The Intersection of Chapter 11 and UCC Article 9

Journal Issue

Jul/Aug 2006

Column Name

Chapter 11 - “201”

Citation

ABI Journal, Vol. XXV, No. 6, p. 20, August 2006

Topic Tags

Practice and Procedure

Uniform Commercial Code/Article 9

Journal HTML Content

Editor's Note: This is a
follow-up column to the contributing editors' previous column, Chapter
11 - "101," which ran in the ABI Journal from
2003-05. We asked the contributing authors to reintroduce an updated
column because of the overwhelming response the previous column received
from judges, professors, law students and professionals alike. The
"201" series will examine how chapter 11 applies in
conjunction with various other laws. </blockquote>Some say chapter 11 practice is one of the last
bastions of "general practice lawyering" in the
large—or even medium-size—firm settings. This seems
counterintuitive at first. After all, bankruptcy is considered a
consummate example of specialization in what is increasingly a
profession of specialists. Step back and consider, however, what a
chapter 11 debtor lawyer does day in and day out, and one quickly
understands that the lawyer's role is very similar to that of an
outside general counsel, and indeed requires at least a basic working
knowledge of a myriad other areas of the law. Another apt analogy is
that of a general contractor of a construction project. Sure, we're
all expected to know the Bankruptcy Code "cold," but that's
not enough. Just as a general contractor has to know enough about
plumbing, electricity and carpentry in order to monitor and speak with
subcontractors, so too a chapter 11 lawyer must know enough about
litigation, corporate law, tax and a host of other specialties to
adequately advance a client's interests. At a minimum we must know
enough to spot issues as they arise, and consult with or bring in
other specialists as needed. It is with this perspective that we
provide our first installment of Chapter 11 - "201," a new
column that will discuss the intersection of chapter 11 practice with
other areas of the law. To do this, each installment will be written
with the assistance of specialists from a variety of legal areas.

The Basics of UCC Article 9 This month, we discuss the
intersection between Article 9 of the Uniform Commercial Code and
chapter 11 practice. The Uniform Commercial Code (UCC) is not the law
in any state. Rather, it is a compilation of suggestions to state
legislators for laws. These "suggestions," however, have
been wildly successful; nearly every state has adopted nearly every
provision of the UCC. The UCC is divided into 11 "Articles,"
each one addressing a different area of commercial law. The Articles
of the UCC are: • Article 1: General Provisions •
Article 2: Sales • Article 2A: Leases • Article
3: Negotiable Instruments • Article 4: Bank Deposits 
• Article 4A: Funds Transfers • Article 5: Letters of
Credit • Article 6: Bulk Sales • Article 7:
Warehouse Receipts • Article 8: Investment Securities

