When businesses extend credit to commercial buyers, they are assuming a certain amount of risk, which is mitigated through sound credit risk management policies. Regardless of how diligent your credit approval processes are, you will inevitably have businesses that fall on challenging times and into bankruptcy. Refusing to extend credit to a business going through bankruptcy or with a bankruptcy event in recent history may seem like an obvious business decision. However, depending on the customer, the type of bankruptcy filing, and certain other factors, extending credit to these companies may not be a poor choice. For example, you may decide to extend additional credit to an existing customer with pre-bankruptcy debt even after that company petitions for bankruptcy. Why? Here’s an overview of the benefits, challenges, and best practices for lending to customers during or after bankruptcy filing.
Corporate bankruptcy filings
When a company finds itself struggling to pay its debts, bankruptcy is often the only solution. Bankruptcy is a process meant to help businesses pay off their debts and either reorganize to stay in business or shut down. The business will file a petition in bankruptcy court, and all debt collection efforts against that company must stop. The type of bankruptcy filing will determine how that debt is repaid and whether the company will continue to do business. The three main types of bankruptcy include:
Chapter 7. Filing bankruptcy under Chapter 7 is the most common type of commercial bankruptcy filing. It’s used when companies don’t have the cash flow to keep their business running. With this type of filing, the business is liquidated, and the money is distributed to creditors, with secured creditors first.
Chapter 11. With this type of filing, the company is reorganized and continues to operate. It will make an effort to keep afloat, but that doesn’t always happen.
Chapter 13. Chapter 13 is similar to Chapter 11, except it is only for small businesses.
Your customer filed bankruptcy. Now what?
When a customer files bankruptcy, it’s important to understand what it means for your business. Knowing what to do next and determining whether to extend credit to a business in bankruptcy will depend on the type of bankruptcy filing, whether they are a current or potential customer, and other factors. Here are some rules and tips to help you decide how to proceed.
- When a debtor files Chapter 7 bankruptcy, the company is liquidated and all assets are distributed to creditors, with first priority given to secured loans.
- File a Proof of Claim for the debt owed. If a claim is not filed, you will not receive any of the distributed proceeds from the liquidation.
- If your customer is in Chapter 7 bankruptcy, suspend further dealings. If it is a prospective customer, do a careful credit analysis to determine benefit versus risk. Put strict terms in place or ask for Cash on Delivery (COD) payment.
- If the customer is in Chapter 11, you should file a Proof of Claim. Without a claim, you will not recover the money owed. Unsecured debts likely will be repaid cents on the dollar.
- A customer in Chapter 11 bankruptcy remains open for business. It may be prudent to extend credit to this customer to help keep them operating. Perform due diligence and require tight credit terms if you decide to go forward with the client.
- Payments made within 90 days of bankruptcy could be considered preferential and possibly returned to the trustee for purposes of repayment and debt restructure.
- If the customer is a small business in Chapter 13 bankruptcy, file the Proof of Claim to recover debt.
- If you decide to continue doing business with them, be sure to perform a credit analysis, put strict terms in place, and ensure other safeguards are in place such as COD or a personal guarantee.
Commercial bankruptcies are becoming more common in these uncertain economic times, and you will likely have to deal with customers who file or who have filed bankruptcy. Before you are in that situation, it’s important to have a written credit policy that will protect you in such situations. When you do find yourself with a customer in bankruptcy, it’s important to understand your rights as a creditor and how to best proceed to improve your chances of getting repaid. A bankruptcy doesn’t have to be the end of the road for that business, nor does it have to mean the end of your relationship with that customer, as long as you proceed carefully, with safeguards in place.