How to Become a Secured Creditor on Personal Property

By: Serge Filatov, Esq.

A mistake that I often see inexperienced lenders make when making secured loans is that they do not take all the steps necessary to become a secured creditor. There are numerous traps for the unwary and people should be careful when documenting secured loans to make sure that they actually end up secured. It’s always hard having to tell a new client after reviewing their documents that they are unsecured because they didn’t follow some step or didn’t draft their documents properly.

Before diving into specifics of how to become a secured creditor on personal property, please note that the rules for securing real property (ie. real estate) are different. If you plan to take real property as collateral, the following is not entirely applicable to your situation.

Securing Collateral – A Two Step Process

One mistake that people often make in securing personal property is that they simply state that the loan agreement or promissory note is secured without doing anything further. Simply stating that a loan is secured is not enough to make it secured!

In order to become a secured party, one must (i) prepare a document which grants a security interest (which is the agreement between the parties) and (ii) also perfect on that security interest (which is the notice to the world of the security interest). Without both steps occurring, the lender will be unsecured.

Step 1 – Attachment

To grant a security interest in personal property, one must have a security agreement which contains (i) a statement granting the security interest and (ii) the description of the collateral. There is no specific requirement that the security agreement be a standalone document.

In order to properly grant a security interest, one must use language which explicitly grants the security interest. In order to properly describe the collateral, a lender must use language which reasonably identifies the collateral. One common mistake that people make in describing collateral is that they forget to include “proceeds” of the collateral as part of the description of the collateral. What occurs in such instances is that once the collateral is sold (assuming, for example, that the collateral is equipment), the money received is no longer part of the collateral pool and the lender is therefore unsecured as to that money unless the money itself is separately identified as collateral.

Step 2 – Perfection

To perfect a security interest, one generally files a UCC financing statement at the state level where the debtor lives or where the debtor was formed. Filing a financing statement does not perfect a security interest in all types of collateral, however. One should talk to an attorney to make sure that a UCC financing statement is appropriate for their needs. For instance, perfecting a lien on someone’s shares of stock requires physical possession of the stock certificates. Also, there are special rules for vehicles, boats, mobile homes, and aircraft.

If there’s one major point to take away, remember that becoming a secured creditor requires both the grant of security and the perfection of that security interest. Simply stating that you have a security interest in an agreement is not enough.

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.

Not So Fast Getting Out of that Guaranty! (A story about a real estate loan and guaranty.)

By: Jack Easterbrook, Esq.

The enforceability of the guaranty of a commercial real estate loan is a question presented to the courts with regularity. A new case, LSREF2 Clover ** testing whether a lender can enforce its guaranty, was decided by a California Court of Appeals in October 2016. Broadly speaking, the court held that under California law properly written guaranties will be enforced notwithstanding the fact that, among the borrower and guarantor, a complicated structure of affiliated entities and control is involved. This is precisely the sort of sophisticated structure often found when the borrower is a special or single purpose entity (SPE). The court rejected the argument that these loan structures are intended to avoid California’s single action and anti-deficiency rules, which could leave the guaranty unenforceable.

Some of the “take away” points made by the court, which provide guidance to lenders and guarantors alike, are highlighted in the last section below.

Summary of the Loan

A limited partnership known as Festival Fund entered into a purchase and sale agreement to buy commercial property and then approached the Lender to obtain a loan. A term sheet was issued by the Lender indicating the borrower was to be a single purpose entity to be determined and Festival Fund was to be a limited guarantor. (The original lender was Anglo Irish Bank, but after several assignments and by the time of the lawsuit, the lender was RSLEF Clover Properties 4, LLC. We will refer to these collectively as the Lender.) Festival Fund subsequently set up 357 LP to be the borrower and FRF1 LLC to be the general partner of the borrower. Festival Fund entirely controlled general partner FRF1 LLC, which held a .01% interest in borrower 357 LP while Festival Fund itself retained the remaining 99.99% interest in 357 LP.

The loan was made for approximately $25 million in 2007 and Festival Fund signed a limited, $1.5 million guaranty, but by 2011 the loan was in default and Lender commenced foreclosure proceedings. As well, Lender made demand under the guaranty by Festival Fund and it was this guaranty that was eventually litigated.

