This is the first in a two part series on how a lock box works – and what it means for clients who borrow finances with dominion lenders / financiers and the customers of those clients.
This Part 1 will cover some of the options for implementing a lock box and will highlight how and why the conventions exist the way they do and where flexibility may be found.
There are two broad categories of lending / financing relationships that typically require use of a lock box as follows:
1.Bank Asset Based Lending
2.Commercial Finance Asset Based Lending and Factoring
Bank Asset Based Lending
Although there are some smaller local banks that offer this product (or a hybrid of it) in transaction amounts as small as $1 million, the Bank Asset Based Lending market is a very large one in the aggregate and is generally thought of as $10 million and up in individual transaction amounts. It is a business that is dominated by larger banks and is offered to clients that while still “bankable”, are marginally more risky than a solidly “bankable” client and one where the Accounts Receivable are a large and important component of the collateral package.
In these transactions the bank will contractually require the borrower to have all Accounts Receivable proceeds (i.e. payments of invoices by the borrower’s customers) be processed directly through a lock box controlled by the bank. Implementing this type of lock box is typically done via a Change of Remittance address letter – which is a letter typically from the borrower and bank jointly to all of the customers of the borrower announcing the new banking relationship and directing the customers to mail or wire all payments discharging their invoices to the bank lock box. In Bank Asset Based Lending transactions the borrower is contractually required to remit all AR payments through the lock box – so even if a customer makes a mistake and mails their check directly to the borrower, the borrower is required to only deposit that check in the lock box account.
Commercial Finance Asset Based Lending and Factoring
While the commercial finance asset based lending and factoring market is probably equally as large as the Bank Asset Based Lending market in terms of volume, the customs and conventions are broader and less well defined. Perhaps the easiest way to think about what conventions that might apply in any particular situation would be to try to understand the perceived riskiness involved. The level of risk of course is in the eye of the beholder and we won’t attempt to parse the contributing factors here. Suffice it to say that the lending / financing market is a rather efficient one and just a small amount of shopping will provide a borrower a fairly precise view of how financiers perceive their level of risk. Below are some of the aforementioned risk control tools that might be implemented – and a broad gauge of the range of outcomes for each individual item that might occur in practice:
A. Who is the letter to the borrower’s customers from? Commercial finance company and borrower in less risky deals – Commercial finance company only in more risky deals. In either case, the commercial finance company often takes charge of physically mailing the letters.
B. In what name is the customer instructed to make payment? Borrower if less risky – commercial finance company if more – very often both names are on the check
C. Is there a formal assignment? (i.e. does the letter say that account has been assigned to the commercial company?) In a large portion of non-bank deals the answer is yes – and even if not there is often explicit language essentially stating that the borrower has obligated itself to use of the lock box and only the lock box.
D. How much contact does the commercial finance company have with the customer? When implementing the lock box, often times only the letter – unless the customer keeps sending their checks to wrong place in which case they will often be contacted to ensure the change has been made in their system.
There are a number of other questions that we are often asked about verification of information and how that works and also how customers perceive the receipt of such letters. We will address some of those questions in a follow up article after Part 2 of the Demystifying the Lock Box series has been completed.