Chapter 4B. UCC Article 9 Insurance

Chapter 4B UCC Article 9 Insurance By James D. Prendergast1 1 James D. Prendergast, Senior Vice President and General Counsel of the UCC Division of...
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Chapter 4B UCC Article 9 Insurance By James D. Prendergast1

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James D. Prendergast, Senior Vice President and General Counsel of the UCC Division of First American Title Insurance Company, Adjunct Professor of Secured Transactions Law at Pepperdine University School of Law. In view of my position with First American I recognize that I may have a bias in favor of the utility and risk management functionality of UCC insurance. Terms used in this Chapter shall have the meaning or usage applied to such terms in the Uniform Commercial Code or the applicable UCC insurance policy reproduced in App. 4B, infra. With respect to the discussions of the UCC policies in this Chapter, there are exceptions, exclusions and conditions to coverage contained in the policy. Some coverages may not be available in certain jurisdictions, or for specific transactions, due to legal, regulatory or underwriting considerations. 999999.294 - 1357379.2

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TABLE of CONTENTS § 4B.01 The Why and When of UCC Insurance [1] History [2] UCC Insurance as Data Management [3] Real Estate Law Analogies Don‟t Work With Article 9 [4] Comparison To Land Title [5] Land Title, P&C and UCC Insurance

§ 4B.02 THE LENDER’S POLICY [1] Coverage [2] Filing office Error And UCC Insurance [3] Coverage Continued [4] Exclusions from Coverage [5] Endorsements [6] Other Policies

§ 4B.03 THE UTILITY OF UCC INSURANCE [1] Real Estate Mezzanine Lending [2] Mixed Collateral Transactions [3] Co-Ops, Timeshares and Houseboats [4] Legal Opinions and UCC Insurance [5] To Offset Other Risk

§ 4B.04 LAW FIRM RISK AND UCC INSURANCE [1] Debtor Name [2] Human Error

APPENDIX 4B Form 4B-1 Form 4B-1a Form 4B-2 Form 4B-2a

Model Forms Lender’s UCC Insurance Policy Schedules to Lender’s Policy Buyer’s UCC Insurance Policy Schedules to Buyer’s Policy

§ 4B.01 The Why and When of UCC Insurance 999999.294 - 1357379.2

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[1] History The purpose of this Chapter is to provide the reader with an understanding of the risk management functionality of UCC insurance. UCC insurance is now available nationwide from most of the major land title insurance companies and is designed fundamentally to insure the attachment, perfection and priority of security interests in personal property collateral.2 However, UCC insurance has not been around for over one hundred years as has real property title insurance. Rather, UCC insurance is of fairly recent vintage, having been introduced by The First American Corporation. [2] UCC Insurance as Data Management First American has come to see its business as data management and retrieval, and, where appropriate, the offering of insurance to insure the results of the data searches. The UCC central filing office is just another data base. It is possible to search the state registry and insure the accuracy and completeness of the search, and offer security interest priority insurance, something lawyers don‟t provide in their legal opinions, and insure over otherwise uncovered factual issues, such as filing office error. Thus was born the UCC insurance industry. [3] Real Estate Law Analogies Don’t Work With Article 9: Real estate land title insurance people and lawyers generally are unfamiliar with the Uniform Commercial Code or UCC insurance. Most, if not all, of the analogies between real property law and commercial law are wrong, and dangerously so. The differences between the title recordation regime of land title and the notice system for security interests under Article 9 are significant. For example, the concerns over equitable subordination to a second mortgage if change is made to the senior mortgage are not germane to the UCC. There is therefore no need to bring down a UCC policy if the amount of indebtedness under the first security interest is increased. Inapplicable analogies to real property law include the conclusion that when the debt is paid off the financing statement falls. This is not correct. A financing statement generally remains alive for 5 years, unless continued, and can be reloaded in its original priority position. Further, under the baseline rule of “First-to-File-or-Perfect,”3 the secured party can prefile a financing statement, much later enter into a security agreement with the debtor, and then advance funds. At the moment the debtor has rights in the collateral, the secured party‟s security interest will be

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The First American Corporation, through the creative efforts of Clifford L. Morgan, Senior Vice President – New Product Development, introduced the UCC Lender‟s Policy in October 2000. The principal draftsperson on the policy was Steven O. Weise of Heller Ehrman White & McAuliffe LLP. Edwin Smith of Bingham McCutchen LLP and Jeffrey Davidson of Stutman, Treister & Glatt were the other draftspersons. Following First American‟s development and introduction of the UCC Lender‟s Policy, the other major land title companies introduced their own versions of the policy. Today, UCC insurance is widely accepted in the commercial and real estate lending markets as an effective tool of risk management. The UCC Division of First American Title Insurance Company now offers a full range of personal property priority lien perfection and priority insurance products including the EAGLE 9® UCC Insurance Policy (the “Lender’s Policy”) and the EAGLE 9® UCC Insurance Policy for Buyers (the “Buyer’s Policy”) that insures the lien status of acquired assets. 3

See UCC §9-322(a)(1).

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perfected. The priority date as against any other secured party perfected by the filing of a financing statement, however, will be the original filing date. Land title policies typically have an exclusion for post policy events. This exclusion has been carried over to other UCC lender‟s policies. The First American policy includes no such exclusion thereby insuring priority position for the life of the covered indebtedness, which indebtedness may revolve. Also, other UCC lender‟s policies may contain a provision that there can be no claim under the personal property coverage unless other coverage is exhausted, such as land title insurance coverage in mixed collateral transactions. No such limitation is contained in First American‟s policy. The moral here is to compare policy jackets and all attached schedules. [4] Comparison To Land Title: We will discuss in detail later in this Chapter the coverages, exclusions and exceptions in First American‟s Lender‟s Policy. The purpose of raising the comparison issue at this point is to stress the differences between land title and personal property lien priority insurance. Land title insurance covers two distinct issues: (1) “ownership” or “title” to the real property in question, and (2) the status of encumbrances to that real property. UCC insurance, on the other hand, covers lien priority and not ownership. The first point of reference is that except for certain specific types of personal property which are the subject of civil registries of one sort or another, such as vessels and aircraft, there is no methodology for a buyer or a lender to determine whether a seller of personalty actually owns the personalty it is purporting to own. Therefore, to state the obvious, the UCC insurance program is not “title” insurance. It does not replace the due diligence of the buyer of personal property or the lender lending against the security of personal property to determine if the seller or borrower actually has rights in the personal property. The EAGLE 9® UCC insurance program, as will be more fully discussed below, insures the attachment, perfection and priority of security interests in personal property, and generally does not insure the ownership of or title to the personal property collateral. It is important to bear this distinction between “title” or ownership in the realty, and lien status or priority when we consider the UCC insurance program. Inherently, UCC insurance is similar to land title insurance in that it involves the search of a registry and then insures the results of the search. This search methodology demonstrates the fundamental distinction between title insurance and property and casualty insurance (“P&C”). Real property title insurance, since its inception, has offered a type of insurance significantly different from other forms of insurance that involve the assumption of a particular stated risk, such as for fire or for an automobile accident, and provide financial indemnity if the stated covered event occurs. P&C insurance is given through an actuarial determination and a pooling of the risk, thus spreading any losses over a large class of policyholders. In real property title insurance one of the goals of the carrier is to minimize the risk caused by defects discovered in the search of the real property title records and thereby prevent future losses from arising. Land title, and UCC, insurance therefore fall under the broad category of risk elimination insurance. As a theoretical matter, and assuming no human frailty intervention, if the land title underwriter does its job correctly in searching the land title records, there should never be a claim. On the other hand, property and casualty insurance is based on an actuarial model. For example, there will be houses that burn down regardless of what the P&C fire underwriter does. This property and casualty type of insurance is usually classified as risk shifting insurance, shifting the unavoidable probability of fire from the insured to the underwriter. There are clearly coverages of land title insurance that involve risk shifting instead of pure risk elimination. Examples of risk shifting would include filing office error, lack of authority and 999999.294 - 1357379.2

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capacity of the mortgagor, and similar matters. However, in the main, land title insurance is risk elimination insurance. Another feature distinguishing real property title and UCC insurance from P&C insurance is its single premium. There is only one premium collected at the time the policy is sold. The coverage continues for so long as the real property is owned or the loan is unpaid, and even longer if the owner or lender is responsible under warranties given at the time of sale by the insured owner or lender.

