Articles Tagged with The Ninth Circuit

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You have fresh goods delivered to your largest customer daily, as has been the case for as long as you can remember.  You noticed over the last few months that payments have become less frequent—weekly instead of twice weekly—and occasionally have been paid over a week late.  On top of that, rumor in the industry is that your customer is suffering liquidity problems and may ultimately file bankruptcy. So, what do you do? Stop deliveries, despite the fact that you are still receiving timely payments, and possibly exacerbate your customer’s cash flow problems? Or, do you continue delivering goods and accepting payments, which, if your customer ends up filing for bankruptcy, runs the risk of having a bankruptcy trustee seek to claw back any payments you received for an entire 90-day period before the bankruptcy was filed?

It is a scenario that is all too common in the insolvency world, which, thankfully, has been addressed with vendors in mind by the courts.  The facts in the recent Eleventh Circuit case of Kaye v. Blue Bell Creameries, Inc. (In re BFW Liquidation, LLC), 899 F.3d 1178 (11th Cir. 2018) are not unlike our hypothetical.  Blue Bell delivered fresh ice cream daily to Bruno’s Supermarkets, a 60-store grocery chain located in Alabama and Florida.  Bruno’s payments to Blue Bell began to slip, going from twice weekly to weekly, but Blue Bell continued its deliveries up until the point that Bruno’s filed for bankruptcy.  After the filing, Blue Bell found itself in the unfortunate position of being on the receiving end of a lawsuit from the bankruptcy trustee to recover all payments made to Blue Bell during the 90-day pre-bankruptcy period as “preferences” under 11 U.S.C. § 547.

Congress—recognizing that vendors should be encouraged, rather than discouraged, to extend credit to financially troubled entities—included in the Bankruptcy Code what is known as the “new value” defense, which is found in 11 U.S.C. § 547(c)(4).  In short, the new value defense prevents a trustee from clawing back payments made to the vendor when the vendor has provided subsequent “new value” to the bankrupt customer (e.g. in the case of Blue Bell, new ice cream deliveries).

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One important attribute of any successful entrepreneur or business owner is knowing when to enter a new line of business or invest in equipment or employees to bolster an existing, growing service line. Another (perhaps even more important) attribute is knowing when to stop spending time, money and effort on a venture that will likely never work out or is not proceeding as planned. These two decision points—when to move forward and when to make a strategic retreat—are central to the success of any venture.

It is extremely hard to walk away from a project in which an executive is personally and financially invested. But the future viability of the organization always requires clear thinking, with all sentimentality, preconceptions, and vested interests cast aside. This inability or refusal to make a sensible, financial, and analytics-driven decision after a significant investment has been made in a project or an idea is known as the “sunk-cost fallacy.” As one textbook puts it:

“The sunk cost fallacy is the view that sunk costs should matter. Whenever issues involving sunk costs arise, it is always seems natural to think that it would be a pity to waste all the money that has been spent already. But that natural tendency does not lead to the best decisions. . . .”[i]

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As we learned during the downturn in 2008, the economic climate can change rapidly. When things are going well, many businesses forget the lessons of the past. No matter what industry your business is in, there may be occasions when you are asked to enter into a relatively long-term contract, i.e. longer than three years. Such agreements are sometimes favorable because of the stability and predictability they can provide. However, before entering into such an agreement, you should consider that the longer the contract, the greater the risk of a change in the contract counterparty’s financial situation. A safe credit risk in 2017 might find itself filing for bankruptcy by 2020.

If your response is: “I am not concerned about the other party filing bankruptcy. I had my attorney include a bankruptcy termination clause in our agreement,” then you may want to think again. The U.S. Bankruptcy Code has a lot to say about the rights of both the debtor and the non-debtor party once a bankruptcy is filed – often to the chagrin of the non-debtor party.

It is true that many business agreements contain clauses which provide that a party filing bankruptcy is deemed to have breached the agreement, and the other party may terminate the agreement (a “Right to Terminate” clause). Or the provision might say that if one party files bankruptcy, that party’s rights terminate automatically (an “Automatic Termination” clause).

