Protecting Your Right to Get Paid Vol. 2: Filing Security Interests

June 21, 2022 by Leave a comment

In my last post, I discussed the value of establishing a security interest to protect your right to get paid when you extend credit terms.  In this post I will discuss how to establish a security interest when you sell an aircraft part (and in my next post I will discuss how to establish a security interest in aviation maintenance transactions). I also discuss the concept of perfection, which helps to give your lien priority over other later-filed liens.

The typical security interest is reflected by two documents.  The first document is called the security agreement.  The second document is called the financing statement.  In addition to these two documents you generally need to think about how you will “perfect” the security interest. 

Security Agreement

A security agreement is the record that describes the relationship that gives rise to the security interest. It can be a stand-alone agreement or it can be part of a larger agreement (like a sales agreement). A conditional sales contract can be one form of a security agreement. In order to have a valid security agreement, you typically need to include:

  • A description of the asset that is secured by the Agreement (a “reasonable identification” sufficient to allow others to identify the collateral)
  • A signature or other authentication from the debtor (to confirm the Agreement)

In order to support a security agreement, there should be an exchange of value (known as “consideration”) and also the debtor should have the right to grant a lien in the asset (this includes the rights obtained through a purchase of the asset, even though the purchase is conditioned on the security agreement). One example of how this works is if a buyer purchases on credit, and signs a sales agreement that includes a security agreement, then the buyer’s promise to pay is part of the consideration, and the buyer’s acceptance of the asset gives the buyer the power to grant a lien against the title to the asset.

Most security agreements are going to be far more complicated than these simple bullets, above. Typical feature of the security agreement will often include:

  • Identification of the parties to the transaction (who is the debtor and who is the creditor)
  • The amount that is secured
  • Payment terms
  • Terms of default (e.g. when can the creditor foreclose)
  • Remedies in the event of default
  • Potential limits on what the debtor can do with the asset before it is fully-paid

The FAA has a template for an Aircraft Security Agreement when a security interest or other lien is established against an aircraft.

Financing Statement

A financing statement is used for giving the world notice of your security interest; as a consequence it will look a little bit like a summary of the key points in your security agreement.  A typical financing statement must include the following three elements at a minimum:

  • the name of the debtor;
  • the name of the secured party (generally, the creditor); and
  • the identification of the asset (collateral) covered by the financing statement.

Because the purpose of the financing statement is to provide notice of a security agreement, it allows such a notice to be provided without disclosing all of the elements of the security agreement.

There is a standard form for financing statements called a UCC-1. It is published in the Uniform Commercial Code and thus appears in the state versions of the Uniform Commercial Code.

Filing for Perfection

The terms of the security agreement will typically apply to the parties to that Agreement. But how do we make sure that it provides the creditor with priority against other creditors?

There is a concept in secured transaction law called “perfection.” The concept of perfection is that you need to do something in order to secure your rights relative to the rest of the world. Perfecting your lien typically give you priority against other lien holders who might perfect their liens at a later date.

It is normal to file a financing statement to perfect a lien. One important exception is that if you seek to perfect a lien by filing it with the FAA, then you will file the security agreement instead of the financing statement.

If you fail to perfect your lien then other lien holders who perfect their liens may take a priority over your rights, which means that in the event of a cash disposition of the collateral (like a judicial sale / auction), the other lien-holders with priority get their money first from the cash disposition proceeds.

Most normal rules to follow on how to accomplish perfection of a lien will be found in the state law of the state where the asset (collateral) can be found. So if the asset is added to an inventory in Florida, then Florida law typically applies. Although the Uniform Commercial Code helps to standardize commercial law, the specifics of perfection nonetheless vary from state to state.

Where Do You File?

Where to file can be a complicated question, especially in aviation. It is a question that is going to be based on state law. States can have different requirements about where and how to file and you need to identify the state whose law applies to the collateral.

Federal law can also influence filing requirements. Liens against aircraft, and certain engines and propellers, are filed with the FAA Registry Office in Oklahoma City. There are some state laws that specifically allow you to claim a lien in an aircraft if you furnish goods or services for that aircraft, so this may allow some parts sales transactions to yield a lien against the aircraft (but such a lien would likely be junior to other previous-perfected liens). If you establish a lien against an aircraft then you definitely want to file it with the FAA Registry to perfect it.

Some state laws can also require simultaneous filing with the state. The purpose of the federal registry was to preempt state filing laws, but state laws affecting the underlying validity of a lien will tend to be applied. If there is a state law requiring filing then you may want to follow both the state law and federal law in your filing practices, especially if past case law has been inconsistent in your jurisdiction. This is particularly true in cases of aircraft parts.

When it comes to aircraft parts, there are laws that permit some transactions (like transactions in air carrier parts) to be filed with the FAA registry. This can be found in federal laws and regulations, and you can find corollary requirements for federal filing in the laws of some states. Case law has even explained that if the collateral for a security agreement consists of “spare parts maintained by or on behalf of a certificated air carrier” then the security agreement must be filed with the FAA in order for the lien to be perfected. In re Avair, Inc., 98 B.R. 261 (Bankr. W.D. Va. 1988). The problem is that as a practical matter, the FAA Registry will not accept a filing of a lien in one or more discrete aircraft parts. Some courts have chosen to ignore this fact, and declared that federal filing for spare parts is nonetheless a necessity. It appears that filing the lien with the federal government (even if the filing is rejected) may be sufficient in some transactions but a state filing for a spare parts lien is probably a good idea (in many states) to ensure your lien perfection is recognized.

Failure to properly perfect the lien can mean that other (perfected) liens take priority over your lien. It can also mean that your non-perfected lien might be avoided by a bankruptcy trustee (treated as if there was no lien at all). For this reason it makes sense to work with an attorney to identify the sort of transactions that you want to secure, and to identify the compliance path for securing those transactions.

