Daily Development for Wednesday, April 21, 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

BANKRUPTCY; AVOIDANCE; “PERFECTION:” Lien perfected by a UCC-1 filing that named the debtor only by his commonly used nickname rather than his proper name is NOT “perfected” for bankruptcy purposes, and cannot be avoided. Clarke v. Deere and Co. (In re Kinderknecht), 2004 Bankr. LEXIS 477 (10th Cir. BAP, April 16, 2004).

The debtor's correct legal name was "Terrance Joseph Kinderknecht." According to the court, "it is undisputed that the debtor is informally known as 'Terry.'" John Deere, the secured creditor who held security interests in two farm implements, filed the financing statements in the "appropriate place," listing the debtor as "Terry J. Kinderknecht."

The debtor then filed a Chapter 7 bankruptcy petition, and the trustee argued that John Deere's alleged security interests in the property were voidable under the revised UCC in effect in Kansas, because they were "seriously misleading" and ineffective. The bankruptcy court ruled that the financing statements were sufficient to perfect John Deere's security interests even though the financing statements contained the debtor's nickname.

The parties consented (for whatever reason) to having the appeal heard directly by the BAP for the 10th Circuit, bypassing the U.S. District Court.

Interestingly, the Kansas Secretary of State was granted leave to appear and file an amicus brief arguing reversal of the bankruptcy court's decision. According to the court, "Under Kansas law, the Secretary of State is charged with maintaining the data base used to track the filing of financing statements in Kansas, and with promulgating 'standard search logic' for conducting searches of that data base."

The Tenth Circuit BAP stated clearly that "[f]or a financing statement to be sufficient under Kansas law [to perfect its interest in the debtor's property], the secured creditor must list an individual debtor by his or her legal name, not a nickname."

The court, noting that notice of a secured interest in property is accomplished by searching the debtor's name, referred to Article 9 of the Kansas UCC (as revised and adopted in 2000), which states (in part): "the requirement that a financing statement provide the debtor's name is particularly important,"; that if a financing statement "fails sufficiently to provide the name of the debtor," it is "seriously misleading"; and that the revised Article 9 standard for names is meant to "clarify when a debtor's name is correct and when an incorrect name is insufficient."

The Tenth Circuit BAP noted that before the adoption of revised Article 9 (requiring a stricter standard for names), courts had struggled with the issue of whether debtor names in financing statements (especially trade names) were sufficient to put third parties on notice, with many courts applying a "reasonably diligent searcher" test.

The court acknowledged that the Kansas UCC does not provide any detail regarding the name of an individual debtor (it simply states that the "name of the debtor" should be used), which led the bankruptcy court to find that the use of the debtor's nickname was sufficient. But the Tenth Circuit BAP disagreed, reasoning that the revisions to Article 9 (which were enacted in part to clarify the sufficiency of the debtor's name in a financing statement), the reading of the section as a whole, and the intention of the drafters to eliminate "fact-intensive tests," required the conclusion that the debtor's exact legal name must be used in financing statements. The court further noted the importance of correctly naming the debtor in a financing statement "to facilitate the notice filing system and increase commercial certainty."

The court set forth the following additional "practical considerations" for requiring the debtor's correct legal name in financing statements: 1) to simplify the drafting of financing statements; 2) to "simplify the parameters" of UCC searches; 3) to avoid litigation regarding the "commonality or appropriateness" of the debtor's nickname, and whether a "reasonable searcher" would or should have discovered the name; and 4) to assure the accuracy of the creditor's search (which would not be "burdensome") for the debtor's name conducted by the creditor before taking a secured interest in the debtor's property.

The court also referred to the official Financing Statement Form set forth in the Kansas UCC statute, which (although not mandatory) specifically states that the preparer should include the "DEBTOR'S EXACT FULL LEGAL NAME" [caps in text of statute]. The court reasoned that this form, which was "meant to reduce error," evidenced "an intent to increase certainty in the filing of financing statements by requiring a debtor's legal name."

The court ruled that because of the foregoing considerations the financing statements did not sufficiently provide the name of the debtor and were "seriously misleading" under the Kansas UCC as a matter of law and, therefore, did not perfect its interest in the debtor's property. The court further ruled that although a financing statement would not be deemed seriously misleading if a search of UCC filings under the debtor's correct name, using the filing office's search logic, "would disclose a financing statement that fails sufficiently to provide the name of the debtor," this exception was inapplicable in this case because a search performed by John Deere's legal counsel in the Kansas UCC search systems (both official and unofficial) disclosed no matches for the debtor's correct legal name. This fact, the court stated, "underscores the need for a clear-cut method of searching a debtor's name in UCC filings."

