Over the last two years, courtesy of a once-a-century pandemic, government-mandated business closures, nationwide stay-at-home orders, and—unprecedented—disruptions to the global supply chain have illuminated, previously unknown, vulnerabilities across a whole host of industries. Would anyone have seriously questioned the viability of office space two years ago? Now, inflation, in keeping with the recent chaos, may be upending the viability of another tried-and-tested institution: the supply contract.
Supply contracts, a critical component of many retailers’ operations, have long provided certainty to both the vendors who supply goods and the retailers that sell them. Typically, supply contracts involve retailers purchasing and vendors selling goods at an agreed upon price and quantity. In recent memory, this agreement is a win-win. Both parties sacrifice a bit of optionality, in terms of haggling for lower or higher prices on a one-off basis, but, in turn, obtain a sense of security. Enter inflation.
While inflation is, like taxes, inescapable, current levels are beyond the market’s expectations. As a result, many of the prices vendors accepted in supply contracts may no longer be sufficient to break-even, much less profit. Vendors trapped in these economically unviable contracts may find salvation in the unlikeliest of places: bankruptcy.
Phoenix Services International LLC, a large provider of on-site steel mill services, filed for bankruptcy in the United States Bankruptcy Court for the District of Delaware on September 27, 2022.1 In his first-day declaration, Phoenix’s CFO notes that Phoenix’s most significant challenge is its customer contracts. Among other things, inflationary pressures appear to have rendered Phoenix’s customer contracts unsustainable, eating away at Phoenix’s liquidity. To this end, bankruptcy—often viewed as a “cure” worse than the disease—offers vendors, like Phoenix, a way to do what, likely, could not be done otherwise: renegotiate.
Section 365 of the bankruptcy code enables debtors to assume or reject executory contracts.2 While a debtor must “cure” defaults under an executory contract before assuming it, there is no such requirement for a debtor to reject an executory contract. Furthermore, rejection under section 365 amounts to a prepetition material breach of the contract, giving the counterparty a claim for damages, which, almost invariably, is paid in “bankruptcy dollars,” as opposed to “real dollars.” This ability to, unilaterally, terminate, at minimal if not de minimis cost, an otherwise binding, but unsustainable, supply contract offers a troubled vendor something critical: leverage.
Without section 365, these vendors’ counterparties would have no incentive to renegotiate these, now negative value, supply contracts. The ability to reject these supply contracts, however, creates leverage such that counterparties may willingly renegotiate at prices that may be below market, but are significantly higher than the initial, unsustainable price. After all, counterparties who refuse to “play ball” may have these crucial supply contracts rejected, for often de minimis breach payments, and then be forced to renegotiate, on equal footing, these critical agreements.
Whether Phoenix’s filing will be indicative of a larger trend remains to be seen, but one thing is clear: Both retailers whose contract-counterparties may use bankruptcy to force renegotiation, and vendors currently entering into supply agreements should consider inflation and how it might impact current or prospective supply contracts.
1 In re Phoenix Services Topco LLC, et al., 1-22-BK-10906(MFW), (Bankr. D. Del. 2022).
2 11 U.S.C. § 365.