Lending to Restaurants Pitfalls in Perfecting Security Interests
Lenders have historically shied away from lending to restaurants for a variety of reasons, with the high restaurant failure rate ranking top among concerns. But as the restaurant industry is poised to experience its fifth consecutive year of growth, lenders should consider adding restaurants to their portfolios. Anderson Kill Attorney Inez M. Markovich discusses four potential pitfalls that jeopardize the priority of a lender’s security interest in a restaurant’s assets.
According to industry forecasts, sustained by improved consumer confidence and encouraging economic statistics, the U.S. restaurant industry expects measured growth in 2015. Among industry trends, experts predict that restaurant merger and acquisition activity will remain strong, and that franchise operators will continue to expand. Although American consumers increasingly consider restaurants to be a vital part of their lifestyle, and the restaurant industry continues to play an ever more important part in the U.S. economy, lending to restaurants is still considered a risky investment.
Restaurant failure rate is one of the reasons why lenders continue to treat lending to restaurants with extra caution. Additionally, lenders do not always understand a restaurant’s concept and cannot make a confident assessment of how the restaurant will make money. Finally, lenders often lack confidence in restaurant collateral.
Collateral Due Diligence
Despite the apparent risks, as the restaurant industry continues its upward trend it will present new lending opportunities that should be explored by banks and other finance companies. A lender can lend to a restaurant if the lender can be sure that it will be able to collect its loan in the event of the restaurant’s failure. Among the major factors that can ensure that lending to a restaurant can be an acceptable credit risk is collateral due diligence.
Typically, collateral will include restaurant equipment and — when premises are owned by the borrower — real estate. However, lenders also commonly secure restaurant financing with a blanket lien on the restaurant’s assets, including receivables. Lenders should be aware of the following four potential pitfalls that may jeopardize the priority of a lender’s security interest in a restaurant’s assets.
Banks and finance companies lending to restaurants must be aware that UCC, judgment, tax and real property lien searches will not disclose all liens potentially encumbering a restaurant borrower’s assets, particularly its accounts receivable. Among the so-called “hidden liens,” lenders to restaurants need to be aware of the super-priority liens of suppliers under the Perishable Agricultural Commodities Act (PACA).
PACA creates a floating, non-segregated trust on the buyer’s accounts receivable and inventory. This provides PACA suppliers with a right to payment before all other creditors, including secured lenders with blanket liens. This super-priority status means that when a buyer purchases produce from a PACA supplier, it must account to the supplier before all other creditors. Until the buyer does, the trust operates by placing a lien on not only the inventory derived from the produce, but also on accounts receivable and proceeds from the sale of the produce.
Not all foods supplied to a restaurant are subject to a PACA lien. To establish a PACA trust, the goods in question must be fresh or frozen fruits and vegetables that have not been altered from their original state. The supplier must also provide the buyer with written notice that the goods are sold subject to PACA.
Lenders should protect themselves against potential PACA liens by reviewing their borrowers’ accounts payable aging reports prior to extending financing. They should review the aging of the borrower’s accounts payable during the term of the loan. Finally, lenders can include a provision in the loan documents requiring the borrower to keep a certain minimum amount, either in reserve or in the form of inventory, to cover potential PACA claims.
The federal super-priority tax lien is another very common super-priority lien. It arises when a taxpayer fails to pay a tax after the assessment and demand by the IRS. The IRS lien obtains a super-priority status on all assets of the taxpayer 45 days after the filing and service of the lien, trumping the priority of many previously perfected liens. It is not required that the lien be served on a secured lender.
The Internal Revenue Code does not provide a priority scheme for resolving competing lien interests. Instead, the competing priority statuses of the IRS lien and the other security interests are analyzed under the “choateness” test, which was developed through a series of cases decided by the U.S. Supreme Court.
The choateness test follows the general rule for resolving lien priorities: The lien that is “first in time” is “first in right.” The federal tax lien is “choate” as of the assessment date. However, to be considered first in time in addition to being properly perfected the nonfederal lien must be “choate,” that is, sufficiently specific, when the federal lien arises. A state-created lien, such as a security interest under Article 9, is “choate” when the following three elements are met: the identity of the lienor, the property subject to the lien and the amount of the lien.