Reporter’s Comment 1: As noted by the court in a footnote (which quoted from the brief filed by the Kansas Secretary of State), revised Article 9 "allows a searcher to rely on a single search conducted under the correct name of the debtor and penalizes filers only for errors that result in the nondisclosure of the financing statement in a search under the correct name."

Reporter’s Comment 2: Under former UCC Article 9, the test for whether a filing under a particular name was effective was whether the incorrect variation of the name was "seriously misleading." In 2001, revised Article 9 ("Revised Article 9") of the UCC was enacted into law in every state. (Revised Article 9 also was enacted into law in the District of Columbia; only Puerto Rico has not adopted Revised Article 9.) Revised Article 9 has significantly expanded the scope of property and transactions covered by Article 9, and has simplified and clarified the rules for creation, perfection, priority, and enforcement of a security interest. Under § 506(a) of Revised Article 9, a financing statement is not rendered ineffective by minor errors or omissions in the debtor's name (or collateral) unless they make the financing statement "seriously misleading." Although this standard is similar to the standard under former Article 9, the revision specifies that a name error is seriously mis leading unless a search under the correct name using the filing office's search logic would disclose the defective financing statement.

Under § 9-705 of Revised Article 9, an effective financing statement filed before July 1, 2001 continues to be effective until it lapses or until June 30, 2006, whichever occurs first. Thus, a "seriously misleading" filing (effective before July 1, 2001) remains effective until the earlier of June 30, 2006 or the date that it lapses by its terms. However, current search logic, which uses the stricter standard, will not find such "seriously misleading" but nonetheless effective filings. This poses a problem with respect to filings under former Article 9 and tax liens that remain effective under the former Article 9 standard, which are not yet subject to the Revised Article 9 standard, and it remains necessary to search for such seriously misleading filings. In addition, some courts are not applying the former Article 9 standard to financing statements entered into and effective before July 1, 2001, i.e., they are incorrectly applying the harsher Revised Article 9 standard. See, e.g ., In re Grabowski, 277 B.R. 388, 391 (Bankr. S.D. Ill. 2002) (dealing with incorrect legal description and finding that "exceedingly general" standard under Revised Article 9 was sufficient); Nazar v. Bucklin Nat'l Bank (In re Erwin); 2003 Bankr. LEXIS 692 (Bankr. D. Kansas, June 27, 2003), at *22 (holding that use of debtor's nickname was sufficient under Revised Article 9, but not mentioning standard under former Article 9).

Reporter’s Comment 3: Under former Article 9, human judgment was relevant because the courts determined whether an error was seriously misleading by asking whether a hypothetical "reasonably diligent searcher" could discover the erroneous filing. See, e.g., Knudson v. Dakota Bank and Trust Co. (In re Knudson), 929 F.2d 1280, 1283 (8th Cir. 1991) (holding that under former Article 9, financing statement was not seriously misleading if third-party searcher searching under debtor's correct name would be "reasonably likely" to find financing statement); Pearson v. Salina Coffee House, Inc., 831 F.2d 1531, 1531, 1534-36 (10th Cir. 1987) (employing "seriously misleading" and "reasonably prudent creditor" standards); Citizens Nat'l Bank & Trust Co. v. Star Automotive Warehouse, Inc. (In re Thriftway Auto Supply, Inc.), 39 F.3d 1193 (10th Cir. 1994), 1994 U.S. App. LEXIS 31831, at *7 (finding that under Kansas codification of UCC, use of a trade name substantially similar to legal name w as not seriously misleading). While the old manual search systems could tolerate certain variations in names, the computerized search logic now available and used by the state filing offices results in a precise standard that has little (if any) tolerance for variations. The focus is now solely on the degree of tolerance built into the computerized search logic utilized by the applicable filing office. The search logic could be very liberal, very strict, or somewhere in between. In 2001, the International Association of Corporate Administrators promulgated Model Administrative Rules ("MARS"), which created a standard rules for search logic that tend toward the "strict" end of the spectrum. The majority of states have now adopted some version of MARS, although many states have modified the rules in some respect (which has resulted in a great deal of inconsistency; furthermore, some states have not adopted any rule on search logic at all). In general, when a debtor's name has been modified by the applicable search logic, the search will produce a financing statement only if the names "exactly match." If there is no match, the security interest will (as demonstrated by the In re Kinderknecht case) be "seriously misleading," and therefore unperfected and susceptible to a "strong-arm" attack by a bankruptcy trustee or debtor-in-possession (see bankruptcy discussion below).

Reporter’s Comment 4: Although the MARS search logic ignores punctuation, accents, capitalization, spaces, and other "noise words," as well as words or abbreviations indicating the nature of the organization at the end of the name (e.g., "Corp.," "Co.," "Ltd.," and "Attorneys at Law"), it does not treat common variations, minor misspellings, or typographical errors as equivalent to the correct name. Under § 506(c) of Revised Article 9, an error in the debtor's name is fatal if a search under the correct name, using the filing office's standard search logic, would not disclose the financing statement. As the result of this stricter standard under revised Article 9 and the MARS search logic, there is an appreciably greater risk that failure of perfection will result due to an incorrect spelling of the debtor's name on the financing statement.

