Written for “Business Credit,” The Publication for Credit and Financial Professionals
November/December 2011 by Roger Barter and Steve Becker, Corporate Intelligence Services co-founders.
“What in the world is going on out there? My best customers are closing their doors, out of the blue!” – Sales Manager, Lumber Distributor
This scenario is playing out more and more as the economy spirals into unchartered territory. Credit managers are expected to see what, at first glance, cannot be seen, and to be world class experts on predicting the future of every account that comes across their desk. Instead of being called the credit department it might be more apt to rename it, the “Prophet Department”.
Credit Management 101, teaches that the best way to shrewdly evaluate credit and anticipate problems is by adhering to the basics, otherwise known as the 5 C’s.
1. Character – The willingness of the debtor to pay obligations promptly. It consists of an account’s reputation for honesty and dependability.
2. Capacity – The ability of the account to conduct its business successfully. It includes management ability and technical know-how.
3. Capital – The most important source of information on capital is the financial statement and its analysis to determine whether the account will be able to pay its obligations. This factor highlights the financial condition and trend of operations. Unfortunately, most privately run companies are not willing to provide this.
4. Conditions – The external influences not traceable to any of the credit factors fall under the conditions category. General economic conditions in the nation, in the community, and in the industry will exert a modifying influence on the final analysis of the account.
5. Collateral – To ensure payment and avoid the loss of a sale, special written legal arrangements are made when an account appears weak and unacceptable after an evaluation of character, capacity, capital and conditions. Personal Guarantees and Corporate Guarantees are often requested to provide reassurance and commitment.
Unlike a bank, which protects itself by tying each loan to an asset equivalent to the loan value, credit managers often have their hands tied, since it is unusual to require a customer to identify their individual assets (much less the book value) even though they may be receiving significant credit lines of $10,000 or a million dollars or more.
Plan “A” is that your customers will pay 100% of their bills. But suppose they don’t.
What is your Plan “B”? What is your end game in a worst case situation? What, if even your best customers close their doors out of the blue?
For most, the answer is collection agencies, attorneys, lawsuits, and judgments; usually in that order. Unfortunately, 80% of judgments are not satisfied because there are too few assets or no assets at all.
But is that surprising? Why do problematic customers have so few assets? After all, didn’t they complete their credit application, looked good on their D&B, Experian, Equifax, or Cortera report, offered good references, and at least satisfied four of the five C’s?
The answer may be that they in fact have assets, but as a cautionary move they have diverted or hidden their assets out of your sight. After all, you may not have asked at the time of their credit application process what if any assets did they have either corporately or personally.
Now, out of desperation, you have to know where to look or risk losing every penny that is owed.
Even having a personal guarantee might be meaningless unless it is established that there are specific assets which can be identified as a last resort. A personal guarantee is a false insurance policy unless you at least have knowledge of their assets, their location, and their book value. The objective should be to identify viable unencumbered assets.
Let’s Investigate This Subject Further
In the area of trade credit, credit managers and business owners are not on the same footing as with their counterparts at the bank. In most cases, the trade creditor will be in the class of creditors known as unsecured creditor. Your customer, however, will without hesitation consent to a UCC-1 filing to induce a bank or financial company to extend them a loan and/ or a working capital line of credit.
However, if a trade creditor were to require a security agreement naming an asset of the customer as collateral, well, you can just imagine what the response would be from your customer as well as your sales manager!
Wouldn’t it be wonderful if trade creditors had the same access to their customers’ assets as secured creditors? Unfortunately, this isn’t the case in most instances. So, when that customer of yours stops paying, you are confronted with a stone wall that they lack the necessary funds to satisfy their obligation to your company.
Conversely, wouldn’t be nice to be able to approve a customer that had a weak credit analysis once the traditional credit application had been processed because the customer had a viable, unencumbered asset such as real estate, motor vehicles, aircraft, watercraft or insider stocks that you were aware of and that could be attached in the event that the customer defaulted on their obligations?
It’s important to understand that if you extend credit, you are a lender and that you must think like a bank. Even though you may not have a security agreement with you customer, you still can gather information on your customer’s assets whether or not they have any encumbrances on them. By understanding what your customer has for assets, you can have a “Plan B” in place to recover you money.
Collecting information on a customer’s assets including parcel numbers on real estate, vehicle identification number and license plate number, hull numbers and aircraft registration to name a few, are all important to have on file if the need were to arise. Additionally, the book value of the particular asset is important in order to understand the customer’s equity position in the asset. Has a piece of real estate been refinanced in excess of its market value? What is the worth of that motor vehicle and does the customer have clear title? What is the market value of the insider stocks versus the purchase price?
It is as important to collect information on any existing encumbrances on any assets that have been identified. The creditor with the primary lien position on a customers’ asset will have a much bigger hammer to wield.
What About Hidden Assets?
When a customer is having difficulties meeting their obligations and they are astute, they understand the need to be protected from their creditors’ attempts to seize them. Hidden assets can take many forms. It could be that piece of real estate that has been sold to a spouse or relative to “hold until the storm passes.” It could be a piece of real estate that is transferred into a corporate name of a newly formed realty LLC. Perhaps the customer owns several other businesses and simply sells the property to the corporate entity to “shelter” the real estate. Whatever the case may be, it is important to be able to sift through you customer’s smoke screens and obtain security and any asset possible and that includes uncovering any hidden assets. Even more difficult to detect is a savvy debtor’s attempt to hide their cash.
Some of the ways a debtor can hide their cash is through a mortgage pay down. Hiding their cash assets in property either in their name or in someone else’s. “Sweetheart lawsuits” are bogus lawsuits brought against the debtor to obtain a false judgment. The debtor pays the judgment amount and claims that they have no cash. Once the storm passes, the bogus judgment creditor returns the money minus a handling fee. Some savvy debtors may even “over pay” the IRS as a place to park their money. Dead and dissolved corporations can also serve as an excellent hiding place for all kinds of assets.
So, it’s not enough to know where all the obvious assets are and what their value is, but also knowing if there are hidden assets, their location, and value.
Today there really is no margin of error. Just one overlooked account in which no collateral was accessible can be devastating to a company in the event the account ends up in litigation. Try to include asset knowledge in your check list for evaluating credit limits on the front end. Whether you get a personal or corporate guarantee, it is better to know that the $50,000 line of credit that you approved is backed up, not only by good intentions, but tangible collateral. That’s Plan “B” and that can be the difference between your profit or your loss.