Getting First In Line When Your Dot-Com Fails To Pay

Scott E. Blakeley, Esq.

Dot-coms, whether distributors or e-tailers, now proliferate the business community and provide a new opportunity for sales for vendors. However, as headlines highlight, liquidation is a growth industry for dot-coms. It appears that the name of the game for dot-coms, at least for the near future, is consolidation. Given the uncertain climate for selling to a dot-com and the fleeting value of the dot-com when it runs into financial difficulty, a vendor may be forced to act quickly when the dot-com unequivocally indicates it may not pay, or fails to pay, on the credit sale. While terms such as “race to the courthouse” and “dismembering the debtor” may have negative connotations to the fast-acting vendor, the nature of the dot-com’s perishable value may require prompt action. What must the vendor do to get first in line?

A. The Fleeting Value Of A Financially Struggling Dot-Com Prompts Vendor To Act Quickly

The value of most dot-coms is intellectual property, such as customer lists, licensed technology and engineering teams. In comparison, vendors selling to a “bricks-and- mortar” company, such as a manufacturer, that runs into financial difficulty may act collectively and agree to support the company by consenting to an out-of-court workout that calls for a moratorium on payment of all vendor debt in an attempt to allow the debtor to work through its financial difficulties. Generally, not so for the dot-com. Vendors dealing with a dot-com that runs into financial difficulty usually cannot work together to support the dot-com because of its fleeting value. Further, the hallmark of an out-of-court workout is consensus with vendors. However, as the dot-com generally lacks sufficient assets and operating history, recalcitrant vendors may upend the out-of-court.

Underscoring the need of a vendor to act early when the dot-com fails to pay, or the vendor obtains information that the dot-com may not pay on its account, is that Chapter 11 bankruptcy is also generally not a viable alternative for a dot-com. If financing and merger efforts by the dot-com fail and it is forced to file an e-bankruptcy, it is probably already too late to preserve these assets for the benefit of vendors for a bankruptcy sale or reorganization.

In many cases, the going concern value is gone when key personnel are gone—-chasing stock options of another dot-com. With a dot-com Chapter 11, a creditors’ committee, in which vendors act collectively, may not be appointed given the short duration of the case or lack of interest.

B. Getting First In Line When Your Dot-Com Fails To Pay

Given that a credit professional may be forced to act quickly when a dot-com has financial problems, what are the vendor’s next steps to get first in line? Did the vendor provide goods or services? If the vendor provided goods to the dot-com, Article 2 of the Uniform Commercial Code provides the selling vendor with a number of remedies.

If the goods have been consumed, or the vendor has provided services, the vendor has a number of remedies under state law, and possibly federal law, to obtain a money judgment.

In considering the next step to obtain the goods back or payment for the value of the goods or services, the credit professional should review the credit file, sale’s file and interview sales people responsible for the account. The credit professional should identify any disputes, accounting or credit issues or counterclaims in documenting the delinquent account. Below are some remedies available to the vendor. This list is not intended as an exhaustive list of remedies available to the vendor.

1. Uncertainty Of Dot-Com’s Payment Prompts Demand For Assurance Of Payment

a. Right To Adequate Assurance Of Performance

Where the vendor has sold goods to the dot-com on credit and has grounds that the dot-com may not pay (termed “grounds for insecurity” under Article 2 of the UCC), the vendor may demand written assurance that the dot-com will perform. If the vendor receives no assurance from the dot-com within a reasonable time, or the assurances offered are not adequate, the vendor may suspend future deliveries. The two questions for the vendor with this remedy are whether the grounds for insecurity are reasonable, and whether the dot-com’s assurance of performance is adequate.

b. Turning A Credit Sale Into A Cash Sale

Where the vendor has agreed to sell goods to the dot-com on credit, the vendor may refuse delivery and demand cash upon discovering that the dot-com is insolvent, as provided under Article 2 of the UCC. The UCC defines insolvent as either balance sheet insolvent (liabilities exceeds assets) or fails to meet debts when they become due.

