Asset-Level Eligibility Series: Delivery of Promissory Notes

This Legal Update explores why, in order for an underlying loan to be included in a warehouse facility’s borrowing base, its original promissory note (if any) must be delivered to the collateral agent or custodian.

Example of Eligibility Criteria:

• The original promissory note evidencing such loan has been delivered to the collateral agent (or its custodian).

What does it Mean for a Promissory Note to be “Delivered”?

In the context of a credit facility, the term “delivery” generally refers to the appropriate and most effective method of perfecting a security interest in an asset under the Uniform Commercial Code (UCC). An asset is typically not credited as eligible collateral under a warehouse loan facility until it has been “delivered” in accordance with applicable perfection requirements.

With respect to an original promissory note (typically executed in wet ink), Article 9 of the UCC governs the creation and perfection of a security interest in the promissory note. If the promissory note qualifies as a “negotiable instrument” under the UCC, the preferred method of perfection is possession. A secured party perfects its security interest in such a note by taking physical possession of the original instrument, which may also be endorsed in favor of the secured party or in blank.

Accordingly, “delivery” of a promissory note under a warehouse facility typically requires physical transfer of the original promissory note to the secured party, along with any necessary endorsements, to effectuate perfection and render the asset eligible to be included in the warehouse facility’s borrowing base. In warehouse facilities, a warehouse borrower typically complies with this criterion by delivering the original promissory note to the custodian who is acting as “bailee” of the secured party, which is usually the collateral agent, acting on behalf of the lenders.

What Protections does Delivery of a Promissory Note Provide to a Secured Party?

Delivery of a negotiable promissory note to a secured party, accompanied by proper endorsement, is beneficial under the UCC and, more practically, for enforcement purposes. Under the UCC, negotiable instruments may be transferred by delivery and endorsement. If the secured party takes possession in good faith, for value, and without notice of any adverse claims, it may attain the status of a “Holder in Due Course.”

A Holder in Due Course enjoys immunity from certain defenses that the obligor on the promissory note may have had against the original lender, such as claims of breach of contract or fraud in the inducement. This protection enhances the enforceability, marketability, and transferability of the underlying promissory note.

From a perfection standpoint, possession of the promissory note constitutes perfection of the secured party’s security interest by possession. Possession also enables the secured party to enforce the instrument directly against the instrument’s obligor through presentment of the original note, which may be helpful following the occurrence of an event of default by the borrower under the warehouse facility.

Conclusion

The benefits of appropriate delivery and possession of a negotiable promissory note have generally led to the standard practice of requiring that any such notes be physically delivered to the warehouse facility’s collateral agent, or its custodian, before the related asset is deemed eligible for inclusion in the warehouse facility’s borrowing base. This practice is generally advisable, and ensures that the secured party holds a perfected security interest and can enforce its rights directly against the note’s obligor.