As the economic fallout from the COVID-19 pandemic continues, businesses are facing nearly unprecedented risk that their commercial customers, who may have been transformed from financially strong to seriously distressed in a matter of days, will be unable to continue paying for goods and services. Effectively managing this credit risk will become both more difficult and important for businesses as the economic crisis continues. This will undoubtedly require decisions whether to keep supplying goods or providing services when a customer’s solvency is in doubt.
Some doubtful credit situations can be managed by adjusting sales terms for new orders, such as requiring more frequent or advance payments. However, the situation is much more complicated if long-term supply or service agreements are in effect, or if an already accepted order is to be fulfilled over time. In such cases, a business may find itself contractually obligated to continue providing goods and services despite substantial doubt about whether payment will ever be received. Fortunately, tools exist within the law to manage such circumstances. For example, a contract can be readily terminated when a customer acknowledges it will not be able to meet its payment obligations. But what about customers that are not as forthcoming?
Section 2-609 of the Uniform Commercial Code, which is the law in nearly every state, allows a seller of goods that has an objectively reasonable basis to believe that its customer cannot make payment (or meet other obligations under the contract) to suspend deliveries and demand reasonable assurances that the customer can, indeed, fulfill its obligations. The form and scope of such assurances will vary with the circumstances but could include measures such as providing financial information establishing the customer’s ability to pay or posting security such as a letter of credit or personal guarantee. The seller is not obligated to resume shipments unless such reasonable assurances are provided. If a buyer is known to be insolvent, it may also be possible to recover recently shipped goods pursuant to Section 2-702 of the Uniform Commercial Code, but there is a very narrow window of opportunity to do so.
Service contracts, unlike contracts for the sale of goods, are not subject to the Uniform Commercial Code. As such, service providers have not historically enjoyed the same rights to demand equivalent assurances from their clients. However, a more recent trend, now articulated in Section 251 of the Restatement (Second) of the Law of Contracts, has been to extend these protections to other contracts as well. More and more courts have adopted this view, but there is not complete unanimity and a service provider’s right to demand reasonable assurances varies by state.
Businesses can take several steps if it appears likely that commercial customers will be unable to meet their payment obligations during the current crisis:
- Maintain channels of communications with distressed customers. Attempt to analyze whether current financial difficulties are likely to pass with the current crisis, or if the business is imperiled.
- Consider modifying sales terms for new orders, such as by requiring payment in advance, on a more frequent basis, or upon delivery of goods or services.
- When sales terms are subject to an existing agreement and cannot be changed, a properly tailored demand for assurances can be a valuable tool to manage and assess risk when there are concerns about a customer’s ability to make future payments.
Although the current economic turmoil requires businesses to take decisive action to protect their interests, the decision to resort to any of these remedies, as always, should be balanced against the need to maintain customer relationships after the current crisis has passed.