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Sarbanes Oxley

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By Scott Blakeley, Esq and Douglas Fox, CCE
Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP

Credit Hold and Converting a Credit Sale to Cash

Effective August 2004, Section 409 of the Sarbanes Oxley Act (SOX) expands the number and type of financial events companies must disclose in 8-K forms. Until this change, most companies reported very few significant corporate events, often waiting to disclose the financial information in quarterly or annual reports.

This new rule may aid suppliers selling to these companies by increasing the number of material events that must be disclosed, versus what is currently required. In the past, there was a long lag time between the event and the company disclosing the event to the public, including suppliers selling the company on credit.

The new rule adds developments that must be reported on Form 8-K and shortens the filing deadline to four days. Previously depending upon the nature of the disclosure, companies had between five business days and 15 calendar days after a triggering event to file 8-K's.

Given the more prompt and full disclosure that a public customer must make regarding its financial condition, the disclosure may result in you taking action earlier and perhaps holding orders more timely, thereby reducing the risk of loss. A Section 409 disclosure may trigger a process in which you determine whether or not open account terms are still appropriate, and if so, under what terms and conditions future sales can be made safely.

More Timely Financial Disclosures Under SOX

Section 409 requires public companies to make additional disclosures to the financial markets:

  1. The removal or resignation of any corporate director and the entering into or withdrawing from an important agreement;
  2. Agreements that are made or terminated outside the company's ordinary course of business;
  3. Entry into a material agreement;
  4. Termination of a material agreement;
  5. Creation of a material, direct financial obligation or a material obligation under an off-balance sheet arrangement;
  6. Events triggering a material, direct financial obligation or a material obligation under on offbalance sheet arrangement;
  7. Material impairments;
  8. Notice of de-listing from stock exchange or failure to satisfy listing standards and transfer of listings; and
  9. If the company concludes, or the auditors inform the company, that previously issued financial statements, or a related audit report or completed interim review, should not be relied upon.

The SEC estimates these new disclosure requirements will cost American corporations at least $44 million a year to comply. Given that the disclosure requirements will impact suppliers selling to these companies on credit, how do you best protect your interest in the face of a Section 409 disclosure? While a disclosure may indicate future financial difficulty, you may find that a breach of the credit sale may not yet have occurred.

At this stage you are looking to reduce the risk of loss. If you treat the credit sale as repudiated because of the customer's apparent financial difficulty, you may find that you have acted prematurely and be liable to the customer for damages. In light of the more timely and complete financial disclosure caused by Section 409, what should you do to reduce your credit risk however not find yourself the target of claims by the customer that you breached the agreement? What protections does Art icle 2 of the Uniform Commercial Code offer you as a creditor?

Demands For Assurance Of Payment In Light Of SOX Disclosures

Right To Adequate Assurance Of Performance

Given SOX Section 409's disclosure requirements, what are your rights to place an account on credit hold? Where a supplier has sold goods to the customer on credit and has grounds that the customer may not pay (termed "grounds for insecurity" under Article 2 of the UCC), you may demand written assurance that the customer will perform. Section 2-609 of the UCC provides:

a. A credit sale requires the buyer/ customer, and the seller/supplier, to perform. Should grounds for insecurity arise with a buyer's performance, you may demand, in writing, assurance of performance. Until you receive such assurance, you may suspend performance.

b. The customer's failure to provide assurance within a reasonable time, not exceeding 30 days, repudiates the contract and you have no further obligation.

The two questions for you with this remedy are whether the grounds for insecurity are reasonable, and whether the customer's assurance of performance is adequate.

A sample form for an Adequate Assurance Demand Letter follows this paper.

Where Credit Documents Provide For Supplier’s Unilateral Right To Terminate Credit Terms

Credit professionals may attempt to short cut the UCC adequate assurance requirement by including in their credit documents the unilateral right to modify or terminate the extension of unsecured credit. The following language may be considered in your company’s credit application or in a vendor agreement:


If the buyer fails to fulfill [mitigated by any Force Majeure clause] the terms of payment of any invoice or if the financial responsibility of the buyer shall become impaired or unsatisfactory to the Seller, or if necessitated by any acts of any governmental authority, including financial disclosures mandated by Section 409 of Sarbanes Oxley Act, the Seller reserves the right to change terms of payment and/or deter or discontinue further shipments without prejudice to any other lawful remedy, until past due payments are made and satisfactory assurances of Buyer's credit standing are received by the Seller or until such acts of requirements of such governmental authority shall have been complied with.

