Business bankruptcy filings are trending downward, due in part to the availability of cheap money and lenders’ willingness to extend or refinance troubled loans. Nevertheless, customer credit risk remains a problem for sellers of goods. A bankruptcy filing notification sets off alarms even among veteran credit managers, who know that it may lead to significant write-offs for their company.
Bankruptcy doesn’t close the door on recouping losses, but the best strategy is to avoid getting mired in a customer’s financial collapse. Here are some steps to reduce risk:
Develop early warning systems. In large or long-term contracts, require the customer to provide financial statements periodically. Even unaudited financials may provide warning of developing issues. Conversely, a customer’s failure to report may provide a basis for early contract termination if you decide to cut your losses. If you fail to take action and the customer files for bankruptcy, you may be forced to perform even if the contract states that bankruptcy constitutes grounds for cancellation.
Obtain purchase money security. Contract clauses retaining title until the seller is paid are ineffective. If you ship goods on consignment, or your customer is a reseller who holds products in inventory, consider taking a purchase money security interest (PMSI) in goods consigned or sold. A PMSI establishes a property interest in the goods to secure payment and afford the seller priority over a customer’s lenders. A PMSI is essential to retain rights in consigned goods. With assistance of counsel, taking a PMSI is relatively simple and inexpensive. It requires a short-form agreement, a file search in the state where your customer is organized (which can often be accomplished online), a form filing and written notice to the customer’s inventory lender. The grant of a PMSI can be incorporated in a frame agreement with other terms and conditions of sale.
Obtain credit enhancement. “Standby” letters of credit, surety bonds and guarantees are independent undertakings by a bank, surety or other third party. They are generally enforceable even if a customer is in bankruptcy, and can provide meaningful credit enhancement. A guaranty generally costs nothing, but there may be problems with enforcement. The guarantor may enter bankruptcy. A guaranty may be “clawed back” if it rendered the guarantor insolvent. But a well-drafted guaranty with a solvent parent company may offer substantial protection. The person signing the guaranty should represent in writing that she is duly authorized to act on behalf of the guarantor and sign in the appropriate capacity. Once a guaranty is in place, take care not to create defenses to payment. If the terms of the customer contract are changed, the guarantor should acknowledge any changes and reaffirm its liability under the guaranty.
Shorten the distribution chain. From a credit perspective, it is safer to sell directly to end-users. Each link in the distribution chain creates additional credit risk. Sellers do not appreciate customers promising to “pay when paid.” If you must sell through a troubled intermediary, a properly structured direct-pay arrangement with your customer’s buyer (with customer consent) is preferable to a joint check.
Watch for changes in payments. Deviations in payment patterns could be a sign of financial stress; monitoring for them may allow you to identify and resolve possible issues short of litigation or bankruptcy. Was a recent invoice paid by the customer’s affiliate, a stranger to the contract? That payment may have strings attached if the affiliate proves to be insolvent. Ask the customer to replace the check (and return it after you receive the replacement).
Invoke statutory rights. Article 2 of the Uniform Commercial Code supplements a seller’s contract rights with statutory rights. Consult with an attorney. Depending on the facts, you may have the right to withhold or stop delivery if the customer becomes insolvent, fails to make progress payments or bounces checks. You may have the right to reclaim goods in possession of an insolvent customer upon timely written demand. Even before payment is due, you may have reason to deem yourself insecure based on bad credit reports, past-due accounts and the “word on the street.” Consider making a written demand for assurances of future performance of outstanding orders, with relief crafted to meet your needs. If your customer refuses to accommodate reasonable requests, you may have a lawful basis for terminating orders without incurring liability for failing to make further shipments.
If your customer files for bankruptcy, don’t assume that all is lost. Reorganization cases occasionally pay creditors in full. Experienced bankruptcy counsel can help to protect your rights.
Pamela Smith Holleman is a partner in the bankruptcy & restructuring practice group and litigation department of Sullivan & Worcester LLP and an adjunct professor of law at Boston College Law School.
