Ettelman & Hochheiser, P.C.

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ARTICLES AND NEWSLETTERS

“THE LEGAL BUZZ”
BANKRUPT BREWERS AND THE
EFFECT ON DISTRIBUTORS

If you want a sure fire way to raise the blood pressure of the chief financial officer if any manufacturer or supplier, just tell them that one of their wholesaler customers has filed bankruptcy. Immediately they assume that whatever money they are owed will not be paid. Unfortunately, more often than not this turns out to be the case. But what about when the shoe is on the other foot and the supplier files for bankruptcy? What effect does that have on wholesalers?

At first blush, you might think that the effect is not that great because typically suppliers do not owe wholesalers significant sums of money so wholesalers do not have to worry about getting paid. Suppliers do, however, typically “owe” wholesalers product – unfilled purchase orders – and certainly filing bankruptcy can have an adverse effect on the supplier’s ability to fill these orders both in the short-term and the long-term. A less obvious but even more significant issue for wholesalers of bankrupt suppliers is the potential ability of a supplier to terminate a wholesaler’s distribution agreement – even in the face of a state beer franchise statute which allows termination only for cause. By now you must have heard about the recent bankruptcy filing by Pittsburgh Brewing Co., the makers of Iron City Beer. Brewing bankruptcies are not as uncommon as you might think. Prior to the Pittsburgh filing, G. Heileman, Stroh’s, Schmidt’s, Oldenberg, Ahrens, Evansville and Anchor, to name a few, all had filed for bankruptcy. Certainly, it is not far fetched that the current slump in the industry could be a harbinger of other brewery filings. Hopefully, that is not the case, but if it does happen, as the boy scouts say, it’s always best to be prepared. In this article, we will focus on what we believe is the most troubling aspect of brewer bankruptcies; the potential ability of the brewer to terminate wholesaler distribution agreements – even in the face of a state beer franchise statute which prohibits termination without cause.

BACKGROUND ON THE FEDERAL BANKRUPTCY LAWS

Contrary to popular thought, bankruptcy is not a four letter word. Bankruptcy (at least in the context of Chapter 11) is simply a means by which a financially troubled company is given the opportunity to reorganize its business; primarily by relieving it of certain debt and other obligations. Chapter 11 reorganizations are based upon the idea that otherwise fundamentally sound businesses are entitled to a little breathing room in order to attempt to put together a plan, which is subject to creditor approval, to repay their debts and remain in business. The breathing room is accomplished by Section 362 of the Bankruptcy Code – the automatic stay – which prevents creditors from attempting to collect their obligations while the company is still in bankruptcy. The automatic stay is perhaps the single largest reason that companies file for reorganization. All lawsuits are stayed, all attempts to collect debts are stayed and all payments to unsecured creditors are stayed as well. Thus the Debtor is free from emergent issues that are interfering with the normal operations of the company and, in theory, can attempt to formulate a plan for repaying its debt – typically in a vastly reduced amount – over time.

A perfect example of the use of the automatic stay is the recent Pittsburgh filing. You may recall hearing that Pittsburgh owed millions of dollars for delinquent sewage charges and to its employees’ pension fund. In fact, the brewery was threatened by the Pittsburgh Water & Sewer Authority with having its water and sewage shut off if they did not pay. We’re not brewers, but we imaging it’s pretty tough to make beer without water! By filing, the automatic stay precluded the utility from turning off the water, and the beer has continued to flow.

More important to distributors however, is the ability of a debtor to either assume or reject executory contracts. Generally speaking, an executory contract is one where both parties to the agreement have additional obligations yet to perform. Significantly, franchise and distribution agreements have been recognized as “executory contracts” under the Bankruptcy Code. Section 365 of the Bankruptcy Code sets forth rules under which a Debtor may “assume” or “reject” an executory contract. Assumption means that the Debtor has elected to perform the contract. Rejection means that the Debtor has repudiated or cancelled the contract. If a Debtor rejects an executory contract the other party to the agreement has the right to file a claim for damages, however, the claim is deemed to arise the day before the filing of the petition. What this means is that the claim is typically lumped together with all other pre-petition unsecured claims, and paid, if at all, at a fraction of the total value.

For example, if Pittsburgh was to reject a distribution agreement with one of its wholesalers, the wholesaler would file a claim for the full value of the terminated distribution rights. Let’s assume that value was $250,000. Then, let’s assume that the Debtor’s ultimate plan provides for the payment of 20% of unsecured claims. The terminated distributor would actually receive only $50,000, and most likely over a period of years. Furthermore, the value of the terminated distribution rights might be subject to determination in the bankruptcy court by a bankruptcy judge; typically not a venue which is prone to granting high valuations.

Obviously, the ability to reject distribution agreements is a powerful tool. Does it mean, however, that if a brewer in bankruptcy attempts to reject a distribution agreement the wholesaler is toast? Fortunately, the answer is not necessarily. Once again, wholesalers have a weapon and once again it is the Twenty-first Amendment to the Constitution.

