Security Interests in Collateral – Don’t Look Back! (A Lender is Prevented From Scooping Up Collateral Granted in an Earlier Agreement)

By:  Jack Easterbrook, Esq.

Loan documents used by institutional lenders always have a description of collateral in a secured loan transaction. But what happens when a lender tries to use an “old” security agreement, initially agreed upon and signed in connection with an earlier loan, to scoop up collateral not specifically covered in a later security agreement? That was the question put to a court in the case of Jipping v. First National Bank of Alaska.*

The old security agreement, entered into in 2009, specifically covered deposit accounts as collateral. It also had a future advances clause and a cross-collateralization provision. That is, the language in the 2009 security agreement said the collateral secured not only the advance made at loan closing but any future advances made by the lender as well. The borrower paid off this loan in 2011.

Two years later, in 2013, the borrower obtained another loan from the same lender, which was booked with a whole new set of loan documents, including a new security agreement that contained a different collateral description that did not mention any deposit accounts. The 2013 loan agreement contained a standard form integration provision stating that the 2013 loan agreement and other loan documents related to the loan contained the entire agreement between the parties with respect to the subject loan. The 2009 loan documents were never terminated although the loan had been paid off.

Later, when the borrower suffered financial trouble and filed a bankruptcy petition, the lender argued that the 2009 security agreement, which included the deposit accounts, was still effective and gave the lender a lien on the deposit accounts. In its ruling (after an appeal), the 9th Circuit Court of Appeals, the federal court with jurisdiction in California, leaned on the integration clause and a “common sense” interpretation. The court held that, notwithstanding the broad cross collateralization and future advance provisions of the 2009 security agreement, the lending bank did not hold a lien on the deposit accounts. The integration clause in the 2013 security agreement, the court ruled, meant what it said and the parties at that time did not contemplate relying on the 2009 security agreement. The court analyzed in detail several provisions of the 2013 security agreement and concluded it would, in the court’s words, “[give] ordinary words their ordinary meaning….” Given the integration clause, the Court was not inclined to include the old 2009 security agreement among the “related documents” that evidenced the loan. The court thus held that the 2009 security agreement had no effect and the broader language it contained did not apply.

The takeaway for lenders is that the more or less boilerplate integration clause in virtually every loan and security agreement actually means something! If you are relying on a earlier-signed documents and are concerned an integration clause may leave them out, having the borrower reaffirm the prior document(s) is one way (and generally an efficient way) of ensuring they have effect in a new transaction. In any event, always be careful and thoughtful if you are relying on documents executed earlier in time than the new loan or promissory note. And if you are viewing it from the borrower side, you may want to ensure that loan documents have express termination dates.

One additional comment: in a non-bankruptcy situation the lending bank would still be able to rely on its banker’s lien rights to obtain access to the borrower’s deposit accounts. However, the Jipping case involved a bankruptcy and the trustee’s strong arm powers enabled the trustee, in these circumstances, to take priority over the lender’s banker lien rights.   This nuance is unique to deposit accounts held at the lender. The important point here is to recognize how an appeals court construed the language in serial loan documents and the integration clause, and not focus on the particular collateral discussed. The principle set forth in the Jipping case remains broadly valid whenever a lender is relying on the enforceability of earlier loan documents as applied to a new loan.

*Jipping v. First National Bank of Alaska (In re. Omni Enterprises, Inc.) 568 B.R. 321 (2017).

All blogs on this site are for educational purposes only, do not constitute legal advice or opinion, and should not be applied to your situation, or any specific situation, without consultation with counsel. Strategy Law, LLP does not provide any legal advice concerning any matter discussed in a blog except upon formal engagement including, without limitation, execution of Strategy Law, LLP’s formal legal services agreement, and with respect to specific factual situations.  No blog constitutes a guaranty, warranty, or prediction regarding the result of any legal matter discussed in the blog or any representation.

Negative Covenants in Loan Agreements – Think Through What You Really Want To Add

By: Serge Filatov, Esq.

When documenting a loan, lenders often have to determine which negative covenants they want to add to their loan agreement. Before determining which negative covenants to add, it is important to understand the purpose of negative covenants.

What Are Negative Covenants?

Negative Covenants are restrictions in a loan agreement which are inserted for the following reasons: (i) to help establish guidelines for business operation, (ii) assess continued creditworthiness, (iii) identify problems before an event of default occurs, and (iv) ensure that the borrower can repay its loans to the lender.

What are examples of Negative Covenants? Examples of commonly used negative covenants include the following:

Indebtedness Limitations . These provisions restrict the ability of the borrower to take on additional debt other than the loans made under the loan agreement. The purpose of such a covenant is to ensure that the borrower does not take on more debt than it can repay and to restrict the borrower from having other creditors who will compete for repayment.

