If your business has borrowed against its equipment, receivables or inventory, there’s a good chance one or more of the lenders is holding a UCC-1 financing statement, typically filed with the secretary of state. What happens to these loans if you file Chapter 11? If a lender went through the proper legal steps to file a UCC-1 statement against your business, that’s a perfected lien and it’s going to survive the filing. Lenders don’t always perfect their liens correctly, and there is a chance that the lien won’t hold up to scrutiny. In that case, it might not survive the bankruptcy. The rest of the post will explain the relationship between bankruptcy and UCC filings in more detail.
Security Interest
The “UCC” is the Uniform Commercial Code, a model set of rules that states adopt as their own. Almost every state has adopted almost all of the UCC. A UCC lien is called a “security interest” in personal property. This type of lien is described in Article 9 of the UCC. Can you put equipment, a car, a copier, a copyright, or accounts receivable up for loan? Yup, all that stuff is collateral. (By contrast, real estate is not covered by Article 9. Mortgages on real estate are governed by state mortgage laws.)
A security interest isn’t worth much if it can’t be enforced. Before a security interest can be enforced against the debtor, the security interest must have “attached”. The basic requirements for attachment are:
- value has been given;
- the debtor has “rights in the collateral”; and
- the debtor has signed a security agreement.
The second step is perfection. Perfection means that the lender has taken some additional step to put the rest of the world on notice that it’s claiming a lien. UCC-1 financing statements are the most common form of perfection. The difference matters. An attached but unperfected lien can lose against someone else, such as a judgment creditor that levies on the collateral. If the lender has attachment but not perfection, the lender’s security interest is good against you, but not against the bankruptcy trustee.
Bankruptcy is very weird and at times highly counterintuitive. Ch. 11 creates an automatic stay that freezes the world of your company. Lenders can’t repossess equipment or foreclose on a mortgage without asking the bankruptcy court for relief from this automatic stay. Meanwhile, on the date the petition is filed, the debtor in possession (the DIP) acquires the rights of a “hypothetical lien creditor” by virtue of Bankruptcy Code section 544(a)(1). Your company is treated as if it had won a judicial lien on everything it owns at the moment the case began. The UCC provides in section 9-317 that an unperfected security interest is subordinate to the rights of a lien creditor.
Put those rules together. Consequently, if the lender has a perfected security interest as of the petition date, the lender can step up and get paid first from its collateral. However, if the lender’s security interest has not been perfected as of the petition date, the lien is avoided and the lender becomes a general unsecured creditor. In other words, the lender’s lien is eliminated, and the lender’s claim is satisfied along with all of the other general unsecured creditors on a pro rata basis.
Unless… There is an exception called “filing plus”. If the lender had filed a financing statement and also had done at least one of the following:
- the parties signed a security agreement;
- the lender made an advance; or
- the debtor acquired rights in the collateral, then the lender can still prevail over the lien creditor.
Lenders need to get their liens perfected long before a bankruptcy ever gets filed. But often, a bankruptcy is the event that gets them to go back and check the paperwork. Meanwhile, when the filing is made the DIP should be checking the same paperwork for holes, and if it doesn’t the creditors committee (which represents the general unsecured creditors) probably will. The questions are practical ones. Can you perfect a lien on this type of collateral by filing a UCC-1? Does the lien attach to all the collateral listed? Did the debtor authorize the UCC-1 (e.g., in the security agreement)? Is the collateral sufficiently described? Filed where it’s supposed to be? Is the debtor’s name correct? Has the debtor changed its name or business structure, or relocated to another state? Were continuation statements timely filed? Problems with any of these could mean that the DIP can argue that the lien is unperfected, avoid it and preserve it for the benefit of the estate, and the lender will become a general unsecured creditor.
Adequate Protection, Sale and Cram Down
If the lien is valid and cannot be avoided, the DIP can do quite a bit with it. However, the lender will be entitled to “adequate protection” of its interest. The lender is also subject to the automatic stay. If it wants to enforce its remedies, it must seek relief from the stay; or it can seek adequate protection of the value of its collateral. (Code 362(a), (d)(1).) Section 361 defines adequate protection fairly loosely: The lender can get periodic cash payments, additional or replacement liens, or the “indubitable equivalent” of its interest. But to be clear: “adequate protection” does not mean promoting the lender to administrative expense status.
Adequate protection mitigates some of the risk of allowing the debtor to keep using the collateral. The most common form of adequate protection is periodic payments to offset wear and tear and depreciation on equipment which the DIP keeps using. But an equity cushion can work by itself. For instance, if the lender is owed $20,000 and the collateral is worth $35,000, the court may well find that the lender faces little risk and is not entitled to periodic payments.
The DIP can sell the lender’s collateral either subject to its lien or free and clear of it under Code 363(f). When it’s sold free and clear, the normal form of adequate protection is a replacement lien on the sale proceeds. Under 363(k), the lender has the right to “credit bid” using its debt instead of cash. In other words, the lender does not have to pay cash to buy the asset. That lets the lender ensure that the collateral is not sold for too little; it can bid its debt instead and take the collateral in exchange for forgiving the debt, or let the DIP sell to the highest third-party bidder.
Finally, the DIP can cram down the lender under its plan of reorganization if the requirements of Code 1129 are satisfied. Very roughly, this means that the lender must receive at least the present value of its collateral, either through immediate payment, deferred payments (with interest), or by giving the collateral to the lender. If your business can do that, it has a shot at confirming a plan over the lender’s objection.
In short, for an owner of a struggling small business, a perfected security interest is preserved but the practical scope of that interest may be limited by the stay, adequate protection, sale and cram down provisions of the Code. Where a security interest is unperfected, it may be avoided, leaving the lender as an unsecured creditor. Early professional evaluation of filings is prudent. How many people have filed UCC financing statements against my company? The good news? If you want a preliminary answer in a snap, the answer may already be public. Pull those filings and go over them with a bankruptcy attorney before you file.
