When is an automobile not a motor vehicle in the eyes of compliance? When it is “inventory,” of course. Unsold cars are considered inventory assets, and therefore not subject to state laws that apply to vehicles that have been sold to consumers or another business. It is crucial for lenders to understand what assets are considered collateral when it comes to securitizing auto loans and leases.
Commercial lending basics
When seeking business loans, automobile dealers, like most businesses, routinely pledge “all business assets” as collateral, usually in the form of a line of credit used to fund the business’s normal operations. “All business assets” is an idea rooted in the Uniform Commercial Code (UCC) and typically consists of all accounts, chattel paper, commercial tort claims, deposit accounts, documents, equipment, fixtures, general intangibles, goods, instruments, inventory, investment property, leases and rents of real property, letter of credit rights, letters of credit, money and supporting obligations.
Unsold cars waiting on the lot are, therefore, inventory assets of the borrower, and a lien on such assets is perfected by recording a financing statement with the appropriate office in the state where the business is located; this usually means filing a UCC-1 form with the secretary of state. So, while those cars may be collateral as they sit on the lot, they are not yet “motor vehicles,” in that they are not subject to applicable state certificate of title (COT) laws governing title to and liens upon said cars. COT laws come into play once the automobile is sold to a commercial or consumer retail purchaser.
Auto loan and lease securitizations and the scale of the market for such securities have gotten a lot of press lately. But, when trying to make sense of these sometimes-complicated instruments, it is helpful to return to the basics of commercial lending. Before engaging in any complicated structured finance programs — such as securitizations — or any dealer-specific commercial borrowing plans — such as floorplan lending — it is important to understand which business or entity has title to which assets, and which assets are collateral for corresponding indebtedness. In addition, as in consumer finance and especially commercial finance, automobile finance lenders and borrowers may run into problems when there is uncertainty about lien priority as to cars sitting on the lot.
This often comes up in bankruptcy proceedings and is frequently the result of a dealer’s honest but misguided effort to sell the cars, generate revenue, and try to catch up on already-defaulted loan obligations. A good-faith purchaser who is not in default will usually take the vehicle, but resolving the lien priority issue will be determined by who eats the loss between the floorplan lender, the dealer borrower and some other creditor.
When evaluating the pool of assets to be securitized, investors and portfolio managers who deal in auto asset-backed securities need to consider many of the same issues as floorplan borrowers and lenders when evaluating the pool of assets to be borrowed against, such as:
- Market demographics;
- Quality of the fleet;
- Average time a vehicle sits on the lot;
- Original loan term; and
- Loan-to-value ratio.
Further, if a securitization contains repayment tranches, it is important to know which tranche is subordinate in payment obligations, and why. Likewise, many finance borrowers or lenders must understand the lien priority when the same collateral has been pledged to secure different lines of indebtedness.
Just as floorplan lending and consumer finance models emerged in the first half of the 20th century and auto asset-backed securities exploded in size and value since their introduction in the 1980s, future financing products in the auto industry will invariably be developed.
Indeed, the automobile finance industry is witnessing these developments today with the emergence of fintechs offering new lending models, along with the increased presence of subscription-based services. A thorough understanding of payment priorities in lot financing and auto loan securitizations is critical for understanding the business in the coming years — much as it was in 1926 or 1986.
As cars cost more but last longer than ever, with correspondingly long-term lengths in new consumer finance transactions, it is critical to understand which collateral is pledged as security to pay specific indebtedness in order to understand the interaction between various lending activities in the automobile finance market.
Mike B. Schwegler is a Member (Partner) in McGlinchey’s Nashville office who represents lenders and creditors in commercial lending issues, from transactional to litigation matters.
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