A Factor’s Legal Guide to the Supply Chain
Factors and asset-based lenders play an important role in the supply chain. As each link becomes more stressed in the current environment, it is important for factors and lenders to understand their rights and the legal nuances of the supply chain from a financing perspective.
BY STEVEN N. KURTZ, ESQ., LEVINSON ARSHONSKY & KURTZ, LLP
As I was formulating this article, the tragic news of Bert Goldberg’s passing was released by his family on social media. The news hit me hard, as I’m sure it did with others. If one were to write about all of Bert’s good qualities and his accomplishments, it would be a very long book. Please read and re-read the obituary and tribute to Bert, as it will give you a taste of the impact he’s made on others. One way to honor Bert’s memory and legacy is to donate to his favorite charity: Beta Foster Care. I urge you all to do so now while it’s fresh in your minds before you go on with the rest of this article.
One of the issues dominating the news cycle is the interruption to the supply chain and its effect on the economy and our daily lives. Although the concept of the supply chain is deeply layered and complicated, here is a concise definition borrowed from Investopedia: “A supply chain is a network between a company and its suppliers to produce and distribute a specific product to the final buyer. This network includes different activities, people, entities, information and resources. The supply chain also represents the steps it takes to get the product or service from its original state to the customer.”
The supply chain is a complex organism with domestic and international components, including financing. As you all know, when financing accounts or inventory, your rights as a factor or asset-based lender are linked to your factor client’s/borrower’s performance under its contract. In the supply chain, your rights and ability to be repaid are also closely linked to those who are ahead of, beyond and next to you in the sequence of events. Hence, it is important to understand where you fit in the process to ensure that your rights are protected.
Pay Warehouses and Carriers
You might be surprised to learn that when financing deals for inventory or accounts from the sale of inventory for a factor client/borrower who is importing goods from outside the United States, your lien against the inventory while it is in transit is unperfected. This is because UCC perfection does not operate outside the United States. UCC Sec. 9-301(2) provides that the law of the jurisdiction where the collateral is located governs perfection, and UCC Sec. 9-501 addresses the proper state to file financing statements, meaning there is no place to perfect your lien when the collateral is located outside the United States. Hence, assuming your factor client/borrower took title to the goods in the country of origin (more on this later), while the goods are in international waters, airspace or on a truck, the lien against the inventory does not actually become perfected until the goods are in the United States, which, in practical terms, is when the goods have cleared customs. However, while the goods are in transit, they will be subject to the rights of the international carrier.
Once the goods come into the United States (or if they originated in there), the product must make its way from its point of origin to the ultimate destination, whether that be the end user or the person who will take possession and then resell the products, meaning goods must be stored and moved. This is where Article 7 of the UCC, called “Documents of Title,” comes into play. This section deals with the rights of the warehouse folks and the carriers. Article 7 goes into intricate detail on bills of lading and warehouse receipts. When this section was written, the drafters were dealing with people that signed things in at least triplicate with lots of papers floating around that evidenced the various parties’ rights in the goods that were being stored and moved. Article 7 now allows for electronic records and will eventually transition into allowing a blockchain system.
Article 7 grants liens for the warehouse and carriers to secure their services. These liens are not hard to obtain, but I’ve seen it done wrong in the past. They do not necessarily jump ahead of you as the factor/lender, but, as the warehouse and carriers are integral in the supply chain and are in possession of your collateral, they do need to get paid; if they don’t, they won’t release the goods until they are, and there are infamous transportation collection groups that can cause all kinds of problems. The key to avoid all of this is to pay the warehouse folks and the carriers, otherwise the transaction breaks down.
Bills of Lading and FOB
One cool and exciting tip involving bills of lading (assuming this topic can be cool and exciting), is that UCC Sec. 1-307(a) provides that the facts set forth in bills of lading are presumed to be true and that the burden of proof about these facts shifts to the other side. This section is helpful when there is a dispute with an account debtor over payment. When the factor client or ABL borrower is not around to help you, your proof of receipt of the goods will be the bill of lading. With this proof, the account debtor must refute the presumption (which is favorable to you) that the goods were delivered. Then the clock will start ticking on the account debtor’s responsibilities, as will be set out below.
