In any secured financing, a borrower's undertakings relating to collateral can have significant implications for its cost of compliance and for its business operations. In leveraged loans, which are commonly used by non-investment-grade borrowers for acquisitions, refinancings, dividends, and other general corporate purposes, the borrower's collateral undertakings deserve special attention because of the numerous categories of property covered by the secured parties' liens, which are often referred to as "blanket liens."
The "Blanket Lien": What's In and What's Not
To begin with, a blanket lien generally consists of a grant, often to an agent bank for the benefit of the secured parties, by a borrower and its subsidiaries of liens that cover most, if not all, types of property, but can be subject to some very significant exceptions. Indeed, although parties often refer to a blanket lien as covering "all assets," the reference to "all assets" is a misnomer, as few, if any, financings result in perfected security interests in all property. Exclusions are common to address various concerns the borrower has with respect to: cost (in terms of time or out-of-pocket expense), compliance, and operational flexibility.
Exclusions Related to Cost
De minimis value. A great many secured financings exclude property of de minimis value if that property requires incremental effort to create a security interest. Thus, for example, if liens on deposit accounts are not excluded altogether, it is standard for the borrower and the agent bank to agree that deposit accounts with balances below a threshold will not be subject to a deposit account control agreement, which is the agreement by which a secured party acquires a perfected interest in deposit accounts, and which can be time-consuming to negotiate. Indeed, if deposit accounts are to be included in a collateral package, it is ideal from the borrower's perspective to limit the security interest to those accounts that hold significant amounts of uncommitted cash. Therefore, zero balance accounts, payroll, or other disbursement accounts are commonly exempt from control agreements. Other examples of property that may be excluded when valued below an agreed threshold include immaterial subsidiaries and real estate.
Implicit in all of these de minimis exclusions is a calculus that the benefits of a lien in an asset with so little value are not worth the incremental cost to provide the lien. (By contrast, because little, if any, incremental effort is required for a security interest in personal property, such as goods, that becomes subject to a perfected security interest with no more than a proper security agreement and UCC filing, a de minimis exclusion rarely, if ever, applies to such property.)
Explicit Cost-Benefit Tests. Often, an explicit cost-benefit test is used to exclude assets that the agent bank and the borrower agree are insufficiently valuable to justify the cost of perfecting the lien in such assets. And sometimes cost-benefit considerations apply implicitly, such as when loan documents require a borrower to undertake good faith, commercially reasonable efforts to obtain a lien on an asset before it may be excluded; with the understanding that the cost of such efforts is sufficiently modest in relation to the possibility of procuring the lien.
Other Costs to be Avoided: Tax. In addition, several types of property are excluded from a blanket lien for reasons that implicitly relate to cost. For example, the U.S. Tax Code can impose tax costs on a U.S. borrower if a non-U.S. subsidiary provides credit support, including credit support in the form of a pledge of the subsidiary's assets or a pledge (by the U.S. borrower) of more than two-thirds of the subsidiary's stock. For this, and for other reasons explained below, a U.S. borrower typically pledges no more than 65 percent of the stock it owns in a non-U.S. subsidiary, and the non-U.S. subsidiary itself does not provide collateral or other credit support in any form for the obligations of the U.S. borrower.
Other Costs to be Avoided: Non-U.S. Collateral. In cross-border financings, for non-U.S. entities that are not subject to these tax considerations, costs of obtaining perfected security interests may still be very substantial, and can include such things as high stamp tax on the creation and/or registration of liens, costly notarization or translation requirements, documentation formalities that require long lead times, or execution of powers of attorney by all secured parties (and not just the agent bank). In addition, the borrower must also consider the time and effort involved in coordinating with local counsel in non-U.S. jurisdictions. Local law documents, including multiple security agreements and opinions, may be required to achieve liens on assets in a particular jurisdiction, and execution formalities outside of the United States can be time-consuming. These burdens, together with the tax considerations for U.S. borrowers outlined above and the regulatory and compliance issues that we mention below, will typically result in total or near-total exclusion of foreign assets owned by U.S. borrowers and significant limitations on collateral to be provided by non-U.S. borrowers and subsidiaries; indeed, if collateral is to be included at all in non-U.S. jurisdictions, borrowers and lenders often specify in detail the particular basis (generally referred to as "Agreed Security Principles") on which collateral is to be provided or excluded.
