Security interests and guaranteesCollateral and guarantee support
Which entities in the organisational structure typically provide collateral and guarantee support for bank loan financings? Are there limitations on which entities in the organisational structure are permitted to provide such support?
The guarantor group in respect of bank loans made to a US debtor varies depending upon several factors, including whether the debtor is a public company or privately held, the purpose of the bank loans and the tax status of the debtor and its subsidiaries. As a general matter, bank loans to a US debtor will be guaranteed by the US subsidiaries of the debtor, but not by the non-US subsidiaries of the debtor, owing to certain adverse US tax consequences to the debtor if a ‘controlled foreign corporation’ provides guarantee or collateral support for the loans. In addition, US subsidiaries that function as holding companies for foreign assets may also be excluded from the guarantor group owing to the same tax considerations.
If the debtor has a parent holding company, the entity will often provide a ‘downstream’ guarantee of the bank loans. This is often the case in financings for leveraged buyouts, where the purchaser establishes a holding company to acquire the stock of the target company, which ultimately becomes the debtor. The holding company structure allows the lenders to receive a pledge of the equity interests of the debtor, thereby providing the lenders with the ability to foreclose on the stock in the event the debtor fails to repay the loan and sell the debtor as an operating enterprise (although for practical reasons relating to the US Bankruptcy Code it is very rare for the lenders to actually foreclose on the collateral).
Although not always the case, it is typical for any entity that provides a guarantee of the US debtor’s bank loans to also provide some form of collateral support for such loans.
What types of obligations typically share with the bank loan obligations in the collateral and guarantee support? If so, are all such obligations equally and ratably covered by the collateral and guarantee support?
The collateral and guarantees will cover all the obligations under the bank loan documentation, including principal and interest on the bank loans, unreimbursed disbursements on letters of credit, fees accruing on the unutilised bank commitments, fees payable to the issuers of letters of credit as compensation for fronting those letters of credit for the lenders, expenses of the agent banks for administration of the bank loan documentation and the collateral documentation, and indemnification obligations arising in connection with the bank loan documentation and the transactions thereunder.
In addition, the bank loan documentation will often extend the coverage of the collateral and the guarantees to ancillary services provided by the bank group to the debtor and its related parties, such as interest rate, foreign exchange and other hedging arrangements, and cash management and treasury services, such as account overdraft protection. The extension of collateral and guarantee coverage to these services provides the bank group members with an incentive to offer to the debtor services that are necessary for the ordinary course operation of the debtor’s business.
While the relative treatment of the secured and guaranteed obligations may differ from deal to deal, it is most often the case that the obligations under the bank loan documentation, the hedging arrangements and the cash management arrangements will share ratably the proceeds of collateral and guarantees, although all those obligations will be paid out after reimbursement of any administrative expenses of the collateral agent arising from the exercise of remedies under the bank loan documentation.Commonly pledged assets
Which categories of assets are commonly pledged to secure bank loan financings? Describe any limitations on the pledge of assets.
Collateral generally falls into two categories: real property and personal property.
Real property comprises land, minerals and other interests in the ground, and structures, such as buildings, on the land.
Personal property comprises all other types of property that do not constitute real property. This category of collateral includes inventory, receivables, equipment, investment property (such as securities), deposit accounts and general intangibles (such as intellectual property and payment obligations).Creating a security interest
Describe the method of creating or attaching a security interest on the main categories of assets.
The creation of a security interest in personal property is governed by state law rather than federal law. Article 9 of the Uniform Commercial Code, which is a collection of uniform commercial statutes promulgated by each of the 50 states and the District of Columbia, governs, among other things, the creation, perfection and priority of security interests in personal property. Under article 9 of the Uniform Commercial Code, a security interest generally attaches to personal property when it becomes enforceable against the debtor, which, in turn, requires that:
- value has been given by a secured party (eg, the secured party has extended credit to the debtor);
- the debtor has rights in the collateral or the power to transfer rights in the collateral to a secured party; and
- the debtor has executed a security agreement that provides a description of the collateral.
The security agreement includes a granting clause by which the debtor grants to the secured party a security interest in the collateral so described.
Like security interests in personal property, security interests in real property are created under state law. However, unlike security interests in personal property, the law governing the creation of security interests in real property is not uniform across the states. Generally, a security interest in real property is created by the execution and delivery of a security agreement referred to as a mortgage or, in some states, a deed of trust.Perfecting a security interest
What steps are necessary to perfect a security interest on the main categories of assets? What are the consequences of failing to perfect a security interest?
