In Advanced Legal Issues Today
Beyond CIA and COD: Four Ways to Protect Yourself on Open Account Sales
By Daren R. Brinkman
Vendors would always like to have more protection for their open credit sales. Yet, cash in advance (CIA) and cash on delivery (COD) sales often are beyond the means of a troubled account. The purpose here is to serve up the recipes for some “magical potions” that savvy creditors use to protect what would otherwise be open credit sales.
Most effective among these “magical portions” are the collective protections of consignment trusts and collective vendors’ liens, which should be attempted whenever a debtor reaches a troubled or workout stage, if not sooner. Even without collective steps, an individual creditor should consider the use of “perpetual” or multi-event reclamation, and consignment “sales” with the proper account.
In considering these more creative or “magical” protections, one should always keep in mind the level of protection offered by more tried and traditional creditor’s alternatives to open account sales like a purchase money security interest in the vendor’s product.
This does not always work, however. A debtor may not be willing to provide the necessary UCC-1 because of the need to protect its borrowing base in its loan covenants with its operational lender.
Even if the buyer is willing, the vendor may not value its product in the debtor’s hand because it is perishable, fungible/non-traceable, otherwise incapable of being returned, or of little value if and when returned.
Individual Protections
Individual creative protections include “perpetual” or repetitive reclamation and consignments in lieu of sales.
1. Consignments in Lieu of Sales
Some vendors may overlook consignments as not applying to sales of new goods. They may be tempted to think of this type of transaction as limited to the sale of used merchandise in specialty retail stores.
However, nothing prevents a seller of new goods from placing its goods with a “buyer” (actually becoming a “consignee”) on a consignment basis. The main difference is that title does not pass to the “buyer”. (Be careful to file a UCC-1 financing statement to protect your title against the debtor’s creditors.)
Theoretically, the proceeds of sale also are not the debtor's property. However, a seller doing a consignment must be careful to protect the proceeds of its goods. Unfortunately, unless a vendor has a very large account with the debtor, setting up the procedures to protect the proceeds of its product may be too expensive and cumbersome.
Moreover, a consignor filing a UCC-1 faces the same difficulties and obstacles seen with purchase money security interests. As discussed below, however, consignments done collectively with other vendors of the same debtor may successfully surmount many of these obstacles.
2. "Perpetual" or Repetitive Reclamation
Perhaps the most creative way an individual vendor may protect its credit sales is the use of "perpetual" reclamation. Most creditors are aware that under UCC section 2-702, a vendor of goods may seek to reclaim goods sold to insolvent debtor within 10 days of delivery. Although this is most often applied right after a debtor files bankruptcy, the concept can be applied any time a debtor is insolvent.
Some companies have successfully used this concept to improve their position in a bankruptcy that occurs weeks and sometimes months into the future. When selling into a distressed debtor situation, these clients have gone so far as to serve reclamation notices along with the invoices and/or packaging slips. Notwithstanding the written record seeking reclamation of the goods resold, the vendor orally reassures the debtor of its desire to see the debtor pay for the goods rather than have them returned. The vendor is careful in its wording, however, to reassure the debtor that it seeks prompt payment for the goods resold, the vendor orally reassures the debtor of its desire to see the debtor pay for the goods rather than have them returned. The vendor is careful in its wording, however, to reassure the debtor that it seeks prompt payment for the goods resold, or it will make good on its written reclamation demand.
For some, this means a series of short credit sales ending with actually seeking to obtain possession of the reclaimed goods on the last sale for which the vendor is not repaid.
Greater risk takers may be willing to go to longer credit terms on multiple sales where their types of inventory are not quickly resold or consumed in the normal course of a debtor's business.
Technically speaking, the law in most states does not require that the vendor actually pick up the goods immediately but only seek demand for reclamation within 10 days of delivery.
The vendor merely risks that the goods will be resold or consumed in the debtor's hands while it waits to pick up its goods. In one case, a company was able to successfully reclaim goods from three or four months worth of sales when the debtor finally filed bankruptcy.
