Getting Cross-Eyed: Focusing on Cross-Collateralization

by Kenneth P. Weinberg Monitor 101 2021

Kenneth P. Weinberg goes over the complicated details of cross-collateralization for equipment leasing and finance transactions with the hopes of helping those engaged in this practice to see the right solution more clearly.

Kenneth P. Weinberg,
Shareholder,
Rimon, P.C.

Generally speaking, cross-collateralization is a fairly straightforward concept to people active in commercial finance. The idea is that any collateral pledged to a lender by its customer (referred to in this article as a debtor) secures every single obligation of that customer to the lender. However, like many concepts in the law, a detailed look at the issue can leave a viewer temporarily confused, particularly in the context of equipment leasing and finance transactions. So put on your spectacles as we take a closer look at a handful of issues that may need to be considered when someone broadly discussing cross-collateralization.

Describing Collateral Broadly

One common way of cross-collateralizing multiple transactions is to make sure all collateral is described every time you obtain a grant of a lien. For example, if a lender’s collateral is very broad, such as when a lender describes the collateral by referencing every category of collateral in Article 9 of the Uniform Commercial Code, using that same description every time the debtor grants a lien to secure an obligation would by definition mean every secured obligation is secured by the exact same collateral.

However, this approach can be more difficult in the equipment leasing and finance industry since the collateral often involves specific equipment acquired over an extended period of time, some of which may not be known (or even manufactured) when the first transaction to be cross-collateralized is funded. For example, consider a relationship where a debtor enters Schedule 1 in 2019 to finance a forklift and Schedule 2 in 2021 to finance computer equipment. Unless the lender in 2019 looks through a crystal ball, it could not know that the grant of lien in the 2019 transaction needed to cover computer equipment and it could not describe the computer equipment with any specificity at that time.

For this reason, equipment leasing and finance companies that rely on this approach refer generally to equipment financed in the future. For example, the grant of lien may be with respect to the “equipment” as defined in each and every past, present or future schedule incorporating the applicable master agreement. If worded properly, this approach should work since it “reasonably identifies” the collateral under Article 9.1 Nonetheless, there is always room for debate, as evidenced by the flurry of cases and articles surrounding the use of cross-referencing techniques in financing statements.2 For this reason, some lenders use (as a belt and suspenders or otherwise) a different approach to cross-collateralization.

Describing the Obligations Broadly 

Another approach to cross-collateralization that can be easier in the context of an equipment leasing and finance transaction is to make sure each grant of lien secures all past, present and future obligations broadly. To use this approach in the context of our hypothetical 2019 and 2021 transactions, the debtor’s grant of a lien in the forklift in 2019 would secure all past, present and future obligations, thereby covering the present obligation incurred by the debtor to acquire the forklift and ostensibly the future obligations the debtor later incurs in 2021 to acquire the computer equipment. Similarly, the grant of the lien in the computer equipment in 2021 would secure all past, present and future obligations, thereby covering the present obligation incurred by the debtor to acquire the computer equipment and ostensibly the past obligations the debtor incurred in 2019 to acquire the forklift.

This second approach seems cleanest, but it is best to use both it and the first approach (focusing on the grant of the lien) since contrary case law unfortunately exists. For example, in Equity Bank v. Southside Baptist Church of Lead Hill, a bank loaned a debtor approximately $2.6 million secured by a mortgage on real property (Note 1). Around four years later, the bank entered into a second loan secured by fixtures, furniture and equipment (FF&E) evidenced in part by a separate promissory note (Note 2). The security agreement executed for the FF&E included a cross-collateralization provision which read “[i]n addition to [Note 2], this agreement secures all obligations, debts and liabilities, plus interest thereon, of [debtor] to [bank], or any one or more of them, as well as all claims by [bank] against [debtor] or any one or more of them, whether now existing or hereafter arising, whether related or unrelated to the purpose of [Note 2], whether similar or dissimilar…”

The sole issue on appeal was whether the proceeds of the FF&E could be applied to Note 1. The appellate court affirmed summary judgment in favor of the debtor, holding that the proceeds could not be applied to Note 1. According to the court:

When a mortgage is given to secure a specific named debt, the security will not be extended to antecedent debts unless the instrument provides and identifies those debts intended to be secured in clear terms…

[Bank] would have us hold that the language “all obligations” [and] “now existing” are “clear terms” sufficient to identify Note 1. We disagree. A debt created after the mortgage, being not yet in existence, may not in all cases be clearly indicated; whereas antecedent debts may always be definitely stated… If [bank] had intended for the collateral securing the indebtedness on Note 2 to serve as additional security for Note 1, it had the opportunity to unambiguously identify Note 1 at that time.

Other Items Worthy of a Focused Glare

There are numerous other aspects of cross-collateralization that can be dizzying for those who have never looked at the issue closely. For example, it is important to be mindful of situations where you may not have the same secured party. This often happens with bank-owned equipment leasing and finance subsidiaries that are different legal entities than the bank. Even though the bank may enter into other transactions directly as lender, the underwriting decision may still require the transactions to be cross-collateralized. In such situations, the relevant documents must be reviewed carefully to make sure the cross-collateralization concepts discussed earlier in this article still work. For example, does the grant of lien in both sets of documents secure past, present and future obligations to the named lender and its affiliates? What if the rights claimed by one of the lending affiliates in the collateral are asserted merely through a set-off clause? Some would argue that the other affiliate lender (a separate legal entity) would need a grant of lien in the same assets of the debtor for those assets to be viewed as available to satisfy the obligations to both lenders (which is what most people think of when discussing the concept of cross-collateralization).

Having different secured parties also raises perfection issues. After all, if one of the affiliate lenders is not perfected in some of the assets it obtained as part of the cross-collateralization, its lien will not be of much value. A carefully worded intercompany collateral agency agreement is an important part of the overall protection in this context.

In other instances where there are different secured parties, it may not be appropriate to have cross-collateralization. Consider, for example, the headaches that could arise if multiple schedules incorporating a master agreement were cross-collateralized initially but then some schedules were held by the original and others were sold to different, unaffiliated entities. In many contexts (the vast majority in equipment finance), the originator and its assignees would no longer want to have their specific schedules cross-collateralized with schedules owned by unaffiliated third parties. Of course, if the originator still owned multiple schedules, it would want them cross-collateralized. Similarly, an assignee who purchases multiple schedules would want all of those purchased schedules to be cross-collateralized. Careful drafting in the underlying loan documents with the debtor can address these situations. Cross-collateralization can also be waived in the assignment documents, but that approach only works if every assignment document takes the same approach. Since any given assignee is unlikely to see all assignment documents, this approach requires an assignee to trust the originator on this issue.

Long story short, and as this author hopes readers of this article have, er, seen, a focused glare at the concept of cross-collateralization can cause one to become a bit cross-eyed. For this reason, people wanting this protection should discuss their goals and carefully consider whether their documents and procedures accomplish the desired ends. •

  1. See UCC §§ 9-108(b), which provides “a description of collateral reasonably identifies the collateral if it identifies the collateral by [certain listed methods, including] category [or] any other method, if the identity of the collateral is objectively determinable.”

  2. See e.g. In re I80 Equipment, LLC, 938 F.3d 866.

Kenneth P. Weinberg is a shareholder at Rimon, P.C., and practices in the area of commercial finance, focusing on equipment leasing, equipment finance and renewable energy project finance. He has penned Dispatches from the Trenches since 2002.

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