By Paul Hodnefield, Esq.

Most commercial transactions require some level of due diligence by the parties involved. That frequently includes a search for financing statements filed under Article 9 of the Uniform Commercial Code (“UCC”). Due diligence, however necessary, is an expense that the parties may seek to minimize by cutting corners. Unfortunately, shortcuts can be extremely risky in the UCC search process.

One of the riskiest yet common shortcuts is for the searcher to omit terminated UCC records from the search results. This article explains why this practice is risky and offers suggestions for avoiding potential pitfalls when dealing with terminated financing statements that appear on search results.

The UCC Search Termination Trap

Those who search the UCC records sometimes insist on omitting terminated financing statements from the search results. This practice is rooted in the belief that terminated financing statements are not effective. Therefore, it does not make sense to spend the time and expense required to review them. The Roswell case in 2010 offered support for this position.[1] The court stated in dicta that “potential creditors must be able to rely on termination statements filed in the public record, “even if they were filed in error or without authorization” (emphasis added).

Despite Roswell, omitting termination statements from search results is an extremely risky practice. Other courts have since thoroughly discredited the Roswell dicta and held that financing statements may remain effective following the filing of a termination statement in certain situations.[2]

Those who rely on the public record alone could find their resulting security interest subordinate to one of those “terminated” financing statements. The effect of a termination statement is based not on whether it was filed, but on the filer’s authority.

Effectiveness of a Filed Termination Statement

Upon the filing of a termination statement, the financing statement to which it relates ceases to be effective. However, that general rule is limited by the operation of UCC § 9-510(a). Like most other amendments, a termination statement is only effective under § 9-510(a) to the extent that the record was filed by a party that may file it under § 9-509.

A person may file a termination statement under § 9-509(d) only if the secured party of record authorizes the filing.[3] Thus, a termination statement is only effective if it was authorized by the secured party of record. An unauthorized termination statement is not effective.

Filing offices cannot possibly determine the filer’s authority for any UCC record. Moreover, filing offices play a ministerial role in the filing process under Article 9. They must file any record that meets the statutory requirements without any reference to the filer’s authority. Consequently, a searcher cannot safely assume that a termination statement is effective simply because the filing office accepted and indexed the record.

The Filer’s Authority

The burden of determining whether a termination statement was authorized by the correct party falls solely on those who search the UCC records. That is no simple task. The authority of the party that filed a termination statement cannot be determined from the public record. Nothing in Article 9 requires an indication of the filer’s authority. Even the name of the secured party that authorized the amendment field in Item 9 of the UCC3 Amendment form is not a reliable indication of authority. That field is not even required by Article 9 either for sufficiency of the record or to avoid rejection by the filing office.[4]

Unauthorized termination statements regularly show up on UCC searches. Frequently, these are the result of a simple clerical error. The initial financing statement file number is the only data the filing offices use to associate the termination statement with a particular record. If that file number is incorrect and corresponds to an unrelated active record, the filing office will nevertheless index it with that record. That unrelated financing statement will show a filed termination on later search results, yet will remain fully effective because the secured party did not authorize the filing.

There are many other circumstances that can result in the filing of an unauthorized termination statement. For example, the new lender in a refinance transaction may assume that it is entitled to file a termination statement once it pays off the outstanding balance. Article 9, however, grants no such authority. Moreover, there may be good reasons why the secured party wants the financing statement to remain in place.

Occasionally, a debtor will file a fraudulent termination statement without the secured party’s knowledge before selling the collateral or using it to secure new financing. In that case, the financing statement will remain effective. Fortunately, those situations are rare, but they do have the potential to mislead a searcher.

Even a termination statement filed with the secured party’s authorization may not be sufficient to terminate the effectiveness of the financing statement to which it relates. The reason is § 9-510(b), which provides that an amendment filed by one secured party of record does not affect the financing statement with respect to another secured party of record. Again, Article 9 does not require the termination statement to indicate the filer’s authority. A filed termination statement may be approved by more than one secured party, but it is not required to indicate this fact.

The scope of authority for the termination statement simply cannot be determined from the record itself. In fact, the filer’s authority is not even determined under Article 9. It is an issue determined by the court, typically based on the state law of agency.

Search Best Practices

What all this means for those who search the UCC records is that an allegedly terminated financing statement may remain fully effective. To reliably establish the filer’s authority and, therefore, the effect of the termination statement on the record, the searcher must look beyond the public record. As noted in the official comments to § 9-502: “Further inquiry of the parties concerned will be necessary to disclose the full state of affairs.”

Interested parties can manage the risks arising from purportedly terminated financing statements through sound due diligence practices. As a first step, anyone conducting a UCC search must treat all terminated but unlapsed financing statements as effective until further investigation confirms the status of each record.

The only way to know with certainty whether a financing statement was effectively terminated is for the interested party to contact the secured parties involved and verify that each did in fact authorize the filing of the termination statements. That can be a costly and time-consuming proposition. Therefore, the interested party will need to balance the costs of sufficient due diligence against the risks involved for a particular transaction. The amount a lender is willing to spend on due diligence will depend on the facts and circumstances of the particular transaction.

Conclusion

Assuming that the filing of a termination statement alone renders a financing statement ineffective is a risky practice. Until further investigation confirms otherwise, those who search the UCC records must assume that all unlapsed financing statements are effective, including those that include a filed termination statement.

Paul Hodnefield is associate general counsel for Corporation Service Company (CSC) and a frequent speaker/writer on UCC due diligence issues. Please feel free to contact him with questions or comments at phodnefi@cscinfo.com or 800-927-9801, ext. 62375.



[1] Roswell Capital Partners v. Alternative Construction Technologies, 2010 U.S. Dist. LEXIS 90695 (S.D. NY, Sept. 1, 2010)

[2] See, e.g., In re: Motors Liquidation Company, 2013 Bankr. LEXIS 814 (Bankr. S.D.N.Y. March 1, 2013)(a termination statement was not effective where the secured party did not authorize the filing).

[3] The debtor also has the power to authorize the filing of a termination statement if it follows the statutory steps set forth in § 9-513. Termination statements filed by the debtor are rare and outside the scope of this article.

[4] A few filing offices will reject a record that does not provide the information in Item 9 and some require it to exactly match the name of a secured party of record. However, the filing offices generally lack statutory authority for this requirement. Most filing offices will accept an amendment with no information in Item 9.

Avoiding The UCC Search Termination Trap