REAL ESTATE LAW AND PRACTICE Course Handbook Series Number N-652 Commercial Real Estate Financing 2017 Co-Chairs Steven R. Davidson Joshua Stein Everett S. Ward To order this book, call (800) 260-4PLI or fax us at (800) 321-0093. Ask our Customer Service Department for PLI Order Number 185886, Dept. BAV5. Practising Law Institute 1177 Avenue of the Americas New York, New York 10036
13 The Uniform Commercial Code for Dirt Lawyers R. Marshall Grodner McGlinchey Stafford PLLC R. Marshall Grodner is a member of McGlinchey Stafford PLLC resident in its Baton Rouge, Louisiana office. Marshall can be emailed at mgrodner@mcglinchey.com. He is a fellow in the American College of Real Estate Lawyers and the American College of Commercial Finance Attorneys. Marshall is also the Vice Chair of the Commercial Finance Committee of the Business Law Section of the American Bar Association and the Vice President of the Association of Commercial Finance Attorneys. For more information about Marshall see http://www.mcglinchey.com/r-marshall-grodner/. R. Marshall Grodner 2017 If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written. 337
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INTRODUCTION One aspect of real estate financing with which many real estate practitioners are unfamiliar is the intersection of real estate law and the Uniform Commercial Code (the UCC ). 2 This article is a brief overview of the provisions of the UCC, particularly those provisions that are customarily encountered in the area of real estate finance. I. TERMINOLOGY There are several terms with which the real estate practitioner need to be familiar in order to enter the world of the UCC. These definitions include the parties, the categories of collateral and some miscellaneous definitions. A. The Parties There are several parties to which reference is made in the UCC. These include debtor, obligor and secondary obligor. A debtor is the person granting a security interest in the collateral. 3 It is important to note that the debtor under the UCC is not necessarily the obligor on the obligation secured. An obligor is the person who owes the principal obligation secured by the security interest. 4 The debtor and the obligor, however, can be the same person. The secured party is the person to whom a security interest is granted. 5 A secondary obligor is generally a guarantor. 6 B. Collateral Collateral is defined as the property subject to the security interest. 7 It is important to distinguish the various categories of collateral under the UCC. Important categories in real estate finance are as follows: 1. Accounts generally arise from the provision of goods or services on credit. 8 2. References to the UCC used in this article are as published by the Legal Information Institute, Cornell University Law School at https://www.law.cornell.edu/ ucc. Note there are state by state variations to the UCC, so the applicable state s version of the UCC should be consulted. 3. UCC 9-102(a)(28). 4. UCC 9-102(a)(59). 5. UCC 9-102(a)(73). 6. UCC 9-102(a)(72) 7. UCC 9-102(a)(12). 3 339
2. Deposit Accounts are accounts maintained with a bank. 9 3. Investment Property is an uncertificated or certificated security, a securities entitlement or securities account. 4. Goods are basically tangible personal property. Goods include equipment and inventory. 10 Inventory are goods held for sale or lease. 11 Equipment is the residual category and are goods that are not inventory, farm products or consumer goods. 12 5. General Intangibles are any other type of personal property covered by Article 9 that are not otherwise defined. It is the residual category. General intangibles, include rights under contracts, licenses and permits, etc. 13 6. Payment Intangibles are general intangibles in which the principal obligation is a payment obligation. 14 7. Fixtures are goods that are so related to real estate that an interest in them arise under real estate law. 15 II. SCOPE OF ARTICLE 9 Generally, Article 9 applies to any transaction that creates a security interest in personal property or fixtures by contract. It also applies to the sale of accounts, chattel paper, payment intangibles or promissory notes. An important exception is the creation or transfer of an interest in or lien or real property. 16 III. ATTACHMENT AND PERFECTION There are several important concepts dealing with collateral under the UCC. These concepts include attachment and perfection. Attachment generally makes the security interest enforceable between the debtor and 8. UCC 9-102(a)(2). 9. UCC 9-102(a)(29). 10. UCC 9-102(a)(44). 11. UCC 9-102(a)(48). 12. UCC 9-102(a)(33). 13. UCC 9-102(a)(42). 14. UCC 9-102(a)(61). 15. UCC 9-102(a)(41). 16. UCC 9-109. 4 340
secured party. Perfection makes the security interest enforceable as to third parties. A. Attachment Generally, attachment requires: (i) value be given; and (ii) the debtor has rights in the collateral or the power to transfer the collateral. Also required are either (i) an authenticated security agreement containing a description of the collateral, (ii) possession of tangible personal property or certificated securities pursuant to an agreement, or (ii) control of deposit accounts or investment property pursuant to the debtor s security agreement. 17 It is important to note that a description in a security agreement is required to be by specific listing, category, or a type of collateral defined in the UCC. 18 B. Perfection For the most part, perfection in all types of collateral can be accomplished by filing a financing statement. 19 The principal exceptions in the real estate financing arena are deposit accounts and certificated securities. 20 1. Financing Statements There are two important concepts regarding financing statements. There first is the content of the financing statement, and the second is where to file the financing statement. a) Contents of Financing Statement A financing statement is required to contain the name of the debtor, the name of the secured party or its representative and an indication of the collateral. 21 In addition, if the financing statement covers fixtures, then it must indicate it covers fixtures and that it is to be filed in the real property records, provide a description of the real property, and, if the debtor does not have a record interest in the real property, provide 17. UCC 9-203. 18. UCC 9-108. 19. UCC 9-310(a). 20. UCC 9-310(b); 9-312(b)(1). 21. UCC 9-502(a). 5 341
