Lending and taking security in the United States: overview
A Q&A guide to finance in the United States. The Q&A gives a high level overview of the lending market, forms of security over assets, special purpose vehicles in secured lending, quasi-security, negative pledge, guarantees, and loan agreements. It covers creation and registration requirements for security interests; problem assets over which security is difficult to grant; risk areas for lenders; structuring the priority of debt; debt trading and transfer mechanisms; agent and trust concepts; enforcement of security interests and borrower insolvency; cross-border issues on loans; taxes; and proposals for reform.
To compare answers across multiple jurisdictions, visit the Lending and taking security in country Q&A tool.
This article is part of the global guide to finance. For a full list of contents visit www.practicallaw.com/finance-guide.
Overview of the US legal system
In the US federal system, both the federal government and the individual states have the power to pass statutes or laws.
Loan documents underlying secured transactions are based on contract law. The laws governing contracts are generally governed by state rather than federal law. This Q&A describes general principles of law governing secured transactions and does not describe differences between the laws on contracts of the various states. As New York law is widely used in commercial transactions, the information in this Q&A is based primarily on the law of the state of New York.
The laws governing creation and perfection of security interests in most property are state rather than federal laws. Security interests in most personal property are governed by Article 9 of the Uniform Commercial Code (UCC), as enacted in the applicable states. The UCC is a model law promulgated jointly by the National Conference of Commissioners on Uniform State Laws (NCUSL) and the American Law Institute. Versions of Article 9 have been enacted with various non-uniform changes in all US states.
The following principles apply to real and personal property.
Real property. The law of the state where the property is located will govern many aspects of the security interest in that property.
Personal property. Even if the parties select, for example, New York law to govern the security agreement, mandatory choice of law rules may result in the laws of another state governing perfection with respect to many of the assets.
This Q&A intends to summarise the general legal principles in this area, and is not intended as a comprehensive guide.
Overview of the lending market
The loan market in the US has continued to offer attractive terms to borrowers in the last 12 months. Interest rates remained low and covenants remained on the borrower-friendly side of the spectrum. Non-US borrowers continued to look to the US markets for their financing needs. Certain deals that could have been financed by European banks in the past were instead financed with covenant lite Term Loan B financings marketed in the US.
Although 2015 got off to a relatively slow start as compared to the early part of 2014, the market has since rebounded. Increased regulatory scrutiny and focus on the Federal Reserve Leveraged Lending Guidelines, the Office of The Controller of the Currency and the Federal Deposit Insurance Corporation has had an impact on the market this year. Overall leverage levels are down and arrangers are increasingly sensitive to terms that can garner regulatory scrutiny, such as incremental facilities. Such terms can impact repayment profiles given the focus in the guidelines on a borrower's ability to repay 50% of its total debt or 100% of its senior secured debt from cash flows within five to seven years.
Competition among arrangers is high for those deals that appear to fall within the guidelines. This has also served to push terms on those deals to the more aggressive side of the spectrum. Some companies have been looking to alternative debt providers to arrange or fund their deals in cases where banks subject to the guidelines are restricted from doing so. As a result, several non-bank bookrunners are playing a more significant role than ever before in arranging deals.
Forms of security over assets
Real estate is immovable property including any land and permanent improvements (for example, buildings). The scope of what constitutes real property will vary depending on the law of the jurisdiction in which the real property is located.
Common forms of security
A lien on real property will typically take the form of a security instrument, the nature of which depends on the jurisdiction in which the property is located, with a mortgage being the typical security instrument used in New York. Other security instruments include:
Deeds of trust.
Security deeds, that is, deeds to secure debt.
The security instrument creates a valid lien on real property and grants certain rights to the mortgagee or, in the case of a deed of trust, to a trustee for the benefit of the mortgagee, to secure the payment of a debt or performance of other obligations.
The requirements to create a lien on real property are set by local law and vary widely from jurisdiction to jurisdiction, but most jurisdictions will at least require an executed and notarised mortgage agreement with a legal description of the mortgaged land. Additional formalities are often numerous and particular and may include typographical layout of the legal documentation, such as font and margin requirements. Secured lenders typically request a legal opinion from the borrower's legal counsel as to the enforceability of a mortgage as assurance that all legal formalities have been properly complied with. Failure to comply with such formalities can render the mortgage ineffective.
To obtain priority over subsequent secured parties, it is generally sufficient to record the mortgage in the public real estate records of the county in which the property is located. Mortgagees commonly seek title insurance from the mortgagor as assurance of lien priority.
Fixtures are goods which are so related to particular real property that an interest arises under real property law. Whether a particular item is a fixture or not will depend on the law of the jurisdiction in which it is located. In most jurisdictions a security interest in fixtures can be perfected by doing either of the following:
Filing a UCC-1 financing statement.
Recording a mortgage covering the real property, if the law of such jurisdiction so permits.
