Lending Against Government Receivables
Contracting with the federal government can be good business for a borrower. Most federal government contracts require that the government pay “promptly” -- typically within thirty days of invoice unless specified in the contract -- or require the government to pay interest on the billed amount, even if not specified in the underlying contract.[1] Also, the government’s likelihood of payment is heightened by the fact that the account debtor literally prints its own money.
Despite these apparent advantages, most forms of asset-based credit facilities exclude from borrowing availability accounts owing by the federal government unless the borrower has complied with the Federal Assignment of Claims Act. Whether a lender follows or foregoes this standard formulation is a credit decision made on a case-by-case basis. A well-informed decision requires an understanding of the purpose, scope, and relative benefits of compliance with the Assignment of Claims Act.
UCC 9-406 and the Federal Assignment of Claims Act
The most common exit strategy in a accounts receivables facility is the ability for the lender to “collect out” the borrower’s receivables. The Uniform Commercial Code (the “UCC”) gives a lender a powerful tool to enforce that right of collection. Under UCC Section 9?406, the lender can send or require the borrower to send notice to the borrower’s account debtors to pay the lender directly. Upon the account debtor receiving notice, the account debtor must pay the lender to discharge its obligation under the account. If the account debtor ignores the notice and continues to pays the borrower, it must pay the obligation a second time directly to the lender.
As with most rules, there are exceptions. Section 9-109 of the UCC provides that Article 9 does not apply to the extent that, among other things, a statute, regulation, or treaty of the United States preempts Article 9. In the case of payments by the federal government on accounts owing by it, two statutes govern the assignment of payments. They are (a) the Anti-Claims Act,[2] which applies to claims for work that have been completed, and (b) the Anti-Assignment Act,[3] which applies to claims under executory contracts. Together, they are commonly referred to as the “Federal Assignment of Claims Act” or the “FACA”. Among other goals, the FACA aims to reduce the risk of misdirected payment by the federal government that could result if there were more than one party claiming a right to payment under a single government contract.
By limiting the right to assign payment, the FACA had the unintended consequence of reducing the ability of private contractors to obtain third party financing. In response to World War II and the need to supply adequately the war effort, the Federal Assignment of Claims Act was amended to exclude from the scope of prohibited assignments certain assignments to financial institutions. This expanded the universe of potential government contractors by enabling smaller companies to obtain the external financing needed to participate in the government contract bidding process.
Overview of the FACA
As a preliminary matter, it is important to note that the FACA only governs the obligation of the federal government to pay a third party and can only be enforced and raised as a defense by the federal government.[4] It does not preempt or otherwise affect the rules regarding the validity, enforceability, and perfection of a security interest, as to which the UCC provides the applicable law.[5] A secured party must still be granted a security agreement in the borrower’s accounts and must still file a UCC financing statement identifying the borrower’s accounts as collateral to perfect its security interest. The “first-to-file” rule still governs the priority of the lender’s security interest in the accounts and all proceeds of such accounts.
Assuming the lender has a perfected security interest in accounts, it can then turn to the rules regarding the scope of, and eligibility and compliance under, the Federal Assignment of Claims Act, which are contained primarily in the Federal Acquisition Regulation (the “FAR”).[6]
A. Contracts Eligible for Assignment.
A lender first must determine whether the contract in question is eligible for assignment. Pursuant to the FAR, a contractor may assign monies that are due or to become due under a contract with the federal government only if all of the following conditions exist:
1. The aggregate payments under the contract are at least $1,000.
2. The assignment is made to a bank, trust company, or other financing institution. The lender must be in the business of lending as its primary function. For example, a “one-off” loan by a party not otherwise engaged in lending (such as a supplier to the borrower) would not be eligible to be an assignee under the FACA.
