What should my business do when a lender says to pay them instead of our vendor?

A small business receives a plain first-class letter from an unknown collection company, demanding that the business pay it, not its vendor, for the vendor’s invoices. The letter arrives while the accounts-payable clerk is on vacation, and the letter drifts around the office until she returns. She thinks it’s a scam.

The supplier was paid automatically by ACH debit each month, and in fact the relevant month’s payment had gone out the very day before the clerk returned, so the notice seemed irrelevant.

The clerk throws the letter away, and 3 more payments go to the vendor. The collector sues the business over the four unpaid invoices.

Unfortunately, the business still owes the collector for the invoices, though it paid the vendor. The supplier won’t send any more deliveries, but that’s just the start of it. The supplier complains that the collector is gouging it on late fees and legal costs. How did it become the customer’s problem?

Lenders and buyers of receivables can take strong action to get the customer, or account debtor, to pay them directly, and not to the vendor, under Article 9 of the Uniform Commercial Code. After a buyer sends proper notice to the account debtor - the company that owes the receivable - a customer that still pays the vendor risks paying the invoice twice.

As a rule, a vendor can assign its receivables to someone else, even if the vendor’s contract with the customer bans the assignment. Under UCC Section 9-406(d), such a contract clause does not stop the assignment, nor does it create a breach that would let the customer get out of the contract. That lets vendors raise money by selling or pledging receivables.

Under Section 9-406, an “assignee” is an entity that either bought the receivable outright from the vendor or took a security interest in the receivable as collateral for a loan to the vendor.

Valid Notice

UCC Section 9-406(b) lets the assignee send the customer a notice of the assignment or pledge.

To be legally valid, a notice has to be signed, but an electronic signature does the job. But two things can still make the notice invalid.

First, the notice is only valid if it is clear and complete enough that the customer can tell what the assignee’s rights are.

A second situation is a notice that tells the customer to pay less than the full installment or periodic payment due. If the customer chooses, that notice does not count.

If the customer is unsure or objects, UCC Section 9-406(c) gives it the right to demand that the assignee prove the assignment really happened.

The assignee can back up its notice with a copy of the signed document by which the vendor assigned the receivable. A UCC financing statement alone is not enough.

If the assignee does not answer the proof request within a reasonable amount of time, the customer can pay the vendor and be discharged from the debt. The Code does not set a deadline for that answer. The customer may pay the vendor when a payment comes due, or even earlier, if reasonably necessary to avoid defaulting on the contract, according to Comment 4 to UCC Section 9-406. But paying the vendor well before it is due will not discharge the customer’s debt unless the assignee failed to answer in time.

Apart from the exceptions discussed above, a customer’s payment to the vendor after valid notice of assignment still leaves the debt. The assignee can collect on the receivable from the customer. The customer must chase after the vendor for a refund, or end up paying twice.

But the assignee gets no better rights than the vendor had. So the assignee must take into account any term in the customer’s contract with the vendor. Also, the customer can use against the assignee any legal defenses or offsets it had against the vendor arising from that deal. In general, any separate claim against the vendor does not apply to the assignee, unless the claim arose before the customer got a signed notice of assignment.

This topic is getting more important as small businesses that need cash turn to “factoring” deals. Factoring is selling receivables to finance companies at a discount to get quick cash. So expect to see more 9-406 notices from banks, factors and other finance companies. Avoid any delay in responding to a Section 9-406 notice.

• Step one: Check the validity of the notice. Make a checklist of the points above and write your findings next to each point.
• Step two: Tell your check writer and whoever makes the wires to stop paying that vendor.
• Step three: Any outside attorney for the assignee should deal with your company’s counsel. Lawyers are not supposed to contact someone else’s client without the client’s lawyer’s consent.
• Step four: Show the checklist to your legal department.
• Step five: Confirm the amount the assignee demands is right. Sometimes payments sent earlier, but before the notice, will reduce the amount the assignee is due. If there is any open dispute over what the customer owes for the relevant period, the amount may be less.
• Step six: Write the assignee to ask for any proof it has not sent. State any contras, set-offs or counterclaims.
• Step seven: Tell the vendor that you have a legal notice of assignment, and that you must pay the assignee from now on. Tell the vendor payments may be briefly delayed while you get proof from the assignee.
• Step eight: If you think the assignee has a valid notice and the proof is complete, change the payee details, using your usual checks to verify new payment information.
• Step nine: If you do not hear back in a reasonable time and the payment due date is coming up, talk to your legal department. Then send the assignee a final notice and pay the vendor.
• Step ten: Sometimes the vendor and assignee fight with each other over who gets the money. If this gets very involved or they do not agree, ask your legal department to look at an interpleader. That means paying the disputed funds into the court’s hands, which can force them into court to fight it out.

Notice of an assignment or pledge on a receivable doesn’t have to mean that the vendor is struggling. But at times the customer may face an assignee with its legal power while its supplier is strapped for cash. That can be a worry. The vendor who can’t pay its workers may end up with people going home. Short of cash, a vendor may cut back on deliveries. If the vendor can’t or won’t fulfill the contract, that is a breach. That in turn can mean the customer has a counterclaim to set off against the receivable. That is bad for the lender. A quick settlement, where everybody gives a little, often beats a worse outcome from a long and costly court fight.