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Unauthorized UCC Terminations May Extinguish Secured Lenders’ LiensYou Thought You Had a Priority Lien:

The due diligence is complete, the loan documents are signed and the UCC financing statement has been filed and recorded in the proper jurisdiction. A lender should therefore reasonably anticipate that its priority position will continue to be secured, right? According to a recent case in the Southern District of New York, this expectation may be completely wrong. • By Jason I. Miller, Esq.

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Roswell Capital Partners LLC v.

Alternative Construction Technolo-

gies, 2010 LEXIS 90695 (S.D.N.Y. Sept. 1,

2010) contradicts both the policy and

statutory language of Article 9 of the

Uniform Commercial Code (UCC) and

creates obligations for secured parties

of active oversight of post-closing

UCC filings not intended by statute.

Because this case involves issues of

perfection and priority, lenders and

their counsel are rightly taking notice.

In Roswell, JMB Associates (JMB)

provided financing to Alternative

Construction Technologies (ACT) under a

convertible promissory note dated June

1, 2006. The promissory note permitted

the conversion of ACT’s debt obligation

into ACT equity at JMB’s option. The

promissory note also provided that if

the price of ACT’s shares fell below $2.00,

JMB would have the option to unwind

the transaction and convert the equity

back into debt. The loan closed, JMB

filed a UCC financing statement and JMB

exercised its option to convert the debt

into shares of ACT stock.

Subsequently, Roswell Capital

Partners LLC, as collateral agent for

a group of lenders, negotiated with

ACT in connection with a proposed

additional financing for ACT. Roswell

and the lenders conducted due dili-

gence prior to the funding, and their

inquiries revealed that the prior loans

from JMB to ACT had been converted

into equity.

On June 30, 2007, Roswell and ACT

entered into security agreements un-

der which ACT granted Roswell a sup-

posed first lien on its assets. On July 2,

2007, without prior authorization from

JMB as required by the JMB promis-

sory note, ACT filed a UCC termination

statement terminating JMB’s financing

statement. Three days later, Roswell

filed a UCC financing statement to

perfect its security interest.

In July 2008, ACT’s stock price

dropped below $2.00 per share and

JMB exercised its option to convert

its equity back to debt. JMB asserted

that these actions reconstituted the

original debt evidenced by the June 1,

2006, promissory note. Meanwhile, ACT

defaulted on its loan from Roswell and

Roswell initiated a suit to foreclose

on ACT’s collateral. JMB joined the suit

and disputed the seniority of Roswell’s

security interest, as well as the valid-

ity of the UCC termination statement.

Roswell moved for summary judgment

and the court granted its request.

The court held that the debt-to-

equity conversion extinguished

JMB’s security interest, and therefore

Roswell had a prior perfected security

interest in ACT’s assets. Though it

acknowledged that its decision on the

conversion issue alone was sufficient

to grant Roswell summary judgment,

the court went on to address a second

issue at length: whether the filing of

the UCC termination statement was

effective, despite ACT filing it without

JMB’s express authorization. The court

found for Roswell again.

Although the determination regard-

ing the extinguishment of the security

interest may raise a number of issues,

the court’s holding with respect to

the UCC termination statement is

particularly troublesome. The court

decided that there is a “clear rule” that

filing a termination statement, even

if done so mistakenly, extinguishes a

secured creditor’s lien on the debtor’s

property. The court extended this rule

even further by explaining that “[p]

otential creditors must be able to

rely on termination statements, even

if they were filed in error or without

authorization.”

According to the court, if an un-

authorized termination statement is

filed, the only remedy available to a

secured party is to sue the debtor for

damages and noncompliance under

UCC § 9-625. JMB stressed to the court

that the UCC is a “notice filing” sys-

tem, and it therefore argued that after

becoming aware of the termination

statement, Roswell (like all prospec-

tive lenders in the same situation)

had the duty to investigate further to

ascertain the full state of affairs. The

court rejected this argument on the

grounds that the duty of further inqui-

ry expressed in the Official Comment

to UCC § 9-502 only applies to financ-

ing statements and not to termination

statements. In addition, the court

pronounced that “[t]he UCC places

a burden on monitoring potentially

erroneous UCC-3 filings on existing

creditors who are aware of the true

state of affairs as to their security in-

terests, rather than potential creditors

who will not be in a position to know

whether a termination statement was

authorized or not.”

The troublesome implications

of this decision are clear. Roswell

supports the proposition that an

unauthorized termination statement

is fully effective in undermining a se-

cured party’s perfection. It also explic-

itly imposes a burden on the secured

party of record to monitor the public

records periodically for unauthorized

and erroneous filings. This new burden

will impose administrative hardships

for lenders and may increase transac-

tion costs for borrowers.

Fortunately, there are reasons se-

cured parties need not panic over the

Roswell decision. The case is flawed

and it will prove difficult for other

courts to follow the reasoning and

conclusions of the court. Moreover,

no other court has previously adopted

the court’s interpretations of Article 9

and the policies underlying it.