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An asset based loan (“ABL”) is often the financing of choice for retail borrowers – and for good reason. In its simplest form, an ABL is a credit facility, usually in the form of a revolving line of credit, the availability of which is based exclusively on the value of a company’s “eligible” assets.  In the retail context such eligible assets are, for the most part, the company’s accounts receivable and inventory.  There are numerous advantages of an ABL over a traditional loan: an ABL is typically easier to obtain since it is based on a company’s assets and not cash flow; an ABL provides ready cash to support liquidity needs; an ABL often includes flexible borrowing and repayment terms and less restrictive financial covenants; and, particularly beneficial to retailers, an ABL commonly accounts for seasonality and allows more borrowing during periods of slower sales.  The borrower in the ABL is required to submit a “borrowing base certificate” on a monthly or even weekly basis, which details the current inventory levels (and accounts receivable), deducts certain amounts such as letters of credit, applies the applicable borrowing percentage (usually a percentage of the net orderly liquidation value (“NOLV”) of their inventory), and the result is the amount of cash available.  In addition to borrowing base certificates, the company is also subject to field examinations and inventory appraisals conducted at least once a year, if not more often, which determine the percentage applied to their borrowing base calculation.

iStock-184621155-1024x682When retail sales are booming, the company and the ABL seemingly work like a well-oiled machine: inventory is rapidly converted to cash, which is then used to pay the loan and fund purchases of new inventory, which, in turn, increases the amount the company can borrow at any time, commonly known as the “borrowing base”. A difficulty arises, however, when one of these necessary steps is obstructed – which is exacerbated in the bankruptcy context.  There seems to be an inherent conflict between the fluid nature of retail inventory flow and the fixed nature of a borrowing base.  It would certainly be maddening if American Express restricted my credit limit on a weekly or daily basis depending upon what was, or was not in my closet at any given time.

When the amount you can borrow depends upon your inventory levels, the retail company is incentivized to keep inventory levels high through new inventory purchases, which, in turn, often requires drawing cash from the credit facility.  This vicious circle illustrates what is colloquially referred to as the “ABL Trap”.  Even when it may be in the company’s best interest to reduce or hold off on inventory purchases, the selling of inventory without replenishment will lower its borrowing base and increase the risk of an overadvance – that is, when the amount borrowed exceeds the calculated availability.

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As a creditor, the news of a debtor who owes you a substantial sum of money filing bankruptcy is often the most alarming news you can learn—that is, until you seek advice of counsel and learn that payments the debtor made to you within 90-days prior to the bankruptcy will be the subject of a lawsuit and likely recoverable by the bankruptcy estate as a “preference.”  This is usually the point I offer soothing chamomile tea to the client.

Recovery of “preference” transfers in bankruptcy cases, though seemingly unfair to the individual creditor, serve an important role and offer a degree of protection to the creditors as a whole.  The primary elements of a preference transfer are relatively straightforward: a debtor who is insolvent, makes a payment or payments to a creditor, within 90 days[1] prior to the bankruptcy filing, to satisfy at least a portion of a pre-existing debt[2], and the creditor receives more than it would have had the debtor filed a chapter 7 (liquidation) bankruptcy case.  Though the “don’t rob Peter to pay Paul” concept appears clear enough, the Ninth Circuit has recently illustrated how complicated the matter can become in In re Tenderloin Health[3] where the court addressed the often overlooked final element to a preference—the “greater amount” test.

As the Ninth Circuit noted, the “greater amount test … ‘requires the court to construct a hypothetical chapter 7 case and determine what the creditor would have received if the case had proceeded under chapter 7’ without the alleged preferential transfer.” Id. at *7.  This task of creating a hypothetical chapter 7 liquidation grows ever more daunting as a case grows more complex, leading to uncertainty for a creditor client, especially when unresolved legal issues come up within the hypothetical bankruptcy.

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Any property owner which has experienced the bankruptcy of a tenant is doubtless keenly aware of the limitation on damages which the Bankruptcy Code imposes on the landlord. A new decision by the Ninth Circuit bolsters the position of landlords in this long-running tussle.

Section 502(b)(6) Cap Refresher

Before getting to the Ninth Circuit’s recent opinion, here is a quick review for those who have not confronted the issue recently: Bankruptcy Code section 502(b)(6) generally “caps” a landlord’s claim for “damages” against a bankrupt tenant when a lease is terminated before or during the bankruptcy case to (a) the greater of the next year of rent due, or 15% of all the remaining rent due up to 3 years of the remaining term, and (b) any unpaid rent owing as of the date of the bankruptcy, or the date the tenant lost possession of the premises if prior to bankruptcy.  Fairly or not, the policy justification for the cap is that large claims of landlords, which are by their nature long-term and hard to calculate, should not overwhelm the claims of other trade creditors.