Tangible movable property
Tangible movable property
Article 9 of the UCC defines "goods" as all things that are movable at the time the security interest attaches, dividing them into the following mutually exclusive categories:
Timber to be cut.
Goods also include fixtures and computer programs embedded in goods, so long as the goods do not consist solely of the medium in which the program is embedded, for example, a computer disk.
Goods do not include any of the following:
Commercial tort claims.
Letter of credit rights.
Letters of credit.
Oil, gas or other minerals before extraction.
Common forms of security
The primary form of security granted over goods is a security interest, typically arising out of a:
In this context a security interest means an interest in personal property or fixtures which secures payment or performance of an obligation. Under Article 9, a person having an interest in personal property (debtor) grants a security interest in such personal property (collateral) in favour of another party (secured party) to secure an obligation of the debtor to such person, usually the payment of money. Under the UCC, a purported title retention by a seller of goods will be treated as a security interest, as many consignments will (see Question 11).
Attachment. A security interest has been created (attached), when it is enforceable against the debtor. For a security interest in any form of personal property to be enforceable, all of the following must apply:
Secured party must have given value to the debtor.
Debtor must have rights in the collateral.
Debtor must have authenticated, that is, signed in writing or its electronic equivalent, a security agreement that describes the collateral.
Except in commercial tort claims (Question 5), a description of the collateral by type using the applicable Article 9 categorical definitions ("goods", "inventory", "accounts" and so on) will fulfil the statutory requirement of describing the collateral. Although the first two requirements listed above are mandatory, an oral security agreement might be sufficient if the secured party is in possession of the collateral. However, it would be rare for a commercial transaction to not have a signed written security agreement.
Perfection. The most common method of perfecting a security interest in goods is by filing a financing statement in the appropriate filing office. The financing statement must contain:
The debtor's name, address and jurisdiction of organisation.
The secured party's name and address.
A description of the collateral.
Unlike the description of collateral contained in a security agreement, the description of collateral in a financing statement can be generic (such as "all assets"). The effect of the financing statement is to perfect a security interest in the described assets to the extent it has attached. In other words, the financing statement cannot expand the scope of the security interest granted under the security agreement.
To most "registered organisation" debtors (including most corporations, limited liability companies and limited partnerships) organised under the law of a US state, the financing statement will be filed at the office of the secretary of state in the jurisdiction in which the debtor has been organised. For debtors that are organised under foreign law and do not have their chief executive office in the US, if the jurisdiction in which the debtor's chief executive office is located does not have a filing system satisfying the requirements of the UCC, the financing statement will be filed in Washington, DC. There are special rules for certain:
Debtors such as branches of foreign banks and foreign air carriers.
Collateral such as fixtures, extracted collateral and timber to be cut.
Although it is an uncommon method of perfection, it is also possible to perfect a security interest in goods by possession.
Financial instruments comprise the following types of personal property, each as defined in Article 9 of the UCC:
Investment property: all securities, whether certificated or uncertificated, security entitlements, securities accounts, commodity contracts and commodity accounts.
Instruments: negotiable instruments or any other writing evidencing a right to the payment of a monetary obligation (which is not itself a security agreement or a lease), of a type that is ordinarily transferred by delivery.
The two most common forms of financial instruments pledged as collateral in secured lending transactions are:
Securities representing the equity interests in the borrower and in any subsidiaries guaranteeing the debt.
Any promissory notes evidencing debt owed to the borrower or any guarantors.
Common forms of security
The primary form of security granted over financial instruments is a security interest.
Attachment. The general rules of attachment are described in Question 3, Formalities: Attachment.
In the absence of an authenticated security agreement, the third requirement of attachment for investment property can also be satisfied by the secured party taking possession or control of the investment property under an oral security agreement.
Generally, however, a commercial agreement will have a signed written security agreement (see Question 3, Formalities; Attachment).
Perfection. Filing a financing statement is sufficient to perfect a security interest in both instruments and investment property. The rules and requirements for filing financing statements described in Question 3, Perfection are generally applicable to both instruments and investment property.
The following methods are also permissible:
Instruments: A secured party can also perfect its security interest by obtaining possession of the instrument. A secured party who has perfected by possession generally will have priority over a competing perfected security interest perfected by another method. Therefore, a secured party will usually seek to take possession of any material instrument if possible, even if a financing statement has been filed. In certain limited situations, typically to accommodate administrative matters relating to the delivery of instruments, a secured party can also be perfected in instruments temporarily without having filed a financing statement or taken possession. A security interest perfected by such a method generally will, however, be subordinate (that is, inferior in terms of priority) to a competing security interest perfected by possession.
