By Jeff Sistrunk

Law360 (October 16, 2020, 1:12 PM EDT) -- As the COVID-19 pandemic has roiled markets around the world and devastated many businesses, companies of all stripes are increasingly seeking out trade credit insurance — a form of coverage that shields a business against the risk of its customers failing to pay for shipments.

"Trade credit policies are very valuable means of transferring [accounts receivable] risk, especially for companies that are transacting business across international borders," said Pillsbury Winthrop Shaw Pittman LLP partner Joseph Jean. "The key to transferring that risk is having the broadest coverage available, on the most simplified terms."

Here, attorneys discuss how policyholders can maximize their trade credit coverage and avoid potential pitfalls.

Know Your Coverage Trigger

Trade credit insurance is designed to cover losses that an insured company suffers when a customer fails to pay for a shipment made during the policy period. Coverage typically applies once a buyer has been in default on a payment for a certain number of days specified in the policy's "waiting period," which may extend for 60 or more days beyond the payment's initial due date. But policies vary on what constitutes a default, and it is important for a company to negotiate that language with the insurer at the outset, according to attorneys.

"The big issue is whether to define 'default' as the failure to make full payments or just the failure to make any payments — or to agree to different payment terms going forward," said Walter Andrews, head of Hunton Andrews Kurth LLP's insurance coverage practice. "Some policyholders would prefer to negotiate for a while. It is important to address that at the drafting stage and not when the payments come due. It could be defined many different ways with or without additional premiums charged."

John Gibbons, a partner in Blank Rome LLP's insurance recovery practice, pointed out that a policyholder may be hesitant to immediately place a customer into default for failing to pay for a shipment, especially if the two businesses have had a longstanding relationship.

"When there is nonpayment or late payment, pressure arises," he said. "A company does not usually want to immediately place a counterparty into default."

Depending on the terms of a trade credit policy, a policyholder may have an opportunity — or in some cases, an obligation — to work with a customer to try to avert a default.

"There may be technical terms in these policies that do two things," Gibbons explained. "One, they may expect you to minimize your loss, which may involve working with the counterparty. Also, they do not want you extending the payment terms without notice or acceptance by the insurer."

As a result, it is critical for a policyholder to communicate early and often with the insurer once a buyer is late on a payment, Gibbons continued.

"One of the ways to protect yourself is to make sure you have leeway in terms of providing notice to the insurer before you put the entity into formal default or nonpayment after their obligation has come due," he said.

Understand Your Share of the Risk

When purchasing trade credit insurance, a company should be mindful of the size of the deductible it is expected to pay before coverage kicks in, and whether it will be required under a "co-insurance provision" to assume responsibility for a certain percentage of any loss over the deductible.

For example, a policy may assign the insurer 90% of a loss in excess of the deductible, which would mean that the policyholder would be on the hook for the remaining 10%. In that scenario, if a buyer fails to pay for a shipment worth $10 million, the policyholder could find itself having to pay $1 million out of pocket on top of its deductible. According to attorneys, deductibles in trade credit policies often reach $100,000 or more.

"That could result in a dual blow to the policyholder, if they already had to pay a deductible," said Gibbons. 

Therefore, Gibbons said, companies should ensure during the policy purchase process that they are not assuming responsibility for an excessively high percentage of any insured loss.

Narrow Any War Exclusions

Trade credit policies commonly bar coverage for losses arising out of war, but the terms of those exclusions vary widely. As a result, policyholders will want to secure as narrow a definition of war as possible to avoid unexpected coverage denials down the road, according to attorneys.

"If you do a lot of business in the Middle East, for example, and there is a war exclusion for wars among the countries in the Middle East, that could be a problem," Pillsbury's Jean said. "Also, how broad is the exclusion? Does it include many types of strife, or just declared war? If you have concerns, given the countries in which you do business, you are going to want to define that."

The prevalence of hacking and other forms of digital warfare makes it all the more important for policyholders to narrow the scope of war exclusions, Jean added.

"If you provide or use electronic services, and are susceptible to cyber warfare or hacking, then you want to look out for an overbroad war exclusion that could preclude coverage," he said.

According to Andrews of Hunton, some overbroad war exclusions could even encompass international disputes such as trade wars.

"The definition of a war exclusion has to be limited to traditional 'armed conflict' or 'kinetic or physical' war," he said. "That is the way to exclude 'trade wars,' which this administration says we are engaged in all the time."

Document and Report Everything

Trade credit insurers require policyholders to provide detailed information up front about the shipments for which they are seeking insurance, as well as the customers that have contracted to buy those shipments. But policyholders' documentation and reporting requirements don't end there. Policies typically mandate that insured companies provide regular updates to their insurers regarding the dates of eligible shipments and payments, ranging from every two weeks to every three months, according to attorneys.

"Reporting requirements are, to me, a substantial technical aspect of this insurance that people have to be aware of and ready to look at," said Blank Rome's Gibbons. "We know from experience that insurers may cite these requirements to potentially limit or eliminate coverage when a loss arises. Insurers rely on policy conditions as a basis to deny coverage far more frequently than any exclusion."

Jean said it is incumbent upon the policyholder to diligently track shipments and the status of payments due, so they have all the necessary information to submit to the insurer in the event of a loss. Some companies may run into trouble if they lack sufficient internal reporting mechanisms to track when a shipment was sent and when payments were received, "such that they know exactly where their loss is," he said.

"These policies are almost like light switches. You make a shipment, the payment is due within a certain time, there is a waiting period, and then once that period is over the insurer has to pay the outstanding amount," Jean said. "But if during that period of time you were supposed to report the shipment and failed to, the insurer can come back and say, 'You never reported, so you are in violation and we are not paying.'"

Honor Your Warranties and Covenants

Trade credit policies require policyholders to make a number of "warranties and covenants" when the policy is issued, and it is absolutely essential that they continue to honor those guarantees throughout the policy period, according to attorneys. 

For one, policies typically mandate that the policyholder cease shipments to any buyers that have become insolvent or have been past due on a prior payment for a certain length of time, often 90 days. 

"If you keep shipping after the 91st day, and your policy says you have to stop when they are late, then you are on the risk for any shipments after they are late," said Jean. 

In addition, trade credit policies usually provide that the policyholder cannot extend the deadline by which a buyer must make a payment beyond the "maximum terms of payment" specified in the policy. For example, if an insured company's policy states that a customer must pay within 30 days of receiving a shipment, and the company extends that deadline past 30 days, it would potentially be violating its warranty and covenant, Jean explained.

"Make sure, then, that you have maximum terms of payment in your policy that meet what your actual business is," he said.

--Editing by Kelly Duncan and Michael Watanabe.

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