|Business Credit Articles
On April 20, 2005, the U.S. Bankruptcy Code was finally overhauled, with the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (Reform Act). As discussed in my article, �AS OCTOBER 17 NEARS, WATCH FOR RED FLAGS THAT YOUR CUSTOMER MAY BE FIXING TO FILE BANKRUPTCY�, the changes to the U.S. bankruptcy laws taking effect on October 17th will make the bankruptcy process more restrictive, burdensome and expensive for a vendor�s customer, whether a corporation, LLC, partnership, sole proprietor as well as a personal guarantor, whether the customer files a Chapter 11 reorganization or Chapter 7 liquidation.
The press is reporting a meaningful increase in bankruptcy filings due to the Reform Act�s October 17th deadline. In light of this, vendors may consider looking to credit enhancements and alternative payment mechanisms to reduce credit risk through October 17 for certain customers that may be determined as candidates that may file bankruptcy prior to the effective date of the Reform Act. In dealing with the customer that may be showing red flags of financial strain, creditors should look for the credit enhancement tool that is most readily converted into cash, and is unlikely to be affected by a customer�s bankruptcy. Some of those alternatives are discussed below.
1. Letter of Credit
A letter of credit (L/C) is a promise by an issuer, the bank, to pay the creditor, as beneficiary, when the customer has defaulted on the sale. The customer uses its assets as collateral for the L/C, so that the credit of the bank is substituted for the credit of the customer in favor of the creditor. The customer pays the issuing bank a fee to issue the L/C. If the creditor submits proper documents upon default, the bank will pay the L/C and the customer reimburses the bank. An L/C may be either revocable or irrevocable. An irrevocable L/ C can be modified only with consent of the creditor. The bank without the consent of the creditor can modify a revocable L/C. The creditor can obtain a standby L/C, which assures payment after the customer�s default. The creditor should insist on an irrevocable L/C with the customer sale.
L/C�s are independent from the underlying contract between the customer and the creditor. The bank honoring the L/C is concerned only to see that the documents conform to the requirements in the L/C. If the documents conform, the bank will pay, and obtain reimbursement from the customer. The bank need not look past the documents to examine the underlying sale of goods. Thus, a creditor is given protections that the issuing bank must honor its demand for payment (which complies with the terms of the L/C), regardless of whether the goods conform to the underlying sale contract. The amount of the L/C should equal the amount of the line of credit.
The L/C�s independence of contracts allows a creditor to avoid the impact of a customer�s bankruptcy, as a general rule. The creditor is paid by the bank and does not wait until the debtor confirms its plan. Bankruptcy courts recognize that the proceeds of a letter of credit are not property of the customer�s bankruptcy estate, and that a bankruptcy court generally does not have authority to bar payment under a L/C, notwithstanding the effects of the automatic stay.
2. Certificate of Deposit
A CD may be issued by the customer�s bank in the name of the creditor, or the creditor may hold a customer�s deposit to reduce the risk of nonpayment with the credit sale. The CD is unconditionally payable to the creditor upon demand, and automatically renews for the length of the credit line. The principal amount accrues to the benefit of the creditor, and interest is paid to the customer. The creditor should have a written agreement with the customer that states this deposit arrangement.
The CD should be entrusted to the creditor and thus not part of the bankruptcy estate. A creditor would likely need to obtain relief from the automatic stay from the bankruptcy court to draw down on the CD upon a bankruptcy filing.
3. Credit Insurance
A creditor purchases credit insurance (CI) to avoid loss on a speculative customer, but retains the accounts receivable. CI may cover a variety of credit risk, such as a customer�s bankruptcy, a default or dispute. An example of the terms of a credit insurance policy might stipulate that the CI generally covers up to 90% of the insured account. The risk premium for CI may be measured by the creditor�s accounts receivable risk profile. The credit insurer may monitor the buyer�s financial condition. The term of the policy may be one year.
