This is the second installment of a multiple-installment article
This is the second part of an asset-specific guide to creating and perfecting security interests with respect to commonly encountered assets. In Part I of this installment, we explored the concepts of attachment and perfection, and identified the process for perfecting security interests in deposit accounts, accounts, chattel paper, commercial tort claims and general intangibles.
In Part II, this article shall further explore the process of perfection in the common context of filing a UCC-1 financing statement. In particular, typical pitfalls will be identified and a few basic guidelines will be illustrated. Furthermore, this article shall identify the proper way to perfect security interests in promissory notes, instruments, letter-of-credit rights, investment property and proceeds.
Asset-Specific Perfection Methods
Similar to Part I of this article, the below discussion shall identify certain categories of assets identified under Article 9 of the UCC, translated based on descriptions of the same assets commonly used in the real world. Again, the proper method of perfecting a security interest in each asset is identified to provide a road-map for creditors to prevent a strong-arm challenge by a bankruptcy trustee or competing claims from other secured creditors.
A “promissory note” is defined as “instrument that evidences a promise to pay a monetary obligation, does not evidence an order to pay, and does not contain an acknowledgment by a bank that the bank has received for deposit a sum of money or funds.” UCC § 9-102(a)(65). In other words, a “promissory note” is basically a right to repayment of a loan that does not fall within the categories of special instruments issued by banks, such as drafts, negotiable instruments, money orders or checks.
A security interest in a promissory note may be perfected either by filing a UCC-1 or by taking possession of the note. UCC § 9-312(a); § 9-313(b). Though less nimble than filing, taking possession of the note is superior in instances where a debtor double-pledges the note as collateral or sells it to a third-party, in which case bona fide purchasers will take free and clear of any liens established through filing alone unless the third-party had actual knowledge of the competing lien. UCC § 9-330(d). Perfection in a note also perfects a security interest in any deed of trust or mortgage supporting the note. UCC § 9-308(d). This is known as the maxim that the “deed follows the note.” Thus, perfection of an interest in real estate (albeit indirect) may be accomplished without ever dealing with the County Recorder’s Office.
An “instrument” is defined as “negotiable instrument or any other writing that evidences a right to the payment of a monetary obligation, is not itself a security agreement or lease, and is of a type that in ordinary course of business is transferred by delivery with any necessary indorsement or assignment.” UCC § 9-102(a)(47). A negotiable instrument is an unconditional promise or order to pay a fixed amount of money (UCC § 3-104(a)), and generally includes checks, cashier’s checks, teller’s checks, traveler’s checks and certificates of deposit. For example, debtors will occasionally liquidate accounts into cashier’s checks or traveler’s checks to prevent detection or avoid enforcement by banks. As noted above, promissory notes are one subset of the broader category of instruments.
Perfection of a security interest in an instrument generally may be accomplished by filing a UCC-1 financing statement. UCC § 9-312(a). Exceptions exist in limited circumstances where perfection is automatic upon attachment — but only for a 20-day period — where new value is given (UCC § 9-312(e)) or where the secured party furnishes the instrument to the debtor for the purpose of sale, exchange, or in connection with presentation, collection, enforcement, renewal, or registration of transfer. UCC § 9-312(g).
A letter-of-credit right “means a right to payment or performance under a letter of credit, whether or not the beneficiary has demanded or is at the time entitled to demand payment or performance.” UCC § 9-102(a)(51). A letter-of-credit right does not include “the right of a beneficiary to demand payment or performance under a letter of credit.” Id. Therefore, under the revised UCC Article 9, the term “letter-of-credit right” includes the right to obtain letter-of-credit proceeds from the bank (whether the issuing bank of the seller, or the confirming or nominated bank of the buyer), provided that the beneficiary draws upon the letter-of-credit. The Article 9 definition does not include the right to actually draw on the letter-of-credit, only to receive proceeds once this occurs. Thus, a creditor with a security interest in a debtor’s letter of credit rights would not be able to receive the proceeds of this security interest without the debtor’s consent, or without a previously executed draft (a compliant document drawing upon the letter-of-credit) combined with power of attorney.
Perfection of a security interest in a letter of credit is generally accomplished by control. UCC § 9-312(b). With respect to letter-of-credit rights, “control” means obtaining the consent of the issuing or nominated bank. UCC § 9-107. Like promissory notes, an exception exists where the letter-of-credit rights are a supporting obligation for a secured party’s perfected security interest in collateral. See UCC § 9-308(d). For example, suppose a debtor pledges a promissory note as collateral, backed by a letter-of-credit right as a supporting obligation. As discussed above, the secured party would obtain a perfected interest in the promissory note by filing a UCC-1 financing statement, and the perfected security interest would automatically “drop down” to create a perfected security interest in the letter-of-credit right as a supporting obligation. Accordingly, unless letter-of-credit rights are pledged as a supporting obligation for separate collateral, perfection and enforcement of a security interest in letter-of-credit rights can be complicated.
