Manage the Risks of Post-Closing Changes
A secured party’s ongoing perfection is not guaranteed after the filing of a financing statement. A number of events can occur post-closing that can threaten perfection or priority unless the secured party takes immediate action within strict deadlines, even if it was unaware of the change.
This recorded presentation helps secured parties and their legal counsel manage the risks of post-closing changes to debtor or collateral information that could threaten either the perfection or priority of the security interest. Attendees will learn the essential rules for dealing with post-closing changes, including:
- Which post-closing events require prompt action by the secured party.
- How to identify the relevant post-closing events.
- The applicable deadlines for action following different post-closing events.
- What actions a secured party must take to remain perfected and retain priority.
Disclaimer: Please be advised that this recorded webinar has been edited from its original format, which may have included a product demo. To set up a live demo or to request more information, please complete the form to the right, or if you are currently not on CSC Global, there is a link to the website in the description of this video. Thank you.
Annie: Hello, everyone, and welcome to today's webinar, "Protecting Perfection from Post-Closing Changes." My name is Annie Triboletti, and I will be your moderator.
Joining us today is Paul Hodnefield. Paul is the Associate General Counsel for CSC, where he is responsible for advising the company regarding real estate reporting, notary, Uniform Commercial Code, and other public records transaction services. And with that, let's welcome Paul.
Paul: Thank you, Annie. Yeah, in my role at CSC, it's my responsibility to be the subject matter resource for all things related to the search and filing process for UCC records. And in doing that, I monitor case law. I monitor legislation. I get involved with filing offices in troubleshooting and things like that. And so, needless to say, I get a lot of information from a lot of different directions, and one of the funnest parts of my job is when I can share that information with our customers.
And today, what I'm going to share is on a topic that generates a lot of questions that I receive, and that has to do with protecting perfection from post-closing changes. I mean, really, what is this all about?
Well, prior to perfecting a security interest, lenders and legal counsel make great efforts to do everything right. They conduct thorough due diligence, verify the accuracy of their financing statements, and are very careful to ensure the record is properly filed in the correct jurisdiction. Then when the deal is closed and the security interest is perfected, sometimes a secured party might think that it's fully protected if the debtor later defaults or files for bankruptcy.
Alas, this isn't always the case. A secured party's risk does not end when the deal closes and the security interest is perfected. No matter how diligent the filer was before closing, certain post-filing changes involving the debtor or the collateral could place the secured party's perfection and priority at risk.
Now, not every post-closing change requires the secured party to take action or creates risk for the secured party. Many types of changes have no effect on the perfection or priority of the security interest at all.
However, when certain critical changes occur, the secured party must take the actions specified in Article 9 and do so within a short statutory deadline. The secured party's failure to take the required action may lead to harsh results.Therefore, it is important that lenders and legal counsel know, first of all, how to identify critical post-closing events, but also what actions they need to take in response to those.
Now, that might seem easy enough, but post-closing changes can raise some of the most complex filing issues that arise under Article 9. The rules can be confusing and counterintuitive. Moreover, it can be difficult to identify all the rules that apply to a particular change event. Those rules are not always neatly organized together within the code. They can be dispersed throughout Article 9.
Despite this complexity, Article 9 requires secured parties to strictly comply with the statutory requirements when critical post-closing changes occur. Substantial compliance isn't enough. The secured party cannot even claim lack of knowledge as an excuse for non-compliance following critical post-closing changes.
The stakes are very high, and the complexity of the issues can be challenging. This leads to a lot of questions about the process of dealing with post-closing changes. So this program is intended to help lenders and legal counsel better understand post-closing change issues and how to manage the risk associated with these changes.
What I plan to do today is begin with a brief introduction to the Article 9 filing system to offer a better understanding of why post-filing changes are so important. Then I'll move on and address the different types of post-closing changes of greatest concern, namely a debtor name change. What happens when a new debtor becomes bound by the security agreement? Sometimes it's called the double debtor issue. A change to the governing law or a transfer of collateral to a third party.
For each of these events, I will focus on two separate issues — the effect of the event on collateral existing at the time the event occurs and then also the impact of the event on after-acquired collateral. I'll explain what actions the secured party needs to take and the applicable deadlines. And at the end of the presentation, I'll offer some suggestions for how secured parties can track at least some of the post-closing changes that are of concern. And, of course, there will be time for questions at the end.
So, without any further ado, we'll go ahead and get started. First, when it comes to the introduction, I want to begin by noting that, you know, we're talking about security interests here. And a security interest is an interest in property. It's a lien, a consensual lien that arises by contract between the debtor and the secured party.
Now, because the debtor is granting the secured party rights in the collateral, it's really affecting the interests that third parties might have in the same assets. For example, an unsecured creditor may want to, I guess, enforce its claims against the assets of the debtor, and if those assets aren't available, that means that security agreement has impacted that third party.
As a result, the courts generally don't enforce security interests between the debtor and secured party unless the secured party has done what's called perfect the security interest. Perfection is merely a way of providing notice to third parties of the claim security interest. And this enables the third parties to protect themselves so they can be aware before they enter into a transaction with the debtor that whatever assets the debtor has already pledged are not available to satisfy that third-party's claims.
Now, in most cases, perfection is accomplished by filing a financing statement in the designated repository, typically the secretary of state at least for central filing, and that gives third parties a place where they know they can go and look and identify claims against a debtor's collateral.
