Vendors Must Beware of Administrative Insolvency in Chapter 11

Vendors providing credit to a debtor after the date of its bankruptcy should consider the relevance of administrative insolvency in Chapter 11 to avoid additional losses on post-petition goods.

Vendors considering post-petition credit from bankrupt companies should take what the debtor says with a grain of salt. They must regularly demand financial information and not rely on representations and promises.

Vigilant monitoring by the court, official committees, and the US Trustee program are essential to reducing the risk of administrative insolvency. More decision-useful monthly operational reports, or MORs, would enable better monitoring, help vendors evaluate credit risk, and reduce the incidence and severity of administrative insolvency.

Financing and Credit

At the outset of a Chapter 11 case, debtors typically seek debtor-in-possession financing. DIP lenders commonly obtain super priority administrative expense status under Section 364(c)(1) of Chapter 11 of the Bankruptcy Code, plus post-petition liens on all assets.

In Chapter 11 bankruptcy financing, a “roll-up” refers to a strategy where a lender consolidates existing pre-bankruptcy debts into a new post-bankruptcy loan. In many cases, the DIP adds little liquidity.

Where the DIP loan may not provide the debtor with sufficient liquidity, debtors will seek post-petition trade credit to bridge the gap. Lenders urge the debtor to obtain post-petition trade credit because new inventory and its proceeds become collateral, thereeby reducing the need for new-money borrowing from the lender.

Post-petition vendors hold administrative expense claims under Section 503(b)(1)(A), but those claims aren’t guaranteed payment. They sit behind any DIP super priority claims and potential adequate protection super priority claims (Section 507(b)). When estate value is fully encumbered, ordinary administrative expenses—including trade—may be unpaid.

Debtors often publicize DIP approval to reassure vendors of timely payment of post-petition invoices. But if the facility rolls up old debt, liquidity may not improve. Labeling post-petition trade as “administrative” is frequently presented by the debtor as a guarantee, but it isn’t. Super priority claims and liens can leave little unencumbered value to satisfy ordinary administrative expenses.

Cash Flow

Chapter 11 debtors may fail to meet projections of cash flow for various reasons: business-specific, industry-wide, and macroeconomic factors, as well as issues related to the accuracy and reasonableness of the projections themselves.

The consequences of failing to meet cash flow projections are significant in bankruptcy, as they may constitute cause for conversion or dismissal of the case under Section 1112(b). Failure to meet cash flow projections is a warning sign for post-petition vendors of the debtor’s potential inability to pay its obligations timely.

Projections that aren’t grounded in reasonable business expectations or fail to account for foreseeable risks are more likely to be missed. A Chapter 11 debtor may fail to meet cash flow projections due to, among other things, declining revenue, operational missteps, inaccurate or unreasonable projections, inability to access credit or refinance, or administrative and operating expenses outpacing income.

Debtors may obscure administrative insolvency by:

• Using overly optimistic cash flow projections, such as presenting projections that assume revenue or financing that is uncertain
• Using DIP financing strategically, such as borrowing under a debtor-in-possession loan to cover ongoing losses
• Delaying payment with promises of future compliance

Potential Fixes

Section 105(a) authorizes courts to issue orders necessary to comply with the Bankruptcy Code. The court should designate a responsible officer to file a notice on the docket when a required MOR will be filed late or has been filed incomplete.

The court also should require the designated person to promptly advise the court and US Trustee on a monthly basis (a) of the percentage ofaggregate dollar amount of accounts payable that are past due and (b) the extent to which actual cash flow is less than budgeted or projected cash flow.

Vendors assessing a debtor’s post-petition credit should demand a copy of the court-approved DIP budget. They also should demand and review MORs, which include a statement of cash receipts and disbursements, statement of operations, a balance sheet, and schedules of post-petition payables.

These reports should help vendors better assess a debtor’s ability to pay obligations arising after the date of bankruptcy . This is because a debtor can show accrual profits while remaining administratively insolvent. Forward cash projections and a variance analysis are essential to gauge whether the debtor can meet obligations when due.

To improve vendor decision-making and reduce administrative insolvency risk, monthly operating reports should do a few things.

• Tie to the DIP budget: Provide period and cumulative budget-to-actual statement of cash receipts and disbursements comparisons, with explanations for material variances
• Look forward: Include an updated rolling 13-week cash flow forecast beginning the day after the MOR period ends, with key assumptions and identification of upcoming “hurdle” payments
• Clarify post-petition payables: An accounts payable aging report primarily shows outstanding payables categorized by their due dates. It typically breaks down the amounts owed into different time frames.

While the MOR indicates how long payables have been outstanding, it doesn’t specifically highlight payables that are due later. The accounts payable schedule attached to the MOR should reflect what is incurred and currently due, what is incurred and past due, and what is incurred but not yet due so creditors can better assess cash needs.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Kenneth Rosen practices debtor and creditors’ rights law and advises companies on practical strategies for resolution of financial distress.

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