All businesses and industries can be subject to a customer or multiple customers filing for Chapter 11 bankruptcy protection. While some companies have the resources to get through an economic decline, all companies should take steps to protect themselves against lost revenues when its customers do not fare as well.
Proactive measures to manage and even reduce credit risks can assure that a company will not suffer an even greater loss when its customers file for bankruptcy.
Some of the possible steps that a company can take to minimize credit risk and protect itself against a customer’s bankruptcy filing include:
- Avoiding long-term contracts with at-risk customers: Because the U.S. Bankruptcy Code can potentially eliminate the ability to terminate a long-term contract with a bankrupt customer, it may be advisable to enter into only month-to-month contracts with any customer who is potentially at risk.
- Structure contracts that qualify for administrative claims: Under the Bankruptcy Code, there is an allowance for “administrative claims” against a customer for the value of any goods received by the customer within 20 days before the filing of bankruptcy, as long as the goods have been sold in the ordinary course of business. Thus, if a customer files for bankruptcy, the company would have the right to a 100% payment for the value of goods received by the customer for the 20 days before the bankruptcy petition was filed.
- Requiring a deposit from the customer: For customers who do not agree to the 20-day payment term, you can require a deposit equal to the value of approximately 40-60 days of goods supplied. Each month thereafter, the company can invoice the customer for the amount needed to replenish the deposit account. This, coupled with 100% administrative claim rights on goods supplied within 20 days, can substantially insulate the company from credit risk.
- Purchase money security interests: The Bankruptcy Code does not allow a customer to file a preference action for payments made prior to the bankruptcy if the company has a “security interest” in goods sold to the customer. To achieve this protection, the security interest must secure the value of future goods sold as of the signing of the security agreement. This does not include value of past goods sold. In order to take advantage of this protection, the financially distressed customer should be asked to sign a “purchase money security interest” agreement in favor of the company.