Another important concept to understand is that the UCC is a notice filing system. All a UCC record does is indicate that a security interest may exist. It is not a lien in and of itself. The financing statement that's filed to perfect a security interest is simply intended to alert third parties of the claim security interest so that the secured parties can protect themselves.
As I said, UCC records are not liens. They're not security interests in and of themselves. They are not enforceable documents. Nobody can sue to enforce a financing statement, for example. They're just notices.
Now, these notices are essential, though. They are there to protect third parties. And the impact of a post-closing or post-filing change to information contained in the financing statement is that it may prevent the third party from finding the record and therefore being able to protect itself in further transactions with the debtor. So that's why the changes are really so important is because if the information changes somehow, the result can be that the lien becomes a hidden lien in full or at least partially, and as a result, third parties are placed at risk. The whole filing system exists to protect third parties, and therefore certain types of changes anyway are very serious under Article 9 and require action by the secured party.
Now, if there is a critical post-closing change, well, the effect on the secured party, if it takes no action, is that the perfection of the security interest may be fully or partially at risk with a corresponding impact on the ability of the secured party to enforce its security interest. It may lose perfection in whole or in part. It may lose priority in whole or in part.
As I mentioned earlier, these are some of the most complex issues that can arise under Article 9. The rules are not necessarily located in one place, and, in fact, it's so complex that the courts oftentimes struggle with these issues in trying to resolve post-closing change matters.
This wouldn't be so bad maybe, except that the UCC and the courts are also unforgiving of secured parties that fail to comply with the rules following a post-closing change. Remember, the whole system is designed to protect the rights of third parties, and if something changes, the third party can't protect itself, that's a problem.
And Article 9 allocates the risk of these changes solely to the secured party. The secured party is exclusively responsible for taking the necessary action to ensure that their security interest remains perfected, in other words, that third parties are still able to find that security interest or that claim.
And as I previously mentioned, the lack of knowledge of the post-closing change alone is not an excuse for non-compliance. The courts are very strict and, again, unforgiving if a secured party does not take action within the necessary time frames.
I mentioned that one of the reasons for the complexity is that the rules that might apply to any particular post-closing change are found in different sections scattered throughout Article 9. I did a quick inventory in preparing for this presentation, and these are the sections that I found that might have to be consulted as part of any post-closing change transaction in trying to determine what needs to be done and when. As you can see, there's quite a roadmap here to wind through with the applicable sections. Not all of them apply in every case.
There is one hint I want to give you, though, about how to find your way through this path, and that is take a look at the official comments to Article 9. If you run into a post-closing change, check the applicable section of Article 9 and look at the official comments because it will point you to other sections that are relevant to that particular kind of change.
So, with that introduction, we'll go ahead and move on and talk about the different types of post-closing events and at least those that are critical that secured parties will have to react to. Some of them like a simple debtor address change doesn't necessarily require an amendment to the financing statement.
But one thing that changes and actually frequently changes, it's a fairly common occurrence, is that the debtor will change its name. And if a debtor changes its name in such a way that the filed financing statement becomes seriously misleading with respect to the old name . . . Yeah, with respect to the new name, I'm sorry, that can be a problem, and that's governed by Section 9-507.
Before I get to the effect of 9-507, I want to talk a little bit about what is a debtor name change event. Well, it has to do with the name of the debtor for purposes of the financing statement under Section 9-503(a). Not all changes to the way a debtor is known would necessarily be a name change. For example, a change to a trade name alone isn't going to trigger the need to file an amendment or anything like that.
A debtor name change event will depend on the type of debtor involved. If the debtor is a registered organization, a debtor name is sufficient if the debtor is registered organization only if the financing statement provides the name stated to be the name of the registered organization in the public organic record. Well, in that case, a change to the public organic record will be a name change if it purports to change or restate the name.
So, if Article 1 of the articles of organization, for instance, say the name of the company is ABC, LLC, and then an amendment to the articles is later filed that says the name of this entity is XYZ, LLC, that's been a name change. But merely having an amendment filed that mentions a variation to the name without stating that the name was changed may not be a name change in and of itself.
For other types of organizations, Article 9 says that, for purposes of the financing statement, it's the organizational name of the debtor. It isn't very clear. So, here, it's a little bit more difficult to determine when a non-registered organization's name changes.
The only way to tell really is to conduct thorough due diligence and ongoing due diligence to identify if a company has changed the way its name is. For example, a general partnership may change its name outside the public record in some cases merely by changing its partnership agreement or something like that.
If the debtor is an individual, in most states the financing statement is sufficient only if it provides the name of the debtor indicated on the debtor's driver's license. And in some states, if the debtor doesn't have a driver's license, it would be the state-issued ID card. Here, if the driver . . . Now, the driver's license to be the sufficient source of the debtor name must be unexpired and issued by the state where the record is filed. If the debtor's driver's license changes, that can be a name change event if they change the name in the driver's license. Likewise, if the driver's license expires and provides some sort of variation of the debtor name, that wouldn't be sufficient otherwise, that can be a name change event.
There's all sorts of things that can affect the name of an individual, especially if they don't have a driver's license or state-issued ID, or it's in one of those states that don't require the driver's license or state-issued ID. I think there's six of them that just provide that as a safe harbor. And that can be difficult to determine.
