By Luis Torres

Project lenders who were not paying attention to their calendars may have less security in a debtor’s assets than they think they do.

July 1 marked an important deadline under new “secured lending” rules adopted by most states — including New York — just over a year ago. The new rules, which are based on a revision of article 9 of a uniform group of laws called the “Uniform Commercial Code,” govern lending transactions in which a lender stakes a claim in a borrower’s assets as collateral for making a loan. If the borrower defaults, the lender — the “secured party” — can seize the asset. The interest a lender takes in a borrower’s assets is known as a “security interest.”

July 1 was the expiration date for one of the grace periods in the new rules that gave lenders time to “re-perfect” security interests that were established under the prior rules.

“Perfection” is the mechanism by which a lender puts the world on notice that he has a claim on a particular item of the debtor’s property. This makes future lenders aware that the first lender has “priority” over that asset. Perfection allows the secured party to enforce its security interest against the debtor, while protecting its claim on the asset against claims of third parties such as creditors who came later in time or who agreed to stand second in line with respect to the debtor’s assets.

Lenders who perfected their claims under the prior rules, but missed this deadline, need to re-perfect their security interests as soon as possible. Otherwise, they run the risk of being displaced by other creditors, who may “perfect” first and obtain a better claim over the collateral.

Background

In order to facilitate a transition to the new rules, new article 9 “grandfathered” certain security interests that had already been perfected under the old rules. New article 9 contains two key grandfather provisions. The rule that applies to a particular set of facts depends on the type of property that secures the loan. (Different types of assets are secured in different ways.) The first provision applies to types of collateral that were perfected under the old rules by the filing of financing statements. This includes property like trade instruments and general intangibles. In these cases, if the financing statement filed under the old rules was filed in the same jurisdiction in which it should be filed under the new rules, then such a financing statement — and, therefore, such perfected security interest — is valid until the earlier of its scheduled lapse date or June 30, 2006.

The second grandfather provision is the one that expired on July 1, 2002. It applies to collateral that was perfected under the old rules by methods other than filing. This category includes certain “waterfall” accounts and letter-of-credit rights that were perfected by possession. The rule provides that if the perfection requirements for this collateral under the old rules are different than the perfection requirements under the new rules, then the parties had until July 1, 2002 — one year after new article 9 entered into effect — to comply with the new requirements. If there was no compliance by July 1, 2002, then the security interest became “unperfected.” In other words, the world no longer has notice of the secured party’s priority over the respective collateral, and other third parties, such as creditors who should have a lower claim to the collateral, can perfect a security interest over the collateral and obtain a higher level of priority.

Areas of Concern

There are at least three areas of concern for lenders who missed the July 1, 2002 deadline.

The first area of concern to project finance lenders relates to “waterfall accounts.” Often established in loan agreements or collateral account agreements, waterfall accounts are accounts through which a project’s earnings are funneled so that the lender knows the borrower is using the project’s income to keep the project running instead of distributing the cash to itself. Funds in waterfall accounts must often be used to service debt, satisfy operations and maintenance costs, and maintain reserve requirements, and the lender typically takes a security interest in them. Most project finance lenders treat these cash collateral accounts as “securities accounts,” which have not been affected by the July 1 deadline. However, because these accounts may hold cash as well as certain securities, there is the possibility that they may be characterized as “deposit accounts,” which do fall under the new secured lending rules. The consequence of characterizing a waterfall account as a deposit account is that a perfected security interest in the account should have been continued before the July 1 deadline.

There are differences of opinion about whether any steps were necessary to continue a lender’s security interest in waterfall accounts prior to July 1, 2002. On one side, some argue that no additional steps were necessary because these accounts are often expressly considered to be securities accounts. Advocates of this view point out that most project finance agreements governing waterfall accounts contain a representation that the waterfall accounts are indeed securities accounts. Therefore, there is little room to argue that such accounts are better characterized as deposit accounts. Advocates of this view also argue that even if the waterfall accounts are deposit accounts, security interests in securities accounts and in deposit accounts are perfected through the same mechanism and, thus, no additional steps were necessary to continue perfection of a security interest in these accounts.

Some lenders take a conservative approach and amend a project’s collateral accounts agreement to reflect the possibility that the accounts could be characterized as either securities accounts or deposit accounts. One consequence of amending account agreements this way is that financial agents that act as “securities intermediaries” in connection with the control of securities accounts have now been requested to act also as “banks” for purposes of obtaining control over deposit accounts. In practice, these are very similar roles, so most agents have accepted the change. The agents’ non-adverse reaction is not surprising — these amendments or supplements do not change the basic relationship among the parties that existed prior to the entering into effect of the new rules. Instead, they simply clarify the rights of the secured parties and the role of the agents in the event that the waterfall accounts are considered deposit accounts.

The second area of concern to project finance lenders relates to security interests perfected through a “bailee’s” possession of the collateral. A lender can perfect a security interest in certain types of collateral (such as goods, instruments, or CDs) by appointing a third party — known as a bailee — to hold the property for the duration of the loan. If a lender perfected a security interest in this manner prior to July 1, 2001 but took no subsequent steps to continue its perfection prior to July 1, 2002, then the lender should notify the bailee of its security interest and obtain an acknowledgment from the bailee that it holds the collateral for the benefit of the lender.

A third area of concern relates to letters of credit. If a lender perfected a security interest in a letter of credit prior to July 1, 2001 by taking possession of the letter of credit but took no further steps to continue its perfection after July 1, 2002, then the lender should obtain “control” of the letter of credit in order to continue perfection. To obtain control, the lender must obtain the issuing bank’s consent to assign the proceeds of the letter of credit.

Final Thought

In addition to taking any of these steps, lenders who did not meet the July 1, 2002 deadline may wish to seek assurances that no other creditors have obtained a higher level of priority. A lender may do so by obtaining a representation from the borrower, as well as from a bank, bailee, or issuer of a letter of credit, as applicable. The representations should confirm that no other party has a security interest over such collateral and that the lender’s security interest constitutes a perfected, first-priority security interest over such collateral.