Perfection of Security Interests in Instruments and Documents

A condensed comparison

I. INTRODUCTION

Modern-day commercial transactions often require that a buyer, or seller, or both, have access to credit prior to execution of a purchase sale contract. Generally, the seller may require credit to manufacture the goods to be sold including obtaining raw materials inventory and to pay for manufacturing costs. Furthermore, the buyer may require credit to pay for the purchase price of the goods and other expenses.

In transactions taking place between parties within the United States, the credit may be obtained from a bank, an asset-based lender or the seller herself who will secure the credit via an Article 9 security interests over the tangible collateral. In Mexico credit can be obtained from a banking institution or a conditional seller. However, due to the present uncertainties in Mexican secured transactions law, the creditor will most likely limit its credit to commercial enterprises with a substantial net-worth and credit history--and even then, only to those willing to enter into a personal guarantee arrangement. Otherwise, the bank will raise the price of credit and intermediation fees in order to compensate for the legal uncertainty of the security interest.

In transactions between foreign buyers and sellers, the security interest issue becomes proportionately more complicated. To understand the players and issues in a cross-border transaction consider a case where a Yucatan Mexico seller is going to sell goods to a Washington State buyer, or vice versa. If the parties have a long-standing relationship, the seller may be willing to ship the goods on open credit relying only on the willingness and ability of the buyer to pay. However, if the parties are not familiar with each another, a letter of credit would be a viable solution.

As mentioned, we are assuming the seller will require credit to manufacture or purchase the goods to be sold and the buyer will require credit to pay for them. Under such an arrangement, the creditors to the transaction will require a security interest to secure the payment of the loans on both sides. Thus, there will be at least five parties to the transaction: the seller and her creditor, the buyer and her creditor, and at least one carrier. Furthermore, assume this setting will require the following documentation: purchase/sale contract, letter of credit (with presentment documentation usually consisting of negotiable bill of lading, invoice, insurance policy, inspection certificate, export license and certificate of origin), note, warehouse receipt, and security agreements.

In order to secure the payment of the loans extended in our hypothetical transaction, the creditors for both the seller and buyer desire to take a security interests in the pertinent documents. The issues of perfecting this security interest will be analyzed in the remainder of this memorandum. The following sections will first tackle the perfection question in instruments and documents under U.S. law, turning then to an analysis under current Mexican law and finally under the statute proposed by the NLCIFT for creation and perfection of security interests in Mexico.

II. U.S. LAW

In general, security interests in personal property collateral are perfected by filing a financing statement. However, Article 9 establishes two exceptions to this rule: perfection by possession and temporary perfection. UCC Article § 9-302.

Security interests in instruments--except for the provisions on temporary perfection--can be perfected only by the secured party’s taking possession of the instrument pursuant to §§9-304 and 9-305. In contrast, security interests in documents may also be perfected by filing pursuant to §9-304. Furthermore, both instruments and documents may be perfected temporarily by automatic perfection pursuant to §9-304(4) and (5).

A. Filing:

We must keep in mind that Article 9 does not provide a perfection by filing alternative where instruments are involved. Official comment 1 to Model UCC §9-304 explains the rationale behind the filing limitation by stating that

Where the collateral consists of instruments, it is universal practice for the secured party to take possession of them in pledge; any surrender of possession to the debtor is for a short time; therefore it would be unwise to provide the alternative of perfection by filing which _*** would serve no useful purpose. Conversely, no such limitation is established for documents.

For purposes of our discussion, it is sufficient to say that using the perfection by filing option over documents will add certainty to the transaction by providing an additional form of notice to third parties, and by providing the secured party with priority over the original collateral and its proceeds. However, the security interest will continue in the proceeds only if the financing statement indicates the property constituting the proceeds pursuant to §9-306(3)(a).

B. Possession:

A security interest in an instrument or document may be perfected by possession. §9-302 establishes that "... (a) financing statement must be filed to perfect all security interests except a security interest in collateral in possession of the secured party." Furthermore, §9-305 expressly establishes that a security interest in letters of credit, goods, instruments (other than certificated securities), negotiable documents, or chattel paper may be perfected by the secured party’s taking possession of the collateral. If the collateral is being held by a bailee, §9-305 further provides that "... the secured party is deemed to have possession from the time the bailee receives notification of the secured party’s interest." Under §9-305, giving the bailee notice of the security interest has the same effect as the secured party taking possession of the goods.

