"What's in a name? Misidentifying the Debtor under Revised Article 9.

This article addresses the harsh penalties imposed on a creditor for incorrectly naming a debtor entity on a financing statement.

As you might expect, misidentifying a debtor on a financing statement can mean the difference between having a secured claim and an unsecured claim. However, what you might not expect is the degree of error necessary to render a financing statement “seriously misleading” under revised Uniform Commercial Code §9-506, thereby rendering it ineffective.

The new legal standard, coupled with strict search logic standards being adopted by filing offices are making it much easier to challenge the perfection of a security interest on the basis of minor errors in the debtor’s name.

So… "What's in a name? Well, when trying to perfect a security interest under Revised Article 9, “that which we call a rose by any other name definitely does not smell as sweet."

INTRO:

[PMSI]
In today’s economy, selling unsecured on open account may carry significant risk for vendors. However, taking a security interest in the merchandise sold may reduce or eliminate such risk. This type of security interest, called a purchase money security interest or "PMSI", is the most common and important secured transaction under article 9. To obtain a valid PMSI, the debtor must first execute a security agreement giving the vendor a security interest in described merchandise. Then, the vendor perfects the security interest by filing a financing statement with the filing office (generally the Secretary of State). The vendor who takes the proper steps to perfect its PMSI is entitled to the cash proceeds from the sale of its merchandise.

[Strong Arm Powers]
Section 544(a)(1) of the Bankruptcy Code gives the trustee in bankruptcy the status of a judicial lien creditor. This allows the trustee the power to avoid any Article 9 security interest that would be subordinate to the rights of such a lien creditor and is commonly referred to as the trustee’s ‘strong-arm’ power. Accordingly, the trustee can avoid a security interest that has not yet been perfected as of the date the bankruptcy petition was filed. Since most security interests are perfected by filing a financing statement, the standards for measuring compliance with the filing requirements are critical when determining whether a security interest can be avoided.

[Revised Article 9 Intro]
In general, the changes introduced by Revised Article 9 will make it more difficult for security interests to be avoided in bankruptcy. Revised Article 9 reduces the types of errors that can render the recordation of a financing statement ineffective. Only errors in the debtor’s name, secured party’s name or indication of the collateral can render the financing statement ineffective. However, financing statements are indexed by the debtor’s name, and the debtor’s name is the essential element to locating the financing statement in the registry. Given the new standards that determine whether a financing statement sufficiently lists the name of the debtor, the degree of error necessary to render a financing statement ineffective because it is “seriously misleading” may be less than what was previously allowed.

[Filing a Financing Statement]
Financing statement registries generally offer an online database that searchers can use to explore financing statements. A search under the debtor’s name might display an alphabetical list with 20 entries, with the exact or nearest match at the top the list. To view additional results, the searcher can utilize “previous” and “next” buttons, which generally appear on the results screen.

[Comparison]
While Revised Article 9 provides clearer rules for determining the correct name to use for a debtor on a financing statement, it also removes human judgment from the determination of when the searching party has satisfied it’s burden. Likewise, it has shifted the burden from the searching party, who used to be required to search under alternative reasonable permutations of the debtor’s name, to the filing party, who is now required to ensure the security interest will be found when a searcher uses the correct name.

Under the OLD ARTICLE 9, as long as a financing statement substantially conformed to the requirements of the statute, minor errors were not misleading. Instead, courts created and relied upon a “reasonably diligent searcher” standard, which allowed the reviewing court to determine whether a hypothetical reasonable search would have resulted in the discovery of the non-conforming financing statement despite the error in a debtor’s name. This “reasonably diligent searcher” standard allowed courts to second-guess what searchers should or should not have discovered in their search.

Under REVISED ARTICLE 9, the reasonably diligent searcher standard is replaced with a bright line standard based on the computerized search logic of the filing office. Here, if a particular security interest cannot be located using the state’s standard search logic, the filing is deemed ‘seriously misleading’. In other words, a financing statement is effective if the computer search run under the debtor’s correct name produces the financing statement with the debtor’s incorrect name. If the financing statement with the debtor’s incorrect name is not produced, then the financing statement is ineffective as a matter of law. Thus, the revised article 9 removes the burdens placed on searchers because searchers no longer have to perform multiple searches using countless variations of the debtor’s name.

