As the economic fallout of the COVID-19 pandemic continues to be felt, even companies that seem to be weathering the crisis are facing cashflow issues due to bad debt and possibly insolvency. As such, your clients are preparing for what could be a wave of bankruptcy filings in their customer portfolio this year...
As the threat of insolvency looms, it’s important to carefully review the covenants in your clients’ loan agreements with a focus on material adverse change clauses and how these will be interpreted and what impacts they will have. It is also essential that you take steps to ensure your clients’ security interests are properly filed and current.
Against this backdrop, we explore how you can help each client mitigate the risks of insolvency and protect their UCC position.
Mitigate the risks of insolvency
Much of the risk can be mitigated by proper planning and by familiarizing a client with actions they can take to protect their interest.
One of the most important actions is to obtain a lien on a debtor’s assets to secure payment.
- A blanket lien on the assets of the debtor affords the most extensive protection. It can be obtained by executing a security agreement and filing a UCC Financing Statement.
- Your client can also place a lien on a specific asset (such as equipment used in the manufacturing process) or inventory.
If the debtor files bankruptcy and several parties assert claims against the company’s assets, your client will have priority over the debtor’s collateral—if the UCCs are properly filed
Be aware: Per UCC Article 9, a third-party lender can obtain senior lien rights on the debtor’s collateral as a purchase money obligation.
Other steps to mitigate risk include the following:
- Making sure mortgages are properly recorded
- Verifying that all UCC financing statements are up-to-date, complete, and filed correctly. UCC-1 statements expire and must be continued by filing a UCC-3 form. Even a one-day lapse in priority can have unfortunate consequences. Make sure to monitor expiration dates for UCC-1s.
- Checking to see if the IRS has filed liens on accounts receivable and inventory
If the reviews disclose any issues, your client should work with their borrower to address these gaps, including obtaining additional collateral.
Your client should also seek to protect cash collateral. During bankruptcy, a debtor can’t use cash collateral without the consent of the creditor or the court.
Understand the concepts of “attachment” and “perfection”
Your client gains rights to property of the debtor via a two-step process: “attachment” and “perfection”. Both are governed by the Uniform Commercial Code. The key distinctions are the parties involved and the extent of protection offered.
Attachment requires a properly executed security agreement between your client (the creditor) and the debtor. Without attachment, the creditor has no rights in the property.
Note: Attachment also requires that the debtor give value in exchange for the assets and that the debtor has some rights to use the collateral. For example, your client sells an extrusion machine to a business. The amount paid for the machine satisfies the value requirement, and the debtor’s use in the factory satisfies the right-to-use requirement.
While the attachment process is a necessary first step, your client’s protections are extremely limited without the follow-up of perfecting the security interest.
Perfection puts the world on notice that your client has an interest in the debtor’s property. The goal is to have the best claim to the property in the event the debtor files bankruptcy or seeks to dispose of the property.
Although not governed by UCC Article 9, most clients are familiar with the concept of a mortgage. There can be a first, second, or even more mortgages. If the house is sold, the mortgage holders line up with their hands out for their share of the mortgage. Perfection and priority under UCC Article 9 use different mechanisms to achieve the same result. As an attorney, you want your client to be first in line, with an unchallengeable claim to the property or proceeds.
Your client’s security interest can be perfected in a number of ways, but the most common is by filing a UCC-1 Financing Statement. Other far less common methods include taking possession or control of the asset.
The UCC-1 form is relatively straightforward, but it must be completed with absolute accuracy and filed with the proper authorities. The form must properly identify the debtor and describe the collateral. In most instances, only a state-level filing with the Secretary of State is necessary. But, this is not always the case, so it is essential to know what state laws govern the transaction and the proper filing locations.
Be aware: Priority, which governs the order in which creditors receive money, is generally awarded in the order in which a correct UCC-1 statement was filed. The adage “first-in-time, first-in-right” governs this area with limited exceptions. Misspelling the debtor’s name or not having the correct entity listed can spell disaster in a bankruptcy.
Small business relief provided
In February 2020, a new subchapter (Subchapter 5) was added to the U.S. Bankruptcy Code under the Small Business Reorganization Act (SBRA) to reduce the cost and complexity of Chapter 11 reorganization for struggling small businesses.
Subchapter 5 streamlines the process and simplifies the standard for confirming a Chapter 11 reorganization plan — essentially giving small businesses more control. Under SBRA, only the debtor can file a reorganization plan eliminating the risk of creditors filing competing plans. The plan must be filed within 90 days of filing for bankruptcy. Costs are kept low since the debtor isn’t required to file a disclosure statement, and there is no committee of unsecured creditors.
The SBRA was further amended with the passing of the CARES Act, which temporarily increased the debt threshold for filing for relief under Subchapter 5 from $2,725,625 to $7,500,000.
COVID-19 triggered international law changes
To mitigate the impact of COVID-19 on business operations and finances, many countries have changed or amended their insolvency laws. In Australia, for example, dollar thresholds have been increased and deadlines extended. Currently, the deadline for a business to respond to a statutory demand from a creditor has increased from 21 days to six months. The dollar threshold for a creditor to begin bankruptcy proceedings has been raised from AU$5,000 to AU$20,000.
Do your research to understand how new international laws may serve to protect your clients at this time.
Learn more about how CT can help with your UCC filing needs. Call us at (844) 701-2064 (toll-free U.S.).