A Question of Morality

In prior posts (see "Caveat Emptor”, from November 2009 and “Blanket Security vs A Security Blanket” from June 2009) I’ve commented on The Receivables Exchange’s policies regarding both filing UCC Financing Statements to provide additional security for Buyers, and its practices regarding existing UCC Statements that have a position of priority with respect to the TRE filings.

First, as a reminder, the TRE filings encumber only those receivables that the Sellers sell on the Exchange. This is as opposed to the practice followed by many (I could probably say “most” without being inaccurate) in the industry to obtain a lien on ALL of the receivables of a factoring customer.

Second, early descriptions of the Exchange’s work on behalf of Buyers suggested that efforts would be made to obtain releases of or subordinations of liens held by others that have claims prior to those of TRE.

As one who considers this an important issue, I actually DO review the UCC filings of new TRE Sellers and, when it appears that there is a prior claim on receivables, I DO check for evidence of the lien holder’s release or subordination.

I must say that there are many instances where prior liens encumbering a Seller’s receivables do exist but that there are relatively few such instances where I also find a release or subordination.

It’s not fair to say, based on that evidence alone, that efforts to obtain releases are not made. I don’t know how hard the Exchange tries to get those releases. I do know that, in my own non-TRE business, it’s tough to get any bank or other entity that holds a security position today on ANYTHING, to release it!

But that’s only the lead-in to my real point today.

A couple of weeks ago I was in a conversation with a number of traditional factors and the issue of buying an invoice in the presence of a prior UCC filing came up. An opinion was voiced that not only was it a poor business practice to buy in such a situation but that it was actually IMMORAL! The theory was that someone else had a security interest in that receivable and purchasing it deprived that person of a portion of his rightful protection.

While I acknowledge that there are situations in which buying invoices in the presence of a prior lien might be poor business practice, I’ve thought about this question a good deal since then, and I cannot find any justification for an assertion that it is IMMORAL!

In my normal business I almost never buy when a prior lien exists but there have been two instances in which I have. In one case, every time I made a purchase from the client I withheld enough cash to make the payments to the prior lien holder for a certain period of time and I actually made those payments myself in order to assure that there would be no default during the period my funds were outstanding.

In the second case, the prior lien secured a loan whose balance was small, representing a de minimus percentage of the typical receivables balance and, to my mind, a de minimus risk of loss even in the event of default.

There are cases of TRE Sellers where it is clear that the obligations secured by the liens are very significant and, in the event of a default, could become really problematic for a Buyer.

There are also cases where the documentation of UCC filings is quite lengthy (there was a case not too long ago where the UCC file ran to 104 pages, for instance) and it’s a real job to try to figure out what’s still current and what is encumbered by whom).

Each Buyer will approach the question of assessing the risk posed in such cases differently. Some will just steer clear of auctions in which prior liens exist. Some will simply ignore them and hope for the best. Some will take the position that the filing is only problematic in case of a default by the Seller giving rise to action by the lien holder, and attempt to assess that risk.

One of the problems in assessing such a risk is that, often, it is unclear from the Seller’s financial statements, what the size of the secured obligation is. Another is that, often, the age of the financial statements makes the accuracy of the PRESENT liability structure uncertain.

Yet another is the uncertainty of a Seller’s disclosing the presence of any litigation that might have arisen potentially triggering the right to levy on receivables (although I would hope that the TRE fraud-protection group would devote a decent amount of time to this).

(Did anyone read this week-end about the apparent practice of many large banks of drastically reducing borrowing in the days immediately preceding financial-statement dates, only to dramatically increase borrowings during the middle of a quarter?)

So, my point is that the assessment of and response to the business risk of buying in the presence of prior liens, is obviously being approached differently by different Buyers.

But what about the MORALITY of the issue?

I have to say that, while I respect the individual whose position I quoted above, I just can’t see that this is a matter of morality.

At the most obvious level, an invoice-purchase transaction, of itself, takes nothing significant away from the security of the lien holder. A less-liquid asset, the invoice, is removed from the balance sheet. And a more-liquid asset, cash, replaces it (at least to the immediate extent of the advance amount).

Any well-written UCC filing will include in the description of security some language that extends the lien to the proceeds of the sale of any encumbered assets. So it could be argued that, as long as the proceeds of sale remain in some way in the business, the aggregate security of the lien holder is not damaged.

Conceptually, it can also be argued, I think, that to the extent that the assets encumbered exceed the value of the debt, restricting either the Seller or the TRE Buyer from converting the excess, less-liquid assets into more liquid assets, would be an unfair restriction of management. In such a case, it might be analogous to a first mortgage-holder prohibiting or preventing a property owner from using the proceeds of a second-mortgage to put a new roof on the house.

And from a purely practical point of view, except in the case of some kind of court-ordered immediate action to freeze (or seize) operations, it is highly unlikely that the ACTUAL invoices being bought by a factor would still be on the books of the seller by the time the holder of the first lien could get through the legal process required to levy on them.

Others might have different experience, but my own has been that the time required to get to the point of actually levying on receivables is so long that the AR Schedule at the time of levy bears little resemblance to the one at the time of default.

The issue of buying receivables in the presence of a prior lien raises all sorts of real and difficult business risk problems.

But I don’t find it to be a MORAL issue.

Do you?