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On Becoming a Secured Creditor

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By Michael C. Dennis, M.B.A., C.B.F.

Secured creditors enjoy an advantage over unsecured creditors

Any creditor, including a trade creditor can become a secured creditor. Secured creditors enjoy an advantage over unsecured creditors in the event that a customer files for bankruptcy protection - and even in cases in which the customer is delinquent. Why? Because in the event of default or bankruptcy the secured creditor is entitled to 'foreclose' on the assets pledged as collateral, or in the alternative a secured creditor is entitled to receive something of equal value.

The process of becoming a secured creditor is complex. Errors in 'perfecting' a security interest result in improper filings. An improper filing can result in a creditor having only the illusion of security. A creditor must "perfect" its security interest to make it enforceable against third parties. Perfection is done by filing, often with the Secretary of State. Some of the most common errors creditors make in trying to perfect a security interest include:

Failing to list the debtor's business name - and instead filing under their d.b.a.
Having significant discrepancies between the financing statement and the underlying security agreement [the contract].

Failing to file with the correct State or local government entity or entities
Using generic descriptions of collateral, such as "all assets." Instead, creditors should be more specific and use collateral descriptions commonly found UCC financing statements.

Failing to provide an adequate description of the collateral the debtor has pledged

Failing to amend the filing if the debtor moves, changes its name, or moves your collateral
Shipping goods prior to perfection of the security interest

Failing to file a continuation statement before the expiration of the security interest

Failure to include the appropriate fees with your application

Using the wrong UCC form[s] or out of date forms

Submitting documents without signatures

Filing a security interest in assets pledged by the debtor against which a previous, perfected security interest already exists. [In this scenario, the creditors has a second priority lien. The first priority creditor must be paid in full before the second priority creditor will receive proceeds from the sale of the pledged collateral.]

The Uniform Commercial Code says, in part, that a financing statement substantially complying with the filing requirements will be effective even though it may contain minor errors - provided those errors are not "seriously misleading." The trouble with this rule is the term "seriously misleading" is not clearly defined and therefore is subject to interpretation by a Court of law. Unfortunately, the consequences of even a minor spelling error found by a Court to result in a seriously misleading filing can mean the difference between having a fully secured claim against a debtor's assets, or having no security and standing in line with the rest of the debtor's unsecured claim hoping to receive something from the debtor in bankruptcy – even if it is only a few cents on the dollar.

The UCC has created a mechanism to identify which creditor's claim is superior to another creditor's security interest. As a rule, the creditor that properly files the lien first has the superior claim. In order to record a security interest in the property of the debtor, the creditor has to file a document with a particular State official in the State in which the asset pledged as collateral is located. That document filed is called a financing statement. A financing statement is intended to put other creditors, who may be offered the same asset(s) as collateral in the future, on notice that a perfected lien or security interest already exists on the assets in question. Creditors should be reluctant to rely on statements made by the debtor that the asset or assets being pledged are unencumbered by previously filed and perfected security interests. Creditors usually arrange to have the public records examined to determine if prior liens exist.

There are several pitfalls to using financing statements, including these:

The process of perfecting a security interest can be different in each State.

Creditors cannot perfect a security interest in inventory after it has already shipped. Therefore, creditors must hold orders until this process is complete if they want to have a perfected security interest in an asset of a debtor company. This can create problems between the customer, the credit department and the creditor's salesperson.

Debtors are sometimes reluctant to allow trade creditors to become secured creditors. In some cases, debtors are prohibited under bank loan agreements from offering assets as collateral to trade creditors. In other instances, debtor companies flatly refuse to pledge assets of the company to creditors. Two of the most frequently stated reasons are that doing so would send the wrong message to other creditors, and that if the debtor does this for one creditor they may have to offer this to all major trade creditors.

Credit professionals should also be aware that the requirements for accuracy in filing a financing statement are rigorous. For example, filing a statement listing the Debtor Company as ACD Bread Company would probably not stand up against a challenge from a creditor who recorded a financing statement later, but correctly listed the debtor company name as the ABC Bread Company. The second creditor to file would be correct in relying on the fact that no one had perfected a security interest in the assets of 'ABC Bread Company.' While a search of the public records would show a filing for ACD Bread Company, a creditor is not required to check the public filings for every single possible misspelling of the customer name. In this scenario, under the UCC, the rights of the second creditor to hold a security interest in the assets of the debtor would be superior to those of the first creditor.

Article 9 of the Uniform Commercial Code (UCC) governs the perfection and priority of competing creditors on personal property. The purpose of Article 9 is two-fold:

It establishes a scheme that provides maximum protection to the secured creditor who has followed its provisions; and
it provides a predictable system of creditor priorities.†

To obtain a valid and enforceable Purchase Money Security Interest [PMSI] in the goods sold by the debtor, vendors must comply with a multi-step process. The vendor's PMSI will receive a higher priority than a pre-existing inventory-secured creditor's lien only if (l) the PMSI is already perfected at the time the debtor receives possession of the merchandise (there is no 10-day grace period for perfection as there is with other types of collateral), and (2) the vendor seeking the PMSI gives written notice to any other pre-existing creditor with a perfected security interest in the debtor's inventory.†

The vendor will need to check with the applicable filing office or offices to determine the creditors that have filed financing statements covering inventory and after-acquired property in order to provide the required advanced written notice to these pre-existing secured creditors. The written notice to the secured creditor with inventory as a collateralized asset must state that it is taking a Purchase Money Security Interest in merchandise, and it describe the type of merchandise. The notice must be sent and must be received by the secured creditor or secured creditors before the debtor takes possession of the merchandise for the PMSI to be enforceable. Some cautions to consider when evaluating the PMSI option include:

If the vendor fails to perfect before the debtor receives possession of the collateral, the vendor's priority is governed by the "first to file" rule. This means that the inventory-secured creditor will have the first priority claim in the vendor's inventory.

The reason the UCC requires vendors to give notice to inventory-secured creditors to perfect their PMSI is to protect inventory-secured creditors against fraudulent debtors who might pledge the same asset[s] as collateral first to one or more creditors and then to companies interested in extending credit only in exchange for a perfected PMSI.

Republished in the April 2004 Edition of NACM's
"Business Credit Magazine"

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