C. Temporary Perfection:

A security interest in instruments and documents may be perfected for 21 days without possession or filing in a couple of different circumstances. The first is where the security interest is originated for new value, the security interest has attached, and there is a written security agreement. §9-304(4). For example when a bank lends money to enable the debtor to purchase goods and some time (less than 21 days) will elapse between the extension of the credit and delivery of the document covering the goods acquired.

The second circumstance where security interest may be perfected for 21 days without possession or filing arises when the secured creditor has possession and returns the collateral to the debtor for sale, exchange, collection or registration of the instrument. §9-304(5). The secured party may surrender a document to the debtor and still have a perfected security interest for 21 days if the document is needed for shipping, manufacturing, or processing of the goods covered by the document. Ultimately, subsection (5) specifically contemplates the case in which the debtor not only takes possession of the instrument or document but also of the goods represented thereby. Although subsection (5) does not explicitly state that the 21 day period commences when possession of the goods or paper is given to the debtor, many commentators have stated that there is no other sensible interpretation. In both of the mentioned circumstances, continued perfection at the end of 21 day period depends upon proper filing or possession of the collateral under §9-304 or temporary perfection over the proceeds under §9-306.

D. Proceeds:

As mentioned, an additional temporary perfection provision is found in §9-306(3) which states that:

The security interest in proceeds is a continuously perfected security interest ... and becomes unperfected ten days after the receipt of the proceeds by the debtor unless

a) a filed financing statement covers the original collateral and the proceeds are collateral in which a security interest may be perfected by filing in the office ... where the financing statement has been filed and, if the proceeds are acquired with cash proceeds, the description of the collateral in the financing statement indicates the types of property constituting the proceeds; or

b) a filed financing statement covers the original collateral and the proceeds are identifiable cash proceeds; or

c) the security interest in the proceeds is perfected before the expiration of the ten day period.

E. Application:

In our hypothetical transaction, let us assume that the Washington seller requires credit to purchase or grow apples which it intends to export to the Yucatan buyer. Once seller obtains credit and purchases the apples, she will deposit the goods in a warehouse awaiting agreement with buyer regarding price and other matters. Upon agreement, and the eventual execution of a purchase sale contract, seller will take the goods to port and deposit them with a mutually agreed carrier for transportation to the buyer.

As applied to our hypothetical transaction, the seller’s creditor could extend credit to the seller by first taking a security interest in the apples. When the apples are stored in the warehouse, the creditor could perfect its security interest by taking possession of the warehouse receipt or by giving notice of the valid security interest to the bailee. Furthermore, when the goods are deposited with the transport carrier, the creditor would perfect its security interest by taking possession of the issued bill of lading.

Possession under the above example works fine for a while. However, we should note that the secured creditor must turn over the possession of the documents to the debtor at two junctures of the transaction. First of all, in order to transport the apples to port and eventually contract for shipment to Yucatan, the debtor will require possession of the warehouse receipt to withdraw the apples from the warehouse. This does not present a problem since the secured creditor will have a period of 21 days in which she will be temporarily perfected. Furthermore, the transportation to port and arrangements with the carrier should take less than 21 days. Within this period of time, the debtor will deliver the goods to the carrier who in turn will issue a bill of lading. The secured creditor can then take possession of the bill of lading and re-acquire a perfected security interest over the goods.

Second, when the carrier arrives in Yucatan, the buyer will have to present the bill of lading for delivery of the goods. Therefore, the secured creditor will, once again, be required to relinquish possession of the bill of lading collateral. The secured creditor will be willing to do so, because as with the warehouse receipt, she has the 21 day cushion of perfection. It is expected that the buyer and her bank will pay for the goods within the temporary perfection period, thereby enabling the seller and her bank to arrange the payment of the secured debt within the statutorily prescribed period.

We should also recall that payment of this transaction will take place under a letter of credit and that the buyer requires an extension of credit to pay the letter. Additionally, in order for buyer to obtain the credit, buyer’s bank will take a security interest using the apples as collateral. For the sake of simplicity we will further assume that buyer’s secured creditor is the same party issuing the letter of credit and that seller’s secured creditor is the correspondent bank.

