Ten Things Every Fund Funding Banker Should Know About UCC
The initiative to draft a code that would unify commercial transactions between American states began in 1942. The drafters set to work in a remarkable setting which, apart from a world war, was marked by clashes of ideologies from the Great Depression and the New Deal era. The group spent most of the next decade completing a fully published version of the Uniform Commercial Code (the “UCC”) for submission to states, then the initial process of state enactment continued until 1968. Given this background, the origin and development of UCC has spawned a seemingly endless supply of legal research material. We put all of that aside here and narrow it down to what we consider UCC’s must-see points for fund finance bankers.
1. Getting it right is important. Following the steps to get a valid collateral is fundamental to properly assessing risk – secured loan margins are best over secured loans. In connection with this point, the essential value of perfect security is the advantage it provides to a secured creditor in the event of bankruptcy. In the event of bankruptcy, subject to a few limited exceptions, a perfect secured security interest will take precedence over the security over other potential claimants, including over judicial preferred creditors and the bankruptcy trustee. The position of the secured creditor in bankruptcy is, of course, also a useful negotiating lever outside of the courtroom context. An error as to the validity and enforceability of a security right can be costly.
2. The UCC is not entirely uniform. Most of the time when “UCC” is mentioned, it refers to a model code. States have followed their own processes to enact the model code into law and, in the legislative process, have often made some variations from the model. Florida and Tennessee, for example, are adding tax compliance and financial statement disclosure requirements. While security documents and the process part of the transaction process can feel like flushing and repeating, in practice variations in state mean that the security aspect of every transaction requires close legal attention.
3. The financing of the Fund is mainly concerned by article 9 of the UCC. Because the UCC establishes a unified framework for commercial transactions between states, it covers a wide territory, including sales of goods, leases, securities, etc. Fund financing transactions are mainly concerned by article 9 of the UCC, which deals with guaranteed transactions.
Specifically, section 9 deals with any interest in personal property (as opposed to real estate) that secures payment or performance of an obligation. This type of interest is called security interest and the asset that is the subject of the security is called the collateral. Some other key terms: The person who holds an ownership interest in the collateral is called the debtor; the person who owes the guaranteed obligation is the debtor; and the person in whose favor the security is granted is the secure part.
4. Seizure occurs when the contractual rights between the debtor and the secured creditor become enforceable. A security attached to the guarantee when it becomes enforceable against the debtor with regard to the guarantee. (The parties may agree that the time of foreclosure occurs at a later time in the future.)
In any event, enforceability is the key concept behind the seizure. By focusing on the important points in the context of fund financing, a collateral is enforceable when the following criteria have been met: (1) value has been given (a binding commitment to lend money is one way of giving value); (2) The debtor has rights in the collateral or the power to transfer rights in the collateral to a secured creditor; and (3) The obligor has authenticated a security agreement which provides a description of the collateral or, failing that, the collateral is a deposit account and the secured obligee has control.
5. The security agreement must reasonably identify the security. The drafters of the UCC set out to do away with some old legal formalities and favor function over form in business transactions. The security agreement is an example of how this goal has been achieved.
The security agreement is simply the agreement that creates or provides for the security. The security agreement does not need to be a stand-alone document, and by virtue of the so-called composite document rule, multiple documents executed between the parties can be read to constitute the security agreement.
To be effective, the security agreement must reasonably identify the collateral and must be authenticated. The requirement to “reasonably identify” for the description of the collateral proves that the obligor and the secured party have agreed on what constitutes the collateral. To this end, super generic descriptions, such as “all debtor’s assets”, are not considered a reasonable way to identify collateral.
The requirement that the security agreement be “authenticated” is a relatively new development in UCC that aims to move beyond signed paper to accommodate electronic communications, although UCC does not specify exactly what constitutes authentication.
6. Perfection describes the position of the secured creditor relative to other potential claimants. Perfection is a post-foreclosure step that serves to lock in the secured creditor’s interest in the collateral against other potential claims.
The process required for perfection depends on the type of collateral. Under the subscription facility, the perfection of a security on the capital commitments (and the associated bundle of sticks, including the call rights of capital and the proceeds of the calls of capital) is accomplished by the deposit a financing statement (UCC-1). A security in a deposit account can be perfect by control.
7. It is important to enter the exact name of the debtor on the financing statement. In fact, there is more than one important point to understand in a financing statement, but the name of the debtor is at the top of the list. The purpose of filing funding statements is to provide a searchable database of existing deposits indexed by debtor names. Since the system depends on searching for records by debtor, the UCC emphasizes getting the right name by linking the effectiveness of the funding statement to the debtor’s name. The correct debtor name for a financing statement is the name listed on the debtor’s “organic public record”, referring to debtor training documents registered with the state. An error in the debtor’s name can make the funding statement ineffective if the deposit cannot be found by searching for the correct name of the debtor using the deposit office’s standard search logic.
8. Funding statements expire. Funding statements expire after five years and require a filing to be renewed within six months of the expiration date, a point Isabella Shaw has already written more about in Fund Finance Friday here. (Probably not a inescapable fact, but it’s 10 years in Wyoming.) To preserve the priority of a collateral, a lender will need to file a UCC-3 continuance statement in a timely manner.
9. The collateral on deposit accounts is perfect by control. Rather than going through the process of filing the funding statement, a guaranteed interest in a deposit account is perfect from the time the secured party gets control of the account and it continues as long as the secured party maintains control. Control can mean one of two things: (1) The secured party is (or becomes) the bank with which the account is held, or (2) The secured party has the authority to direct the disposition of funds under ‘an agreement with the debtor.
ten. Quick filing or perfection protects priority. Perfect security will prevail or may be considered to have priority on, the claims of unsecured creditors of the debtor in respect of the collateral. Priority issues become more delicate, however, when two secured creditors hold competing claims on the same collateral. In such a dispute, the secured creditor who filed (and later perfect) or perfect will have priority and will retain priority until its perfection has expired. Because filing timing and perfection determine priority, lenders and their attorneys file funding statements right after closing.