When the Security Interest Has Been Paid

Most states (and the FAA’s registry, too) have rules that say that when the lien has been paid, you must file a release statement expressing this full payment with the filing office. This action shows the world that the previously-filed security interest has been satisfied and no longer affects the title to the asset.

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Steps to Perfection: Security in a Time of Insolvency

June 12, 2020 by 1 Comment

Last week we had a brief overview of some bankruptcy issues and talked about the some of the risks presented by bankruptcy filings in these uncertain times. Today we are going to expand on ways to mitigate some of those risks when we aren’t in a position to demand and receive cash in exchange for goods.

The most important step to take to ensure you are protected against the risks of an insolvent customer is to attach and perfect a security interest in the goods sold to the customer. A security interest in the goods you sold on credit helps you to get paid first (before unsecured creditors, shareholders, and others, who often get nothing) in the event your customer enters bankruptcy.

Many companies are good at attaching a security interest to goods sold on credit by including terms that state the buyer grants the seller a security interest in the goods sold to secure the purchase price. If your sales agreements do not include such a provision you should work with a lawyer to make sure that they do.

An attached security interest on its own, however, has little effect in truly securing you as the seller (and more importantly, as creditor). In order to be effective, a security interest must be perfected. A perfected security interest gives notice to the world that you have a security interest in the particular goods so that others who may attempt to attach a security interest later know that they are behind you in priority.

Let’s drill down a bit deeper on the ideas of “attachment” and “perfection.”

Attachment

The Uniform Commercial Code (UCC) provides that “[a] security interest attaches to collateral when it becomes enforceable against the debtor with respect to the collateral . . . .” (UCC § 9-203). The debtor in this case is your customer. The UCC goes on to explain what it means for a security interest to become “enforceable.” (We have limited the text to be relevant for our purposes, because some very specific things, like descriptions of timber to be cut, simply don’t apply!)

Under the UCC, “a security interest is enforceable against the debtor and third parties with respect to the collateral only if:”

(1) value has been given

In this case, the goods sold in exchange for the promise to pay the purchase price in the future—for instance on net 30 terms—is value given.

(2) the debtor has rights in the collateral or the power to transfer rights in the collateral to a secured party

Here, the debtor (your customer) gains the rights in the collateral and power to transfer rights when they receive the goods.

And finally, (3) one of the following conditions is met (only one is applicable for the purposes of this discussion):

(A) the debtor has authenticated a security agreement that provides a description of the collateral

A security agreement is any agreement that provides a security interest, for instance our sales agreement (with appropriate terms, as mentioned above). To authenticate the agreement, the debtor (customer) merely needs to sign it (or otherwise accept the record through electronic sound, symbol, or process). The security agreement must also provide a reasonably detailed description of the collateral. The part number, nomenclature, and quantity that appears on our documentation is an example of a reasonably detailed description.

Although verbose, the process of attaching a security interest is relatively straight forward and many or most of you may be doing it now. You should review the terms and conditions that appear on your quotes, confirmations, invoices, and other sales documents to be sure. If there are questions, remember to consult your attorney.

Perfection

Merely attaching a security interest, though, is not enough to protect you. In fact, an attached security interest without more provides little security indeed. In order to protect your interests, you must perfect the security interest. This gives notice to others that you have a security interest (in the form of a lien) against the goods. That way if they attempt to attach their own security interest to the goods or other assets to protect their extension of credit (for instance in the form of a loan), they know that they are behind you in order of priority with respect to those goods. (We’ll have more to say about priority in our next post—sometimes a previous secured lender like a bank may have priority for even newly acquired goods).

The exact details of perfecting a security interest are a matter of state law, but in general the primary method of perfecting a security interest is by filing a financing statement with the relevant public office—usually the Secretary of State. The UCC specifies the elements required in a financing statement in § 9-502:

  • The name of the debtor
  • The name of the secured party
  • An indication of the collateral

Typically, you can use as your financing statement a Form UCC-1, which is a standardized form that is widely available online, often via the very state agency with which it must be filed.

The most important thing to note in completing the financing statement is that the name of the debtor (your customer) must be precise. The UCC explains that it should be the name that is listed on the company’s most recently filed document in its jurisdiction of registration. (See UCC § 9-503). Put another way, the debtor name on the financing statement should be the most up-to-date name of the organization as filed in its state of incorporation. This level or precision is necessary because the financing statement is recorded under the debtor’s name and it must be of sufficient detail to put other potential secured parties on notice.

The secured party’s name is more straight forward (your company) and the indication of the collateral can be the same as appeared on the security agreement we discussed above, for instance, part number, nomenclature, and quantity.

The financing statement is generally filed where the debtor is incorporated, so make sure you are identifying the appropriate jurisdiction’s requirements. You can often kill two birds with one stone because the Secretary of State is typically where the financing statement is filed (and can be found) and you should also be going there to identify the correct name of the debtor for the financing statement anyway. As always, if you have any questions, you should consult an attorney.

As a secured creditor you can have confidence you will get paid (at least in part) even if a company becomes insolvent, because the liquidated assets of an insolvent company are first used to pay secured creditors. Specifically, the money raised from the liquidation of your secured goods is used to pay your security interest. This also applies to proceeds from those goods when the proceeds are directly identifiable. Creditors with no security are often left hoping for a share of what little is left after the secured creditors are paid.

Attaching and perfecting a security interest in goods sold is a valuable risk mitigation strategy. While it may not be as relevant when the economy is hot, when the economy gets rocky and the industry sees upheaval it is an important way to protect yourself against the unpredictability of the global aviation market.

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