RECEIVABLES FINANCING

RECEIVABLES FINANCING Asset-Based Financing Strategies 2015 Practising Law Institute February 27, 2015 Scott A.Lessne Crowell & Moring LLP

I. The Role of Receivables in Asset- Based Lending A. What are Receivables? 1. A business term not defined in Article 9, but generally understood to mean a right to payment 2. Under Article 9, a receivable could be a right to a stream of payments represented by an account, a contract right, chattel paper, instruments, general intangibles or other obligations 2

The Role of Receivables in Asset- Based Lending (cont d) B. Receivables Provide a Source of Current Working Capital 1. Using receivables as collateral can create a steady stream of income and enables a borrower to unlock the value of its liquid assets sooner than through ordinary course collections 2. Receivables may form the collateral base for several different structures: a. Fully Followed Formula Based Loans b. Receivables Factoring Arrangements c. Secured Financing with an all assets lien (ABL Lite) d. Securitizations 3

C. Collateral Liquidity Spectrum Most Liquid Least Liquid Cash Receivables (all types) Inventory Machinery & Equipment Real Estate 1. When receivables are part of the borrowing base, the lender is financing the most liquid piece of a borrower's business. In a worst case scenario, the lender can act quickly to realize on a portion of its collateral by directly collecting the borrower s receivables while in the process of liquidating inventory and equipment 4

Collateral Liquidity Spectrum (cont d) 2. Accounts created for goods sold or services rendered are the most common type of receivable used in an asset-based loan facility to support cash advances 3. The most common type of asset-based structures utilizing accounts as a basis for cash advances are revolving credit facilities and factoring arrangements 4. There are legal and business requirements to be addressed when accounts form part of the asset base, and both are of equal importance 5

II. The Business Requirements Revolving Credit A. Revolving credit - the borrower may borrow, repay and reborrow within certain limitations based on a formula calculation known as the borrowing base B. Cash from the conversion of receivables repays the loan C. The loan agreement will establish the extent of control the lender will have over the collateral and cash proceeds D. Generally, borrower is expected to apply cash received to the revolver balance 6

The Business Requirements Revolving Credit (cont d) E. Some revolvers are underwritten to allow the borrower to use cash proceeds in the business until otherwise notified F. Receivables may be the sole collateral included in the borrowing base, or other collateral, such as inventory and equipment, may be included in the calculation G. Typically, the lender will take a security interest in all assets, even if they are not borrowing base assets in order to avoid priority conflicts (particularly with respect to proceeds of asset dispositions) with other lenders, e.g., a lender financing inventory 7

D. Collateral Requirements 1. As asset-based financing is driven by the quality of the collateral, detailed definitions of eligible accounts and eligible inventory should be part of the documentation of the loan. These provisions address issues of quality and value of collateral, and are concepts separate and apart from the lender s security interest 2. Upon determination of collateral eligibility, the lender will apply a formula to reach the amount of the advance 8

E. The definitions of eligibility and borrowing base formula limitations reduce the amount of cash advances available to a borrower based on its total pool of accounts and inventory 1. Lender s will not lend dollar-for-dollar 2. Establishing a balance between collateral quality and lending level is critical and will vary from loan to loan Total Pool of Assets Perfected Security Interest Eligibility Criteria Borrowing Base Limitations Cash Advance Availability 9

F. Eligibility criteria for accounts receivable usually are stated in the form of exclusions from the larger asset pool 1. such account is more than (i) 90 days past due, according to the original terms of sale, or (ii) 120 days past the original invoice date thereof a. Rationale: - As receivables age they become harder to collect - Lender can employ a tiered advance rate as receivables age: the advance rate decreases the longer the receivable remains uncollected Incentivizes early collection of receivables 10