The Seller also reserves the right in the case of any of the foregoing events to cancel the contract, in which event the Buyer shall compensate the Seller for any commitments, obligations, expenditures, expenses, and costs including attorney fees, the Seller may have incurred in connection with the contract.

Each shipment by the Seller shall be considered a separate transaction and if payment is not received therefore within the periods specified herein, the Seller at its option may bring a separate suit to recover the contract price of each such shipment. If any of the following events occur, Seller shall have the right to demand assurance from Buyer that payment in full will be made:

  1. Buyer is delinquent in making payment hereunder for a period of 45 days after payment was due.
  2. Buyer fails to meet his obligations with one or more other suppliers as the obligations occur.
  3. A Writ of Attachment or Judgment is entered in any court of competent jurisdiction.

On written demand for assurance by Seller, Buyer shall, within five (5) days after receipt thereof, furnish, in amount sufficient to secure the full payment of the balance of any monies due hereunder on account of the purchase price, either a penalty bond issued by a competent financially solvent surety company, or financial security, bank irrevocable letter of credit, or other liquid collateral to be held in escrow by an attorney at law as designated by Seller, to secure the payment of the purchase price aforesaid."

Turning A Credit Sale Into A Cash Sale Upon Insolvency

Where a supplier has agreed to sell goods to a customer on unsecured credit, the supplier may refuse to deliver and demand cash upon discovering that the customer is insolvent, as provided under Article 2 of the UCC. The UCC defines insolvent as either balance sheet insolvent (liabilities exceeds assets) or fails to meet debts when they become due.

If Your Company is a Public Company

In the event that your company is itself a public company, and the customer represents a significant portion of your company's accounts receivable portfolio, then your company may be obligated to disclose the possibility of default by a major customer; and/or increase its bad debt reserves to reflect the possibility of the customer's default.

A Note Regarding Written Contracts

In certain industries it is common practice for the creditor and customer to have a written contract for the sale. For example, on large public construction projects, it is common for the owner and general contractor (i.e., seller/creditor) to agree that the general contractor cannot stop its performance for any reason.

Also, Moreover, these contract provisions in virtually all cases these contract provisions “flow down” to other creditors such as to subcontractors, lower tier subcontractors and suppliers/vendors.

Although this may at first glance appear to be horrific from a creditor's perspective, the specific circumstances of the project may suggest such draconian remedies. For example, the repair or replacement of a bridge located on which is an integral part of an interstate highway can cause significant public inconvenience and extreme consequential costs. Typically in all public construction projects, all buyers and sellers agree not to stop work under any circumstance for any reason; and to provide performance and payment surety bonds in order to guaranty their obligations and thus to protect one another in the event of the insolvency of the other. Unfortunately, these wide spread legal provisions have resulted in the bankruptcy of many well known and established contractors (e.g., Guy F Atkinson Company, Morrison Knudson Corporation, Washington Group, J A Jones, etc.). Due to awards based upon the lowest bids, profit margins are often too thin in the industry to compensate a contractor at any tier in the event of unforeseen circumstances. On-line reverse auction bidding in construction projects is rapidly becoming out of favor and legislation is pending to make it unlawful. Sureties, incidentally, usually receive “super priority status” for post-petition bonding in the event of the contractor's bankruptcy.

Consequently, in the event of disclosure under SOX Section 409, the creditor already has the protection of a previously established performance and/or payment bond; and thus, adequate assurance has already been given (Note: typically, there are also large liquidated damage penalties in the event of delays.)

Reducing Credit Risk As A Result Of SOX

For the credit professional, determining if a customer has repudiated the credit sale can be complicated, especially based exclusively on a Section 409 disclosure. However, complying with the adequate assurance requirements contained in Article 2, you may reduce the risk of loss for your company and reduce the risk that you wrongfully terminated the contract.

Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP

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