Chapter 3

Extending Credit Carefully While Controlling Your Risk

In This Chapter

Figuring out whether a customer qualifies for credit terms

Compiling and applying vital credit information

Handling credit applications and financial statements

Discovering alternatives to extending credit

Securing liens and getting personal guaranties

In a perfect world, all your customers pay their bills on time and in cash. You never have to offer credit terms. But you live in the real world, and your customers want credit. Lots of credit. Odds are you do too when your business is someone’s customer.

So how do you expand your customer base and make credit attractive while controlling risks to prevent bad debt write-offs? To minimize risk, you need to set reasonable guidelines as to how much credit any individual customer can get. Yet when credit managers focus primarily on controlling risk, the perception (and sometimes the reality) can be that they’re effectively weeding out customers. You don’t want to turn customers away by creating huge obstacles to their getting credit.

The sensible extension of credit may improve your relationships with your individual customers. Some customers get credit, and for the rest you look for alternatives that work for them while protecting you. Customers you don’t give credit to can remain customers as long as you treat them with respect and give them the opportunity to earn credit terms in the future.

In this chapter, we explain what factors affect a customer’s creditworthiness and how to gather information that helps you reduce your risk when extending credit. You also discover how you can use credit insurance, factoring, and personal guaranties to further reduce your risk.

Determining Which Customers Are Worthy of Credit (And Which Aren’t)

Every extension of credit is a risk. Some customers are worthy of more risk than others. Deciding whether or not to extend credit is a tricky business — it’s really an art more than a science. Much of the process is rooted in your instincts toward a customer and conditions in general. Your instincts are guided by the credit risk factors and the five Cs of credit (character, collateral, capacity, capital, and conditions), which we outline in Chapter 2.

The core concept isn’t complicated: Some customers are better credit risks than others are because their financial condition, age, payment history, industry, quality of management, or willingness to provide liens or guaranties make them more likely to pay for their purchases.

But after you trust a customer enough to extend credit, how much credit should you give? The answer varies by business and industry. A $50,000 line of credit may be a minimal risk for some businesses, but a $5,000 line of credit may be high for others. The key here is your margin of profit; your ability to take risks while extending credit rises and falls with your profit margins. The smaller your margins, the less risk you can afford. (We address this topic in more detail in Chapter 2.)

So you track credit information, apply the five Cs, and carefully consider your customer’s situation and industry trends. You set up a system to gradually extend credit to customers who are newly formed or are just new to you. You watch for red flags that indicate trouble ahead. The following sections demonstrate how to do just that.

Also check out “Creating Credit Ratings for Your Customers” later in this chapter for tips on rating a customer’s creditworthiness.

Gathering and using vital credit information to determine your risk

Your customer suddenly wants to double or triple credit purchases. Your sales department wants the increase in business, but your credit department is going to have to deal with any credit headaches that result. Whether you’re evaluating a new customer or a large order, conducting a routine periodic credit review, or responding to concerns about a customer that’s slowing down in its paying habits, you need your customer’s financial information to evaluate credit.

The most important reason to maintain current credit information in your customer’s file is to spot trends. Downward trends are red flags that indicate increased credit risk and require action (see Chapter 5).

Balance sheets

A balance sheet is a snapshot of the assets and liabilities of a company on a specific date. Start with a current balance sheet. Some customers may use a CPA to create an audited balance sheet, but they may only generate that balance sheet once per year, typically at the end of the calendar year or their fiscal year. Many small- and medium-sized companies don’t employ CPAs because they don’t want to incur the expense and instead rely on accountants who may have lesser qualifications, experience, and skills. Getting an unaudited balance sheet doesn’t necessarily mean that your customer’s balance sheets are less accurate, but it may increase the chance of mistakes, omissions, or even misrepresentations.

The numbers on a balance sheet are only valuable if you have other balance sheets to use for comparison. Even if your customer prepares its own balance sheets or can only produce an audited balance sheet once per year, you should require balance sheets every three to six months to compare with any audited balance sheet and to monitor financial trends. As with unaudited balance sheets, any time you receive a financial statement that has not been audited you must watch for errors and omissions. We cover financial trends and what they mean in more detail in “Reviewing statements to spot trends” later in this chapter.

Operating statements

Operating statements measure sales and profits (or losses) over a specific time frame, such as 3 months, 6 months, or a year. They tell you how much money a business took in during that specific time frame and how much profit it made after deducting various costs. As with balance sheets, get a series of operating statements so you can see trends and changes over time.

Aging sheets

You should maintain aging sheets for all of your credit accounts. Your aging sheet lets you know at a glance whether an account is current or past due, and how slow your customers are with their payments. They also help remind you to rebill customers who are past due.

