Best Practices: Make NO Mistake – Circuit Courts Rule Against Lenders for Minor Errors in Security Documents

When financing a government guaranteed loan through the Small Business Administration (“SBA”) 7(a) program, lenders must not only identify all collateral required by the SOP 50 10 but also obtain a valid and enforceable security interest in that collateral pursuant to Article 9 of the Uniform Commercial Code (the “UCC”). In order to comply with the UCC, a Lender must complete two steps:

1. “Attach” their interest in a debtor’s personal property by executing a security agreement that adequately describes both the secured indebtedness and the collateral securing the debt; and
2. “Perfect” this interest by filing a UCC-1 financing statement in the appropriate state or county filing office.

Any mistake in the security agreement or UCC filing – even a minor one – could be fatal to the creditor’s secured status, particularly after the debtor files for bankruptcy. For example, in State Bank of Toulon v. Charles E. Covey (In re: Duckworth), the United States Court of Appeals for the Seventh Circuit recently ruled that the Chapter 7 trustee in the debtor’s bankruptcy case could avoid the bank’s security interest, even though the debtor voluntary signed the security agreement and note with the intention to be bound by both. The reason for this decision: the security agreement referred to the date of the promissory note as December 13, 2008 instead of the correct date, December 15, 2008.

The court refused to hear any evidence that both the lender and debtor intended the loan to be secured by the improperly dated note. Instead, the court the treated the trustee like a hypothetical judicial lien creditor, who may rely solely on the plain meaning of the agreements even if those agreements do not reflect the actual intention of the parties.

This harsh lesson comes only months after the Sixth Circuit also ruled against a lender for a similar, seemingly harmless error. In 1st Source Bank v. Wilson Bank & Trust, et. al., the Court held that the lender had not properly perfected its security interest in the debtor’s accounts receivable because the bank failed to include “accounts” or “accounts receivable” as part of the UCC financing statement, even though the term “accounts” appeared in the parties’ security agreement.

For SBA guaranteed loans, these minor mistakes in the description of the secured debt and collateral in the security agreement can be fatal not only to the bank’s secured status but also to the lender’s SBA guarantee. While, at its core, this is a technical issue; failing to properly attach or perfect a security interest can result in a repair or denial of the SBA guarantee. In addition, these errors are not consistent with the idea of prudent lending practices.

Ultimately, the most important take away from these cases is consistency – in dates, descriptions, and all other details. Double and even triple checking all security documents can minimize the risk of future costly and time-consuming litigation (or appealing a repair or denial of the guarantee) and the loss of secured status to a subsequent secured creditor or judgment creditor asserting a competing security interest and/or lien in the same collateral or a bankruptcy trustee seeking to avoid the creditor’s unperfected security interest.

For more information on properly attaching and perfecting a security interest under UCC article 9, please contact Katherine at ktohanczyn@starfieldsmith.com or 267-470-1187.