A lender financing the purchase of equipment traditionally files a UCC-1 financing statement with authorities in the appropriate jurisdiction. In some instances, prior liens exist on the assets a debtor desires to pledge as collateral, and as a condition precedent to providing financing, a debtor may be required to obtain either a subordination agreement or a release/termination statement from the prior secured creditor. When a subordination agreement is involved, the process is relatively simple since the document is executed by the parties, binding the prior creditor to a subordinate position. But when a release or termination statement is required, the transaction becomes more complex.

Since a UCC-3 statement of release or termination is required to be filed with the appropriate Secretary of State, financing often occurs on the condition that this statement will be or is in the process of being filed. But if the financing occurs and a UCC-3 is never filed, the legal question arises as to which party has priority over the collateral. The Florida Bankruptcy Court recently addressed this very scenario in a matter involving GE Capital of Puerto Rico.

In In re Florida Tube, GE Capital loaned $4 million to the debtor and received a security agreement covering all of debtor’s equipment and machinery. The debtor requested that GE Capital apply a portion of the loan proceeds to pay off existing loans including those of creditors holding prior perfected security interests on the debtor’s equipment and machinery. GE Capital wire transferred the funds without obtaining a UCC-3 or subordination agreement.

GE Capital then filed its own UCC-1 financing statement covering all of the debtor’s machinery and equipment. The debtor filed for bankruptcy and when GE Capital moved for adequate protection payments, a creditor ("Linc") objected, claiming that it had first priority. Linc had purchased the loan account at issue from the FDIC, successor to Hamilton Bank, one of the previous secured creditors paid from the proceeds of the GE Capital loan. Because no UCC-3 was filed, Linc claimed that it had the same first priority enjoyed by Hamilton. This left GE Capital to argue that there was an oral agreement with the Hamilton to release its UCC-1s and Linc, therefore, could not have purchased a secured account.

Fortunately, GE Capital was able to point to documents from Hamilton’s files and affidavits from the relevant parties to the effect the prior UCC-1 was released, and after briefing on summary judgment, Linc capitulated and agreed that GE Capital had the first security position in the debtor’s equipment and machinery. The matter was then settled favorably for GE Capital.

However, not every court upholds the validity of oral releases, and oral releases are hard -- and expensive -- to prove. Therefore, the moral of this story is simple. Prior to extending financing in a similar situation, be sure to have an executed UCC-3, subordination agreement or an authenticated demand (i.e. a written demand) by the debtor to the appropriate creditor to release its UCC-1. Without one of these, a lender risks the possibility of losing priority and any chance of recovery in the event of default.