Understanding corporate distress requires more than just knowledge of the Bankruptcy Code, as we discuss in Installment 7 of this series. Taking a step back and understanding other areas of business law—particularly Article 9 of the Uniform Commercial Code, or “UCC,” as it’s more frequently referred to—provide a foundation for understanding the relationships between a company and its various creditors. In this installment we introduce you to the UCC generally, focusing on Article 9 to illustrate its importance in the context of business distress.
The UCC is a comprehensive set of model laws drafted and proposed by the Uniform Law Commission with the goal of having uniform state laws to govern commercial transactions in the United States. Today, nearly every state in the U.S. has adopted the UCC in its entirety.
The UCC is divided into 11 “Articles.” Article 1 sets forth general provisions applicable to each of the other Articles. Each Article addresses a different area of commercial law, which are:
Article 2 governs the sale of goods. It does not apply to transactions.
Article 2A applies to any transaction creating a lease of personal property (not real estate).
Article 3 governs negotiable instruments representing a promise by one party to pay another (e.g. checks, promissory notes). An instrument is considered negotiable if the holder of the instrument can transfer it (and consequently its right to payment) to another person or entity, and the party who originally promised payment is still held responsible for payment.
Article 4 governs transactions like check processing and automated interbank collections.
Article 4A governs transfers of funds, though it does not govern electronic funds transfers.
Article 5 governs Letters of Credit (often referred to as an “L/C”), which are issued by banks and other financial institutions to their customers to facilitate ongoing commercial activity by guaranteeing a buyer’s payment to a seller.
Article 6 governs sales of assets in bulk, including at auctions and liquidations.
Article 7 governs transactions relating to warehouse receipts and bills of lading, including provisions establishing warehouseman’s liens, carrier liens, and the negotiation and transfer of warehouse receipts and bills of lading.
Article 8 governs transactions relating to equity interests (shares of stock, LLC member units, etc.) issued by registered investment companies under federal investment laws, as well as other equity interests in investment vehicles like trusts and face-amount certificate companies.
Article 9 governs secured transactions under which a borrower grants a security interest in personal property for the benefit of a lender, in exchange for money loaned. The personal property acts as collateral for the lender, which the lender can look to for repayment of the borrower’s loan obligations in the event the borrower does not or cannot repay the loan. Notably, Article 9 does not address secured transactions relating to real estate.
UCC Article 9 governs “security interests” in personal property, and it contains detailed rules regarding (a) the creation, “attachment,” and “perfection” of security interests in various types of collateral; (b) the relative priorities of security interests; and (c) “defaults,” and remedies available to a creditor upon default.1
For our purposes, security interests and liens can be thought of interchangeably. Security interests and liens are fundamental legal tools in our modern economy. They provide lenders with the comfort of having a source of repayment available to them in cases where debtors default.
A security interest is a present grant of a property right.2 It is usually, but not always, nonpossessory, since the debtor/borrower wants to be able to use the collateral while the security interest is in force. A security interest may ripen into a full ownership interest through the process of default and foreclosure. The collateral—the personal property that is encumbered by the security interest—may be tangible or intangible. For example, personal property may include tangible items like trucks, office furniture, or inventory; but personal property can also include intangible items, like a trademark or an account receivable.3
The UCC standardized the rules and procedures for taking, preserving, renewing, and releasing security interests. This standardization dramatically lowered transaction and enforcement costs that previously arose by virtue of individual jurisdictions enacting and enforcing their own nonuniform rules governing personal property security interests.
Article 9 was completely revised and restated in 2001, and every state in the nation has adopted the revised version of Article 9. But even though revised Article 9 is now the law of the land, “old” Article 9 is still relevant because of the vast amount of case law construing its provisions, many of which were incorporated into revised Article 9. And while there is some variation between states’ applicable UCC, these variations are relatively minor and limited in number.
Since Article 9 has been so widely adopted, it is essential for debtors and creditors—especially when entering into a secured lending transaction where a creditor intends to take a security interest in a debtor’s personal property—to at least be familiar its fundamental applications and concepts to understand what is needed to create and enforce a valid lien, or what can be done to challenge a purported lien.
As we state above, Article 9 governs the creation, “attachment,” and “perfection” of security interests in various types of collateral, which is to say that a valid security interest doesn’t appear out of thin air. If a creditor and debtor intend to create a valid security interest with the highest priority available, they (mostly the creditor) must jump through the hoops created by Article 9 to do so.
A security interest “attaches” to collateral when it is valid and enforceable against the debtor. Attachment does not always make a security interest valid against third parties, though. For example, an intervening judgment creditor can levy on a secured creditor’s collateral, even if a security interest has previously attached to the collateral, and gain a higher-priority security interest over the secured creditor.
When is a security interest enforceable against a debtor and third parties? For the answer, we look to UCC § 9-203(b), which provides that a security interest is enforceable against a debtor and third parties if (1) value has been given; (2) the debtor has rights in the collateral (or the power to transfer rights in the collateral to a secured creditor); and (3) the debtor has signed a security agreement, the collateral is in the possession of the secured creditor, or, in the case of certain types of collateral, the secured creditor has “control” of the collateral.4
Secured creditors can avoid the judgment creditor situation described above by “perfecting” their security interests in a debtor’s collateral, which we discuss next.
