All dealers accept trade-ins from customers. Leaving aside the inherent economic risk of making a bad deal by putting too much money in a trade, it is important to remember that dealers also have legal risk associated with liens your customer put on the trade-in equipment.
This risk can turn quickly into an economic risk if the customer’s lenders aren’t paid and the lenders come looking for collateral you thought was yours.
Even though there is always a risk that a customer will get into financial trouble, these risks increase dramatically in an economic downturn. All segments of dealers are experiencing this now given the relatively high interests rates impacting both dealers and customers. Dealers selling large agricultural equipment are facing enhanced risks due to low commodity prices and an overall tough economic climate for farmers. Due to this environment, we are seeing an uptick in customer delinquencies and a corresponding increase in dealer issues with their customers’ lenders.
This article will give dealers a basic overview of the issues involved with trade-ins and liens your customer put on the trade-in as well as some practical tips for processes to implement to help reduce risk.
Why is a dealer liable to the bank?
The Uniform Commercial Code (UCC) was developed to give secured creditors (banks) protection by establishing rules designed to provide certainty to the banks with respect to the collateral the banks take when making loans. In the trade-in situation, the UCC says that the bank’s lien stays with the equipment after it is traded to the dealer unless the dealer is a “buyer in the ordinary course”. Unfortunately, a dealer cannot be a “buyer in the ordinary course” unless the seller (the customer) typically sells that type of equipment. The problem is that the customer is not in the business of selling equipment, meaning the bank’s lien remains attached to the trade-in after the dealer takes title.
If the lien stays on the equipment, it means the bank is entitled to the value of the equipment to satisfy the customer’s debt to the bank. If the bank comes after the dealer for this amount, the dealer will be hit twice – first, by giving the customer credit for the trade-in value by reducing the cash purchase price for the new equipment and second, by turning over the trade-in to the bank (or paying the bank cash of approximately the same amount). In addition, in situations where the trade-in has already been sold, it is also possible that a lender might pursue profits received on the sale of the trade-in.
It is important to note these rules don’t just apply to a lien that the customer put on his equipment to finance the purchase of that equipment… the same rules also apply to a customer’s blanket lien (i.e., a lien against all of the customer’s assets or all of the customer’s equipment) that was given as collateral for the customer’s operating line of credit. Unfortunately, while dealers and customers are often aware of liens against a specific piece of equipment, blanket liens are usually not on the ra- dar and therefore create the biggest problems for dealers.
If you run into this situation, you will generally have the right to pursue your customer for your losses. Of course, we all understand that right offers little comfort since the customer is in financial trouble (and perhaps bankruptcy), leaving you little chance of full recovery.
Unfortunately, while dealers and customers are often aware of liens against a specific piece of equipment, blanket liens are usually not on the radar and therefore create the biggest problems for dealers.
What steps can dealers take for protection from this situation?
Dealers can limit risk in this type of situation by implementing the following processes or best practices:
• Incorporate a lien search process into your trade-in intake process. Determining the appropriate process involves a balancing act of the risks vs. the administrative time involved in introducing another step in the trade-in process. For example, after considering your dealership’s prior experience with these issues, you may decide that only transactions over a certain value require a lien search. Another decision that must be made is whether the cost for performing a UCC search will be passed on to your customer. Finally, you will want to determine who will be involved in this process and how they will be held accountable. After making these determinations, remember to document them in the form of a process and communicate it to your sales and financing personnel.
• Ask the customer some basic questions about the trade-in and document the responses to these questions on a standard form. If the customer discloses a lien, you should obtain a lien release even if you don’t run a UCC search to confirm the lien.
• If a UCC search is conducted, determine the state in which the search needs to occur. This isn’t always the state in which your customer’s business is located. For example, if your customer is an LLC or a corporation, the place to search will usually be based on the state in which they were formed.
• If a lien does show up when you do a search, remember that you aren’t just checking to see if the specific equipment is listed as collateral. If the UCC filing indicates that the lien covers “equipment” or “all property” or similar phrases that might include the equipment you are taking on trade, that lien will also cover the trade-in and you’ll need to get a lien release.
• If it is determined that the trade-in has one or more liens against it, the trade-in should not be accepted unless the bank gives its written consent to the transferof the trade-in free and clear of the lien. If asked, the bank will normally consent because the customer is getting replacement collateral with equity available to the bank that is equal to the value of the trade-in.
• For corporate customers, consider requiring one or more of the individual owners of the customer to guarantee the obligations of the corporate customer to provide the trade-in free and clear of all liens. This may reduce risk by giving you another person to pursue for reimbursement of amounts paid to a lender even if the customer is in financial distress.
I would encourage every dealer to check their processes for addressing liens on trade-in equipment and at least assess the level of risk that the dealership will accept in these types of situation. If you decide to update or implement processes relating to the intake of trade-in equipment, please also visit the member’s only section of the website for the North American Equipment Dealers Association at www.naeda.com for additional resources.
LANCE FORMWALT is the leader of the Equipment Dealer Group at Seigfreid Bingham, P.C. The firm serves as legal counsel to the North American Equipment Dealers Association and many individual equipment dealers. Lance may be contacted at lancef@sb-kc.com or 816-265-4106. Also see www.sb-kc.com. This article is intended to provide general recommendations and is not intended to be legal advice. You should always consult your attorney for advice unique to you and your business.
