By Paul Hodnefield, Esq.
“Rock-Paper-Scissors” is a popular game for breaking ties and settling arguments. It works quite well with two players. However, add a third player and the outcome becomes less than clear. Rock beats scissors, scissors beats paper, and paper beats rock. But who wins if all three players choose separate options and no do-overs are allowed?
Just like Rock-Paper-Scissors, the fixtures priority rules work well for resolving disputes between two claimants. In the recent case of Sturtz Machinery, Inc. v. Dove’s Industries, Inc., 2014 U.S. Dist. LEXIS 49235 (N.D. Ohio April 8, 2014), a court applied the UCC priority rules to a dispute between two parties in which each claimed a security interest in fixtures. The case, however, left open the question of how the fixture priority rules work when multiple claimants have perfected by different means. As discussed in detail below, the result in such circumstances can be circular priority.
In this case, Dove’s Industries, Inc. (“Dove”), a Pennsylvania Corporation, entered into a contract with Sturtz Machinery, Inc. (“Sturtz”), to purchase machinery (the “fixtures”) for the manufacture of vinyl windows. In 2011, the fixtures were delivered to Dove’s factory in Pulaski County, Virginia. At that time, Sturtz did not file a financing statement with the Pennsylvania Secretary of State, nor did it make a fixture filing in the Pulaski County, Virginia, real estate records.
In January 2012, Dove borrowed money from M&T Bank (“M&T”) to purchase additional equipment. To secure its obligations under the loan agreement and provide additional security for outstanding loans with M&T, Dove granted M&T a security interest in collateral that included the fixtures and proceeds of the fixtures.
M&T perfected its security interest in Dove’s assets on February 2, 2012, by filing a financing statement with the Pennsylvania Secretary of State. The financing statement described the collateral to include fixtures.
A few months later, in August 2012, Dove defaulted under the terms of the M&T loan agreement. At the time, Dove still owed M&T just over $1.5 million. Dove also still owed Sturtz over $500,000. Once Sturtz realized that Dove was having financial trouble it attempted to protect its interest by filing a UCC financing statement as a fixture filing in the Pulaski County, Virginia, real estate records on August 17, 2012.
The following month, Dove hired an auctioneer to sell the personal property at its plant in Pulaski County, Virginia. The auctioneer sold the property and placed the $1.5 million in proceeds in an escrow account.
It was undisputed that M&T was entitled to about $900,000 of the escrowed funds. However, both Sturtz and M&T claimed to have the superior interest in the remaining $600,000. Sturtz filed a complaint seeking to recover the remaining escrowed proceeds of the sale. M&T disputed Sturtz’s claim and asserted it was entitled to the remaining proceeds. M&T then removed the case to federal district court and brought a motion for judgment on the pleadings in its favor.
M&T argued that it was entitled to the disputed proceeds because it filed a financing statement covering the fixtures with the Pennsylvania Secretary of State a full six months before Sturtz recorded its fixture filing in Virginia. In opposition, Sturtz claimed that under Virginia law a security interest in fixtures is perfected only by filing with the office where a mortgage would be recorded on the related real property (emphasis added).
As a threshold issue, the court noted that there are three ways to perfect a security interest in fixtures: by filing a financing statement covering fixtures at the central filing office of the state where the debtor is located; by filing a UCC fixture filing; or by recording a record of mortgage that is effective as a fixture filing under § 9-502(c). In this case, both M&T and Sturtz perfected their interests by different but equally acceptable methods. Thus, the only issue was priority.
To determine priority between the Pennsylvania Secretary of State UCC filing on fixtures and the Pulaski County, Virginia, fixture filing, the court applied the general UCC priority rules set forth in § 9-322(a). Those rules provide that priority ranks from the earlier time of filing or perfection. In this case, M&T perfected six months before Sturtz. The court therefore held that M&T was entitled to priority in the disputed proceeds because it was the first to file.
While this case neatly resolved the issue between two creditors with UCC security interests, fixture priority issues can get messy when competing claims arise under state real property law. A record of mortgage that satisfies the requirements of UCC § 9-502(c) is effective as a fixture filing for Article 9 purposes, but priority relative to perfected UCC security interests in fixtures is determined under a different provision, § 9-334.
Adding a hypothetical third creditor to the facts of the Sturtz case demonstrates the problem. Assuming there was a third creditor that perfected its interest in the fixtures by recording a record of mortgage after the other two parties, then the general rule in § 9-322(a) would still determine priority between Sturtz and M&T, but § 9-334 would determine the priorities relative to the third creditor.
The result leads back to the Rock-Paper-Scissors circularity. The Pennsylvania UCC financing statement beats the Virginia fixture filing under § 9-322(a) because it was the first filed; the prior UCC fixture filing takes priority over the later mortgage under § 9-334(e)(1); and, completing the circle, § 9-334(c) subordinates the Pennsylvania UCC financing statement to the mortgage. Unlike Rock-Paper-Scissors, however, no do-overs are allowed.
The important thing to take away from the Sturtz case is that determining the priority of competing interests in fixtures is not always simple or intuitive. Lenders should file promptly, as always, to ensure the earliest file date, but also consider using one or more fixtures perfection methods to avoid circular priority problems. Those who search the UCC records also need to include both the state-level UCC index and the county real estate records when looking for security interests in fixtures.
Paul Hodnefield is Associate General Counsel for Corporation Service Company (CSC) and a frequent speaker/writer on UCC due diligence issues. Please feel free to contact him with questions or comments at phodnefi@cscinfo.com or 800-927-9801, ext. 62375.