UCC insurance is similar to land title in that it is primarily risk elimination insurance rather than risk shifting insurance.4 If the underwriter does its job in searching the central filing office, there should theoretically never be a claim. However, human error creeps in to generate claims. Further, UCC insurance covers matters that are risk shifting in nature, as does land title. In 4

Although the UCC insurance program is not “land title” insurance, the structure of the insurance product has certain similarities with land title insurance products as the following chart describes: UCC Eagle 9® Insurance Policy

ALTA (Real Estate) Loan Insurance Policy Exclusions reflect applicable law, including:

Coverage

Exclusions reflect applicable law, including:

1.Matters created suffered, assumed by the insured

1. Insures ownership of real estate

1. Does not insure ownership of pledged assets

1. Matters created, suffered, assumed by the insured

2. Matters known to the insured and not disclosed in writing to the insurance company

2. Insures validity and enforceability of lender‟s lien (security interest (SI)) for loans secured by real property

2. Insures validity and enforceability of lender‟s SI (lien) for loans secured by personal property

2. Matters known to the insured and not disclosed in writing to the insurance company

3. Insures against prior unknown liens (SI‟s) affecting the real property

3. Insures against prior unknown SI‟s (liens) affecting the personal property

4. Coverage for loss due to forgery, fraud, undue influence, duress, incompetency, incapacity or impersonation affecting the lien on the mortgage (SI) on real property

4. Coverage for loss due to forgery, fraud, undue influence, duress, incompetency, incapacity or impersonation affecting the insured SI (lien) in the personal property

3. A change in the law after date of policy

4. Bankruptcy, insolvency, creditors rights, fraudulent conveyance or transfer, preference or equitable subordination, except as covered 5. Failure to comply with applicable doing business laws 6. Usury, truth-in-lending And consumer protection laws

5. Insures against failure of any assignment shown in Schedule A to transfer the insured mortgage on real property to the insured, free and clear 6. Coverage for some challenges to insured mortgage lien (SI) brought in bankruptcy 7. Provides indemnity

for

defense

and

8. Conditions and Stipulations: similar to EAGLE 9® Insurance Policy; coverage follows the ownership of the indebtedness

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5. Insures against failure of any assignment shown in Schedule A to transfer the insured SI in personal property to the insured, free and clear 6. Provides challenges (mortgage bankruptcy rules

coverage for certain to the insured SI lien) brought in under appropriate

7. Provides for defense and indemnity 8. Conditions and Stipulations: similar to ALTA Real Estate Loan Insurance Policy, but reflects applicable law; coverage follows the ownership of the indebtedness

3. A change in the law after date of policy (this does not apply to the 2001 revisions to Article 9 of the UCC) 4. Bankruptcy, insolvency, creditors rights, fraudulent conveyance or transfer, preference or equitable subordination, except as covered 5. Failure to comply with applicable doing business laws 6. Usury, truth-in-lending and consumer protection laws

addition to the basic lien priority coverage, UCC insurance covers many of the risks associated with the perfection of a security interest through the central state filing system, such as the authorized execution of the lien granting document by the debtor, mis-indexed filings, unauthorized termination statements filed against the record, the correctness of the debtor name, filing in the appropriate jurisdictions, and similar matters. Additionally, the coverage insures over the gap period from the date of the initial search of the UCC records to the date of the search to reflect the filing of the secured party‟s financing statement, a coverage especially useful to those asset-based lenders who traditionally have not advanced until they receive a clean search to reflect their filing. [5] Land Title, P&C and UCC Insurance: Personal property, that is the subject of UCC insurance, is generally any thing that is not real property. This coverage includes movable collateral such as equipment or inventory, fixtures, intellectual property such as patents, trademarks and copyrightable matters (but not materials as to which security interests therein are excluded from perfection under the UCC by federal preemption), software and software embedded in goods, general intangibles such as contract rights, payment intangibles, and investment property such as common stock in corporations. The principal UCC insurance policy that will be discussed in this Chapter is the “Lender‟s Policy.” This policy is for the more typical situation where the insured is the lender and the policy insures the priority of the lender‟s security interest in the collateral of the debtor. There is another type of UCC insurance policy, the “Buyer‟s Policy.” The Buyer‟s Policy covers the lien status of assets being acquired by a buyer, such as in an asset acquisition, merger and the like. If a lender is providing the financing for an asset acquisition, the lender will want a Lender‟s Policy coupled with a “seller‟s lien” endorsement to insure the lien status of the assets being acquired. The buyer may want its own UCC policy regarding the status of the acquired assets and would use the Buyer‟s Policy.

§ 4B.02 THE LENDER’S POLICY [1] Coverage The Appendix to this Chapter contains the two major UCC insurance forms, the Lender‟s Policy and the Buyer‟s Policy. The first, and principle, UCC insurance form is the EAGLE 9® UCC Insurance Policy (the “Lender‟s Policy”). First American‟s form of Lender‟s Policy is substantially similar to the lender‟s policies offered by the other major land title companies. UCC policies are typically divided in three major sections: Coverage, Exclusions from Coverage, and Conditions and Stipulations. Associated with the policies are related schedules that further define the coverage, list exceptions to coverage and provide additional policy information. The insuring clauses for the Lender‟s Policy begin with insuring attachment, perfection and priority of the insured‟s security interest in the collateral of the debtor as defined in the related security agreement. Attachment and perfection are subsumed in priority and only Insuring Clause 3 is really needed. However, insurance companies like to include more specific insuring clauses to aid the insured in understanding the situations to which the coverage applies, hence a separate breakout. The first point that has been made before is that UCC insurance, except in the context of equity collateral and the interplay between Article 8 and Article 9, generally does not insure ownership or title to specific items of collateral. 999999.294 - 1357379.2

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Insuring clause 4 insures against priming liens of Lien Creditors. “Lien Creditor” is not synonymous with the lien of a creditor. Lien Creditor is defined in Section 9-102(52) of Article 9 to mean: (A) a creditor that has acquired a lien on the property involved by attachment, levy, or the like; (B) an assignee for benefit of creditors from the time of assignment; (C) a trustee in bankruptcy from the date of the filing of the petition; or (D) a receiver in equity from the time of appointment. Insuring clause 6 provides coverage under both Former Article 9 and Revised Article 9. As we move further away from the Transition Period, this insuring clause loses relevance and will soon be deleted. Insuring Clause 7 is a catch all provision and makes clear, although surplusage to Insuring Clauses 1, 2 and 3, that the attachment, perfection and priority coverage maintains regardless of the basis for the challenge to attachment, perfection or priority. This Insuring Clause expressly covers filing office error, and perhaps it is useful at this point to discuss the serious problem of filing office error. [2] Filing Office Error And UCC Insurance: Errors in the filing system may result in missed priming liens. The phrase “filing office error” is not intended as a pejorative, or intended to indicate a level of culpability on behalf of the filing office for human or machine error. The term is intended as a neutral statement to indicate that a problem has occurred at a filing office that has resulted in the search results not being complete or accurate. Filing office systems and procedures are not infallible. Error does occur and that is a statement of fact and not an assignment of blame. The “fact” that errors do occur in the filing and search process and that the occurrence of such errors cannot be totally avoided no matter what level of care is applied merely brings into play the risk management utility of UCC insurance and the comparison of third-party insurance with self-insurance. The cost of a filing office error generally cannot be recovered through an action against the state, owing to the doctrine of sovereign immunity among other things. Third-party insurance or self-insurance are the only two available options. The percent of error is small, but so is the premium for UCC insurance. [3] Coverage Continued Insuring Clause 7 discussed above demonstrates the point that the UCC Lender‟s Policy provides coverage against the loss of attachment, perfection or priority resulting from matters typically covered by the opinion of counsel for the borrower, with the exception of the remedies opinion.5 5

To buttress this conclusion, First American issues the following endorsement for only a minimal work fee:

BORROWER’S STATUS ENDORSEMENT Attached to EAGLE 9® UCC Insurance Policy No. ____________________ Issued By First American Title Insurance Company

The Company hereby insures the insured against actual loss or damage sustained or incurred by the insured by reason of lack of Priority of the insured security interest in any portion of the Collateral as a result of any of the following:

1.

the failure of the debtor to be a corporation validly existing and in good standing under the laws under the state of [California];

2.

the failure of the debtor to be qualified to do business as a foreign corporation in each of the following jurisdictions: ;

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Insuring Clause 8 extends coverage to assignees of the coverage listed in Schedule B to the Policy. Insuring Clause 9 provides coverage for any claim covered under Insuring Clauses 1 through 8 that arises out of any case filed by or against the debtor under the Bankruptcy Code in connection with an adversary proceeding to determine the extent, validity or priority of the insured security interest filed against the insured under Federal Rule of Bankruptcy Procedure 7001(2). The intent of this provision is to provide coverage in a bankruptcy proceeding involving the debtor if there is a challenge fundamentally to the priority of the security interest insured under the Lender‟s Policy, but only in an adversary proceeding. The limitation to an adversary proceeding is to require an evidentiary stage within which the priority of the security interest is to be contested. Although the underwriter may decide to appear earlier in a Chapter proceeding to defend its coverage requirements, such as a debate over lien priority during a hearing on first day orders, the underwriter is not required under the policy to do so. If Insuring Clause 9 was more broadly drafted, to require defense in any aspect of a Chapter where debate over lien priority may occur, the policy would constitute bankruptcy defense insurance, which it is not, and also require full defense in motion and other practice where the issues cannot be fully joined.

