In In re Jarvis, Case No. 19-10085; the U.S. Bankruptcy Court for the Western District of North Carolina determined that the grant of a security interest to a corporate lender will not necessarily "spread" that security interest to the lender’s affiliates. This decision underscores the need for precision and care in the drafting of loan documents, particularly with respect to the granting language contained in security agreements.

Background

Jacob D. Jarvis obtained a $17,000 loan from Strategic Funding Source, Inc. on Oct. 6, 2015 and, in connection therewith, granted Strategic a security interest in certain of its assets, including all accounts, documents, equipment, inventory and general intangibles. Two days later, Strategic, through its representative, Corporation Services Co., filed a UCC-1 financing statement to perfect Strategic’s security interest. The financing statement listed only Corporation Services Co. as the secured party, and did not reference Strategic or any of Strategic’s affiliates (indeed, pursuant to the Uniform Commercial Code, an agent or other representative of the principal/secured party may file a financing statement in its own name, with the effect of perfecting the security interest of the unnamed principal in the collateral. See UCC Section 9-503(d)). Jarvis paid Strategic’s loan in full in February 2016.

Thereafter, on Feb. 20, 2018, Jarvis obtained two additional loans from Money Works Direct, a wholly-owned subsidiary of Strategic. Money Works and Jarvis entered into separate security agreements for these loans, both of which contained language granting Money Works a security interest in certain of Jarvis’s assets. In pertinent part, the security agreements provided as follows: "To secure … obligations to … its affiliates … Mr. Jarvis hereby grants to Money Works a security interest …"

The bankruptcy court noted that Money Works failed to file a UCC-1 financing statement covering either of these agreements. In addition, Strategic did not assign its own financing statement to Money Works, nor did it amend its financing statement to name Money Works as a secured party.

On March 11, 2019, Jarvis filed for bankruptcy protection pursuant to Chapter 13 of the Bankruptcy Code, and listed Money Works as an unsecured claimant on his schedules and statements. The servicer on the Money Works loan, however, filed a proof of claim asserting a secured claim on account of the loan extended by Money Works to Jarvis. Ultimately, Jarvis objected to this claim, arguing that the debt should be treated as unsecured because Money Works had failed to file a financing statement evidencing the security interest that Jarvis had granted it. Money Works, in response, asserted that the filing of a financing statement was unnecessary because of the UCC-1 financing statement previously filed by Strategic. It argued that Strategic and Money Works were part of an "investment syndicate," Strategic was the lead syndicate, and Strategic had invested its own funds in all three transactions. Money Works concluded that, because it was a wholly-owned subsidiary of Strategic, the secured parties were "all the same" and Strategic, not Money Works, was actually the lender/secured party under the Money Works security agreements.

In furtherance of its argument, Money Works pointed to the language of the security agreements which referenced Mr. Jarvis’s indebtedness to Money Works "and its affiliates." That language, it argued, sufficed to elevate Strategic (as the "actual" lender) to the status of a secured lender. Consequently, because Strategic had filed a UCC-1 financing statement, Money Works urged that the debt in question be deemed one subject to a perfected security interest.

Opinion of the Bankruptcy Court

The issue addressed by the bankruptcy court was whether the claim in question should be treated as a secured or an unsecured claim. In analyzing the nature of the claim and the property interests claimed by Money Works, the bankruptcy court looked to Virginia state law, which was the governing law written into the security documents. Under Virginia’s version of the Uniform Commercial Code, a security interest is subordinate to the rights of a party that becomes a lien creditor before perfection of the security interest. As the Bankruptcy Code provides that a bankruptcy trustee is granted the status of a hypothetical lien creditor in all of the debtor’s property as of the debtor’s bankruptcy petition date, the court reasoned that if the Money Works security interests were not perfected as of the petition date, the bankruptcy trustee’s interest would supersede Money Works’s interest and the claim would consequently be treated as unsecured.

Upon reviewing the Money Works security agreements, the bankruptcy court found that the agreements conveyed security interests exclusively to Money Works, and did not grant security interests to Strategic or any other affiliate of Money Works. Relying on Adirondack Timber, Case No. 08-12553, (Bankr. N.D.N.Y. Apr 28, 2010) the court noted that "a security agreement executed solely between a debtor and creditor does not grant an affiliate of the creditor a security interest in the collateral." The bankruptcy court referred to the specific language of the Money Works security agreement: that language granted a security interest to Money Works alone for Jarvis’ indebtedness to Money Works or any affiliate of Money Works. Quoting from the Adirondack Timber opinion, the bankruptcy court concluded that "‘a security agreement executed solely between a debtor and a creditor does not grant an affiliate of the creditor a security interest in the collateral.’" Unfortunately for Money Works and Strategic, the only security agreements in force as of the date of Jarvis’ bankruptcy filing were the agreements granting security interests to Money Works for debts owed to Money Works and its affiliates.

Based on the facts before it, the bankruptcy court sustained Jarvis’ objection to the Money Works secured claim and relegated the claim to unsecured status.

Conclusion

The Jarvis decision provides an invaluable cautionary lesson to any secured lender intending to include related "beneficiaries" of a security interest in its loan documents, and points up the different standards for the language to which security agreements and UCC-1 financing statements are held.

In filling out a financing statement, an agent for the secured creditor may identify itself as the secured party, and still effectuate perfection of its principal’s security interest. On the other hand, in order for a creditor to become "secured," it must ensure that the granting language of the security agreement identify, with as much specificity as possible, the creditor and any other parties to which the security interest is being granted. More specifically, in order for both a creditor and its affiliates to enjoy the benefit of collateralization, the language of the security agreement must reference not only the debtor’s indebtedness to the creditor and affiliates, but the actual grant of the security interest must be explicitly in favor of the creditor and its affiliates as well.

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors’ rights.

Drew S. McGehrin, an associate at the firm, practices in the areas of commercial finance, financial restructuring and bankruptcy.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.