Accounts Receivable: The 125% Solution

A few years ago, the President of a client ("Supplier") called me about a "bad debt" problem. Its customer ("Debtor") had fallen behind and now owed Supplier about $70,000. Apparently that check never really made it into the mail.

"Should we sue them?" asked Supplier's President. "Several other suppliers were already filing lawsuits to "recover" their outstanding accounts receivable ("A/R") from Debtor. My litigation firm says we should do so right away."

"Perhaps," I replied, "but first let's explore the facts a little more closely." We then discussed several very pertinent facts.

Debtor was a corporation. Did the Debtor corporation own any unsecured assets? As far as we knew, all equipment and the premises were leased. In essence the Debtor appeared to be "judgment proof" (i.e., there were no assets or cash to attach for paying off any court judgment which might be awarded to Supplier.) A plaintiff generally cannot collect from shareholders the unpaid court judgments won against corporations. Partnerships and sole proprietorships lack this corporate shield.

Was any other supplier willing to do business with Debtor? No. Did Debtor still have any customers? Yes. Would Supplier make a profit on each new sale to Debtor if Debtor paid promptly? Yes. Did Supplier still want to supply products to Debtor if we could make Debtor pay promptly? Yes.

I then advised Supplier to offer to continue supplying Debtor if Debtor paid COD (as in cash; no checks, money orders or even cashier's checks) equal to 125% of each new order. Debtor readily agreed and after 14 months Debtor had paid down $55,000 of the outstanding A/R. As a bonus, Supplier earned a profit on the additional $220,000 in new cash sales to Debtor. Another three months later, Debtor filed bankruptcy (and all of the 25% surcharges paid by the Debtor on each COD order during those 3 months had to be disgorged (paid over) to the bankruptcy trustee as a preferential payment to a creditor.

In the end each other supplier settled for about $0.07 on the dollar of bad debt (not counting their lawsuit costs). On the other hand, our client, Supplier, received a total of about $0.84 on the dollar (counting our COD arrangement and the bankruptcy settlement) but not counting Supplier's profit on the additional sales.

Sometimes you must file a law suit. At other times, suing may not be the best solution. Ask your attorney about the pros and cons of both litigation and alternative means of resolving the dispute. Consider the cost (attorney fees, court filing fees, lost revenue and lost productivity) of pursuing a lawsuit as well as any message which inaction would send to other debtors.