3.

the failure of the debtor to have the corporate power and corporate authority to enter into the [lien granting document/loan agreement], to own its property and carry on its business as it is currently being conducted;

4.

the failure of the debtor to have duly authorized and approved by all requisite corporate action on its part the execution and delivery of the Loan Agreement and the performance of the transactions contemplated thereby;

5.

the execution or performance of the [lien granting document/loan agreement] resulting in a breach of, or constituting a default under, any of the following agreements or contracts of the debtor identified on Schedule 1 hereto in the form delivered by debtor to the Company prior to the date hereof;

6.

the failure of the debtor to obtain any consent to the execution or performance of the [lien granting document/loan agreement] required under the laws of the United States or under the laws of the state of [California];

7.

the failure of the [lien granting document/loan agreement] to have been duly executed or delivered by a duly authorized officer of the debtor or not constituting the legal, valid and binding obligation of the debtor, [enforceable in accordance with its terms, other than a failure resulting from any of the following: (a)

[standard bankruptcy exception in policy],

(b) the unenforceability of certain provisions of the Loan Agreement so long as such unenforceability does not render the Loan Agreement invalid as a whole or preclude; (i) the judicial enforcement of the obligation of the debtor to pay the principal sum, together with interest thereon (to the extent not deemed a penalty), as provided in the Loan Agreement, (ii) the acceleration of the obligation of the debtor to repay such principal, together with such interest, based upon and in the occurrence of a default under the Loan Agreement resulting from a material breach of a material covenant contained in the Loan Agreement, or (iii) the foreclosure in accordance with applicable law of the Your security interest in the Collateral upon maturity thereof or upon acceleration pursuant to clause (ii) above.] This endorsement is made a part of the policy and is subject to all of the terms and provisions thereof and of any prior endorsements thereto. Except to the extent expressly stated, this endorsement neither modifies any of the terms and provisions of the policy and any prior endorsements, nor does it extend the effective date of the policy and any prior endorsements, nor does it increase the face amount thereof. First American Title Insurance Company By: ___________________________________ Authorized Signatory E9– [] Borrower‟s Status Endorsement (02/03/05)

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[4] Exclusions from Coverage: The next major section of the Lender‟s Policy is the section setting forth exclusions from coverage. In a sense this is where the policy says that the underwriter didn‟t really mean all those broad insuring clauses set out at the beginning of the policy. As we will see, however, most of the exclusions in the Lender‟s Policy are the result of the application of Article 9 to the transaction. Unlike the typical land title policy, the UCC Lender‟s Policy does not have a “post policy” exclusion. Rather, the UCC Lender‟s Policy insures the priority of the lender‟s security interest for the life of the Indebtedness. Given this ongoing coverage, many of the exclusions merely state the obvious operation of Article 9 as to continuing priority, such as the security interest of a lender being stripped from inventory collateral that is sold in the ordinary course of business of the debtor, the security interest automatically attaching to proceeds of the sold inventory. Nothing can be done to stop this result as a matter of law. The exclusions set forth in the Lender‟s Policy are broken down to track the insuring clauses. Exclusions 1(a) and (b) relate to attachment. The first and most significant of the exclusions is 1(a) that excludes attachment coverage (and consequentially perfection and priority coverage) if the debtor does not have rights in the collateral.6 This exclusion is needed because, in any broadly functioning policy, the priority of a security interest in everything from membership interests in an LLC to plywood in an inventory revolving credit facility can be covered provided the personal property is subject to Article 9.7 The baseline is that, with certain exceptions, there are no registries for tracking ownership in personal property. The baseline UCC policy insures that the lender has a first priority security interest in whatever the debtor may have rights in, in the warehouse, but the policy does not insure that the debtor has any particular rights in the particular used computer monitors in the warehouse. Exclusion 1(b) excludes coverage if the collateral is solely proceeds of other collateral, where the proceeds are not identifiable. This exclusion raises at the attachment stage the issue of proceeds, which follows through perfection and priority. Basically, the Lender‟s Policy insures only perfection in identifiable cash proceeds. The reason is Section 9-315.8 As can be seen from a review of Section 9-315, whether or not a secured party with a first priority security interest in a category of collateral as original collateral retains that priority in proceeds is not a simple matter. Because of the complexity, and because of the desire to avoid a post-policy exclusion so as to insure priority status for the life of the indebtedness involved in a transaction, and to facilitate the underwriting process, the decision was made that proceeds coverage would be effectively limited to perfection in identifiable cash proceeds.

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It is probably useful at this point to refer to the lead in paragraph to Section A of the Conditions and Stipulations of the Lender‟s Policy. The first sentence of Section A.1. provides that “Any capitalized term or phrase used in this policy, not defined in this policy, and defined or used in the Uniform Commercial Code, shall have the meaning given to it in the Uniform Commercial Code by definition or applicable usage” (emphasis added). This definition by “usage” must be kept in mind because on many occasions I have had the question: “Rights (or another term) is capitalized in your policy but it‟s not defined in the policy or for that matter it is not defined in the UCC.” The term “Rights” is “used” in the UCC and the definition of Rights in the policy is to the manner of usage in the UCC. Rights in this context are broadly construed as any interest constituting property; could be the noble peppercorn. 7

See, UCC §9-109(d). UCC §9-315. SECURED PARTY'S RIGHTS ON DISPOSITION OF COLLATERAL AND IN PROCEEDS. 8

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In most, if not all commercial transactions, proceeds is not an issue. For most ABL transactions, effective control over proceeds is accomplished through cash dominion and the Lender‟s Policy covers proceeds indirectly by insuring control priority over deposit accounts collateral. In summary, for attachment, the proceeds coverage is the broadest, to identifiable proceeds. For perfection, proceeds coverage is restricted to collateral being solely the proceeds of other collateral (original collateral; see definition of “Collateral”), unless the proceeds are identifiable cash proceeds (Exclusion 2(c)). For priority, the policy does not insure against a priming security interest if the insured priority position is subordinate to a purchaser9 claiming an interest in any proceeds of the collateral solely as proceeds of the collateral (Exclusion 3(g)) or claiming an interest in the collateral solely as the proceeds of its collateral (lower case in the text of the policy to mean collateral other than the collateral described in the debtor security agreement). Exclusions under Section 2 involve perfection. Exclusion 2(a) excludes coverage if any of the information provided on Schedule A to the policy is not as stated in Schedule A. Two initial observations are in order. The first is that any UCC policy comparison between competitors offering UCC insurance cannot rest solely on a policy jacket to policy jacket comparison, but must include a comparison of the schedules as completed and attached to the policy jacket and the required representations and warranties made by the insured therein, including attested descriptions of collateral and other matters. Secondly, one needs to read into the policy a “materiality” requirement over all of the exclusions and other provisions of the policy, and the requirement of good faith and fair dealing. That being said, any material change in the information in Schedule A on an ongoing basis could affect coverage. For example, should the debtor change its name, perfection coverage could be affected after four months if the change in the debtor‟s name made the filed financing statement materially misleading.10 There are exceptions to the accuracy requirement of Exclusion 2(a). Typographical errors are excluded as are errors in the name of the debtor if the debtor is a Registered Organization. The underwriter accepts the risk of an error in the debtor name if the debtor is a Registered Organization because, as part of its underwriting process, the underwriter reviews the organizational documents of the debtor and passes on the accuracy of the information included in the financing statement for filing. A similar exception applies to type of entity, jurisdiction of organization and organizational identification number, if any, and the appropriate jurisdiction for filing to perfect the security interest. Exclusion 2(b) precludes coverage, without further action, of perfection by a method other than by the filing of a financing statement, possession of possessory collateral or control of control collateral. For example, if the collateral is certificated collateral, such as vehicles, where the perfection step is the filing of a certificate of title with a vehicle registry, such as a Department of Motor Vehicles, the policy would exclude perfection coverage without further action. However, Item 5 of the Schedule extends coverage to those categories of collateral as to which a different perfection step is requested to be insured, such as possession of an instrument in senior position to perfection of a security interest in an instrument through the filing of a financing statement; where perfection is required to be by a method other than the filing of a financing statement, such as possession of money or perfection in a deposit account through a control agreement, the only permissible methods of perfection; or where perfection is through the filing of a financing statement but at a different registry than the central filing office, such as filing against asextracted collateral or timber-to-be-cut in the county land record office or the filing of a certificate of title with the DMV. 9

