FOR EDUCATIONAL USE ONLY

Term

 

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Practising Law Institute

Commercial Law and Practice Course Handbook Series

PLI Order No. A0-002B

April, 1999

 

Asset-Based Financing 1999

 

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INTRODUCTION TO SECURED LENDING AND COMMERCIAL FINANCE

 

Marsha E. Simms

 

Copyright (c) 1999 Weil, Gotshal & Manges LLP. All rights reserved.


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A. What Distinguishes a Secured Loan?
A typical unsecured financing is basically an agreement between two parties setting forth the terms and conditions upon which credit will be extended. Aside from usury, set off and, in the worst case, bankruptcy laws, an unsecured loan agreement has more grounding in lending custom and practice than in law.
On the other hand, the special protections afforded a secured lender are only

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available if the lender complies with the laws governing the creation, perfection and priorities of security interests, which are found primarily in Article 9 of the Uniform Commercial Code (the "UCC"). [FNa1] A careful examination of, and compliance with, the UCC is necessary for a lender if it wants a superior position vis-a-vis a borrower's other secured and unsecured creditors.
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B. Obtaining a Perfected and First Priority Security Interest
1. Attachment of a Security Interest
The initial step in obtaining a perfected security interest in collateral is that the security interest must attach. Under UCC 9-203, a security interest attaches when:
a. the collateral is in the possession of the secured party or the debtor has signed a security agreement describing the collateral,
b. value has been given by the lender, and
c. the debtor has rights in the collateral. Section 9-319 of Revised Article 9 makes it clear that consignees have rights in collateral, thereby strengthening the rights of consignors against a consignee's creditors.
2. Security Agreement
Unless the collateral is stocks or bonds held under a pledge arrangement or other collateral as to which perfection takes place by possession, a security agreement is needed to create a security interest. Although a security

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agreement can be an extensive document covering each party's rights and remedies with respect to the collateral, or can be as little as one or two paragraphs in a *11

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loan agreement or promissory note, there are three essential elements -- a grant of the security interest, a description of the collateral and a signature by or on behalf of the debtor. As many lenders have found to their chagrin, a financing statement, unless it contains the elements set forth below, is not a security agreement.
a. A typical granting clause is as follows:
As collateral security for the full and prompt payment when due (whether at stated maturity, by acceleration or otherwise) of, and the performance of, all the Obligations and to induce the Lenders to make the Loans pursuant to the Credit Agreement, the Grantor hereby assigns, conveys, mortgages, pledges, hypothecates and transfers to the Secured Parties, and hereby grants to the Secured Parties, a security interest in, all of the Grantor's right, title and interest in, to and under the following (all of which being hereinafter collectively called the "Collateral"):
(i) all Accounts;
(ii) all Inventory; and
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(iii) to the extent not otherwise included, all Proceeds of each of the foregoing and all accessions to, substitutions and replacements for, and rents, profits and products of, each of the foregoing.

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The description of the collateral in the security agreement can be broad, but should reasonably identify which items of the debtor's personal property are included. Section 9-108(b) of Revised Article 9 will provide a safe harbor if a secured party uses Article 8 or 9 categories, but the security agreement must specifically refer to commercial tort claims and, in a consumer transaction, consumer goods, a security entitlement, a securities account or a commodity account in order to perfect in those items of collateral. It should also be more precise than the description of the collateral in the financing statement, on the theory that the financing statement puts a person on notice of a security interest and the security agreement defines the actual collateral covered. In any event, the narrower of the two descriptions will define the lender's actual collateral for perfection and priority purposes. However, Section 9-504 of Revised Article 9 will provide that a description of "all personal *13

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property" will be sufficient for a description of the collateral on the financing statement, so long as the security agreement contains an appropriate definition. Section 9- 108(c) of Revised Article 9 makes it clear that such a description does not reasonably describe the collateral. Following are the accompanying definitions of Accounts and Inventory:
"Account" means any "account," as such term is defined in Section 9-106 of the UCC [9-102(a)(2) of Revised Article 9], now owned or hereafter acquired

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by the Grantor and, in any event, includes, without limitation, (i) all accounts receivable, book debts and other forms of obligations now owned or hereafter received or acquired by or belonging or owing to the Grantor (including, without limitation, under any trade name, style or division thereof) whether arising out of goods sold or services rendered by the Grantor or from any other transaction, whether or not the same involves the sale of goods or services by the Grantor, (ii) all of Grantor's rights in, to and under all purchase orders or receipts now owned or hereafter acquired by it for goods or services, and all of Grantor's rights to any goods represented by any of the foregoing (including, without limitation, unpaid seller's rights of rescission, *14