Generally, perfection of security interests in personal property is governed by state law, although for certain categories of property, such as registered copyrights, federal law pre-empts state law with respect to perfection. With certain exceptions, such security interests are perfected by filing a Uniform Commercial Code financing statement in the central filing office of the state where the debtor is organised. For certain categories of personal property, perfection can also be achieved by possession of the property (eg, instruments) or by control of the property (eg, securities). However, security interests in certain categories of property, such as deposit accounts, can only be perfected by control.
Security interests in real property are perfected by filing the applicable mortgage or deed of trust in the central filing office in the local jurisdiction (typically, at the county level) where the real property is located.
If a security interest in any collateral has not been perfected at the time that a bankruptcy proceeding has commenced, then the secured party will be treated as an unsecured creditor with respect to the collateral in the bankruptcy proceeding. Furthermore, if a security interest is not perfected within 30 days after the security interest attaches, then the secured party is at risk of having the perfection step voided by the bankruptcy trustee as a preferential transaction in the event that a bankruptcy petition is filed against the debtor within 90 days (or, if the secured party is an insider, one year) after the perfection step is taken.Future-acquired assets
Can security interests extend to future-acquired assets? Can security interests secure future-incurred obligations?
The Uniform Commercial Code states that a security agreement may create or provide for a security interest in after-acquired collateral, except for commercial tort claims and, in certain circumstances, consumer goods. However, once a bankruptcy petition has been filed, an existing security interest will cease applying to after-acquired collateral, except for proceeds of prepetition collateral.
The Uniform Commercial Code further states that a security agreement may provide that collateral secures future advances or other value, regardless of whether such future advances or value are given pursuant to a pre-existing commitment. However, the security interest covering a future advance may have junior priority to intervening liens unless that future advance is made pursuant to a pre-existing commitment and, in the case of certain intervening federal liens (eg, federal tax liens and liens imposed by the Pension Benefit Guaranty Corporation), that security interest may have junior priority to such liens regardless of whether that future advance is made pursuant to a pre-existing commitment.Maintenance
Describe any maintenance requirements to avoid the automatic termination or expiration of security interests.
Uniform Commercial Code financing statements generally expire five years after the filing. To continue the perfection, and maintain the priority, of a security interest in the assets covered by a financing statement, the secured party must file a continuation statement in the applicable filing office within six months before the date on which the financing statement expires. Failure to file a continuation statement would cause the security interest in such assets to cease to be perfected until the secured party files a new financing statement covering such assets. Even if the secured party files a new financing statement with respect to such assets, the Uniform Commercial Code provides that the priority of the secured party’s lien would date back only to the date of the new filing (and not to the date of the original filing, as would have been the case if a continuation statement was properly filed). As a result, any existing lien on such assets that is perfected prior to the date of filing of the new financing statement would have priority over the secured party’s security interest in such assets.Release
Are security interests on an asset automatically released following its sale by the debtor? If so, are the releases mandated by law or contract?
US law generally provides that a lien remains attached to the collateral upon its sale, other than in limited circumstances. For example, a buyer of goods (such as inventory) in the ordinary course of business will receive the goods free of the creditor’s pre-existing security interest in the goods created by the buyer’s seller. For a buyer to qualify as a ‘buyer in the ordinary course of business’, the buyer must purchase the goods:
- in good faith;
- without knowledge that the sale violates another person’s rights in the goods;
- in accordance with usual or customary practices in the business of the seller; and
- from a person in the business of selling goods of that kind.
Most bank loan documentation provides for a contractual release of the secured party’s lien on assets sold by the debtor. So long as the sale is made in accordance with the covenants in the bank loan documentation, and not made to another affiliate of the debtor that is pledging its own assets to support the debtor’s obligations under the bank loan documentation, the secured party’s lien on the assets sold will be automatically released upon the sale of such assets. The bank loan documentation provides that the secured party will, at the debtor’s cost, take actions reasonably requested by the debtor to reflect such release, such as terminating Uniform Commercial Code financing statements.Non-fulfilment of guarantee obligations
What defences does a guarantor have against claims for non-fulfilment of guarantee obligations? Can such defences be waived?