Lien Limitations . These provisions restrict the borrower’s ability to encumber any of its assets other than the lien put on by the lender or other approved third parties. The provisions protect lenders against other creditors by restricting who can be a secured creditor.

Fundamental Change Limitations . These provisions restrict the borrower’s ability to enter into any transactions that fundamentally change the borrower’s business, such as mergers, sales of substantially all of the borrower’s assets or liquidations. The restrictions ensure that the borrower maintains the same business during the life of the loan and that the borrower does not incur indebtedness or become subject to liens as a result of a transaction such as a merger.

Material Agreement Change Limitations . These provisions often restrict the borrower from amending the terms of any material agreements, such as a sales contract with a significant customer or borrower’s underlying governing documents. The restrictions helps ensure borrower continues to maintain a business which is similar to the business that existed at the time when the lender made its credit decision about the borrower.

Sale of Asset Limitations . These provisions restrict the borrower’s ability to sell, transfer or dispose of its assets outside of the ordinary course of its business. The restrictions ensure that the borrower’s assets remain substantially the same during the life of the loan. This is especially important for loans which are collateralized by the borrower’s assets.

Equity Payment Limitations . These provisions restrict the borrower from making payments to its equity holders, for example including making any distributions and equity redemptions or repurchases of the borrower’s equity. The restrictions ensure that the borrower will repay the lender prior to making payments to its equity holders.

Investment Limitations . These provisions restrict the borrower’s ability to make investments, including any loans, advances, equity purchases, note purchases, and asset acquisitions. The restrictions help ensure that the borrower will use its cash to pay down its debt to the lender rather than using it for investments.

Affiliate Transaction Limitations . These provisions restrict the borrower from entering into transactions with affiliates, or require that any such transactions are at least on an arm’s length basis and on terms no less favorable to the borrower than it could obtain if the transaction was with a third party. The restrictions help ensure that the borrower does not transfer its assets to a party which is not part of the loan and also ensures that the borrower does not enter into sweetheart deals which are not favorable to it.

Capital Expenditure Limitations . These provisions restrict the borrower from making capital expenditures, usually not exceeding a certain amount in any fiscal year. Since the funds used to make the capital expenditures could otherwise be used to repay the loan, lenders often put in restrictions to limit cash flowing out of the borrower.

Prepayment Limitations . These provisions often restrict the borrower from prepaying its loan early. Sometimes prepayments are not allowed at all while other times lenders will allow prepayments but will add prepayment penalties if a borrower tries to repay principal early. These restrictions help ensure that the lender will meet certain earnings targets on the loan.

Material Adverse Effect Limitations . These provisions often are used as default triggers so that if a borrower suffers any change which could cause a material adverse effect to its business, it is automatically in default under the loan. The provisions are often broad and provides the lender a catch-all provision to use in a problem loan scenario.

The above list of negative covenants is just a sample of the various restrictions that can be used to protect a lender. Additionally, each of these covenants can be written with exceptions and carve outs to accommodate a borrower based on a borrower’s unique situation.

If you are an institutional lender, don’t just rely on “stock” covenants. If you are a private lender, think hard about whether you want to add covenants to your loan. Either way, carefully consider what restrictions you want to put on the borrower based on the borrower’s risk profile and use restrictions that work for the specific deal.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

FinTech 2017: The Changing World of Financial Services and Customer Expectations. A Primer about the FinTech Influence.

By: Jack Easterbrook, Esq.

Financial technology companies, or FinTechs, have experienced a meteoric rise over the last five years. During that period, the amount of investment funneled into FinTechs has risen from $1.5 billion to about $24 billion. They received another shot in the arm several months ago when the Comptroller of the Currency (OCC) announced plans for a new type of license that will allow FinTech companies to provide services nationally under a Special Purpose National Bank Charter, and thereby avoid the arduous process of individual state licensing. To be eligible for this coveted charter, the FinTech Company will have to be engaged in at least one of the following banking functions: receiving deposits, paying checks or lending money.

At the moment, the FinTech occupy only a small part of the overall banking market in the U.S., particularly in the commercial or wholesale markets. However, we have already seen how technology is directly reshaping or disrupting economic sectors including retail, ride sharing (taxi services) and vacation rentals/ travel among them. There is little doubt the FinTechs will have a significant influence on banking services in the future. We may not know yet exactly how, or how fast, but it appears changes are coming.

At Strategy Law, we spend much of our “working day” addressing banking issues, structuring debt transactions, and negotiation and drafting all manner of loan documents. While it is far from clear how FinTech companies will affect the wholesale banking sector in the future, most of the action thus far being on the consumer side of things, one must anticipate that inroads will be made.

