Protect Your Business from Defaults

Bankruptcy is one of the worst things that can happen to a business. And we're not even talking about your own bankruptcy (thank goodness). Even if you've managed to steer clear of danger so far in this recession, an unprecedented rise in corporate insolvencies can derail otherwise sound businesses. A customer who files for bankruptcy is like Kryptonite to the small business superhero.

When a company files for bankruptcy, secured creditors—usually lenders with liens on specific collateral—are first to be paid. Next come bankers, lawyers, accountants, and other professionals working on the case. Whatever they don't siphon off goes to the unsecured creditors. Most small businesses fall into this category. While bankruptcy law ensures that all unsecured creditors get the same percentage of what they are owed, in the end, they're lucky to get pennies on the dollar.

By the time a filing takes place, your Benjamins may have turned into Jacksons for good. So your best strategy is to try to avoid bankruptcy settlements altogether. To do this, identify the warning signs of customer bankruptcies and reduce your exposure while that's still possible.

Fortunately, insolvency doesn't happen overnight, and you don't need X-ray vision to detect danger. Distress at large companies is commonly splashed across the headlines for weeks prior to a filing. And trouble at public companies is often accompanied by analyst downgrades and sharp stock price declines.

But you should also be suspicious if a customer is paying late or asking for more credit when his or her business is clearly not growing. Industry gossip gleaned through salespeople, collections departments, and factoring and trade receivables professionals can also help you detect signs of trouble. Even if your customers appear to be financially sound, consider some preventive measures. Tight control of receivables is the most important. Close attention to your days sales outstanding will help identify disturbing trends early on.

Even funds that you've already collected can be at risk in a bankruptcy. So-called preference provisions allow the debtor's estate to seek recovery of any payments made within 90 days of a filing. But payments made within the "ordinary course of business"—30 to 45 days, depending on the industry—are exempt, so it's worth your while to make sure you always get paid within that time frame.

If you are having trouble collecting and suspect a filing is imminent, consider negotiating a reduced payback. Getting only 50 cents to 70 cents on the dollar may be disappointing, but it's still far better than you'll do as an unsecured creditor. Even these collections can be subject to preference provisions, however.

Once a filing is made, your options are limited. Start by filing a proof of claim, a one-page form that officially records your claim. If you recently made a shipment to the bankrupt company, you can try to get those goods back by filing a motion of reclamation. This has to be done within 45 days of when your customer received the goods or within 20 days of the filing.

Alternatively, if the bankrupt company can't operate without you, you can seek critical vendor status, which will get you full payment of any money owed pre-bankruptcy. The logic is that a key supplier won't keep working with a company that owes it money. Critical vendor status has come under more scrutiny over the past few years, so be ready to justify your position in court.

If neither reclamation nor critical vendor status applies, there's no need to hire a lawyer. Instead, a committee representing all unsecured creditors will select one. Unfortunately, your fate will lie in their hands.

To read all of Monica Mehta's Cash Fix columns, go to

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