ROCK, PAPER, SCISSORS: ANALYZING WHETHER TO FORECLOSE ON THE DEBTOR’S TANGIBLE ASSETS OR BENEFICIAL INTERESTS
Rod Clement, Brunini, Grantham, Grower & Hewes, PLLC, Jackson, Mississippi
Aasia Mustakeem, Powell Goldstein LLP, Atlanta, Georgia
This article reviews issues for lenders to consider when deciding whether to foreclose on a debtor’s tangible assets or on the debtor’s stock, limited partnership or limited liability company interests. Particular emphasis is given to the problems of combining a foreclosure on real estate with the remedies available under the Uniform Commercial Code and practical problems in foreclosing on securities.
Rock, Paper, Scissors: Analyzing Whether to Foreclose on the Debtor’s Tangible Assets or Beneficial Interests
The purpose of this paper is to walk through steps that a secured party might consider in determining whether to foreclose on a debtor’s tangible assets or on the debtor’s stock, limited partnership (“LP”) or limited liability company (“LLC”) interests. This paper assumes that the secured party has both a security interest in the debtor’s tangible real and personal property assets and also a security interest in the debtor’s stock, LP interests or LLC interests. The debtor’s stock, LP interests or LLC interests are sometimes referred to in this article as the debtor’s beneficial interests.[1]
To maintain some uniformity throughout the analysis, we are using the term “secured party” to describe the beneficiary of a deed of trust or mortgagee on real property as well as the grantee of a security interest in personal property. We also refer to the interest of a beneficiary of a deed of trust or mortgagee in real property as a security interest, although that term is usually used in connection with personal property.[2]
I. Foreclosing on tangible assets.
A.Is the loan secured by real property?
1. What law determines whether the deed of trust or mortgage is adequate to create a security interest in real property and its priority?[3]
2.What options does the secured party have for foreclosing on the real property?
a.Filing an action for a judicial foreclosure.
b. Conducting a nonjudicial foreclosure.
c.Accepting a deed in lieu of foreclosure.
B.Is the loan secured by personal property?[4]
1.Article 9 of the Uniform Commercial Code (“UCC”) will govern creation and enforcement of security interests in most personal property.[5]
2.Does the secured party have a valid security interest in the tangible personal property?[6]
3.Is the secured party’s security interest perfected?
a.What law governs perfection?[7]
- The general rule is that a financing statement must be filed to perfect a security interest in tangible personal property.[8]
c.A secured party may perfect a security interest in negotiable documents, goods, instruments, money and chattel paper by taking possession of the collateral.[9]
d.Special rules exist for perfecting agricultural liens[10] and security interests in intellectual property,[11] deposit accounts,[12] letter of credit rights,[13] money,[14] and goods covered by documents.[15]
e.Has perfection lapsed?
i.Have continuation statements been filed for security interests perfected by filing?[16]
ii.If secured party has perfected by possession, has the secured party maintained possession?
4.What is the priority of the security interest?[17]
5. What are the secured party’s options for foreclosing on the personal property?
a.Opting out of Article 9 and foreclosing under real property law.[18]
b. Conducting a public sale of the collateral.[19]
c. Conducting a private sale of the collateral.[20]
d.Retaining the collateral in satisfaction of some or all of the debt.[21]
e.Obtaining judgment on note and executing on the judgment.[22]
f.Filing an action for a judicial foreclosure.
C.Options for foreclosing on loans secured by both real and personal property.
1. Opting out of Article 9 and foreclosing on the real and personal property under real property law.[23]
2.Foreclosing on the real property under real property law and then foreclosing on the personal property or accepting the personal property in satisfaction of the indebtedness under the UCC.
a.Foreclosing on the real property at a public sale and then subsequently selling the personal property to the purchaser of the real property at private sale.[24]
b.Foreclosing on the real and personal property simultaneously.[25]
3.Accepting a deed in lieu of foreclosure on both the real and personal property.[26]
D.Considerations in foreclosing on real and tangible personal property together or separately.
1. Does the state whose law governs the foreclosure have a one-action or similar rule requiring that all actions against the property to be brought together?
