Vendor-Financing Agreements and Financial Accommodations Contracts in Bankruptcy

Whatever their ultimate business decision may be, practitioners would be well-served to consider the implications of Section 365(a) of the U.S. Bankruptcy Code when they are first negotiating a vendor-financing agreement.

Consider the following scenario: A lender and a manufacturer enter into an inventory-financing program for dealers of the manufacturer’s products. Pursuant to the agreement reached between the manufacturer and the lender, the lender agrees to finance the purchase of more than $100 million worth of the manufacturer’s products by various dealers, which will then sell the products to commercial or consumer third parties.

Then the manufacturer begins experiencing supply-chain issues, increases in its production costs, and workforce shortages brought on by a global pandemic. The manufacturer seeks relief from its financial pressures by filing a Chapter 11 bankruptcy petition. After filing, it contends that the lender must continue to perform under the inventory financing program agreement by making loans to the dealers, notwithstanding the manufacturer’s material covenant defaults and significant uncertainty about the manufacturer’s future viability, including its ability to honor warranties for the purchased inventory.

In such a scenario, could the lender be forced to perform under the inventory financing program agreement, including making new loans to the dealers? The answer, which is dependent upon both contract law and the statutory framework of the bankruptcy code, is not always straightforward or predictable. In order to examine the issue more closely, a short explanation of the interplay between vendor finance agreements and bankruptcy is appropriate.

Inventory financing program agreements, pursuant to which a lender agrees to provide financing to dealers to enable them to purchase inventory produced by a specific manufacturer, are regularly used for a variety of equipment classes and across industries. Simplified, these agreements are programs between a lender and manufacturer wherein the lender agrees to provide inventory financing for the purchase of the manufacturer’s products (secured by a lien against such products) to the manufacturer’s dealers who, in turn, sell the equipment to third parties.

Vendor financing program agreements contemplate extensions of cash or a line of credit to finance the purchase of inventory by a dealer, as distinguished from leases or contracts entered into with the end-user of the equipment. While regularly used among lenders, manufacturers, and dealers, treatment of these finance products in bankruptcy is not uniform, and uncertainty exists with respect to how such agreements may be treated in the context of a manufacturer’s Chapter 11.

Executory Contracts and the Financial Accommodation Contract Exception

Once a manufacturer files for bankruptcy protection, its prepetition contracts are considered to be assets of the bankruptcy estate. Section 365(a) of the Bankruptcy Code, 11 U.S.C. Section 365, provides that “the trustee, subject to the court’s approval, may assume or reject any executory contract or unexpired lease of the debtor.” While the term “executory contract” is not defined by the U.S. Bankruptcy Code, most courts have interpreted the term to mean any contract under which the obligation of both the debtor and the nondebtor party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other.

In a Chapter 11 case, a debtor’s rights under an executory contract are considered to be an asset of the debtor’s bankruptcy estate. Thus, the Bankruptcy Code includes provisions to protect and preserve those rights, and also to give the debtor the opportunity to maximize its options with regard to future performance under its executory contracts while it attempts to reorganize its business operations.

One such protection, codified in Section 365(e)(1) of the Bankruptcy Code, provides that:

an executory contract … may not be terminated or modified, and any right or obligation under such contract … may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such a contract or lease that is conditioned on: the insolvency or financial condition of the debtor… the commencement of any bankruptcy case; or the appointment of or taking possession by a trustee in a bankruptcy case … 11 U.S.C. Section  365(e)(1).

As a result of this statutory language, contractual provisions that would otherwise permit a counterparty to an executory contract to terminate or modify the contract solely because of the debtor’s financial condition or bankruptcy filing, typically referred to as ipso facto provisions, are generally unenforceable in bankruptcy.

It follows, therefore, that a nondebtor party to an executory contract may be obligated to perform under the contract following the petition date, subject to exceptions set forth in the Bankruptcy Code. This obligation, however, is not absolute. The Bankruptcy Code includes exceptions to the obligation for continued performance, including an exception if a contract is determined to be a “financial accommodation” contract.

Specifically, Section 365(a) of the Bankruptcy Code expressly excludes “financial accommodations” contracts from the provisions that are generally applicable to executory contracts, including the debtor’s rights to assume and/or assign such contracts or to compel performance. 11 U.S.C. Section 365(a) (providing a contract is executory if it is a “contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor…”). Unfortunately, like the term “executory contract,” the term “financial accommodation” is not defined by the Bankruptcy Code, leaving the parties and, ultimately, the courts to deliberate about its meaning.

Are Vendor Financing Program Agreements ‘Financial Accommodation’ Contracts?

