Bankruptcies are on the rise and what this means for transactional attorneys

(As published in Legal Reader)

As we enter the latter half of 2023, we’re seeing a continued rise in bankruptcy filings.  According to the Administrative Office of the U.S. Courts, business filings rose 23.3% in the 12-month period ending June 30, 2023. Chapter 11 filings have jumped 68% in the first half of the year, as compared to prior year. For context, bankruptcy filings over any 12-month period have increased rarely since the peaks of 2010.

Multiple factors have contributed to the wave of bankruptcy filings, in a domino-like effect. The U.S. economy has been fighting to shake the effects of the COVID-19 pandemic, where supply chain shortages led to the highest inflation in 40 years.  In response, the Federal Reserve increased interest rates 11 times between 2022 and 2023, with borrowing costs hitting a 10-year high. This made refinancing difficult, resulting in a spike in bankruptcy filings. 

So, what does this mean for transactional attorneys? At a minimum, transactional practitioners should review and tighten their due diligence practices. If you represent lenders or other secured creditors, you’d want to ensure that your clients’ security interests are perfected. Following are common pitfalls in the lien perfection process and insights to ensure that your client’s position gets priority should the debtor file for bankruptcy. 

Are your clients’ liens perfected?

For those representing lenders and creditors, the recovery rates in bankruptcy underscore the importance of perfecting liens. According to data compiled by NGR on 1H bankruptcy filings, the average recovery rate on first position lien debt in Chapter 11 bankruptcies was 68%, while the recovery rate for unsecured debt averaged 35%. Put differently, first position lienholders were able to recover $0.68 for every dollar owed, while unsecured creditors recovered only $0.35 for every dollar owed. While there are many deals where lenders knowingly take on greater risk by holding unsecured debt in the hopes of a higher returns, there are unfortunately also many situations where lenders believe to be secured only to find out in bankruptcy proceedings that their lien was unperfected. In bankruptcy, unsecured debt is the least preferred position and the last to recover.

Under the Bankruptcy Code, for a secured lienholder to have a priority to the debtor’s assets, it must be perfected under Article 9 of the Uniform Commercial Code (UCC). This means that the lien had to be filed on the public record in line with statutory requirements of the applicable jurisdiction. 

Top mistakes in lien perfection

The top four pitfalls in the perfection process that have prevented lenders from recovering in bankruptcy have been (1) getting the debtor name wrong, (2) filing in the wrong jurisdiction, (3) using the wrong UCC forms, and (4) forgetting to attach/update the collateral description. 

1. Using the correct debtor name

   Under § 9-506 of the UCC, a financing statement that substantially satisfies the requirements of the UCC is effective even if it has minor errors or omissions, unless such errors or omissions make the financing statement “seriously misleading.” Getting the debtor name wrong is one of the strictest rules under UCC Article 9, but one that is naturally derived from the purpose of the UCC itself.  UCC Article 9 is an indexing system aimed to give notice to searchers of a security interest in a debtor’s assets. The system is searchable using the debtor name.  However, if a secured party filed the financing statement under the wrong name, it means that other potential creditors of the debtor would not be able to find the filing, thereby deeming it ineffective. That said, UCC Article 9 has very specific rules as to what debtor name to use, and these rules depend on the type of entity that the debtor is — whether the debtor is a registered organization (such as a corporation or an LLC), not a registered organization, or an individual – the rules will be different and may vary by state.

   Some of the most common mistakes in debtor names are ones that may seem minor at first blush. Here are just a few examples:

   • Using “&” instead of “and” in the debtor name
     • In Myers v. Am. Exch. Bank (In re: Alvo Grain and Feed, Inc.), the secured party erroneously filed a UCC-1 under “Alvo Grain & Feed, Inc.” instead of “Alvo Grain and Feed, Inc.”, which the court found to be seriously misleading and deemed the filing ineffective.
   • Having an extra space between two characters
     • In United States SEC v. ISC, Inc. the secured party filed a UCC-1 using the debtor name as “ISC, Inc .” where the debtor name in its charter document was “ISC, Inc.”, the difference between the two being the extra space between the “c” and the period. The court deemed the filing seriously misleading and ineffective because the search logic of the filing jurisdiction did not disclose the lien.
   • Adding additional verbiage after the debtor name to designate a dba or an fka
     • In Fishback Nursery v. PNC Bank, N.A., the debtor’s true legal name was “BFN Operations LLC” but the Secured Party filed a UCC-1 erroneously listing the debtor as “BFN Operations LLC abn Zalenka Farms”. The court found the filing seriously misleading.

