Six Ways From Sunday: How to Handle Conflicting Liens
by Kenneth P. Weinberg January/February 2018
Sometimes a UCC search will reveal a conflicting lien on equipment to be financed. Ken Weinberg reviews several approaches to address this common issue while preserving lenders’ rights.
Kenneth P. Weinberg, Shareholder, Baker, Donelson, Bearman, Caldwell & Berkowitz
In certain circumstances, a lender providing equipment financing may be unable or unwilling to obtain or rely on the super-priority lien afforded to a purchase money security interest under §9-324 of the Uniform Commercial Code. In these circumstances, the lender must search the UCC records for any prior filings that claim an interest in the equipment being financed.
This edition of Dispatches from the Trenches addresses the approaches typically used by equipment lenders to address conflicting liens revealed by these searches. Each approach involves the lender communicating with the secured party of record on the UCC financing statement that claims a competing interest in the equipment and asking the conflicting secured party to take some form of action. Although several different approaches are customary, some approaches are more protective of the lender’s rights.
UCC-3 that Deletes the Applicable Equipment
One way to address a conflicting lien is for the lender to ask the conflicting secured party to file, or authorize the lender to file, a UCC-3 financing statement to delete the applicable equipment from the scope of its conflicting filing. This solution addresses the issue within the confines of the statutory rules by removing the conflicting secured party’s perfected status as a matter of statutory law, and eliminating the possibility of the conflicting secured party or its assignees claiming perfected based on a contractual legal basis. Of course, the party filing the UCC-3 must either be the secured party of record (i.e. the conflicting secured party) or authorized by the secured party of record.1
Filing a UCC-3 deleting the applicable equipment merely results in the conflicting lien being unperfected. Without further action, that lien technically remains a subordinate lien. Even if a conflicting secured party’s lien is subordinate to the lien of the lender, the conflicting secured party still has the legal power under the UCC to foreclose on the collateral. Such a foreclosure would not discharge the lender’s lien, since the UCC provides that “[a] secured party’s disposition of collateral after default 1) transfers to a transferee for value all of the debtor’s rights in the collateral, 2) discharges the security interest under which the disposition is made and 3) discharges any subordinate security interest or other subordinate lien.”2
In other words, since the lender’s lien is a prior lien, a foreclosure by a subordinate lienholder would not discharge the lender’s lien. As a result, any prudent buyer in a foreclosure sale would involve the lender in an effort to obtain the release of the lender’s lien. In any event, the power of a conflicting secured party to repossess the applicable equipment and to begin foreclosure proceedings can be a tool used by the conflicting secured party to force the lender to take action. One example is when the applicable equipment is worth more than owed to the lender. Another example is when the lender has more at risk, and the applicable equipment is essential to the debtor’s overall business. In the latter situation, the subordinate lienholder can exert leverage in hope of being paid to go away.
Except under special circumstances, very few lenders worry that a conflicting secured party with an unperfected security interest in the applicable equipment will undertake foreclosure actions. However, as discussed in more detail later in this article, the risk can be heightened when the conflicting secured party has a perfected but subordinate security interest.
In any event, the risk posed by a conflicting secured party with a perfected but subordinate security interest in the applicable equipment is present in many transactions in our industry. The most common example occurs when lenders rely on purchase money priority to obtain a first priority security interest. Although the purchase money provisions in the UCC, if properly followed, afford lenders with a first priority lien, these provisions do not clear subordinate liens, which would remain in effect.
Lien Release Agreement
Even if a UCC-3 financing statement is not filed to delete the applicable equipment, the conflicting secured party can execute a lien release agreement or similar documentation to contractually release its lien on the applicable equipment (or acknowledge that it never has had, and will not in the future claim, any such lien in a document sometimes referred to as a no interest letter).
A contractual solution, like this one, can raise various theoretical issues that are not applicable with respect to a structural solution, like the filing of a UCC-3 financing statement in public records. Some examples of contractual issues include disputes over whether the lien release contract was duly authorized, executed and delivered, or whether the conflicting secured party’s agreement was supported by adequate consideration. Lawyers reading this issue of Dispatches may remember discussions regarding detrimental reliance during the first year of law school. In the event of a dispute, a lender relying on shorter forms commonly used in our industry may find itself enforcing a contract that does not have the type of notice, governing law, venue, jury trial waiver and similar boilerplate provisions commonly included in the documents to which they are accustomed.
