Avoiding and Handling Your A/R Disputes From Your Lawyer’s Perspective

An unfortunate part of business is dealing with account receivable (A/R) disputes.  In any business, getting paid is the bottom line. The best strategy is to avoid A/R disputes, which can often be accomplished by properly identifying and addressing credit risks, and identifying and responding to problems early.  But when A/R disputes are unavoidable, you need to take steps to maximize your recovery and resolve the dispute in the most cost-effective way possible, using a legal strategy which is suitable for your situation.

Can the Receivable be Collected?

It's important to know who you are doing business with. Commonly, a customer has not paid down a receivable because they lack the funds or liquidity to do so.  Collectability is a threshold issue in receivables enforcement and can be addressed in several ways:

1. Underwrite Your Risk

In making your credit decision, you should consider access to the assets which you are relying on.  Make sure that those assets are actually held by the contracting party – not by its parent or affiliate entities with whom you have no contractual relationship.  Likewise, if those assets are located in a foreign jurisdiction or are the collateral of another creditor, then you will face additional hurdles in enforcing against those assets.  Similarly, if you are dealing with an individual, you need to be careful of community property issues – certain jurisdictions protect community property assets from creditor claims. 

One approach that can incentivize your sales staff to make good underwriting decisions, is to give them a stake in collectability so that they consider creditworthiness when they qualify new customers.

It is important to retain all information you receive during the credit evaluation process.  This information can be critical during a dispute or insolvency situation.  Your lawyer can use this information to create liens in the assets of the other party, pending the result of the dispute through provisional remedies or ultimately to enforce any resulting judgment.  

2. Address Your Identified Risk

You can protect yourself against identified credit risk through limiting terms, selling goods C.O.D., requiring retainers or deposits, requiring progress payments, requiring guaranties, or by taking a pledge of collateral.  There are, however, issues associated with such measures.  For example, any asset transferred or lien created within 90 days prior to a bankruptcy filing may be subject to being set aside as an improper preference.  Likewise, the acceptance of real property collateral may require you to first enforce against that collateral before enforcing against other assets.  There are a number of other factors to be considered – however, knowledge of the risks and safeguards will permit you to make an informed decision about the transaction before entering into it.

3. Identify and Respond to Problems Early

Not only does early problem identification give you an opportunity to resolve the dispute before it grows, it also gives you a chance to improve your legal position in the event that the dispute does not go away.  You may need to mitigate your damages through the liquidation of product – time is not on your side for this.  Technology may become irrelevant or products may become stale.  You may also need to gather evidence and investigate what went wrong – memories fade and documents are lost with the passage of time.

Have The Right Customer Contacts. It is important to know who the real customer stakeholders are and to have an open line of communication to them.  This way, problems can be discussed and resolved as they arise and before they grow. 

Be Diligent on Receivables. Through prompt invoicing, you will bring disputes to the surface before they grow.  Since you may not know of a dispute until payment is withheld, it is important to promptly request payment.  This approach will also create the added benefit of improving your cash flow.

Know Your Customer’s AP system.  Make sure that you know the channels of how to get your invoices processed promptly.  Also, be sure to invoice in a timely manner.  It is better to know whether your customer will honor your invoice sooner as opposed to later, when you have delivered an increasing quantity of products or services and extended a larger amount of credit.  Diligently track your accounts receivables agings and follow up with your customers as soon as an invoice becomes delinquent.  This is where knowing the correct stakeholders will be helpful. 

Do Your Documents Help You to Resolve the Dispute Efficiently?

Your deal documents should maximize your ability to collect receivables. Contractual terms that appear to be neutral may have practical enforcement problems.  Moreover, the correct contractual terms will discourage litigation and encourage a prompt resolution of most disputes. 

1.  Include an Alternate Dispute Resolution Clause

One of the key provisions in your contract should be an alternate dispute resolution (“ADR”) clause.  Lawsuits are expensive and the judicial process can be lengthy – contractually avoiding the courts can be advantageous for a party who is seeking to efficiently enforce its receivable claim.  Such ADR processes include mediation and arbitration.

Mediation Clauses. Mediation is a voluntary process through which the parties meet with a third-party neutral to try to resolve their dispute.  All settlements which are reached in mediation are voluntary.  Since most lawsuits ultimately end up in mediation, it makes sense to lead with the mediation process in an effort to avoid incurring unnecessary legal fees.  It is best for most contractual documents to include a requirement for the mediation of disputes prior to litigation.  Depending on the governing law of the agreement, there are various requirements to make this enforceable.  Issues to consider include who will pay for the mediator’s fees and where the mediation proceeding will occur.  One way to encourage mediation is to condition participation in mediation as a pre-requisite to the recovery of prevailing party attorneys’ fees.