   If you are filing new liens on behalf of your client, check the applicable UCC rules of your filing jurisdiction and ensure that your debtor name meets the requirement of UCC § 9-503.  Helpful to all filers in ensuring their liens have been properly filed, indexed, and perfected is running a search to reflect, which shows how your filing appears on the public record using the search logic of the filing jurisdiction. 

   If your client has any liens that have already been filed against the debtor and where a search to reflect has not been run, now is the time to do it. If you do find a mistake in the debtor name, you would need to refile the lien using the correct debtor name (and hope that no other liens have been filed since your file date). 
   
   

2. File in the correct jurisdiction

   Ensuring that your lien is filed in the correct jurisdiction is as important as using the correct debtor name: if a creditor files in the wrong jurisdiction, then other potential creditors will not be able to find the filer’s lien.

   So where should UCC liens be filed? The official comments to UCC § 9-301 provide that the law governing perfection of security interests in both tangible and intangible collateral is the law of the jurisdiction of the debtor’s location. To determine where the debtor is located, we look at § 9-307.  If the debtor is:

   • A registered organization that is organized under state law, the debtor is located in that state.  For example, a Delaware LLC is located in Delaware.  A lien against such an entity would be filed with the Secretary of State in Delaware.
   • A non-registered entity, the debtor is located in the jurisdiction where the entity has its chief executive office.
   • An individual, the debtor is located at the individual principal residence.

   There are exceptions to the general rule, such as where the underlying collateral is comprised of fixtures. Fixtures are defined as goods that have become so related to real property that an interest in them arises under real property law – examples include certain manufacturing equipment attached to the property, windows, and fences. Interests in fixtures must be filed where the real property is located, typically in the real estate records. Additional exceptions apply to oil, gas, minerals, goods covered by certificate of title, and other types of collateral. Consult the applicable UCC rules to determine where such liens must be filed.
   
   

3. Use the correct UCC form

   Although the UCC is meant to be uniform, states have adopted it with variation. This also applies to the forms used by the states. While most states have adopted the forms proposed by the International Association for Commercial Administrators (IACA), there are still local variations to reflect jurisdictional requirements. On July 1, 2023, IACA amended the national forms and, since then, the states have started announcing whether and how they will adopt the revisions. Most states will be accepting the newly revised forms and will also continue accepting the older versions. However, in some cases states have announced deadlines after which they will either reject or impose additional fees for using the older forms. Always check with the filing jurisdiction to ensure you’re using the correct UCC form before filing your lien.
   
   

4. Don’t forget your attachments
   To be legally sufficient, a UCC financing statement must include the debtor name, secured party information, and collateral description. Oftentimes secured parties reference an attachment in the collateral description box and attach an exhibit containing the collateral description. Unfortunately, filers often fail to run a search to reflect—only to find out in bankruptcy that the exhibit did not make its way to the public record. Consequently, the financing statement fails to meet the legal sufficiency requirements of UCC § 9-502 and can be deemed ineffective. To avoid this and ensure that the attachment is properly reflected on the record, always run a search to reflect with copies.

Sources

• https://www.uscourts.gov/news/2023/07/31/bankruptcy-filings-rise-10-percent
• https://www.reuters.com/legal/bankruptcy-filings-surge-first-half-2023-us-epiq-2023-07-03/
• https://pitchbook.com/news/reports/q1-2023-global-ma-report
• https://www.pwc.com/gx/en/services/deals/trends.html
• https://info.bankruptcydata.com/q12023recovery
• https://www.iaca.org/secured-transactions/forms-2/
• https://www.wolterskluwer.com/en/expert-insights/ucc-forms-guide