Alternative Payment Mechanisms:
Don't let your Inventory End up on
a Dot-Com Liquidators Website!
By Scott Blakeley

Liquidation is a growth industry for dot-coms and the vultures of the Internet are arriving. A number of dot-coms now specialize in buying a failed dot-com's inventory at a steep discount and reselling the goods on the Internet. Bankruptcy trustees, too, have been buoyed by the dot-com bust as they auction off the dot-coms' remains over the Internet. Vendors have learned a painful lesson that there are few assets to pay vendors from an insolvent dot-com. Given the recent volatility of dot-coms, a credit professional must now consider alternatives to a credit sale to the dot-com. But the credit professional also appreciates that demanding a cash sale may mean losing business, perhaps significant business, as B2B and the Internet evolves. What credit enhancements or alternative payment mechanisms are available to protect the vendor in the event that the dot-com fails to pay?

Looking For Guaranteed Payment

The vendor is looking for the credit enhancement that is most readily converted into cash, and is unlikely to be affected by an out-of-court liquidation or bankruptcy of the dot-com.

Letter of Credit
A letter of credit (L/C) is a promise by an issuer, the bank, to pay the vendor, as beneficiary, when the dot-com has defaulted on the sale. The dot-com uses its assets as collateral for the L/C, so that the credit of the bank is substituted for the credit of the dot-com in favor of the vendor. The dot-com pays the issuing bank a fee to issue the L/C. If the vendor submits proper documents upon default, the bank will pay the L/ C and the dot-com reimburses the bank. An L/C may be either revocable or irrevocable. An irrevocable L/C can be modified only with consent of the vendor. A revocable L/ C can be modified by the bank without the consent of the vendor. The vendor can obtain a standby L/C, which assures payment after the dot-com's default. The vendor should insist on an irrevocable L/C with the dot-com sale.

L/C's are independent from the underlying contract between the dot-com and the vendor. The bank honoring the L/C is concerned only to see that the documents conform with the requirements in the L/C. If the documents conform, the bank will pay, and obtain reimbursement from the dot-com. The bank need not look past the documents to examine the underlying sale of goods. Thus, a vendor 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 may allow a vendor to avoid the effects of a dot-com's bankruptcy. Bankruptcy courts recognize that the proceeds of a letter of credit are not property of the dot-com's bankruptcy estate, and that a bankruptcy court does not have authority to bar payment under a L/C, notwithstanding the effects of the automatic stay.

The vendor may insist on an L/C that provides for the maximum exposure under the credit line. For example, if the vendor specially manufactures goods, those goods that are in process yet not billed to the dot-com should be included in the amount of the L/C.

Certificate of Deposit
A CD may be issued by the dot-com's bank in the name of the vendor. The CD is unconditionally payable to the vendor upon (continued on page 6) demand, is funded by the dot-com, and automatically renews for the length of the credit line. The principal amount accrues to the benefit of the vendor, and interest is paid to the dot-com.

Credit Insurance
A vendor purchases credit insurance (CI) to avoid loss on a speculative customer, but keeps the accounts receivable. CI may cover a variety of credit risk, from a dot-com's bankruptcy, a default or dispute. The CI generally covers up to 90% of the insured account. The risk premium for CI may be measured by the vendor's accounts receivable risk profile. The credit insurer may monitor the buyer's financial condition. The term of the policy may be one year.

Bankruptcy Swap
Like credit insurance, a vendor may purchase a bankruptcy swap to reduce credit risk but keep the account receivable on the books, unlike factoring where the account may be sold. A swap involves a third party that investigates the credit quality of the buyer of goods. Swaps are common with commercial banks and investment banks that look to diversify their credit risk. The vendor pays a periodic fee for the swap. Unlike credit insurance, the swap can be sold over the market. The buyer of the swap pays the vendor only in the event the dot-com files bankruptcy. The swap provides the vendor some protection against a dot-com's bankruptcy.

Factoring
Factoring provides for the vendor to sell its dot-com account receivable at a discount to a third party, the factor, who is usually a financial institution. The sale is often non-recourse, which means that the factor is responsible for the dot-com account in the event of default. The vendor usually invoices the dot-com but is payable to the factor's address. The vendor sends the invoice to the factor, who pays a discounted amount of the invoice.

Guarantee
A guarantee, whether corporate or personal, is not the preferred credit enhancement, as it requires the vendor to take legal action to get paid when the dot-com fails to pay. However, a guarantee may be used as leverage by the vendor to force the dot-com to pay by threatening to pursue the guarantor, who may be a principal of the dot-com. Dot-coms are often financed by deep-pocketed venture capitalists. If the vendor is a key supplier of the dot-com, the vendor may look to the venture capitalist to guarantee the sale.