[Search Logic]
There is no standard search logic. It is still evolving and some states may adopt unique standards. However, the International Association of Corporation Administrators has promulgated a set of Model Administrative Rules for revised Article 9 that has already been adopted in a few states. The Model Rules are at www.iaca.org and, as of early September, had been adopted in whole or party in Iowa, Minnesota, New Mexico, Virginia and Washington. These rules exemplify how small a margin for error may be provided by the new search logic based test for seriously misleading errors.

[Search Logic Example]
To illustrate, consider the following. For registered organizations such as corporations, the financing statements must list the name of the debtor as it appears in the public records of the jurisdiction state where it is organized. Before names are entered into an index, they are converted into a standardized format. The search logic, as the IACA’s Model Rules suggest, ignores punctuation, accents, capitalization and spaces. Further, suppose “noise words” are also ignored so that the “the” or like words is disregarded. Also, perhaps abbreviations that indicate the nature of the organization, like “Corp.”, “Co.”, or Ltd.”, are ignored. Thus, the presence of these types of errors will not render the statement ineffective. Then the computer conducts a search and produces a result based on exact matches between the search criteria and the database of filings.

If the debtor’s correct name is “The Blakeley & Blakeley Company, the filing system would see the name as blakeleyblakeley. If a secured creditor incorrectly listed the debtor’s name as Blakeley & Blakeley LLC, the system would still see blakeleyblakeley and the error would not be seriously misleading.

However, once the names have been modified by the search logic, the search will produce financing statements only if the names “exactly match”. Thus, even a minor misspelling or a typographical error can be fatal. For example, under the prior law, spelling the debtor’s name as Blakely & Blakely probably would not have rendered the filing ineffective under the “reasonably diligent searcher” test. However, under the Model Rules, such an error would render the security interest unperfected and susceptible to a “strongarm” attack by the bankruptcy trustee.

[Case Example]

The case of In re John’s Bean Farm of Homestead Inc., 378 B.R. 385 (Bankr S.D. Fla 2007) is another good example of how strictly the new requirements are being interpreted. In In re John’s Bean Farm, the court was faced with deciding whether the financing statement filed by the creditor conformed to Florida’s filing requirements or was seriously misleading. The court held that the incorrect name used on the financing statement did, in fact, constitute a seriously misleading financing statement.

In In re John’s Bean Farm, the creditor loaned the debtor money to purchase equipment. The debtor defaulted so the creditor took a security interest in the equipment which was evidenced by a security agreement and a secured promissory note. However, the creditor’s financing statement, as did all of his documents, identified the debtor as “John Bean Farms Inc.” instead of the debtor’s actual name of incorporation, “John Bean Farm of Homesead, Inc.”.

The bankruptcy trustee objected to the claim and argued that the creditor’s misidentification failed to comply with the rule governing the sufficiency of debtor names on financing statement, and therefore, the creditor’s claim was unstructured. The creditor responded by arguing that the financing statement was not seriously misleading and was therefore adequate to perfect his interest in the debtor’s equipment.

The trustee had conducted a search of the Florida Registry’s online financing statement database using the debtor’s correct name and did not find a match on the results screen listing 20 names. However, the creditor’s financing statement was found after clicking the ‘previous’ button 60 times. The creditor attempted to argue that a searcher must go beyond the first page of the search result, however the court disagreed by noting that if the creditor’s view is correct, then ‘search result’ means something other than what the search page displays.

The court found that scrolling through pages of results is exactly what the statute was intended to prevent. While the court stated that the purpose of revised art 9 was “to create a framework for the perfection of security interests that is less arbitrary, that includes statutory guidance of simplifying the search, while allowing or ‘minor’ errors”, it did explain that if it were to interpret revised Article 9 to avoid an absurd result, then a “reasonable limit to the search would be no more than one ‘previous” or “next” screen after the initial search input.

Any error, careless or inadvertent, in naming the correct entity on the financing statement could potentially result in a secured creditor’s claim becoming characterized as an unsecured claim. What, then, practically speaking, is the best practice for a company to reduce this risk? The credit executive selling on a secured basis simply must not only make sure they properly record their financing statement using the debtor’s exact legal name but must also ensure that, given the particular search logic used by the local records office, the filing is easily located. In addition, a vendor must remain vigilant with regard to staying "perfected". A vendor's failure to file an amended UCC-1 financing statement after a debtor corporation has changed its name, for example, could result in that vendor's financing statement being "seriously misleading" – thereby creating a risk that the bankruptcy trustee can unseating the lien. As a result, the secured creditor might not be able to obtain full recovery on the claim if the estate is administratively insolvent.