Caveat Venditor-Let the Unsecured Seller Beware
NAW Legal Advisory - October 2005
To survive and be successful, a wholesaler-distributor must not only sell its goods and services, it must also receive timely payment from its customers. Proper care and attention to the extension of credit to customers and the development of procedures to monitor customer credit performance is certain to improve a firm's profit potential. Avoiding bad debts and uncollectible receivables is every bit as vital to the health of the wholesaler-distributor's business as increasing sales or lowering operating costs and expenses.
The old legal maxim of caveat emptor -- let the buyer beware -- has little application today to the customer who purchases goods on open account. In extending unsecured credit, a modern day seller can more closely identify with another maxim, caveat venditor, or let the seller beware.
The Federal bankruptcy law has generally eased the burdens on debtors and made it more difficult for creditors to collect their due. Honest, undisputed debts do go unhonored today. Unsecured sellers are dismayed to learn that collection lawsuits are costly, oftentimes do not result in recovery of any of the monies that are legally due, and can be immediately halted if the debtor seeks protection under the Federal Bankruptcy Code.
In extending credit and collecting receivables the wholesaler-distributor's credit executive needs to comply with applicable state and Federal laws governing these activities. The law, however, does provide the wholesaler-distributor with some rights and remedies to avoid a loss when selling on open account. A number of preventive measures which a wholesaler-distributor, with the assistance of legal counsel, can take to protect its bottom line are discussed below.
Recovery of Seller's Attorneys Fees
Oftentimes the only way to collect monies due for goods sold on open account is to file a lawsuit. Even where the amount due from the customer is recovered in full, the seller generally must bear its own attorneys fees. In most states attorneys fees incurred in a collection action can only be recovered from the customer where specifically authorized by a contract between the seller and customer, or by state statute. Except in rare cases, state statutes do not permit the seller to recover its attorneys fees from the customer when suing on an open account.
To remedy this, the seller may seek an agreement on fees when forced to file suit. This agreement is often part of a written credit agreement signed by the customer, submitted to the seller and accepted after due investigation of the customer's financial condition, trade references and bank references. Language that could be used could be similar to the following (specific language should be prepared for each seller's particular needs if it is to be utilized): "Customer understands that seller's terms are net _____ days. It is understood and agreed by customer that in the event legal action shall become necessary in order to effect collection for goods purchased by customer from seller, customer agrees to pay all seller's costs of collection including reasonable attorneys fees."
Personal guarantees from the principals or owners provide additional protection to the seller from a loss on an open account sale. However, difficulty is usually encountered when attempting to obtain guarantees and there may be problems in collecting on a guarantee when there is a default by the customer.
For example, some courts have released guarantors from the obligation when there is a further extension of credit or a change in credit terms to the customer without the written consent of the guarantors. In fact, guaranty agreements are strictly interpreted and may be voided by any substantial change in the obligation guaranteed. A well-drafted guaranty agreement will address this problem area and others so that the agreement may not be voided by the courts in an enforcement action. The signator's social security number and residential address should appear on the guaranty agreement so it is clearly signed by the individual.
Subordination of Inside Debt
As an alternative or supplement to personal guarantees, the seller may request a subordination agreement. Smaller firms often have a debt owing to the principals of the company due to a loan or advance made for working capital. In this situation the seller asks to be paid by the customer before payments are made on the indebtedness owing to the firm's principals.
A subordination agreement would state that no repayment would be made on the debt until all debts to the seller are paid in full. This agreement may not prevent an unauthorized payment to the principals. However, a properly drafted subordination agreement would permit the seller to proceed against the principals who incur personal liability to the extent that unauthorized payments are received in violation of the agreement.
Collecting on NSF Checks
A number of states grant a seller a legal remedy where the customer tenders a check in payment for goods purchased and a check is dishonored due to nonsufficient funds or other reasons. For example, in many states a person who issues a bad check is liable to the payee for all its costs and expenses (including reasonable attorneys fees) incurred in collecting the amount of the check, plus treble damages.
Right to Recover Goods Delivered to Customer
What can a seller do if goods are sold on unsecured credit, and the seller learns that the customer has become insolvent (i.e., ceased to pay debts in the ordinary course of business, or cannot pay debts when due, or is insolvent within the meaning of Federal bankruptcy law), or has made an assignment for the benefit of creditors, or entered into bankruptcy proceedings? Under the Uniform Commercial Code, the seller has a legal right to reclaim the goods if seller delivers a written notice for reclamation upon the customer within 10 days after the customer receives the goods. Oral notice is acceptable, but it must be confirmed in writing and received by the customer within the 10-day period. The seller must have proof that the written notice was received by the customer within the 10-day period. Finally, if the customer has made a specific written misrepresentation of solvency to the seller within three months before delivery, the 10-day limitation does not apply.
