Concern over whether a customer is having financial problems has always been a central issue for credit managers. Their role is defined by being able to pick which companies are worth the risk. With bankruptcy filings rising, default and delinquency rates also trending upwards, its the issue of insolvency that’s getting the spotlight at the moment.
Even worse for credit departments is the customer on the verge of filing a Chapter 11 petition. These creditors face the risk of a decrease in or a substantial delay to the recovery of their pre-petition unsecured trade claim. Not to mention the additional risk of continuing to extend credit to the customer.
But there are options. Creditors can gamble by selling their pre-petition unsecured claim or by entering into a put agreement that shifts the credit risk of dealing with a financially distressed company to a third party. Debt markets continue to flourish and over the last two decades have evolved tremendously with the amount of public information available through the Internet and services like PACER, providing an educated seller or buyer with a sizeable advantage.
“It all sounds wonderful. And the market allows trade creditors to cash out of their claim,” said Bruce Nathan, Esq., partner, Lowenstein Sandler PC. “But, when you get that offer to buy the bankruptcy claim you’ve got to tread carefully. You’ve got to do your homework and make sure you’re getting the best price.”
Nathan talked about two options available to credit managers in the CMA-sponsored teleconference “Selling Your Bankruptcy Claim—the Risks and Rewards.” First, there are buyers that will purchase a put agreement—a product equivalent to credit insurance—for a trade creditor’s claim in the event of their customer’s bankruptcy filing.
A put agreement is an agreement for the buyer to purchase the claim in the future at an agreed-upon price. It’s used as protection against insolvency. They require the creditor that is entering into the put agreement with the buyer to pay a non-refundable fee, which could be as much as 1% to 3% per month of the amount being insured. They can be for a claim against a financially distressed company that has not filed bankruptcy yet, or they can be for an administrative claim where the creditor has sold goods or provided services to a company that is in Chapter 11.
“They are two very different products,” explained Nathan. “There are more pitfalls for a put with respect to a Chapter 11 administrative claim if it is not drafted appropriately, but the benefit of a put agreement is that it induces creditors to continue to extend credit to a financially troubled company, whether that company is in or out of bankruptcy.”
The difference between a put agreement and credit insurance is the credit insurance usually involves insuring a pool of receivables—good receivables and the more troubled accounts. Put agreements are insuring against the insolvency of a particular company that is in financial distress. Because of this, puts can be a lot more expensive than credit insurance.
“If you’re paying a hefty fee, you want to make sure you are getting the best for your bargain,” said Nathan.
As in all contractual environments, signers need to be wary. Some agreements may contain objectionable provisions that are intended to shift the risk off of a bad investment from the buyer back to the seller. Others may allow the buyer, in circumstances of their choosing, to force the seller to buy the claim back because of some breach of agreement. Nathan warned that there are many outs in these agreements a good claims buyer can take advantage of if they decided they no longer want to invest in the claim, or they found out information after the fact. So, the standard mantra applies: credit managers must review the documentation that they are being asked to sign.
“The key is that if you are an informed buyer, or an informed seller, and you know what needs to be changed and what needs to be negotiated, with the help of counsel you can have an agreement that works really well for you,” said Nathan. “One that allows you to liquidate your claim and to insure yourself against the risk of bankruptcy. But if you carelessly sign on the dotted line, you may find that while you sold the claim and realized some cash, or what you thought may have required a buyer to buy the claim in the event of a bankruptcy, you find out that there are lots of horrors and lots of outs.”
Another option available for creditors is selling their claim against a financially distressed company to a prospective buyer. In cases of puts or a sale of claim, there is typically a discount in price if the company is already involved in a bankruptcy. In both products, there are a number of matters to be considered, as well as a cadre of pitfalls to avoid.
“When you are negotiating a put agreement, or for that matter a sale of claim agreement, you need to make sure that the debtor—the customer—is properly identified,” warned Nathan. “In more and more cases, you are dealing with multiple entities where there may be lots of different companies that make up the debtor.”