Daily Development for Friday, April 9, 2004
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin Kansas City, Missouri dirt@umkc.edu

PERSONAL PROPERTY; ARTICLE NINE; APPLICATION TO REAL ESTATE INTERESTS; PROCEEDS OF SALE CONTRACT: Secured creditor's security interest in proceeds of a real estate sale contract is not an "interest in or lien on real estate" of the kind specifically excluded from the scope of Article 9 of the UCC, but was in the nature of a general intangible interest. Consequently, it can be “perfected” only by filing in the home state of the debtor, and if the creditor files in the wrong state because it was misled by the debtor as to the proper address, the creditor’s interest is still not perfected.

In Fleet National Bank v. Whippany Venture I case (In re The IT Group Inc.) (D. DE., March 16, 2004)

The court also ruled that the debtor had failed to properly perfect its interest in the sale contract, and that "good faith reliance" on the address provided by the debtor is no defense to a failure to file a financing statement in the proper jurisdiction.

Debtor entered into a contract to sell approximately 35 acres of real property in New Jersey to Sterling. In connection with the sale, Debtor obtained a loan from Fleet, which was evidenced by a Line of Credit Note. Debtor also executed an Assignment Agreement (which was recorded in New Jersey), whereby Debtor assigned its rights under the Sterling sale contract, including all sales proceeds. Before the sale was consummated, Debtor filed bankruptcy. The bankruptcy court subsequently approved and conducted an auction of all of Debtor's assets, subject to an escrow of funds sufficient to satisfy Fleet's claim. Debtor assumed the Sterling sale contract and assigned its rights thereunder to the successful bidder at the auction. Fleet then filed an action for "Determination and Payment of Secured Claim" and sought summary judgment.

The bankruptcy court denied Fleet's request for relief, ruling that Fleet did not have a perfected security interest in the Sterling sale contract. As a threshold matter, the court concluded that Article 9 of the UCC applied to Fleet's interest in the Sterling sale contract. (The court quoted sec. 9-104(j) of the U.C.C., which "excludes the creation or transfer of an interest in or lien on real property.") The court noted that Fleet had acknowledged at the bankruptcy court hearing that its interest was not an interest in real property but an interest in the sale proceeds, and was thereby correctly characterized as an intangible interest under the UCC.

The district court agreed with the bankruptcy court that Fleet failed to perfect its security interest as required by Article 9-103(3)(b) of the UCC, which governs the perfection of a security interest in general intangibles and provides, in pertinent part, "the law (including the conflict of law rules) of the jurisdiction in which the debtor is located governs the perfection ... or nonperfection of the security interest." The court noted that the location of a debtor maintaining multiple places of business is the debtor's chief executive office. (As the comments to the U.C.C. explain, the term "chief executive office" means the place from which the debtor manages its business operations). The court further noted that this analysis applied under both Colorado and New Jersey law. The court concluded, based on the facts in this case, that Fleet was required to perfect its security interest in Colorado, because the debtor's chief executive office was in that state. In reaching this conclusion, the court stated that "the Bankruptcy Court correctly considered the manner in which Whippany managed its business and examined this issue from the perspective of where a creditor would normally look for credit information on the debtor. (citation omitted). The Court agrees with the Bankruptcy Court's conclusion, in light of the factual circumstances in this case, that Fleet was required to file its financing statement in Colorado to perfect its security interest." Furthermore, according to the district court, "the question is not where the main part or main asset of the debtor's business is located, but rather, from where the main part of the debtor's business is managed. . . . [H]ere, the main business of the debtor is the management of real estate."

The district court held that a secured creditor is not excused from the filing requirements for perfecting a security interest as a result of the creditor's error in filing its financing statement in the wrong jurisdiction, even where that creditor's error was based on its good faith reliance on the address provided by the debtor. The court ruled that public policy supports the conclusion that the correct location for filing should not turn on the private representations of the parties, but on the public and objective information available to all creditors concerning where the debtor manages its business. At the time of the transaction, counsel for the debtor issued an opinion letter directed to Summit Bank, the predecessor in interest to Fleet, stating (erroneously) that perfection of the security interest required filing of the requisite statements with the Office of the Department of the Treasury of New Jersey (where the collateral was located).

Fleet filed its financing statements in New Jersey, consistent with the opinion letter rendered by the debtor's counsel. The district court noted that, "[w]ith respect to the opinion letter specifically, Fleet contends that the Bankruptcy Court's decision will have a chilling effect on commercial lending practices, because lenders will be less likely to make loans if they cannot rely upon the four corners of an opinion letter." The debtor responded that "Fleet cannot perfect its interest through an opinion letter, and the opinion letter never gave an opinion on perfection of interests." As to the relevance of reliance on the opinion letter, the district court agreed with the Bankruptcy Court that the opinion letter was not dispositive on the issue of location for filing. According to the district court, "As courts have recognized, a secured creditor is not excused from the filing requirements for perfecting a security interest as a result of the creditor's error in filing its fina ncing statement in the wrong jurisdiction, even where that creditor's error was based on its good faith reliance on the address provided by the debtor."

Reporters’ Comment 1: This was a well-reasoned decision, and perhaps highlights the efficacy of UCC policies offered by some of the major title companies, which would have caught this issue in a heartbeat and saved the lender a heap of trouble (and expense). One also would suspect that, as a result of this decision, the debtor's counsel is ripe for a malpractice action.