An aging sheet gives you quick insight into how your customer manages its cash flow. Calculating your customer’s days sales outstanding (DSO) gives you quick insight into how your customer manages its cash flow. For any given sales period, calculate both the customer’s total receivables and total credit sales. To get the DSO, divide total receivables by total credit sales, and multiply the resulting figure by the number of days in the period. For example, if at the end of a 180 day period a customer has $50,000 in outstanding receivables after purchasing $150,000 of goods on credit, the customer’s DSO for that period is 60 days (($50,000 ÷ $150,000) × 180), meaning it takes you 60 days on average to collect your receivables from the customer.

Additional documents

Beyond balance sheets and operating statements, you can get a lot of valuable information from

Credit reports: You can get credit data from a credit reporting agency such as Experian, TransUnion, or Equifax, or from public records. For easy access at a price, commercial services such as LexisNexis (www.lexisnexis.com), Accurint.com, and KnowX.com pull public records information together and provide easy, instant access. Chapter 11 discusses consumer and business credit bureaus — flip there for more on them and how to find their Web sites.

Your customer’s credit file: Keep copies of documents that relate to your customer, including contracts, change orders, purchase orders, personal guaranties, and credit applications.

Industry- or customer-specific documents: You may want some documents or records that are unique to your industry or customer that you just want to have in the file. If you think a document may be helpful, trust your instinct and keep a copy.

You must approach your customers on a regular basis for updated information. You can make these requests yourself or, if your customer is comfortable working with its sales contact from your company, you can have the sales contact take care of it.

Spotting warning signs of a high-risk customer

Regardless of how much profit you have built into your products or services, some customers pose too much risk and should not get credit. So what does a high risk customer look like? Here are the biggest warning signs:

Balance sheets: Its balance sheets and operating statements show a declining net worth.

Operating statements: Its operating statements reflect a downward trend in sales or profits, or both.

Credit reports: Its credit report shows deterioration in its paying habits. For example, a customer that used to reliably pay in 30 days now pays in 60 days.

The five Cs of collection: Its owners have a history of misleading statements or broken promises or a bad track record in their other business ventures. Customers who aren’t worthy of your trust also aren’t worthy of credit.

Past transactions: Its history with you is spotty or outright bad — maybe the owners have lied, paid late, or bounced a check. Fool you once, shame on them. Fool you twice . . . .

Days sales outstanding (DSO): DSO gives you quick insight into how a customer manages its cash flow and how long you’re likely to have to wait for payment. Check out “Aging sheets” earlier in the chapter for more on DSO.

Unexpected events: Be on the watch for events that affect a customer or your industry, or even for general economic trends that may impact your customers’ ability to pay. We can’t tell you what they are — they’re unexpected. But consider the rapid collapse of the auto industry when gas prices hit $4 per gallon in 2008. Similarly, your customer’s margins may suffer if a new competitor enters the market, worsening your customer’s financial position.

Bankruptcy: Extending credit to customers who have filed bankruptcy but are allowed to continue in business (such as customers in Chapter 11 or Chapter 13 bankruptcy) is very risky. Don’t forget, the customer wouldn’t be in bankruptcy if it didn’t have serious financial problems. We cover bankruptcy laws in Chapter 6.

Sure, you may really like your customer, or (worse) your boss may really like your customer, but your job is to protect your profits. That means sticking to your credit policies and getting comfortable with the word no.

Creating Credit Ratings for Your Customers

You know what information to collect to help you decide whether to extend credit. You know how to assess risk based upon your knowledge of your customers. With that information in hand, you can use your customers’ creditworthiness factors to assign them credit ratings based upon their risk of late payment or default.

Starting with a credit application

The process of creating a credit rating starts with accumulating information. Thus, when a customer first applies for credit, you should have it complete a formal application. This credit application helps you determine the exact identity of the debtor, the debtor’s bank account (for possible later garnishment on a judgment), addresses, tax identification numbers, and Social Security numbers, all of which are valuable resources if the account falls delinquent and goes into collection.

This chapter and the accompanying forms provide a framework for creating your credit application, but you should treat them as guidelines for the creation of your own forms. Have your counsel review all credit applications you create for compliance with state and federal law. Credit applications are regulated by the Federal Equal Credit Opportunity Act (ECOA), a law discussed in detail in Chapter 6. Because each state has its own set of credit and consumer protection laws, legal requirements for credit applications also vary from state to state.

Components of an effective credit application

An effective credit application contains

Information about the business

• Contact information: Get the correct and full legal name of the applicant, the physical address (not merely a post office box), and the position of the individual who is applying for credit on behalf of the applicant (treasurer, president, and so on). Also be sure to get the company phone number, e-mail, and Web site address.

