THE NUTS, BOLTS AND WIDGETS

THE NUTS, BOLTS AND WIDGETS OF ASSET-BASED LENDING Presented by the American Bar Association Business Law Section, Young Lawyers Division, Standing Committee on Paralegals and Center for Professional Development

American Bar Association Center for Professional Development 321 North Clark Street, Suite 1900 Chicago, IL 60654-7598 www.americanbar.org 800.285.2221 CDs, DVDs, ONLINE COURSES, DOWNLOADS, and COURSE MATERIALS ABA self-study products are offered in a variety of formats. Find our full range of options at www.shopaba.org Discuss This Course Online Visit http://www.americanbar.org/groups/cle/course_content/cle_discussion_boards.html to access the discussion board for this program. Discussion boards are organized by the date of the original program, which you can locate on the preceding page of these materials. The materials contained herein represent the opinions of the authors and editors and should not be construed to be the action of the American Bar Association Business Law Section, Young Lawyers Division, Standing Committee on Paralegals or Center for Professional Development unless adopted pursuant to the bylaws of the Association. Nothing contained in this book is to be considered as the rendering of legal advice for specific cases, and readers are responsible for obtaining such advice from their own legal counsel. This book and any forms and agreements herein are intended for educational and informational purposes only. 2014 American Bar Association. All rights reserved. This publication accompanies the audio program entitled The Nuts, Bolts and Widgets of Asset-Based Lending broadcast on December 9, 2014 (event code: CE1412NBW).

TABLE OF CONTENTS 1. Presentation Slides 2. The Nuts, Bolts and Widgets of Asset-Based Lending

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The Nuts, Bolts and Widgets of Asset-Based Lending Tuesday, December 9, 2014 1:00 PM Eastern Sponsored by the ABA Business Law Section, Young Lawyers Division, Standing Committee on Paralegals and the ABA Center for Professional Development www.americanbar.org www.abacle.org Scott A. Lessne Program Chair and Moderator Senior Counsel Crowell & Moring LLP Washington, D.C June L. Basden Director Carruthers & Roth, P.A. Greensboro, NC Panelists C.J. Blagg General Counsel for Commercial Lending CapitalSource, a division of Pacific Western Bank Chevy Chase, MD Thomas J. Welsh Principal Brown & Welsh Meriden, CT www.americanbar.org www.abacle.org

I. Overview of Asset- Based Finance Historical Antecedents Characteristics of ABL Facilities Secured v. Unsecured Lending Revolving Facility Calculating Amount of Loan Interest Rates and Fees Evergreen Nature of ABL Facilities ABL Facilities Match Borrower s Cash Needs Repayment www.americanbar.org www.abacle.org I. Overview of Asset- Based Finance Underwriting Diligence Strength of Borrower s Collateral Examination of Books, Records and Hard Assets Asset-Based Lending Terminology Eligibility Requirements Borrowing Base Types of Asset-Based Facilities Floor Planning Factoring Securitization Other Types of Asset-Based Transactions www.americanbar.org www.abacle.org

Collateral Liquidity Spectrum Most Liquid Least Liquid Cash Receivables (all types) Inventory Machinery & Equipment Real Estate www.americanbar.org www.abacle.org II. Collateral Considerations and Related Documentation Requirements Accounts and Inventory Accounts Receivable Inventory Equipment How Defined Lending Structures Purchase Money Financing Term Loan Facility www.americanbar.org www.abacle.org

II. Collateral Considerations and Related Documentation Requirements Article 9 Considerations Grant of Security Interest and Perfection/pre-filing Requirements Description of Collateral Granting of Security Interest Attachment Perfection of a Security Interest Possession/Collateral www.americanbar.org www.abacle.org II. Collateral Considerations and Related Documentation Requirements Borrowing Base/Eligibility Requirements Borrowing Base Eligibility Eligible Accounts Eligible Inventory www.americanbar.org www.abacle.org

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 www.americanbar.org www.abacle.org II. Collateral Considerations and Related Documentation Requirements Representations/Covenants Peculiar to ABL Facilities Collateral Accounts Inventory Equipment Clean-up Provisions Overadvance Concepts www.americanbar.org www.abacle.org

II. Collateral Considerations and Related Documentation Requirements Reserves and Dilution Issues Availability Reserve Dilution Reserve Inventory Reserve Minimum Availability Reserve Rent Reserve www.americanbar.org www.abacle.org III. Ancillary Documentation and Closing Considerations Conditions Precedent to Closing Payoff and Termination Letters Timing and Notice to Existing Lender Release of Debt Release and Discharge of Security Bank Accounts and Checks Mechanics of Payout www.americanbar.org www.abacle.org

III. Ancillary Documentation and Closing Considerations Cash Management, Deposit Control Account Agreements and Lockboxes Collateral Access Agreements Landlord Agreements Bailee, Storage, Processing and Other Third Party Waivers Subordination/Intercreditor Agreements Insurance Requirements www.americanbar.org www.abacle.org IV. Monitoring/Administration and Enforcement Collateral Audits Bankable Loans Decline of Business Operations Decline of Collateral Value Asset-Based Loans Decline of Business Operations Decline of Collateral Value Fraud and Detection www.americanbar.org www.abacle.org

IV. Monitoring/Administration and Enforcement Article 9 Repossession and Liquidation Default Commercial Reasonableness Requirement on Disposition Collection and Enforcement Against Rights to Payment Removal of Accessions and Enforcement Against Fixtures Collateral Other Enforcement Options Notices and Accountings Required Acceptance of Collateral in Full or Partial Satisfaction Deficiencies Waivers www.americanbar.org www.abacle.org IV. Monitoring/Administration and Enforcement Bankruptcy Considerations in Enforcement by Secured Parties Automatic Stay and Relief from Stay Issues No Lien on Post-Petition Collateral Without Authorization (Bankruptcy Code 552) Use of Cash Collateral (Bankruptcy Code 363) and Adequate Protection (Bankruptcy Code 361) Preferences (Bankruptcy Code 547) Fraudulent Conveyances (Bankruptcy Code 548) Post-Petition Transfers (Bankruptcy Code 549) Setoff Restrictions (Bankruptcy Code 553) General Avoidance Powers (Bankruptcy Code 544) www.americanbar.org www.abacle.org

Questions? All attendees can submit questions via the chat feature on the webinar interface www.americanbar.org www.abacle.org

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ABA WEBINAR The Nuts, Bolts and Widgets of Asset-Based Lending December 9, 2014 1:00-2:30 PM Eastern Time PANELISTS Scott A. Lessne Program Chair and Moderator Senior Counsel Crowell & Moring LLP Washington, D.C. C.J. Blagg General Counsel for Commercial Lending CapitalSource, a division of Pacific Western Bank Chevy Chase, MD June L. Basden Director Carruthers & Roth, P.A. Greensboro, NC Thomas J. Welsh Principal Brown & Welsh Meriden, CT

Scott A. Lessne, Program Chair and Moderator, is a Senior Counsel in the Financial Services Group of Crowell & Moring LLP s Washington, D.C. office. Scott s practice involves the representation of financial institutions in connection with the negotiation and documentation of secured and unsecured commercial, asset-based and real estate loan restructures as well as advising clients on legal issues arising in complex single and multi-lender loan workouts and restructures. In addition, Scott advises financial institution clients on creditors rights remedies including judicial and non-judicial enforcement actions and bankruptcy strategies. Scott s practice also includes structuring, negotiating and documenting new complex commercial loan origination transactions across multiple industries. His prior experience includes tenure as the senior in-house lawyer at a major global bank responsible for providing and managing all legal services for the commercial and real estate loan workout division of the corporation. Scott has also served as the General Counsel for the healthcare finance division of a commercial finance company and more recently as the General Counsel of the finance company s regulated bank subsidiary. Prior to his in-house experience, Scott was in private practice where he developed his expertise in asset-based lending, commercial loan restructuring and creditors rights. Scott began his legal career as a law clerk to the Superior Court Judges of the State of Connecticut. Scott is a past President of the Association of Commercial Finance Attorneys, Inc. and is a Fellow and former Regent of the American College of Commercial Finance Lawyers. He recently co-chaired the ABA Commercial Finance Committee s subcommittee on Loan Documentation and is currently a member of the Commercial Finance Committee s Programs subcommittee. He has taught Secured Transactions as a member of the adjunct faculty of Suffolk University Law School. Scott is a regular speaker on topics relating to commercial finance, loan workouts, creditors' rights and bankruptcy.

June Basden, is a Director at the Greensboro, North Carolina law firm of Carruthers & Roth, P.A., is both an attorney and a Certified Public Accountant with more than 27 years of experience in commercial finance and banking law. She represents national, regional and community banks, financial institutions and commercial lenders in a variety of finance transactions, with a special focus on commercial lending and creditors' rights. June has extensive experience in asset-based lending, factoring and single-lender credit facilities, loan workouts and modifications, foreclosures, bankruptcies and commercial real estate transactions. She is a fellow of the American College of Commercial Finance Lawyers (ACCFL) and one of only six ACCFL fellows practicing law in North Carolina. Her clients have found her strategic counsel especially critical in the current financial landscape as she advocates for ways to achieve the best possible outcome. In 2014, June was named Best Lawyers 2014 Greensboro Banking & Finance Law Lawyer of the Year and was included in Business North Carolina magazine's 2014 "Legal Elite" in both business and bankruptcy law. June is a frequent lecturer on various aspects of secured lending transactions and bankruptcy law.

C.J. Blagg is the General Counsel for Commercial Lending at CapitalSource, a division of Pacific Western Bank. In this capacity, C.J. oversees all legal aspects of CapitalSource s commercial lending operations. C.J. has worked at CapitalSource since 2004. Prior to joining CapitalSource C.J. worked as a corporate finance attorney at a number of major law firms, most recently at DLA Piper. Over his career, C.J. has extensive experience representing both lenders and borrowers in a wide variety of commercial lending contexts, including, among others, assetbased lending, cash-flow lending, mezzanine and subordinated financing. C.J. received his J.D. from the University of Virginia School of Law and his B.S.F.S. from Georgetown University.

