Events like the COVID-19 pandemic, earthquakes, wildfires, and floods, as well as rampant inflation, the Great Resignation, and supply chain shortages, threaten the solvency of many companies. Even companies that seem to be weathering these crises can face cash flow issues due to bad debt. As such, your clients are preparing for what could be a wave of bankruptcy filings in their customer portfolios.
When the threat of bankruptcy or 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 perfected by filing a UCC-1 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 for bankruptcy and several parties assert claims against the company’s assets, your client will have priority over the debtor’s collateral — if the UCC-1s are properly filed and were perfected first.
However, there are some exceptions. For example, 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 tax 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.
Attachment requires a properly executed (or authenticated, to use the UCC terminology) security agreement between your client (the creditor) and the debtor. Without attachment, the creditor has no rights in the property.
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 a claim to the property superior to other creditors in the event the debtor files for 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. (Although it may be noted that under the 2022 UCC amendments governing emerging technologies, security interests in digital assets perfected by control have priority over security interests perfected only by a financing statement. You may wish to keep track of state adoptions of these amendments.)
The UCC-1 form is relatively straightforward, but it must be completed properly and filed in the proper state and with the proper filing office. The form must include the exact legal name of the debtor, a description of the collateral, and the name of the secured party. 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 perfected UCC-1 statement was filed. The adage “first-in-time, first-in-right” governs this area with limited exceptions. Not setting forth the debtor’s exact legal name or not having the correct entity listed can spell disaster in 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 streamlined the process and simplified 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.
COVID-19 triggered international law changes
To mitigate the impact of COVID-19 on business operations and finances, many countries changed or amended their insolvency laws. In Australia, for example, dollar thresholds were increased and deadlines extended. Many of those changes were temporary, so do your research to understand how international laws may serve to protect your clients at this time.
Decrease your risk exposure and increase your time-to-serve your clients with CT Corporation’s UCC solutions. Learn more about how CT can help with UCC search and filing needs. Call us at (844) 878-1800 (toll-free U.S.).