If you took a loan against the equipment in your business, or the inventory you have on hand, or the receivables you’re owed by your customers, the lender almost certainly recorded a UCC-1 financing statement, otherwise known as a UCC lien, with the secretary of state. A bankruptcy filing doesn’t just wipe out the lien. You can have the UCC lien removed in Chapter 11, but only if the lender made a serious mistake. The lien depends on whether the lender perfected its security interest in accordance with Article 9 of the Uniform Commercial Code on the date you filed. Article 9, the section of state law governing security interests in personal property, is adopted in essentially identical form in every state. (Real estate mortgages are governed by state law, of course, but that’s another story.)
Unperfected Security Interest
When does a security interest “attach”? It attaches when it becomes enforceable against the debtor. For a security interest to be enforceable, you generally need three things: the secured party has given value (like a loan), the debtor has rights in the collateral, and the debtor has signed a security agreement (or the secured party has possession or control of the collateral, depending on the type). But just attaching isn’t enough to beat everyone else. If, for example, a judgment creditor levies on the collateral after attachment but before perfection, the judgment creditor can usually beat the secured party. To avoid that, the secured party needs to “perfect.” The easiest way to perfect most personal property is to file a UCC-1 financing statement in the correct public office (typically the secretary of state). Once perfected, the security interest is good against the whole world. If your lender fails to perfect, then even if it has a valid security interest against you, because it did not perfect against the world, it can fail in bankruptcy. It is not a part of bankruptcy that causes it to fail, but the fact that the lender did not perfect does.
The reason is Section 544(a)(1) of the Bankruptcy Code. When a business files for bankruptcy, it steps into the shoes of a hypothetical creditor who had a lien against all of the debtor’s property at the commencement of the case. UCC 9-317 tells us that an unperfected security interest is subordinate to a lien creditor. So on the day your business files, the security interest gets subordinated to a deemed judicial lien (unless it’s been perfected). A security interest that is perfected on the petition date will have priority over the business in bankruptcy. The estate gets the benefit of the collateral only after the creditor’s debt is satisfied. But a security interest that is unperfected on the petition date can be avoided. If it is, the creditor ranks with the other general creditors.
There is one exception that helps lenders. Under 9-317, a lender that was not perfected in time can still win, but two things must have occurred: 1) the creditor must have filed a financing statement; and 2) something must have been done to initiate the transaction, such as signing an agreement, making a money advance, or the debtor obtaining rights in the collateral. This rule, titled “filing plus,” is premised on the notion that it is the public warning that matters. Once the public is on notice, it should not matter when the deal is made. This rule was added to the UCC in 2000.
When a debtor files for bankruptcy, the debtor-in-possession (DIP) or, failing that, the unsecured creditors committee will investigate the debtor’s loan documents for problems to the advantage of the bankruptcy estate, while the secured creditors may or may not look at their loans until after the bankruptcy filing. Some typical inquiries: Did the debtor authorize the UCC-1 for example in the security agreement? Is the collateral adequately described? Was the UCC-1 filed in the correct location? Is the debtor’s name listed correctly? Did the debtor change names or its corporate structure or move to another state? Were continuation statements timely filed? Any of these problems may lead the DIP to successfully argue that the lender never perfected its security interest, therefore permitting the DIP to avoid the secured creditor’s interest for the benefit of the debtor’s estate. The result is that the previously secured creditor would now be a mere unsecured creditor.
Adequate Protection
If someone has a valid lien on goods that your business owns (like a truck or a piece of equipment), then they’re usually bound by the “automatic stay” under Bankruptcy Code section 362(a) and have to file a motion for relief from the automatic stay before being able to take any action to enforce his or her rights; or alternatively, they can seek adequate protection of the value of his or her collateral. The options for adequate protection under section 361 include periodic cash payments, additional or replacement liens, or the indubitable equivalent of the creditor’s interest. An administrative expense claim does not suffice. If the bankrupt debtor keeps using equipment or other personal property, the most common form of adequate protection is periodic payments to reflect the depreciation in the value of the property. A significant equity cushion itself may be adequate protection: for example, if the creditor is owed $20,000 and the value of the collateral is $35,000, then the court is likely to conclude that there is little risk to the creditor and the creditor is not entitled to receive periodic cash payments.
Keeping the collateral is not the only option: the debtor-in-possession may sell the collateral, either subject to or free of the lien. The latter is called a “free and clear” sale, and the secured creditor’s “adequate protection” in that case usually consists of a lien on the proceeds of the sale. Under § 363(k) the secured creditor can “credit bid,” bid the amount of its debt in lieu of cash. In other words, the secured creditor effectively chooses between the highest bidder and the collateral itself.
Cramdown a Plan on a Nonconsenting Secured Creditor
You’re in chapter 11, you want to restructure and you want to confirm a plan. But there’s a debt secured by your inventory or equipment, and that lender says no to your proposed deal. Can you go forward without the lender’s permission? Possibly. One of the great benefits of chapter 11 is the power to cramdown a plan on a nonconsenting secured creditor, assuming certain minimum requirements are met. It’s pretty complicated — 11 U.S.C. section 1129 — but in its simplified form, you can do it if the secured creditor gets at least the present value of its collateral. If you pay it up front, or pay it off over time at the appropriate interest rate, or if you simply return the collateral, you have a real shot at confirming a plan over its objection.
In short: the UCC lien that was perfected by the time you filed for chapter 11 sticks around, but the law still gives you lots of ways to slow the lender down - automatic stay, “adequate protection” limits, selling the property under section 363, the “cramdown” process in section 1129. Any UCC lien that was not perfected by the time you filed can be erased, making the lender just another unsecured creditor that shares pro rata with everyone else. That’s why, when you’re the owner of a business looking to file for chapter 11, the first thing you do is have the security agreement and UCC filing documents carefully examined - it can all depend on the details of the paperwork.
