Credit risk: Between having a legally enforceable claim, and getting paid, falls . . . the shadow.

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 that we draft 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. You are a cardboard manufacturer who is owed $200,000 by a customer. This receivable is now two months overdue, and you are tired of getting the runaround. Your lawyer reviews the paperwork and assures you that the customer has no legal basis for not paying. In other words (legal words, to be exact), you have a legally enforceable claim against the customer for $200,000. What do you do now to collect this amount? Here's a likely progression of steps:

• Ask nicely one more time.
• Ask less nicely.
• 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 you for the receivable is likely to be a small fraction of the actual face amount of the claim.
• If you don't sell the receivable, you file a lawsuit against the customer for breach of contract. (This assumes you are willing to go to war with your customer, which you probably aren't if it's an important one.)
• The litigation goes on forever, and both you and your customer pay the lawyers for that privilege.
• Finally, you win! The trial judge signs a piece of paper called a judgment, which states that your customer has to pay you the $200,000.
• The customer files an appeal. More litigation. More lawyer bills.
• You win the appeal! As you are walking out of the courthouse, you wave the judgment at your ex-customer, telling him how to make the check out. He looks at you with disdain, and silently walks away.
• You put in several telephone calls to him. No answer.
• Your trial lawyer tells you that it is the responsibility of a civil litigant to enforce her own judgment. He refers you to another lawyer who enforces judgments for a living. More lawyer bills.
• Eventually, a sheriff posts a notice that he intends to conduct a sale of your customer's assets to satisfy your judgment.
• Before the sale occurs, however, your customer files a bankruptcy petition. Because of the "automatic stay" that protects debtors in bankruptcy, you are prevented from directly seeking payment from the customer, and the sheriff's sale can no longer take place. Instead, you must now assert your claim in the bankruptcy proceeding. You guessed it: more lawyer bills.
• When the bankruptcy proceeding finally draws to a close, you think to yourself, "Aha! NOW I get paid." But there's bad news: the value of the customer's assets is $300,000. The various professionals retained in the bankruptcy proceeding are owed $100,000, and are entitled to get their bills paid first. There is a $150,000 bank loan that is secured by a lien on the customer's assets, so that claim gets paid next. You and the other unsecured creditors (together, your claims add up to $500,000) share ratably in the $50,000 of remaining value in the bankruptcy estate. The bottom line: two years after the original due date, you receive $20,000 on your $200,000 claim, which is not enough to cover the bills of all the professionals that have assisted you in this noble endeavor.

This is just an example of some of the impediments that stand between having a legally enforceable claim and getting paid. In a future issue, we will look at various mechanisms that can be used to protect against credit risk, such as escrows, collateral, covenants, guarantees and letters of credit.