United States: SCOKY Reverses ‘Secret Lien’ Holding!

Last Updated: July 1 2014
Article by Richard A. Vance

Last year, in a decision criticized here, the Kentucky Court of Appeals held that liens and security interests in assets of governmental entities are entitled to priority even if they are not perfected by the filing of financing statements under UCC Article 9. Fortunately, the Supreme Court of Kentucky has reversed, eliminating this type of secret lien. Delphi Automotive Systems, LLC v. Capital Community Economic/Industrial Development Corp., Case No. 2012-SC-000249 (Ky. June 19, 2014).

The perfection provisions in Article 9 of the Uniform Commercial Code were designed to minimize the risk of loss to creditors due to "secret liens." Banks and other financing lenders customarily search for liens before extending credit, but "secret liens" are liens on personal property that, for one reason or another, are not required to be filed or recorded with the Secretary of State or County Clerk. Since such liens do not show up on the public record, they can unexpectedly have priority over a new lender's lien on the same collateral.

In Delphi Automotive Systems, the economic development agency for Franklin County (CCEDC) used a federal community development block grant to provide financing to a local machine tool business seeking to increase its capacity and workforce. The CCEDC loan was in the form of a financing lease for a machine tool press, and the business expected to acquire ownership of the press after making monthly payments for five years. CCEDC did not file a UCC-1 financing statement.

Later, Delphi provided financing to the machine tool company, obtaining a security interest in the company's equipment and other assets, and perfected it by filing a UCC-1 financing statement with the Kentucky Secretary of State. When the business failed and its assets were liquidated, both the CCEDC and Delphi claimed the proceeds of the machine tool press. Delphi claimed its UCC filing prevailed over CCEDC's unperfected lien. CCEDC argued that the transaction was outside the scope of Article 9 for two reasons: first, because its lease was a "true lease," and second, because Article 9's governmental transaction exception applied.

The court of appeals correctly rejected the "true lease" argument, finding that the company's right to become the owner of the machine after five years of payments meant that the "lease" was a secured transaction.

The court then went on, however, to hold on public policy grounds that the CCEDC's unrecorded "secret" lien had priority over Delphi's filed perfected security interest. Specifically, the court of appeals relied on Kentucky's UCC provision 9-109(4)(q), which states that Article 9 and its priority rules do "not apply to ...[a] public finance transaction or a transfer by a government or governmental unit."

The Kentucky Supreme Court recognized that the UCC drafters intended this "government entity exception" to address disputes between creditors when a government entity is the borrower, not when the government entity is the secured lender. When the government entity is a debtor, later creditors are on notice that they are dealing with a special entity and can protect themselves accordingly. On the other hand, if a government entity makes a loan to a non-governmental debtor, and its security interest in perfected without filing, a prospective creditor lender has no way to determine that the government agency already has a lien on the debtor's property. The Kentucky Supreme Court, like courts in other states, recognized that the governmental entity exception should not be extended to situations where the governmental entity is the secured party.

In addition, the Supreme Court declined to create a public policy exception in favor of county economic development agencies, finding nary a word in the statutes to support it.

The Kentucky Supreme Court reached the right result, confirming the role of the UCC filing system as a means of perfection and constructive notice to purchasers and prospective creditors.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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