Lenders may be able to reduce litigation risk by obtaining express consent when a borrower pledges the assets of a wholly-owned subsidiary as collateral

By Stephen J. Shapiro

A recent decision by the United States Court of Appeals for the Third Circuit suggests steps that lenders who accept the assets of a borrower’s wholly-owned subsidiary as collateral should consider taking to reduce the likelihood of litigation in the event the lender must pursue the collateral. In Wachovia Bank National Association v. WL Homes LLC (In re: WL Homes), borrower WL Homes pledged the bank account of JLH, its wholly-owned subsidiary, to Wachovia as collateral on a loan. When WL Homes later filed a bankruptcy petition, Wachovia brought an action in the bankruptcy court for a declaration that its security interest in JLH’s bank account was enforceable. The bankruptcy court ruled in Wachovia’s favor because it concluded that JLH had consented to WL Homes’ pledge of its bank account, and the district court affirmed that part of the bankruptcy court’s holding.

On appeal, the Third Circuit began its analysis by setting out the circumstances under which a security interest in a bank account becomes enforceable under the law of California, which governed the action. Such a security interest becomes enforceable under California’s Commercial Code when, among other circumstances not at issue in the case, “the debtor has rights in the collateral.” A debtor is deemed to have rights in collateral that it does not own when the owner of the collateral consents to the debtor’s pledge of the collateral. Therefore, the issue before the Third Circuit was whether JLH had consented to the pledge of its bank account as collateral for the loan to WL Homes.

In its analysis of whether JLH had consented to the pledge, the Court focused on the fact that the CFO of WL Homes, who had negotiated and signed the loan agreement with Wachovia, also was the president of JLH. Therefore, the Court imputed knowledge of the loan to JLH and concluded that this knowledge manifested JLH’s consent to WL Homes’ pledge of its bank account as collateral. Because the Court deemed JLH to have consented to the pledge, it concluded that Wachovia had an enforceable security interest in JLH’s bank account.

Although the result in the WL Homes case is not surprising, the case suggests steps that lender can take to reduce the potential for litigation when accepting a pledge of non-owned assets from a borrower. Specifically, lenders should consider obtaining express written consent to the pledge from the owner of the asset, even if the owner is a wholly-owned subsidiary of the borrower. Such clear, written consent could dissuade opponents from litigating the enforceability of a lender’s security interest, thereby potentially sparing lenders from the expense of litigating the issue of consent.

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