The Cost of Credit


Gregory FoxManufacturers, distributors and other merchants of goods who
sell their products on credit terms routinely accept a high level of risk of
defaulted payment from their customers. In good times, credit-related losses
are relatively predictable as a percentage of sales and can be offset by
variations in pricing and volume across a seller’s sales transactions.
Unfortunately, we are far removed from the good times. The prolonged economic
slump has resulted in increased payment defaults and a 150 percent rise in
business bankruptcies since the summer of 2007. In this economic climate, a
seller’s legal documentation and credit terms can make the difference between
payment in full and a bad debt write-off. Now more than ever, companies that
sell goods on credit must diligently evaluate their credit policies and make
informed decisions with respect to their documentation, credit enhancements (or
lack thereof) and exercise of post-default remedies. 

Credit Enhancements

A seller on credit may request various credit enhancements
from its customer to improve the odds of collecting in the event of default. In
larger international sales transactions, sellers often shift the risk of
non-payment to third parties by obtaining trade credit insurance or letters of
credit. In the event of a default, the seller may collect payment from the
trade insurance company (if payment is not disputed) or the letter of credit
issuer. However, these types of enhancements are typically impractical in
smaller domestic transactions.  

Personal guaranties and security interests constitute the
primary credit enhancements in domestic sales transactions with private
companies. A personal guaranty from an owner of a closely held purchaser
provides the seller with another source of repayment and increases the odds
that the customer will elect to pay the debt before it pays debts owing to the customer’s
other creditors. Personal guaranties are often included as part of a credit
application rather than in a separate guaranty.

A seller may also obtain a security interest (personal
property lien) in the goods it sells on credit and all proceeds derived from
those goods (e.g., the customer’s accounts receivable). A security interest
greatly enhances collection, as it allows repossession of the goods sold on
credit and the assertion of a secured claim in their proceeds, and, perhaps
most important, provides a defense in bankruptcy to preference claims. In
general, a seller can claim and fully enforce a security interest if the
customer signs an agreement granting the seller a security interest in the
delivered goods, and if the seller properly files a financing statement. The
procedure for perfecting a security interest in delivered goods is relatively

Sales and Credit Contracts

Well-drafted terms and conditions and credit agreements can
strengthen a seller’s collection efforts. A good credit agreement will include
a forum selection clause allowing the seller to file suit and obtain a judgment
in the seller’s jurisdiction. Other key credit terms include the provision for
default interest and a clause allowing the seller to collect attorneys’ fees
and costs in the event of a default.

Exercise of Reclamation Rights and Priority Claims

Both the U.S. Bankruptcy Code and state law
allow a supplier to “reclaim” goods shipped to an insolvent buyer. The exercise
of reclamation rights entitles the seller to the return of its goods, or
payment of the cash value of those goods. A seller generally has 20 days after
commencement of a bankruptcy case to file a written reclamation demand for
goods delivered within 45 days of the bankruptcy case. In addition, the
Bankruptcy Code allows a seller of goods to assert an administrative claim for
the value of goods delivered within 20 days of the bankruptcy filing. Outside
of bankruptcy, a seller generally has 10 days after delivery of goods to make a
reclamation demand. It is important to understand and timely assert these

Gregory R. Fox is a shareholder at Lane Powell, where he focuses his practice on commercial law. He represents financial institutions, trade creditors and other interested parties with respect to credit and sales documentation and advice, bankruptcy and receiverships, credit enforcement and related commercial litigation. He can be reached at  206.223.7129.

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