G. HEILEMAN’S ATTEMPT TO TERMINATE SOME OF ITS WHOLESALERS

As most of you probably recall, G. Heileman Brewing Company declared bankruptcy in the early nineties. Alan Bond, the Australian financer and yacht racing maven, purchased Heileman in 1987. Ironically, Bond’s first purchase in the United States was Pittsburgh Brewing, which he had bought the prior year. Bond paid the astronomical sum of $1.7 billion for Heileman, then the fourth largest brewer in the United States. Brewing legend Russ Cleary had built Heileman from a small regional brewer into a powerhouse, but Bond’s financial team severely overvalued the brewer.

Soon after the purchase, Heileman’s sales began to decline. Bond’s empire in Australia also began to crumble and in 1991, faced with declining sales and huge bank debts, the highly leveraged Heileman was put into bankruptcy and ultimately taken over by its bank lenders. Once in bankruptcy, Heilemen attempted to consolidate its distribution network. One of the distributors targeted was an Oregon distributor, Maletis, Inc. Heileman asked the Bankruptcy Court to allow it to reject its distribution agreement with Maletis. Maletis opposed because Oregon State law requires terminations to be for good cause only. In colorful language, the Bankruptcy Court judge described the issue as follows:

Like the Debtors before us, we are required to brew the hops of law to arrive at a result that satisfies the Debtor’s thirst, for rehabilitation and Maletis’ quest for the high life in the State of Oregon.

Translated, the Court had to resolve the conflict between federal law - the Bankruptcy Code’s provision which allowed Heileman to terminate Meletis’ distribution agreement - against state law - Oregon’s beer franchise statute which prohibited terminating beer wholesaler agreements without good cause.

Fundamentally, under the Supremacy Clause of the United States Constitution, Federal statutes such as the Bankruptcy Code pre-empt or prevail over conflicting state statutes. In fact, it is virtually beyond dispute that state franchise laws which prohibit termination without cause are inapplicable under the Supremacy Clause of the Constitution because such state laws conflict with the Bankruptcy Code. However, the inquiry does not end there. As one court has noted, beer is not cheese, and the rules that apply to cheese do not necessarily apply to beer.
Fortunately for Maletis, and potentially for beer distributors in other states with beer franchise statutes which prohibit termination without good cause, the Bankruptcy Court found that because Oregon’s statute was a direct exercise of the states’ powers to regulate the distribution of alcohol under the 21st Amendment, Heileman could not reject Maletis’ distribution agreement. In other words, the Bankruptcy Court held that because the state law was supported by the 21st Amendment, the state law trumped the federal law.

HEILEMAN COULDN’T BUT OTHERS MAY

Although Maletis was successful in avoiding termination of its distribution agreement, the prognosis for other distributors faced with the precise situation is not by any means certain. As our prior articles on direct shipping reflect, the extent of the application of the 21st Amendment has arguably been limited by recent decisions. Therefore, even though the 1991 Heileman decision has never been overturned, and no other courts have ruled on the precise issue, it is far from clear that a court would reach the same conclusion today. The Bankruptcy Code is an exercise of Congress’ power under the Commerce Clause. The Heileman decision represents one of the extremely rare cases where a state statute was deemed to take precedence over a conflicting federal statute. Several recent cases, however, have held that the Federal Arbitration Act (another act of Congress) took precedence over conflicting state beer franchise statutes. One case even suggested that the 21st Amendment has no application to Supremacy Clause issues, stating that if Congress has acted then a conflicting state law is inapplicable. This is an extremely narrow view, however, and one that finds little support in Supreme Court precedent. Moreover, in these arbitration cases the courts have specifically held that the competing state interest – having disputes decided in a court rather than by an arbitrator - was not a “core” power under the 21st Amendment. On the other hand the state interest in not allowing distribution agreements to be terminated without cause would seem to implicate a “core” power and thus a wholesaler faced with the rejection of its distribution agreement by a bankrupt supplier would have a more compelling argument against enforcement of the conflicting federal law.

BE VIGILANT

So, is there anything that a wholesaler can do to avoid the potentially drastic problems that arise if one of its suppliers files bankruptcy? As usual, there is, but the key is diligence and persistence. First and foremost, do everything in your power to assure that your state has legislation which prohibits termination without good cause. Without such state legislation, a bankrupt supplier can virtually reject your distribution agreement at will. Next, pay attention. If you are getting concerned that a supplier is having financial problems, you should probably stock up on inventory to the extent feasible. This way you can avoid potential adverse effects of short-term supply problems which frequently occur when financially troubled companies file for bankruptcy. As far as long-term supply problems, including potential termination, are concerned the old adage “don’t put all your eggs in one basket” is probably the best advice. Diversification is important not only in your investment decisions, but also in your businesses. The more brands and volume you have, the less you will be affected by the potential loss of any one brand.