• Entity type: For reasons described in Chapter 2, your customer’s business entity can make a big difference when you extend credit. To make sure you get a clear answer, provide check-boxes for proprietorship, corporation, limited liability company (LLC), and partnership. Get a tax I.D. number for an incorporated entity and the owner’s Social Security number for a proprietorship.

• Trade names: Record any trade names the company uses. For example, if your customer is the Brake Shop, a division of Win Management Corporation, the application should list both names along with the relationship between the two.

• Products sold: Note what products or services the applicant offers.

• Years in business: Make sure you know what year the business was formed.

• Authorized purchasers: Get names, addresses, and telephone numbers of any authorized purchasers at any branches.

• Partners and officers: Request names, addresses, telephone numbers, cell phone numbers, email addresses and, ideally, Social Security numbers of partners and officers.

Social Security numbers are hard to get these days because people are very security conscious. Also, under federal law, you have an obligation to destroy that personal information when you’re done with it.

• Banks: Ask for the name, address, and telephone number of the bank where the company maintains its accounts.

• References: Require names, addresses, and telephone numbers of at least two (and preferably three or more) trade references. Keep in mind that your customer is not going to (intentionally) give you a reference that will make negative statements about its creditworthiness. Watch for weak references, such as landlords or utility companies, because those are the bills your customer is likely to pay first, before suppliers like you.

• Financial statements: Get multiple balance sheets and operating statements so you can identify financial trends.

The applicant’s credit needs

• Amount of credit requested

• Anticipated monthly purchases

Agreements and Authorizations

• Authorization of a credit check: Include a statement similar to the following: “A signature on this document provides permission to pull a credit bureau report on any individual who may be liable under this agreement (such as a personal guarantor, proprietor, general partner, or similar person).”

• Agreement to pay interest: Also include a statement that the customer agrees to pay interest at a specific percentage rate, or the maximum legal rate of interest from the date of the last invoice.

• Funny language on checks: Have your customer agree that you’re not bound by language concerning specially endorsed checks. For example: “Checks marked payment in full are invalid unless sent to [a specific person/credit manager]. We may return your check within 90 days of cashing it and under no circumstances will a payment-in-full-settlement check be allowed except in accordance with separate written agreements. Otherwise, it will be presumed that the full-payment check was tendered in bad faith and will not be accepted in full settlement.”

• Notice of disputes: You should include a statement concerning billing discrepancies claims, requiring any problems to be promptly brought to your attention. For example, “Any claims of errors or discrepancies in the billings must be submitted to our office in writing within 15 days of receiving a bill. Otherwise, all such objections are deemed waived and the account will become stated.”

A template for credit applications, and a listing of factors that should be included in a good credit application, are provided on the CD that comes with this book (Form 3-1).

Beware customers who won’t complete the application

What if your customer refuses to sign a credit application? These customers often have something to hide:

They may have failed to form a legal business.

The owners may be well known as crooks.

Their financial information may reflect distress.

They may have burned their bridges with other vendors, and their credit references may reveal bad credit.

They may not want to disclose their addresses or other personal information to make it harder for you to chase them when they don’t pay their bills.

They may have bad banking relations, such as a history of bad checks or defaults on loans.

They may not want you to know that their business is brand new.

They may not want you to draw a credit report on them.

Treat customers who play their cards close to the vest with the utmost caution; you must consider whether you’re willing to risk extending any credit at all. In general, their refusal suggests that they may not plan on playing by the rules. They may be setting you up to make a big sale they don’t pay for, or have no intention of ever paying their bills.

Here’s a trick you can use to get a credit report out of these folks anyway: Soften up the image by giving your credit application a different name, such as customer information or helpful data. Or don’t label it at all. Preface your questions with a very polite paragraph or two explaining why the applicant is a valuable customer. Tone and perception mean a lot.

Reviewing financial statements to spot trends

The two basic forms of financial statements are the balance sheet and the operating statement. As we discuss earlier in this chapter, a balance sheet is a snapshot of a company’s financial condition as of the date it was prepared. The operating statement shows profit (income minus expenses). With both forms, you want financial statements for different dates so that you can track a customer’s financial condition over time.

Trends can be particularly important with newer companies. Many new businesses don’t turn a profit during their first three years of operation. Audited financial statements can help you figure out if a newer business is on the right track and will soon be turning a profit, or if it’s struggling and may potentially fail.

Financial statements are an important factor when determining creditworthiness but are far from the only factor involved. Never extend credit based solely upon your reading of financial statements.

Balance sheet

If the sheet you have was professionally audited, it’s probably accurate. If not, you have a greater chance of inaccuracy or misrepresentation. Sometimes you have a customer that doesn’t create balance sheets at all, so you must make your credit decision without that tool.