“Purchase” and “purchaser” are defined in UCC Rev. §§ 1-201(b) (29) and (30) respectively. As a result of the definitions, “Purchaser” means any consensual transferee, including not only a purchaser/buyer but also a Secured Party. 10 UCC §9-507(c). 999999.294 - 1357379.2

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Item 5 is an extremely important section of the Schedule to the Lender‟s Policy and highlights the statement made above that accurate policy comparison can only be made by comparing policy jacket and associated schedules. Item 5, through its lead-in, contains the broad language of the insuring clauses to cover only collateral as to which a security interest can be perfected through the filing of a financing statement. Collateral types and alternative methods of perfection are added back to coverage through the collateral specific boxes that comprise Item 5. Additional underwriting must be undertaken to determine perfection in these cases and for the collateral types listed, and therefore coverage is added back only if the additional and different perfection step is determined to have been satisfied. For example, if the collateral type is a deposit account as to which perfection can only be accomplished through a control agreement meeting the statutory test,11 the underwriter will review the control agreement used in the transaction being underwritten, determine if the requirements for an effective control agreement have been met, compare the account numbers involved with available bank account documents, determine if the holder of the account is a depository bank, and any other underwriting steps needed to add the deposit account to Item 5 as covered collateral and an exception to the exclusion of policy coverage to collateral as to which a security interest has been perfected by filing. The exclusions in Section 3 pertain to the priority insuring clause. The first exclusion in this section is 3(a) that involves conflicting rights of a purchaser not known to the company but known to the insured.12 Such knowledge of conflicting rights could adversely affect priming priority over the conflicting security interest under the applicable provisions of the UCC. The exceptions to the exclusion involve those collateral types such as instruments where knowledge of a conflicting security interest perfected by the filing of a financing statement would not affect the senior position of the subsequent security interest perfected by possession. The next priority exclusion, 3(b), provides that the policy does not insure against rights or interests of a purchaser who obtained its rights or interests from a prior owner of the collateral. The classic example is the debtor who buys encumbered equipment out of the ordinary course of business. The security interest of the lender to the seller would follow the equipment into the hands of the debtor. Because, as has been discussed often in this Chapter, there is no registry for most collateral types to track liens, as there is in land title, the policy excludes liens of this type from coverage absent a specific endorsement. There are, however, exceptions to this exclusion. The first exception applies where the insured holds a security interest in the collateral by possession of “Possessory Collateral.” “Possessory Collateral” is defined in the policy as certificated securities, instruments, money, negotiable documents of title, and tangible chattel paper. Bearing in mind exclusion 3(a) where actual knowledge of an adverse security interest can defeat coverage for certain types of collateral, this exception to exclusion 3(b) covers those types of collateral where either possession alone is the method of perfection, e.g., money, or perfection by possession will trump prior perfection by filing, e.g., instruments. The next exception to Exclusion 3(b) covers where the prior owner of the collateral was a Registered Organization that has been merged of record into the debtor, and the debtor is a Registered Organization and is the surviving entity. The key words for this exception are “of record.” The obligation of the underwriter is to review the corporate record of the debtor and, if 11

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UCC §9-312(b); §9-314; §9-104.

This exclusion highlights the importance of the introductory language to the “Definition of Terms,” Section A of Conditions and Stipulations”. Capitalized terms in the policy jacket not defined in the jacket have the meaning ascribed to such term in the UCC. Knowledge is defined in the UCC as “actual knowledge.” Capitalizing “Known” in the policy jacket brings that restrictive definition into the policy. Using the same lead-in language and then lower casing ”known” or “knowledge” would give the term a much broader meaning, probably including constructive knowledge. Implying constructive knowledge to an exclusion such as 3(a) radically alters the policy in favor of the underwriter at the expense of the insured. 999999.294 - 1357379.2 11

the debtor is a Registered Organization, an “of record” merger will be discovered and the underwriter can search the UCC central filing office germane to the non-surviving party and discover any potentially priming security interests to the insured secured interest. The next exception to exclusion 3(b) involves the situation where the prior owner was located in a jurisdiction different than the location of the debtor and the transfer of collateral to the debtor occurred prior to one year before the date of policy. This exception to the exclusion states the effect of §9-316(a)(3), and is the reason for the cutback in the breadth of the exclusion. Exclusion 3(c) limits priority coverage as against only those adverse security interests that have been perfected by either the filing of a financing statement or possession of possessory collateral. The reason is that, without additional effort and due diligence, the underwriter could not ascertain perfection of a security interest in a registry other than the central UCC filing office, e.g., for certificated collateral such as motor vehicles where perfection of the security interest would be through registration at a Department of Motor Vehicles. Further, the reason control collateral is excluded while possessory collateral is included, is that the insured ought to know if it is in possession of possessory collateral, and possession will trump prior perfection by filing and certainly preclude another secured party perfecting by possession in the same collateral. Perfection by control in control collateral does not offer the same assurance to the underwriter. Even though the insured has entered into a control agreement with an issuer of uncertificated securities, for example, there can be no assurance sufficient that there is not a senior priming security interest perfected by control in the same investment property collateral. Section 9-328(2) provides a temporal priority rule that the first secured party that perfects by control is prior to a subsequent security interest perfected by control. Exclusion 3(d) states the obvious that policy coverage is denied if the perfecting financing statement lapses. This exclusion would also come under the “suffer, assumed or agreed” umbrella of Exclusion 12. If the insured lets the financing statement lapse, so be it for coverage. First American does offer a tracking system as part of its coverage and agrees to notify the insured within six months of pending lapse date. If First American fails to notify the insured, coverage will not be interrupted by the lapse. However, if after the notice, the insured permits the financing statement to lapse, e.g., by not notifying First American to file a continuation statement, the risk of lapse is now back on the insured. Exclusion 3(e) deals with the priming effect of a complying PMSI security interest. Nothing can be done to stop the priming effect of a PMSI in inventory and other goods as provided in Section 9-324. Exclusion 3(f) follows in similar manner the priming effect of the conforming security interest of a consignor. Exclusions 3(g) and (h) restrict further the coverage of proceeds, from the proceeds limitation under Exclusion 2(c) to identifiable cash proceeds. Exclusion 3(g) precludes lien priority coverage for proceeds as against a purchaser claiming an interest in any proceeds of the “Collateral” solely as proceeds of the “Collateral,” therefore excluding a priority contest between the insured and an adverse claimant both claiming a prior position in specific personal property as proceeds and not as original collateral. Exclusion 3(h) precludes coverage as against a purchaser claiming an interest in the “Collateral” solely as the proceeds of its collateral, such as another secured party who perfected in inventory and is in a priority dispute with the insured over accounts generated by the sale of the inventory as against the insured who claims priority in the accounts as original collateral. Putting these two exclusions together, there is no priority coverage for proceeds and given the complexity of Section 9-315 discussed above and the fact that the Lender‟s Policy does not have a post policy exclusion, it is easy to see why the policy does not cover priority rights in proceeds.

