Thursday, July 14, 2011

Appropriate Compensation #7: The Lien Position

In this series of posts we've identified a number of ways in which the TRE Buyer is assuming incremental risk when compared to typical factoring transactions. The goal is to ultimately draw a conclusion regarding the appropriate level of incremental return necessary to compensate for that additional risk.

Today I want to return to the issue of the lien position that the TRE Buyer acquires in the assets of the TRE Seller. We’ve addressed this issue before.

Please see:

• Caveat Emptor #2: December 15,2009, and
• Blanket Security vs. a Security Blanket: June 29, 2009

There are two principal conditions in the Buyer’s lien position that give rise to risk in TRE transactions that would not normally be accepted in typical factoring transactions:

1) The TRE Buyer obtains a lien ONLY on the invoices purchased from the TRE Seller, and

2) It is often the case that other parties already hold prior liens on the receivables of a TRE Seller, so the TRE Buyer might hold a second or even more-junior lien position on the receivables it purchases.

The fact that the Buyer’s lien attaches only to the receivables purchased is made more problematic by the lack of a full notification process that we’ve recently discussed. If the invoice purchased is defective and the Buyer’s lien attaches only to that invoice, the value of the lien is questionable.

And the fact that other parties might have superior lien positions with respect to the assets of the TRE Seller, puts the TRE Buyer at risk that the rights and actions of others, which neither TRE nor the Buyer can control, can substantially reduce the value of the Buyer’s lien.

Compounding that problem is the fact that I know of no truly reliable warning system to alert the TRE Buyer to the existence of action or threatened action by a 3rd party in time for protective measures to be taken by either TRE or the Buyer.

In typical factoring relationships there is an opportunity for ongoing dialog and business-condition assessment. That is not the case in the TRE environment.

In the TRE environment the Buyer is almost always going to be behind the curve, learning of problems after the fact. Even if a Buyer is an astute analyst of financial data, able to tease out indicators of developing problems, the information available on the TRE platform is always dated. And, as we’ve discussed, the quality of the information contained in internally-generated financial statements – always less-assured than audited data – is far more likely to be inaccurate in conditions where Sellers are in trouble or heading in that direction.

Becoming aware of a threat to one’s position via notice of a superior lien-holder’s action is unpleasant.

On the subject of the breadth of the Buyer’s lien position I’d like to add a point to the prior conversation that I haven’t brought up before. The UCC filings in typical factoring relationships very often extend beyond creating a security interest in all accounts receivable. Often they are either “all-asset” liens; or extend to all of the personal property of the Seller in addition to its accounts; or specifically include other named property.

More and more often, especially in the cases of companies that are in the various “tech” sectors, the critical assets of the TRE Sellers are intangible. A Seller that is a software development firm, for instance, might have a copyright, trademark, patent or other intangible as its primary revenue-producing asset. Without some means to control or, at least, threaten that asset, the leverage of a creditor is substantially diminished.

This limited security position in the assets of the Seller is obviously quite attractive to the Seller. It is used to attract Sellers to the TRE platform in the same way the lack of a personal guarantee requirement is used. It has a flavor of the “you can’t get this anywhere else” to it.

Of course, there’s a reason it’s not generally available and that reason is that it increases the risk to the provider of funds.

It increases risk not only because the security might be defective or a because a superior lien position might be asserted but also because any action to cure a default that depends on attaching assets that have limited lives (i.e. the receivables portfolio of a Seller might be liquidated and its proceeds “evaporated” before any substantive court action can be commenced) carries the incremental risk of dependence on a wasting asset.

There is no question that the TRE Buyer should demand incremental compensation for the incremental risk assumed because of the limited security provided by its lien position.

[Note: To be fair, there is a potentially mitigating factor in the form of the right of TRE and its Buyers to attach Seller cash balances in the TRE lock-box. Mitigating factors will be discussed as a part of the wrap-up of this series of posts.]

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