Issues to Consider When Entering Subordination Agreements with the SBA
With the financial assistance and the extension of the loan programs offered to small business under the CARES Act, factors and asset-based lenders will need to keep working with the SBA to enter subordination agreements to obtain priority in their clients’ collateral, among other issues. Jared Ullman outlines the key points of the process and how to avoid hurdles and mitigate these issues.
BY JARED ULLMAN, ESQ.
Millions of small businesses have received financial assistance from the Small Business Administration during the ongoing COVID-19 pandemic. Many factoring companies that provide working capital to businesses have found that prospective and existing clients have obtained SBA loans, creating the need for factors to seek subordination agreements from the SBA. This article discusses certain key provisions that may be contained in SBA subordination agreements, potential risks and ways in which factors may try to minimize or mitigate these issues.
BACKGROUND ON THE CARES ACT
First, let’s look at some background information about the SBA’s significant role in mitigating the economic impact of the COVID-19 pandemic. In response to the COVID-19 public health emergency, Congress passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which was signed into law on March 27, 2020. The CARES Act significantly expanded the scope of certain SBA loan programs and created new loan programs to provide financial support and loans to qualifying small and medium-sized businesses. The CARES Act, among other things, created the Payroll Protection Program and significantly increased the SBA Economic Injury Disaster Loan (EIDL) program.
The CARES Act remains the federal government’s primary legislative response to the economic crisis that the pandemic precipitated. The breadth of the CARES Act is astounding. By March 21, 2021, the SBA had approved a whopping $718 billion by way of more than 8.2 million individual PPP loans. As of Feb. 21, 2021, the SBA had approved more than 3.7 million EIDL loans for a total of more than $200 billion dollars. To put these figures into perspective, the combined figure of $918 billion exceeds the government’s Medicaid expenditures in fiscal 2020 as well as the Department of Defense’s entire budget for fiscal 2020.
DIFFERENCES BETWEEN THE PPP AND EILD
There are several important differences between the PPP and EILD programs. The PPP gives the SBA funding and authority — with support from the Treasury Department — to provide unsecured loans to small businesses adversely affected by the COVID-19 crisis. On the other hand, the EIDL program offers long-term financial assistance to eligible entities — including small businesses, sole proprietorships and independent contractors — affected by covered disasters such as the COVID-19 pandemic.
While EIDL borrowers also may obtain a PPP loan, they must use the proceeds from each for different purposes. Borrowers may deploy EIDL loans for working capital, notes payable, accounts payable and other expenses resulting from COVID-19’s impact. Unlike the PPP, under the EIDL program, loans made by the SBA in excess of $25,000 must be secured by the borrowers’ assets.
Under the EIDL program, borrowers that receive business loans from the SBA are required to enter into certain documentation with the SBA, including a loan authorization and agreement and note and security agreement. The SBA’s security agreement contains a provision that grants to the SBA a security interest in the borrower’s assets, which may include all, or substantially all, assets, including accounts and inventory to secure the borrower’s obligations under the SBA note.
Accordingly, if a factor wishes to provide factoring facilities to a business that received an EIDL loan and granted the SBA a priority security interest in its assets, including accounts and general intangibles, the factor must request a subordination agreement with the SBA in order to, among other things, acquire a priority security interest in the assets of the business that is senior in priority to the SBA’s security interest.
ISSUES APPLICABLE TO THE SUBORDINATION PROCESS
In 1979, the United States Supreme Court, in the case of United States v. Kimbell Foods, Inc., announced the rule that when fashioning the federal law that governs the priority of liens and security interest stemming from SBA lending programs, courts must look to nondiscriminatory state laws (e.g., the Uniform Commercial Code), absent a congressional directive to the contrary. Following the Kimbell Foods, Inc. case, lower courts generally have applied Article 9 of the Uniform Commercial Code to determine the priorities and rights among competing security interests held by the SBA and other creditors. Uniform Commercial Code section 9-339 expressly provides that the UCC does not preclude secured .arties from entering into subordination agreements to modify priority rights.
The SBA has implemented procedures to permit EIDL borrowers to submit a subordination request to the SBA. The SBA’s approval of a subordination request is conditioned upon, among other things, the lender or factor entering into a written SBA form subordination agreement in the form approved by the SBA, and the transmission of the executed subordination agreement to the SBA via email to pdc.pdcac-countscollateralreview@sba.gov.
After reviewing several versions of the ‘one-size fits all’ form of EIDL subordination agreement used by the SBA, with each agreement approximately two pages in length, it appears the SBA is reluctant to agree to make material changes to the terms of subordination agreements. Factors and other types of entities that wish to provide financing facilities to businesses that have obtained an EIDL may find the SBA’s subordination agreement spartan compared with certain non-SBA commercial intercreditor agreements.