You certainly don’t need to be a CPA to identify trends. For example, if you’re extending credit on June 30 of a year, demand financial statements from December 31 two years ago, December 31 this past year, and then June 30, the month you’re extending credit. When you look at the numbers, ask yourself these questions:

Has the customer’s net worth gone up or gone down? Needless to say, your preference is up.

Is accounts payable a larger percentage of cash and accounts receivable today than it was previously? You’re hoping for a yes.

Has the ratio of cash plus accounts receivable and inventory to accounts payable plus other current liabilities increased or decreased? You want the ratio to increase because that translates into an increase in financial strength.

Do assets exceed liabilities? Compare the total of cash plus accounts receivable plus current work in process to the total of accounts payable plus current borrowings of less than one year (current liabilities). If debt is higher than assets, the company may not be able to pay its bills on time. On the other hand, if cash and accounts receivable are significantly higher than accounts payable and current borrowings, the company is likely to remain solvent and be able to pay its bills.

A sample balance sheet form comes on the CD that accompanies this book (Form 3-2). You may use that form to familiarize yourself with the layout and information typically provided on a balance sheet.

Operating statement

Try to get an operating statement dated every six months over the last two years. You can use those statements to determine whether the company’s sales are increasing or decreasing. More importantly, you can compare whether the company is still profitable and whether its profit is trending up or down. Decreasing profits suggest problems that may eventually cause the company to make late payments or potentially default on its creditors. Increasing profits show you the opposite and provide reassurance when you establish a line of credit for your customer.

You can find a sample operating statement on the accompanying CD (Form 3-3).

Putting your research together to assign a rating

Search for “credit scoring” in your favorite Internet search engine, and you come across a number of companies that compile huge amounts of data and offer credit scoring to customers, and others who provide computer software jampacked with algorithms and number crunching tools. But those companies don’t know your company’s needs, so you may want to implement your own system to evaluate the information you obtain from your customers. Based on the material discussed in this chapter, you can put together a simple scoring system that allows you to be more objective and uniform when evaluating the creditworthiness of credit applicants.

Credit scoring was created as a way to more efficiently and objectively review credit applications (particularly large numbers of them), but a credit score is just a starting point. No credit scoring system can replace the instincts and intelligence of an experienced credit professional. Also, credit scores are a tool for comparing applicants, so the fewer credit applications you have, the less helpful a scoring system becomes. Getting meaningful data often requires the analysis of thousands, if not tens of thousands, of applications; if you’re reviewing fewer than 1,000 credit applications each year, you’ll lack the comparative and historical data essential to determining how a credit score correlates to customer payment.

The model presented here is based upon a simple 50-point scoring system. You should feel free to add additional points that you believe to be relevant and to change the weight of factors to better represent the needs of your company.

Financial Documents:

• Audited semiannual or annual financials +5

• Unaudited semiannual or annual financials +1

• No financials available -5

Liquidity as determined from the applicant’s balance sheet. (You can find a liquid ratio calculation on the spreadsheet Form 3-2, line 17 on the CD.)

• Liquidity 2 or higher +5

• Liquidity 1 to 2 +2

• Liquidity a negative number -5

Income

• Profitable 3 or more years +5

• Profits are higher this year than last +2

• Losses reported this year -5

• Losses reported last two years -10

• No operating (profit/loss) information provided -10

Stability:

• In business for more than 10 years +10

• In business for more than 5 years +5

• In business for 3 years or less -10

Public records:

• Tax liens -5

• Judgments -15

• Bankruptcy -15

Payment history, at least 3 vendors reporting:

• Prompt +15

• Some slowness to 30 days +10

• Some slowness 60 to 90 days -10

• Severe slowness, 90 days plus, placed for collection -20

Credit reports:

• Excellent rating +10

• Medium rating +5

• Neutral, no rating given 0

• Negative rating -10

A credit applicant with a score of 50 has a perfect score. Based upon your experience with your scoring system, you’ll determine what additional scrutiny you should apply to applicants with less than perfect scores. For example, a score below 40 may require additional review. An applicant with a score below 30 may still qualify if you are able to take measures to protect you in the event of default, such as getting a lien, personal guaranty, or confession of judgment.

Considering Options to Reduce Risk

You don’t want to wait and see whether your customers pay their bills? The two leading alternatives to the traditional collection of accounts receivable are

Credit insurance: An insurance company actually insures the account receivable, typically for a fixed percentage of its value.

Factoring: You sell the account receivable at a discount to another company (usually called a factor) for cash.

The following sections tell you more about these options. You can also improve your odds of payment by getting a personal guaranty from your customer, making her personally liable for her company’s debt to you.

