Perfection! An Asset-Specific Guide to Creating Security Interests – Part One

Introduction

This is the first installment of an article that will continue in future newsletters.

It is a misconception that ensuring the perfection of security interests should be left for bankruptcy lawyers. It may then be too late.  More often than not, protecting your rights requires pre-bankruptcy planning.  In bankruptcy, a lien that was not properly perfected prior to the date the bankruptcy petition is filed is subject to avoidance pursuant to, among other things, the trustee’s “strong-arm” powers under 11 U.S.C. § 544; meaning the lien may be stripped away to leave a less valuable claim as an unsecured creditor.  Further, the enforceability of lien rights is critical in collections outside of bankruptcy.  Accordingly, perfection of security interests is necessarily a pre-bankruptcy consideration.  Each time you consider spending money to secure a judgment; each time you negotiate to secure payment under a settlement agreement – the ability to enforce these rights inevitably leads to consideration of perfection of security interests.  Understanding principles of perfection can keep you from over-estimating your rights based on potentially unenforceable language in an agreement.

Perfection of property interests is an asset-specific inquiry, and the road-map for creating security interests in personal property (as opposed to real property) depends on identifying which category the asset in question falls into under Article 9 of the Uniform Commercial Code (“UCC”).  This article will discuss the concepts of attachment and perfection of such personal property interests under the UCC.  Next, it will discuss the specific way to create perfected security interests in a series of asset categories.  Lastly, it will conclude with thoughts recommending that attention be paid to enforcement concerns earlier in the dispute process, and preferably at the inception of a relationship and before any dispute has arisen.

Attachment & Perfection

To create a security interest that will withstand an avoidance challenge in bankruptcy, a security interest must have attached and must be perfected.  The concepts are different.

“Attachment” is a lawyerly way of describing the process for properly conveying a security interest from a debtor to a creditor in conformance with Article 9 of the UCC.  Three elements must be satisfied: 1) value must be given by the creditor (i.e., a peppercorn of consideration, which may take the form of an extension of credit to the debtor), 2) the debtor must have rights in the collateral or the right to transfer it, and 3) most often, a security agreement exists describing the collateral (alternatives exist for possession, delivery of certificated securities and control of certain assets).  UCC § 9-203(b).

Whereas attachment basically refers to the two-party transaction of conveying a security interest, “perfection” refers to the process the creditor must undertake to communicate its security interest to the world.  Article 9 of the UCC is intended to provide a uniform manner of perfecting security interests based on “current” business practices, its treatment of “standing timber” and “unborn young of animals” notwithstanding.  UCC § 9-102(a)(44).  Below, this article discusses the manner of perfecting security interests in a few assets commonly encountered in civil disputes, identified under the categories set forth in Article 9 of the UCC.

Asset-Specific Perfection Methods

Despite the drafters’ intent to provide uniform rules based on current business practices, personal property does not always fit neatly within the categories identified under the UCC.  Each of the headings below identifies the UCC category, and the discussion below that category identifies the particular assets that fall within it.  This article next addresses how to perfect those assets such that a security interest will survive a strong-arm challenge from a bankruptcy trustee.

Deposit Accounts

A “deposit account” is defined as “a demand, time, savings, passbook, or similar account maintained with a bank,” see UCC § 9-102(a)(29), but it is more commonly referred to as a savings or checking account.  Investment vehicles offered by banks with similar features, such as “money market savings accounts,” are also properly characterized as deposit accounts under UCC Article 9.

A security interest in a deposit account is perfected by control.  UCC § 9-312(b)(1).  A creditor may establish control in three ways: (1) being the bank in which the account is maintained, (2) becoming the bank’s “customer” with respect to the account, and 3) the debtor, creditor and bank agree pursuant to an authenticated record that the bank will honor the creditor’s instructions as to disposition of account funds without the debtor’s further consent.  UCC § 9-104(a).  The second option involves taking title to account funds, which includes tax implications and which is generally unadvisable.  The third option, which is typically referred to in surety circles as a “control account,” is the most common method for non-banks to perfect a security interest in a deposit account.  To be clear, filing a UCC financing statement (“UCC-1”) does not create a perfected security interest in deposit accounts.  Deposit accounts are not to be confused with money, which is perfection by possession.  UCC § 9-312(b)(3).