Thomas J. Welsh is a principal of the law firm of Brown & Welsh, P.C. located in Meriden, Connecticut. He is a Fellow and a former Regent of the American College of Commercial Finance Attorneys, a member of the American Law Institute, a member of the Executive Board of the Association of Commercial Finance Attorneys and is a member of the Connecticut Bar Association, being a member of the Executive Committee of the Commercial Law and Bankruptcy Section and Chairman of the Commercial Finance Section. He has lectured on commercial law and bankruptcy matters and written on commercial law topics. Attorney Welsh is a co-author of E. Weiss, T. Welsh & E. Yen, Connecticut Secured Transactions Under Revised Article 9 of the Uniform Commercial Code Forms and Practice Manual (2002), rev. to 2010, published by DataTrace Publishing Company and is a co-author of the 2008 revision to Chapter 5C on Letters of Credit and Negotiable Instruments of Rabkin & Johnson s Current Legal Forms With Tax Analysis published by Matthew Bender. Mr. Welsh was a member of the Connecticut Law Revision Commission advisory committee on the 1999 revision to Article 9 - Secured Transactions of the Uniform Commercial Code and was a primary proponent and spokesperson for the Connecticut Bar Association in the adoption of revised Article 9 in Connecticut. He also authored, and was the spokesperson of the Commercial Law and Bankruptcy Section of the Connecticut Bar Association in the adoption by the Connecticut General Assembly, of the 2003 technical amendments to Article 9 of the Uniform Commercial Code and related statutes. Attorney Welsh received a Citation from the Connecticut General Assembly for his work in the adoption of revised Article 9. He is also a member of the Connecticut Law Revision Commission and was the co-chair of the Advisory Committee on 2010 revisions to UCC Article 9 that were passed by the Connecticut General Assembly in 2011. He was also the co-chair of the Connecticut Law Revision Commission panel drafting a bill to adopt the Uniform Certificate of Title for Vessels Act in Connecticut, which will be pending before the Connecticut General Assembly in the 2014 session.

Table of Contents I. Overview of Asset-Based Finance... 1 A. Historical Antecedents...1 B. Characteristics of ABL Facilities...2 C. Underwriting Diligence...4 D. Asset-Based Lending Terminology...6 II. Collateral Considerations and Related Documentation Requirements for an Asset-Based Loan... 9 A. Accounts and Inventory...9 B. Equipment...11 C. Article 9 Considerations Grant of Security Interest and Perfection/pre-filing requirements...13 D. Borrowing Base/Eligibility Requirements...16 E. Representations and Covenants Peculiar to ABL Facilities....22 F. Representations and covenants are made on a continuing basis and are explicitly deemed to be remade with each advance....23 G. "Clean-up" Provisions...24 H. Overadvance Concepts...25 I. Reserves and Dilution Issues...25 III. Ancillary Documentation and Closing Considerations... 28 A. Conditions Precedent to Closing...28 B. Payoff and Termination Letters...29 C. Cash Management, Deposit Account Control Agreements and Lockboxes...30 D. Collateral Access Agreements...30 E. Subordination/Intercreditor Agreements...30 F. Insurance Requirements...31 IV. Monitoring/Administration and Enforcement... 32 A. Collateral Audits...32 B. Fraud and Detection...35 C. Article 9 Repossession and Liquidation...36 D. Bankruptcy Considerations in Enforcement By Secured Parties...41 i

I. Overview of Asset-Based Finance A. Historical Antecedents 1. There are several age old business problems that date back to the earliest days of organized commerce: a. businesses can be asset rich and cash poor; b. the need to expand can outstrip the ability to pay for expansion with available cash; c. sales of assets can be seasonal and/or cyclical; and d. customers want to pay on credit. 2. The earliest form of asset-based finance was probably a rudimentary form of factoring; the purchase of receivables (current claims for payments due in the future) from a seller of assets or a provider of services. 3. Over time as both legal systems and economies have become more sophisticated, the use of assets as the basis for obtaining immediate cash has grown into a multi-billion dollar global finance industry. 4. The introduction of Article 9 of the Uniform Commercial Code ( UCC9 ) in the early 1960 s created a unitary security device by which a lien on personal property could be created and perfected. 5. Since the enactment of UCC9, the asset-based finance industry has flourished, albeit with ups and downs as the financing and legal structures tend to lag behind rapid economic developments. 6. Factoring, floor planning and traditional asset-based lending were the norm throughout most of the 1960 s, 70 s and 80 s. a. The typical candidate for an asset-based finance arrangement was a small to middle-market business with cash-flow issues. b. In the eyes of a traditional bank underwriter, many of these candidates were not bankable because of their cash flow issues. c. Companies like CIT, Foothill and Barclay s, along with a myriad of other smaller specialty commercial finance shops stepped in to fill the 1

void, developing financial products based on the strength of a candidates assets, not its cash flow; ultimate repayment would be from the orderly or forced liquidation of assets. 7. Over time, asset-based finance products evolved as economic conditions changed. a. Securitizations became a form of high end, sophisticated asset-based product. b. Companies taking advantage of asset-based financing structures were no longer small or middle market enterprises in dire or near dire financial straits. c. Asset-based products found their way into large cap leveraged, structured and acquisition finance. d. At the height of the financial crises, Ford Motor Company obtained a multi-billion dollar asset based loan to help ease cash concerns at this asset rich company; it was the largest asset-based loan to date. B. Characteristics of ABL Facilities 1. Secured vs. Unsecured Lending a. Financing facilities not secured by any assets are deemed to be unsecured facilities. b. Financing facilities secured by a UCC9 security interest may or may not be an asset-based financing facility. i. Many commercial loan facilities are secured by personal property, but for underwriting purposes, repayment is based on the overall financial strength and cash flow of the business enterprise. ii. Asset-based financing facilities, on the other hand, while secured by personal property, look to the value of the assets for repayment. c. A typical definition of an asset-based loan may read as follows: an asset-based loan is a commercial loan that is structured so that the credit extended to the borrower is monitored in relation to the collateral that has been pledged to support the credit... [these loans] are underwritten primarily as revolving credit facilities with 2

borrowings limited by specific advance rates against the underlying collateral that generally consists of ever changing pools of assets such as receivables and inventory. d. Failure of the business enterprise is less relevant for the asset-based lender because of reliance on asset value rather than the financial strength of the business. e. That is not to say that the financial health of the business does not factor into asset-based underwriting; the value of certain types of collateral is directly related to the health of the industry on which it is used. For example, the value of oil rigs, the basis for many assetbased loans in the 1980s, plummeted when the US oil exploration industry collapsed. While underwriting took into account the liquidation value of the collateral, having collateral that could not be sold at any price was not an anticipated outcome. 2. Revolving Facility a. Asset-based loans typically take the form of a revolving loan facility secured by all of the borrower s personal property assets, i.e., borrower s accounts receivables, inventory, equipment or other assets. b. Revolving loans will allow a borrower to take advances on the loan when it has assets available to support an advance and will allow the loan to then be repaid as money is collected, and then re-advanced again at a later date. This allows the borrower to draw against the loan as many times as needed up to the lesser of the available borrowing base, the note amount or another established sub-limit. 3. Calculating Amount of Loan. The amount of money that a lender will advance against certain types of assets will be directly tied to the liquidity profile of the asset. MOST LIQUID LEAST LIQUID 3

Loan advances will be a percentage of the amount of eligible collateral available (or outstanding in the case of accounts receivable) at any particular time, with the lender establishing eligibility criteria for each asset class. 4. Interest Rates and Fees a. Interest rates and fees for asset-based facilities are typically higher than those charged by a lender for a more traditional term loan. This is primarily because the lender is taking on a greater administrative burden (e.g., in the form conducting periodic inventory or accounts receivable audits and the borrower s compliance with various ratios and covenants). 5. Evergreen Nature of ABL Facilities a. Asset-based facilities typically renew automatically from year to year unless one of the parties exercises its termination rights. As the facility revolves, it automatically adjusts to the borrower s needs (and lender s corresponding willingness to lend) because it is tied to the borrower s sales or inventory volume (assuming there is no aggregate dollar cap in the loan agreement). This is in contrast to a standard term loan, which must be repaid (or refinanced) at maturity, whether or not the borrower requires additional capital. 6. ABL Facilities Match Borrower s Cash Needs a. Loans are structured to allow borrowers to minimize interest payment by borrowing only what can be supported by the asset base. 7. Repayment C. Underwriting Diligence a. Unlike cash flow lending, the asset-based lender is counting on (i) a long-term relationship, (ii) another lender willing to refinance the loan, or (iii) liquidation value of the collateral. 1. Strength of Borrower s Collateral a. Receivables and Inventory Ratios. Unlike traditional financial statement lending, the lender s diligence in an asset-based arrangement will not focus on the borrower s liquidity, leverage, solvency and profitability ratios. Rather, diligence and willingness to lend will focus on the strength of the borrower s receivable or 4

inventory turnover ratios because these assets will form the collateral base from which the borrower s borrowing base can be derived. b. Implementation of Collateral Monitoring. The ability to obtain the requisite number of audits and field exams is critical to maintaining accurate and current information about the collateral. c. Collateral Accessibility. Access to the collateral post-default is key to a successful exit strategy. Impediments to access known at the underwriting stage will potentially change the lending formula. d. Local Legal Impediments. Peculiarities in the local law, both state and federal, of the jurisdiction where rights and remedies are to be exercised may have an impact on the structure of the loan and loan availability. 2. Examination of Books, Records and Hard Assets a. The lender also must conduct a thorough examination of the accounts receivable/inventory/equipment to determine if there is sufficient eligible collateral to support the borrower s stated credit needs. Such diligence typically involves an examination of the borrower s books and records as well as a field exam to count the inventory. b. The most problematic issues for an asset-based lender arise in fraud at the time the financing is entered into, or during the ongoing administration of the credit. i. Fraud can come in the nature of inventory miscounts, or can be as extreme as empty boxes of finished goods in the warehouse. ii. Receivables fraud can arise in a variety of ways: (a) falsified sales data and collection documentation (b) use of the same receivables to obtain financing from more than one lender (c) diversion of cash or collateral proceeds (d) misrepresentation of purchase orders (e) intentionally mis-aging receivables 5

