As the country has been in a recession for the past year, many companies have endured economic hardships. These hardships include loss of revenue, lay off of qualified employees, debtor defaults, bad cash flow, delayed cash flow and vanishing credit lines just to mention a few. When a customer does not pay a bill that is owed to a company, this is known as a debtor default. It is especially devastating for the company that either sold or rendered a service to the customer or client because the company, in fact, expended their own money, took certain risks, and put their hopes and existence into the expectation that the customer would pay the bill. When the customer does not pay the bill, the company is left holding the bill for what the customer was obligated to pay. This advisory focuses on how sellers can structure sales transactions in order to prevent this type of loss.
Using a Secured Transaction
Companies use secured transactions to ensure property in many sales transactions. Generally, when the property is sold, a financing statement is filed in the state where the product is sold; thus, if a debtor defaults or files bankruptcy on the obligation to pay, the creditor (company) can regain possession of the item sold. Although a secured transaction is designed to achieve this result, it does not always work in this fashion. There are events that cause even secured property, to fall out of the hands of the company when a debtor defaults on an obligation.
The Secured Transaction is governed by Article 9 of the Uniform Commercial Code (UCC). As a practical matter, all 50 states have adopted Article 9 of the UCC. This inclusion even affects the state of Louisiana, which follows a more Non-Anglican form of law.
Don’ts of Secured Transactions
When using a security agreement, do not blindly assume the security agreement alone will secure your property. Though you may have properly completed the security agreement, it does not entitle you to completely abandon caution in your dealings. It is therefore useful NOT to do the following while using a secured transaction in a sale: 1) Put blind faith in a client with a poor credit rating; 2) Depend solely on the secured transaction; 3) Forget to record the transaction with the state.
Do’s of Secured Transactions
As with any sale or service, approach any transaction with a healthy degree of financial skepticism. Do not assume the customer is going to default on the transaction, nor assume any customer will make good on the purchase because the customer seems honest or of good character. Be sure to DO the following in any secured transaction: 1) Check credit ratings; 2) Properly file the UCC arrangement; 3) Explore the possibility of leasing equipment to customers (capital lease); 4) Be willing to rent equipment to customers (operating lease); 5) Sell on a conditional sales contract to be ultra secure.
Use of the Conditional Sales Contract
A Conditional Sales Contract is a type of contract wherein the merchandise or product’s title is retained by the seller. Once ALL of the required payments have been made and the contract has been performed in its entirety, the seller then passes title to the buyer. It is a simple way to ensure first priority in a bankruptcy situation or customer default. In this form, because title remains with the seller at all times, the legal protections of retaining title stay with the seller until all of the conditions of the sale are met. This simply means the seller, during the course of payments, owns the property.
The concept of renting is universally understood and occurs. It is quite simply when a property owner allows use and possession of property, for a fee, to another for a stated or unstated amount of time. In these transactions, title always remains with the owner.
The Capital Lease is a somewhat more complex idea than the conditional sales contract and renting. In a capital lease, a buyer makes payments on property, in substantial amount equivalent to the value of the property, with the intent that the equipment be purchased with a final, bargain purchase price. Title also remains with the seller until the lease is completed, rendering full legal protection as well in the event of buyer default.
The recession this country is currently facing is one for the record books. Though Article 9 of the UCC is designed to assist sellers in retaining property in the event of customer default and bankruptcy, it cannot be used in blind reliance. Utilizing other measures such as the conditional sales contract, lease agreements, and rental agreements during this time could be a seller’s best hope of keeping his/her business safe from large losses.
By: Dr. Bart Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors