Drafting Collateral Descriptions That Pass the Sniff Test
by Kenneth P. Weinberg & Jennifer L. Howard Nov/Dec 2014
In part one of a two-part series, Kenneth Weinberg and Jennifer Howard analyze collateral descriptions in security agreements and financing statements. They advise careful consideration of collateral descriptions to avoid getting pricked.
What’s in a name? In Shakespeare’s Romeo and Juliet, the heroine argued, “That which we call a rose / By any other name would smell as sweet,” suggesting that labels are meaningless. When analyzing collateral descriptions in security agreements and financing statements, courts may be more inclined to agree with Gertrude Stein’s suggestion that names have a direct relationship to an actual thing: “A rose is a rose is a rose.” When drafting collateral descriptions, lawyers should say what they mean, and mean what they say.
This two-part edition of Dispatches from the Trenches discusses some issues to consider when describing collateral in connection with equipment leasing and equipment finance transactions, although comprehensive treatment of the topic of collateral descriptions is beyond the scope of this article. This first part addresses how descriptions used on financing statements are subject to a different standard than descriptions in security agreements, and also provides some advice with respect to broad descriptions by collateral category as well as more specific descriptions based on make, model and serial numbers.
Roses are to Rootstock as Financing Statements are to Security Agreements
Questions related to the sufficiency of collateral descriptions arise in two contexts: security agreements and financing statements. Different rules apply to the analysis of each, which arise out of the fact that collateral descriptions in security agreements implicate different policy considerations than those in financing statements. Security agreements are drafted to create the security interest and allow it to be enforced as between the secured party and debtor. Financing statements, by contrast, are filed to give notice of the potential of the filer’s security interest to various third parties, including other secured parties, lien creditors and purchasers of the collateral.
Because the purpose of financing statements is to give notice to third parties, requirements for collateral descriptions in financing statements are somewhat less exacting. Indeed, when the substantial revisions to Article 9 were made back in 1998, becoming effective in 2001, several changes were scattered throughout the Uniform Commercial Code with respect to the thoroughness of the collateral description that is required. The older version of Article 9 was often interpreted as requiring “a description of the collateral” in financing statements. However, the current version of Article 9 provides that the financing statement is effective if it “indicates the collateral covered by the financing statement.” The distinction between a description and an indication may not appear to be much at first glance. However, Official Comment No. 1 to §9-504 makes clear that “indication” is an easier standard to satisfy, and all that is required is that a searcher have notice that a person may have a security interest in the collateral claimed. Indeed, the commentary expressly states that an indication of collateral would satisfy the revised Article 9 requirements even if it did not satisfy the older Article 9 requirements.
Section 9-504 provides that a financing statement sufficiently “indicates the collateral” if it provides either a description of the collateral pursuant to §9-108 or an indication that the financing statement covers “all assets or all personal property.” Accordingly, in a financing statement, it is permissible to have a super-generic description such as “all assets of the debtor,” even though such descriptions are specifically prohibited in security agreements.
Notably, the official comment to §9-504 describes the methods for identifying collateral set forth in that section as “safe harbors,” suggesting that courts may find other types of descriptions to be sufficient for purposes of a financing statement. Even more flexibility can be found in §9-506, which provides that a financing statement that substantially satisfies the requirements of a filing is effective, “even if it has minor errors or omissions,” unless the errors or omissions make the financing statement “seriously misleading.” To be on the safe side, however, the conservative practitioner should aim to satisfy the descriptive requirements of §9-108 when drafting collateral descriptions in both security agreements and financing statements, except when drafting a financing statement that appropriately uses an “all assets” description.
In contrast to the relaxed requirements for collateral descriptions — or perhaps we should say collateral indications — in financing statements, Article 9 continues to require more specificity in the security agreement itself. The key provisions are found in §§9-108 and 9-203 of the UCC. Section 9-203(b) explains that a security interest cannot attach and be enforceable against the debtor unless, among other requirements, the debtor authenticates a security agreement that describes the collateral. Section 9-108 states the general rule that a description of collateral is sufficient, whether or not it is specific, if it “reasonably identifies” what is described. This section also sets forth some examples of collateral descriptions that satisfy this standard. In particular, collateral descriptions are generally sufficient under §9-108 if they identify the collateral by: 1) specific listing, 2) category, 3) a type of collateral defined in the UCC, 4) quantity, 5) computational or allocational formula or procedure; or 6) any other method if the identity of the collateral is “objectively determinable.”
There are a few exceptions that are not commonly applicable in equipment leasing and financing transactions. In addition, §9-108(c) expressly prohibits “super-generic” descriptions in a security agreement. It is also worth noting that the flexibility provided for minor errors or omissions with respect to the indication of collateral in financing statements is not available for errors in the security agreement, as §9-506 applies only to financing statements and Article 9 has no corresponding provision applicable to security agreements.
At the end of the day, the best practice is for the financing statement and security agreement to use collateral descriptions that fall within one of the methods outlined in §9-108, except where the financing statement uses the “all assets” description. In equipment leasing and equipment finance transactions, “all assets” descriptions are somewhat unusual, and the more typical transaction involves specific goods. The trick in such cases is to draft a collateral description that is broad enough to sweep in all of the specific items of collateral that the parties intended to secure the debt, but not so broad that the specific items of collateral cannot be identified among the debtor’s remaining unencumbered property. To some extent, the facts and circumstances of the particular case matter in determining how such collateral descriptions should be drafted.