Factors (and asset-based lenders) that want to enter into a subordination agreement with the SBA to provide factoring facilities should take into consideration and address any one or more of the following subjects or provisions contained in the SBA’s subordination agreements.
1. Types of Subordinated Collateral
Factors may decide to make a request that the SBA subordinate the SBA’s security interest in accounts and other assets of the EIDL borrower. If the SBA agrees to subordinate its security interest only in accounts, and not in the borrower’s inventory, the factor is assuming certain risks if the borrower’s account debtor (i.e., customer) elects to reject the inventory or revoke acceptance of inventory sold and/or return the inventory delivered. If the SBA does not also subordinate its security interest in the inventory returned, then the factor may be unable to repossess the inventory and/or dispose of the inventory in order to apply the proceeds to the payment of the obligations under the factoring agreement. Accordingly, it behooves factors to seek to obtain a subordination from the SBA in both accounts and inventory sold giving rise to the accounts.
2. Senior Debt Cap
SBA subordination agreements may require a factor to agree to limit the subordination to a maximum dollar amount (i.e., a senior ‘debt cap’), making the SBA’s security interest subordinate to a factor’s security interest in the collateral only up to the senior debt cap amount as reflected in the subordination agreement. Factors should consider the impact of the debt cap provision on their ability to increase the maximum factoring facility amount and/or make over-advances to the factoring client in an amount greater than the debt cap. If a factor requests the SBA’s approval to exceed the debt cap, and the SBA refuses such a request, then any advances made that exceed the debt cap may be subordinate to the rights of the SBA in the collateral. In addition, in a draconian scenario, the SBA may treat advances made by the factor to the factoring client in excess of the debt cap as being made in violation of the subordination agreement. Accordingly, factors should carefully consider a factoring client’s future cash flow needs when determining the amount of the factoring facility provided for in the SBA subordination agreement (i.e., the debt cap).
3. Notice of Default Provisions
SBA subordination agreements also may contain a provision that requires a factor to provide the SBA with written prior notice, sometimes as least 30 days prior notice, before any action may be taken by the factor as a result of the factoring client’s breach of the factoring agreement. If a factor violates such a notice provision by failing to provide prior notice to the SBA before taking any action against the factoring client, or the collateral, the factor may be in breach of the subordination agreement and the SBA may seek to hold the factor liable for potential exposure.
The SBA may agree to waive the notice requirements, otherwise, factors should consider the effect of this provision on their ability to exercise default rights in the event of a default under the factoring agreement. Factors also should consider the internal administrative process that needs to be implemented by a factor to best ensure that the people who are responsible for enforcement of the factoring agreements are aware or are made aware of the duty to provide such notice.
4. Increases in EIDL Loan Amounts
The EIDL program initially capped loans at $150,000; however, that limit will increase to $500,000, effective as of the week of April 6, 2021. Existing COVID-19 EIDL borrowers will be able to request an increase beginning April 6. A spokesperson said the SBA will provide updated instructions on how to request a loan increase on the SBA’s website and also will reach out directly via email to existing COVID-19 borrowers with loans approved prior to the increased loan limit.
Some SBA subordination agreements may not restrict the SBA’s ability to increase the EIDL facility amount to the borrower. Therefore, the SBA may have the right to increase the EIDL loan amount without a factor’s knowledge or notice, which may give rise to a default under the factor’s factoring agreement. As a practical matter, factors should consider implementing an administrative procedure in order to, among other things, verify that clients remain in compliance with the terms of the SBA’s note, including any obligations due as a result of an increase in the SBA loan amount.
Factors and asset-based lenders that enter into subordination agreements with the SBA may find it beneficial to consult with counsel in order to augment factoring agreements with a rider containing provisions that seek to address certain foreseeable risks. In addition, other issues may arise in connection with the enforcement of the subornation agreement that are not addressed in this article, including, but not limited to, default remedies, bankruptcy issues, etc., and factors should consult with their counsel to address these matters.
Disclaimer: This article is not legal advice. Readers should seek legal counsel for specific help. No attorney-client relationship is created by the dissemination of this article.
Jared Ullman is a partner with the law firm Ullman & Ullman, P.A. located in Boca Raton, FL. Ullman & Ullman has been co-counsel to the International Factoring Association for more than 20 years and has been advising and counseling factors and lenders for more than four decades. Ullman represents factors, forfaiting companies and various asset-based lenders, including purchase order, equipment and inventory finance companies in a host of areas, including, among others, transactions, due diligence issues, regulatory matters, workouts, Chapter 11 bankruptcy matters (including post-petition debtor-in-possession financing), and litigation in state and federal courts, as well as complex commercial domestic and international arbitration. Ullman can be contacted at 561-338-3535 or jared.ullman@uulaw.net.