Expert’s Corner: Court Finds New Note did not Extinguish Purchase-Money Security Interest

May 2, 2013

By Paul Hodnefield, Esq.

One of the most powerful risk management tools available to commercial lenders is the purchase-money security interest (“PMSI”). The PMSI provides the secured party with a super priority over conflicting security interests in the same collateral. However, the secured party must strictly comply with the UCC perfection requirements and also maintain the PMSI character of the transaction until the obligation is satisfied. Otherwise, the secured party could lose its PMSI priority if the debtor defaults. A recent case, In re: Saxe, 2013 Bankr. LEXIS 1224 (Bankr. W.D. Wis. March 22, 2013), illustrates some of the challenges PMSI secured parties can face and how courts approach those issues.

The Saxes (the “Debtors”) were spouses engaged in farming. In 2004, the Debtors borrowed money from the United States Department of Agriculture’s Farm Service Agency (the “FSA”). In exchange for the loan, the Debtors granted the FSA a security interest in “farm and other equipment” including “1 skidsteer to be purchased.”

The FSA perfected its security interest by filing a financing statement on September 9, 2004. Approximately two weeks later, the Debtors used a portion of the loan proceeds to purchase the skidsteer.

In 2006, the Debtors executed a new note in favor of the FSA. The new note changed the payment schedule and extended the payment term of the FSA loan from seven to 10 years. The FSA advanced no additional funds under the new note and it retained the 2004 note and security agreement. The FSA filed a continuation statement in March 2009 to extend the effectiveness of the financing statement until 2014.

In June 2012, the Debtors filed a Chapter 7 bankruptcy petition. The Debtors listed the FSA as a claimant in the amount of $160,000. However, the Debtors asserted that the FSA held a nonpossessory, non-PMSI security interest in the skidsteer. Under those circumstances, a state law exemption for “tools of the trade” would allow the Debtors to avoid the non-PMSI security interest in the skidsteer. The Debtors, therefore, brought a motion to avoid the security interest on the grounds that FSA failed to obtain a PMSI in the skidsteer.

The Debtors first argued that the FSA security interest was not a PMSI because there was no separate security agreement or financing statement related to the skidsteer. Furthermore, neither the security agreements nor the filed UCC records state that the security interest is a PMSI.

The court was not persuaded. The court noted that the UCC is clear that obligations can be secured simultaneously by PMSI and non-PMSI collateral without disturbing the PMSI character of the security interest. Thus, no separate PMSI security agreements or financing statements were necessary. Moreover, the UCC contains no requirement that the PMSI character of a security interest be specifically described in the security agreement or financing statement. Therefore, the court rejected the Debtors’ first arguments.

Next, the Debtors claimed that even if the original security agreement created a PMSI, the 2006 note was a novation that destroyed the PMSI character of the security interest. Therefore, FSA no longer held a PMSI in the skidsteer.

Under applicable state law, a novation must extinguish or cancel the original indebtedness. The 2006 note advanced no new funds, was secured by the same collateral as the 2004 note and referenced payment rescheduling. The FSA never marked the 2004 note “paid” or “replaced.” Nor did it deliver the original note to the Debtors. Based on these facts, the court found the 2006 note did not destroy or terminate the PMSI character of the FSA’s security interest.

The Debtors’ final argument was that, even if the security interest was a PMSI, the payments they made on the debt should be applied first to the PMSI on the skidsteer, thus satisfying that lien. Again, the court was not persuaded.

The primary question facing the court was whether the Debtors’ payments on the loan should be applied first to the skidsteer and thus satisfy the PMSI, or whether the PMSI should be preserved. To answer this question, the court relied on the intention of the parties as expressed in the terms and conditions of the notes.

The notes did not clearly address application of the payments. Nor did federal regulations for these types of loans or the UCC provide any guidance for allocation of payments between PMSI and non-PMSI collateral. However, based on UCC commentary and bankruptcy code provisions, the court found a clear inference that the holder of a PMSI is entitled to the preservation of its interest against the claims of other creditors. Therefore, in this situation, the payments should be applied to the whole debt.

The court concluded that the PMSI is removed from the collateral only after the entire debt has been satisfied. The amount of equity at issue in this case did not come close to satisfying the outstanding obligation, so the court held that FSA’s PMSI remained intact. Consequently, the court denied the Debtors’ motion to avoid the FSA’s lien.

There are a number of important points to take away from this case. One is that a secured party need not specifically claim a PMSI in its security agreement, financing statement or other loan documentation. There are no special content requirements for PMSI loan documentation. Another point is that a secured party has flexibility under the UCC to modify the terms of a loan. However, the secured party should be careful that any subsequent modifications do not go too far and inadvertently extinguish the original obligation. Finally, the secured party can further protect its PMSI by using loan documents that expressly allocate payments first to unsecured debt, next to non-PMSI secured debt, and only lastly to any outstanding PMSI obligations.

Paul Hodnefield is Associate General Counsel for Corporation Service Company and a frequent speaker/writer on UCC search and filing issues. Please feel free to contact him with questions or comments at phodnefi@cscinfo.com or 800-927-9801, ext. 62375.  Visit cscglobal.com for more information on UCC searches and filings.