Upon arrival at the Mexican port, the issuing bank ( buyer’s secured party) will pay the seller’s secured creditor (correspondent bank). The correspondent bank will then deliver the bill of lading to the issuing bank which, in turn, will deliver it to the buyer to pick up the goods from the carrier. However, the delivery of the bill of lading may take place before actual payment by the issuing bank in which case the correspondent bank would have a temporarily perfected security interest for the mentioned 21 day period.

Upon payment, the correspondent bank (seller’s secured creditor) may set-off the secured credit amount to pay for the debt or deliver the amount to the seller and wait for payment. Under §9-306, seller’s secured creditor will have a security interests in the cash proceeds under subsection (1), a temporarily perfected security interest in the proceeds for ten days pursuant to subsection (3), by having filed a security interest in the original collateral pursuant to subsection (3)(b), or by filing a financing statement prior to the expiration of the ten day period pursuant to subsection (3)(c).

III. MEXICAN LAW

Analyzing the present transaction under Mexican law we find that there is relatively little legislation and case law regulating the creation and perfection of security interests in instruments and documents. Additionally, few secondary sources deal expressly with the subject matter. Furthermore, unlike in the United States, there is no single uniform mechanism used for securing a credit transaction. Instead, we are confronted with an array of provisions within the General Law of Credit Instruments and Operations [Ley General de Títulos y Operaciones de Crédito, hereinafter "LGTOC"], the General Law of Auxiliary Credit Organizations and Activities [Ley General de Organizaciones y Actividades Auxiliares de Crédito, hereinafter "LGOAAC"] and the Law of Credit Institutions [Ley de Instituciones de Crédito, hereinafter "LIC"].

Before we begin, it is noteworthy to mention that the analytical approach employed in the present section will differ from our analysis under U.S. law. In the previous section we looked at the varying methods of perfection under Article 9, starting with filing and ending with temporary perfection. Under Mexican law, we will focus on the proper method for creating and perfecting a security interest in a Warehouse Receipt a Bill of Lading, turning then to other legal considerations affecting our analysis.

A. Warehouse Receipt::

Under the LGOAAC, only properly licensed warehouses controlled by the federal government may issue a negotiable warehouse receipt; any other warehouse receipt will not qualify as a document of title. Under Mexican Law, the possessor or endorsee of the warehouse receipt and its coupons has exclusive rights to claim the warehoused goods upon presentation of the documents.

In order to take a security interest in the warehoused goods the creditor may take possession of coupons attached to the receipt in the so called bond pledge (bono de prenda). Under the LGTOC, the warehouse receipt accredits title to the goods and the bond pledge coupons establish the creation of a pledge over the goods represented by the document. Since the law creates the bond pledge expressly to provide a security mechanism, one would think this would be the exclusive method for perfecting a security interest. However, the creditor has the option of perfecting a security interest directly in the warehouse receipt.

Under this bifurcated system, when acting over the document itself, the creditor must take possession of the warehouse receipt if it has been issued to bearer (LGTOC art. 334 I). If the receipt has been issued in the debtor’s name, the creditor may take a security interest in the document by having the document endorsed, in security, in its favor (art. 334 II).

Article 230 of the LGTOC establishes that negotiable warehouse receipts will attach documentation (coupons) necessary for the creation of a bond pledge. One coupon is attached for a single item and when the warehoused goods are specific. Several coupons may be attached for a quantity of fungible goods (such as 200 fungible refrigerators of 150 tons of apples) pursuant to the instructions of the bailor. Said documents or coupons will be left blank until the a creditor decides to loan against the document. Once a debtor-creditor relationship is considered between the bailor and a bank, only the duly authorized warehouse can fill in the pledge bond documentation. The security interest over the goods is then perfected by removing the completed coupon(s) from the warehouse receipt and delivering them to the secured creditor.

Under this scenario, we have 2 documents that may be further negotiated. On the one hand, the debtor-bailor has possession of the warehouse receipt which it may transfer to a third party by endorsement. On the other hand, we have a secured creditor with possession of the bond pledge coupon which it may also negotiate independently. Furthermore, in cases where the warehoused goods are fungible, the debtor-bailor may create more than one bond pledge secured credit agreement over the multiple coupons issued. It is also conceivable that the creditor may require possession of both the coupon and the warehouse receipt.

