The UCC search is an essential part of many commercial transactions, and with good reason. A party’s failure to conduct an adequate search, or perform sufficient due diligence into the status of the disclosed UCC records can carry harsh consequences. The potential cost of insufficient due diligence was demonstrated in the recent case of Western Mortgage & Realty Co. v. KeyBank National Association, 2015 WL 5611579 (D. Idaho Sept. 9, 2015).
Two Young brothers (the “Youngs”) owned farms and some related businesses. In 2000, the federal government sprayed a pesticide on acreage near the Youngs’ land. Due to drift, the pesticide severely damaged the Young’s crops. The Youngs and their businesses, including Nature’s Best Produce Inc. (“Nature’s Best”), sued the federal government and others over the incident, seeking damages of $117 million (the “Spraying Litigation”).
The Youngs ran into financial difficulties due to the loss of their crops. They had to borrow money from several lenders to keep their farm and businesses afloat until the Spraying Litigation was resolved. In 2004 and 2005, the Youngs took out several loans totaling $23.5 million from KeyBank National Association (the “Bank”). To secure those loans, the Youngs and Nature’s Best granted the Bank a security interest in any potential recovery from the Spraying Litigation. The Bank filed the appropriate financing statements to perfect its security interest.
In 2006, the Youngs decided to divide the ownership of their various businesses. As part of this reorganization, one of the brothers took full ownership of Nature’s Best and asked to be released personally from his obligations under the Bank’s loans. The Bank agreed to the release. However, instead of filing an amendment to delete the individual debtor, the Bank filed a termination statement to terminate the effectiveness of its financing statement.
At the same time, Western Mortgage & Realty Company (“Western”) began negotiations with the Youngs to acquire the business assets owned by each of the brothers. Western also began negotiating with the Bank to purchase the loans the Bank had made to the Youngs and Nature’s Best. In 2007, Western and the Bank entered into a Loan Sale Agreement (“LSA”) for those loans.
Among the assets covered by the LSA was the Bank’s security interest in the Spraying Litigation proceeds. The Bank warranted that it had good title to the assigned assets and that it had not previously assigned the assets covered by the LSA.
As part of the LSA transaction, Western was provided with a list of all the UCC financing statements related to the security interests being purchased. However, Western did not verify the status of any of the financing statements to confirm that they were still effective.
At the loan sales closing, the Bank and Western signed an “Assignment of Security Agreement, Control Agreement and Assignment of Commercial Tort Claims without Recourse and Without Warranty.” This document provided that the assignment of the security interests in the Spraying Litigation were without warranty and without recourse.
In 2010, Western’s attorney conducted a UCC search and discovered that the Bank had terminated its financing statement for the security interest in the Spraying Litigation proceeds. One of Western’s officers later testified that he assumed the termination statement had been filed in error. Western did not conduct any due diligence to determine whether there had been an error with the UCC record.
The Youngs and Nature’s Best settled the Spraying Litigation in 2011. Western received the bulk of the proceeds. However, Western claimed that approximately $4.5 million was improperly paid to Nature’s Best because the Bank had terminated the financing statement that perfected its security interest in Nature’s Best’s share of the proceeds. Consequently, Western brought suit against the Bank for a variety of contract claims and fraud.
With respect to the fraud claims, the court noted that the alleged fraud of the Bank misrepresenting the status of its security interest in Nature’s Best in the LSA had to have been first discovered by reasonable diligence sometime after April 9, 2010, three years before the complaint was filed. Otherwise, the claim would be barred by the three-year statute of limitations.
Western received a list of financing statements related to the LSA in 2006 or 2007. However, it never conducted any due diligence into the effectiveness of those records, even though Western’s officers knew how to search for that information. Instead, Western claimed it didn’t have to check the status of the UCC records because the Bank warranted they were all good.
The court did not accept Western’s arguments. Western had represented in the LSA that it had completed all necessary and appropriate due diligence. Western had the full list of financing statements in 2007 but didn’t check the status of the records. The court further observed that Western should not be allowed to turn a blind eye and not complete due diligence based on facts it was aware of as early as 2006.
The court concluded that Western knew or should have been able to learn before 2010 that the LSA contained misrepresentations or a fraudulent warranty. Consequently, the court ruled that Western’s claim of fraud based on the LSA was barred by the statute of limitations.
Western had also raised a fraudulent misrepresentation claim against the Bank. However, the court dismissed that count on the grounds that failure to conduct any due diligence regarding the termination eliminated any reliance on the Bank’s communications being justified.
The important thing to take away from this case is that a party to a commercial transaction cannot always rely solely on the other party’s representations when they relate to UCC records. It is essential that each party conduct its own search to find the relevant records and then perform reasonable due diligence to confirm the effectiveness of those disclosed records.
Paul Hodnefield is Associate General Counsel for CSC 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.