When we negotiate and draft a contract that is clear and precise and that accurately reflects the intent of the parties, we are helping our clients achieve the benefit of the bargain. But whenever an agreement imposes on another party an obligation to pay our client, the issue of “credit risk” arises. This is the risk that an obligor will be financially unable to satisfy its payment obligation when due. Merely creating an airtight contractual claim does not reduce this risk.
Let’s look at a simple hypothetical. Your client is a manufacturer who is owed $200,000 by a customer. This receivable is now two months overdue, and the client is tired of getting the runaround. At the client’s request, you review the paperwork and assure the client that the customer has no legal basis for not paying. In other words (legal words, to be exact), your client has a legally enforceable claim against the customer for $200,000. What does the client do now to collect this amount? Here’s a likely progression of steps:
• Ask nicely one more time.
• Ask less nicely.
(a) Sell the claim to a collection agency, at which time collection becomes the collection agency’s problem. However, the price that the collection agency pays to the client will be significantly less than the face amount of the claim, or
(b) Sue the customer. Obviously, this will involve additional legal fees.
• If path (b) is chosen, ultimately (how long it takes is likely to be a function of how hard the customer fights back) your client will get a judgment against the customer. Now your client has another piece of paper (this one signed by a judge!) that says that the customer owes your client $200,000.
• Your client waves the judgment in the customer’s face. The customer sneers and gives your client impolite instructions as to where the judgment should be filed.
• Your client goes to the judge, saying “Waah! The customer isn’t paying me, like you said it was supposed to.” (Your client didn’t tell you it was planning to do this, because if it had, you would have told it to not bother, because the judge will merely kick it out of the courtroom. It is not the court’s job to enforce judgments.)
• The judge kicks the client out of the courtroom.
• The client engages the sheriff, who has the power to attach the customer’s assets (assuming the customer’s assets can be located (a) at all, and (b) in the sheriff’s jurisdiction) and ultimately sell them, with the client’s claim being paid from the proceeds of sale.
• Before the sale is consummated, however, the customer files for bankruptcy. The automatic stay stops the sheriff’s sale in its tracks. Now, your client must pursue its claim against the customer in the bankruptcy proceeding. (Surprise: a new set of legal fees.)
• At the conclusion of the bankruptcy case, your client may or may not be paid something, depending on the value of the customer’s assets and the total amount of claims against it.
Don’t ever lose sight of the simple truth that a promise to pay is not the same thing as payment. If appropriate under the circumstances of an individual transaction, you can mitigate credit risk by getting third-party guarantees; by obtaining liens on assets to secure your client’s claims; by getting other creditors to subordinate their claims; and by creating escrow and cash collateral arrangements.