• Article 9: Secured Transactions Article 9 of the Uniform
Commercial Code governs "security interests" in personal
property. It contains detailed rules regarding (a) the creation,
"attachment" and "perfection" of security interests
in various types of collateral; (b) the relative priorities of
security interests; and (c) default and remedies upon default. When
you are looking at an issue under Article 9, you should look at the
applicable state's statute to see how, if at all, it differs from the
UCC version. However, there typically will be no such difference, and
we write this article with reference to the UCC version. Article 9
was completely revised and restated in 2001. Every state in the nation
has adopted the revised version of Article 9. Pre-2001, Article 9
remains relevant, however, due to the vast amount of case law
construing its provisions, many of which have been incorporated into
new provisions. The revision is so extensive that the old and new
numbering do not match. Accordingly, lawyers must use care in locating
applicable provisions of the revised UCC. Security interests and
liens—for our purposes, these two terms mean the same
thing—are fundamental legal tools in our modern economy. They
provide lenders with comfort and a source of repayment in cases where
debtors default. A security interest is a present grant of a property
right.1 It is usually, but not always, nonpossessory, as
the debtor or borrower wants to be able to use the collateral while
the security interest is in force. It may ripen into a full ownership
interest through the process of default and foreclosure. The
collateral—the "thing" that is encumbered by the
security interest—may be real property, like an office building,
or personal property, tangible or not, like a car, a copier, a
copyright or an account receivable. (But note that the office building
lien would not be covered by Article 9; instead it would be covered by
state mortgage laws because the collateral is real estate).
Article 9 Is Good for Business The UCC standardized the
rules and procedures for taking, preserving, renewing and releasing
security interests. The provisions of the UCC, and its widespread
enactment, are among the most important developments of 20th Century
American commercial law. This standardization dramatically lowered
transaction and enforcement costs from the costs resulting from each
jurisdiction enacting and enforcing its own rules governing personal
property security interests. Although some variation between the
states continues, even with the revised Article 9 such variations are
relatively minor and limited in number. Attachment A
security interest "attaches" to collateral when it is valid
and enforceable against the debtor, but attachment does not
necessarily make the security interest valid as against third parties.
For example, an intervening judgment creditor can levy on the
collateral, even if a security interest has previously attached, and
gain a higher-priority security interest. The way the secured creditor
can avoid this is to "perfect" its security interest. For
personal property, perfection is generally accomplished by filing a
properly completed form UCC-1 financing statement in the appropriate
public records, most often the office of the secretary of state. So
when is a security interest enforceable against a debtor? Look at UCC
9-203(b). It provides that a security interest is enforceable against
the debtor and third parties if (1) value has been given, (2) the
debtor has rights in the collateral (or the power to transfer rights
in the collateral to a secured creditor) and (3) the debtor has signed
a security agreement or the collateral is in the possession of the
secured creditor or, in the case of certain types of collateral, the
secured creditor has "control" of the collateral.2

Perfection and Priority The twin topics of perfection and
priority are addressed in UCC 9-301, et seq. Think of
"perfection" as making the security interest good against
the world, not just between the parties. If a judgment creditor levies
upon collateral in which a secured party has a perfected security
interest, the judgment lien is junior to the security interest and
will only be paid if the senior secured creditor is paid in full or
agrees to take less than full payment in satisfaction of the lien.
How is a security interest perfected? A security interest is
perfected when the creditor and the debtor have done everything that
needs to be done (including executing and filing documents) to
complete the transaction or transfer (e.g., the creditor has
loaned the money, the debtor has promised to pay it and has promised
that the creditor has first dibs on the collateral if the debtor does
not repay the loan) and that the creditor has done what is necessary
under Article 9 to tell the world ("give notice") that he
claims a stake in the collateral. Usually, you give notice by filing a
document—a form UCC-1 (the Code calls it a "financing
statement")— in the public record. The DIP as Judgment
Creditor Of all the provisions in Article 9, the most important
in terms of its interaction with the Bankruptcy Code is UCC 9-317. It
is UCC 9-317 that provides that an unperfected security interest is
subordinate to a judicial lien on the property. So if a judicial lien
is slapped on the property before it is encumbered with a perfected
security interest, that judicial lien has priority. Why is this
important in terms of the Code? Because of Code §544(a)(1). Under
that section, as of the petition date, the trustee or
debtor-in-possession (DIP) is cloaked with the rights and powers
of:<blockquote> a creditor that extends credit to the debtor at the
time of the commencement of the case, and that obtains, at such time
and with respect to such credit, a judicial lien on all property on
which a creditor on a simple contract could have obtained such a
judicial lien, whether or not such a creditor exists.