Investment property: A secured party can also perfect its security interest by obtaining control of the investment property. The requirements for control vary based on the type of asset involved. For certificated securities, control would be accomplished by delivery of the certificated security to the secured party together with a share power or other endorsement (delivery of the certificate alone would be sufficient for perfection but insufficient to achieve the extra priority benefits of control unless accompanied by a share power or endorsement). For securities accounts there are several methods of obtaining control. The most common method would be a tri-party "control agreement" between the debtor, the secured party and the securities intermediary maintaining the securities account in which the securities intermediary agrees to comply with the secured party's instructions and orders without further consent of the debtor. Control over uncertificated securities can be accomplished by, among other methods, a similar control agreement with the issuer of the uncertificated securities.
Claims and receivables
Security interests in the following types of claims and receivables are governed by Article 9 of the UCC.
Accounts. This is right to payment of a monetary obligation, for or arising out of:
Dispositions of property.
Issued insurance policies.
Use or hire of a vessel.
Credit card usage.
Government-operated lottery winnings.
Healthcare insurance receivables.
Chattel paper. This is a record evidencing a monetary obligation and a security interest in specific goods, most common in automobile financings.
Commercial tort claims. This is a tort claim in which the claimant is an organisation, or if the claimant is an individual, the claim arose in the course of the claimant's business operations and does not arise out of personal injury or death.
Letter of credit rights. This is a right to payment under a letter of credit.
General intangibles. This is a residual category of personal property not already covered by other Article 9 asset categories, including payment intangibles.
Cash deposits. See Question 6.
Instruments. See Question 4.
Common forms of security
The most common form of security in claims and receivables is a security interest.
Attachment. For the general rules of attachment, see in Question 3, Attachment.
A description of the claims and receivables in the security agreement is sufficient if it reasonably describes the collateral, including, except in the case of commercial tort claims, a description as an "account", "chattel paper" or any other applicable Article 9 category. A description of a commercial tort claim must be described specifically; a description of the claim solely as "commercial tort claims" is insufficient. Additionally, while after-acquired property clauses are generally permitted to cover future assets of the debtor (see Question 8), they will not cover future commercial tort claims.
As factoring of receivables is common, the UCC treats most sales of accounts and chattel paper as security interests for which the UCC attachment and perfection requirements would be applicable, even where the transaction is styled as a sale rather than a traditional security interest.
In the absence of an authenticated security agreement, the evidentiary requirement for attachment of claims and receivables can be achieved by entering into an oral security agreement, together with either of the following:
Possession, if the receivable is tangible chattel paper.
Obtaining control together with an oral security agreement, if the receivable is electronic chattel paper or letter of credit rights.
Generally, however, a commercial agreement will have a signed, written security agreement (see Question 3, Formalities; Attachment).
Perfection. The method of obtaining perfection of a security interest in claims and receivables varies depending on the type of collateral:
Accounts: filing of a financing statement is generally required, but certain limited assignments of accounts will be perfected automatically on attachment.
Chattel paper: can be perfected by:
filing a financing statement; or
taking possession, in the case of tangible chattel paper; or
obtaining control, in the case of electronic chattel paper.
Commercial tort claims: filing a financing statement is the only method of perfection.
General intangibles: filing a financing statement is the only method of perfection. For certain IP, a filing under federal law may be required.
Letter of credit rights: obtaining control is the only method of perfection. Control requires obtaining the consent of the issuer to the assignment of the proceeds under the letter of credit.
While notification to the account debtors of the security interest does confer some legal benefits concerning set-off and collection rights, it is not an effective method of perfection in the US.
Common forms of security
Article 9 of the UCC defines "deposit accounts" as any demand, time, savings, passbook or similar account maintained with a bank. The primary form of security granted over deposit accounts is a security interest.
Attachment. For the general rules of attachment, see Question 3, Attachment.
While not common, an oral security agreement would be sufficient if the secured party has "control" of the deposit account as discussed below (see below, Perfection).
Perfection. Except as proceeds of other collateral, a security interest in deposit accounts can only be perfected by control. Filing a financing statement is not sufficient to effect perfection.
There are several methods by which a secured party can obtain control over a deposit account. The most common method is a tri-party control agreement whereby the debtor, the secured party and the deposit bank enter into a written agreement under which the deposit bank agrees to comply with all instructions issued by the secured party directing disposition of funds in the deposit account without further consent of the debtor.
If the deposit bank that establishes and maintains the deposit account is the same legal entity as the secured party, then the secured party is deemed to be in control of the deposit account and is perfected automatically. A secured party can also obtain control by becoming the deposit bank's customer with respect to the deposit account.
In some states, including New York and Delaware, recent non-uniform amendments to the UCC have provided for two additional forms of control:
The name on the deposit account is the name of the secured party, or indicates that the secured party has a security interest in the deposit account.
Another person has control of the deposit account on behalf of the secured party.
A debtor will commonly grant a security interest in most or all of its IP. This includes the debtor's rights in all of its copyrights, trademarks, service marks and patents, whether registered or unregistered, and possibly any licences of these IP rights.