Eligibility criteria for accounts receivable usually are stated in the form of exclusions from the larger asset pool (cont d) 2. the account debtor on such account has filed a petition for bankruptcy or any other relief under the Bankruptcy Code or any other law relating to bankruptcy, insolvency, reorganization or relief of debtors a. Rationale: - Significantly increased uncertainty of collection 11

Eligibility criteria for accounts receivable usually are stated in the form of exclusions from the larger asset pool (cont d) 3. the account debtor on such account or any of its affiliates is also a supplier to or creditor of the borrower or any of its subsidiaries a. Rationale: - An account debtor may claim offsets on moneys owed to it which will decrease the amount owed 12

Eligibility criteria for accounts receivable usually are stated in the form of exclusions from the larger asset pool (cont d) 4. the sale represented by such account is to an account debtor outside the United States, unless the sale is supported by a letter of credit or other terms acceptable to the lender, or otherwise insured via credit insurance a. Rationale: - Vagaries of foreign laws together with local political issues may significantly impact collectability or even the ability to obtain an enforceable security interest - Foreign Currency Translation Risk 13

Eligibility criteria for accounts receivable usually are stated in the form of exclusions from the larger asset pool (cont d) 5. the sale to such account debtor on such account is on a bill-on-hold, guaranteed sale, sale-and-return, sale-on-approval or consignment basis a. Rationale: - Each of those structures pose verification and tracking issues 14

Eligibility criteria for accounts receivable usually are stated in the form of exclusions from the larger asset pool (cont d) 6. X% or more of the outstanding accounts of any account debtor that constituted Eligible Accounts at the time they arose have become ineligible for other reasons a. Rationale: - Trigger to minimize risk associated with an account debtor experiencing financial difficulties 15

Eligibility criteria for accounts receivable usually are stated in the form of exclusions from the larger asset pool (cont d) 7. the sale represented by such account is denominated in other than United States dollars a. Rationale: - Currency fluctuation issues 16

Eligibility criteria for accounts receivable usually are stated in the form of exclusions from the larger asset pool (cont d) 8. accounts of such account debtor represent more than X% of the Eligible Accounts at such time a. Rationale: - Concentration of a large percentage of accounts with one account debtor creates an additional layer of credit risk should the account debtor experience financial difficulty 17

G. Borrowing Base 1. Once the amount of eligible accounts has been determined, then the borrowing base - the total amount of cash advances available to be borrowed at any time - can be determined 2. The borrowing base serves as a mandatory prepayment trigger - if the amount outstanding exceeds the borrowing base, then the borrower is obligated to immediately repay the excess or provide additional eligible collateral 18

Borrowing Base (cont d) 3. Asset-based lenders are generally not under-secured as they will require a security interest in 100% of the borrower s assets, creating a collateral cushion, but it may be out of formula or over-advanced, meaning that the amount of cash advances outstanding exceeds the limitations of the borrowing base formula a. the lender may provide for planned over-advances to mitigate cash flow swings resulting from seasonal sales cycles b. the expectation is that seasonal over-advances are to be repaid at the end of the cycle c. an inability to repay the over-advance may indicate a fundamental credit weakness d. Some lenders may require periodic clean-up periods where the outstanding balance is paid down to zero 19

Sample Receivables Borrowing Base Certificate Net AR by Aging Under 30 days 2,000,000 31-90 days 1,000,000 91-120 days 500,000 Over 120 days 500,000 Unbilled 100,000 Net AR Pool 3,900,000 Ineligible Detail 50% of 91-120 250,000 Over 120 days 500,000 Not payable in US $ 50,000 Gov t Accounts 10,000 Concentrated Accounts - 0 - Disputed Accounts 10,000 Cross-Aged Accounts 5,000 Insolvent Account Debtor 1,000 Contra Accounts 2,000 Total Ineligible 828,000 Gross Eligible 3,072,000 Borrowing Base (A/R) a) Gross Eligible Accounts 3,072,000 b) Advance Rate 80% A/R Availability 2,457,600 20

