Common Mistakes. Deposit Accounts

Transcription

1 Common Mistakes under the UCC Your collateral is only as good as your lien. When it comes to deposit accounts and equity interests in limited liability companies, subtle errors can sometimes result in unperfected or defective liens. Find out some of the more insidious perfection traps when dealing with these types of collateral and get some practical advice on how to avoid such traps. One of the goals in amending the Uniform Commercial Code (UCC) as part of the sweeping revisions of 2001 was to simplify the UCC and to make it more user-friendly. Notwithstanding some laudable progress in that regard, Article 9 of the UCC remains a complex body of interrelating regulations steeped in nuance and rife with relatively arcane terminology. Thus, even those attorneys who regularly deal with the UCC may be vulnerable to a number of traps for the unwary when it comes to dealing with even the most common types of collateral. This article discusses such traps relating to deposit accounts and limited liability company interests. Deposit Accounts One of the more dramatic changes ushered in with the 2001 revisions was to bring deposit accounts within the ambit of the UCC. Previously, deposit accounts were excluded from the scope of the UCC in all but a handful of states such as California, Hawaii and Illinois. Perfection of a security interest in such accounts was typically governed by the common law, and perfection of a security interest under such common law regime was cumbersome and often unworkable. But today deposit accounts are covered by the UCC in all jurisdictions and routinely serve as collateral, along with securities accounts. The UCC 1 provides only one mechanism for perfecting a security interest in a deposit account: namely, by obtaining control in accordance with Section See 9-312(b)(1) & 9-314(a). 2 Section of the UCC provides three methods to achieve control with respect to a deposit account. It states, in relevant part, that a secured party has control of a deposit account if (1) the secured party is the bank with which the deposit account is maintained; (2) the debtor, the secured party and the bank have agreed in an authenticated record that the bank will comply with instructions originated by the secured party directing disposition 34 CFA s Keynote Speaker has said her dream job would be commissioner of the NFL.

2 by René Ghadimi of the funds in the deposit account without further consent by the debtor, or (3) the secured party becomes the bank s customer with respect to the deposit account (i.e., the secured party becomes the owner of the account). 3 The first and third methods are often neither practicable nor palatable from a borrower s perspective. The most common means of achieving control is option number two the execution and delivery of a tri-party account control agreement whereby the deposit bank agrees to follow the instructions of the secured lender without further consent of its borrower. Such deposit account control agreements have become commonplace, and the American Bar Association has even generated its own model form. Typically, however, deposit banks require use of their own proprietary form, blessed by an in-house legal department. These forms have become fairly uniform in their basic provisions and work well in the typical tri-party configuration. However, it is not uncommon in financing transactions to have multiple creditors looking to the same account as original collateral. The problem is that banks are understandably reluctant to enter into multiple control agreements, conferring concurrent control upon two or more potentially competing creditors. If stuck between competing claims, such a bank is likely to interplead funds an outcome that few secured lenders would welcome. And deferring to the terms of an intercreditor agreement to which it is not party gives a deposit bank little comfort. This sets the stage for the first of the traps for the unwary. Controlling Party Liens The parties in a financing transaction with a senior and subordinate lien on a bank account will often address the multiple-creditor problem by utilizing a single, four-party account control agreement that shifts control to the dominant creditor at a given point in time. These provisions are drafted in a variety of ways. A typical provision, involving two creditors, SP1 and SP2, could be something along the following lines: The Bank will comply with instructions originated by the Controlling Party directing disposition of the funds in the deposit account without further consent of the Borrower. The Bank acknowledges and agrees that SP1, as of the date hereof and at all times hereafter, until Bank receives written notice from SP1 that its Obligations have be repaid in full and its security interest in the Account has been released (a Succession Notice ), shall be the Controlling Party hereunder. Upon receipt of Succession Notice, SP2 shall automatically and immediately become the Controlling Party under this Agreement. SP2, the secured party with the subordinate interest and deferred control in this scenario, unwittingly risks being unperfected in its security interest at worst and subject to a preference risk at best. There is no question that the lien of the Controlling Party in the foregoing