Two exceptions are common to the debtor's broad grant:
Foreign IP, because the expense associated with perfecting such security interests often outweighs the value granted.
"Intent-to-use" applications for registrations of trademarks and service marks, because such a security interest is arguably grounds for cancellation of the secured application or any registration issuing from that application.
Common forms of security
The most common form of security granted over IP is a security interest.
Article 9 generally governs the creation, attachment and perfection of security interests in IP collateral. Certain exceptions are discussed below.
Attachment. The general rules of attachment described in Question 3, Attachment apply to IP. The collateral must be described in an authenticated security agreement.
Perfection of a security interest in IP involves an imprecise interplay between the UCC and federal law. Accordingly, in most cases, secured parties will do all of the following:
File a UCC-1 financing statement covering the IP collateral in the appropriate filing office for the debtor (see Question 3, Formalities: Perfection).
Record their interest in the US Copyright Office (USCO) or US Patent and Trademark Office (USPTO), as applicable.
Typically a short form security agreement which only covers the IP would be recorded in the appropriate federal filing office.
With respect to registered copyrights, the case law indicates that the federal Copyright Act's recording provisions preempt or override state law methods of perfection such as the methods prescribed by Article 9. Perfection of a security interest requires recordation of the security interest with the USCO.
Since it is not possible to file an unregistered copyright with the USCO, the only way to perfect a security interest in such copyrights is to file a UCC-1 financing statement. However, inconsistent case law in this area leaves the validity of this method somewhat unsettled.
While a properly filed UCC-1 financing statement should be sufficient to perfect a security interest in patents and trademarks, secured parties typically also record any such security interest with the US Patent and Trademark Office (PTO). Parties may also be required to file with the PTO a short-form security agreement to protect against subsequent bona fide purchasers acquiring the IP free of the security interest.
With very limited exceptions, a security interest in future assets (after-acquired property) can be granted if the security agreement so provides. No additional action for attachment is required. Commercial tort claims are an exception because they need to be identified specifically for attachment to occur.
If the security agreement covers after-acquired property, then the security interest will automatically attach once the debtor acquires rights in the property unless the security agreement expressly delays attachment. In most cases, the existing financing statement will be sufficient to perfect any after-acquired property of a type that can be perfected in that filing office. An amendment to the financing statement might be required if the collateral description was narrowly drafted to only cover specific assets rather than all assets. Additionally, additional action can be required to ensure perfection of the security interest if the after-acquired property is of a type that:
Cannot be perfected by filing of any financing statement, such as deposit accounts.
Requires a specific local financing statement, such as extracted collateral.
Any property acquired by a debtor after bankruptcy commences will be excluded from the security interest by operation of federal bankruptcy law. Identifiable proceeds of property subject to a valid security interest that is perfected prior to the bankruptcy are exempt from this rule.
Fungible assets can be problematic if the secured party is taking a security interest in a part rather than the whole of those assets. In such cases, there needs to be a method of determining what the security interest extends to. Where practical, segregation of the portion of the fungible assets subject to the security interest is advisable. If not, taking a specified percentage of all of such fungible assets should be sufficient for attachment. This can, however, result in issues with enforcement.
Certain assets are excluded from the scope of Article 9 of the UCC and, as a result, it is more difficult to obtain a good security interest over those. Some examples are:
Insurance. This is excluded from the scope of the UCC as original collateral in most states, including New York, and a common law assignment would be required.
Aircraft and related assets. Perfection of a security interest in such assets requires a filing with the Federal Aviation Administration in Oklahoma City and often an international filing pursuant to the Convention on International Interests in Mobile Equipment 2001 and the Protocol thereto on Matters Specific to Aircraft Equipment 2001 (Cape Town Convention).
Ships and other vessels. A security interest in such assets will require recordation of a ship mortgage under federal law.
Rail cars and other rolling stock. A security interest in such assets will also require a filing under federal law.
Contracts where the counterparty is a government entity. These present a number of potential issues, including:
taking and perfecting a security interest in such contracts can require additional filings to be valid;
there can be limited enforcement rights against the government as account debtor, or it can be impossible to obtain a valid security interest in such contracts at all;
any government licences, such as Federal Communications Commission licences, gaming licences and liquor licences, are either not assignable at all or are subject to significant restrictions.
Release of security over assets
The terms of the loan documentation will typically provide that the security agreements will terminate and all security interests granted by the borrower and the guarantors will automatically be released, on the occurrence of both of the following:
Payment in full of all outstanding secured obligations under the loan agreement.
The termination of all commitments to make future loans.
It is common for such termination and release to be documented in a pay-off letter which serves all of the following functions:
Calculates the full "pay-off amount" of the outstanding obligations as at a certain date.
Provides for the automatic release of all security interests on receipt by the secured parties' agent of the payoff amount.
the termination of financing statements;
the relinquishment of control or possession of all collateral;
any other action required to terminate the perfected security interests previously granted to the secured parties.
