For Purposes of Determining Avoidability of a Preference Under the Bankruptcy Code, Timing of Perfection of Security Interest is Determined by Federal, and Not State, Law

In In re Johnson, 2007 WL 4465186, a Chapter 7 trustee brought an adversary proceeding to avoid, as a preference, a purchase money lender’s security interest in a vehicle that was perfected shortly before the debtor filed bankruptcy.

On February 8, 2005, the debtor had purchased the vehicle, executed an installment sales contract and security agreement with the lender, and took possession of the vehicle.  On February 17, 2005, the dealership mailed a title lien statement, application for certificate of title, and the required fees to the appropriate county clerk’s office.  The county clerk received the mailed documents and fees on February 22, 2005, but did not stamp the documents as received and upload the lender’s lien for recordation until March 7, 2005.  On March 25, 2005, the Kentucky Transportation Cabinet issued the certificate of title reflecting notation of the lender’s lien on March 7, 2005.  Less than ninety days later, on May 11, 2005, the debtor filed a petition for relief under Chapter 7 of the Bankruptcy Code. 

In response to the trustee’s avoidance claim, the lender argued that its lien fell within the “enabling loan” exception to avoidable preferential transfers.  Such an exception protects from avoidance the creation of a security interest in property acquired by the debtor if the security interest is perfected on or before twenty days after the debtor receives possession of the property.  The lender argued that its security interest on the certificate of title was deemed perfected under KRS 186A.195(5) within twenty days of the debtor taking possession of the vehicle because it had tendered the required fees and appropriate documents to the county clerk within the twenty days and the county clerk subsequently noted the lender’s security interest on the certificate of title, causing the security interest to relate back to the date the documents and fees were tendered.  Accordingly, argued the debtor, its security interest was not avoidable by the trustee.

Although the bankruptcy court agreed with the lender, the Bankruptcy Appellate Panel of the Sixth Circuit disagreed, pointing out that while state law determines the means of perfection, the timing of perfection is governed by federal law when the issue is the voidability of a preference under the Bankruptcy Code.  Under federal law, perfection is not a legal conclusion that may be reached by applying a state’s relation-back rule, but instead may only be reached at the time the secured party (or governmental employee, if required) has actually performed all of the acts necessary to perfect its interest.  Since actual notation by the county clerk of the lender’s security interest on the certificate of title did not occur until March 7, it was only then that the lender’s security interest was perfected.  As this date was outside of the twenty day window, the lender’s security interest did not fall within the enabling loan exception and was avoidable by the trustee as an impermissible preferential transfer.

Posted by: LeAnders L. Jones

Categories: Bankruptcy & Banking Law