Learn how to avoid the trickle-down effect of your customer's financial trouble.

Consider this scenario: Your longtime customer is experiencing financial troubles and rumors abound that he is heading for bankruptcy. He has just called and asked you to take on a new job for him. You have worked with him for years, but are afraid that he might not be able to pay-and in this economy your cash flow is already tight. However, because of the economy, you are slow and need the work. Besides, you think, if you help him now when others will not, it might benefit you if and when he turns his business around. What should you do?

Working with financially troubled customers is risky business. Some commonly held beliefs are counterintuitive because of the rules of bankruptcy. For example, you might be more secure selling to a customer in bankruptcy than to a customer not in bankruptcy. Knowing some basics about bankruptcy and some of the signs a customer might be headed for trouble can help you choose your course of action and keep your customer's bankruptcy from becoming yours.

The Automatic Stay

When a company files bankruptcy, the automatic stay goes into effect. The automatic stay prevents you from attempting to collect prepetition debts-debts that arose before the company filed for bankruptcy-from the bankrupt company. Attempting to collect in violation of the automatic stay can cause trouble for your company and might cause a bankruptcy court to disallow your claim. If a customer files for bankruptcy, stop all collection efforts until you understand the situation. If the receivable is large, it might be worth consulting a professional who specializes in bankruptcy.

The Absolute Priority Rule

The order in which creditors of a company in bankruptcy get paid is dictated in the bankruptcy code by something known as the absolute priority rule. According to the absolute priority rule, creditors of a lower priority are not paid until all creditors of a higher priority have been paid in full. A bankruptcy can be a very complicated process and the absolute priority rule is not always absolute.  All things being equal, it is better to be a higher priority creditor.  It is important to know where your claim stands in priority. The priority is, briefly, as follows:

1. Secured creditors

2. Liabilities incurred during the bankruptcy

3. Liabilities incurred between the filing of an involuntary bankruptcy and the conversion to a voluntary bankruptcy

4. Wages ($10,000 within 180 days of filing)

5. Employee benefit plans ($10,000 per participant)

6. Amounts to farmers and fishermen

7. Personal deposits ($2,225)

8. Taxes

9. Unsecured creditors


10. Equity holders

When selling to a customer who might be headed for bankruptcy, it is better to be a secured creditor than an unsecured creditor. If you are a contractor, be certain you are taking the necessary steps to protect your lien rights so that if the customer does file, you will have a higher priority, and thus a greater likelihood of getting paid in full. If you are selling goods or providing services to which a lien does not normally attach, as is the case with mechanic's/contractor's liens, perhaps you can negotiate for a lien as a condition of making the sale. However, you must negotiate for the lien at the time of the sale. Generally, if you acquire the lien after the fact, the lien will not be valid.

Exercising your right of reclamation is another way to acquire a lien if you have shipped goods. Basically, this allows you to demand return of the goods you provided. If the client files bankruptcy, by making a demand for reclamation you may obtain a lien on assets or move your claim to a higher priority. If your receivable is large, it is worth consulting a professional experienced in bankruptcy who will explain your rights.  The period of time to make your claim is short, so move immediately.

Understanding the absolute priority rule also helps you to understand why it might be safer to sell to a company in bankruptcy rather than a company on the edge of bankruptcy. Because of the absolute priority rule, if you sell on credit to a company the day before it files for bankruptcy, you have to stop all efforts to collect and you become an unsecured creditor, near the bottom of the list of payment priorities. It could be months or years before you get paid and then it might be pennies on the dollar, or nothing at all. However, if you sell to a company the day after it files for bankruptcy, you become an administrative claim in the bankruptcy and you are near the top of the list of priorities. In order to continue to operate in bankruptcy, a company must meet its obligations as they become due. Therefore, as counterintuitive as it seems, it may be safer to sell to a company operating in bankruptcy than to a company teetering on the edge.

Preference Claims

A problem in selling to a company teetering on the edge of bankruptcy is the potential for preference recoveries. A payment received from a company within 90 days before it files for bankruptcy might be a preferential payment. The bankrupt company can demand that you return payments received in the 90 days before the company filed for bankruptcy even though it owed you the money.


There are, however, defenses against a preference claim. If a payment was made in the ordinary course of business, you have a defense against a preference claim. For example, if a regular customer who normally paid you in 60 days continues to pay you in 60 days during the 90 days before filing for bankruptcy, you have an ordinary course defense. There is also an exception if new value is provided. For example, if a customer pays you and you contemporaneously provide goods or services of an equal value, you have a new value defense.  It is better to avoid getting into a situation where you might expose yourself to preference claims.  Reduce your exposure by staying on top of your receivables and keeping them current.

Recognizing the Signs

Knowing signs that a customer is headed for trouble can also keep you out of trouble. Have payment terms slipped? This is often an early sign that a customer is headed for trouble. Find out why. Do not be bashful. The longer you wait, the harder it becomes to straighten out.

Has there been a change in purchasing patterns? For example, has a customer suddenly started ordering more? This could be a sign of an improving customer relationship and that your sales efforts are paying off-or it could be a sign of a customer headed for trouble. Other suppliers might have cut him off for non-payment so he is increasing his orders and the amount that he owes you. The same holds true for a new customer. In short, it pays to know your customers.

What to Do if a Customer Files for Bankruptcy

If a customer files for bankruptcy, quick action can lessen your losses. As discussed above, stop all collection efforts and determine if you have any right of reclamation. Determine how much you are owed and assess your likelihood of recovering any or all of your accounts receivable. When a company files bankruptcy, it must disclose its financial affairs so you will be able to assess the company's financial situation. You must also assess whether to continue selling to this customer. Assess whether he will be able to meet his obligations as they become due, as well as his chances of emerging from bankruptcy.

You also need to assess your own financial situation. What will the loss of the customer and the loss of the receivable mean to your business? Will it cause your cash flow to deteriorate so that you begin to have difficulties? Will the loss of the receivable cause your line of credit to be out of formula? Are you in danger of violating bank covenants?

A financial model of your business can help you answer these questions. In fact, it is good practice to maintain a financial model of your business in good times and bad so that you can plan for growth and analyze the impact of negative situations such as a customer's bankruptcy. The more warning that you have of impending trouble, the more options you will have in dealing with the problem.

If you have customers, eventually you will have a customer in trouble. If you know your customers and maintain discipline in collecting receivables and keeping records up to date (particularly if you have lien rights), your customer's bankruptcy does not have to become yours.


Construction Business Owner, November 2010