Recent Challenges to Perfection and Protection of Security Interests

Two recent decisions by the United States Bankruptcy Court for the Central District of Illinois raise serious concerns for many financial institutions and lenders related to the perfection of security interests in their collateral. Currently, these two decisions are only controlling in the Central District of Illinois. However, if these decisions are upheld on appeal, borrowers and other third parties, such as bankruptcy trustees and subsequent purchasers, may have acquired a useful albeit unexpected asset to contest the perfection of security interests in Illinois.

In January 2012, the Bankruptcy Court for the Central District of Illinois upheld a debtor’s challenge to a lender’s financing statement by finding that Section 9-503 of the Illinois Uniform Commercial Code requires a financing statement to contain the debtor’s legal name in order to perfect a security interest. In In re Miller, the financing statement was filed by the lender under the debtor’s commonly used name, “Bennie A. Miller” and not his legal name, “Ben Miller.” Although the debtor’s driver’s license, social security card, Capital One credit card, and federal income tax returns all used the name “Bennie Miller”, the debtor’s birth certificate, however, listed his name as Ben Miller. A UCC lien search for “Ben Miller,” using the Illinois Secretary of State’s standard logic search, did not disclose the Bank’s financing statement. According to the Court, if a search of the debtor’s legal name using the Illinois Secretary of State’s standard search logic does not disclose the financing statement (because it was filed under a different name or variation of that name), then that financing statement is “seriously misleading” and subject to avoidance under the Bankruptcy Code. For this reason, the Court ruled that the Bank’s financing statement, filed under the name “Bennie A. Miller”, failed to perfect a security interest in the debtor’s assets.

Four months later, the same court, in In re Crane, found that recorded mortgages that do not include all the elements found in Section 11 of the Illinois Conveyances Act (765 ILCS 5/11) — including the amount of indebtedness, the maturity date and the underlying interest rate in the promissory note – fail to provide constructive notice of the lien and, thus, can be avoided by either a bankruptcy trustee or subsequent bona fide purchaser. Section 11 of the Illinois Conveyance Act states in pertinent part: Mortgages of lands may be substantially in the following form: The Mortgagor (here insert name or names), mortgages and warrants to (here insert name or names of mortgagee or mortgagees), to secure the payment of (here recite the nature and amount of indebtedness, showing when due and the rate of interest, and whether secured by note or otherwise), the following described real estate (here insert description thereof), situated in the County of …., in the State of Illinois. Dated (insert date).

In the Crane case, the recorded mortgage documents failed to identify the interest rate and the maturity date of the promissory note. The Court ruled that the provisions of Section 11 of the Illinois Conveyances Act are not permissive, but rather mandatory (despite the fact that the statute uses the word “may” rather than “shall”). Accordingly, in order for a mortgage to provide constructive notice to a bona fide purchaser or a trustee in bankruptcy, the recorded mortgage documents must include the elements listed in Section 11 of the Illinois Conveyance Act. Although the Court found that the mortgages were effective between the debtors and the lender, the mortgages did not provide constructive notice to the bankruptcy trustee or subsequent bona fide purchasers due to the failure to include the interest rate and maturity date in accordance with Section 11 of the Illinois Conveyance Act. As a result, the Court ruled that (i) the bankruptcy trustee was allowed to avoid the lender’s liens on the real estate, (ii) the real estate was to be preserved for the benefit of the debtors’ bankruptcy estate, and (iii) the lender’s lien was avoidable as to unsecured creditors.

Even though both of the above decisions are currently being appealed and there is pending legislation to address these decisions, lenders and financial institutions should understand that the perfection of their security interests may be challenged if they failed to strictly comply with Section 11 of the Illinois Conveyance Act and the Uniform Commercial Code. Lenders and financial institutions should consider taking the necessary steps, in light of the above decisions, to address and remedy any deficiencies that may exist in their documentation in order to adequately perfect and protect their security interest in collateral.

If you would like to discuss the significance of these cases in greater detail or would like to discuss methods to remedy any such deficiencies, please feel free to contact us.

We are pleased to announce that Saskia Nora Bryan was made Partner in the Commercial Litigation Group, Puneet Cham has joined the firm as a Partner in the Wealth Management Group and Chad Poznansky has joined the firm as an Associate in the Real Estate Group. If you would like to speak with Saskia, Puneet, Chad or any other attorney at our office, please do not hesitate to contact us.