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replevin, reclamation and stoppage in transit and rights to returned, reclaimed or repossessed goods), (iii) all moneys due or to become due to the Grantor under all contracts for the sale of goods or the performance of services or both by the Grantor (whether or not yet earned by performance on the part of the Grantor or in connection with any other transaction), now in existence or hereafter occurring, including, without limitation, the right to receive the proceeds of said purchase orders and contracts, and (iv) all collateral security and guarantees of any kind given by any Person with respect to any of the foregoing.
The definition of "account" in Section 9-102(a)(2) of Revised Article 9

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will be expanded to include rights to payment arising out of intangibles, instead of being limited to the rights to payment arising out of the sale of goods or services. This change is intended to expand the items of collateral that fall within the "sale of accounts" rules and facilitate the securitization of assets.
"Inventory" means any "inventory," as such term is defined in Section 9- 109(4) [9-102(a)(48) of Revised Article 9] of the UCC, now owned or hereafter acquired by the Grantor, and wherever located, and, in any
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event, includes, without limitation, all inventory, merchandise, goods and other personal property now owned or hereafter acquired by the Grantor which are held for sale or lease or are furnished or are to be furnished under a contract of service or which constitute raw materials, work in process or materials used or consumed or to be used or consumed in the Grantor's business, or the processing, packaging, delivery or shipping of the same, and all finished goods.
While not required, a security agreement usually contains a description of the obligations secured. The description of the obligations does not have to include the amount of the loan or its maturity, and probably should not. Following is the related definition:
"Obligations" means the Loans and all other advances, debts, liabilities, obligations, covenants and duties owing by the Borrower to any Lender, any

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affiliate of any of them or any indemnitee, of every type and description, present or future, whether or not evidenced by any note, guaranty or other instrument, arising under the Credit Agreement or under any other Loan Document, whether or not for the payment of money, *16

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loan, guaranty, indemnification, foreign exchange transaction or interest rate contract or in any other manner, whether direct or indirect (including, without limitation, those acquired by assignment), absolute or contingent, due or to become due, now existing or hereafter arising and however acquired. The term "Obligations" includes, without limitation, all interest, charges, expenses, fees, attorneys' fees and disbursements and any other sum chargeable to the Borrower under the Credit Agreement or any other Loan Document.
A security agreement should also contain warranties and covenants relating to the collateral, further assurances clauses, and provisions detailing the remedies of the lender relating to the collateral in case of a default by the borrower.
b. Value
Under UCC 1-201(44) a person gives value for rights if it acquires them (i) in return for a binding commitment to extend credit or for the extension of immediately available credit, (ii) as security for the satisfaction of a pre-existing debt, or (iii) in return for consideration sufficient to support a simple contract.

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c. Rights in the Collateral
A security interest does not attach until a debtor has rights in the collateral. While ownership is clearly a right in the collateral, limited rights such as those of a lessee or bailee are sufficient to support the creation of a security interest. Section 9-319 of Revised Article 9 makes it clear that consignees have rights sufficient to grant a security interest in goods consigned to them even if they do not own the goods.
If the grantor of the security interest is a corporation, the secured party should also insure that the corporate formalities are observed -- the corporation has the power and authority under its charter and by-laws to grant the security interest, the grant of the security interest has been authorized under corporate law and that the security agreement has been signed by a duly authorized officer of the corporation.
3. Perfection of a Security Interest
Under UCC 9-303, a security interest is perfected when it attaches and when the appropriate steps for perfection have been taken. A security interest in accounts is perfected by filing a financing statement against
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the debtor in the state of the debtor's principal place of business. (See UCC 9-103, 9- 401). A security interest in inventory is perfected by filing a financing statement against the debtor in the state where the inventory is located (See UCC 9-103, 9-401). However, if the debtor's right to receive payment is

