Introduction

Businesses have many debt financing options available to them in order to obtain a loan. In most financings, a borrower receives money in exchange for the payment of interest to the lender as well as other consideration (including providing equity in the borrower’s business). A loan agreement can often provide a borrower the ability to incur other indebtedness. While contract laws and the Uniform Commercial Code (the “UCC”) provide the default framework that determines which lender will receive payment first upon in the event of a default, most sophisticated lenders will enter into intercreditor agreements that precisely define the priority of liens and payments.

Financing arrangements often become intricate in more complex situations, and having the right attorneys to negotiate on both the borrower’s and lender’s behalf is essential to create a partnership that benefits both parties. A loan agreement is a living document that survives after the initial loan is made, and therefore it is essential to ensure it works for your business. Below is a brief summary of the considerations for borrowers and lenders entering into a secured financing. Please contact Mehak Rashid (mehak@legalscale.com) for any follow up questions or to discuss how Legal Scale can assist you with your secured financing arrangements.

Secured and Unsecured Loans

In exchange for a lender’s provision of a loan to a borrower, the borrower will agree to certain obligations, such as payment or performance of certain covenants. These payment and performance obligations are either unsecured or secured by collateral.

All-Assets Lien

With a secured loan, a borrower grants a security interest in certain assets (called collateral) in exchange for a loan from the lender. Certain loans may be secured by all assets of the borrower (also known as a “blanket lien”). This would provide the lender with a security interest in a borrower’s currently owned assets as well as any assets acquired by the borrower in the future.

Lien Over Certain Assets

On the other hand, some loans may be secured by only certain assets of the borrower. For example, lenders may make loans to fund the purchase of expensive machinery or equipment to a borrower in return for a lien on the equipment, which allows them to take possession of the loaned equipment upon an event of default. In this scenario, the lender’s security interest would only extend to the financed equipment.

Unsecured Loans

In contrast, an unsecured loan is not secured against the borrower’s assets and therefore has no backing other than the borrower’s obligation to pay. As these loans have greater risks, lenders may require a higher interest rate, faster amortization schedule or other lender-favorable terms.

Priority of Liens and Subordination

In many situations, a borrower might incur multiple loans from different creditors, all of which may be secured by the same pool of collateral. In the event of a default by the borrower, the order of repayment will depend on each lender’s lien priority. Structuring debt with different lien priorities gives a borrower the ability to take on additional debt to continue to grow its business. When a borrower has granted a first priority security interest to an existing lender, additional lenders may choose to provide the borrower with different tranches of debt either through (1) subordinated debt or (2) second-lien financings.

Subordinated Debt

A lender may subordinate its right to repayment to that of another lender. This subordinated debt will only be permitted to be paid as agreed between the junior and senior lender. Certain subordinated debt may not be repaid during the loan term. Conversely, other subordinated debt may be permitted to be repaid on a fixed schedule but may not be accelerated or otherwise paid in full before the payment of the senior debt. In these situations, a borrower and a lender will enter into an intercreditor agreement that specifies the rights and remedies of the junior lender and the senior lender.

First-Lien and Second-Lien Financings

Alternatively, a lender might opt to be secured by a second lien on the collateral, which would rank immediately behind the first lien on that same collateral, but is not subordinated in its right to payment. Like subordinated loans, second-lien loans are usually accompanied by a higher interest rate or fees, or by more lender-favorable terms. Moreover, second-lien loans tend to have looser financial covenants than first-lien loans to permit the borrower with flexibility to incur the additional second-lien debt.

In the case of an event of default by the borrower, the obligations owed to the first-lien lender (inclusive of principal, interest and fees) will be satisfied first by the proceeds of the collateral. The remaining value then passes to the second-lien holder. Any amount remaining after the obligations owed to the secured lenders are satisfied is then paid to any unsecured creditors of the debtor. Over the last decade, second-lien financings have begun to replace subordinated debt as the most frequently used form of junior debt financing, given that the use of second-lien debt offers more security to the lender than subordinated debt and certainly more than unsecured debt.

Crossing Lien Structures

Crossing lien structures can be useful to grant two lenders who each hold a security interest in a pool of assets priority over a subset of those assets. This often arises in the context of coexistence of an asset-based loan and a term loan, both secured by the same collateral pool. For example, two lenders may each hold a blanket lien on the assets of an ecommerce company. One lender (usually the asset based lender) would be granted priority over the cash, accounts receivable and inventory of the borrower, while the other lender (usually the term loan lender) would be granted priority over the equity interests and intellectual property assets of the borrower.

Crossing lien structures are complicated and often vary from situation to situation. They are thoroughly negotiated through an intercreditor agreement, which requires complex understanding of lien priority, bankruptcy events and distribution of assets. If you’re considering using this structure in a financing, we recommend reaching out to Legal Scale or another qualified law firm to ensure adequate protection.

Perfecting a Lien

A well-defined security agreement related to a loan is not the only requirement for a creditor to be granted a security interest in the collateral. Once granted, a lender must perfect its lien. Perfected liens have priority over other creditors and, among equally perfected liens, the first lien to be perfected has priority in the event of a default.

Perfection of a lien depends on the governing law for the collateral in question – either the UCC or other applicable law. For example, mortgages are usually perfected by recording the mortgage at the recorder’s office in the county where the real property is located. To perfect a security interest over a copyright, a copyright security agreement must be filed with the United States Copyright Office. Collateral that is subject to the UCC is usually perfected with the filing of a UCC financing statement with the secretary of state in the jurisdiction where the borrower is incorporated. Perfection of a lien is essential to a functional loan and a well-versed attorney can help guide you through the process.