When an Important Customer Files for Bankruptcy

Can my company do anything to protect itself before an important customer goes bankrupt?

Few things strike more fear in the hearts of business owners than word of a bankruptcy filing by a major customer who owes them a lot of money.  Ideally, your business will never have to manage the headaches caused when an important business partner files for bankruptcy protection.  However, if a company is fortunate enough to be in business for any extended period of time, it will inevitably feel the affects of having to deal with one or more bankruptcy issues, in some form or fashion.  Unfortunately, the inexperience that most companies have in dealing with these issues opens the door to unforeseen, and oft-times negative, consequences.  With the help of competent bankruptcy counsel, your company may avoid a potential catastrophe by taking a few relatively simply steps.

For instance, one simple but often neglected protective step is to require pre-loan or pre-transaction disclosure of credit or other pertinent financial information.  Such disclosures could reveal valuable information that could forecast impending financial difficulties. A prudent business owner should not shy away from requesting such information simply to close the deal.  Nor should he ignore obvious signs of problems with a potential customer, or accept implausible explanations for clear deficiencies.

Another simple step that could alleviate the pain of bankruptcy is to require personal guarantees of corporate accounts.  This is particularly applicable when dealing with new companies without an established track record, or companies with questionable credit histories.  A personal guarantee may allow the creditor/business owner to have a 100 cent-on-the-dollar recovery option against the individual owners or principals of debtor companies in the event of a Chapter 7 or 11 filing.

Similarly, business owners can structure their transactions so as to minimize the impact of a customer’s future bankruptcy.  For example, instead of providing goods or services to a customer/potential debtor on credit, a business owner/creditor can require cash-on-delivery (C.O.D.) payments.  Such payment arrangements would decrease the chances of the debtor/company being able to avoid and recover pre-bankruptcy payments made to the owner/creditors under the preference avoidance provisions of the bankruptcy code.  If C.O.D. credit terms are not available, the owner/creditor might be able to obtain a security deposit against unpaid sums, and/or a security interest in the goods sold, or some other collateral.  The bankruptcy code affords greater protections to secured creditors, and having a valid security interest in the goods sold or other collateral greatly enhances a creditor’s chances of being made whole again despite the initiation of a bankruptcy proceeding.

In most commercial transactions, contracts govern the relationship between the parties.  A prudent business owner should always keep in mind that the bankruptcy code embodies the power to alter contract rights and, because of this fact, the code is itself a part of every contract.  Accordingly, contract drafters should consider including provisions that specify, to the extent permitted by law, how the parties’ view their respective rights in the event of bankruptcy.  Although such provisions of pre-bankruptcy contracts may not be binding after the commencement of a chapter 11 case – indeed, the debtor may choose to reject the contract altogether – such provisions may influence judges as they address post-bankruptcy issues. 

There are several strategies a business owner can use to minimize the impact of customer bankruptcies.  This article is certainly not meant to be an exhaustive list of all the possible remedial steps, but only a discussion of the types of things business owners should think about at the inception of commercial relationships that could ease the pain if the road ahead turns unexpectedly rocky.