The following language is an example for written notice of reclamation (specific language should be prepared for each seller's particular needs based on the circumstances of each case): "The undersigned seller hereby gives notice of its demand for the immediate return of goods listed in invoices numbers ______ pursuant to section 2-702 of the Uniform Commercial Code due to your insolvency. Any sale, use or transfer of said goods is expressly prohibited." It is important for the seller to immediately take steps to recover the goods from the customer. If the customer sells the goods to a good faith purchaser, the seller's rights to reclaim the goods may be lost.
If the customer has filed for bankruptcy, under the new bankruptcy law (effective October 17, 2005) the seller may recover the goods from the bankruptcy trustee if the goods were received within 45 days before the bankruptcy filing date. The seller must make its written reclamation demand not later than 45 days after receipt of the goods by the customer, or not later than 20 days after the filing date if the 45 day period expires after the filing date. Sellerís reclamation rights are subject to prior security interests in the goods or proceeds.
What if the seller is still in possession of the goods when the customer's insolvency is discovered? The seller's remedy under the Uniform Commercial Code is to refuse delivery of the goods unless cash payment (such as a certified check or wire transfer) is made, even though the transaction was originally on credit.
What if the goods are in transit to the customer? Again, the Uniform Commercial Code permits a seller to stop delivery of the goods to the customer. The seller must notify the customer and the third party in possession of the goods (common carrier, warehouse, etc.) of the stoppage. The notification must be received by the third party so that, through reasonable diligence, delivery to the customer can be prevented. The right of stoppage expires when the customer receives the goods.
Seller's Insecurity as to Payment
Where a seller has reasonable grounds for insecurity with respect to the performance of the customer, the Uniform Commercial Code allows the seller to make a written demand for assurance of due performance (including the payment obligation). Until such assurance is received from the customer, the seller may, if commercially reasonable, suspend any performance for which he has not already received the agreed return. This insecurity with respect to performance relates to all performance due from the buyer, including payment for the goods.
By monitoring the aging of receivables and other signs of credit problems, the seller is in a position to request adequate assurance of payment by the customer and suspend sale of the goods pending receipt of such assurance.
Security Interest in Goods Sold
The Uniform Commercial Code provides for a "special" security interest for the sale of goods on credit. A purchase money security interest is a security interest the seller obtains in the goods sold to the customer. Oftentimes there are prior security interests covering all or some of the assets of the customer (such as a bank loan). However, if a seller receives a written purchase money security agreement signed by the customer, and files the appropriate financing statements, the purchase money security interest in favor of the seller will prevail and be superior to most prior recorded liens.
The customer must consent to a purchase money security interest. Many customers refuse to consent since doing so could violate the terms of their bank loans or credits lines. If the customer does consent, then the seller must give written notification to all the customer's prior lien-holders of the creation of the purchase money security interest and a general description of the goods which are to be sold by the seller to which the security interest will attach. Even if the prior lien-holders object, a properly perfected purchase money security interest will stand and come ahead of any prior general or floating liens.
Wholesaler-distributors are often surprised to learn that under the Bankruptcy Code payments received from a customer within 90 days preceding the date the customer files for bankruptcy may have to be paid back to the bankruptcy trustee. These payments are called "preferential transfers" because certain sellers (who are unsecured creditors of the customer) are favored with payment over other unsecured creditors of the customer. However, not all payments received within the 90-day period have to be paid back. There are several exceptions or defenses. The most common defense asserted by trade creditors is the ordinary course of business defense.
The new bankruptcy law (effective October 17, 2005) made several important changes to the ordinary course of business defense:
- In defending against a preference claim the seller now needs to prove either (1) the payment was made in the ordinary course of business of the seller and customer, or (2) the payment was made according to ordinary business terms in the industry generally. Under prior law, the creditor had to meet both tests.
- Under the new law, the trustee may not recover preferential transfers to a seller aggregating less than $5,000.
- Under prior law the trustee typically filed, or threatened to file, a suit (called an adversary proceeding) against a seller in a distant bankruptcy court to recover a small preference payment. The seller would often elect to settle rather than incur defense costs. Under the new law, with some limited exceptions, these suits seeking to recover less than $10,000 may be filed only in the federal district court where the seller is located.
Potential problem accounts need to be monitored carefully by the credit executive. One public source of information is PACER, or Public Access to Court Electronic Records. PACER is an internet-based free government service that provides a database of information on cases filed in many Federal courts, including the Bankruptcy Courts. The database may be searched using the name of a company or individual and searches may be limited to all Bankruptcy Courts listed on PACER. Users must first register at http://pacer.psc.uscourts.gov/
The foregoing discussion of rights and remedies available to a wholesaler-distributor is not all-inclusive. Because the complicated nature of the debtor-creditor laws, especially the bankruptcy law, assistance of counsel is recommended to assure that proper action is taken under the particular circumstances in each case.