A False Sense of Security

As an industry, we are hung up on the idea that being secured lenders gives us protection on our collateral. As factors, what does that even mean? The age-old question is; Are we lenders or purchasers? If you have recourse and reserves, the courts have ruled you are a lender. If you buy with a simple discount and no recourse, you are a purchaser. In both cases, we have been granted a security interest in the paper we are given. That sounds good, but what does a security interest in paper actually mean or give you? Simply stated, it means that piece of paper represents an outstanding loan to a borrower and depending on when you file your UCC will determine if you have first, second or third rights to it. Let’s examine the benefits of that. 

In the case of factoring, the debtor, or who is really the borrower, is actually the purchaser of some goods or services that were sold or provided to a seller or vendor. So, when you say you have security, what you are holding as security is a piece of paper that represents an unsecured loan a vendor made to a buyer of goods and or services. 

Now you are yelling, “but, but, I have more than a security in the paper, I have security in all of the assets of the company in addition to that piece of paper.” Sure, let’s go with that. If you do your work properly, and your client, the seller did their work properly, the buyer will pay that unsecured loan, and everyone is happy. It’s a simple transaction that really doesn’t need a security interest at all, unless there are competing interests claiming the collateral at the same time.

“But, but, what happens if the invoice doesn’t get paid?” You have two choices, sue the buyer for non-payment or sue the client for giving you a piece of paper that isn’t worth they ink printed on it. Can’t you do that without a security interest? You certainly can. You can sue the buyer and or seller for non-payment without a security interest. A security interest doesn’t give you the rights to sue. It doesn’t even help you get through the courts any faster. No one is standing at the courthouse saying, “you are special, a secured lender, step this way.” 

Saying you have a security interest in a lawsuit against the seller or the buyer doesn’t give you some magic powers to sue. The only reason you mention it in a lawsuit with the buyer is to frame your rights to sue under a contract you have. That contract doesn’t have to be a secured contract to sue. 

Mastercard and Visa, two of the largest unsecured lenders in the world, don’t need to mention a security interest when they sue. They don’t mention it, because they don’t have a secured contract. They have a simple contract that says, "I give you money, you pay me back. You don’t pay me; I will sue you." No magic powers required to file with the court. Secured lenders really don’t either. It’s the contract that gives you your rights, not the security interest. 

So, is a security interest important in lending? Well, it depends. It doesn’t help you to collect from the buyer. That’s an unsecured transaction between the buyer and seller as we mentioned above. Well then, it must help to collect from the seller. Maybe. If there is a bankruptcy and you are in what they like to call first position, you have the first right to pick over the collateral of your debtor. That is unless a lessor of equipment, the trustee in the bankruptcy, the lenders to motor vehicles, a holder of titles, government agencies, judges allowing use of cash collateral, the labor board, assignment for the benefit of creditors, or unions don’t make claims to their collateral and possibly yours. To protect that security first position, you might have to fight like hell. If there is no bankruptcy you can collect on your collateral in the ordinary course of business secured or not. 

We give too much weight to a security interest. Truth is, more loans are made unsecured, than secured, and those loans get paid every day without much notice. Chances are you are taking out an unsecured loan as you read this. Did you just buy something on Amazon with your Visa? That’s an unsecured loan to you from Visa. Just check out of a hotel with your Amex? That’s an unsecured loan made to you from American Express. A security interest isn’t making you pay, and a security interest isn’t required for Visa, Mastercard or Amex to collect. 

Vendors are the largest providers of unsecured business credit in the world. They are most likely your factoring customer. An unsecured lender. Those dashboards made in Indiana sold to Ford in Detroit on Net 30 terms are an unsecured loan to Ford that you might factor. Those little screws made in China sold to Home Depot on net 60, that’s an unsecured loan to Home Depot. 

Do you really think a seller of automotive seat covers to General Motors needs a security interest to collect from GM? Absolutely not. Now if GM should go bankrupt, it’s helpful, but what are the chances of that? 

Trillions of dollars are done in business purchases each year with nothing more than an invoice sent to a buyer and a promise from the buyer to pay. No contracts were signed, no applications filled out, no security interests filed. A business transaction is a simple request from buyer to purchase goods or services from a seller, for which the seller sends an invoice to the buyer after delivering the goods or services. If the buyer doesn’t pay, the seller, without even a written contract, just the invoice and shipping documents in hand has a right to sue. 

This is what factors, banks and asset-based lenders are lending on. A piece of paper that represents an unsecured sale of goods or services, no other documents.  In reality, other documents might trump your rights. Having a security interest doesn’t give you any more rights in that single transaction then the seller has. 

“But, but I have a UCC filed that should give me some protection?” As for the transaction above, not really. A UCC on its own means nothing. It’s your contract that gives you your security interest, not the UCC. Even without the UCC, you can still have a security interest by contract. The UCC is merely your notice that you have a secured contract. It on its own doesn’t allow you to walk into someone’s factory and pick up your collateral. For that you first need a judgment, and for that, you need to go to court and sue. And to do that, you don’t need a security interest. 

Any creditors without a security interest, that has not been paid, can go to court and sue. When that unsecured plaintiff sues and wins a judgement, that unsecured creditor is now technically secured. Filing that judgement makes them a secured creditor. 

“But, but at least I am in first position, and they will have to wait in line.” No, not really. The Judgment creditor is now in a position to notify the first position creditor, all the creditors, of their intent to start foreclosure on the collateral. In the case of accounts receivable, they can even jump ahead of secured creditors on AR with notice. After waiting out a 45-day notice they can start collecting on AR. Yes, you can be primed by a judgment creditor the same as the IRS after 45 days notice. So much for your security position. 

What does this all mean? In the 21^st century and the world of fintech, AI, Early Pay and Blockchain, the world of lending is going to change. The archaic world of secured lending is evolving. The ones holding on to the illusion that a security is a necessary component of lending on AR are going to be in for a rude awaking. Like the drip, drip, drip of a faucet, the pie will get smaller and smaller, until secured lending is a niche form of financing with starving lenders foraging for scraps.

by Steve Troy