If perfection of a security interest lapses after a bankruptcy filing because the lien creditor fails to file a continuation statement, does the junior lien creditor jump ahead?
Invoking the so-called freeze rule where security interests are determined on the filing date, Bankruptcy Judge Thomas J. Catliota of Greenbelt, Md., said the answer is “no.”
Judge Catliota also said, in dicta, that a lapse in perfection after filing would not allow a debtor or trustee to avoid the security interest, which would remain valid as to the debtor.
The Facts
There were two secured lenders, both with liens on all the debtor’s assets. The holder of the first lien on the filing date had a secured claim for about $300,000, while the second lien creditor had a secured claim for some $3.2 million. Both were perfected at filing.
The senior lienholder’s UCC-1 financing statement lapsed after bankruptcy. The senior creditor filed a UCC-3 continuation statement about two weeks after the original filing lapsed.
The trustee sold the assets, but the price would not pay both lien holders in full.
The junior lienholder contended that it stepped into the first position when the senior lienholder failed to file a continuation statement on time. The lienholders filed cross motions for summary judgment.
In his September 25 opinion, Judge Catliota ruled in favor of the senior lienholder, although perfection had lapsed under the Uniform Commercial Code, or UCC. His opinion is like a law school UCC section game, with a bankruptcy twist.
The UCC and Bankruptcy Code Provisions
UCC § 9-515(a) provides that the effectiveness of a financing statement lapses in five years “unless before lapse a continuation statement is filed . . . .” Section 9-515(d) provides that a continuation statement may be filed “only within six months before the expiration of the five-year period . . . .”
Outside of bankruptcy, the lienholders agreed that the lapse would allow the junior lienholder to jump into the first position. Outside of bankruptcy, they also agreed that the senior lienholder would not lose its security interest entirely.
Notably, neither the UCC nor the Bankruptcy Code has been static on this issue.
Previously, UCC § 9-403(2) provided that a security interest that otherwise would have lapsed after bankruptcy would remain perfected throughout bankruptcy and for 60 days thereafter. However, Section 9-403(2) was repealed in 2001, in response to an amendment to the Bankruptcy Code.
In 1994, Section 362(b)(3) was added to the Bankruptcy Code. It provides an exception to the automatic stay by allowing the filing of a UCC continuation statement, among other things. Section 362(b)(3) made former UCC § 9-403(2) unnecessary.
Judge Catliota’s Analysis
Judge Catliota began with Butner v. U.S., 440 U.S. 48 (1979), for the proposition that property interests are determined by state law, absent a federal interest that requires a different result. Giving rise to the freeze rule, he quoted Isaacs v. Hobbs Tie & Timber Co., 282 U.S. 734, 738 (1931), for saying that valid liens on the filing date are “preserved” in a bankruptcy proceeding.
Critically, Judge Catliota quoted Comment 4 to UCC § 9-515, which says that “if the debtor enters bankruptcy before lapse, the provisions of [the UCC] with respect to lapse would be of no effect to the extent that federal bankruptcy law dictates a contrary result (e.g., to the extent that the Bankruptcy Code determines rights as of the date of the filing of the bankruptcy petition).”
Judge Catliota interpreted the comment to mean that the drafters of the UCC “left the courts to decide whether the security interest should be determined as of the petition date or the date of lapse.”
Invoking the freeze rule and following the majority of courts, Judge Catliota chose the filing date for determining the validity of security interests. He cited decisions from the First and Seventh Circuits, both decided before the adoption of Bankruptcy Code Section 362(b)(3).
Arguably, the two circuits might change their opinions in light of the later adoption of Section 362(b)(3). However, it is not clear that Congress intended to modify the freeze rule in the context of lapsing financing statements. Were he bound by First or Seventh Circuit authority, Judge Catliota would not be at liberty to disregard the appeals courts’ precedents.
Judge Catliota buttressed his opinion by referencing a majority of courts that have ruled that the lapse of a UCC filing after bankruptcy does not enable a trustee or debtor to avoid the security interest. In that respect, his conclusion is grounded on the UCC.
Because a trustee is a “lien creditor,” not a purchaser for value, UCC § 915(c) “does not allow a trustee to avoid a lien where the financing statement has lapsed post-petition,” he said.
Judge Catliota drew that conclusion because the UCC provides that the lapse of a UCC-1 “does not result in the security interest deemed never to have been perfected against a ‘lien creditor.’” In turn, UCC § 9-102(55) defines a “lien creditor” to include a bankruptcy trustee.
To counter the effect of the freeze rule, the senior lienholder cited Bankruptcy Code Section 362(b)(3). Judge Catliota responded by saying that Section 362(b)(3) “allows” but does not “require” the filing of a continuation statement.