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We have been asked to provide a $1 million line to a small privately held customer that has one decent trade reference and no credit rating. The one 'saving grace' is the fact that the sale is made to the federal government. How serious is the credit risk? What about becoming a secured creditor under the UCC? Any other ideas?

Answer: Becoming a secured creditor is under the UCC is complex. If you don't do it correctly, you may invalidate your right to the pledged collateral. Also, your customer may not be in a position to offer you a security interest - example, under their bank loan agreement they may be prohibited from doing so...or as is often the case your customer may not have any assets worth collateralizing.

Your customer may have [this often is the case] pledged all of its assets to another creditor such as its bank in which case you have what amounts to a second mortgage or even a third mortgage, and therefore the 'value' of your pledged collateral to you in liquidation may be next to nothing. Another problem: You may be offered assets as collateral that are 'transitory' - such as a security interest in your raw materials -- or the proceeds from the sale of your merchandise, or a security interest in the debtor company's A/R and/or inventory. The problem is that the values of these assets change...and often by the time a creditor recognizes a problem and 'forecloses' on its pledged collateral these transitory assets have been sold or used or converted into cash and the cash has been spent.

This is a brief explanation of a complex problem. Suggestion: Consider requesting a Documentary Letter of Credit covering the sale.

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