United States: Court of Appeals Decision Highlights Need for Careful Loan Diligence.

United States

Court of Appeals Decision Highlights Need for Careful Loan Diligence.

A decision by the US Court of Appeals, Second Circuit, arising from the General Motors bankruptcy has shaken law firms that serve the loan market.  A simple oversight drastically decreased the value of a $1.5 billion secured loan by J.P. Morgan Chase Bank (“JPMC”).
JPMC was administrative agent on two separate secured loans to General Motors Co. (“GM”) – a $300 million synthetic lease (the “Synthetic Lease”) and a $1.5 billion term loan (the “Term Loan”), and filed a UCC-1 statement to put the public on notice of its lien as to each loan.   GM paid off the Synthetic Lease.  GM’s own counsel prepared the statements (on form “UCC-3”) to terminate JPMC’s lien in the collateral securing the Synthetic Lease, and mistakenly included the liens securing the Term Loan as well.  Drafts of the documents were reviewed by JPMC and its counsel, and approved.  No one noticed that the UCC-3 statements included the Term Loan security interest along with the Synthetic Lease security interest. GM thereafter filed for bankruptcy and JPMC realized the mistake.  JPMC argued that the termination statements were mistakenly filed, and that termination of the Term Loan security interest was thus unauthorized and ineffective.  The Unsecured Creditors disagreed and claimed the termination statements were effective, making JPMC an unsecured creditor, thus leaving more for GM to pay its unsecured creditors, proportionately (rather than paying the full amount to JPMC as a secured creditor).   In the bankruptcy court, everyone agreed that no one intended to file termination statements for the Term Loan. The bankruptcy court first sided with JPMC, finding that the termination statements were unauthorized under the doctrines of actual authority, apparent authority, implied authority or ratification. On appeal, the Second Circuit considered the following:
Under UCC Article 9, . . . for a UCC-3 termination statement to effectively extinguish the perfected nature of a UCC-1 financing statement, is it enough that the secured lender review and knowingly approve for filing a UCC-3 purporting to extinguish the perfected security interest, or must the secured lender intend to terminate the particular security interest that is listed on the UCC-3?
The Delaware Supreme Court held that authorization, even without intent or understanding, is enough for effectiveness of a lien filing or termination, finding it is sufficient that the secured party authorizes the filing to be made for the filing to become effective.
Because JPMC and its counsel had the chance to review the draft termination statements before they were filed and approved them for filing, the Second Circuit concluded that although JPMC never intended to terminate the liens, it authorized the filing of aUCC-3 termination statement that had that effect, thus releasing the security interest in the Term Loan collateral.  In the U.S., when a secured loan is paid off, lenders typically rely on the borrower’s counsel to prepare and file UCC termination statements, for purposes of costs and because such preparation and filing has been seen as largely administrative.  The Second Circuit’s decision, as well as the publicity of the errors that led to the decision, may change that custom.