(f) delay in collections reporting to artificially boost receivables (g) creation of fictitious receivables (h) pre-billing D. Asset-Based Lending Terminology 1. Eligibility Requirements. By nature, asset-based lending will in all cases depend on the collateral made available by the borrower. The borrower s ability to borrow against its assets will be subject to a formula which is based on the quantity and quality of its assets (i.e., receivables or inventory). Eligibility requirements will be carefully established in the loan agreement. Some requirements are generic to all loans while others are industry specific. 2. Borrowing Base. The borrowing base is the total amount available to be borrowed at a given time and is dependent upon what constitutes eligible collateral. Typically, the borrowing base serves as a mandatory prepayment trigger if the amount outstanding at any time exceeds the borrowing base, the borrower is required to pay the excess or provide additional collateral. Total Pool of Assets Perfected Security Interest Eligibility Criteria Borrowing Base Limitations 3. Types of Asset- Based Facilities 4. Floor Plan Financing a. Under a floor planning arrangement, the loans are made against the security of specific identifiable assets, usually constituting the inventory of a seller of goods. Typically such arrangements are used 6

5. Factoring to finance dealer inventories for items such as automobiles and home appliances. b. Although there is typically an outside date, the loan is paid off upon the sale of the subject asset. a. What is Factoring? i. Factoring is the sale or transfer of title in specific accounts receivable at a discount and is most common in the manufacturing and retail sectors. b. Factoring Arrangements i. Factors assume the credit risks relating to receivables by purchasing them without recourse, thus extending credit to their clients customers. ii. iii. Because factors bear the credit risk of the transaction, factors will require that their clients obtain approval of the amount, terms, delivery date and other conditions of each sale to a purchaser. The end-purchaser of the product is notified (typically by a legend printed on invoices) that the factor has purchased the receivables and that payments should be made directly to the factor. The borrower must immediately notify the factor of any remittances made directly to the borrower and factoring agreements typically provide that borrower holds any such funds as trustee for the benefit of the factor. 6. Securitization a. Securitizations take the form of a sale of receivables to the lender, typically on a batch basis (i.e., a certain number of receivables at specified intervals), rather than a loan secured by the borrower s receivables. b. The borrower retains the obligation to collect on the receivables and settles up with the lender at specified intervals. 7

c. Securitizations are known as off balance sheet financing, in that the arrangement, from an accounting perspective, is structured as a sale rather than a loan. 7. Other Types of Asset-Based Transactions a. equipment leasing b. purchase of chattel paper, payment intangibles, promissory notes 8

II. Collateral Considerations and Related Documentation Requirements for an Asset-Based Loan A. Accounts and Inventory 1. Accounts Receivable. While there are other types of properties that can be the "assets" in asset based loans, accounts receivable and inventory are most often considered appropriate collateral. The frequent borrowings and repayments of asset based loans depend on the liquidity of accounts receivables and inventory. a. What is an account receivable or account? The Uniform Commercial Code ("UCC") defines Account as follows: "Account"... means a right to payment of a monetary obligation, whether or not earned by performance, (i) for property that has been or is to be sold, leased, licensed, assigned, or otherwise disposed of, (ii) for services rendered or to be rendered, (iii) for a policy of insurance issued or to be issued, (iv) for a secondary obligation incurred or to be incurred, (v) for energy provided or to be provided, (vi) for the use or hire of a vessel under a charter or other contract, (vii) arising out of the use of a credit or charge card or information contained on or for use with the card, or (viii) as winnings in a lottery or other game of chance operated or sponsored by a State, governmental unit of a State, or person licensed or authorized to operate the game by a State or governmental unit of a State. The term includes health-careinsurance receivables. The term does not include (i) rights to payment evidenced by chattel paper or an instrument, (ii) commercial tort claims, (iii) deposit accounts, (iv) investment property, (v) letter-of-credit rights or letters of credit, or (vi) rights to payment for money or funds advanced or sold, other than rights arising out of the use of a credit or charge card or information contained on or for use with the card. 9-102(a)(2) b. Borrowers generally use accounts receivable financing when there is a mismatch between collection of receivables (sources of cash) and expenditures necessary to conduct the business, such as payroll and replenishment of inventory. Today more companies delay payment of receivables to stretch their own cash flow, which can hamper a growing business. But cash shortages don't always indicate a thriving 9

2. Inventory business. Cash flow shortages can also be early warning signs of a failing business. The lender must have done its due diligence and know where on the spectrum the borrower lies. See Section IV below for further discussion. a. What is inventory? The UCC defines Inventory as follows: "Inventory" means goods, other than farm products, which: (A) (B) (C) (D) are leased by a person as lessor; are held by a person for sale or lease or to be furnished under a contract of service; are furnished by a person under a contract of service; or consist of raw materials, work in process, or materials used or consumed in a business. 9-102(a)(48) b. Because inventory is a subset of goods, then we must determine what "goods" are. i. "Goods" means all things that are movable when a security interest attaches. The term includes (i) fixtures, (ii) standing timber that is to be cut and removed under a conveyance or contract for sale, (iii) the unborn young of animals, (iv) crops grown, growing, or to be grown, even if the crops are produced on trees, vines, or bushes, and (v) manufactured homes. The term also includes a computer program embedded in goods and any supporting information provided in connection with a transaction relating to the program if (I) the program is associated with the goods in such a manner that it customarily is considered part of the goods, or (ii) by becoming the owner of the goods, a person acquires a right to use the program in connection with the goods. The term does not include a computer program embedded in goods that consist solely of the medium in which the program is embedded. The term also does not include accounts, chattel paper, commercial tort claims, deposit accounts, documents, general intangibles, instruments, investment property, letter-of-credit rights, letters of credit, money, or oil, gas, or other minerals before extraction. 10

9-102(a)(44) ii. iii. A security interest in inventory may be limited to a specific item or items of inventory or may include all inventory and may include inventory acquired in the future. 9-214(a). A security interest in inventory automatically attaches to proceeds of inventory which would include accounts receivable. Proceeds include whatever is received when the inventory is sold, leased or otherwise disposed of. A lender considering providing a line of credit based on accounts must determine not only if there are existing security interests in accounts but also if there are security interests in inventory. If security interests in inventory are effective, without a release or lien subordination, the lender proposing to make loans based on the value of inventory may not receive a first priority lien in proceeds. Property in the hands of one debtor may be inventory and in the hands of another debtor may be equipment. For instance, if the debtor is a farmer, the truck that takes produce to market is probably equipment. However, if the debtor operates a car dealership, then the truck is probably inventory (held for sale or lease). B. Equipment 1. Equipment is defined by exclusion and is defined as goods which are not consumer goods, inventory or farm products. Equipment is often not easily converted to cash and, while included as collateral for asset based loans, its relative illiquidity requires its value to be considered and used differently than accounts and inventory. 2. When equipment is included as collateral in asset based lending transactions, there are several forms of lending structures which may be used, depending on the needs of the borrower and other factors: a. purchase money - capital expenditure/equipment line of credit b. term loan - equipment and sometimes other capital assets (real estate) serve as security for a term loan facility c. additional collateral for revolving line of credit 11

3. Purchase Money Financing - This type of financing occurs when the lender provides funds to its borrower for purchases of equipment. 9-103(a)(2) defines "purchase money obligation." The "obligation" may include not only the actual price of the equipment but also expenses incurred in connection with the purchase, such as sales taxes, freight charges, etc. ("soft costs"). Purchase money financing allows the lender to obtain purchase money priority in non-inventory collateral if the lender properly perfects its security interest by filing a financing statement not more than 20 days after the borrower receives possession of the equipment 9-324(a). If perfected, the lender's security interest will have priority over other conflicting security interests in the collateral (i.e., after acquired property provisions) even though other creditors may have earlier filed financing statements. a. Comment 3 to 9-324 helps determine when "possession" occurs if the borrower takes delivery in stages with assembly occurring after delivery. In this situation, the buyer takes "possession" after the equipment has been inspected. However, when "possession" occurs and triggers the 20 day filing deadline is not always clear. 4. Term Loan Facility - If equipment serves as the collateral for a term loan, the lender must consider that the value of equipment generally declines as the equipment ages, is used, and/or becomes obsolete. Repayment of loans based on equipment values thus must be paid from the cash flow of the borrower. While the initial loan is based on the value of the equipment, a lender will require that the borrower have sufficient cash flow for payments at least equal to the depreciation of the equipment. The "value" of the equipment can vary however it is most often determined by the liquidation value of the equipment, which assumes a short sale period. a. With both equipment lines of credit and term loans, if equipment is sold, the net proceeds from the sale of any such equipment should be paid to the lender to either increase availability under an equipment line of credit or applied to last maturing installment under the term loan. If the borrower uses proceeds to purchase additional equipment in which the lender will have a first priority security interest, the lender may not require it receive the proceeds from the sale but should insure it maintains its perfected lien in the replacement equipment. De minimus sales of equipment are sometimes permitted without the lender's consent and/or without the payment of proceeds from the sale of the equipment to the lender. 12

C. Article 9 Considerations Grant of Security Interest and Perfection/pre-filing requirements 1. Description of Collateral When describing the collateral in the granting instrument, the collateral description can be relatively broad or narrow; however, very broad descriptions in the granting instrument such as "all assets" or "all personal property" will not be effective to reasonably identify the property. 9-108(c). a. The description of the collateral in the financing statement doesn't have to be as specific as the description in the security agreement. The security agreement describes the personal property or types of personal property to be encumbered while the financing statement puts third parties on notice that a security interest exists. Section 9-504 provides that the more generic collateral description in a financing statement is sufficient if the security agreement provides sufficient definition of collateral so a security interest can attach. 2. Granting of Security Interest - The security agreement can be simple or complicated but it doesn't have to be complicated to be effective as long as it contains the following required elements. a. The Grant of a Security Interest - The granting language in a security agreement is usually straight forward: i. "The Borrower hereby grants to the Lender, to secure the payment and performance in full of all the Obligations, a security interest in and pledges and assigns to the Lender, the following properties, assets and rights of the Company, wherever located, whether now owned or hereafter acquired or arising, and all proceeds and products thereof (all of the foregoing being hereinafter called the "Collateral"):" ii. The security agreement would then describe the types or classes of assets in which the lender is to receive a security interest. b. A Description of the Collateral The list of personal property included in the definition of "Collateral" is often the types or classes of assets defined in the UCC. Often, if the lender intends to receive a security interest in all the personal property of the borrower, the description of the collateral will include a general phrase such as "all personal property of every kind;" however, it is imperative that the security 13

