Protecting Your Receivables
Five Simple Steps Toward Improving Your Chances of Collection
By: Reynold T. Berry
Revised: March 2013
There are simple steps that can be taken to lessen the blow non-paying receivables can levy against your bottom line. Although some losses are inevitable (you still can't squeeze blood from a turnip), the better the systems you have in place, the higher your realization rate will be on your receivables. Although litigation to collect your receivables is a last resort, the key to prevailing in a lawsuit often depends more on what you have done in creating and maintaining the credit account than on what happens once a default has occurred.
1. Know Your Debtor. One of the most overlooked aspects in the creditor/debtor relationship is the precise identity of who you are doing business with. The business structure utilized by a debtor determines whether the owners are personally liable for the debts of the entity. Generally, a commercial credit applicant will be a sole proprietorship, partnership, corporation, limited partnership, limited liability partnership, limited liability company, or professional corporation. Information regarding the type of entity or business structure can be obtained from the Secretary of State in the state where the debtor's primary place of business is located. A savvy creditor will rely not only on the information provided by the debtor in a credit application, but will confirm and periodically re-confirm that information. Most states maintain websites with easily searchable databases containing the information necessary to determine who your debtor is and what sort of entity they are. For most partnerships and sole proprietorships, the owners are personally liable for the business' debts. Virtually all other business entities, however, provide a limitation on the liability of the owners, which preclude the principals from being held liable for the business debts, except in very rare circumstances. Knowing who your debtor is, what sort of business structure the debtor utilizes, where the debtor is located, and who owns the business, will help determine what sort of protectionary measures you will want to institute to accord the highest level of protection for your receivables.
2. Get it in Writing. It seems axiomatic that any application for the extension of credit should be in writing and, for some transactions, it is also the law. Nonetheless, many creditors instead rely on invoices and periodic statements of account to evidence the contract between the parties and, although that may be sufficient to effectuate collection, by forgoing a written credit application, the creditor is also forgoing various other rights and remedies to which it may be entitled. Generally, a written credit application should contain all of the information necessary to identify the debtor and creditor. It should be signed by the debtor, or an authorized representative of a corporate entity. Above the signature should be an acknowledgment that the debtor agrees to certain terms and conditions, including a specified interest rate, recovery of collection costs and attorneys fees, and an explicit reference to the specific court and location where any litigation regarding the account may be filed (also called a jurisdiction/venue provision). These provisions can provide powerful leverage and will, hopefully, convince a debtor to pay without the need for protracted litigation.
Other terms to consider would be an exclusion or disclaimer of certain warranties which the Uniform Commercial Code may otherwise imply into every contract. These include the warranties of merchantability and fitness for a particular purpose. By excluding these warranties, you can eliminate potential issues for litigation or defenses of the debtor. It is also wise to exclude incidental or consequential damages arising from the transaction, and to provide a clear statement regarding which party bears the risk of loss when the goods are damaged or destroyed during transit. There are a whole host of other beneficial provisions which can and should be considered with the advice of counsel.
3. Get a Personal Guaranty. There is perhaps no more effective mechanism for ensuring payment on an account than obtaining a personal guaranty of your debtor's business account. A guaranty obligates a person or entity, other than the person or entity primarily responsible for an obligation, to pay a debt of that other person or entity. Guarantees are most often used to obligate the owners of limited liability entities to pay the debts of the entities they own; however, the guarantor need not be an owner. As discussed above, both debtors and creditors occasionally make mistakes in determining what type of entity is involved, and requiring personal guarantees on every application simplifies the credit application and lessens the burden of investigation otherwise placed on the creditor.
Guarantees have various requirements and the enforceability of a guaranty may depend on the actions of the creditor and debtor on the account. In virtually every state, a promise to pay the debt of another must be in writing and signed by the guarantor in order to be enforceable. A guaranty can be continuing, in that it continues in effect to guaranty payment or performance of future obligations of the principal debtor, or it can be limited in any fashion, for example, limited to payment of a particular debt or a maximum dollar amount, or for a fixed period of time.
