How To Modify Contracts With Struggling Vendors

By Kenneth A Rosen

The global economic landscape has been thrown into disarray by the COVID-19 pandemic, leaving vendors facing a multitude of difficult decisions. One such decision is whether to modify credit terms for struggling customers or even withhold credit altogether. While these measures may seem drastic, they can be necessary to protect a vendor's financial interests. However, it's crucial to approach these decisions with caution and ensure that any actions taken are legally justifiable.

Determining Insolvency: A Delicate Balancing Act

The Uniform Commercial Code (UCC), the governing law for commercial transactions in the United States, defines insolvency in three ways:

• General Cessation of Payments: A customer is considered insolvent if they have generally stopped paying debts in the ordinary course of business, excluding instances where non-payment stems from a bona fide dispute.

• Equitable Insolvency: A customer is considered insolvent if they are unable to pay debts as they become due.

• Balance Sheet Insolvency: A customer is considered insolvent if their liabilities exceed their assets, as defined by federal bankruptcy law.

While these definitions provide a framework, determining insolvency in practice can be challenging. Vendors must gather sufficient evidence to support their belief that a customer is insolvent before taking any action. Relying on mere hunches or suspicions is not enough.

Assessing the Situation: Unveiling the Signs

Gathering financial information for smaller, nonpublic customers can be particularly difficult. Vendors' requests for such information may be perceived as threatening or invasive. However, there are several ways to gather valuable insights into a customer's financial health:

• Financial Reporting: Traditional business and financial news sources often provide valuable insights into a company's financial performance. Setting up news alerts for specific customers can help vendors stay informed about any significant developments.

• Site Visits: Sending a salesperson to visit a customer's premises can provide valuable visual cues about their inventory levels, business activity, and overall well-being.

• Credit Exchanges: Membership in a credit exchange can offer access to a wealth of information, including a customer's credit history, interactions with other members, and insights from industry experts.

  
  

Red Flags: Indicators of Potential Insolvency

While no single indicator is definitive, several red flags may signal a customer's potential insolvency:

• Excessive Use of Premium Freight: A customer's preference for expensive shipping methods may indicate cash flow issues or an attempt to expedite deliveries before creditors catch on.

• Cancellation of Shipments: Unexplained or frequent order cancellations may suggest financial difficulties or a desire to avoid accumulating debt.

• Out-of-Balance Inventory: Excessive or depleted inventory levels can be a sign of poor management, supply chain disruptions, or a lack of demand.

• Slow Payments: Delayed payments, especially those that become increasingly frequent, are a strong indicator of cash flow problems.

• Unusual Sales of Assets or Collateral: Disposing of assets or granting additional collateral may be a last-ditch effort to raise funds or secure additional financing.

• Changes in Purchase Patterns: A sudden shift in purchasing behavior, such as drastic increases or decreases in order volume, may signal financial instability.

• Payment to a Lockbox: A customer's redirection of payments to a lockbox can be a sign of financial distress and an attempt to shield funds from creditors.

• Excessive Employee Turnover: High employee turnover, particularly among key personnel, can indicate internal strife, mismanagement, or a lack of confidence in the company's future.

• Delayed Financial Statements: Untimely release of financial statements can be a sign of internal disarray or attempts to conceal financial difficulties.

• Default under a Loan Agreement: Failure to repay loans or meet other financial obligations is a clear indicator of insolvency.

• Changes in Senior Leadership or Outside Accountants: Sudden departures of key executives or changes in accounting firms can signal instability or an attempt to distance oneself from potential legal issues.

• Litigation by Other Creditors: Legal action by other creditors is a strong indication of financial distress and potential insolvency proceedings.

• Retention of Turnaround Specialists: Engaging consultants or financial advisors specializing in corporate turnarounds suggests a company is facing severe financial challenges.

• Slowness or Lack of Communication: Unresponsive communication or a lack of transparency from the customer can be a sign of internal problems, attempts to avoid scrutiny, or a lack of willingness to address concerns.

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Preparing for the Worst: Protecting Vendor Interests

Chapter 11 bankruptcy, while sometimes unavoidable, can have a significant impact on vendors' financial recovery. To protect their interests, vendors should take proactive steps:

1. Determine Insolvency: Vendors must carefully assess the customer's financial situation and gather sufficient evidence to support a determination of insolvency.

2. Exercise UCC Rights: The UCC

In the face of the current economic challenges, vendors must be vigilant in assessing their customers' financial health and taking proactive measures to protect their interests. By carefully evaluating the indicators of insolvency, vendors can make informed decisions about modifying credit terms, reclaiming goods, or even withholding credit altogether. The UCC provides valuable tools to assist vendors in these endeavors, enabling them to safeguard their financial standing amidst the turbulence of the market.

Navigating the complexities of insolvency determinations can be a daunting task, but vendors equipped with the right knowledge and strategies can emerge from the challenges with their financial well-being intact. By remaining vigilant, proactive, and informed, vendors can effectively manage their customer relationships and ensure their own financial security in an ever-evolving economic landscape.