Supplier Vigilance in Chapter 11: Protecting A/R & Reducing Preference Risk

1. Preparing for Your Customer's Chapter 11: the Rise of Supplier Vigilance to Protect A/R (Including 503(b)(9) Claims) and Reduce Preference Risk Brad Boe Director of Credit Brad.boe@pfgc.com Scott E. Blakeley, Esq. Partner seb@blakeleyllp.com Ronald A. Clifford, Esq. Partner rclifford@blakeleyllp.com

2. State of the Retail Industry • Intense competition • Capital intensive • Saturated industry • Fickle consumers • Expansion through incurring debt • Leased real estate

3. Major Bankruptcies • American Apparel • BCBG Max • Garden Fresh Restaurant Corp • Gordmans • Gymboree • HHGreg • Ignite Restaurant Group • Logan’s Roadhouse • Payless Shoes • Rue21 • Sports Authority

4. State of the Retail Industry MACRO TREND CONSIDERATIONS • Cost of Goods –demand for higher quality will result in significant COGS increases, narrowing already thin margins • Oversupply, competition and labor related concerns • Rising interest rates • Increasing competition from grocery and convenience store offerings • What factors are affecting you industries

5. Supplier Strategy with Insolvent Customer: Alone or Team Approach Alone Benefits Same priorities Threat of an involuntary petition Share costs Risks Antitrust concerns Share results with others Freerider risk Supplier Pact • Benefits • Unique claim • Negotiate repayment plan • Race to the courthouse: first to the assets • Risks • Expense and resources to act alone • Customer silence • Preference risk • Complaining about customer’s silence: defamation and libel

6. Trade Creditor Pre-Petition Concerns • Key Market Share Losses • Multiple agencies track data and are found in industry news publications, analysts’ reports and subscription services • Declining same store sales • Changes in lending agreements • Frequent covenant breaches and forbearance agreements • Poor store presentation • Departure of CEO/CFO and/or insertion of a CRO • Employee rumors and mass departures/layoffs • Changes in communication patterns

7. Trade Creditor Pre-Petition Concerns • Financial metrics • Capital Structure • Declining EBITDA • Declining same store sales • Eliminating or drastically reducing capex spending • Requests from customers for extended terms • Wage increases • Reducing total amount of retail locations • Slowdown of customer payments • Eliminating discounts and impact on bottom line • Technological investment

8. Trade Creditor Post-petition Concerns • Request appointment to the unsecured creditors committee • Obtain critical vendor status • Undergo a preference defense analysis – ordinary course and new value • Assert 503(b)(9) claims – enter into a trade creditor agreement for pre-petition payments of 503(b)(9) claims in the ordinary course in exchange for post-petition terms of sale • Set-off right

9. 503(b)(9) Administrative Priority Claims • Bankruptcy Code section 503(b)(9) grants goods suppliers a priority claim for goods received by debtor within 20 days prior to filing • 503(b)(9)’s must be paid before a plan can be confirmed • Debtor may load up on inventory on credit terms and then delay planned bankruptcy filing to limit 503(b)(9) claims • In many Chapter 11’s, 503(b)(9) claims are the only claims paid of the supplier class • Suppliers at risk of losing on 503(b)(9)’s can file an involuntary bankruptcy petition, which allows the 20 day look-back to start the day it is filed • Petitioning creditors preference evaluation before filing

10. The Involuntary Bankruptcy Petition • Petitioner's due diligence • Eligibility to file: • Claims subject to bona fide dispute • Contingent claims • Unsecured claims aggregate $15,325 • Three or more petitioning creditors • The Standard: The debtor generally not paying its non-disputed debts as they come due • Bad Faith filings

11. Trade Creditor Post-petition Concerns • Can you protect post-petition trade credit with liens on unencumbered assets or letter of credit carve outs • Evaluate strategic alternatives – pursue a strategy that maximizes value for the unsecured creditors – this may men a lower recovery for the GUC’s while increasing while increasing liquidity for the debtor to give a longer runway toward • Assess whether the restructuring will create a viable business going forward or whether the process is being run solely for the benefit of the secured creditors • Determine whether restructuring is preferable or whether a sale is in the best interest of creditors and will generate greater recoveries

12. Trade Creditor Post-petition Concerns • Review short term liquidity projections – do the short term cash flow projections allow for reasonableness of the size of the DIP and exit facilities • Is the DIP large enough to get the debtor through a confirmed plan of reorganization with post confirmation financing or is the DIP structured only to get through a 363 sale • Assess the terms of the DIP – preserve and pursue the pre-petition unencumbered assets for the benefit of the GUC’s

13. Trade Creditor Post-petition Concerns • Are the DIP carve outs adequate to cover committee professional fees and investigate the validity of the pre-petition liens • Assess the debtor’s go forward business plan and projections-review the long and short term projections and develop an independent point of view of the business plan along with long term liquidity

14. Trade Creditor Post-petition Concerns • Are locations cash flow positive or negative? Is EBITDA positive or negative? • Has a complete four wall analysis been performed on all locations? • Key Employee Retention Plan (KERP) – are they necessary and are they overinflated? Make KERP performance based upon obtaining key financial metrics.

