There he is, your big new client, in one of his regular television ads for his family's chain of mattress stores.
"With the economy the way it is, who can sleep anyway?" says the local King of Beds as he announces a going-out-of-business sale after 25 years dominating local bedrooms and late-night TV.
Except your company just delivered three truckloads of bed frames to him. The king promised they would be the metal underpinnings of every bed he sold next year. So far, he's only paid you a deposit.
This is the kind of story that is all too common now and will become only more common in the days and months ahead: Once-thriving businesses clobbered by the economy and consumer fears suddenly skidding belly up and dragging their vendors ever closer to the edge. Businesses will fail, often suddenly, leaving behind unpaid bills for supplies and merchandise already delivered.
At least, in this case, you know that if you could take back those bed frames, you might be able to resell them. So the key question is can you get them back?
Under California commercial law and federal bankruptcy law, the answer is maybe. Both sets of statutes give sellers the right to "reclaim" goods sold to insolvent buyers. But the sellers have to act quickly. And they have to be a little bit lucky.
The California's version of the Uniform Commercial Code sets the rules that apply to nearly all sales of goods and merchandise. Section 2702(2) declares that if "the seller discovers that the buyer has received goods on credit while insolvent, [the seller] may reclaim the goods upon demand made within 10 days after their receipt … ."
There are some conditions and exceptions. For instance, the goods must have been sold "in the ordinary course of business." That is, you probably can't reclaim something your kid sold the King of Beds at your family's first-ever garage sale.
Second, the buyer must have been insolvent when he received the goods. If he goes under after the goods are delivered, you're just another creditor with no special rights.
Third, the seller must make "timely written demand" — that is, you must ask the buyer for the merchandise back within the 10 days permitted by the law, and you must do it in writing.
Finally, the buyer must still have the goods in his possession when he receives the written demand to reclaim. A seller can't get back goods the buyer already has sold to retail customers, for instance.
What if the buyer files for bankruptcy? Federal bankruptcy law gives the seller more time to act, plus several layers of additional complexity.
Bankruptcy Code Sections 546(c)(1) and (2) say that a seller can seek to reclaim goods received by a bankrupt buyer up to 45 days before the filing of the bankruptcy petition. Put another way, the seller gets a 45-day "look back" for old sales he might reclaim.
That's provided, of course, that the goods were sold "in the ordinary course of the seller's business," the buyer was insolvent when he received them and the seller makes timely written demand.
Under the bankruptcy code, the seller gets 45 days from delivery, rather than 10, to submit the written demand. Alternatively, if that 45th day falls after the buyer files for bankruptcy, the seller can take up to 20 days from the filing date to put in the written demand.
And if the seller blows both those demand deadlines? He still can seek some relief. In that situation, he only gets a "look back" at sales 20 days prior to the bankruptcy filing, and he cannot actually have the goods returned. Instead, he can ask the bankruptcy court to give him an "administrative priority claim" against the debtor's assets for the value of the goods.
Those administrative claims get paid before most other unsecured claims but after any secured claims. And they may not be paid until the debtor's reorganization plan is figured out and confirmed by the judge.
Until confirmation, any available cash may be needed to pay pressing bills, like taxes and payroll. A lender assisting in the debtor's reorganization also may have put restrictions on how its cash is spent.
Even if the seller does all he needs to do to reclaim his merchandise, he may not get it back. For instance, if the buyer has sold the goods to others, the goods are gone. Those later buyers take free and clear of any reclamation right.
If the money from those second sales all goes immediately to a secured creditor in the bankruptcy, then the seller may not even be able to obtain an administrative priority claim. Some courts have held that, in that situation, the seller becomes nothing more than another unsecured creditor.
Similarly, if the buyer at some point received financing from a lender who kept a security interest in the all the buyer's inventory, then that secured lender would come ahead of any right to reclaim goods now in the inventory. As an example, in one case, a wholesaler that sold used cars to a bankrupt new-car dealer found its right of reclamation blocked by the new-car manufacturer's "floor-plan loan" for opening the dealership.
So what's a surprised seller to do? If he learns about the buyer's bad fortune in time, he can try to back out of delivering the goods in the first place.
That's not hard if he hasn't shipped them yet. Under Commercial Code Sections 2702, 2703 and 2705, an unpaid seller may stop delivery of goods to an insolvent buyer. He can also pull them back from a carrier or bailee, like a delivery company or warehouse.
Of course, the seller can't undeliver goods the buyer already has. Doing that takes reclamation and all its steps.
He also can't get goods back from a bailee who has acknowledged to the buyer that it is holding the goods for the buyer. And the seller can't hang on to goods after documents have been issued transferring legal title to the buyer or a third party.
But the good news is that if the seller is in a position to stop delivery, even a secured creditor or downstream purchaser can't prevent him from doing so.
Related to all this is another scenario, particularly as the economic bad times linger. If many of your old customers are in bankruptcy, should you keep them on as customers? Do you sell to them? How do you do it safely?
The first question, of course, is does your bankrupt customer have access to money to pay for your merchandise? Where is it coming from? He might well be a "debtor in possession" trying to run his company back out of debt. If so, he may have cash from loans approved by the bankruptcy court specifically to keep the business afloat.
If you do decide to sell to the debtor, you should to take steps to guarantee you're paid for your products. You might demand payment up front or keep some sort of security interest or lien in any goods you deliver. You may raise your prices for any credit sales to offset the greater risk. Alternatively, you may want to trim prices in hopes of getting the customer back on his feet again quickly.
For old customers now in bankruptcy, other questions come up. For instance, you and your customer may have pre-existing conflicts that need to be sorted out, such as old invoices you can't collect on or old claims against you for problem merchandise. He may have unsold goods he wants to return.
If you still want to resume sales to him, you may have to put those issues aside for the bankruptcy plan to resolve.
However, you may have other old-customer problems that can't wait. If your customer paid some of your invoices shortly before filing bankruptcy, other creditors may cry foul. They might claim he gave you an unfair preference and try to saddle you with "preference liability." In that situation, you could have to give the money back to the bankruptcy trustee for all the creditors to share.
On the other hand, you might be able to argue that your products are "essential" for the debtor to keep his business running, particularly if they're goods he can't get anywhere else. Courts are growing more reluctant, but they still allow some such "critical vendors" to get paid ahead of other creditors.
Despite the complexities and risks, business must and will continue during difficult economic times. Conducted intelligently, trading with companies in trouble shouldn't pull other companies down.
-written by Penelope Parmes, partner, Financial Practices