Anyone who has been in private business long enough has likely observed a key vendor or customer suffer some form of financial distress or, even worse, file for bankruptcy.
Upon learning that a key customer is on shaky financial ground, while perhaps sympathetic to their customer’s situation, many businesses respond by taking ad hoc actions that are intended to limit the short-term damage to their own enterprises. For instance, a business might force the customer to remit payments via wire transfers or begin implementing collection practices to which other customers are not subject or that significantly deviate from standard industry practices.
But when businesses do this, they are unwittingly putting themselves in the way of potential financial liabilities should the customer ultimately declare bankruptcy, not to mention a burdensome amount of work detangling your company from theirs. We’d like to think the extent of our exposure to a bankrupt customer is a handful of unpaid invoices. But in reality it could be worse – and often is.
For instance, once the sting of getting stuck with a few unpaid invoices begins to fade, you will probably receive, 12 or even 18 months later, a letter demanding that you disgorge all payments received from your former customer in the 90 days before its bankruptcy petition date — return to the company the payments received for products or services provided. These so-called preferential transfer claims are rooted in Chapter 5 of the U.S. Bankruptcy Code, which sets forth how courts are to consider prepetition transfers of a debtor’s assets, such as when they pay an unsecured supplier’s bill.
The intent of the law is to take back monies that were paid to the “preferred” vendor and equally redistribute those monies to all creditors. While the fairness of this is debatable, the harsh reality is that the Code creates significant liability for enterprises that are engaged in commerce with distressed companies — something manufacturers and suppliers need to be especially mindful of given the number of recent and anticipated bankruptcies in the retail industry.
Once a creditor receives the demand letter — or becomes party to a lawsuit — the die is cast, and there is very little that can be done. The set of facts brought before the judge will be comprised of processes and actions undertaken well before the debtor filed for bankruptcy, and a creditor’s eventual liability hangs on those facts. That’s why it is so important to plan ahead and put into place sound business practices that can minimize exposure to bankruptcy preference claims well before a key customer declares itself bankrupt. So what should be done?
Keep a Close Eye on Your Customers’ Health
Ideally, it should never be a surprise when a key customer or supplier declares bankruptcy.
The reality, of course, is that surprises do occur. For instance, last year, the entire North American production line for one automotive manufacturer was threatened with a potential shutdown when the automaker’s only supplier of acoustic damping materials went bankrupt and halted its operations in a move that took the automaker by surprise.
It is no less damaging when a manufacturer’s key retailing customer enters bankruptcy. When a large shoe retailer declared bankruptcy in April, it owed its trade creditors some $240 million. These creditors no doubt learned the importance of monitoring their customers’ financial health, although for some the opportunity to learn the lesson came too late.
Keeping a close eye on the financial health of the customer is always a manufacturer’s first line of defense. Publicly reported information and news outlets can be helpful in this regard. If you have the luxury of a supply contract you can include terms that require the customer to provide you with periodic financial information. But even without this detail sometimes the reddest of red flags can be found within the data that suppliers have right at their fingertips.
For example, each existing customer relationship will have an established baseline of days-sales-outstanding (DSO). Manufacturers and suppliers should invest in resources that automate the analysis of DSO information so they can have real-time comparisons of every customer’s 12-month moving DSO average versus that of current payments. If there is a substantial deviation away from the 12-month moving average — especially when the deviation is coupled with other indications of financial distress — then this should be a big red flag for potential preference exposure once the customer files for bankruptcy.
Be Consistent in Dealing with Customers
Ascertaining the true financial health of customers, however, is only half of the solution to limiting exposure to bankruptcy preference claims.
In these instances, one of the most powerful ideas at a creditor’s disposal is the so-called “ordinary course of business” defense which, ideally, shields a creditor from much of the preference analysis that courts undertake and that could potentially increase an individual creditor’s liability. In order to credibly assert this defense, however, there has to be an underlying pattern of commercial behavior that defines what is “ordinary.” Establishing consistency in one’s dealings with customers is of paramount importance in the bankruptcy setting. For example, one can demonstrate consistency by showing that the DSO for the invoices paid during the 90-day period before bankruptcy was very close to the 12-month DSO average.
Consistency doesn’t just apply to specific dealings with a troubled customer. There also needs to be an enterprisewide effort to establish and apply uniform procedures for dealing with past due invoices and credit limits. This across-the-board consistency is critical because, when any particular customer shows signs of weakness, the methods used for addressing the situation will then come to be seen as standard operating procedure rather than the desperate one-off attempt to “opt out” of a relationship with a financially distressed customer.
It is also important that each customer’s payment terms are consistent with the industry at large. If payment terms are relatively extreme — i.e., very low or very high for your industry — they can jeopardize a manufacturer’s ability to assert the “ordinary course of business” defense against clawback actions. Of course, excellent, consistently applied credit practices cannot solve every issue, but they can significantly reduce a manufacturer’s or supplier’s exposure to bankruptcy avoidance actions.