representation to the buyer; or the buyer receives by negotiation a negotiable document of title covering the goods.  Depending on your shipping terms, these other deadlines may be more applicable to your situation.

[8] The ten-day limitation does not apply, however, if within three months before delivery the buyer made a written misrepresentation of its solvency to you.

[9] If the bankruptcy petition is filed before expiration of the 45-day period, you must make the demand within 20 days of the petition date.  Please note that this can shorten that 45-day period (e.g., if you deliver on Day 1, and the petition is filed on Day 2, you only have until Day 22 to file your reclamation demand).  Note also that this analysis presupposes that the buyer was insolvent on the date of receipt, and did not become insolvent sometime after.  In the latter instance, the Bankruptcy Code won’t help you, except with respect to your right to a 503(b)(9) administrative priority claim.