Auto Bankruptcies Show ‘Astounding’ Lapses in Loan Paper Trail

Consumer defaults and poor documentation practices have pushed some companies that heavily rely on secured transactions into bankruptcy, calling into question whether they properly used safeguards from a somewhat-obscure section of federal commercial law.

Auto parts conglomerate First Brands Group LLC and subprime lender Tricolor Holdings LLC both filed for bankruptcy in September with billions of dollars in debt.

Allegations of fraud and questions surrounding money management will play out as the cases develop, but concerns over account documentation under Article 9 of the Uniform Commercial Code should be addressed now, several bankruptcy experts said in interviews.

“No one was minding the store,” said Bruce Markell, former Nevada bankruptcy judge, now a Northwestern Pritzker School of Law professor. “No one was using the tools that Article 9 and other laws give them to monitor these transactions.”

Article 9 regulates secured transactions by providing rules for loans, including how to settle debts for security interests that can be tangible, such as cars, or intangible, such as digital accounts. Article 9 deals with collateral in everything that isn’t land.

‘Chattel Paper’

Companies such as First Brands tend to deal with invoices or factoring agreements known as “chattel paper"—as defined in Article 9—that sell the right to receive money.

First Brands’ customers commonly had 30 days to pay invoices.

Lenders can look up a company’s register with a state to get a list of everyone who has a financing stake. That list will show accounts receivable and banks can lend money based on it, which should prevent any artificial inflation of inventory or profits, Markell said.

“It’s astounding that these procedures failed or weren’t being utilized,” he said.

First Brands is looking for new financing backed by receivables invoices, Bloomberg News reported Tuesday.

Companies similar to Tricolor also use chattel paper to borrow against a customer’s promise to pay or lease and the collateral interest in the car.

Those documents are taken to a bank for a loan to pay a car manufacturer for the vehicle that was already sold. The lending practice doesn’t typically involve multiple loans using the same vehicle, which could be a sign of loan-stacking fraud.

The US Supreme Court said in 1925 that loaning money and taking a collateral interest while leaving a debtor in possession of the receivables is fraud, but Article 9—first proposed decades later and since enacted throughout the US—stands for the idea that there is a “social utility in lending,” Markell said.

“People can’t buy cars if they can’t borrow money to buy cars,” he said. “If they can’t borrow money to buy cars, businesses can’t operate.”

Double-Pledging

An initial review of Tricolor’s records showed that about 40% of the company’s roughly 70,000 active loans contained identical vehicle identification numbers and other attributes identical to at least one other loan, also known as double-pledging, Bloomberg News reported. The company has more than $2 billion in debt.

If lenders had followed Article 9 procedures and checked to see what they were pledging against, some of their risk would’ve been lower.

“The cases are very ugly and lenders are very angry,” said Robert Miller, a University of South Dakota law professor. “They think they have first lien on X, when in reality they may have first lien on nothing.”

Lenders should want to know what they’re pledging against and if someone already has the collateral so an informed decision can be made, he noted.

“If you want to lend against it, good luck, you’re in second place,” Miller said.

The routine but private nature of this type of lending may allow the bad habits of a particular company to fly under the radar until the business is too far underwater.

“The type of lending itself is fairly common, but the extent of the money, and maybe the irregularities or problems or double-pledging, the sort of secrecy is what makes this so interesting and particularly tricky to uncover,” said Laura Coordes, a bankruptcy professor at Arizona State University.

Off-Balance Sheet

Factoring agreements and off-balance sheet transactions played what seems to be the biggest role in First Brands’ downfall.

Since collateral can be a security interest, documentation should always say where the money is held, who has control over an account, and how transactions are being monitored on a daily basis, Coordes said.

Following the letter of the law could prevent a company meltdown, but, “Article 9 isn’t going to come in and slap your wrist and prevent you from doing something wrong,” she said.

First Brands sued its founder Patrick James on Nov. 3, alleging he siphoned more than $700 million from the company to fund his lavish lifestyle, which the new CEO testified about Nov. 10. Several parties in the case, including the company and its former CEO, have requested the appointment of an independent examiner.

The auto parts supplier had $6.1 billion of funded debt obligations at the start of its bankruptcy, including at least $2.3 billion in factoring liabilities.

“That’s billions of dollars, nine zeros,” Markell said. “That’s not the kind of thing that happens overnight.”

How Systemic?

While the amount of money allegedly double-pledged in Tricolor and First Brands’ handling of off-balance sheet transactions is extreme, it doesn’t necessarily signal systemic fraud, academics said.

“Maybe these will be canaries in the coal mine,” Miller said. “But everyone could be way more overblown on this than it’s actually going to be.”

Coordes noted the collateral in these cases isn’t like security interests in equipment that can be seen. It’s accounts coming in and getting paid off, which require close monitoring and tracking, she said.

First Brands and Tricolor may be warnings for companies and lenders to strictly adhere to Article 9’s safeguards.

“These are financial irregularities that you see time and time again in all kinds of financial scandals,” Miller said. “I don’t view them as systematically problematic, but as a wake-up call for private credit.”