Other Costs to be Avoided: Vehicle Registrations, Leasehold Mortgages, and Regulatory Disclosure. For most borrowers, vehicles and other goods subject to certificate of title statutes are generally perceived to have little value relative to the borrower's other property, and the cost and burdens of obtaining security interests under certificate of title statutes are almost always deemed not justifiable. When vehicles are in fact significant in value, special forms of secured financings may be deployed. Leasehold mortgages, which require the consent of third parties, are generally perceived to be costly, if not impossible, to obtain, and financing facilities will often exclude them entirely or require no more than good faith, commercially reasonable efforts by the borrower to obtain mortgages in material leased properties. For issuers of secured bonds to be registered under the Securities Act of 1933, the cost of disclosure requirements under the U.S. securities laws can be burdensome. Rule 3-16 of Regulation S-X, for example, requires separate financial statements for any subsidiary whose stock constitutes a substantial portion of the collateral of a class of debt that is registered, with the result that there is a common exclusion in secured bond financings for the pledge of any such stock.
Exclusions Related to Compliance
Beyond cost issues, borrowers also concern themselves with compliance with law and with other obligations.
Although it is generally the goal of the secured parties to a leveraged loan to include as many assets as possible in the collateral package, local law, especially in civil law jurisdictions, may impose significant limitations on a non-U.S. borrower's ability to grant liens on its collateral. Local laws may impose, for example, a "corporate benefit" test that must be met in order to justify the board's approval of the grant of a guaranty and/or security. Or a jurisdiction might have laws that make it impractical or even impossible for a lender to obtain liens on a particular category of assets, such as by requiring that the lenders take possession of inventory or continually update schedules of receivables in order to perfect their security interest. In such cases, directors are particularly sensitive to the need to document the corporate benefit to the foreign subsidiary of guaranteeing and/or securing loans of a parent or affiliate, and generally require that there be some evidence that the subsidiary will receive proceeds of the loans (either directly to repay existing indebtedness or for working capital purposes or indirectly by way of documented intercompany loans). In addition, some jurisdictions impose "financial assistance" limitations that effectively prohibit a subsidiary from granting guarantees or collateral in favor of its parent company's debt incurred in connection with acquiring such subsidiary. Noncompliance with some local laws can even result in criminal sanctions. To address all these concerns, the relevant guaranty and security documentation should contain appropriate exclusions, restrictive language, and/or dollar caps.
Nor are compliance concerns limited to law; borrowers must comply with all of their contracts. It is standard for security agreements to exclude contract rights that are subject to anti-assignment provisions (which prohibit the granting of liens on rights in licenses or in other agreements) in order to avoid a breach of those anti-assignment clauses. Often there is a workaround to this exclusion: UCC § 9-408(a) limits the effect of anti-assignment clauses in general intangibles (a category that includes intellectual property licenses and other contracts), stating that such clauses are ineffective to the extent that the terms (a) would impair the creation, attachment, or perfection of a security interest, or (b) provide that the assignment or transfer or the creation, attachment, or perfection of the security interest may give rise to any default, breach, right of recoupment, claim, defense, termination, or remedy under the agreement. Thus, UCC § 9-408(a) permits the secured lender to have a valid security interest in a borrower's license or other contract right, despite anti-assignment terms. However, it does not go so far as to deprive the third party of all benefit of the anti-assignment terms; it provides, for example, that the secured party may not enforce its security interest in the rights that are otherwise subject to an enforceable anti-assignment term. To further protect a borrower against breaching its anti-assignment obligations, this workaround is typically qualified so that it only applies when section 9-408(a) (or any similar law) is in fact applicable, binding, and enforceable.
Exclusions Related to Operational Flexibility
Aside from cost and compliance concerns, borrowers require a certain amount of flexibility to use and dispose of their property in a manner consistent with the operation of their businesses. Thus, security agreements often exclude liens on property when the lien would interfere with business activities of the borrower that are not prohibited by the credit agreement, such as purchase money financings, sales of subsidiaries and of other assets, receivables financings, deposits, and consignments.
For example, a borrower's need to develop and establish trademarks results in a common carveout from the intellectual property collateral package for "intent-to-use" trademark applications (ITU applications), applications for which a statement of use has not be filed. Although U.S. trademark law generally requires actual use of a trademark before an application for registration may be filed, ITU applications are permitted if the applicant has a bona fide intention to use the trademark described. But an assignment of a trademark under an ITU application prior to the filing of a full trademark application or verification of a statement of use, may result in the voiding of both the ITU application and the associated trademark. And, while a security interest in an ITU application alone does not necessarily constitute an assignment, foreclosure may be considered an assignment. So to avoid the possibility that an ITU application and associated trademark may be void if it is assigned prior to the registrant filing a full application or a statement of use, borrowers (and lenders) exclude ITU applications from pledged collateral.