3. The terms of the contract do not prohibit the assignment. An agency can elect to insert a “Prohibition of Assignment of Claims” clause if it determines that it is in the government’s interest to prohibit assignment of the right of payment.[7]
4. Unless, expressly permitted in the contract, the assignment is (a) for the entire amount of the contract not already paid, (b) made only to one party (which includes an agent or trustee for multiple parties participating in the financing) and (c) not subject to further assignment.[8] These restrictions are consistent with the FACA’s general purpose of preventing multiple claimants under a single contract.
B. Steps for Assignment.
If the contract is eligible for assignment, the lender then must take care to ensure that the assignment complies with all requirements of Federal regulations. Failure to comply with all necessary steps will render the assignment invalid.[9] Compliance includes all requirements under the FAR, but may also including requirements under supplements to (or exemptions from) the FAR for specific governmental agencies, including, among others, the Department of Defense and Federal Aviation Administration.[10] Under the FAR, compliance requires (1) a valid assignment by the borrower to lender, (2) a valid notice of assignment by the lender to the applicable government agency and other potential third party recipients, and (3) the lender’s current registration with the System for Award Management (which allows the federal government to pay by electronic funds transfer). Each of these is discussed below.
1. Assignment. The assignment is an agreement made by the borrower to the lender. There is no particular form that must be used, but the instrument of assignment must include an assignment to the lender of all “moneys due or to become due” under the contract, the effect of which is to grant the lender, as assignee, ownership of the proceeds of the contract. Assignments which are overly broad (e.g., all rights under the contract) may be rejected by the applicable governmental entity because the FACA permits only the assignment of rights to payment. Similarly, a grant that is too narrow (e.g., a grant of a security interest) may not be sufficient to indicate a present assignment of the right to payment. A lender concerned about rights other than the right to payment should rely on its loan documentation with the borrower, including, (a) the security interest granted by the borrower in favor of the lender and (b) the filed UCC financing statement naming the borrower as debtor and the lender as secured party which perfects such security interest.
In addition to the language contained in the instrument of assignment, the FAR also contains specific requirements regarding how the assignment must be signed by the borrower. These include, for example, requirements that assignments by a corporation be (a) signed by an authorized officer, (b) attested to by the corporation’s secretary or assistant secretary, and (c) impressed with the corporation’s seal or, in the absence of a seal, a copy of the resolutions authorizing the signing officer to sign on behalf of the corporation. Again, failure to comply with these seemingly ministerial requirements will render the assignment invalid.[11]
2. Notice of Assignment. The notice of assignment is signed by the lender. Unlike the instrument of assignment, the FAR contains a preferred form of assignment.[12] Nonetheless, due to the supplemental rules of certain Federal agencies, it is important to confirm whether the particular contracting agency may have any additional requirements.
Once complete, the FAR requires that the lender send one original and three copies of the notice of assignment, together with one “true copy” of the instrument of assignment, to (a) the contracting officer or agency head, (b) the surety on any bond applicable to the contract, and (c) the disbursing officer designated in the contract.[13]
3. System for Award Management. In order to be paid, the lender will need to have registered with the System for Award Management (“SAM”). SAM provides for a centralized system to facilitate paperless payments through electronic funds transfers. When registering with SAM, the lender will be issued a Commercial and Government Entity (“CAGE”) Code, which will also be needed to process the assignment. Once registered, the lender needs to renew with SAM each year to maintain its active status.[14]
If the assignment and all related documents presented by the lender are in proper form, the contracting officer or agency head will acknowledge the assignment and return it to the lender. While the assignment is effective upon its receipt, case law provides that the federal government has a reasonable opportunity to determine if the assignment is valid.
C. Considerations For Lenders.
Considered individually, each requirements may not appear overly burdensome. Compliance may become more involved, however, when considering the number, dollar amount and term of the contracts. If there are a multitude of contracts, or if the terms of the contracts are of short duration, the documentation needed for compliance grows exponentially. Moreover, if the relative dollar amounts of each contract are small, a borrower may request borrowing eligibility for some or all of those contracts without the need to comply with the FACA.
