Although the factor’s purchase of the invoices through payment and assignment provides rights to collection, there exists another problem. What is to prevent a business owner from securing a loan from a bank or traditional lender, pledging its accounts receivable (invoices) to the bank as collateral, and then subsequently applying for a factoring arrangement and pledging the same accounts a second time to the factor? If done, the collateral would be financed twice and in theory, shared equally by both the factor and the bank. A battle surely would ensue to see who gets paid first in the event of default by the borrower. To prevent such a problem and enjoy a truly “secure” transaction, factors and lenders file a document called a Uniform Commercial Code Financing Statement. Here’s what all brokers should know about the Uniform Commercial Code.
What is the Uniform Commercial Code?
The Uniform Commercial Code (UCC) is a body of business-related law that governs commercial transactions in all 50 states and especially those transactions involving the sale of goods, their transportation and delivery, and the payments upon such goods. The UCC is comprised of a series of articles or sections which, among their many focuses, define certain business-related transactions and rights regarding those transactions. Included among these are sales of goods, leases, deposit transactions, letters of credit, negotiable instruments, etc. Most important to factors and the asset-based finance community, is something called “Article 9”, which deals with the laws and rules involving secured transactions. In fact, without the provisions setforth in the UCC’s Article 9, most forms of asset-based finance would be impossible to implement.
When financing a company based on an asset or assets, a lender will file a “security interest” in those assets as collateral for the loan or financing. This filing document, called a UCC-1 Financing Statement, is said to “perfect” the lender’s security interest in the collateral. In layman’s terms, the UCC-1 filing:
- provides notices to the world that a financing is in place
- describes and defines what specific collateral secures the loan
- determines the “pecking order” regarding who’s entitled to the collateral in the event the borrower defaults on the loan
When filed, a UCC-1 is time stamped and in the world of UCCs, first to file wins. The first filer (lender) is said to be senior lender, and is entitled to collect upon the collateral first in the event of default. Second or lower position filers are junior lenders. In the event of default, a junior lender is only entitled to proceeds from the collateral after the senior lender is satisfied fully. In factoring-styled business finance, the factor must always be senior lender on accounts receivable. If when underwriting a new prospective client, if a prior lien and active financing is uncovered during a UCC search, a factoring relationship cannot be established unless:
- the previous senior filing is terminated
- the loan related to the previous senior filing is paid off from the factor’s advance
- the UCC-1 filing is subordinated to the factor
Searching the UCC Filing Database for an Active Lien
When underwriting a new prospective client, one of the very first tasks a factor or any lender will perform is to search the appropriate UCC database to determine if the collateral for a loan is available or if it is already pledged and subject to lien by some previous lender or factor. UCC databases are typically housed within the Secretary of State’s website in any given state.
The UCC’s Article 9 requires that a UCC-1 security interest filing be:
- filed in the UCC filing database in the borrower’s (client’s) state of incorporation.
- filed under the legal name of the borrower and exactly as it appears in the corporate records in the Secretary of State’s office. For lenders, such a standardized filing and database system makes determining the availability of any collateral a relatively simple process. Lenders can search confidently for current active UCC filings on most business collaterals.
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