“Investment property” is defined as “a security, whether certificated or uncertificated, security entitlement, securities account, commodity contract, or commodity account.” UCC § 9-102(a)(49). Generally speaking, a “security” includes stock in a corporation, but not a limited liability company or partnership. See UCC § 8-102(15); UCC § 8-103(c). Exceptions exist when the interest in an LLC or partnership is publicly traded, where such interest is expressly defined as a security governed by Article 8 of the UCC (described as “opt in”) or where such interest is an investment company security (for example, mutual funds). Commodity contracts and accounts include commodity futures contracts and options, as well as accounts maintained by intermediaries in which such contracts and options are carried. UCC § 9-102(a)(14)–(15).
Perfection of a security interest in investment property is generally accomplished by filing a UCC-1 financing statement or by control. UCC § 9-310(b)(8); UCC § 9-312(a). As discussed in Part I of this installment, because creditors may become properly perfected with respect to interests in partnerships or LLCs by filing a UCC-1 financing statement, they do not necessarily need to worry about requiring debtors to “opt in” such interests to Article 8 to be treated as securities, so long as the underlying security agreement covers general intangibles. With respect to security interests in favor of brokers or intermediaries, perfection occurs automatically upon attachment. UCC § 9-309(10).
Proceeds are defined broadly to include all money or property acquired upon disposition of collateral, all property distributed or collected on account of collateral, rights arising out of collateral and rights arising out of damage to or loss of collateral to the extent of the collateral’s value, including insurance proceeds. UCC § 9-102(a)(64).
A security interest in underlying collateral automatically attaches to identifiable proceeds of that collateral. UCC § 9-315(a)(2). Therefore, perfection of an interest in proceeds depends on whether the creditor became properly perfected as to the underlying collateral before the debtor received the proceeds. For example, suppose a UCC-1 financing statement was filed to create a security interest in “general intangibles” and the debtor later received a tax refund from the federal government. (See Part I of this Installment). The creditor’s lien would follow the traceable proceeds of this collateral deposited in a bank account, even though the creditor does not have “control” of the deposit account, which would otherwise be required for perfection.
Filing a UCC-1 Financing Statement
As noted above and in Part I of this article, many security interests, but not all, can be perfected by the filing of a UCC Financing Statement, which we refer to in this article throughout as “UCC-1” for short. This section of the article discusses various recommendations in preparing and filing a UCC-1.
First, in order to file a UCC-1, there must be an underlying security agreement, and the security agreement should provide that it may be filed as a UCC-1. However, a common, mistaken belief on the part of creditors is that simply having a security agreement is enough without more—not so; hence, the subject of this article regarding the need for the proper method of perfection. Nevertheless, the security agreement is not to be forgotten because it is an essential precondition to perfection, including that a UCC-1 may not be filed unless there is an underlying security agreement.
A UCC-1 is filed on a national UCC-1 form, which may generally be obtained from the Secretary of State. The UCC-1 is filed with the Secretary of State in the jurisdiction where the corporation is registered.
Typically, the UCC-1 form guides a creditor in identifying the necessary information, including the debtor’s and creditor’s name and mailing address. Note that the form typically required identification of the debtor’s social security number, but due to privacy rules, this box has been blocked out and effectively removed from the UCC-1 form in most jurisdictions.
In addition, the UCC-1 form provides that the creditor must provide a description of the “collateral,” which is the assets in which the security interest has been given. Technically, the collateral description is sufficient if it either provides a description of the collateral (UCC § 9-108) or an indication that the UCC-1 covers all assets or all personal property of the debtor, such as in so-called “blanket UCC-1” liens (UCC § 90594(2)). However, note that while the collateral description in a UCC-1 may be so broad as to be “super-generic,” as in the case of the blanket lien, the description of collateral in the underlying security agreement itself should not be so generic for fear of raising an attack as to the sufficiency of the collateral description. (UCC § 9-108, 9-203; and see 9-101, comment § 4h.)
Additionally, in the opinion of the article writers, it is the better practice that the collateral description should generally match the description of collateral in the security agreement. An exact match is not required but the lien asserted by the UCC-1 should generally be commensurate with that given through the security agreement. As such, typically creditors will be best advised to describe the covered collateral either by re-typing the collateral description from the security agreement into the UCC-1, or simply attaching a copy of the security agreement to the UCC-1 and stating in the body of the UCC-1 that the covered collateral is “All collateral set forth and covered in the security agreement entitled dated by debtor(s) in favor of secured party, a copy of which is attached hereto as Exhibit A and incorporated herein by reference as though set forth in full.” Please note that the latter, a description of “all collateral set forth and covered in the security agreement” should only be used if in fact the security agreement is attached to the UCC-1. Because the purpose of the UCC-1 is to put the world on notice as to the scope and extent of the lien, a creditor who refers to a document not in the records risks invalidation for lack of adequacy of description if the referenced security agreement is not attached. Finally, note that if the security agreement is attached to the UCC-1, the social security numbers, if they appear in the security agreement, should be redacted in full first before filing.
The above issues are important at both the genesis of a transaction and at the stage of collections. When assets taken as collateral in a security agreement are adequately identified and perfected through the proper method, security interests are powerful tools to protect the investment of a creditor or secured party.