Purchasing credit insurance

Credit insurance, also referred to as trade credit insurance, is offered by insurance companies and some government export credit agencies. This insurance usually covers a fixed percentage of the account receivable. In other words, if the customer fails to pay a bill, your insurance company reimburses you for a portion of that unpaid bill. You must absorb the cost of the insurance as a business expense, and you still take a bit of a hit in the event of a default if you insure for less than the full value of your receivables. Your bank may be impressed if you carry credit insurance and may be more inclined to loan you money, particularly if you carry high-risk accounts receivable.

Factoring

Instead of insuring your accounts receivable, you may decide to simply sell them. Your factor determines which accounts receivable it wants to purchase and at what discount. For example, if a customer owes you $10,000, your factor may offer you $9,000 for the account. You get your money when you sell the account receivable regardless of when (or whether) your customer pays. You gain quick payment with no credit risk, but you lose the amount of the discount.

Knowing when to insist on a personal guaranty

In the credit industry, rejection typically follows when an applicant’s net worth doesn’t justify the extension of credit for the amount requested. One way to extend credit to applicants who fall into this category is to request that the customer obtain a guaranty of payment from either a person or another company. You can incorporate a guaranty into your credit application, or it may be a separate document.

Guaranties come in two forms: guaranty of payment and guaranty of collection or performance. With a guaranty of payment, you can collect payment from the guarantor without first trying to collect from the primary debtor. With a guaranty of collection or performance, you must first attempt (and fail) to collect from the primary debtor before you can collect from the guarantor. You always want a guaranty of payment, and that’s the form we describe in this book.

When considering extending credit based on a guaranty,

Confirm that the guarantor is creditworthy. To ensure that the guarantor is financially sound, you can informally rely on business reputation, the impressions of the salesperson on the account, or information from someone else within your company who is familiar with the general financial condition of the proposed guarantor. A more sophisticated approach is to get a credit report for the proposed guarantor.

If the guarantor is a corporation, require a resolution from the board of directors authorizing the individual to sign the guaranty.

If the guarantor is an individual and you can do so while following the constraints of the ECOA, have the guarantor’s spouse sign the guaranty so that you can collect action against joint assets.

If you get a guaranty,

The guaranty should be in writing and signed. Don’t allow the signer to qualify the signature with a title such as “president” or “agent” because those words completely void the personal guaranty. Make sure the guaranty is dated and clearly states that it’s a personal guaranty of payment (not of performance) with words such as “I personally guaranty payment . . .” Likewise, title the document itself “personal guaranty,” or words to that effect, in bold print.

The document should be signed in front of one or more witnesses. If the guarantor later denies his or her signature, the burden of proof is always on the creditor. A handwriting expert is not only very expensive but also unreliable. Therefore, don’t allow the guarantor to take the document with her and return it with a signature. Have her sign in the presence of a sales representative or credit manager and at least one other witness if at all possible.

When you obtain a guaranty, remember to build up your customer’s credit file. Your notes from discussions and documents, such as letters acknowledging the debt and promissory notes, will be of enormous assistance if the account becomes delinquent and you seek payment from the guarantor.

Steps you take that benefit one of the principal debtors, such as changing the terms of the agreement (for example by extending the time for the debtor to pay the debt) or releasing security may have the side-effect of releasing the guarantor from liability. Be careful when offering relief to your principal debtors, as the release may follow from your actions even if you don’t intend to release the guarantor.

What if your customer files for bankruptcy? A discharge in bankruptcy of the principal debtor generally doesn’t release the guarantor. Similarly, the automatic stay in the principal debtor’s bankruptcy case doesn’t prevent you from enforcing your rights against the guarantor.

A customer may call you for assistance in filling out the personal guaranty. See Figure 3-1 for a quick walk through the language of a guaranty so that you can explain it to your customer.

A template for a personal guaranty is provided on the CD that accompanies this book (Form 3-4).

Maximizing Your Leverage: Filing Liens for Protection

When a customer doesn’t pay, sometimes you just want to pretend the sale never took place. You want to go out to your customer’s location and take your stuff back. When goods are sold on open account terms, that option isn’t available unless the customer voluntarily returns the merchandise. That’s why liens were invented. A lien provides security in the sense that if you don’t receive payment for the item you sold, you have the right to take it back.

When you take lien on the property you sell to your customer, your sale is referred to as a secured transaction, giving you an Article 9 Lien. Under Article 9 of the Uniform Commercial Code (covered in Chapter 6), the buyer and seller can agree to create a voluntary lien (consensual lien or security interest) in assets other than real estate. After the assets are secured, they’re typically available to satisfy a debt if the buyer’s account becomes delinquent.

To secure the assets, you and the debtor first enter into a security agreement, setting forth your rights to the collateral securing the transaction. You then file a financing statement, a formal notice to other potential creditors of your lien, with the appropriate government office for your state and the type of lien, usually the secretary of state’s office or your county’s register of deeds.

