If your business has fallen behind on a secured loan, one of the worst calls you can get is from a customer who just received a letter from your lender. The lender can simply tell your customers to pay their debts to it instead of to you. Wages and suppliers are getting no money anymore, and it’s all going to the bank. Generally, the lender is allowed to do this under Article 9 of the Uniform Commercial Code. Here is how the process works, and what else the lender can do once a default goes uncured.
Article 9 of the Uniform Commercial Code aims to create a consistent system across the United States for creating and enforcing security interests. All states have adopted Article 9, though some have made minor modifications or adopted the more recent version of the UCC. The numbers for the sections may vary slightly from state to state. Be sure to check your own state’s version of the UCC. The section numbers below follow New York’s version.
The process typically begins with a notice of default and a chance to cure. Generally speaking, when a business defaults on a secured loan and fails to cure the default within the cure period (which, note, often runs just 10 days, unless the loan documents specify something else), the lender can pursue its rights under Article 9 of the Uniform Commercial Code.
Accounts Receivable
Under Section 9-607, if your lender has a perfected security interest in your accounts receivable, it can collect those accounts without your help. If the lender knows who owes money, it just sends a letter directing the customers to pay. In the statute’s language, the “account debtor” in this case is your customer. If the lender sent a written request for payment directly to people who owe you money, then once they got the notice they would have to pay the lender. If they still pay you, then they still owe the money. In effect, they have to pay the debt twice. If customers receive a letter from the bank directing them to pay the bank, you can pretty much forget about cash flow to your business.
Of all the remedies, this is the one that hurts an operating business the most, because cash is life. If you can’t get cash from customers, you can’t keep making payments, you can’t pay your employees, and you can’t pay your suppliers. Without cash, you can’t operate. In this way, you’re actually being cut off from your own cash flow.
Your bank account is exposed too. When a lender has perfected a lien on the cash in a business’ bank account, the lender can use the balance in that account to pay off the debt.
After the cash, the lender can turn to equipment and inventory. Under Section 9-609, a secured party can ask the debtor to help put the collateral (equipment, inventory) together, and the creditor may take possession of the collateral as long as the debtor cooperates.
Then comes the sale. According to §9-610, the lender can sell the collateral but the process must be “commercially reasonable.” §9-612 says that a 10-day notice after default is a “commercially reasonable notice” for a non-consumer (business) sale. The sale itself can be by public auction or in a private transaction. If the lender is selling collateral at a private sale, they have to prove the sale was commercially reasonable, usually by getting a third-party estimate of what the collateral was worth. If they set a sale price close to that estimate, they will be able to defend the price; selling at a properly marketed public auction may be more appropriate if they don’t have information on the collateral’s value.
If you cooperate, the whole sale process takes around 100 days: 10 days (or the loan’s cure period) after the demand, then 60 days to market and do an auction sale (the 10-day notice of sale can go out during the marketing period), and then 30 days for the buyer to close and remove the collateral. A private sale can be done faster if the lender can find a buyer quickly.
Not every lender relies on self-help. The lender can take the borrower to court and get an order making the borrower hand over the collateral, and authorizing the sheriff to repossess it. Then the lender doesn’t have to worry about breaching the peace or conversion liability. But judicial foreclosure is slow and expensive, not governed by the UCC, and the process varies from state to state.
Review Your Business’s Loan Documents
So what should you take away from all of this? Once a default occurs and is not cured within the time specified in the loan documents, a secured creditor can do a lot of really bad things to your business. Start with the paperwork. Review your business’s loan documents. Pay special attention to what a default is, when it triggers, how to cure it, and what happens after default. Realize that you get your real shot at fixing the problem in the short period of time after receiving the default letter, before your customers get letters to pay the bank directly. You should seek professional guidance to negotiate that process as early as possible.
