Some credit unions are originating business loans withdocumentation deficiencies that could result in unenforceablepromissory notes and collateral documents.

If notes and collateral documents are deemed unenforceable andthe credit union does not take steps to correct the situation,losses could result. For credit unions using automated loandocumentation programs that produce flawed notes or collateraldocuments, small dollar business loans could multiply intopotentially large losses.

A common cause of inappropriate documentation begins with themisinterpretation of business loan regulations that state businessloans of less than or equal to $50,000 and business loans fullysecured by a one-to-four family dwelling are not considered memberbusiness loans.

Institutions confuse the statutory MBL exemptions noted abovewith the legal context of business lending. It is extremelyimportant that all institutions realize that a business-purposeloan (generally defined in the commercial banking sector as a loanwhere 51% of the proceeds of the loan are for a commercial orbusiness purpose) must meet all contractual legal documentationrequirements regardless of size or collateral.

Inadequate business loan documentation can come in many forms.The most common are improper signatures on promissory notes andcollateral documents made to entities and lack of proper attachmentand perfection of collateral due to either signature orownership.

These deficiencies arise due to lack of knowledge or attemptingto utilize automated loan products, which are generally designedfor consumer loans, which do not have proper commercial loandocumentation capabilities.

Who is the borrower?

If an entity (other than an individual) is the borrower orco-maker/borrower, the institution must have documentation of whois authorized on behalf of the entity to borrow (borrowingresolution) and the note must reflect the proper signature of theauthorized borrower.

For entities, a typical promissory note signature block wouldbe:

Borrower: XYZ Inc.

Signature block: XYZ Inc.

by: __________________

John Smith, President

What we see, especially in institutions using consumer loanproducts to originate business loans, is:

Borrower: XYZ Inc.

Signature block: [signed by an individual]

This is not a proper signature block for a business loan to anentity. The question could arise: Do we have an enforceable loan toXYZ Inc.?

Who owns and pledges collateral?

For some business loans, the real or personal property used tosecure the borrowing transaction (pledged as collateral) may beowned by an individual or an entity, other than the borrowingentity, who pledges the collateral on behalf of the borrower.

In such cases, collateral documentation must reflect the properownership and pledge of property to the borrower. Common methods ofattaching property owned by someone other than the borrower arereferred to as third-party pledges, hypothecation agreements orgrantor.

Security or collateral documentation must include a method ofattachment of the property to the borrowing transaction. Perfectingthe security interest or collateral must then be accomplished.

Again, as with the promissory note, care must be taken to havethe proper signature of the owner of the real property or personalproperty.

For entities, a typical signature block for the owner or grantor(owned by an entity other than the borrower) of collateral wouldbe:

Borrower: XYZ Inc.

Grantor: ABC Inc.

Signature block: ABC Inc.

by: _________________

[Authorized owner (grantor) of the property]

We see, especially in institutions using consumer loan productsto originate business loans, the security agreement or deed oftrust or mortgage being signed:

Borrower: XYZ Inc.

Signature block: [signed by an individual]

This is not a proper signature block. The question could arise:Do we have an enforceable pledge of collateral?

For a business loan transaction where the individual owns thecollateral and signs the collateral document, care must be taken toensure the pledge of the collateral to the borrowing transactionhas occurred via a third-party pledge, hypothecation or grantorlanguage.

If you discover improper loan or collateral documentation,address the situation immediately and consult competent legalcounsel.

Brian D.Robertson is president of PCMS Inc.in Missoula, Mont.