​Using Credit Enhancements To Minimize the Fallout From Another Company’s Bankruptcy

June 6, 2016Articles

The oil and gas industry has seen unprecedented levels of volatility in pricing and sustainability over the past year. Since 2015, more than 50 oil and gas exploration and production companies have filed for bankruptcy. While some of these firms will emerge from a Chapter 11 as healthy companies, the negative consequences for their creditors can be substantial.

Bankruptcies will always reverberate throughout the business community, but companies that take a thoughtful approach can go a long way toward ameliorating the uncertainty and the costs that often come along with the news that a major customer is in bankruptcy.

In an earlier three-part series, we examined in depth the usefulness of letters of credit in commercial transactions. In this article, we outline a handful of popular credit enhancements companies may use to minimize their risk or exposure to a counterparty that they believe may be having financial difficulties. There are many different types of credit enhancements depending on the parties’ leverages, cash flow, size and risk. All of these factors should be considered to arrive at an enhancement best tailored to address the concerns of specific circumstances.

Tighter Payment Terms

The simplest credit enhancement is negotiating tighter payment terms or even prepayment for goods or services provided. This requires a vendor to negotiate the contract ahead of time to obtain more favorable terms, such as shortened payment terms, getting paid more quickly or more often (for example, bi-monthly) or even receiving prepayments or cash on delivery.

The advantages of this credit enhancement include that it involves minimal risk with minimal effort. It also has the capability to assist both parties’ cash flow and it should not make a meaningful cash difference to the counterparty. It also has an indirect benefit of minimizing a vendor’s preference exposure if its counterparty files for bankruptcy. The disadvantages of this credit enhancement include the remedies that are practically available if the counterparty defaults and what a company’s exposure may be if payment is not made. Specifically, how quickly a company can terminate a contract or service upon default will ultimately determine how effective this credit enhancement can be.

Consignment

Sale on consignment is an effective credit enhancement in which a party retains title to its property until it is sold by the other party, although at all times the property is in that counterparty’s possession. The advantages of this credit enhancement is that the party retains title and control over its property and gets its goods back if the property is not sold. The disadvantages are that a vendor does lose some control over the process since its property will be in possession of another and the sale must carefully adhere to state law to qualify as a consignment. In addition, there are concerns that the counterparty’s secured lender could come ahead of a consignment party if state law is not carefully adhered to.

Security Interest

Taking a security interest in the goods sold — whether as a purchase money security interest or otherwise — is another option to secure the counterparty’s obligation to pay. The advantages of this credit enhancement are that it minimizes credit risk by obtaining collateral to secure payment and it provides an alternate source of payment if there is a default. The disadvantages include that the effective remedies may be cumbersome and costly and require a party to proactively exercise remedies. In addition, if the counterparty files for bankruptcy, the party holding a security interest will be subject to the bankruptcy and have to appear in the bankruptcy case to obtain relief.

Security Deposit

Obtaining a security deposit is a reliable credit enhancement in which actual cash is posted with a vendor to cover a specific exposure. The advantages of this credit enhancement are that it involves real cash to offset a credit exposure, it provides more control to the vendor, and it minimizes preference exposure in a bankruptcy case because the vendor may be deemed a secured creditor. The disadvantages are that the vendor will get caught-up in a bankruptcy of its counterparty and subject the vendor to the automatic stay before it can effectuate taking the security deposit to offset any exposure. Furthermore, the vendor may not have sufficient leverage in the credit relationship to obtain a security deposit.

Credit Insurance

Third-party credit insurance is an option that allows a party to shift the risk or exposure for possible liabilities that a vendor regards as too great to bear. This credit enhancement literally is going out on the market and obtaining insurance to provide coverage in the event that a vendor is not paid. There are various types of credit insurance including a general policy that would cover all accounts and customers, a policy specific as to a specific customer, a policy specific as to one invoice, or a “put” where, for a specified premium, the vendor has a right to “put” the account receivable to the insurer and be paid a reduced amount under the policy leaving the insurer the burden of collection as the new account owner.

Guaranties

A close cousin to insurance is the third-party guarantee — a legally binding promise from a third party that it will pay if the primary obligor defaults. The primary advantages to guaranties are that they are relatively easy to request and implement and are a powerful tool to keep principals honest. The disadvantages . are that unless the guaranty is secured, it will only be as good as the creditworthiness of the guarantor. Furthermore, if there was a default and failure to pay on the guarantee, the vendor will have to sue in court to recover on the guarantee.

Setoff

Effectuating and asserting setoff rights is a useful credit enhancement in multifaceted, complicated, multiparty transactions involving “due-tos” and “due-froms” various parties, netting or offsetting can ensure that the vendor is not owed money from one entity but yet owes money back to that company that defaulted. What does this mean? For example, assume a vendor supplies goods to its counterparty for which counterparty owes $100. However, the vendor has the obligations to warrant or guarantee that the goods provided are what they say they are. If the counterparty claims that goods are defective, for example in the amount of $20, a vendor is certainly going to want to offset the $20 it may owe its counterparty against the $100 the counterparty owes the vendor, leaving a net amount owed of $80 as opposed to having to pay the $20 over but still be owed $100. Asserting and protecting offset and setoff rights are a powerful way to reduce credit risk in complicated transactions.

We have touched on many of the credit enhancements that are available in a commercial setting. Vendors and other parties in complicated commercial transactions are advised to seek the advice of counsel to minimize credit exposure in any given transaction by ensuring that the proper credit enhancements are in place. If you have any questions, please contact Raymond M. Patella at 609.572.2254 or [email protected] or Michael Viscount at 609.572.2227 or [email protected] or any member of Fox Rothschild’s Financial Restructuring & Bankruptcy Department.