Although the fourth-quarter 2009 has shown modest signs of stabilization in consumer sectors, the nation�s economy remains fragile, with many indicators suggesting a broadening of the credit crisis to commercial and corporate sectors of the economy. Particularly exposed is the credit quality and capital of secured lenders, the reliability of traditional underwriting tools employed by secured lenders, the quality and creditworthiness of their corporate borrowers, the fund adequacy of the FDIC and potential liability to taxpayers.By Theodore H. Sprink
Fidelity National FinancialLarge and small banks electing to not utilize contemporary underwriting and risk mitigation tools now offered by the private sector, and the failure of secured lenders to properly perfect their security interest in reliance collateral or to maintain their collateral lien priorities in the face of rising corporate defaults, can be expected to experience an adverse effect on bank loan recoveries.
Diminished loan recoveries on defaulted loans will deplete regulatory bank capital. Depleted bank capital may result in institutional insolvency. Bank insolvency may result in FDIC intervention. Too many FDIC interventions can be anticipated to adversely impact the FDIC insurance fund, potentially leading to Treasury assistance. Treasury assistance is referred to by many as a taxpayer bailout.
The private sector has developed a proven, simple, effective and low-cost risk mitigation program to contribute to bank underwriting processes. It is a valuable new tool that secured lenders, credit executives, risk management officers, equity investors, shareholders, bondholders, regulators, bank examiners, rating agencies, industry analysts and public policy makers may come to embrace as an effective collateral lien priority insurance program with which financial institutions and the nation�s fragile economy can be protected.
This white paper will remind readers that, despite the availability of modern risk management tools such as UCC insurance, tradition-bound bankers continue to inadequately mitigate risks associated with commercial loans secured by personal property as defined by Article 9 of the Uniform Commercial Code (UCC), particularly in a dramatically unstable economic environment. Has the banking industry prepared for what could be a cascade of defaults on non-performing commercial loans? It seems clear that such defaults will drain capital from the nation�s banks, thereby further imperiling the fragile national economy. Though many economists are predicting a slow economic recovery in consumer sectors beginning in the fourth quarter of 2009, the nation can ill afford another credit shock.
Earlier this decade, a stable, robust economy masked defects in commercial loan documentation that in today’s unstable market significantly exposes lender’s reliance collateral securing commercial and corporate loans. But the devastated economy is beginning to reveal a shocking number of documentation defects related to the attachment, perfection and priority of a lender’s security interest. And they can be expected to directly impact balance sheet value and recoverability of commercial loans secured by personal property collateral.
Reports that 30% of commercial loans suffer documentation defects that could result in the bank’s loss of collateral reflect needless exposure to bank capital and liquidity upon loan default. The Wall Street Journal reported that corporate bankruptcy rates for commercial loans secured by non-real estate collateral have quadrupled in the past two quarters — and that this trend appears to be continuing into the fourth quarter of 2009 and first quarter of 2010.
There is significant risk to the nation’s financial sector associated with the rising tide of corporate bankruptcies. Tremendous pressure is mounting on banks to avoid mark-to-market write-downs, charges to an already battered income statement and the recognition of under-collateralized rolling loans with little chance of repayment. Some loans may be in technical default, some in monetary default and some in so-called maturity default.
Many of the debtors that are responsible for these loans will file for bankruptcy. In many cases there will be a contest for control of collateral. More importantly, the lender’s lien perfection and/or priority will be set aside as a result of multiple challenges uncovering documentation defects. The bank’s failure to properly perfect and obtain a first priority security interest on reliance collateral will adversely affect recoveries. Diminished loan recoveries on defaulted loans will deplete bank capital. Depleted bank capital may result in institutional insolvency
One recent study by Deutsche Bank suggested that there may be $3 trillion to $5 trillion in commercial real estate and corporate loan defaults through 2013. These defaults, many of which result in bankruptcy filings, are to a large degree the result of frozen, or crippled credit markets in which permanent financing or refinancing is unavailable. Many of these loans, originated when credit was too loose, are now the victims of initially unrealistic asset values and loan-to-value ratios. As a result, the borrower has little skin in the game (in terms of equity), and therefore little motivation to work out the problem for the benefit of the lender.
