Damage Control

If you're like most businesspeople, you're watching expenses more closely than ever. That kind of prudence is praiseworthy — but are your customers doing the same thing. If not, and if one of them files for bankruptcy protection, your own company could be in for a financial drubbing.

Business insolvency has become a front-burner concern lately. Everyone has heard about WorldCom, with more than $103 billion in assets, filing the largest bankruptcy in history last year. Other recent headline-makers were Enron, Global Crossing, Kmart and US Airways.

Bankruptcy may not be pretty, but in times of lagging revenues it can be the only recourse available to 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. Here's how.


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.

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 says your first reaction 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, "Get Your Lawyer Here.")

Your attorney should make sure that you check the details on what is called a "schedule of liabilities." This document is filed in the bankruptcy court in the federal courthouse of your closest big city. (Some courts have online filing.) 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 the 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. The catch is that in order 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 may fax a notice to the customer and his or her attorney. Additionally, you may send people to the purchaser's location and do an inventory to establish what you can still reclaim.


If your contact information and the amount of outstanding debt is listed correctly on the schedule of liabilities, you are not required to respond. If you see errors, or if the listed debt is marked "disputed," then you should file a "proof of claim." This is a form that shows your company name and the amount of the debt, and whether it's secured or unsecured. There is usually a space to describe the origin of the debt. For example, amounts may be owed for the sale or renting of a Bobcat.

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 schedule, request a copy that the courthouse stamps with date and time. Ask your attorney to send you a copy for fact checking. Note that if your customer goes into Chapter 7 bankruptcy, it is required that you file a proof of claim to protect your interests.

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.


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 get very 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 the 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 be able to 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 for negotiation, they distribute 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 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," says Heidt. "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 the law firm 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 to 20 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."

When you hear about a customer entering bankruptcy, the best way to protect your interests is to react quickly. In any case, you need the help of an experienced professional. Says Agin: "This stuff is not simple and not intuitive, so what you think is the correct thing to do is not always right."

Editor's Note: While this column provides a good background on the bankruptcy process, neither the author nor the editors of AQUA are qualified to give legal advice. Be sure to consult a lawyer for specific situations.

Get Your Lawyer Here

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 recommendations from 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," says Agin. The ABI maintains an informational Web site at abiworld.org. To search for accredited bankruptcy attorneys in your region, go to the Web site of the American Board of Certification (ABC), which is sponsored by the ABI. Point your browser to abcworld.org.
  • Participation in major bankruptcy associations. "Lawyers who get involved with bankruptcy groups spend a lot of time staying on top of the issues," says Agin. In addition to the ABI, the American Bar Association maintains a Committee on Business Bankruptcy. Go to 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 martindale.com, click on "Lawyer Locator" and then on "Location and Area of Practice."

Avoid 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 payment. "Creditors tend to take these warning signs less seriously than they should," says Warren E. Agin, a partner at Swiggart & Agin, Boston. "If nothing else you should put more serious controls in place and keep an eye on those accounts."

An increase in collection time is also cause for concern. "When a company gets in trouble the first thing they try to do is to slow down their accounts payables and speed up their receivables," says Stanley S. Fishbein, president of CapQuest Group, a New Yorkbased 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 Agin. "Or you might say that you will set all of the old invoices aside but you want C.O.D. going forward." As for using a collection agency, that 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."

For More Information

A comprehensive Web-based source of bankruptcy information is available at the Bankruptcy Lawfinder, swiggartag in.com/ lawf ind /. You'll find links to relevant legal resources such as statutes, regulations and court cases, government agencies, and answers to frequently asked questions.

Consider Factoring

Factoring can be one way of sidestepping collection problems down the road. Using this technique, you sell a basket of your receivables to a factoring company, which then turns around and collects from your customers.

Nothing comes without cost, of course. While factors make their money by deducting a percentage (usually 3 percent) from the total amount due, the cost can be worth it in terms of reduced risk and faster cash flow. "Selling your receivables for 97 cents on the dollar might be a better deal than what you could get by collecting out of that account," says Stanley S. Fishbein, president of CapQuest Group, a New York-based specialty finance and consulting company.

Fishbein notes that while some less-than-stellar accounts can be included in what you sell the factor, you will need to put together an attractive group. "Sell off some of your good accounts to create a balance in the pool so the factor will take everything," says Fishbein. "But really bad accounts — such as those that are six months past due — won't be accepted by the factoring company."

When you use a factor you need to be concerned about two things: You don't want your customers to feel you are pressuring them for money, or that your own company is in trouble. Both risks can be minimized through the proper use of language in letters sent to customers. "Most factors use the appropriate language,"

says Fishbein. The letter from the factor might say: "During this rapid period of growth of XYZ Company they have sold your receivables to us." And you can send your own letter to your customers stating that "business is so good that during this period of rapid growth we have decided to hire a factoring firm to handle our accounts receivable."

Factoring can become expensive if the collection agency can't collect within 30 days of the time it buys the basket of receivables from you. After that time, the fee often rises by one percentage point for every 10 days an account is past due.

But there's good news: "Companies take seriously the letters they get from factors," says Fishbein. "Debtors are more inclined to make payments right away because it's widely known that factors report their collection experiences to all the credit agencies."

Doctrine Of Necessity

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.

— P.P.

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