Author: Jennifer McLain McLemore
Customers and suppliers may not willingly admit they are in distress, even when sources of economic pressure can be found everywhere. However, there are some practical steps you can take to increase your situational awareness of customer and supplier stress levels to better prepare you and your business to respond to a customer’s or supplier’s strategic errors, or just simple supply chain delays.
1. Consider your portfolio of suppliers and customers.
Businesses can struggle for many reasons, ranging from poor decisions to strategic miscalculations to mere interest rate hikes. However, in the current environment all businesses have exposure to at least some supply chain concerns, staffing shortages, inflation risk and fuel cost burdens. While you and your business may have these issues under control, if your suppliers or customers cannot manage the current combination of economic pressures, this fact could increase the risks for your business.
Recognizing that some industries are better prepared than others to manage these economic conditions, how do you identify customers or suppliers that might be at risk? Step one, do your due diligence.
External Due Diligence
Online resources are a great place to start. Google the businesses you’ve identified as potentially at risk to see if they are the subject of any headlines. You may be surprised at what hints may be found in public reporting. News of interest could include changes in leadership, closing locations or rapidly opening too many locations, the inability to staff normal business hours, an increase in or sudden layoffs, branching off into a new line of business that seems risky or the curtailment of well-known business lines on short notice. As a starting point to gauge your research, look to public sources of information to see whether, viewed objectively, a valued business partner may be facing headwinds.
Internal Due Diligence
Another place to examine potential risks facing your customers is your own internal data. Specifically, examine your Accounts Receivable records. Are there any customers that have started to slow down their once-regular payment practices? Have extensions of payment deadlines been requested? Have credit limits been exceeded, or have credit increases been requested? There are many reasons for these sorts of events, but, in the current economic environment, a conversation to better understand the cause of a particular event would be prudent. Once the payments have stopped or the customer has asked for new terms, you’ve lost some advantage in the discussions.
Similarly, with your suppliers, search your records to determine whether their inventory has started to show up subject to unexplained delays. Has there been a change in the level of quality of the product, packaging, service or support related to the purchased product? In the current environment, it is important to be proactive and seek to address such developments in real time rather than at the point that the delays or disruptions have an impact on your contribution to the supply chain.
2. Once you identify a contact of concern, review your agreements with that party.
- Are your contracts, extensions, modifications, and all other terms and agreements in your files?
- Have these documents been fully executed by all necessary parties?
- Do the deal terms still make sense in the current circumstances?
- Do the deal terms reflect your current practices?
- Have the parties orally agreed to modify the current agreement?
- Do your agreements provide you with lien rights?
- Is your collateral still valuable in the current economic cycle?
- How were those liens to have been perfected? Do you have copies of recorded perfection documents in your files (UCC financing statements, mortgages, fixture filings, etc.)?
- Are the descriptions of your collateral in the recorded document complete and accurate?
- Is the name of your customer correct on the Security Agreement, UCC financing statements, and any other recordable documents?
- Were the filings recorded in the right place?
- Is there any risk that a filing may have expired?
- Does your agreement contemplate a guaranty, a bond to be posted, or a letter of credit?
- Were those documents executed and are they in your files?
- What triggers your ability to exercise your rights under the guaranty, bond, or letter of credit?
- Are you able to exercise those rights now or does some other default have to occur first?
- What are the calendar deadlines and waiting periods in those documents?
3. If you find a gap in your documentation, early action will allow you to address it.
If the list above helps you to identify a flaw in your records, and before there is a default under your agreements, you should raise the open issue with your customer or supplier. Prior to a default, get documents fully executed, correct errors in recordable documents or other collateral, or enter into an amendment or modification to better reflect your course of dealing. To ensure that your protection from the customer or supplier is complete and everything is up to date, consider requesting updated listings of pledged collateral, and valuations for such collateral. Inquire about insurance maintained on pledged assets. Confirm that letters of credit or bonds are not in need of some form of update.
4. Keep the lines of communication open.
In addition to an open dialogue allowing you to raise issues regarding missing or incomplete documentation of your agreements, such conversations can allow you to have an understanding of a supplier’s retention/employee issues, payment delays, credit stressors, etc., which, in turn, can help you to meaningfully adjust your customers’ expectations. Further, using your connections in the industry, you may be able to serve as a resource to the supplier in a manner that will assist in keeping product flowing or in clearing existing hurdles to production.
