With Covid-19 wreaking havoc on global supply chains, vendors continue to face some difficult choices. Modifying the credit terms of contracts with struggling customers and even withholding credit is probably prudent. It’s also definitely legal—but only if the vendor has a bona fide reason to believe the customer is insolvent.
That’s where things get tricky. Determining insolvency under the Uniform Commercial Code (UCC), which governs all commercial transactions in the United States, often trips up vendors and will likely continue to do so. The national and world economies might be poised to rebound, but some customers will be digging themselves out of a hole for years—and the hard decisions will continue for many vendors.
This article provides tips on how those vendors can make insolvency determinations and how they can exercise rights to change credit terms if appropriate.
What Constitutes ‘Insolvent’
The UCC defines “insolvent” as:
- Having generally ceased to pay debts in the ordinary course of business other than as a result of a bona fide dispute
- Being unable to pay debts as they become due, known as “equitable insolvency”
- Being insolvent within the meaning of the federal bankruptcy law, known as “balance sheet insolvency”
That’s a good starting point. But the rub is determining whether the supplier you’re working with actually meets the relevant criteria. A mere hunch of your customer’s financial difficulties won’t satisfy the standards. Rather, grounds for insolvency must be reasonable (which is a question of fact based on the circumstances of each case) and determined by commercial standards of good faith. But both criteria are dependent on the industry in question—meaning the question of solvency will depend on a lot of details.
How To Assess The Situation
Access to financial information for smaller, nonpublic customers can be difficult to come by—and vendor demands for it may be viewed as threatening. Financial reporting from traditional business and financial news sources provides insight—and a bevy of news alerts can provide crucial information. But that’s still not always enough to make critical decisions. Vendors should consider sending a salesperson for a site visit to review inventory and gain a sense of activity.
Membership in a credit exchange can also provide valuable information, especially for a non-public customers. Members may have a history with the customer or unique access to members of management to obtain answers to questions or to explain things that seem odd.
If there are troubling signs, a vendor should stop shipping goods to a customer that might be unable to fulfil its contractual obligations. Those signs might include excessive use of premium freight; cancellation of shipments; out-of-balance inventory; slow payments; unusual sales of assets or grants of additional collateral (both of which can be found in lien searches); changes in purchase patterns; payment to a lockbox; excessive employee turnover; delayed financial statements; default under a loan agreement; changes in senior leadership or outside accountants; litigation by other creditors; retention of a turnaround consultant, financial advisor or investment banker; and slowness or lack of communications.
Additionally, where there are no public shareholders, an indenture respecting outstanding bond indebtedness will be available from the SEC—including upcoming interest and principal payments as well as maturities. But any of the signs noted above might not be enough on their own to not establish insolvency; but in combination they may show a need to probe—and of bad things to come.
How To Get Ready
Of course, chapter 11 can be one of those bad things.
While some such cases leave trade creditors unimpaired, smart vendors won’t take the chance. They’ll determine if a customer is insolvent and then, as allowed by the UCC, protect their rights before a bankruptcy. They’ll move forward with modifying credit terms and reclaiming the goods they have shipped. They also might stop delivery of goods and change credit terms or withhold credit.
The UCC provides extremely useful tools to an alert and nimble vendor, which is why they need to remain hyper vigilant regarding their customers’ financial wherewithal—especially in times of economic turmoil.
Reprinted with permission from the May 18, 2021, issue of Financial Advisor. © 2021 Charter Financial Publishing Network Inc. All Rights Reserved.
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