How to Analyze a Trade Lien

<p>Whenever a business files chapter 11, a familiar "dance" begins between the debtor
and its suppliers. The business debtor becomes desperate for trade credit because its
suppliers often withdraw it as soon as the bankruptcy is filed. The trade lien has
become increasingly common in the larger chapter 11 bankruptcy cases as a way to
harmonize the needs of debtors and their suppliers to encourage suppliers to extend
favorable post-petition trade credit on a secured basis. With the recent flurry of
large businesses filing chapter 11 reorganizations, trade creditors and their counsel
need to understand how to analyze a trade-lien program in order to assess what
protection it will (and won't) provide.

</p><p>The trade lien was devised approximately 14 years ago during the chapter 11
reorganization of Revco Drug Stores. Since then, it has been used in numerous
chapter 11 reorganizations, including Phar Mor, Cumberland Farms, Affiliated
Foods, Boston Distributors, F&amp;M, Central Hardware, Witte Hardware, White's
Fresh Foods and Kmart. In the absence of a trade lien, the post-petition supplier
gets an administrative expense claim, which will get paid before pre-chapter 11
unsecured and priority claims, but after all secured creditors (both pre- and
post-petition) get paid. If a chapter 11 reorganization plan is confirmed, then
pursuant to <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=… U.S.C. §1129(a)(9)</a> all allowed administrative expense claims
must be fully paid (unless the administrative expense claimant consents to different
treatment).

</p><p>In reality, however, not all chapter 11 cases result in a confirmed plan. If
the chapter 11 estate is administratively insolvent, then administrative expense claims
won't get fully paid, and the post-petition suppliers effectively get burned twice—once
on their pre-petition claims and again on their post-petition claims. It is this—the
fear of getting burned twice—that often causes post-petition suppliers to withdraw credit
and demand COD or cash in advance as soon as the debtor files chapter 11. From
the debtor's perspective, COD and cash in advance are costly, impractical, and
inimical to the debtor's reorganization efforts because they threaten the debtor's ability
to maintain appropriate inventory levels. The trade lien was devised to assuage the
fears of post-petition suppliers, allowing the debtor to obtain post-petition credit
on the same favorable terms it enjoyed pre-petition. The trade lien works by granting
suppliers a lien (rather than just an administrative expense claim) to secure payment
for all goods and services they furnish post-petition in exchange for the post-petition
supplier's agreement to give the debtor credit on terms similar to (or better than)
the pre-petition credit terms the debtor enjoyed from that supplier. Pursuant to <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=…
U.S.C. §364</a>, establishment of a trade lien program requires bankruptcy court
approval, and the debtor must prove the same elements that are required for other
secured financing under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=… U.S.C. §364(c)</a>, namely that it is unable to borrow
money or obtain credit on an unsecured basis or by granting an administrative expense
claim and that the trade lien is necessary for an effective reorganization. If the
trade lien is going to prime other liens, then the debtor must satisfy <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=… U.S.C.
§364(d)</a>.

</p><p>Generally, post-petition suppliers want the trade lien to have the highest possible
priority in the greatest volume of the debtor's assets. They would like the trade lien
to have higher priority than all lenders and believe this is justified because the
post-petition trade credit enhances the value of the lenders' collateral; without it,
the entire reorganization is in jeopardy. The debtor's lenders tend to view the
situation differently and are often opposed to a trade lien. Indeed, frequently the
first problem is to convince the debtor that it needs to institute a trade lien, and
then to convince the lenders to go along. Many times, the debtor either doubts that
it needs a trade lien, or is unwilling to force the issue with its lenders. This
scenario can spell disaster in the retail reorganization. If the debtor doesn't push
for a trade lien and post-petition credit is not forthcoming, suddenly the debtor
cannot get merchandise on the shelves. Once the shelves are bare, the debtor's
customers shop elsewhere and there is no business left to reorganize.

</p><p>Experienced counsel for the creditors' committee needs to get involved early in the
case and convince the debtor that it needs a trade lien in order to reorganize, and
that it is important for the debtor to force the issue with its lenders as soon as
possible in order to avoid any disruption in inventory shipments and to maximize the
chances for a successful reorganization. Once the debtor begins to push for a trade
lien, vigorous negotiations often ensue among the creditors' committee, lenders (both
pre-petition and post-petition), debtor and other constituencies.

</p><p>For those of us who represent post-petition suppliers, it is important to know
what to look for when analyzing the trade lien program so that we can advise our
clients about the protection it affords (or, more importantly, doesn't afford) them.
Generally, it is important to analyze the following factors:

</p><p><i>Scope and Priority of the Trade Lien:</i> To what does the trade lien attach and
with what priority? Obviously, the post-petition suppliers will want to see a first
lien in all assets with priority over everyone, including lenders. However, the
debtor and/or its lenders will want the trade lien to be junior to bank debt and/or
limited to a particular category of assets (such as inventory). A junior lien, or
a lien on a particular category of assets, can greatly diminish the actual protection
that the trade lien provides. For example, if the trade lien is junior to the
lenders' lien, its protection is dependent upon how much equity remains in the assets
and the aggregate dollar amount of the post-petition supplier claims that seek
protection from that equity. If the trade lien attaches to a particular category of
assets (such as inventory), its protection is limited to the value of that pool of
assets. If the trade lien is both junior and restricted to a limited pool of
assets, it is important for the post-petition supplier to know whether there is a
"marshalling" provision in the trade lien program that requires the senior lienholders
to first seek collection from assets other than those that are subject to the trade
lien. In the absence of such a marshalling provision, protection of the trade lien
might be illusory at best.