Banks are lenders not partners, with the responsibility to their shareholders to protect bank assets, maximize recoveries and (common in today�s parlance) avoid further government and taxpayer intervention. Banks are charged with the responsibility to operate in a safe and sound manner, utilizing all risk management tools available to identify, measure and manage risk. The forthcoming wave of corporate bankruptcy filings will tend to make the banks look like partners. With no alternative sources of capital, banks will be forced to protect their collateral, to recognize capital-depleting charge-offs or enter into a series of short-term modifications that will likely reduce principal, interest rates and principal balance. Defaults, workouts, bankruptcies, receiverships, foreclosures, liquidations, ultimately write-offs and litigation over collateral are coming. There will be significant challenges by debtors, trustees in bankruptcy and/or unsecured creditors committees to the bank�s assertion that it has a properly perfected security interest. Banks would be well advised to seek new and contemporary tools for the tool kit.
In September 2009, the Associated Press reported concerns with the FDIC’s anticipated funding requirements (to rescue insolvent banks). This was the result of significant bank failures, driven by increasing loan defaults. The FDIC identified 305 “troubled” banks during the first quarter, referred to as“surging bank failures.” Eighty-one banks have failed, and been seized by the FDIC so far this year … approximately a 300% increase over last year. These failures are the result of violation of regulatory capital requirements, usually the result of defaulted loans, failed workouts and write-offs.
Camden Fine, the president of the Independent Community Bankers of America, is quoted as expressing concern that “significantly increased assessments on the banks to keep the FDIC solvent are likely.” Gerrard Cassidy, a banking analyst for RBC Capital Markets, predicted that up to 1,000 banks, or one in eight, could disappear within three years (as the recession deepens and broadens).
The FDIC may need $70 billion to cover bank failures projected thought 2013. The FDIC recorded $19 billion in losses in the first quarter of 2009. While the FDIC is dealing with banks that are dealing with the fallout of bad consumer and residential real estate loans, it appears that the commercial loans secured by personal property collateral remain on a back-burner and beneath the surface.
The Wall Street Journal reported on September 14, 2009 that sick banks now top 400 in number with the banking industry continuing to slide as bad loans pile up. According to The Journal, the banking industry continues to deteriorate with regulators adding 111 lenders to their list of endangered banks in the last quarter, even as the economy shows signs of stabilizing. The article also referred to government reports (concerning bank capital and liquidity) spotlighting potential risk to the broader economy. The report referred to banks socking away cash leaving them less capital to lend, thus constricting credit just as the economy appears poised to revive. FDIC Chairman Sheila Bair acknowledged: “Credit problems will outlast the recession by at least a couple of quarters.” And, many of these problems reside at the nation’s leading financial institutions, which appear to be relying on risk management practices that were designed for “normal” economic circumstances�not a severe recession with a weak and prolonged recovery.
A Shared National Credit Program Report, compiled by the FDIC, OTS, OCC and Federal Reserve as reported on September 25, 2009, stated that, U.S regulators say “�losses from loans facing banks and other financial institutions tripled to $53 billion in 2009 due to poor underwriting standards and the continued weakness in economic conditions.” The report was critical that soaring “assets rated special mention, substandard, doubtful and loss” touched $642 billion representing 22.3% of the bank loans reviewed in the regulatory report, compared to 13.4% just one year ago. Classified assets as �doubtful and loss� loan categories reached a staggering $447 billion — rising almost fourteen fold from the prior year.
On September 3, 2009, the U.S. Department of Treasury issued a report concerning Stronger Capital and Liquidity Standards for Banking Firms and the safety and soundness of individual banking firms. In this report, the Treasury stated that the existing “regulatory framework has failed to prevent the build-up of risk in the financial system in the years leading up to the recent crises. Major financial institutions had reserves and capital and buffers that were too low�” The Treasury also stated, “Capital requirements should be designed to protect the stability of the financial system � and that capital requirements for all banking firms should be increased, and capital requirements for firms that pose a threat [those whom have accepted government TARP funds] to overall financial stability should be higher than those for other banking firms.” The report added, “The rules used to measure risk embedded in bank�s portfolios and the capital required to protect against them must be improved.”
Another recent Wall Street Journal report discussed shrinking loan portfolios at major banks, indicating that most lending is the renewal of old loans, not the providing of capital to businesses in the form of new loans. In the article, Rep. Spencer Bachus (R-AL) pressed the Treasury Secretary as to why TARP money has failed to deliver the multiplier effect as advertised. Fifteen banks hold 47% of the TARP funds, and loan portfolios have declined at 13 of the banks. Based on the article, it appears that banks continue to add to loan-loss reserves rather than originate new commercial loans.