But the driver's licenses do change. They can and do change. For example, people that on their driver's license might only show a middle initial, go in and get a Real ID-compliant driver's license. Now, it comes back with the full middle name. That can make a difference in how the search logic treats the name and, therefore, the sufficiency of the name on a financing statement.
So that's how name changes can occur. But not every name change necessarily requires immediate action. The first step, when becoming aware of a debtor name change, is to determine, does the name change render the financing statement seriously misleading? Not every name change will do that.
Now, Article 9 has some very precise requirements for what is the name of the debtor. And the general rule is that to be sufficient, the debtor name must strictly comply with the requirements of Section 9-503(a). And when I say strictly, I mean strictly. Even a comma out of place means it's not the name of the debtor required by 9-503(a) if it differs from the source document. And if it differs at all, then the name renders the financing statement seriously misleading under 9-506(b), and it will not be effective.
There is an exception to that, and that is under 9-506(c). There's a savings clause, and what that says is that if the search of the filing office records on the correct name of the debtor using the jurisdiction standard search logic would disclose the record, then it's not seriously misleading. It doesn't render the financing statement seriously misleading, notwithstanding the insufficient debtor name that was provided. And this makes sense, because if you search on the correct name of the debtor and the financing statement is disclosed, then there's no harm caused because the financing statement is there and the searcher is aware of it and it serves it. It's no dysfunction to protect the third party that's conducting that search.
However, the standard search logic used by most jurisdictions is very strict. It will compensate somewhat for minor variations in spacing, punctuation, and ending noise words, like Inc. and LLC, in most jurisdictions, but not all. Some of them have even more strict, exact match search logic. Others use a phonebook style. But most of them use a pretty close to exact match, only compensating for those minor variations. And as a result, there's not a lot of leeway here. So, if it doesn't exactly match, it's generally a pretty good indicator that maybe an amendment is required, even if it technically doesn't render it seriously misleading under the search test.
Also, bear in mind that search logic can and does change sometimes, and those changes can render a financing statement that previously showed up on a search of the correct name can render it seriously misleading if it no longer shows up, because if the filer left the old name on there and didn't correct it, in all likelihood they're going to be responsible for it.
So, in order to determine whether any particular change has rendered the financing statement seriously misleading, the first step is to conduct a search as set forth 9-506(c). Search on the new name, the new correct name of the debtor using the jurisdiction standard search logic, and if it shows up, well, at least, you know, it's not seriously misleading at that point in time. However, again, the secured party should still file an amendment. If it doesn't show up, that's a red flag that the secured party will need to take action. If the record isn't disclosed, then Section 9-507(c) is going to cause the secured party to have to take action.
Now, a couple of words of caution about making the debtor name sufficiency determination. As I said, it's risky to rely on search logic for perfection if the debtor name doesn't exactly match the name on the source document under 9-503(a) because search logic can and does change. So, regardless of how much the name has changed, any change in a debtor name should generally prompt the secured party to file an amendment to add the correct name to the financing statement just to be on the safe side.
Now, if the debtor name has changed so as to render that financing statement seriously misleading, that's when Section 9-507 kicks in, and what 9-507 says is, first of all, for existing collateral, if the name on the financing statement now renders it seriously misleading, the effect is that the financing statement will remain effective for collateral acquired by the debtor before and within four months of the name change. So the change to the debtor name, even if it renders that financing statement seriously misleading, it doesn't mean that the secured party is completely out of luck in all cases, but they will be rendered unperfected for collateral acquired more than four months after the name change, unless the secured party files an amendment to add the new name. Actually, I think the code says to render or to make the financing statement not seriously misleading. And the secured party has to do that within that four-month time period.
So if the secured party does so in that time period, they remain perfected. If they don't, they become unperfected in that collateral. So it might be best to illustrate this graphically as to what the different effects are.
First of all, if the debtor has changed its name and it renders the financing statement seriously misleading, and the secured party takes no action, the secured party will become unperfected in after-acquired collateral. So, here, if the name change took place on March 1st and the secured party didn't file their amendment, they will become unperfected on July 1st for after-acquired collateral. They will remain perfected for existing collateral.
I do want to note that oftentimes, though, the after-acquired collateral will be the most valuable collateral, because things like accounts and inventory that may make up the bulk of the debtor's assets constantly turn over, and, therefore it won't take long before it's all after-acquired collateral. So there is very real risk here for the secured party.
Now, if the secured party does file its amendment within that four-month period, the secured party will remain perfected in the after-acquired collateral as well as in the existing collateral, and that perfection will relate back with the priority date of the filing of the original financing statements. So they'll get that continuity of perfection and priority.
Now, in a third scenario, if the secured party didn't file its amendment within that four-month window and then learns of the name change later and gets around to filing its financing statement, what happens? It will become unperfected four months after the name change. In this case, with a March 1st name change, it will become unperfected on July 1st. And then assuming that they file a new amendment to add the new debtor name on November 1st, they will again be perfected in the after-acquired collateral, but not relating back to the original file date. The amendment will only be effective to perfect that security interest in the after-acquired collateral as of November 1st. So they lose their priority in the after-acquired collateral. Thus, it is critical for secured parties to be aware of debtor name changes and to take action within that very short time period.