Of course, a vendor who attempts "perpetual" reclamation faces the same defenses as one who only uses it once. If the vendor does not move quickly, to establish the amount of goods in the debtor's hands at the time of the reclamation, the information, and the vendor's reclamation rights, may be lost with the passage of time.
Furthermore, if a debtor contests the reclamation, and the secured lender's lien encumbers and is worth more than all assets in the debtor's estate, the reclamation rights will be wiped out by the lienholder's rights.
Moreover, if a debtor successfully shows that it was solvent at the time of the reclamation, this will prevent the reclamation rights from legally arising. We have also been concerned that aggressive repetitive reclamation or reclamation demands accompanied by affirmative denials of true intent to reclaim will be subject to a waiver type defense.
These concerns aside, a number of companies have successfully employed this self-help remedy, some even with months of such demands actually preceding the debtor's subsequent bankruptcy.
Once again, this strategy is, of course, not practical with perishable or fungible/non-traceable type goods. But it may sometimes work where the debtor is not willing or able to execute or deliver a UCC-1 for a purchase money security instrument, and where the collective protections discussed below are not available.
Collective Protections Improve Rights
Creditors frequently do not realize that they might improve their rights in ways they could not achieve individually. Such collective measures include consignment trusts and collective vendors' liens.
1. Consignment Trusts
A number of companies have successfully avoided the problems with individual consignments of goods by setting up a collective consignment trust with other creditors and placing the debtor under the control of a formal trust agreement to protect the respective vendors' rights to the proceeds of sale of their goods.
As discussed above, an individual consignment offers certain promises, but can be administratively difficult and costly for the creditor to monitor the position of its goods in the debtor's hands and the receivables and cash proceeds of those goods when sold. By organizing with other vendors of the same debtor, the vendors can share the administrative costs of setting in place inventory and cash monitoring and control systems.
Moreover, when most of a debtor's largest vendors become involved, the consignment trust can sometimes be sold to a debtor as a lower cost alternative to an asset-based lender. Indeed, the consignment trust can minimize, if not totally supplant, the need for an outside lender.
Companies that have employed this sort of arrangement have felt much more in control of a debtor that slides into insolvency and have always preferred this to waiting for the operational lender to take nearly everything in a final liquidation.
These arise sometimes in pre-bankruptcy workouts, but sometimes such arrangements can even be worked out post-bankruptcy as creditors organize together.
2. Floating Vendors' Liens
A similar collective approach to the consignment trust is the floating collective vendors' lien. This approach to vendor protection offers many of the benefits of a consignment trust and involves the same strategy of selling the debtor on the benefits of avoiding the high costs of an outside lender.
As with the consignment trust, this vendor protection offers the same cost sharing benefits of having one security agreement and debtor monitoring system. In addition, this strategy allows the encumbering of all of a debtor's assets, not just the inventory sold by the major supplies. This makes it particularly attractive in industries where the debtor's inventory is perishable or fungible/non-traceable or where services constitute a large proportion of value conveyed.
On the other hand, the all-inclusive lien makes it difficult to apply where there is already an outside secured lender. Sometimes, this can still be applied where the vendors' lien is not so all inclusive.
Frequently, this type of lien may be set up successfully after a bankruptcy, where a judge, using the priority lending and cash collateral provisions of bankruptcy law allows the vendors' lien to gradually supplant the outside lender.
Once again, vendors usually express a higher degree of satisfaction with this sort of collective arrangement among fellow vendors as opposed to allowing one outside lender's lien to have priority over them all. Often, vendors feel more in control of the creditor/debtor relationship and better protected if the debtor ultimately liquidates.
Creative approaches to open credit sales generally help to protect vendors who would otherwise be forced to sell on open credit or not sell at all. Vendors are generally very pleased with the results when through the collective protections of consignment trusts or vendors' liens, they are able to diminish or eliminate the outside secured lender. Vendors maintain a better grasp on the debtor's operations and protect themselves better in the even of liquidation.
Daren R. Brinkman is the owner of Brinkman, Portillo, Ronk, PC. Telephone (818) 597-2992