Once a collateral package has been agreed to and a leveraged loan with a blanket lien has closed, a borrower will be subject to ongoing compliance obligations, generally consisting of near-term completion of steps to perfect security interests in the collateral, information reporting, and covenants regulating the use and disposition of collateral.
The borrower should make certain that it has allowed enough time to complete any collateral delivery and perfection requirements. While an agent bank may seek the shortest conceivable deadline, the borrower should make its own appraisal of the time required and also should allow for unforeseen circumstances that might cause delay. The borrower should take account of such things as the time needed to locate stock certificates or promissory notes, obtain releases from third parties whose debt has long since been repaid, and negotiate control agreements with depositary banks and securities intermediaries. Cross-border transactions in particular tend to have extensive post-closing schedules that have been heavily negotiated amongst local counsel regarding local registration formalities and deliveries.
In addition, the security documentation will contain representations and covenants relating to the collateral that may impose a notice requirement if the borrower changes its name, address, or corporate form, forms new subsidiaries or makes certain types of acquisitions or investments, opens new bank accounts or acquires a commercial tort claim. Some borrowers prefer, for ease of reference, to have such collateral update requirements in the affirmative covenant section of the credit agreement, together with all other periodic delivery requirements. Other borrowers prepare extensive compliance summaries or implement specific compliance procedures.
In any event, it is important during the loan documentation stage for the borrower to focus on these compliance burdens and negotiate for appropriate materiality thresholds, baskets, and notice requirements. Although it may not seem particularly difficult to keep track of such things as changes in corporate names or addresses, as a practical matter, employees of a borrower have many responsibilities and, in the course of performing them, may inadvertently trip up covenants that require advance notice of such changes. For this reason, it is always better from the borrower's perspective to limit the notice and informational requirements to those that are essential, and to provide that timing of such notices may occur after an event, and within periods that can be extended by an agent bank, which is likely to take a practical and sensible approach to compliance. For similar reasons, the borrower should try to limit the frequency of informational updates to no more than once per year.
When a borrower's obligations are secured by collateral, the credit agreement will provide that the collateral will automatically be released from the security agreement upon the occurrence of (1) the full repayment of the borrower's underlying secured obligations, and (2) any permitted dispositions of assets. Partial release provisions will often reference the permitted dispositions covenant in the credit agreement and may require a detailed notice to the agent bank. Typical release language will state that the liens are terminated and all rights in the collateral revert to the borrower "automatically," without further action by any party. Nonetheless, a diligent borrower will request that the agent bank provide evidence of even an "automatic" termination.
In connection with the release of collateral, the borrower should obtain from the secured party such things as Form UCC-3 termination statements for which the secured party has provided authorization to file, control agreement terminations, and intellectual property security agreement releases, which are executed by the secured lender. The borrower should promptly file all UCC termination statements and IP releases in the appropriate offices, to ensure that the public records accurately reflect the termination of liens. A security interest that remains on record after the underlying obligations have been released becomes, with the passage of time, increasingly difficult to expunge, as former secured parties may have little incentive to act expeditiously to sign requested releases, may have little institutional knowledge of the obligation that gave rise to the security interest, and may even cease to exist. For similar reasons, a borrower should remember to request the return of any possessory collateral such as stock certificates with accompanying stock powers.
Although payoff letters should and often do contain further assurances provisions, such that a former secured party will be obligated to take future action (customarily at the borrower's expense) to release its security interests in the collateral and return possessory collateral, timely filing of releases, retrieval of possessory collateral, and proper record-keeping of termination documents help reduce the diversion of cleaning up the records during the negotiation process of the borrower's next secured financing.
During the course of negotiations of an "all assets" secured financing, it is crucial for both the borrower and its counsel to carefully consider the coverage of the blanket lien and to focus on compliance requirements that will be effective throughout the term of the loan. The principals tend to spend significantly more time reviewing and negotiating provisions of the principal financing agreements that may more directly and obviously impact the economics of the loan, and do not always appreciate how the provisions relating to the collateral can impact the operations of the borrower's business. Lenders and borrowers should endeavor to work together to craft a collateral package that strikes a balance between the lender's desire for collateral coverage to secure its loan and the borrower's need to limit related transaction costs and retain operational flexibility.