Customer Alert: Critical Texas Supplier: It’s a Rodeo | Shumaker, Loop & Kendrick, LLP

In Chapter 11 proceedings, a supplier has the best chance of having its pre-bankruptcy debts discharged by being classified as a “critical supplier.”

In connection with the Chapter 11 proceeding filed by U.S. bankruptcy trustee Zachry Holdings in the Southern District of Texas on May 21, 2024, the bankruptcy court made troubling remarks regarding the treatment of critical suppliers.

Specifically, the bankruptcy court ordered the debtor’s counsel, without notice, to revise the critical supplier’s order so as not to limit the debtor’s remedies if the critical supplier stopped supplying the debtor with goods at any time. The court specifically stated that the supplier should be in contempt of court and held liable for any damages the debtors suffered as a result.

The debtor’s attorney had not requested this, and the critical supplier’s instructions proposed by the debtor provided the following:

6. In the event that a commercial plaintiff fails to maintain or restore commercial conditions at least as favorable as those during the twelve months preceding the petition date during the pendency of the Chapter 11 cases, any payments made pursuant to this injunction after the petition date shall, in the reasonable discretion of the debtor, be deemed to be applied toward amounts payable to the commercial plaintiff after the petition date or to be an unauthorized post-petition transfer recoverable from the debtors under Section 549 of the Bankruptcy Code or other applicable law, whether or not a commercial agreement was signed.

Essentially, the debtors sought as a remedy the repayment of the payments or their application to supplies made after the insolvency proceedings (instead of payment of pre-insolvency claims).

The revised critical supplier order, in response to the bankruptcy court’s “overly limited” comments, provided the following:

6. In the event that a commercial plaintiff receiving payment under this injunction fails, during the duration of the Chapter 11 proceedings, to maintain or restore its terms of trade at least as favorable as those which existed during the twelve months preceding the date of the petition, the debtors shall be entitled to all remedies available at law or in equity with respect to such commercial plaintiff and the payment made to such commercial plaintiff, whether or not a commercial agreement has been entered into.

The order effectively removes the protections afforded to unsecured creditors under contract law, including the Uniform Commercial Code with respect to the sale of goods, and under the Bankruptcy Code. If a supplier supplies goods or services to a debtor based on a purchase order and invoice without a formal sales contract in place, it is not obligated to continue supplying or providing credit terms (although debtors sometimes claim that an open purchase order constitutes an agreement). If a supplier receives full payment of its pre-bankruptcy debts, the appropriate consideration is the continuation of the business relationship with the debtor as it existed before the filing of the Chapter 11 bankruptcy petition.

A key difference between dealings before Chapter 11 and during Chapter 11 is that the customer has filed for bankruptcy, and in many Chapter 11 cases, debtors become “administratively insolvent” (insufficient liquidity to pay their current debts as they come due) or the debtor’s assets are liquidated through a Section 363 sale. Buyers never assume unpaid obligations incurred during Chapter 11 and before closing. Sales to Chapter 11 debtors are inherently higher risk.

In addition, prior to filing for Chapter 11 bankruptcy, a supplier has the right to stop supplying or extending credit terms if it has reasonable grounds to believe that the customer is insolvent or if it learns that the customer is insolvent.

When a supplier sells to a customer/debtor under a written purchase or delivery agreement, the Bankruptcy Code prohibits the seller from terminating or modifying the agreement solely based on any contractual provision relating to the debtor’s insolvency or financial condition or the commencement of a Chapter 11 proceeding.

However, the Bankruptcy Code provides a further exception to the foregoing when “governing law” excuses a party from performance. Both the common law relating to contracts and the Uniform Commercial Code relating to the sale of goods are such “governing law.” UCC 2-609 (which codifies the common law relating to contracts) allows a seller of goods to stay performance if it has good cause for uncertainty of the customer’s ability to pay. UCC 2-702 allows a seller to resort to prepayment credit terms regardless of whether a term of the contract requires credit terms.

The Zachry Holdings critical supplier ruling appears to remove these supplier rights.

It is common for key supplier agreements to be captured in a written “commercial contract.” Over the years, we have successfully negotiated ongoing supply and credit terms into key supplier commercial contracts that allow the supplier to stop supplying or extending credit terms if certain terms are violated or events occur during the Chapter 11 proceedings that indicate a lack of working capital or liquidity to operate in the normal course of business and pay bills. Zachry Holdings will make this even more difficult in the Southern District of Texas.

It is doubtful that Delaware, the Southern District of New York, or the District of New Jersey will follow Texas’ extreme approach.

It is important that suppliers (1) object to critical supplier contracts that do not recognize creditors’ legal rights and (2) negotiate exits when a debtor defaults on its obligations or fails in Chapter 11 proceedings.