Chrysler and General Motors have filed bankruptcy cases. In addition to the losses investors and lenders will suffer, those cases will impose financial losses on many service providers and suppliers. These filings highlight the need for companies in all industries to reassess whether their credit risk strategies are aligned with the current economy and their credit risk tolerances. Your answers to the following three questions will help you in that reassessment.
1. Should you change the terms on which you extend credit to certain customers? If you are extending credit to a customer, you should keep a close eye on how the customer is paying its bills. If you decide you need to impose tighter credit terms, you have a number of options. You can, among other things:
- Require the customer to pay on a cash before delivery or cash on delivery basis,
- Reduce the customer’s credit line or shorten the time in which it has to pay an invoice, and
- Require the customer to provide credit enhancement for some or all of its future purchases, such as a standby letter of credit, personal guaranty, or a security interest in the goods you sell to the customer or other assets.
In any event, you should review your contracts and terms of sale to confirm you have the right to change credit terms.
2. Does your company have a first-priority security interest in the goods it sells? If you do, you will likely have a right in any bankruptcy case to receive an amount equal to the current value of (a) the equipment you sold to the customer, or (b) the inventory you sold to the customer that the customer still has in stock when the customer files its bankruptcy case. If you do not, you will be an unsecured creditor, and likely will receive only cents on the dollar from the bankruptcy estate. For your company to obtain a first-priority security interest, you must do a number of things.
- First, you must have the customer sign a security agreement.
- Second, you must perfect the security interest, usually by filing a financing statement at the office of the Secretary of State in the appropriate state.
- Third, your perfected security interest must have priority over other creditors. Generally, an earlier filed perfected security interest has priority over a later filed one. In many instances, a bank will have filed an earlier blanket security interest on all of the customer’s assets which gives the bank priority. However, you can obtain a purchase money security interest (“PMSI”) which will have priority over an earlier filed security interest. In order to obtain a PMSI, you must extend credit to the customer to allow it to purchase the goods and take proper steps, including filing a financing statement before the customer receives the goods or, in most states, within 20 days after the customer receives the goods. You must take additional steps to gain priority if the goods are inventory in the hands of the customer.
The number of technical steps involved in obtaining a first-priority security interest make it advisable to consult with your lawyer to navigate this process.
3. Will your actions increase the chances of a preference claim against your company? If your customer enters bankruptcy, you face the potential of a preference claim from the bankruptcy estate. A preference claim is a demand for the return of a payment your customer made during the 90 days immediately preceding the date on which the bankruptcy petition was filed (one year if the customer made the payment to an insider). There are a number of defenses to preference claims, including the ordinary course of business defense or the subsequent new value defense. In general, if your company has a first-priority security interest in the goods it sells to the customer, the payments the customer makes to your company during the 90-day period will not be preferences. The risk of a preference claim, and the ability to do some planning to reduce the risk, make it advisable for you to discuss with your lawyer how you should address changing credit risks.
Contact Information: If you have questions or need additional information please contact:
Stephen R. Hunting
Albert E. Guarnieri
William L. Esser IV
Kevin W. Chapman