My recent article on California Assembly Bill 2116 focused on a provision that could make certain commercial financing agreements unenforceable if the provider was not properly licensed. I thought that was troublesome enough. Then Jim Grant, senior vice president of the equipment finance division at Ameris Bank, formerly Balboa Capital, asked me a very simple question: What happens when a bank buys the receivable?
That question may expose an unintended consequence of AB 2116 that could be considerably more important to the equipment finance industry than the licensing requirement itself.
Banks have historically occupied a different position from nonbank finance companies under the California Financing Law (CFL). Existing Financial Code § 22050 exempts banks and certain other regulated financial institutions from the CFL. Banks also routinely purchase commercial finance receivables originated by nonbank finance companies.
Proposed Financial Code § 22658 potentially complicates that practice. It states that a covered commercial financing agreement is “not enforceable” unless one of several conditions is satisfied, principally that the person providing the transaction was a licensed commercial financing provider.
Notice what it does not say. It does not merely say that an unlicensed provider may not enforce the agreement. It says the agreement is not enforceable. That difference could become extremely important when the agreement is sold.
Suppose a nonbank finance company originates a portfolio of California commercial transactions and sells $20 million of the receivables to a bank. The bank performs its normal diligence and purchases the portfolio. Several customers later default and the bank sues. Their lawyer asks: Was the company that originated these transactions properly licensed? Assume the answer is no. The bank may be exempt from the CFL licensing requirement applicable to the originator. But that may answer the wrong question.
The issue under § 22658 may instead be whether the agreements the bank purchased were enforceable in the first place. And AB 2116 does not appear to provide an express safe harbor for an assignee acquiring an agreement originated in violation of § 22658.
In Royal Bank Export Finance Co. v. Bestways Distributing Co. (1991) 229 Cal.App.3d 764, a bank purchased commercial purchase orders and invoices and later attempted to collect them. The Court of Appeal held that the bank, as assignee, acquired no greater rights than its assignor and took the receivables subject to defenses the customer could assert against the assignor.
California Commercial Code § 9404 reflects a similar rule for accounts and chattel paper, subject to statutory exceptions. Put those principles next to AB 2116. If the originating provider lacked the license required by § 22658, and the statute consequently makes the commercial financing agreement “not enforceable,” does selling the receivable to a regulated bank cure the defect? Nothing in § 22658 expressly says that it does. The issue therefore becomes whether the bank purchased an asset containing a preexisting enforceability defense.
Many commercial finance documents contain provisions preventing customers from asserting against an assignee defenses they may have against the original financing provider. Commercial Code § 9403 generally recognizes such provisions when an assignee takes for value, in good faith and without notice of specified claims or defenses. That gives the purchasing bank a substantial argument.
But § 9403 does not protect against defenses of a type that may be asserted against a holder in due course under Commercial Code § 3305. Those include illegality which, under applicable law, nullifies the underlying obligation. That brings us to an interesting California case.
In Wilson v. Steele (1989) 211 Cal.App.3d 1053, an unlicensed contractor transferred a promissory note and deed of trust to parties who qualified as holders in due course. Because California’s contractor licensing law rendered the underlying contract illegal and void, the Court of Appeal held that the licensing defect could be asserted even against the holders in due course. Transferring the instruments did not eliminate the defense.
Wilson did not involve AB 2116, and AB 2116 says an agreement is “not enforceable,” rather than expressly declaring it “void.” The case therefore does not answer our question. But it establishes an important principle: a statutory licensing defect can affect an obligation so fundamentally that transferring the paper to an otherwise protected assignee does not necessarily cleanse it. Whether a court would apply that principle to § 22658 remains to be seen.
If AB 2116 becomes law in its present form, purchasers of California commercial finance receivables may need to add a new question to their due diligence: Was the originator properly licensed when each covered transaction was originated? That could make licensing status an asset-eligibility issue. Representations and warranties concerning licensing will become more important, as do repurchase and indemnification provisions. The same issue may concern warehouse lenders, participants and securitization parties. A portfolio may have excellent credit quality. That doesn’t help much if some of its payment obligations cannot legally be enforced.
The Legislature could resolve the issue easily. If § 22658 is intended merely to prevent an unlicensed provider from enforcing its own transaction, it could say so. If the licensing defect is intended to follow the agreement into the hands of subsequent assignees, it could say that instead. It presently says neither.
Commercial finance receivables are routinely sold, assigned, participated, syndicated, pledged and financed. A statute affecting their enforceability therefore potentially affects not merely originators, but the market for the paper itself.
AB 2116 began as a commercial finance licensing bill. Section 22658 may make it something considerably more consequential. If an originator creates a commercial financing agreement that is unenforceable because it lacked the required license, ordinary California assignment principles create a substantial risk that transferring the agreement to a bank or other assignee will not make it enforceable.
Wilson v. Steele demonstrates that California courts have previously allowed a licensing-based illegality defense to follow an obligation even into the hands of a holder in due course. Whether courts would reach the same result under AB 2116 remains an open question. But purchasers of California commercial finance receivables should be asking that question now. Because after AB 2116, the most important representation in a portfolio purchase agreement may no longer be that the receivables are valid and enforceable.
It may be the representation explaining why they are.
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