International Lending for Asset-Based Finance

Alissa Palatiello is the winner of the essay contest held this past summer sponsored by CFA's: Women in Commercial Finance Committee.

Asset-based lending has evolved from a primarily small and middle-market driven business with single-lender facilities to a lending mechanism that caters to companies of all sizes, including syndicated transactions with total facility sizes in excess of Si billion. In recent years, ABL has become a preferred source of debt capital to clients in many industries due to the flexibility that borrowers have to operate their business without restrictive covenants. As ABL continues to interest sophisticated borrowers with multinational operations, cross-border lending is an area that warrants exploration. This essay will discuss the legality of conducting asset-based lending in foreign jurisdictions.

Common Law vs. Civil Law

In the United States, the UCC grants secured lenders perfection on certain types of assets and the ability to use the proceeds from the sale of those assets to recover on their loans in liquidation scenarios. Mayer Brown has outlined in their piece Security Interests under the UCC and Civil Law Jurisdictions that "the UCC is an outgrowth of the common law legal system-the legal system currently followed in the United States, Canada, the United Kingdom, Singapore, Hong Kong and a number of other former British colonies.''The firm continues to discuss that common law is structured to develop with court decisions which allows the law to adapt to the current environment. The court adopts, interprets, clarifies and expands the law's scope. The common law system has made it possible for lenders in the United States and other former British Colonies to have the ability to perfect on dynamic assets. For example, security is possible on an entire category of assets (A/R, inventory, etc.) rather than a specific asset at a point of time.

While the common law system accommodates secured financing, many of these jurisdictions distinguish between two different types of liens. These liens (or "charges" in local parlance) are distinguished as a "fixed charge" that receives preferential treatment with priority over government claims whereas a "floating charge" is subordinated to such claims. These claims could include: taxes, pensions and other claims. The differentiating factor is that, when a company can freely dispose of the asset without the lender's consent, it must be a floating lien. Therefore, A/R and inventory generally have floating liens because the borrower disposes and replenishes these assets in the normal course of business. In certain instances, a secured lender can transform its floating lien on accounts receivable to a fixed lien by obtaining cash dominion.

In contrast, many European and Latin countries have a civil law-based system. The legislature has the sole ability to create and change laws. It is the court systems' responsibility to apply and enforce the law. This is opposed to common law, where courts can interpret the law to fit a case-by-case situation. This has made it difficult for asset-based lenders to obtain perfection in these jurisdictions as the legislature has not changed laws to accommodate such security.

Under the common law system, the ability to have a floating lien on dynamic assets under the UCC or similar codes has made asset-based lenders comfortable with their security interest. Furthermore, this security interest has been proven in court. Under the civil law, a floating lien may not exist. Typically, the secured assets (collateral) must be specifically described in detail. For example, secured A/R must include the date incurred, account debtor and the amount. Therefore, future A/R is not secured unless the borrower periodically updates its security lists. Even with this, most jurisdictions lack a central filing system where liens are housed. Additional obstacles include: The account debtor must sometimes be notified if a lender has a lien on their payable to the borrower; interests that prime a secured lender in the event of foreclosure on perfected assets; and the secured creditor has limited control over the process. Despite the obstacles for secured lenders under the civil law system, ABL market conditions have influenced lenders to consider indudingassets under civil law jurisdictions in their borrowing bases.

While there are general guidelines for securing certain asset types, each transaction is unique and must be evaluated independently by legal counsel. When determining whether it is practical and reasonable to include foreign assets in the borrowing base, lenders should take note of the quality of the courts, predictability of the outcome of proceedings, priming liens and levels of dilution.

Foreign Receivables Owned by a U.S. Borrower

Foreign receivables that are owned by a U.S. borrower have fewer priming issues than foreign receivables owned by a foreign borrower entity. The UCC grants security on receivables owned by a U.S. borrower because it is within its jurisdiction. The possible issue is whether the foreign debtor's courts will recognize and enforce this security. Legal counsel can advise lenders as to whether additional documentation is required for the country in which the receivable is created and the extent to which the foreign country's legal system will recognize this security. Many countries require that the account debtor be notified of the fact that their payable to the borrower is subject to a security interest in favor of a lender.

A lender might take precaution on its ability to recover on the borrower's foreign receivables by requiring that the borrower obtain credit insurance on such accounts or that the receivable be backed by a letter of credit. It is important that proper diligence is conducted on this coverage because, if the borrower is out of compliance with these agreements, the lender's protection may be compromised.

