Manufacturers, distributors and other merchants of goods who sell their products on credit terms routinely accept a high level of risk of defaulted payment from their customers. In good times, credit-related losses are relatively predictable as a percentage of sales and can be offset by variations in pricing and volume across a seller’s sales transactions. Unfortunately, we are far removed from the good times. The prolonged economic slump has resulted in increased payment defaults and a 150 percent rise in business bankruptcies since the summer of 2007. In this economic climate, a seller’s legal documentation and credit terms can make the difference between payment in full and a bad debt write-off. Now more than ever, companies that sell goods on credit must diligently evaluate their credit policies and make informed decisions with respect to their documentation, credit enhancements (or lack thereof ) and exercise of post-default remedies.
A seller on credit may request various credit enhancements from its customer to improve the odds of collecting in the event of default. In larger international sales transactions, sellers often shift the risk of non-payment to third parties by obtaining trade credit insurance or letters of credit. In the event of a default, the seller may collect payment from the trade insurance company (if payment is not disputed) or the letter of credit issuer. However, these types of enhancements are typically impractical in smaller domestic transactions.
Personal guaranties and security interests constitute the primary credit enhancements in domestic sales transactions with private companies. A personal guaranty from an owner of a closely held purchaser provides the seller with another source of repayment and increases the odds that the customer will elect to pay the debt before it pays debts owing to the customer’s other creditors. Personal guaranties are often included as part of a credit application rather than in a separate guaranty.
A seller may also obtain a security interest (personal property lien) in the goods it sells on credit and all proceeds derived from those goods (e.g., the customer’s accounts receivable). A security interest greatly enhances collection, as it allows repossession of the goods sold on credit and the assertion of a secured claim in their proceeds, and, perhaps most importantly, provides a defense in bankruptcy to preference claims. In general, a seller can claim and fully enforce a security interest if the customer signs an agreement granting the seller a security interest in the delivered goods, and if the seller properly files a financing statement. The procedure for perfecting a security interest in delivered goods is relatively simple.
Sales and Credit Contracts
Well-drafted terms and conditions and credit agreements can strengthen a seller’s collection efforts. A good credit agreement will include a forum selection clause allowing the seller to file suit and obtain a judgment in the seller’s jurisdiction. Other key credit terms include the provision for default interest and a clause allowing the seller to collect attorneys’ fees and costs in the event of a default.
Exercise of Reclamation Rights and Priority Claims
Both the U.S. Bankruptcy Code and state law allow a supplier to “reclaim” goods shipped to an insolvent buyer. The exercise of reclamation rights entitles the seller to the return of its goods, or payment of the cash value of those goods. A seller generally has 20 days after commencement of a bankruptcy case to file a written reclamation demand for goods delivered within 45 days of the bankruptcy case. In addition, the Bankruptcy Code allows a seller of goods to assert an administrative claim for the value of goods delivered within 20 days of the bankruptcy filing. Outside of bankruptcy, a seller generally has 10 days after delivery of goods to make a reclamation demand. It is important to understand and timely assert these rights