So what are the best practices when a debtor name changes? Well, one of the most important practices is for secured parties to be diligent to identify debtor name changes. That's always the greatest challenge is for the secured party to identify when a name change occurs. I mean, let's face it. It's not always the first thing on the debtor's to-do list when they change their name to run down to the secured party and let them know. They may not ever even think of it. It's one of these things that frequently flies below the radar. In fact, in some cases, especially with individual names, the debtor may have no idea that their name has changed. For example, if the driver's license changes, you know, John D. Doe, it now becomes John David Doe, as far as the debtor is concerned, that's still his name. It's the same name. It just is spelled out now. They don't realize the technical implications when it comes to Article 9.
So be diligent. And that means closely monitoring debtors, to the extent possible, to identify debtor name changes. They are not always readily apparent. I've heard stories of secured parties who found out about debtor name changes, in one case, because the banker drove by the debtor's location every day going to and from work, and one day the banker was driving by, and there was a new sign going up on the debtor's workspace and had a different name on it. And that's how they learned of the name change. They did more investigation, and, sure enough, the debtor had changed its name without notifying the secured party.
There's other ways too. Sometimes it's necessary to make sure that customer service personnel are aware of the implications of address changes. A debtor may call in and say, "Yeah, we've changed our name and address. Can you please update our file?" Unless that makes it to the people that are responsible for amending financing statements and keeping track of that information, it doesn't do much good. Same thing when checks . . . for those that still pay by physical check. If they come in and suddenly they're coming from a different company name, that might be a red flag. So be alert for these red flags.
Now, if a name change is identified, it's important to file an amendment to that financing statement as soon as possible, in any event within four months to make a record not seriously misleading. And that can be done either through an amendment to change or to add a new debtor. I usually recommend add a new debtor, because it's very clear that the new debtor name is being added to the financing statement, not necessarily replacing the old name. That may have implications. In the right circumstances, it could create issues in trying to enforce it.
And remember, it has to be filed before or within four months after the name change event occurs. And the courts again are very strict on this. Article 9 is very strict on this. If it's not done within that four-month period, the secured party becomes unperfected in the after-acquired collateral. Period. End of story. There's no grace period. It's not calculated from the date when the secured party gets knowledge of the name change. It's calculated from the name change. That's why the monitoring burden is placed squarely on the secured party.
And then finally, I think it's always a good idea, whenever adding or amending a name on a financing statement, to conduct a post-filing search to verify that the new name does show up on the financing statement, you know, something to show that it was received an indexed correctly. And if it doesn't show up, then that should be a big red flag that the secured party needs to go out and fix the issue.
Now, there is case law out here having to do with the debtor name changes, and I'll run through some of that. One of them is In re Lifestyle Home Furnishings. What happened here is the debtor changed its name from Factory Direct, LLC to Lifestyle Home Furnishings, LLC. The secured party either didn't know of the name change or didn't file its amendment. One way or another it didn't file its amendment, and well, unfortunately, the debtor defaulted. And I think this was a bankruptcy situation if I recall correctly, and the secured party was found not to be perfected in after-acquired collateral because it did not file its amendment within four months after that name change. It's a pretty straight up and down situation.
Another case is the Broyhill case. In this one, the debtor granted its bank a security interest in all of its assets, and the bank perfected by filing under the correct name of the debtor at the time, which was IFR Hudson Valley LLC. Later the debtor granted Broyhill, a furniture manufacturer, a purchase money security interest in certain inventory that Broyhill was providing to it. After that deal closed, the debtor changed its name to Hudson Furniture Galleries. Broyhill learned of the change and went ahead and filed a new financing statement under the new name. It also had the debtor execute a new security agreement in the new name, but the bank did not amend its financing statement.
Well, of course, the debtor defaulted, the inventory was sold, and Broyhill and the bank were left to fight over the proceeds. Broyhill brought suit for a declaratory judgment that its security interest was superior to that of the bank's and that Broyhill, therefore, was entitled to the proceeds of the inventory. But the bank argued that it had priority because Broyhill did not comply with the requirements for purchase money security interest in inventory by sending notice to prior lenders, prior secured parties, those with a conflicting security interest.
Broyhill, on the other hand, claimed that it wasn't necessary to comply with the PMSI rules, the purchase money security interest rules, because the bank's financing statement was seriously misleading with respect to the inventory, because the inventory came more than four months after the debtor name change, and therefore it was entitled to the proceeds.
Well, the court took a look at the situation, and what it determined was that even though Broyhill was the junior secured lender, the mere fact that it had actual knowledge of the name change didn't relieve the bank from its affirmative duty to refile or amend the financing statement. And as a result, Broyhill won. And again, this could have been avoided had the bank filed an amendment within the four months after the name change, but the bank either wasn't aware or didn't get around to filing it.
Another case of interest is a fairly recent one. It's In re Wastetech. And this is kind of unusual because what happened was the debtor entered into an agreement with the secured party, and they closed the deal, but between the time the deal closed and the time the secured party filed its financing statement, the debtor changed its name. And in that case, it wasn't a post-filing name change. It was a post-closing name change, but not a post-filing name change. And because the name had changed before the secured party filed its financing statement under the old name, the financing statement was seriously misleading from the get-go, and the secured party was entirely unperfected.
So I guess the takeaway from this is that it's solely the secured party's responsibility to monitor for debtor name changes and to take the required action, which means filing an amendment to add the new debtor name before or within four months after that name change. Otherwise, the secured party is at risk of becoming unperfected in after-acquired collateral.
