Lenders face known and unknown risks when making loans to businesses
Lending money to any business involves risks. That’s why it’s so important for lawyers to help their clients with their due diligence review of the business to determine its credit worthiness and the likelihood they’ll be repaid. And while due diligence can uncover many risks, it can’t uncover them all. There are events that neither a borrower nor lender can anticipate.
Recent history shows that events like pandemics, wars, and nature disasters, as well as rampant inflation 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, lenders need to prepare for what could be a wave of bankruptcy filings in their customer portfolios, and their lawyers need to be prepared to help them.
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 position as secured party lenders.
Mitigate the risks of insolvency by filing a UCC-1 financing statement
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. Liens can be obtained by executing a security agreement and perfected by filing a UCC-1 financing statement.
- A blanket lien on the assets of the debtor affords the most extensive protection. In a blanket lien, the collateral is all or almost all of the debtor’s assets instead of on a specific asset.
- 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, in most cases 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 creditor with a properly perfected Purchase Money Security Interest (PMSI) can obtain priority over other creditors in specific collateral if the funds borrowed were used to purchase the collateral. A PMSI ranks higher, even over interests in the collateral that were perfected earlier.
- In states that adopted Article 12 and the 2022 amendments to Article 9, where the collateral consists of Controllable Electronic Records (CERs), a creditor who perfects by control has priority over a creditor who has perfected by filing a financing statement, even if the financing statement was filed first.