Expert’s Corner: UCC Fixture Filing Prevents Debtor in Possession from Avoiding Unrecorded Mortgage

March 10, 2014

By Paul Hodnefield, Esq.

On occasion, a filed UCC financing statement may purport to claim a security interest in real property that extends beyond just fixtures, timber to be cut or minerals to be extracted. While those who search the UCC records may be tempted to disregard these claims because they appear to exceed the scope of collateral covered by UCC Article 9, searchers must be aware that a financing statement may have an effect beyond its intended purpose.  In that case, the record may trigger a duty for interested parties to inquire further into matters that would ordinarily be governed by other law. An example of how this might occur is found in the case of In re: Municipal Corrections, LLC, 501 B.R. 119 (Bankr. N.D. Ga. Sept. 30, 2013).

Municipal Corrections, LLC, (the “Debtor”) owned a detention facility and real property in Irwin County, Georgia (the “County”). The Debtor had an arrangement with the County whereby the County would lease the detention facility from the Debtor and pay rent based on the number of County prisoners confined in the facility.

The Debtor financed construction of the facility through various tax-exempt trust indenture arrangements beginning in 1990. In each arrangement, the County would issue bonds and then loan the proceeds to the Debtor. A trustee named in the indenture (the “Bond Trustee”), was responsible for administering and enforcing the bonds on behalf of the bond holders.

In 2007, the Debtor obtained $55 million in additional financing through trust indentures to satisfy existing bond obligations and finance expansion of the facility. To secure payment of the bonds, the indenture included a pledge of various assets by the Debtor, including the lease with the County and the Debtor’s interest in the real property.

Aside from the indenture, the Debtor never executed a deed or other conveyance document to secure the debt. Nor was the indenture ever recorded. It was not even in recordable form. However, the Bond Trustee did record the lease, a memorandum of the trust indenture and, on August 28, 2007, a UCC-1 fixture filing.

The UCC-1 fixture filing stated that the Bond Trustee had a security interest in fixtures. It went on to state that the Debtor had pledged and assigned the real property to the Bond Trustee to the extent provided in the indenture.

After a few years, the facility did not have enough detainees to generate enough rent to cover operating expenses and service debt obligations. The Debtor eventually sought Chapter 11 bankruptcy protection.

The Debtor, with the powers of a bankruptcy trustee as debtor in possession, brought an adversary proceeding against the Bond Trustee, seeking to avoid the Bond Trustee’s lien on the grounds that it was unenforceable against a hypothetical bona fide purchaser under Georgia law. The Debtor then brought a motion for summary judgment in its favor. The Bond Trustee responded with its own cross motion for summary judgment.

As a threshold issue, the court determined that the indenture, despite not being in recordable form, created a valid mortgage between the Debtor and Bond Trustee. Next, the court turned to the issue of whether that unrecorded mortgage was enforceable against a bona fide purchaser.

Under federal bankruptcy law, a bankruptcy trustee, and therefore the Debtor, cannot avoid an unrecorded interest in real estate if the unrecorded interest is nevertheless effective under state law principles of constructive or inquiry notice. Under Georgia law, a purchaser takes property free of a prior unrecorded interest unless the purchaser had actual or constructive notice of it or if the circumstances give rise to a duty of inquiry that would have led to the discovery of the prior interest.

The court determined that a UCC fixture filing indexed in the county real estate records under the debtor name was sufficiently within the chain of title to provide a purchaser with constructive notice. Ordinarily, a UCC fixture filing would only provide notice of the secured party’s interest in fixtures on real property. In this case, however, the record also stated that the Bond Trustee claimed a security interest in the real property to the extent set forth in the indenture.  The court found this sufficient to put a purchaser on inquiry notice because a title examiner who comes across a reference to an unrecorded document in the chain of title cannot ignore that reference.

The court concluded that the UCC fixture filing contained sufficient information to put a purchaser on notice of the Bond Trustee’s prior unrecorded interest in the real property. Furthermore, references in the fixture filing to the pledge of the Debtor’s interest would excite the attention of the purchaser and trigger the duty to inquire further into the Bond Trustee’s interest. Therefore, the court found the mortgage enforceable against a bona fide purchaser under Georgia law.

The important thing to take away from this case is that a UCC record may contain information that triggers a duty for interested parties to look into issues outside the scope of Article 9.  While this case turned specifically on Georgia law, similar issues could arise under the law of other states. As a result, a diligent searcher cannot always safely disregard a claim made in a financing statement just because the matter would normally be governed by another area of law.

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