the name of a record owner. 22 Generally, a mortgage can also be a fixture filing if it meets certain requirements. 23 There are some specific requirements regarding debtors names and descriptions of collateral in financing statements. Generally, most debtors are registered organizations. A registered organization is an entity whose existence requires the filing of a public organic record with a state or the United States. 24 Registered organizations include corporations, limited partnerships, limited liability companies and most statutory trusts. The name of the debtor as to registered organizations is sufficient if the name is the registered organizations name on the public organic record most recently filed in the applicable jurisdiction. The use of a trade name alone is not a sufficient name. 25 There is a safe harbor for minor errors in debtors names. If a UCC search under the correct name of the debtor reveals the financing statement, the name of the debtor is not seriously misleading, and therefore, the financing statement is sufficient as to the name of the debtor. 26 The collateral description is sufficient if it meets the requirements for a security agreement. 27 Unlike a security agreement, a financing statement can contain a more generic description such as all assets or all personal property. 28 b) Where to file a financing statement Now the financing statement is appropriately filled, where do you file it? The UCC explains that the effect of perfection or non-perfection is governed by the law of the jurisdiction where the debtor is located. 29 Despite this round-about way of getting to where to file, the straight forward answer is that a financing statement is filed in jurisdiction where the debtor is located. An individual debtor is located at the individual s 22. UCC 9-502(b). A standard national form financing statement is contained in UCC 9-521. 23. UCC 9-502(c). 24. UCC 9-102(a)(71). There are specific rules for individual debtor names, but these rules are outside the scope of this article. 25. UCC 9-503(c). 26. UCC 9-506(c). 27. UCC 9-504(1). 28. UCC 9-504(1). 29. UCC 9-301(a). 6 342
principal residence. 30 An organization (not a registered organization) is located at its principal place of business, if it has only one, or at its chief executive office, if it has more than one principal place of business. 31 Most importantly, a registered organization is located in the state of its formation. 32 An important exception to the general rule is fixtures. A fixture filing is made in the real property records of the local jurisdiction. 33 2. Control Collateral An important exception in the real estate financing context to perfection by filing is a security interest in deposit accounts, such as operating accounts, accounts containing proceeds of leases and rents, and accounts containing reserves. A security interest in deposit accounts can only be perfected by control. 34 There are three way for a secured party to obtain control of a deposit account. The first is if the secured party is the depository bank, it has automatic control. 35 Second, and the most common, the debtor, the secured party and the depository bank must into an agreement providing that the depository bank will comply with the instructions of the secured party as to disposition of the funds in the account without further consent of the debtor. 36 This document is commonly called a deposit account control agreement. 37 The last method to obtain control is by the secured party becoming the depository bank s customer as to the deposit account. 38 Although a security interest in investment property, including ownership interests in corporations, can be perfected by filing, a security interest in investment property can also be perfected by 30. UCC 9-307(b)(1). 31. UCC 9-307(b)(2) and (3). 32. UCC 9-307(e). 33. UCC 9-301(3)(A). 34. UCC 9-312(b)(1). 35. UCC 9-104(a)(1). 36. UCC 9-104(a)(2). 37. For more on deposit account control agreements see the reports and forms promulgated by the Joint Task Force on Deposit Account Control Agreement, Business Law Section, American Bar Association. These reports and forms can be found here: http://apps.americanbar.org/dch/committee.cfm?com=cl710060&ct=b6a1c59b427 a3ca6a9875906d10d1750bdc8fec875157a92a1fd67c2a8c034db8c33cd5258679cd fa5fb90c2a1ad944306d47e409d4e51e68a88c140891e56f7. 38. 7 343
