Thorough due diligence can help the secured party avoid later perfection and priority problems with a secured loan. In fact, the failure to conduct adequate due diligence may leave the secured party without access to equitable remedies, even if the debtor prevents the secured party from perfecting its security interest. That was the situation in a recent case, Fangio v. DivLend Equipment Leasing, LLC (In re Ajax Integrated, LLC), 2016 WL 1178350 (Bankr. N.D.N.Y. Apr. 4, 2016).
On May 20, 2013, DivLend Equipment Leasing, LLC (“DivLend”) loaned Ajax Integrated, LLC (the “Debtor”) $1.1 million pursuant to an equipment lease agreement (“Agreement”). DivLend acknowledged that this lease was actually a security interest.
To secure the obligation, the Debtor granted DivLend a security interest in 30 vehicles. The Agreement included a provision that required the Debtor to execute financing statements or other documents requested by DivLend to perfect its security interest.
Shortly after the loan closed and the debtor received the funds, DivLend proceeded to inquire of the New York Department of Motor Vehicles how to add a lienholder to the certificate of title. It took more than a month before DivLend compiled all the required Notice of Lien forms and sent them to the Debtor with a request that they be signed and returned.
The Debtor received the Notice of Lien forms for the vehicles and DivLend’s request on July 2, 2013. However, the Debtor never signed nor returned them to DivLend.
The Debtor made the first seven of the 36 monthly payments due to DivLend under the Agreement. However, the Debtor failed to make any payments after that.
DivLend later claimed that it made multiple attempts to get the Debtor to sign and return the Notice of Lien forms, although the Debtor denied that was the case. Nevertheless, in early 2014, DivLend retained legal counsel to try and collect the debt. In addition, DivLend asked its legal counsel to determine if the vehicle liens could be perfected without the Debtor’s signature.
Alas, DivLend’s collection efforts were for naught. On March 24, 2014, an involuntary bankrtupcy petition was filed against the Debtor. The vehicles that served as DivLend’s collateral were liquidated by order of the bankruptcy court and the proceeds held in escrow.
To determine which party had the right to the escrowed sale proceeds, the bankruptcy trustee brought an adversary action against DivLend. The trustee contended that DivLend failed to perfect its security interest in the vehicles. Therefore, DivLend’s security interest was subject to the trustee’s avoidance powers. The trustee then brought a motion for summary judgment on its claim.
DivLend argued that the Debtor’s refusal to sign the Notice of Lien forms prevented it from perfecting its security interest in the vehicles. Therefore the court should use its equitable powers to either impose an equitable lien or a constructive trust to defeat the trustee’s avoidance powers.
The court first addressed the equitable lien claim. According to authorities cited by the court, an equitable lien arises when there is proof of an intention to create a lien and the secured party is prevented from perfecting its security interest by an uncooperative debtor. The Debtor in this case was clearly uncooperative, so the court recognized an equitable lien in favor of DivLend in the vehicles.
Unfortunately for DivLend, the court went on to explain that UCC Article 9 treats an equitable lien as an unperfected security interest. Furthermore, under New York law, an unperfected security interest is subordinate to a lien creditor’s interest, which includes that of a bankruptcy trustee. Consequently, the court found that DivLend’s equitable lien was subordinate to the interest of the trustee.
The court then turned to DivLend’s claim that the court should impose a constructive trust in its favor on the escrowed vehicle sale proceeds. One of the elements that the party seeking the equitable remedy of a constructive trust must prove under New York law is unjust enrichment. However, unjust enrichment cannot be established when the party seeking the constructive trust had an adequate remedy at law.
In this case, the court determined that the Agreement did provide DivLend with an adequate remedy at law. DivLend had the right to require the debtor to sign the Notice of Lien forms prior to closing the loan. Yet, DivLend failed to conduct the due diligence necessary to determine how to perfect the vehicle liens until after it advanced the funds.
Even after the closing, the Agreement provided that the Debtor’s failure to timely sign the required documents constituted an event of default. DivLend could have then accelerated the outstanding payments, reclaimed the vehicles or otherwise availed itself to other adequate remedies at law. Yet, DivLend failed to take advantage of such remedies for several months.
Because DivLend had adequate remedies at law and failed to conduct adequate due diligence, the court refused to impose any equitable remedies. As a result, the court granted summary judgment in favor of the trustee.
The most important thing to take away from this case is that secured parties must conduct sufficient due diligence prior to closing, not just into the debtor’s affairs, but also into the steps it must take perfect its lien. Failure to do so may limit the remedies available to the secured party if the debtor defaults or files for bankruptcy, even if the debtor prevented the secured party from perfecting its security interest.
Paul Hodnefield is associate general counsel for Corporation Service Company® and a frequent speaker/writer on UCC due diligence issues. Please feel free to contact him with questions or comments at email@example.com or 800-927-9801, ext. 61730.