Third Circuit Addresses What Happens When Fraud Results in Two First Priority Liens on the Same Assets

Contributed by Damon P. Meyer
In Merrill Lynch Business Financial Services, Inc. v. Kupperman, the Third Circuit discussed the order of priority between two secured lenders, each of which, as the result of fraud, held a first-priority lien on substantially the same assets.  In 2002, a borrower, PITTRA G.B. International, Inc., granted Merrill Lynch a security interest in all of its current and future assets to secure a series of loans.  Merrill’s security agreement provided that the security interest was binding on PITTRA’s “successors and assigns.”  Merrill properly perfected its security interest by filing a financing statement.
Thereafter, without informing Merrill, PITTRA fraudulently transferred a substantial amount of its assets to a newly-created entity, PGB International, LLC, which had the same principals and employees as PITTRA.  PGB then granted a security interest in all of its current and future assets – the same assets in which Merrill held a security interest – to JPMorgan Chase to secure a series of loans.  JPMorgan filed a financing statement to perfect its security interest; however, because neither bank was aware of the asset transfer, Merrill had not filed a new financing statement naming PGB as the debtor, and JPMorgan did not run a lien search against PITTRA.
Three years after the asset transfer, PITTRA filed for bankruptcy under chapter 7 of the Bankruptcy Code.  As part of a settlement with the chapter 7 trustee, Merrill waived its claims against PITTRA, but filed suit in the District Court against PGB asserting claims arising from the secured loans made by Merrill to PITTRA.  In the case, Merrill asserted priority over all other creditors of PGB and named JPMorgan as a defendant.  In response, JPMorgan asserted a first priority security interest in PGB’s assets and sought to foreclose.  On summary judgment, the District Court ruled in favor of Merrill, and JPMorgan appealed.
JPMorgan first alleged that Merrill’s security interest was not enforceable against PGB.  The Third Circuit, however, found that PGB was a successor to PITTRA based on the undisputed facts that the two companies were in the same industry, were located at the same address, were operated by the same individuals and there was a transfer of assets from PITTRA to PGB.  Because Merrill’s security interest was binding on PITTRA’s successors and assigns, the security interest was binding on PGB.
In the alternative, JPMorgan asserted a priority lien on the assets on a number of grounds, the most interesting of which was that Merrill’s security interest was in “collateral in which a new debtor has or acquires rights,” and was, thus, under 9-508 and 9-326 of the Uniform Commercial Code, junior to a lien created and perfected in the same assets.  UCC 9-508 states that a filed financing statement remains effective to perfect a security interest in collateral in which a new debtor has or acquires rights.  UCC 9-326, however, states that a security interest that is only perfected under UCC 9-508 is subordinated to a security interest in the same assets that is perfected by other means.  Thus, JPMorgan asserted, its financing statement filed against PGB was senior to Merrill’s financing statement filed against PITTRA.
JPMorgan failed to raise this issue at the District Court level, and, as a result, the Third Circuit held that JPMorgan had waived the argument.  Nonetheless, however, the Third Circuit addressed the claim.  The Third Circuit looked to comment 2 to UCC 9-326, which states that UCC 9-326 subordination does not apply when a financing statement filed against an original debtor remains effective against the collateral transferred by the original debtor to the new debtor.  Pursuant to UCC 9-507(a), a filed financing statement remains effective with respect to disposed collateral, and, therefore, Merrill’s security interest remained effective against the transferred collateral and was senior to JPMorgan’s security interest.
The Third Circuit affirmed the District Court’s ruling on all grounds and held that JPMorgan’s security interest, which was created later in time, was subordinate to Merrill’s.  This decision seems correct based on the statute and the facts.  At the same time, however, it begs the question of what JPMorgan could have done to limit its risk of being in such a situation.  Although nothing can fully protect against fraud, careful diligence can mitigate risk.  Prior to lending, banks should conduct thorough diligence relating to the origin of the assets that make up their collateral package by, among other things, getting copies of bills of sale, and should conduct lien searches on any entity from which the assets were acquired.