Guarantors of bank loan facilities have several common law and statutory defences to the fulfilment of their guarantee obligations, including:
- material alterations of the underlying debt (eg, increases in the size of the bank loan facility or the interest rate accruing on the loans);
- release of co-guarantors;
- impairment of any collateral underlying the guarantee;
- failure of the guaranteed party to notify the guarantors of adverse facts concerning the debtor;
- statute of limitations;
- failure by the guaranteed party to demand payment of the amounts due (known as ‘presentment’); and
- debtor’s defences on the underlying debt (eg, violation of usury laws).
The guaranteed parties typically demand that the guarantors waive all common law and statutory defences available to them. Depending on the law of the state that governs the guarantee, the guarantee may be required to waive certain defences expressly rather than rely on a blanket waiver of all available defences.Parallel debt requirements
Describe any parallel debt or similar requirements applicable in a secured bank loan financing where an agent acts for multiple investors.
Under US law, an agent is permitted to serve as the secured party on behalf of multiple interchangeable lenders under the bank loan facility without the need for a parallel debt provision.Enforcement
What are the most common methods of enforcing security interests? What are the limitations on enforcement?
Typically, the collateral agent is authorised by the lenders under the bank loan documentation to enforce remedies if an event of default has occurred and is continuing. The remedies available to the collateral agent may be set forth in the bank loan documentation or may arise under law, such as the Uniform Commercial Code, or both. The collateral agent may obtain a judgment on the debt in court and foreclose on the collateral pursuant to court proceedings conducted in accordance with state law rules. Under the Uniform Commercial Code, the collateral agent may also exercise ‘self-help’ remedies without the assistance of a judicial process. For example, the debtor may deliver the collateral to the collateral agent, or the collateral agent may take possession of the collateral by entering the premises of the debtor, so long as such action does not breach the peace. Once in possession of the collateral, the collateral agent may arrange for a sale of the collateral at a public or private auction. However, the Uniform Commercial Code requires that the collateral agent’s actions be commercially reasonable and that the lender enforce its remedies in good faith. This may require that the collateral agent provide the debtor with advance notice of any sale of the property conducted by the collateral agent.
However, upon the filing of a bankruptcy petition against the debtor, an ‘automatic stay’ is immediately triggered. With limited exceptions, the automatic stay prevents the collateral agent from taking substantially all actions against the debtor and its property, including the enforcement of remedies against the collateral.Fraudulent conveyance and similar doctrines
Describe the impact of fraudulent conveyance, financial assistance, thin capitalisation, corporate benefit and similar doctrines on the structure of bank loan financings.
A transfer of assets by a debtor, or the incurrence of an obligation by the debtor, will be fraudulent (and subject to avoidance) if either the transfer or incurrence is made with the intent to defraud or hinder creditors (known as ‘actual’ or ‘intentional’ fraudulent conveyance) or the debtor was insolvent on the date on which the transfer or incurrence is made (or became insolvent as a result of such transfer or incurrence) and the debtor received less than a reasonably equivalent value in exchange for such transfer or incurrence (known as ‘constructive’ fraudulent conveyance).
In US bank loan financings, the risk of ‘constructive’ fraudulent conveyance is addressed in several manners. Where the proceeds of the bank loan financing are expected to be paid to the seller or shareholders of an acquired company in connection with an acquisition financing, or to the shareholders of the debtor in connection with a dividend recapitalisation financing, the bank loan documentation will include a representation by the debtor that, at the time of and after giving effect to the transaction, the debtor will be solvent, thereby attempting to rebut one of the two prongs of the ‘constructive’ fraudulent conveyance analysis. Rebutting the ‘reasonably equivalent value’ prong of the ‘constructive’ fraudulent conveyance analysis is difficult in such transactions given that the loan proceeds are not retained by debtor.
Similarly, where a debtor’s obligations under a bank loan facility are being guaranteed, on a joint and several basis, by its subsidiaries, or where such subsidiaries are providing collateral support for such obligations on a joint and several basis, the bank loan documentation will include a similar solvency representation with respect to the debtor and its subsidiaries, taken as a whole, given that the guarantee or collateral support itself would be a transfer by the applicable subsidiary for purposes of a fraudulent conveyance analysis. In addition, the bank loan documentation will provide that each guarantor make, on a ratable basis, a contribution payment to any other guarantor that is required to make a guarantee payment or transfer assets to support the debtor’s bank loan obligations, on the theory that the inter-guarantor contributions would allow the creditors to make a fraudulent conveyance analysis based on the combined financial position of the guarantor group rather than solely on the financial position of the individual guarantor making the payment or transferring its assets.
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27 May 2020.