A recent article published in USA Today reported growing concerns with credit quality, loan delinquencies and defaults that resulted in an increasing number of banks failing to pay the quarterly TARP dividend to the government. According to USA Today, banks are preserving capital by defaulting to the Treasury (taxpayers). The article called into question which banks are deemed healthy by the Treasury, and provided as an example, that due to credit quality, capital and liquidity problems, CIT is involved in finalizing a prepackaged bankruptcy, which will eliminate $2.33 billion owed to taxpayers. Yet, it appears that CIT and other major lenders, which have benefited from TARP/taxpayer assistance, are not utilizing all of the contemporary risk management tools available in the private sector toolbox to improve credit quality in their own underwriting.
A private sector Risk Management Program could serve to give the banks a greater degree of confidence in their corporate lending, with a new level of insurance protection available to protect their secured lending documentation and related secured collateral.
Historically, real estate title insurance has played an important role in loan transactions by insuring proper perfection and priority of collateral, and by protecting lenders from fraud, forgery and documentation defects. UCC insurance for non-real estate collateral is the natural evolution of this concept in light of the growing need to protect and enhance the strength and quality of commercial loan reliance collateral.
Escalating commercial loan delinquencies, defaults, charge-offs and bankruptcy filings are anticipated to result in substantial pressure on reliance collateral. Many of the nation’s lending institutions are failing to implement basic, low-cost and readily available collateral protection, thereby failing to insure against defects and documentation errors that could, in the event of a third-party challenge to the lender’s perfection or lien priority, result in the bank�s security interest being set aside. This loss of collateral position would severely reduce recoveries in the event of a loan default, eroding the capital and liquidity in an already fragile banking system.
UCC insurance, available from the nation�s leading real estate title insurance companies, is a relatively new program for the financial markets. Similar in many respects to traditional real estate title insurance, UCC insurance was introduced specifically to insure the commercial lender’�s security interest in personal property collateral for validity, enforceability, attachment, perfection and priority.
A tradition of relying on legal opinions offered by the borrower’s lawyers appears to be the primary reason the commercial lending industry does not yet require UCC insurance as a matter of course for non-real estate secured commercial loans. As detailed below, a legal opinion is not uniform across the country. No claims reserves stand behind the legal opinion, and no cost of defense is included in the legal opinion.
This is clearly a time of economic uncertainty and instability in which the best practice risk management of balance sheet liability, and protection of reliance collateral, are becoming increasingly important in the secured lending segment.
Bank analysts, bondholders, stockholders, rating agencies, regulators and public policy makers expect banks to utilize all the tools available in their “risk management toolbox” to protect credit quality, capital, liquidity, shareholder investment and, by extension, the FDIC and taxpayers.
At some time in the near future, it is likely that the old school practice of the nation’s financial institutions not insuring their lien perfection and priority on reliance collateral, in a manner similar to what is required in the real estate loan segment, will be considered a glaring deficiency to the stakeholders mentioned above.
As we saw in the real estate markets several decades ago, it is likely that the banks� outside counsel would prefer low-cost insurance for the bank’s lien priority as a very attractive alternative to the liability associated with the lender being secured but not insured.
Clearly, the failure to rely on tradition, and not utilize contemporary best practice risk management tools could have a grave effect on the health of the commercial lenders and the nation’s economic recovery.
The Current Economic Milieu
Most economists believe the current economic downturn originated in the residential real estate market and the associated effect this downturn had on capital and liquidity in the banking industry. An avalanche of poorly underwritten real estate loans put many of the nation�s largest banks on unsteady footing. Seemingly overnight, credit dried up as banks directed cash toward shoring up their delicate balance sheets. A collapse in housing prices dampened consumer spending. Personal default rates soared, and repercussions rippled out from the housing market to nearly every corner of the national economy.
Although residential real estate markets in many regions appear to be stabilizing, according to the Federal Reserve, commercial loan charge-offs and delinquency rates are escalating at a rate faster than the decline in the residential real estate market. By the end of the second quarter of 2009, the Fed reported that charge-offs and delinquency rates for non-real estate commercial loans had hit 2.31% — nearly a 300% increase of the level of just one year before.¹ Clearly, an increase in delinquencies signals a concurrent and significant increase in problems associated with commercial loans secured by personal property collateral.
