Reducing risk

Stories of companies laying off employees and reporting higher than expected losses have caused business owners to reanalyze strategies and relationships.

With the prospect of decreased sales and consolidating markets,owners are trying to eliminate payment and performance risk while maintaining growth. Understanding business transaction documentation and payment practices in a changing market is necessary to help achieve these goals.

The first way to eliminate payment and performance risk is to determine whether the company’s day-to-day documentation will govern its transactions, and what happens if another party’s forms contradicts its forms. Although the business environment plays a large part in deciding these questions, a company should have a good set of purchase orders and order acknowledgments to combat the battle of the forms successfully, or at least break even.

Without having language to try to make one’s sales or service terms control, a business may find it has agreed to warranty, delivery, price and payment terms that are unexpectedly imposed by the small print of the other party.

Even if a business utilizes good purchase and sale forms, it may still face the prospect of a nonpaying customer or nonperforming supplier. Without the benefit of a guarantor, performance bond, security interest or letter of credit, a company would be required to obtain a personal judgment in court against the nonperforming party, procure a writ of execution directing the sheriff to seize any nonexempt property and hold a sheriff’s sale.

The risks include the prospect that the assets have been sold, subject to prior execution, encumbered by a secured loan or subject to bankruptcy. To reduce these risks, businesses utilize security and performance arrangements.

Security interests

One of the most common protections for a seller is to obtain a security interest in collateral owned by the buyer. Under this arrangement, the seller provides to the buyer value in the form of loan proceeds, goods or services in exchange for retaining as security tangible or intangible property owned by the buyer. If the seller wants to protect its security interest in the collateral against competing third parties, it must perfect its status by taking possession of the collateral or filing a financing statement.

If secured, a seller may use self-help repossession or a writ of replevin. Once the seller possesses the collateral, it may hold a foreclosure sale and go after the buyer for any deficiency.

A special type of security interest that generally provides a seller a security interest ahead of any that would otherwise be entitled to priority is a purchase money security interest or PMSI. Under a PMSI, a seller is given a security interest either in collateral it has provided to the buyer or that the buyer acquired by the use loan proceeds given by the seller.

A PMSI may not be granted in intangible property, except in software acquired by the buyer for the principal purpose of running the software on hardware in which the seller has a PMSI or with the acquisition of the related hardware. Although the law governing PMSIs in goods has been recently revised enabling PMSI debt to be secured by additional non-PMSI collateral, and PMSI collateral to secure non-PMSI debt, a seller must follow statutory filing, notice and delivery requirements to obtain PMSI status.

Also, PMSIs are susceptible to very complicated rules governing sales proceeds and competing PMSIs.


As an alternative, some inventory suppliers deliver goods to a sales representative on consignment, whereby the rep takes possession but not title to the goods. To obtain consignment status, a supplier must comply with filing, notice and signage laws.

Although a consignor may have protected its title to the goods, it still must put in place protections to reduce payment risk. Whether utilizing consignment or a security interest arrangement, a seller should conduct a lien search of the buyer.

Letters of credit

Rather than rely on the credit of a buyer, a seller may rely on the credit of a third-party guarantor or an issuing bank. Under a letter of credit transaction, a buyer directs its bank to pay the sales price of goods or services upon the seller’s timely presentation to the bank of documents specified in the letter of credit.

Documents normally include the seller’s invoice, bill of lading, a draft ordering the bank to pay the seller, packing list, insurance certificate and inspection certificate. The letter of credit entitles the seller to prompt payment by the issuing bank despite the existence of a dispute or claim by the buyer in the underlying transaction.

Unlike a guaranty, with which the guarantor may raise all the defenses of the buyer, the issuing bank may not raise those defenses.

Another form of letter of credit used to provide payment in lieu of the performance of nonmonetary obligations is a standby letter of credit — the issuing bank is merely ”standing by,” just in case the underlying transaction is not performed by the obligor.

For example, if the underlying obligation is a loan, the issuing bank would pay the lender upon presentation of a draft or demand for payment and a document certifying the borrower is in default under the loan, as well as assure the payment of monetary obligations.

Letters of credit are not perfect. Along with increasing transaction costs, they may be subject to economic and political risks that include issuer solvency and reputation (accustomed to issuing letters of credit), payment location (governmental restrictions or war zones) and the timeline to produce the letter of credit documents. Pat Flynn ([email protected]) is an attorney at Arter & Hadden LLP and a member of the firm’s E-Group where he focuses his practice on corporate, finance and securities matters. The E-Group is a multidisciplinary group of attorneys who focus their practice on entrepreneurial, emerging growth, Internet and e-commerce companies. Flynn can be reached at (216) 696-5696. For additional information about the E-Group and to read SBN ”Matter of Law” reprints, visit mailto: