UCC Filing System Shenanigans: Protecting Perfection From Debtor Fraud

Written By: Paul Hodnefield, Esq., Associate General Counsel, Corporation Service Company

Lenders, factors, and others who rely on the security interest as a risk management tool in commercial transactions generally understand the importance of the Uniform Commercial Code 1 (UCC1) financing statement in the perfection process. They make every effort to ensure the financing statement provides the correct debtor name, sufficiently describes the collateral, and is filed in the proper location. While these procedures are all important, the lender cannot assume that its security interest will remain perfected after filing the financing statement. 

However, when a debtor gets into financial trouble, they sometimes get very creative as they attempt to avoid enforcement of a security interest. This may include resorting to fraudulent actions by the debtor. This article identifies two of the common fraudulent actions taken by desperate debtors, fraudulent termination statements and unauthorized transfer of the collateral, and what measures the secured lender can take to minimize the impact of these frauds.   

Fraudulent Termination Statements

The filing of a fraudulent termination statement generally occurs when the filer, who may be the debtor or a third party, wants to make it appear that the collateral is no longer subject to a security interest. This may be so the debtor can sell the collateral or fraudulently use it to secure other first-priority financing. 

A secured lender that discovers one of its financing statements has been fraudulently terminated will naturally be concerned. Fraudulent termination statements can complicate enforcement of the security interest. The secured lender may have to litigate against competing claims from other secured parties that relied on the fraudulent termination statement. Likewise, bankruptcy trustees or other creditors may challenge the sufficiency of a financing statement after the filing of a fraudulent termination statement. All this leads to delays, added legal fees, and other increased costs for the secured lender.

To make matters worse, secured lenders often don’t find out that someone has filed a fraudulent termination statement until after the debtor is already in default or has filed for bankruptcy.

It’s true that upon the filing of an authorized termination statement, the financing statement to which it relates ceases to be effective. Fortunately, that isn’t the case with a fraudulent termination statement. The fraudulent filer doesn’t terminate the effectiveness of a financing statement simply by entering the secured lender’s name at the bottom of the UCC3 form. Nor does a fraudulent termination statement become effective just because a filing office accepts and indexes the record. 

To be effective like any UCC record, a termination statement must be filed with the authorization of a party that’s entitled to do so under UCC § 9-509. In the case of a termination statement, the filing must be authorized by the secured party of record. If the secured party did not authorize the filing of the termination statement, it’s not effective, even if it was filed by the filing office and appears on search results.

A fraudulent termination statement generally lacks the secured lender’s authorization. Therefore, it’s of no effect and does not terminate the effectiveness of the related financing statement. The security interest remains perfected by the financing statement. As noted, however, even an ineffective termination statement can increase the cost and resources required for the secured lender to enforce its rights.

Upon learning that someone has filed a fraudulent or unauthorized termination statement, the secured lender has options for how to respond. The secured lender could choose to do nothing because an unauthorized termination statement is not effective. While taking no action is an option, it’s often to the secured lender’s advantage to avoid problems down the road by alerting third parties that the effectiveness of the termination statement is in dispute. Interested parties then have notice of the situation before they enter into a transaction with the debtor. This will reduce the risk of disputes should the debtor default. 

The easiest way to provide such notice to third parties is by filing a UCC5 Information Statement. The UCC5 allows the secured lender to put comments in the public record to explain the effectiveness of the termination statement is in dispute. Any search of the UCC records that discloses the financing statement will also disclose the UCC5, so interested parties will then be put on notice that they need to conduct further inquiry to learn the full state of affairs. If they proceed in reliance on the fraudulent termination statement alone, they do so at their own risk. 

Unfortunately, many victims of fraudulent termination statements don’t discover them until after the debtor has filed for bankruptcy or is subject to foreclosure proceedings. By then, it’s too late for the filing of a UCC5 Information Statement to do any good. Successfully managing the risk of fraudulent termination statements depends on the secured lender receiving notice of the filing at an early enough point that it can take meaningful action.