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evidenced by an instrument or chattel paper, possession may be necessary or desirable. (See UCC 9-304, 9-305 and 9-308). Section 9-301 of Revised Article 9 will provide that perfection will occur by filing where the debtor is "located" for all collateral. If the debtor is an entity that registers to come into existence (e.g., a corporation, limited partnership or limited liability company), then the debtor is "located" in the state of registration (See Section 9-307(e) of Revised Article 9). The transition rules in Part 7 of Revised Article 9 will provide a grace period for refiling, if necessary, under Revised Article 9.
Section 9-402(1) requires that the financing statement be signed by the debtor. Section 9-502(a) of Revised Article 9 omits this requirement, eliminating the need for a signature in order to facilitate electronic filing.
Section 9-402(7) provides that a financing statement sufficiently shows the name of the debtor if it gives the individual, partnership or corporate name of the debtor, whether or not it adds trade names. Section 9-402(8) provides that a financing
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statement substantially complying with Article 9 is effective even though it contains errors which are not seriously misleading. A great deal of confusion and bad case law have arisen from instances in which the debtor is not correctly named on the financing statement, usually because a trade name has been used instead of the corporate name, or a d/b/a instead of the sole proprietor's name. The advent of computer searches has only added to

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the confusion. Section 9-503 of Revised Article 9 will provide that a debtor's registered name must be used, and that an incorrect name is materially misleading if a search does not find it.
Finally, Section 9-521 of Revised Article 9 will remove much of the discretion that is currently exercised by local filing officers by providing that financing statements that comply with certain minimum criteria must be accepted for filing. These criteria are as follows: (i) the record is communicated by a method or medium of communication authorized by the filing office, (ii) an amount equal to or greater than the filing fee is tendered, and (iii) the filing office is able to index the record).
Remember, if the secured party's lien is not perfected, the secured party loses as against a bankruptcy trustee or another perfected creditor. The secured party's lien is still good as against the debtor.
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4. Priority of Security Interests
The priority rules of the UCC are found in Part 3 of Article 9. Section 9-312 contains the basic priority rules as between two perfected secured creditors. In general, if two competing security interests are both perfected by filing, the first to file has priority. In general, if one security interest is perfected by filing and the other by possession, the first to perfect has priority. However, these general rules are subject to various exceptions -- those relating to purchasers of chattel paper ( 9-308 [ 9-330]), purchase

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money security interests in inventory ( 9-312(3) [ 9-324(a)]) and buyers of inventory ( 9-307 [ 9-320]) being particularly relevant for this discussion.
5. Special UCC Provisions Relating to Accounts
Section 9-318 contains various provisions governing the rights of account debtors as against assignees of accounts. Section 9-318(4) contains an important provision for assignors -- it provides that any term of a contract that prohibits the assignment of an account or prohibits the creation of a security interest in a general intangible for money due is unenforceable. Thus while an assignor may be contractually prohibited from assigning its performance obligations under a contract, it can, notwithstanding the terms of the
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contract, assign its right to be paid. Section 9-406(d)(1) of Revised Article 9 will contain a comparable provision which will also include payment intangibles.

II. THE ROLE OF ASSET BASED LENDING

A. Provides Working Capital

Extensions of credit based upon a borrower's accounts and inventory are a primary source of working capital. There can be a period of 4-6 months between the time production starts in an item of inventory and that piece of inventory

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is sold and paid for, and during that time the borrower has all of the expenses related to operating its business. By obtaining financing, a borrower is able to provide itself with a more steady stream of income, and is also able to realize the value of its assets prior to realization thereon in the ordinary course.
From the lender's point of view, it is financing the most liquid piece of a borrower's business. If borrowing levels are correctly set and appropriate monitoring occurs, the lender will profit from the transaction. In the worst case, the lender should be able quickly to realize on its collateral by either liquidating the inventory and/or collecting the debtor's accounts.

B. Forms of Facilities

1. Most accounts receivable and inventory financing is revolving
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credit -- that is the borrower may borrow, repay and reborrow within certain limitations, the two most important being the aggregate amount of the facility and the borrowing base. This enables the borrower to borrow only when it needs the money and therefore to reduce its financing costs.
2. Asset based financing has traditionally been done on an uncommitted basis, through lines of credit, with the lender reserving the right to make advances and demand repayment at its discretion. These lines of credit often had no

