When businesses pay for goods and services, they generally like to receive them. Unfortunately, as any bankruptcy lawyer will tell you, this consistent desire is not matched by uniform experience.
Most recently, the bankruptcy of KSL Media again illustrated the risks and concerns when an advertiser entrusts significant funds to an entity that is too thinly capitalized or, as some allege, guilty of diverting funds that were to be passed through and in breach of a fiduciary duty to its clients. KSL’s bankruptcy, of course, was also noteworthy not because KSL was a start-up, but because it was not. We might expect capitalization risks with start-ups. But KSL was an established media company that failed. So the question remains: how can advertisers protect funds entrusted to suppliers, particularly those that are earmarked for payments to third parties?
First and foremost, a little research goes a long way toward preventing surprise and disappointment. This is true with any supplier, even those not entrusted with funds. But where pass-through funds are given to a supplier, it is irresponsible not to investigate the financial stability of the supplier as a first step.
When considering engaging any supplier, the advertiser should, at a minimum, ask the following questions:
- What is the company’s operations history?
- What does its balance sheet look like?
- How is the entity capitalized? Is the entity funded with capital or debt, and – if the latter – when are interest payments or principle reduction payments due?
- What strain does debt service put on the company’s cash flow and its ability to make capital investments?
- How has the company grown? Did it grow by taking on debt as opposed to organically?
- Are bank references available? Are there any other credit reports?
- Have you seen certified financials?
Where cash is given to a supplier in anticipation of a “pass through” of the cash to the eventual provider of a good or service, several additional questions should to be asked:
- Who “owns” the money as it is transferred along the chain of distribution?
- How are the relevant accounts structured? Are dollars earmarked for the company or are those earmarked for pass-through co-mingled?
- Who has control over those accounts?
- What is the procedure for the release of funds? Who has the right to release the funds, and under what circumstances?
- Are there any “secured” creditors with potential claims to the relevant funds? Over what funds do those secured creditors have a right to assert a claim? Is there an agreement with creditors defining the relative rights to those funds?
- If the funds are not passed through on a timely basis or if they are diverted for improper purposes, what are the ramifications to the advertiser? The KSL bankruptcy best illustrates how the seller (the media company) will go up the supply chain and demand payment from the advertiser, asserting that everyone in the supply chain was an agent for the advertiser. And it’s not just about media buying. It applies to any supplier entrusted with pass-through monies. An astute advertiser will also determine if non-pass-through of the monies creates statutory violations, e.g., sales tax, payroll, and associated taxes.
- Are funds from multiple clients pooled together in a common fund and, if so, how are respective rights to such monies determined?
What advertisers should be wary of is reliance on indemnities or contractual provisions that adopt the concept of sequential liability, or assert that the supplier is acting as a principal and not an agent. All too often, particularly with media buys, the media does not agree with sequential liability or that the media buyer is acting as a principal. Nor is the advertiser necessarily told what the media will agree to. Instead, media outlet forms generally provide for joint and several liability, i.e., the media outlet can go after either or both the media buyer and/or the advertiser. In such circumstances there is no “meetings of the mind” with respect to debtor(s) against whom a claim can be asserted. This creates a textbook case of who is liable to third parties in an agent/ principal relationship. Absent extenuating circumstances, the law is clear: an agent is not responsible for third-party obligations it incurs on behalf of its principal, regardless of whether the principal has paid the agent. While the principal may be able to seek reimbursement from the agent, non-payment by the agent is not a defense to paying the third party what it is due. Over the years, all too many advertisers have been stung by such double payments, and an agent that has either gone bankrupt or diverted the entrusted funds to other (sometimes illegal) purposes.
The bankruptcy of a supplier entrusted with pass-through monies can be even worse. The classic bankruptcy-court example is the case of a buyer who prepays for goods or services, and the would-be supplier goes out of business prior to delivery. In such circumstances, the funds earmarked for the purchase may not be traceable and, even if they are, they may be the subject of a senior claim of a lender or other party and therefore not recoverable. Worse, in some industries, the customer of the bankrupt service provider may remain responsible for the services that the bankrupt supplier was supposed to perform, and liable if they are not performed.
Undercapitalized or over-leveraged suppliers present a challenge to those who do business with them. It is important to make sure that you will get what you pay for. And in order to be safe, a goodly measure of investigation is crucial.