Customers who don't pay are an unfortunate but inevitable reality of doing business. Some will tumble into bankruptcy; others will continue to operate and perpetuate the suppliers' risk of nonpayment. Usually in this environment, communication from the customer is substantially reduced, if not stopped. What can a supplier do to better evaluate this risk and act to minimize its potential loss?
There is a powerful "self-help" remedy for creditors in Article 2 (Sale of Goods) of the Uniform Commercial Code (UCC), which recognizes that the essential purpose of a contract is actual performance, not merely a promise and the right to win a lawsuit. Specifically, the remedy is a supplier's right to demand assurances of performance under §2-609, which provides as follows:
- A contract for sale imposes an obligation on each party that the other's expectation of receiving due performance will not be impaired. When reasonable grounds for insecurity arise with respect to the performance of either party, the other may in writing demand adequate assurance of due performance and until he receives such assurance may, if commercially reasonable, suspend any performance for which he has not already received the agreed return.
- Between merchants, the reasonableness of grounds for insecurity and the adequacy of any assurance offered shall be determined according to commercial standards.
- Acceptance of any improper delivery or payment does not prejudice the aggrieved party's right to demand adequate assurance of future performance.
- After receipt of a justified demand, failure to provide, within a reasonable time not exceeding 30 days, such assurance of due performance as is adequate under the circumstances of the particular case, is a repudiation of the contract.
If a supplier has reasonable doubts about its customer's ability or willingness to pay, the supplier may suspend its own performance upon a demand to the customer for "adequate assurances" of performance. If the customer does not provide such assurances in writing within 30 days, the contract is deemed repudiated by the customer. In effect, this would constitute a breach of the contract by the customer, allowing the supplier to avail itself of "sellers" remedies provided for in the UCC including, but not limited to, a claim for all amounts owed, a cessation of further performance and a claim for incidental and consequential damages.
Note that before a supplier can utilize this remedy, it must have a good-faith basis for its "reasonable grounds for insecurity." Like many legal terms, there is no hard-and-fast definition. Most courts would likely conclude that no "reasonable grounds for insecurity" exist based on general market or industry conditions, or a payment delay that is consistent with the prior course of dealing between the parties. A loan covenant violation alone would also not likely trigger "reasonable grounds for insecurity." On the other hand, confirmed reports of termination of a primary working capital facility would almost certainly give rise to "reasonable grounds." Without a working capital facility, the ability of a customer to pay its normal-course obligations is at risk. With respect to SEC reporting companies, any development resulting in the filing of an 8-K regarding a material adverse event may provide guidance. One court held that a customer's refusal to discuss the account after repeated attempts by the supplier constituted "reasonable insecurity." Once a supplier has determined that it indeed has reasonable grounds for insecurity as contemplated by UCC §2-609, the supplier is entitled to make a written demand for adequate assurance of due performance and, until the supplier receives such assurance, may suspend the supplier's performance for which it has not already been paid.
Upon a demand for assurances of performance by the supplier, the UCC requires that the customer provide the supplier "adequate assurances" of performance, within a reasonable time not exceeding 30 days. These assurances must be "adequate under the circumstances of the particular case." Mere statements by the customer that it intends to pay, or that refinancing is imminent, will not suffice. Rather, a customer will have to come forward with information sufficient to convince a reasonable merchant that performance is likely. This could include the following:
- financial statements showing liquidity sufficient to meet cash obligations;
- status of lending facilities, and the likelihood it will continue at levels sufficient to cover operating costs;
- projections showing ability to meet operating expenses and
- inventory, accounts receivable and accounts payable agings.
Thus, demanding adequate assurances of performance can be an effective tool for obtaining information that a customer might otherwise avoid providing. In appropriate situations, demanding adequate assurances of performance can also serve as an opportunity to insist on a face-to-face meeting with a customer. Such meetings often precipitate a flow of information that enables the supplier to better evaluate risks, and can often result in an agreement regarding payment.
Although beyond the scope of this article, it is important to note that once a customer files for bankruptcy, any existing contract may be considered an "executory contract" under the provisions of the Bankruptcy Code. A formal supply agreement between parties would almost certainly be deemed an executory contract. However, unperformed purchase orders that meet the essential elements of a contract (price, quantity and terms) can also be deemed "executory contracts." The key is whether there exists a contract where each party owes material performance to the other (i.e., delivery of goods and payment). If an "executory contract" exists, §365 of the Code provides that a nondebtor party (the supplier in this example) to such contract is required to perform its obligations under the contract until the debtor makes its election to assume or reject the executory contract. Thus, a bankruptcy filing may limit a supplier's ability to suspend performance based on the UCC. However, some bankruptcy courts have ruled that the right to demand "adequate assurances" continues to exist in bankruptcy.
Best practices would be for a supplier to make a demand for adequate assurances of performance under UCC §2-609 pre-bankruptcy and as early as possible based on warning signs of a potential insolvency or payment problem. If a customer has filed a chapter 11 proceeding, suppliers should first evaluate the risks of making a demand. In either case, it is important to objectively evaluate whether reasonable grounds for insecurity in fact exist. If so, UCC §2-609 can be a significant self-help tool for suppliers to compel payment of debts owed. At a minimum, the remedy will allow suppliers to better understand and manage risk, which very well may result in fewer write-offs.