Securing Promises to Pay or Perform

Whether you are selling goods or services, loaning money, or entering into other contracts requiring payment or performance by the other party, there is always a risk that you will be left "holding the bag" if the other party does not pay or perform as agreed.  A promise to pay or perform under a loan or contract, without more, leaves the payee/promisee with the right to file a lawsuit if payment or performance is not received.   This is fine, but you didn't bargain for the right to file a lawsuit when you entered into the contract.  It was payment or performance by the other party you were looking for. 

   Fortunately there are several ways to increase the chance that you will receive the required payment or performance under your contract.  Various security devices exist which increase the likelihood that the other party will pay or perform as agreed, and provide a remedy if they don't.  These include various forms of collateral security, such as mortgages, letters of credit and UCC liens, as well as personal guarantees.  

   Mortgages.   If you lend money or extend credit in connection with the sale of goods or services, you can secure the obligation to pay by obtaining a mortgage against real estate from your borrower/buyer.  This gives you a lien in real estate owned by the other party which would allow you to seize and sell the real estate to satisfy your debt in the event of a default in payment.  Mortgages like this are commonly used by banks in connection with commercial financing, but can also be used in other commercial transactions to secure any type of promise to pay or perform.

   Letters of Credit.  A letter of credit is a security device whereby a borrower/debtor causes his bank to issue a promise to a third party (you) that if payment or performance does not occur the bank will pay an agreed amount equal to the loss caused by the failure to pay or perform.  Many sales of goods transactions are secured by letters of credit where the bank issuing the letter of credit agrees to pay for the goods if they are not paid for by the buyer.  The seller simply has to notify the bank that payment has not been made as agreed and the bank issues a check to the seller.  Letters of credit of this type are typically irrevocable (non-cancellable) and without conditions (unconditional.)

   UCC Liens.  Security liens against other property can be obtained under the Uniform Commercial Code typically by filing a UCC-1 financing statement against the borrower/debtor which describes specific collateral in which a security lien is being obtained.  For example, if you were selling a large refrigeration unit to a buyer in exchange for the promise of future payments you could secure the payment obligation by recording a UCC lien against the refrigeration unit so that it could be taken back (repossessed) if payment is not received.  This concept applies to the sale of any type of goods.  UCC liens are like real estate mortgages but are recorded against different collateral.  They can be used to secure virtually any promise of payment or performance, similar to mortgages.

   Personal Guarantees.  In the commercial world we often deal with entities like corporations, limited liability companies, and limited partnerships.  Often these entities have limited assets, and thus present a credit risk if payment or performance is not received as agreed.  One way to reduce this risk is to obtain the personal guarantee of the owner of the entity, which is a written agreement to pay or perform in the event the entity does not do so.  Personal guarantees are a great way to keep people honest since personal liability typically exposes the assets of the individual to seizure and sale to satisfy an outstanding unpaid obligation.

   These are just a few of the ways that you can protect yourself from a defaulting promisor.  It is also worth observing that if a potential borrower/customer or buyer balks at providing additional security it is a strong indicator that your potential borrower may present more of a credit risk than you originally estimated.  After all, if your borrower/customer has the ability to pay and intends to pay you, there should be no hesitancy in providing security to back up that promise of payment.  Why should you take the risk?