Think of the financing statement in a secured transaction as being like a promissory note in a real estate deal; the security agreement is like the mortgage or deed of trust. The principle is the same: The collateral subject to the lien secures the debt.

The two most common documents needed to create a valid lien in products that you sell (that is, to attach and perfect your lien) are a security agreement and a financing statement. That rather simple paperwork, signed by your customer, allows you to file a lien on products that you sell. Samples are provided on the CD that accompanies this book (see Forms 3-5 and 3-6).

Although the overall process is pretty much the same, the time needed to file a lien and laws describing how and where to file vary by state. Know and follow the laws for your own state to make sure your lien is perfected.

Understanding liens and how they can help you

Of course, you don’t actually want to take back a product after you’ve sold it. You want to get paid. If you secure your transaction, your customer knows that you can take back the product if he doesn’t pay, and that may inspire him to pay on your account. More importantly, your right to take back the merchandise helps minimize your risk of loss on a transaction. If the product you pick up still has value, you can repackage and resell the product item to another customer. And you can still pursue collection against your delinquent customer for any loss you take.

What if your customer files bankruptcy? Liens come into play, big time. Even in bankruptcy, you can take your stuff back with a valid lien. Without a lien, you have to file a claim as an unsecured creditor and, even in good economic times, that typically means you’re going to get ten cents on the dollar or less. As if it needs to be asked, which outcome would you prefer?

Examining types of securable personal property

You can obtain a security interest in just about any property. Using a security agreement and financing statement, items that may be secured as collateral include

Accounts

Consumer goods

Crops

Documents

Drafts

Equipment

Farm products

Fixtures

Inventory

Livestock

Tort claims

Proceeds and products derived from collateral can also be secured through a UCC financing statement and security agreement.

A security interest in inventory may require a floating lien, described in “Sometimes perfection isn’t enough” later in this chapter, to include what the UCC describes as after acquired property. A floating lien can be legitimately secured through a security agreement and a financing statement. Similarly, future advances may be covered under an existing security agreement and financing statement.

Documents and financial instruments such as negotiable warehouse receipts, notes and certificates, and money must be secured through physical possession. In contrast, accounts receivable may be secured through a security agreement and financing statement.

Consumer goods can be secured through a simple security agreement and, as described in “Exploring attachment and perfection of liens” later in this chapter, perfection may occur without filing.

For titled property, such as motor vehicles, motor homes, and some boats, to perfect a security interest you must file a lien on the title. Aircraft can only be secured by filing a lien through the Federal Aviation Administration. Real estate transactions are governed by a very different set of rules, requiring a note and a mortgage or deed of trust to be filed with the Register of Deeds office.

Other possessory liens may arise outside of the UCC. For example a repair shop has a “mechanic’s lien” on a car to secure an unpaid repair bill, secured through possession of the car until the bill is paid.

Looking at how long liens last

All states limit how long a security agreement can last. Financing statements, for example, usually expire in five years. When the parties to a security agreement agree to end it, a termination statement is filed with the government office where the security interest was originally filed. Similarly, if the parties want to continue a security agreement past its expiration date, they can file a document typically referred to as a continuation statement.

A secured creditor must keep track of security agreements, by computer or by some form of tickler system, to make sure that lien perfection doesn’t expire. After perfection expires, you no longer hold a lien. That is, you become an unsecured creditor. If the debtor then defaults on payment, you don’t get your product back if there are competing liens on the same materials, and in bankruptcy proceedings you’re treated as an unsecured creditor.

Exploring attachment and perfection of liens

The concepts of attachment and perfection are very simple. A lien attaches when it becomes valid as between the debtor and the creditor. A lien is perfected when it becomes binding on all parties who deal with the debtor.

To create a lien, the parties simply complete and sign the documents that describe the collateral and pledge the collateral as security to the debt, such as a promissory note and a security agreement. After those documents are signed, the lien attaches.

Proper filing (usually with the secretary of state in each state where the property is kept) perfects the lien; check your local laws — sometimes a copy is filed in the county where the property is kept. The filing process is very inexpensive and forms are readily available. These forms are typically referred to as UCC 1 forms or financing statements.

When extending credit based upon a borrower’s collateral, lenders search public records to find evidence of other secured creditors. A search of the secretary of state’s records reveals all filed financing statements. The creditor uses that information to decide whether the borrower has sufficient collateral for a loan.

You can also perfect your lien by taking possession of the collateral. This method is most likely when the collateral consists of financial instruments, such as stocks, bonds, or chattel paper. The UCC actually requires physical possession of stocks, bonds, and investment securities in order to achieve perfection rather than the standard filing of a financing statement.

