Log in to view the full article
If you're like most business people in this challenging economy, you're watching expenses more closely than ever. This kind of prudence is praiseworthy, but your customers may not be doing the same thing. If one of them files for bankruptcy protection, your own company could get a financial drubbing.
Business insolvency has become a front-burner concern in the wake of recent news headlines. Everyone has heard about WorldCom, with more than $103 billion in assets, filing the largest bankruptcy in history last year. Enron, Global Crossing,Kmart and U.S. Airways also made headlines.
Bankruptcy isn't pretty, but in times of lagging revenues, it can be the only recourse for overextended businesses. Unfortunately, such filings for court protection leave payments to creditors—businesses like yours—subject to the will of the courts.
While you can't eliminate the risk of customer bankruptcy, you can take steps to limit your exposure.
Take the right steps
Suppose you hear about the bankruptcy of one of your customers. Maybe you get the information from another customer, read it in a newspaper, or even receive a court notice in the mail. What should you do?
Your first reaction, says Kathryn R. Heidt, chair of the American Bar Association's Committee on Business Bankruptcy and professor of law at the University of Pittsburgh School of Law, should be to stem ongoing losses: "As soon as you find out a bankruptcy has been filed, start demanding cash on delivery from that customer. Don't supply any additional materials or services on credit."
An equally important step, says Heidt, is to contact an attorney knowledgeable about bankruptcy matters. Bankruptcy law is determined at the federal level by the U.S. Bankruptcy Code and at the state level by the Uniform Commercial Code (UCC). (For guidance on finding an attorney, see the sidebar"Selecting a Lawyer" on page 50.)
Your attorney should make sure you check the details on what is called a schedule of liabilities. This document is filed in the bankruptcy court of the federal courthouse of your closest major city. Some courts in today's Internet-savvy world have online filing, and sometimes you can get this document from the debtor's attorney.
Be aware that if you are shipping purchased goods to a customer, you may have what is called a right of reclamation under UCC. This means that if someone files bankruptcy and you have shipped them goods during the 10 days prior to the filing,you may have a right to get the goods back from them. The catch is that, to exercise that right, you have to make a timely and proper demand for the merchandise. Even a couple of weeks of delay may prevent recovery. To reclaim your goods,your attorney should fax a notice to the company and its attorney. Additionally,you may send someone to the purchaser's location to conduct an inventory assessment to establish what you still can reclaim.
File a proof of claim
If your contact information and the amount of outstanding debt are listed correctly on the schedule of liabilities,there is no need to respond. If you see errors, or if the listed debt is marked"disputed," you should file what is called a proof of claim (this is required for Chapter 7 bankruptcy). This is a form with your company name and the amount of the debt, as well as an indication as to whether the debt is secured or unsecured. There usually is a space to describe the origin of the debt. For example, amounts may be owed for the sale or rental of a sander.
Heidt says you may want to file a proof of claim even if the data looks correct. "The debtor may amend the schedule later," she says, in which case your filed document will support your dispute to changes. If you do file your proof of claim, request a copy that the courthouse has stamped with the date and time. Ask your attorney to send you a copy for fact checking.
As a debtor, you will receive all major notices pertaining to the bankruptcy. These include the confirmation of the Chapter 11 plan and the hearing for discharge of debt. You may want to be placed on the list to receive notices of other events the court deems of lesser importance.
After filing your proof of claim, consider how important a vendor you are. If you are a critical supplier, you may be able to get early payment under what is called the doctrine of necessity. This doctrine is not written in the bankruptcy code but has arisen from judicial decisions.
The task here is to convince the court of two things: First, you are essential to the survival of the bankrupt customer. Second, the only way you can continue to supply the debtor is to receive what you are owed. If the court agrees with both points and sees that paying off your bill will lead to the distribution of more money to the other creditors, you may get your money early.
Chapter 7 vs. Chapter 11
There are two common varieties of bankruptcy. Under Chapter 7, a liquidation, the business folds. A trustee, appointed by the court, collects all non-exempt assets and distributes them to creditors. (In contrast, an individual who goes into Chapter 7 may retain some assets and there is a discharge hearing just as there is under Chapter 11.)
If your customer is in Chapter 7, you should look at the amount of money that the debtor has in unsecured assets and the amount of liabilities. The company's finances will be in especially bad shape, and it's likely you're not going to recover much, according to Heidt. "In many cases, it's not worth spending a lot of money on attorneys," she says. "You need to ask, 'What is the likely outcome of the bankruptcy?'
