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Financial Services FLASHPOINTS June 2020

June 15, 2020Print This Post Print This Post

Michael L. Weissman, Levin Ginsburg, Chicago
312-368-0100 | E-mail Michael L. Weissman

Lender Overcomes Filing Office Error

A very significant portion of Uniform Commercial Code (UCC) cases involves disputes between lenders to the same borrower. Davis Trust Co. v. Citizens Bank of West Virginia, Inc. (In re Reckart Equipment Co.), Case No. 12-bk-670, 2017 WL 943909 (Bankr. N.D.W.Va. Mar. 9, 2017), was one of those cases. It was unusual because it arose out of a filing office error rather than an error committed by one of the competing creditors.

Citizens made two loans to Reckart Equipment Company in November 2007. Concurrently, it made a loan to Reckart’s sister company, DSTS, Inc. Intending to perfect a security interest in each borrower’s collateral, Citizens mailed an envelope via USPS to the West Virginia Secretary of State’s Office containing UCC1 Financing Statements for each borrower. It included a ten-dollar check to cover the filing fee that stated on the memo line, “Recording Fees Reckart Equipment Company.” 2017 WL 943909 at *2. An attachment to the Reckart UCC1 Financing Statement contained an extensive list of the collateral it covered; it was intended to create a blanket lien on Reckart’s personal property.

What happened next is what created the controversy. The envelope was received by the West Virginia Secretary of State in early January 2008. At that point, personnel in the Secretary of State’s Office stamped both financing statements with the same record identification number, deposited the ten-dollar check, and indexed both financing statements under DSTS. The effect, of course, was that a search conducted against Reckart would not reveal the 2008 financing statement.

In May 2009, Davis granted Reckart a line of credit. Davis did a UCC search on May 21, 2009, and did not find a financing statement filed against Reckart (more about that later). That financing statement (the Davis financing statement) covered equipment, inventory, and accounts receivable. Another financing statement Davis filed on July 10, 2009, expanded the coverage to “inventory, accounts and equipment; whether any of the foregoing is owned now or acquired later.” 2017 WL 943909 at *3.

Davis discovered Citizen’s 2008 financing statement on March 1, 2011. (The opinion does not say how, but it is probable that it was discovered through a current UCC search.) It had been backdated to January 10, 2008. And then a critical fact was revealed: In 1974, Citizens had filed a financing statement against Reckart covering certain types of equipment. Citizens had filed continuation statements, from time to time, to continue the effectiveness of that financing statement.

In addition, the owners of Reckart had filed a UCC1 Financing Statement against the company in 2007 that was intended to create a blanket lien on all the company’s personal property. On March 25, 2011, that financing statement was assigned to Citizens and thereafter was continued in effect by continuation statements. There was considerable doubt as to whether that filing was bona fide.

Reckart filed for Chapter 11 bankruptcy protection on May 7, 2012. At that time, the UCC filings were, in chronological order, as follows:

  • 1974 — Citizens against Reckart related to certain equipment
  • August 2007 — Reckart principals against Reckart blanket filing assigned
  • January 2008 — Citizens against Reckart incorrectly indexed
  • May 21, 2009 — Davis filing against Reckart
  • July 10, 2009 — Davis filing against Reckart
  • September 2, 2009 — Citizens 2008 filing backdated to January 10, 2008

Citizens argued that it had priority in Reckart’s assets because of the error of the West Virginia Secretary of State; it said its priority position was established on January 10, 2008. Davis contended that it had priority because it had filed its financing statement before the Secretary of State made the necessary correction. Both Citizens and Davis dismissed the significance of the financing statement assigned to Citizens as well as the 1974 Citizens UCC filing. The West Virginia Secretary of State (who was being sued by both Citizens and Davis for negligence) argued that Citizens had priority.

Turning to the Citizens’ UCC filing in 1974 and continued thereafter from time to time without a break, the court said: “[T]o the extent that any of that property held by [Reckart] at the time of filing its bankruptcy petition was either proceeds of the property described by the 1974 Financing Statement or is currently property of the type described in the 1974 Financing Statement, Citizen’s perfection relates back to 1974 and it maintains priority over Davis Trust.” 2020 WL 943909 at *6.

Further substantiating Citizen’s priority, the court addressed the fact that when Citizens did its 2008 filing, the check it submitted was not adequate to cover both financing statements. But the check Citizens submitted contained the following reference on the memo line: “Recording Fee Reckart Equipment Company.” 2020 WL 943909 at *8. Therefore, the bankruptcy judge ruled “that the 2008 Financing Statement [was] effective as of the filing date even if the WVSOS refused to accept [it].” Id. Cited in support of that conclusion was UCC §9-516, which provides that a tender of a financing statement makes it effective “if the WVSOS accepted and improperly indexed the record.” Id.

