April 1, 2011
By: Paul A. Greco
Whether you are looking for a line of credit to improve cash flow, a term loan to purchase new equipment, or you are a lender funding a loan to a rapidly expanding new business, the lending environment has changed dramatically in the past several years. Today’s lenders are more cautious and their due diligence, especially in regards to a borrower’s non real estate based assets, more demanding. Accordingly, it is not surprising that we are receiving many calls from borrowers and lenders alike questioning how lenders secure their interests in a borrower’s accounts receivable, inventory, machinery, equipment, intellectual property and other tangible and intangible assets. These assets are the lender’s collateral in many asset based loans. This article will provide the lender and the borrower a working knowledge of how this type of collateral is collateralized and, in the event of a default, collected.
In an asset based loan transaction, the lender secures its rights in the collateral by entering into a security agreement with the borrower. The security agreement grants to the lender the right, in the event of a default, to seize and sell the collateral to satisfy the debt. The lender places the world on notice of its lien against the collateral by filing with the secretary of state of the relevant jurisdiction a financing statement. The financing statement, like a mortgage recorded with a recorder of deeds, provides notice to third parties of the lender’s rights in connection with the collateral.
When a default occurs, a lender may accelerate the debt owed to it and exercise its rights under the security agreement, including seizing control of and selling the the collateral in accordance with the Uniform Commercial Code (the “UCC”). Significantly, the UCC permits this process to go forward without judicial supervision. Accordingly, if the collateral includes the borrower’s accounts receivable the lender may simply notify the borrower’s customers that future payments to the borrower must be made directly to the lender.
Often times however, the valuable collateral may be a piece of equipment, inventory or even a customer list. In these cases, the Lender must first gain possession of the collateral before it can conduct a sale. This may be challenging. Undoubtedly, the security agreement will require the borrower to surrender control of the collateral upon demand but if the borrower refuses the lender may then peacefully repossess the collateral. If attempts at peaceful repossession fail the lender will need to seek judicial intervention in a replevin action.
Once in control of the collateral the lender may conduct a sale. There are other options, but typically the sale is a public sale. A public sale is similar to a judicial sale of foreclosed real estate, and like such a sale, competitive bidding is required. The overriding principle for any sale of collateral is that it must be conducted in a commercially reasonable manner. To accomplish this, strict adherence to the requirements of the UCC is essential. Minimally, notice of the sale must be given to the borrower, other lien holders and any guarantors of the loan. The sale must also be advertized in a manner that is likely to generate interest amongst the members of the public likely to purchase the collateral. This includes advertizing the date, time and place of the sale in appropriate trade journals or other publications.
The successful bidder at the sale (who can be the lender) will receive title to the property free of all liens inferior to the lien of the party conducting the sale. The sale proceeds are applied to pay the costs associated with the sale, including attorney’s fees and selling commissions. The remainder of the sales proceeds is applied to the loan and any subordinate debts with the surplus, if any, being returned to the borrower. Notably, the sale does not have to be approved in any judicial process and upon the conclusion of the sale the borrower has no right to redeem the collateral.
A sale conducted in accordance with a security agreement and the UCC generally cannot be reversed. However, if the sale was not conducted in a commercially reasonable manner the borrower may be entitled to a money judgment against the lender and/or the lender may jeopardize its right to a deficiency judgment against the borrower and any guarantors.
Securing and collecting an asset based loan requires the lender to understand and stay informed about the borrower’s business and the borrower to be capable of presenting a clear and concise picture of its operations. Each transaction is unique and upon default each collection will have its own challenges. When in doubt about whether you are giving up too much control to the lender or if a lien against the intended collateral is being properly perfected you should seek legal advice. However, the general considerations detailed above do provide both the borrower and the lender the perspective to begin discussions about an asset based loan.