Welcome back to our second lecture on secured transactions.
Now that we have thoroughly examined the nature and creation
of security interests, we are ready to turn our attention to
the critical concepts of perfection and priority under
Article 9 of the Uniform Commercial Code, which we will
refer to as the UCC. These two concepts, perfection
and priority, are essential for understanding the rights of
secured parties, especially in relation to third parties such
as other creditors, buyers, and lion holders.
Even if a security interest is valid between the debtor and the
secured party, meaning it has attached under UCC Section
9-203, that interest is not fully protected against third
parties until it is perfected. Perfection serves as a public
notice function alerting the world to the secured parties
claim to the collateral. Let us begin by defining
perfection more formally. Perfection is the process by
which a secured party establishes its rights in the
collateral against the claims of third parties.
In most cases, this means that the secured party must take some
additional step beyond attachment, most often filing a
public notice to give the rest of the world fair warning that
the collateral is encumbered. It is important to stress here
that perfection is not required to make the security interest
valid between the debtor and the secured party.
Attachment suffices for that. However, perfection is necessary
to protect the secured party's rights against others, including
other secured creditors, judgment creditors, and
bankruptcy trustees. Now, let's take a closer look at
the primary methods of perfection under Article 9.
Broadly speaking, there are 4 main avenues for perfection.
Filing a financing statement. Possession of the collateral.
Control over the collateral. Automatic perfection by
operation of law. Let's explore each in detail.
First, the most common method is perfection by filing a financing
statement under UCC section 9-310-A secured party perfects
its interest by filing a UCC -1 financing statement in the
appropriate public office, typically the office of the
Secretary of State in the state where the debtor is located.
For individuals, this is generally their principal
residence. For registered organizations, it
is the state of incorporation. The financing statement serves a
critical public notice function. It must contain three basic
elements, the debtor's name, the secured party's name, and an
indication of the collateral covered.
Importantly, the financing statement need only provide a
general indication of the collateral.
It does not need the same level of specificity as the security
agreement. For example, all assets or all
personal property is generally sufficient in the financing
statement, even though such language would likely be
inadequate in the underlying security agreement.
Let me give you an example here. Suppose Acme Manufacturing
grants First Bank a security interest in all its equipment in
inventory. To perfect the interest, First
Bank files a financing statement that lists Acme's legal name as
the debtor, identifies First Bank as the secured party, and
describes the collateral as all assets.
Even though the security agreement itself must
specifically describe the collateral, the financing
statements broad language is permissible because its purpose
is merely to provide notice that a secured interest might exist,
not to provide the detailed terms of the arrangement.
Next, let's explore perfection by possession.
Certain types of collateral, such as negotiable instruments,
tangible chattel paper, or certificated securities, can be
perfected simply by the secured party taking physical
possession. This method eliminates the need
for filing, and it can offer greater protection in some
cases, particularly when the collateral is transferable by
delivery under UCC Section 9-313.
Possession serves both as a method of perfection and as a
signal to the world that the secured party has a claim to the
property. For example, imagine a
pawnbroker who lends money against a customer's gold
necklace. By taking physical possession of
the necklace, the pawnbroker perfects its security interest
without filing anything. The pawnbrokers possession
serves as a visible sign of its rights in the collateral.
Moving on, perfection by control applies to certain intangible
assets such as deposit accounts, investment property, and
electronic chattel paper. Under UCC Section 9-314, control
occurs when the secured party has the ability to direct the
disposition of the asset, typically through contractual
arrangements or account agreements.
For deposit accounts, control is usually achieved by becoming the
bank itself, entering into a control agreement with the bank
and the debtor, or otherwise gaining exclusive authority over
the account. For example, if First Bank holds
a security interest in Acme's deposit account at Big Bank,
First Bank can perfect by entering into a control
agreement with Big Bank and Acme, giving First Bank the
right to direct transfers from the account.
Finally, there is automatic perfection where no filing,
possession or control is required.
Under UCC Section 9-309, certain security interests are
automatically perfected upon attachment.
The most common example is a purchase money security interest
PMSI in consumer goods. If a seller provides financing
to a buyer for the purchase of consumer goods, for example, a
furniture store that sells a couch on credit, the seller's
security interest is automatically perfected without
filing. However, it is crucial to
understand the limitations. Automatic perfection applies
primarily to consumer goods for inventory and equipment.
Even a PMSI requires filing to gain priority over conflicting
interests. Now that we have examined the
methods of perfection, let's turn to the rules of priority,
which determine whose rights take precedence when multiple
parties claim an interest in the same collateral.
Under the general rule set forth in UCC Section 9-322, priority
is determined by the 1st to file or perfect principle.
This means that between two perfected secured parties, the
party who first filed A financing statement or otherwise
perfected its security interest as priority, even if the
security interest attached later.