If there is no outstanding secured obligation and no obligation on the part of the secured party to make further advances or give further value, the UCC imposes a duty on secured parties to do both of the following:
Terminate filed financing statements
Relinquish control or possession of collateral within certain specified timeframes.
Failure to do so can result in compensatory or statutory damages.
Special purpose vehicles (SPVs) in secured lending
SPVs are rare in ordinary secured lending transactions; secured parties will simply take security over the borrower's and other debtors' assets. However, SPVs are, however, widely used in the securitisation of receivables and other assets where it is important, as a business matter, to isolate the assets from the credit risk of the borrower and to reduce the risk of bankruptcy affecting the secured party. If taking a direct security interest in an important debtor's asset is legally prohibited or otherwise difficult to achieve (for example, many government licences), a pledge of the equity of an SPV that holds that asset can be an effective way to obtain a synthetic security interest in the asset where a more direct method is not feasible.
The determination of whether a particular transaction creates a security interest depends on its economic substance and not on:
The label the parties have assigned to it.
The subjective intent of the parties creating it.
Therefore, a risk inherent in any financing transaction is that a court can re-characterise it as a security interest even if it purports to be something different. For instance, many consignments and all title retention of goods sold and delivered to the debtor will be treated as security interests.
Sale and leaseback
A sale and leaseback is a transaction in which an owner transfers ownership of property to a buyer while simultaneously entering into a long-term lease of the same property. The owner, therefore, receives proceeds from the sale while retaining use of the property in its business.
These transactions run a great risk of being recharacterised as secured loans. It would be customary for the lessor to also obtain and perfect a "back-up" security interest in the property subject to the sale and lease back. Whether a transaction creates a lease or a security interest is determined by the facts of each case. However, the lease will be treated as a security interest under the UCC where either of following applies:
The lease is not terminable by the lessee and the lease, along with any mandatory renewals, extends to or beyond the economic life of the goods.
The lessee has the option to become the owner of the goods on expiration of the lease for either no additional consideration or nominal consideration.
It is not uncommon to finance the purchase of equipment through lease financing. Like a sale and leaseback transaction, a lease to finance the acquisition of equipment is at risk of being re-characterised as a secured lending transaction. In such cases, the sale and leaseback factors and back-up security interest approach would apply.
Factoring is a financial transaction in which a buyer purchases an account receivable, usually at a discount, from a seller. Whether or not a court will respect this as a "true sale" or treat it as a secured loan will depend on a number of factors, including whether the:
Risk of loss has been fully transferred to the buyer.
Buyer has any recourse to the seller.
While treatment as a "true sale" has many advantages, particularly in cases of a seller's bankruptcy, the sale of most receivables will be treated as a type of security interest under the UCC that requires perfection.
Hire purchases, known as "rent-to-own" transactions in the US, are leases of goods which provide for the transfer of title to the buyer or lessor at the end of the lease. Title remains with the seller during the term of the lease. Such a transaction, even if nominally structured as a lease, can be economically indistinguishable from a transaction in which the seller of the goods makes a loan to the buyer for the amount of the purchase price for the goods and takes a security interest in the goods to secure the buyer's obligation to repay the loan. A court will look to the substance of the transaction rather than its form in determining whether a transaction creates a security interest. These transactions are at great risk of being re-characterised.
Retention of title
Retention of title is a sale of goods in which the title to the goods purports to remain with the seller until the buyer has paid the purchase price in full. It is clear that such a transaction creates a security interest in the goods under Article 9 of the UCC.
The law of New York and other states recognises the right to set-off mutual non-contingent debts.
Risk areas for lenders
The ability to incur or guarantee debt or grant a security interest in personal or real property in the US is generally not limited by "financial assistance" laws of the type seen in many European jurisdictions.
There are generally no restrictions on the ability of a parent company to provide a down-stream guarantee of the obligations of its subsidiaries. Both up-stream (a subsidiary guaranteeing the obligations of its parent) and cross-stream (a company guaranteeing the obligations of a sister company owned by the same parent) are also widely used. Whether this is permissible, however, might depend on:
The type of entity.
The jurisdiction of organisation.
Whether the guarantor entity is wholly owned.
Whether the organisational documents of the guarantor contain any restrictions on the ability to guarantee the debt.
Even where permissible, guarantees are subject to certain potential vulnerabilities. Under the US Bankruptcy Code and similar state fraudulent conveyance laws, such guarantees, as well as any security interest securing such guarantees, could be invalidated as a "fraudulent conveyance" if, even absent fraudulent intent, both of the following occur:
The guarantor receives less than "reasonably equivalent value" in exchange for taking on the obligation.
One or more of the following apply to the guarantor:
the guarantor was insolvent at the time or as a result of the transfer; or
the guarantor was engaged in a business for which it had unreasonably small capital; or
the guarantor intended to incur or believed it would incur debts beyond its ability to repay.
