On rare occasions, a security interest perfection or priority question may arise for which UCC Article 9 provides no answer. When that occurs, the courts must resolve the issue based on other factors. That situation occurred in a recent case, Pet Food Experts, Inc. v. Alpha Nutrition, Inc., 2016 R.I. Super. LEXIS 58 (R.I. Sup. Ct. May 10, 2016).
In September, 2014, Alpha Nutrition, Inc. (“Alpha”) borrowed $700,000 from Pet Food Experts, Inc. (“PFE”). To secure the obligation, Alpha granted PFE a security interest in substantially all of Alpha’s current and after-acquired assets, including “equipment.” PFE promptly filed a UCC1 Financing Statement with the appropriate filing office to perfect its security interest.
Several months later, Alpha purchased a new Cadillac Escalade (the “Vehicle”). Alpha financed the purchase through Greenwood Credit Union (“Greenwood”). Alpha executed the loan and security agreement for the Vehicle on March 6, 2015. The following day, March 7, 2016, a certificate of title (the “Title”) was issued for the Vehicle. Significantly, the Title listed Alpha as the owner, but it did not list any lienholders.
Alpha later defaulted on the obligation to PFE. PFE filed suit against Alpha and filed a motion seeking pre-judgment attachment against Alpha’s assets. Alpha failed to respond and the court entered a default judgment against it.
PFE then filed a motion for a writ of replevin, claiming that it was entitled to repossess and liquidate the Vehicle. Greenwood objected to the motion on the grounds that it maintained a security interest in the Vehicle superior to that of PFE. To address the motion, the court had to determine which party held the priority interest in the Vehicle.
As a threshold issue, the court determined neither PFE nor Greenwood had perfected its security interest. PFE did file a financing statement, but state certificate of title law governs perfection of a security interest in a motor vehicle. PFE never applied to have its security interest listed on the Title in compliance with the certificate of title law. Likewise, Greenwood also failed to have its security interest listed on the Title.
Ordinarily, a perfected security interest takes priority over an unperfected security interest. However, in this case neither security interest was perfected. Under Article 9, the first security interest to attach or become effective has priority between unperfected secured creditors. Consequently, the court turned to when the security interests at issue attached to the Vehicle.
A security interest attaches to collateral when three requisites are met: first, the secured party must give value; second, the debtor must have rights in the collateral; and, finally there must be an executed security agreement that describes the collateral.
The court determined that PFE had given value and both PFE and Alpha had executed a security agreement that described the collateral. Therefore, the security interest attached to the vehicle at the time Alpha gained rights in the collateral. According to the court, the debtor gained rights in the collateral when Alpha executed the purchase contract on March 7, 2016 and PFE’s security interest attached at that time.
Next, the court had to decide when Greenwood’s security interest attached to the Vehicle. Like PFE, Greenwood and Alpha had entered into a security agreement that sufficiently described the collateral. Greenwood had given value to Alpha when it agreed to extend credit on March 6, 2015. However, also like PFE, Greenwood’s security interest didn’t attach to the Vehicle until Alpha signed the purchase contract on March 7, 2016. As a result, the court concluded that the security interests of PFE and Greenwood attached to the Vehicle simultaneously.
The court noted that Article 9 does not provide a mechanism to determine priority between two unperfected secured creditors with security interests that simultaneously attached to the same collateral. To make the priority determination in such circumstances, the court decided it was appropriate to exercise its equitable powers.
There were two of the factors of particular note that influenced the court’s equitable inquiry. One was that PFE at least conducted due diligence and took all actions necessary to perfect its security interest in the original collateral. Greenwood, however, did not exercise due diligence because it failed to perfect its security interest or search for other possible creditors. The court found it inequitable to reward such inaction by Greenwood. Instead, the court found it equitable to give priority to PFE because it exercised the most diligence in complying with Article 9.
The other factor with significant influence on the court’s decision was that PFE had no way of knowing that Alpha purchased the Vehicle, which required PFE to apply so it could be listed as lienholder on the Title. Moreover, Greenwood was the first to know and could have been the first to perfect its claim. For that reason, the court determined that it was equitable to give PFE the priority interest in the vehicle.
Based on its analysis, the court determined that PFE satisfied the requirements for a writ of replevin. Therefore, the court granted PFE’s motion.
The takeaway from this case is that the outcome of a perfection or priority dispute may turn on the court’s perception of fairness when Article 9 is silent on the particular issue. When that occurs, a secured party that can demonstrate it made commercially reasonable efforts to comply with the applicable Article 9 requirements is likely to be in a better position than a less diligent secured party.
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 firstname.lastname@example.org or 800-927-9801, ext. 61730.