The Guarantor’s Position

Guarantor Festival Fund asserted that it was actually the primary obligor on the loan and the guaranty was a sham and, therefore, not enforceable. In support of its position Festival Fund made a number of arguments, including: (1) the Lender required it to enter into the guaranty; (2) FRF1 LLC was entirely controlled by Festival Fund and there was a unity of interest between FRF1 LLC and Festival Fund making Festival Fund the de facto general partner of borrower 357 LP (and, thus, the primary obligor); (3) the Lender had required Festival Fund to submit its organizational documents and financial information for review and was actually relying on Festival Fund for repayment; (4) the Lender had drafted all of the loan documents; and (5) some of the loan document provisions could be interpreted to say that Festival Fund was an obligor on the loan, not just a guarantor.

The Court’s Decision and the Take-Aways

The Appeals Court did not buy these arguments and the opinion provides lenders and guarantors with some guidance concerning the situations in which guaranties will be enforced, as was the case here.

  1. The guarantor created and implemented the SPE-borrower and guarantor structure, including establishment of a new borrower and its general partner, before the time the loan was granted. The organizational architecture, the court held, was designed by the guarantor and not the Lender.
  2. Both lenders and borrowers can benefit from the SPE structure and it does not imply an intention to circumvent single action-anti deficiency rules.
  3. The fact the Lender requires submission of financial information of a guarantor does not mean the guarantor is the borrower. There is a significant difference between a Lender requiring for review the organizational and financial documents of a guarantor and positioning the provider of that information – the guarantor – as a primary obligor of a loan.
  4. The lender’s analysis of the project and property is evidence that it is primarily relying on the cash flow of the property and the SPE borrower for loan repayment, not the guaranty.
  5. Guarantor Festival Fund was not a party to the loan agreement and could not use the purported language of the loan agreement referring to it as an obligor to claim it is the primary obligor.

In short, the court said that the fact a guarantor may have control over a borrower through direct or indirect interests does not mean it is the borrower. The use of the SPE borrower structure with partial or full guaranties by principal parties is not improper if appropriately done. This sort of loan and guaranty structure is frequently used today by institutional and commercial lenders for real estate loans.

Caveat: We continue to note that the recent cases, LSREF2 Clover included, do not delve into the situation in which the lender requires the intended borrower to switch positions and become a guarantor, and set up or identify a wholly new borrower for the loan immediately before closing. If the purported guarantor can show real duress resulted from a lender’s last minute demand to change the loan and guaranty structure, the outcome could possibly be different. This is the situation described in the often cited 1995 case of River Bank America v. Diller . Thus, a final tip for lenders might be to make decisions about the acceptable loan structure early in the process and stick to it.

** See, LSREF2 Clover Property 4, LLC v. Festival Retail Fund 1, LP, 2016 Cal App Lexis 844 and 2016 WL 5765423

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.

Loans and Liens and . . . What Can Go Wrong Here (Part 2)? The Devil is in the Details – Protecting a Lender’s Collateral Position Under the UCC

By: Jack Easterbrook

The lender gets loan documents signed by the borrower and takes collateral from the borrower to secure the debt. It sounds easy and familiar. So what could go wrong? The progression of cases interpreting the Uniform Commercial Code (UCC) provides insight into the mistakes, large and small, that can create unexpected exposure for lenders and surprise defenses for borrowers. Earlier this year two new cases shed additional light on this question. This article takes up the second of these two (and follows an earlier article by the author , which addressed the other new case).

Don’t Count on Equitable Arguments to Work in Protecting Lien Rights

DivLend (“Lender”) made a loan to Ajax (“Borrower”) secured by 30 vehicles. The agreement between Lender and Borrower granted the security interest in the vehicles. Although this agreement was titled a lease agreement, the court observed and the parties agreed that the transaction was really intended to be a secured loan. Title to the vehicles (the collateral) was evidenced by certificates, so the Lender was required to deliver the original certificates to the department of motor vehicles along with a notice of lien signed by the borrower (owner of the vehicles) and the requisite fee. The lender obtained the certificates, but the loan closed without the Borrower executing the notices of lien.

The loan agreement contained provisions, as well, that the Borrower must cooperate with the Lender. Relying on these, the Lender made multiple attempts to have the notices of lien signed but they never were executed. About seven months later an involuntary bankruptcy petition was filed against the Borrower.

The court disregarded the Borrower’s non-cooperation and held that the Lender was unsecured because it had not perfected its security interest (the case was decided under New York law). According to the court, the Lender could have protected itself by: (1) having the notices signed before advancing funds; or (2) exercising its rights to accelerate and reclaim the vehicles once it became apparent that the Borrower was not signing the notices. The Lender had not done either of these.

The bankruptcy court conceded that the Lender held an equitable lien based on the Borrower’s lack of cooperation. While this might have had value in some situations, in bankruptcy it did not trump the trustee’s strong arm powers to avoid an equitable lien.

