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Banking & Finance Law Report

Default by a Customer: Knowledge is Power

Posted in Bank Lending

This article is Part Three in a seven-part series on how to structure sales and what to do when your customer fails to pay. You can find previous article in this series here: Structuring Sales to Ensure Payment, Signs of Trouble Before Payment Default. Please subscribe to this blog by entering your email in the box on the left, or check back weekly for additional articles in the series.

By understanding your position prior to or shortly after a default by the customer, it may be possible to negotiate favorable terms with the customer to avoid default, proceed with litigation against the customer before there is a deluge or prepare for a bankruptcy by the customer. To identify your options and rights as a vendor you must first determine the following:

1.      Default provisions;

2.      Default notice requirements;

3.      Permitted interest, late charges and attorney fees;

4.      The existence of guaranties (corporate or individual);

5.      Existing or potential collateral and available equity; and

6.      Where you would need to sue, i.e., jurisdiction. 

Access Public Information

Much of the information you need to obtain on your customer is available as public information.

Ohio and other states offer a wealth of free on-line information, including the following: 

1.      UCC filings with the Ohio Secretary of State’s Office. Has your customer granted someone a security interest in all of their assets?

2.      Lien information is available at most County Recorder’s offices (this covers consensual liens such a mortgages, and non-consensual liens like mechanic’s liens and tax liens).

3.      More formal certified tax and lien searches are available through title companies for a fee.

4.      You can search many court dockets for free and determine if your customer is being sued, particularly for non-payment.

Workout Options

Vendors generally prefer restructuring a distressed credit to having the customer seek protection from its creditors under the Bankruptcy Code, especially if the receivable is unsecured or undersecured. Vendors prefer the predictability of restructuring a distressed credit to participating in the protracted and arcane world of bankruptcy proceedings. In contrast, if the vendor and customer cannot restructure an existing receivable, the parties may face many months (or years) of litigation or bankruptcy proceedings.

Before agreeing to restructure a customer’s existing obligation, a vendor must be satisfied that the customer will be able to meet the terms of the rewritten agreement. Among the items a vendor should consider before approving any workout are the following:

1.   The customer’s ability to apply adequate resources toward repayment of restructured credit;

2.   The customer’s ability to provide collateral;

3.   Obtaining guaranties or additional guaranties; and

4.   The competence and trustworthiness of customer’s management team.

The key to a successful workout is good communication. The customers’ management should expect to provide immediate answers to the vendor’s questions and should make itself available to meet or speak with the vendor at the vendor’s request. Management’s goal is to convince the vendor that the workout is necessary, prudent and will succeed by permitting the customer breathing room to reestablish its fiscal health.

If the customer hopes to successfully restructure its existing obligations, its management should expect increased scrutiny from the vendor. Management should expect the vendor to actively review the company’s financial position, its sales or production figures, its aged receivables and its obligations and liens extended to other lenders or suppliers. The vendor, or its agents, may conduct site visits, talk to the company’s vendors, inspect its audited financial statements and interview key management. 

Accounting and Financial Reporting

A vendor considering a restructure should obtain copies of the customer’s financial statements, preferable audited statements, and should require copies of future accounting and financial reports at regular intervals, whether monthly, quarterly or semi-annually. These intervals should be included in the terms of the restructuring. By reviewing these reports, the vendor can monitor the customer’s fiscal health and can determine if the customer is meeting any benchmarks established by the terms of the restructure agreement. If the vendor senses the company is not performing as anticipated after the restructuring, the vendor needs to be able to quantify its concerns and inform management of the non-performance.

Termination of Negotiations

If you have reached an impasse, if further negotiation appears fruitless or if you or your customer lack authority to continue, set a time limit for further negotiations. Do not let yourself be strung along by a customer who is promising to reach a settlement, but is in the mean time secreting or transferring assets.

In contrast, if you have reached a settlement, immediately send a confirming email or letter stating the full amount of the claim, the settlement amount, the date by which it will be paid, and any other terms. Request that your customer contact you immediately if it does not agree. Follow up promptly with documentation, including:

1.      A note representing the old balance. Converting an aged receivable to a promissory note may also benefit you as vendor, to the extent the aged receivable could not count toward your borrowing base with your lender; 

2.      Admission of balance/ waiver of defenses;

3.      Interest;

4.      Warrant of attorney- this is language in a note that permits a lender/ vendor to take judgment against a borrower without notice, and is a very powerful tool. Warrants of attorney are permitted in Ohio and a few other states, are limited to commercial (not consumer) transactions, and must be used in strict compliance with the applicable statutes; and

5.      A security agreement, mortgage or guaranty.

In this economy, many providers of goods and services are finding that their customers are stretching payments, thereby making the vendor an involuntary bank, providing a kind of line of credit. Don’t be the bank. In the event of a customer default, assess your rights, communicate promptly and determine if a restructure is possible. If your customer is not responsive to your reasonable requests for information, is not honest or does not have the ability or willingness to repay even a restructured obligation, it may be time to go to court. Tune in to next week’s blog for a discussion on use of litigation to recover your receivables.