Chapter VII. Contract Protection
| Jurisdiction | United States |
VII. Contract Protection
There are several contractual protections a party can utilize to regain confidence in a transaction with a financially strapped entity.
A. Payment in Advance/Cash on Delivery
Payment in Advance (PIA) and cash on delivery (COD) are contractual terms that require payment for goods either in advance of delivery or upon delivery of the goods. "The object of so marking the goods [COD] is to instruct the carrier not to deliver the goods until the price has been collected."69 The UCC has adopted the COD method of payment in § 2-507, which provides: "Where payment is due and demanded on delivery to the buyer of goods or documents of title, his right against the seller to retain or dispose of them is conditional upon his making the payment." Under the UCC, a buyer is not excused from paying if the contract requires payment upon delivery.70
COD is an efficient tool to manage a financially strapped customer, as it substantially shortens the time between delivery of the goods and payment, thus avoiding a default in payment.71 While a seller's change to COD mid-contract may lead to preference exposure, it is better to have the payment in hand and be subject to a preference action (possibly years later) than to not be paid at all.72
One further item a seller should consider is ensuring that the shipper (if one is used) can comply with the terms of the contract that require the buyer to pay COD. Many shippers have terms and conditions governing their use and acceptance of COD payments.73
B. Letters of Credit
When entering into a contract, the party receiving payment for its goods or services may request a letter of credit as payment or guaranty of payment. Letters of credit are separate transactions entered into between a seller and buyer of goods or services and an issuer bank (sometimes including a second bank as well). In a letter-of-credit transaction, the buyer of the goods or services (the applicant) applies for the bank (the issuer) to issue the letter of credit for the benefit of the seller of the goods or services (the beneficiary). If the buyer fails to pay for the goods or services, or if the letter of credit is the sole consideration for the underlying transaction, the seller may seek compensation through the letter of credit's terms.
Typically, all that the seller must do is present the documents required under the letter of credit, and the bank will pay.74 "If the beneficiary's demand for payment conforms to the terms of the letter, then the issuer is obligated to pay irrespective of any nonconformity in goods shipped and irrespective of most defenses which the bank's customer can separately raise against the beneficiary."75 The bank's obligation to pay on the letter of credit is independent of the circumstances of the underlying transaction.76
Parties use letters of credit where the seller of goods or services has its doubts about the ability of the buyer to pay, or where other circumstances make direct payment difficult, such as international transactions.77 "The shifting of liability to the bank rather than to the services or goods provider is the main purpose of the letter of credit. After all, the bank is in a much better position to assess the risk of its customer's insolvency than is the service or goods provider."78
Further, letters of credit and their proceeds are not considered property of a debtor's bankruptcy estate under § 541 of the Bankruptcy Code.79 A seller of goods may draw on a letter of credit regardless of whether the buyer/applicant has sought bankruptcy protection.
While letters of credit transactions are governed by state law, nearly all, if not all, states apply some form of Article 5 of the Uniform Commercial Code and the Uniform Customs and Practice for Documentary Credits.
C. Guaranties
Guaranties can bolster the creditworthiness of a party to a transaction. A guaranty is a promise by a person or entity that is not a party to the underlying contract to answer for a party's obligations in the contract. "A guaranty is, by its very nature, a conditional promise to pay because the guarantor promises to pay only on the condition that the principal debtor fails to pay and is immediately enforceable if that event occurs."80
Guaranties are especially beneficial when dealing with a start-up company that is an offshoot of a private-equity firm or relies on angel investors to keep the company afloat. More often than not, these companies will struggle at the outset of their existence. Being able to go after a guarantor for nonpayment of the company is tantamount in these situations.
There are two types of guaranties. A guaranty of payment is an unconditional promise of the guarantor to pay the debt, allowing the creditor to enforce the guaranty without first seeking relief against the contract debtor.81 The other is a guaranty of collection. "In a guaranty of collection, the guarantor undertakes the responsibility to pay if and only if the debt cannot be collected from the principal through legal proceedings."82 The presumption is that an unconditional guaranty is a guaranty of payment.83
D. Title
Taking formal title to the property at issue in a contract also provides a party with protection. By holding title...
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