Asset-Based Lending in England and the U.S.: A Comparative Insight for Cross-Border Transactions

Historians believe that asset-based loans arose in Mesopotamia in 3,000 BC, where farmers used crops as collateral. However, the modern asset-based loan emerged in the U.S. during the Great Depression when traditional funding sources were harder to come by, and the use of ABL continued to grow following World War II. The adoption of Article 9 of the Uniform Commercial Code (UCC) in the U.S. in the 1950s added a level of certainty and national uniformity to the scope of a secured creditor’s rights in receivables, inventory and other forms of liquid collateral, and by the 1980s, ABL was a standard product in the U.S. financial markets. By 2000, modern ABL emerged in the English market as a mainstream financing tool and further gained in popularity during the 2008 financial crisis. To support the continuously growing industry, the English Loan Market Association released their recommended form of borrowing base facility agreement in 2021.

Assets Included in the Borrowing Base
ABL spans a wide spectrum of assets. At one end are flexible, relatively liquid assets, such as receivables and inventory, that are well-suited to a borrowing base that fluctuates in a borrower’s ordinary course of business. At the other end are less liquid assets, such as plant and machinery, real estate and oil and gas reserves, where borrowing capacity is driven by periodic valuations rather than day-to-day operations.

Historically, the assets that traditionally secured asset-based loans were primarily limited to inventory and receivables. However, as the industry has developed, non-traditional assets such as distribution rights, intellectual property, motor vehicles and media rights can also be included in a borrowing base. Perhaps as a throwback to 3,000 BC Mesopotamia, lenders sometimes even are willing to take crops and livestock as collateral.

Of course, for assets that are less liquid or that are harder to value, the amount that a lender will advance against these assets will be a lower percentage of their value than the lender would use for more traditional borrowing base assets. It is also likely that a lender would require more frequent valuations, or request guarantees on income (such as a guarantee of a minimum royalty) or additional insurance to be taken out to support lending against less traditional assets.

As a practical matter, while ABL can and does include a broad range of assets under its technical definition, it is most often used to describe an inventory and/or receivables financing.

Basics of a Borrowing Base
The amount that a borrower can borrow in an asset-based loan is expressed as a percentage of the value of the assets that are being secured in favour of the lender. Each asset is given a value and a percentage of that value against which the lender is willing to lend (the loan-to-value). If assets are sold (such as inventory) or the value of an asset goes down (such as real estate or oil and gas reserves), then the borrowing base will also go down. In this case, if the outstanding principal amount of the loan at any time exceeds the amount of the borrowing base, the borrower will need to either (i) repay a portion of the loan or (ii) include and secure more assets in the borrowing base. Similarly, if there is an increase in the borrower’s level of receivables or inventory, then the borrowing base will increase, subject, of course, to a cap. The cap could be an overall cap (typically equal to the aggregate maximum amount of the loan commitments of all lenders in the ABL facility), or it could be a cap on the maximum value of one or more of the types of assets in the borrowing base.

The operation of the borrowing base will differ significantly depending on the nature of the underlying assets. For flexible assets such as receivables and inventory, the borrowing base is intended to adjust frequently (such as quarterly) as assets are produced, collected or sold. By contrast, where the borrowing base is supported by less flexible assets such as real estate or oil and gas reserves, the borrowing base is typically fixed for longer periods and only recalibrated following a valuation or information covenant breach.

Although a borrowing base is typically seen in revolving credit facilities and for working capital purposes, it can also appear in term loan facilities and, in certain circumstances, may even be used to finance acquisitions. The latter, however, is risky because acquisition financing is often meant to be long term debt, and a fluctuating borrowing base can result in unanticipated short term liquidity issues.

Eligibility Criteria for Lending Against Receivables
For receivables to be included in the borrowing base the lender must determine if they are “eligible” or “ineligible” receivables. Receivables that are easy to quantify normally receive 80-85% of their value in the borrowing base, while ineligible receivables are completely excluded. Ineligible receivables tend to be those that are potentially uncollectable, so the lender will not lend against them (for example, by attributing to them a value of 0% in the borrowing base). These normally include receivables that are past their due date, receivables due from a particular customer over a fixed amount (or from a particular customer entirely if it has a history of slow payment), receivables that are difficult to obtain security over, cash-only accounts and certain U.S. federal government receivables (the latter because of legal complications in perfecting a security interest). Even beyond those basic limitations, eligibility criteria can be very detailed. For example, a lender may limit the number of eligible receivables (or may assign a lower valuation percentage) from a specific product line of the borrower or owed from customers in a particular industry sector or geographic region.

ABL Security in England
The types of security in England that are most suitable for asset-based loans are: (i) mortgages, (ii) assignments and (iii) charges. Liens are more likely to apply to trade creditors and pledges require the physical delivery of an asset, so neither are commonly used in the ABL space.

Receivables: are normally secured by way of assignment. Ideally the security will take the form of a legal assignment and will be considered such if it complies with the Law of Property Act 1925, meaning it must be in writing, not purport to be only a charge and be notified to the third party in writing. If any of these requirements fail, the assignment will take effect as an equitable assignment, though it may still be perfected at any time in the future. This is a common approach taken for future receivables where a notice of assignment cannot be served to the third party until the receivable exists.