agreement include a specific list of the asset types or classes such as accounts, goods, instruments, etc. c. An Authentication by Debtor - The debtor must sign or otherwise indicate its acceptance of the security agreement. "Authenticate" is defined in the UCC to mean either (a) to sign or (b) with present intent to adopt or accept a record, to attach to or logically associate with the record an electronic sound, symbol, or process. 9-102(a)(7). A "record" is defined as information that is inscribed on a tangible medium or which is stored in an electronic or other medium and is retrievable in perceivable form. 9-102(a)(70) 3. Attachment a. When the security interest becomes enforceable against the debtor, it is called attachment. 9-203(a). For a security interest to attach, the following events must occur: (a) value is given by lender, (b) the debtor has rights in the collateral and (c) either (i) the debtor authenticated a security agreement, (ii) the collateral is not a certificated security and is in the possession of the secured party pursuant to 9-313 pursuant to security agreement, (iii) collateral is a certificated security in registered form and the certificate is delivered to the secured party pursuant to 8-301 pursuant to security agreement, or (iv) the collateral is deposit accounts, electronic chattel paper, investment property or letter of credit rights and the secured party has control under 9-104, 9-105, 9-106 or 9-107 pursuant to the security agreement. 9-203(b) b. Attachment is important because attachment of a security interest gives the lender rights in the collateral and proceeds of the collateral. 9-315 4. Perfection of a Security Interest a. In order for the security interest to be effective against the borrower, third parties and others claiming through the borrower, such as a trustee in bankruptcy, the security interest must be perfected. Section 9-308 provides a security interest is perfected if (a) it has attached and (b) the steps for perfection in 9-310 through 9-316 have been satisfied. 14

b. Elements to attain "perfection:" i. Section 9-310 - provides as a general rule that perfection requires that a financing statement must be filed. Other sections (9-311 through 9-316) provide rules for perfection of security interests in particular types of property such as chattel paper, deposit accounts, and when filing isn't necessary, for instance when the secured party has possession of the personal property. ii. Section 9-310 says you should file a financing statement but where should it be filed? The "where" is determined by the debtor's location. Section 9-307(b) provides the "location" of a debtor/borrower is determined as follows: (1) A debtor who is an individual is located at the individual's principal residence. (2) A debtor that is an organization and has only one place of business is located at its place of business. (3) A debtor that is an organization and has more than one place of business is located at its chief executive office. iii. However, if the debtor is an entity that registers under a state law to be formed, then Section 9-307 provides "the registered organization that is organized under the law of a State is located in that State." Before the 2001 amendments to the UCC, financing statements were filed in each jurisdiction in which the debtor's assets were located and some of those jurisdictions required filing in both a central office, such as a secretary of state, and a local office, such as a register of deeds, to perfect security interests in the property located in those jurisdictions. Now, only one filing is necessary - a filing in the office designated by the state in which the debtor was organized. 5. Possession/Control a. When is possession of personal property necessary or desirable for perfection of a security interest? Section 9-313 provides that, with limited exception, "a secured party may perfect a security interest in negotiable documents, goods, instruments, money, or tangible chattel paper by taking possession of the collateral." A secured party may perfect a security interest in certificated securities by taking delivery of 15

the certificated securities under Section 8-301. But wait - it says "may." Does that mean it is optional? When considering how to perfect security interests in instruments, certificated securities, tangible chattel paper, and goods, a financing statement can be filed but possession will result in the secured party with possession having priority over a secured party perfected only by filing. 9-312(a), 9-304, 9-305 and 9-308. Money is a type of collateral in which a security interest can only be perfected by possession. b. With some types of property, control is the only method of perfection. A common type of collateral in asset based loans is a deposit account. Other types include investment property, electronic chattel paper and letter of credit rights. Each of the UCC sections dealing with control of an asset class describe how control is achieved. For instance, "control" of investment property contemplates delivery of the property if certificated, an agreement by the issuer of uncertificated securities that the issuer will honor instructions from the lender without further consent of the borrower and an agreement by a bank or other securities intermediary holding a securities account that it will instructions from the lender without further consent of the borrower. D. Borrowing Base/Eligibility Requirements 1. What is a borrowing base? The borrowing base is the sum of the amounts the borrower may borrow against the collateral and has several components. Together with the maximum credit facility, the borrowing base limits the amount a borrower can borrow at any one time. The maximum is usually described as the lesser of (1) the revolving line of credit amount or (2) the borrowing base (i.e., the sum of 80% of the value of Eligible Accounts plus 50% of the value of Eligible Inventory) less the principal amount of the revolving loans then outstanding. Other deductions from the borrowing base are discussed below. 2. What collateral is included in the calculation - concept of eligibility a. All Accounts are not treated equally for purposes of borrowing against their values. An Account owing by an account debtor in bankruptcy will not be as valuable to the borrower or the lender than an Account owing by a non-bankruptcy account debtor. Eligibility criteria are generally lengthy and detailed, especially in loan transactions where the facility is extended pursuant to a commitment and the lender must lend on the eligible collateral (as contrasted with discretionary 16

facilities where the lender may or may not advance funds based on its discretion). The definition of Eligible Accounts generally starts by including all Accounts, then describing general minimum requirements for inclusion, and then listing the exclusions from eligibility. Below are some common eligibility criteria for Accounts with brief explanations. i. Eligible Account - an Account which arises in the ordinary course of Borrower's business from the sale of goods or rendition of services, is payable in Dollars, is subject to Lender's valid and duly perfected first priority Lien, and is deemed by Lender, in its discretion based on its usual and customary credit and collateral considerations, to be an Eligible Account. Without limiting the generality of the foregoing, no Account shall be an Eligible Account if: Account Eligibility Criteria it arises out of a sale made by a Borrower to a Subsidiary or an Affiliate of any Borrower, or a Person controlled by an Affiliate of any Borrower it is due or unpaid more than (x) 60 days after the original due date shown on the invoice or (y) 90 days after the original invoice date 20% or more of the aggregate amount of unpaid Accounts from the account debtor are deemed not to be Eligible Accounts hereunder the aggregate amount of unpaid Accounts from the account debtor exceeds 10% of the aggregate amount of all Eligible Accounts or exceed a credit limit established by Lender for such account debtor, in each case, to the extent of such excess any covenant, representation or warranty contained in this Agreement with respect to such Account has been breached Explanation/Purpose prevents advances against intercompany transactions, which may be more easily manipulated and less likely to be paid ensures Lender isn't advancing against old Accounts for which collection may be doubtful; prevents extended dating if more than the stated percentage of the accounts are ineligible, the lender can exclude the remainder which could prevent the lender from having to advance against new accounts owing by an account debtor in financial distress (often referred to as "cross-age" this prevents a concentration of loans based on the credit worthiness of a single account debtor. This percentage may vary by account debtor, depending on financial strength or weakness ensures the representations and covenants in the loan documents relating to Accounts are true (i.e., borrower is the owner of the account; lender has a perfected first priority lien) 17

Account Eligibility Criteria the account debtor is also Borrower's creditor or supplier, or has disputed liability with respect to such Account, or has made any claim with respect to any other Account due from such account debtor to Borrower, or the Account otherwise is or may become subject to any right of setoff, counterclaim, recoupment, reserve, defense or chargeback, an Insolvency Proceeding has been commenced by or against the account debtor or the account debtor has failed, suspended or ceased doing business the account debtor is not solvent the account debtor is organized under the laws of any jurisdiction outside of the United States or has its principal office, assets or place of business outside the United States, except to the extent that the Account is supported or secured by a letter of credit or credit insurance that is acceptable in all respects to Lender and duly assigned to Lender it arises from a sale to the account debtor on a billand-hold, guaranteed sale, sale-or-return, sale-onapproval, consignment or any other repurchase or return basis Explanation/Purpose ensures the Account will be paid in full and not subject to set off or dispute; generally ineligibility limited to the amount of the dispute, setoff, etc. excludes all Accounts owing by a bankruptcy account debtor, whether pre- or post-petition if the account debtor is insolvent (not able to pay debts as they become due; fair market value of liabilities greater than fair market value of assets; unreasonably small capital) payment to Borrower is doubtful considers the lower likelihood of collection from a foreign account debtor considers the inventory sale giving rise to the Account may be returned 18

Account Eligibility Criteria the account debtor is the United States of America or any department, agency or instrumentality thereof, unless the applicable Borrower is not prohibited from assigning the Account and does assign its right to payment of such Account to Lender, in a manner satisfactory to Lender, so as to comply with the Assignment of Claims Act of 1940 (31 U.S.C. 3727 and 41 U.S.C. 15), or is a state, county or municipality, or a political subdivision or agency thereof and Applicable Law disallows or restricts an assignment of Accounts on which it is the account debtor the account debtor is located in any state which imposes conditions on the right of a creditor to collect accounts receivable unless the applicable Borrower has either qualified to transact business in such state as a foreign entity or filed a Notice of Business Activities Report or other required report with the appropriate officials in such state for the then current year the Account is subject to a Lien other than a Permitted Lien the goods giving rise to such Account have not been delivered to and accepted by the account debtor or the services giving rise to such Account have not been performed by Borrower and accepted by the account debtor or the Account otherwise does not represent a final sale the Account is evidenced by Chattel Paper or an Instrument of any kind, or has been reduced to judgment the Account represents a progress billing or a retainage or arises from a sale on a cash-ondelivery basis Explanation/Purpose contracts with the United States giving rise to Accounts are subject to specific requirements not found in the UCC; many states have explicit restrictions on the assignability of accounts owing by them (the prohibitions override the free assignability provisions in the UCC) some states have provisions which prohibit a party from availing itself of use of the court system unless the party is qualified to do business in such state or has filed required reports. if the Account is subject to a prior lien, proceeds of the collection should be paid to prior lienholder; if Lender receives the proceeds the proceeds may be subject to the prior lien non-acceptance of goods and non-performance of services give rise to defenses; as assignee, Lender takes assignment subject to defenses, set offs, etc. to which borrower is subject if evidenced by chattel paper or instrument, the debt is not an Account borrower's performance is not complete 19