example is perfected. However, the Controlling Party, at the time the control agreement is executed and delivered (and until the Succession Notice is given), is only SP1. Thus, it is questionable whether SP2 s security interests are perfected. If the borrower filed bankruptcy before the Succession Notice is given, SP2 may be an unsecured creditor insofar as the deposit account is concerned. This is because the UCC requires that an authenticated record be entered into whereby the bank will comply with instructions originated by the secured party... without further consent by the debtor ( 9-104). The language presented earlier provides only that the bank will follow the instructions of the Controlling Party, which is, until notice is given otherwise, arguably only SP1. The language of the agreement confers no such control directly to SP2. The mechanism of a Controlling Party in this example is really nothing more than means of effecting a springing perfection upon redesignation of the role of Controlling Party by the relevant parties within the confines of the underlying deal. 4 Once SP1 gives the requisite notice, SP2 will, in fact, be perfected. In the meantime, however, one can argue that SP2 is not. And once it is perfected, SP2 s liens will be subject to avoidance under Section 547 of the Bankruptcy Code as constituting a preference, if the borrower files for bankruptcy within 90 days of the redesignation of the Controlling Party. Agency The problem of faulty perfection in the context of multiple secured parties takes on a more insidious manifestation when the parties try to use the concept of agency to solve the control problem. In this scenario SP1 and SP2 are parties to one account-control agreement relating 1 Unless noted otherwise, references to the UCC are to the model Uniform Commercial Code Secured Transactions promulgated by the American Law Institute and the National Conference of Commissioners on Uniform State Laws. 2 The court in Counceller v. Ecenbarger, Inc., 834 NE2d 1018, 59 UCC Rep.Serv.2d 524 (Ind.App., 2005) settled the question under Indiana law as to whether one could perfect a security interest in a deposit account by filing a financing statement describing the collateral as the subject deposit account, holding that such that filing was not effective to perfect any security interests. 3 In order to determine which state s laws govern perfection, the effect of perfection or nonperfection and the priority of a security interest maintained with a bank (which may differ from the parties choice of governing law in the security agreement that governs the creation and attachment of the security interest), one needs to determine the bank s location under Section of the UCC. Some states have adopted nonuniform rules, and individual state laws should be consulted. For example, Section of the Delaware UCC provides two additional alternatives to achieve control, as follows: (4) the debtor, secured party, and bank have authenticated a record that (i) is conspicuously denominated a control agreement, (identifies the specific deposit account in which the secured party claims a security interest, and (iii) contains one or more provisions addressing the disposition of funds in the deposit account or the right to direct the disposition of funds in the deposit account; or (5) the name on the deposit account is the name of the secured party or indicates that the secured party has a security interest in the deposit account. the secured lender May/June

3 The problem of faulty perfection in the context of multiple secured parties takes on a more insidious manifestation when the parties try to use the concept of agency to solve the control problem. to the deposit account; the agreement provides that so long as the obligations owed to SP1 remain unpaid, SP1 shall be the secured party and will act as the agent on behalf of SP2 solely for purposes of perfection. Perfection of security interests through a common agent is quite common. But, in this case, SP2 s security interests may, again, be unperfected. The UCC expressly permits a secured party to perfect vicariously through a third party with respect to investment property and securities accounts (e.g., see Section 8-106(d)(3) or Section 8-301(a) (2) or (b)(2)). When the model code was revised in 2001 to, among other things, bring deposit accounts within the ambit of the UCC, the drafters modeled Section on Section The two provisions are largely analogous and the perfection mechanisms are strikingly similar. 5 But Sections and depart from each other in at least one significant respect: there is no provision in Article 9 that is analogous to subsection 8-106(d)(3), which permits control through a third person on behalf of the secured party. 