[Author: Samuel I. Kreamer, J.D., C.P.A., Kreamer Law Firm, P.C., 2016 | Keywords: Business, Operations, Liens]
For some, the answer to this question is, “tens of thousands of dollars.”
This is an increasingly common situation facing dealers. An item is taken by a dealer as a trade-in from a customer on a new purchase. After the trade-in item is sold, the dealer receives a demand letter or even a lawsuit from the customer’s bank.
The end result could be that not only did the dealer get too little for the equipment sold to the customer, but the dealer is now liable to the customer’s bank for the value of the item the customer traded-in.
How can this be?
It is a standard practice for banks and/or other lenders to take collateral for the loans they make to borrowers (in this case, the dealership’s “customer”). In order to get an enforceable interest in the collateral, the Uniform Commercial Code (UCC) requires the lender to file a notice of their interest in the property with the Secretary of State. This is a public record, and provides notice of what collateral serves as security for the loan.
Commonly, lenders will require that all of the borrower’s assets or classes of the borrower’s assets (like “all farm equipment”) serve as collateral for their loan. This is sometimes referred to as a “blanket lien” since it covers many assets with one loan.
If the lender files the requisite document with the Secretary of State (which they almost always do), the bank’s rights to the collateral described in the filing continue, even if the borrower (the dealership’s customer) uses the bank’s collateral as a trade-in to purchase new equipment or sells it. This even continues in the hands of someone who buys it from the dealer who obtained it in trade, in addition to any subsequent purchaser.
Take this as an example:
- Suppose Customer 1 has a piece of equipment which serves as collateral on a loan to Customer 1 from the bank.
- Customer 1 purchases new equipment from the dealer using old equipment as a trade-in.
- Dealer gives Customer 1 a $30,000 credit for old equipment. Dealer then sells old equipment for $30,000 to Customer 2.
- Customer 1 defaults on the loan two years after purchase.
- Bank sues the dealer for return of their collateral (old equipment) and/or for the value of the collateral at the time of the default on the loan.
The end result: The bank will win the lawsuit against the dealer!
NOTE 1: Customer 1 is still liable to the bank and is required to reimburse the dealer. However, in these cases Customer 1 is normally broke and has no assets to repay the bank and/or dealer.
NOTE 2: Customer 2 may also be required to return the collateral to the bank, but Dealer is liable to Customer 2. Hence, EVEN IF Customer 2 returns the old equipment to the bank; the dealer is “stuck” for the value of the old equipment.
What should you do?
Each time you take equipment in trade and/or buy used equipment:
First, ask the customer/seller (even if you have been doing business with them for years):
- Under what name or names do they operate in addition to their personal names? (For instance, “Jones Farms” might be listed differently than Michael Jones.)
- In what states do they have operations (particularly important for dealerships in towns near a state border)?
- Does the customer have any outstanding bank loans? If so, with whom?
- Is the equipment being traded-in for purchase collateral for a bank loan?
Second, regardless of the customer’s answers to the preceding questions, check with the Secretary of State for UCC filings:
- In each state the customer has a business (including farming) operation.
- Under each name the customer does business, including their own names.
Third, if a search of the Secretary of State’s records turns up any UCC filing, download it (or all of them) and contact the “secured party” (the lender who holds an interest in the collateral). Ask the secured party:
- Does the secured party claim that the property the customer is trading-in/selling is collateral for their loan?
- If the Secured Party does not claim that the equipment is their collateral continue to close the transaction, but make sure you document who gave you the information and when.
- If the Secured Party does claim that the equipment is their collateral you need to ask them what further steps are necessary to obtain a “release” of the collateral. Do not continue the transaction without a release (or the promise of a release upon payment by you. Do not rely on the customer to make the payment necessary to obtain the release. When you obtain the release (or the promise of a release upon payment by you) then you can conclude the transaction.
NOTE: It is extremely important to document all the steps in this process. Our law firm has prepared some “generic” forms for your use which are available through I-NEDA. As with all legal forms, each dealer should consult with their legal counsel before using legal forms.
At the time of this writing, our law firm is representing a dealership who failed to follow these procedures. Since their customer failed to pay the bank loan, the dealership (which took some equipment in trade and then sold it) is now on the hook for a significant sum. Although the customer has liability to the dealership, you can’t get blood from a turnip. As President Ronald Reagan once famously said, “trust… but verify.” This sound advice is also applicable to accepting trade-ins and purchasing used equipment.
Contact Samuel I. Kreamer, J.D., C.P.A. of the Kreamer Law Firm, P.C. at [email protected] or at 515-727-0900 if you need assistance in these or other legal matters confronting your dealership. The Kreamer Law Firm, P.C. is an I-NEDA associate member.