Loans to directors
The Sarbanes-Oxley Act 2002 makes it unlawful, subject to certain limited exceptions, for any issuer of public securities to, directly or indirectly, extend credit to any of its directors or executive officers (section 402, Sarbanes-Oxley Act 2002).
In general, laws restricting the maximum legal interest rate at which loans can be made are a matter of state rather than federal law. Depending on the state statute, a loan with an unlawfully high interest rate can be either or all of the following:
Partially or fully unenforceable against the debtor.
Void at its inception.
Provide grounds for civil or, in some cases, criminal penalties against the lender.
Maximum interest rates, available remedies and exceptions to the laws vary widely from state to state. New York law provides for a large number of exceptions to its usury law and generally exempts loans in excess of US$2.5 million.
The US Internal Revenue Code creates adverse tax consequences for a US parent company if a direct or indirect subsidiary of such US parent that is a "controlled foreign corporation" provides credit support to the parent company (section 956, US Internal Revenue Code). To avoid a taxable "deemed dividend" with a value of up to the full amount of the credit support provided by such foreign subsidiary, all of the following are typical of loan agreements:
An exclusion of subsidiaries that are controlled foreign corporations from the obligation to provide guarantees.
A limit on the pledge of such foreign subsidiaries' voting equity interests to less than two-thirds of such equity interests.
Loan agreements will occasionally also exclude domestic disregarded entities and domestic holding companies, the sole assets of each of which are stock in one or more controlled foreign corporations, from the obligation to provide guarantees and limit the pledge of such domestic subsidiaries' voting equity interests to less than two-thirds of such equity interests.
Regulations T, U and X of the Board of Governors of the Federal Reserve System limit the amount of credit that can be extended for the purchase or carrying of securities. It is unlawful to accept credit in violation of these margin rules.
A lender who has only lent to the owner of or taken security in a contaminated site generally will not be primarily or secondarily liable under environmental laws for the actions of the owner. However, if a lender exercises management over the property beyond that of a traditional lender then there can be some risk of liability. Similarly, if a lender forecloses on and becomes the owner of a contaminated property, there is a risk that the lender may be liable.
Structuring the priority of debts
Contractual subordination, often referred to as payment subordination, is an agreement by which subordinated creditors expressly agree to subordinate their right to payment and agree to turn over to senior creditors any payments (other than certain expressly permitted payments) that they receive from the borrower or guarantors, whether or not related to collateral, until the obligations owed to the senior creditors are satisfied in full. Although less common than lien subordination, such agreements do exist. The terms of the subordination are effective by virtue of their inclusion in an enforceable subordination agreement and not by operation of any other law.
Structural subordination of a claim occurs by virtue of the debtor's capital and corporate structure rather than by agreement. If debt exists at both a parent and subsidiary, the parent's creditors are considered structurally subordinated to the subsidiary's creditors since, in an insolvency situation, the subsidiary's creditors must be paid in full before subsidiary can pay out any residual value as a dividend to the parent. As a result, creditors of a parent company will often require any subsidiary with significant third party debt to also guarantee the obligations of the parent to mitigate the effect of structural subordination. Note that an upstream guarantee of this type may be subject to fraudulent conveyance and other issues (see Question 13).
Intercreditor arrangements (lien subordination)
Intercreditor agreements are arrangements in which separate groups of creditors with secured claims in the same collateral agree to establish lien priority amongst themselves with respect to the collateral (notwithstanding the priority amongst the agreeing creditors that Article 9 would otherwise provide). Article 9 specifically contemplates that creditors who would otherwise have priority in collateral may agree to subordinate their claim, and such intercreditor agreements are very common.
In contrast to payment subordination, the payment claims of the junior priority creditors are not subordinated and the subordination and turnover provisions relate solely to collateral and the proceeds of collateral. The terms of the lien subordination will depend on the nature of the intercreditor agreement between the classes of creditors. In addition to the basic subordination of the subordinated creditor's claims to the proceeds of the collateral, such agreements will typically also limit the subordinated creditors' ability to take actions with respect to the collateral during a default or in cases of outstanding senior creditors' obligations.
Intercreditor agreements can also govern the relationship between two or more classes of creditors that share in the collateral on an equal basis.
Debt trading and transfer mechanisms
Loans, like other financial products, are actively traded in the US. Most loan agreements let lenders either assign or participate their interests in the loan to another entity (see below).
An assignment is a full transfer of the assignor's rights and obligations as a lender under the loan agreement to the assignee. An assignment creates direct contractual rights between the borrower and the assignee.
The loan agreement will typically provide a form of assignment and assumption agreement which establishes the assignee as a lender under the loan agreement. As a lender, the assignee becomes entitled to all of the benefits that the assigning lender enjoyed, including the security interests and guarantees.
