by Joseph Sullivan
Let’s be clear: Payouts and notes are never good. They are usually the consequence of a mistake or a series of mistakes as goods have continued to be advanced to risky customers. However, they are better than not getting paid at all—except under some bankruptcy conditions, which can result in the lender getting sued and having to pay legal fees on top of giving a lot of money back. That’s a very bitter pill.
The first step in avoiding the pitfalls of payouts and notes is to recognize the important differences between the two:
1. Payouts are informal agreements. If not put in writing, they may still have legal effect in as a sort of oral contract if the lender (i.e. the distributor) can legally prove up the elements of a contract, which may be tough. There is just no question that having a written agreement is a better idea—but even that might not work if it isn’t competently drawn. Consider asking a lawyer to draw up a valid form to have at hand ready for use. (Be sure to update it from time to time as well.)Payouts can contain any terms that are enforceable in the state in which they are used. Typical terms include:
- An additional percentage of every new invoice to be applied towards the past-due debt (for example, the customer pays new invoices when due plus 10% until the debt is paid)
- A ratio payment (for example, $1.50 of new credit for every $2 of old debt that is paid down)
- A fixed monthly payment
- Interest
- Dual payee checks including you, when you advance product before the debt is current
The list could include almost any defensive maneuver imaginable, so long as the customer will agree and the courts will uphold it.
Payouts are practical, straightforward, and relatively palatable to many customers. The problem is that when push comes to shove they don’t give you any standing over any other creditor. They are just general obligations of your customer. This is where notes come in.
2. Notes are formal and, if competently drawn, enforceable. Generally speaking, they have a higher claim on the customer than does a general obligation. Lenders should file a UCC-1 form (official legal notification of your standing) in order to legally preserve their collection rights. Notes should always be drawn by a lawyer in order to avoid loopholes through which a customer might wiggle.
So what can go wrong? Plenty. Lots of customers will strongly resist notes, especially with UCC-1 filings, because they make the banks and other creditors nervous. In fact, some banks and creditors prohibit them. Of course, they make a lender’s own bank nervous too. Notes and payout plans will almost certainly be excluded from a lender’s borrowing base calculations.
The bankruptcy law is the big risk. Customers who need payouts or notes are in some kind of trouble, so know what kind and how deep before advancing another dollar of goods. The danger zone runs for 90 days immediately before bankruptcy. If the lender changes the way it does business with that customer during that period, there is a good chance that the court will force the lender to return everything you collected during that period. Say the customer owes $150,000. Within the 90 days, the lender received a note with a down payment of $20,000, and then sells them $20,000 more while being paid on time and collecting another $5,000 on the note. The note changed the way business was being done and the court might well require that the the $25,000 collected on the note is returned, as well as all of the payments received for the new goods sold thereafter.
It is a tricky area of law. Good legal advice is key, as is to inquiring deeply into a customer’s condition before any deal is cut. Gather as much information as possible to ensure sure that whomever is analyzing the credit knows what to look for in troubled companies.
Ultimately, payout plans and notes have salvaged many a string of overdue invoices. But they must be used with skill and care.
Joseph Sullivan is president of JSA, a consulting firm with electrical distributor clients in North America, Puerto Rico, and Mexico. Reach him at 972-463-1125, or joe@joseph-sullivan.com.
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