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The next category of exclusions involves the “Lien Creditor”13 insuring clause. Exclusion 4(a) tracks Exclusion 3(a) with respect to priming liens of Lien Creditors. Exclusion 4(b) partially tracks Exclusion 3(b) by exempting from the exclusion an insured security interest in possessory collateral perfected by possession. Because we are now dealing with a Lien Creditor and not an adverse secured creditor perfected by control, the exemption to the exclusion is expanded to provide coverage against an adverse Lien Creditor where the insured has perfected by control in control collateral. Exclusion 4(c) tracks Exclusion 3(c). The reason that the exclusions in Section 4 are fewer than in Section 3 is that the range of priority conflicts between and among secured creditors is much more complex than the areas of priority contest between a Lien Creditor at date of policy and the insured. The exclusions in Section 5 enumerate a number of situations under Article 9 where a purchaser of collateral will take the collateral free of the insured security interest. Most of the exclusions speak for themselves, such as the black letter law that a buyer in the ordinary course of business of goods will take free of the security interest of a lender to the seller of the goods.14 The lien stripping or lien subordination transaction types set out in Exclusion 5 are usually noncontroversial because the lien stripping or lien subordination result happens as a matter of law and cannot be insured against. Exclusion 6 subsections are similar to the subsections of Exclusion 5 in that they cover transactions where the purchaser of collateral will have priority over the insured security interest as a matter of Article 9 or other law, where the insured has perfected its security interest by the filing of a financing statement or by automatic perfection. Again, the priority position for the various categories of purchasers set forth in Exclusion 6 are usually non-controversial because the senior priority result happens as a matter of law and cannot be insured against. Exclusion 7 excludes from policy coverage of the senior priority position of the insured security interest the subsequent priming security interest of a securities intermediary or bank where (a) the securities intermediary holds its security interest in a securities entitlement or a securities account maintained with the securities intermediary;15 or (b) the bank holds a security interest in a deposit account maintained with the bank.16 There is an exception to this exclusion for a deposit account where the insured becomes the bank‟s customer, stating the result under Section 9-327(4). Again, Exclusion 7 is non-controversial and merely states the result under the various provisions of Article 9.17 Exclusion 8 states that coverage will fall if either the facts giving rise to the information set forth in Schedule A to the policy or the documents described in Schedule A materially change after

13

UCC §9-320 (52) defines "Lien creditor" to mean: (A) a creditor that has acquired a lien on the property involved by attachment, levy, or the like; (B) an assignee for benefit of creditors from the time of assignment; (C) a trustee in bankruptcy from the date of the filing of the petition; or (D) a receiver in equity from the time of appointment. 14

UCC §9-320(a).

15

UCC §9-328(3).

16

UCC §9-327(3).

17

As with many of the provisions of the Lender‟s Policy, an Exclusion can be modified by a specific endorsement provided that the applicable insurance regulatory jurisdiction permits custom endorsements for a specific transaction. Many jurisdictions are “filed form” jurisdictions where the insurance regulatory must give prior approval to the use of forms by the underwriter. This regulatory limitation may make it difficult for the underwriter to be responsive to the needs of an insured because the review process is usually time consuming and certainly not responsive to the urgency of the typical financing transaction. 999999.294 - 1357379.2

13

date of policy. The UCC Lender‟s Policy, as discussed above, does not have a post-policy exclusion for subsequent events as do most land title policies. The insured priority position of the insured security interest continues for so long as the policy remains in effect. The safeguard for this opened ended priority coverage is that the underwriting is based on the facts and documents set forth in Schedule A, as representations of the insured, and any change that materially affects the coverages of the policy will limit coverage.18 For example, if the debtor merges into another entity and the debtor is not the surviving entity, priority of the insured security interest in the collateral of the surviving entity on a going forward basis could be materially affected by the merger. The dissolution of the debtor, or the change of name or address of the debtor, could also affect coverage.19 Exclusion 9 is similar in its obviousness to Exclusion 8. The policy does not cover a claim resulting from a change in applicable law after date of policy or from the application of foreign law. As an example of domestic law change, the policy would not continue priority coverage in goods after a change to other state law provided that a security interest under Article 9 would no longer be applicable to goods, however unlikely that event would be. The underwriter does not take the unforeseen risk after date of policy of change in law. Also, the underwriter does not take the risk of the application of foreign law that may cause a claim under the policy. An example might be a priming lien granted under local law against collateral of the debtor located in a foreign jurisdiction. Exclusion 10, unlike many of the other exclusions, is somewhat complicated and requires further explanation. Exclusion 10(a) excludes from coverage any claim arising as a result of the operation of bankruptcy, receivership, assignment for the benefit of creditors, insolvency or similar creditors‟ rights laws or proceedings, and any laws that operate only in the event of such proceedings, including any claim that is based upon fraudulent transfer or fraudulent conveyance, the application of the doctrine of equitable subordination, or preferential transfer (except where the preferential transfer results from the failure of the underwriter to follow the instructions of the insured to timely file a financing statement). This exclusion is conventionally called the “creditor‟s rights exclusion,” and, notwithstanding what may be custom with respect to land title insurance, the providers of UCC insurance have, to date, refused to acquiesce to a request to delete this exclusion. The primary reasons for the consistent refusal of the industry to remove the creditors‟ rights exclusion for UCC insurance are two: 1) as discussed above, UCC insurance, like land title insurance, is risk elimination rather than risk shifting insurance, and shifting a known fraudulent conveyance risk to the underwriter is intellectually inappropriate, regardless of what has gone on in the world of real property title insurance, and especially for free; and 2) and more importantly, the treatment of real and personal property lien and title rights are so significantly different both in and outside of bankruptcy that the risk analysis clearly argues to retain the exclusion in the context of personal property lien priority insurance. Further, this exclusion is limited to matters “as a result of…” the bankruptcy proceeding, such as the priming effect of a court approved administrative claim. An administrative claim is a result of the application of the Bankruptcy Code, not the UCC, and therefore not covered by the policy. Exclusion 10(b) precludes coverage for claims “arising out of” a bankruptcy case filed by or against the debtor. Excluded from the exclusion is the coverage offered by insuring clause 9, coverage for adversary proceedings. The purpose of this exclusion is to avoid the policy becoming general bankruptcy insurance and requiring defense coverage from the first day motions onward in a proceeding. Although the underwriter may chose to defend early on in a

18

This significance of this Exclusion is demonstrated by the information set forth in Schedule A to the various competitive UCC policies. Care should be taken in what information is in fact listed in Schedule A and tempered with the realization that the insured is responsible going forward for the accuracy of the stated information. 19 See, e.g., UCC §§9-316, 9-325, 9-326 and 9-508. 999999.294 - 1357379.2 14

proceeding, its obligation to defend under the policy is limited to adversary proceedings where issued can be effectively joined in an evidentiary proceeding. Exclusion 11 precludes coverage for claims arising out of the insured‟s failure to comply with doing business statutes. Exclusion 12 is the classic insurance exclusion precluding coverage for matters “created, suffered, assumed or agreed to” by the insured. Finally, Exclusion 13 precludes coverage for claims arising as a result of usury, interest rate limitation, truth-in-lending, and consumer protection laws. The back end of the Lender‟s Policy is similar to a standard land title lender‟s policy and this Chapter will not discuss these provisions in detail. Two provisions however need some explanation. As mentioned above, Section A.1. to Definition of Terms provides that “[a]ny capitalized term or phrase used in this policy, not defined in this policy, and defined or used in the Uniform Commercial Code, shall have the meaning given to it in the Uniform Commercial Code by definition or applicable usage.” The use of the term “usage” is key. Certain capitalized terms in the policy, such as “Knowledge,” are specifically defined in the Code. The definition of “Knowledge” is, for example, defined in Revised Section 1-202(b). “Rights” on the other hand, although capitalized in the policy, is not defined in the Code, but acquires its meaning through the way the term is used in the Code.20 Conditions and Stipulations G.2. provides that the “Amount of Insurance,” the maximum liability of the underwriter under the policy, shall not exceed the least of: (a) the Maximum Amount of Insurance, the amount of insurance for which the premium for the policy has been charged and as set forth in Schedule A; (b) the Indebtedness (defined broadly in the Definition of Terms section of the policy) outstanding at the time the loss or damage insured against by the policy occurs, reduced by any amounts the insured is able to recover from the collateral; and (c) the “Value” of the collateral (as defined in the policy), reduced by any amounts the insured is able to recover from the collateral. The theory behind the Lender‟s Policy is that coverage should put the insured in the position it would have enjoyed had its security interest in the collateral been in first position as insured. The policy is NOT credit insurance insuring the ability of the debtor to pay or perform its obligation secured by the collateral. A comparison of the premium cost for credit insurance verses UCC insurance would highlight this distinction. Also, the policy does not insure the value of the collateral, and most personal property collateral, unless replaced, declines in value over time, unlike typical real property collateral. If the Lender‟s Policy insures first position in a tractor, the policy coverage will not exceed the value of the tractor over time regardless of the amount of insurance contracted for under the policy. Again, the theory of the policy is to put the insured in the same position where it would have been had its security interest priority been as insured. Therefore, given the “least” of these criteria, it is important not to over insure a transaction. Typically the Maximum Amount of Insurance will be the amount of the initial indebtedness. However, in revolving credit and term facilities, the initial value of the collateral will typically exceed the amount of indebtedness and the Maximum Amount of Insurance. If, for example, the credit facility has a $20,000,000 revolving credit subline secured by 75% of “qualified” receivables, and a $20,000,000 “going concern” term piece, the appropriate Maximum Amount of Insurance is probably $20,000,000 and not $40,000,000. [5] Endorsements:

20

See Footnote 6 supra.

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Briefly on endorsements, the Lender‟s Policy was structured to provide the intended and usually needed and sufficient coverage without endorsement. The UCC Lender‟s Policy provides effective coverage without endorsement, except in a few situations such as where the collateral is equity interests in entities and Protected Purchaser status coverage under Article 8 is desired or the collateral is of a type as to which a security interest is perfected in another registry than the UCC central filing office, such as vehicles, and perfection coverage for the non-standard registry is requested. Protected Purchaser coverage is provided for the primary obligor as pledgor through the Mezzanine Endorsement to the Lender‟s Policy, and in the secondary obligor context, where the pledgor is a guarantor, through the Pledged Equity Endorsement. There are available, at no additional charge, endorsements to cover specific collateral types and certain circumstances. The following are a few of the available endorsements assuming regulatory permission:21

21



Borrower’s Status - Covers loss of security interest priority as a result of matters covered by the typical provisions of a borrower‟s counsel‟s legal opinion, excluding the remedies opinion.



Seller’s Lien - Insures that assets acquired by the debtor from a seller to it are free of any lien.



Tax Lien - Coverage for tax liens, done by endorsement because often additional information and searching is needed, for example in the location of the jurisdiction of the chief executive office for Registered Organizations rather than the jurisdiction of organization.



Renewal - Continues coverage for a policy that would otherwise lapse such as on termination of the underlying loan agreement.



Lender’s Aggregation - Provides combined coverage between two policies, such as tying a UCC policy to a land title policy with common coverage to avoid the necessity of determining whether a specific item of property, such as a turbine in a power plant, is personal or real property or a fixture; and use of the endorsement may result in a lower aggregate premium if coverage can be allocated between the real and personal property because of the cost difference between UCC and land title premium rates in many jurisdictions.



Mezzanine Endorsement – See §4B.03[1] below.



Pledged Equity Endorsement – See §4B.03[1] below.



Modification - Covers changes to the policy such as adding different collateral types or an additional debtor.



Change of Debtor Name - Amends the policy to reflect a change in the name of the debtor)



Periodic Bring-Down – The underwriter will conduct periodic searches, such as every 30 days for priming federal tax liens, or every 90 days for changes in debtor name, or periodically for post-policy judgments, and bring down policy coverage to cover the subsequent priming lien or event.

Many states require the prefiling and approval of forms, including both policy jackets and endorsements. Many of the endorsements listed above, and certainly the ability to customize endorsements to fit insured‟s requirements, turns on whether an endorsement form must be preapproved. The approval process through the typical insurance regulatory agency tends to be time consuming and arduous at best, with personnel with experience in either real estate or auto insurance specialists trying to understand commercial lending or the intricacies of the UCC. 999999.294 - 1357379.2 16

Custom endorsements may also be available, provided the transaction has an appropriate nexus to a jurisdiction that does not require regulatory approval of endorsements. A major utility of a custom endorsement may be the ability to use UCC insurance to bridge a factual issue that is inappropriate for a legal opinion. For example, under Section 9-311(d) if a person holds collateral otherwise subject to a certificate of title statute as inventory, and the person is in the business of both selling and leasing collateral of that type, the certificate of title regime does not apply and perfection against the collateral would be by a filing in the central filing office against inventory. In one circumstance a single UCC filing suffices, in the other many (perhaps hundreds or even thousands) individual certificates of title notations are required. Counsel correctly views the issue as a factual, and not a legal, question and inappropriate for a legal opinion. By endorsement to a UCC Lender‟s Policy, the underwriter, if comfortable with the facts of the transaction, may agreed to insure that a single centrally filed financing statement suffices. Thus, in the right context, UCC insurance and a custom crafted endorsement may be able to bridge a factual uncertainty. This is of particular value in transactions, such as securitizations, where opinions, or equivalents, are required. [6] Other Policies: In addition to the Lender‟s Policy, the following UCC related policies are generally available, again depending on the insurance regulatory issues in certain states: a) EAGLE 9® UCC Insurance Policy for Buyers – The Buyer‟s Policy (reproduced in Appendix A below) generally insures the lien status of acquired assets, and performs the same function as the Seller‟s Lien Endorsement to the UCC Lender‟s Policy. The policy is effective as of date of acquisition and contains a post policy exclusion. If the acquired assets include equity interests in Registered Organizations, an Equity Ownership Endorsement can be attached to the Buyer‟s Policy to provide Protected Purchaser status coverage to the buyer. Because the Buyer‟s Policy speaks as of the date of acquisition, there are minimal exclusions to lien status coverage. The primary Insuring Clause of the Buyer‟s Policy insures against the existence of any security interest of any secured party perfected against the seller (or sellers if more than one of the acquired assets) in any portion of the acquired assets. As at the date of the policy the buyer of the acquired assets is acquiring the assets free of any Article 9 security interest. The policy also insures against the existence of any lien of any Lien Creditor in any portion of the acquired assets suffered by the seller. The Buyer‟s Policy can be combined with an Equity Ownership Endorsement, an endorsement similar in scope to the Mezzanine Endorsement for the Lender‟s Policy, to insure the “Protected Purchaser” status of a purchaser of equity, such as the membership interest in an LLC that owns real property. b) Insured Search™ – The Insured Search™ insures against filing office error, such as mis-indexed filings or the incorrect rejection of a filing, and against loss resulting from the underwriter‟s review process of the borrower or seller. The coverage runs to the benefit of insured and insured‟s counsel. c) Insured Filing™ - The Insured Filing™ insures the adequacy of the filed financing statement and providing GAP coverage against intervening liens; perfection insurance for Registered Organizations, coverage as to the correctness of name and filing location, and 999999.294 - 1357379.2

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coverage for unintended lapse of a Financing statement. The coverage runs to the benefit of insured and insured‟s counsel. d)EAGLE Protection® Vessel-Under-Construction Insurance Policy and Commitment to Issue Vessel Title Insurance Policy – This policy insures the secured creditor status of the financing buyer constructing a vessel through loans to a shipyard, and is intended to be issued in conjunction with a Vessel Title Policy that insures to the owner the documented vessel title. Combining the two policies provides continuous coverage from the first bolt, through construction and sea trials, to the documentation of the vessel. Both lenders and owners can utilize the coverage. e) EAGLE 9® UCC Insurance Vacation Interest Policy – generally insures the existence and ownership of “points” in non-deeded time share systems and, in conjunction with a UCC Lender‟s Policy, can insure the priority of the security interest of a lender to a time share developer in the take-back points purchase financing, whether instruments or accounts. Through endorsement the lender can be added as an additional insured as to coverage on the existence and ownership of the points.

