View original on Law360: https://www.law360.com/articles/1088680/ucc-incorporation-by-reference-an-imperfect-way-to-perfect

Article 9 of the Uniform Commercial Code allows a fair amount of flexibility in the descriptions of collateral contained in UCC-1 financing statements that would be sufficient in order to perfect a security interest over such collateral created under the related security agreement.[1] A recent bankruptcy case from the district court of Puerto Rico, however, clearly demonstrates the limits of this flexibility while providing lenders’ counsel with clear and unambiguous instructions on how to avoid the mistakes made by counsel for the “secured creditors” in that case, which caused its client’s security interest to be unperfected. The decision is a reminder to secured creditors and their counsel to take care in preparing UCC financing statements, and that references to extrinsic documents for collateral descriptions may insufficiently describe collateral, even if the referenced document is publicly available.[2]

In In re Financial Oversight & Management Board, the U.S. District Court for the District of Puerto Rico held that a UCC-1 financing statement is ineffective to perfect a security interest if the public document to which its collateral description referred is not available at the local clerk’s office where UCC records are maintained.[3] The court, in a decision by Judge Laura Taylor Swain of the Southern District of New York (appointed by U.S. Supreme Court Chief Justice John Roberts to oversee the Puerto Rico bankruptcy case), reasoned that a search requiring a third party to look beyond the local clerk’s office to ascertain a description of the collateral is too “open-ended” to provide adequate notice to a third party.[4]

In the case, the debtor, the Employees’ Retirement System of the Government of the Commonwealth of Puerto Rico, or ERS, issued bonds to several bondholders pursuant to a pension funding bond resolution.[5] In connection with the resolution, the parties executed a security agreement in which the bondholders took “‘a security interest in (i) the Pledged Property, and (ii) all proceeds thereof and all after-acquired property, subject to application as permitted by the Resolution.’”[6] The resolution, which was publicly available electronically on the websites of the debtor, the Government Development Bank, and the Electronic Municipal Market Access System, detailed the “pledged property” in full, and the security agreement incorporated the resolution’s description by reference to the resolution only, never describing the collateral itself.[7]

Attempting to perfect their security interest, the bondholders filed UCC-1 financing statements with a collateral description describing the collateral as “the pledged property described in the Security Agreement attached as Exhibit A hereto and by this reference made part hereof.” The filed financing statement attached the security agreement without the accompanying resolution as an exhibit.[8] Thus, an interested third party reading the financing statement and the attached security agreement would know to look for the resolution to find a detailed description of the collateral but would not be able to find the resolution at the Department of State of Puerto Rico, the applicable financing statement filing office.

Generally, a UCC-1 financing statement’s collateral description is sufficiently descriptive when it refers to details provided in an attachment.[9] Some courts have additionally validated references to documents or instruments that were not attached to the filed financing statement but were otherwise “publicly available” for review.[10] For example, a collateral description that refers to an unattached, lapsed financing statement may be sufficient when the UCC-1 includes the financing statement’s filing number.[11]

As the district court of Puerto Rico noted, however, in each case where a court approved a collateral description that refers to an unattached extrinsic document, the referenced document was available for review at the local clerk’s office that maintains UCC records.[12] According to the court, the “basic notice function of Article 9” is not served by any search that requires looking elsewhere, even if the financing statement puts the interested third party on notice that it must do so.[13]

Notably, the court chose a bright-line rule rather than an intractable standard to weigh the difficulty of the search. Whereas other courts have attempted to delineate a standard to determine when a search became too onerous for interested third parties,[14] the district court of Puerto Rico held that any search, which must extend beyond the local clerk’s office, is ipso facto too burdensome for Article 9 purposes. The court put no weight on the fact that the referenced resolution was posted on several websites because the search process failed to meet this initial threshold.

Although this bright-line rule tightens court oversight of the incorporation by reference doctrine, it provides needed clarity moving forward for practitioners — particularly those looking to save a bit of work or time by not including a full collateral description on the financing statement itself. Lenders should refrain from drafting collateral descriptions that rely on extrinsic documents, especially when the referenced document is not attached as an exhibit to the financing statement. Lenders should take particular care when using collateral descriptions that contain terms that are defined in nonpublicly available documents, such as credit agreements and security agreements, if those documents are not attached to the financing statement, and this decision suggests that financing statements may be insufficient to perfect if not all applicable defined terms are specifically included on the financing statement itself or on an exhibit annexed to the financing statement. Lenders should ensure that interested third parties can sufficiently identify the covered collateral without having to take additional steps in the search process. If further sleuthing is needed, the UCC-1, and the drafting skills of its scribe, may be deemed imperfect.