The Seven Golden Rules

Historically, lenders/trade creditors and lessors do not call upon their bankruptcy and workout counsel until a default occurs and it is “too late” to fix underlying problems in the deal documents.  Once a loan is in default, and litigation or bankruptcy has commenced, the creditor must generally deal with the documents and the situation as it is at that point with little or no opportunity to improve its position.

Foresight is the best defense.  It is important to understand that having counsel involved in structuring or drafting a new transaction or just reviewing your routine documents can put you in a substantially better position when default occurs.  This paper outlines seven golden rules . . . issues which, if addressed at the outset, can make it much easier (and more profitable) to deal with a defaulted loan or credit transaction. 

*Eliminate Default Cure Periods

Many contracts have default provisions that require the creditor to give notice of default and allow a cure period before the creditor may exercise its remedies.  Lengthy notice periods delay action when promptness is sometimes the key to collection.  A long cure period may give the debtor the notice it needs and the opportunity to dispose of collateral or file for bankruptcy.  Commercial documents should therefore have certain critical default provisions which do not require any notice of acceleration or opportunity to cure.  Aside from the delays that cure opportunities create, they also increase the probability of litigation over whether notice of default and right to cure were properly given and whether a cure was actually effected.  This issue is even more critical for those with ongoing contracts or leases.  If the contract is an executory contract (one with performance remaining on both sides), the cure period gives the debtor the time it needs to file bankruptcy and tie up the creditor so that the contract cannot be cancelled and the creditor must continue to honor the contract in bankruptcy in spite of default.

*Make Notices Effective Upon Transmission

Any notice that is required to be given under a contract should be effective when sent by the creditor, not when received by the debtor.  Notice provisions should also provide for notice by facsimile, hand delivery, overnight delivery, etc.

*Create Multiple “Ways Out”

When you are involved in an ongoing contract, you generally cannot exercise your remedies until you terminate the contract.  This requires having a specific default which gives you a basis to terminate.  If a bankruptcy ensues and you have not terminated an executory contract prior to the bankruptcy, you are usually prevented or at least substantially delayed in getting relief.  Conversely, if you have properly terminated a contract pre-bankruptcy, you may avoid all of the delays inherent in the bankruptcy case. 

Many leases, loan documents, purchase orders and other contracts typically have default clauses which say that the filing of a bankruptcy or the insolvency of the contract party is a default.  These provisions are not enforceable in bankruptcy but are not illegal.  While it is permissible to continue to include these provisions in case they have any deterrent value, other specific requirements and covenants which give you an ability to call a default and terminate the contract prior to bankruptcy are essential.  Trade creditors can include cross default mechanisms such as indicating that any default by your customer under its loan agreement with its primary lender will be an event of default under your contract.  Loan agreements as well as trade agreements can have specific covenants related to the financial stability of the borrower/customer.  Be creative and include covenants that will give you grounds for default when you need them.  If you are relying on the other party to the contract to handle funds or goods in a certain way, spell out the expectations and build in a monitoring mechanism and a default if the other party fails to comply with the covenants. 

*Obtain A Guaranty or Letter of Credit If Possible

Having a guaranty from the principal of your debtor entity or from an affiliated business entity will not only provide another source of recovery but may ensure that your debt receives priority treatment.  Taking it even further, require the guarantor to “secure” the guaranty with a security interest in property owned by the guarantying party.  Consider also requesting a letter of credit from a financial institution to protect the payment due to you, particularly if selling under open credit terms.  If you obtain a guaranty, include language saying it is a guaranty of payment not of collection.  Remember that it is far easier to obtain a guaranty or letter of credit up front when everything is positive and the debtor is sure they can perform. 

*Check Your Attorney’s Fee Clause

There are plenty of bankruptcy cases which indicate that an attorney’s fee clause that says that you can collect fees “if the matter is turned over to an attorney for collection” are not enforceable in a bankruptcy case.  Your attorney fee provision should be broad and specifically say that it covers any attorney’s fees and expenses incurred to protect or enforce your rights whether or not litigation is commenced, specifically including monitoring or responding to pleadings filed in a bankruptcy by or against your debtor.

*Provide For Interest on Past Due Balances

Loans generally provide for a higher default rate of interest effective upon default.  Agreements governing sales on open account frequently fail to include interest when the account is in default.  Consider having your standard contracts and documents reviewed to see if changes can put you in a better position when default occurs.  All sales on open accounts should provide for interest on past due or balances with said interest to accrue from a specific point such as the date of delivery or due date.  Also, be clear regarding when the right to interest arises.  For example, “All past due balances are subject to interest at the rate of X percent effective upon default.  Interest will accrue from date of invoice until paid.”

*Provide For Rights of Offset and Recoupment

Every contract should expressly provide for rights of setoff and recoupment.  The Bankruptcy Code specifically acknowledges these rights if they are contained in the contract.  Generally, the right of offset allows Party A to offset an obligation it owes to Party B against an obligation owed by Party B to Party A.  Recoupment goes a step further and is similar to offset but specifically relates to offsetting claims which arise out of the same transaction, or sometimes the same contract.  This is an important right at common law but also in bankruptcy since the Bankruptcy Code specifically recognizes recoupment as well as setoff.  More importantly, the right of recoupment, if it exists, enables the creditor to offset a pre-petition claim against a post-petition claim, something not ordinarily allowed.  This is because recoupment relates to a single transaction which crosses over the filing date barrier.

*Summary

Many of these vaccinations are fact specific and must be considered in light of the types of transactions generally undertaken by the creditor.  When times are good, it is the best time to take a step back and review your documents before the next wave of defaults hits.

The Poyner & Spruill attorneys will provide an initial review of your credit documents for a nominal fee and point out areas which would benefit from revision.

If you have any questions regarding this article, please contact Judy Thompson at 704.342.5299 or jthompson@poynerspruill.com.

This electronic publication is published by Poyner & Spruill LLP to provide general information about significant legal developments. Because the facts in each situation vary, the legal precedents noted herein may not be applicable to individual circumstances.