§ 4B.03 THE UTILITY OF UCC INSURANCE [1] Real Estate Mezzanine Lending: One market segment that has found significant utility from UCC insurance is mezzanine lending. The loan is made to the owner of the equity interest in a real property owning entity, e.g., the member in the real property owner LLC or the partner if the property owner is a partnership. The loan to the member(s) or partner (s) is secured by the equity in the property owner entity. As mentioned above, the typical UCC insurance policy contains an exclusion from coverage that assumes that the debtor “has Rights in the Collateral.” Because of the interplay between Article 8 and Article 9 of the UCC, if the lender to the mezzanine borrower can attain the status of a “Protected Purchaser” under Article 8 (gives value, is unaware of adverse claims to its property interest in the pledged equity collateral, and perfects its security interest in the investment property collateral by control) then the UCC insurance company will remove the requirement that the debtor have rights in the equity collateral, effectively insuring that the mezzanine borrower “in fact” owns the pledged equity interest in the real property owner. The result is equity title insurance and this coverage has found wide acceptance in mezzanine lending. This “mezzanine UCC” insurance has utility in any transaction where equity collateral is involved, not just in mezzanine real estate transactions. For the Lender‟s Policy, the Mezzanine Endorsement is used to insure “Protected Purchaser” status where the mezzanine borrower is the equity pledgor. The Pledged Equity Endorsement is used where an accommodation pledgor as secondary obligor is pledging equity collateral in support of the borrower‟s obligation to the mezzanine lender.22

22

On March 29, 2007 Moody‟s Investors Service issued a new Rating Methodology: “US CMBS and CRE CDO: Moody’s Approach to Rating Commercial Real Estate Mezzanine Loan”(the “Moody‟s Report”). The Moody‟s Report states: “Therefore, Moody‟s generally expects that mezzanine loans presented for rating will have the benefit of … in all cases … a „UCC insurance policy‟ where available.”

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An endorsement similar to the mezzanine or pledged equity endorsement is available in conjunction with the Buyer‟s Policy. Assuming that the buyer meets the status of a “Protected Purchaser” under Article 8 of the UCC, an endorsement can be added deleting the assumption that the buyer has rights in the acquired equity, thereby insuring that the buyer has acquired the equity interest in the issuer as described in the Buyer‟s Policy. This endorsement, as is the case with the Mezzanine and Pledged Equity Endorsements, effectively insures the buyer‟s ownership interest in the acquired equity Given the interplay between Article 8 and Article 9, and assuming bargaining power is with the lender, the secured lender should: •

require that the issuer of pledged equity collateral, consisting of membership interests in limited liability companies or partnership interests, opt-in to Article 8; • file a precautionary financing statement against the pledgor/borrower even if the only reliance collateral for the mezzanine loan is the pledged equity interest; • require that the pledged equity be certificated by the issuer and the lender should perfect by control of the certificated equity, possession plus an endorsement; • require that the inability to issue additional equity or opt-out of Article 8 be specifically set forth in the organizational documents of the issuer and that the organizational documents preclude amendment of these provisions without the consent of the lender;

[2] Mixed Collateral Transactions:

In transactions involving both real and personal property, including hotels, hospitals, and power plants, using both land title and UCC policies in combination can have a number of very useful results. If the lender can allocate loan value between the real and personal property collateral and both the land title and UCC policies are land title policies in the relevant jurisdiction, the aggregate premium for the combined policies may be less than if the entire loan value was insured under a land title policy. This result is because the premium per thousand dollars of coverage is less for UCC insurance in most jurisdictions than the premium per thousand dollars of coverage for land title insurance coverage. The UCC policy may also provide more effective coverage that that in endorsements to a land title policy, and often at a lower aggregate premium. Finally, a land title company may, depending on the jurisdiction involved, be able to provide a discount against its UCC policy premium if the insured uses their company for land title insurance on the same project. Another benefit of tying land title and UCC policies together is that the whole issue of what is a “fixture” goes away.

[3] Co-Ops, Timeshares and Houseboats: This category is somewhat open-ended, but demonstrates the utility of UCC insurance to cover different categories of collateral, and linkage of UCC insurance to land title insurance. If we consider co-operative housing arrangements, the collateral involved may not be fee ownership of the realty, but interrelated collateral of a ground lease coupled with equity ownership in a cooperative association. The ground lease is real property and outside the scope of UCC insurance 999999.294 - 1357379.2

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(except for New York, as discussed in Section 8.04[5] of Chapter 8, below), but the equity ownership component is what UCC insurance does best. The Equity Ownership Endorsement discussed above can be used to insure that the borrower, the owner of the equity interest in the co-operative association, in fact owns the equity ownership interest. Time share interests are another “what is it” kind of issue. Deeded interests are straightforward and are interests in real property, the ownership of which is to be covered by land title insurance. Non-deeded interests are another matter. Many developers now like non-deeded interests because in the event of buyer payment default they can terminate the transactions for breach and recapture the sold “points” and avoid a judicial or non-judicial real property foreclosure. But if a developer to whom a loan is being made is securing its repayment obligation with its accounts receivable from the point purchasers, what does the lender do. UCC insurance provides an answer. The developer‟s accounts are the payment obligation of the points purchaser for the purchase price for the points. The Lender‟s Policy will insure that the lender has a first priority position in the accounts of the developer. But what if the developer is filing against the points purchaser to secure the purchaser‟s payment obligation with the points and collaterally assigning its security interest position to its lender. The Lender‟s Policy can be endorsed to insure the lender against any loss resulting from the developer not being in first position with respect to the points. The Vacation Interest Policy (“VIP”) couples UCC insurance with a points inventory control system that insures both the lender and the individual ultimate purchaser that not only are Article 9 liens in first position, but the VIP insures that the points actually exist to be sold to the purchaser by the developer. This VIP effectively insures the lender against points overselling by the developer and provides added confidence that is otherwise missing because the non-deeded systems do not have the benefit of a real property recording system to police the selling of the points. Houseboats, manufactured homes, and the like also raise the issue of “what is it.” Putting aside documented vessels, houseboats are personal property that may or may not be “certificated” collateral. Because they are not real property, only a UCC policy will provide lien priority coverage. By endorsement, the UCC policy can cover perfection in a certificated collateral filing system, such as a DMV. The same reasoning is true for manufactured homes, putting aside state systems that may allow the morphing of the house-trailer into real property, which would then permit coverage through a land title policy. This same rationale applies to whatever may be affixed to the realty. (See Chapter 8, Section 8.02, below, for a full discussion of fixture, including manufactured home, issues.) UCC insurance eliminates the worry of collateral mischaracterization. [4] Legal Opinions and UCC Insurance The “standard” borrower‟s counsel legal opinion regarding perfection of the lender‟s security interest only covers perfection, and not priority. Priority is covered by UCC insurance. Further, such opinions tend to be circular, in essence saying that if the lender files in the appropriate jurisdiction, then it is perfected in the described collateral provided it can perfect by filing in the described collateral. UCC insurance provides some of what is afforded by a legal opinion, and a lot more. UCC insurance is insuring the effective grant of the security interest by the debtor, and, at least as to the grant of the security interest, is insuring the due organization of the debtor if the debtor is a 999999.294 - 1357379.2

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Registered Organization, and the authorization, execution and delivery of the lien granting document, typically a security agreement. As part of its underwriting process, the insurance company will review the articles and bylaws of the debtor, and other documents, to reach its underwriting conclusion. This coverage does not get the insured an enforceability opinion but the UCC insurance does get the lender some of the stuff covered by a borrower‟s counsel opinion, as reflected in the Borrower‟s Status Endorsement discussed in Section 4B.04[2],below UCC insurance also provides a greater functionality than that provided by a typical borrower‟s counsel opinion, including priority insurance and GAP coverage as discussed above. How can the insurance company cover such matters that cannot be factually determined, such as covering filings in the GAP? The answer points out the great difference between UCC insurance and a legal opinion. A legal opinion should be viewed as a due diligence document and NOT an insurance policy. A lawyer‟s job is to review the record and reach reasoned conclusions based upon that review, such as whether the borrower is duly formed. An insurance company is just that, a provider of insurance, and makes prudent business judgments with regard to risk based on probability of occurrence. The lawyer determines what can be discovered from the record, and the insurance company shifts prudent risks from the lender to the insurance company.