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covenants or events of default, with the bulk of the operative provisions relating to the nature and quality of the collateral. Over time, however, the documentation of lines of credit in many ways began to resemble a committed facility, particularly when the documentation contained covenants and events of default.
Courts have questioned whether or not lenders can exercise the discretion reserved to them in the documentation to cease funding and demand payment, particularly when the documentation contains provisions such as covenants and events of default and the borrower has not violated them. In many instances, courts have imposed a good faith obligation on a lender, requiring the lender to give the borrower notice that it will no longer make advances and a reasonable period to obtain alternate methods of financing before demanding payment.
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The primary case setting forth the good faith obligation is K.M.C. Co., Inc. v. Irving Trust Company, 757 F.2d 752 (6th Cir. 1985). Cases which have addressed the issue of whether covenants and events of default override the discretionary nature of a facility include Bank One Texas, N.A. and FDIC as Receiver for MBank Houston v. Taylor, 970 F.2d 16 (5th Cir. 1992) and First Fidelity Bank v. People Care, Inc., No. L 001554-90 (New Jersey Sup. Ct. 1991). Courts have also questioned the exercise of the lender's discretion in instances where the lender has decided to terminate the borrower's line of credit because the lender has made a determination to cease lending in the

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borrower's line of business. See Crowne Pointe Center Ltd. v. Mellon Bank Corp., No. 91 CA 1104 (Colo. Ct. App. Jan. 27, 1994) and American National Bank & Trust Co. v. Hanson Construction Co., Inc., 865 S.W.2d 302 (Ky. 1993). Notwithstanding this line of cases, many lenders prefer to maintain uncommitted facilities and rely on their rights contained in the documentation. Support for their position can be found in Seattle - First National Bank v. Westwood Lumber Inc., 829 P.2d 1152 (Wash. Ct. App. 1992).
3. On the other hand, many lenders, including most large commercial banks and finance companies, prefer to extend credit through committed facilities. In addition to collecting a commitment fee, the lender is also able to more closely monitor the borrower through financial
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covenants and other financial information, and may be able to spot problems with a borrower prior to their being reflected in a deterioration of the collateral.
Also, lenders who make advances "pursuant to a commitment" have certain advantages under the UCC over lien creditors ( 9-301 [ 9-317]), purchasers of inventory ( 9-307 [ 9-320]) and other secured parties with respect to future advances ( 9-312 [ 9-323]). Section 9-105 [ 9-102(a)(68)] defines an advance made "pursuant to commitment" as one which "the secured party has bound itself to make, whether or not a subsequent event of default or other event not within his control has relieved or may relieve him from his obligation...."

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C. Collateral

Since asset based financing is driven by the quality of the collateral, detailed definitions of "eligible accounts" and "eligible inventory" are contained in the documentation. These definitions are the heart of the borrowing base, and set forth the types of accounts and inventory the lender will lend against. These provisions address the issues of quality and value of collateral, and are separate and apart from the lender's security interest. Even if a specific account does not fit the eligibility requirements, the lender should still have a security interest in it.
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A list of the typical exclusions from eligible accounts and inventory, and an explanation for the exclusions, follow.
"Eligible Receivables" means the gross outstanding balance, less all finance charges, late fees and other fees which are unearned, sales, excise or similar taxes, and credits or allowances granted, of those Accounts of the Borrower arising out of sales of merchandise, goods or services in the ordinary course of business, made by the Borrower to a Person which is not an affiliate of the Borrower, which are not in dispute, and which constitute Collateral in which the Lender has a fully perfected first priority security interest, and, if the account debtor is a Governmental Authority, the Borrower or such Subsidiary has assigned its rights to payment of such account to the Lender pursuant to the

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Assignment of Claims Act of 1940, as amended, in the case of a federal Governmental Authority, and pursuant to applicable state law, if any, in the case of any other Governmental Authority, and such assignment has been accepted and acknowledged by the appropriate government officers; provided, however, that an Account shall in no event be an Eligible Receivable if:
(a) such Account is more than (i) 90 days past due, according to the original terms of sale, or (ii) 120 days past the original invoice date thereof; or
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(b) any warranty contained in this Agreement or any other Loan Document with respect either to Accounts or Eligible Receivables in general or to such specific Account is not true and correct with respect to such Account; or
(c) the account debtor on such Account has disputed liability or made any claim with respect to any other Account due from such account debtor to the Borrower or any of its Subsidiaries; or
(d) the account debtor on such Account has filed a petition for bankruptcy or any other relief under the Bankruptcy Code or any other law relating to bankruptcy, insolvency, reorganization or relief of debtors; made an assignment for the benefit of creditors; had filed against it any petition or other application for relief under the Bankruptcy Code or any such other law; has failed, suspended business operations, become insolvent, called a meeting of its creditors for the purpose of obtaining any financial concession or

