By: Harold J. Lee, Esq.
ABL Advisor, July 9, 2013
While the lending attorney is the main point person in the drafting and negotiating of the underlying ABL loan documents, it does not hurt for ABL principals to be aware of the various ways in which their clients (and, more likely, their attorneys) can effectively create holes in the loan documentation from an ABL’s point of view. Of course, what is one person’s “hole” is another person’s “carefully negotiated point of flexibility,” so the beauty here can be in the eye of the beholder.
In the “good old days” of asset-based lending, it was not uncommon for Borrowers to simply accept whatever terms were placed in front of them by their lender. However, as Borrowers of the more sophisticated varietal exert their negotiating leverage, the result may be loan documentation that could potentially give ABL underwriters some heartburn.
Such tactics are common, and I summarize some of the more common ones as follows:
1. Collateral Leakage. Security agreements with “excluded collateral” carveouts are not uncommon, particularly when it comes to such items as intent-to-use trademarks or situations where the granting of a lien eviscerates the underlying collateral. One common carveout is the stock of a pledgor’s foreign subsidiary to the extent it causes a “deemed dividend” issue under Section 956 of the Internal Revenue Code. While such carveout is common, Borrowers often attempt to get a carveout for any situation that “may” result in adverse tax consequences for the borrower. Such carveout should be limited to scenarios that actually do cause material adverse tax consequences. For after-acquired collateral, security agreements can contain exceptions from the borrower’s obligation to alert the lender of such collateral. Lenders should be cognizant of the aggregate amount of carveouts granted and consider each category of collateral. After-acquired collateral that potentially requires perfection actions beyond the filing of a standard blanket UCC-1, like copyrights or commercial tort claims, should be more carefully considered.
2. Broadly Worded “P’s”. To the extent that the loan document is not completely draconian from the borrower’s point of view, it will likely contain certain allowances such as the presence of debt that was not issued by you or the existence of other liens—in other words the “P’s”: permitted debt, permitted liens, permitted investments, permitted distributions, permitted affiliate transactions, etc. The lender should be careful not to put itself in a situation where a broadly worded permitted category can prime your lien. For example, one should be careful not to grant a general bucket of permitted debt in conjunction with a general bucket of permitted liens. Voila—you have now created a pool of secured indebtedness that can potentially prime you, even though it is not uncommon to grant either category on a separate basis. It is also not uncommon to grant the borrower the flexibility to make intercompany investments and advances. However, be wary of uncapped cash leakage from loan parties to non-loan parties. In general, it is wise to conduct a sanity check to evaluate whether you have crossed the line from offering customer-friendly operator flexibility into the abyss of offering overly inclusive permitted actions that do not fit the borrower’s industry or day-to-day realities. Finally, while it is perfectly fine to incorporate the concept of permitted acquisitions so long as they fit within pre-approved parameters, be sure that such provision does not present a back-door option for the borrower to incorporate acquired assets into the borrowing base without the lender’s opportunity to properly diligence such assets.
3. If this were a cash flow deal…but it’s not. Have you ever had a significant other tell you that you would look a lot better if you only changed your sense of style? This phenomenon is not much different from credit-takers educating you on what your ABL transaction would look like if you employed typical cash flow provisions, whether it involves constraining a lender’s ability to implement reserves against the line or implementing looser collateral reporting requirements. Furthermore, credit-takers can occasionally fall into the trap of believing that the only collateral you care about are those assets contained in the borrowing base. That may be true based on the specifics of your transaction, but does not mean you do not track your overall collateral coverage. Although it sounds obvious and self-evident, always keep a broader perspective of the differences of an ABL deal vs. a cash flow deal, whether it plays out during negotiations of financial covenants or on pricing. The philosophies outlined above are not necessarily at play in every transaction. Sophisticated borrowers will bring nuanced, idiosyncratic needs for flexibility to every transaction, and lenders in a competitive landscape should take note. However, we face a real risk that the further down the rabbit hole we go on our ABL loan provisions, the deeper we get trapped in a quagmire of over-engineered complexity that misses some broader points.