Think of “perfection” as making a security interest good against the world, not just between the parties to a security agreement. Once perfected, a secured creditor’s priority status against the collateral concerned will be fixed. The twin topics of perfection and priority are addressed at UCC § 9-301, et seq.
Let’s return to our judgment creditor example. If our intrepid judgment creditor levies on collateral in which a secured creditor has a properly perfected first position security interest, the judgment lien will be junior in priority to that security interest, and the judgment creditor will only be paid from the proceeds of the collateral if the senior secured creditor is first paid in full, or agrees to take less than full payment in satisfaction of its lien.
So now that you know the power of perfection, you may naturally want to know how a security interest is perfected. A security interest is perfected when the creditor and the debtor have done everything that needs to be done (including executing and filing documents) to complete the transaction or transfer (e.g., the creditor has loaned the money, the debtor has promised to pay it, and has promised that the creditor has first dibs on the collateral if the debtor does not repay the loan) and that the creditor has done what is necessary under Article 9 to tell the world (“give notice”) that it claims a stake in the collateral. For personal property, perfection is generally accomplished by filing a properly completed form UCC-1 (referred to in the UCC as a “financing statement”) in the appropriate public record, most often the office of the secretary of state.
Understanding the basic mechanics surrounding the creation and perfection of a security interest would be sufficient if we were talking about these concepts in a vacuum. But we’re here to understand distress, which in the context of a secured transaction, is nearly always accompanied by a debtor in “default,” on its obligations to its secured lender. A default exists when a borrower fails to honor one or more of its obligations to a secured creditor under the terms of the security agreement. Most frequently, a default occurs when a debtor fails to make timely payments to its secured lender as required under the security agreement. Security agreements will almost always include specific terms that set forth other events that will trigger an event of default (breaching covenants under a security agreement, for example), so even if a debtor is current in terms of payment, it may nevertheless be in default because some other triggering event has occurred.
When a default exists, a properly perfected secured creditor will have a host of rights under Article 9 to enforce its lien against the debtor and levy upon the collateral securing its lien. Depending on the specific facts at issue, the remedies available to the secured creditor and debtor are diverse. What is important to understand is that, if a default occurs, the secured creditor will have to right to foreclose its security interest, repossess the collateral, and liquidate the collateral to pay down its secured claim against the debtor.5 The secured creditor may also obtain a judgment in court against the debtor, and if the value of the collateral is not enough to pay down the secured creditor’s claim in full, the judgment obtained in the secured creditor’s favor will typically grant it the right to enforce its judgment for a “deficiency claim,” e.g. the difference between what the collateral was worth, and the amount the secured creditor is still owed after liquidating the collateral.
As we discuss in Installment 5, a distress situation gives rise to numerous roads down which creditors and debtors may travel. From the perspective of a secured transaction governed by Article 9, it is important that a secured creditor do what it can to ensure its lien has been properly documented and perfected long before an event of default occurs or a debtor files for bankruptcy, because in the event of a default or chapter 11 filing, parties may come out of the woodwork to attack the validity, extent, and priority of an asserted lien. These parties may include the debtor, a creditors’ committee in chapter 11, or other secured creditors jockeying for position on the priority tower.
As we have illustrated, Article 9 (and the UCC generally) have broad implications for doing business, whether you’re a debtor who’s financed your business with a secured lender, the secured lender itself, or an unsecured creditor trying to understand where you stand in relation to a distressed debtor’s other creditors. Knowing Article 9, or at least having enough of a familiarity with it to know when to contact a professional, is therefore an essential tool in any businessperson’s toolkit.
The authors are corporate restructuring and insolvency attorneys. Read more about three of them at the end of Installment 1.
Understanding all this stuff in the context of bankruptcy is important, but not every distressed company winds up in bankruptcy. So, you also need to understand how it works outside of bankruptcy. Read Installment 13 to get the rest of the story.
To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):
©2022. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Jonathan Friedland is a principal at Much Shelist. He is ranked AV® Preeminent™ by Martindale.com, has been repeatedly recognized as a “SuperLawyer” by Leading Lawyers Magazine, is rated 10/10 by AVVO, and has received numerous other accolades. He has been profiled, interviewed, and/or quoted in publications such as Buyouts Magazine; Smart Business Magazine; The M&A…
Jack is a corporate and restructuring partner in the Chicago office of Sugar Felsenthal Grais & Helsinger LLP. Jack’s practice covers a range of healthy and distressed business engagements. He is widely recognized for his excellent work as a restructuring attorney including recognition by various organizations for his strategic thinking and tactical expertise, including SuperLawyers…
Hajar is an associate with Much Shelist in both its Business Transactions Group and its Restructuring & Insolvency Group.
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Dealing With Defaults Under Article 9 of UCC: A Player’s Guide for the 21st Century
How a Distressed Company Can Manage Cash and Stakeholders in a Liquidity Crisis
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