UCC insurance: what, why, and when?

RMA Journal, The, May, 2004 by Bernard Bittner

Many commercial bankers have a nodding acquaintance with this insurance, but they're not yet on a first-name basis. This article shows the benefits UCC insurance has to offer and the circumstances in which it should be used.

It's been around for three years. Don't you think it's time for introductions? In a nutshell, UCC insurance takes from the lending institution most of the risk inherent in taking personal property security interests and transfers it to the insurance company. It also provides an opportunity to outsource some of the security-interest-related document production and, in certain instances, offers an opportunity to reduce the transactional costs associated with a loan.

Let's start off with a somewhat typical commercial bank loan situation. Creditworthy Cal comes to Bernie's Bank, where you work, requesting a loan for $350,000. Cal offers his company's receivables and inventory as collateral and agrees to give you his personal guarantee. Although an inventory and receivables-secured loan of this size is somewhat out of the ordinary for Bernie's Bank, Cal is a good customer, so you decide to make the loan. You quickly find out that this decision comes with a few challenges.

The first step, of course, is to obtain UCC searches. Cal's business is incorporated in Delaware, and although he lives in your state, he also operates his business in a neighboring state. You aren't quite sure what searches to complete and where. You do the logical thing, which is to call bank counsel, explain the situation, and ask if counsel can take care of this. Sure, counsel can, but with all of the searches involved, preparing and filing of documents, etc., she expects her fee will be between $1,000 and $2,000.

Your attorney suggests that since she is only licensed to practice in your state and Cal's business is incorporated in Delaware and operates in two states, it will be important that borrower's counsel provide an opinion about due authorization, execution, and delivery of the documents as well as the proper attachment, perfection, and priority of the lien. At first, you think "no problem," but then you realize that Cal is already unhappy with the 1% loan fee that Bernie's Bank would like to receive. What is he going to say about 0.5% or so in bank legal fees and who knows how much for his attorney's opinion letter? You inhale deeply and call Cal.

Cal promptly calls his attorney. During the ensuing conference call with Cal and his lawyer, you find out that his attorney will have to charge at least $1,000 to $1,500 for an opinion and maybe even more for the total of Cal's legal services. He informs you that he will not be able to opine on the law in Delaware or in the other state in which Cal does business. Oh, and one last thing: Cal's lawyer makes it clear to you that he will not opine on the priority of the lien--you'll have to rely on Bernie's Bank's attorney for that. Cal then asks in frustration, "Do you really need an opinion letter?"

You call your attorney and she quickly lets you know that she will not give any opinion, certainly not one on priority and certainly not for the fee that she agreed to. She does point out that you could reduce her fee if you did all the searches and produced all of the documents and she just reviewed everything.

And how now, down Cal? Once you include a valuation on his inventory, the loan fees, the legal fees, searches and filings, and title insurance on the second mortgage on his house that you would like to include as collateral, Cal is looking at well over $10,000 in fees for his $350,000 loan. He is also probably looking at other banks!

What do you do? Should you forget the legal opinion? Should you try to renegotiate the legal fees? Should you do the does yourself and have your counsel look everything over? Should you do it all on your own without the use of outside counsel?

There's another and possibly better alternative in UCC insurance. Before considering that alternative, let's look at some of the risks inherent in Cal's transaction. What would happen if the searches were not done in the proper jurisdictions, or if the searches were not done correctly and a prior lien was missed? Or what if there was a misindexed filing due to an error in the Department of State or county recording office filing process, and an existing lien could not be found? What if the UCC filings are prepared incorrectly, or the listing of the collateral is not adequate, or the filing is filed in the wrong location? A lot can go wrong.

UCC Insurance: The What

A lender's UCC insurance policy (1) insures against losses relating to the attachment, perfection, and priority of a UCC Article 9 security interest in personal property (in some limited instances, Article 8 of the Code may also apply). The policy ensures that the security interest as created by the security agreement is enforceable against the borrower, that the security interest has been perfected by filing, possession, or control, as the case may be, and finally, that the lender has obtained the desired lien priority in the collateral. (2) The policy can be used to insure any type of collateral for which a security interest can be perfected under UCC Article 9.