A. Chapter 1 of TEXT, p. 1 -18, packs a lot of information into a very few pages. These notes (including a number of links) provide background information to help illustrate the information you are given in Chapter 1. PLEASE DO NOT FEEL OVERWHELMED by the details of this background information. I will guide you to the important parts. You can return to this background as needed to aid your understanding.

B. First, I have created a very simple ABL or 'asset-based-lending' credit facility for you to look at. It is posted in PDF. You may annotate it, print it out, use it to line a bird cage. It is called BABY ABL CREDIT AGREEMENT. It has two simple exhibits. Ex. A is a form of BABY ABL REVOLVING PROMISSORY NOTE. Ex. B is form of BABY ABL SECURITY AGREEMENT. You should read these documents together with TEXT p. 1-18. In truth, these basic four pages get you ninety-five percent of the way home for any asset-based loan of any size to any borrower. The hundreds of extra pages found in actual documentation for large transactions has, for most purposes, an incremental benefit at best. But that is what we commercial lawyers do, I suppose. Sometimes additional details are important.

C. And, a complex corporate structure of a large borrower is simply a reality that must be dealt with. A significant part of the document complexity found in a secured financing flows from corporate structure and not the particulars of the law governing secured transactions, financings, or the buying and selling of goods (which is complicated enough in its own right).

D. Mastering the BABY ABL CREDIT AGREEMENT will make your review of the COMMERCIAL SECURITY AGREEMENT at p. 18 of TEXT (the 'Ed Smith' Security Agreement) and the INSTALLMENT SALES CONTRACT at p. 36 of TEXT much easier for you. I have made a PDF file of the 'Ed Smith' Security Agreement which you may print out. You may wish to annotate it or look at it alongside other pages of the TEXT (without the need to flip pages back and forth).

A. I have made a short video for you which describes how scarce assets of a debtor are allocated among different creditors in a bankruptcy proceeding. HERE is the related HANDOUT for that presentation. The allocations schemes differ depending on whether a creditor is an unsecured creditor or a secured creditor. As a general matter, a bankruptcy court allocates assets to unsecured creditors on a pro rata basis. A secured creditor with a 'perfected' security interest has a priority claim to the assets subject to the security interest ahead of unsecured creditors. Any assets remaining after application to satisfy the secured claim are allocated pro rata among the remaining unsecured creditors. As a general matter, a conflict between two perfected security interests in the same assets is resolved by giving priority to the first-in-time security interest (by a timing rule which determines 'first' by the first to 'file' or 'perfect').

B.A major exception for the priority given to a first-in-time security interest is the priority given to a 'purchase money' security interest or PMSI. A purchase money security interest is a security interest given to enable a debtor to acquire a good such as equipment or inventory. It might be provided by the seller of the good or by a third-party lender.

C. A major reason why a lender might prefer secured lending to unsecured lending is because the lender will receive a priority bankruptcy distribution in scarce assets of a debtor ahead of other creditors. This priority is essentially a zero-sum game. The greater the distribution priority given to a secured creditor, the lesser the distribution received by unsecured creditors.

D. Notice that this distribution priority is given to a secured creditor as a result of a private ordering 'by contract' between a secured creditor and a debtor.

E. This legal scheme of giving priority to certain creditors over other creditors as a result of a private ordering raise significant policy questions. Is it fair or just to allow a private contract to reduce a payment to an unsecured creditor? Do you feel differently about another 'voluntary' creditor' as compared with an 'involuntary' creditor such as a tort claimant? To help you think about these questions of justice and fairness, consider the following article about a possible 'carve-out' in bankruptcy: Lynn M. LoPucki, Should the Secured Credit Carve Out Apply Only in Bankruptcy? A Systems/Strategic Analysis, 82 Cornell L. Rev. 1483 (1997). For an analysis of Elizabeth Warren's approach to future claims in bankruptcy, see Adam Levitin's summary in: Credit Slips

F. Keep in mind that a security agreement is a special kind of contract because it can create an interest in property (i.e. the security interest) which is enforceable against third-parties if it is properly perfected. This is different from a mere covenant as typically found in most contracts. Prohibiting asset transfers, dividends, incurrence of indebtedness (including guaranties) and mergers by a negative covenant does not prevent these actions from occurring. The covenant merely gives the beneficiary of the covenant a breach of contract action. The breach of covenant may permit the lender to accelerate the maturity of its debt. This means that the lender can ask for its money back. If, however, the debtor does not pay the accelerated maturity, the lender will need to sue for payment. The presence of an accelerated claim may cause the debtor to file for bankruptcy. There is no assurance that, in a bankruptcy proceeding, the court will restore the structure to the status quo prior to the covenant violation. In another e-Presentation we will consider the doctrine of equitable subordination. Briefly, equitable subordination is a doctrine that might permit the debt of one creditor to be subordinated to the debt of another creditor based on bad actions taken by the first creditor. For example, if a creditor knowingly induced the debtor to violate a covenant in order to improve its position vis-à-vis another creditor who benefited from the covenant, the second creditor may argue to the court that the claim of the bad creditor should be subordinated to its claim.