Account Eligibility Criteria Borrower has made any agreement with the account debtor for any deduction therefrom, except for discounts or allowances which are made in the ordinary course of business for prompt payment and which discounts or allowances are reflected in the calculation of the face value of each invoice related to such Account Borrower has made an agreement with the account debtor to extend the time of payment thereof the Account represents, in whole or in part, a billing for interest, fees or late charges, provided that such Account shall be ineligible only to the extent of the amount of such billing Explanation/Purpose if outside the normal course and not reflected on the invoice, discounts and deductions dilute the value of the Account payment terms may be changed for any number of reasons but a change to accommodate an account debtor's deteriorating financial condition should be monitored; extensions of due dates may have a material effect on borrower's ability to repay the advances lender should finance inventory replacement or buildup and sales of that inventory; inclusion of interest and other charges inflates the face amount of the account b. As with Accounts, Inventory has its own set of eligibility criteria. i. Eligible Inventory - Inventory which is owned by Borrower (other than packaging or shipping materials, labels, samples, display items, bags, replacement parts and manufacturing supplies) and which Lender, in its discretion based on its usual and customary credit and collateral considerations, deems to be Eligible Inventory. Without limiting the generality of the foregoing, no Inventory shall be Eligible Inventory unless: Inventory Eligibility Criteria it is finished goods Explanation easiest to sell; in some circumstances, raw materials may be eligible Inventory; a lender doesn't want to advance on inventory that needs further work before it can be sold and an Account created 20

Inventory Eligibility Criteria it is held for sale or lease by Borrower in the ordinary course of business and it is not held by Borrower on consignment from or subject to any guaranteed sale, sale-or-return, sale-on-approval or repurchase agreement with any supplier is not damaged, defective, shopworn or otherwise unfit for sale or lease it is not slow-moving, obsolete or unmerchantable and is not goods repossessed from an account debtor; it meets all standards imposed by any Governmental Authority and does not constitute hazardous materials under any Environmental Law it conforms in all respects to the warranties and representations set forth in this Agreement and is fully insured in the manner required by this Agreement it is at all times subject to Lender's duly perfected, first priority Lien and no other Lien except a Permitted Lien is not in transit or outside the continental United States and is not consigned to any Person (excluding Inventory in transit in the continental United States between Borrowers or their Subsidiaries and customers of Borrowers or their Subsidiaries in the Ordinary Course of Business) it is not the subject of a negotiable warehouse receipt or other negotiable Document it has not been sold and Borrower has not received any deposit or downpayment in respect thereof in anticipation of a sale Explanation if inventory is owned by a third party yet is in borrower's possession, lender's lien can't attach and inventory is subject to repossession by owner inventory must be saleable slow-moving or obsolete inventory that isn't saleable should be written off by borrower; increases in obsolete inventory or write-offs often provide warning to lender re liquidation values, life cycle of borrower's business inventory not meeting specific standards and specifications is subject to return or rejection by purchaser ensures the representations and covenants in the loan documents relating to Inventory are true (i.e., borrower is the owner) if the Inventory is subject to a prior lien, proceeds of the collection (i.e., the Account) may be subject to the prior lien considers the risk of loss of inventory in transit to a buyer and the likelihood of not being able to easily retrieve inventory outside the US; consigned inventory difficult to monitor and control such inventory is not in the control or possession of borrower and requires delivery of a negotiable document to obtain possession inventory subject to bill and hold or similar arrangement isn't owned by borrower and should be segregated from owned inventory 21

c. What are the appropriate advance rates against eligible collateral - generally, a lender will advance between 80%-85% of the value of Eligible Accounts and between 50%-60% of the value of Eligible Inventory. The appropriate advance rates depend on the underwriting of the credit facility (see Section IV below) and the liquidation value of the asset category. Less cushion is needed for loans against Eligible Accounts than for Eligible Inventory because accounts are more readily converted to cash than inventory, which has not yet been sold, resulting in higher advance rates against accounts. d. What is the maximum revolving credit facility made available to the borrower - the maximum credit facility depends on the borrower's needs, the eligible collateral and the lender's underwriting criteria. See Section IV below e. Are there other amounts to be added or deducted from the borrowing based calculation - see paragraph F of this Section II E. Representations and Covenants Peculiar to ABL Facilities. Certain representations and covenants appear in almost all loan agreements. These include but are not limited to representations and covenants as to the borrower's corporate/limited liability company good standing or existence in the state of its formation and in other states in which it must be authorized to do business, authority to enter the loan documents, completeness of financial statements provided to the lender, and the existence of no litigation. However, there are certain representations and covenants that are peculiar to asset based facilities relating to the collateral and its value. 1. Collateral 2. Accounts a. borrower owns the collateral b. the collateral is and will be insured against loss or damage c. lender will have the right to obtain updated appraisals (both inventory and equipment) d. borrower will preserve the value of all collateral e. will be located on the premises disclosed to lender a. accurate and complete records of accounts and all payments b. no undisclosed discounts, disputes, returns 22

3. Inventory c. authority of lender to verify accounts e. Equipment d. maintenance of deposit account to receive proceeds of accounts (not always required) a. accurate and complete records of inventory purchases and withdrawals b. returns promptly disclosed to the lender c. no consignment, bill and hold inventory d. borrower will produce, use, store and maintain all Inventory with all reasonable care and in accordance with applicable law f. accurate and complete records and schedules of equipment g. dispositions only as permitted pursuant to the provisions of the loan agreement or as otherwise consented to by lender in writing h. maintain and preserve in good operating condition and repair, and all necessary replacements of and repairs thereto, normal wear and tear excepted F. Representations and covenants are made on a continuing basis and are explicitly deemed to be remade with each advance. 1. The lender may rely on borrowing base as to which accounts and what inventory are eligible and that all accounts and inventory, unless disclosed otherwise, meet the eligibility criteria 2. Each Account: a. is genuine and not evidenced by a judgment b. arises out of completed sale of goods or rendition of services in the borrower's ordinary course of business c. is for sum certain d. lender's lien in the account won't be subject to offset, lien, deduction, defense, dispute, counterclaim 23

3. Inventory: e. the contract under which the account arose doesn't prohibit assignment of the account unless consent of account debtor obtained f. no agreement for any extension, compromise, settlement or modification of the account or any deduction therefrom, except discounts or allowances which are granted by borrower in the ordinary course of its business g. no facts known to borrower which would impair collectibility of the account h. to the best of borrower's knowledge, the account debtor had the capacity to contract and is solvent and borrower has no knowledge that account debtor's financial condition has suffered a material adverse change i. visits and audits G. "Clean-up" Provisions j. no other liens except as specifically permitted a. will be located on the premises disclosed to lender b. will not be stored with a bailee, warehouseman or similar party without Lender's prior written consent c. will be new Inventory of good and merchantable quality, free from defects. 1. An asset based lender may expect there will be loans outstanding during the entire term of the line of credit. Often a borrower is penalized for failure to use the full line of credit by the imposition of an unused line fee. Theoretically, if a lender has committed to its borrower that it will have the funds available to loan to the borrower, when the borrower doesn't use, or under uses, the line of credit, the lender hasn't achieved the return on its funds it expected. Conversely, there may be circumstances under which the lender may want a borrower to repay the loans in full for a limited period of time. This required repayment, or "clean up," may be appropriate if a lender, such as a bank, has less stringent monitoring requirements (i.e., fewer borrowing base certificates and audits of the collateral) and further has the expectation that the loans will be repaid primarily from operating cash flow and not from the collection of accounts and the sales of inventory. Often the "clean up" 24

period is selected so that the payout, usually for a 30 day period, is to occur when the borrower's need for cash is typically low. Smaller financial institutions with fewer monitoring capabilities might require the "clean up" to assure itself that the borrower, in fact, has the ability to repay the line of credit at maturity. H. Overadvance Concepts 1. If the total revolving loans exceed the borrowing base, an "overadvance" exists and the amount of the overadvance is required to be paid immediately. For example, an overadvance may arise when there is a limit on the amount of loans which may be outstanding based on the value of inventory (i.e. 50% of the total loans outstanding) and there is a large payment on accounts without a similar increase in sales. 2. Overadvances may arise because of the seasonal nature of the borrower's business. The borrower may require a large build up of inventory to meet future demand and sales aren't currently projected. For instance, a fireworks manufacturer may spend the winter months building inventory for July 4 celebrations; however, sales of the inventory are anticipated to occur for many months. If the borrower and lender have not planned for such seasonality, overadvances will occur annually. 3. Additionally, overadvances may be a warning sign of a failing borrower. Inventory may remain unsold or collections of accounts may be doubtful. Recurring and unpaid overadvances should be closely monitored. I. Reserves and Dilution Issues 1. Reserves against availability under a line of credit can be established for a variety of reasons. In most ABL transactions, there will be, at minimum, a general availability reserve. The reserve does what it says - it subtracts from amounts otherwise available under the borrowing base formula amounts the lender considers may be necessary to be paid (i.e., to pay rent for the location at which books and records relating to accounts and inventory and equipment is located so the lender can access its collateral), to account for changes in financial condition, or which the lender believes will affect the value of the collateral. Below are some examples of reserve provisions. 2. Which reserves are established is dependent on the financial strength of the borrower, underwriting requirements, the materiality of the potential payment and other factors. For instance, if the borrower has one location and a modest rent/lease payment or the landlord is an affiliate of the borrower, the lender 25

may agree a rent reserve isn't needed; however, if the borrower has multiple retail locations with relatively high rents plus obligations for repair, maintenance, taxes, insurance, and common area expenses, not reserving for the payment of those amounts following an event of default could result in a significant expenditure which the lender will be forced to advance as an additional loan. a. Availability Reserve - on any date of determination thereof, the amount equal to the sum of: (i) the Minimum Availability Reserve, (ii) the Inventory Reserve, (iii) the Rent Reserve; (iv) the Dilution Reserve; (v) any amounts which the Borrower is obligated to pay to Lender or other Persons pursuant to the provisions of any of the Loan Documents that Lender elects to pay for the account of the Borrower in accordance with authority contained in any of the Loan Documents; (vi) the aggregate amount of reserves established by Lender from time to time in its sole discretion in respect of Banking Relationship Debt [hedging obligations; credit cards; cash management agreements with the lender or any of its affiliates]; (vii) the aggregate amount of all liabilities and obligations that are secured by Liens upon any of the Collateral that are senior in priority to Lender's Liens if such Liens are not Permitted Liens (provided that the imposition of a reserve hereunder on account of such Liens shall not be deemed a waiver of the Event of Default that arises from the existence of such Liens) or are Permitted Liens under the Loan Agreement; and (viii) such additional reserves, in such amounts and with respect to such matters, as Lender gent in its discretion may elect to impose from time to time. b. Dilution Reserve - an amount equal to the excess of (i) non-cash reductions to Borrowers' Accounts during a 12-month period prior to the date of determination as determined by Lender, expressed as a percentage of Borrowers' Accounts outstanding during the same period over (ii) 5%, multiplied by an amount equal to Eligible Accounts as of the date of determination. c. Inventory Reserve - such reserves as may be established from time to time by Lender with respect to reflect changes in the salability of any Eligible Inventory in the ordinary course of Borrower's business or such other factors as may negatively impact the value of any Eligible Inventory. Without limiting the generality of the foregoing, such reserves may include reserves based on obsolescence, seasonality, theft or other shrinkage, imbalance, change in composition or mix, markdowns, and vendor chargebacks. 26

d. Minimum Availability Reserve - a reserve in the amount of $. e. Rent Reserve - on any date, the aggregate of (i) all past due rent, fees or other charges owing on such date by the Borrower to any landlord of any premises where any of the Collateral is located or to any processor, repairman, mechanic or other person who is in possession of any Collateral or has asserted any Lien or claim thereto, and (ii) a reserve equal to 3 months rent or other charges with respect to any Collateral in the possession of, or at a location owned by, a Person other than a Borrower if such Person has not duly executed and delivered to Lender a landlord's lien waiver satisfactory to Lender. 27

