Four Steps to Spot, Prep for a Customer’s Bankruptcy Filing

With bankruptcy looming, you could be looking at thousands, if not millions, of dollars of unpaid invoices, inventory, and work in process with no ...
Andrew FlameOctober 21, 2016

When your business customer is showing signs of financial distress, it can be a frightening and uncertain time. With a possible bankruptcy on the horizon, you could be looking at thousands, if not millions, of dollars of unpaid invoices, inventory, and work in process with no buyer.

Andrew Flame

Andrew Flame

Businesses can take proactive steps to prepare for a customer’s bankruptcy.  These can help them legally recover what is due them, while continuing to maintain a relationship with the customer post-bankruptcy. These steps are also important to shield the business from aspects of the bankruptcy law that can put it at risk for penalties or repayment of amounts received from the customer.

Here are four steps you and your company should take to identify a customer in financial distress and to prepare for that customer’s potential bankruptcy.Opinion_Bug7

1. Look for warning signs your customer is in financial distress. The key to good collection practices and pre-bankruptcy planning is recognizing that your customer is having financial problems. Look for changes in your customer’s historical payment or purchasing patterns. These could include the customer’s stretching of the time it takes to pay your invoices, changing its method of payment, or submitting an order that’s uncharacteristically large or small in quantity or value.

Another sign is sudden workforce changes like employee layoffs, changes in the senior management team (particularly the customer’s CFO), or hiring of a chief restructuring officer or crisis manager.

Finally, check for lawsuits against your customer by its other suppliers or its customers.

2. Evaluate your relationship with the customer.  To enable you to make informed decisions about the future of your relationship with a financially-challenged customer, you must first gather information internally and from external sources, including the customer itself. Many companies make it through times of financial distress without resorting to the bankruptcy process. The question is whether you want to be part of your customer’s efforts and maintain your existing relationship into the future.

The first step is to evaluate your financial exposure to your customer by determining how much the customer owes you, both in real dollars and compared to monthly or annual sales and profits. This analysis should include review of the volume and value of goods/services sold to the customer and the importance of future sales to your financial viability.

You should also evaluate your contracts with the customer to determine what flexibility you have in changing these agreements. Questions to consider include:
• How do your pricing and contract terms compare to market terms? Can you sell the same goods or services to a different customer at better pricing and terms and with less risk?
• Does your customer have an alternative source from which it can readily get the same goods or services? If not, can you increase pricing or improve other terms in your contract to reduce risk and/or increase future profit?
• Are you contractually obligated to sell to your customer? Does your agreement with the customer require you to continue delivering goods or services? Do you have a basis under the contract or applicable law to terminate your relationship with the customer?

Beyond the more objective financial and contractual issues, you need to gather anecdotal information on the client’s situation and its plan for navigating its financial situation. Your customer’s senior management should present you with a clear explanation of the financial challenges facing their company and its plan for improvement. You need to have trust and faith in both the plan and management.

Don’t trust your judgement only. Ask suppliers and other clients about their opinions and willingness to continue working with the customer, but be careful about sharing financial information.

3. Stop collection efforts as required by the Bankruptcy Code’s automatic stay.
Upon the filing of a bankruptcy petition, the “automatic stay” of the U.S. Bankruptcy Code goes into effect immediately. This means that creditors and others must immediately cease all efforts to collect what is owed to them pre-bankruptcy, with some limited exceptions. You cannot call your debtor/customer seeking payment of amounts owed for the pre-petition or pre-bankruptcy period or take other steps to collect your pre-bankruptcy receivable.

Also, you can’t attempt to take possession of property owned by or in the possession of your bankrupt customer. As for your contracts with the debtor/customer, despite having not been paid, you cannot terminate the contract without prior court approval.

The automatic stay is intended to maintain the status quo while the debtor, its creditors, and the bankruptcy court figure out how creditors are going to get paid. But if a creditor is suffering material harm as a result of the automatic stay, the creditor can seek the Bankruptcy Court’s assistance.

Debtors and bankruptcy judges take violations of the automatic stay seriously and violations can result in compensatory or punitive damages.

4. Create separate accounts for pre-bankruptcy and post-bankruptcy receivables. Your debtor/customer and the bankruptcy court will make a distinction between money that is owed to you (and other creditors) pre-bankruptcy and post-bankruptcy, respectively.

It’s a good idea to have your accounting department keep track of what goods and services are delivered post-bankruptcy versus pre-bankruptcy. To ensure that you can properly track amounts owed for goods or services delivered post-bankruptcy, set up a new customer account for invoicing of amounts owed and received for your post-bankruptcy delivery of goods and services. This new account should be separate and distinct from the account for the pre-bankruptcy period.

Another reason to set up a separate post-bankruptcy customer account is to avoid violating the automatic stay. The automatic stay prohibits you, for example, from applying post-bankruptcy payments to pre-bankruptcy receivables.

Further, you will be prohibited by the automatic stay from setting off (i.e. netting) amounts your debtor/customer owes you pre-bankruptcy from amounts you may owe your debtor/customer for the post-bankruptcy period.

Once I had a client whose computer system automatically set off amounts owed pre-petition by one of its bankrupt vendors when processing payment for that vendor’s post-bankruptcy services. Although my client replaced the check within 48 hours and was not sanctioned by the bankruptcy court, it had to endure two months of litigation defending against the debtor’s allegations that my client had violated the automatic stay.

By following the above steps four steps, you and your company will be well prepared to spot and curb risk arising from a customer’s financial distress.

Andrew Flame is a partner in the Philadelphia office of Drinker Biddle.