The next post-closing event I want to cover is what happens when a new debtor becomes bound by the security agreement. "New debtor" is a term defined in Article 9, and what it means is a person that becomes bound by a security agreement entered into by another person. This is sometimes called the double debtor problem.
Now, a person becomes obligated or bound by another person's security agreement. It can be by operation of law other than Article 9 or by contract if the security agreement becomes effective to create a security interest in that new person's property, or the new person becomes generally obligated on the obligations of the first debtor, the original debtor, including the obligation secured under the security agreement and acquires substantially all the assets of the other person. So if a new debtor becomes bound by the security agreement, the original debtor security agreement becomes enforceable against the assets of the new debtor, and no new security agreement is necessary in that case.
Now, there's a number of reasons why a new debtor may become bound. Some common ones are an acquisition. One company acquires another and, in doing so, succeeds to the security agreements entered into by that original debtor, the target of the acquisition.
This can also arise by merger, where the survivor of the merger becomes bound by the security agreements entered into by the other party or parties to the merger.
It can also happen through a change in business structure. For example, if a company, say it's a corporation, and it decides to become an LLC, depending on the applicable state law for business organizations, the LLC that forms out of that corporation may be an entirely separate company, in which case it's a new debtor that would become bound. In other cases, it may be a successor, or there may be continuity, so it's the same company just in a different format. Again, it depends on the applicable state's business laws. If it's deemed the same entity under state law, then it may only be a simple name change governed by 9-507. But if it is a change in structure so that it's a different entity entirely, then it becomes perhaps a new debtor becoming bound.
Now, if a new debtor becomes bound, then the rights and responsibilities of the secured party are governed by Section 9-508. And as we get into the effect of this, there's a couple of assumptions I want to lay out first.
One, we're going to assume that the new debtor name is sufficiently different from the original debtor name that the filed financing statement becomes seriously misleading with respect to the new debtor name. Also, we're going to assume that the new debtor and the old debtor are both in the . . . They're both located in the same jurisdiction.
So what happens when a new debtor becomes bound? What's the effect on existing collateral? Well, under Section 9-508, the rule is very similar to the rule under 9-507. If the financing statement, as a result of the new debtor becoming bound, becomes seriously misleading with respect to the new debtor name, then that financing statement nevertheless remains effective to perfect the security interest in collateral acquired before and within four months after the new debtor became bound by the security agreement. So it's a very similar rule to a debtor name change.
With respect to after-acquired collateral, the financing statement, naming the original debtor, is not going to be effective to perfect the security interest in collateral acquired more than four months after the new debtor became bound by the security agreement.
The exception to that under Section 9-508 is that the secured party will remain perfected in after-acquired collateral if it files an initial financing statement naming the new debtor, and it has to do that before that four months expires after the new debtor has become bound.
Now, the secured party will remain perfected in after-acquired collateral if it files its initial financing statement in that time. But there is one thing to consider, and that is that under Article 9, specifically Section 9-326(a), a security interest in after-acquired property created by the original debtor may be subordinated to a security interest created by the new debtor. So the secured party may remain perfected in after-acquired collateral, but the security interest in the after-acquired collateral, the priority there may be subordinated to another lender for a security interest created by the new debtor. And that's the case even if the original security interest from or the security interest against the original debtor predated the security interest against the new debtor. But that's only with respect to after-acquired property, not for existing collateral.
Now, as far as what the secured party has to do, the text says, in 9-508(b)(2), that the secured party must file an initial financing statement naming the new debtor. So that would imply that the secured party has to go out and file a UCC-1, and there's certainly nothing wrong with filing the UCC-1 naming the new debtor.
However, in Section 9-512, specifically the official comments, they state that an amendment to add the new debtor would constitute an initial financing statement naming the new debtor. So whether it be an initial financing statement on UCC-1 or an amendment to add the new debtor, there they would have the same effect. So, under 9-512, at least as the official comment states, an amendment can be an initial financing statement as long as it adds the debtor. A word of caution here. If it's filed as a debtor change, the result could be that it wouldn't qualify as an initial financing statement because that would appear to change the name of the existing debtor. So I strongly recommend, when filing an amendment here, to go ahead and file on the name or file to add the debtor. File an amendment to add the debtor and not to change the debtor.
So when it comes to new debtor events and the best practices for dealing with them, the first thing, bear in mind the secured party needs to file an initial financing statement naming the new debtor, and that initial financing statement must provide the correct name, be filed before or within four months after the new debtor becomes bound. And according to the official comment, the initial financing statement requirement can be satisfied by filing an amendment to add a new debtor. Just be careful not to change the debtor, not to file an amendment to change.
It's also a good idea to keep that original financing statement active in the filing office records. You know, just filing a continuation every five years isn't a very large burden, and if you prevent it from lapsing, then that will preserve evidence of perfection and priority in the public record.
And then finally, as with any UCC filed to amend or change a debtor name, I strongly recommend conducting a UCC search to reflect that filing so that you can demonstrate that the new debtor name does show up the way it's supposed to.
Our next post-closing event that I want to cover is a change in the governing law. Now, this can happen by itself, or it can happen in conjunction with a new debtor becoming bound. But what is a change in the governing law specifically?
Well, the law that governs perfection and priority of a security interest is the law of the jurisdiction where the debtor is located under Section 9-307. And that law is going to govern perfection and priority of a security interest or agricultural lien, and therefore that determines the state in which a record is filed and therefore the state in which a record will be searched.