15. Trade Creditor Post-petition Concerns • Is there a Plan Support Agreement (PSA) and has it been reviewed by the committee? • What does acceptance or rejection of your contract mean to your organization? • Are you entitled to contract rejection damage claims? • Proofs of claims – accounts receivable, proprietary inventory and contract rejection damage claims.

16. Trade Creditor Post-petition Concerns • Investigate pre-petition liens – validate properly perfected liens • Minimize dilution of recoveries – understand contract rejection and potential damage claim (employee wages) • Assess possible causes of action – analyze pre-petition transactions, current and former management, insiders, and challenge blanket releases for negotiations to maximize unsecured creditor recoveries

17. Considerations And Options When Faced With A Troubled Account • Tension between credit and sales • Get the money vs. concern for unusual conduct • Additional dunning or financial reporting • Manner of payment • Changes in invoice terms or credit limits • Letting payment times slide • Settling outstanding amounts

18. Hedging Nonpayment Risk • Letter of credit • Credit insurance • Certificate of deposit • Personal guaranty • PMSI • Consignment • Sale through distributor • Drop ship to vendor controlled warehouse

19. Dealing with Chapter 11 Filing • The preference clawback • Purpose of this provision is two-fold • Creditors discouraged from racing to courthouse • Debtors discouraged from preferring certain creditors • Elements of a preference • Statutory defenses • Contemporaneous exchange • Ordinary course of business • Subsequent new value

20. Responding To Preference Demand Letters • Make sure preference defense analysis has been completed • Was there consistency in the amount and manner of payments which were tendered to you prior and during the preference period? • Was there an absence of any unusual collection activity or other action taken by you to gain an unfair advantage as a result of the debtor’s deteriorating financial condition? • Did you continue doing business with and extending credit to the debtor as a financially distressed customer?

21. Responding To Preference Demand Letters • Was there consistency between the alleged preference payments and the debtor and your payment history and other aspects of the relationship? • Did the debtor ever assert that any type of dispute existed concerning the consistency of the alleged preference payments with the debtor’s prior payments to you as to timing, amount and manner of delivery of the payment and the circumstances surrounding the payments? • Was there any difference in the manner, method and circumstances of the debtor’s payments of the alleged preferences compared to the payments made prior to the preference period?

22. Responding To Preference Demand Suits • Push back • Cost of defense analysis – what discount is the trustee offering? Is your potential out of pocket expense greater than your potential liability as stated in the complaint? Are the trustees numbers accurate? How much money does the trustee have to litigate? Is the trustee simply throwing everything against the wall to see what sticks? Is the trustee basically trying to extort a small settlement? • File an answer to the complaint • File a motion to dismiss the complaint prior to trial based on undisputed facts

23. Responding To Preference Demand Suits • Metrics that can be used in a preference defense analysis are as follow: • Payment days – payment days = payment date - invoice date • Days sales outstanding • Percent current • Percent over 90 days • Average days delinquent/average days beyond terms • AR turnover • Average beyond due date • Net bad debt reserves as a percent of total AR • Collection effectiveness index • Business delinquency score/business failure score/business failure risk class/paydex score

24. Asset Sale Through Chapter 11 • The stalking horse bid is often set just above the amount of the market chain’s secured debt and estimated administrative claims • The timetable to complete a sale of assets continues to compress • Once the bankruptcy sale is complete and the sale is approved by the court, the market chain may propose a plan of liquidation, structured dismissal of the Chapter 11 or conversion of Chapter 7 • If vendor selling to market chain on an invoice-by-invoice basis, vendor’s prepetition claim will be paid pro-rata based on available sale proceeds

25. Chapter 11 Considerations • Keep market chain within 20-day terms • If selling beyond 20-day terms, consider moving from PO-based to supply contract based • If selling commodities to market chain on future date and at fixed price, contract may qualify as forward contract under Bankruptcy Code • Vendor can elect to sell pre-petition claim, at a discount, if customer files for bankruptcy • Vendor has no further obligation to sell to customer