The second common form of bankruptcy, Chapter 11, or "reorganization,"occurs more often than Chapter 7. In this case, the business continues operating and old debts are replaced with new ones of lesser value. The actual dollar amounts and payment schedule are determined through a process of negotiation between the debtor and two committees of secured and unsecured creditors. The committees look at the viability of the business and whether it looks as if the owners will make a go of it. That's important because while the company continues to operate, the old creditors will be paid out of future profits. The final disposition is subject to confirmation by the court judge.
After the two committees work out a plan of negotiation, they distribute what is called a disclosure statement. Once approved by the court, this document is sent for a vote to all unsecured creditors. If the document is approved by at least half of the unsecured creditors who represent at least two-thirds of the total outstanding dollar amount, then the court can confirm the plan if certain other requirements are met.
On the other hand, if voters turn down the plan, the court can still confirm it if something called the absolute priority rule is met: This calls for all of the current owners' shares to be distributed to the unsecured creditors. "Things seldom get to this point," Heidt says. "The vast majority of cases are consensual plans because the shareholders want to keep their company, and they can't keep it without coming to an agreement with creditors."
How much do creditors get on the dollar? "It's really a mixed bag," says Warren E. Agin, a partner at Swiggart & Agin in Boston. "Sometimes creditors get paid in full, but that's fairly rare. There are cases in which creditors get nothing, even in a Chapter 11 filing." Retrieving only 10 to20 percent of the outstanding debt is not atypical, according to Agin. "We always tell our clients to get their claim filed early, but don't expect much. This is why taking reclamation steps early is so important."
Avoiding future problems
Reacting quickly and properly to a customer bankruptcy is critical. Equally important, though, is protecting your business down the road: How can you spot the warning signs of customer bankruptcy?
• Watch for early indicators. Be especially sensitive to what many regard as the two biggest warning signs of pending bankruptcy: A bounced check and a failure to respond to inquiries about late payments. "Creditors tend to take these warning signs less seriously than they should," Agin says. "If nothing else, you should put more serious controls in place and keep an eye on those accounts."
• A lengthening in collection time also is cause for concern. "When a company gets in trouble, the first thing they try to do is to slow down its accounts payables and speed up its receivables,"says Stanley S. Fishbein, president of CapQuest Group, a New York City based specialty finance and consulting company. "So a payables slowdown is a sign there is a troublesome financial situation. You should start to take a closer look at that client and not just take their financial stability on faith."
Determining the exact point at which to get tougher on terms or stop shipping altogether is more art than science. "At some point you may say that you won't ship unless payment is made in 20 days,"says attorney Agin. "Or you might say that you will set all of the old invoices aside, but you want COD going forward." Using a collection agency, however, will cost you a portion of the amount due and will leave a bad taste in the customer's mouth.
Good customer relationships will make collections easier. "Business owners should come down out of the ivory tower and have some customer contact," says Fishbein. "In these times, you want to be close to the customer. For one thing, you get a lot of useful information in the course of face-to-face conversation. For another, the customer who is strapped for cash will more likely pay the creditor he likes before one he doesn't like."
When you hear about a customer entering bankruptcy, the best way to protect your interests is to react quickly. This article has provided a number of common steps that may limit your financial exposure; however, you need the help of an experienced professional. Says attorney Agin: "This stuff is not simple and not intuitive, so what you think is the correct thing to do is not always right."
Bankruptcy 411
A comprehensive Web-based source of bankruptcy information is available at the Bankruptcy Lawfinder at www.swiggartagin.com/lawfind. You’ll find links to relevant legal resources such as statutes, regulations and court cases, government agencies, and answers to frequently askedquestions.
Selecting a Lawyer
When you first get wind of a customer’s bankruptcy filing, you will need to contact a lawyer to protect your business interests. Which attorney to select? Here are some things to look for, according to Warren E. Agin, a partner at Swiggart & Agin in Boston:
• Certification by the American Bankruptcy Institute (ABI). “Although many bankruptcy attorneys are not certified by the ABI, such certification is one favorable indication,” Agin says. The ABI maintains an informational Web site at www.abiworld.org. To search for accredited bankruptcy attorneys in your region, go to www.abcworld.org, which is the Web site for The American Board ofCertification (ABC), which is sponsored by the ABI.
• Participation in major bankruptcy associations. “Lawyers who get involved with bankruptcy groups spend a lot of time staying on top of the issues,” Agin says. In addition to the ABI noted above, the American Bar Association (ABA) maintains a Committee on Business Bankruptcy. Go to www.abanet.org/buslaw/busbnkcy, and click on the “Committee Leadership” link to access names and addresses.
• Listing as a bankruptcy specialist in Martindale Hubbard (one of the most commonly used resources for evaluating and selecting outside counsel). To search for attorneys by specialty and geography go to www.martindale.com, click on “Lawyer Locator” and then on “Location and Area of Practice.”