The Son of Debtor: Remedies Available to Factors When Collateral Moves to a New Entity

If a factor or lender’s collateral is transferred to a new entity, whether legitimately or via unscrupulous actions, it’s important to utilize state law and UCC remedies to avoid headaches like successor liability and other such claims. Steven N. Kurtz, Esq., of Levinson Arshonsky Kurtz & Komsky LLP provides an in-depth exploration of such remedies. 

BY STEVEN N. KURTZ, ESQ., LEVINSON ARSHONSKY KURTZ & KOMSKY LLP

One of the most challenging problems in the commercial finance industry is when a factor or lender’s collateral is moved to a new entity. Sometimes this happens after a default as an attempt to “save the business” and sometimes it occurs by innocent and legitimate means. No matter the reason, the entity the factor or lender was originally financing is either no more or is a shell, and the collateral is now with someone else, even if that someone else is actually the same company that underwent a simple name change. I affectionally call this transferee and holder of collateral the “Son of Debtor,” and these entities  kick in two levels of analysis for factors and lenders to address. 

The first level focuses on the state law remedies which apply when a factor or lender’s collateral is in the hands of a new entity because of a bad actor. This usually leads to successor liability, alter ego, piercing corporate veils and conversion type claims against a factor client/borrower, the entity now holding the collateral and possibly others. The second level of analysis that must be addressed is protecting the rights and remedies of a factor or lender under the Uniform Commercial Code, most of them in Article 9.  The UCC remedies apply equally to innocent and bad actor transfers.

The underlying concern behind the Son of Debtor problem is whether or not a factor or lender’s financing statement becomes misleading. Commonly, a misleading financing statement is a fancy way of saying “you got the debtor’s name wrong” on your UCC-1 filing. Most of you will know the rules on getting the financing statement correct, but as a refresher, for an entity, it means filing the financing statement in the state of the factor client/borrower’s organization using the exact name of the factor client/borrower as reflected in the organizational documents on file with the state. For an individual, it usually means filing the name that appears on their state-issued identification. If a certified search using the state’s official search logic reflects the financing statement of record, the factor or lender is all set.  However, according to UCC 9-506, if the financing statement is not reflected using the foregoing search protocol, then the financing statement is considered seriously misleading and the factor or lender’s lien against the collateral is no longer perfected.

The typical Son of Debtor does not usually transact business using the company’s original name. This means that factors and lenders can be in danger of losing their rights as a perfected secured creditor when their collateral is either held by a new person or company, or if there is a simple name change made by the company, such as a sole proprietorship incorporating under the individual’s trade name. 

Fortunately, the UCC provides a deep foundation to protect secured creditors, and if you, as a factor or lender, ever get in litigation over a Son of Debtor problem, or any other problem, it helps to site as many UCC sections that are to the point as possible. Some examples include:

• UCC Sec 9-102(a)(56), which contains the definition of a new debtor

• UCC Sec 9-203(d) and (e), which address the attachment of security interest as against the new debtor

• UCC Sec 9-509, which provides for authority to file new financing statements against the new debtor

• UCC Sec 9-315, which provides that a lien stays attached to the collateral transferred without the factor or lender’s consent and outside the ordinary course of business 

Now that we have taken a mini tour of Article 9 and explored the foundation, let’s now focus on making sure that your financing statement does not become seriously misleading, because if it does, the mess gets bigger.

UCC Sec. 9-507 addresses the transfer of a factor or lender’s collateral to a new person and provides that the factor or lender’s financing statement is effective against the transferred collateral unless the financing statement becomes seriously misleading. For the collateral that is acquired within four months of the financing statement becoming seriously misleading (again, a new named debtor), the collateral is perfected against collateral acquired within the four months but not as to collateral acquired by the entity after four months unless the factor or lender files an amendment to the financing statement with the new name of the debtor. If the factor or lender files the amendment with the correct new name within that four-month window, the factor or lender’s lien will stay perfected against the collateral acquired after the four months. 

UCC Sec. 9-508 addresses the transfer of a factor or lender’s collateral to a new debtor who by law becomes bound by the security agreement the factor or lender entered into with the “old debtor.” This section contemplates either a corporate reorganization, merger, acquisition, a sole proprietor becoming a corporation or LLC, or something of the like. If there is a name change, through UCC Sec. 9-507, for example, the factor or lender’s financing statement perfects the collateral that is transferred and acquired within four months of the financing statement becoming seriously misleading and does not operate to perfect the factor or lender’s lien against new collateral acquired after four months, unless a new financing statement is filed before the four months is up. UCC Sec. 9-508 also provides that it is not effective if there was a transaction that fits within UCC Sec. 9-507(a). UCC 9-508 was drafted to deal with corporate law changes, while Sec. UCC 9-507 deals with an outright transfer of collateral.

Usually, a Son of Debtor will operate under a new name. As previously mentioned, the factor or lender may not learn about this bad conduct until after it happens. If the factor or lender is not involved during all steps of the events which result in the transfer of its collateral to someone or another entity with a different name and are forced to learn about what transpired after the fact, it won’t know the real story.  However, as a factor or lender, you need to know the real story because you will also be faced with one remedy that calls for an amendment to your financings statement and another section that calls for a new financing statement and limiting language which states that UCC 9-508 does not apply to UCC 9-507 fact patterns. This can be confusing and troubling since the circumstances surrounding the event were hidden from you. The simple answer to the conundrum is to use both remedies by filing an amendment with the name of the new entity and a new financing statement with the same name. When my firm gets involved, we typically have language and UCC section sites that make it clear that this is not a regular financing statement and should be investigated by someone considering providing credit to the Son of Debtor. 

The Son of Debtor can be a big problem. However, the UCC provides a clear set of rules and procedures to follow which when followed makes state law remedies outside the UCC even stronger. Invariably, the Son of Debtor intends to continue in business. This means that the Son of Debtor will likely go out to the market and seek new financing from one of a fellow factor or lender. That’s why it’s critical to stay on top of things and immediately act when you find out you have a Son of Debtor.  When the Son of Debtor gets financing from another source, the problem magnifies. The Son of Debtor has now turned into the dreaded Double Debtor, which can easily lead to a priority dispute with the new creditor. With that in mind, stay tuned for part two of this feature, which will address the double debtor problem, i.e. two sets of secured parties claiming rights to the same collateral with different named debtors in each entity’s security agreement.