PEB Commentary Casts Doubt on Incorporation-by-Reference Approach to UCC-1 Collateral Descriptions

Introduction

In the context of secured transactions, the importance of a properly completed and filed UCC-1 financing statement (“UCC-1”) cannot be overstated.

While a UCC-1 is often the simplest document in a transaction — i.e., a one-page form with a handful of blanks to complete, as compared to the lengthy and highly negotiated contracts that compose the remainder of any deal checklist — failure to properly complete and file a UCC-1 can leave a secured creditor with an unperfected security interest, and thus harm or even negate the secured creditor’s bargained-for protections.

PEB Commentary No. 26

With the importance of UCC-1s in mind, all secured creditors should be mindful of the conclusions drawn by the Permanent Editorial Board for the Uniform Commercial Code (the “PEB”) in PEB Commentary No. 26: Indication of Collateral in a Financing Statement (the “Commentary”). The Commentary examines whether a UCC-1 sufficiently describes the collateral it covers if the description simply references collateral described in a security agreement that is not attached to the UCC-1.

With this Commentary, the PEB addresses an issue on which courts have been split. In 2019, the U.S. Court of Appeals for the Seventh Circuit held in its ruling in In re I80 Equip., LLC, 938 F.3d 866, 874 (7th Cir. 2019) that a UCC-1 that incorporates a description of collateral by reference to an unattached security agreement sufficiently “indicates” the collateral, such that a separate and additional description of the collateral is not required to properly perfect a secured creditor’s security interest in that collateral. This ruling ran counter to a First Circuit ruling from earlier that same year, Altair Global Credit Opportunities Fund (A) LLC v. Financial Oversight and Management Board for Puerto Rico (In re Financial Oversight and Management Board for Puerto Rico),914 F.3d 694 (1st Cir. 2019), wherein the court ruled that a UCC-1 is insufficient if it describes collateral by reference to a document not found in the filing office. These conflicting rulings have caused confusion, particularly in states not within the jurisdiction of the aforementioned circuit courts, as to whether an incorporation-by-reference approach in a UCC-1 is a valid method of perfection.

The Commentary, while not binding, puts a thumb on the scale for secured creditors that are considering this question. The Commentary clearly states: “A financing statement that supplies information about the collateral that it covers solely by reference to a record not attached to the financing statement is not sufficient because it does not indicate the collateral that it covers as required by UCC § 9-502(a)(3).”

With this proclamation, the Commentary raises considerations for secured creditors with respect to both past and future approaches to collateral descriptions in UCC-1s.

Considerations for Secured Creditors

Existing UCC-1s

For any existing UCC-1 filed by a secured creditor that includes a collateral description solely describing collateral as defined in an unattached security agreement, the secured creditor must contend with the risk, now heightened by the Commentary, that such UCC-1 did not properly perfect the secured creditor’s security interest in that collateral. Any such secured creditor should consider amending the applicable UCC-1 to restate the collateral description in a manner that clearly complies with the requirements of Article 9 of the Uniform Commercial Code (the “UCC”). And such secured creditor should be mindful that a court may find that such UCC-1 did not perfect the underlying security interest until the date of any such amendment.

A secured creditor that considers amending any of its existing UCC-1s in light of the Commentary should also consider running lien searches against the applicable debtors. Lien searches can confirm for the secured creditor whether its security interest may have been further compromised by subsequent UCC-1s filed with respect to the same collateral. Assuming any such subsequent UCC-1s had sufficient collateral descriptions, and thereby perfected the underlying security interests, the person filing such UCC-1 may have priority over the secured creditor as a result of that perfection.

Future UCC-1s

For any secured creditor that historically has used an incorporation-by-reference approach to UCC-1s, consideration should be given to pivoting to a different approach going forward. In order for a UCC-1 to perfect a security interest in the collateral it covers, Section 9-504 of the UCC states that “[a] financing statement sufficiently indicate[s] the collateral that it covers if the financing statement provides:

(1) a description of the collateral pursuant to Section 9-108 (‘Option One’); or (2) an indication that the financing statement covers all assets or all personal property (‘Option Two’)” (bolded definitions added for ease of reference).

