By Luis Torres

The rules for perfecting a security interest in assets of a borrower are expected to change on July 1.

Many banks and other lenders must take steps to resecure their loans or they may find themselves without the protection they thought they had when the loans closed after a borrower fails to repay his debts.

Lenders have one year to rework their security arrangements for some types of collateral and five years for other types.

The rules for secured lending are in article 9 of the Uniform Commercial Code, or UCC. The UCC is a uniform set of laws that all states have adopted to govern commercial transactions. The conference of commissioners on uniform state laws rewrote article 9 in 1999, and the states have been gradually replacing their existing statutes with the new one. The uniform conference tentatively set July 1 this year as the date the new rules will take effect. However, if not all state legislatures have adopted the new rules by then, the date could be delayed.

Two basic questions arise in any secured lending transaction. One is in what types of assets of the borrower it is possible for the lender to take a “security interest.” A secured lender has priority over unsecured creditors of the borrower in the event the borrower is unable to repay all his debts. The other question is how the lender can “perfect” his interest, or put the world on notice that he has a claim so that others whose claims arise later in time come behind him in line. There our four ways to perfect a security interest. Some ways give the lender priority over other creditors, even though the others perfected their interests earlier in time.

New Types of Collateral

The first thing the new rules do is add to the types of collateral over which a lender can take a security interest. This is a move that was welcomed by the project finance community.

One new type of collateral is deposit accounts, such as “waterfall accounts” deposited in a bank. A lender perfects a security interest in these by obtaining “control” over the account. This can be done in one of three ways. The lender has control if a) it is the depository bank where the account is maintained, or b) the depository bank agrees to follow the lender’s instructions regarding the account without the need for the borrower’s consent, or c) the account is maintained in the name of the lender. This last approach of putting the lender’s name directly on the account gives the lender a type of super priority ahead even of the depository bank’s rights of recoupment or setoff.

Another new type of collateral is rights over letters of credit. The security interest would be in the cash to be withdrawn by a beneficiary of the LC, but not in the drawing right itself. As with deposit accounts, the lender must perfect his interest by gaining “control.” In this case, “control” is achieved by obtaining consent to the assignment from whomever is obligated to give value under the letter of credit — usually the LC bank.

Another new type of collateral is supporting obligations, like guarantees. A lender will get a security interest in these automatically to the extent he has a security interest in the underlying obligation. For example, if a third party has guaranteed the value of an asset that has been pledged as security for a loan, the lender gets an interest in the guarantee automatically without the need for further action. His interest in the guarantee has the same priority as his interest in the underlying asset.

“Payment intangibles” will also be subject for the first time to article 9. An example of a payment intangible is a cash flow stream that one uses to borrow against in a securitization transaction. This should facilitate securitization transactions, since the rules will now be clearer for how lenders protect their interests in the cash flow standing behind the securitization. New article 9 will also cover the sale of promissory notes.

Beware that in order to accommodate new types of collateral, the definitions given to existing types of collateral have been substantially revised. This is important because how one perfects a security interest in collateral depends on which category of collateral is involved. To the extent classifications have changed, then different steps may have to be taken than in the past to secure an interest in a particular asset of the borrower.

Priorities

A lender needs to “perfect” his security interest — or put the world on notice — before the interest has much meaning. There are four ways to perfect a security interest under existing article 9. These have not changed.

However, how one perfects a security interest depends on the type of collateral involved and — to the extent that particular assets have moved into different collateral categories under the new rules — a lender with existing loans may have to take action to ensure he preserves his place in line in relation to other creditors.

The four ways to perfect a security interest are a) automatic perfection by operation of law, b) filing a financing statement, c) taking physical possession of the collateral, and d) obtaining “control” over the collateral.

The dominant method of perfecting security is by filing a financing statement. Under new article 9, most financing statements must be filed where the borrower is located. This is a change from current law. Most filings today are made where the collateral is located. US corporations, partnerships and limited liability companies are considered located in their states of “registration,” meaning the state under whose laws the entity was formed. Thus, where a Delaware LLC is the borrower for a project in Oklahoma, the financing statement will have to be filed in the future in Delaware. In the case of a “nonregistered” entity, like a sole proprietorship, the filing must be in the place where the entity has its sole place of business or where its chief executive has his office. Foreign borrowers from countries where the law does not provide for public filing of financing statements — for example, Russia or Holland — will be treated as if they are located in the District of Columbia.

Even though new article 9 requires filing where the borrower is located in most cases, it retains local filing for real-estate-related collateral. There are also special filing provisions for utilities that own transmission grids.

A security interest perfected by filing is inferior in rank to certain security interests perfected by means of “control” even if the filing was made before the other creditor secured “control.” For example, this is true of deposit accounts, “investment property” like the permitted investments a borrower makes of spare cash, and letter of credit rights. As a consequence, most lenders try to secure control over these types of assets even while they rely on filing or automatic perfection to perfect security over the rest of the borrower’s assets.

Permitted Investments

New article 9 changes the rules for “investment property” — like permitted investments that a borrower makes of spare cash. First, for perfection, a lender may exercise control for the first time through a third party, such as an agent, who must acknowledge that it has control on behalf of the lender. Second, all security interests perfected by control will no longer rank equally; instead, the first in time will prevail. Finally, a lender’s control over a securities account that is in the name of the borrower need not be unconditional. Thus, the lender’s “control” can be subject to a default by the borrower or consent by a more senior lender before it comes into play.

Enforcement Proceedings

Until now, a lender planning to foreclose on security had to foreclose on all the security at once. New article 9 allows “partial strict foreclosure,” or the ability to accept collateral in partial satisfaction of the borrower’s obligations. This should give lenders more tools in default situations. Lenders will be able to accept collateral in full or partial satisfaction of the obligations as long as some conditions, such as consent by the debtor and notice to other lienholders, are met.

In another change from current law, new article 9 will also impose on creditors who sell or otherwise dispose of collateral the duty to extend warranties of possession, title, quiet enjoyment and the like, although these warranties can be explicitly disclaimed or modified. Statutory liability will be imposed on creditors who fail to comply with their obligations; debtors are allowed to obtain injunctive relief and monetary damages for any loss caused by the secured party’s noncompliance.

When a lender forecloses, it can only cover its “loss” out of the borrower’s assets. There are three ways to calculate loss currently. New article 9 adopts a single way to calculate it as a rebuttable presumption. This is probably for the good since it eliminates current uncertainties.

Transition

The new article 9 rules are expected to take effect on July 1. Old security arrangements will need to be updated.

If a lender perfected his security interest by a means other than filing a financing statement, then he has just one year from when the new rules take effect to comply with the new rules. After that, he is in danger of no longer having a perfected security interest. There is no need to wait until after July 1 to act. At a minimum, many lenders are already reviewing their portfolios, assessing what needs to be done to resecure their positions under the new rules, and taking action.

Lenders who perfected their security by filing financing or continuation statements have five years to file new financing statements. A new filing will relate back in time to the original filing, even though it may have been in another state, as long as it identifies the original filing.