Now, a change in the governing law is going to affect that. A change in the governing law is a change to the debtor situation, or it can involve a transfer of collateral to a person in a different jurisdiction. And if the debtor's location changes or the location of collateral changes, that can result in a change in the governing law, and that means that a different state's law would govern perfection and priority.
So when does the governing law change? What kind of things can trigger that? Well, if the debtor is a registered organization, it would be triggered if the registered organization re-domesticated to another state. And I'm not talking about merely, say, moving its headquarters from one state to another, but rather if it re-domesticates by moving the formation documents or where it's charter, I guess, is located. For example, you might have a company that's formed under the laws of, I don't know, Arizona, and it decides to re-domesticate to Delaware. If Delaware law provides that it's the same entity, then you've got a change in the governing law. Some state laws do provide that when you've got a re-domestication like that, it's the same entity, it just now becomes a Delaware corporation rather than an Arizona corporation.
Same thing can happen in the case of, say, a merger or other transaction where the original debtor in Arizona either merges into another company or something like that, and if that company is located in a different jurisdiction, that's a change in the governing law. But the governing law for a registered organization will not change unless the domestication of that entity changes.
For any other type of organization, the governing law is determined by the location of the organization, and under 9-307, the organization is located at its place of business, or if it has more than one place of business, it's located at its chief executive office. So if the company moves its single place of business or its chief executive office to a new state, then that's going to trigger a change in the governing law. So this might happen if you've got any entity that is not a registered organization. It could be a general partnership. It could be, I suppose . . . I don't know, anything that isn't a registered organization.
For an individual, an individual is located, under 9-307, in his or her principal residence. And so the location of the individual's principal residence will determine what state's law governs perfection and priority. If an individual moves and relocates to a new principal residence across state lines, that is going to trigger a change in the governing law.
As I mentioned, if a new debtor becomes bound and that new debtor is located in a different state, that's a change in the governing law in some cases, pretty much all cases.
And a transfer of collateral to a party that is located in a different state can trigger a change in the governing law in some cases. That can actually get kind of complex as we'll see in the case law.
So what's the effect of a change in the governing law on existing collateral? Well, it depends on the nature of the change in the governing law. If it's simply a matter of the debtor relocating or re-domesticating to a new state, it's the same debtor. They're just now located in a different state under Article 9 so that it has caused a change in the governing law. Then the secured party has four months in which to perfect in the new jurisdiction. If they don't perfect by filing a financing statement in the new jurisdiction within that four-month period after the debtor has relocated, they are going to become unperfected in the existing collateral.
If a new debtor becomes bound and that new debtor is located in a different jurisdiction, and this would include transfer of collateral as well to another debtor that's located in a different jurisdiction, then the secured party might have up to a year following the new debtor becoming bound to the transfer of the collateral. They would have up to a year to re-perfect in the new jurisdiction.
Now, if the secured party doesn't file by the applicable deadline here, the secured party is going to become unperfected in both the existing and the after-acquired collateral. It's as simple as that. And that makes sense because, again, remember that these rules are out there to protect third parties, and if a third party is, you know, conducting a search in the new jurisdiction where the debtor is located, and they don't see these financing statements in the old jurisdiction, they can't protect themselves. They don't know to look there. They do know that if the debtor has recently relocated, they're going to have to look in another jurisdiction, but after that period of time, they shouldn't have to look there. So that's why the rule is the way it is. It's to protect third parties, so they know where to look and simplify the process.
Now, there is a limitation here on these deadlines. The deadlines in some cases can actually be shorter because the secured party is only going to have to the shorter of or to either the statutory deadline, be it four months or one year, depending on the circumstances, or if the lapse date of the record in the original jurisdiction is earlier, they have to file before that record lapses. Otherwise, when they file in the new jurisdiction, they will only get perfection and priority from the date they file. It won't relate back. If they do file before the deadline and before the record in the original jurisdiction lapses, they retain their perfection and priority relating back to the original file date in the original jurisdiction.
As far as after-acquired collateral goes, when revised Article 9 first came in, in 2001, secured parties automatically wound up unperfected in after-acquired collateral. Even if they did file in the new jurisdiction within the four-month period, it wouldn't relate back to the original file date. They'd only get priority from the date filed in the new jurisdiction.
That changed with the 2010 amendments, which most states enacted back in 2013. Now, there is a four-month grace period. If the secured party re-perfects in the new jurisdiction within four months after the change in the governing law, they will remain perfected in after-acquired collateral with the original priority date. There's a word of caution here. Remember, there are circumstances where the secured party has up to a year to file in the new jurisdiction, but they may have up to a year, but they only have four months for the after-acquired collateral. So it's always a good idea to file within four months regardless of whether or not the secured party has up to a year. So, in any event, the secured party must refile within that four-month period to continue its perfection and priority, the original perfection and priority in after-acquired collateral.
So what are the best practices when there's been a change in the governing law? Well, first of all, as far as timing goes, the secured party needs to re-perfect in the new jurisdiction ideally before the debtor relocates if it's at all possible, but otherwise within the strict statutory deadlines. I always recommend, you know, get it within the four-month window, and then you don't have to worry about differences between the after-acquired and the existing collateral.
Keep the original financing statement active. This is a good idea in the original jurisdiction. Again, filing a continuation statement is a fairly low-cost solution for that, and it continues to ensure that perfection and priority is still evident in the public record, because if it's not continued, it will lapse, and the year after that, it may be gone and now the secured party has to demonstrate that they were perfected as of that original date. This is just a way of ensuring that that actually happens.