control. Control can be important in the real estate financing context where a mezzanine lender only security is the parent company s equity interest in the special purpose entity that owns the real estate. Before discussing how to obtain control of investment property, it is important to point out what is included and is not included in the definition of investment property. Investment property is a security, security entitlement or securities account under Article 8 of the UCC. 39 Generally a security is an equity interest represented by a certificate or a book entry which is divisible into a class or series of interest and is or is a type dealt in or traded on securities exchanges. 40 It is important to note that equity interests of a limited liability company or a limited partnership, as opposed to a corporation, may not be of a type dealt with on securities exchanges. 41 There is, however, and opt-in provision in Article 8. A membership interest in an LLC may become a security if the LLC elects to make its equity interests a security for purposes of Article 8. 42 This opt-in provision becomes important for purposes of priority as discussed below. To obtain control of investment property, there are several different methods depending on the type of investment property. For certificated securities, i.e. those represented by a certificate, delivery is all that is necessary for control if it is in bearer form. 43 If the certificated security is in registered form, then control can be obtained by delivery with any necessary indorsement or by becoming the registered owner listed on the certificate. 44 For uncertificated securities, a secured party has control if it becomes registered owner on the books and records of the issuer or if the issuer has agreed that it will comply with instruction of the secured party without further consent of the debtor. 45 For securities entitlements (brokerage accounts), the secured party has control if it becomes the named owner of the securities account or if the security intermediary (i.e. the broker) agrees to comply with entitlement orders originated by the secured party without further consent of the 39. UCC 9-102(a)(49). 40. UCC 8-102(b)(15). 41. UCC 9-103(c). 42. UCC 8-102(b)(15)(iii)(B);. 43. UCC 8-106(a) 44. UCC 8-106(b) 45. UCC 8-106(c); 8-301. 8 344
debtor. 46 Usually, the latter is documented by a securities account control agreement. 47 3. Perfection by Possession Another important category of collateral in the real estate financing context is instruments, particularly those instruments secured by a mortgage. An instrument is a negotiable instrument or a written promise to pay, that does not contain a security agreement or a lease, including promissory notes. 48 A promissory note is an instrument that is not check, draft or certificate of deposit. 49 Article 9 applies not only to instruments as collateral, but also to sales of promissory notes. 50 So an assignment of a promissory note secured by a mortgage is governed by Article 9. Another important point is that the mortgage follows the promissory note under the rules of Article 9. 51 A security interest or sale of an instrument can be perfected by filing. 52 Perfection in an instrument can also be perfected by possession. 53 The differences between the methods of perfection can be important as to priority. 4. Automatic Perfection Another method of perfection is called automatic perfection. Automatic perfection takes place when a security interest is automatically perfected upon attachment without anything further needing to be done. One particularly important type of collateral for real 46. UCC 8-106(d). 47. A securities account control agreement is similar to a deposit account control agreements. Sometimes it is difficult to distinguish between a securities account and a deposit account. 48. UCC 9-102(a)(47) and (65). It is important to note three things. First, instruments include not only negotiable instruments, but also non-negotiable instruments to the extent the definition is met. An instrument, also, must be a writing it cannot be in electronic form. Last, if the writing contains a security agreement, such as a security interest in deposit accounts held by the payee (as many pre-printed/computer generated forms do), then it is not an instrument. If it is not an instrument, it is probably a payment intangible. See discussion of payment intangibles in Section III(b)(4) below. 49. UCC 9-102(a)(65). 50. UCC 9-109(a)(3). 51. UCC 9-308(e). 52. UCC 9-312(a). 53. UCC 9-313(a). 9 345
estate financing is payment intangibles. In this context, a participation interest in a loan is a payment intangible for purposes of the UCC, unless represented by an instrument. Also important is that Article 9 applies to sales of payment intangibles. Therefore, when a participant purchases a participation interest, it must perfect its interest under Article 9. Luckily, Article 9 provides that sales of payment intangibles are perfected upon attachment. 54 5. Fixture Priority The general rule as to priority in fixtures is that a security interest in fixtures is subordinate to a prior conflicting interest of a mortgagee or owner of the related real property. There are certain limited exceptions. The most important is purchase money priority. If the security interest is a purchase money security interest, 55 and the security interest is perfected before the goods become fixtures, in will out-rank a conflicting interest in the real property. 56 C. Priority; Diligence The next issue important in the real estate financing area is determining whether a secured party s security interest has priority over other security interests. The main priority rule is a temporal rule and provides that the first to file or perfect takes priority over subsequent filed or perfected security interests. 57 This is the first to file rule. So if you are relying on the first to file rule for priority, you need to do a UCC search to determine if there are any prior conflicting security interests of record and obtain a termination or other agreement with the prior secured party to assure your interest is protected. 58 There are numerous exceptions to this first to file rule providing for non-temporal perfection. The two most important exceptions in the real estate financing context deal with instruments and certificated securities. For instruments, a secured party or purchaser who has possession of the instrument for value and in good faith takes priority over any other secured party perfected by a method other than possession, such as filing, even if the filing of the financing statement is 54. UCC 9-309(3). 55. See UCC 9-103. 56. UCC 9-334(d). 57. UCC 9-322(a)(1). 58. See discussion of subordinations and intercreditor agreements in Section IV(A) below. 10 346
