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Know Thy Stuff: The Pearlman Doctrine and Other Potential Pitfalls

June 19, 2013, 07:00 AM

During my lending career, I have reviewed many asset-based lending companies with the intention of either financing these companies or acquiring them. Performing due diligence as effectively as we knew how, we hoped to consummate either the lending transaction or the purchase. As such, we sought to identify weak management, project business potential, evaluate collateral, and avoid loan losses in any event. As a financial services expert and industry consultant, I still observe lending organizations lacking the sophistication they should possess to manage their businesses. These organizations make questionable credit decisions and as always, the devil is in the details.

In my field, I am often asked interesting questions by attorneys interviewing me about my knowledge with regard to matters that are of concern to them. I received a call from a litigation attorney inquiring into my knowledge of “The Pearlman Doctrine.” I responded I hadn’t any recollection of ever hearing that specific doctrine and I requested an explanation in layman’s terms. The attorney described what I understood broadly as a mechanic’s lien. In general, my attorney friend described a super-priority for work performed under a subcontract that was superior to a lender’s lien on that contract. I knew the fundamental collateral principle but not the legal nomenclature, which references the U.S. Supreme Court case Pearlman v. Reliance Ins. Co., 371 US 132(1962).

In 1963, I joined James Talcott, Inc. as a field auditor. Talcott assembled a very sophisticated audit staff managed by several Big Eight-trained audit managers and had created the best and most practical collateral audit handbook for its staff, which, among many other things, outlined how the possible existence and priority of mechanic’s liens by subcontractors’ mitigated the collateral value. This provided me with a firm grasp on the workings of mechanics’ liens. My role was to audit the prospective borrower’s or the borrower’s financial statements to the general ledger and books of original entry. I also evaluated the collateral to be pledged for the loans.

Here’s a situation I encountered only a few years back. Finance Company X was managed by several well-known, highly regarded asset-based lenders. Company X’s salesman solicited a new business loan to a contractor. The contractor subcontracted work on many contracts. This prospect possessed a history of losses and had several federal payroll tax liens filed against it. This prospect’s existing bank eventually called the loan resulting in Company X experiencing a few financial shortfalls. Later also, X terminated the salesman, however the salesman had negotiated a contingent fee to be paid him if the loan closed. After the salesman left, Finance Company X closed the loan yet its due diligence did not include a field examination prior to committing to the loan or even a pre-closing the loan examination. At the same time, X relied upon a boilerplate loan and security agreement prepared by their outside counsel. The salesman attended the closing and was paid his promised commission.

Shortly after the closing, severe cash flow issues caused the borrower to seek additional loan accommodations. Six weeks after the loan closing, X engaged a professional field examination company to conduct an audit of the borrower. During the audit’s first day, the field examiner discovered mechanics liens. The field examiner immediately alerted X’s (inexperienced) loan officer. In depositions, X’s management claimed to have no knowledge of the existence of mechanic’s lien priorities. The auditor discovered federal payroll tax lien filings and the IRS possessed lien priority over the borrower’s accounts for quite some time prior to the loan closing. Company X’s management knew of the IRS issue. Additionally, X significantly over advanced on the loan and a long and troubled time period ensued for X, its management, employees and equity holders.

To compound the trouble, several loan participants funded this credit accommodation with X as their agent. Company X’s participation agreements guaranteed principal repayment to the syndicate and its investors had to dig into their own pockets to fund Finance Company X’s wind down. The reputational damage made anteing up necessary.

The End Result:

  • Finance Company X’s investors learned an expensive lesson.
  • Finance Company X’s management and staff were out of jobs.
  • More problems ensued stemming from fundamental collateral issues.

On a personal note, I was very disappointed in X’s management. Despite the collective experience of Finance Company X’s management, this team had little collateral experience and was extremely careless in its due diligence practices. In looking back at this situation, I’m compelled to repeat the old adage: The devil is in the details. Here’s another old adage: Time reveals all things. By that I note that during my lending career, I competed with the various management team members who on the surface appeared very professional and knowledgeable. Obviously I had over-estimated their abilities. Today, I feel fortunate not to have participated in syndicated transactions led by any of them.

Walter M. Einhorn
President & CEO | Einhorn Group LLC
Einhorn serves as president and CEO of Einhorn Group LLC, a litigation support and consultant firm offering the business and financial expertise accumulated during fifty years. Einhorn Group has worked with attorneys, bankruptcy trustees, accountants, lenders (both banks and non-banks), borrowers, crises managers, investors and corporations.

His expertise covers all aspects of commercial lending such as marketing, credit standards, risk management, accounting, loan due diligence, portfolio purchases, legal and accounting issues. Einhorn founded Sunrock Capital Corp. in 1997, with capital provided by Nissho Iwai America. From 1997 to 2003, he served as Sunrock’s chief executive officer, president, chairman of credit committee.

Prior to Sunrock, he was president and CEO of Meridian Commercial Finance (1994-1996) and senior vice president and manager of the asset-based finance business at Girard Bank/Mellon Bank from 1969 to 1994. From 1959 to 1969, he practiced public accounting and began his financial services career in 1963 with James Talcott.

He graduated from Villanova University in 1959 and became a certified public accountant in 1963. Einhorn is a past chairman of the Commercial Finance Association.
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