Also, and bear in mind too, when it comes to calculating the deadlines, take a look at the lapse date and the original jurisdiction, because if the lapse date is earlier than the deadline, the secured party must take action by the lapse date. Otherwise, they are at risk of becoming entirely unperfected.
There are some cases out there involving changes in the governing law that are worth taking a look at. One other thing before I get to that, and that is, again, as with any new filing that names a debtor, the financing statement filed in the new jurisdiction. After doing that, the secured party should do a search to reflect, to verify that it was received and properly indexed within that time period.
Let's take a look at some of the case law out there on this. The first case I want to talk about, Farm Credit Services v. Wilson, what happened here was that the debtor transferred collateral to a third party that was located out of state, and, in this case, the secured party did not file a financing statement in the new state. But because the person was a buyer and not a secured party, or there were no other competing interests in the collateral, the court said that the secured party still wins because the security interest filed the collateral, and the limitation as far as becoming unperfected in the new jurisdiction only applied to competing security interests and not the interest of the transferee in this case.
The next case I want to talk about is First National Bank of Picayune v. Pearl River Fabricators. This was an interesting and very confusing case. What happened here was the bank financed certain equipment of the debtor, which was a Missouri corporation, and it filed its financing statement with the Missouri Secretary of State. The debtor later sold the equipment on credit to, we'll call him Buyer 1, which was an Indiana corporation. But the equipment didn't move. Buyer 1 then sold the equipment on credit to Buyer 2, and Buyer 2 was a Nevada corporation. Buyer 1 filed its financing statement I believe in Louisiana, because Buyer 2 moved the equipment to Louisiana. So Buyer 1 perfected its security interest by filing against Buyer 2 in Louisiana. Later on, when the bank realized that the equipment had been moved to Louisiana, it filed its financing statement against the debtor in Louisiana as well. Then the debtor defaulted, and the bank sued to recover the equipment. Buyer 2, however, argued that the bank failed the re-perfect by filing in Louisiana within one year after the collateral was moved there, and the court agreed with Buyer 2. The court said that the bank's failure to timely re-perfect in Louisiana left it unperfected.
Now, one of the reasons I have this case in here is just to illustrate how confused the courts can get. Remember, these are all corporations I'm talking about here, which means they're all registered organizations. None of them were Louisiana corporations. The proper place to file against any of these debtors was not Louisiana. The bank filed in the proper place, Mississippi for the Mississippi corporation, the original buyer, but nobody filed in Nevada, and nobody filed in Indiana, where, you know, these other debtors were located. And it's not even clear, arguably, that any type of filing was required because the security interest follows the collateral. So the court seemed rather confused here, and it may have reached the right result. It may not have reached the right result. But bottom line, it gave the wrong rationale. It gave a mistaken rationale for its decision.
Next, I want to move on and talk about . . . I want to talk about situations involving the transfer of collateral. And what I'm talking about here is where there's a transfer of collateral from the debtor to some other third party who either buys the collateral or is a transferee of the collateral.
And the issue here is going to be whether the transferee is a buyer in ordinary course of business. And the reason is that, under Article 9, a buyer in ordinary course of business takes free of a security interest created by the seller, even if the security interest is perfected and the buyer in ordinary course of business is aware of the security interest.
The idea here is that we want to protect people that are buying in ordinary course of business. One example, let's say a person walks into a big box electronics store and buys a monster TV, and lay out $10,000, take it home, set it up, and then it turns out that the bank has a security interest in the inventory of the retailer, and next thing you know, the individual has somebody knocking at the door saying, "We're going to take that TV back." No, that's not the way it's supposed to work. That's not the way anybody expects it to work. So there is protection in there for that buyer, a buyer from a seller engaged in selling goods of the kind and buys it in ordinary course of business. They're going to take free of that security interest created by the seller.
Now, if they're not a buyer in ordinary course, then that exclusion doesn't apply, and they take subject to the security interest. And this applies both in the consumer type of situation in my example, but also in a commercial situation. A landscaping company goes in and buys heavy equipment from a dealer in heavy equipment. They're going to take free of that security interest if they're a buyer in ordinary course, just as a consumer would. And again, if they're not in ordinary course, they take subject to the security interest.
Now, if they are a buyer in ordinary course, that doesn't mean that the secured party has lost the value of that collateral, but it does limit the remedies. The secured party can only look to the proceeds of that collateral in the hands of the debtor. They can't go after a replevin or conversion action against the buyer in ordinary course.
Now, if the transferee is actually a successor in interest to the original debtor, that may be a situation that's a new debtor becoming bound under Section 9-508. So it's important to take a look at all the facts and circumstances surrounding the transfer of collateral.
Let me talk about some of the case law out there related to transfers of collateral, because that can probably explain the buyer in ordinary course concept better than just going over the statutes.
The first one I want to cover is a case called Teague v. Taylor. And what happened here is that the debtor, which was a landscaping company, bought a loader, a heavy piece of equipment, and that was financed by Caterpillar, and it was purchased from a dealer. Caterpillar perfected its security interest by filing a financing statement. Everything was fine with that. But then the debtor sold the loader to a third party, Teague, without the knowledge or permission of Caterpillar. Then the debtor filed for bankruptcy. Caterpillar sought to recover the loader from Teague, but Teague brought a motion for summary judgment claiming that he was entitled to it because he was a buyer in ordinary course and took free of the security interest.