2. Does the state whose law governs the foreclosure is taking place permit nonjudicial foreclosures?
3.Are the real and personal property operated together as a single unit?[27] If so, is it commercially reasonable to sell the real and personal property separately?[28]
4.Are there transfer taxes due on the sale of the assets that would not be due on a sale of the debtor’s stock?
5.Does the secured party anticipate purchasing the personal property collateral at the sale? If so, the secured party may not want to conduct a private sale of the personal property collateral.[29]
6.Does the secured party have the possibility of collecting a deficiency judgment following foreclosure? If so, the secured party will not want to take a deed in lieu of foreclosure on the real estate or accept the personal property collateral in satisfaction of the indebtedness.[30]
- Are there any junior judgments or creditors with junior priority interests? If so, the secured party may want to sell the real and personal property collateral and extinguish the junior interest rather than take a deed in lieu of foreclosure.[31]
8.Will the secured party have access to the personal property prior to the foreclosure so that the secured party can prepare the property for sale[32] and potential bidders can inspect the personal property[33] If not, this fact may cause the secured party to opt out of Article 9 and foreclose on the personal property under real property law, or hold separate sales of the real and personal property.[34]
9.Is the debtor an individual and in the military service? If so, the Servicemembers Civil Relief Act may bar foreclosure on tangible assets.[35]
II. Foreclosing on the debtor’s beneficial interests.
A. Is the stock, LP or LLC interest a general intangible or a security?[36]
1.Stock: Under the UCC, a share of stock in a corporation is a security. [37]
2. LP and LLC interests.[38]
a. Did the debtor “opt in” to Article 8?[39] In most cases LP and LLC interests will be securities only if the debtor affirmatively “opts in” to Article 8 by providing in its partnership or operating agreement that its LP or LLC interests are governed by Article 8.[40]
b.Has the issuer “opted out” of Article 8?[41]
3.If the LP or LLC interest is not a security, it is a general intangible.[42]
B.Has the secured party’s security interest been perfected?
1. What law governs perfection of the security interest?
a.Under the general choice of law rules, the law governing perfection and priority of a security interest in general intangibles is the law of the jurisdiction in which the debtor is located.[43]
b.Under special rules for securities, the governing law may be the law of the jurisdiction where the certificated security is located or the law of the issuer’s jurisdiction.[44]
2. Filing is the only way to perfect a security interest in a general intangible.[45] If each stockholder is a debtor, then a financing statement must be filed in every state in which the debtors are located.[46]
3.A security interest in a security can be perfected by filing[47], by obtaining control[48] or by delivery of a certificated security.[49]
C.What is the priority of the secured party’s security interest?
1.General intangibles: priority of a security interest in a general intangible is determined by the usual “first to file” rules.[50]
2.Securities.
a. If a security interest in a security is perfected by filing only, then the general “first to file” rules govern priority.[51]
b. If the security interest is perfected by control, the priority is determined by the time the secured party obtains control.[52]
c.If a security interest in a certificated security is perfected by delivery, the priority is determined by the time of delivery.[53]
d.A secured party that perfects a security interest in a security by control obtains priority over a secured party that had previously perfected by delivery of a certificated security[54] or perfected by filing only.[55]
e.A secured party that perfects a security interest in a registered security by delivery has priority over a security interest perfected by filing only,[56] but is junior in priority to a security interest perfected by control.[57]
f.A secured party that perfects a security interest in a security by control can become a “protected purchaser” and thereby acquire its interest free of any adverse claims.[58]
D.Is the security interest still perfected?
1.Security interests perfected by filing.
a. Has the security interest been continued?[59]
b.Has the debtor changed its name so that the filed financing statement becomes seriously misleading?
2.If the secured party perfected by taking possession of a certificated security, does the secured party still have possession of the security?[60]
E.Are there permits necessary to the project that a purchaser of the assets at foreclosure would have to obtain, but a purchaser of the debtor’s beneficial interests would not have to obtain?
F.What special problems exist in foreclosing on the beneficial interests?