2. Getting Your Goods Back

Where a vendor has shipped goods, as opposed to providing a service, a vendor’s strategy when a dot-com fails to pay depends on when the goods were shipped.

a. Stopping Goods In Transit

Under Article 2 of the UCC, a seller may stop goods in transit in two instances, where the debtor is insolvent or where the buyer repudiates or fails to pay prior to delivery. However, once the goods have been received by the buyer, the right of stoppage is lost.

b. Reclamation

If the dot-com has received the goods, the vendor’s right of reclamation may be available to recover the goods. Reclamation is the right of a seller to recover possession of goods delivered to an insolvent buyer. The remedy of reclamation is needed when the vendor is unable to retrieve goods or stop them in transit. A reclaiming vendor need not prove fraud. A vendor must establish the goods were sold on credit while the dot-com was insolvent. The vendor must also make a written demand for the return of the goods within ten, or in certain cases twenty, days after the goods were delivered to the debtor, and the debtor had possession of the goods at the time of the reclamation. Reclamation is a state law right that does not require a dot-com’s bankruptcy filing.

C. Collecting On Your Delinquent Account

If the vendor seeks a money judgment against the dot-com, consider the following. Of course the credit professional should consider the collectability of any judgment against the dot-com. There should be a review of available assets to satisfy a judgment and a UCC search to determine whether there are any preexisting secured creditors, and the effect of other creditors’ actions to collect against the dot-com or block the vendor’s collection efforts.

1. Claims Against The Dot-Com

a. Breach of Contract, Conversion And Fraud Claims

With the typical dot-com credit sale, the dot-com will have completed the vendor’s credit application. The dot-com sends a purchase order for goods or services. The vendor invoices the dot-com and ships for provide the service. The credit terms are, say, 15 days. The dot-com fails to pay. The vendor has a breach of contract claim against the dot-com for failing to pay, absent a legal excuse. If the dot-com has misrepresented its intention of paying for the goods or services, the vendor may have a claim for fraud against the dot-com, and perhaps officers of the dot-com.

b. Provisional Remedies For The Vendor

i. Writ Of Attachment

In addition to filing a lawsuit to collect on the delinquent account, a vendor may move to attach a dot-com’s assets prior to a final determination of the claims sued on. The attachment creates a lien on the dot-com’s property, and the vendor may have certain property of a dot-com seized before judgment and held by a levying officer for execution after judgment to protect the vendor’s priority. The theory is to preserve collateral and obtain a lien that is not voidable after 90 days.

The practical use of a writ of attachment is for settlement and may prevent prolonged litigation.

ii. Claim And Delivery

A vendor holding a security interest in personal property of the dot-com may move a court to recover possession of the property before judgment. The vendor must know the location of the collateral.

2. Finding Another Pocket For Payment

The vendor may consider another pocket for payment even where first in line for payment against the dot-com’s assets, as the dot-com may have insufficient assets to pay the delinquent account, or satisfy a money judgment.

a. Claims Against The Dot-Com’s Insiders

The vendor may consider whether claims may exist against the dot-com’s officers, directors and shareholders.

i. Breach Of Personal Guarantee Claim

Where the dot-com has breached the contract and the vendor obtained a guarantee from one of the dot-com’s insiders, the vendor may look to collect against the guarantor.

The basic legal principle is that the guarantor is not a party to the principal debt. The guarantor’s undertaking is independent of the dot-com’s promise to pay. Merely because both contracts are on the same paper, for example, the credit application — the dot-com’s promise to pay for the vendor’s goods or services, and the guarantor’s promise to pay if the dot-com does not — does not change the independence of the agreements.