Perfecting liens in consumer transactions

If you sell to consumers, it may seem impossible to get liens to secure your sales. Your sales are too small or too numerous to justify the cost and paperwork. But you’re in luck: For consumer transactions, the UCC allows you to perfect simply by your naming the collateral in a security agreement, which may be as simple as your sales receipt.

For example, a customer purchases a central air conditioning system from a store. The store wants to take a security interest in the air conditioning system until the debt is paid. By stating that the system remains as collateral for the debt until the debt is paid, the receipt becomes a security agreement, and the store achieves perfection.

This simplified process only applies to consumer transactions. In commercial transactions, except where perfection is achieved through physical possession of the collateral, the financing statement must be duly filed.

Sometimes perfection isn’t enough

Despite a valid security agreement and properly filed financing statement, a secured creditor may not be able to repossess or foreclose upon the collateral even though the lien is perfected. Here are some situations where this scenario may occur:

The debtor files bankruptcy. Despite your valid security interest, you can’t take possession of the collateral unless you first file a motion with the bankruptcy court for the turnover of the collateral, and the court grants your request.

Your customer resells the collateral in the ordinary course of business. For example, you sell radios to a retailer, and the retailer in turn sells those radios to its customers. Each time the retailer sells a radio to a consumer, you lose your collateral interest in that radio. When you make this type of sale you’re deemed to have a floating lien, because the value of your collateral rises and falls with the number of radios in your customer’s inventory.

Another creditor has priority. When more than one creditor files a lien against the same collateral, the order of priority of these liens is determined based on their date of perfection. A creditor who perfects a lien on an earlier date has priority over subsequent lienholders, meaning that if the debtor defaults, that creditor gets the first opportunity to claim the collateral to satisfy its lien.

The general “first come, first served” rule of priority has some exceptions. For example, your customer may have an arrangement with its bank under which the bank loans it money and takes a secured interest in all of its inventory and other assets (a blanket lien). You later sell that customer a specific item of inventory and take a lien for the price (purchase money security) in that item. A purchase money security interest always has priority to a blanket lien. If you later find yourself competing with the bank to repossess assets from the debtor, you have a higher priority than the bank in the inventory that you sold.

Enforcing security agreements

When a creditor loans money to a debtor and the debtor defaults, a secured creditor wants to enforce its rights against the collateral. But how does the creditor take back the collateral, sell it, and apply the proceeds to the debt? The process available to you, along with measures meant to protect both the debtor and creditor, are specified in the UCC.

The secured creditor can’t claim repossession of the collateral until the debtor defaults. Sometimes the security agreement defines what constitutes default. Examples of circumstances that may be defined as default include

Failure to make a payment when it’s due

Failure to provide satisfactory insurance

Death or incapacity of the borrower

The debtor’s insolvency, filing of bankruptcy, or the appointment of a receiver

Failure to make payments to other lenders

Competing liens being filed by other secured creditors

Significant damage to the collateral

When you define what constitutes default, your rights and remedies are a matter of contract. Whatever the default provisions are, both the creditor and the debtor are confined to the agreements they made.

With your valid security interest, you can recover the collateral secured by your lien through repossession (sometimes called foreclosure on personal property, or claim and delivery). Self-help repossession occurs without going through a court. When allowed, self-help saves you time and money and avoids your having to hire a lawyer and go to court.

Here’s a simple script you can use to request your customer’s cooperation with repossession: “[name of debtor], you know I have a valid lien on [the property you liened]. I’m sending a truck out to recover it because you haven’t paid for it timely. Does a 10 a.m. pickup tomorrow work for you?” If the debtor agrees, send the truck and get your stuff back. If the debtor disagrees and won’t release the collateral, you can

Pick it up when debtor isn’t around. You can legally repossess the collateral as long as you don’t break into any structure to get it or cause a disturbance (breach of the peace).

File a court action to recover the goods and damages (foreclosure or claim and delivery). As a secured creditor, you can ask a court to order that the collateral be turned over to you and often also to order the debtor to pay a deficiency balance if the value of the collateral is inadequate to cover the entire debt.

Although self-help repossession is the cheapest way to recover your collateral, it has its limits. A secured creditor can’t “breach the peace” in order to recover collateral. If the debtor is standing in your way, you can’t push the debtor aside to reach the collateral. If the debtor has locked the collateral away, you aren’t allowed to force entry into a building. If the debtor resists the repossession of collateral, you’re forced to obtain a court order.

Be aware that laws and courts disfavor breaches of the peace. They generally disallow any type of breaking into any type of structure, even if it’s a rickety old fence or a broken screen door. Similarly, in the event of any form of confrontation at all, such as debtor showing up on the scene and requesting that you leave, you must leave. Before you engage in self-help recovery, talk to your lawyer for concrete advice about what you can and can’t do, as the law varies a bit from state to state.