Most often, the concept of financial accommodation contracts in bankruptcy arises in the context of a prepetition loan made directly to a debtor. As set forth above, after the petition date, the lender is, therefore, not required to advance additional amounts or provide financial accommodations to or for the benefit of the debtor. In addition, a financial accommodation contract could not be assumed by a debtor and assigned to a third-party purchaser without the nondebtor party’s consent, as may occur with executory contracts.

Vendor financing agreements, however, do not typically involve the extension of credit directly to the manufacturer/debtor. As such, bankruptcy courts must engage in a fact-specific analysis of whether the vendor finance agreement provides a financial accommodation for the benefit of the debtor.

While the financial accommodation exception has generally been interpreted narrowly by bankruptcy courts, predicting the outcome of a particular contract’s characterization as a financial accommodation contract is problematic for two reasons: First, the terms “financial accommodation” and “to or for the benefit of the debtor” are not defined in the Bankruptcy Code. And second, the plain language of the statutory section is much more broad than its application by the courts.

Notwithstanding this lack of clarity, a judicial consensus appears to be emerging: If the extension of credit or the financial accommodation is merely “incidental” to a contract for the sale of goods or services, the executory contract may not qualify for the exception.

The analysis regarding whether an executory contract is a “financial accommodation” contract, however, is highly factual in nature. As a result, there is substantial room for interpretation and variation within the jurisprudence when it comes to individual contracts.

Some factors that courts have considered when analyzing whether a vendor financing agreement is a “financial accommodation contract” for the purposes of Section 365 include the following:

In light of the fact that vendor-financing agreements typically provide financing to the dealers, and not directly to the manufacturer/debtor, the question of whether such financing is “for the benefit of” the manufacturer/debtor has also been the topic of debate in bankruptcy courts. Among other things, bankruptcy courts will look to the specific language of the vendor financing agreement to determine the specific financing or financial accommodation being provided for the benefit of the manufacturer/debtor, including the exact nature of the benefit the manufacturer/debtor is receiving in its business operations or otherwise.

Unfortunately, these financial accommodations and benefits are often not expressly enumerated in ways that make them easily identifiable by the reviewing bankruptcy court. The lack of specificity in the contract itself may sometimes cause the bankruptcy court to overlook the direct financial benefits a manufacturer/debtor may receive from the lender’s agreement to provide financing to its dealers.

Practice Tips and Pointers

Unfortunately, many practitioners are not considering the implications of the financial accommodations exception when drafting a vendor-financing program agreement. In failing to include contractual language that confirms the parties’ intentions regarding the financial benefits and accommodations being provided by the lender, they run the risk of leaving the post-petition enforceability and assignability of that contract open to interpretation by a bankruptcy court. This oversight can have drastic implications for the positions of both the lender and the debtor/manufacturer in bankruptcy.

If a vendor-financing agreement is deemed to be a “financial accommodation” contract, the debtor/manufacturer’s dealers may lose critical access to inventory financing loans at the same time they are facing disruption in their business due to the manufacturer’s bankruptcy filing. At the same time, a lender may have reservations about being forced to perform under a vendor-financing agreement after the manufacturer’s bankruptcy has commenced, and may balk at having the manufacturer’s rights under the agreements assigned to a third party as part of an asset sale under Section 363 of the Bankruptcy Code. This is especially true where, as is often the case, a manufacturer may have warranty, repurchase, or guaranty obligations under the vendor-financing agreement.

All parties in interest to a vendor-financing agreement would be wise to consider their risk in the event of a future insolvency event, including whether to build language into their agreements that makes it more clear to bankruptcy courts that the contracts are intended to provide financial accommodations for the benefit of the manufacturer.

At the same time, that increased clarity could imperil the possible assumption and assignment of the vendor-financing agreements in bankruptcy, including the payment of cure claims associated therewith, and could limit the parties’ optionality.

Whatever their ultimate business decision may be, practitioners would be well-served to consider the implications of Section 365(a) of the Bankruptcy Code when they are first negotiating a vendor-financing agreement. This forward thinking could protect them in the event of a future insolvency event and may guard against unwanted lending obligations.

From left to right: Ann Pille is a partner in Reed Smith’s Chicago office and a member of the firm’s financial industry group. She can be reached at apille@reedsmith.com. Richard Tannenbaum is a partner in the firm’s New York office and a member of the firm’s financial industry group. He can be reached at rtannenbaum@reedsmith.com. Alexis Leventhal is an associate in the firm’s Pittsburgh office. She is a member of the financial industry group and can be reached at aleventhal@reedsmith.com. Emily Costantinou is an associate in the firm’s Pittsburgh office and can be reached at ecostantinou@reedsmith.com.

From: The Legal Intelligencer

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