A participation transfers only the economic interest of a lender to the participant. The participant does not become a party to the loan agreement and is not entitled to all of the other rights that lenders enjoy, including, for example, the right to vote on amendments or other matters. Contractual privity in a participated loan remains solely between the borrower and the original lender.
Agent and trust concepts
Syndicated loan agreements generally provide for an administrative agent to facilitate the making, repayment, and administration of the loan. The grantors will grant the security interests to either the administrative agent or a separate collateral agent who will hold such security interests on behalf of the secured parties (see Question 18).
The loan agreement will define the scope of the agent's authority. Although the agent can normally take routine or ministerial actions with respect to the loan and the collateral, he cannot deal with substantive matters without the consent of some or all of the lenders.
Enforcement of security interests and borrower insolvency
It is usually possible to accelerate a loan and to make a demand for payment against any guarantor of the loan if a default under the relevant loan documentation occurs. Failure by the borrower or guarantor to pay the demanded sums allows secured parties to realise on the collateral securing such unpaid obligations.
A lender seeking to enforce the loan, guarantees of the loan or the security interests securing such obligations must comply with the relevant legal requirements under applicable law or contract. Primarily:
Article 9 of the UCC for personal property.
Applicable real property law for real property.
Any enforceable terms of the underlying loan documentation.
The UCC provides debtors with various protections that they cannot waive in the security agreement or elsewhere prior to default, for example, the right to receive notice and the right to have any sale of the collateral conducted in a commercially reasonable manner.
In the event of a bankruptcy filing, the automatic stay will prevent a secured party from foreclosing or exercising any other rights or remedies without leave of the court.
Methods of enforcement
Subject to certain exceptions, notice to the debtor, any guarantor and certain other secured parties will be required.
Under the UCC, various forms of non-judicial remedies may be available, depending on the type of collateral including:
A private or public sale of the collateral.
Retention of the collateral in full or partial satisfaction of the debt with the acquiescence of the debtor.
Direct collection of amounts payable by account debtors or other persons obligated on the collateral.
Taking physical possession of the collateral if this can be done without breaching the peace.
A public or private sale of collateral must be conducted in a commercially reasonable manner. A secured party can also exercise its contractual rights under any control agreement, such as a deposit or securities account control agreement. Although judicial foreclosure is also available, it would rarely be a secured party's first choice with respect to personal property. With respect to real property matters, however, judicial foreclosure is the common method, even though some states permit non-judicial foreclosure. Limitations on collection and foreclosure vary from state to state and a detailed description of these requirements is beyond the scope of this Q&A.
Rescue, reorganisation and insolvency
Bankruptcy or other insolvency regimes are the basic statutory schemes for rescue and reorganisation.
Outside of bankruptcy or insolvency proceedings, parties can consensually agree to a restructuring of obligations. In order to avoid filing for bankruptcy, a borrower and its lenders can agree to amend, waive or otherwise modify the existing loan documentation to avoid a default and acceleration of the debt. The modification can take a number of forms, including:
Deferral of principal and interest payments.
Lender consent to specific actions to be taken that would otherwise be prohibited by the loan documents.
Individual lenders can choose to approve or reject this relief. The loan documentation will specify the percentage of lenders (measured by the amount of loans and commitments they hold) who must consent for the modification to be effective. Similar provisions govern modifications to the terms of any guarantee or collateral.
The commencement of insolvency proceedings will result in an automatic stay of the following actions against the debtor and its property:
Commencement or continuation of collection proceedings.
Enforcement of pre-petition claims or judgments.
Repossession or sale of collateral.
Exercise of rights of set-off.
Enforcement of security interests.
Creditors can obtain relief from the automatic stay from the bankruptcy court under certain circumstances. For example, relief can be granted for lack of "adequate protection" of the creditor's interest in certain property. A claim for adequate protection arises when the trustee or the debtor uses a secured party's collateral in administration of the bankrupt's estate and, in doing so, denigrates the value of the collateral to the secured party's detriment. A claim for adequate protection can also arise if the secured party's collateral is declining in value through the passage of time, either because of the nature of the asset or movements in the market for the asset.
The stay on particular pieces of property can also be lifted if all of the following apply:
The debtor does not have ownership of those pieces of property.
The property is not necessary for reorganisation.
The bankruptcy trustee possesses broad powers to set aside certain pre-bankruptcy transfers of the debtor's interests to third parties. The rules and their exceptions are numerous, but the following are of the most importance to secured lenders.
The trustee can:
Recover actual or constructive fraudulent transfers that permit it to nullify or recover both:
pre-petition transfers, made for less than reasonably equivalent value, while the debtor was insolvent;
transfers made by the debtor with the intent to delay, hinder or defraud its creditors.
Void transfers that could be set aside under state fraudulent transfer laws.
