Eyes Wide Open: Avoiding Nightmare Scenarios in Secured Transactions

Posted on 10-07-2013 by
Tags: Real Law

Brought to you by the Real Law Editorial Team

The word “nightmare” has an interesting etymology. It derives from the Old English “mare,” an evil spirit, demon or goblin that rode on people’s chests while they slept and tormented them with frightening dreams. However, the mare is also found in a Norse Fornaldarsaga (literally, a “tale of times past”) from the 13th century, which suggests that belief in such a creature is much older.

Mythology aside, a variety of conditions can lead to nightmares. An understandable dislike of them has prompted the habit of referring to events that are adverse or particularly unpleasant as “nightmare scenarios.” Such scenarios can take many forms, of course, whether they are personal or professional and depending on one’s occupation. Their existence is certainly familiar to those in the legal profession.

For bankers and their legal counsel, some nightmare scenarios are related to the possibility of seeing a security interest wiped out. Therein lies a serious concern. Amendments to Article 9 of the Uniform Commercial Code (UCC), which governs secured transactions, were published in 2010 with an effective date of July 1, 2013. Most states have enacted the amendments in one form or another, but there is a widespread lack of awareness of the changes and how they affect what financial institutions need to do now to ensure that they have the strongest possible position with respect to both perfection and priority of their security interests.

Indeed, the current situation is one that could lead to some very disturbed nights as dreaded scenarios unfold in unexpected ways.

Taking Stock of the Provisions

Most of what’s new in Article 9 is technical and addresses shortcomings perceived in the more comprehensive set of UCC amendments approved in 2001 and subsequently enacted across the country. Nevertheless, the changes are significant given the importance of perfecting security interests, particularly in commercial lending, and the enormous amount of litigation that occurs in matters relating to incorrect information included in UCC financing statements.

More precisely, the 2010 Amendments include provisions designed to remove potential ambiguities in naming individuals and organizations (such as corporations, limited partnerships and limited liability corporations) as debtors. Other aspects relate to perfection arising on after-acquired property when a debtor moves to another jurisdiction or is a successor entity resulting from a merger.

There are also some elements connected with electronic chattel paper and Internet foreclosure sales that Barkley Clark and Barbara Clark—widely regarded as authorities on analysis and advice for shoring up assets, enforcing security interests and the effect of bankruptcy law on secured transactions—say better adapt Article 9 to the digital age, when filing systems are virtual and foreclosures on the courthouse steps are becoming an anachronism.

Barkley Clark is a partner at Stinson Morrison Hecker LLP in Washington, D.C., and an expert on commercial and financial services law. Barbara Clark is a former federal prosecutor and commercial litigator who is now a partner in the Commercial Law Institute in Greenwood, VA.

Together, the Clarks are co-authors of the definitive national treatise The Law of Secured Transactions Under the Uniform Commercial Code, now in an updated third edition, as well as several other treatises that are used by attorneys and financial institutions, and have been cited by many federal and state appellate courts. They also publish the authoritative Clarks’ Secured Transactions Monthly, a newsletter that identifies and critiques important developments, including new case law of interest, to those concerned with perfecting security interests.

In the Clarks’ view, a lot of what is contained in the 2010 Article 9 provisions will go a long way toward preventing many of the nightmare scenarios that financial institutions fear most, provided action is taken to comply with the new laws where they exist (and an awareness of where they have not yet been enacted is exercised).

The Perils of a Single Oversight

While all of the Article 9 amendments are important, the Clarks acknowledge that most attention has been given to the new provisions for naming individual debtors. “It’s crucial, absolutely crucial, that you get the debtor’s name right,” says Barkley Clark. “If you don’t, your security can become unperfected and if the debtor goes into bankruptcy, you have a big problem.”

Both the Clarks cite numerous cases in which courts have invalidated financing statements due to misspelled debtor names, resulting in substantial losses to financial institutions, and they note the volume of proceedings that occur in which “unsecured creditors and trustees in bankruptcy are saying ‘no, no, no, you didn’t get the individual debtor’s name right and so you lose everything’.”

“The cost of those adversary proceedings is just enormous,” Barkley Clark says.

Managing the Risks

Another cost that is hidden and few in the banking industry or legal profession want to talk about relates to lending lawyer malpractice suits that arise in relation to secured transactions that are invalidated due to compliance or other administrative errors. How often do such suits actually occur? “It’s hard to say,” Barkley Clark responds. “They get filed and they usually get settled. But certainly there have been a lot of cases. In fact, the bonding people for law firms say that one of their biggest concerns is secured lending and the failure to perfect.”

For lawyers, a malpractice suit is at the extreme end of the spectrum of nightmare scenarios that can develop when a security interest is challenged. In fact, there are a variety of risks to be managed, which is why the Clarks offer practical insights and strategies in their monthly newsletters as well as in the two-volume treatise on secured transactions. But a worry remains.

“These amendments are enormously complicated, and the subject area is incredibly complex,” says Barbara Clark. “Secured lenders need to pay attention to the transition rules, particularly the grace periods established by the grandfather clauses. The perfection requirements in the new law must be satisfied or lenders are going to lose their security interests.”

She adds: “Needless to say, this is a huge compliance challenge.”

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