The law regarding guarantees has evolved in such a fashion as to provide various rights and defenses regarding changes in the underlying debt, payment delays, release of collateral, and requirements of notices to the guarantor upon the principal debtor's default. A well-drafted guaranty will waive these defenses and these waivers are generally enforceable. It is best to discuss with your attorney the drafting of an absolute and unconditional guaranty which waives these defenses in order to prevent the unintended release of a guarantor.
4. Know your Interest in Collateral and Protect it. Creating and maintaining a security interest in the personal property of your debtor may provide an alternative avenue for payment. An interest in collateral (often called a security interest) is a consensual and contractual lien against personal property of the debtor, which is pledged by the debtor to secure repayment of a debt. Although a security interest can be created by agreement, it must be perfected in order to be effective as against third parties (other creditors). Generally, perfection is accomplished by filing a financing statement (also called a UCC-1) with the Secretary of State in the state where the debtor is located. Location means the state of formation for entities that must register to come into existence. Common types of collateral are equipment, inventory, and other physical goods, but collateral may include less tangible properties of the debtor, such as goodwill or a right to payment.
Having a security interest in debtor's property that is granted and perfected prior to the filing of a bankruptcy petition is the best manner to ensure repayment if the debtor seeks bankruptcy protection, because the creditor will be treated as secured and afforded preferential treatment over unsecured creditors. Another manner for converting an unsecured obligation (one without collateral) to a secured debt would be through the filing of a mechanic's lien against the real property upon which the goods supplied were incorporated. Every state has different requirements and filing deadlines for the creation of a mechanic's lien, which deadlines are generally very short. Accordingly, if you have supplied goods which were utilized in a construction project and you have not been paid, you will want to investigate any lien rights you may have as soon as possible. Which brings us to our final topic:
5. Know When to Enlist the Service of an Attorney. For most collection claims, litigation is a last resort that is employed only when attempts to obtain payment voluntarily have failed. Often, such as in the creation and maintenance of a mechanics' lien or other security interest, obtaining legal assistance is essential to protecting your rights. Likewise, although a struggling debtor may continue to ignore your invoices and requests for payment, a demand from an attorney may garner a response. If, however, your demands and those of your lawyer continue to go unheeded, you will want to determine whether to prosecute your claim through litigation.
The decision to file suit is as much a business decision as a legal one. Some creditors hesitate to litigate for fear of jeopardizing an ongoing business relationship, fear of getting a reputation of being litigation happy, and/or because the perceived costs of litigation exceed the expected benefits. Your attorney can advise you both as to the business decisions above, and the legal concerns associated with filing a lawsuit. For example, if it is apparent the debtor has certain defenses and/or will vigorously dispute the claims, you may well reach a point of diminishing returns, whereby the time and expense necessary to prosecute the lawsuit is outweighed by the realistic best-case scenarios outlined by your attorney. Likewise, if a corporate debtor is insolvent and there is no personal liability, a lawsuit will be a waste of time and money.
Ensuring that the point of diminishing returns is not reached is best accomplished by maintaining copious business records, sending regular invoices and statements of account, obtaining a clear, written credit application and/or guaranty and maintaining the entire paper trail surrounding each transaction in an easily referenced filing system. The better your claim is supported, the fewer the defenses available to the debtor, and the sooner the claim can be reduced to judgment. If a debtor is not paying your invoices, it is likely that other creditors exist, and the sooner judgment is obtained, the higher the likelihood the debtor's assets can be garnished to pay your judgment ahead of other creditors.
In sum, protecting your receivables is always important, and following the above guidelines will help maximize the return on your collections in any economic climate. Don't be afraid to enlist the services of an attorney to make sure your credit practices align with the above recommendations. Spending a little time and money now to protect your receivables will pay huge dividends down the road.
These materials are intended for general informational purposes only. Accordingly, they should not be construed as legal advice or legal opinion on any specific facts or circumstances. Instead, you are urged to consult counsel on any specific legal questions you may have concerning your situation.
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