Similarly, dialogue with a customer in distress may create a situation where you can address defaults before they happen by setting up manageable payment terms or adjusting credit terms to better suit the customer’s current needs. If the payments due to your company are overwhelming to a customer that has just stopped paying, consider resetting the past-due obligations with a promissory note. While a promissory note obligation doesn’t erase the past-due balances, it may create an emotional shift that allows the customer to feel like it is back on track with a clean slate. At the same time, the promissory note can give your business some additional assurance of repayment, while getting cash payments to resume.
Such conversations can also be used to request current financial reports, to confirm your understanding of the level of distress on the supplier or customer. You can request the current and former business plan to understand how the customer plans to address the current, stressful environment. If you are receiving such reports, be sure to validate any of the projections provided. With this information you can determine whether there is a real business to save or whether you should mitigate your risks by adjusting your business practices.
If you have concerns, keep any guarantors apprised.
If you are going to communicate in writing, consider your tone. Treat anything you write as something that may be read back to you later in court.
For in-person meetings, consider including an objective witness or at least someone taking good notes on what was said.
After the lines of communication have been opened, consider whether there is a real business to be preserved. Has the market or industry changed without your customer or supplier addressing innovation? Is management and/or leadership part of the solution or part of the problem? Do you trust what was said in these dialogues?
5. Early action with a distressed party secures more options and flexibility.
In addition to being able to address gaps in your documentation, addressing customer or supplier distress early allows you an opportunity to analyze the depth of the distress. If a restructuring of debt or payables is possible, you can work to create a plan that suits the interests of both parties. If more capital is required to keep your customer or supplier in business, and if you are willing to invest in the business, you may have an opportunity to get more collateral, more protection of your existing interests, or contract rights to help manage your relationship if a bankruptcy is filed or a receiver is appointed.
6. Consider your contract remedies and other creditors.
Once you have confirmed that the perceived distress in your supplier or customer is real, and perhaps too deep for you to assist with, it may be time to look to the remedies in your documents. Consider whether there are any commitments, deadlines, or obligations in the agreements that have been breached or are in default already. If so, review the breach and default requirements, including notice requirements, addresses to which notices must be sent, cure rights and obligations, and make note of what rights and remedies remain after a default is left uncured after the expiration of any applicable cure period. If there has been a breach, can it be cured easily if the customer or supplier can find funding? If there has been a breach or default, is it possible that sending a notice will motivate your customer or supplier to cure? If you haven’t yet been able to fix your documents through conversation, can you use this default and cure opportunity to improve your position, or fix your documentation?
Similarly, you should review the termination requirements, the notice and cure provisions, and the provisions that remain in effect in your agreements after termination. If you terminate an agreement, will you improve your position or place your interests at risk? If the termination is curable, will you have created an irretrievable rift in the relationship?
If you decide to send a termination or default notice, calendar any deadlines that have been triggered by a notice of breach, notice of default, or notice of termination. You want to be certain when you have a right to proceed in a new direction without the burdens of your current supplier or customer.
As you work through these matters, also consider whether other potential creditors could be lining up or may already be ahead of you in priority. Consider running a lien search to get an idea of the current landscape of other potential creditors. You can use this information to determine whether there is a risk of reclamation of goods that may be needed for your products. You should also consider whether there is a potential for later arising mechanics’ liens on property you may have been relying on for collateral or that may have been important to your supplier or customer for other borrowing obligations. Try to determine whether your customer or supplier is keeping up with lease obligations.
7. If all else fails, a forthcoming bankruptcy for your supplier or customer may be a blessing.
Bankruptcy provides a framework for an equitable recovery for all creditors. While secured creditors receive great deference in the bankruptcy process, contract counterparties do as well. For example, the sale of assets to a new entity will provide for a better balance sheet for the supplier or customer and, potentially, a better partner for your business going forward. If your customer or supplier ends up in a Subchapter V of Chapter 11 proceeding, which is a newer, faster form of bankruptcy for smaller businesses, move quickly to stay on top of this new form of efficient restructuring.
Don’t sit on your rights in a bankruptcy proceeding. Be proactive. Bankruptcy cases can cause a waiver of bargained for rights if they are not asserted and defended.
