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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
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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 *15
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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 *18
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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 *19
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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 *21
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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 *22
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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. *23
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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 *24
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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 *32
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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 *33
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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 *34
(Cite as: 791 PLI/Comm 7, *34) |
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
(Cite as: 791 PLI/Comm 7, *34) |
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. *35
(Cite as: 791 PLI/Comm 7, *35) |
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.
*39
(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. |
*43
(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 |