</blockquote>In other words, the DIP (or trustee) is a
hypothetical lien creditor that enjoys the protections of UCC 9-317.
So if a secured creditor is perfected as of the petition date, its
security interest trumps the DIP, and the estate benefits from the
secured creditor's collateral only after the secured creditor is
repaid. However, if the secured creditor is not perfected as of the
petition date, then the DIP prevails and the secured creditor shares
pro rata with other unsecured creditors. The import of UCC
9-317 can best be seen if we imagine that the section was not enacted
in a particular jurisdiction. If that were the case, unperfected
security interests would be enforceable against the DIP and the
estate.3 But UCC 9-317 has been enacted in every state, and
that section, together with Code §544, make it clear that an
unperfected security interest is subordinate to the trustee's
hypothetical lien and is avoidable by the trustee. The net result is
that Code §§362(a) (the automatic stay) and 544, together
with UCC 9-317, on the petition date, sound a whistle and scream
"freeze: All the value in the debtor's property not subject to a
perfected security interest becomes the property of the
estate."4 What remains is taking a closer look at just
exactly how we fit the trustee's power under §544(a) together with
the UCC. The critical language is in §9-317(a)(2). It says:
<blockquote> A security interest...is subordinate to the rights
of...a person that becomes a lien creditor before the security
interest...is perfected.... </blockquote>A "lien
creditor" is a creditor who acquires a lien through the judicial
process. Just how that's accomplished is a matter of non-uniform state
law. Consider this hypothetical: Donald the debtor owns a case of fine
champagne. Your client, Cartman Corp., just won a lawsuit against
Donald. You send out the sheriff to pick up the champagne to satisfy
the claim. Under California law, once the sheriff lays his hands on
the champagne, you've got a lien; other states may date the lien from
the time you send your order to the sheriff, or perhaps even from the
time you win your lawsuit. To recap: If some secured creditor is
perfected before Cartman Corp. gets its lien, then that secured creditor
gets first dibs in the champagne. Otherwise, first dibs go to the
Cartman Corp. Perfection Is Not Always Necessary for the Secured
Creditor to Beat a Lien Creditor This system works well enough
in practice, but oddly enough, the UCC doesn't stop there. Section
9-317 says the secured creditor may trump the lien creditor even if he
does not perfect in time, provided he meets two conditions. First,
there must be a "financing statement" on file to warn the
world that the creditor claims a stake. Second, creditor and debtor
must have taken at least a beginning step toward their deal. For
example, there must be an agreement, or the creditor must have
advanced money, or the debtor must have rights in the collateral. In
other words, "filing plus" is enough. The reasoning here
seems to be that it is the public warning that counts; once the public
is on notice, it really shouldn't matter when the deal is actually
completed. This seems plausible enough on its face, but it raises a
question: If you can trump the lien creditor with only part of a
security interest, why would you ever want to bother to get the whole
thing? In other words, if you win with this "second" rule,
why do you need the first? Why would anyone bother with more than
"filing plus"? One answer is that getting "the whole
thing" provides you with additional rights under the UCC beyond
merely defeating a judicial lien creditor. But discussion of those
rights is beyond the intersection of chapter 11 and the UCC that is
the subject of this article. Another answer is that what we may
have here is a case of culture lag: "Perfection" is the
"old rule." It has been in the UCC since the beginning.
"Filing plus something else" is new: It came into the UCC
only in the year 2000. The drafters, in tentatively extending their
reach, may have lost sight of the fact that they don't need the old
handhold (at least not as much) any more. Practically Speaking:
The Chapter 11 Case Has Been Filed—What You Need to
Understand In an ideal world, secured creditors would make sure
that their liens have been documented and perfected properly long
before a bankruptcy case. But alas, we don't live in an ideal world.
Often it is the bankruptcy filing that causes the secured creditor to
review its credit documents and make sure that all of its ducks are in
a row. At the same time, the DIP should be reviewing those documents
looking to punch holes in them for the benefit of the estate. If the
DIP isn't doing that job, the creditors committee—representing the
interests of general unsecured creditors—is likely to do so.
Questions to ask when reviewing the documents include: • Is
the collateral property in which a security interest can be perfected
by a UCC-1 filing? • Did a security interest attach for all
of the collateral identified in the financing statement (as you want
to know if you have a classically perfected security interest or one
that you will defend based on 9-317's filing plus provisions)?