The basic legal principle is that the guarantor is not a party to the principal debt. The guarantor's undertaking is independent of the dot-com's promise to pay. Merely because both contracts are on the same paper, for example, the credit application - the dot-com's promise to pay for the vendor's goods or services, and the guarantor's promise to pay if the dot-com does not - does not change the independence of the agreements.

The guarantee should include a statement that the signing party is personally guarantying the debt of the dot-com referenced in the credit application. The guarantee should have under the signature block a line for the individual guarantor's social security number and a line for the individual guarantor's home address. The guarantee should be signed before a notary to reduce the risk that the guarantor may contend that the guarantee was forged.

Purchase Money Security Interest
The vendor may consider taking a security interest in the goods it sells to the dot-com, and the proceeds from the sale of the goods. Under the amended Article 9 of the Uniform Commercial Code, for the vendor to obtain a valid purchase money security interest (PMSI) in the goods it sells to the dot-com a multi-step process must be complied with. The dot-com first executes a security agreement describing the goods covered in favor of the vendor, which gives the vendor a security interest in those goods. The vendor 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 vendor's PMSI will prime the inventory secured creditor's lien only if: (1) the PMSI is already perfected at the time the dot-com receives possession of the goods; and (2) the vendor gives written notice to any other preexisting inventory secured creditor. If the vendor fails to perfect the PMSI, including giving notice, the vendor's priority is governed by the "first to file" rule. This means that an inventory secured creditor will prime the vendor's PMSI.

Some problems with a PMSI can be that it requires the consent of the dot-com, may require the consent of the dot-com's lender, can be complicated to properly perfect and can be cumbersome for the vendor frequently selling in small lots.

Consignment
Article 9 of the UCC's perfection requirements provides the means whereby a vendor can establish a valid security interest in its own inventory, even when that inventory has been delivered to the dot-com. The vendor's compliance with the perfection requirements of the UCC not only protects ownership of inventory; in the event of a dispute over the goods, the vendor will prevail over a competing creditor.

An agreement is executed describing the relationship of the parties involved (i.e., the vendor owner is consignor and the dot-com seller is consignee); a description of the inventory; and agreement that title to the merchandise only passes to third-party buyers. Then the vendor completes a UCC-1 financing statement, which again describes the inventory and makes clear that the inventory is delivered on consignment. The vendor then files the statement with the filing office (usually the Secretary of State).

A vendor must give notice to any creditor asserting a security interest in the dot-com's inventory in order to avoid any appearance that inventory coming to the dot-com is free from ownership claims. To have priority in the accounts receivable generated by the sale of consigned goods, the vendor must also comply with the UCC notice-filing requirements as to accounts receivable.

Like PMSI, some problems with a consignment can be that it requires the consent of the dot-com, can be complicated for the vendor to properly perfect and can be cumbersome for the vendor frequently selling in small lots.

Alternative Payment Mechanisms
When Dot-Com Cannot Furnish Credit Enhancement

The dot-com and the Internet are not only changing the way vendors bring their goods to market, but also they are changing the way in which vendors may be paid on their sale. A vendor may turn to credit cards and e-payments where a credit enhancement is unavailable or not workable.

Credit Card
Payment by credit card is appealing to the vendor as it allows for payment prior to goods being released to the dot-com. However, a vendor may risk chargeback of disputed balances. The dot-com's credit card company is not obligated to verify whether the dispute is legitimate. The vendor may also be responsible for unauthorized purchases and fraud. A vendor may accept a personal credit card for a commercial sale; however, it may be an indicator that the company the person is purchasing for is in financial trouble. However, it may mean 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.

E-Checks
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 vendor may chose to have a third party accept the payments in an e-lockbox or have the receipt directed to the accounts receivable department for handling. E-checks use digital signatures where federal legislation recently recognized their use.

CheckSpace
CheckSpace enables the vendor to send invoices and receive payments from the dot-com electronically. The service provides for B2B payments between the vendor and the dot-com with e-mail addresses and bank accounts. The service also provides for online accounting with a listing of payables and receivables as well as a check register for payments made online.

Credit Enhancements Or E-Payments Can Make The Dot-Com Sale

Credit professionals are in the business of "making the sale." The key to a credit enhancement is to structure the instrument so that the vendor will realize the maximum recovery upon a dot-com's liquidation or bankruptcy. By choosing credit enhancements or alternative payment mechanisms the credit professional can maximize the sale and minimize the risk.

Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP
Summer 01