The language in the guarantee should clearly state that the particular individual signing the guaranty is agreeing to answer for the debt of another. The guaranty should include a statement that the signing party is personally guarantying the debt of the dot-com referenced in the credit application. The guaranty should have under the signature block a line for the individual guarantor’s social security number and a line for the individual guarantor’s home address. The guarantee should be signed before a notary to reduce the risk that guarantor may contend that the guarantee was forged. A dot-com often receives investments from deep-pocketed venture capitalists. If the vendor is a key supplier, the vendor should demand the venture capitalist guarantee the sale.

ii. Piercing The Corporate Veil Claim

A court may disregard the corporate shield and hold shareholders personally liable for the dot-com corporation’s debts upon a showing of certain factors. Those factors include the dot-com corporation’s separate identity is not honored, a commingling of the dot-com’s funds for personal use, a failure to observe corporate formalities and a failure to contribute capital. A vendor must also establish that injustice would result if corporate shareholders escape liability. The alter ego liability is most commonly applied where the corporate dot-com has few shareholders.

iii. Preference Claim

Did the dot-com’s officers and directors receive extraordinary bonuses or other compensation that drained assets from the dot-com that should have been used to pay vendors? Federal bankruptcy and state preference laws are intended to treat parties of the same priority equally. To that end, extraordinary transfers to insiders may be recaptured up to a year prior to a bankruptcy filing, while the dot-com was insolvent. Generally, this claim is pursued by a creditors’ committee or bankruptcy trustee, in a Chapter 7.

iv. Fraudulent Transfer Claim

A vendor may avoid two forms of transfers by a dot-com that are fraudulent as to vendors: (1) the intentional fraudulent transfer, wherein the dot-com transfers assets with the intent to hinder, delay or defraud its creditors; (2) the constructive fraudulent transfer, wherein the dot-com transfers assets for less than reasonably equivalent value while it was in financial straits (such as insolvency at the time of transfer, had unreasonably small capital as a result of the transfer, or incurred debts beyond its ability to repay by virtue of the transfer).

Both the intentional and constructive fraudulent transfer provisions are part of the Uniform Fraudulent Conveyance Act or the Uniform Fraudulent Transfer Act. Each state has adopted a variant of these Acts. In certain states under the Uniform Fraudulent Transfer Act, an intentional fraudulent transfer may be avoided up to one year after the transfer. A vendor need not establish that the dot-com was in financial straits at the time of the transfer.

In certain states under the Uniform Fraudulent Transfer Act, a constructive fraudulent transfer may be avoided up to four years (and possibly seven years) after the transfer. The policy supporting the constructive fraudulent transfer is that a debtor may transfer assets for any value while it is financially healthy and paying its creditors. It is where the debtor is in financial straits and creditors will not be paid in full, may the transfer be attacked as one where the transfer did not yield fair value for the asset. Generally, this claim is pursued by a creditors’ committee or bankruptcy trustee, in a Chapter 7.

v. Breach Of Fiduciary Duty Claim

The officers and directors of a corporate dot-com owe fiduciary duties to the vendors when it is insolvent, as the shareholders’ interest is lost. These fiduciary duties are a duty of due care (exercise of proper judgment) and the duty of loyalty (not take advantage of corporate opportunity). Approval of a dot-com’s board of directors of a liquidation sale may expose the officers to personally liability for failure to maximize the dot-com’s value and breach of its fiduciary duty. With a publicly traded dot-com, there may be D&O insurance available to cover these claims.

vi. Illegal Dividend Claim

A state may have legislation that bars an insolvent dot-com from making a distribution to shareholders while insolvent. If a dot-com’s shareholder, such as a venture capitalist, received such payment it may be recaptured for the benefit of creditors. The theory is that such a distribution circumvents the state law priority scheme that a creditor is paid prior to a shareholder with an insolvent company.