III. Ancillary Documentation and Closing Considerations A. Conditions Precedent to Closing: The parties to an ABL transaction should insure that the there is a clear path to closing the initial transaction. Counsel for both the lender and the borrower should agree on documentation and procedures that are required to be completed and in place in order for the transaction to close. The following is a list of typical conditions precedent to closing, some of which are typical for all loan closings, and others peculiar to and asset-based transaction: 1. Loan Documents, including Borrowing Base Certificate 2. Minimum Availability (based on borrowing-base formula plus available cash) 3. Collateral Audits, Appraisals and Inventory Reporting (necessary to confirming Availability) 4. Cash Management Systems and Deposit Account Control Agreements (with Agent or third-party financial institution) 5. Collateral Access Agreements, including agreements with Landlords, Mortgagees, Bailees and other third parties in possession of collateral (in a work-out situation, these forms of agreements are critical for Lender to gain access to the collateral and to protect it from third parties) 6. UCC and other Lien Searches (special consideration should be given as to where to search and what to search) 7. Repayment of Prior Lender Obligations and Terminations of Existing Liens (Lien searches may turn up additional liens that require terminating) 8. Insurance, including general liability, property, and key man life 9. Corporate Matters, including Charter Documents, Good Standing Certificates, Certificates of Foreign Qualification, Authorizing Resolutions, Incumbency Certificates and Secretary s Certificates 10. Officer s Certificate as to factual representations in the Loan Documents 11. Solvency Certificate 12. Legal Opinions, including local counsel opinions 13. Financial Statements and Projections 14. Payment of Fees 28

15. Intercreditor and Subordination Agreements (negotiation and documentation of these types of agreements can be time consuming, and they should be early lead time items) 16. No Material Adverse Change 17. Know Your Customer Information 18. Post-Closing List (careful consideration as to which items may be closed over ) B. Payoff and Termination Letters 1. Timing and Notice to Existing Lender, including confirmation of compliance with or waiver of any advance notice requirements for early termination of existing commitments and/or early termination or pre-payment fees. 2. Release of Debt a. Limit to obligations under Existing Credit Agreement and related Loan Documents b. Carve out for any remaining obligations not being transferred to the new lender (Letters of Credit, Swaps other Bank Products) 3. Release and Discharge of Security a. Delivery of lien releases or authorization to terminate liens b. Third Party Documents requiring Notice of Termination c. Return of Physical Collateral (stock certificates, notes, etc.) d. Clawback provisions (new lender wants to reduce Borrower s exposure to prior lender) e. Further assurances 4. Bank Accounts and Checks a. Mechanism and Time Frame for Chargebacks b. Termination of Existing Deposit Account Control Agreements 5. Mechanics of Payout 29

C. Cash Management, Deposit Account Control Agreements and Lockboxes 1. Bank Accounts with Agent or Another Institution 2. Acknowledgment of Security Interest and Control (special considerations in cases of government healthcare receivables) 3. Cash Sweep a. Effective on Closing b. Springing upon Trigger Event (Minimum Availability or Event of Default) 4. Collection Accounts 5. Chargebacks 6. Indemnity from Agent to Account Bank D. Collateral Access Agreements 1. Landlord Agreements a. Landlord Waiver of Rights to Distraint or Levy b. Notice of Amendment, Consent, Waiver and Default c. Access Rights for Agent and its representatives prior to Default d. Access Rights for Agent and its representatives after Default i. Disposition Period ii. Extension for Stay in Bankruptcy e. Borrowing Base Rent Reserves 2. Bailee, Storage, Processing and Other Third Party Waivers E. Subordination/Intercreditor Agreements 1. Identify Nature of Competing Liens (First Lien/Second Lien, Revolving/Term Liens, Full Subordination) 2. Priorities (payment and security) 3. Restrictions on Repayment 30

4. Standstill F. Insurance Requirements 1. Certificate of Insurance 2. Insurance Policy Endorsements 3. Agent as Loss Payee 4. Agent as Additional Insured 5. Notice of Cancellation or material Amendment 6. Termination of Prior Lender s Loss Payee and Additional Insured Rights 31

IV. Monitoring/Administration and Enforcement A. Collateral Audits 1 1. Bankable Loans: The focus on these loans is more upon the business operation of the debtor and the cash that is generated with collateral coverage in the event that the business fails however usually leaving the borrower in control of its cash and negative covenants in the loan documentation. These loans usually have loan agreement covenants that are tested on a periodic basis with periodic reports usually independent accounting financial reports, supplemented with more frequent internally-generated borrower reports and certifications financial, A/R, Inventory, ratios, etc. Guarding against: a. Decline of Business Operations: Trip-wire financial covenants in documentation, tested by financial statements and documents, for example: i. Minimum Net Worth: Tangible or modified net worth covenant stating minimum at any time. ii. iii. iv. Minimum Net Income Current (or Quick) Ratio: Minimum ratio of current assets to current liabilities ability to pay current indebtedness from current assets being tested. Debt Service Coverage Ratio: Usually a minimum ratio of EBITDA to the total debt service of the borrower - showing the ability of the borrower to pay its total debt service. v. Fixed Charge Coverage Ratio: Minimum ratio of EBITDA minus cash taxes minus distributions minus capital expenditures to total debt service showing the ability of the borrower to pay its debt service from net available earnings cash in the business. vi. Others: Covenants usually structured to measure the performance of the Borrower in its particular industry for example, in healthcare census numbers, Medicare approvals, patient mix, etc. 1 Note the difference in loan treatment and concerns in loans that are bankable (i.e. lines of credit with asset-based borrowing covenant limits) versus true asset-based loans (typically evergreen loans with capture of all cash proceeds, factoring, etc.). 32

b. Decline of Collateral Value: Somewhat less concern for bankable business where the source or repayment is considered to be the ongoing business operation and collateral is viewed as a stop-gap in the event the business fails and cannot be sold as a going concern. i. Initial Determination of Collateral Value: Initial inventory of equipment and real estate as boot collateral and initial audit of inventory and listing of accounts receivable (usually with a blank letter to be sent to account debtors after a default to make payments to the Lender). The usual test is at the closing of the loan and is updated periodically by internal reports of A/R and Inventory, as required in the loan documentation. ii. Occasional Periodic Checks and Appraisals After Closing: (a) On a periodic basis with schedule set in loan documentation with the cost of any independent audit or appraisals paid by borrower subject to negotiation in the loan documents by limit on number or cost. (b) At any time at discretion of lender, at borrower s cost, upon occurrence of an event of default (i.e., one of the trip wires ). iii. Periodic Compliance Certificates: In such bankable loans frequently the borrower is required on a periodic basis (monthly or quarterly) to prepare a certification to the lender stating the amount of the borrower s eligible A/R, Inventory and other components of the loan agreement covenants to demonstrate compliance. If the borrower does not comply with these covenants it is considered an event of default, but at that point the line of credit loan has already been advanced. 2. Asset-Based Loans: These loans are much more focused on the value and operation of the collateral underlying the advances, with the thought that if the borrower fails the lender will be made whole on the loan, plus prepayment fees and expenses of liquidation of collateral purely from the collateral. Frequently the lender is in control of the cash generated from the proceeds of the collateral for example, through notification to account debtors to pay through lock-boxes controlled by the Bank that are swept on a frequent basis in payment of the floating loan balance (with usual allocation to fees, interest, costs and then to principal). These loans frequently require the borrower to update its borrowing base (by copies of A/R invoices to account debtors, 33

delivery receipts and use reports for purchased inventory, etc.) and to borrow on a daily basis. As a result the theory is that (absent fraud or an overadvance) the borrower cannot receive more than the amount of the advance rates applied to the components of the borrowing base. [NOTE: The fact that the borrower is constantly borrowing and repaying its loan on a daily basis, many times without substantially reducing the general amount of the outstanding indebtedness, resulted in calling these types of loans Ever- Green. ] a. Decline of Business Operations: Similar trip-wire covenants and the requirements of financial statements and reporting are added to the loan documentation for asset based loan transactions more for the purpose of catching a change in business that could affect the value of the collateral and to provide early warning of when to liquidate the collateral or require the business to be sold. Similar periodic reports are required but with more frequent checks. b. Decline of Collateral Value: The preservation of the value of the lender s collateral is very much at the forefront in asset-based lending transactions. Note that due to the frequent borrowing and updating of the borrowing base to permit frequent borrowing, the lender has a great deal of information on the actual performance of the A/R and Inventory. Notwithstanding this, due to risks of fraud or mismanagement of the borrower s business asset-based transactions typically require a greater degree of checking of the collateral and audits than a bankable loan transaction. Typical methods for investigation and verification include the following. i. Dilution of A/R: The advance rates for accounts receivable are established based upon historical and industry patterns and percentages of collections. The greater the amount and number of accounts that exceed the limit for eligibility (usually 90 days after invoice date) or that are ineligible due to concentration, foreign accounts, returns or claims, etc., the greater the dilution of the pool of accounts and the lower the advance rate should be for that borrower. This information is checked by the invoices sent to the lender as part of the borrowing base and the actual collections on these invoices received in the lender s lock box. 34