H. Monitoring 1. Receivables lending is a high touch/high control endeavor for both the borrower and the lender 2. Lender s perspective a. compliance with administration requirements is labor intensive requiring experienced back-office staff b. lenders must have tight internal audit controls and strong management information systems c. ability to maintain lockbox compliance and cash flow tracking in and out of deposit accounts d. must be able to identify trends in receivables quality, turnover rates and concentration e. must be able to examine and compare receivables agings (sometimes by customer) and compare movements from one borrowing base certificate to the next 21

I. Fraud Prevention 1. Fraud is the leading cause of loss to assetbased lenders a. regular collateral monitoring including account verification, field audits and cash reconciliation 22

Fraud Prevention (cont d) 2. Fraudulent borrower may: a) submit falsified sales data and collection documentation b) use the same receivables to obtain financing from more than one lender c) divert cash or collateral proceeds d) misrepresent purchase orders e) intentionally mis-age receivables f) delay collections reporting to artificially boost receivables g) create fictitious receivables h) pre-bill 23

III. Factoring A. Factoring is the sale or transfer of title in specific accounts at a discount prior to collection B. More common in the manufacturing and retail sectors, where factors provide a large portion of accounts receivable financing C. Factoring Arrangements 1. Manufacturers or wholesalers, the factors clients, sell their accounts on an ongoing basis without recourse at a discount 2. The factor assumes the credit risk relating to the purchased accounts, thus extending credit to their clients customers 24

D. Credit Approval 1. Factors will require that their clients obtain approval of the amount, terms, delivery date and other conditions of each sale to a customer of the client 2. The factor reserves the right, prior to shipment of goods by the client, to withdraw any credit approval previously granted 25

E. Notice and Payment 1. The customer of the client is notified by either the factor or the client that payments should be made directly to the factor 2. The client agrees to act as trustee of an express trust for the benefit of the factor as to any remittance made directly to the client 3. The latter is generally known as non-notification factoring a. Avoids notifying the customer of the factoring arrangements 26

F. Administration 1. Some factoring arrangements provide that the factor keep records of the accounts, while others place the burden of administration on the client 27

G. Payment of Purchase Price 1. The factor agrees to pay its client the face amount of each account purchased, less a fee and a discount, either (a) upon purchase, or (b) upon receipt of payment, but in any event within a specified period after maturity 28

H. Legal Issues Related to Factoring 1. Section 9-109 of Article 9 brings factoring arrangements within the coverage of Article 9, even though the sales of accounts involved in factoring may only be of specified accounts. The perfection and priority rules of Article 9 apply to sales of accounts and as a result, a factor also has to file financing statements in order to prevail in a bankruptcy proceeding or against other potential lienors 2. Factor versus the accounts receivable financer: as in other cases, the first-to-file rule governs a. Intercreditor arrangements are common to avoid priority disputes 29

IV. The Legal Requirements A. Definition of Account Found in 9-102(a)(2) 1. A right to payment of a monetary obligation, whether or not earned by performance... for property sold, leased, licensed or otherwise disposed of... for services rendered or to be rendered... and includes healthcare insurance receivables... but does not include deposit accounts B. Definition of Deposit Account Found in 9-102(a)(29) 1. Demand, time, savings, passbook, or similar account maintained by a bank, but does not include investment property or accounts evidenced by an instrument 30

The Legal Requirements (cont d) C. The Basics of a Security Interest in Accounts 1. Attachment 2. Perfection a. Filing a financing statement b. Automatic perfection upon attachment for: i. limited assignments of payment intangibles and promissory notes ii. sales of payment intangibles and promissory notes and iii. the assignment of health-care-insurance receivables, if the assignment is made to the healthcare provider that provided the healthcare goods or services 31