What’s the point? This case demonstrates the advisability of continuing a UCC filing against a debtor even if there is a hiatus during which no credit facility is in place. As along as the borrower does not request a termination statement and is likely to return for new or additional financing it is to the lender’s advantage to have a UCC filing in place. But the case also demonstrates the necessity of doing a post-filing UCC search to make certain the filing has been indexed properly. Electronic filing clearly reduces the instances of human error.

Attaching a Security Interest: Rights in the Collateral

The requirements for a UCC security interest to attach to collateral are (1) the borrower (the “debtor” in the UCC world) must have signed a security agreement or given possession of the collateral to the bank (the “secured party” in the UCC world); (2) the debtor must have assignable rights in the collateral; and (3) the secured party must have given something of value to the debtor (in the case of a bank, the proceeds of a loan, issuance of a letter of credit, or forbearance on an existing debt).

A recent case, In re Mason, 600 B.R. 765 (Bankr. E.D.N.C. 2019), called into question whether a purported secured party had successfully attached a security interest to a debtor’s partnership interest.

James Alexander Mason, Jr., was the bankrupt party, and it was he who purportedly had granted Mutsy 1, LLC, a security interest in a partnership interest he had with Charles E. Merritt and David Jeffrey. It was a limited liability partnership organized under Delaware law with its principal place of business in Durham, North Carolina, called MMJ Partners.

At the time of his bankruptcy, Mason owned a 15-percent interest in an entity named Tier One Solar, LLC (TOS). About one year prior to his bankruptcy, TOS borrowed $850,000 from Mutsy. 600 B.R. at 767. As part of the transaction, Mason executed a personal guarantee and a security agreement in which he granted Mutsy all of his right, title, and interest under the MMJ partnership agreement as well as all dividends and distributions payable in respect of his partnership interest. The security agreement stated that it would be governed by and construed in accordance with the laws of the State of New York.

In the security agreement, Mason warranted that he was the owner of the partnership interest, that his execution and performance under the agreement would not violate any other agreement to which he was a party, and that no consent, approval, or authorization by any other party was required for the execution and delivery of the agreement. Mason, a North Carolina resident, was in New York when he signed the security agreement.

Mutsy was not given a copy of the partnership agreement prior to, or at the time of, the loan closing. Had that happened, the outcome of the case would undoubtedly have been far different.

The partnership agreement specifically provided that a transfer of a partnership interest was null and void unless made in accordance with its terms and that no partner could pledge his partnership interest to secure a debt without the consent of the managing partners. No such consent had been obtained either before or after Mason’s bankruptcy petition was filed even though Mutsy had repeatedly asked for it.

In Mason’s bankruptcy case, an assignee of Mutsy’s claim against Mason (Landress) filed a proof of claim asserting that he was secured by the pledge of Mason’s partnership interest. The trustee in bankruptcy objected to Landress’s proof of claim because Mason could not “pledge or assign his partnership interest without unanimous consent of other MMJ partners, which did not occur.” 600 B.R. at 770 – 771.

The initial question before the court was which state’s law controlled the resolution of the controversy. The partnership agreement called for Delaware law, the security agreement called for New York law, and the case was pending in North Carolina. But the court easily resolved the issue. It said that North Carolina courts follow the “internal affairs doctrine,” which calls for a court to look to the law of the state in which the business entity was organized to settle matters pertaining to the entity’s “internal affairs.” 600 B.R. at 772. The court’s decision was that it “must determine whether [Mason] could successfully pledge his interest in MMJ as security for the Note under Delaware law.” 600 B.R. at 773.

A provision of Delaware law stipulated that an attempted transfer of a partner’s interest in a partnership in violation of a restriction on transfer in the partnership agreement was ineffective. From there, the court went on to state: “An enforceable security interest is dependent upon the debtor having rights in the collateral or the power to transfer rights in the collateral to the secured party. . . . [Mason] did not have the power to transfer rights in his partnership interest in MMJ when he executed the Security Agreement, and Landress does not have an enforceable security interest in [Mason’s] partnership interest.” [Citations omitted.] 600 B.R. at 776.

What’s the point? Lending against collateral that consists solely of organic documentation that does not appear in any public record or is not readily observable calls for a level of due diligence that includes a review of the organic documents (partnership agreement, trust agreement, stockholders agreement, etc.) The question that has to be addressed is this: Does the proposed borrower have assignable rights in the collateral offered as security?

For more information about financial services, see COMMERCIAL AND INDUSTRIAL LOAN DOCUMENTATION — 2018 EDITION. Online Library subscribers can view it for free by clicking here. If you don’t currently subscribe to the Online Library, visit www.iicle.com/subscriptions.

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