ASSET FINANCE INTERNATIONAL

IN ASSOCIATION WITHWHITE CLARKE GROUP

AUTO & ASSET FINANCE COUNTRY SURVEY 2015

United States

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The legal and regulatory environment

Stephen T. Whelan assesses recent developments in the US equipment and auto finance market

The year 2015 witnessed several noteworthy developments in equipment and auto finance, from both the courts and regulatory agencies. This article discusses the more important events, some of which are of immediate significance and one of which will come down the chimney on Christmas Eve, 2016.

Delivery and acceptance

In Wells Fargo Equipment Finance, Inc. v. Titan Leasing, Inc., the Seventh Circuit Court of Appeals ruled in favour of Wells Fargo in a dispute involving a lease of a locomotive where the contract provided that shipment of the locomotive constituted acceptance thereof by the lessee. When the item was delivered to the lessee, it was rejected because the lessee asserted that repairs were needed. Meanwhile, the lessor had pledged the lease to Wells Fargo as collateral for a loan, under which the lessor had warranted that the equipment “has been delivered and accepted by the Lessee and the Lessee has acknowledged receipt and acceptance of such Equipment.” When Wells Fargo learned that the lessee had neither accepted the equipment nor made any lease payments, it declared an event of default, accelerated its loan, and asserted recourse against Titan Leasing for breach of its warranty.

In reversing the trial court decision which had relied upon the lease contract language, the appellate court cited the more detailed loan agreement warranty, which required both delivery and acceptance. The court observed that delivery and acknowledgment of acceptance are significant indicators that the obligations of the lessee have commenced and that the lender is justified in making a loan where the principal source of repayment would be rental payments under the lease. This favourable decision, not only for leveraged lease lenders but also for equipment financiers which purchase leases from third party originators, underscores the wisdom of requiring that the lessee certify its receipt and acceptance of the equipment and that it has no knowledge of any claims or defenses against the lessor.

Hell and high water

In General Electric Capital Corp. v. FPL Service Corp., the lessee’s premises were flooded during Hurricane Sandy and the leased equipment was destroyed. When the lessor sued to enforce the lease, the lessee asserted that it should not be responsible because the destruction made its performance commercially impossible and because it was not possible to insure the equipment against this kind of risk. Rejecting the lessee’s claim, the court observed that the contract “expressly deals with improbable contingencies by assigning the risk of those contingencies” to the lessee. Significantly for readers of this Survey, the court went on to announce that “hell or high water” clauses would be enforceable “regardless of whether they are found in a lease or secured transaction.” The circumstances of this dispute have led some wags to refer to this case as one involving “hell and high water.”

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Asset-backed securities

The Dodd-Frank Wall Street Reform and Investor Protection Act of 2010 contained several provisions which impact securitization of auto and other equipment leases and loans. During the past year, two of those provisions were implemented in Regulations issued by the Securities and Exchange Commission.

• Regulation RR applies to auto and equipment asset-backed securities (ABS), both privately placed and publicly offered, issued on or after December 24, 2016. It covers mandatory risk retention, hence the moniker Regulation RR. Anyone who sponsors an ABS transaction by selling or transferring assets, either directly or indirectly, to the issuer of the ABS must retain a portion of the risk that those assets will suffer losses. The general rule is that the sponsor must retain the aggregate credit risk equal to 5% of the fair value of the assets transferred to the issuer of the ABS.

There are various way to accomplish risk retention. Horizontal risk retention involves the sponsor holding the first level of risk if any assets default and recoveries are inadequate to cover the contract balance of the defaulted lease or loan. Horizontal risk retention would begin with the excess cash flow from the collateral pool, the residual values of the leased equipment, and the sponsor’s ownership of any of the most subordinated classes of ABS.

Vertical risk retention requires that the sponsor hold the same percentage of every one of the ABS interests, including the equity securities of the issuer. A reserve account which complies with the Regulation RR requirements also can be used to satisfy all or a portion of the 5% risk retention requirement.

