Strategies for dealing with financially troubled customers

While some leading indicators show an upward trend in the economy, many business owners know that collecting receivables remains a challenge. In the last issue of Legal Insights, we discussed initial strategies for businesses to enhance their collections and reduce their credit risks. In this issue, we discuss tools you can use if problems persist.

When it's time to take action against delinquent customers, there's plenty of ammunition:

  • RATTLE YOUR SABER.

    Send a letter demanding payment and threatening further action if the customer does not contact you by a stated date to make payment arrangements. Make sure to check any written agreement with the customer so that you allow at least the minimum specified time for notice of default and the right to remedy the default by making payment. Also, be sure to specify the principal amount due and, if your contract so provides, the full amount of interest and any collection costs, including attorneys' fees, that you are contractually entitled to if you are not paid promptly.

  • TAKE A FIRST PRIORITY LIEN IN OTHER COLLATERAL.

    This is generally the best form of protection but may be unavailable if the customer has a senior secured lender with a blanket lien against all the customer's assets, which is often the case. Consider asking the customer for a subordinated lien if the value of the collateral is sufficient (this may require senior lender consent and can be cumbersome).

  • RELY ON YOUR PMSI.

    Vendors generally retain a purchase money security interest (PMSI) in the goods they sell. With a PMSI, you can repossess the items you sold and resell them as a means of reducing your exposure. Further, having a security interest in specified goods elevates the status of your claim if the customer ends up in bankruptcy. To obtain priority for a PMSI over existing senior security holders you must do the following before the customer receives your goods:

    • Provide notice to other secured creditors that have filed financing statements under the Uniform Commercial Code (UCC).
    • File your own financing statement in the appropriate secretary of state's office.

    PMSIs are not without limitations. Because you have to notify all senior secured lenders to establish a PMSI, taking this step could disrupt the customer's relationship with its other sources of funds. In addition, if the products sold are custom goods, a PMSI may be of little practical value: even if you recover them, you may not be able to resell them.

  • REQUIRE COD PAYMENTS FOR NEW PURCHASES.

    This can be the simplest and best option for treading water and protecting against increased exposure. Customers easily understand this option and might be accustomed to it with other suppliers in this economy—although the more that customers are paying others COD, the less cash they have to pay you.

    Selling goods COD should protect the cash you receive from a clawback by a bankruptcy trustee as a preference (more on this in a future newsletter). But insist on payment by either a wire transfer or a cashier's check to maximize this protection.

    The COD option can have drawbacks. Customers may agree to pay COD for current shipments but, because of a cash flow squeeze, stop paying on old receivables. In addition, if goods are custom made and the customer can't make the required COD payment, you could be stuck with unsalable goods.

  • REQUIRE AN EVERGREEN DEPOSIT.

    An evergreen deposit is a cash deposit used to pay for shipments on order. The cash on deposit is used to pay for an order, and the customer replenishes it before the next shipment or when the amount on deposit falls below an agreed-upon minimum. In some cases a deposit is more practical for the customer than a COD arrangement because it allows for less frequent payments while providing the seller an equivalent protection. Furthermore, if the deposit pays only for current deliveries (as opposed to old receivables), it should avoid a bankruptcy clawback.

    The disadvantages of an evergreen deposit are that it squeezes customer liquidity, and it can be slightly more complicated to set up than a COD arrangement.

  • REQUIRE A STANDBY LETTER OF CREDIT.

    A standby letter of credit (LOC) is issued by a bank, often the customer's senior lender, and represents an unconditional obligation of the bank to pay a supplier when a specified event occurs—such as the delivery of the ordered goods or a customer default. To issue an LOC, the lender will require the customer to post sufficient collateral to cover the maximum amount that can be drawn on the LOC. The lender will treat the face amount of the LOC as borrowed money, thus squeezing the customer's liquidity, and will charge the customer a fee to issue and renew the LOC.

  • REQUEST ADEQUATE ASSURANCE OF PERFORMANCE.

    If a supplier and a distressed customer do not have a written agreement that sets forth such terms, either party may unilaterally change delivery and payment terms. In that case, a supplier should be able to protect itself by requiring advance payments or COD purchases until the customer regains its financial footing.

    If you have a supply agreement or other written contract, however, you will be bound by its terms, but you can demand assurances from the distressed customer. This is a powerful right provided under the UCC. It entitles the supplier in certain cases to stop its deliveries of product until the distressed customer provides adequate assurances that it will pay. Moreover, if the customer does not provide such assurances, the supplier is ultimately permitted to cancel the contract, refuse to perform and sue the customer for breach.

  • REQUIRE A GUARANTY FROM A CREDITWORTHY THIRD PARTY.

    Sometimes a customer's owner will guarantee the customer's payment with a written personal guaranty agreement. Obviously, such a guaranty is only as good as the guarantor's ability to pay personally. You should pay attention in the guaranty agreement to whether the guarantor's obligations are primary or contingent (i.e., do you have to exhaust your remedies against the customer before pursuing the guarantor?), whether you can get an immediate judgment against the guarantor (a so-called cognovit guaranty) and whether the guarantor will still be liable if you grant the customer concessions. A carefully drafted guaranty agreement will address all these questions.

  • CONSIDER SUING AND ASKING FOR A PREJUDGMENT ATTACHMENT.

    A creditor may bring suit and ask for a preliminary court order freezing the customer's assets until the matter is settled in or out of court. This usually prompts a defendant to seek a quick settlement, because it can't conduct business with its assets frozen. Prejudgment attachments may be obtained in only limited circumstances, such as when the claim is for labor, the customer is a foreign corporation or when the customer does or is about to do any of the following:

    • So conceals itself that a summons cannot be served.
    • Is about to remove property out of the jurisdiction of the court, with the intent to defraud creditors.
    • Is about to convert property into money to place it beyond the reach of creditors.
    • Has assigned, removed, disposed of or is about to dispose of property with the intent to defraud creditors.
    • Has fraudulently or criminally contracted the debt.

While the likelihood of success can be enhanced by combining a number of the measures outlined above, consulting counsel experienced in creditors' rights will maximize your chances of getting paid.

—Bruce L. Waterhouse Jr.
waterhouse@nicola.com