An alternative solution is that, if the receivable is due to a U.S. manufacturer (exporter), the borrower may qualify for the American government-backed Ex-lm product. Some banks have credit authority to underwrite Ex-lm facilities for their clients. This program guarantees that the secured lender will recover up to 90% of the loan on foreign receivables that it lends against. Ex-lm will only repay the lender if all other sources of repayment are exhausted (i.e., it functions as a deficiency guaranty). Only the lender is covered by this product and it isa last-resort situation.

Foreign Receivables Owned by a Foreign Borrower

If the receivables are owned by a foreign entity, such as a foreign subsidiary of a U.S. entity, a security interest in the asset must be created under the laws of the country in which the company is domiciled. When a subsidiary is involved, it is important to determine the true owner of the assets.

The process of securing the assets could be tedious and cost-prohibitive; therefore, it is important that the lender considers this before attempting to add these receivables to the borrowing base. Additional paperwork, which sometimes must be updated periodically, is likely outside of common law-based countries because securing future assets might not otherwise be possible.

As discussed in regard to foreign receivables owned by a U.S. company, foreign receivables owned by a foreign entity might also require that the account debtor is notified of the security interest. It is also notable that the country may not have a centralized filing system to record the liens. This could cause problems for the lender if there was a competing lien on an asset that the lender was unaware of until liquidation. Furthermore, fees and taxes to register a lien may not justify the availability that such collateral provides.

In addition, the lender may not qualify for a lien/pledge of the assets if it is not a registered entity under the jurisdiction. This could potentially be worked around if the lender appoints a registered entity as an agent to act on its behalf.

A significant consideration, when lending to a foreign borrower, is to understand the possible claims that would prime a secured lender's position. For example, one of the most common such claims is the "retention of title" that is very common in foreign jurisdictions. In certain jurisdictions, particularly Germany, this claim could give the supplier a first priority claim on receivables due from inventory that the borrower has sold in the event that the supplier has not received payment for such inventory. In this scenario, it would be recommended that a reserve for the accounts payable amount be included in the borrowing base. Further, some countries give employees' wages a priority claim against a secured lender. A reserve for accrued wages could be appropriate.

A lender should be familiar with the insolvency laws in the borrower's jurisdiction. The lender should have an idea of how such a proceeding would occur, the likely outcome, the extent to which it can recover on its loan and the lender's ability to control the sale process of its collateral.

Foreign Inventory

A lender must comply with the secured financing laws of the jurisdiction of which the inventory is located, regardless of the owner of the inventory. This is the result of a legal principle known as lex situs or lex rei sitae. In most countries, this concept is deeply imbedded in law. Under this principle, a security interest in tangible property, such as inventory, equipment and real estate, is governed to a large extent by the secured transaction laws of the country where the property is physically located and, therefore, must be documented in accordance with those laws. The UCC reiterates this concept; as part of achieving perfection under the U.S. law, one must comply with the laws of the country in which the inventory is located.

Many foreign subsidiaries of domestic entities are restricted by local law from guaranteeing a loan to the domestic parent. There are laws and regulations in many countries that the board of directors of the foreign subsidiary must act in the best interest of the subsidiary, not the parent. Therefore, if the subsidiary does not benefit from guaranteeing the loan (i.e., have access to the loan proceeds), the board of directors could be liable if they allow this guarantee. Further, certain European Union countries are restricted from providing acquisition financing that uses the security of acquired company's assets to finance the transaction under the Financial Assistance Laws.

Each country has its own nuances to securing inventory. As with securing accounts receivable, there might be some obstacles for a U.S. lender to secure its interest under a foreign jurisdiction; however, there may be solutions to work around this which should be investigated with legal counsel.

While this is a broad overview of the topic, a secured lender should be aware of these legal concepts when conducting business internationally. Each country has specific laws that apply to its jurisdiction. A lawyer should be consulted before transacting in foreign jurisdictions. As ABL borrowers expand their international financing needs, there will be market incentive to accommodate such requests, given that lenders can perfect their security interest. This will require familiarity with the varying laws in each jurisdiction. Such expansion will offer additional growth opportunity to the ABL market. In addition, an assetbased solution could offer liquidity to a borrower that was limited by cash-flow restraints under traditional financing structures. It appears that there are economic drivers to exploring secured lending in jurisdictions that previously seemed incompatible.

Aiissa Palatiello is a part of the wholesale training program at Wells Fargo Capital Finance. The program includes four rotations through different divisions of the asset-based lending group. Currently she is a part of the Underwriting Group for Business Finance in New York. Aiissa graduated from Bentley University in 2012 with a B.S. in economics and finance with a Global Perspectives liberal studies major. Aiissa is on the board of the Mmofra Trom Foundation, an organization that raises funds to send children in Ghana to school.