The takeaway here is that the courts cannot be counted on to protect the lender, even when the borrower’s conduct is causing the problem. The courts, instead, expect the lender to take advantage of its legal rights if it is not obtaining the cooperation it needs. Fangio v. DivLend Equipment Leasing, LLC (In re Ajax Integrated, LLC), 2016 WL 1178350 (Bankr. N.D.N.Y. Apr. 4, 2016).

A related item: if a loan agreement has post-closing requirements, the lender must take action if the requirements are not met. The argument that the borrower would not cooperate is unlikely to prevail, at least in bankruptcy court.

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.

LOANS AND LIENS AND. . .WHAT CAN GO WRONG HERE? PROTECTING A LENDER’S COLLATERAL POSITION UNDER THE UCC – ONCE AGAIN THE DEVIL IS IN THE DETAILS

 

The lender gets loan documents signed by the borrower and gets collateral to secure the debt – that is, a lien on the borrower’s property. It sounds easy and familiar. So what can go wrong here? The progression of cases interpreting the Uniform Commercial Code (UCC) provides insight into the mistakes, large and small, that can create unexpected exposure for lenders and surprise defenses for borrowers. Earlier this year two new cases shed additional light on this question. This article takes up the first of these.

Situation – A Lien on an LLC

The case involved an LLC membership interest offered as collateral for a commercial loan. 11 East 36 th, LLC (“36 LLC”) was the sole member of Morgan Lofts, LLC (“Lofts LLC”), which owned numerous units in a building. Both entities along with a third entity (the Borrower in this situation) were controlled by common family interests. As security for a loan to Borrower, the controlling family agreed to have 36 LLC pledge its sole membership interest in Lofts LLC.

When the transaction was documented, the pledge agreement granted a lien in favor of the lender in the Lofts LLC membership interest held by 36 LLC. The UCC-1, however, described the collateral as specific units in the building that were owned by Lofts LLC.

Bankruptcies were subsequently filed by 36 LLC and Lofts LLC and the lender’s security interest was challenged. The court held that the lender was unsecured as its UCC collateral description incorrectly described the collateral as the real estate owned by Lofts LLC and not the membership interest of 36 LLC in Lofts LLC. Although the lender had its security interest correctly described in the loan papers, it did not really matter because the UCC-1 had it all wrong. The court explained that 36 LLC had no interest at all in the real estate units owned by Lofts LLC; rather, its lien was on the membership interest and it never perfected that security interest. Accordingly, the lender was a mere unsecured creditor in the bankruptcy. In re 11 East 36 th, LLC, 2016 WL 1117588 (S.D.N.Y. March 21, 2016). The takeaway? A security interest in an LLC membership interest is very different than a security interest in the assets actually held by that LLC. The lesson is clear: make sure you accurately describe the collateral in the UCC-1 to properly perfect your interest in that collateral.

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.

The Loan Commitment or Term Sheet – Have You Thought Through Everything That You Are Agreeing To?

By: Serge Filatov

With interest rates still at historically low rates, many people here in Silicon Valley and San Jose are taking out inexpensive debt to finance their business and real estate needs . The first step in obtaining commercial debt is obtaining a loan commitment or term sheet from a lender. Loan commitments set forth the basic economic terms of the loan and include items like:

  • loan amount;
  • maturity date;
  • interest rate;
  • payment terms; and
  • security that the lender will take (if any).

While the items listed above are certainly important, many people often only focus on these “major” items and do not worry about the other details of the loan. Unfortunately, those “less important” details are often the major cause of future headaches for the unwary borrower.

When reviewing a term sheet or loan commitment, and before entering into an agreement with a lender, a potential borrower should consider the other common restrictions or requirements often imposed by lenders, which may include:

  • Financial covenants, including debt service coverage ratios;
  • Entity structure requirements;
  • Loan fees;
  • Prepayment fees and restrictions;
  • Reporting requirements;
  • Reserves for taxes, insurance premiums, capital expenditures, or other future costs and expenses;
  • Guarantees; and
  • Affirmative and negative covenants.

While the list above is by no means exhaustive, it is representative of the type of items that a borrower should consider when reviewing a loan commitment or term sheet. It is important to know about all that you are agreeing to – even the details. In many loan agreements, if you breach any part of the loan agreement, you will be in default of the loan and the lender could potentially accelerate all of the amounts owed under the loan. Will you be in the financial position to pay back the loan in full when the lender demands payment? Don’t put your business or property at risk by not thinking through the details of the loan.