6 Any such provision is conspicuously absent from Section 9-104, and the UCC simply does not provide a comparable mechanism for perfection in a deposit account through a third party. In a typical syndicated credit facility, the lenders may appoint a collateral agent for purposes of serving as the secured party on their collective behalf. This includes serving as agent with respect to perfecting security interests in deposit accounts. But, in such cases, both the grant of the security interest and the UCC financing statements (or control, in the case of a deposit account) run in favor of the collateral agent. The collateral agent is the secured party of record. In the situation where there are different secured parties, each with its own security interests, one such party cannot act as agent for the other for purposes of perfecting such other party s security interest in a deposit account. The notion that a security interest granted to SP2 is perfected through the agency of SP1 is not recognized under the UCC for deposit accounts. So, SP2 s liens are unperfected. The solution, in these dual-creditor agreements, is to reunite the grant with the perfection mechanism by establishing an express agency relationship and having a single lien run in favor of a single agent, much as is done in a syndicated credit facility. As between two competing creditors, one would be appointed as agent to act on both their behalves and the granting clause would run in favor of this designated agent. This would require either a granting provision contained within the control agreement or the establishment of the agency relationship within the separate security agreement. Another, less certain solution (where a single grant cannot run in favor of one agent, for example) might be to have the requisite control language run in favor of both secured parties (e.g., the bank hereby agrees to follow instructions originated by SP1 without further consent of the borrower, and the bank hereby agrees to follow instructions 4 This is analogous to a typical syndicated loan facility in which an agent is the sole secured party of record on behalf of a lender group. The lien typically runs in favor of the agent and only the agent s name appears on the UCC financing statements as the secured party (though typically identified as serving in its capacity as Agent). The individual lenders in the bank syndicate do not have liens. Such lenders rely, instead, on the agency provisions of the underlying credit agreement in order to obtain the vicarious benefits of the security interests in the collateral. Their interests in the collateral rest on the laws of agency and contract, not on the UCC, and their recourse is limited to the agent, not directly to the collateral. 5 The similarity in the provisions is immediately apparent. For example, subsections 9-104(a)(1) (control by secured party being the deposit bank), (a)(2) (control by tri-party agreement), and (a)(3) (control by secured party becoming the owner of the account) correspond to subsections 8-106(e) (securities intermediary with interest in security entitlement has control), (d)(2) (control by tri-party agreement), and (d)(1) (the secured party becomes the entitlement holder), respectively. Furthermore, subsection 8-106(d)(2) states that, The securities intermediary has agreed that it will comply with entitlement orders originated by the purchaser without further consent by the entitlement holder. Subsection 9-104(a)(2) states that control is achieved when the debtor, secured party, and bank have agreed in an authenticated record that the bank will comply with instructions originated by the secured party directing disposition of the funds in the deposit account without further consent by the debtor. 6 Subsection 8-106(d)(3) states that a secured party has control if another person has control of the security entitlement on behalf of the [secured party] 36 CFA s Keynote Speaker s name is derived from a musical expression meaning with sweetness.

4 originated by SP2 without further consent of the borrower). Notably, control under the UCC must be unilateral (at least vis-à-vis the borrower), but arguably control need not be exclusive (or unconditional). The language of the UCC, on its face, supports the position that one can have multiple secured parties with concurrent control. 7 (Indeed, Section of the UCC addresses priority battles among competing secured parties, each perfected by control, by reverting to the familiar temporal test of first in time being first in line.) The relevant issue is not whether anyone else can issue instructions to the bank at any given time (e.g., the Borrower typically retains the right to issue instructions to the bank), but rather only whether a creditor can exercise unilateral control independently of the borrower. The UCC doesn t appear to concern itself with the context in which a bank may subject itself to multiple directions or with sorting out the vagaries of the business relationships underlying multiple grants of a security interest, but rather on whether the secured party achieves the requisite degree of control over the account vis-à-vis the borrower. The economic test remains whether the secured party can effect a disposition of the funds in the deposit account without further consent from the debtor. Both SP1 and SP2, therefore, can have control vis-à-vis the borrower and the security interests of each creditor would appear to be perfected. The agreement should then provide that as between SP1 and SP2, the bank will follow only the directions of SP1 until the bank receives written notice from SP1 that it is releasing its liens on the account and designating SP2 as the Controlling Party. The UCC makes it clear that the imposition of conditions on the bank s obligation to follow the secured party s instructions does not vitiate control, as long as those conditions do not tie back to consent of the debtor. Thus, the fact that the ability of SP2 to direct disposition of funds is conditioned upon action by SP1 does not vitiate control for SP2. 