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accommodation, or had or suffered a receiver or a trustee to be appointed for all or a significant portion of its assets or affairs; or
(e) the account debtor on such Account or any of its Affiliates is also a supplier to or creditor of the Borrower or any of its Subsidiaries unless such supplier or creditor has executed a no-offset letter satisfactory to the Lender; or
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(f) the sale represented by such Account is to an account debtor outside the United States, unless the sale is on letter of credit or acceptance terms acceptable to the Lender (See UCC 5-114, 9-107, 9-409); or
(g) the sale to such account debtor on such Account is on a bill-on-hold, guaranteed sale, sale-and-return, sale-on-approval or consignment basis; or
(h) such Account is subject to a Lien in favor of any Person other than the Lender; or
(i) such Account is subject to any deduction, offset, counterclaim, return privilege or other conditions; or
(j) the account debtor on such Account is located in Minnesota (or any other jurisdiction which adopts a statute or other requirement with respect to which any Person that obtains business from within such jurisdiction or is otherwise subject to such jurisdiction's tax law must file a "Business Activity Report" (or other applicable report) or make any other required filings in a timely manner in order to enforce its claims in such jurisdiction's courts or arising

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under such jurisdiction's laws); provided, that such Accounts shall nonetheless be Eligible Accounts if the Borrower has filed a "Business Activity Report" (or other applicable report) with the applicable state office or is qualified *28

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to do business in such jurisdiction and, at the time the Account was created, was qualified to do business in such jurisdiction or had on file with the applicable state office a current "Business Activity Report" (or other applicable report); or
(k) the Lender, in accordance with its customary criteria, deems such Account ineligible; or
(l) 50% or more of the outstanding Accounts of any account debtor that constituted Eligible Receivables at the time they arose have become, or have been determined by the Lender, in accordance with the provisions hereof, to be, ineligible; or
(m) the sale represented by such Account is denominated in other than United States dollars; or
(n) the Lender believes, in its sole discretion, that the collection of such Account is insecure or that such Account may not be paid; or
(o) such Account is not evidenced by an invoice or other writing in form acceptable to the Lender, in its sole discretion; or
(p) the Borrower, in order to be entitled to collect such Account, is required to perform any additional service for, or perform or incur any

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additional obligation to, the Person to whom or to which it was made; or
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(q) Accounts of such account debtor represent more than ____% of the Eligible Receivables at such time.
The corresponding explanations are:
(aa) This provision assures that a lender will not lend against stale receivables, or receivables with an extended payment date.
(bb) This provision picks up the representations and warranties in respect of the accounts otherwise included in the documentation. These representations relate to the borrower's ownership, the lender's liens and to the compliance of such account with the definition of account contained in the agreement.
(cc) This protects the lender from lending against accounts with a lower likelihood of collectibility, or one where the account debtor may exercise setoff rights.
(dd) This excludes accounts of an account debtor involved in bankruptcy proceedings, whether or not they are post-petition receivables.
(ee) Absent a "no-offset" provision, the lender would not know the actual balance of the account.
(ff) This provision takes into account the lower likelihood of collectibility from a foreign account debtor.
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(gg) Since these accounts may be reduced or eliminated by actions of the account debtor, they are not deemed to have a high level of collectibility.

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(hh) (ii) Self-explanatory.
(jj) Each of these states has a provision prohibiting a person from availing itself of the benefits of that state's courts unless it is qualified to do business or has filed a notice of business activities. Unlike most states, in these states the failure to have qualified or filed cannot be cured retroactively. Since the lender, as assignee, takes the accounts with all defenses the account debtor has against the assignor, the account debtor would be able to assert the borrower's failure to qualify or file as a defense to payment.
(kk) This provision allows the lender to exclude other categories of accounts that it does not lend against in the ordinary course.
(ll) This provision allows the lender to exclude all accounts of an account debtor if more than half of the account debtor's accounts do not otherwise constitute eligible accounts, thereby insuring that the lender does not have to lend against new accounts of an account debtor in financial difficulty.
(mm) This eliminates currency, as well as collectibility, exposure.
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(nn) This provision gives the lender discretion to exclude specific accounts.
(oo) This gives the lender some control over the sales and account documentation of the borrower, since the lender, as assignee, is bound by the terms of the borrower's contracts.