1.What does the purchaser at a foreclosure sale get?
a.Typically corporate bylaws, LP agreements and LLC operating agreements restrict the transfer of beneficial interests. Such restrictions will be applicable to a creditor who takes a security interest in the beneficial interest and will limit its interest and right to obtaining proceeds or distributions rather than a full ownership interest.[61]
b.The UCC limits the restrictions on creating a security interest in general intangibles,[62] but the UCC does not override restrictions against creating security interests in securities or entitle the secured party to enforce its security interests.[63]
2.The purchaser at the foreclosure sale is stepping into the shoes of the debtor not only with regard to known liabilities but also with regard to any unknown liabilities of the debtor.
3.Can an involuntary sale of securities be made without violating federal securities laws?
a. The comments to the UCC suggest that a public sale of securities is subject to federal securities laws.[64] This issue is particularly problematic since a foreclosure is involuntary in nature and the debtor is not likely to cooperate in complying with securities laws. The comments to the UCC also suggest that a public sale may qualify as a private placement under federal securities laws.[65]
b. Apart from the issue of complying with securities laws, can you have a commercially reasonable public sale if bidding is limited to persons who could purchase securities in a private placement?[66]
4.Timeliness of notice of sale.
a. The UCC provides that whether a notice of sale is timely is a question of fact,[67] but that notice sent at least ten days before the sale is reasonable.[68]
b.A sale of all of the beneficial interests of a debtor is in essence the sale of the business. Despite this ten-day safe harbor, will ten days notice of the sale of a business be commercially reasonable?[69]
5.Foreclosing on the debtor’s beneficial interests, of course, will not extinguish any junior liens or security interests on the debtor’s assets.[70]
1
The authors would like to thank Nadine S. Evans of Powell Goldstein LLP for her assistance in the preparation of this article.
[1] Loans secured by the debtor’s beneficial interests are sometimes referred to as mezzanine loans. Lenders often prefer to make mezzanine loans rather than take a second mortgage on the debtor’s assets. For a discussion of issues in mezzanine loans, seeSteve Horowitz & Lise Morrow, What You Need to Know about Mezzanine Financing, 16 Practical Real Estate Lawyer 9 (May 2000); Marc B. Friedman & Michael A. Rudolph, Exercising Remedies under Mezzanine Loans, presented at the Spring 2002 ACREL meeting; and John C. Murray, Mezzanine Financing Endorsements to Title and UCC Insurance Policies, available on the ACREL website. Mr. Murray has written additional articles about mezzanine loans that are available in the John C. Murray Reference Library on the First American Title Insurance Company website,
[2]While it is more common for the interest of the mortgagee to be described as a “lien”, “security interest” may be more accurate since the mortgagor voluntarily grants the interest. Section 4.1 of the Restatement of the Law (Third) Property-Mortgages states that a mortgage creates a security interest in real property. See also Shutze v. Credithrift, 607 So. 2d 55, 59 n. 2 (Miss. 1992) (beneficiary of a deed of trust has a security interest and not a lien).
[3] The real property law of the state in which the real property is located generally governs creation and priority of a security interest in real property, even if the parties choose the law of another state.
[4] A thorough discussion of creating, perfecting and enforcing security interests in personal property is beyond the scope of this article. Readers with an interest in this topic should consult some of the treatises that address these topics in detail, such as Barkley Clark, The Law of Secured Transactions under the Uniform Commercial Code, and James White & Robert Summers, Uniform Commercial Code.
[5] Section 9-109 of the uniform version of the UCC describes the personal property that is excluded from the scope of Article 9. This article is limited to the personal property that is subject to Article 9. Article 9 was amended effective in most states on July 1, 2001. For a description of the changes, see W. Rodney Clement, Jr. & Baxter Dunaway, Revised Article 9 and Real Property, 36 Real Property, Probate and Trust Journal 511 (Fall 2001), and Philip H. Ebling & Steven O. Weise, What a Dirt Lawyer Needs to Know about Revised Article 9, 37 Real Property, Probate and Trust Journal 191 (Summer 2002).
[6] The general rules regarding attachment of a security interest are in Section 9-203 of the UCC. The general choice of law rules in Section 1-301(c)(1) of the UCC will govern creation of security interests for most collateral.
[7] The general rule is that the law of the state in which the debtor is located governs perfection. UCC § 9-301(1). For timber to be cut, as-extracted collateral and fixtures, the law of the state in which the collateral is located governs. UCC § 9-301(3), (4). Special rules exist for agricultural liens (UCC § 9-302), goods covered by certificates of title (UCC § 9-303), deposit accounts (UCC § 9-304), investment property (UCC § 9-305), and letter of credit rights (UCC § 9-306).
