Intercreditor Agreements Between Factors and Inventory Lenders - From Conflict to Cooperation
Written By: Jim Cretella, Member of the law firm Otterbourg, P.C. and Chairman of the Firm’s Banking & Finance Department
Factors and inventory lenders frequently work together to provide a comprehensive financing solution to businesses in need of both accounts receivable and inventory financing. However, the involvement of both a factor and inventory lender can introduce a range of challenges, including conflicting interests and overlapping collateral. These challenges are typically addressed in an intercreditor agreement between the factor and the inventory lender. As both the factor and the inventory lender provide financing against working capital assets, the intercreditor agreement between them can be a bit different than, for example, an intercreditor between a factor (or working capital lender) and an equipment lender. The following are some of the more unique areas of negotiation in an intercreditor agreement between an inventory lender and a factor.
Receivables as Proceeds of Inventory
Factors and inventory lenders generally agree in concept that inventory is the inventory lender’s priority collateral and accounts receivable are the factor’s priority collateral. However, because the sale of inventory on terms gives rise to an account receivable, the inventory lender will generally take the position that, unless it is paid for that sale, its security interest in the resulting receivable should have priority over the factor’s security interest.
Factors will often attempt to address this issue by offering to pay the inventory lender all amounts due from the factor to the client. Of course, most factoring facilities are discretionary and also allow the factor to pay down its exposure by any or all such amounts due from factor to the client. As the amounts due from factor are necessarily uncertain, most inventory lenders will want more than a right to receive the amounts due from factor in exchange for their agreement to subordinate the priority of their security interest in the receivables arising from sales of inventory.
In addition to a right to claim all amounts due from the factor to the client, an inventory lender might also want to be paid a certain amount of the receivable at the time it is submitted by the client to the factor. While the specific mechanics of the “buyout” can vary from deal to deal, depending in large part on how the inventory facility is structured, the general concept remains the same. The factor has the option to pay, or to not pay, the buyout price for a receivable from amounts otherwise payable to the client. The intercreditor agreement will in turn provide that the factor has the priority security interest on receivables for which it pays the agreed buyout price and the inventory lender has the priority security interest on receivables for which the factor declines to pay the buyout price.
While the buyout concept outlined above is generally agreeable to factors and inventory lenders alike, factors and inventory lenders often disagree as to the buyout amount required to flip, from the inventory lender to the factor, the relative priority of their respective security interests in an account receivable arising from the sale of inventory. Inventory lenders often want the right to increase the buyout amount for an account receivable to up to 100% of the face amount, arguing that they should have an absolute right to claim all proceeds from inventory sales because inventory is ultimately their priority collateral. By contrast, factors often want to cap the buyout amount for an account receivable at less than 100%, generally with the cap tied to the inventory lender’s advance rate plus some cushion. From the factor’s perspective, a cap on the buyout amount leaves the factor with some potential for “dry powder” in the receivable should the factor need to fund protective advances or pay down a shortfall in its exposure. The factor also points out that, if the inventory lender wants to realize all of the inventory value for itself in the event of a default under the inventory loan facility, the inventory lender can always foreclose upon the inventory. Regardless, the buyout concept, particularly with respect to the cap on the buyout amount, is often a heavily negotiated point in intercreditor agreements between inventory lenders and factors.
Other Overlapping Collateral
Separate and from the issue above, the intercreditor agreement will also set forth the relative priorities of the respective security interests of the factor and inventory lender in assets other than inventory and receivables. It is not unusual for both the factor and inventory lender to have an “all asset” security interest in the existing and future assets of the client. Factors will always want to ensure their priority collateral includes assets ancillary or related to the receivables, such as books and records evidencing the receivables, general intangibles related to the receivables and, if applicable, bank accounts.
As to the remaining assets, particularly equipment and intellectual property, many intercreditor agreements between factors and inventory lenders provide for their respective security interests to be of equal priority, with any recoveries from those assets distributed pro rata between the factor and inventory lender. However, in deals where the equipment is necessary to convert raw materials or work in process inventory to finished goods, or the inventory is branded, the inventory lender is more likely to push for the equipment and intellectual property to be part of its priority collateral or, if equal priority collateral, to at least have a use period before it can be foreclosed. Ultimately, this is a deal specific negotiated point.
Collections
As a general rule, most intercreditor agreements say that the creditor with the priority security interest in collateral has the exclusive (or at least the first) right to exercise remedies against that collateral. However, application of this general rule to an intercreditor agreement that includes the buyout concept above, or that otherwise allocates some receivables as factor priority collateral and other receivables as inventory lender priority collateral, can lead to problems. For example, if the factor elects to not remit the buyout price of a receivable, application of this general rule could result in both the factor and inventory lender seeking to collect from, and possibly sending conflicting remittance instructions to, the same account debtor. As such, most intercreditor agreements between a factor and inventory lender, especially those that include the buyout concept discussed above, will expressly give the factor the exclusive right to collect all receivables, whether constituting factor priority collateral or inventory lender priority collateral.
The factor will, of course, need to turnover to the inventory lender any collections it receives from receivables that are inventory lender priority collateral. Further, if the factor elects to not send a notice of assignment to an account debtor, the intercreditor agreement will generally permit the inventory lender to do so and undertake direct collection from that account debtor, subject to a similar turnover obligation with respect to any collections the inventory lenders receives from receivables that are factor priority collateral. The point being that, even if some receivables are factor priority collateral while other receivables are inventory lender priority collateral, it is in the best interest of both the factor and inventory lender to ensure that account debtors do not receive conflicting or confusing instructions from the factor and inventory lender.
As illustrated above, intercreditor arrangements between a factor and an inventory lender can present some unique challenges. Effective negotiation requires a thorough understanding of each party’s needs and a willingness to strike a balance between competing interests. A well drafted, well thought out, agreement minimizes the potential for future conflict and also fosters a collaborative relationship between the factor and inventory lender.
About Jim Cretella, Member, Otterbourg, P.C.:
James M. Cretella is a Member of the firm’s Banking and Finance Department and the Chairman of the firm’s Alternative and Specialty Finance Department. He represents institutional lenders, factoring companies and specialty lenders, as well as borrowers, in a variety of asset-based lending, specialty finance and corporate transactions. Mr. Cretella has worked on financing transactions covering a wide range of industries, including staffing, technology, fintech, lender finance and government contracting. He has extensive experience in supply chain, recurring revenue and specialty finance transactions, including off-balance sheet receivable purchase facilities.
The views expressed in the Commercial Factor website are those of the authors and do not necessarily represent the views of, and should not be attributed to, the International Factoring Association.