vii. Equitable Subordination Claim

Do the dot-com’s owners hold unsecured claims for supposed “loans” to the dot-com? The shareholder “loans” may be reclassified as shareholder contributions and subordinated to vendor claims. The legal doctrine of equitable subordination may provide for a subordination of the insider’s claim. Equitable subordination is unique to the Bankruptcy Code. Courts commonly look at three factors to support equitable subordination: (1) the claimant engaged in some form of inequitable conduct; (2) the misconduct must have resulted in injury to he creditors of the bankrupt or conferred an unfair advantage on the claimant; and (3) equitable subordination of the clam must not be inconsistent with the provisions of the bankruptcy laws. This claim is used to leap frog ahead of the shareholder for payment. It does not seek payment from the shareholder.

b. Claims Against Third Parties

i. Fraud And Negligent Misrepresentation Claim

Finding reliable historical financial information as well as forecasts for future operations of a dot-com can be difficult. The usual sources of public and private financial and credit information that a credit professional may consider, often do not have meaningful information on the dot-com. The credit professional may consult with members of his or her credit industry group, or vendors of the dot-com not provided as references. The credit professional may also contact the venture capitalists who invested in the dot-com, the owner who invested in the dot-com or the bank that has financed the dot-com for information.

Suppose one of these parties managing the dot-com’s account provides the credit professional statements regarding his or her belief the dot-com’s assets are sufficient to cover the vendor’s credit sale to the dot-com. The dot-com fails to pay. Does the vendor have a claim against the investor or bank for fraud or negligent misrepresentation for the statements?

With the dot-com shakeout, venture capitalists of the dot-com, in particular, may be exercising more direct participation in hopes of preserving their investments. This may lead to potential claims by vendors if they are not paid on their credit sale. However, courts are reluctant to impose liability on third parties, such as venture capitalists, based on causal remarks or speculative future performance predictions. Similarly, a court may question whether a vendor justifiably relied on statements by a third party unless they are supported by material financial information necessary for an informed business decision.

ii. Joint Venture Claim

Venture capitalists of the dot-com may be exercising more direct participation in hopes of preserving their investments. Does this participation between the venture capitalist and the dot-com create a join venture claim by the vendor against the venture capitalist, wherein the venture capitalist was unjustly enriched because of the vendor’s sales?

The basic rule of a joint venture is an undertaking by two or more entities, with or without a corporate or partnership designation, formed for carrying out a particular transaction. The parties agree to share losses and profits, and combine their property, money, efforts, skills, or knowledge in a common undertaking. The parties must also jointly participate in the management and control of the business. Under this theory, a vendor may contend that the venture capitalist has obligated itself to pay for the goods or services.

iii. Restitution Claim

If the dot-com has a lender that purports to have a security interest in the dot-com’s inventory, including after acquired inventory, the so-called “floating lien”, the lender may foreclose upon the dot-com’s default and sell the dot-com’s inventory to satisfy its secured claim. Under limited circumstances a vendor may have a cause of action against the lender to recover the value of its goods. Courts look to either inequitable conduct by the lender or the nature of the vendor’s contribution to the collateral. Where a lender encourages transactions between the debtor and vendor and benefits from the merchandise, there may be an opportunity for the vendor to unwind the transaction. If the lender had an active hand in promoting the vendor’s sale to the dot-com, courts reason that the lender should not escape when a vendor is left without. A vendor may have a claim that the lender was unjustly enriched.

The more difficult issue for courts may be the lender’s acquiescence when a vendor provides goods to the dot-com. When a vendor provides goods or a service that is necessary to preserve the collateral this is an expense the lender would ordinarily incur as part of its duty to maintain the collateral.

In these situations, the lender directly benefits and a vendor’s claim for restitution may stick. However, it becomes less clear for a vendor when its merchandise or service is not essential but merely useful. In this sense the collateral available to the lender for liquidation is merely being made more accessible. In these situations courts are reluctant to disrupt the transaction out of concern that a favorable ruling to a vendor could encourage swarms of litigants to challenge what may otherwise be clear rules contained in Article 9 of the Uniform Commercial Code.

