In Depth: A Problem of Perfection with a Hidden Solution | Cadwalader, Wickersham & Taft LLP

Most US lenders are familiar with the requirement to file a Uniform Commercial Code Financing Statement to perfect a security interest in collateral. Most lenders also know that financing statements need to be updated if the debtor changes name, organization jurisdiction, etc. However, when a debtor moves from one type of entity to another (for examplea corporation converts to a limited liability company), a technical difficulty arises that many lenders would struggle to overcome.[1] Unfortunately, the consequences may include loss of third-party effectiveness or priority of the lender’s security. This note describes the problem and explains the best way to solve it.

It is important to note that the problem described below was identified years ago by John Hilson and Steve Weise[2]and the solution was implemented by updating the official comments in relation to the 2010 UCC amendments.[3] However, since the solution has been fully implemented in the official UCC comments, and not in the UCC text itself, the solution (and indeed the problem) may not have been brought to the attention of certain lenders and their advisors. This is especially true because at present, official commentary on how to avoid the problem has not made its way into the LexisNexis Goldbook used by many New York commercial attorneys or into the District of Columbia’s codification of the UCC (which usually includes official comments). As a result, even a lawyer who diligently examines both the UCC text and the official comments may be left in the dark. The purpose of this note is to bring the problem to light.

The problem arises when a debtor moves from one type of entity to another[4] and in the process changes its name in such a way that a search for the new name would not return the original funding status of UCC1.[5] In this case, the secured creditor must take steps to maintain the third-party effectiveness of its security right. But what should be done?

If the borrower is the same legal entity before and after the conversion, the UCC considers the conversion as a simple change of name. In this case, the typical approach would be to file a UCC3 modifying statement updating the debtor’s name, as provided in Section 9-507(c).

On the other hand, if the conversion is effected by extinguishing the original entity and creating a new entity, then under the UCC there has been a disposition of the collateral and a new debtor has become bound by the contract of safety. In this case, the typical approach would be to file a UCC1 financing statement naming the new debtor, as provided in Section 9-508.

The problem is that the correct choice depends on the type of conversion that occurred – one that preserves the same entity or one that creates a new entity. The UCC does not govern this issue but rather leaves it to another law to resolve. In some cases, the non-UCC law governing the conversion process is ambiguous as to whether a new entity is formed.

This ambiguity is unfortunate because if the lender chooses the wrong approach, it can suffer serious consequences. If the lender files a new UCC1 financing statement when it should have filed a UCC3 amending statement updating the debtor’s name, then its original UCC1 will cease to be effective to perfect a security interest in security acquired more than four months after the name change. The new UCC1 should maintain perfection, but its filing date would not be linked to the original UCC1, with potential consequences for the priority of the lender’s security (and with even more serious consequences if the borrower files a bankruptcy petition less than 90 days after the new CCU1 is filed).

Worse still, if the lender files a UCC3 amending statement changing the debtor’s name when they should have filed a new UCC1 financing statement, then the lender will not have an effective financing statement against the debtor. Unless he perfects his security by some other method, the lender will be unsecured.

As a result, the question of whether a new debtor was formed in an entity transformation was traditionally a crucial question for a secured lender, and there was no safe alternative in the face of ambiguity. Lenders had to estimate at best, and if they were wrong, they suffered the consequences.

To resolve this issue, the Official Comments have been updated as part of the 2010 UCC Amendments. In particular, Official Comment 5 to Section 9-512 now states that in the face of this situation, a secured party may simply file a UCC3 amending statement adding a new name for the debtor. This would meet the UCC requirements for both a debtor name change and an assignment of security to a new debtor, so it covers all the bases.

Of course, a lender can choose to take any of the traditional approaches outlined above, and if they choose the right one, they will be fully protected. But since the same result can be achieved with absolute certainty by filing a UCC3 amendment adding the borrower’s new name, this should be considered the most advanced approach when a borrower converts to a new type of borrower. ‘entity.[6]

This resolution, while effective and elegant, tended to fly under the radar due to the confluence of the factors described above. But now, when your debtor converts to a new type of entity, you’ll know what to do.

[1] The same issue can arise when an entity merges with another entity, but for simplicity the focus here is on a conversion from one entity type to another.

[2] Hilson and Weise’s commentary can be found at:

https://www.uniformlaws.org/HigherLogic/System/DownloadDocumentFile.ashx?DocumentFileKey=efa6b9bc-4067-9757-9506-795f13cccf00

[3] See Official Comment 5 to UCC Section 9-512, discussed in more detail below.

[4] This entire note assumes that the conversion takes place in a single jurisdiction – for example, a corporation organized in a given jurisdiction converts to an LLC organized in the same jurisdiction. A cross-border entity conversion would raise additional issues.

[5] If a search of the new name would return the original UCC1 funding statement, then the conversion did not render the funding statement “seriously misleading” under 9-506(c) and it remains effective for improve security.

[6] As noted in Official Comment 5 to Section 9-512, the lender may consider filing both the UCC3 described above and a new UCC1 against the debtor’s new name.