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(pp) Since the borrower's performance is not complete, this account is not eligible until such time as performance has been completed.
(qq) This provision prevents the lender from having too much exposure to any one account debtor of the borrower.
"Eligible Inventory" means the lower of the aggregate book value (based on a FIFO valuation) or fair market value of all raw materials and finished goods inventory [(specifically excluding all work in process)], owned by the Grantor and in which the Lender holds a valid and perfected first priority security interest, less appropriate reserves determined in accordance with GAAP but excluding in any event:
(a) inventory which is not in good condition or fails to meet standards for sale or use imposed by governmental agencies, departments or divisions having regulatory authority over such goods, and
(b) inventory which is not usable or saleable at prices approximating their cost in the
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ordinary course of a Grantor's business (including without duplication the amount of any reserves for obsolescence, unsalability or decline in value).

D. Borrowing Base

Once the amount of eligible accounts and eligible inventory has been

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determined, then the borrowing base -- the total amount available to be borrowed at that time -- can be determined. The borrowing base is a percentage of each category, with the percentage for inventory being lower than that for accounts, due to the length of time before, and the likelihood of, collection of payment for the inventory. Thus the definitions of eligibility and borrowing base reduce the amount of credit available to a borrower based on its total pool of accounts and inventory.
In a committed facility, the borrowing base will constitute only one limit on the amount of credit available to the borrower, with the facility limit being another. In both types of facilities, the borrowing base serves as a prepayment trigger--if the amount outstanding exceeds the borrowing base, then the borrower is obligated to immediately repay the excess or provide additional collateral.

E. Collections

From a lender's point of view, one of the most important
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elements of asset based lending is the control of the collections of the accounts. This control is effected in two primary ways, either through the use of a lockbox or a blocked account system. In each case the goal is to give the lender a lien on, and control over, cash collections.

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At present, only the California, Hawaii, Idaho, Illinois and Louisiana versions of the UCC provide that a security interest in a deposit account can be taken as original collateral. Section 9-203(b)(3)(D) of Revised Article 9 will provide that a security interest can be taken in a deposit account by obtaining "control" over it. Section 104 of Revised Article 9 provides that a secured party has control of a deposit account if: (1) the secured party is the bank with which the deposit account is maintained; (2) the secured party, the bank and the debtor have agreed in an authenticated record that the bank will comply with instructions originated by the secured party directing disposition of the funds in the account without further consent by the debtor; or (3) the secured party becomes the bank's customer with respect to the deposit account.
A lockbox arrangement is one in which account debtors are directed to make payments to specified post office boxes. These boxes are emptied by local banks, and the checks are deposited in accounts with such banks. These banks, in turn, agree to transfer all funds on deposit on a daily basis
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to an account of the lender, or as the lender so directs.
A blocked account arrangement is one in which the borrower is allowed to collect payments, but is obligated to deposit those payments into a specific account in the name, and under the dominion and control, of the lender. The lender monitors this account on a daily basis to see if deposits are being made in the expected amounts. This arrangement is used with more creditworthy

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borrowers, or in situations in which the borrower does not have a sufficient number of receivables to warrant the expense of a lockbox arrangement.
In each of the arrangements described above, the lender always reserves the right to notify the account debtors to make payment directly to the lender. The lender may have the contractual right to do this at any time, or as is more often the case in a committed facility, upon the occurrence of an event of default (see Section 9-502(1), which also gives the secured party the right to notify an account debtor on default (which is not defined in the UCC)).
Whether collections are paid to the lender under a lockbox or a blocked account arrangement, the question always arises as to the borrower's right to access the cash. In an uncommitted facility, the lender generally takes the cash and applies it to the outstanding balance, reserving the right to relend to the borrower.
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In that instance, the frequency of application, and whether the balance is reduced for funds received, but not yet collected, are always the subject of negotiation. In a committed facility, the cash collected in the lockbox is usually transferred to the borrower on a daily basis, or the borrower is allowed to write checks drawn on the bank up to the amount in the blocked account, unless there is an event of default or the borrower has exceeded the borrowing base. With a committed facility, the balance of the loan generally is not reduced unless the borrower makes an optional prepayment.

(Cite as: 791 PLI/Comm 7, *35)

F. Monitoring the Facility

In addition to any financial information that the lender receives about the borrower, the lender should closely monitor its collateral. This is done primarily through periodic borrowing base reports provided by the borrower, and through collateral audits conducted by the lender.
The borrowing base report is a report that sets forth by category all eligible accounts and inventory, and calculates the amount available to be borrowed. These reports are usually provided on a monthly basis, but may be provided on a weekly or even daily basis in the case of financially distressed borrowers. In addition, the borrower has an obligation to notify the lender if, between borrowing base reports, the loans exceed the borrowing base. An example of a borrowing base
*36

(Cite as: 791 PLI/Comm 7, *36)

report is attached as Exhibit A to this outline.
The lender generally reserves the right to conduct onsite audits of the borrower's accounts and inventory, usually not less often than quarterly. A team of auditors from the lender will verify the existence of accounts, whether or not all payments are being directed as agreed, and review the borrower's billing, aging and collection procedures. An inventory audit will include verification of the existence and location of the inventory, and how much of it is obsolete or unsalable. Often, these audits are the first notice the lender has of problems with the borrower's operations.