ii. iii. Verification of Accounts: Periodically the asset-based lender may inspect the borrower s records to verify the amounts of the accounts and will contact a sample of the account debtors to verify (i) the identity and essential information relating to account debtors (including United States nexus and no insider status), (ii) the amounts and timing of payments due on invoices; (iii) that no claims or offsets are being asserted or exist; and (iv) no concentration of accounts in a few account debtors (at least without substantial credit evaluation of these account debtors). This process also verifies the information needed in the event that the lender has to exercise its rights to collect the accounts under UCC Article 9. Inventory Issues: A periodic physical inventory of the work in process, inventory and finished goods located at the borrower s locations also is usually required to (i) verify the amount of inventory physically present; (ii) identify outdated or slow moving inventory that should be valued differently (subjected to a lower advance rate); (iii) verify no bill and hold or consignment or similar arrangement that could reduce the value of the inventory or accounts by indicating third parties with interests in the inventory or offsets to associated accounts; (iv) verify that inventory is not held in an independent warehouse or bailee (at least without obtaining a bailee agreement or negotiable document in favor of the lender). B. Fraud and Detection 1. Clearly one of the purposes of the reporting requirements and audits discussed above is to verify that the economic situation envisioned by the lender in the approval of the loan and is structure remains correct. A considerable number of times, however, when pressed for additional money to continue or expand operations, borrowers will view the advance rates being set by the lender as too conservative, justifying their view that they can take unilateral action to unlock value that they believe belongs to them and should be used in their business rather than to provide comfort for the lender. Examples include: a. Bill and Hold b. Fictitious Accounts or Inventory c. Change of Account Debtors or Businesses 35

d. Diversion of Payments From the Lock Box e. Kiting Schemes C. Article 9 Repossession and Liquidation 1. In general, specific rules are provided in Part 6 of Article 9 of the Uniform Commercial Code ( UCC ) in an attempt to provide bright line rules to reduce litigation. The Article 9 Part 6 default and enforcement rules are generally effective as of the effective date of Revised Article 9 in that state generally July 1, 2001, but October 1, 2001 in Connecticut and later in a few other states for transactions entered into before and after that date. UCC 9-702(a) In a conflict between Part 6 rules and loans governed by Retail Installment Sales Financing Act enacted in that state, RISFA prevails. 2. Default: Default is not a defined term. The agreement of the parties prevails on what constitutes a default and permits the secured party to exercise its remedies. UCC 9-601, Comment 3. 3. Commercial Reasonableness Requirement on Disposition: a. In secured party s disposition of collateral and collection of accounts, if recourse, every aspect must be commercially reasonable. UCC 9-610(b) and 9-607(c) b. The fact that a greater price could have been obtained does not make the disposition not commercially reasonable, but a low price will lead to greater review of the disposition. UCC 9-627(a) and Comment 2. c. However, low price dispositions to parties related to secured party or to secondary obligors may be subject to adjustment of any deficiency. UCC 9-615(f) d. Examples of commercially reasonable disposition are given in UCC 9-627(b) i.e., usual manner or current price on recognized market and conforming to reasonable commercial practices among dealers in similar property. e. This requirement cannot be waived or varied, but parties can determine standards which are effective if not manifestly unreasonable. UCC 9-602(7) and 9-603(a) f. However, the parties cannot set standards for breach of the peace. UCC 9-603(b) 36

4. Collection and Enforcement Against Rights to Payment: a. Secured party may exercise rights against account debtors and any other party obligated to make payment or performance. UCC 9-607(a) b. Note that the requirements for the notice to account debtors by the secured party are not contained in Part 6, but are in UCC 9-406. The account debtor is authorized to pay the debtor/assignor until it receives notification that the account has been assigned and that payment is to be made to the assignee. UCC 9-406(a) This notice is not effective unless the notice reasonably identify the rights assigned. UCC 9-406(b)(1). In addition to the above requirements for the notice, please note that the account debtor also may have no obligation to pay the secured party if either (a) another agreement (enforceable under other law) between the account debtor and the debtor restricts the right to assign the account; or (b) the notification requires the account debtor to pay only a portion of the amount owed to the debtor. UCC 9-406(b). Note that account debtors may also assert by right of recoupment any claim arising under the agreement giving rise to the account. Also the account debtors may assert a right of setoff against the account for any defense or claim which accrues against the debtor prior to the account debtor receiving a notification that the account has been assigned by the account debtor to the secured party. c. In considering commercially reasonable efforts in collection of accounts some steps or procedures that should be considered by the secured party include: i. Analysis of individual accounts; ii. iii. iv. Document all collection efforts; Close contact with debtor including cooperation or consulting agreements with principals of the debtor; Retention of professional collection agency in accounts of the kind; v. Obtaining account records and maintaining records of collections and responses by account debtors; and 37

vi. Protection of claims against account debtors and no impairment of claims or collateral for account debtor obligations without consideration of guarantors and effect on deficiency. d. Secured party may also take proceeds, and, if a depository bank, may apply the contents of any deposit accounts of which it has control or, if not a depository bank may instruct depository bank to turn over balance under a control agreement. e. If a sale of right to payment is with no recourse, commercial reasonableness and other requirements of Part 6 do not apply. UCC 9-607, Comment 9 f. Secured party may enforce a mortgage or other lien or may enforce rights in supporting obligations of other parties. UCC 9-607(b) and Comment 8. g. Some states (such as Connecticut) limited the nonjudicial foreclosure remedy in 9-607(b) so it is only available if permitted under other law. h. Noncash proceeds need not be applied against the secured obligation, unless not commercially reasonable. UCC 9-615(c) i. Junior secured parties may keep cash proceeds of a disposition in good faith and without knowledge that it violates the rights of a senior secured party. UCC 9-615(g) 5. Removal of Accessions and Enforcement Against Fixtures Collateral a. Enforcement of a right in fixtures is either under Article 9 (i.e,. removal and sale of the collateral) or under real property foreclosure law. UCC 9-604(b) and (c) b. If fixtures are removed, the secured party must reimburse the owner or encumbrancer of the property for the cost of repair of any physical injury caused by the removal, except for reduction in value due to the absence of the goods. [NOTE: by non-uniform amendment Connecticut permits this right to the debtor, as well. Be sure to check the applicable state.] Such owner or encumbrancer, other than the debtor, can withhold permission from the secured party to remove the fixtures until the secured party gives adequate assurance of performance of the reimbursement obligation. UCC 9-604(d) 38

c. Same rule on reimbursement of damages applies to removal of goods that are accessions. UCC 9-335(f) 6. Other Enforcement Options: Secured party may license collateral after default, in addition to sell lease or otherwise dispose of collateral. UCC 9-610(a) a. Implied warranties of title, possession, quiet enjoyment, etc. arise in disposition of collateral. UCC 9-610(d) However, these warranties may be disclaimed under UCC 9-610(e). 7. Notices and Accountings Required a. Notification of Disposition of Collateral: Except for collateral which is sold on a recognized market, is perishable or is speedily declining in value, notification of intended disposition at a public or private sale must be given. UCC 9-611(b) i. To: (a) the debtor; (b) any secondary obligor; (c) any party that has notified the secured party of a claimed interest in the collateral; and (d) any other party that held a security interest or lien perfected by filing a financing statement which is on file ten days before the notification date as to the debtor and said collateral. UCC 9-611(c) Note that this includes senior secured parties. ii. iii. Safe harbor for secured party that requests, in a commercially reasonable manner, a UCC search on the debtor between 20 and 30 days before notification and either does not receive a response or a secured creditor s interest is not shown on the search. Debtor, obligors and other secured parties have a right to redeem by tendering full amount of secured obligations. UCC 9-623(a) and (b) b. Safe Harbor Forms of Notice: i. Non-consumer form is found in UCC 9-613 Substantial compliance with requirement sufficient for non-consumer notice unless seriously misleading. UCC 9-613(2) and (3) 39

ii. Consumer form is found in UCC 9-614. Strict compliance with basic information as to: (a) debtor and secured party, (b) subject collateral, (c) method of intended disposition, (d) entitlement of debtor to accounting and any charges, (e) the time and place of public sale or time after which other disposition will occur, (f) description of any liability for a deficiency by notified party, (g) a telephone number to get payoff information for redemption, and (h) telephone number or mailing address to obtain additional information. UCC 9-614(1) and (5). c. Accounting for Surplus or Deficiency: Required for consumer goods transactions under UCC 9-616 after disposition of collateral. i. Explanation to be sent to consumer before secured party accounts to debtor and pays surplus or demands deficiency or within 14 days after receiving a request or send a notice waiving any deficiency. UCC 9-616 ii. iii. By Connecticut non-uniform amendment, failure to send such a notice imposes a statutory fee of $500.00 on secured party. Conn. Gen. Stat 42a-9-625(f). [ NOTE: Check your state law!!!!] No fee is permitted unless request is made more than once per 6-month period and may not exceed $25.00. UCC 9-616(e) 8. Acceptance of Collateral In Full or Partial Satisfaction: Significant expansion from old Article 9. A secured party may now propose to retain collateral in full or partial satisfaction of the obligation (except for consumer cases, where only full satisfaction is permitted). UCC 9-620 a. Intangible collateral may also be subject of strict foreclosure. UCC 9-620, Comment 7 b. Secured party must send authenticated proposal for retention in full or partial satisfaction to same parties as for notice of disposition of collateral and not receive an objection within 20 days. UCC 9-620(a) and 9-621. c. Debtor must consent, or be deemed to have consented (for retention in full satisfaction only) if no objection within 20 days. UCC 9-620(c) 40