Arbitration Clauses.  Arbitration is a proceeding in which the parties pay a third-party to decide their dispute, often roughly based on the procedural requirements of most courts.  The benefits of arbitration are that the parties can avoid the expense and uncertainty of having a jury decide their claims, as well as the delays associated with a backlogged judicial system.  There are some important issues to be aware of when agreeing to arbitration.  First of all, you can select in your contract which arbitration service will decide your dispute – but do so carefully.  Certain associations assign very expensive arbitrators – as much as $1,000 per hour.  This can add up quickly.  Also keep in mind the contract should specify where the arbitration will occur, who will pay for the arbitrator’s fees, and what rules will govern.  Many arbitration associations provide for expedited arbitration proceedings which favor a creditor and therefore favor a seller/vendor. 

2. Consider Where the Dispute Will be Resolved

Another contractual term to consider in your deal documents is a forum selection clause – which governs where the dispute will be resolved.  This can be very important – you do not want to be dragged into a foreign jurisdiction to litigate your dispute.  Likewise, causing a foreign situated customer to resolve their dispute in your jurisdiction will discourage disputes.

3. Decide Whether to Include a Prevailing Attorneys' Fees Clause

One of the biggest issues to consider is whether your contractual documents include a prevailing party attorneys’ fees clause.  Depending on your circumstances, this can be favorable or very detrimental.  As a practical matter, most disputes settle and those settlements rarely include payment of the other party’s attorneys’ fees.  The advisability of a prevailing party attorneys’ fees clause is a case-by-case determination based on the nature of the contract and the positions of the parties.

4. Ensure that the Governing Terms of the Contract are Yours

It is also important to make sure that your terms are the ultimate terms of the contract.  Parties often send competing terms back and forth in their deal documents, such as their purchase orders, receipts, order confirmations, invoices etc.  There is a risk that if you do not handle the transaction properly that the other party’s terms, not yours, will govern. 

Can You Live with the Cost of Prosecuting the Claim?

Problems can arise when clients do not enter into an arrangement with their counsel which suit their needs.  The correct arrangement benefits both the client and the lawyer; the incorrect arrangement puts them at odds with each other. 

1. Hourly Rate Compensation

Hourly rates are traditional and give the client all of the upside of a positive result.  This also gives the client all of the downside.  This approach also lends to uncertainty in legal expenditure because of the nature of litigation – which is difficult for clients who need to budget their expenses.  An hourly basis engagement makes sense for certain clients and certain disputes.  An unfortunate risk of this arrangement is that your counsel may be incentivized to aggrandize issues in the dispute to maximize their fees.  If your company has a high volume of similar transactions, you should consider developing a form set of dispute documents.  These omnibus forms can be slightly modified for each dispute and significantly reduce legal fees associated with hourly rate engagements.

2. Pure Contingency Arrangements

Clients who do not want to invest liquid funds into a dispute will often pay their lawyers on a pure contingent basis – this is commonly the model of collection firms.  Under this model, the attorney receives a portion of the lawsuit proceeds and therefore is only compensated if they succeed.  What is not readily apparent, however, is that the client and the lawyer’s interests are not always aligned under this model.  The lawyer has an incentive to do as little work as possible and recover the lowest hanging fruit, thereby maximizing the lawyer’s profit margin.  Unlike the client, the lawyer can increase total revenue while maintaining a high profit margin by increasing the volume of the cases he/she handles.  Moreover, the client may not take into consideration non-monetary costs that a contingent lawsuit may entail, such as the time that the client’s staff must invest in gathering information or providing testimony during the discovery process.

3. Alternative Fee Arrangements

The other fee basis, which can be very successful, is an alternative fee arrangement which is based on the result achieved by the lawyer.  One such model is a flat rate with a success bonus.  The client agrees to pay the lawyer a certain amount, often a monthly rate, to handle the dispute.  Then, based on the result, the lawyer receives a success bonus.  This aligns the client’s and the attorney’s interests and provides the client with anticipated fees for budgeting forecasts.  The success bonus can be tailored to incentivize certain goals, such as an expeditious resolution.

Receivable disputes are inevitable; however, reasonable steps can reduce the number of disputes and can increase the likelihood of a favorable outcome.  With the benefit of hindsight, it is often easy to see what went wrong and how the dispute could have been avoided.  Often, operational and contractual defects are the cause, and can even fuel, A/R disputes. Planning ahead to make sure that your customers are creditworthy, your documents help you maximize recovery, and your lawyers are aligned with your desire for cost effective strategies, will help you to reduce the number of disputes you face, can collect more when disputes are unavoidable.

Matthew Kenefick is a trial lawyer and partner at Jeffer Mangels Butler & Mitchell LLP in San Francisco. He has significant experience in the enforcement of account receivable claims and works with his clients to identify policy and document changes to avoid future disputes and to maximize recovery from the disputes that cannot avoided. Contact him at MKenefick@jmbm.com or 415.984.9677.