Bridging the Gap to Turn the Economic Corner

by H. Han Pai & Neal Salisian 2014
The financial services industry is entering unchartered territory as the economy attempts to navigate itself out of recession and into recovery. Salisian | Lee LLP partner Neal Salisian and associate H. Han Pai discuss borrowers' search borrowers for new avenues as lenders became increasingly reluctant to extend credit in the face of increased defaults and bankruptcy filings.

The financial services industry is entering unchartered territory as the economy attempts to navigate itself out of recession and into recovery. Borrowers have been scurrying for new avenues as lenders became increasingly reluctant to extend credit in the face of increased defaults and bankruptcy filings, expensive enforcements efforts and stronger pressures from government regulators.

The credit crunch has been particularly grim for start-ups and small- to mid-sized businesses, which typically do not have the resources of their more established counterparts. But it is precisely these borrowers who are in the most need of capital.

In response, there has been an influx of non-traditional lenders providing alternative financing vehicles. One such recent vehicle is the short-term bridge loan. Bridge loans are characterized by their short terms, ranging anywhere from two weeks to one year, and quick processing and funding. The loans are typically used by borrowers as gap financing to “bridge” their capital needs until permanent financing is secured, to satisfy an existing obligation, or to pay current operating expenses.

While bridge loans seem like a viable solution and certainly serve to bolster the continued recovery of the economy, they come with risks to the lenders making them. Fortunately, there are steps bridge lenders can take in the initial phases of the lender/borrower relationship to mitigate against the legal risks associated with this type of lending. The following are some of the material issues that should be considered.

Forum Selection Clause

Loan agreements will usually include a forum selection clause stating that if a dispute arises, the borrower consents to resolving the dispute in the jurisdiction chosen by the lender. This is usually the state where the lender is located. Generally speaking, such forum selection clauses control unless there is a showing that enforcing the clause would be unreasonable and unjust. See, e.g. M/S Bremen v. Zapata Off-Shore Co., 407 U.S. 1, 15 (1972).

Recent U.S. Supreme Court authority reaffirms this principle, and in fact, makes it easier to enforce such clauses. The high court ruled that where a forum selection clause is present in a contract, (1) when a plaintiff initiates a lawsuit in someplace other than agreed on in the contract, the plaintiff’s choice of forum is ineffective and carries no weight, and that plaintiff bears the burden to establish that a transfer to the parties’ originally-designated forum is unwarranted; (2) convenience of the parties and other fairness arguments are not to be considered, because the contract represents the parties’ bargained-for interests as to choice of forum; and (3) when a plaintiff initiates a lawsuit in a different forum, the choice-of-law rules of the originally-designated forum should be applied, in order to prevent “forum-shopping” by plaintiffs. See Atlantic Marine Constr. Co. v. United States Dist. Court, 134 S. Ct. 568 (2013).

This updated analysis would apply regardless of whether the forum specified in the clause is a federal, state or foreign court. Because the federal transfer statute at issue in the Altantic Marine case codifies the forum non conveniens doctrine — the common law doctrine used to enforce a clause pointing to a state or foreign forum — the same balancing standard applies.

This ruling becomes relevant, for example, for a high-volume bridge loan lender based in California but whose borrowers operate across the country. And it may impact how it decides to word its forum selection clauses.

On one hand, the simple scenario is if the lender resides in a lender-friendly state. There, the lender has an incentive to explicitly designate that forum in a forum selection clause. On the other hand, an argument exists that intentionally crafting the forum selection clause more vaguely may actually be beneficial, for example, by including a permissive forum clause and leaving the discretion of forum to the lender. Doing so arguably prevents application of this binding Supreme Court authority, allowing more flexibility in a choice of forum in the event a dispute arises.

Perfecting the Lien

Although commonly crafted as unsecured loans, lenders will often include a broadly-worded provision where the borrower grants the lender an optional security interest to secure the obligation against some type of collateral, usually inventory, accounts or equipment.

To perfect the lender’s lien on the borrower’s collateral, and give the lender rights superior to other creditors, a UCC-1 Financing Statement must be filed. The importance of perfecting the lien becomes particularly crucial in the event the borrower files for bankruptcy. Specifically, for purposes of a bankruptcy case, the question is whether the security interest was properly perfected pre-petition (i.e., before the borrower files for bankruptcy). If the lender’s security interest was unperfected at the time of the bankruptcy filing, then the security interest is “avoidable” in the bankruptcy, meaning the debtor or a trustee could undo the particular transaction for the benefit of the bankruptcy estate.

In essence, once a borrower files for bankruptcy, the borrower/debtor and all creditors are entitled to rely on the secured or unsecured status of each of the other creditors in pursuing their respective claims. Consequently, if a lender has not timely perfected its security interest prepetition (by filing a UCC-1 Financing Statement), all other parties are now entitled to rely on that lender’s status as an unsecured creditor. The unsecured status will affect, for example, the treatment of that lender’s claim in the bankruptcy, which is typically prioritized after administrative and other priority claims, as well as claims of the secured creditor. The potentially perilous consequences that could arise simply from failing to file a form are not hard to envision.

Nevertheless, there is one narrow exception to this seemingly harsh rule. That is, if a creditor’s interest in the debtor’s property arises pre-petition, bankruptcy law allows up to a 30-day period in which to perfect that interest, so long as there is a non-bankruptcy law that allows for such a retroactive perfection. Essentially, the rule operates as a 30-day grace period for perfection, but the loan must have been entered at or around the bankruptcy petition.

The application of this exception is limited. Thus, short of any compelling reasons otherwise, the sensible course would be for a lender to perfect its security interest immediately after entering into the loan agreement to avoid any complications if the borrower later declares bankruptcy.

Due Diligence on Borrowers

Finally, given the shaky state of the economy, basic, common-sense practices cannot be forgotten. In particular, simple due diligence of a potential borrower’s ability to repay should be conducted before entering into any loan transaction. The typical documents to review include:

  • Annual receipts compared against the loan amount requested
  • Credit files
  • Corporate records
  • Dun & Bradstreet Reports
  • Public records searches, such as UCC, judgments, and/or tax liens
  • Bank statements for the certain period prior to making the loan
  • Google search with an aerial photo of the borrower’s business location
  • Verification from a borrower’s landlord of the businesses’ existence

Simple precautionary measures at the outset can help to avoid the default battle altogether.

As lenders and borrowers alike forge ahead in largely unpredictable waters, there are no magic bullets. Nonetheless, old-fashioned gumption goes a long way to help navigate those tides. And should the inevitable occur, prior preparation will have paid off.

As the bridge lending market evolves, so too should its lenders. While these lenders are bridging us closer to a solid economy for small business, eagerness to grow must be tempered with prudent lending and business practices to avoid a repeat of the credit crisis, which essentially created this market.

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