G. One of the primary techniques used in structured financing and asset securitization transactions is to create what is known as a special purpose vehicle or SPV. Typically, the SPV acquires assets and borrows money. The lender satisfies itself that the assets of the SPV are adequate to service and repay its loan. It relies on the separateness of the SPV from the other members of the corporate group to give it priority over different lenders to other members of the group and to give it certain other benefits. Thus, a lender may rely on the existing corporate structure of a consolidated group in making a loan or it may recommend changes in the corporate structure, such as creation of an SPV and the transfer of assets to the SPV, as a condition to extending credit. In either case, consideration of corporate structure and the priority that it creates is essential in formulating a lending strategy.

SPV’s go by various names. Sometimes they are referred to as special purpose corporations or SPC’s. Other times they are referred to as bankruptcy remote subsidiaries.

An SPV structure is often used in larger financing transactions in place of the 'factoring' transaction described in the TEXT at p. 13-16. Both the SPV and the factoring transaction rely on a 'true-sale' of receivables. The benefit of a true sale of receivables is that it gets the assets outside the bankruptcy estate of the debtor. If you have purchased the receivables in a true-sale, they are your assets and you can collect them despite the fact that the debtor who sold them to you has filed for bankruptcy. If you had merely made a loan secured by those same receivables and the debtor files for bankruptcy, the automatic stay in bankrtupcy will delay any recovery by the secured creditor. It often is hard to distinguish the financial outcome between a loan secured by receivables and a sale of receivables to a factor or an SPV. The economic substance of the transaction can be very similar (just as the purchase and the lease of an automobile can be structured to acheive a similar economic result.

Note well the difference stated at TEXT p. 14 between 'recourse' factoring and 'non-recourse' factoring. Non-recourse factoring will almost certainly be a 'true' sale which is sufficient to transfer the receivables outside the bankruptcy estate of the debtor. This is a good thing because the secured party/purchaser may collect and retain the proceeds received from payments made by account debtors (the folks who owe the debtor for the purchase of goods or services). In contrast, a 'recourse' factoring may not be a true sale. Rather, a recourse factoring might be recharacterized by a bankruptcy court as a disguised secured loan. Article 9 of the UCC treats both a loan made on the security of receivables and a sale of receivables (such as to a factor) as the same type of transaction. The debtor is the 'seller' of the receivables and the secured party is the 'purchaser' of the receivables in a factoring transaction. More details are given about the true-sale idea at the end of these notes.

A. I have given you the outline of how distributions are made in bankruptcy so that you might understand the concept of a 'loss-given-default'. This is a fancy term used by rating agencies. In ordinary terms, it simply means that the expected loss on a secured loan is less than the expected loss on an unsecured loan, other things being equal.

B. The basic fact that secured credit has a lower expected 'loss-given-default' explains why lenders can charge a lower interest rate on a secured loan than they need to charge on an unsecured loan. HERE is a HANDOUT which provides some detailed numercial examples so you can begin to understand how secured credit might be priced. Of course, some borrowers are such a poor credit risk that a lender will only extend credit to them on a secured basis.

There are a number of studies which analyze the returns on different kinds of financial instruments. See e.g. Moody's, Recovery Rates on North American Syndicated Bank Loans, 1989-2003. And relaxed lending standards are setting the stage for a lower expected recovery in a loss-given-default scenario. See e.g. Reuters, Lower recovery rates to haunt U.S. leveraged loans (August 17, 2018). The expected recovery percentage in a loss-given-default scenario is a function of the presence or absence of security, the nature of the security, the financial covenants and overall credit underwriting standards. See generally Standard & Poor's, A Guide to the Loan Market (September 2011) (particularly focus in the Guide on p. 23-26 to supplement the TEXT discussion at p. 8-12).

A. A transfer of assets to a subsidiary may be accomplished either by a sale or by a contribution of assets to the subsidiary. [Comstock v. Group of Institutional Investors, 335 U.S. 211, 229 (1948).] The transfer of assets to a third-party such as a factor are accomplished by a 'true' sale of those assets. The rights of a transferee of property are subject to any applicable avoidance powers recognized under the Bankruptcy Code. Otherwise, the transferee’s interest in property that is transferred prior to the filing of a bankruptcy petition is defined by non-bankruptcy law. [Butner v. United States, 440 U.S. 48, 55 (1979).]

B. A central question to be answered in many transactions is whether the transfer of assets constituted a true sale of the assets or instead should be characterized as a mere secured loan. Courts consider a variety of factors in making this determination including: compliance with applicable law to effect a transfer, the intention of the parties, and the allocation of risks and benefits associated with ownership. In a future class discussion, we will outline the factors in detail and discuss the relevant case law. [In re Bevill, Bressler & Schulman Asset Management Corp., 67 B.R. 557 (D.N.J. 1986); In re OMNE Partners II, 67 B.R. 793 (Bankr. D.N.H. 1986); Major’s Furniture Mart, Inc. v. Castle Credit Corp., 602 F.2d 538 (3d Cir. 1979); In re Kassuba, 562 F.2d 511 (7th Cir. 1977).]

C. In summary, a separate legal person or entity provides no benefit to a financier if the assets on which the financier is relying are not owned by the separate legal entity or by the financier itself. In setting up a financing structure, often assets must be rearranged within a consolidated group of companies. These transfers must be considered complete transfers and not mere limited security interests to be effective. The matter is of significant importance and, accordingly, rating agencies often require the delivery of legal opinions that confirm certain transfers will be considered true sales by a court in a properly presented case.