Given the current state of our economy, business owners may be well advised to take preemptive measures to better ensure the receipt of payment for their goods or services. There are relatively basic protections available to businesses, which may provide not only a level of protection but also some peace of mind. For the most part, it will be necessary for a business to secure its protective rights as part of the original contract with a customer or client. However, even if a contract does not specifically incorporate the business creditor's various protections, there may still be rights and remedies available to the business under relevant controlling law.
One simple protective pre-contract step for a business is to understand the financial status of a customer or client. Requiring a pre-loan or pre-transaction disclosure of credit or other pertinent financial information can help obtain enlightening information. Financial disclosures often reveal valuable information that could forecast impending financial difficulties. An additional benefit of requiring financial disclosures is that if there are intentional inaccuracies in the disclosures that are relied upon by the business in entering into the transaction, the debt may be held non-dischargeable in a bankruptcy proceeding. A non-dischargeable debt survives the bankruptcy process and the creditor can collect any remaining balance after the bankruptcy process is completed.
Another protective step to consider during contract negotiations is a requirement that the customer pledge security, also referred to as collateral, for the loan or transaction. A security interest is a legally recognized interest in the property of another, which is acquired consensually (i.e. by contract) for the purpose of securing payment or performance of an obligation. The main purpose of the security interest is to allow the beneficiary of the security interest to seize, and usually sell, the property pledged in the event of a default in order to satisfy the obligation for which the security interest is given. A security interest also gives the beneficiary certain preferential rights in relation to the assets pledged. Sources for security may include both personal and business assets. For example, security may be in the form of real property, equipment, tools, boats, vehicles, jewelry and accounts receivable.
With the notable exception of a security interest in real property, the Uniform Commercial Code, also known as the UCC, usually governs the attachment and perfection of a security interest. A security interest may be unenforceable unless it is properly attached and perfected under the UCC. Any business considering the use of security should seek the advice and guidance of legal counsel to ensure all relevant provisions of the UCC are satisfied.
Two additional similar types of protection are a personal guarantee and a cosigner. The two concepts are basically the same as far as responsibility is concerned. If the primary obligor defaults, the guarantor or cosigner is on the hook for the entire debt. However, a personal guarantee is only responsible for the debt after a demand has been made on the debtor, whereas a cosigner may be responsible for the debt without a demand having been made on the debtor.
With a personal guaranty, a third party promises to pay back the debt if the party with primary responsibility defaults. For example, it is fairly common for the principal (i.e. owner) of a corporation or limited liability company to personally guaranty the debts of the entity. However, when considering whether to accept the personal guaranty of a principal, a creditor should consider whether a principal truly provides an alternative source of recovery, or if her entire income and worth is derived from the primary obligor.
The obligation to pay the debt owed under a personal guaranty arises upon an event of default. In the event of default, demand for payment will first be made on the primary debtor, and if the debtor fails to pay, the party subject to the personal guaranty will be responsible for payment.
Conversely, a cosigner and the debtor are equally responsible in the first instance for repayment of the debt. In other words, payment may be demanded on the cosigner before or even instead of demanding payment from the primary debtor.
In addition to taking protective measures at the contract negotiations stage, there are also some protective measures a business owner can implement when a customer starts to shows signs of financial distress.
Depending on the contractual rights of the parties, some of available measures include:
* requiring payments on outstanding invoices before shipping new orders.
* applying payments to past-due invoices.
* requiring new orders to be paid in advance of delivery.
* requiring the customer to pay invoices on a current basis.
* requiring all future payments be done on a cash on delivery or cash in advance basis.
Implementing any of these measures may assist in protecting a business owner's future accounts receivable from going sour.
After learning a customer is insolvent, or has filed for bankruptcy, a creditor may be able to exercise reclamation rights. Reclamation is a means by which a seller may claim or demand back goods that were sold and shipped to a customer on credit, prior to the seller learning that the customer was insolvent. In order to exercise a reclamation right, the goods must have been sold in the "ordinary course" of the vendor's business, the seller must make a written demand for return of the goods to the buyer, and the buyer must have possession of the goods at the time the written demand was received. The reclamation demand must be in writing and made within 45 days of the receipt of the goods by the debtor.
Given the expansive protections of the bankruptcy code's automatic stay, a business owner would be well advised to seek guidance from a bankruptcy attorney to ensure no violation of the stay occurs. There may be serious and substantial consequences for violating an automatic stay, knowingly or unknowingly.
Bruce Beesley is a partner and Tricia Darby an associate with the law firm of Lewis and Roca LLP in Reno.
