In virtually every ABL or factoring transaction, a borrower switches from one lender (or factor) to another, benefitting the new lender (the Incoming Lender) with increased outstandings, and harming the old lender (the Outgoing Lender) by the loss of a presumably beneficial business transaction. The strange thing about this commonplace transaction is that it could not happen unless the Outgoing Lender (the one which is hurt by the transaction) performs a completely voluntarily act, which is contrary to its immediate self-interest! Do Outgoing Lenders understand that without this purely voluntary act, they would not lose the borrower? Or do Outgoing Lenders simply perform this act on the assumption that what goes around comes around, and if they do not cooperate with their borrower and the Incoming Lender, at some time in the future, the roles might be reversed to the detriment of the Outgoing Lender? Let’s explore this interesting dynamic.

Assume that a borrower from Outgoing Lender finds a new lender which offers the borrower a better deal. Further assume that its loan agreement with Outgoing Lender is about to expire, or assume that the borrower may terminate without penalty during the term of the agreement. The Incoming Lender will document the transaction and will, if they are on top of their game, pre-file their UCC-1, and order a post-filing search, which discloses their filing and the filing by Outgoing Lender. Obviously the Incoming Lender must get into a position that when it makes its initial advance to the borrower, it is in first position (i.e. the Outgoing Lender’s UCC-1 must be terminated).  The conventional way to accomplish this is with a “payoff letter,” “takeout letter,” or similar transactional device.

While the content of the payoff letter will vary, one provision is crucial, without which the Incoming Lender cannot close the transaction. The Outgoing Lender must agree that upon receipt of $X, it will terminate its UCC filings against the borrower (an even better provision for the Incoming Lender would be the Outgoing Lender’s agreement that upon receipt of the payoff amount the Incoming Lender is authorized to terminate all the Outgoing Lender’s filings. In this way the Incoming Lender does not have to follow up with the Outgoing Lender for the filings.)  With this provision, the Incoming Lender knows that once it pays the payoff amount to the Outgoing Lender, it will be in first position.

What happens if the Outgoing Lender simply refuses to sign a payoff letter? Has it breached a duty to the borrower, or to the Incoming Lender? The answer is clear – “No.” It has no duty whatsoever to the Incoming Lender, and it has a vague duty to the borrower, which is found in UCC Section 9-210(b). (1.) That section requires that if the borrower requests “an accounting of the unpaid obligations” (2.) the Outgoing Lender must respond in 14 days. Although the statute is not clear, it seems to state that the obligation reporting in the accounting is 14 days old. This would be completely useless to the Incoming Lender, and it could not close its transaction with the borrower.

What might an Incoming Lender do when faced with an uncooperative Outgoing Lender? Not much. It might try to determine what the unpaid obligations are and pay that amount to the Outgoing Lender, but this presents a clearly unacceptable risk, since it would be making a payment for the account of the borrower without being assured that the borrower’s obligation is secured by a first lien.

It might rely on a statement of account issues by the Outgoing Lender and send that amount to the Outgoing Lender, but that is equally risky. If the amount is wrong, by even one penny, the Outgoing Lender will have no duty to terminate its filings and the Incoming Lender will be in second position.

The borrower might have a right to a current statement of account under its loan documents, but I have never seen such a provision. The borrower might have a bad faith type of claim against the Outgoing Lender, but that would require a trial.

Many Outgoing Lenders aware of their superior bargaining position will in fact agree to sign a payoff letter, but only if it contains additional benefits to it, such as preference protection for claims arising after the borrower moves to the Incoming Lender, and other transactional goodies. (3.)

I am amazed that all takeouts in fact occur in spite of the fact that the Outgoing Lender can simply prevent it. The Golden Rule trumps the UCC every time.

Endnotes:

1. Note that a “buyer of accounts” (i.e. a factor) is excluded from this duty.
2. UCC 9-210(a)(2)
3. In my transactional templates, I have always had two forms of takeout letters, one if my client is the Outgoing Lender (which I would resist if I was representing the Incoming Lender) and the other if my client is the Incoming Lender.