A lender can achieve perfection of its security interest in a borrower’s accounts receivable from the U.S. government (“Federal A/R”) in the same manner as any other type of accounts receivable. The lender must file a Uniform Commercial Code ( “UCC”) financing statement in the proper filing office (typically in the state of formation of the borrowing entity) in order to provide record notice of the lender’s security interest. The difference with Federal A/R is that a lender cannot request or compel the federal government to pay the lender directly after an event of default by the borrower unless the lender has first complied with requirements set forth in the Federal Assignment of Claims Act (“FACA”). Compliance with FACA, therefore, is not an issue of perfection, but rather about the ability of a lender to actually control and collect the payments due from the federal government to a borrower.
With non-federal government receivables, upon an event of default, a secured lender has the right to collect receivables due to the borrower by sending written notices to the borrower’s customers (referred to as “account debtors” under the UCC) to require that all subsequent payments be made directly to the lender. If an account debtor refuses to remit payments to the secured lender, the lender can then seek a court order (i.e., injunctive relief) directing the account debtor to pay over to the secured lender all amounts that are due to the borrower. With respect to Federal A/R, if the secured lender has not complied with the requirements of FACA, the federal government cannot be compelled to pay the secured lender directly instead of the borrower, and has a right of setoff with respect to any amounts the borrower owes to the federal government. As further discussed below, FACA compliance is the method by which a secured lender can require payments of Federal A/R be made directly to it after an event of default.
Federal law has long prohibited government contractors from assigning contracts, or the right to be paid under them, to another party. This policy exists so that the federal government does not have to be the arbiter with respect to competing claims to the same payment. FACA creates the exception to this policy and makes federal government-contract lending more attractive, and feasible, to secured lenders. If the requirements are met, a contractor may assign its right to be paid to a lender, and the federal government will then pay the lender directly. This process occurs regardless of whether an event of default has occurred under the borrower’s loan. While the following requirements are not complicated, strict compliance is mandated, otherwise the assignment does not bind the federal government:
- The contract must call for payments of at least $1,000 and must not by its terms prohibit assignment (some federal agencies do prohibit assignment of Federal A/R).
- The assignment must be in favor of a bank or other lending institution, and only to one party, though that party may act as an agent for syndicated lenders.
- The assignment must cover all remaining payments under the contract. It is not possible to assign less than 100% of the contract.
- The lender must file written notice, with a copy of the assignment, with three separate parties: the federal contracting officer, the federal disbursing officer (who actually issues payment), and the surety on any bond.
While filing the FACA paperwork is relatively routine, the process can be slow. An acknowledgment back from the federal government can sometimes take months. This timing delay is one reason why lenders often (and perhaps typically) forego requiring compliance with FACA at the closing of a loan and may require that compliance occur on a post-closing basis.
Even if a lender complies with FACA, it is important to note the following:
- The federal government still has a right of setoff. Unless the applicable contract contains a rarely used “no-setoff” provision, the federal government may still reduce the payments made to a secured lender in order to cover the borrower’s other debts to the federal government, including unpaid federal taxes and claims on other contracts with the borrower.
- FACA compliance does not perfect a lender’s security interest. An assignment simply directs the federal government where to send the payment. Perfection is still a matter of filing a UCC-1 in the correct name and in the right place. Neither is a substitute for the other.
- If the borrower is a subcontractor, it is being paid by the prime contractor, not by the federal government, and therefore FACA compliance does not apply. The amounts due to a subcontractor are “ordinary” receivables and are perfected in the normal manner under the UCC.
- If a borrower/contractor has multiple federal government contracts, a lender must follow the FACA requirements for each contract – one filing by the lender is not sufficient, since FACA compliance must be achieved on a contract-by-contract basis.
Many borrowers object to their lender’s compliance with the FACA process due to the added cost, increased paperwork, and ongoing requirements of FACA compliance whenever they enter into a new federal contract. When a borrower has multiple federal contracts, lenders will often agree to forego the FACA process, but will require additional loan enhancements as follows:
- In order to have greater control over Federal A/R, a lender can establish a blocked or lockbox account typically with the lender or subject to a deposit account control agreement (“DACA”) if held with a third-party institution. A lockbox or DACA structure is the single most effective substitute for FACA compliance. Payments made to the lockbox can then be swept daily by the lender and moved to the operating account of the borrower.
- The federal government remits payments to whatever bank account the borrower has listed in its federal vendor registration. The borrower, however, is able to change this account information at any time. The credit agreement with the borrower, therefore, should require that (i) the borrower must obtain the lender’s consent before the borrower sends any change to the payment instructions to the federal government, (ii) the borrower should provide to the lender any updates to the current registration instructions, and (iii) any unauthorized change would constitute an event of default under the loan.
- If there are particularly large (and thus material) contracts comprising the borrowing base for a borrower, the lender can consider requiring the borrower to sign undated FACA compliance documents in blank at closing (along with a power of attorney in favor of the lender) which would be held pending an event of default. Upon an event of default, the lender can elect to complete and file these documents with the federal government in order to achieve FACA compliance.
- The lender may require the borrower to provide a schedule with each borrowing base certificate identifying the agency, contract number, contracting officer, disbursing office, remaining value, and whether the federal contract bars assignment. While this is a prudent requirement whether or not a lender requires initial FACA compliance, these types of regular disclosures enable a lender to more quickly complete and file signed FACA documents being held by the lender if an event of default occurs under the loan obligations of the borrower.
Lenders who make the business decision not to require FACA compliance can take a certain amount of comfort in knowing that noncompliance does not void the lender’s security interest. The lender’s lien on Federal A/R, once properly perfected, is fully enforceable against the borrower, competing lenders, and judgment creditors. If a borrower files for bankruptcy, the lender would be considered a secured party with respect to Federal A/R regardless of compliance with FACA as lien priority is determined in the usual way – by who filed first and not by who first complied with FACA. A bankruptcy trustee cannot use noncompliance with FACA to unwind an otherwise validly perfected security interest.
Compliance with FACA does not create the lender’s security interest or determine the priority of the lender’s lien on Federal A/R. If a lender has decided not to require FACA compliance, the lender can, instead, institute a variety of mechanisms to better control the flow of funds coming to a borrower from the federal government and to respond to potentially adverse actions by a borrower. Whenever a borrower’s collateral includes Federal A/R, it is good practice to review with lender’s counsel the legal impact of waiving, filing, deferring, or collecting in blank such assignments.
As always, please contact us if you have questions on this or any other lending or business topic.
This communication is for informational purposes only and is not legal advice on any specific facts or circumstances. In addition, the firm undertakes no obligation to update the information discussed in the foregoing article.