Extract taken from 'The Lending and Secured Finance Review' – edition 5

Credit support and subordination

i Security

Taking a security interest in assets that are located in the United States is relatively streamlined, and is governed in most instances by Article 9 of the Uniform Commercial Code (UCC). In general, a security interest will attach if the collateral is in the possession of the secured party pursuant to agreement or if the borrower has signed a security agreement that describes the collateral, value has been given and the debtor has a right to the collateral. If all three of these conditions are met, the security interest 'attaches' and is enforceable. Notably, in the United States a single security agreement can effectively create a security interest in substantially all of the assets of a borrower. However, unless that security interest is 'perfected', it may not come ahead of other security interests taken in the same collateral, and perfection can differ depending on the assets comprising the collateral. Under the UCC, a lender may perfect its security interest in collateral by satisfying the requirements for perfection outlined in the UCC, and once perfected that security interest will take priority over all other security interests that are not perfected or that have been perfected subsequently. Each state has adopted variations from the standard UCC, so although they are generally very similar, the UCC adopted by the relevant state should be referred to when taking a security interest.

The most common way to perfect a security interest in assets covered by the UCC is to file a UCC-1 financing statement in the appropriate filing office. The UCC-1 financing statement generally requires the names of the debtor, and the secured party or its representative, and a description of the collateral. The description can be as general as 'all assets' but will more typically track the description of the collateral found in the related security agreement. UCC filing fees are typically small, and there are few, if any, other costs related to taking security interests in the property covered by UCC filings. For borrowers that are US corporations, limited liability companies or registered partnerships, the appropriate filing offices will be their respective jurisdictions of organisation. For non-US entities that do not have a filing system for perfection in their home jurisdictions (which is most other jurisdictions besides provinces of Canada other than Quebec), the appropriate filing office would be the District of Columbia. Although a UCC-1 filing will serve to perfect most collateral, certain kinds of UCC collateral, most notably deposit accounts and cash, can only be perfected by control or possession, most often by housing the account with the agent or another lender, or by entering into a control agreement with the bank where the account is located. In addition, some assets may be perfected by more than one method under the UCC, although one method may be preferable to another. For example, perfection by possession of a stock certificate will take priority over a UCC-1 financing statement that was filed earlier and covers the same stock.

In addition to deposit accounts, cash and stock noted above, there are a number of assets that are governed by special rules relating to perfection and priority or other special considerations. These include, but are not limited to, agriculture; aeroplanes; fixtures; intellectual property; letters of credit; vehicles; oil and gas, and other mineral rights; railcars; real property; satellites; ships; and warehoused inventory. The laws governing taking security interests in real property, for example, vary from state to state, generally take longer to satisfy and can involve significant costs. There are often recording taxes and fees imposed by state and local laws, which can be excessive, so lenders sometimes take assignment of mortgages in connection with new financings rather than enter into new ones. Loans secured by mortgages may be limited to the value of the property rather than the amount of the loan to avoid onerous mortgage taxes. To secure interests in intellectual property, such as registered trademarks, copyrights and patents, federal filings will be required that specifically list each item, and these filings must be updated for any property acquired afterwards.

ii Guarantees

Guarantees are commonly provided by parents, subsidiaries and side-by-side subsidiaries of a common parent in the US corporate loan market. In large-cap transactions, parent guarantees are often limited in recourse to the stock of the subsidiary borrower, although this is less often the case in middle-market loans. Subsidiary guarantees are typically full and unconditional, but they are often limited to guarantees from domestic subsidiaries to avoid adverse tax consequences to the borrower of a non-US guarantee (discussed in Section III), and may be limited to wholly owned domestic subsidiaries. Guarantees may be supported by security interests in the guarantors' assets to the same extent that the loans are secured by the borrower's assets.

iii Priorities and subordination

There are three primary methods of achieving priority in US corporate lending transactions:

  1. possessing a prior, perfected security interest in the assets of the borrower or being the beneficiary of an intercreditor agreement establishing priority in liens;
  2. being 'structurally senior' to the other debt; and
  3. being the beneficiary of a subordination agreement.

When a lender obtains a first priority perfected security interest in the assets of the borrower in a US loan, the lender obtains the right to receive a priority distribution equal to the proceeds of sale (or value) of that asset to the exclusion of any other creditors (except for holders of certain statutory liens). This means that in the event of a foreclosure, bankruptcy or other liquidation, the secured lender will be entitled to be paid out of the proceeds of the assets securing the loans before any lender having a junior security interest or no security interest in the asset may be paid. Priority in liens is typically established by perfection, as discussed in Section IV.i, but it can also be established contractually by an intercreditor agreement. Lenders under a senior secured credit agreement may agree to allow the borrower to incur additional first lien indebtedness or second lien indebtedness, and enter into an agreement with the lenders of that indebtedness as to priority in security, as well as to how remedies will be enforced in respect of the collateral, among other things.

While achieving structural seniority in the US corporate loan market, like other markets, depends entirely on lending to a level within the borrower's capital structure that is below the level to which another lender extends credit, contractual seniority is established by a subordination agreement. Contractual subordination is achieved by an agreement in which the subordinating creditor agrees that in the event of a bankruptcy or other distribution of assets of the debtor, any amounts otherwise distributable to the subordinating creditor will instead be paid to a specified creditor or class of creditors holding 'senior debt' until they are paid in full. The class of 'senior debt' is usually defined as all indebtedness for borrowed money whether now existing or incurred hereafter, as well as capital leases. It is not necessary that the subordination agreement be between the subordinated creditor and the senior creditor, and often the senior creditor is the third-party beneficiary of an agreement between the borrower and the subordinating creditor. Subordination terms in the United States also typically provide that if there is a payment default on the senior debt, no payment may be made on the subordinated debt until the default is cured or the senior debt is paid in full. In addition, many subordinated debt provisions state that, in the event of a non-payment default on the senior debt, there will be no payments on the subordinated debt for a specified blockage period, which typically runs between 90 and 180 days. Although subordinated debt issuances were common in the US market in the 1990s, they are relatively rare in the current US corporate loan market.