No Exceptions: How Government Creditors are Not Exempt from Article 9’s Perfection Requirements

By: Thomas Sica

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

Recently, in Delphi Automotive Systems, LLC v. Capital Community Economic/Industrial Development Corporation,[1] the Supreme Court of Kentucky held that a governmental-entity creditor must comply with Article 9 of the UCC’s perfection requirement in order to ensure that such creditor’s lien has priority over subsequent security interests.[2]  In Delphi, a governmental-entity creditor and a manufacturer entered into a “lease” covering certain equipment, which provided that the manufacturer would own the equipment upon making the final payment.[3]  A private creditor subsequently extended credit to the manufacturer and perfected a security interest in all of the manufacturer’s personal property to secure the loan.[4]  After the manufacturer defaulted on the loan, the private creditor filed an action to enforce its lien against all of the manufacturer’s personal property, including the “leased” equipment.[5]  First, the governmental creditor argued that the manufacturer did not own the equipment because it was leased.[6]  The court, however, swiftly dismissed this argument because the governmental creditor’s interest in the equipment was better defined as a security interest than an ownership interest.[7]  Second, the governmental creditor opposed the private creditor’s action, arguing that KRS § 355.9-109(4)(q) excused them from perfecting their security interest because the statute excluded “a transfer by a government or governmental subdivision or agency.”[8]  In response, the private creditor argued that KRS § 355.9-109(4)(q) did not excuse the governmental-entity creditor’s compliance with Article 9’s perfection requirements because that statute only applied to situations where the governmental unit was the debtor or borrower.[9]  The trial court ruled in favor of the governmental creditor[10] and the intermediate appellate court affirmed.[11]  The Supreme Court of Kentucky, however, reversed and directed a verdict for the private creditor.[12]

In particular, the Supreme Court of Kentucky held that (1) the governmental-entity creditor’s “lease” was a disguised security interest,[13] (2) KRS § 355.9-109(4)(q) did not excuse the governmental creditor from complying with Article 9 because that section only applies where the governmental unit is a borrower, not a creditor,[14] (3) KRS § 355.9-103(3)(b) was not applicable because there was no statute expressly governing the security interest at issue,[15] and (4) there was not a valid public policy exception to allow an unperfected security interest priority over a perfected interest.[16]  The Delphi decision is consistent with case law from other jurisdictions.  Indeed, federal and state courts in Alaska,[17] Colorado,[18] Illinois,[19] Massachusetts,[20] Mississippi,[21] and Oklahoma[22] have all held that a governmental-entity creditor must comply with Article 9 and its perfection requirements as the phrase “transfer by a government or governmental unit” is limited to situations where the government was the borrower or debtor.[23]

A few jurisdictions, however, have excused governmental creditors from complying with Article 9’s perfection and priority requirements.[24]  For example, in In re City of Moran,[25] the court ruled that a governmental-entity creditor did not have to comply with Article 9’s requirements because the security interest at issue was considered a “lease-purchase agreement” by the parties that was authorized under Kansas’s Economic Development Revenue Bond Act, which was passed before Kansas enacted the UCC.[26]  The Moran court noted that the legislature intended that a “lease-purchase agreement” would not fall under Article 9 because “[t]o do otherwise would certainly discourage bondholders who would be dependent upon the city or the county to protect their interest by filing a financing statement.”[27]  The Delphi court explicitly distinguished Moran by finding that the legislature “ha[d] not singled out governmental entities such as [the governmental creditor] for special treatment when it is a secured creditor so, like other creditors, it must comply with Article 9 in perfecting a security interest.”[28]  Similar to Moran, in In re Allstate Life Insurance Company Litigation, a federal district court in Arizona held that a governmental creditor was excused from complying with Article 9’s perfection requirements[29] because the Arizona version of the UCC provided that “Article 9 does not apply to transfers, pledges, and similar actions by this state or governmental unit of this state.”[30]  The Allstate court held that the Arizona UCC’s language did not only apply to situations where the governmental unit was the debtor or creditor because the comments to the Arizona UCC indicated that this limitation had been replaced.[31]  The Delphi court made no reference to the Allstate decision.

Delphi is significant because it demonstrates that a governmental entity must comply with Article 9’s filing and perfection requirements for security interests when the entity is acting as a secured creditor.  As such, a governmental-entity creditor is held to the same standard as a private creditor.  Therefore, a governmental unit that extends credit to a borrower should perfect its security interest by following Article 9’s perfection requirements for the particular collateral. Moreover, as Delphi demonstrates, the governmental unit should file a UCC-1 in the appropriate recording office even if the debtor is only “leasing” the collateral.  Indeed, the process for perfecting a security interest is not difficult for most collateral and perfecting its security interest will ensure that the governmental-entity creditor has priority over competing security interests.  Moreover, if a state wishes to allow government creditors to be exempt from Article 9 filing requirements, the state merely needs to enact such an exception as Kansas and Arizona did.[32]  Ultimately, absent such an exemption, a governmental creditor should perfect their security interests in accordance with Article 9’s perfection requirements so that the creditor maintains its priority.