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Bench & Bar of Minnesota is the official publication of the Minnesota State Bar Association.

Representing the Small Business in Troubled Times

Small businesses in the best of times face the challenge of getting paid for goods and services rendered, but troubled times increase the risk that a customer will default.  While there are no guarantees, a few tools are available to maximize the prospect of getting paid.

Trying to come up with the definition of a small business is like trying to define obscenity: I’m not sure how to describe it, but I know it when I see it.  Small businesses come in all shapes and sizes (except that by definition they are not huge), and usually have three things in common: (1) they have to keep their old customers and generate new ones; (2) to do so they often have to extend credit; and (3) they must get paid on time, which means constantly and immediately.  In this economy, it’s a basic rule that as the need for credit grows, getting paid on time becomes ever more difficult.  Sometimes getting paid at all is a stretch.  But there are a few things the small business person can do to maximize his or her odds.

The Personal Guarantee

The advantage of personal guarantees is that they avoid entity-based liability shields by focusing ultimate responsibility for payment on an individual.  The small businessperson dealing with a corporation or LLC should always obtain a written guarantee of payment from the owner if he can.  Anything that gives him leverage may be helpful down the road.

However there are two problems with personal guarantees.  First, other than an extra promise to pay, the personal guarantee doesn’t, by itself, provide security for the credit being extended.  Second, as the customers of the small business become bigger, they are less likely to give a guarantee for the simple reason that there isn’t anyone to sign such a document.  The guy in Purchasing, the one you’re dealing with, just isn’t going to sign personally for that first order of widgets; neither is the woman in the corner office.  At the other end of the scale, if the customer is small enough that she has to personally guarantee her company’s obligations, it’s not unlikely that when the company goes under, she will too.  A personal guarantee is only an unsecured promise to pay.  Once you’ve obtained such a promise, you then have two unsecured promises to pay, the second of which may be worth no more than the first.

Security Interests

A security interest created through a security agreement is more than a bald promise to pay.  In the security agreement, the customer is saying, “I promise to pay you, but if I don’t come through, here’s your pound of flesh.”  Answering the nuanced questions of whether a security agreement creates a security interest, if the security interest has been perfected, and does it have priority over other security interests is the kind of thing careers are made of.  Nonetheless, here are a few important things that the small business supplier of goods should know about what are called purchase money security interests.

Purchase Money Security Interests. A purchase money security interest is a security interest in collateral which is taken by the seller of that collateral to finance payment of its purchase price.1 If you sell widgets to Home-O-Rama on the faith that Home-O-Rama will pay you at the end of the month, and you’ve entered into an agreement with Home-O-Rama pursuant to which you’ve taken a security interest in the widgets along with the proceeds from the sales of the widgets, you have created a purchase money security interest in the widgets.  This means that if you’re not paid at the end of the month, you have the right to repossess the widgets you sold to Home-O-Rama, or take the proceeds from Home-O-Rama’s subsequent sales of the widgets (or other monies to which those proceeds can be traced).2 If Home-O-Rama is doing a good business, it may have already sold the widgets by the time you realize you’ve been stiffed, so the purchase money interest in the proceeds may be more important than the interest in the widgets themselves.  Moreover, because the security interest is a purchase money security interest, if it is perfected it will take priority over the security interests of other secured lenders who would normally be entitled to priority under the first-to-file-or-perfect rule.3

To perfect its secured interest, the seller has to take a few necessary procedural steps before shipping the widgets.  He must enter a written security agreement with Home-O-Rama and file a UCC-1 financing statement with the Secretary of State.4 He must also send a letter to anyone else who has a security interest on file against Home-O-Rama’s goods and inventory, notifying them he’s claiming a purchase money security interest in the same collateral.5 Like most new things, the steps may be a bit tricky the first time or two.  But once the seller has it down, it’s quite straightforward, and she’ll sleep better knowing she’s not completely at the mercy of Home-O-Rama’s better angels.

Future Orders. It used to be that a supplier had to go through all of these steps every time he shipped a new order of widgets to the same customer.  This could be so cumbersome that in many cases it wasn’t worth the trouble.  But in 2001 the UCC was revised in Minnesota.  Now a supplier can claim a security interest, not only in the goods being supplied at the time the initial security agreement is entered, but also in what is called “after-acquired property”—such as inventory shipped on a later occasion or many later occasions—without having to enter new agreements and make new security filings every time.6 One caveat here is that the initial security agreement should state clearly that it applies to “after-acquired goods,” as should the initial UCC financing statement.

 

Conclusion

As most people are painfully aware, this is a tough economy.  It makes its unpleasantness known in different ways to different people, but not least to the small businessperson struggling to keep her products flowing and then to get paid once they’ve been delivered.  While small business people are no better able than others to squeeze blood from a turnip, there are a few things they can do to maximize their prospects in this environment.  A good purchase money security agreement is one of them.

Notes

1 MSA 336.9-103.
2 MSA 336.9-609;336.9-315.
3 MSA 336.9-324(g)(1).
4 MSA 336.9-310.
5 MSA 336.9-324(b).
6 MSA 336.9-204.

 Jeff Alden is a Minneapolis lawyer whose practice focuses on businesses and business litigation. 

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