d. The secured party is not to be deemed to have accepted collateral in satisfaction in absence of proposal by it. UCC 9-620(b) e. No safe harbor for a search of the filing office as with notice of disposition of collateral, however. f. The secured party may not retain consumer goods if 60% of cash price or secured obligation has been paid. UCC 9-620(e) 9. Deficiencies: A secured party is to apply the proceed of a disposition to pay reasonable costs of collection and enforcement, including reasonable attorneys fees and expenses, then to satisfy the secured obligation and finally to any junior secured parties that made demand on the secured party prior to distribution or to the debtor. The obligor is generally liable for any deficiency. UCC 9-608 and 9-615. a. Rebuttable presumption rule adopted for failure to comply with commercially reasonable disposition of collateral or non-compliance with Part 6. UCC 9-626(a) b. No inference on rule in consumer cases, but established approaches may be employed by courts in determining a rule. [NOTE: Connecticut specifically references RISFA as one such approach which might (but need not) be applied by analogy in consumer cases.] UCC 9-626(b) c. Statutory damages for non-compliance by secured party also found in UCC 9-625. d. Note the burden of proof requirements and shifting of the burden in UCC 9-626(b) 10. Waivers: The debtor or secondary obligors may waive right to notification of disposition of collateral, waive mandatory disposition of consumer goods collateral rather than strict foreclosure and waive the right to redeem collateral only by an agreement entered into and authenticated after default. UCC 9-624 Non-waivable provisions are contained in UCC 9-602. D. Bankruptcy Considerations in Enforcement By Secured Parties 1. Automatic Stay and Relief From Stay Issues. a. Automatic Stay (BC 362(a)): Immediately upon the filing of a petition under the Bankruptcy Code, either voluntary or involuntary, 41

all actions against the debtor and property of the debtor is subject to an automatic stay of any action for: i. Commencement or continuation of a judicial, administrative or other action against the debtor to recover a prepetition claim against the debtor that could have been commenced before the case. ii. iii. iv. Enforcement of a prepetition judgment. Any act to obtain possession of or control over property of the estate. Any act to create, perfect or enforce any lien against property of the estate. v. NOTE, however the exception for filings to perfect a purchase money security interest ( PMSI ) or continuation of financing statements. BC 362(b)(3) and 546(b)] b. Exceptions (BC 362(b)): i. Criminal proceedings. ii. iii. iv. Family proceedings. Certain lien (PMSI) filings and continuation statements. Enforcement by governmental entities of non-monetary police or regulatory power. v. Certain specified financial transactions commodity, stock, repurchase agreement transactions. vi. vii. Act by a lessor to regain possession of leased property where the lease term had expired or expires during the case. Miscellaneous governmental exceptions (i.e., IRS audits, etc.) c. Duration of Automatic Stay: i. Until the subject property is no longer property of the estate (whether by abandonment or otherwise). ii. The bankruptcy case is closed or dismissed. iii. A discharge is issued or denied under Chapter 7. 42

iv. BAPCPA 2 new rules making termination of the stay automatic for bad faith and multiple filings (i.e., if an individual s case was dismissed less than 1 year prior to the current filing, the stay expire 30 days after the filing of the later petition, unless extended by court order for good cause.) v. The court grants relief from the automatic stay on a motion by and interested party or a trustee i.e. vi. vii. viii. ix. For cause, including lack of adequate protection in property. Debtor does not have equity in the property and the property is not required for an effective reorganization. Single asset real estate entity rules. Transfers of real property or multiple filings to delay, hinder and defraud creditors. x. NOTE BAPCPA adds automatic termination of the stay 60 days after a motion for relief is filed, unless the court rules on the motion within the 60 days or sets a specific deadline date for specified good cause. d. Penalties for Violation of the Automatic Stay: Actual damages may be awarded, and in proper cases, attorneys fees and punitive damages. e. Additional Consumer and Small Business Restrictions on the Automatic Stay under BAPCPA. 2. No Lien on Post Petition Collateral Without Authorization (BC 552). Section 552(a) of the Bankruptcy Code provides that any property acquired by the debtor after the commencement of the bankruptcy case is not subject to the lien of any security interest entered into prior to the commencement of the case. Two (2) exceptions are set forth in subsection 552(b) for (i) proceeds of collateral acquired by the debtor prior to the commencement of the case that is subject to a security interest entered into prior to the commencement of the case; and (ii) in rents of property and fees, charges, accounts or other payments for the use or occupancy of rooms and other public facilities in hotels, motels or other lodging properties in which case the security interest 2 Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ( BAPCPA ) P.L. 109-8, 119 Stat. 23 this Act became generally effective on October 17, 2005. 43

continues in these payments generated after the commencement of the case unless and until the bankruptcy court orders otherwise 3. Use of Cash Collateral (BC 363) and Adequate Protection (BC 361) Note that the proceeds of the pre-petition collateral of the debtor that are subject to the secured party s security interest remain in effect under BC 552 and are defined and referred to as cash collateral in BC 363(a). Although the trustee (and debtor in possession ( DIP ) under Chapter 11) are not to use this cash collateral without the secured party s consent (and are to segregate and account for any cash collateral received), the trustee or DIP is specifically authorized to use cash collateral after an order of the bankruptcy court under BC 364(c)(2)(B), provided that the court provides adequate protection for the interest of the secured party. Adequate protection is defined by example in BC 361 to include (i) periodic payments to the extent that use results in a diminution in value (i.e., argument for interest), (ii) providing for an additional or replacement lien to the extent of the reduction in value -- rationale for a replacement lien on post-petition accounts and inventory for A/R and Inventory lender whose collateral is being consumed by the use; or (iii) such other relief as will give the entity the indubitable equivalent of its interest in the property. 3 4. Preferences (BC 443) a. It is common for lenders prior to taking enforcement action to have counsel the documentation to determine if additional collateral is available to reduce any potential losses or is or required to allow the secured party to effectively liquidate or to sell the business assets as a going concern. Typically if this review indicates that additional collateral is available or required the lender will use its influence over the debtor to require the debtor to grant additional liens or security interests to the lender to secure its indebtedness these actions are typically done prior to bankruptcy and, if concluded within 90 days prior to the filing, may result in scrutiny as a preference. 3 NOTE that under most circumstances advance rates requiring advances of less than 100% of the value of this collateral are used by debtors to argue that the secured party is over-secured and courts are typically sympathetic to these arguments. Counsel must present evidence of the dilution of accounts and the reasons for these advance rates to preserve them in a post-petition order for use of cash collateral. Typically secured creditors are best advised to negotiate with debtors to enter into stipulated orders and incorporation of pre-petition loan document terms and conditions to preserve these provisions, if possible. [NOTE: Panel members have seen horror stories of court allowance of 100% of the amount of all cash collateral, which, even with replacement liens, resulted in a substantial loss to the lender when the debtor s business declined during the course of the bankruptcy case and had to be liquidated or sold at an extreme discount.] 44

b. Definition of a Preference: The trustee may avoid a preference requiring it to be repaid to the estate under BC 547. A preference is a transfer of any interest of the debtor in property: i. to or for the benefit of a creditor; ii. iii. for or on account of an antecedent debt owing before the transfer was made; made while the debtor was insolvent a debtor is presumed to be insolvent 90 days prior to the filing of the petition [BC 547(f)] and a creditor has the burden of proving otherwise [BC 547(g)]; iv. made on or within 90 days prior to the filing of the petition unless made to an insider within one year prior to the filing; and v. which payment enables the creditor to receive more than the creditor would have received if the payment was not made and the creditor received a distribution in the case under Chapter 7. c. Exceptions (BC 547(b): Major exceptions for business purposes include the following: i. A contemporaneous exchange for new value. ii. iii. iv. A transfer made by the debtor in the ordinary course of business or made in accordance with ordinary business terms. [NOTE: BAPCPA changed the requirement to no longer require both tests to be satisfied.] Perfection of a contemporaneous exchange purchase money security interest (PMSI) within 30 days after the debtor receives the goods. [NOTE: BAPCPA extended the period from 20 days to 30 days and many states are now amending UCC Article 2 to follow.] To the extent that the creditor gave new value to the debtor after the preferential payment on an unsecured basis. v. Revolving security interests in accounts receivable and inventory permitted with a 90 day look-back test for improvement of position this period is one year for payments to an insider. 45

vi. New general business exception under BAPCPA of transfers of up to $5,000.00. d. Completed Transfer (BC 547(e)): A transfer occurs when a bona fide purchaser of real property or a judicial lien creditor cannot acquire a superior interest. e. Time Limit to Bring Case ( 546(a)): Note that a preference action must be brought against a creditor before the case is closed or dismissed and before the later of: i. Two years after the entry of the order for relief; or ii. One year after the appointment of a trustee in bankruptcy. f. New BAPCPA Exception: Any transfer made to a creditor that is a preference to an insider (for example payment of a debt guaranteed by an insider) between 90 days and one year before filing the petition is limited to being a preference to the insider not to the creditor. To finally overrule the DePrizio case. 5. Fraudulent Conveyances (BC 548) a. The trustee may avoid a fraudulent conveyance requiring it to be repaid to the estate. A fraudulent conveyance is a voluntarily or involuntarily transfer of any interest of the debtor in property or an obligation incurred (including, under BAPCPA, an employment agreement with an insider) within two years prior to the order for relief (formerly one year), if: i. made by the debtor with intent to hinder, defraud or delay creditors -- whether then existing or in the future; or ii. the debtor received less than reasonably equivalent value and (i) was insolvent, (ii) was rendered insolvent, (iii) was left with unreasonably small capital to engage in business, (iv) intended or believed it would incur debts beyond its ability to pay; or (v) was made to an insider other than in the ordinary course of business [NOTE: (v) is new under BAPCPA]. 6. Post-Petition Transfers (BC 549) a. The trustee may avoid any transfers of property of a debtor that is not authorized under the Bankruptcy Code after a voluntary petition is filed or after an order for relief has entered in an involuntary case. 46

7. Setoff Restrictions (BC 553) a. General Rule: Setoff of mutual claims is generally permitted. b. Exception: Mutual debts and claims acquired by assignment to obtain a setoff right within 90 days prior to, or after the commencement of, the bankruptcy case, while the debtor is insolvent will not be permitted. c. Improvement in Position Test: The trustee may also recover from the creditor any decrease in the amount of any insufficiency on the date of the commencement of the case and 90 days prior to the filing of the case. 8. General Avoidance Powers (BC 544) a. Real Property: The trustee may avoid any transfer of an interest granted by the debtor in real property if the trustee, as a hypothetical bona fide purchaser of the real property from the debtor on the date of the commencement of the case could avoid or have superior rights to the transferee under state law. b. Hypothetical Judgment Lien Creditor: The same concept gives the trustee the rights of a hypothetical judgment lien creditor under state law on the date of the commencement of the case to test transfers of any property. c. Hypothetical Execution Creditor: The same concept gives the trustee the rights of a hypothetical judgment creditor with an unsatisfied execution under state law on the date of the commencement of the case to test transfers of any property. d. Actual Creditor: The trustee can exercise the rights of any actual creditor that has an allowed unsecured claim in the bankruptcy case that could avoid the transfer under state law. 47