The Bankruptcy Court for the District of Maryland recently ruled that a secured creditor retains its priority over other junior creditors even though its UCC financing statement lapsed during the bankruptcy case. The case resolves a conflict between federal bankruptcy law and UCC state law. The freeze rule maintains the petition-date priority of the secured creditors throughout a bankruptcy case.
The Case: Firstrust Bank v. Indus. Bank (In re Essex Constr., LLC), 591 B.R. 630 (Bankr. D. Md. 2018)
Essex Construction, LLC filed for bankruptcy under chapter 11. On the petition date, two banks held perfected security interests in the debtor’s assets: Firstrust Bank and Industrial Bank. On the petition date, Industrial held the senior interest. Industrial recorded its UCC-1 financing statement in 2012; Firstrust in 2014. The debtor filed for bankruptcy in 2016. One year later, in 2017, and while the case was still in chapter 11, Industrial’s financing statement lapsed.
The issue centers on the post-petition lapse of Industrial’s financial statement. Neither bank disputed that Industrial held the senior interest on the petition date. They disagreed on the effect of the post-petition lapse. Firstrust argued that state law—Article 9 of the UCC—mandates that it should jump Industrial in priority and that a chapter 11 proceeding should not change this result under state law. Industrial asserted that the freeze rule in bankruptcy rendered the post-petition lapse inapplicable for determining priority.
Priority Lost: Article 9 of the UCC
Under section 9-515 of Maryland’s UCC, a filed financing statement remains effective for five years. Industrial filed its statement in 2012, and it remained effective until 2017. Absent the filing of a continuation statement, the financing statement lapses on the expiration date and rendered unperfected pursuant to section 9-322(a)(2), which states that a perfected security interest has priority over a conflicting unperfected security interest. In short, a secured creditor will lose its place in line if it fails to file the continuation statement. Under this rational, Firstrust argued that its security interest had priority over Industrial’s conflicting unperfected security interest because of the lapse in 2017.
Firstrust relied on legislative history. It noted that the UCC used to state the following: “[i]f a security interest perfected by filing exists at the time insolvency proceedings are commenced by or against the debtor, the security interest remains perfected until termination of the insolvency proceedings.” That language was removed in the current version of the UCC. Firstrust argued that the removal of this language evidenced the legislature's intent to eliminate the freeze rule. That rational, however, was not supported by the comments to the section 9-515, which explain that the legislature did not intend to eliminate that rule. Rather, the comments confirm that the effect of the lapse on priority is left to courts to decide based on federal bankruptcy law.
Priority Regained: Freeze Rule in Bankruptcy
In bankruptcy, the freeze rule freezes the priority of a security interest as of the petition date, which will remain the priority throughout the bankruptcy case. This principle has been recognized by the U.S. Supreme Court since at least 1931: “valid liens existing at the time of the commencement of a bankruptcy proceeding are preserved.” Isaacs v. Hobbs Tie & Timber Co., 282 U.S. 734, 738 (1931).
Two leading cases explain how the freeze rule works. In Halmar Distributors, a debtor moved its inventory to Massachusetts. The senior secured creditor filed proper financing statements in New York, but the junior filed in both New York and Massachusetts. Under the UCC, the senior had to file in Massachusetts within four months to maintain its position. It failed to do so. Yet the court found that the senior maintained its position because the lapse occurred after the debtor filed for bankruptcy. The senior secured creditor’s position was frozen in time on the day of the petition.
The second case is Chaseley’s Foods. It also involved the effect of a lapsed financing statement on a secured creditor’s priority. Again, the court found that the secured creditor maintained its status despite failing to file a continuation statement during a bankruptcy case. The court also addressed the effect of the UCC. It concluded that a bankruptcy case maintains the priority of a secured creditor regardless of whether a provision in the UCC reaffirms this principle. The lapse makes no change.
That is what happened here. Before bankruptcy, Industrial had priority over Firstrust. On the day of the bankruptcy filing, Industrial had priority over Firstrust. Throughout the bankruptcy case, Industrial had priority over Firstrust. Nothing changed when Industrial’s financial statement lapsed shortly after the bankruptcy filing. Under the UCC, Industrial would have lost priority. But the freeze rule maintained Industrial’s priority—a result that the drafters of the UCC affirmed in their comments to Article 9. A senior secured creditor in bankruptcy need not file a continuation statement to maintain its priority.