WARNING: Some material in this post may trigger profuse sweating, stomach cramps, or hallucinatory flashbacks for readers who did not enjoy Secured Transactions or Bankruptcy courses in law school. Reader discretion is advised.
In Dan’s earlier post today, he calls our attention to the case of the $50 million filing mistake. Those of us lucky enough to teach Sadistic Secured Transactions (the few, the proud, the anointed ones) remind our students on numerous occasions to “file early, often, and everywhere.” As a general rule, a filed financing statement will perfect a creditor’s security interest in most types of collateral. Also, as a general rule, he who files first enjoys priority over competing claims. Finally, a filing is effective for five years, but a creditor can extend that life for additional periods of five years by timely filing a continuation statement.
These filing rules are simple. They are straightforward. But they are (usually) inflexible. And a mistake can be expensive. Verrrrrrry expensive. Especially if the debtor falls into bankruptcy. Just ask Bank of America and Citibank (as I explain below the jump).
As a general rule, a secured party must file a financing statement in the state records to perfect its security interest. (The law abhors secret liens, so the purpose of the filing is to give notice.) An unperfected security interest is still effective between the debtor and the secured party and usually enjoys priority over most other unsecured claims. But an unperfected security interest will not enjoy priority over a perfected security interest. So outside of bankruptcy, claims often rank as follows: (1) perfected secured claims, (2) unperfected secured claims, (3) unsecured claims.
In the story that Dan mentions, the banks filed a financing statement in January 1991 to perfect their security interests. Filings are effective for five years. To extend the life of the filing, the secured party must file a “continuation statement” during the last six months of the original (or any subsequent) five-year period (and not a day earlier or later). So assuming that the banks had timely filed continuation statements in late 1995 / early 1996, late 2000 / early 2001, and late 2005 / early 2006, the next continuation statement would be due in late 2010 / early 2011.
Apparently, the banks filed a statement on August 3, 2007. This is a premature date (a date prior to the magical six-month continuation window). A continuation statement filed too early has no effect. But it also doesn’t harm the secured party (unless the applicable five-year period expires, the secured party fails to discover that it has not timely filed a continuation statement, and now finds itself unperfected and no longer first in line).
So one would think that the premature filing of the continuation statement in this case would be a non-story (no harm, no foul) until early 2010. But here’s what went wrong. The banks, like most secured parties, used a standard UCC-3 form as its continuation statement. The standard UCC-3 form, however, can be used to indicate termination, continuation, assignment, or amendment. And guess which box was checked? The “termination” box. A mistake? Sure looks like it. But this isn’t the first time that a filer has checked the wrong box. And the decisions I recall all rule against the filer. The result? The banks have become unperfected. They can file another financing statement, but now the gap in perfection leaves them at the end of the line (other junior, but perfected, creditors have moved ahead). And rather than feasting at the head table, the banks now find themselves scrounging around for a few table scraps. (Listen closely, and one can hear the feeble cry of Oliver Twist – “Please sir. May I have more”?)
The banks did later catch their mistake and filed a correction statement in October 2008 (telling the world that the August 2007 filing “was filed in error and as a result of a clerical error”). My guess is that this so-called correction statement has no legal effect. Unless the banks can prove that the August 2007 filing was somehow an unauthorized filing (rather than an authorized, but fatally erroneous, filing), their claims are unperfected. (Query, though, whether the banks have a malpractice claim against the person or entity who prepared the August 2007 filing.)
So we fast-forward a few weeks, when Heller files its bankruptcy petition in late December 2008. Now the August 2007 filing raises two new concerns. First, what effect, if any, does the mistake have on debt which Heller still owes to the banks as of the bankruptcy filing date? Second, what effect, if any, does the mistake have on payments previously made by Heller to the banks in the short period preceding the bankruptcy filing?
As to the first question, the August 2007 mistake probably has converted the banks’ perfected claim into an unperfected claim. And rarely do unperfected claims get paid anywhere near 100 cents on the dollar (and because Heller is in bankruptcy, the banks’ secured but unperfected claim has effectively become an unsecured claim under the “strong arm” clause of BC § 544).
As to the second question, any payments made by Heller to the banks within the 90 days preceding the bankruptcy filing date may be deemed “voidable preferences” under BC § 547. Those payments are not illegal, unethical, or immoral. But they upset the collective process of the bankruptcy distribution scheme and, if left untouched, (i) permit debtors to unfairly favor some creditors at the expense of others and (ii) encourage creditors to start picking at the carcass at the first scent of blood. If the trustee (or debtor in possession) can prove all of the elements of a preference action (including that the payments allowed the banks to recover more on their claims than they would have recovered if the payments had never been made and the debtor was in a Chapter 7 liquidation – an element that appears to be easier to prove, now that the banks are probably unperfected on the bankruptcy date because of the August 2007 filing mistake), and the banks cannot invoke at least one of the many statutory exceptions, then the banks may find themselves disgorging all of Heller’s eve-of-bankruptcy payments.
And all of this because someone checked the wrong box on a piece of paper.
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