A Proactive Lender is a Better Protected Lender

June 2, 2020

The loan market has been significantly impacted by COVID-19 with waves of defaults, bankruptcies and ratings downgrades. Many industries are currently facing unprecedented difficulties, including difficulties resulting from distressed supply chains and/or drastically decreased demand. One thing that all lenders should consider doing at this time is conducting a comprehensive collateral review of each of their borrowers to ensure that there is no value leakage in their collateral package. An important point to note is that if there are defects that cause a lender’s security interest to be unperfected, corrective action should be taken quickly, because a prior security interest that is perfected within 90 days of a borrower filing for bankruptcy can be deemed invalid by a bankruptcy trustee. Based on our experiences, below is a roadmap for a collateral review process, which highlights common areas where value can be lost. We note that while this is simply the first step in dealing with a distressed borrower, it is nonetheless a very important one.

The Collateral Review Process:

Different assets call for different collateral review measures. Lenders should consider the following steps (many of which can be done quickly and inexpensively) when undertaking a comprehensive collateral package review:

  1. Financing Statements. The lender should run Uniform Commercial Code searches and review all filings to ensure that all security interests are perfected and all necessary continuation statements have been filed.
  2. Promissory Notes. The lender should confirm that all promissory notes and other physical debt instruments are in its possession or in the possession of a custodian with control agreements in place. To the extent a promissory note or other debt instrument cannot be located, the lender may have to provide an affidavit of lost note and request that the borrower issue new note.
  3. Stock Certificates. The lender should confirm that the originals of all certificates representing equity interests, instruments of transfer and related stock powers (signed in blank) are in their possession. To the extent that any of them are missing, the lender may have to provide an affidavit of lost certificate and request that the borrower to re-certificate.
  4. Specialized Perfection Issues. The lender should make sure that all other actions have been taken to perfect its security interest, including, without limitation, actions and filings with respect to real estate, intellectual property, commercial tort claims, vessels, motor vehicles, electronic chattel paper, uncertificated securities, letter of credit rights, goods held by a bailee and insurance.
  5. Control Agreements. The lender should review all account pledges and account control agreements to ensure that it has control of applicable bank accounts.
  6. Account Sweep Mechanism. The lender should consider modifying or engaging any sweep mechanism to accelerate the repayment of the loan.
  7. Trade Debt. The lender should ask the borrower for a breakdown of historical and current trade payables in order to identify imminent problems. For instance:
    1. Independent Audit — Consider encouraging the borrower to engage outside auditors or restructuring consultants to evaluate trade payables;
    2. Sequester Operating Expenses — Encourage the borrower to sequester operating expenses into separate locked accounts to ensure sufficient funds to make trade payments; and
    3. Separate Business Lines — If relevant, suggest that the borrower separate profitable operations from unprofitable ones.
  8. Location of Movable Collateral. The lender should locate and track, or engage a third-party service provider to locate and track its collateral.
  9. Condition of Assets. The lender should consider retaining a surveyor and/or independent consultant to assess the physical condition of its collateral.
  10. Insurance Review. The lender should obtain an insurance report relating to its collateral.
  11. New Subsidiaries, Businesses and Assets. The lender should confirm that its collateral package covers any new subsidiaries, businesses or assets of the borrower intended to be part of the lender’s collateral.
  12. COVID-19 Issues. The lender should consider what practical limitations there may be both internally and externally in realizing on collateral in a timely manner, given office closures and other restrictions on access to resources.

These recommendations are a starting point and are not meant to be a one-size-fits-all approach or address any local law considerations for collateral located outside of the United States. Regardless, if you are concerned with a borrower’s financial condition, a proactive approach is best.