Alternatively, if you are a lender, it can be advantageous to include the points above (and perhaps others, depending on the transaction) to minimize later negotiations with the borrower and ensure you do not invest more time in working on a transaction that will not get to closing because the parties are unable to agree on important final terms.

A term sheet or commitment letter can also be construed as a binding agreement in some instances, and the parties must use care to avoid this – assuming they do not want the term sheet or commitment letter to represent an actual, binding agreement.

If you are interested in avoiding problems later, it may be wise to have an attorney help you navigate the potential pitfalls of a term sheet, commitment letter and debt package and provide you with the best possible outcome for success.

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.

We Are Not Going There! The Limits of Waivers in Loan Guaranties

By: Jack Easterbrook

Question: if a person signs a loan guaranty and it contains a long waiver section in which the signer gives up defenses (and the guaranties all have these sections, right?), is the guaranty still enforceable if the lender breaches the loan agreement? That is, can the lender claim that the guarantor is obligated to pay under the guaranty even though the lender was a cause of the defaults in the loan? That was the question in the DelPonti* case and the court came down on the side of the guarantors. (The case citation and the pertinent facts of the case are discussed below.)

What are the takeaways?

The court in the DelPonti case described two things the lender apparently did, which affected its rights under the guaranties taken from the borrower’s principals:

First, the court said the lender failed to honor approved payment applications (requests for advances) from the borrower on a construction loan. This is a reminder that the lender needs to be very careful that its loan documents thoroughly describe the conditions borrowers must satisfy to obtain advances. Stopping an advance without proper cause under the loan documents may jeopardize the lender’s ability to enforce its guaranties.

Second, in a subsequent loan workout the lender told the guarantors they would be exonerated if they did certain things in connection with the construction project, but later changed its position and tried to enforce the guaranties. The lesson is obvious: the lender needs to be careful about its communications with the borrower and the guarantors but if there is an agreement, stick to it!

Finally, while the guarantor may waive all of its defenses under the terms of the guaranty, the DelPonti court says that the lender continues to have a duty of good faith and fair dealing under the loan documents. The lender, according to the court, cannot sidestep that duty and use the broad waiver language in the guaranty to ensure repayment of a loan. This outcome actually seems rather consistent with the long standing trend in the courts to strictly construe loan documents and demand lender good faith. The DelPonti case addresses an area that the California courts had not previously discussed but the holding likely is not a surprise to those following the issue and familiar with the history of lender liability litigation.

Details of the DelPonti Case:*

The lender in the DelPonti case (a predecessor bank taken over by California Bank & Trust) made a construction loan in the amount of $6 million to an LLC developing a townhome project and took the personal guaranties of the principals. As the first phase of the project was nearing completion, the lender failed to honor requests for advances from the borrower which resulted in the first phase not being completed and sold. This triggered loan defaults by the borrowing LLC. The DelPonti case does not elaborate on the specifics of this; it states, however, that the trial court, after reviewing the evidence, found that lender’s failure to honor the payment applications (for loan advances) was a breach of the loan agreement by the lender. Subsequently the parties entered into a workout agreement, which was spelled out in an email from the lender. The lender agreed to exonerate the guarantors if they performed certain tasks related to the construction project. The guarantors did these things but the lender nevertheless foreclosed on the real estate collateral and pursued the guarantors for the deficiency.

The lender did not dispute the factual findings of the trial court but argued on appeal that even if the guarantor had such defenses, they were waived in the guaranty. The court discussed at length California Civil Code Section 2856, which is broad in scope and provides that a guarantor may waive the rights and defenses that would otherwise be available to the guarantor, including defenses that may exist because the loan is secured by real estate collateral.

The court said that the question of whether the waivers in a guaranty can be enforced under such circumstances had not previously been addressed in California. The lender’s argument, however, did not sway the court, which held that a guarantor’s waiver of defenses is limited to legal and statutory defenses expressly set out in the agreement. The court would not extend this to include “the predefault waiver of the Bank’s own misconduct.”

A Win for Long Guaranty Forms ?

When opining on the waiver’s effectiveness, the court emphasized that “a guarantor’s waiver of defenses is limited to legal and statutory defenses expressly set out in the agreement…” This suggests one additional point of interest to those concerned about the length of commercial loan documents: those long waiver provisions in the guarantees actually serve a purpose if a dispute arises! If a defense otherwise available to a guarantor is not expressly set out in the waiver portion of the guaranty, the courts are likely to narrowly construe the matter and interpret it to the benefit of the guarantor.

