November 11, 2008
Sales of goods or services on an open account create only an unsecured claim against the customer. Thus, when nonjudicial attempts at collection are unsuccessful, the seller’s only recourse is to commence a lawsuit on the account. The process of obtaining and enforcing a judgment is expensive and time-consuming and, if the customer has no unencumbered assets with which to satisfy the judgment, fruitless.
There are several ways to reduce credit risks.
Credit checks. A seller should obtain and carefully review a customer’s financial statements, especially its balance sheet and income statement. This review will identify potential credit problems and determine whether credit protection is necessary.
Don’t give it. Of course, one way to eliminate credit risk is to eliminate credit. Obtaining payment in advance (CIA) or on delivery (COD) eliminates the “credit” nature of the sale and the related credit risks.
Cash deposits. A seller can require that a customer deposit an amount of cash as security. For maximum protection, the deposit should equal the amount of credit. If sales total $10,000 over a 30-day period, and the terms of sale are 30 days, the cash deposit should be at least $10,000. If the customer fails to make payment, the seller may apply the cash deposit to outstanding invoices and stop additional sales until another deposit has been made.
General security interests. A seller can obtain a security interest or a mortgage in all or a portion of the customer’s assets. If the customer fails to pay, the seller can sell the assets and apply the proceeds to the debt. (In cases involving real estate collateral, and in many cases involving personal property collateral, a lawsuit is necessary to accomplish these things.) To obtain and perfect a security interest or mortgage, appropriate documents must be executed and filed in certain governmental offices. If the customer’s assets are already pledged to other creditors, this approach may provide little or no protection.
Targeted security interests. A seller can obtain a security interest in the specific goods being sold. This is known as a purchase money security interest (PMSI). If the proper steps are followed, the seller’s PMSI will take priority over any interest that other secured creditors may have in the goods being sold. These steps include the execution and filing of appropriate documents and, in some cases, notice to the existing secured creditors. Keep in mind, however, that the special priority of a PMSI extends only to the goods themselves and their identifiable (noncommingled) cash proceeds. Thus, a PMSI has no value if the goods have been sold and the sale proceeds expended or commingled in the buyer's accounts.
Letters of credit. Perhaps the best way to reduce credit risks is to require that the customer provide a letter of credit. There are two types of letters of credit available for this purpose. A “commercial” or “direct pay” letter of credit is intended from the outset of the transaction to be the source of payment for the goods. When payment is due, the seller presents the required documents to the bank issuing the letter of credit, whereupon the bank makes the payment. A “standby” letter of credit is intended to be drawn only if the customer defaults in payment. Thus, in order to draw on a standby letter of credit, the seller would ordinarily present to the issuing bank documents that establish that the customer has failed to make the payment.
The most critical considerations in connection with obtaining a letter of credit are the creditworthiness of the issuing bank and the conditions for drawing under the letter. The number of documents and certifications that must be provided to the issuing bank should be kept to a minimum so that the requirements for drawing on the letter of credit can be easily satisfied.
A seller considering any of these methods of reducing its credit risks should consult with its attorney so that appropriate documentation and filing are completed. During the consultation, the seller should ask about its right to reclaim goods from the customer, its right to stop goods in transit to the customer, and its right to a priority administrative expense claim for goods delivered within 20 days of a customer’s bankruptcy. These rights may further reduce credit risk by providing additional remedies in the event of a customer’s actual or anticipated default.
Of course, there are important business considerations involved in the decision to pursue credit protection. Steps taken to reduce credit risks often will reduce sales. Some customers cannot agree to these arrangements because of agreements with their bank lenders or other creditors. Some customers simply will not agree, perhaps because the goods or services are available from another seller who is not requiring similar protection. Every business, large or small, must balance the benefits of the sale (profits and potential future business opportunities) with the risk of nonpayment.