Business and Corporate Section Monthly Article


Advising the Private Money Lender on Matters Involving Business to Business Lending, Perfecting the Security Interest Under the UCC & Enforcement Considerations

ADVISING THE CLIENT

            “If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.”

 ― Sun Tzu, The Art of War

In the context of advising clients, the Sun Tzu quote above in my view is in perfect accord with the state of mind a client, and its attorney, must have in order to obtain a successful result in a given matter.  Counseling clients on business to business loans involving security agreements is always interesting to me because each case has its own unique aspects, and there is generally a chasm in the client’s expectations and the practical realities attendant to enforcement of a security agreement.  When counseling clients who want to lend money to businesses, I have grown to espouse a fixed belief that proper counseling on the anticipated transaction requires that the attorney go beyond the academics and familiarity with the UCC and the technical legal aspects of the transaction; and also requires that the attorney have a sound understanding of the particular dynamics of the underlying business that is taking on the indebtedness.  Having such an understanding allows the attorney to counsel the client on aspects such the overall risk involved, fluctuations or seasonal trends effecting revenues of the business, and other various factors which ultimately impact the likelihood that the loan will be repaid as promised.    By delving into these considerations, the attorney not only enhances the relationship with the client by engaging in a genuine advisory role that helps the client to understand the full context of the contemplated transaction, but also prunes the client’s overall expectations at the early stages of the representation.  The net effect is that by developing with the client an understanding of the particular dynamics of the business they are about to lend to, the client can better anticipate what challenges the debtor may encounter during the term of the loan, and better posture themselves as well as the debtor, for a successful transaction, or in the alternative successful enforcement.  To the contrary, where the attorney merely serves as a scrivener of perhaps technically sound legal documents, but that understanding of the underlying business in not developed and thus the client is not counseled on such, by analogy, the client will be the warrior who does not know its enemy, and will suffer defeat.    

By example, and in the context of counseling the client on the risks of entering into the transaction, if the borrowing business has a pattern of seasonal fluctuations in revenues, the client may be well counseled to structure the repayment plan to have larger payments during peak seasons, and smaller payments during slow seasons.  Proactively planning for this, rather than making the often mistaken assumption that the debtor will retain funds earned during peak times to carry them through the slow times to make fixed payment all year long, will posture both parties for success. 

An additional example, in that same context, where having a more particular understanding of the debtor’s business may allow the attorney to counsel the client the risk of entering the transaction, a sound understanding of the debtor’s business may allow the lender to identify local market trends that impact the viability of the business through the term of the loan e.g. the debtor uses a particular material in its production process such as steel, and evidence supports an impending shortage- thus an increase in costs production and decrease in profitability.   

In the context of enforcement of the agreement, knowing when inventories, deposits, or accounts receivables are at their highest may make a significant difference when timing enforcement actions or proceedings.

In the present legal services market environment where there remains an apparent influx of practitioners separating from larger law firms and venturing into solo practice, and where consumers of those legal services are mistakenly attached to the concept that legal services are fungible tasks, costs of which can be driven down by comparative bids, it can be tempting to “unbundle” one’s services, thereby limiting the scope of the engagement to preparing the legal documents without the comprehensive counseling, in an effort to be competitive.  By resisting that temptation, and providing the comprehensive counseling, the client is better equipped to decide to lend or not to lend.  And where the decision to lend is made, the best strategies for promoting success of the transaction, or in the alternative successful collection.     

PERFECTING THE SECURITY INTEREST

With respect to collection, let us review briefly the pertinent parts of Article 9 of the Uniform Commercial Code, the “Code” which addresses secured transactions, for the lender to become a secured party there are some procedural steps which must be taken. Specifically we review attachment of the security interest and perfection of the security interest.  

Under section 9203 and its state law counterpart, a security interest attaches to collateral when it becomes enforceable against the debtor with respect to the collateral, unless an agreement expressly postpones the time of attachment.  There are three general requirements for the security interest to become enforceable against the debtor: (1) Value is given, (2)  The debtor has rights in the collateral or the power to transfer rights in the collateral to a secured party, (3) One of the following conditions is met: (A) The debtor has authenticated a security agreement that provides a description of the collateral and, if the security interest covers timber to be cut, a description of the land concerned, (B) The collateral is not a certificated security and is in the possession of the secured party under Section 9313 pursuant to the debtor's security agreement, (C) The collateral is a certificated security in registered form and the security certificate has been delivered to the secured party under Section 8301 pursuant to the debtor's security agreement, (D) The collateral is deposit accounts, electronic chattel paper, investment property, letter-of-credit rights, or electronic documents and the secured party has control under Section 7106, 9104, 9105, 9106, or 9107 pursuant to the debtor's security agreement.

To help ensure priority over other creditors, including a bankruptcy trustee, the security interest must be validated or “perfected”.  Perfection of the security interest is generally effectuated by: (1) filing a UCC-1 financing statement with Secretary of State, or other appropriate public office, (2) taking possession of the collateral, (3) by controlling the collateral, or in some instances see section 9309 (4) perfection is automatic upon attachment of the security interest.

ENFORCEMENT CONSIDERATIONS

The first consideration is verifying the security interest is perfected.  In the context of repossession or seizure of the collateral, determine whether obtaining possession can be achieved without a breach of the peace.  Further, take into account any local jurisdictional limitations or requirements.  Perhaps of greatest importance, analyze whether there are any alternatives to repossession, seizure, or judicial intervention, specifically, a voluntary surrender of the collateral, or other work-out.

With a sound understanding of the underlying business as discussed above, the attorney is better equipped to counsel the client regarding the viability of various alternatives to seizure, surrender of the collateral, or judicial intervention.  Some of the problems with those options include that the loan amount may be such that seizure or surrender of the collateral will not yield sufficient proceeds to satisfy the indebtedness, further, judicial intervention can be expensive, and take a long time before judgment is obtained, and require even more resources to attempt to enforce a judgment.  Equally concerning, is that these efforts could ultimately cripple a business that is otherwise able to be rehabilitated, and perhaps suffering only some temporary downturn- The net effect then being, the enforcement actions not only choke the life out of the business, but they also ultimately destroy any meaningful chance of collecting the primary target- the money loaned.

In some cases, the debtor will leave the lender with no alternatives but to take those other enforcement actions, but in an equal amount of circumstances, the debtor, when faced with the reality of either bringing to the table some meaningful work-out terms or closing their doors, the debtor will avail themselves to those terms.  Knowing the underlying business, including equipment requirements, appropriate inventory levels, etc., will allow the client to formulate a work-out program that may include a hybrid of direct assignment of receivables, or liquidating superfluous inventory or equipment.  For the client, knowing themselves and their debtor, analogous to the Sun Tzu quote above, they need not fear the result of hundred “battles”, or in the context of the client, a hundred transactions. 

This article is for information purposes and does not contain or convey legal advice. The information herein should not be relied upon in regard to any particular facts or circumstances without first consulting with a lawyer.
                       
– Dimitri Panagopoulos, LL.M., Founding Shareholder of Panagopoulos Embry P.C.

**This article is intended for informational purposes only and does not constitute legal advice. Any views expressed are those of the author only and not of the SDCBA or its Business & Corporate Law Section.**