Thus, courts are reluctant to upset the priorities scheme provided under Article 9, and the predictable system of creditor priorities that it provides. A secured creditor is entitled to payment before a vendor who has not complied with Article 9, and generally has the right to take possession of and sell the collateral if the dot-com defaults.

iv. Auditors “Going-Concern” Clause Misleading

A vendor’s due diligence of the publicly traded dot-com usually includes analyzing the dot-com’s annual financial statements. Were these financial statements prepared by the dot-com’s auditors on the presumption that the dot-com is a “going-concern”; in other words, that the dot-com will continue for at least another 12 months? But weeks after the vendor’s credit sale, the dot-com files bankruptcy. An auditor is to disclose that if there is substantial doubt about a client’s ability to continue as a going concern, this is to be disclosed in the dot-com’s financial statements. If the auditor does not make the “substantial doubt” disclosure, this does not assure the vendor that the dot-com will be around for a year. However, the auditor is responsible for identifying key points that may raise whether the dot-com may survive, such as sufficient capital to continue to operate. It certain circumstances, vendors that relied on the auditor’s financial statements in deciding to ship on credit may have claims.

v. Beating The Secured Creditor: Avoidance Powers Claim

Upon a bankruptcy filing, a number of rights and powers are created for the benefit of unsecured creditors. Those powers include the ability of a trustee, debtor in possession, or creditors’ committee in appropriate circumstances, to avoid the fixing of a lien on a debtor’s property. The avoidance powers may allow for unseating a lien not properly perfected prior to the commencement of the bankruptcy filing, as well as a lien that was properly perfected but recorded during the preference period.

As a general rule, outside of bankruptcy, an unperfected security interest is binding between a debtor and vendors. Thus, a secured creditor has priority over unsecured vendors even if the creditor has not strictly complied with the state (Article 9 of the UCC, of example) or federal statutory scheme to perfect its claim. The lack of perfection creates a problem for the alleged secured creditor only when an intervening third party obtains a perfected security interest that trumps the unperfected interest.

This means that upon the bankruptcy filing, a debtor, or a creditors’ committee (in Chapter 11), may act as a hypothetical judgment lien creditor with the ability to unseat prior, unperfected liens. With the assignment of the avoidance powers by the debtor or trustee, a creditors’ committee may use the “strong arm” powers to unseat the creditor’s alleged lien.

A creditor’s lien may also be avoided even if properly perfected but recorded during the preference period, in certain circumstances. The Bankruptcy Code’s preference law, which is part of the avoidance powers, provides for the recapture of payments made to creditors within the 90 days prior to a debtor’s bankruptcy filing. The preference law also provides for unseating a creditor’s lien recorded during the preference period in certain situations.

c. Claims Against Buyer

i. Sale Of Assets In And Out Of Bankruptcy

Where a dot-com sell its assets outside of bankruptcy and the vendor is not paid, the vendor may have claims against the buyer for unjust enrichment, as the dot-com benefited from vendor’s goods or service and from the sale of its business.

The Bankruptcy Code provides that a company may buy the assets of the bankrupt company without taking its debts. Because a buyer is protected from the bankrupt debtor’s creditor with an asset purchase, Chapter 11 has become a popular method for buyers to purchase assets.

D. Solutions

Given the lack of alternatives for an insolvent dot-com, the vendor may be forced to act quickly if a dot-com fails to pay, or there is concern that the dot-com may not perform. The above remedies are a starting point for a vendor to get first in line for a dot-com’s assets, or, possibly, claims against a third party.

Given the speculative value of a dot-com once it runs into financial difficulty, the vendor may look to have the dot-com post assets, or provide other forms of security to reduce or eliminate the risk of non-payment. My article “GUARDING YOUR SALES TO THE DOT-COM WITH CREDIT ENHANCEMENTS: DON’T LET YOUR INVENTORY END UP ON A DOT-COM LIQUIDATORS WEB SITE!” discusses various credit enhancements that a vendor may take advantage of, from letters of credit, to certificate of deposit’s to insurance to consignments, to eliminate or reduce the risk of a credit sale to a dot-com.

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