[5] Search Company and Filing Office Error

As has been mentioned, UCC insurance is, after all, insurance. Its role is fundamentally different than the role of a lawyer in a financing transaction. Its role is also fundamentally different than the role of a search company. It is standard practice for the UCC search companies to disclaim any liability resulting from the use of the information provided, and to provide a limitation of damages equal to the fee paid for the service. The limit on damages is not difficult to understand or justify. Loss of priority can result in the loss of significant amounts of money and a search company does not want to face that degree of contingent liability for a $50 search fee. The search company is not an insurance company nor are the law firms reviewing the searches. The State itself is normally not liable for a mistake under sovereign immunity. The answer is for the searching party or its lawyer to utilize UCC insurance to provide the protection against search company or State filing office error. The land title insurance companies offering UCC insurance ARE insurance companies, with underwriting guidelines and pools of customers over which to spread assumed risk. §4B.04 Law Firm Risk and UCC Insurance The trustee or unsecured creditors‟ committee will most likely attack the secured creditor‟s perfected status from one of three directions: 1) the secured party filed in the wrong jurisdiction, 2) the collateral description is incorrect in some manner, or 3), and most important, the name of the debtor is seriously misleading. [1] Debtor Name: The third and most important area of fatally defective financing statements involves the name of the debtor. Revised Article 9 is, in many ways, more restrictive and less forgiving than Former Article 9. The reason for this apparent reduction in name flexibility is that Revised Article 9 falls 999999.294 - 1357379.2

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back on the “standard” search logic of each State under Section 9-506(c), providing for a safeharbor but minimal flexibility to the requirement for debtor name “correctness”. This leads into a brief review of cases that have considered the adequacy of the filed debtor name and whether that name, different than the “correct” debtor name, is sufficient for purposes of Section 9-506(c). The following chart sets forth the names of certain cases, the name debate, and whether the case is Good or Bad Law. “Good Law” categorizes a case that, in this author‟s opinion, follows the language or intent of Article 9 in reaching its conclusion regardless of whether the case reaches an equitable or “fair” result. “Bad Law” describes a case where the court did not fully grasp the intent of Article 9 or the language of the statute, whether or not the decision is correct under other law, such as Spearing Tool.23

23

United States v. Crestmark Bank (In re Spearing Tool & Mfg. Co.), 412 F.3d 653 (6th Cir. 2005), en banc rehearing denied, 12/30/05, 2005 U.S. App. LEXIS 29219, U.S. cert denied, Dkt. No. 05-1271, 127 S. Ct. 41; 10/02/06. See, also, James H. Breay, The Unfortunate Consequences of Spearing Tool, 124 Banking L.J., Feb. 2007 at 99. 999999.294 - 1357379.2

22

Name of Case

Name of debtor as Filed

“Correct” Name of the debtor

Spearing Tool25

Spearing Tool & Mfg. Company.

Kinderknecht26

Terry

Spearing Tool and Manufacturing Co., Inc. Terrance

Planned Furniture27 Host American28

Benjamin S. Youngblood K W M Electronics Company Roger

Benjamin S. Youngblood, Inc. K. W. M. Electronics Company Rodger

Tyringham Holdings Net work Solutions, Inc.

Tyringham Holdings, Inc. Network Solutions, Inc.

Summit Staffing

Summit Staffing of Polk County, Inc.

Michael A. Erwin33

Mike Erwin

Michael A. Erwin

Genoa National Bank34

Mike Borden

Michael Borden

Pankratz

29

Tyringham30 Receivables Purchasing Company31 Summit Staffing32

Effective Filing

Ineffective Filing

Good UCC Law24

Bad UCC Law

  





    

    

   



24

But not necessarily good public policy or an equitable result because of the effect of “exact” search logics.

25

See footnote 22.

26

In re Kinderknecht, 308 Bankr. 71 (B.A.P. 10th Cir. 2004). 27

Planned Furniture Promotions, Inc., Plaintiff v. Benjamin S. Youngblood, Inc., d/b/a/ Honey Creek Home Furnishings; Benjamin S. Youngblood; Laura Youngblood; Citizens Bank of Fort Valley, Georgia; United States Internal Revenue Service; State of Georgia Department of Revenue, Defendants, 374 F. Supp 1227 (M.D. Ga, 2005). 28

Host American Corp. v. Coastline Financial, Inc., 60 U.C.C. Rep. Serv. 2d 120, 2006 U.S. Dist. LEXIS 35727, (D. Utah, May 30, 2006 ). 29

Pankratz Implement Company v. Citizens National Bank, 33 Kan. App. 2d 279, 102 P. 3d 1165, 2004 Kan. App. LEXIS 1173 (Kansas Ct. App. 2004). 30

The Official Committee of Unsecured Creditors for Tyringham Holdings, Inc. v. Suna Bros. Inc. (In re Tyringham Holdings, Inc.), Case No. 06-32385-DOT, Adversary Proceeding No. 06-03142-DOT, 2006 Bankr. LEXIS 3332 (Bankr. E.D. VA., December 1, 2006). 31

Receivables Purchasing Company, Inc. v. R&R Directional Drilling, 263 Ga. App. 649; 588 S.,E.2d 831, 2003 Ga./ App. LEXIS 1284; (Georgia Ct. App., 4th Div. 2003). 32

In re: Summit Staffing of Polk County, Inc., 305 B.R. 347; 2003 Bank. LEXIS 1911; (Bankr. Middle District of Florida, 2003). 33

In re: Michael A. Erwin v. Bucklin National Bank, 50 U.C.C. Rep. Serv. 2d 933; 2003 Bankr. LEXIS 692 (Bankr. District of Kansas, June 27, 2003). 34 Genoa National Bank v. Southwest Implement, Inc (In re Borden), Case No. BK05-41272, A06-4013, 2006 Bankr. LEXIS 2911, (Bankr. District of Nebraska, November 2, 2006). 999999.294 - 1357379.2

23

In re Berry35 Corona Foods

36

Mike Berry

Michael Berry

Armando Munoz

Armando Munoz Juarez Richard Morgan Stewart IV Sang Woo Gu

Morris37

Richard Stewart

All Business Corp. 38

SangWoo Gu

 

 









In summary, the filer must get the name of the debtor correct, which requires a determination of the “correct” debtor name, and then filing exactly against that name. Standard search logics can be changed by the state, so relying on forgiving search logic is probably unwise. A typographical error resulting in the loss of perfection is not a risk any lawyer should be willing to assume.

[2] Human Error: But search logic and exactness of name are not the only issues facing the law firm preparing and filing the financing statement. The other, and perhaps more serious issue, is the problem of just human error. Dropping the “d” in “Rodger” or not separating “Sang Woo” can have a catastrophic result, namely the failure of the security interest to be perfected. Accuracy is the This is where UCC insurance can provide a cost effective risk management tool to a law firm. The strict name requirement of Article 9, the lack of forgiveness in the search logics of many states and the speed of electronic filing argue for the law firm to off-load to the UCC insurance company the UCC perfection risk in commercial finance transactions. And, UCC insurance protects the creditor/lender as well as its counsel, while providing coverage for those matters typically included in the opinion of borrower‟s counsel.39

Appendix 4B

Model Forms

35

Parks v. Berry (In re Berry), Case No. 05-14423, Chapter 7, Adv. No. 05-5755; 2006 Bankr. LEXIS 3361 (Bankr. District of Kansas, December 1, 2006). 36

Corona Foods & Veggies, Inc. v. Frozsun Foods, Inc., 143 Cal. App. 4th 319, 48 Cal. Rpt. 3d 868, 2006 Cal. App. LEXIS 1479 (California Ct. App. 2006). 37

Morris v. Snap On Credit, L.L.C., f/k/a Snap-On Credit Corporation (In re Stewart), Case No. 04-16838, Chapter 7, Adv. No. 05-5090; 2006 Bankr. LEXIS 3014 (Bankr. District of Kansas, November 1, 2006). 38

All Business Corp. v. Choi, 280 Ga. App. 618, 634 S.E.2d 400, 2006 Ga. App. LEXIS 669 (Georgia Ct. App. 2006), cert. denied, 11/20/06, 2006 Ga. LEXIS 1016 (Ga. Supreme Ct. 2006). 39

In clarification of the assertion that UCC insurance provides the substance of the typically required opinion of borrower‟s counsel in a commercial finance transaction, we provide the Borrower‟s Status Endorsement to our EAGLE 9® Lender‟s Policy. See Footnote 5 supra. 999999.294 - 1357379.2

24

Form 4B-1 Form 4B-1a Form 4B-2 Form 4B-2a

999999.294 - 1357379.2

Lender’s UCC Insurance Policy Schedules to Lender’s Policy Buyer’s UCC Insurance Policy Schedules to Buyer’s Policy

25