The Internal Revenue Code provides limited protection for security interests securing commercial loans, preserving their priority in a taxpayer’s assets granted pursuant to a security agreement entered into between the taxpayer and its lender prior to the filing of the federal tax lien. However, the lender’s priority status will extend only to the collateral acquired before the 46th day after the federal tax lien is filed, and to advances made within 45 days of filing (or sooner, if the lender receives knowledge of the IRS lien). Thus, a lender’s security interest in a restaurant’s accounts receivable will take priority over a subsequently filed federal tax lien only to the extent of specific accounts receivable that existed within 45 days after the date on which the tax lien was filed.
Lenders are advised to obtain a federal tax lien search prior to closing on any restaurant loan. However, as such search will only identify tax liens filed as of such time lenders should conduct periodic tax lien searches and obtain copies of the borrower’s filed federal tax returns during the term of the loan.
MCAs & Blanket Liens
Another potential group of creditors with competing interests in a restaurant’s assets, particularly its accounts receivable, is comprised of companies operating merchant cash advance (MCA) or dining rewards programs. MCA providers typically advance cash to member restaurants by buying credits for discounted meals from the restaurants. The MCA providers then sign up consumers who purchase the credits and cash them in when they dine at the participating restaurants. As part of the agreement, the restaurant repays the principal advanced for the dining credit by selling a significant portion of its future accounts receivable generated through credit to the MCA provider and paying a fee (i.e., disguised interest) on each transaction. Some MCA providers offer ancillary services, such as marketing, to participating restaurants.
MCA funding typically comes with rather draconian terms. MCA providers are not regulated and do not have to comply with state usury laws. A typical MCA provider will buy dining credits at a very significant discount rate, while charging interest or fees of at least 25% of the total amount financed.
Further, the documentation required to be signed in connection with an MCA advance program, together with the UCCs filed by the MCA provider, often create a blanket lien on the restaurant’s assets. Therefore, lenders should carefully review all UCC liens filed against a prospective restaurant borrower. If a UCC search reveals a blanket lien filing by an MCA provider, the lender should negotiate a subordination agreement with the MCA provider prior to making a loan to the restaurant.
Liens on Liquor Licenses
Finally, a potential lender to restaurants must address the complexities inherent in the perfection of security interests in a restaurant’s liquor license. In many geographic locales a valid restaurant liquor license can be a very valuable asset. However, the availability of such a license to secure a commercial loan varies by jurisdiction.
Pennsylvania treats a liquor license as a privilege, not a property right. However, in 1987, Pennsylvania passed an amendment to the Pennsylvania Liquor Code stating that as between third parties, a liquor license is to be considered personal property. As such, the restaurant may grant a security interest in its liquor license to a third-party lender. Such security interest can be perfected by the filing of a UCC financing statement identifying the license. If the lender properly creates and perfects its security interest, the secured creditor can levy and execute upon the liquor license — but can then only transfer the liquor license to a qualified third party, subject to the approval of the PLCB (just like any other transfer of a liquor license).
In contrast, in neighboring New Jersey, the Alcoholic Beverage Control statute does not allow for a liquor license to be pledged as collateral for any debts. Unable to take a security interest in the borrower’s liquor license, banks lending to restaurants in New Jersey have developed the practice of requiring a pledge of the corporate stock, or partnership or membership interests in the borrower from all of the owners of, or investors in, the restaurants. While this structure provides lenders with certain additional value in the event of a bankruptcy filing by the restaurant, the lender will not be able to exercise the pledge of the ownership rights in the restaurant to liquidate the liquor license. In fact, in the absence of other collateral, the lender will be treated as a general unsecured creditor in the bankruptcy case. Therefore, a clear understanding of the applicable state’s laws governing the creation and perfection of security interests in a liquor license is critical to a lender’s underwriting of loans to restaurants.
Although certain risks are inherent in lending to restaurants, lenders can manage these risks through initial and ongoing due diligence designed to maximize the strength of the collateral securing restaurant loans.
Inez M. Markovich is a shareholder and the chair of the banking and lending practice group at Anderson Kill P.C. She concentrates her practice on the representation of banks and finance companies in all aspects of commercial lending transactions, including ABL transactions, lease finance, bankruptcy and debt restructuring, and creditors’ rights. Markovich can be reached at (267) 765-8216 or