B. Bill of Lading:

Under Mexican law, perfecting a security interest in a bill of lading is simpler than a warehouse receipt because our options are limited to the traditional endorsement and pledge of the document. Furthermore, there is no perfection independent of the document. Article 20 of the LGTOC and article 170 of the Law of Navigation and Maritime Commerce jointly establish that any transaction, negotiation, security interest or embargo over the shipped goods will be invalid unless such transactions are effectuated with the document itself in hand.

Therefore, in order to perfect a security interest in a bill of lading issued to bearer, the secured party must take possession of the document (LGTOC art. 334 I). Furthermore, If the bill of lading is issued to in the name of the debtor, a security interest is perfected by endorsing the document, in security, to the secured party (art. 334 II). A third alternative for perfection is the endorsement or delivery of the document in favor of a third party at the disposition of the secured party (art. 334 IV).

C. Application of the Law of Credit Institutions:

Our analysis of Mexican law has focused primarily on the pledge under LGTOC. However, our hypothetical transaction employs a properly authorized banking institution as the pledgee of the documents utilized. Therefore, we must be aware that the LIC establishes a banking pledge of its very own.

The LGTOC defers to the application of the LIC when dealing with banking transactions. The reason that our analysis has not focused on the LIC is simply that the LIC implicitly defers jurisdiction back to the LGTOC. On the one hand, article 345 of the LGTOC establishes that its pledge rules (art. 334 et. seq.) do not modify either dispositions related to the bond pledge (contained in LGTOC art. 229 et. seq.) nor the rules contained in the LIC. In other words, art. 334 of the LGTOC regulates all commercial pledges except the bond pledge and the banking pledge which are governed by their own special provisions. However, regardless of this deference in application, article 69 of the LIC provides that a bank pledge will take place according to the dispositions of the LGTOC.

It would appear that neither the banking nor the credit legislator wishes to regulate the banking pledge--instead they each state that this transaction will take place according to the regulations of the other. However, an analysis of Mexican supplementary application rules indicates that we must use the LGTOC since this law provides particular rules for establishing the pledge over documents and the LIC does not.

This rule notwithstanding, it is necessary to indicate that article 69 of the LIC establishes one exception to the pledge constitution rules of article 334 of the LGTOC; namely, that "the credit document must include sufficient data for identifying the pledged goods in order for the pledge to be constituted properly." Therefore, the banking pledge must be constituted by adding this requirement to those established in the LGTOC.

This requirement is somewhat confusing since the identification of the goods requirement established by the LIC appears to be provision designed to provide proper notice to third parties. To wit, we are required to draft a pledge contract describing the goods already described in the pledged document. Therefore, instead of a pledge referencing a negotiable document describing the goods represented thereby, we encounter a pledge document making direct reference to the goods represented by the document. Furthermore, as we have seen, both the bill of lading and the warehouse receipt must be delivered or endorsed to the creditor in order to perfect the pledge. Therefore, a third party would be on notice simply by the secured party’s possession of the document or by an endorsement in her favor. Furthermore, there is no requirement that a third party further ask to see the pledge contract. Likewise, we do not encounter a filing requirement since the security interest already provides possessory notice. Should filing be required to perfect the security interest, a description of the goods would better serve the notice function.

D. Application:

In our hypothetical transaction, let us assume that the Yucatan seller requires credit to purchase or grow coffee which it intends to export to the Washington buyer. Once seller obtains credit and purchases the coffee, she will deposit the goods in a warehouse awaiting agreement with buyer regarding price and other matters. Upon agreement, the seller will make shipping arrangements.

As applied to our hypothetical transaction, the seller’s creditor could extend credit to the seller when the coffee is stored in the warehouse, and would perfect its security interest by either: 1) taking possession of the warehouse receipt if the receipt was issued to bearer; 2) by having the receipt endorsed in its favor if the document was issued in the debtor’s name; or 3) by having the licensed bailee issue a bond pledge coupon in it’s favor to the extent of the credit provided to the bailor. Later, when the goods are deposited with the transport carrier for shipment to the buyer, the creditor would perfect its security interest by taking possession of the issued bill of lading.