[8] UCC § 9-310(a).
[9] UCC § 9-313(a).
[10] UCC § 9-308.
[11]See generally Steven O. Weise, The Financing of Intellectual Property Under Revised UCC Article 9, 74 Chi. Kent L. Rev. 1077 (1999).
[12] UCC § 9-312(b)(1).
[13] UCC § 9-312(b)(2).
[14] UCC § 9-312(b)(3).
[15] UCC § 9-312(c), (d).
[16] The general rule under the UCC regarding lapse is that a filed financing statement is effective for five years after the date of filing. UCC § 9-515(a). The financing statement will lapse at the end of the five-year period unless a continuation statement is filed in the six-month period before the expiration of this five-year period. UCC §§ 9-510(c), 9-515(d). Financing statements filed in connection with public finance or manufactured housing transactions are effective for thirty years before lapse. UCC § 9-515(b). If the debtor is a transmitting utility, and the financing statement so indicates, the financing statement is effective until a termination statement is filed. UCC § 9-515(f).
[17] The general priority rules under the UCC are that a perfected security interest has priority over an unperfected security interest, and that conflicting perfected security interests rank according to priority in time of filing. UCC § 9-322(a). Special rules exist for priorities of security interests in future advances (UCC § 9-323); purchase money security interests (UCC § 9-324); transferred collateral (UCC § 9-325); deposit accounts (UCC § 9-327); investment property (UCC § 9-328); letters of credit (UCC § 9-329); and chattel paper and instruments (UCC § 9-330). See text accompanying notes 51-58 (discussion of priority of security interests in securities).
[18] Section 9-604 of the UCC provides, “If a security agreement covers both personal and real property, a secured party may proceed…(2) as to both the personal property and the real property in accordance with the rights with respect to the real property, in which case the other provisions of this part do not apply.” If a deed of trust or mortgage contains a grant of a security interest and otherwise meets the requirements for a security agreement, then the secured party should be able to foreclose on the personal property under real property law. Note that Section 9-604(a) does not require that the real property and personal property be sold as a package. The personal property described in the deed of trust or mortgage must be perfected according the regular rules for collateral of that type; filing the deed of trust or mortgage in the land records will not perfect the secured party’s security interest except for timber to be cut, as-extracted collateral and fixtures, as provided in Section 9-301(3) and (4) of the UCC.
[19] UCC § 9-610(a).
[20] UCC § 9-610(a).
[21] UCC §§ 9-620 to -22. The secured party can propose to accept personal property in full or partial satisfaction of the secured indebtedness. UCC § 9-620(a). The secured party must give notice of this proposal to any junior secured parties and lien creditors. UCC § 9-621. The secured party cannot employ this remedy if any junior secured parties or lien creditors object. UCC § 9-620(a)(2).
[22] UCC § 9-601(e). If the secured party obtains a judgment, the priority of the judgment will relate back to the date that the secured party perfected its security interest. Id. If a third party obtains a judgment against the debtor, of course, the priority of the judgment will be determined by the date of the judgment or the date the judgment attaches, depending on state law.
[23] If the secured party “opts out” of Article 9, then presumably the secured party does not have to meet the requirement in Section 9-610(b) that every aspect of the sale must be commercially reasonable (or at a minimum, compliance with the requirements for sale of real estate will be deemed commercially reasonable.) This is an important benefit to the secured party because whether a sale is commercially reasonable is a fact-intensive issue (and therefore usually not subject to being decided by summary judgment). The secured party also does not have to comply with Article 9’s potentially toxic advertising and notice requirements.
[24] This method may be appropriate if the debtor will not voluntarily allow the secured party to have access to the premises for purposes of cleaning the personal property and allowing potential bidders to inspect the personal property in connection with a sale under the UCC, and the secured party is not willing or able to go through a replevin suit to get possession. See notes 32-34. This option is particularly practical when the secured party can conduct a relatively quick and inexpensive nonjudicial foreclosure on the real property.The potential issue here is whether it is commercially reasonable to sell the real property and personal property separately. See note 28.