When financing inventory or accounts deriving from inventory, your rights in the collateral do not accrue until your client/borrower has rights. These rights accrue once title to the goods vests with your client/borrower. Article 2 of the UCC, entitled “Sales,” addresses this issue. Most written agreements dictate when title to the purchased goods rests with a buyer. Article 2 uses the term “free on board” or “FOB” to determine when title to goods is transferred. It’s an antiquated term and its only practical use is to determine when title to goods transfers upon a shipment. The underlying contract, invoice or purchase order will usually specify when title transfers to a buyer. If the title is FOB place of shipment, then the goods have transferred to the buyer once the goods are tendered to the entity that is shipping the goods. If the title is FOB place of delivery, the seller bears risk of loss and owns the goods until the goods are transferred to the buyer once the goods arrive at the place of shipment and are unloaded. Once the goods are transferred to the factor client/borrower, then the factor/lender’s security interest attaches and all other rights pertaining to the inventory kick in.
Know Your Rights
As a factor/lender, your security interest in inventory or accounts automatically includes proceeds, the definition of which includes a basket of rights and litigation claims. Your security agreement likely specifies certain rights inherent in your collateral that are always available in case of problems. There are certain rights that directly involve the supply chain, especially for goods in transit from your factor client/borrower to the account debtor.
If you learn that the account debtor is insolvent right after a big order was financed and the goods are in transit, you can always exercise the right of stoppage. This means you literally stop the transportation and do not authorize the goods to be delivered. This right is seldom used and should be relatively easy once this information is reduced to an electronic record.
Next, one of the most powerful rights is the right of reclamation. This right is set out in UCC Sec. 2-702 and allows the seller to reclaim (take back) goods within 10 days of delivery (remember the FOB for when title transfers) or up to 90 days if the buyer misrepresented its solvency in writing (think credit applications or other electronic records). The U.S. Bankruptcy Code, in Section 546(c), allows for reclamation rights for goods delivered within 45 days of the bankruptcy filing. These bankruptcy reclamations will be subject (and junior) to a lender with a lien on inventory but can result in an administrative claim, meaning the claim for goods delivered within 20 days of the bankruptcy filing is paid before unsecured creditors.
Article 2 contains a number of other rights dealing with a sale of goods. It has a very comprehensive scheme that basically starts from the beginning of the deal until the end and can figure out rights when you have a smattering of purchase orders, invoices and other writings, which often contain contradictory terms.
As a factor or lender with a lien on accounts or inventory, your most focused area in Article 2 is getting paid. Article 2 can be every factor or lender’s friend when figuring out rights. These rights include how long the buyer has to inspect goods, raise claims or irregularities, how to deal with claims, and rights and damages after raising claims. Please check the IFA website for its approved invoices which, on their face, look simple but are designed to protect the IFA community and address these rights in your favor. If the rights for inspection, time to raise claims, rights after claims are made and time for payment are not spelled out, all these gaps can be filled in using Article 2. If the buyer has failed to timely raise or particularize its claims, then it is deemed to have accepted the goods. Once the goods are accepted, there is a statutory duty to pay. The beauty of Article 2 is that there is a comprehensive statutory scheme of rights and obligations that can be used as a checklist when addressing the actions or non-actions of the account debtor.
You as a factor and asset-based lender are an important and critical piece of the supply chain. The factoring and ABL industry help keep the flow of products and services moving. Hopefully this article will help you understand the process and help you watch out for trouble as you navigate your way through the supply chain. As for Bert, he will be deeply missed, but he has left the IFA in an incredible place. His vision will continue to guide and inspire the organization, as well as each of us who he touched so deeply. Again, please honor his memory by making a donation to his favorite charity: Beta Foster Care.