The Double Debtor Problem

Written by: Steven N. Kurtz, Esq., Levinson Arshonsky Kurtz & Komsky LLP

This is a loosely structured continuation of my last article, “Son of Debtor”, which addressed what happens when your collateral winds up in the hands of a “new debtor”. While the dreaded Son of Debtor is bad, the problems get much worse when the new debtor obtains secured financing from a new lender or factor and pledges your collateral to secure the new deal. Now, we have the same debtor, pledging the same collateral to two creditors, whilst in default, or triggering a default, and both sets of creditors are looking to the same collateral to recover on their bad deals.  Unfortunately, the double debtor problem happens frequently.  

The priority between competing creditors in personal property is governed by Article 9 of the Uniform Commercial Code (“UCC”), which has a strict set of laws designed to protect secured creditors from pretty much every situation under the sun. Article 9 is a pure race statute, unlike real estate laws in most jurisdictions, where the first to record is first in priority even if the first person to record knows about the other creditor. UCC Sec. 9-322. Article 9 requires certainty and the only way to get certainty is that the first person to record wins - end of story.  When your collateral is transferred without your consent, your lien follows and sticks to your collateral that was improperly transferred. UCC Sec. 9-315. For those that factor accounts, once the debtor (your factor client) sells the account to the factor, the debtor no longer has any legal or equitable rights to the account, because the accounts are owned by the factor.  UCC Sec. 9-318. While there are good foundational rules protecting you as the secured party, the strict rules can just as well cause you to lose your priority if you never learn about the transfer and subsequent financing, or don’t act in time.  

Most of you know that for an entity, the financing statement must be filed in the state in which the debtor is organized, using the exact name in the state official registration system. For example, if you finance a Nevada corporation, you file the financing statement in Nevada using the exact name as reflected in the factor client/borrower’s Articles of Incorporation. To determine your lien priority against a different secured party, a creditor trying to enforce litigation claims (known as a lien creditor), or a bankruptcy trustee, if a search using the debtor’s exact name reflects your financing statement, you are good. If not, you have what is known as a misleading financing statement. UCC Sec. 9-506. The misleading financing statement is where the original secured creditor gets into trouble, causes massive headaches, and dictates what you need to do, as outlined in the Son of Debtor Article.  

Once you learn about the transfer of your collateral, you need to immediately kick in your default procedures.  Confirm your documents are in order, everything is signed, and all “i”s are dotted and “t”s crossed. We like to advise folks to do a “perfection analysis”, which is a hypercharged lien search with a few other things added in, to assess what problems are out there.  You also need to understand exactly what your collateral is- literally. The type of collateral you have will get your lawyer’s head wrapped around the upcoming potential priority problem. Remember, your lien follows your collateral in an unauthorized transfer. If you have a warehouse of equipment that can be quantified and “looked it”, then it’s easier for the first creditor to establish priority even if the transfer is not discovered until much later and even if the Son of Debtor is financing with a new person.  If it’s inventory, you are little better, but inventory is sold and replenished, but as discussed below, you have a 120-day window to perfect against the Son of Debtor if there is a new secured party. If you are dealing with a temp staffing entity with just accounts, contracts and general intangibles, that requires a closer look. A transfer of your factored or collateral accounts to the Son of Debtor, as discussed below, will require the Son of Debtor to comply with Article 9.  

Here is the rule for improperly transferred collateral other than accounts. As discussed in the Son of Debtor Article, your lien follows the collateral, but in order to protect your priority and not have a misleading financing statement, you need to re-perfect your lien against the Son of Debtor. The combination of UCC Secs. 9-506 and 9-507 requires an amendment to the financing statement. The combination of UCC Secs. 9-506 and 9-508 requires a new financing statement. As discussed in the Son of Debtor Article, you file both an amendment and a new financing statement, using special language as you want to make sure that you have the right situation covered, and both sets of documents create a little more drama than just one.  

If the Son of Debtor obtains new financing, the priority is as follows. The first secured party will have a lien against all new collateral acquired by the Son of Debtor within the first 120 days. For new collateral acquired by the Son of Debtor after the 120 days, the first creditor loses its priority on the new collateral acquired after 120 days, unless it either files a new financing statement or an amendment, as the case may be, which is why we recommend to do both. If a new secured creditor comes into the picture and finances the Son of Debtor, it all depends on if the first creditor files a UCC-1.  If the first creditor files properly within 120 days of the transfer, the new creditor is junior. If the first creditor does not file its UCC-1 within 120 days, the new creditor is senior on all new collateral acquired after the 120 days, but junior on new collateral within the initial 120 days. 

Here is the priority rule for accounts. The UCC is definitionally based and the UCC has a broad definition of accounts in UCC Sec. 9-102(a)(2), which can include work or services not completed and purchase orders for work or services in the future. UCC Sec. 9-109(a)(3) provides for compliance with Article 9 for the sale of accounts. That means you must have the attachment (lien granting) and perfection of a security interest in accounts.  UCC Secs. 9-203 and 9-308. The official comments to UCC Secs. 9-109 and 9-318 discuss the concept of a sale of accounts, and the effect of an account purchaser not perfecting its rights to a purchased or transferred account and the priorities between two competing secured creditors. The net result is that the Son of Debtor, as the “purchaser” of the accounts, must comply with Article 9 and have the grant of a security interest in accounts perfected by a financing statement. Generally, parties to a Son of Debtor transfer are not good actors and fail to understand the nuisances of Article 9. This means that if the first secured party had a perfected security interest in the original debtor’s accounts and the original debtor transfers the account in any way to the Son of Debtor, the Son of Debtor who was the transferee of the account transferred without the original secured party’s consent, must comply with Article 9 against the original debtor, with a security agreement and UCC-1 perfection. If the Son of Debtor finances the account with a new secured party under the foregoing facts, the first secured party has priority over the accounts transferred to the Son of Debtor and financed by the new creditor. If the Son of Debtor has a sociopathic lawyer who understands these Article 9 rules, complies with Article 9, and the Son of Debtor pledges the first secured party’s accounts, that’s an open question on who wins in priority, but I think the first secured party wins.

What happens when the situation is so messed up that the two competing creditors are unable to sort out their priority and their collateral? Picture an omelet with a bunch of ingredients and now try to sort out who has what share of the mushrooms and avocados. The UCC addresses this mess in Sec. 9-336 which is entitled comingled goods. It’s a pari parseu deal, meaning you take the value of the comingled goods (basically inventory and equipment), and each person gets its share based upon the dollar number of each creditor’s claim. While this section only discusses comingled goods, the same concepts would generally hold true for other collateral. Generally, folks in the IFA community, with one or two bad apple exceptions, don’t care to go to war against other factors/lenders over collateral, and a good lawyer or  mediator in a priority dispute of this type, would generally steer the parties in this direction.  

The double debtor can be a nightmare for the financial community. Accordingly, it can’t be stressed enough to have your eyes on your collateral and your factor client/borrower. Due diligence is key. One should follow your instincts as well. Lenders and factors don’t want to be in litigation with each other over double debtor problems. Unfortunately, this problem is something that most people will face in their career and one that each of you should have in the back of your mind.