In addition to (or in lieu of) an assignment, a charge can be taken over receivables. Unlike a mortgage, the title to a charged asset stays with the borrower, but the lender will obtain the right to take possession of the asset in certain circumstances set out in the security document. It is likely that this security will take the form of a floating charge, so the borrower would not need to seek permission from the lender every time that type of receivable is disposed of. This would also allow the lender to take future security over any receivables.

Inventory: is secured by way of floating charge. This would allow the inventory to fluctuate and not disrupt the borrower’s daily operations. For more information about floating charges, please refer to our prior client alert.

Plant and machinery: tend to be secured by a fixed charge, and the lender’s name and description of the security document can be included on a plaque showing any other potential lender or purchaser that the item is secured. From a practical perspective, control can be increased by housing plant and machinery in a warehouse or other location at which a lender has or controls access (note that this concept applies to inventory as well). Lender consent would be required for the borrower to dispose of any such assets.

Real estate: is secured by way of legal mortgage. Usually, a mortgage is backed by information and loan-to-value covenants in the facility agreement, and the amount of the loan does not change unless there is a covenant breach (in which case it only goes down unless further property is introduced into the portfolio). Along with the Companies House filings required for security given by an English company, the mortgage over any registered land will need to be registered at the Land Registry.

Oil and gas reserves: are secured by way of floating charge. There will usually be a mechanism in the facility agreement for valuations to take place, either at the lender’s request or at set timeframes. The results of the reserves report produced at these valuations will be the basis by which the loan-to-value will be calculated. Similar to real estate, it is unlikely the amount being lent will increase unless new wells are drilled or performance data indicates initial recovery estimates were inaccurate.

ABL Security in the U.S.
A lender takes a security interest in borrowing base assets through the usual array of security documentation. Specifically, inventory, receivables and other items of personal property are made subject to a written security agreement between the borrower and the lender (or a collateral agent for the lender). The security interest is perfected by means of a filed UCC-1 financing statement, and when other methods of perfection are available, by utilizing those other methods as well. They would include such measures as obtaining bailee and warehouseman acknowledgments and control agreements, where relevant. In ABL facilities that include real estate in the borrowing base, the real property is subjected to a mortgage or deed of trust, as applicable, in the state where the property is located. Understandably, all security interests and real property liens must be of the first priority.

Not only must the borrowing base assets be subject to first-priority security interests and liens in favour of the lender (or a collateral agent) but so must the deposit accounts to which customers make payments on receivables. In addition, those accounts must be subject to the dominion and control of the lender (or collateral agent), even if only on a “springing” basis (meaning that exclusive control in the hands of the secured party springs into existence simply upon the secured party providing notice to the account-holding bank), by means of a deposit account control agreement. ABL lenders seldom are willing to rely on “proceeds” perfection in relation to borrowing base assets.

Assigning a Contract with a Non-Assignment Clause 
Given that receivables tend to form the majority of ABL security, the lender’s security package in England will most likely be heavily weighted towards assignments as opposed to charges. However, what happens when the underlying contract contains a non-assignment provision?

In England, such clauses are subject, to the extent it applies, to the Business Contract Terms (Assignment of Receivables) Regulations 2018, SI 2018/1254 (the Regulations). The Regulations apply to any contract that was entered into on or after December 31, 2018, and unless excluded by, for example, being a contract regulated by the Consumer Credit Act 1974 (as amended) of the United Kingdom, the Regulations will make any non-assignment provision ineffective if the following circumstances apply: (i) it is a contract between businesses relating to the supply of goods, services or intangible assets, (ii) the party claiming the receivable is not a large enterprise or a special purpose vehicle and (iii) the contract was entered into (by at least one of the parties) during its course of carrying on business in the UK. If despite the Regulations, the assignment is found to be effective, the lender can still take security in the form of a charge, and in any event, a belts and braces approach would see the lender taking both an assignment and a charge over the asset.

In the United States, the issue of non-assignability of contracts is addressed in sections 9-406 and 9-408 of the UCC as in effect in every U.S. state and the District of Columbia. In essence, those code sections invalidate anti-assignment clauses in contracts, at least insofar as they otherwise would prevent the pledge or assignment of “accounts” (the UCC term for receivables) and “payment intangibles” arising out of those contracts. However, UCC 9-406 and 9-408 contain exceptions, and determining the applicable law sometimes can be an issue. ABL lenders often will exclude from the borrowing base any receivable that arises under a contract that contains an anti-assignment clause that has not been amended or waived by the applicable account debtor, or if they are willing to rely on UCC 9-406 and 9-408, at least will insist on a lower eligibility percentage for those receivables.

Conclusion
ABL transactions are a flexible financing solution for asset-rich borrowers that can unlock borrowing availability from assets that would otherwise sit idle. ABL’s growing adoption in England reflects how current conditions have stretched the financial markets and how lenders are increasingly amenable to lend against easily realisable assets.

It is anticipated that ABL transactions will continue to grow in the coming year in both England and the U.S. Understanding the mechanics for creating and perfecting effective security will be important for borrowers considering this alternative source of funding and lenders looking to expand their portfolio. For any advice in this respect, please contact a member of the Pillsbury Finance team.