In In re K & L Leasing, Inc., 665 B.R. 364 (Bankr. E.D. Tenn. 2024), the U.S. Bankruptcy Court for the Eastern District of Tennessee held that a security interest in inventory can only be perfected by filing a UCC-1 financing statement even though the collateral was also subject to a certificate of title statute under Tennessee law. 

Background

K & L Sales & Leasing, Inc. (Borrower 1) was in the business of selling big rig trailers. Greeneville Federal Bank (Lender 1) and Borrower 1 entered into a revolving loan agreement. As security for the loan, Borrower 1 granted Lender 1 a security interest in virtually all of Borrower 1’s assets, including all current and after-acquired inventory. The security agreement also provided that Borrower 1 would not, without Lender 1’s consent, sell Lender 1’s collateral, except in the ordinary course of business, or permit another lien, security interest or other encumbrance to be placed on any of the collateral.

In March 2019, Borrower 1 transferred 10 trailers (Subject Trailers), which were subject to Lender 1’s security interest, to its affiliate, K&L Trailer Leasing, Inc. (Borrower 2). Lender 1 did not take any affirmative action to release its security interest in the Subject Trailers as it did when Borrower 1 sold trailers in the ordinary course of business. 

To finance the acquisition of the Subject Trailers, Borrower 2 borrowed funds from First Farmers & Commercial Bank (Lender 2) and granted Lender 2 a security interest in the Subject Trailers. The title documents for each of the Subject Trailers reflected a first lien security interest in favor of Lender 2 and did not reflect a security interest in favor of any other party, including Lender 1.

Lender 2 did not give notice to Lender 1 of its security interest in the Subject Trailers, did not make any payments to Lender 1 with respect to its blanket security interest in the Subject Trailers, and took no action to obtain a release from Lender 1 as to the Subject Trailers. 

At the time that Lender 2 acquired its security interest from Borrower 2 in the Subject Trailers, examination of Borrower 2’s documents of ownership for the Subject Trailers reflected that each trailer was acquired from Borrower 1.   

The Lien on the Subject Trailers Was Perfected By a UCC-1 Financing Statement

Tennessee’s version of UCC Section 9-311 provides that “a financing statement is not necessary or effective to perfect a security interest in property subject to . . . [a] certificate of title statute . . . covering . . . trailers . . . which provides for a security interest to be indicated on a certificate of title as a condition or result of perfection.”  

However, an exception exists—where filing a financing statement is necessary—if the collateral is inventory held for sale by a person in the business of selling goods of that kind. In other words, a UCC-1 financing statement is necessary to perfect a security interest in inventory that is being held by a person selling that type of inventory in the ordinary course of that person’s business. 

Here, a UCC-1 would ordinarily not be needed to perfect an interest in the Subject Trailers because they are subject to Tennessee’s certificate of title statute. However, because the Subject Trailers constituted inventory to Borrower 1, a UCC-1 financing statement was the only way to perfect since Borrower 1 was in the business of selling trailers. 

Lender 1’s security interest in the Subject Trailers was perfected because it filed a UCC-1 financing statement covering the Subject Trailers.   

In an effort to sidestep this result and assert a first lien on the Subject Trailers, Lender 2 argued that, since the Subject Trailers were sold to Borrower 2 and Borrower 2 is not in the business of selling trailers, Lender 1 lost its perfection when Lender 2 noted its liens on the certificates of title on the Subject Trailers. 

The court rejected Lender 2’s argument, noting that “[s]uch an argument jumps over and wholly misapplies the foundational protections of secured parties under Article 9 when collateral is disposed of by a debtor and no exception applies to allow the disposition to be free of the security interest created by the debtor.”

Applying section 9-311(d), the court held that Lender 1’s only method of perfecting its lien on Borrower 1’s inventory, including the Subject Trailers, was to file a UCC-1 financing statement. In fact, the court observed that comment 4 to section 9-311 makes clear that compliance with the certificate-of-title statute would have been unnecessary and ineffective for Lender 1 to perfect a security interest in the Subject Trailers because they were Borrower 1’s inventory.

According to the court, adopting Lender 2’s argument would mean that a properly perfected inventory lien “would not survive the transfer even if the sale was not to a buyer in the ordinary course.” The court further found that Lender 2’s argument conflated “questions of how to perfect inventory that is subject to the state’s certificate-of-title law and what happens when property is transferred in contravention of the rights of secured parties under the UCC.”

The court also noted that section 9-315(a) of Tennessee’s version of Article 9 provides that “a security interest . . . continues in collateral notwithstanding sale . . . or other disposition thereof unless the secured party authorized the disposition free of the security interest . . .” Moreover, Section 9-507(a) provides that “[a] filed financing statement remains effective with respect to collateral that is sold, exchanged, leased, licensed, or otherwise disposed of and in which a security interest or agricultural lien continues, even if the secured party knows of or consents to the disposition.” 

Thus, “[s]ection 9-507(a) coordinates with section 9-315(a) to make clear that the secured party’s perfection is uninterrupted by disposition of collateral when section 9-315(a) applies to continue the security interest.” 

Lender 1 did not authorize the transfer of the Subject Trailers free of its security interest. While there are exceptions to section 9-315(a), the court found that none applied based on the facts before it. As a result, Lender 1 had the first priority security interest in the Subject Trailers even though Lender 2’s security interest was noted on the certificates of title.

Conclusion

The holding in K & L Leasing, Inc. provides a reminder to lenders taking a lien on collateral that is subject to a certificate of title statute that is not enough to review only the certificate of title for a prior perfected lien. Lenders also need to consider whether the collateral may have previously been considered inventory covered by a lien perfected through a UCC-1 financing statement.