It can be a unique challenge to persuade a debtor to enter into such a control account after the debtor has defaulted on its obligations unless accomplished through a debt modification process.  Although business concerns may chill early requests for control accounts, the most realistic time to open this dialogue may be at the beginning of an underwriting process or business transaction.

Accounts

An “account” is not to be confused with a “deposit account” referenced above.  An “account” is defined as a right to payment of a monetary obligation, whether or not earned by performance, for various property or services listed in the UCC, see UCC § 9-102(a)(2), and generally refers to accounts receivable.  Perfection of a security interest in accounts is accomplished by filing a UCC-1.  See UCC § 9-310 (a UCC-1 must be filed to perfect all security interests except those specifically mentioned, and there is no exception for accounts).

Although the method of perfection of accounts is through simply filing a UCC-1, levy on the account may prove to be more problematic due to the following, for which a UCC-1 is of limited use: (1) levy on an account is effectuated by service of a notice to the account debtor and there is no requirement in the levy process that all other creditors be noticed of such levy; therefore, the creditor risks that other creditors may have already levied on the debtor’s accounts without notice to it; (2) certain transfers of accounts are excluded from the scope of the UCC-1 lien (UCC § 9-109(d)); and (3) the statute of limitations on collection of the underlying account may have run.  Investigations into the status and health of the underlying accounts should be performed before assuming that the creditor’s lien is viable for collections purposes.

Chattel Paper

“Chattel paper”  consists of a monetary obligation together with a security interest in or a lease of specific goods if the obligation and security interest or lease are evidenced by a “record or records.”  UCC § 9-102(a)(11).  This comprehends transactions where a seller or lessor transfers possession and control of goods to another but retains a security interest or a lease interest in the goods.  Examples are conditional sales contracts, chattel mortgages and leases, and installment purchase contracts with the requisite security or lease features (such as are used for heavy industrial equipment).  Such transactions give rise to essentially term obligations on the part of the purchasers and lessor using the goods and paying the rent or installment payments thereupon.  As such, chattel paper is sometimes sold or pooled and used as collateral for financing.  Electronic chattel paper is chattel paper stored in an electronic medium. UCC § 9-102(a)(31).  A security interest in chattel paper may be perfected either by possession or by filing.  UCC §§ 9-312(a), 9-313(a).  Special rules apply to what constitutes possession of electronic chattel paper, which is defined in terms of control rather than possession.  UCC § 9-314.

Commercial Tort Claims

A “commercial tort claim” is a claim arising in tort with respect to which either (1) the claimant is a business; or (2) the claimant is an individual and the claim arose in the course of claimant’s business or profession and the claim does not arise out of personal injury or death of the individual.  See UCC § 9-102(a)(13).  Unique to this asset category is that the commercial tort claim must exist at the time that the debtor granted the security interest.   Official Comment 4 to UCC § 9-204.  Therefore, unlike other collateral, the creditor cannot take a blanket inchoate lien against “all commercial tort claims of the debtor.”

General Intangibles

“General intangible” means “any personal property, including things in action, other than accounts, chattel paper, commercial tort claims, deposit accounts, documents, goods, instruments, investment property, letter-of-credit rights, letters of credit, money, and oil, gas, or other minerals before extraction,” and includes “payment intangibles and software.”  This category is a catch-all for assets not covered under other categories of Article 9.  For example, “things in action” means a “chose in action” other than a commercial tort claim, such as a lawsuit alleging breach of contract.  See Gold Medal Products, Inc. v. Love Enterprises, Inc., 766 S.W.2d 759, 761 (Ct. App. Mo. 1989).  It also generally includes a debtor’s interest in a partnership or LLC.  In re Hartman, 102 B.R. 90, 94 (Bankr. N.D. Tex. 1989).  “General intangible” has been held to include a debtor’s prospective right to receive a tax refund.  In re Martin, 167 B.R. 609, 619 (Bankr. D. Or. 1994).  Perfection of a general intangible is accomplished by filing a UCC-1.  UCC § 9-310; § 9-312(b).

Conclusion

Too commonly, attorneys and clients spend money to establish entitlement before considering how to enforce a judgment or survive a strong-arm challenge.  In addition, clients sometimes rely on perceived rights conferred by an agreement that does not actually accomplish attachment or perfection, such as an indemnity agreement that purports to provide a security interest in deposit accounts.  Such “rights” mean little without an end-game, for debtors are often obligated to more than one aggrieved creditor.  This means identifying particular assets that will serve for enforcement purposes and creating a properly perfected security interest in these assets.