No Security by Obscurity: The Importance of Clearly Identifying Collateral

Contributed by Alana Katz.
More is more, right? Not according to the Bankruptcy Court for the Northern District of Florida. The court recently ruled that when a creditor tries to capture the maximum amount of collateral in its security interest, this could have the opposite effect and result in an entirely unsecured claim. As most creditors know, the treatment of a claim in bankruptcy is governed not only by the Bankruptcy Code, but also by state law. The extent to which a creditor has a claim secured by a valid, enforceable security interest in the borrower’s assets often is governed by the applicable state’s Uniform Commercial Code (“UCC”). 
Generally, in order for a security interest to attach to collateral under the UCC, three requirements must be met: (1) value must have been given; (2) the debtor must have rights in the collateral; and (3) depending upon the type of collateral, there must be an authenticated security agreement that provides a description of the collateral. As seen in In re Hintze, the sufficiency of such collateral description can be critical in defining the nature and extent of a secured creditor’s claim in bankruptcy.
Two individuals, Matthew and Larina Hintze, delivered a $375,000 promissory note to a lender. The promissory note contained the following language: “As security for the payment of the principal, interest and other sums due under this Note, Maker hereby grants to Holder a security interest in all of Maker’s assets.” Over 18 months later, the lender filed a UCC-1 financing statement that contained a more detailed description of the collateral pledged in the note:   “All personal property owned by the [debtors], including cash or cash equivalents, stocks, bonds, mutual funds, certificates of deposit, household goods and furnishings, automobiles, and water craft.”
Subsequently, the Hintzes commenced a chapter 7 case and listed the lender in their schedules as a secured creditor with a security interest in “all personal property of the debtors,” including a 100% interest in TutoringZone, LC – an entity owned by Matthew Hintze. When the chapter 7 trustee later filed a notice of intent to sell all of the debtors’ non-exempt equity interests, the lender argued that Matthew’s interest in TutoringZone should be excluded from any sale by virtue of the lender’s own valid security interest in the stock of TutoringZone.
Statutory Analysis
The court first analyzed the lender’s argument from a statutory perspective. Florida’s adaptation of the UCC demands the same three requirements for a valid security interest: value, rights in the collateral, and a security agreement providing a description of the collateral. Further, the Florida UCC states that the description of the collateral must “reasonably identify” the real or personal property it describes. A blanket description of collateral in a security agreement, such as “all of [Maker’s] assets,” is not sufficiently descriptive to identify the collateral for the purposes of a security agreement.   This requirement is different from the rule relating to the description of collateral in a financing statement, which does sufficiently indicate the collateral if it “covers all assets or personal property” of a debtor. As a result, the defendant’s broad description in the granting clause of the promissory note was therefore insufficient.
The court held that, because the UCC states that an enforceable security interest is created only if all required elements are present — including a specific description of the collateral it seeks to capture — the promissory note’s insufficient description of the collateral necessarily meant that the lender lacked any enforceable security interest. Therefore, even though the lender tried to capture the most collateral possible in the note, he ended up with a completely unsecured claim in the debtors’ bankruptcy.
The Composite Document Rule Argument
Having failed to prove that the promissory note conferred a valid security interest, the lender raised an alternate argument in support of his security interest. Florida’s composite document rule allows one or more documents executed by the same parties, at or near the same time and concerning the same transaction or subject matter, to be read and construed together as a single contract. The defendant argued that the description of “all of Maker’s assets” in the promissory note should be read in conjunction with the more specific description set forth in the UCC-1 financing statement.
In rejecting this argument, the court cited numerous cases in which courts have held that the composite document rule allows loan agreements or notes to be read together with financing statements. Those cases, however, all involved loan documents executed contemporaneously–or within several days of each other – or that specifically referenced attached or existing documentation containing a sufficient description of the collateral. Because the lender filed a UCC-1 financing statement more than 18 months after the execution of the promissory note, it was not contemporaneously filed, nor meant to be included as part of the note, and the composite document rule therefore did not apply.
Although this case involved relatively small stakes in the world of security interests in bankruptcy, the requirements of the UCC apply to all secured creditors. The lesson to be learned is clear:   To obtain a valid and enforceable security interest, both inside and outside of bankruptcy, the documents creating the security interest must provide a sufficient description of the collateral. This description must not only be understood by the parties, but must also be clear enough for an objective third party to understand which collateral is secured. Without such a description, the treatment of a creditor’s claim could have devastating results.