This commentary was first published in the Financial Post on November 4, 2008.
Last August, 4,500 Zoom Airlines passengers found themselves stranded across North America, the West Indies and various European countries when the airline ran out of money and grounded its planes. Passengers were left to pay for their return journey home and figure out how to recover the payments they had made to the airline. Their prospects were dim.
Since Zoom Airlines had declared bankruptcy, the best the passengers could expect was to be treated as unsecured creditors of the airline-- ranking at the bottom of the ladder in the distribution of Zoom's assets. Passengers must yield to the prior claims of Crown trust claims (for unremitted employment insurance premiums and tax deductions), secured creditors and preferential creditors. Typically, unsecured creditors recover no more than five cents on the dollar of their claims and often nothing at all.
Each year, thousands of unsecured creditors, commercial as well as consumer, find themselves in a similar position to Zoom's stranded passengers when their debtors have gone bankrupt. Consumer creditors feel the bite more keenly, often failing to even appreciate that there is a risk of non-payment. In the case of contracts for the sale of goods, pre-paying consumers may be left empty handed even if they thought specific goods had been earmarked by the seller for the buyers' benefit. "Layaway" plans, often promoted by jewellers and other gift shops encouraging shoppers to pay for an expensive item by instalments prior to delivery at Christmas time, are a good example since the buyers have no means of knowing whether the merchant will still be in business when they seek to collect their purchases.
Commercial creditors -- in theory, at any rate -- are assumed to be better able to protect their interests. Yet consider the common challenge facing Canadian suppliers of goods of all types to Canadian supermarkets and department stores. The amounts involved are often substantial and may represent a significant part of the supplier's turnover for a year, especially where the goods were manufactured to the supermarkets' or department stores' specifications or were designed to meet a seasonal market. The suppliers would like to retain title to the goods, or obtain an equivalent security interest under the provincial Personal Property Security Acts, until the goods have been paid for, but the buyers won't agree.
Typically, the buyers have the upper hand because there is no shortage of suppliers and the suppliers are remitted to the end of the creditors' queue if the buyer becomes bankrupt.
The suppliers wrung a modest concession from Parliament when the federal Bankruptcy and Insolvency Act was amended in 1992. It entitles unpaid suppliers to recover the goods if the goods were delivered within 30 days prior to the buyer's bankruptcy and if the supplier makes its demand within 15 days of the buyer's bankruptcy. Unfortunately, so many other statutory conditions are attached to the suppliers' entitlement to reclaim the goods that the conditions are often difficult or impossible to meet in practice. The banks are usually the main beneficiaries of these legal hurdles since, almost invariably, they hold a general security interest in the buyer's inventory.
The banks argue that they extend lines of credit to the supermarkets and department stores so that these borrowers can pay for the incoming inventory, and that the banks cannot be expected to police the borrowers' proper disbursement of the bank loans.
This example shows how difficult it may be for the federal government (or for the provinces where the issue involves the adjustment of provincial laws) to reconcile the competing claims of creditors.
But there are ways for consumers and businesses to protect themselves. Visa and MasterCard are providing an important source of relief for consumers, merchants and professionals. In the case of consumers, these credit card companies have adopted a policy of reversing a debit item where the merchant has failed to deliver goods or to provide the promised service. (Thus, at least some of the stranded Zoom airline passengers may recover the cost of their abortive trips.)
For the retailer and other service providers, credit cards are also reducing risk. They no longer have to give credit to customers, clients and patients if they choose not to. The ubiquitous credit card ensures that the goods and services are paid for contemporaneously and the risk of non-payment is shifted from the supplier to the credit card company.
This is not irrational since the credit card company is often in a better position to diversify the risks of non-payment than suppliers. What is more, if the customer has maxed out his line of credit with the credit card company, the supplier will be advised of it immediately.