Five Tips to Protect Yourself From Your Cash-Strapped Customer

by Ryan Hardy

 It’s a troubling scenario: A customer who has reliably paid his bills on time begins slow-paying. Sixty days turns to 90 and 90 to 120. But finding customers is challenging, and you work hard to keep the ones you have. So your instinct is to accommodate them as much as you can.

That’s a fine instinct, but it must have its limits. It is important to remember that sometimes a customer may be in worse condition than he first appears. And if he becomes insolvent while you’ve been extending him unsecured credit – providing services on a net-30 basis, for instance – his problem has become your problem.
Here are five ways to protect yourself. The details necessarily vary by industry and circumstance, but keep these steps in mind.
1. Recognize the signs. If you’ve received a notice of bankruptcy, you’ve already missed out on your best opportunities to help yourself, so you have to catch the signs early. Yes, you raise an eyebrow when you hear someone is going to “meet with their lender next month.” But you must be vigilant for other meaningful changes in behavior. The customer you chased for years who suddenly shows up at your door may only be dissatisfied with the fact that your competitor’s payment requirements are too strict for his cash-strapped position. The customer who always paid by business check who is now paying with a personal credit card probably has a reason for it – and it’s not so she gets the bonus miles.
Understand, too, that these changes in behavior are important for another reason: If the customer files for bankruptcy protection and files a preference action to claw back payments you received in the 90 days preceding her filing, these changes may prevent you from successfully asserting the powerful “ordinary course of business” defense that might otherwise allow you to keep your money. In short, by failing to recognize these changes, you may not only find yourself with uncollectable A/R, but you may also have to return money you’ve already received.
2. Consider contemporaneous or advance payment. This will not be feasible for everyone. You must consider your industry, the number of competitors looking to take the business and how important your product is to this customer. But if you are observing signs of financial difficulty from your customer, this is something to consider – even if it means offering a small discount. Bonus: no lag in receivables!
3. Know the consequences of your dunning letter. In determining whether a bankruptcy debtor’s payments to you can be recovered by the bankruptcy estate, courts will look at changes in your behavior as creditor. If you commence collection efforts, the chances increase that you have to return payments you receive. That doesn’t mean it’s not worth it, but you should make the decision thoughtfully, not reflexively. It may be in your best interest to simply cease doing business with that customer instead. Which leads to …
4. Don’t be afraid to stop doing business with a customer. It seems obvious, but we see small-business owners overlook this solution all the time. It’s painful, but sometimes your choice is between doing work and not getting paid or not doing work and not getting paid. The latter is better. Again, there’s no need to be hasty. Run a credit check. Reach out to your contacts to see whether the conditions in your customer’s industry warrant your concern. But remember that you owe it to yourself to make an honest assessment.
5. Understand your leverage in bankruptcy. Trade creditors often don’t fare well in bankruptcy, but you may have more leverage than you think. For instance, if you sold tangible items to your customer in the 20 days before he filed his petition, you may be entitled to some priority treatment. Certain “critical vendors” may be able to leverage their importance to obtain preferential payment as encouragement to continue doing business with their bankrupt customer’s estate, although recent developments have brought this theory into question. Finally, even if you cannot justify incurring legal expenses yourself, consider banding together with other creditors to form a creditor committee whose legal expenses will be paid out of the bankruptcy estate. If your customer is a substantial one, you are wise to contact an attorney if the customer has filed for bankruptcy or you think he will.
Cash-strapped and insolvent customers have unfortunately been a frequent spectacle over the last few years and likely will continue to be as the economy continues its tepid recovery. Small-business owners must remain sensitive to their A/R aging and other critical signals from their customers. To succeed, you must always remember: A customer who is not paying is not really a customer.

Ryan Hardy is an attorney in the St. Louis office of the Midwest law firm Spencer Fane Britt & Browne LLP. He concentrates his practice on commercial disputes in trial courts, appellate courts and bankruptcy courts. He has successfully represented manufacturers, contractors, banks and property management companies.