Sometimes the little documents at a loan closing assume critical importance.
As recent court cases continue to illustrate, many lenders forget that the failure to complete a Uniform Commercial Code financing statement properly will transform a secured loan into an unsecured loan faster than a politician can deny responsibility for a bad economy.
Too often, lenders spend hours negotiating and closing a secured loan only to fail to properly complete the uniform-code financing statement. The result is a disaster - an unsecured loan.
Usually the mistake is discovered only after the borrower has defaulted on the loan and a subsequent (but perfected) secured party is challenging the validity or priority of the security interest of the first lender.
The role of a Uniform Commercial Code financing statement in a secured loan transaction is breathtakingly simple. In order to perfect a security interest in typical types of collateral (e.g., equipment, receivables and inventory), the code requires a secured party to file a UCC-1 financing statement in the public records.
The purpose of this filing is to provide sufficient information to a potential lender searching the public record to put the lender on notice that a debtor's assets have been pledged as security to another lender. The financing statement must include the debtor's legal name (as well as the name of the secured party and a description of the items or types of collateral).
It is hard to imagine a more basic requirement or one that is easier for a potential lender to satisfy. How could a lender not know the legal name of its borrower? Nonetheless, lenders not infrequently misspell the debtor's name or use a trade name.
The lender is even at risk when it includes the legal name of the debtor on the uniform-code financing statement but a prior secured lender does not. This is because the code provides that a financing statement is not rendered ineffective as a result of errors that are not seriously misleading.
Accordingly, a financing statement bearing an incorrect name for the debtor may be effective to perfect a security interest, and that security interest may have priority over that of a subsequent secured lender. Including a completely different debtor name on the UCC-1 will render the filing ineffective, thereby failing to perfect the security interest.
However, a certain degree of error in the rendering of the debtor's name is allowed, so long as it does not seriously mislead the searcher. If the discrepancy between the debtor's legal name and the name indicated on the financing statement is so great that a reasonably diligent searcher would not have the minimum information necessary to locate a filing, the filing will fail to perfect the security interest.
In this age of electronic search mechanisms, the inquiry focuses on whether a computer search would be able to locate the financing statement.
In order to for a potential lender to minimize the risk that there is an existing secured lender, the potential lender must not only conduct a search of the records under the legal name of the proposed debtor but under names which courts would recognize as similar enough to the proposed debtor's name as to be discoverable while searching for the debtor's legal name in the public records.
Consider a March 1996 New York bankruptcy court decision interpreting New York law involving a debtor named "Mines Tire Company Inc." The lender's UCC-1 financing statement incorrectly named the debtor as "Mines Company Inc.", omitting the word "Tire." The Court held, despite the failure of a computer search for the specific name "Mines Tire Company" to discover the lender's filing, that the omission of the word "Tire" was minor and would not impede a reasonably diligent searcher from discovering the existence of the financing statement and related lien.
The court based its finding on the fact that it conducted its own Westlaw search using only the first word of the debtor's name, "Mines," which produced 109 entries. Using this search as a starting point, the court proceeded to inspect the documents produced until it uncovered the erroneously filed statement indexed under "Mines Company Inc."
This bankruptcy court decision highlights that institutions wishing to lend money to a debtor can no longer simply rely on a UCC search under the debtor's true name, but must instead be prepared to broaden the scope of their inquiry and potentially sift through hundreds, if not thousands, of irrelevant financing statements. (Imagine how many filings would be generated if the debtor's first name were "International" or "First.")
Even worse, courts have long struggled with how to approach errors in the recitation of the debtor's name in a financing statement - and produced an unpredictable body of case law in the process.
One common financing statement error is the omission of a word from the debtor's name. In one case, financing statement for the debtor "Nara Non Food Distributing Inc." was filed without the "Non Food" in its name. The court held that anyone searching for liens against the company would find the erroneous filing despite the omission.
In another case, however, the complete omission of the debtor's given name failed to provide adequate notice as to the existence of the security interest.
The court held that the use of only "Gail Keaton" on the financing statement filed against the debtor "Charline Gail Keaton" would have prevented its discovery. The court believed that it was unreasonable to expect a searcher to look through all of the filings indexed under the surname "Keaton." Is that any harder than searching through 109 filings against companies whose name starts with "Mines?"
Financing statements are sometimes filed with additional words in the debtor's name. For example, the Court of Appeals for the Second Circuit found valid a financing statement in which the debtor's name was listed as "Excel Department Stores Inc." - when its true name was simply "Excel Stores Inc."
The Court said that anyone searching for liens against Excel would come upon the erroneous filing and be put on notice.
A New York appellate court similarly found valid a financing statement for "The Kohn's Supermarket Inc." which was erroneously filed with the name "Kohn's Supermarket d/b/a Best K Foods Inc."
Omissions and additions of words are not the only type of errors that occur in financing statements.
Misspellings frequently call into question the validity of a security interest. In measuring the effect that a misspelling would have on a searcher, courts have recognized the necessity of an exact spelling of a debtor's surname. A New York appellate court held that the misspelling of the surname "Dragan" as "Dragon" on a financing statement rendered the security interest unperfected.
Misspelling of the name "Ranalli Construction Inc." as "Ranelli" similarly resulted in the security interest being declared invalid.
However, courts have exhibited more flexibility in regard to given names. Although the omission of Charline Gail Keaton's first name was held to be a serious error, a New York appellate court, said that the misspelling of her given name as "Charlene" was only a minor error, and any searcher would have the minimum information necessary for a proper inquiry.
The potential for problems exists whenever an error is made in a financing statement. Lenders should be careful to list the legal name of the debtor.
The specific facts of each case will dictate what constitutes a reasonable search and when an error is not sufficiently misleading. The simple lien search using only the debtor's true name, however, may not always be enough.
Mr. Miller is head of the banking practice at Wilkie, Farr & Gallagher, and Mr. Kurzweil also is associated with the New York law firm.