prior in time to the possessory purchaser. 59 So when purchasing an instrument secured by a mortgage, the purchaser should take possession of the instrument to ensure this non-temporal priority. A similar non-temporal rule applies to investment property. A person having control of investment property takes priority over a person perfected in another manner, for example filing. 60 This fact is important in mezzanine financing in the real estate context. Usually, the mezzanine lender s only or main security is the parent s interest in the owner of the real estate, usually a special purpose entity. If the mezzanine lender has control of the shares, it will take priority over any other secured party perfected by filing. Where the special purpose entity is a corporation, usually obtaining control is easy, particularly if the shares are certificated. Remember, however, that an equity interest in a limited liability company or a limited partnership is most likely a general intangible. In this case, a mezzanine lender should require that the entity opt-in to Article 8 so that the equity interest becomes a security in which a security interest can be perfected by control to take priority over any other perfection method. 61 Another step that should be taken is to make the interest a certificated security so that control can be obtained by delivery to the secured party with any necessary indorsement. 62 IV. MISCELLANEOUS There are several other issues that arise in the intersection of the UCC and real estate finance. These include where there are two lenders, one lending based on the fixed assets and the other lending on the accounts and inventory. Also, there may be issues regarding restrictions on transfers of collateral, proceeds and letter of credit rights. A. Multi-lender Transactions A relatively common scenario is that one lender makes a term loan on fixed assets, including real estate and equipment, and another lender makes a revolving facility available based on inventory and accounts. These parties will need to establish their relative priorities as to the security interests in the personal property. The UCC allows 59. UCC 9-330(d). 60. UCC 9-328(2). 61. UCC 8-102(a)(15)((iii)(B); 9-328(1). 62. UCC 8-106(a) and (b)(1). 11 347
a secured party to subordinate consensually its security interest. 63 Usually, the parties enter into an intercreditor agreement to establish the relative priorities among other matters. 64 B. Proceeds A security interest in collateral also includes proceeds of that collateral. 65 Proceeds are whatever is obtained on the disposition of collateral, rights arising out of the collateral and insurance proceeds. 66 Priority as to the original collateral is the priority as to cash proceeds of the original collateral. 67 C. Restrictions on Transfer Many types of collateral, including contracts and licenses, contain restrictions on transfer. Real estate lenders often require assignments of the contracts and licenses. These assignments are governed by the UCC since they are intended as security. For contracts, such as construction contracts or franchise agreements, a modification of the underlying contract is effective against the assignee if made in good faith. 68 Second, the underlying contract or license may contain a restriction on assignment. Under the UCC, a term that limits the assignment of a contract, permit, license or franchise to the extent it would impair the attachment or perfection of a security interest. 69 Such a term is also ineffective to the extent it creates a default or right to terminate the underlying general intangible. 70 The same rules apply to legal restrictions and legal consent requirements on assignment, including those restrictions created by statutes, rules or regulations. 71 Although the restrictions contained in the terms of the underlying contract or 63. UCC 9-339. 64. For more on intercreditor agreements, see Committee on Commercial Finance, Report of the Model First/Lien Second Lien Intercreditor Agreement Task Force, 65 The Business Lawyer 810 (May 2010). It can be found here: http://apps. americanbar.org/dch/committee.cfm?com=cl190029&ct=9061c46f122534221688 28a99603de377d6ae039d6052fa64457d3a5f3da484712fa6d0ce84cec83fc9d102a6 e96b2895ce03268e351c16deacd307599115992. 65. UCC 9-315(a)(2). 66. UCC 9-102(a)(64). 67. UCC 9-322(c)(2). 68. UCC 9-405. 69. UCC 9-408(a)(1). 70. UCC 9-408(a)(2) 71. UCC 9-408(c). 12 348
applicable law are ineffective in certain circumstances, the assignee/ secured party does have the right to use the assigned rights or enforce the security interest. 72 What the UCC does do, however, is to give the assignee priority over subsequently filed security interests and in the proceeds of the sale of the assigned interest, including priority over a trustee in bankruptcy. D. Letter of Credit Rights In many cases, lessors require a letter of credit as a security deposit. Most real estate lenders will want to get a security interest in the payment rights under the letters of credit. A secured party can obtain this security interest by control. 73 A secured party has control if the issuer of the letter of credit consents to the assignment of the proceeds of the letter of credit. 74 CONCLUSION This article is a brief overview of the provisions of the UCC that might affect real estate financing transactions. The actual application of the UCC to various transactions can be complicated. Also, there are variations to the UCC is each applicable state that should be consulted in each particular transaction. 72. UCC 9-408(d). 73. UCC 9-107. 74. Id. See also, UCC 5-114(c). 13 349
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