What Are Risks for Chapter 11 Debtors Selling to Food Retailers?
By Kenneth A. Rosen
A well-known supplier of seafood to major food retailers recently commenced a Chapter 11 case and immediately saw credit dry up and a decline in sales. Chapter 11 turned out to be far more expensive than the supplier imagined because the “cost” was much more than just professional fees.
In evaluating financial restructuring options (bankruptcy, forbearance agreement, out-of-court composition, UCC Article 9 surrender, bulk sale, assignment for the benefit of creditors or refinancing) a vendor that sells to major food retailers should analyze its options not only in terms of the law and potential cost of professional fees, but also from a practical, business-oriented standpoint. If the vendor sells products other than unbranded commodities, its customers – mass merchants, big box food retailers, or supermarket chains – will have little patience for a vendor to resolve its financial problems in Chapter 11 if the vendor’s insolvency creates risk of harm to the retailer.
Chapter 11 has many positives. The Bankruptcy Code is intended to provide a debtor the opportunity to downsize, restructure its debts, and get a “fresh start.” But, the fresh start comes at a steep cost for, among other things, professional fees.
For the vendor to large food retailers, the does not end with the professional fee costs, which can be substantial. Besides the debtor paying its own attorney and financial advisor, the debtor also has the privilege of paying the fees of the attorney and financial advisor for the unsecured creditors’ committee. Furthermore, the secured lender is often entitled, pursuant to its loan documents, to reimbursement of its legal fees and financial advisory fees. Even in a case where the lender is not hostile, these fees can build up rapidly and become crippling.
When considering alternatives for a distressed borrower, the benefits of a settlement with the lender are important to consider. I am not recommending that a debtor “roll over” too easily. I merely am suggesting that, in evaluating a settlement, a debtor should consider the “fully loaded” costs of not settling. So, what are the “fully loaded” costs?
Costs come in several varieties. On top of professional fees, there is the “management diversion” cost; that is, the cost for the time that management must spend on damage control, dealing with concerned customers and vendors, seeking to restore trade credit and addressing the inevitable rumors of the debtor’s demise that will be circulated by competitors. Management is better off growing the business rather than dealing with past problems.
For debtors that sell to major food retailers, there are additional considerations beyond dollar cost, particularly where their business involves a significant lead time between receipt of orders and the actual delivery of goods or services to their food retailer customers.
Major food retailers plan out their programs and promotions far in advance. Items to be included in a newspaper advertisement or seasonal promotions are selected long before delivery. The retailer does not want to risk promoting a product and then learning at the eleventh hour that the debtor cannot deliver, leaving the retailer scurrying to find a suitable substitute product while trying to explain the situation to customers.
The same problem arises when a vendor is accused of product tampering, product mislabeling, unclean handling practices, or unfair labor practices. The major food retailer rarely gives a second chance. Under those circumstances, Chapter 11 only gives the retailer another reason to switch suppliers.
Despite what they may say, no [honest] buyer for a retailer will risk their job for a vendor. No buyer wants to risk having to explain to their boss why they did not second source when they knew that the vendor was in trouble.
In evaluating alternatives, one must take into account not only the debtor’s professional fees, but also the professional fees of all other professionals in the case that may be paid by the debtor. Second, there is the cost value of management time spent on the Chapter 11 process. Third, take into account the opportunity cost of management spending time on the Chapter 11 process rather than on running the business. Finally, take into account the potential “hit” to the business from customers who do not fully understand the Chapter 11 process, only hear the word “BANKRUPTCY” and panic (albeit secretly).
This does not mean that Chapter 11 should never be employed. When it truly is a last resort, the prudent thing to do is file a petition. But for a debtor in Chapter 11, the best way to reduce the harm that arises from nervous customers is to exit Chapter 11 as quickly as possible. In other words, be in a position to tell retailers promptly that you are emerging from the reorganization process and that their faith was warranted – and wherever possible, have a strategy in place to do so before filing. Also, do not get hung up on disputes. A mediocre settlement trumps a good litigation case.
The point is not that a debtor should fear lenders, creditors’ committees, or the financial costs of Chapter 11. The proper conclusion is that a smart vendor to a major food retailer evaluates both the cost of Chapter 11 and the cost of emerging from Chapter 11 in a holistic manner. I still agree with Harry Truman about walking softly and carrying a big stick. But when I am evaluating whether to use the stick or to settle, I want to completely understand the real cost of each.
Kenneth A. Rosen is a partner with Lowenstein Sandler where he leads the law firm’s Bankruptcy, Financial Reorganization & Creditors' Rights Department.