In bankruptcy, void security interests which are unperfected as of the commencement of the bankruptcy case, making the unperfected creditor equal in bankruptcy to a general creditor who had not yet reduced his claim against the debtor to judgment.
Other bankruptcy rules are designed to prevent creditors from improving their claims on assets as compared to other creditors in the months leading up to a debtor's bankruptcy. If the debtor makes a transfer to a creditor on account of an existing debt within 90 days (or within one year, if the creditor is an insider) of filing for bankruptcy, then that transfer can be voided. Although the transfer in this case may be the payment of money, the rule is broad enough to include non-monetary improvements to the creditor's position, such as perfection of an existing security interest.
A fundamental principle of US bankruptcy law is that the status of state law claims and priorities, including those established by the UCC, are recognised and preserved in bankruptcy as they would be outside of bankruptcy. However, because of federal pre-emption, the rules set forth in the Bankruptcy Code will override other non-bankruptcy rules in the event of a conflict. In certain cases, the priority of a perfected Article 9 security interest can be directly altered in bankruptcy (see Questions 2 to 6).
In general, secured creditors receive payment on their obligations equal to the value of their collateral (after taking into account senior security interests), up to the amount of their secured claim. If undersecured, their claim is divided into a secured claim in an amount equal to the value of the creditor's interest in the collateral and an unsecured claim for the remainder. The unsecured claim will share pro rata with payments to general creditors, which have lower priority than secured claims. . In either case, payments need not be in cash and can be in the form of:
Equity of the reorganised debtor.
Exceptions to the general rule
There are a large number of categories of unsecured claims that receive special priority in bankruptcy including:
Administrative expenses, which include:
qualifying loans made to the debtor while in bankruptcy (DIP loans);
claims of adequate protection from secured creditors (see Question 22)).
Domestic support obligations.
The value of any goods sold to the debtor within 20 days of filing for bankruptcy.
Employee wages, subject to a statutory cap per worker.
Claims of general unsecured creditors have a lower priority than secured claims and priority unsecured claims, and can be paid out in mere cents on the dollar. Equity holders have the lowest priority and typically receive little or no value in bankruptcy.
The bankruptcy court has relatively broad discretion to subordinate particular creditors' claims, both secured and unsecured, on equitable grounds. Equitable subordination occurs when a creditor unfairly exercises control over the debtor. An example would be an equity holder who uses its influence as such to benefit its own claims over those of other creditors.
Cross-border issues on loans
There are generally no restrictions but certain tax considerations may apply.
Non-US lenders who do not lend through a US branch are generally subject to a 30% federal income withholding tax on interest payments from a domestic borrower to such lender. Such tax is typically reduced or eliminated under applicable tax treaties, provided they meet certain certification requirements. The Foreign Account Tax Compliance Act (FATCA) also imposes a federal tax withholding on certain payments made by US borrowers to foreign lenders unless either of the following applies to the lenders :
They comply with certain information, reporting and other withholding requirements.
They are otherwise entitled to an exception.
The lender may also need to qualify to do business in a state before it can avail itself of the courts of that state.
There are generally no such controls, unless the lender is located in a country subject to US sanctions. For or a discussion of tax consequences applicable to foreign lenders, see Question 25.
Taxes and fees on loans, guarantees and security interests
There are generally no documentary taxes in the US, although documentary taxes are payable on mortgages recorded in Florida. These taxes can usually be avoided by executing and delivering the documents out of Florida.
Recording taxes on mortgage recordation can be quite substantial in many jurisdictions, including New York. Most states only impose minor filing fees on personal property. A few states, such as Tennessee, however, impose substantial filing fees.
The filing and recordation of real property mortgages or deeds of trust requires the payment of a recording fee and/or tax. In many jurisdictions this is calculated as a percentage of the value of the property. These fees vary from jurisdiction to jurisdiction and, depending on the value of the property, in some jurisdictions, including New York, can be quite substantial.
Although notarised signatures are sometimes required to create and/or perfect a security interest, the costs of obtaining them and their importance to the overall transaction are nominal and significantly less than in other jurisdictions, such as in Europe.
Description. Cornell University maintains a website that contains links to the Uniform Commercial Code in most jurisdictions. Additionally, the laws of most states can also be found either on official websites maintained by the states or in databases of commercial service providers such as Westlaw.
Larry Safran, Partner
Latham & Watkins, LLP
Professional qualifications. US, New York, New Jersey & Washington, DC
Areas of practice. Uniform Commercial Code, banking, structured finance, project finance, and other secured transactions.
Michele Penzer, Partner
Latham & Watkins, LLP
Professional qualifications. US, New York
Areas of practice. Banking (Global Chair), Islamic finance, oil & gas transactions, project finance, special situations.
Brian Rock, Associate
Latham & Watkins, LLP
Professional qualifications. US, New York
Areas of practice. Uniform Commercial Code, banking, structured finance, project finance, and other secured transactions.