For loans primarily secured by a cash flow stream, subscription facility lenders heavily depend on collateral accounts as a key element of the security package. In this Legal Update, we delve into why subscription facilities usually prohibit depositing anything other than capital contributions into the collateral account – often referred to as commingling.

The Potential to Commingle Funds – Automatic and Indefinite Perfection of Cash Proceeds

Under the Uniform Commercial Code (“UCC”), a secured creditor’s perfected security interest in collateral continues and is automatically perfected in the proceeds of such collateral if that collateral is disposed of by the pledgor without authorization from the secured creditor. While this outcome under the UCC is beneficial to a secured creditor because it preserves the creditor’s claim on the proceeds of the original collateral, it can also generate uncertainty because cash credited to a collateral account could consist of the proceeds of another secured creditor’s unauthorized sale of the underlying collateral. For most forms of collateral proceeds, the automatic perfection is generally limited to 20 days, but when it comes to cash proceeds, automatic perfection can survive indefinitely if the proceeds are identifiable.

Considering this fact, subscription facility lenders usually require that the credit parties maintain single-purpose collateral accounts that are contractually limited to hold only capital contributions. Through this limitation, subscription facility lenders safeguard against the risk that a third-party creditor could validly claim credit balances held in the subscription facility’s collateral account as its collateral.

For operational ease, however, many private equity funds (“Funds”) bristle at opening dedicated capital contribution accounts to serve as collateral accounts. Instead, they would prefer to use a single account for multiple purposes, such as to receive capital contributions from investors, hold distributions from underlying assets, and make distributions back to investors. Many Funds push...