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Bankruptcy and UCC-3 Continuations
Practical Law Legal Update 0-530-5265 (Approx. 7 pages)
Bankruptcy and UCC-3 Continuations
by PLC Finance
| Published on 30 May 2013 • USA (National/Federal) |
A discussion about the conflicting case law on the effect of a financing statement that lapses after the filing of a petition in bankruptcy.
Article 9 of the Uniform Commercial Code (UCC) regulates security interests in personal property and fixtures. In a secured financing, the lender wants to obtain and maintain a perfected security interest in the borrower's assets (known as collateral). A perfected security interest means:
- The lender has rights and remedies against the borrower's assets if the borrower breaches its obligations to the lender.
- If the borrower goes into bankruptcy, the lender has additional recovery rights against the borrower's assets compared to other creditors of the borrower.
For information about the UCC requirements for attachment, perfection and priority of security interests, see Practice Note, UCC Creation, Perfection and Priority of Security Interests. Section references in this Note are to the New York UCC.
For most types of collateral, the lender can perfect its security interest by filing a UCC-1 financing statement (UCC-1) in the appropriate filing office. A UCC-1 serves as public notice of the security interest. For information about preparing UCC-1s, see Practice Note, UCC: Preparing and Filing Financing Statements and UCC Financing Statements Preparation and Filing Checklist.
As due diligence for any secured finance deal, a lender should conduct searches against the borrower (and any other grantors of security) to see if there are any existing UCC-1s filed against them (see Practice Note, UCC: Conducting and Reviewing UCC Searches).
Continuations
A UCC-1 lapses five years after filing (UCC § 9-515). If a lender wants to extend the duration of a UCC-1 that perfects its security interest in collateral, it must file a UCC-3 continuation statement within six months before the expiration of the UCC-1 (UCC § 9-515(d)). The UCC-3 continuation cannot be filed any earlier than during this six month window. If a UCC-1 lapses, it ceases to be effective and the security interest becomes unperfected. "If the security interest…becomes unperfected upon lapse, it is deemed never to have been perfected as against a purchaser of the collateral for value" (UCC § 9-515(c)).
For more information about UCC-3 continuations, see Practice Notes, UCC: Maintaining Perfection Post-closing and UCC: Preparing and Filing Financing Statements.
Some uncertainty has arisen when a grantor of security (known as the debtor in the UCC) files for bankruptcy and it becomes time for the lender (known as the secured party in the UCC) to file a continuation statement regarding any UCC-1s filed against the debtor. The issue is whether the secured party must still file its continuation when there is a bankruptcy case in progress for it to remain perfected.
The UCC and the Bankruptcy Code
In the past, liens in effect on the date of filing of a bankruptcy petition continued for the duration of the bankruptcy case. Under a prior version of the UCC, the lapse was tolled if the debtor entered bankruptcy or another insolvency proceeding (UCC § 9-515 OC 4). This caused problems because, while the financing statements were still effective, the UCC-1 records were being removed from the files by filing offices, according to usual practice, as if the records had lapsed. This meant that the UCC-1s would not be found by searching the filing offices and they would no longer be providing public notice of a security interest.
In 1994, Congress amended the Bankruptcy Code to provide that the automatic stay did not apply to acts to continue the perfection of an interest in property (11 U.S.C. § 362(b)(4)). This amendment means that secured parties could now file continuation statements without violating the automatic stay.
As part of the 2001 amendments to the UCC, UCC § 9-515 was amended to delete the provision that provided the security interest remained perfected until termination of the insolvency proceeding and thereafter for a certain period of time. A UCC-1 therefore lapses five years after it is filed and this result is not affected by whether or not the debtor is in bankruptcy. By deleting the tolling provision, UCC § 9-515(c) "thereby imposes a new burden on the secured party: to be sure that a financing statement does not lapse during the debtor's bankruptcy" (UCC § 9-515 OC 4).
These Bankruptcy Code and UCC changes imply that a secured party must file a continuation during a debtor's bankruptcy case to remain perfected. However, not all lenders are aware of this change in law and two 2012 cases, which came to opposite conclusions, may have lead to some confusion.
Case Law
In re Miller
In In re Miller Bros. Lumber Co., Inc., the US Bankruptcy Court for the Middle District of North Carolina considered whether a bank had a properly perfected security interest in a debtor's assets when it failed to file a continuation after the debtor filed for bankruptcy (No. B-11-51405, (Bankr. M.D. N.C. May 8, 2012)). The court found that the bank's security interest was unperfected because it failed to file a continuation statement when it was required to do so. The court relied on the revised language of UCC § 9-515 and the accompanying official comments in its decision that the bank's perfected security interest in the debtor's assets had lapsed postpetition.