When Things Go Wrong
Personal property secured transactions under Articles 8 and 9 of the UCC is one of the most heavily litigated areas of commercial law. Small wonder: recent court cases, as compiled by the American Bar Association’s Section of Business Law, suggest that clerical flaws in documentation and/or perfecting can carry significant negative repercussions for lenders caught unaware.² Cases in which the security interest of a secured lender has been challenged or set aside are generally in one of four categories:
•Failure to file/continue the financing statement
•Incorrect/ambiguous financing statement
•Defective description of collateral
•Incorrect filing jurisdiction
Many commercial loan documentation defects that lead to a lender’s security interest being jeopardized are either clerical in nature or are the result of a lack of detailed knowledge regarding the UCC: Examples include: incorrect name of borrower, search of the wrong jurisdiction, wrong state of filing, the lack of filing the appropriate documents, an error in the collateral description and the like. (See addendum for broad cites.) Moreover, it is often junior staff at either the bank or the law firm that is responsible for perhaps the greatest risk to the lender: the loss of perfection and priority on reliance collateral.
What follows is a general description of common problems that can surface, followed by real-world examples.
Attachment (9-303 of the UCC)
For a security interest to attach to collateral, a borrower must have rights in the collateral, sign the appropriate security agreement granting the lender a security interest and the lender must have given, or committed to give, value. Too often, however, lenders fail to satisfy even these most basic requirements.
In one recent case in the Fifth Circuit Court, for example, an individual signed a security agreement granting a security interest in collateral to secure a loan. It later proved to be unclear if the individual, a sole proprietorship or a limited liability company actually owned the assets. The matter had to be litigated in court to determine if the individual had the appropriate rights in the collateral in the first place that would be required to grant a security interest.³
Perfection (9-308 to 9-316 of the UCC)
Common sense would dictate that a bank should pay careful attention to all steps required to properly perfect its interest in the collateral securing a loan. Lenders need to avoid financing statement inaccuracies, search office and omissions, and indexing inconsistencies. But recent jurisprudence suggests that lenders need to do this with the skill of a surgeon if it is to properly establish and maintain a security interest in a loan secured by personal property.
A 2007 case in South Dakota provides a classic cautionary tale. Here, a financing statement was deemed ineffective because one letter and a comma were omitted from the debtor’s name. But for want of a perfect typist, the debtor listed as Jim Ross Tire Inc., was in fact Jim Ross Tires, Inc. The court ruled that the financing statement was inaccurate, and a $63,033.56 loan was subsequently deemed unperfected.&sup4;
Priority (9-317 to 9-342 of the UCC)
The other common pitfall lenders must avoid is to ensure that they have a first priority security interest in the collateral that secures their loan. Documents perfecting their security interest must be crafted without errors, and filed on a timely basis in the correct jurisdiction. As was the case in the previous examples, the courts tend to punish lenders who demonstrate less-than-perfect due diligence.
In a 2007 case out of New Jersey, a prospective buyer of accounts searched under an incorrect name of a debtor prior to purchase. Because of this error, the buyer did not discover a prior financing statement by a previous secured party. When the buyer later went to collect on some of these accounts, a priority dispute arose between the original secured party and the buyer, resulting in a protracted legal situation.&sup5;
All of these examples offer a vivid reminder that almost perfect simply isn’t good enough when it comes to properly documenting commercial loans secured by personal property. With the courts demanding such precision, even the most diligent banker is exposed to losses based on documentation defects or omissions when originating or modifying commercial loans.
Theodore H. Sprink is senior vice president and director of Business Development of Fidelity National Financial, Inc.�s UCC Risk Management Program. He can be reached by e-mail at: tsprink [at] fnf [dot] com.
Fidelity National Financial is the nation’s largest provider of real estate loan origination, closing and insurance services, operating through the Alamo Title, Chicago Title, Commonwealth Title, Fidelity National Title, Lawyer’s Title, Security Union and Ticor Title insurance brands. Fidelity National has an investment portfolio of approximately $5.5 billion and reserves for claims losses that exceeds $2.3 billion. FOOTNOTES
1 Federal Reserve Statistical Release: Charge-offs & Delinquency Rates on Loans and Leases at Commercial Banks 2009:2.
2 Steve O. Weise, UCC Article 9: “Personal Property Secured Transactions,” in The Business Lawyer 1353 (American Bar Association, Aug. 2008).
