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Article 9 Revisions Increase Risk And Complexity For Lenders
Revisions to Article 9 of the Uniform Commercial Code significantly change
the scope, rules and procedures of UCC fillings and will probably make
perfecting security interests significantly more challenging and expensive.
BY THEODORE H. SPRINK
A local developer sought to purchase a hotel in New York to serve as its
East Coast flagship for expansion into a major national chain of hotels. The
developer was able to find a suitable old hotel that needed some renovation
in a prime location, and he put together the capital and loan approval to
purchase the building for $100,000,000.
The lender took back a deed of trust for the real property portion of
the purchase, $60,000,000, and a security agreement and financing
statement believed to be perfected in first position for personal property,
valued at $40,000,000. The personal property included beds, industrial
kitchen equipment and machines, bedding, telephones, televisions,
cleaning equipment, pictures, cash registers, couches and all other manner
of personal property involved in running and maintaining a hotel business.
Although the developer successfully renovated the hotel and opened
the doors on schedule, competition forced his prices down, and ultimately
he lost too much ground and was obliged to declare Chapter 11
Bankruptcy. The developer continued to make payments on the building
loan, but in the process of the bankruptcy, it was discovered that the UCC-1
Financing Statement had been initially rejected by the Secretary of State
and never re-filed.
The lender was an unsecured creditor, and the developer stopped
making payments on the unsecured portion of the $40,000,000 loan. The
Chapter 11 Bankruptcy was subsequently converted to Chapter 7, and the
assets were sold. The lender was able, along with the other unsecured
creditors, to collect $.04 on the dollar and wrote off a $38.4 million loss.
As many commercial lenders know, revisions to Article 9 of the
Uniform Commercial Code, effective July 1, 2001, will likely make the
process of properly perfecting security interests significantly more
challenging and expensive. Although intended to standardize and simplify
the rather non-uniform Uniform Commercial Code, lenders should be
keenly aware that the revision required 178,000 words to describe and
document!
Revisions require lender attention
The revisions to Article 9 require significant lender attention, as do the
complex transition rules. New exposure to incorrectly documenting
commercial loan transactions increases risk to lenders. The hotel
transaction described above serves as a good example of uninsured risk
associated with documentation deficiencies.
Significantly, documentation-related losses have been masked by the
very strong economy in recent years. Commercial defaults and bankruptcy
filings have been minimal in comparison to other timeframes in recent
history and, as a result, documentation defects on uninsured commercial
loans may not have surfaced internally or to regulators. This concept is not
lost on Wall Street, the Federal Reserve Board or the regulatory agencies.
Article 9 is the body of law determining the manner in which secured
loans are transacted. The revisions to Article 9 represent the first major
revision to Article 9 since 1972. There are significant changes in scope,
substantive rules, and procedures. The revisions are intended to bring
greater certainty to financing transactions.
The revised Article 9 seeks greater certainty through two primary
techniques:
- expanding the scope of property and transactions covered by Article
9, and
- simplifying and clarifying the rules for creation, perfection priority
and enforcement of a security interest.
The process of revising Article 9, which was begun in 1990, was
completed in late 1998. The sponsoring organizations, the American Law
Institute and the National Conference of Commissioners on Uniform State
Laws, have given their approval. Article 9 will become the law in a significant
number of (if not all) states, effective July 1, 2001.
The changes to Article 9 will have a substantial impact on how
secured lenders grant, perfect and enforce security interests. There are
important changes in the description of collateral in certain instances, and
significant changes in the filing forms and filing jurisdictions.
A look at revisions
Lets take a brief look at the revisions and the basic steps lenders can
take to prepare for the transition. Article 9 expands to include software-
imbedded goods as part of "goods." "Accounts" have been broadened to
include not only payment obligations arising out of the sale, lease or license
of both tangible and intangible property, but software license fees and
credit card receivables.
Healthcare insurance receivables sold in financing transactions are
now included under Article 9. Control procedures have been established for
tort claims, deposit accounts, letter of credit rights and electronic chattel
paper. Certain collateral, such as instruments and investment property
such as stock certificates, previously perfected only by possession, can be
secured by filing under the new Article 9.