The bank did not succeed in its argument in this case that the automatic stay fixes and protects priorities as they exist on the petition date. The court therefore held that the debtor's trustee in bankruptcy may avoid the bank's security interest pursuant to its strong-arm powers under section 544 of the Bankruptcy Code.
While this case supports the position that secured parties must file a continuation to remain perfected, a question remains about whether this case was wrongly decided. The issue is that the case involved a secured party competing with a debtor's trustee in bankruptcy.
The last sentence of UCC § 9-515(c) provides that if the security interest lapses, it is deemed never to have been perfected as against a purchaser of the collateral for value. This does not apply to lien creditors (UCC § 9-515 OC 3). While a secured party is a purchaser (UCC § 1-201(32) and (33)) and could gain priority under UCC § 9-515, one commentator noted that the court's decision may have been wrong because a trustee in bankruptcy is not a purchaser:
"In exercising its avoidance powers, a trustee in bankruptcy does not qualify as a "purchaser," but is only a hypothetical "lien creditor" from the date of the filing of the petition. UCC § 9-102(a)(52)(C); Bankruptcy Code § 544(a). The clear negative implication from the last sentence of 9-515(c) is that the post-bankruptcy failure to file a continuation statement is not retroactive to the date of the bankruptcy filing and thus does not render the security interest unperfected when the competitor is the trustee under the strongarm clause."
(See Barkley Clark & Barbara Clark, Clarks' Secured Transactions Monthly, Sept. 2012, at 2.)
The commentators argued, relying on UCC § 9-515(c) and official comment 3, example 2 of UCC § 9-515, that since the trustee in bankruptcy is a lien creditor as of the date the petition was filed, the bank's perfected status was fixed as of that date. At that point, the bank still had a perfected security interest in the debtor's assets. The trustee in bankruptcy arguably therefore should not have been able to avoid the bank's security interest under the strong-arm clause (see Barkley Clark & Barbara Clark, Clarks' Secured Transactions Monthly, Sept. 2012, at 3).
In re Wilkinson
In In re Wilkinson, the US Bankruptcy Court for the Northern District of New York found that a secured creditor (Melinda) maintained her priority position over a competing creditor even though she failed to file a continuation statement postpetition (No. 10-62223 363 (Bankr. N.D.N.Y. Apr. 10, 2012)).
In this case, the court was persuaded by Melinda's argument that the critical date for determining the respective rights of the debtor and the debtor's creditors is the date of filing of a petition in bankruptcy and that the postpetition lapse is not determinative of the dispute. She referred to several pre-2001 cases and argued that the UCC § 9-515 amendment was irrelevant.
The court agreed with Melinda and stated that "secured creditors are now permitted - but not required to - file continuations statements notwithstanding the pendency of a bankruptcy proceeding." The court held that a creditor's security interest, perfected and valid at the commencement of a bankruptcy proceeding, but due to expire during the bankruptcy case, does not lapse when the creditor fails to file a continuation.
In re Highland
A recent 2013 case should be helpful in reconciling the two 2012 cases. In In re Highland Const. Mgmt. Svcs., LP, a secured party failed to file a continuation statement after a bankruptcy filing (No. 11-11413, (Bankr. E.D. Va. Mar 29, 2013)). In this case the competing parties relied on In re Miller and In re Wilkinson and the US Bankruptcy Court for the Eastern District of Virginia discussed the split of opinion regarding the effect of the changes to the Bankruptcy Code and the UCC.
The court stated that this case was not an action to avoid a lien, but to determine the priority of existing liens. In its decision on priority, the court found In re Miller more persuasive and that the financing statement in question had lapsed. It found that the plain meaning of the statutes should be given effect in the absence of countervailing considerations. "While the liens survive," the court said, "they do not necessarily emerge from bankruptcy as they entered bankruptcy. They accrue no greater right, strength or duration for having been through a bankruptcy proceeding." The creditor is required to file a continuation, which is a "minor undertaking" and "the integrity of the state records is maintained."
Based on the decisions in In re Miller and In re Highland, and on the plain reading of UCC § 9-515, counsel should advise their lender clients to file continuation statements during a bankruptcy to maintain perfection. It is not an onerous task for a lender and by failing to do so, the lender risks losing priority.