Given the potential for administrative burden, some lenders opt to forgo compliance with the FACA at the initial loan closing but require compliance (1) at the lender’s discretion, (2) based on an objective measurement such as a threshold contract amount and/or duration, or failure to satisfy a minimum availability threshold under the loan agreement, or (3) the occurrence of an event of default. If a lender employs this approach, the loan agreement should include the right for the lender to seek injunctive or equitable relief to force specific performance of the borrower’s compliance with the FACA, which may be required in instances where an event of default may not otherwise exist.
D. Benefits of Compliance with FACA.
As noted above, whether to require or forego compliance at closing requires an understanding of the relative benefits of compliance. These include:
1. Direct payments from the federal government. Compliance with the FACA is the practical equivalent to the lender’s right to notify non-federal government account debtors under Section 9-406 of the UCC. In addition, because the FACA is distinct from the UCC, if a lender foregoes compliance, another creditor of the borrower with a subordinate lien on accounts could comply with the FACA and obtain the right to direct payment from the federal government notwithstanding its subordinate lien. Undoing the FACA assignment likely would include obtaining a court order and serving it on the appropriate government officials, all of which might involve more work than complying with the FACA initially.
2. Only the lender can change payment instructions. This avoids potential fraud risk by preventing a borrower from having payments directed to a deposit account other than that of the lender or over which the lender has control.
3. Payments made are “final” and not subject to clawback. The federal government cannot seek repayment from the lender once payment is made, even if the payment should not have been made (including by reason of penalties, overpayments, misdirected payments, or the federal government’s right of offset for unrelated obligations).
4. No-Setoff Commitment. Certain government contracts may also contain a “no set-off commitment”,[15] which provides that payments to an assignee under the FACA will not be subject to reduction or setoff by the federal government, even if the claims arose prior to the date of the contract. The federal government views itself as a single entity. As such, any liability owing by the borrower to any federal governmental entity can be setoff against the account, including, for example, amounts owing for taxes, fines, penalties, and social security contributions.[16] If included, the no-setoff commitment provides the lender greater assurance of payment on accounts owing under the contract because it negates the risk of setoff due to the various obligations that the borrower may owe to one or more federal governmental agencies.
Note, however, that not all contracts are eligible for a no-setoff commitment. The inclusion of the commitment can occur only when a determination of need is made by the head of the applicable agency and has been published in the Federal Register. Such determinations may be appropriate in contracts to facilitate the national defense, in the event of a national emergency or natural disaster, or to facilitate private financing of contract performance.[17]
E. Other Issues In Dealing With Government Contractors Generally.
Notwithstanding a lender’s compliance with the FACA, the financing of government contractors raises several additional potential issues that a lender should consider. While not exhaustive, these concerns include:
1. Non-Payment for Wage Violations. The federal government can withhold payments under a government contract if the borrower fails to pay its employees in accordance with federal wage and hour laws.[18] Federal courts considering this issue under the FACA have concluded that the lender’s right to payment is derivative of the borrower’s right. Given that the borrower is not entitled to payment due to its violation of federal wage and hour laws, these courts have held that neither is the lender even if a valid assignment exists.[19]
2. Termination for Convenience. A government agency generally has a right to terminate its contracts for “convenience” when in the best interest of the agency (typically meaning that the subject of the contract is no longer needed or the contract is no longer efficient and constitutes a waste of government assets). In such cases, no damages or expected profits would be payable to the borrower as the contracting party.[20]
3. Contract Exculpation for Non-Funding of Government Agency. Many contracts contain provisions that relieve a government agency from performance and damages if they do not receive anticipated funding needed to pay for the goods or services contemplated under the contract.
