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Impact of Bankruptcy on Buying Groups

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Question: What are the ramifications to a buying group when one of its members or vendors files chapter 11 or chapter 7 bankruptcy? What measures should it take to protect itself?

Let’s face it. Even the most careful screening of prospective members cannot prevent one or more of them from going insolvent or bankrupt. Nevertheless, it is wise not to borrow trouble. Members should be required to provide evidence of their financial health before they are permitted to join. Such due diligence on the part of the group could include having them furnish a set of financial statements and ordering a credit report on the prospective member. Checking out their credit references, especially among vendors who sell to the group, is important. Often vendors can be a good source of referrals for new members.

Having credit-worthy members is not only important from the standpoint of making sure they will pay their dues and other debts to the buying group, but also having financially healthy members is essential to the integrity and reputation of the group with its vendors.

Vendors are typically expected to make their group-approved programs available to all the members. If the ability to pay for product is questionable as to any of the members, a vendor will not only refuse to meet that requirement, but may start having doubts about selling to the rest of the group.

The best type of security is for the group to always owe the member more than the member owes the group. The two sources of debt from the group to the member typically are the rebates received by the group attributed to purchases from the member and the value of any equity owned by the member in the group.

If the group has a central billing program, i.e., an arrangement in which the supplier bills the group, the group bills and collects from its members and then pays the supplier, the possibility of the member owing the group more than the group owes it, becomes very real. In such circumstances, the group must take measures to secure itself against the possibility of a member failing to pay its share of the vendor invoice. One easy solution (from the group’s standpoint) is to require the member to provide a letter of credit at least equal to the total credit line the member has with the group. Often members will resist this requirement, because the letter of credit will soak up the ability of the member to borrow funds commercially to fund its operating capital needs. Their ability to expand operations either organically or by acquisition would thus be restricted. Another method would be to withhold and pool rebates earned from the vendors on the central billing system and use that reserve as collateral against the debts of the members. Yet another source of collateral is to have the member pledge its ownership interest in the group back to the group as security for its obligations to the group. More traditional forms of security, such as personal guaranties and pledging the assets of the member to the group are also possibilities.

As an additional safety precaution, the group should require each member to furnish its financial statements to the group, annually. To assure confidentiality, the group can direct that they be sent to an independent accounting firm who will only alert the group if it finds concerns that the group needs to consider. Whatever choices are made or procedures put in place, it is important that the group be well secured so that the debts owed by defaulting member will not pull the group down.

There are at least two provisions the group can include in its agreements with its members to minimize the amounts it will owe the member. One measure is to set the buy-back amount of the equity interest of the member in the group at a minimal amount, regardless of what the member was required to pay for it. If the member knows and agrees going in that only a fraction of what it is paying for the equity interest will be paid back when they leave the group, such an arrangement should be enforceable. Another important provision is to make the payment of rebates received by the group to its members entirely discretionary. The agreement should expressly state that the all rebates are the property of the group when received and no member has any claim on them unless and until they are actually paid to the member. So far, we have not had any trustee in bankruptcy challenge the legitimacy of such provisions.

If the member is discovered to be in financial trouble, or even worse, files for Chapter 11 protection in bankruptcy, the group should take immediate measures to protect itself and the vendors. If the member is purchasing through the group and the group’s credit is on the line for those purchases, then it should consider putting the member immediately on a prepaid or the very least, a cash on delivery basis until such time, if any, as the member’s credit is fully restored. If the group has failed to require collateral of the member in the past, now would be the time to right that ship, assuming the member has not already filed bankruptcy. However, as discussed in more detail below, if such additionalcollateral is provided within 90 days prior to the filing of bankruptcy, it can be set aside as a preference.

If the member goes into bankruptcy, it is often difficult and expensive for the group to have the trustee to release the member’s ownership rights in the group. Due to the automatic stay that goes into effect upon the filing of a petition in bankruptcy court, the group is precluded from foreclosing upon the collateral it holds to secure that member’s debt. It must have a court order to lift the stay for that purpose. One measure the group should consider is filing a proof of claim to protect its rights in the bankruptcy estate. If relatively little is owed to the group by the debtor member and little is owed by the group to such member, then filing the proof of claim may not be worth the expense, even though the cost of filing a proof of claim is not usually substantial. In such circumstance, the group may choose to ride the bankruptcy out and just leave the equity interest of the member on the books as being that of an inactive member. When the bankruptcy is concluded and the dust settles, there are usually ways the equity interest can be redeemed or otherwise handled.

On the other hand, if substantial amounts are involved, filing a proof of claim is usually wise. If funds are legitimately owed to the debtor member’s estate, the trustee will usually cooperate in signing the ownership interest in the buying group back over to the group in exchange for the payment of the net debt owed to the bankruptcy estate.

Another bankruptcy trap to navigate is when a supplier goes bankrupt.

Under the bankruptcy laws if the debtor pays off an “antecedent debt” within 90 days prior to the filing of bankruptcy, the trustee can make a claim that it was a preferential payment and can demand that it be paid back to the bankruptcy estate. The rationale behind this rule is that it is unfair for someone about to file bankruptcy to pick and choose which creditors will be paid in full and which will be left empty-handed.

In the buying group context, the rebates paid by a supplier to the group during the 90-days preceding the date the bankruptcy petition was filed, may be claimed as preference payments and a demand will be made by the trustee in bankruptcy that such rebates be paid back to the estate. Such a demand often is not made until many months after the bankruptcy filing has been made and the rebates have long since been paid out to the members of the group. The demand will usually come from the trustee’s lawyer who will detail all the payments made by the debtor to the group during the 90-day preference period. The letter will conclude with a demand that the rebates be repaid in full in order avoid having an action filed in bankruptcy court for the recover of such amounts.

Fortunately, there are defenses available to preference claims. The three most common defenses are found in Section 547(c) of the Bankruptcy Code. They include: (1) the “contemporaneous exchange for new value” defense; (2) the “subsequent new value” defense; and (3) the “ordinary course of business” defense. The most potent of these defenses in the rebates’ context is the third one, that the payment was made in the ordinary course of business. One of the key elements in establishing this defense is to show that the time distance between the date that rebates were earned and when they were paid during the preference period was consistent with the time intervals that occurred between those two events during the months leading up to the preference period. For instance, if quarterly rebates were typically paid within sixty (60) days of when the quarter closed, during the 12 month-period preceding the preference period and that practice continued throughout the preference period, a defense could be raised that the rebates were paid in the ordinary course of business during the preference period. This defense could be made even more strongly if the payments were made within the contractual terms that previously existed between the vendor and the group.
The trustee generally knows that its preference claims are subject to legitimate defenses being raised. Quite often they will settle for a fraction of the amount of the face amount of their preference claims. If one can learn what percentage the trustee has been willing to accept from others as settlement, that information can be highly valuable in avoiding paying too much to settle a claim. Not surprisingly, though, the trustee requires non-disclosure of such terms as a part of the settlement.

Having knowledgeable legal counsel and following through on the advice so given will enable the group to minimize its damages when a member or a vendor goes into bankruptcy.