June 8, 2022


EDITOR’S NOTE: This article is the first in a series about how small and mid-sized businesses should deal with customers experiencing financial difficulties.

Whether due to the impacts of pre-pandemic economic trends such as the shift in consumer spending toward e-commerce outlets, the effects of the federal and state governments’ responses to the COVID-19 pandemic, or the problems now arising from ongoing supply-chain disruptions, rampant inflation and plummeting consumer confidence, the chances that a key customer will experience financial distress are high. Consequently, it is more important than ever for businesses to identify customers that are experiencing financial distress and take steps to protect themselves.

This article briefly discusses available sources of information about a customer’s financial condition, common signs that a customer is in financial distress, and practical steps that can be taken to mitigate potential losses in the event of a customer bankruptcy.

Monitoring a Customer’s Financial Condition
There are many ways to monitor a customer’s financial condition. For publicly traded companies, financial reporting required under federal securities laws contains a wealth of information. For larger private companies that have issued bond debt or whose bank loans trade on an open market, credit rating agencies’ reports may be consulted. For smaller companies, credit reports can be helpful. Lastly, whether a customer is large or small, requiring periodic financial reporting as a condition to extending trade credit or entering into a long-term supply contract should be considered.

Signs That a Customer Is Financial Distress
Anything that suggests that a customer may not be able to pay its obligations in full when due is an indicator of financial distress. Common signs of financial distress include:

  • Requests to extend payment terms or increase credit limits.
  • Slow payment of outstanding invoices.
  • Filing of lawsuits against the customer or liens against the customer’s assets.
  • Reports of employee layoffs or management turnover, which may be accompanied by retention of an outside financial advisor or appointment of a “chief restructuring officer.”
  • Receipt of credit inquiries from credit reporting agencies, banks, or other vendors.
  • Downgrades by credit rating agencies of the customer’s corporate debt, or disclosures of defaults under the customer’s bond debt or bank loans.
  • Inclusion of an auditor’s “going concern” qualification in the customer’s public filings.

Mitigating Losses in the Event of a Customer Bankruptcy
To be most effective, steps to minimize potential losses in the event that a customer files bankruptcy should be taken as soon as practicable after signs of financial distress are observed. While not every step discussed below will apply in every situation (and legal counsel should be consulted before proceeding), businesses should consider employing one of more of the following strategies:

  1. Lower credit limits and/or accelerate payment terms. If credit limits and payment terms aren’t set by a long term supply contract, exposure can be reduced by lowering credit limits or requiring cash in advance or cash on delivery payment terms for future shipments.
  2. Require credit support. This can take many forms, including parent/shareholder guarantees, letters of credit, and trade credit insurance.
  3. Obtain collateral. Taking a security interest in the customer’s assets, or a “purchase money security interest” in the material sold to the customer, can significantly increase the likelihood of recovery.
  4. Maximize setoff rights. Managing the timing and amount of any payments due to the customer may enable later offset of those obligations against the customer’s own payment obligations.
  5. Enforce contract rights. Supply contracts, purchase orders and invoices should reviewed to determine whether acceleration of payment terms, cancellation or other remedies are available.
  6. Employ contract law remedies. Article 2 of the Uniform Commercial Code, which governs the sale of goods between merchants, also provides many remedies when a customer defaults, including withholding or stopping delivery goods in transit, reselling goods and suing to recover damages, reclaiming goods already delivered, and canceling the contract and suing to recover lost profits.

NEXT: Addressing the impacts of a customer’s bankruptcy filing and ways to maximize recovery through the bankruptcy process.

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