</p><p><i>Reinstatement of "Normal and Customary" Credit Terms.</i> This is a universal
component of any trade lien because the goal of the trade lien is to entice suppliers
to reinstate normal (or better than normal) trade terms with the debtor that are
better than what the debtor's current financial condition would merit absent the trade
lien. In analyzing any trade lien, counsel for the post-petition supplier needs to
address (and hopefully resolve) any confusion regarding the "normal and customary" credit
terms that the supplier gave the customer pre-petition. For example, what terms
constitute "normal and customary" if the credit terms changed pre-petition?

</p><p>In addition, counsel for the post-petition supplier needs to clearly understand what
will happen if that supplier participates in the trade lien program for a while and
is then unwilling to give the debtor "normal and customary" terms. Will trade lien
protection terminate for that supplier, and if so, will the termination apply only
to future shipments, or will it apply retroactively to shipments already made by the
supplier but not yet paid for by the debtor? Also, counsel for the post-petition
supplier needs to carefully consider what will happen if the post-petition supplier
withdraws or reduces credit because of the debtor's material breach of those credit
terms—such as non-payment or repeated late payments. In the interest of fairness,
a trade lien program should require the debtor to timely make all payments to its
post-petition vendors, and should further provide that the protection of the trade lien
does not terminate if the post-petition supplier withdraws or reduces credit in response
to the debtor's non-payment for post-petition deliveries or material breach in those
post-petition credit terms.

</p><p><i>Duration of Trade Lien.</i> How long does the post-petition supplier receive
protection under the trade lien? Obviously, the post-petition supplier will want the
trade lien to remain in place as long as practicable, generally until the earlier of
the effective date of a plan of reorganization, conversion to chapter 7, or the
debtor's default under any of its financing arrangements. Some debtors, however, use
this duration issue to make certain that they are afforded favorable trade credit in
exchange for the trade lien, so they draft provisions to make the trade lien last only
so long as the post-petition supplier offers favorable trade terms. Thus, the issue
of duration of the trade lien and continuation of customary credit terms are sometimes
linked.

</p><p><i>Credit Information.</i> Post-petition suppliers often need ongoing information
regarding the debtor's financial condition. If the trade lien is junior to some or
all secured bank debt or is in limited assets, the post-petition suppliers need to
know the amount of bank debt, the book value of the assets and the amount of debt
secured by the trade lien. This need for information is heightened if, as sometimes
happens, the debtor has agreed not to incur trade debt in excess of a certain dollar
amount or percentage of the book (or other) value of the inventory. Counsel for
the post-petition supplier must consider the extent, frequency and level of verification
of reports the debtor is to provide, and how the post-petition supplier is to get
them (<i>e.g.,</i> directly from the debtor or through an intermediary such as the
creditors' committee).

</p><p><i>Foreclosure Rights.</i> Often a trade lien program will provide that an individual
unpaid post-petition supplier may ask the creditors' committee to file a motion seeking
permission to foreclose and that, if the committee refuses, that supplier can go to
court for permission to foreclose. Such a provision is rarely (if ever) invoked.
In virtually all instances, the dispute is resolved and there is no need for
foreclosure.

</p><p>What if there is a general default by the debtor, such as acceleration of the bank
debt? Sometimes the trade lien program is drafted to eliminate all foreclosure rights
relative to the trade lien until after all lenders and other creditors who are senior
to the trade lien have been paid in full. This tends to adversely affect the value
of the trade lien's protection. If the post-petition supplier's foreclosure rights are
going to be so sharply eclipsed, it makes sense to insist that the debtor provide
written verification (at appropriate intervals, such as weekly) of collateral levels
and the status and level of accounts payable, so that the post-petition vendors can
judge for themselves whether the trade lien will afford them sufficient protection in
exchange for their extensions of post-petition credit.

</p><p>In conclusion, trade liens can vary widely because they are the product of
negotiations among various constituencies. Because the trade creditor is generally "last
in line" when its customer files bankruptcy, most trade creditors (and their counsel)
view the trade lien as a panacea—a quick and easy way to move up the priority
ladder. However, each trade lien program must be carefully analyzed to make sure that
it affords the post-petition supplier an appropriate amount of protection in exchange
for the favorable trade credit that will be extended to the debtor. In each
scenario, the post-petition supplier must carefully weigh whether its interests are best
served by demanding COD or cash in advance (and risk losing the debtor's business
altogether), or receiving a trade lien. Attorneys for post-petition suppliers can
help their clients evaluate these complex business decisions by analyzing the critical
points of the trade lien so that both the lawyer and the post-petition supplier
understand the protection that the trade lien will (and won't) provide.

</p><hr>
<h3>Footnotes</h3>

<p>^{<small><a name="1">1</a></small>} With thanks to Dennis Kayes and Sean Byrne for their assistance. <a href="#1a">Return to article</a>