Financing statements under the new Article 9 are to be filed in the
state of incorporation or, in the event of a non-incorporated business entity,
the state in which the chief executive office is located. If the debtor is an
individual, perfecting takes place in the state of his or her principal
residence.
The new Article 9 disallows the use of fictitious names. Revised Article
9 allows use of the generic "all assets" language to establish the collateral
description on the financing statement, although the security agreement
must provide the full and accurate description.
Debtor signatures as a requirement for filing have been eliminated
under the new Article 9, provided the debtor has executed a security
agreement or other lender authorization. Pre-filing is still allowed, but must
be authorized by the debtor.
The new Article 9 recognizes emerging methods of engaging in
electronic commerce, providing for "authentication" of a "record" rather
than through the signing of a piece of paper.
Review loans and portfolios
In order for lenders to be properly prepared for transition to the new
Article 9, loans and loan portfolios should be closely reviewed in the
following manner:
The security agreement should be reviewed to determine if collateral
under Current Article 9 will remain as it was intended under revised Article
9.
If the security agreement is to be changed and this results in collateral
being included that was not previously perfected under Article 9, prepare
and file the amendment prior to July 1, 2002. This will require a debtor
signature.
If the financing statement has been amended, you will have one year
from July 1, 2002, to file your "in lieu of continuation" to the proper filing
location under revised Article 9.
If the financing statement is satisfactory under both the current Article
9 and the revised Article 9, and you are currently perfected under Article 9,
you will have five years or until normal lapse (whichever comes first) or until
June 30, 2006, to file your "in lieu of continuation" under revised Article 9.
Ensure that a copy of the Articles of Incorporation for "registered
entities" is in the loan portfolio. If it is not, order a copy.
Verify that the debtor name on the UCC filing is exactly as it appears
in the Articles of Incorporation. If it is not, file amendments to all UCC's
currently on file to correct the debtor name.
Verify the State of Incorporation of the registered entity from the
Articles and prepare and file your "in lieu of continuation" in that filing office.
Filing locations
The filing locations under revised Article 9 have reduced the number
of places required to file from potentially many to one filing office for all non-
real property related filings. Filing locations are:
- registered entities - file in the state of Incorporation;
- non-registered entities - file in the state where the chief executive
office is maintained; and
- individuals: file in the state where residence is maintained.
If the filing location under revised Article 9 is different than the place of
filing under the current Article 9, prepare an "in lieu of continuation" for each
debtor name in your loan portfolio. These are to be prepared on an
"original" National UCC-1 Form approved for revised Article 9.
In the collateral area of the form it must be stated the filing is an "in
lieu of continuation" and list each filing by date filed, file number and filing
office that relates to the debtor name you are filing against.
Determine that there is a listing from a search on each filing office
under Current Article 9 in your loan portfolio. This will serve as the
documentation of your secured position in each filing office.
Establish a five-year tracking system
Order a bring-down search to reflect current status of documentation.
Place the filing acknowledgement(s) and the search result(s) in your loan
portfolio as proof of valid perfection.
Lenders can outsource the searching, document preparation, filing
and tracking in an Article 9 "compliant manner," while at the same time
insuring the lien perfection and priority of the entire loan transaction.
Outsource firms can also include "gap" coverage, for coverage between the
initial search and search acknowledgement.
Outsourcing expensive, cumbersome and risky tasks to qualified third
parties is not new to lenders. Nor is insuring real estate transactions. UCC
insurance for commercial loans is a new concept, but not likely for long.
Theodore H. Sprink is vice president, director of the UCC Insurance Division
of First American Corp., based in Santa Ana, Calif. The company's Eagle 9
UCC Insurance Policy, a commercial loan lien perfection and priority
insurance program, offers UCC search, document preparation, filing and
tracking functions to lenders. For more information, visit www.eagle9.com
or call Sprink at (714) 800-3195.
This article was previously published in the January 2001 Issue of Commercial Mortgage Insight
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