In exchange for a loan, services provided or goods sold, a client put up collateral. The collateral may have been accounts receivable, fixtures, inventory, a personal residence, jewelry, a boat or some other asset.
Unfortunately, the client failed to make payment. You want to use the pledged collateral to reduce the amount owed. After all, that was the original intention. Collateralize the transaction to protect yourself.
In theory, it’s a win-win, but is it really?
Deciding to secure and sell collateral to satisfy your claim is a financial decision.
The process, procedure and costs to secure and sell collateral vary based on the type of collateral.
In very general terms, you must first secure or take possession of the collateral. Prior to that, you must give notice to the non-paying client and to others with a security interest. Once you have possession, you must sell the collateral in a commercially reasonable manner. Any monies realized from the sale will offset the liabilities owed. You will then distribute overages, if any, to other lenders.
The type of collateral dictates the method of repossession.
Take, for example, our bank client that finances the acquisition of auto parts inventory. To secure their inventory, the client must prove in court that they had a perfect security interest in the inventory. Once satisfied, the court then issues an order permitting the client to seize the collateral.
There is the example of a lender who loaned money to a company to secure inventory. The company borrowed money to buy pants. The pledged security for the loan is the pants (or inventory). UCCs (Uniform Commercial Code) are filed and the interest perfected. Upon default in payment, the lender will need to give notice to the non-paying client and to other interested parties before taking the pants. The lender may need to pay the warehouse before being able to secure the inventory. But at this point, what would the lender do with the pants? They are not in, or familiar with, the pants business. It costs money to secure and then resell the pants, if legally able to. There might be a restriction on the sale of the pants because of its brand or exclusive label. Probably, the lender would not want to own the pants.
For another example, a personal guarantor can pledge their home. But does the lender want to own real estate? If not, does the lender want to spend the time and money on the costs of foreclosure such as maintaining the house and auctioning it? More importantly, is the client the #1 secured lender or is there another lender that would take the lion’s share of the sale proceeds?
If the home is worth $1 million, the debtor owns the home with a $500K first mortgage, and you gave a second mortgage for $400K, here’s how it would work:
- You advance the costs of foreclosure, which in New York could be $50K -75K.
- Assume you can foreclose and the house’s sale price is $900,000.
- The first monies from the sale – a homestead exemption – would belong to the judgment debtor. The city of New York’s current exemption is $165,550. Different parts of the state have different homestead exemptions.
- The bank holding the first mortgage would realize the next $500K from the sale.
- And what do you get? Nothing. You have a $400K (plus interest and costs) claim and have invested an additional $50K -75K for the foreclosure and sale, throwing good money after bad.
If you are thinking about selling off collateral used to secure a loan and now want to satisfy your claim, things may not be as simple as first thought. To find out if you should proceed with satisfying a debt, please get in touch with us. Let’s see if we can be of assistance.