4. Surety and Bonding Requirements. Many government contracts (including construction) have bonding requirements.[21] Case law generally holds that the surety takes priority over a perfected security interest with respect to the right to payment under the government contract.[22]
F. Suggested Due Diligence for Lenders.
Given the specific requirements for compliance with the FACA and other issues pertaining generally to the right to payment under government contracts, a lender considering lending against accounts owing by the federal government should undertake as part of its underwriting and due diligence:
1. Determine the nature of contract (construction, procurement, etc.) and the specific government agency involved (GSA, FAA, DoD, etc.). Compliance under the FACA may differ across departments and agencies and, in some cases, requirements in addition to the Federal Acquisition Regulations may apply.
2. Confirm whether the contract prohibits assignments. As noted above, compliance with the FACA presumes that the contract does not otherwise prohibit assignments.
3. Confirm whether any obligations are owing by the borrower to the federal government that may be subject to setoff. The scope of potential obligations subject to setoff is rather broad given that separate departments and agencies of the federal government are considered a single entity for setoff purpose.
4. Confirm whether a “no setoff commitment” is included in the government contract.
5. Confirm compliance with applicable wage laws. This can be done during field examinations by the lender as well as part of the borrower’s periodic financial reporting. These requirements will help avoid circumstances where the lender has advanced against a government contract that could be subject to holdback of payments due to the contractor’s failure to pay laborers in compliance with federal wage and benefit requirements applicable to the contract.
Lending against federal government receivables does not come without risk. Like most risks, it can be quantified and through proper due diligence, documentation and verification a lender can protect against the downside that the risk presents. By careful consideration of a particular borrower’s circumstances, including, among other items, the agency involved, the number, dollar amount of term of government contracts, as well as the specific contract terms, a lender can evaluate whether lending against governments receivables can benefit both the borrower and lender.
[1] See Prompt Payment Act, 31 U.S.C. §§ 3901-3907.
[2] 31 U.S.C. §3727.
[3] 41 U.S.C. §6305.
[4] United Bonding Ins. Co. v. Catalytic Const. Co., 533 F.2d 469, 473 (9th Cir. 1976).
[5] See In re Altek Syst. Inc., 14 B.R. 144, 34 UCC Rep. 286 (Bankr. ND Ill. 1981).
[6] 48 C.F.R. Chapter 1 et seq. (2019).
[7] 48 C.F.R. § 32.803(b) (2019).
[8] 48 C.F.R. § 32.802 (2019).
[9] In re Freeman, 489 F.2d 431, 432 (9th Cir. 1973); United Cal. Discount Corp. v. United States, 19 Cl. Ct. 504, 507-08 (1994).
[10] 48 C.F.R. Chapter 2 § 232.8 (Defense Federal Acquisition Regulation Supplement ); 49 U.S.C. § 40110; 48 C.F.R. § 1201.104(d) (2019) (Federal Aviation Administration’s Acquisition Management System).
[11] 48 C.F.R. § 32.805(a) (2019).
[12] 48 C.F.R. § 32.805(c) (2019).
[13] 48 C.F.R §§ 32.802(e) and 32.805(b) (2019).
[14] System for Award Management User Guide – v1.8 § 3.1 (July 23, 2012) (available at https://www.acq.osd.mil/dpap/pdi/eb/docs/SAM_User_Guide_v1.8.pdf).
[15] 48 C.F.R. § 32.803(d) (2019); 48 C.F.R. § 52-232-23, Alternate I (1984).
[16] 48 C.F.R. § 32.804(b) (2019).
[17] 48 C.F.R. § 32.803(d) (2019). The no-setoff commitment does not apply when the lender has not made a loan under the assignment or a commitment to make a loan or the amount due on the contract exceeds the amount of any loans made or any commitment to make loans. 48 C.F.R. § 32.804(c) (2019).
[18] 29 C.F.R. § 4.187 (2019).
[19] United California Discount Corp. v. U.S., 19 Cl. Ct. 504, 510 (1990).
[20] See Federal Acquisition Regulation (“FAR”) Part 49.
[21] The Miller Act (40 U.S.C. §§ 3131-3134) contains such requirements for construction contracts with the federal government.
[22] In re Comcraft, Inc., 206 B.R. 551 (Bankr. D. Or. 1997).