What a Difference One Filing Can Make: A Cautionary Tale

Business deals can move at the speed of light. It is easy for business owners to focus so intently on the deal that they overlook legal nuances that bite them in the pocketbook later. A recent matter in our office – a truly cautionary tale – emphasized that fact.

The Facts

Bob owned a manufacturing machine. It was specialized equipment, and the market was tight. But Bob was highly motivated to sell the machine, as he needed the cash to pay debts.

Bob found a buyer (we will call him “Joe”), and entered into an Asset Purchase Agreement (the “APA”) requiring payments from Joe to Bob over a five-year period. Bob signed a bill of sale in favor of Joe and expressly retained a security interest in the machine to secure payment of the debt.

What Bob failed to do was file a UCC-1 financing statement to put the world on notice of his retained security interest (i.e. “perfect” his interest).

Joe was a fraudster, who almost immediately sold the machine “free and clear of all liens” to an unrelated party (we will call him “Rick”). To fund his acquisition of the machine, Rick obtained a loan from his lender (the “Bank). The Bank, having confirmed that there were no UCC-1 filings recorded against Joe, believed that Joe had the legal right to sell the machine free and clear. Rick granted the Bank a security interest in the machine, and the Bank immediately filed a UCC-1 filing against Rick declaring a security interest in the machine. There was no evidence that either Rick or the Bank had any knowledge of Bob’s unperfected security interest.

Joe did not make any payment to Bob. When Bob sought to replevin the machine, Bob learned that Joe no longer owned it and that the Bank claimed to have a priority security interest in the machine by virtue of its loan to Rick.

The Problem

The practical problem in this scenario was that the two creditors fighting for a priority interest in the machine (Bob and the Bank) were both innocent parties. Bob did not foresee that Joe would sell the machine “out from under him,” nor did the Bank have any suspicion that Joe did not have the ability to sell the machine free and clear of liens. So who wins?

Unfortunately for Bob, his failure to file a UCC-1 financing statement was fatal to his claim. Article 9 of the Uniform Commercial Code awards priority to the Bank under the belief that Bob’s failure to file a UCC-1 could have misled the Bank into extending a loan that it would not have otherwise made. Because Bob’s security interest was not perfected prior to the Bank extending its loan, the general priority rules of Article 9 control and the “first to file” (here, the Bank) wins.

The Lesson

A signed agreement that grants a security interest will convey an interest to the creditor, but will not do anything to give that creditor priority against subsequent creditors. A second step – the perfection of the interest through a UCC-1 filing or other required method – is the only way to avoid the financial loss that befell Bob.

A cautionary tale, indeed.

Written By:
Law Firm of Conway, Olejniczak & Jerry, S.C.