In this short, three-part video series, Greenberg Glusker Partners Andrew Apfelberg and Brian Davidoff discuss important financial considerations for health, beauty and wellness companies in the wake of a pandemic. Part two looks at what options exist for a vendor during bankruptcy, including what a preference is, how to defend against a preference, and what a critical vendor is.

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Andrew: Companies in the health, beauty, and wellness industry are going to need to be agile in order to survive and to thrive. And, by agile, I mean the ability to respond quickly to changes in consumer sentiment and value perceptions. Certainly, one of the biggest obstacles to being agile would be having a supplier or a vendor or critical partner file bankruptcy. I was hoping you could give some advice to our friends in the industry on what to do if that were to happen. So, first things first: what is a preference?

Brian: Well, let’s first talk about why there is a preference. The concept of bankruptcy is that creditors are treated fairly and equally. What I mean by that is that if you have a number of unsecured creditors, the idea behind the bankruptcy is that they all share equally in whatever assets are available for distribution to those creditors. The concept of a preference is designed to further that objective. And what a preference does is that it recaptures for the bankruptcy estate certain payments that have been made preferentially to one creditor over another creditor again with the idea of recovering that preferential payment, putting it back in the bankruptcy estate, and then being able to distribute that money pro-rata to all the creditors. Very basically, the way a preference works is that it looks back for a period of 90 days prior to the filing of a bankruptcy or, in the case of an insider – and an insider being, for example, an officer or director of a company, someone who has significant control over a company – the lookback period is one year. If there is a payment by a company that subsequently files a bankruptcy either within 90 days for a third-party vendor or for an insider for one year, then if that payment is on account of a pre-existing debt – now that’s important to understand because a lot of people get confused when there’s a payment preceding a bankruptcy that they’re concerned about it being a preference. It only becomes a preference if it’s a payment on account of an old debt. In other words, if you ship goods and your credit terms are net 10 days, and you get paid within 10 days, that is not a preference. But, if your credit terms are 10 days and you are getting paid something 60 days later, that may on its face be a preference and, if the other tests are satisfied, may be able to be recovered by the company in bankruptcy.

Andrew: So, how would one of our clients defend against that?

Brian: Well, number one: There are a number of tests that need to be satisfied in order for it to be a preference. As I said, the pre-existing debt is only one of them. It must result in the recipient receiving more than they would have in a liquidation bankruptcy. So say, for example, as a vendor, you have an account receivable outstanding. You’re paid 100 cents on the dollar on account of that old account receivable. And, if it satisfies the other tests in a bankruptcy, you would only get paid 50 cents on the dollar, then maybe that’s a preference. If you’re a secured creditor, secured creditors are entitled to be paid generally 100 cents on the dollar, so that would be one defense. But most bankers are unsecured. What we look at are a series of other defenses available, the most common of which are payments in the ordinary cost. What happens in that analysis is that you evaluate what the practice has been between the parties for the period of time prior to the bankruptcy, maybe looking back for a year or longer. If the practice has been that you’re paid within 30 days, and it turns out that even within this 90-day lookback period, you’re still being paid within 30 days, then that’s a payment made in the ordinary cost – probably won’t be recoverable. One of the other defenses would be – and this is a fairly common one as well – is what’s called subsequent new value. So, the typical scenario over here would be say you have an account receivable – pick a number: $10,000. Your customer pays you $5,000, and let’s assume that that’s a late payment so that it – on its face – would be recoverable as a preference. But after receipt of that money, you then ship another $5,000. If that shipment takes place after the payment, that is subsequent new value and it essentially sets off against what would otherwise be a preferential payment.

Andrew: Many of our clients in the industry will find themselves in an uncomfortable spot where a vendor owes them money for a while but still is asking them to ship. So, what advice would you give in that instance in terms of, obviously they want to get paid on the prior amounts and they also want to get paid on this new shipment. What advice would you give them? What are the best practices in that situation?

Brian: As I was mentioning earlier, you certainly want to be vigilant to not being set up for a preference, and companies that get sued for preferences usually don’t take to that very well as you might expect. Not only are they owed money by their customer, but now they’re getting sued by a trustee in bankruptcy to give money back. So, you really do want to be vigilant. So, what are the things that you can do? If you are going to get paid on account of an old bill, then you do want to try to offset that against new inventory that you’re shipping, but to the extent that you can get assurances that you are going to get paid for that new inventory, and one of the kinds of assurances that you can get is maybe a guarantee or some other kind of credit enhancement. The one alternative is to avoid the preference by shipping new product. The other, and probably the most proactive alternative would be, if possible, to try to keep your shipments and your payments within the ordinary cost of business that you historically have had with that customer so that you don’t fall outside that range and expose yourself to a preference.

Andrew: One of the other questions that I’ve been asked by a lot of clients in the industry is, am I a critical vendor? So, can you tell us what that is and why we should care?

Brian: Well the word “critical vendor” has a commonsense meaning and then it has this bankruptcy sense meaning. The commonsense meaning is, are you a critical supplier to your customer such that they really can’t do without you regardless of a bankruptcy? That often translates into being a critical vendor in a bankruptcy case. And what that means is that, sometimes in a bankruptcy case, the company in bankruptcy will ask the bankruptcy court to designate certain of their suppliers as critical vendors, meaning that those suppliers are critical to the customer’s business. Without them, they can’t survive. If the court designates a particular vendor as a critical vendor, then usually that vendor is going to get enhanced payments. So, whereas typically for a vendor, when the customer files a bankruptcy, there is zero – no payments on account of the old debt, the debt that is owed prior to the filing of a bankruptcy. If, on the other hand, you are designated as a critical vendor, you often will get paid some or even maybe all of your pre-bankruptcy debt in exchange for you continuing to ship post-bankruptcy. Obviously then you get into the whole situation of ensuring that you’ve paid for the post-bankruptcy shipments, but it does enhance your ability to get paid for the pre-bankruptcy accounts outstanding.

Andrew: It sounds like one way we could help our clients would be to help them be designated a critical vendor.

Brian: Yes.

Andrew: When we were preparing for this interview, you were explaining something to me about section 503(b)(9), which sounds very official. What is that?

Brian: Section 503(b)(9) is a section of the bankruptcy code, which allows a vendor to recover goods if the goods are shipped within 20 days of a bankruptcy filing. If that occurs, then you can send the notice to the debtor in possession, as the company is called in a bankruptcy, requesting recovery of those goods. Again, this is something that you really need to watch your timelines on. If you ship and you learn about the bankruptcy, you really need to react very quickly in sending that notice because, if you don’t send that notice timely, then you lose that 503(b)(9) claim. If you do that, then your claim is elevated to an administrative status claim, and an administrative status claims means that it is a higher priority in a bankruptcy case than the payment of general unsecured creditors.

Andrew: Brian, I want to thank you. Navigating this COVID experience is complex. Navigating the bankruptcy code and process is complex. But you really boiled it down and gave our clients in the health, beauty, and wellness industry some practical advice they can follow, and for that I thank you.

Brian: Thanks Andrew. Good to be with you.

Did you miss Part 1? Click here to learn what steps to take when your buyer is financially distressed. Alternatively, if you're ready for Part 3, click here to learn when to consider acquiring a distressed company.

Andrew M. Apfelberg

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