Once again, perfection by possession of the documents works fine temporarily. However, the secured creditor must turn over the possession of the documents to the debtor first to withdraw the coffee from the warehouse and transport it to the port and second to deliver the bill of lading to the buyer so that she may acquire possession of the coffee. Unlike Article 9, Mexican law does not provide for a period of temporary perfection whereby the secured party may deliver the documents and retain its priority for 21 days. Under Mexican law, the secured party loses its security interest in the goods at the moment that it delivers or re-endorses the documents or delivers the bond pledge coupons. Therefore, the secured party will probably require payment in full prior allowing the debtor to take possession of the goods.

In lieu of cash payment, the creditor may require a personal guarantee, a cash bond or other security before releasing the warehouse receipt. This outcome may have a stranglehold effect on the debtor who may not have the funds to pay the creditor until the buyer has the coffee and pays the letter of credit. If the buyer does not have a long-standing relationship with the seller, the buyer will be unwilling to pay for the coffee before she has possession. Therefore, the debtor may be forced to sell the goods locally at a cheaper price. In one instance in which I am familiar, a sympathetic secured party released the warehouse receipt to the debtor so that this party may transport the goods to the shippers location. In this unusual case, the secured party bank had a loan officer accompany the debtor for the entire trek to ensure that the goods actually made it to the right boat. In most instances the creditor will not be willing to go to such lengths preferring not to lend or even if it does lend requiring payment before surrendering perfection. Therefore, we could say that the state of the law would have the effect of ending our transaction long before the goods make it to port.

In the unlikely event that the credit transaction continues through the shipping stage, the creditor can re-perfect its security interest by taking possession of the bill of lading or by having this document issued or endorsed in its favor. However, once again, the creditor must relinquish possession of the document in order for the buyer to take possession of the goods. Considering that the creditor will lose its security interest by doing so, this party will be reluctant to deliver the document. At first glance this problem seems remedied fairly easily by a provision that the letter of credit be paid directly to the secured party bank or by having a right of set off against the loaned funds. However, this outcome is also unnecessarily harsh hindering the asset maneuverability that temporary or filing perfection may provide the debtor.

As we recall, the Washington buyer will also require credit to pay for the letter of credit. The U.S. bank will be willing to loan the funds by perfecting a security interest in the coffee and its proceeds by filing a simple UCC 1 financing statement over said collateral.

IV. LEGISLATIVE DRAFT

The problems inherent in the current Mexican regime should be apparent enough to prompt a movement for reform in the secured financing area. We at the NLCIFT embrace this momentum and are participating in the modernization process by drafting a statute that will alleviate most of the problems in this area of the law. Although the legislative draft encompasses all aspects of secured financing, the following paragraphs will focus exclusively on the provisions designed to remedy the problems presented by our hypothetical.

A. Perfection of a Security Interest in Documents:

Under Article 13 (c) of the draft, a secured party may perfect a security interest in negotiable documents, including warehouse receipts and bills of lading, by having these endorsed in its favor pursuant to Article 36 of the LGTOC, and by taking possession of the paper collateral, or by filing a financing statement. However, when a negotiable document has been issued to bearer, possession will continue as the exclusive method of perfection.

If a secured party which has perfected a security interest by possession or endorsement, and must deliver or re-endorse the document to the secured debtor for withdrawal, warehousing, manufacturing, shipping or sale, the secured party may file a financing statement during the period of time in which the collateral remains in her possession. By doing so, the secured party’s first in time right will be preserved. The financing statement must describe the document collateral and any endorsement must be qualified according to the LGTOC.

As we saw under the section on U.S. law, the official commentators to the UCC considered filing of a financing statement in instruments unnecessary and "unwise" stating that any surrender of possession to the debtor is for a short time and a filing would serve no useful purpose. However, we must remember that the UCC was originally drafted in the mid-1950s when paper based registries may be unduly burdened by multiple filings of short duration, yet the paper filed would be preserved for many years. Furthermore, in order to file, a secured party may have to drive to the capital of the proper filing jurisdiction sometimes adding considerable hardship to the filing burden. However, in a modern world we do not encounter any of these inconveniences as filings can be made via computer at the speed of electronic communication systems and the financing statement can be tagged with any period of duration the secured party deems appropriate. Therefore, these policy rationales seem to have lost their importance making filing a viable perfection alternative which should be adopted by the Mexican statute.

The draft also preserves the notice perfection possibility when the goods are deposited in a warehouse. Under this scenario, the secured party may perfect by giving notice to the bailee and the result will be similar to the secured party taking constructive possession of the warehoused goods.