In order to highlight the court’s

fundamental errors, below is a discus-

sion of the court’s flawed holdings,

which are central to its opinion, and a

comparison of each error with the text

of Article 9.

Roswell Decision: The provisions of

Article 9 that reference a secured party’s

obligation to conduct further inquiry

apply only to “financing statements” and

not termination statements.

Article 9: The court misinterpreted

the duty of further inquiry here. UCC

9-102(93) defines a “financing state-

ment” as “a record or records com-

posed of the initial financing state-

ment and any filed record relating

to the initial financing statement.”

Accordingly, the term “financing state-

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ment” includes the initial UCC financ-

ing statement and all subsequently

filed records, such as attachments,

UCC amendments and terminations,

and UCC information statements. It

is noteworthy that the drafters of

Article 9 generally used the phrase

“initial financing statement” when the

intent was to limit the application of

a certain provision to a UCC financing

statement. Thus, even if the duty of

further inquiry applies to “financing

statements,” it must also apply to

related termination statements.

Roswell Decision: “Even if the termi-

nation statement was not authorized by

[the secured party of record] it, nonethe-

less, extinguishes any perfected security

interest [the secured party] had in the

Collateral . . . This clear rule accords with

the policy of the UCC. Potential credi-

tors must be able to rely on termination

statements filed in the public record,

even if they were filed in error or with-

out authorization.”

Article 9: Putting aside the fact

that the court ignores the specific

requirement in the underlying security

agreement that JMB had to endorse

any termination of its UCC financing

statement for such termination to be

authorized, one of the key concepts

under Article 9 of the UCC is that of

“authorization to file” and the fact

that an unauthorized UCC filing has no

legal effect. Section 9-510(a) provides

that a filed record is effective only to

the extent it was filed by someone au-

thorized to do so under Section 9-509.

Section 9-509(d), in turn, squarely ad-

dresses the filing of UCC amendments

other than those adding collateral

or debtor names (e.g., terminations)

and provides that “a person may file

an amendment . . . only if the secured

party of record authorizes the filing,”

except in certain limited circumstanc-

es not applicable in Roswell. A mistak-

enly filed but authorized termination

statement is effective; however, an

unauthorized termination statement

is not effective.

Roswell Decision: “The UCC there-

fore places the burden of monitoring

for potentially erroneous UCC-3 filings

on existing creditors, who are aware

of the true state of affairs as to their

security interest, rather than potential

creditors who will not be in a position

to know whether a termination state-

ment was authorized or not.”

Article 9: The court provides no

logical basis for its assertion that “the

UCC places a burden on monitoring

potentially erroneous UCC-3 filings on

existing creditors,” nor does the court

explain how its statement squares

with the text of Article 9. Moreover,

the court’s recommendation to

monitor the public record is intellectu-

ally inconsistent with the rest of its

opinion because, based on the court’s

earlier holding, even if a secured party

discovers an erroneous or fraudu-

lent UCC termination filing, it would

always be too late. The unauthorized

termination statement would have

rendered the UCC financing statement

ineffective upon its filing.

The court erred in dismissing JMB’s

argument that the UCC has adopted

a “notice filing” system. Official Com-

ment No. 2 to UCC § 9-502 makes this

abundantly clear. The filing system

provides searchers merely with inqui-

ry notice. Once the 2010 Amendments

to Article 9 are adopted by the states,

a new Official Comment to Section

9-518 will make this even clearer.

The Roswell case is currently on ap-

peal, but unless the courts withdraw,

overturn or otherwise reject the deci-

sion, the case could cause problems

for secured parties. Competing lend-

ers, bankruptcy trustees and debtors

may cite this case as their authority to

terminate a secured party’s security

interest without authorization.

Until Roswell is reversed, what

should a prudent lender do to protect

itself? First, in any debt-to-equity

reconversion scenario and upon

reconstitution of the debt obligation,

the lender should promptly conduct

a search and file a new UCC financing

statement. As the court suggested,

secured parties should consider taking

steps to monitor their filed financing

statements for unauthorized termina-

tion filings. Many search providers cur-

rently provide such a service and charge

a nominal fee for each filing monitored.

If an unauthorized filing is de-

tected, then a secured party may wish

to evaluate whether to discontinue

funding and freeze any further exten-

sions of credit until the situation is

resolved. Although Article 9 does not

require that a secured party take any

action to remain perfected, a prudent

secured party may want to file a new

financing statement as a precaution-

ary measure and file a UCC Informa-

tion Statement explaining the situa-

tion. The UCC will put any subsequent

searchers on notice of the dispute.

Finally, if any junior creditors stand

in line to receive a windfall as a result

of the unauthorized termination, the

secured party may want to seek sub-

ordination agreements quickly from

such junior creditors. These measures

may prove unnecessary if Roswell is

reversed, but until then, this case pres-

ents an increased risk for lenders. TSL

Jason I. Miller is an associate in Blank Rome

LLP’s New York office. He advises secured

lenders, syndicated loan agents, international

banks, finance companies, creditors, debtors

and equity holders in connection with a wide

range of matters. He can be reached at

JMiller@BlankRome.com.