• Was the UCC-1 properly authorized by the debtor, for example
through the security agreement? • Is the collateral
adequately described? • Was the UCC-1 filed in the proper
location(s)? • Is the debtor's name correctly listed? 
• If the collateral includes after-acquired property, has the
debtor changed its name or business structure prior to acquiring some
or all of the collateral? • Has the debtor relocated to a
different state? • Were continuation statements timely
filed? Problems in any of these areas may create the opening for the
DIP (or committee) to assert that the security interest is unperfected
and may be avoided and preserved for the benefit of the estate,
rendering the formerly secured creditor a mere unsecured creditor. To
do this, the DIP relies on §544(b), which allows it to avoid any
transaction that could be avoided by an unsecured creditor under
applicable nonbankruptcy law. Assuming that the security interest is
valid, enforceable and unavoidable, what can the DIP do to or with the
secured creditor's collateral? The answer is a surprising number of
things, all with the caveat that the secured creditor is entitled to
"adequate protection" of its interest in the collateral.
The personal property secured creditor is generally subject to the
automatic stay. If it wants to exercise any remedies, it must seek
relief from the stay. Alternatively, the creditor can seek adequate
protection of the value of its collateral. See Code
§362(a), (d)(1). Like the "due" in "due
process" and "just" in "just compensation,"
the use of the word "adequate" in "adequate
protection" makes a difference. Adequate Protection

Adequate protection is defined in an open-ended fashion in §361
to include periodic cash payments, additional liens or the indubitable
equivalent of the creditor's interest in the property; administrative
expense status is expressly proclaimed not to constitute adequate
protection. The most common form of adequate protection for a secured
creditor whose collateral consists of personal property and is being
used by a debtor after the filing date is periodic payments to
compensate for the wear and tear and depreciation of the personal
property collateral. If there is a substantial equity cushion as of
the petition date, the court may decide that the equity cushion
constitutes adequate protection. For example, if the creditor is owed
$20,000, but its collateral value is $35,000, the court is likely to
find that the collateral value is sufficient so that the creditor
doesn't face much risk and therefore is not entitled to periodic
payments. The DIP may seek to sell a secured creditor's collateral.
If it is sold, it may either be subject to the lien or, under
§363(f), free and clear of the lien. If sold free and clear, the
most common form of adequate protection comes in the form of a
replacement lien on the proceeds. The secured creditor also has, under
Code §363(k), the right to "credit bid" (bid its debt
rather than cash) at the sale to ensure that an appropriate sales price
is realized. In effect this gives the secured creditor a
choice—take the highest price offered by a third-party bidder,
or purchase the collateral in satisfaction of debt. When a chapter
11 plan is pursued, the Article 9 secured creditor may be subject to
nonconsensual cramdown of the plan, assuming that certain minimum
requirements are met. These requirements are set forth in Code
§1129. Grossly oversimplified, the secured creditor has the right
to receive at least the present value of its collateral, either by
payments up front, payments over time with interest, or conveyance to
the creditor of its collateral. If the debtor can provide that to the
creditor, then it has a shot at confirming a plan, even over the
creditor's objection. <blockquote> <blockquote> 
</blockquote></blockquote><h3>Footnotes</h3>1 Security interests are
recognized as property rights, which means that they are entitled to
constitutional protection under the 5th and 14th Amendments to the
U.S. Constitution which prohibit taking property interests without due
process and just compensation (note the use of "due" and
"just," which softens this prohibition somewhat more than
some might assume). 2 Control is required for investment
property, deposit accounts, electronic chattel paper and letters of
credit. UCC 9-203(b) makes this clear. 3 If you believe that
perfection serves a worthy notice function, then this would be an
undesirable result—it would mean creditors could fail to give
the required notice of their lien—perhaps inducing other creditors
to extend credit to the debtor, who would believe the debtor's assets
were unencumbered—and nonetheless prime those other creditors. A
contrary argument is that most unsecured creditors do not extend
credit in reliance upon a search for UCC-1s and an evaluation of a
debtor's unencumbered assets as a source of repayment. See White,
James J., "Revising Article 9 to Reduce Wasteful
Litigation," 26 Loy. L.A. L. Rev. 823 (1993). 4 Of course,
the DIP is obligated to use that value for the benefit of the estate,
which is made up of the claims of creditors, post-petition claimants
and equityholders. So the effect of the trustee's ability to avoid an
unperfected security interest is to capture value for the benefit of
all creditors that would otherwise go to a particular secured
creditor.

Journal Authors

George W. Kuney

John D. Ayer

Jonathan P. Friedland

Michael L. Bernstein

Journal Date

Saturday, July 1, 2006 - 12:00

Bankruptcy Rule