Given the uncertain economic environment and threat
of further economic disruption, the credit professional may consider
alternatives to reduce credit risk, yet still make the sale.
1. Secured Transactions
Revised Article 9 of the Uniform Commercial Code was recently adopted by a
majority of states. A hallmark of revised Article 9 is that it significantly
relaxes the minimum standards that security agreement and financing statement
must meet. Another hallmark is that revised Article 9 eliminates the requirement
of a debtor's signature for both the security agreement and financing statement.
This means that the security agreement can be electronic.
a. Purchase Money Security Interest
The vendor may consider taking a security interest in the goods it sells to
the customer 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 customer
a multi-step process must be complied with. The customer 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 customer 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 customer,
may require the consent of the customer's lender can be complicated to properly
perfect and can be cumbersome for the vendor frequently selling in small lots.
Article 9 of the 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 customer. 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
An agreement is executed describing the relationship of the parties involved
(i.e., the vendor 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 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 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 vendor must also comply with the UCC noticefiling requirements
as to accounts receivable.
Like PMSI, some problems with a consignment can be that it requires the consent
of the customer, can be complicated for the vendor to properly perfect and
can be cumbersome for the vendor frequently selling in small lots.
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 customer
fails to pay. However, a guarantee may be used as leverage by the vendor to
force the customer to pay by threatening to pursue the guarantor, who may be
a principal of the customer. Customers are often financed by deep-pocketed
venture capitalists. If the vendor is a key supplier of the customer, 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 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 vendor'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 include a statement that the signing party is personally
guarantying the debt of the customer 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.
4. Letters of Credit
A letter of credit (L/C) is a promise by an issuer, the bank, to pay the vendor,
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 vendor. The customer 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 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 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 customer's default. The vendor 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 vendor. 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 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 customer's bankruptcy. 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 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 customer should be included
in the amount of the L/C.
5. Advance Payment Guarantees, Bonds and Liens
If the vendor is buying or selling based upon milestone payments, then it is
usually best to obtain (or give) a third party guaranty.
If the vendor is engaged in a selling activity in which someone else's real
property is enhanced by creditor's supply of goods or services, then it is
essential for the vendor to protect its buying and selling activities.
For public works, this is usually achieved by performance and payment bonds
issued by a specialized insurance company commonly referred to as a surety.
For example, the Miller Act of 1935 (40 U.S.C. 270) requires performance and
payment bonds for large Federal public works projects. For example, the U.S.
Army Corps of Engineers requires a prime contractor to obtain a bond for a
$ 100,000 project. The Performance Bond would ensure that the project was completed,
and the associated Payment Bond would help protect any vendors and subcontractors
to the prime contractor.
Each state has enacted what are commonly referred to as "Little Miller Acts." However,
creditors need to be forewarned that not all bonds guarantee full payment;
limitations may apply. At the very least, creditors should request and obtain
a copy of the bond(s) prior to beginning work or manufacture.
For private jobs, most creditors rely upon mechanic's or materialmen's lien
rights. Each state has its own unique requirements. However, time windows do
apply, and some states require first furnishing notices to the owner. Also,
how far removed the vendor is from the owner of the real estate from the standpoint
of the money chain is significant. The further removed, the less likelihood
of prevailing on a lien claim.
Douglas G Fox, GSCFM, CCE is a member of Mid-Atlantic NACM
and is active in the Greater Delaware Valley Region and Philadelphia area.
Scott E. Blakeley is a principal of Blakeley & Blakeley LLP
where he practices creditors' rights and bankruptcy law. He can be reached