3 Id. at 1357, citing Peoples Bank v. Bryan Brothers Cattle Co., 504 F.3d 549, 552 (5th Cir. 2007).
4 Id. at 1362, citing In re Jim Ross Tires, Inc., 379 B.R. 670, 673 (Bankr. S.D. Tex. 2007).
5 Id. at 1364, citing Wawel Sav. Bank v. Jersey Tractor Trailer Training, Inc., 2007 WL 2892956
Exposure to lenders and outside counsel is often revealed in matters involving:
1. Failure to file/continue the financing statement,
2. Incorrect/ambiguous financing statement,
3. Defective description of collateral,
4. Incorrect filing jurisdiction.
Cases generally fitting into these categories include:
1. Receivables Purchasing Company Cite: Georgia Court of Appeals — October 2003
Issue: Debtor�s correct name was Network Solutions, Inc.
The financing statement was filed against Net Work Solutions, Inc. A UCC search on the correct debtor name did not uncover the filing. The court commented that a party filing a financing statement now acts at its peril if it files a financing statement under the wrong name.
Conclusion: The secured party did not perfect properly despite only adding a space in the debtor�s name.
2. Pankratz Implement Company Cite: Kansas Superior Court-March 2006
Issue: Debtor�s Correct Name was Rodger House
The financing statement was filed against Roger House. A UCC search on the correct debtor name did not uncover the filing. The court commented that article 9 had the effect of shifting responsibility of getting the name right on the financing statement to the filing party.
Conclusion: The secured party did not perfect properly despite missing only one letter in the debtor�s name.
3. In Re Tyringham Holdings, Inc. Cite: United States Bankruptcy Court Virginia — December 2006
Issue: Debtor�s correct name was Tyringham Holdings, Inc.
The financing statement was filed against Tyringham Holdings. A UCC search on the correct debtor name did not uncover the filing. The secured party argued that a private search service using a different search logic would have found the filing. The court ruled that the Virginia search logic did not find the filing and the filing was therefore seriously misleading.
Conclusion: The secured party did not perfect properly despite only missing the Inc. in the debtor’s name.
4. Host America Corporation v Coastline Financial, Inc. Cite: United States District Court — Central District of Utah-May 2006
Issue: Debtor�s correct name was K. W. M. Electronics Corporation
The financing statement was filed against KWM Electronics Corporation. A UCC search on the correct debtor name did not uncover the filing. The court ruled that given the importance of the debtor�s name, it should come as no surprise that a failure to adequately provide the name will render a financing statement, “seriously misleading.”
Conclusion: The secured party did not perfect properly despite missing three periods and spaces in the debtor�s name.
5. Fuell v MNTC Cite: United States Bankruptcy Court Idaho — December 2007
Issue: Debtor’s correct name was Andrew Fuell.
The financing statement was filed against Andrew Fuel. The court held that the financing statement was ineffective and that the Debtor’s name on the financing statement was seriously misleading.
Conclusion: The secured party did not perfect properly despite missing only one letter in the debtor�s name.
Publicly adjudicated cases illustrate exposure to lender�s relying on search vendors and/or outside counsel to assure proper attachment, perfection and priority of its security interest in personal property:
•The �Failure to File� a UCC-1 financing statement by outside counsel led to a legal malpractice judgment against a law firm in an action brought by the client, in Kory vs Parsoff, 745 NY S. 2d 218 (2002).
•An �Incorrect/Ambiguous Financing Statement� limited collateral subject to a bank�s filing in Shelby County State Bank vs. Van Diest Supply 303 F. 3d 7th Cir (2002).
•A �UCC Search Vendor�s Liability for Damages� was limited to $25 for the failure/inaccuracy of the vendor�s search in identifying prior liens in Puget Sound Financial, LLC vs. Unisearch, Inc. 146 Wn. 2d 428 (2002).
•A �Defective Description in Collateral� and �Incorrect Filing Jurisdiction� led to a lender failing to properly perfect its security interest in Fleet National Bank vs. Whippany Venture I 370 B.R. 762 (d. Del 2004).