An example of the types of risks associated with a contractual solution, rather than the filing of a UCC-3 financing statement, can be found by considering whether any given lien release agreement is binding on assignees of the conflicting secured party. For example, what happens if the conflicting secured party signing the lien release later sells the transaction subject to the conflicting financing statement and, as part of that transaction, also assigns the financing statement in full? Does the lien release require the conflicting secured party to notify the assignee of the lien release, giving rise to a breach of contract claim if the lender is somehow harmed by the conflicting secured party’s failure to do so? If the assignee has no notice of the lien release, is it bound by it nonetheless? It seems reasonable to assume the conflicting secured party can only assign to the assignee the rights it has under applicable law at the time of assignment (and, in this case, the conflicting secured party has already released its lien in the applicable equipment).
There are other matters of contractual interpretation. Does the lien release cover only the lien of the conflicting secured party in the applicable equipment? Or does it cover any claim to perfection provided by the applicable financing statement listing the conflicting secured party as the secured party of record on such filing? If the lien release covered only the lien of the conflicting secured party in the applicable equipment, and the financing statement is assigned by the conflicting secured party to an assignee that has or obtains a lien in the applicable equipment through some other means, could the assignee’s lien prime the lender’s lien notwithstanding the lien release? After all, the assignee will be the secured party of record on an earlier-filed UCC financing statement covering the applicable equipment, and the original conflicting secured party will have only released its lien on the applicable equipment.
The answers to these questions may depend upon the contractual interpretation of the lien release. The answer may also be gleaned from a more complex analysis of various provisions in the UCC regarding the effect of assignments and other matters. Had the applicable equipment merely been expressly deleted by a UCC-3, none of these exercises would be needed.
In some circumstances, the conflicting secured party wants to retain a perfected, subordinate lien. In these cases the conflicting secured party and the lender may enter into a subordination agreement. Many of the issues raised in the context of a contractual lien release also apply in the context of a subordination agreement. In situations where the lender may be over-collateralized, it is more common to consider the risks that a conflicting secured party with a subordinate lien will initiate foreclosure actions against the applicable equipment if its lien is perfected. Under these circumstances, the conflicting secured party is more likely to force the action if it believes excess proceeds will remain for application to its second lien.
As with lien releases, certain middle market or smaller transactions rely on short and simple form subordination agreements. In larger, more structured transactions, subordination agreements may take the form of a full-blown intercreditor agreement or similar documentation that is several pages long and addresses a variety of issues. For example, more robust intercreditor agreements specifically address whether the lender would have absolute priority (even if it failed to properly perfect, or maintain perfection, in the applicable collateral) or only relative priority. Such agreements also address a variety of bankruptcy elements, such as whether the conflicting secured party may challenge the validity of the lender’s lien in a bankruptcy proceeding, whether the conflicting secured party may object to a request by the lender for relief from the automatic stay and the extent to which either secured party may provide debtor-in-possession financing.
Our industry can be form driven in an attempt to deliver cost-effective and quick service to customers. However, there is no one-size-fits-all solution for dealing with conflicting liens. The willingness of the conflicting secured party to file a UCC-3 financing statement deleting specific collateral and/or to execute a contractual lien release can be a major factor in most transactions, and obtaining both would be best for the lender.
Where only a subordination is available, it may be necessary in some transactions to understand the additional issues associated with perfected but subordinated liens in the applicable equipment, but lenders that are typically comfortable relying on purchase money priority should be mindful that such issues are generally present across their portfolio and may merit additional consideration only in select contexts. Of course, when relying on contractual protections offered by lien releases and subordination agreements, these forms must be carefully drafted to include sufficient provisions to protect the lender while recognizing that, in many transactions, market pressures may not allow for the robust forms required under other circumstances.
The American Association of Commercial Finance Brokers hosted its annual conference this past May in (viva!) Las Vegas. Paul Burnham provides a rundown of the three-day event, which offered attendees the chance to learn, network, and, in the spirit of its host city, maybe go home with an extra prize or two.