In relation to Option One, UCC Section 9-108, clause (b) states that a UCC-1 reasonably identifies the collateral if it identifies the collateral by: “(1) specific listing; (2) category; (3) except as otherwise provided in subsection (e), a type of collateral defined in the Uniform Commercial Code; (4) quantity; (5) computational or allocational formula or procedure; or (6) except as otherwise provided in subsection (c), any other method, if the identity of the collateral is objectively determinable.”

The language under clause (b) of Section 9-108 does not require exact specificity, and there is no reason why a reference to an unattached security agreement cannot be included in the collateral description. The PEB’s view, as expressed in the Commentary, is that the collateral description cannot solely consist of such a reference, but the Commentary goes on to clarify that “[w]hen a financing statement that provides information that meets the standard for sufficient indication under Section 9-504(1) also refers to additional information in an unattached record, this does not cause the financing statement to fail the standards for sufficient indication.”

The fundamental purpose of a collateral description in a UCC-1 is to put the public on notice, and it is acknowledged that additional inquiry may be required on the part of the public in order to fully understand the scope of the collateral referenced in the description. As comment 2 to UCC Section 9-502 states, “[t]he notice itself indicates merely that a person may have a security interest in the collateral indicated. Further inquiry from the parties concerned will be necessary to disclose the complete state of affairs.” Moreover, pursuant to comment 2 to UCC Section 9-504, “[a] financing statement sufficiently indicates collateral claimed to be covered by the financing statement if it satisfies the purpose of conditioning perfection on the filing of a financing statement, i.e., if it provides notice that a person may have a security interest in the collateral claimed” (emphasis added).

As an alternative to Option One, Option Two allows a secured creditor to use the collateral description of “all assets” or “all personal property” in a UCC-1. (As an aside, please note that this type of broad description, while valid in the UCC-1 context, is not sufficient in the security agreement itself, which, under UCC Section 9-108, must describe the collateral by type, category or specific listing.) Option Two greatly simplifies things for a secured creditor, as it eliminates any question as to the sufficiency of a UCC-1 collateral description that may be raised when relying on Option One. So long as the collateral description states “all assets,” it adequately describes the collateral for purposes of perfection under the UCC.

While Option Two is therefore attractive for secured creditors, an all assets collateral description may result in some pushback from a debtor in instances where the underlying security interest granted by the debtor is not, in fact, a security interest in all of its assets. A debtor who has more than one secured creditor or who anticipates additional secured creditors in the future may fear that an all assets collateral description will raise concerns. For example, a bank lending money to a borrower pursuant to a loan agreement may limit the borrower’s ability to grant liens on its inventory. Technically, the debtor may not be in breach of this loan agreement by granting a lien on its accounts to another secured creditor who then uses an all assets collateral description on its UCC-1 to perfect its security interest in the accounts. However, the all assets collateral description in the UCC-1 may cause the bank to inquire with the debtor regarding the underlying deal. And the debtor may want to avoid such inquiries from the bank and the possibility of having to take additional steps to prove to the bank that its new secured financing did not, in fact, breach the terms of the bank’s agreements.

Furthermore, a debtor that is not familiar with the UCC may not understand that an all assets collateral description in a UCC-1 does not actually result in a lien on all of the debtor’s assets. The secured creditor should make sure its debtor understands that a UCC-1 can only perfect a security interest in collateral in which a security interest has been granted — i.e., it is the security agreement, not the UCC-1, that determines the actual scope of collateral. One useful method of drawing a debtor’s attention to this topic, and prompting a helpful discussion, is for the secured party to include specific language in the security agreement that, notwithstanding the actual composition of the collateral, an all assets description will be used in the UCC-1.

Conclusion

While not binding, the Commentary is helpful guidance that will likely influence future court decisions. With this in mind, secured creditors that have used, or that have an inclination to use, an incorporation-by-reference approach to the collateral descriptions in their UCC-1s should consider amending their existing UCC-1s and pivoting to an alternative approach for future UCC-1s.

Questions about your UCC-1? Contact Megan Kelly or another member of LP’s Financial Services & Restructuring group.