The CI contract is not affected by a customer�s bankruptcy. Bankruptcy courts recognize that the proceeds of a CI policy are not property of the customer�s bankruptcy estate, and that a bankruptcy court does not have authority to interfere with payment under a CI policy.
A creditor does not have to obtain relief from the automatic stay from the bankruptcy court to receive payment on the CI policy after the bankruptcy filing.
Factoring provides for the supplier to sell its customer account receivable at a discount to a third party, a factor, who is usually a financial institution. The sale is often non-recourse, which means that the factor is responsible for the customer account in the event of default. The supplier usually invoices the customer, but the invoice is payable to the factor�s address. The supplier sends the invoice to the factor, who pays the supplier a discounted amount of the invoice.
Factoring is an independent agreement between the supplier and the factor, and allows a supplier to avoid the effects of a customer�s bankruptcy. Depending on whether the factoring agreement is recourse, it may be the factor that is the party in interest in the bankruptcy.
Bankruptcy courts recognize that the factor�s pay ment of a supplier�s claim is not property of the customer�s bankruptcy estate, and that a bankruptcy court does not have authority to interfere with payment, notwithstanding the effects of the automatic stay.
A guarantee, whether corporate or personal, is not the preferred credit enhancement, as it requires the creditor to take legal action to get paid when the customer fails to pay. However, a guarantee may be used as leverage by the creditor to force the customer to pay by threatening to pursue the guarantor, who may be a principal of the customer. The basic legal principle is that the guarantor is not a party to the principal debt. The guarantor�s undertaking is independent of the customer�s promise to pay.
Merely because both contracts are on the same paper, for example, the credit application -- the customer�s promise to pay for the creditor�s goods or services, and the guarantor�s promise to pay if the customer does not -- does not change the independence of the agreements.
The guarantee should be signed before a notary to reduce the risk that the guarantor may contend that the guarantee was forged. The guarantee�s independence of contracts may allow a creditor to avoid the effects of a customer�s bankruptcy.
6. Purchase Money Security Interest
The creditor may consider taking a security interest in the goods it sells to the customer, and the proceeds from the sale of those goods. Under amended Article 9 of the Uniform Commercial Code, for the creditor to obtain a valid purchase money security interest (PMSI) in the goods it sells to the customer, a multi-step process must be complied with. The customer first executes a security agreement describing the goods covered in favor of the creditor, which gives the creditor a security interest in those goods. The creditor perfects the security interest when it files a financing statement with the filing office (usually the Secretary of State), which adequately describes the goods.
The creditor�s PMSI will prime the inventory secured creditor�s lien only if: (1) the PMSI is already perfected at the time the customer receives possession of the goods; and (2) the creditor gives written notice to any other preexisting inventory secured creditor. If the creditor fails to perfect the PMSI, including giving notice, the creditor�s priority is governed by the �first to file� rule. This means that an inventory secured creditor will prime the creditor�s PMSI.
The creditor holding a PMSI should be entitled to adequate protection with the customer filing bankruptcy. Adequate protection provides that the creditor�s property interest is entitled to protection from depreciation and is insured against risk of loss.
Article 9 of the UCC�s perfection requirements provides the means whereby a supplier can establish a valid security interest in its own inventory, even when that inventory has been delivered to the customer. The supplier�s compliance with the perfection requirements of the UCC protects ownership of inventory. In the event of a dispute over the goods, the supplier will prevail over a competing supplier.
An agreement is executed describing the relationship of the parties involved (i.e., the supplier owner is consignor and the customer seller is consignee); a description of the inventory; and agreement that title to the merchandise only passes to third-party buyers. Then the supplier completes a UCC-1 financing statement, which again describes the inventory and makes clear that the inventory is delivered on consignment. The supplier then files the statement with the filing office (usually the Secretary of State).
A supplier must give notice to any creditor asserting a security interest in the customer�s inventory in order to avoid any appearance that inventory coming to the customer is free from ownership claims. To have priority in the accounts receivable generated by the sale of consigned goods, the supplier must also comply with the UCC notice-filing requirements as to accounts receivable.