(Cite as: 791 PLI/Comm 7, *36)

Much has been written about the Y2K problem. If you are a lender against a borrower's inventory and accounts receivable, you need to be concerned about you borrower's ability to generate bills, since those bills are the working capital lender's collateral.

G. Remedies

In addition to the lender's foreclosure remedies contained in the UCC, there are other remedies the lender can exercise to protect its position and reduce its exposure. In uncommitted facilities or committed facilities where the borrower is in default, the lender will often reduce the borrowing base and/or change the eligibility requirements, so that the
*37

(Cite as: 791 PLI/Comm 7, *37)

amount it has outstanding to the borrower is reduced.
As was mentioned earlier, the lender can notify account debtors to make payments directly to it. Under UCC 9-406, an account debtor that has received notification is obligated to make payment to the assignee of the account. However, notification may have a negative effect on the borrower's business, because it alerts the borrower's customers to the fact that the borrower is in financial difficulty. Where a lockbox is in place the lender can redirect payments from the lockbox banks directly to it.

(Cite as: 791 PLI/Comm 7, *37)

H. Problems When the Inventory and Accounts Lenders Differ

Often accounts receivable lenders also provide inventory financing to the borrower. If the inventory lender is different, intercreditor issues arise, since the inventory lender's proceeds are the accounts lender's primary collateral, and the inventory lender has priority, provided it is perfected.
Even if the lender is also providing inventory financing, problems may arise if the borrower is obtaining purchase money financing of its inventory. A purchase money lender has priority over a general inventory lender if the purchase money lender perfects before the borrower receives the inventory and notifies the general inventory lender of its security interest (UCC 9-312). The purchase
*38

(Cite as: 791 PLI/Comm 7, *38)

money lender will not, however, have priority with respect to an account generated by the sale of its inventory.

I. International
Accounts Receivable Financing

Given the growth in cross-border financing, there are initiatives under way to harmonize laws on
accounts receivable financing or to create an international convention. The most advanced one is the United Nations Commission on International Trade Law (UNCITRAL), which has prepared a Draft Convention on Assignment in Receivables Financing.

(Cite as: 791 PLI/Comm 7, *38)


III. FACTORING

A. Definition

1. Factoring is the sale or transfer of title in specific accounts receivable at a discount.
2. More common in the manufacturing and retail sectors, where factors provide a large portion of
accounts receivable financing.

B. Factoring Arrangements

1. Under factoring arrangements factors assume the credit risks relating to receivables by purchasing them without recourse, thus extending credit to their clients' customers.
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(Cite as: 791 PLI/Comm 7, *39)

2. Manufacturers or wholesalers, the factors' clients, sell their receivables without recourse at a discount. Upon the purchase of the receivables, the factor receives a commission or factoring fee.
3. Credit Approval
a. Because the factor bears the credit risk of the transaction, factors will require that their clients obtain approval of the amount, terms,

(Cite as: 791 PLI/Comm 7, *39)

delivery date and other conditions of each sale to a purchaser.
b. The factor reserves the right, prior to shipment of goods by the client, to withdraw any credit approval previously granted.
4. Notice and Payment
a. The purchaser is notified by either the factor or the client, in some cases by preapproved legends printed on invoices, that the factor has purchased the receivables and that payments should be made directly to the factor.
b. The factoring agreement also provides that any remittance made directly to the client requires that (a) the client immediately notify the factor of such
*40

(Cite as: 791 PLI/Comm 7, *40)

remittance and (b) the client act as trustee of an express trust for the benefit of the factor, holding the payment as the factor's property and delivering the same to the factor as soon as reasonably possible.
5. Administration
a. Some factoring arrangements will provide that the factor keep record of the receivables while others will place the burden of administration on the client.
b. In the latter event, the client assumes a duty to provide the factor at regular intervals with schedules of the receivables on which the factor is to act as agent for collection, together with copies of invoices, and

(Cite as: 791 PLI/Comm 7, *40)

evidence of shipment and other proofs of delivery if requested by the factor.
c. In either case, the client will retain the responsibility of maintaining files necessary to enable the client or factor to enforce payment.
*41

(Cite as: 791 PLI/Comm 7, *41)

6. Payment of Purchase Price
In most factoring arrangements, the factor agrees to pay its client the face amount of each receivable purchased, less the fee and the discount, either (a) upon purchase, or (b) upon receipt of payment, but in any event within a specified period after maturity, in each case so long as the receivable is not subject to dispute with respect to performance of the underlying contract.

