Part 1: Dealing with Customer Defaults

In the current economic climate companies have to be increasingly mindful of not only their own situations, but also those of their critical suppliers and customers.   In this first note on managing in an economic downturn we examine what can be done to protect against the default of a customer, and how to recognize when this situation may be arising.

The default of a customer can result in business interruption, difficulty in paying your own suppliers and employees, damage to your reputation, and cash flow problems.   As a result, it is vital to be aware of the signs that a customer may default on payments.

So what are the common signs?

1.    Rumours.   While rumours cannot be trusted, they are often prophetic and should not be ignored.   Rumours should at least signal that default is a possibility and spur a closer examination of the customer.

2.    The customer is slow to pay and/or is constantly making excuses about payment.   Some judgment will come into play here, and this will depend upon the history with the particular customer, as to whether the excuses are legitimate or are masking a deeper problem.

3.    Unsubstantiated and vague complaints.   A customer may try to get out of its obligation to pay by claiming that the goods supplied were defective or were otherwise not up to par.   This may be an act of desperation to clear debts that it does not have the means to repay.

4.    Management and employee turnover.   These are people on the inside who have the most knowledge of the customer.   They may be abandoning a sinking ship, or could have been let go by the customer in an attempted cost saving measure.   Regardless of the reason for the departure, it should be taken as an indication that the customer requires closer scrutiny.

5.    Actions by other creditors.   This is the most obvious sign of financial peril and often leads to a domino effect as other creditors also institute actions.   There may be an explanation that is unrelated to the financial stability of the customer, but this sign should never be ignored.

When you see signs of financial difficulty, what can be done to help secure payments?

The most important thing is to follow your contract terms.   If you want to enforce these terms later they must have been consistently adhered to during the life of the contract.

If terms are to be relaxed, it must be done carefully.   Don’t be too generous, as that may work against you later.   Also, be very specific and limit the relaxation in time and quantum.   When you begin to relax terms it can place you on a slippery slope that could significantly reduce the ability to enforce the contract.   As a result, it is important to be cautious whenever doing so and it may be necessary to obtain advice before making those decisions.  

If any relaxation of the contract is occurring it should be used as a time to obtain concessions from the customer.   This is an opportunity to obtain greater access and information in exchange for assistance.

Another option is to restrict payment terms going forward.   How this is done will depend upon the particular customer and the current payment terms.   Examples of restrictions that could be introduced are:

·   Reducing the credit cycle.

·   Requiring payments to be made upon shipment instead of receipt.

·   Requiring payments to be made toward outstanding invoices prior to sending  additional shipments, requiring cash on delivery, or requiring prepayments.

·   Increasing the consequences for default.   This will likely involve making amendments to the contract and should always be done in writing.   If done effectively, this can ensure that your accounts are a priority when the customer obtains funds, and can create a greater incentive to pay.

When dealing with customers in these difficult times it is also important to show loyalty and understanding where possible.   These are often the best times to strengthen a relationship, which can pay dividends when the economic situation improves.   It is a fine line that must be walked, though, as you always have to mindful of protecting yourself and the financial stability of your own company.

To learn more about the law applicable to restructuring and insolvency, visit our website  here.

If you have any thoughts about the above or any questions about managing in an economic downturn, we’d love to hear from you.   You can reach the writer at gary.graham@gowlings.com  or you can visit our website at  www.gowlings.com/industry/md.asp.