Descriptions by Type: A Rose May be Inventory
Prior to the 1998 revisions that became effective in 2001, Article 9 required secured parties in financing statements to either indicate the types of collateral or describe the specific items that were subject to a security interest, and courts therefore still often look to the types of collateral defined in the UCC when analyzing the sufficiency of collateral descriptions. Although Revised Article 9 no longer requires descriptions by item or by type, it is still advisable to use the types where possible.
Secured parties must be careful, however, when using the types of collateral defined in the UCC — particularly since Article 9 defines over two dozen types of collateral, such as equipment, fixtures, accounts and inventory. For example, companies involved in equipment leasing and financing transactions generally refer to the leased or financed property as “equipment” in their underlying lease or loan documents, but the property would technically be “inventory” under Article 9 if the property is leased by the debtor as lessor or held by the debtor for sale or lease or to be furnished under a contract of service.
Serial Number Descriptions: Rose SN123 is not Rose SN124
In many cases, only particular items of property are intended to be included as part of the collateral, and the debtor may have many other pieces of property that are intended to remain unencumbered. In such cases, describing the collateral as “equipment” would be overly broad without more, and some additional description beyond the “type” would likely be required.
One common problem that arises is whether or not to use serial numbers when available.
Although they can be useful, the 1998 revisions made clear that serial numbers are not technically required under Article 9. Of course, serial numbers can be double-edged swords. Where reproduced correctly, these numbers clearly reference the particular piece of equipment, but cases of serial number typos abound, where lenders have misstated the serial numbers by one or more digits in a security agreement and/or financing statement. The outcome of such cases is difficult to predict, but the risk is that a mistake could invalidate the security interest or cause it to be found unperfected. For example, in the case In re Pickle Logging, Inc., 286 BR 181 (MD Ga. 2002), where the debtor was a tree-logging company, the secured party took a security interest in eight pieces of logging equipment, including a 548G skidder, serial number DW548GX568154. Both the security agreement and financing statement described the skidder as a “648G skidder, serial number DW648GX568154,” thus mislabeling the serial number of the piece of equipment by a single digit. The mislabeled serial number caused the number to appear to reference a different model of skidder that was made by the same manufacturer. The court found under those circumstances the financing statement was seriously misleading, and if a serial number is inaccurate, there must be additional information that would allow a third party to identify the collateral. The decision in this case very likely turned on the fact that both the model number and the serial number were incorrect. Nonetheless, the case highlights the importance of getting all of the numbers right when using them to describe the equipment.
Mistaken serial numbers are not fatal in many cases, however. For example, in Bishop v. Alliance Banking Company, 412 S.W.3d 217 (Ky. App. 2013), the court held that a backhoe identified in the bank’s financing statement as a “1999 Case Backhoe 580L” with a serial number of “1100249697” was sufficient to reasonably identify the backhoe, even though the first three digits in the serial number were incorrect. When the debtor defaulted, the bank sought to enforce its security interest against an individual who had purchased the backhoe and claimed to be a bona fide purchaser without notice of the prior lien. The court found that the first part of the description, “1999 Case Backhoe 580L,” was correct and sufficient to put the subsequent purchaser on inquiry notice. The court found that the subsequent purchaser should have noticed the similarities in the serial number and undertaken further inquiry. If the subsequent purchaser had asked the debtor how many “1999 Case Backhoe 580L’s” he owned, or called the bank to determine whether the bank claimed any interest in this backhoe, or called the manufacturer (who could have told him that the serial number was invalid), he could have discovered the mistake. Under these facts, the incorrect serial number was not seriously misleading.
The lesson here is to use serial numbers and model numbers wisely and accurately. If the equipment can be sufficiently described without such numbers, that may be the safest course of action. However, if such numbers are necessary to distinguish the filer’s collateral from other collateral that is otherwise too similar, serial numbers and/or model numbers may be necessary. Consider, for example, a secured party who has financed two items of equipment that are the same make and model as several other items of equipment owned by the same debtor. Those facts were present in the Pickle Logging case mentioned above, where the debtor owned at least two 548G skidders and at least two 648G skidders.
If serial numbers or model numbers are added, care should be taken to make sure they are correct. Some secured parties add language to provide additional protection in the event of an error, such as “any serial numbers, model numbers, identification numbers or similar information have been added by Secured Party in an effort to avoid confusion but are not intended to, and shall not, limit the above description of collateral.”
The Rose is Still Growing
We hope you enjoyed this first part of our two-part edition of Dispatches from the Trenches on collateral descriptions. As any good horticulturalist knows, it takes not only skill, but also patience, to create a beautiful rose bush. Similarly, explaining the roots of an artful collateral description takes time. In the second part of this edition of Dispatches from the Trenches, we will dig further into the topic to plant the seeds necessary for a great collateral description.
Kenneth P. Weinberg is a shareholder at Baker, Donelson, Bearman, Caldwell & Berkowitz, P.C., and practices in the area of commercial finance, focusing on equipment leasing, equipment finance and renewable energy project finance. He has penned Dispatches from the Trenches since 2002.
Jennifer L. Howard is of counsel at Baker, Donelson, Bearman, Caldwell & Berkowitz, P.C., and practices in the areas of equipment leasing, equipment finance and renewable energy project finance.
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