As the Fleet case clearly demonstrates, reliance on an attorney's opinion with respect to UCC filings can be risky to the lender -- not to mention the attorney giving the opinion. The goal of every bankruptcy trustee is to obtain and preserve cash and assets, from all available sources, for the benefit of the estate and its general creditors and to pay the expenses of administering the estate. The trustee therefore will pay a great deal of attention to the sufficiency and validity of any security interest claimed against the debtor's collateral, and will challenge the perfection and lien position of such interest wherever possible.

For a lender that is relying on the protection provided by its security interest in the debtor's collateral, a successful challenge to the perfection or priority of such interest could have (as occurred in the Fleet case) devastating "all or nothing" consequences if its interest is disallowed or reclassified as an unsecured claim. The debtor's (or lender's) counsel also faces severe consequences if the bankruptcy court determines that the lender's security interest is defective or ineffective - including malpractice liability, damage to the lawyer's (and his or her law firm's) reputation, and loss of future clients and income. Many attorneys concentrate their efforts for their lender-clients on the negotiation and drafting of the legal documents that evidence and govern the financing of the debt secured by the debtor's collateral, and delegate to lower-level associates and paralegals such mundane and "ministerial" (and less lucrative) tasks as preparing, reviewing and filing UCC financing statements. The failure, however, to correctly perform these "minor" tasks (or, perhaps, the failure to perform such tasks at all) often results in the most significant - and costly - malpractice exposure faced by attorneys in commercial financing transactions.

The unfortunate fact is that an attorney can delegate authority, but not responsibility, for such actions by subordinates. See, e.g., Lory v. Parsoff, 745 N.Y.S.2d 218 (2002), where the New York appellate court affirmed the lower court's ruling that the plaintiff, a former client of the defendant Parsoff and his law firm, was entitled to summary judgment against Parsoff and the firm, based on per se legal malpractice, because of their failure to file a UCC-1 financing statement that would have perfected the plaintiff's security interest in the assets of an electronics company sold by the plaintiff (which subsequently filed for bankruptcy). The Lory v. Parsoff case is a legal-malpractice case and would not, per se, invoke any of the insuring clauses of the UCC insurance policies offered by some of the major title insurers. The lender's claim would be against its attorney's malpractice insurer. Part of the outsourcing services provided by a UCC insurance provider, however, is the r eview (or, "second set of eyes") function provided in connection with issuance of the policy. The insurer will have reviewed the Security Agreement, the UCC-1 financing statement and other related and relevant documents for attachment, sufficiency, enforceability, and priority of the lender's security interest, and will have ascertained the correct filing location.

Although many large institutional lenders have language in their mortgages (note that the Fleet case did not involve a mortgage) covering proceeds from sales contracts as part of the collateral, it is not that uncommon to see mortgage lenders fail to include in their mortgages a grant of a security interest in agreements relating to or proceeds arising from the sale or exchange of the realty, or for there to be no separate security agreement covering proceeds of realty (which, due to equitable conversion or other theories, are properly classified as personalty).

Lenders also commonly fail to include such protections in documentation in workout scenarios where executory sales agreements respecting the distressed property have been executed but haven't as yet closed. Lenders have been fortunate that other creditors have not raised the issue of perfection in the agreements or proceeds thereof in these settings. Many times an "off-the-shelf" form is used in the belief that it covers the basics and attorneys don't have time or inclination to check for or think about issues like these, which at the drafting phase aren't on anyone's radar.

Reporters’ Comment 3: Section 9-109(d)(11) of Revised Article 9 provides that (with certain limited exceptions) Article 9 does not apply to "the creation or transfer of an interest in or lien on real property." Section 9-102 (a)(42) of Article 9 defines "general intangibles" as "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." The term also includes "payment intangibles (i.e., general intangibles under which the account debtor's principal obligation is monetary) and software. In essence, "general intangibles" is the residual category of personal property that is not included in the other defined types of collateral. A security interest in a general intangible is perfected by filing of a financing statement in the applicable state's UCC records. Se
e § 9-310 of Revised Article 9.

Reporters’ Comment 4: : The issue of "realty vs. personalty" can arise if an individual or entity acquires an option to purchase real estate (i.e., an option unrelated to any other existing interest in the real estate). That individual or entity may be deemed by a court not to have acquired an interest in the real property that is the subject of the option. At least one court has held that the optionee can only obtain an interest in the real estate at such time as the option is exercised according to its terms, and therefore any security interest granted in an unexercised option to purchase would be deemed to be personalty rather than realty and would be governed by Revised Article 9. See In re Merten, 164 B.R. 641 (Bankr. S.D. Cal. 1994).

Reporters’ Comment 5:: The general rule under Revised Article 9 is that the law applicable to the perfection of security interests is the law of the debtor's location, which is generally the debtor's place of business (or, if the debtor is an individual, the individual's principal residence) unless the debtor is a "registered entity," such as a corporation, limited liability company, or limited partnership, in which case the location of the debtor is the state in which it was organized. Under Revised Article 9, most financing statements are filed in a single state-wide office, such as the Secretary of State's office; there is no longer any need to file a financing statement in the local (county) office for collateral that is not related to real estate.

The Reporters for this item were Cheryl Kelly of Thompson, Coburn in St. Louis and Jack Murray of First American Title Insurance in Chicago.

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