Client Bankruptcy: A Guide for Staffing Companies

Strategies for Avoiding and Managing Client Bankruptcies

With predictions of recession in the air, now is a good time for a refresher on the bankruptcy process. Staffing firms have significant bankruptcy risk because they fund their payroll in advance of invoicing. This article covers strategies for avoiding clients with bankruptcy risk and reducing losses when a client files a bankruptcy petition, typically a liquidation under Chapter 7 of the bankruptcy code or a reorganization under Chapter 11.

Avoiding Bankruptcy Losses

1.) Evaluate the credit of new and existing clients. The gold standard is a formal credit check. If your firm does not perform formal credit checks, there are still steps you can take. Conduct an Internet and social media search on the prospective client, which can often yield helpful information about a company and its prospects. Be extra cautious with startups, which are known for funding payroll by using staffing agencies. Do not assume that large clients are always creditworthy.

2.) Do not throw good money after bad. If an existing client falls behind on payments, address the situation promptly. Failure to pay invoices on time is generally considered a breach of contract and may entitle you to cease making further placements until the account is current. There is no excuse for sending thousands of dollars out the door each month when the client is not paying, yet for some reason this happens regularly in the staffing industry, as witnessed by this 2024 Aerotek lawsuit for over $7,000,000 in unpaid fees.

3.) If it seems too good to be true, it probably is. Beware of business that falls into your lap like a gift, especially when it involves payrolling the client's workers. Insolvent companies have been known to utilize staffing agencies as a means to keep the operation running when other credit is unavailable.

After Bankruptcy

The best outcome after bankruptcy is a client that intends to reorganize under Chapter 11 and needs your workers to do it. In such a case, the debtor can seek the bankruptcy court's permission to pay you up to date as a "critical vendor" and keep paying you during the reorganization. An important risk in such a situation is delay in obtaining the court's permission while you continue providing services and then a failure of the client to obtain court approval.

Otherwise, if your client files bankruptcy when behind on payments, you likely have legal grounds to cease providing further services, although you should consult legal counsel before making such a determination. In any event, unless the client chooses to name you as a critical vendor, your unpaid invoices will be at risk of never being paid or being paid for pennies on the dollar months or years later.

Adding Insult to Injury

Unfortunately, the losses from not being paid are not the end. Eventually, you likely will receive a demand for repayment of all sums received from the client during the 90 days before filing the bankruptcy petition. This is known in the bankruptcy world as a "preference claim."

Preference Claims

Bankruptcy law allows the debtor to recover payments made to creditors in the last 90 days before filing if the payments were not "made in the ordinary course of business," meaning they were either late or early relative to the historic payment pattern. The idea is to avoid special treatment some creditors may have received while the company was insolvent. It does not matter whether there actually was special treatment—the Bankruptcy Code assumes there was favoritism whenever payments in the last 90 days do not match the debtor's regular payment pattern. These preference actions, colloquially called "clawbacks," are a standard risk for creditors of a bankrupt company.

The Demand Letter

Before filing a lawsuit in bankruptcy court, the debtor or trustee will normally send the creditor a demand letter seeking to recover the payments made to the creditor during the 90 days before bankruptcy. Do not ignore this letter! If the sender receives no response, a lawsuit will be filed against your firm in the bankruptcy court, and you can expect significant legal expense to defend and resolve the matter.

In most cases, it is in the best interest of both the debtor and creditor to reach a pre-lawsuit settlement of the claim. The negotiations revolve around the applicability of two potential defenses, discussed below. Companies with in-house legal departments or experienced financial personnel can often handle the calculations and negotiations without retaining outside counsel. If outside counsel is retained before a lawsuit is filed, the cost of resolution will be a fraction of that in litigation.

Defenses to Preference Actions

Ordinary course. The first defense is to assert that payments were consistent with past business dealings (ordinary course of business) between your firm and the client. Courts will examine prior payment patterns between the parties and industry norms to determine whether this is the case. If invoices during the 90 days were paid on the usual schedule, and nothing about the payments was unusual, this defense may succeed. There are no set standards as to what constitutes ordinary course, and this can give both parties leeway in arriving at a mutually satisfactory compromise number.

Subsequent new value. Creditors can also offset preference claims by showing they supplied additional services during the 90 days after receiving a preferential payment, and those later services remain unpaid. The idea here is to encourage creditors to continue providing services to a troubled company. The nature of staffing often lends itself to this defense, and when applied, it can substantially reduce the amount the trustee or debtor can recover. New value calculations can be more complicated than ordinary course numbers, especially with multiple payments during the 90 days. Unlike ordinary course calculations, there are no grey areas—it's just math. Often, the attorney representing the debtor has software that will run the calculations quickly if requested, but it is up to the creditor to raise the defense in the first place.

Conclusion

Understanding credit risk and the bankruptcy system is essential to the sound operation of a business and can often make the difference between minimizing losses and compounding them.