8 Whether a court would interpret the UCC as accommodating multiple creditors exercising concurrent control is not, however, entirely free from doubt. Limited Liability Companies Limited liability companies (LLCs) are undoubtedly familiar to all legal practitioners. The first LLC appeared on the legal scene in 1977, based loosely on the GmbH form of business prevalent in Germany. But it wasn t until an IRS tax ruling in 1988 (clarifying how the IRS would treat a particular form of LLC for tax purposes) that LLCs gained traction throughout the United States. By 1996 the National Conference of Commissioners on Uniform State Laws promulgated the Uniform Limited Liability Company Act, and today every state has an LLC statute. The great distinguishing feature of the LLC is the flexibility it confers on the organizers or members. One aspect of this flexibility stems not from the LLC statutes themselves but rather from the malleable nature of such interests under the UCC. The LLC has the ability to determine whether its equity interests will be regarded as general intangibles or as securities under the UCC. Section 8-103(c) of the UCC provides, in part, that An interest in a limited liability company is not a security unless it is traded on securities exchanges or in securities markets, [or] its terms provide that it is a security governed by this Article. Like any other issuer, an LLC is also free to chose whether it will certificate its equity interests. This flexibility has led to some confusion among practitioners and to the next trap for the unwary. Sometimes, a lender s counsel, in determining how to perfect its client s security interest in an LLC s membership interests, will prematurely or erroneously focus on whether those interests are certificated. The issue of certification is often a red herring. The threshold issue is not whether the interests are certificated but rather whether the interests are a security under the UCC. Whether a membership interest is evidenced by a certificate is wholly independent of the nature of the underlying interest. The preface to Article 8 indicates that the issue of certification does not go to any inherent attribute of the security itself but rather merely to differences in how the security is evidenced. Only when the membership interests are securities will the question of whether they are represented by a physical certificate become relevant. If a membership interest is a general intangible, then the only method of perfecting is to file a UCC financing statement. Taking possession or control of a certificate has no legal consequence. The option of perfection by control is simply not available unless and until the issuer has taken the appropriate steps to opt into Article 8 of the UCC. If, on the other hand, the interest is a security, then the issue of how that certificate is evidenced has relevance and the secured party can chose various means of perfecting its security interest. A secured party has three methods to perfect a security interest in a security: filing, possession, or control. These are hierarchical, with control being the superior or priming method of perfection. Even if the membership interests constituting securities are not certificated, one can still obtain possession (i.e., the secured party or its agent becomes the registered owner of the security) or control (i.e., through an issuer control agreement). 9 If the membership interests are 7 The UCC commentary explains that Section is derived from Section of Revised Article 8, which defines control of securities and other investment property. The commentary for Section states that "There is no requirement that the control party's right to give entitlement orders be exclusive" (Cmnt. 4, 8-106). 8 The economic test reinforces this logic. Comment one to (upon which was based) states the test is whether the secured party has taken whatever steps are necessary given the manner in which the securities are held, to place itself in a position where it can have the securities sold, without further action by the owner. (Emphasis added.) the secured lender May/June

5 certificated, then a secured party can file a financing statement, take possession of the certificates (i.e., physical possession in the colloquial sense) or obtain control. Control, in the case of a certificated security, means obtaining possession of the certificate coupled with the power to effect a disposition of the collateral without any further action by the debtor. This is accomplished through the delivery of a stock power or assignment separate from certificate, executed in blank. Armed with such stock power and the certificate, the secured party can assign the membership interests to a third party without further consent of the debtor. The correct analysis with respect to LLC interest can be summarized as follows: First, determine the nature of the collateral. Is one is dealing with a general intangible or a security? The relevant inquiry in this regard is: Did the borrower opt into Article 8 of the UCC? If the issuer did not opt in, then its membership interests are a general intangible. In that event, a secured party should run its lien searches and file a UCC financing statement describing the membership interests as collateral. If, on the other hand, the issuer has opted into Article 8, then the membership interests are treated as securities for purposes of the UCC. Only then does the issue of whether those interests are certificated become relevant. If they are certificated, then a secured party can take possession of the certificates along with assignments separate from certificate and take comfort in knowing its security interests enjoy unassailable priority. 