Under the draft statute, a security interest will also extend to the proceeds of the document under any one of three methods. First off, the security interest will continue in the proceeds if the financing statement covers the original document and the proceeds are described therein in generic fashion. Second, proceeds will be covered if the financing statement covers the original document collateral and the proceeds are traceable cash proceeds. Finally, a security interst is perfected in the proceeds if a financing statement if filed before the document is delivered to the secured debtor and prior to the original colateral conversion into proceeds.

B. Perfection of a Security Interest in the Proceeds of Letter of Credit:

Under Article 13 (b) of the proposed draft, a beneficiary of a LOC may create a security interest in these proceeds by assigning its right to part or all the proceeds. The beneficiary may also do so before presentation as a present assignment of its right to receive proceeds contingent upon its compliance with the terms and conditions of the LOC. To preserve the right of the issuing bank, an issuer or nominated person need not recognize an assignment of proceeds of a LOC until it consents to the assignment. However, this issuer or nominated person has no obligation to give or withhold its consent to an assignment of proceeds of a LOC, but consent may not be unreasonably withheld if the assignee possesses and exhibits the LOC and presentation of the LOC is a condition to honor.

Under the draft, a security interest in a LOC and its proceeds may be perfected by possession. When the secured party has lawful possession of the LOC, it does not have the right to draw under such a LOC unless the LOC has been amended to allow the draw by the secured party or the LOC is transferable and the secured party has become a transferee under the procedures set forth in the banking customary law in force in Mexico. Alternatively, a security interest in the proceeds of the LOC is perfected when the issuer or the confirmer of the LOC has consented to the assignment in a signed writing and communicated this consent to the assignee.

In order to ensure that the secured debtor receives value, the secured party has a given number of days (yet to be determined) after she receives written notice from the issuer of the consent to the assignment and receives a signed demand by the debtor to extend credit or give value to the secured debtor. If no such credit or value is given, the secured party/assignee must send a signed release to the issuer authorizing the issuer to pay on the LOC to its beneficiary or any other assignee or transferee within a given number of days (yet to be determined) after receiving the signed demand from the debtor.

C. Application:

Once again, our hypothetical transaction requires that the Yucatan seller obtain credit to purchase or grow coffee which it will export to the Washington buyer. Provisions of the legislative draft not discussed in the preceding section will deal directly with this type of financing. Once the coffee is warehoused awaiting agreement with buyer the seller’s creditor could extend credit by perfecting it’s security interest by either: 1) taking possession of the warehouse receipt if the receipt was issued to bearer; 2) by having the receipt endorsed in its favor if the document was issued in the debtor’s name; 3) by giving proper notice of the security interest to the licensed bailee; or, 4) by filing a security interest over the document collateral. Furthermore, any one of these same methods can be used later in the transaction to perfect a security interest over the bill of lading.

Filing as an applicable step for perfection allows the secured party to deliver the documents to the secured debtor or the buyer without having to worry about losing its first in time priority. Furthermore, temporary perfection has been replaced by the filing requirement prior to delivery. Therefore, the secured party need not worry about this statute of limitations on priority.

The provision allowing for a security interest in the proceeds of a letter of credit will also enable the secured creditor to continue its relationship with the seller beyond the payment of the LOC. This tool will be of considerable use to the debtor which will be able to use the capital generated by this export transaction in her business enterprise instead of turning over all the cash to the bank in order to pay the out-standing loan. Furthermore, the secured creditor will be willing to provide the credit since its security interest over the goods retains the priority received at the outset of the original transaction.

V. CONCLUSION

We have seen that, unlike Article Nine, the current Mexican system does not lend itself to properly financing import/export transactions. Export transactions find themselves hindered before the goods make it to a foreign buyer and, more often than not, import transactions must be paid in cash. The limited credit there is further subjugated to payment upon sale.

The limitations of the current regime are remedied quite simply by adding a filing method for perfection at delivery of the document and by structuring provisions for the protection of all parties involved. By so doing, the Mexican legislature will go a long way to promoting the competitiveness of Mexican products in the U.S. market while simultaneously opening the doors to further U.S. imports. Isn’t that the whole purpose of the NAFTA?

Copyright 1998 National Law Center for Inter-American Free Trade

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