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Mitigating The Risk Of Extending Trade Credit: Taking Security From Your Delinquent Customer

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Unless you operate a retail business selling to individual consumers, you probably sell your goods and services to customers on credit.  You may, at one time or another, be asked to extend additional credit to a customer that is experiencing a cash-flow problem.  If you have come to rely on that customer's business, the pressure to extend additional credit and preserve the relationship can be considerable. 

But what if your customer's financial condition degrades further and results in a business failure or bankruptcy?  If the account is "unsecured" (i.e., not secured by collateral such as your customer’s equipment or land), then you risk being left with nothing or pennies on the dollar at the end of the business closure or the bankruptcy process.  So what can you do to lessen the potential impact of your customer's closure of business or bankruptcy? 

Require Collateral For A Customer's Account

One thing that you can do when your customer begins to run an account balance is to insist on collateral for the account.  The collateral available to you can vary greatly depending on the nature of your customer's business and assets.  Assets commonly pledged as collateral include land, equipment, inventory, and receivables. 

But you should think creatively about other assets that also may be available for use as collateral, such as bank accounts, securities, intellectual property, and contract rights.  Even if the account already is secured by some collateral, payment problems may indicate that it is time for you to take stock of your collateral and determine whether you should require more before extending additional credit.  In the event of a bankruptcy, having sufficient collateral provides you with important protections and practical benefits that can prevent a total loss. 

First and foremost, if you have enforceable collateral – you would be called a "secured creditor" – you are more likely to obtain a meaningful recovery on your bankrupt customer's account.  Whereas unsecured creditors frequently walk away from a business failure or a bankruptcy with nothing at all, secured creditors often obtain a recovery that is proportionate to the value of their interest in the collateral.  Although it may require some defensive legal action or waiting by you, your customer's closure or bankruptcy cannot divest you of your interest in the collateral even if your customer's direct obligation is reduced or eliminated in the bankruptcy process. 

If you are not paid during your customer's bankruptcy proceeding, then your lien in the collateral will ride unaffected through the bankruptcy process and be enforceable against the collateral once the case has been dismissed or closed.  If the collateral is sold by your customer or a bankruptcy trustee during the bankruptcy, then you will be first in line for the proceeds of the sale once the reasonable and necessary expenses of sale have been paid.  Thus, having collateral gives you a meaningful chance of recovery in a bankruptcy situation. 

In addition, sufficient collateral can actually offer you the chance of a total recovery.  If the value of the collateral is greater than the amount of the debt, then you will be entitled to recover the amount of the unpaid obligation, plus interest, up to value of the collateral.  From your perspective, there is no such thing as too much collateral in a bankruptcy situation. 

Finally, the law protects secured creditors from the depreciation of their collateral during a bankruptcy.  If your collateral is of a type that may decline in value during the bankruptcy, such as through your customer's use of the collateral, then you can seek compensation from your customer.  This compensation is called "adequate protection” and usually takes the form of cash payments or additional or replacement liens on your customer's property. 

Take Collateral Early And Avoid Preferences

Under the U.S. Bankruptcy Code, a debtor or bankruptcy trustee can "avoid" certain transfers of property interests to creditors (including the granting of liens), for or on account of a preexisting debt, if the transfer was made within 90 days before the bankruptcy filing.  Such transfers are called "preferences." 

The longer that you allow your customer to run an account balance and delay taking collateral, the closer a bankruptcy may become.  If you wait too long to take collateral, you run the risk of having your lien fall within the 90-day preference period, which is likely to result in your security being partially or completely invalidated as a preference.  For this reason, it is advisable to take collateral soon after a payment problem arises.

Do Your Due Diligence

You should fully understand the title to any property that you intend to accept as collateral.  Doing so is essential to ensuring that your lien will actually attach to the property and provide equity to secure your customer's account in full in the event of a bankruptcy. 

A lien can attach only to property that is owned by the party pledging it as collateral.  While this concept seems obvious, it can be relatively easy to misunderstand the ownership of property where your customer has one or more related corporate entities.  This is because title to the property may have been placed in the name of a different entity, perhaps for tax or liability purposes, and even your customer's principal may be confused as to the true ownership.  With certain types of collateral, such as land or intellectual property, there are additional ways that your customer's title can be defective or subject to divestment.  A thorough title examination is essential to understanding whether your customer has good and defensible title to the proposed collateral. 

Assuming your customer has title to the proposed collateral, your lien will still be only as valuable as your customer's equity in the property.  That equity will be reduced or even nonexistent if there are one or more preexisting liens against the property that will take priority over your subsequent lien in a bankruptcy or foreclosure.  Since different types of liens are governed by different legal rules, if you do not thoroughly research your customer's title, you may be surprised to later learn that your collateral was already encumbered by other liens when you accepted it as collateral.  Federal tax liens, for example, are notorious for being overlooked by unwary secured creditors because they have such sweeping application to a customer's assets. 

For these reasons, you should take steps to ensure that your customer holds good and defensible title to your collateral so that your lien will actually have the priority on which you expect to rely in a bankruptcy or foreclosure situation.  Obtaining a title opinion for the proposed collateral from a competent attorney is advisable. 

Document The Transaction Properly

Obtaining your customer's agreement to provide collateral and then properly vetting the proposed collateral is only half of the battle.  To be enforceable in bankruptcy or foreclosure, the transaction must be properly documented and perfected.  In the context of a secured transaction, "perfection" is the legal process by which the transaction becomes enforceable against third parties who may later seek to assert competing rights in the collateral.  Perfection puts the world on notice of the transaction, and the method of perfection required depends on the type of collateral being pledged.  An unperfected lien will be unenforceable in bankruptcy and cannot be foreclosed upon. 

A complete discussion of the documentation and perfection of liens is beyond the scope of this article.  In general, however, land is pledged as collateral by the property owner's execution of a properly drafted mortgage or deed of trust.  The transaction is then perfected by the recording of that document with the Office of the Register of Deeds for each county where the property is located.  

If the proposed collateral is personal property, then it may be pledged as collateral using either a physical or electronic security agreement that reasonably describes the property and has been authenticated by the debtor.  The perfection of personal property collateral can be a little more complicated because the method of perfection required depends on the type of asset pledged. 

For most types of personal property, a creditor can simply file a document known a "financing statement" with the Secretary of State for the state where the debtor is located, which may well not be the state where the property is located.  Determining where a debtor is located, for purposes of perfection, can be a complicated legal matter. 

But some types of personal property may require perfection by other means, such as by taking physical possession of the collateral, having control of the collateral, getting the lien recorded on a written document of title for the collateral, or recording a fixture filing in the Office of the Register of Deeds for the county where the personal property is a "fixture" to real property.    

To ensure a security transaction is documented and perfected properly, you should have a competent attorney prepare the necessary documents and advise you concerning the best method to perfect the lien.  Otherwise, your customer's agreement to provide security may not be enforceable in a bankruptcy or foreclosure situation. 

Conclusion

If you want to extend credit to a customer experiencing cash flow problems while also protecting yourself against the risk of a potential bankruptcy, then you should consider requiring collateral for the account.  Once potential collateral has been identified, you should take steps to thoroughly investigate the title to the proposed collateral and then, if acceptable, properly document and perfect the transaction.  By being vigilant and systematic in your approach to taking collateral from your customers, you can mitigate the risks of potential business failures and bankruptcies. 

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© 2024 Ward and Smith, P.A. For further information regarding the issues described above, please contact Norman J. Leonard.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.

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