11 In fact, if the secured party gives value, does not have notice of any adverse claims to the security and obtains control of the security, it achieves the status of a protected purchaser under Article 8 of the UCC (section 8-303(a)). Section 8-303(b) of the UCC states that a protected purchaser acquires its interest in the security free of any adverse claims. Effectively, a protected purchaser can acquire rights superior to the transferor and will take the security free of even security interests previously perfected by filing..12 Assignability The decision to opt in has other consequences. For example, all of the other Article 8 provisions relating to the duties imposed on issuers, the transfer warranties and various assignability restrictions become applicable. It is the intersection of Article 8 of the UCC with the LLC statutes with respect to the assignability issue where one more potential trap for the unwary lurks. The general rule is that antitransfer restrictions are enforceable with respect to securities. When dealing with a general intangible, however, antitransfer restrictions are generally not enforceable (see Section 9-408). Specifically, any provision of a general intangible that purports to restrict the creation, attachment or perfection of a security interest in such general intangible is ineffective. So, typically, any transfer restrictions contained in an LLC operating agreement do not impede the ability of a creditor to get a security interest in the membership interests of that LLC. There are, however, at least two nonuniform states, Delaware and Virginia, where the LLC statutes preempt the UCC. 13 Therefore, Sections of the Delaware UCC or the Virginia UCC are ineffective to invalidate the antiassignment provision found in any Delaware or Virginia limited liability company. In other words, any transfer restrictions in operating agreements of Delaware or Virginia limited liability companies are enforceable even if the limited liability company did not opt into Article 8 and its interests remained general intangibles under the UCC. 14 So,v it is imperative that one check the limited liability agreement for restrictions on ability to transfer when taking a security interest in a Delaware or Virginia limited liability company. TSL René Ghadimi is an attorney with the Banking and Institutional Investing Group in the Chicago office of Skadden, Arps, Slate, Meagher & Flom LLP. He is a graduate of The University of Chicago Law School and has an MBA in finance from Hofstra University. His practice includes the representation of both lenders and borrowers in a broad range of debt transactions. He can be reached at rene.ghadimi@skadden.com. 9 A tri-party agreement is an agreement in which the issuer agrees to follow the direction of the secured party as to the disposition of the interests without further notice to the debtor. 10 If not, then the corollary question becomes, "Should or can you require borrower to opt in?" (i.e., force the borrower to amend its articles.) One should also consider a covenant preventing the borrower from opting in later. 11 Lenders will often file belts and suspenders financing statements in addition to obtaining control. This is inexpensive insurance against things such as the possibilities of losing the membership certificate or the stock power or the borrower opting out of Article 8 and its interests becoming a general intangible. 12 This creates a potential problem with respect to lost certificates, for if such certificates fall into the wrong hands and are sold to an innocent purchaser who, without knowledge of adverse interest, gives value, then such purchaser can cut off the rights of the secured party in the subject security. 13 The foregoing discussion ignores any choice of law issues that may arise where the limited liability company is formed under the laws of a jurisdiction different from the governing law specified in the security agreement. Section of the Delaware UCC has a nonuniform choice of law provision that states, among other things, that if a security agreement is governed by the laws of the State of Delaware, then those laws shall govern the creation, attachment, validity and enforcement of the security interest. If the laws of another state govern the security agreement; however, it is unclear whether Del would govern the assignability issue, notwithstanding the fact that the collateral at issue is membership interests in a Delaware limited liability company. 14 Specifically, Section 9-408(e)(4) of the Delaware UCC provides that this section does not apply to an interest in a partnership or a limited liability company. 38 CFA s Keynote Speaker is Former Secretary of State Condoleezza Rice.