If a lender has a security interest in my receivables, must my customers pay it directly?

The New York Court of Appeals recently issued a decision in Worthy Lending LLC v. New Style Contractors, Inc. The case is about lenders who hold security interests in a borrower’s receivables or contracts. Lenders who take such security interests should keep strong practices.

I’m going to start at the end of this opinion and work my way backwards. That’s because the ending is what anyone reading this will remember. The court held that Worthy could collect on all of Checkmate Communications’ pledged accounts even if Checkmate had not defaulted. Everything else in the opinion is how the court got there. The story is not a difficult one. In 2019 Checkmate executed a note and security agreement in favor of Worthy. The security agreement gave Worthy a lien against all of its assets, including receivables. Worthy perfected with a UCC-1 and later told account debtors that payments to Checkmate would not satisfy their obligations. One debtor did not listen, and even though it had received the letter, continued to pay Checkmate. Checkmate defaulted. Worthy accelerated the note, and sued that account debtor.

UCC 9-406 or 9-607

The real dispute is which provision controls - UCC 9-406 or 9-607. The first deals with assignments of accounts. Section 9-607 says things about pledges generally. But §9-607 says nothing about whether the account debtor has an obligation to the pledgee, and §9-607’s silence on timing questions forms the heart of the question.

The court’s first answer was that NY UCC 9-406 governs security interests in receivables. Its analysis of that section went this way. The assignee includes the holder of a presently exercisable security interest, and the assignor includes the pledgor. Then came the clear result. Once notified, it is the secured creditor only that discharges the account debtor. Payments to anyone else did not work.

That brings us to the second holding, the one likely to matter more often in practice. NY UCC 9-607 itself, the court said, imposes no duty on the account debtor to pay the secured party until the debtor has defaulted. The duty has to come from somewhere else, and it can come from the contract. Here it did: the language in the contract, the court concluded, was clear enough that it had no problem finding it. And the court added that the rule applies whether or not the parties agree on how much money is actually owed.

So what should secured lenders take from this? Mostly that a little work up front saves a lot of trouble later: diligence in taking the interest, clear drafting, and prompt notice to account debtors.

Start before you fund. Most lenders will require a borrower to list its material contracts before funding, and that is the right instinct, but knowing of the contracts is only the beginning. Analyze the duration of the contract, the payment terms, and contact information. If a contract is where the borrower gets its money from a large customer or vendor, that is a contract to look at. A borrower’s big customer or vendor contracts may be responsible for the majority of the borrower’s revenue.

If the lender is taking a security interest, the grant of security interest should be drafted to cover every part of the borrower’s interest in the accounts. Invoices, for example, not just the accounts. The loan documents also should let the lender verify and notify the account debtor and direct where it pays. Something like: “From the effective date, Borrower grants Lender a continuing lien on and security interest in (a) all of its accounts, (b) all of its accounts receivable, and (c) all of its invoices, wherever held.”

At closing, the collateral agent or lender should file a UCC-1 in the borrower’s state of organization. And while you’re at it, also take collateral assignments of material contracts.

The most important part of this, for the lender, is to tell the account debtors at or soon after the loan is funded. The notice should be simple, describing the accounts that are pledged, where the account debtor should send the money it owes, and whom at the lender to contact should the account debtor have any question. A letter that sits in a drawer for three months helps no one.

Account Debtor

Flip the situation. Now you are an account debtor and you receive a letter from a lender. It says that all money owed to a borrower should be paid to that lender, not the borrower. Stop and think. Ask the lender for proof that the borrower pledged its accounts. Once you have it, pay the lender directly. The lender is the person who can release you from your debt, not the borrower. If you just keep paying the borrower, you may have to pay twice: once to the borrower and then again to the lender. Remember, too, that the Worthy decision comes from New York’s Court of Appeals, and other states’ laws may be different. Check, too, with a local attorney. A short call is cheap.