Why Should <I>You</I> Take the Fall?

A big client's bankruptcy shouldn't mean life or death for your business. Insure yourself with a UCC filing.
Magazine Contributor
7 min read

This story appears in the November 2002 issue of Entrepreneur. Subscribe »

In the wake of recent accounting scandals and bankruptcies, entrepreneurs are struggling with a new reality: Even the most solid-looking corporate customers can collapse and crush your flow under the weight of bad . To protect your company from the flu, an ounce of prevention is worth a pound of cure.

Fortunately, recent changes to the Uniform Commercial Code (UCC) make it easier than ever for you to protect yourself as both a creditor and a debtor. Make savvy use of the UCC laws, and you could provide yourself with growth capital through improved cash flow and deeper credit.

Stay Two Steps Ahead

"If you have a nonpaying client and bring a lawsuit, you'll wait six months or more for a judgment," says corporate attorney Kerry Fanwick of San Francisco firm Miller & Fanwick. "Even a judgment in your favor may not result in cash in your pocket. However, you could say to the client, 'Give me a security agreement and a UCC filing,' and you can avoid going to court altogether."

of fast-growth companies do not know what their companies are worth.
SOURCE: PricewaterhouseCoopers

Using a security agreement and a UCC-1 form is the best way you can insure your receivables. Just like when someone takes out a mortgage on a home, a UCC places a lien, or encumbrance, against a particular asset. "The idea behind a UCC filing," explains Fanwick, "is simply that a creditor who has made a loan against an asset gains an additional advantage over other creditors by giving notice to the world."

Where does someone go to file a UCC? Typically, it's the Secretary of State that records the UCC, but you may have to go to the county recorder to file in some states. When you run a credit check on your customers, you may discover that they are already bound by UCC filings from other vendors or banks.

A Small Investment

Negotiating a security agreement and filing a UCC during the sales process is far cheaper than fighting a court battle after default. Drafting a security agreement should be less than a half-day's work for a business attorney. The result is a brief contract that ties an asset to the debt. This contract can then become an integral part of your standard sales order or invoice. Further, new UCC rules even allow security agreements to be part of an electronic order system or e-mail.

Once you have a written security agreement between you and the client, you may record the obligation by filing a UCC-1 form with the state or county. Filing fees are minimal-less than $25 in most states-and you can easily do it yourself or contract with a corporate service bureau.

The return on investment can be significant. Once a UCC is in place, your clients will know that nonpayment has real consequences, and they will likely take their debt to you more seriously. As a result, you may find that your delinquent accounts decrease and improves. In the worst case, if a client simply will not-or cannot-pay, the UCC gives you the right not only to demand the collateral, but also to seize it.

"You can't breech the peace, of course," explains UCC expert and attorney Steven Weiss at law firm Heller Ehrman White & McAuliffe LLP in Los Angeles. "You must be able to take the collateral or property without breaking a door or window. If you can't, you can quickly get a court order and the sheriff will help you. Once you have possession of the collateral, you then auction it off and keep as much of the proceeds as are needed to pay the debt plus recover your collection expenses. Any overage must go back to the customer."

The term UCC is short for "Uniform Commercial Code." It refers to the set of laws that govern nearly every aspect of how companies transact business. Thanks to the National Conference of Commissioners on Uniform State Laws and the American Law Institute, these laws are largely the same from state to state.

The 13 sections of the UCC cover everything from sales contracts to bank deposits. Perhaps the most familiar is Article 9, which regulates both consumer and commercial credit. During 2001 and 2002, major changes in Article 9 were enacted in all 50 states and the U.S. Virgin Islands. These changes are important to businesses of all types, but of particular interest to software publishers and others who buy or sell intellectual property.

If your company has used security agreements or UCC filings in the past, the changes to Article 9 may impact your ability to collect. Check with an attorney or corporate service bureau to be sure your rights as a creditor are protected.

In any case, you avoid a lengthy court case, and you have the right to take action before the client lands in bankruptcy. If the client does go through bankruptcy, you are not guaranteed payment. Your UCC filing does, however, put you ahead of unprotected creditors. Recent changes to the UCC may even put you ahead of general creditors (such as a bank) in cases where the collateral is the actual product that you sold.

The lesson? Always check for UCC filings against your customers before extending credit-and always ask for a security agreement to collateralize the credit you do give. Finally, make sure that the security agreements you get are recorded by filing a UCC-1 form.

Turning the Tables

When you find yourself on the other side of the table, should you allow a vendor or creditor to file a UCC on your assets? The answer may surprise you. Negotiating a security agreement with a key vendor will probably get you a larger credit line-a key tool for fast growth.

But don't give away the farm, cautions Fanwick. "To maximize your ability to borrow, you need to minimize each creditor's claim on your assets." Negotiating clear and concise terms within each UCC filing or security agreement is a critical part of financing. Whether you are negotiating a bank loan or a vendor credit limit, make sure the assets encumbered match the value of the credit you receive.

"Lenders tend to go broad, but the business should give some thought to what they intend the collateral to be," adds Fanwick. If you allow the lender to specify all business assets, you are giving them the ability to seize everything, including intellectual property.

As a borrower, you can limit a UCC to a single asset. Furthermore, you can make that same asset collateral for more than one UCC filing. The first time the asset is encumbered, the creditor may receive "senior" status on the asset. A smaller vendor, however, may be happy to take a secondary, or subordinated, position on the same asset. Carefully constructed security agreements can greatly extend your ability to borrow against all types of assets.

Since laws vary slightly from state to state, speaking with your attorney may be the best place to start.

Play Both Sides

Using UCC filings to your advantage can stretch your credit with both banks and vendors. Likewise, keeping active UCC filings on your biggest customers can not only protect you against a client's nonpayment or bankruptcy but also help you mine extra cash from your accounts receivable.

Play both sides the right way, and UCC filings can become a lynchpin to stronger cash flows and better credit.

David Worrell is a strategy and finance consultant in Charlotte, North Carolina. Contact him by phone at (704) 614-2701 or by e-mail.

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