One solution is for the secured lender to subscribe to a third-party tracking service. These tracking services are available from some service companies and data aggregators. A secured lender that subscribes to a tracking service will receive an alert promptly if a termination statement or other amendment is filed for a particular financing statement. The notification allows the secured lender to protect itself much earlier than would be the case if they discover the termination statement only after the debtor gets in trouble.

Private providers are no longer the only source of tracking services. One state recently took action to alert secured parties to unauthorized termination statements. Utah enacted Senate Bill 43, which imposes a duty on the filing office to notify the secured party of record if the debtor files a termination statement. 

There is, however,  a problem with the legislation. It does not address the issue of how a filing office can tell when the debtor files a termination statement. A crafty debtor can easily avoid detection. For this reason, the Utah Department of Commerce, Division of Corporations and Commercial Code, the central filing office for the state, decided to notify the secured party of record following the filing of any termination statement, regardless of who filed it. 

As of May 1, 2024, the Division of Corporations and Commercial Code began sending notifications upon the filing of any termination statement. However, termination statements for UCC fixture filings may also be filed in the county real property records. It’s unclear how county recorders in Utah will implement the new legislation.

So far, Utah is the only state with a termination filing notification system. Due to the challenges and resources required to implement such a system, it’s unlikely other states will follow Utah’s lead, at least not anytime soon. 

It’s important to note that not all termination statements filed by a debtor are fraudulent. There is a statutory process whereby the debtor can become authorized to file an effective termination statement by following the statutory steps set forth in UCC § 9-513. This process requires the debtor to first make a demand of the secured party for a termination and the UCC3 termination statement must indicate it was filed by the debtor. This provision is transparent and generally not used as part of any fraudulent termination scheme. Consequently, this type of debtor termination is outside the scope of this article.

Fraudulent or Unauthorized Transfer of Collateral

Another common tactic debtors use is the fraudulent sale or transfer of collateral to a third party without the secured lender’s knowledge or consent. Fortunately, the secured lender generally will still be able to enforce its security interest against the buyer or transferee in addition to the debtor. Under UCC § 9-315(a)(1), the general rule is that a security interest “continues in collateral notwithstanding sale, lease, license, exchange or other disposition thereof” unless the secured lender has authorized the disposition free of the security interest. In other words, the security interest follows the collateral. As a result, the debtor generally cannot get around a security interest by selling the collateral or transferring it to a third party. 

Following the fraudulent or unauthorized transfer of collateral, the secured lender can still enforce its security interest against the debtor but may be limited to seeking the identifiable proceeds of the sale or transfer. However, the secured lender may be able to bring an action for conversion and replevin against the buyer or transferee of the collateral. 

Nevertheless, enforcement requires the secured lender to trace the collateral to the buyer or transferee. This can be a challenge because, by its nature, an unauthorized sale or transfer normally takes place without the secured lender’s knowledge. By the time the secured lender finds out, which often isn’t until the debtor defaults, it may be difficult to determine who has possession of the collateral. Moreover, tracking can be further complicated if the buyer or transferee takes the collateral out of state. 

Tracking unauthorized sales and transfers through an automated system generally is not a viable solution for a secured lender. Tracking systems rely on public record data. Unauthorized sales and transfers of collateral normally take place without any entry in the public records. The best a secured lender can do is maintain regular communications with their debtors and stay alert for anything unusual that would suggest a change in the status of collateral. 

Conclusion

The foregoing are by no means the only methods that a desperate debtor might employ to frustrate a secured lender. There are plenty of other actions by debtors, some fraudulent but many innocent, that can place a secured lender’s perfection at risk. The diligent secured lender can protect itself against these risks by implementing an effective tracking system that will identify critical actions by the debtor. Even tracking cannot eliminate all risks so a secured lender should also communicate with their debtors regularly.  

Paul Hodnefield, associate general counsel for CSC, is responsible for advising on real estate recording, notary, uniform commercial code, and other public record transaction services.

The views expressed in the Commercial Factor website are those of the authors and do not necessarily represent the views of, and should not be attributed to, the International Factoring Association.