• Third party due diligence has spawned two new SEC rules: 15Ga-2 and 17g-10, both effective June 15, 2015. Like Regulation RR, they apply to both public and private offerings. Unlike that Regulation, these Rules were inspired by a desire to improve the process by which ABS receive ratings. Increasingly, ABS sponsors have employed third party due diligence providers to verify the accuracy of the data in the sponsor’s offering document, the conformity of the assets to the sponsor’s underwriting standards, or sponsor’s compliance with laws applicable to its kind of contract. The Rules describe investigation such as this, as eliciting factors “material to the likelihood” that the issuer of the ABS will pay interest and principal in accordance with the ABS documents.

Form ABS-15G is to contain the “findings and conclusions” of any third party due diligence (3PDD) provider’s report delivered to the issuer or the investment banker. The form is to be signed by the entity which received the report and is to be filed on EDGAR (the Electronic Data Gathering, Analysis, and Retrieval system) five business days before the “first sale” of the ABS. Form ABS Due Diligence-15E is to be posted by the sponsor on its Rule 17g-5 Website and delivered “promptly” to any nationally recognized statistical rating organization that requests a copy. Just like Form ABS-15G, this form must summarize the 3PDD provider’s “findings and conclusions” and also must describe the 3PDD process “sufficiently detailed to provide an understanding of the steps taken in performing the review”.

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UCC mischief

Readers of this article may be surprised to learn that the Uniform Commercial Code (UCC) financing statement filing system has been abused in recent years, such as by correctional facility inmates filing an all assets financing statement against the judge who sentenced them to prison, when the judge obviously was not a borrower from the inmate and had not pledged any collateral to him. Consequently, legislation has been introduced in various states to address this situation by providing an expedited procedure for termination of unauthorized filings. Early in 2015, Utah Senate Bill 93 not only covered this situation but also, as originally written, would have had some pernicious effects.

For one thing, the debtor who challenged the validity of a filing would have been entitled to a fast-track procedure under which the filing office would have been instructed to terminate the filing promptly after receiving notice from the debtor that it was challenging the financing statement. The secured party would have been entitled to receive notice of the proposed termination but powerless to stop it; its only remedy would have been to bring an action against the filing office to reinstate the filing.

Moreover, during the pendency of that action, the terminated filing would not be effective against a good faith purchaser of any of the collateral from the debtor (a good faith purchaser could be a buyer or a secured lender), thereby enabling a scurrilous debtor to game the system by challenging a duly authorized filing, having it terminated, and then selling or pledging the same collateral to a good faith third party. If the debtor, having double financed the property, were to disappear or declare bankruptcy, then the original secured party would have lost its perfected security interest and be left with an unsecured claim for damages against the feckless debtor.

Alerted to this troublesome proposal, the Equipment Leasing and Finance Association (ELFA) formed a task force of UCC practitioners and succeeded in convincing the Bill’s sponsor to modify several provisions of the Bill. Among other things, these changes made it easier for a secured party to become an ‘established filer’ so that any debtor challenge to one of its filings would have to be reviewed by the filing office to determine − before any termination statement were filed − whether the established filer’s financing statement was unauthorized and filed “with the intent to harass or defraud” the debtor. The revisions also deleted the ability of a good faith purchaser to claim priority over a secured party’s challenged financing statement − even if that terminated financing statement eventually were reinstated. Senate Bill 93 became law, but with much less dangerous consequences than as introduced. Secured creditors nonetheless should communicate with the Utah filing office and do what is needed to receive established filer status.

New Jersey also addressed filing of fraudulent UCC financing statements, as well as adopted new administrative rules affecting the UCC filing process generally:

1) requiring electronic filing of all UCC records;

2) changing the effective date of filing, to the ‘work day’ when the Division of Revenue and Enterprise Services (the central UCC filing office) has verified that the financing statement complies with the legal filing requirements;

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3) requiring the actual legal name of the secured party (or its agent or trustee) to appear on the financing statement; and

4) mandating that the collateral description include a statement that all of the identified collateral falls within the scope of UCC Article 9.

One effect of these rules may be to inspire secured parties to make filings with the assistance of experienced filing entities such as Corporation Service Company.

Stephen T. Whelan is a partner in the New York City office of law firm Blank Rome LLP and a member of the ELFA Board of Directors.

swhelan@blankrome.com