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.
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