D. Priority 1. If two competing security interests are both perfected by filing, the first to file has priority 2. If one security interest is perfected by filing and the other by possession, the first to perfect has priority 3. Additionally, the time of filing or perfection as to a security interest in accounts is deemed the time of filing or perfection as to the proceeds. (UCC 9-322(b)) a. But note priority issues arising in the context of a secured creditor with a security interest in proceeds deposited in a deposit account versus a secured creditor with security interest in the deposit account as original collateral 32

Priority (cont d) b. Deposit account priority issues. i. Example 1) Collections on accounts flow into a deposit account held in the name of asset-based lender at Big Bank; therefore, asset-based lender is Big Bank s customer 2) Asset-based lender has a security interest in all borrower assets, including deposit accounts 3) Big Bank also has a loan to the same borrower secured by the same collateral, but no set-off rights or other interest in that specific deposit account because the deposit account is in the name of asset-based lender Asset-based lender wins versus Big Bank because it has a perfected security interest in proceeds (9-315(c) and (d)) and in the deposit account as original collateral (9-314(a) and 9-104(a)(3)) 33

Priority (cont d) ii. Potentially different result if deposit account at Big Bank is held in the name of the borrower 1) Big Bank has set-off rights in the borrower s deposit accounts and a perfected security interest in the deposit account as original collateral via 9-104(a)(1) control as Big Bank is a secured party and the bank where the deposit account is maintained 2) Per the deposit account priority rules in 9-327, in order for the asset-based lender to prevail over Big Bank, assetbased lender must either become the bank s customer on the deposit account (see example above), or obtain a 9-104(a)(2) control agreement and Big Bank must contractually subordinate its automatically-perfected security interest in the deposit account, as well as its common law set-off rights 34

V. Collections A. From a lender s perspective, one of the most important elements of asset-based lending is the ability to obtain dominion over cash collections (proceeds) arising from accounts receivable B. Dominion can occur through a variety of means: 1. Perfecting a security interest in the deposit account where cash collections proceeds are deposited 2. Blocking borrower access to the deposit account where cash collections proceeds are deposited and/or 3. Establishing a lockbox attached to the deposit account where cash collections proceeds are deposited 35

Collections (cont d) C. Article 9 Control 1. Under Section 9-104, a secured party has (Article 9) control of a deposit account if -- a. the secured party is the bank with which the deposit account is maintained; b. the secured party, the bank and the debtor have agreed that the bank will comply with instructions originated by the secured party without further consent by the debtor*; or c. the secured party becomes the bank s customer with respect to the deposit account * ABA Joint Task Force on Deposit Control Agreements Model Deposit Account Control Agreement http://www.abanet.org/dch/committee.cfm?com=cl710060 General Terms Specific Terms Inserts Standing Deposit Instructions With and Without Standing Block Lockbox Time Deposits First Lien/Second Lien Investment Sweep Non-Demand Deposit Account General and Specific Terms Securitization DACA 36

D. Lockbox Arrangement 1. A lockbox arrangement is one in which account debtors are directed to make payments to specified post office boxes. These boxes are emptied by local banks or other servicers, and the checks are deposited in bank accounts. The banks, in turn, agree to transfer all funds on deposit on a daily basis to an account of the lender, or as the lender so directs. Usually, the lender also has control over these deposit accounts 37

E. Blocked Account Arrangement 1. A blocked account arrangement is one where collections are deposited into deposit accounts to which the borrower does not have access a. The balance on deposit is transferred on a daily or weekly basis to the lender to pay down the loan balance b. The lender will usually have control over that deposit account, but no lockbox is in place 38

VI. Foreign Account Debtors A. Hypothetical: 1. Debtor is a Delaware corporation 2. Debtor s assets include accounts owed to debtor by account debtors located in Mexico 3. Secured party files a financing statement in Delaware covering accounts B. Questions 1. Is secured party s security interest perfected under Article 9? 2. Will the secured party prevail over a creditor using Mexican judicial process to garnish the accounts? 3. May secured party s security interest be challenged under Bankruptcy Code Section 544(a)? 39

Q & A 40