So the court had to decide whether Teague was a buyer in ordinary course. If he was, he got to keep the loader. If he wasn't a buyer in ordinary course, then the security interest followed the loader, and Teague was either going to have to pay the value of that loader a second time or return the loader, one or the other. Well, the court took a look at it and determined that indisputably the loader was a piece of heavy equipment, and the debtor, a landscaping company, was not in the business of selling heavy equipment. The debtor was in the business of landscaping, commercial landscaping. Now, even though commercial landscaping companies may use heavy equipment, they're not considered sellers of heavy equipment. They're not engaged in selling goods of the kind. Therefore, a buyer of the heavy equipment from the landscaping company was not a buyer in ordinary course, and the buyer in ordinary course didn't apply in this situation. So, as a result, Teague lost, unfortunately for Teague.
Another case, a more recent case. This is a case called Element Financial Corporation v. Marcinkoski Gradall Inc. And what happened here was Element financed the purchase of three Bobcat utility vehicles by the debtor. The debtor was a California limited liability company, and Element promptly filed a financing statement in California to perfect its security interest. Unbeknownst to the secured party here, the debtor's managing member, who had personally guaranteed the loan, took the Bobcats and moved them to Florida. There, a company related to the debtor, but that was an entirely separate entity, sold the Bobcats, all three of them, to another buyer. We'll call this one Buyer 2. Buyer 2 then turned around and sold two of the Bobcats to Buyer 3. Well, the debtor defaulted, and Element, the secured party, had been able to trace the location of the Bobcats to the various buyers, and Element sought to enforce its security interest against those Bobcats in the hands of the buyers. The buyers both claimed that they were buyers in ordinary course that took free of the security interest.
The court, in deciding who had the rights to those Bobcats, found that Buyer 2 and Buyer 3 did not purchase the Bobcats from the seller that created the security interest. They may have bought them from a merchant engaged in selling goods of that kind, but because that was not the seller that created the security interest, they were separate persons entirely because the security agreement was not created by the buyers' seller and the buyers took the Bobcats subject to perfected security interest of Element. So the buyers lost in that case.
So it's important to understand in this that the exception as a transferee of collateral, if they're a buyer in ordinary course, they're going to take free of the security interest. Buyer in ordinary course means they bought it in ordinary course of business from a merchant engaged in selling goods of the kind. If they're not a buyer in ordinary course, the security interest generally is going to follow the collateral, and that can be enforced against the collateral, even if it's been transferred multiple times down the road.
So some things related to transfers of collateral to be aware of. One is amending the financing statement. I'm frequently asked, "Do I have to amend the financing statement to reflect the transferee?" The answer to that is normally no, it's not necessary. If the transferee is not a buyer in ordinary course of business, the security interest is going to follow the collateral.
You can certainly file an amendment to add the transferee. They do become a debtor under the definition in Article 9, because they have rights in that collateral. But a word of caution. If it is being amended to reflect the transferee, it needs to be as an add. Add the transferee as a debtor. Do not change the debtor name. Add the debtor name. And the reason is that if a change is filed, then, arguably, the original debtor is no longer part of the financing statement, and they'll lose priority with respect to other secured creditors.
If the transferee is a successor in interest, it may be necessary to follow the rules of Section 9-508 and file an initial financing statement within four months after the transfer.
And beware of a change in the governing law. If the transferee is located in another state, that's going to complicate matters. So you do want to be aware if there's a change in the governing law, it may be necessary to file in the other state on the new debtor or the transferee to be sure that the secured party is properly protected.
Now, I want to talk a little bit about how one goes about identifying these post-closing changes. Sadly, it's not possible to track these things in all cases because transfers can be made without knowledge of the secured party, names change, and things like that, and the secured party simply may not, you know, receive notice of it. They're not going to be able to correctly monitor for these things passively. The secured parties need to be a little more proactive.
Now, this can be done through internal procedures, as I mentioned. It's sometimes a good idea to train all staff that have contact with borrowers what to look out for and make sure that information about changes in address, names, even checks showing up with a different company name on them, that all this information is routed to the correct people.
Also, secured parties can track in the public records for registered organizations. They can do this either by manually searching secretary of state records every 90 days to identify any organizational changes. If a registered organization changes its name or is involved in a merger or acquisition or is re-domesticating, all that information requires the filing of amendments to their business entity documents, and, as a result, there will be a public record. And doing those searches at 90-day intervals can identify them. That, however, is a fairly manual process. It takes a lot of personnel resources to do it manually, and therefore most do not do that. However, there are automated tracking systems that typically will pick up any changes to a registered organization debtor's business documents within 30 days and provide notice.
But there are some limitations, as I said, to any tracking program that's put in place. First of all, individual debtors are notoriously difficult to track. Driver's licenses are not public record, so there's no way to automate that tracking process. The only way to identify changes to the driver's license, which trigger a debtor name change, is really to check with the debtor periodically, certainly about every time they renew their driver's license.
Also, things like transfer of collateral and things like that cannot necessarily be tracked. Short of having an RFID tag on every piece of collateral, it's going to be hard to track transfers.
Because of that, it's always a good idea for lenders to stay in periodic contact with the debtor. Stay up to date on what's going on.