One development at the government level, which may have a profound effect, is the new Special Purpose National Bank Charter, which could be a boon for FinTech companies as they will not be required to obtain a license in every state in which they wish to operate, and where regulatory and compliance costs could otherwise amount to between $2 and $5 million a year per company, based on some estimates. Companies can instead operate nationally under a Special Purpose National Bank Charter. However, FinTech companies are not getting off without regulation. Like their more traditional counterparts, they will still be required to, among other things, address financial inclusion as part of a three-year business plan (a standard regulatory requirement), develop a formal plan for failure and have a hands-on board of directors.

It also is likely new battles will be fought in the political realm concerning the activities of the FinTechs, with or without the Special Purpose National Bank Charters. Traditional banks generally don’t espouse an encouraging view on FinTech companies. Camden R. Fine, Chief Executive of the Independent Community Bankers, said, “A FinTech charter poses risks to taxpayers and the financial system by endowing these nonbank companies with a federal bank charter.” Another nebulous cloud lingering over FinTech companies is the status of the deposit insurance offered by the Federal Deposit Insurance Corporation. A further concern expressed by banks and consumer advocates is the possibility that a national charter for FinTech companies could allow new online lenders to evade state caps on interest rates and other local rules designed to cut down on predatory lending. All such topics are certain to be debated going forward.

Time will determine whether FinTech companies actually develop into the powerhouses their proponents claim as their destiny. Regardless of their future, they have already begun affecting the consumer finance industry as they have, according to many experts, changed the expectations consumers have of financial institutions. The online and app-centric models of FinTechs, sometimes offer customers real convenience in conducting banking activities. Importantly, however, they also create and actively market the image that they are friendlier and more convenient. Banks are investing heavily to compete in these areas as well. This begs the obvious question of whether the traditional banks will be at the forefront of utilizing the best techniques the FinTechs offer, incorporating those innovations into their own business practices. For individuals involved in the wholesale areas of debt financing, a related question is whether or how the application of FinTech led technologies will be incorporated into the wholesale sector.

Several years from now when we look back at the effect the current FinTech period has had on the banking sector, the ability of FinTech companies to alter customer attitudes about financial services may be the point that is most remembered.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions related to this article should be addressed directly to Strategy Law, LLP.

Promissory Notes: Practical Considerations When Entering Into A Note

By: Serge Filatov, Esq.

One of the easiest ways to document a loan is through the use of a promissory note. Practicing here in Silicon Valley and San Jose, I have documented countless promissory notes for clients. If you are considering entering into a promissory note, whether as a lender or borrower, you should know the basic options that you have in structuring the note.

Before we delve deeper into the specifics of preparing promissory notes, one thing to keep in mind is that a promissory note is often entered into as part of a larger loan package. While some loans are just made with a simple promissory note, other loans are made with a variety of documents, which can include documents like a promissory note, loan agreement, security agreement, deed of trust, subordination agreement, guaranty, etc. While the scope of this blog is limited to promissory notes, it is important to consider all of the documents that may be needed as part of a loan, not just a promissory note. The complete set of documents required to evidence a loan are usually driven by the unique business terms of the transaction.

That said, let’s get back to the common considerations of promissory notes. Below is a breakdown of some of the common considerations that I go through with my clients before preparing a promissory note:

Timing of Payments

When will payments be made? Will they be made weekly, monthly, quarterly, annually?

Mode of Payments

Will payments be fixed or variable? Note that a large factor in this is whether the interest rate is fixed or variable.

Will payments be interest only or will they include principal as well? What will be the principal amortization schedule?

What will be the maturity date and will the note have a final, larger “balloon payment” at maturity?

Interest Rate

What will be the interest rate?

Will interest accrue annually, quarterly, monthly, daily?

Will the note be fixed or variable (as mentioned above)?

If variable, will the loan be tied to a reference rate or some other commonly used benchmark?

If the commonly used benchmark ceases to exist, is there a backup index that will be used?

Late Charges

Will a late charge be imposed? If so, will the late charge be a fixed percentage of the regular installment payment or a fixed amount?

Prepayment

Can the note be prepaid? If so, is there a penalty associated with prepayment?

Default

What is considered a default (besides just a missed payment)? What occurs upon default?

Collateral

Will there be collateral for the loan and how does this factor into the documentation?

The list above is an illustration of the type of items that a lender or borrower should consider when entering into a promissory note. This is by no means an exhaustive list and there are always numerous other factors to consider depending on the specific situation of the parties. I always recommend for people to sit down with their attorney to go over the loan concept in detail before documenting it. The less ambiguity that there is in the document, the less likely you will end up in protracted litigation trying to explain the original intent of the parties if there is ever an issue. Ideally, any document that you enter into should be detailed enough that, if necessary, a court can look at it and make a determination on the spot regarding the document without having to look at the intent of the parties – which can become very costly for both sides.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.