How can a lender protect its security interest if a business borrower goes bankrupt?

Even the best and most solid customers can suddenly find themselves insolvent or unable to pay.

Sellers and lenders protect themselves against non-payment by filing documents with the state that perfect their security interest in a borrower’s collateral.

The most typical way of perfecting a security interest is to file a UCC-1 financing statement with the relevant state.

A business loan carries risk of non-payment, but a lender can reduce that risk by doing their diligence on the creditworthiness of the borrower and how they propose to repay the loan. Get a lawyer’s help with every commercial loan, because there are endless ways to lose money if you don’t do the work, or don’t know what work to do. No diligence will ever eliminate every risk of non-payment, however.

Today, many companies’ solvency could be threatened by pandemics, wars, natural disasters, high inflation, supply chain shortages, or for some firms, a perfect storm of multiple overlapping factors. Even many businesses who don’t face total insolvency because of economic factors could still run short of cash because of bad debt. Both sellers and lenders who are owed money should be cautious during emergencies to check on their debtors and make sure they are viable and making an effort to pay as they can.

When a borrower looks like they may be headed toward bankruptcy, check your loan terms and your legal security interests in the borrower’s assets to confirm you know exactly what rights you have and how to enforce them. Then it’s time to make sure covenants in a loan are correct and current (especially material adverse change clauses), and security interests are registered correctly and haven’t expired.

Here are practical steps you can take as a secured lender to lower your exposure if a borrower becomes insolvent.

First, a lawyer can evaluate your contractual rights, payment schedules and security interests and give you options for how to strengthen and defend your position.

Perfects Their Interest by Filing a UCC-1 Financing Statement

The process for securing a debt is a security agreement signed by the borrower which gives the lender rights in a borrower’s assets; then the lender perfects their interest by filing a UCC-1 financing statement. That way, if a debtor fails to repay, the lender can go after the debtor’s assets to cover the loan.

A blanket lien gives the broadest possible protection against non-payment, giving the lender a right in nearly all the debtor’s assets.

Narrower liens give lenders protection in particular assets, like manufacturing equipment or inventory.

Properly filed UCC-1 financing statements also help lenders by publicizing their security interest and giving them priority in bankruptcy. When multiple parties are fighting over a debtor’s assets, it is usually the lender with the first-recorded UCC-1 that has the right to the collateral first.

But lenders should beware because that’s not always the case.

The first exception to the “first in time” rule is a “purchase money security interest,” which refers to a loan or other security agreement intended to pay for an asset the borrower is acquiring. Under UCC Article 9, lenders who provide financing for a sale can acquire a security interest in the collateral they fund, and, once properly perfected, that right is senior to the rights of prior lenders.

The second exception to the first-in-time rule is a relatively recent one. In states that have enacted Article 12 plus the 2022 revisions, lenders with control over a debtor’s controllable electronic records, or CERs, can enforce their rights in them first, even if a lender with a blanket lien filed earlier.

Every mortgage securing your loan has to be recorded correctly.

Negligent record-keeping can blow a security agreement out of the water, even if a lender was careful to create one correctly in the first place. Unless lenders constantly audit and update their records, they could lose out in bankruptcy even if everything else was done correctly.

Ideally, UCC-1 statements run for the entire lifespan of a secured loan, but unfortunately, these documents expire every five years, even if the loan is active and performing. Lenders should also remember to file continuation statements, UCC-3s, which must be filed before a UCC-1’s five-year expiration. Creditors should monitor the expiration dates closely, because even a single day’s lapse can cost priority in bankruptcy.

Next, you can run a “search to reflect” with the UCC filing offices. These show recent filings against an obligor, giving you the chance to spot possible liens, errors and problems.

The federal tax lien registry will show you any IRS liens, and because the agency has broad powers, it can file liens against a borrower’s accounts receivable and inventory.

If the borrower has a problem with a filing or lien, a lender can ask for additional collateral.

Attachment, Then Perfection

A lien attached to collateral usually goes through a two-step process under the UCC: attachment, then perfection.

Attaching a security interest requires a security agreement signed by the debtor that gives the lender an interest in collateral in case of non-payment. The UCC’s word is “authenticated.” No security interest attaches to a debtor’s collateral without a signed security agreement.

Next, a security interest must be secured by value, so a lender gives either cash, or “consideration” with value. It may seem obvious, but one of the key requirements of attaching a security interest in a debtor’s collateral is that the debtor must actually have rights to that collateral itself. A seller of an extrusion machine can take back a security interest in the machine.

Signing and attaching a security agreement does not, by itself, protect you if the borrower becomes insolvent.

Perfecting a security interest puts other parties on notice of the lender’s rights in collateral. Perfection gives a secured party the highest priority over most others with competing interests in the collateral, whether in bankruptcy or a sale. That means the security interest will be senior to most other secured or unsecured creditors.

The metaphor may be clumsy but one way to visualize the dangers of failing to file a UCC-1 financing statement is to think about second mortgages. Mortgages aren’t governed by Article 9. But the first mortgage holder with a properly filed lien will have their rights enforced first. A second mortgage holder will have to watch as the first mortgagee forecloses on the property and the second mortgagee gets pushed back in line. It is similar with UCC-1 financing statements, though the mechanics differ. Because perfected security interests typically enjoy first right in collateral, the process of perfecting them is vital.

The UCC sets out three main methods for perfecting a security interest. Filings are by far the most common method of perfecting a security interest, though the other two ways, possession and control, are still occasionally used, and can be crucial in specific scenarios. The 2022 amendments to the UCC authorized a type of perfected interest in some digital assets, and there control beats filing.

UCC-1s must be completed carefully and accurately, as there are countless opportunities to introduce errors. UCC-1 forms ask for information about the debtor and creditor, and ask for a description of the collateral, and filers must use the debtor’s correct full legal name. Lenders may file their financing statements with the state’s secretary of state, or county, depending on the state and the nature of the collateral. If the collateral is a fixture, filing is often handled at the county recorder’s office. Incorrectly filed records mean a lender may have to compete with other lenders’ interests in the collateral.

Perfected security interests are prioritized based on when they were perfected. So, the first to perfect its security interest in collateral will usually win in a priority dispute in bankruptcy. If a filing has a serious error, such as naming the wrong debtor, your loan could fail in bankruptcy.

Subchapter V

If your borrower does file, know that the Small Business Reorganization Act, or SBRA, which became law in 2020, gives small businesses a tool, Subchapter V, which can make filing for bankruptcy less complex and expensive for them.

The debtor decides when and how to file a proposal for repayment, and creditors can only respond and object. Under Subchapter V, debtors have 90 days after filing for bankruptcy to file a reorganization plan. The SBRA eliminates the need for a debtor to prepare and file a disclosure statement in order to confirm a chapter 11 plan. By eliminating the need for a disclosure statement and a creditors’ committee, the SBRA speeds up confirmation. Subchapter V may mean fewer options for lenders who have a difficult relationship with a debtor, because these debtors retain substantial control over their business and assets in bankruptcy.