Reporter’s Comment 5:. Under § 9-516(d) of Revised Article 9 (as was the case under § 9-403(1) of former Article 9), an improperly rejected filing statement is nonetheless deemed to have been correctly filed and therefore effective. (Unlike former Article 9.) Section 9-516(d) of revised Article 9, however, provides that an improperly rejected filing statement is not effective against a later secured creditor that obtains a security interest for value in reasonable reliance on the absence of the financing statement from the records.) But there is no recourse against the State (or any state agency) for misindexed or misfiled financing statements against a debtor that are undiscoverable but nonetheless may be valid. Similarly, there is no way of ascertaining for certain from a search report that a termination of a financing statement was, in fact, properly authorized by the secured creditor.

Reporter’s Comment 6: The failure to correctly name the debtor in the financing statement can have catastrophic results if a bankruptcy petition is later filed by or against the debtor. 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 devastating "all or nothing" consequences if its interest is reclassified as an unsecured claim. Since most security interests are perfected by filing a financing statement, the standards for measuring compliance with the filing requirements will be critical in determining whether a security interest can be avoided. Section 544 of the Bankruptcy Code gives the DIP, or the bankruptcy trustee, the status of a creditor as of the date of the bankruptcy petition. Section 544(a) incorporates state law into the bankruptcy process and enables the trustee to exercise the rights of creditors under state law. This is the "strong arm" provision of § 544, which enables the trustee or DIP to void any transfer of an interest of the debtor in property that is avoidable under applicable state law. Section 544(
b) vests a bankruptcy trustee with the rights of a hypothetical lien creditor whose lien was perfected at the time of the filing of the bankruptcy petition. If another creditor who claims a lien against the applicable property has not properly perfected its lien as of the filing of the bankruptcy petition, the trustee or DIP can void that creditor's lien. That creditor then becomes merely a general creditor of the bankruptcy estate. The purpose of § 544 is to arm the trustee with sufficient powers to acquire and evaluate all of the property of the estate. The existence of this power, and the willingness and incentive of the trustee or DIP to wield it, makes it extremely important for secured lenders to ascertain that financing statements evidencing their security interests in borrowers' collateral are properly completed and filed to avoid subsequent perfection or priority challenges.

Reporter’s Comment 7:. See also Puget Sound Financial, L.L.C. v. Unisearch, Inc., 146 Wn.2d 428 (2002). It has long been a common practice for UCC search companies to insert express limitations (or even denials) of liability in their invoices resulting from mistakes in, or use of, the information supplied to customers. In this Washington State Supreme Court decision, the court upheld an express limitation of liability for damages to $25 contained in the defendant UCC search company's invoice. The court ruled that the limitation, which would prevent the plaintiff from recovering the losses it allegedly incurred as the result of the search company's failure to disclose a prior filing by another creditor (based on an error in the name of the debtor), was valid and enforceable.

Reporter’s Comment 8:. UCC insurance is now available that would provide both defense coverage and payment on a claim for damages under the circumstances similar to those occurring in the In re Kinderknecht and the Puget Sound Financial cases, supra. Some of the large land-title insurance companies now offer this product. These national insurers are experienced, stable and well capitalized, and are regulated by each of the state insurance departments in which they do business. They are therefore able to spread their exposure among a large pool of customers and charge relatively low premiums for the risk assumed (especially in comparison to the fees that would have to be charged by UCC search companies or individual states to assume such risk). Without such coverage - as clearly illustrated by the In re Kinderknecht and Puget Sound cases, supra - lenders would either have to self-insure such risks or else have their law firms assume them, neither of which is cost effective or resul ts in the extent of coverage provided by UCC insurance.

UCC insurance provides indemnity insurance for the attachment, priority, and perfection of the lender's security interest and transfers the risk of failing to properly create, perfect, or attain the desired priority of, the lender's security interest to the insurer. For a single premium, the lender who purchases a UCC insurance policy (and its counsel) obtains, in addition to an insurance policy that provides full legal-defense costs, the benefit of systems and procedures specifically designed to assure compliance with the Uniform Commercial Code (including legal and procedural changes thereto under Revised Article 9). Knowledgeable and experienced personnel provide a "second set of eyes" and engage in a dialog with both the lender and the lender's counsel. They provide assistance and advice during every step of the transaction, from ordering the policy to filing the required documentation in the proper location(s). The policy benefits include - at no additional cost - record sear ches (with respect to a single search on a single debtor), document preparation, filing, follow-up, and tracking (including timely notice of expiration dates) services, thereby providing peace of mind to lenders and their counsel.

