Secured creditors beware

A series of cases decided by the federal district court in Chicago holds that a properly perfected secured creditor can waive its right of priority in collateral in favor of a judgment lien creditor if it fails to properly act against its collateral following a borrower’s default.

Typically a secured creditor attains perfected status and rights of priority in property upon properly filing its financing statement. The adage “first in time, first in right” is the paradigm. Security agreements typically contain language that grants the secured party rights to pursue its collateral under Article 9 of the UCC following an event of default. These rights of priority are critically important following an event of default particularly if there are creditors with competing interests in the debtor’s property. If the secured creditor enjoys the rights of priority it can not only control the method of realizing upon its collateral (such as through disposition by foreclosure), but also it ultimately has first priority to receive the cash proceeds of its collateral. 

If the security agreement states that the secured party’s rights arise after an event of default, the secured creditor may be limited in its ability to pursue its collateral if it does not take timely affirmative action to pursue its collateral following an event of default. In One CW, LLC v. Cartridge World North America, LLC, 661 F. Supp.2d 931, 935 (N.D. Ill. 2009), U.S. District Judge Holderman held that a lender must take affirmative remedial action before it is entitled to take possession of a debtor’s collateral. “[A] third-party lender cannot, consistent with the UCC, ‘refuse to exercise its rights under the security agreement, thereby maintaining [the borrower/judgment debtor] as a going concern, while it impairs the status of other creditors by preventing them from exercising valid liens.’” In the absence of some “affirmative remedial action,” a lender that has not exercised its rights and remedies following a borrower’s default does not have a present right to the collateral or a basis to object to their release to a lien creditor. Judge Holderman relied upon Judge Zagel’s decision in S.E.I.U. Local No. 4 Pension Fund v. Pinnacle Health Care of Berwyn LLC, 560 F. Supp.2d 647, 651 (N.D. Ill. 2008) (Zagel, D.J.). In Shales v. Pipe-Liners, Ltd., 2012 WL 4793499 (N.D. Ill. Oct. 9, 2012) Judge Dow ruled in the same manner.

In this trilogy, the federal courts found that the lenders had no present rights in their collateral because they had not taken any steps to exercise their rights as secured creditors. Consequently, the judgment lien creditor, who ordinarily would have been subordinate in priority to the prior-filed secured creditor, had superior rights in the collateral – a deposit account. See, One CW, LLC v. Cartridge World North America, LLC, 661 F. Supp.2d 931, 935 (N.D. Ill. 2009) (Holderman, D.J.). The basis for these holdings was the language in the security agreements, which stated that the secured creditor “only takes on the rights of a secured creditor under the UCC after a default occurs.” On the other hand, if the security agreement contains no preconditions or qualifications regarding the security interest being limited in the absence of an event of default, the secured creditor may be able to overcome a waiver argument. See, West Bend Mutual Insurance Company v. Belmont State Corp. 2010 WL 5419061 (N.D. Ill. 2010).

One approach a secured party may consider if it chooses not to take action is to enter into a forbearance agreement in which the debtor acknowledges the default and a timetable is prescribed that addresses the circumstances that will occur if additional defaults occur. A forbearance agreement allows the secured party to formalize its orderly management of a default occurrence, and such an arrangement would probably constitute “affirmative remedial action” to avoid a waiver argument posed by some third party under One CW, LLC v. Cartridge World North America, LLC.

These cases demonstrate that secured parties must be vigilant, carefully monitor their collateral and consider taking appropriate action toward collateral, especially following an event of default.

Frank Buckley Jr. is a member of Thompson Coburn's Financial Restructuring Group.