Original Post 12/28/2008; See Updates At End of this Post

For a supplier confronted with a customer bankruptcy, nothing changes bad to worse like the failure of the customer to successfully reorganize.  This means that a filing under Chapter 11, which creates the possibility that the customer will continue operations, now becomes a liquidation under Chapter 7.  Worse still, the supplier who has received payments on open account during the bankruptcy preference period will likely face a bankruptcy preference claim and faces the real prospect of receiving a demand for repayment of those amounts.

A classic illustration of this situation is unfolding in the bankruptcy of Cadence Innovation LLC (“Cadence”), an automotive components supplier of surburban Detroit.  Cadence filed for bankruptcy under Chapter 11 on August 26, 2008.   Cadence had hoped to restructure its operations or sell its assets as a going concern.  This hope has ended.  On January 2, 2008, Cadence stated in a pleading it filed in the Bankruptcy Court that, “The Debtors are in the process of liquidating their assets in  an orderly manner and expect to be able to pay the Lender in full within the next month or so, as the Debtors collect amounts owed to them by General Motors Corporation and Chrysler, LLC.”  See Debtrors’ Emergency Motion for Approval of Extension of Maturity Date of Postpetition Financing Agreements.

For those suppliers and unsecured creditors looking in on the proceedings, the shift from reorganization to liquidation was very rapid.  On December 10, 2008, Cadence withdrew motions that were preparatory to any sale as a going concern.  This was a red flag that liquidation was imminent.  On that same day, Cadence was informing its key customer GM that it had commenced liquidation.  This was disclosed in a pleading filed by GM on December 24, 2008 and picked up in the trade press a few days later.

What does liquidation mean in terms of bankruptcy voidable preference claims?  In the case of Cadence, bankruptcy preference claims will represent of rich source of funding for the debtor’s liquidation.  There are approximately 800 distinct creditors and suppliers who received one or more payments during the 90 day bankruptcy preference period (see the video presentation on identifying preference payments on this website).  The total possible bankruptcy preference payments during the preference period exceed $60,000,000.

It is still too early to predict when notice of the first bankruptcy preference action will be filed or demand letter will go out.  However, given the potential size of recovery of preferences in this bankruptcy it is a “sooner rather than later” scenario.

What should a supplier do in the context of conversion of a customer’s Chapter 11 reorganization into a liquidation?  Unsecured creditor rights and supplier rights generally have already been fixed 20 days after the filing of the customer’s bankruptcy.  There is potentially an “assumption of contract” gambit under Section 365 of the Bankruptcy Code for a limited group of suppliers who have critical supplier contracts with the bankrupt customer.

However, for all other suppliers, this is the time to pull together those books and records that will be needed to identify each bankruptcy preference payment it received and that are needed to defend a bankruptcy preference claim (see part 6 of the bankruptcy preference video series located on this website).  It is also a time for a preliminary assessment of the supplier potential liability for bankruptcy preference payments both in order to plan and in order to identify contingent liability exposure for purposes of financial accounting.

On December 29, 2008, GM’s motion to recover tooling from Cadence was substantially granted by stipulation and Consent Order.

The benefit to Cadence in agreeing to the turnover appears to be in the sale to GM certain “Designated Equipment.” The sales price is to be determined by a pre-existing appraisal. Payments for the Designated Equipment will total approximately $4,495,000. Given the market, having a purchaser of the equipment at an appraised value is a positive outcome. Most of the payments are going directly to Bank of America.

However, some of the payments are going an escrow account for “vendor Escrow Funds.” In an interesting acknowledgment, the Consent Order states; “GM believes that certain third-party vendors to Debtors may have validly existing liens or security interests on the Vendor Designated Equipment; however, Debtors may wish to challenge the validity of such liens and security interests.” For those vendors with a claim to these funds, the situation may present an opportunity for an omnibus settlement that might also include preference claims.

Cadence apparently has about $350,000 in resins in raw material inventory that was to be used for GM parts. GM also agreed to try and get successor parts suppliers to purchase such resins from Candace.

The liquidation of Cadence seemingly will be very rapid. On January 7, 2009, the Bankruptcy Court entered an order granting Cadence’s Emergency Motion for Approval of Extension of Maturity Date of Postpetition Financing Agreements. This extended the period for Bank of America post petition financing to January 9, 2009. It also allowed for a further extension of the Bank of America financing without Bankruptcy Court approval. However, a further extension beyond February 28, 2009 is not permitted without Bankruptcy Court approval.