With the bankruptcy filing, the creditor that is a party to a consignment agreement with the debtor may find the agreement challenged by a debtor or other party if the creditor fails to adhere with Article 9. The creditor may also have to trace the proceeds the sale of its product that is subject to the purchase money security interest.
Where the creditor has a delinquent account, the creditor may be able to obtain collateral from the customer to secure its delinquent account in the form of a Security Agreement. The Security Agreement between the creditor and customer generally covers all property of the customer concerning the creditor�s pre-existing debt. The creditor�s priority to the customer�s assets is generally chronological to preexisting secured creditors (first to file), and does not require notification to prior secured creditors, as the creditor�s interest is junior to theirs.
The creditor�s lien on all the debtor�s assets is perfected at the time of filing the UCC-1. The debtor�s assets include all things that are movable, but do not include money or general intangibles. The debtor must sign the security agreement and the security agreement must describe the collateral. The requirements for the creditor that must be met in the creation of a security interest are that: value must have been given by the creditor in exchange for the security interest; the debtor must have rights in the collateral it offers; and the debtor must have signed a security agreement which contains a description of the collateral. A creditor perfects the security interest when it files a financing statement with the filing office (usually the Secretary of State) that adequately describes the collateral.
The main purpose in filing a financing statement is to guarantee that any third parties will have been notified of existing security interests in the collateral. The filing creditor thus takes priority over other nonsecured creditors and has the right to take possession of and sell the collateral if the debtor defaults. The creditor holding a secured claim in the debtor�s assets should be entitled to adequate protection with the customer filing bankruptcy.
The right of setoff allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding the situation of making A pay B when B owes A. The right of setoff arises under state law and, if such right exists, is preserved in bankruptcy cases. For a company to offset, three steps must be taken: (1) an authorized officer must make the decision to effectuate the setoff, (2) some action must be taken accomplishing the setoff and 3) the setoff must be recorded.
Offsets allow entities that owe each other money to setoff the debts against one another. The filing of bankruptcy by a debtor dramatically changes the economics of an open account relationship involving the setoff of mutual debts. It is vitally important to preserve the right to setoff debts in the context of bankruptcy.
If the creditor cannot obtain a credit enhancement from the customer, the creditor may consider an alternative means of payment to reduce credit risk.
10. Credit Card
Having a customer pay by credit card is appealing to the seller as it allows for payment prior to goods being released to the customer. However, a seller may be at risk with the customer charging a purchase. The creditor may be responsible for unauthorized purchases and fraud. A seller may accept a personal credit card for a commercial sale; however, it may be an indication that the company the person is purchasing for is in financial trouble. (More likely, it means that the person wants the frequent flyer miles).
Credit card transactions conducted by telephone, fax or the Internet, also known as card-not-present transactions, have a higher risk of fraud. A credit card payment is an independent agreement, and allows a creditor to avoid the effects of a customer�s bankruptcy.
11. E-Checks and Checks by Fax
An e-check is an electronic version of a paper check. The e-check may provide for multiple payers, endorser signatures and is governed by the UCC covering checks. The creditor may choose to have a third party accept the payments in an e-lockbox or have the receipt directed to the accounts receivable department for handling. Echecks use digital signatures where federal legislation recently recognized their use.
Checks by Fax are similar to conventional checks with the difference being that you print your customer's check on your inhouse printer or fax machine and prepare it for deposit. Your customer makes out a check payable to you, signs it, just as if it was to be mailed, and faxes it to you. You then make a bank draft "duplicate" of the check and submit it for deposit, and keep their original check as a record of this transaction. Previously technology was an issue for some smaller local banks, but those issues for the most part have been resolved. Provided that the customer�s e-check or fax check has cleared its account, there should be no bankruptcy risk with a customer paying by that method.
Credit enhancements or alternative payment mechanisms can make the sale and reduce the risk prior to the Reform Act�s effective date of October 17. The key to a credit enhancement is to structure the instrument so that you will realize the maximum recovery upon a customer�s bankruptcy.