To illustrate, suppose First Bank files a financing statement
against Acne's equipment on January 1st, but the loan is not
extended until February First. Second Bank files a financing
statement against the same equipment on January 15th and
extends a loan on January 20th. Even though Second Banks loan
and attachment occurred first, First Bank has priority because
it filed first. This rule encourages early
filing and creates certainty in commercial transactions.
However, there are important exceptions to the general rule.
One key exception involves purchase money security
interests. Under UCC Section 9-324-A,
perfected PMSI in goods other than inventory or livestock has
super priority over conflicting security interests if perfected
within 20 days after the debtor receives possession of the
goods. For PMS eyes and inventory, the
secured party must perfect before the debtor receives
possession and must notify existing secured parties with
conflicting interests. These rules reflect a policy
judgement that sellers or lenders who enable the debtor to
acquire new assets should be given special protection.
For example, suppose Acme buys new manufacturing equipment
using financing from equipment lender who files APMSI within
the required 20 days. Even though First Bank has an
earlier filed blanket lien on all equipment, equipment
lenders, PMSI takes priority with respect to the new
equipment. Another critical exception
involves buyers in the ordinary course of business.
Under UCC Section 9-320, such buyers take goods free of a
security interest created by their seller.
Even if the security interest is perfected.
This rule protects the expectations of buyers and
facilitates commerce. For example, if Acme sells
widgets subject to First bank security interest, a retail
customer who buys a widget in the ordinary course takes it
free of the bank's claim. Let's also address the status of
lien creditors under UCC section 9-317-A.
Perfected security interest has priority over the rights of a
lien creditor. However, if the security
interest is unperfected, the lien creditor prevails.
This underscores the importance of timely perfection as a
secured party who delays filing risks losing priority to
judgment creditors or bankruptcy trustees.
We must also examine the special rules for proceeds under UCC
section 9-315-A Perfected security.
Interest generally continues in identifiable proceeds of the
collateral. This means that if the debtor
sells or disposes of the collateral, the secured parties
interest attaches to whatever replaces it, so long as the
proceeds can be traced. However, if the proceeds are
cash or funds deposited into a bank account, additional rules
may apply, particularly if the secured party lacks control over
the account. Let me illustrate this with an
example. Suppose Acme sells inventory
subject to First Bank security interest and deposits the
proceeds into its general operating account.
First Bank security interest continues in the proceeds, but
if the funds are commingled with other money, the bank may face
tracing challenges. Courts typically apply equitable
principles, such as the lowest intermediate balance rule, to
determine the extent of the secured parties claim.
Now let's bring in some key cases that have shaped the
understanding of perfection and priority.
In Enri Leonard, the court examined whether a financing
statement that misnamed the debtor was effective.
The court held that even minor errors could render a filing
ineffective if they made the statement seriously misleading
as determined by a search under the debtors correct name.
This case underscores the importance of strict compliance
with filing requirements, particularly the accurate
identification of the debtor. Another important case is
Farmers State Bank versus Production Credit Association,
where the court addressed the priority of a PMSI over an
earlier perfected security interest.
The court emphasized that PMSI claimants must strictly comply
with the filing and notice requirements to gain super
priority. Failure to meet these procedural
steps results in subordination to prior secured claims.
We should also mention and re Peregrine Entertainment Limited,
where the court analyzed the priority between competing
security interests in film rights, a form of general
intangible. The court applied the first to
file or perfect rule, demonstrating that even complex
or unusual collateral types fall within the established priority
framework. Let's walk through a detailed
hypothetical to solidify these concepts.
Suppose that Widget Co grants First Bank a security interest
in all its inventory and equipment.
First Bank files a financing statement on January 1st.
On February first, Second Bank extends a loan secured by which
it codes equipment and files a financing statement on February
5th. Under the general rule, First
Bank has priority because it filed first even though Second
Bank security interest attached earlier.
However, if Second Bank has a properly perfected PMSI in the
equipment, it can gain priority over First Banks earlier
interest, but only if it files within 20 days of which it Co
receiving the equipment. If Second Bank misses this
window, its interest is subordinate.
Before we conclude, let's briefly touch on continuation
and termination. A financing statement is
effective for five years, after which it lapses, unless a
continuation statement is filed within six months before the
expiration date. If the financing statement
lapses, the security interest becomes unperfected and may lose
priority. Additionally, once the
obligation is satisfied, the secured party is generally
required to file a termination statement to clear the public
record. To summarize today's expanded
lecture, we have taken an in depth look at the methods of
perfection, the rules governing priority among competing
claimants, the critical exceptions to the general
priority framework, and the doctrinal issues that shape
these rules. We have explored key statutory
provisions, examined illustrative hypotheticals, and
analyzed landmark cases to deepen our understanding of
these complex but vital concepts.
In our next lecture, we will shift our attention to the
issues of default, the remedies available to secured parties,
and the enforcement mechanisms under Article 9.
We will explore how secured parties exercise their rights
when the debtor breaches the statutory framework governing
repossession and foreclosure and the protections afforded to
debtors and third parties. Thank you for joining me today
and I look forward to continuing this exploration with you in our
next session.