Agile Corporation borrows $1 million from Hi Finance Company (HFC). Agile signs a financing statement that describes the collateral, it's inventory and proceeds, and HFC files the statement in the...

Agile Corporation borrows $1 million from Hi Finance Company (HFC). Agile signs a financing statement that describes the collateral, it's inventory and proceeds, and HFC files the statement in the appropriate state office. Using the same collateral, Agile later borrows $500,000 from Metro Bank, which files it's financing statement. Agile defaults on the loans. Metro claims that at the time of its loan it was unaware of HFCs interest. Between these parties, who has priority to the collateral? Explain your answer.

Expert Answers
Stephen Holliday eNotes educator| Certified Educator

In order for a UCC-1 Financing Statement to perfect a creditor's interest in collateral, it must be signed by the debtor, identify the creditor, and adequately describe the collateral in sufficient detail so that there is no ambiguity as to the nature of the collateral.  Assuming the creditor files the UCC-1 with the appropriate entity--usually, the secretary of state in the appropriate jurisdiction--the security interest is perfected.

If, at a later date, Metro Bank  loans money, using the same collateral already secured by HFC, Metro is in "second" position to HFC--in other words, in terms of security, Metro is the junior lien-holder, and HFC, the senior.  In the case of a default on both loans, HFC has a perfected first security interest in the collateral subject to the UCC-1.  Metro Bank, assuming no other UCC-1's exist, has a perfected second security interest.  In practical terms, Metro Bank will probably have to write off its debt because HFC may, in all likelihood, need all the proceeds the collateral can generate.  In bankruptcy situations, second lien-holders are lucky to receive twenty cents on a dollar of debt.

Ignorance of the prior UCC-1 filing is not a defense in this scenario.  Lenders who make commercial loans are expected to take all reasonable measures to protect their interests.  Failing to execute a proper UCC search, which can now be accomplished in minutes on-line in most jurisdictions, is a serious problem for the lender because the law does not allow any remedies unless there has been a demonstrable error on the part of the recording entity, that is, the secretary of state.  Also, if a title company does a search for the lender, and fails to report a properly filed UCC-1, then the lender may have recourse against the title company but still will not have a first security interest in the collateral.

Stephen Holliday eNotes educator| Certified Educator

In the scenario you have outlined, two lenders--HFC and Metro Bank--have each filed a financing statement (UCC-1), with HFC having filed the first UCC-1 and Metro having filed the second.  The collateral secured by the UCC-1s is identical for each lender.

Presumably, Agile, as debtor, and HFC, as lender, have executed a security agreement that properly identifies the collateral, clearly states that a security interest is being granted to the lender, and is executed by both borrower and lender.  I assume the same facts apply to the security agreement and UCC-1 executed by Metro Bank.  In both cases, the lenders are defined under UCC-1 statutes as "secured parties."  The issue at hand is which lender has a priority claim to the collateral.

Assuming the security agreement and UCC-1 Financing Statement executed between Agile and HFC are correctly worded and the UCC-1 is filed with the Secretary of State for the proper jurisdiction (the debtor's state of incorporation), HFC has the prior claim to the collateral and therefore is the senior lien holder.  Metro, having come some time later, and filed its UCC-1 statement after HFC, becomes the junior lien holder.  It would be very unusual for a junior lender not to have done a UCC-1 search to determine the status of the collateral at stake, particularly if it was depending upon having unrestricted access to the collateral if Agile defaulted on its promissory note to Metro.

In short, Metro's failure to perform basic due diligence by performing a UCC-1 search has given it an unhappy surprise.  There may also be recourse to the borrower if Agile has executed a security agreement with Metro that states the collateral is unencumbered by a security interest.