In those circumstances where the filing of a UCC-1 financing statement would be required to perfect the lender's interest, the insurer would provide insurance that the filing was accomplished in the proper jurisdiction and maintained the priority insured in the policy -- and perhaps most important, provide at the insurer's cost a defense against any challenge (whether or not valid or justified) against the attachment, perfection, or priority of the lender's security interest.

As soon as there was a valid claim under the UCC insurance policy, the insurer would be obligated to pay. The fact that the lender might also have a claim against its attorney would be irrelevant and the insured would not be obligated to first pursue any rights it had against the attorney. The insurers will also, generally as a matter of course, waive any right of subrogation against the lender's attorney for indemnification for negligent acts by the attorney. (See also Lory v. Parsoff, 745 N.Y.S.2d 218 (2002), in which 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 for "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).

Editor’s Comment 1: The Reporter for this item was the extraordinarily productive Jack Murray of First American Title Insurance Company. Of course, the last comment above might be considered a violation of DIRT’s commercial message policy, even though it doesn’t name Jack’s employer, which offers this insurance. But the value of the contribution justifies any departure that might be perceived.

Editor’s Comment 2: It is interesting that the UCC drafters are so punctilious about the name requirement, since in other ways the UCC presents many challenges to the party seeking to discover whether there are liens against a debtor’s property. For instance, a filing need only be made in the home state of the debtor, which may be far away from the location of the asset in question. And, in a recent DD, Jack reported a case that concluded that an erroneous choice of home state, based upon the advice of the borrower’s counsel, was insufficient to satisfy the “perfection” test. Fleet National Bank v. Whippany Venture I case (In re The IT Group Inc.) (D. DE., March 16, 2004) (The DIRT DD for 4/9/04).

The editor has always found problematic the decisions permitting extremely broad reading of the description of the collateral. In many cases, the editor would not have concluded that the item in question had been adequately described, but the “real world” determiner - the court, felt otherwise.

The editor suspects that in fact most potential creditors, at least under past practice, have assumed that somewhere, someplace, there was a UCC filing arguably tying up any significant personal property of a debtor, and it was simply a business risk that, if push came to shove, their lien would prevail over the competition. Does the UCC resolve these issues? The prevalence of commercial bankruptcy filings, with the strongarm danger, certainly makes everything a lot more dicey.


Items reported here and in the ABA publications are for general information purposes only and should not be relied upon in the course of representation or in the forming of decisions in legal matters. The same is true of all commentary provided by contributors to the DIRT list. Accuracy of data and opinions expressed are the sole responsibility of the DIRT editor and are in no sense the publication of the ABA.


Parties posting messages to DIRT are posting to a source that is readily accessible by members of the general public, and should take that fact into account in evaluating confidentiality issues.

ABOUT DIRT:

DIRT is an internet discussion group for serious real estate professionals. Message volume varies, but commonly runs 5 15 messages per work day.

Daily Developments are posted every work day. To subscribe, send the message

subscribe Dirt [your name]

to

listserv@listserv.umkc.edu

To cancel your subscription, send the message signoff DIRT to the address:

listserv@listserv.umkc.edu

for information on other commands, send the message Help to the listserv address.

DIRT has an alternate, more extensive coverage that includes not only commercial and general real estate matters but also focuses specifically upon residential real estate matters. Because real estate brokers generally find this service more valuable, it is named “BrokerDIRT.” But residential specialist attorneys, title insurers, lenders and others interested in the residential market will want to subscribe to this alternative list. If you subscribe to BrokerDIRT, it is not necessary also to subscribe to DIRT, as BrokerDIRT carries all DIRT traffic in addition to the residential discussions.

To subscribe to BrokerDIRT, send the message

subscribe BrokerDIRT [your name]

to

listserv@listserv.umkc.edu

To cancel your subscription to BrokerDIRT, send the message signoff BrokerDIRT to the address:

listserv@listserv.umkc.edu

DIRT is a service of the American Bar Association Section on Real Property, Probate & Trust Law and the University of Missouri, Kansas City, School of Law. Daily Developments are copyrighted by Patrick A. Randolph, Jr., Professor of Law, UMKC School of Law, but Professor Randolph grants permission for copying or distribution of Daily Developments for educational purposes, including professional continuing education, provided that no charge is imposed for such distribution and that appropriate credit is given to Professor Randolph, DIRT, and its sponsors.

DIRT has a WebPage at:
http://cctr.umkc.edu/dept/dirt/






-----

To be removed from this mailing list, send an email message to listserv@listserv.umkc.edu with the text SIGNOFF FINANCE.

Please email manager@listserv.umkc.edu if you run into any problems.
See <http://www.umkc.edu/is/cs/listserv/unsubscribing.htm> for more information.