C. Legal Issues Related to Factoring

1. Section 9-102(1)(b) of the UCC brings factoring arrangements within the coverage of Article 9, even though the sales of accounts involved in factoring may only be of specified accounts. See
Major's Furniture Mart, Inc. v. Castle Credit Corp., 602 F.2d 538, 26 UCC Rep. 1319 (3rd Circ. 1979). Thus, a factor also has to file financing statements in order to prevail in a bankruptcy proceeding.

(Cite as: 791 PLI/Comm 7, *41)

2. Factor versus the accounts receivable financer. As in other cases, the first to file rule governs, so that accounts receivable lenders need to be as diligent with respect to sales of accounts as with other secured lenders.

*42

(Cite as: 791 PLI/Comm 7, *42)

D. International Factoring

1. While factoring arrangements in the United States are governed by Article 9 of the UCC, such predictability in the law governing factoring transactions is not always available when factors buy accounts from foreign clients. These international factoring arrangements may be governed by the laws of other countries, and efforts are currently under way to harmonize the law of such arrangements. One such effort was conducted by the International Institute for the Unification of Private Law ("UNIDROIT"), which promulgated the UNIDROIT Convention on International Factoring on May 28, 1988. While the United States is one of fourteen countries to sign this Convention, the Senate has not ratified it, so it is not yet law in the United States.
2. Until the UNIDROIT Convention is general in effect, U.S. -based factors may obtain the benefit of the UCC by (1) having the parties choose the law of a state (to the extent that state's law would give effect to the choice of law) instead of foreign law as the law governing the transactions and (2) having the parties select and submit to that state's law as the exclusive

(Cite as: 791 PLI/Comm 7, *42)

forum for litigating any disputes regarding the contract.

 

FNa1. References in this Article to "Revised Article 9" are to the July 30, 1998 draft of Article 9, which is now a final act. The July 30, 1998 draft of Revised Article 9 may be found on the Web at www.law.upenn.edu/library/ulc/ucc9/ucc9woc.htm.

 

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(Cite as: 791 PLI/Comm 7, *43)

EXHIBIT A

 

FORM OF BORROWING BASE CERTIFICATE


TO:

FROM:

DATE:

The undersigned hereby certifies that the following information is true, complete and accurate as of the close of business on [Date].
(All amounts are in thousands)
Accounts Receivable:
  

(Cite as: 791 PLI/Comm 7, *43)

(1)   Ending balance from prior Borrowing Base Certificate dated _____   
(2)   Sales for the period                                               
(3)   Cash receipts                                                      
(4)   Credits and claims                                                 
(5)   Debit memos, adjustments and chargebacks                           
(6)   Ending balance                                              $_____ 
      Less: Ineligible accounts and past dues                            
(7)   90+ days past due                                            _____ 
(8)   Adjustments (standard reserve)                               _____ 
(9)   Credit balances past due                                     _____ 
(10)  Contras                                                      _____ 
(11)  Non-trade A/R                                                _____ 
(12)  Pre-billing reserves                                         _____ 
(13)  Unapplied cash                                               _____ 
(14)  Add:___Past due portion of ineligibles                       _____ 
(15)  Total Ineligibles and past dues                              _____ 
(16)  Eligible Receivables                                         _____ 
(17)  Accounts Receivable available @ [ ] %                       $_____ 
      Inventory:                                                         
                                                                         
(18)  Inventory                                                    _____ 

(Cite as: 791 PLI/Comm 7, *43)

(19)  Less: Inventory over __ months old                           _____ 
(20)  Eligible Inventory                                           _____ 
(21)  Inventory available @ [ ] %                                 $_____ 
(22)  Total Availability                                          $_____ 
                                                ------------------------ 
  
*44

(Cite as: 791 PLI/Comm 7, *44)

Authorized Signature: __________________________
Title: Chief Financial Officer
Date: __________________
END OF DOCUMENT

Copr. (C) West 1999 No Claim to Orig. U.S. Govt. Works

 

Term