In the United States, a lawsuit to enforce a lien is typically referred to as a claim and delivery action. As a secured creditor, you can file a claim and delivery action through your attorney or, if you’re well-versed in the area and aren’t legally required to work through counsel, by yourself. Consult Chapter 16 for more information on representing yourself in court.

After you get a court order entitling you to possession of the collateral, you turn the order over to a deputy sheriff who has enforcement powers. Within the context of the reasonable exercise of force, breach of the peace is no longer a concern. A deputy can force his way into the premises and force the return of the collateral.

If a balance remains due to a secured creditor after the disposition of the collateral (a deficiency), the creditor can sue for the deficiency balance as long as she used reasonable means to obtain maximum value for the collateral. But the creditor can’t simply sell off the collateral for a minimal amount of money and claim a deficiency. A debtor can defend against a deficiency balance following the sale by claiming that the manner of sale of the collateral was unreasonable.

Considering Letters of Credit for a Risky Customer

Remember when you were a kid, and your friend promised you a nickel if you would jump into the deep end of the pool? You couldn’t trust your friend’s promise, so you had your big brother hold on to the loot to make sure you got paid if you made the big dive. Well, what if you could minimize your risk for your sales by having a third party hold the loot and pay off when your service is rendered or your product is delivered in good order? Check out the letter of credit.

A letter of credit is a financial tool that protects both the seller and the buyer by involving a middleman who holds the money and verifies the documents. The middleman is normally a major bank or financial institution. Sometimes two banks are involved, the seller’s bank and the buyer’s bank.

Banks routinely issue letters of credit and can provide all the necessary forms, contracts, and cost information. An example form is also provided on the CD that accompanies this book (Form 3-7).

Letters of credit are a very effective tool to ensure payment with

New customers

Marginal customers

Customers that may be facing economic hardship

Customers in countries where collection is notoriously difficult

Simply put, a letter of credit is an escrow arrangement. Assuming that the seller is located in the United States and a purchaser in a foreign country, the seller’s bank serves as the escrow agent on the transaction in accordance with the terms of the letter of credit. The steps involved for a successful letter-of-credit transaction are roughly as follows:

1. Money representing the amount of the purchase is set aside in a special account in the buyer’s bank.

2. The buyer’s bank agrees that those funds will be released to the seller’s bank after proper documentation of delivery is presented.

3. When the goods are delivered, the documentation of delivery is presented to the seller’s bank.

4. The seller’s bank contacts the buyer’s bank to ensure that the money has been set aside for the full amount of the transaction.

5. The delivery documents showing that the goods were delivered to the buyer in good condition are then presented to the buyer’s bank.

6. The buyer’s bank is obligated to convey the money to the seller’s bank, thus paying the seller.

For example, a buyer in England wants to purchase 20 cars from a dealer in the United States. The car dealer has no way of verifying whether or not the purchaser is worthy of credit. Does the dealer give credit anyway? Not if he’s read this book, he doesn’t.

However, instead of turning the customer away, the car dealer suggests that an international letter of credit be established. The buyer in England deposits the purchase price with a third party bank named in the letter of credit. After that money is on deposit, the bank becomes the middleman and pays the seller (the car dealer) after the cars are delivered in good order. But before paying, the bank makes sure that the delivery paperwork is in order and that the cars are, in fact, delivered. Only after delivery is verified does the bank release the money to the seller. The seller now has the money and the buyer now has the vehicles. Both sides are happy, and no credit risk whatsoever was involved.

The bottom line is that with a letter of credit, a transaction becomes essentially risk-free. It’s virtually the same as COD or payment by cashier’s check.

Exploring a Confession of Judgment

A confession of judgment allows a creditor to start a lawsuit and enter a consent judgment against a defendant for a default on a payment agreement. In states where they’re legal, confessions of judgment are a powerful way to handle a payment agreement, allowing the creditor to go into court and enter a judgment against a debtor for a default in the payments. The debtor effectively waives any right to defend against a lawsuit and is at the mercy of the creditor.

Confessions of judgment are permitted for business (but not consumer) transactions in states including Michigan, New Jersey, and Pennsylvania, but they’re prohibited in many other states due to the high potential for abuse. Before you have a credit applicant sign a confession of judgment, make sure they’re permitted under your state’s laws.

Never use a confession of judgment for a consumer debt. Even if your state allows it, it’s a violation of federal regulation.

Even where legal, some states require special documents to make a confession of judgment binding. For example, Michigan requires the confession to be on a separate piece of paper, not the document that includes the promissory note or other agreement to pay a debt.