*California Bank & Trust v. DelPonti , 232 Cal.App.4 th 162 (2014)

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.

Loans With High Rates of Interest – Be Careful About Usury

By: Serge Filatov

As a corporate attorney here in Silicon Vall

ey and San Jose, I have numerous clients who need help documenting loan transactions and promissory notes . These clients may be taking on debt or providing a loan to a third party. One area of law that clients are not always familiar with is usury law. The California constitution protects individual borrowers from usury, which in simple terms is the lending of money at very high rates of interest. With some notable exceptions, the general rule is that loans cannot have an interest rate that exceeds 10% per year.

How is it then that your credit card company can charge over 10% interest on your

personal card? The answer to that is that there are numerous exceptions

to the general usury rule. In fact, the general rule is riddled with exceptions that are spread out between sections of the California civil, commercial, corporate, and financial code. Often, an exception concerns a specific item that the legislature was concerned with at the time so the exceptions pop up in random places of the California code.

Examples of common exceptions to the rule include California Civil Code Section 1916.1 which states that usury does not apply to loans made or arranged by a licensed California real estate broker, which are secured by liens on real property. Licensed lending institutions such as banks and credit unions are also exempt from usury laws.

Additional common exceptions, at least for the clients that I work with, are (i) loans made to a business that has $2,000,000 or more in assets at the time of the loan or (ii) loans that are for $300,000 or more. In order to qualify for these exceptions, the borrower must meet the following criteria:

  • The borrower cannot be an individual.
  • The lender must have a pre-existing relationship with the borrower.
  • The borrower must reasonably appear to be able to protect its own interests.
  • The loan must not be primarily for personal, family, or household purposes.

What is the big deal about a usurious loan? The lender could forfeit all interest on the entire loan and may have to pay the borrower 3 times the interest paid during the 12 months prior to the filing of a lawsuit. Also, a lender who willfully and maliciously receives interest in violation of usury law can be found guilty of being a loan shark which is a felony punishable by up to 5 years of jail.

Be careful if you are making a loan with a high rate of interest. If you are considering making such a loan, you should consultant with an attorney to confirm that the loan is not usurious.

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. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

The Secret Side of UCC Financing Statements

In my experience representing banks, asset based lenders and private lenders in San Jose and throughout the San Francisco Bay Area, an overriding concern is to make sure that the lender has the ability to go after the collateral if the borrower does not pay for any reason. Accordingly, a lender, secured creditor or factor taking collateral for a loan* instinctively knows that you need to file a UCC-1 financing statement as part of the transaction. From the earliest days of training, it is drilled into most secured lenders that the UCC-1 is one of those items you must have. It “perfects” the lender’s security interest in collateral, which means that it gives your lien priority and makes the lien rights enforceable against third parties, bankruptcy trustees (if it ever came to that) and others.

UCC Filings and Marketing Strategies

One unintended consequence of UCC filings is beginning to come to light. That is, every filing potentially provides the world – meaning competitors – with information about the lender’s activities. The ongoing development of sophisticated databases allows a person so inclined to figure out who a lender is financing – i.e. who it has as its customers. That, of course, has the potential of leading to targeted marketing efforts. The purpose of this article is to point out that this use of a lender’s UCC filings, which is often not much thought about, is becoming more prolific as database analytical tools become more prolific.

Representative Parties

The requirement of filing a UCC-1 financing statement is so fundamental to credit underwriting and the protections it provides are so substantial that it is out of the question for a secured lender, ABL lender or factor to consider going without one. With that strategy effectively off the table, we are seeing the rise of so-called representative parties or third party representatives who insert the representative’s name rather than the actual lender’s name on UCC-1 financing statements in the secured party box. If a representative party has multiple lenders using the service, it effectively disguises the identity of the actual lender. Of course, this disguise comes with a fee!

The legal underpinning for the use of representative parties is found in Section 9502(a)(2) of the California Commercial Code (and similarly numbered sections in other state’s commercial codes). Section 9502 provides that to be “sufficient” or complete, a financing statement must include the debtor’s name, a description of collateral, and the name of the secured party or a representative of the secured party .

You may hear more about use of representative parties, lender fictitious names and other disguising techniques going forward. The reason is straightforward: it is apparently becoming more necessary to foil the attempts of competitors in the marketplace to obtain a lender’s customer list through analysis of the data bases.

*(Note: The UCC filing is used in connection with liens on most business assets, but does not perfect a lender’s security interest in real estate and certain unique types of assets, which are not discussed in this article. )

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinion 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.