The Supreme Court of Kentucky (SCOKY) is expected to rule shortly on the enforceability of a secret lien in favor of a county economic development authority. The secured transaction provisions in Article 9 of the Uniform Commercial Code were designed to minimize the risk of loss to creditors due to “secret liens.” Banks and other financing lenders customarily check public filing offices for liens before extending credit, but “secret liens” are liens on personal property that, for one reason or another, are not required to be filed or recorded with the Secretary of State or County Clerk. Since such liens do not show up on the public record, they can unexpectedly take priority over the lien of a new lender on equipment or other collateral.

In Delphi Automotive Systems, Inc. v. Capital Community Economic/Industrial Development Corporation, the economic development agency for Franklin County used a community development block grant (CDBG) from the federal government to provide financing to a local machine tool business seeking to expand its capacity and increase its employment. The CCEDC provided a financing lease for a machine tool press, and upon making monthly payments for five years, the business expected to acquire ownership of the press. CCEDC did not file a financing statement.

Later, Delphi provided additional financing to the machine tool company, obtaining a security interest in equipment and other assets, and filing a financing statement with the Kentucky Secretary of State. When the business failed and its assets were liquidated, both the CCEDC and Delphi claimed the proceeds of the machine tool press. Delphi claimed its filing prevailed over CCEDC’s unperfected lien. CCEDC made two arguments in response. First, it claimed that its transaction was a lease, not a secured loan, and so it was not required to file under the UCC. Second, it argued that the financing transaction was exempt from the UCC by the government entity exception.

The trial court and the court of appeals rejected the first argument – they relied on a long line of UCC authority that holds that it is the substance of a transaction that determines whether it will be treated as a lease or a secured loan – and in circumstances such as these, the economic reality of the transaction is that of a secured loan, not a lease.

On the second issue, however, the lower courts both relied on public policy grounds to hold that the CCEDC’s unrecorded lien was superior to Delphi’s perfected security interest. In effect, they held that CCEDC’s “secret lien” was entitled to priority over Delphi’s later filed lien. Specifically, the court of appeals relied on Kentucky’s non-uniform (but adopted in several states) 9-109(4)(q) which states that Article 9 and its priority rules do “not apply to …[a] public finance transaction or a transfer by a government or governmental unit.”

The lower courts erred when they applied the government entity exception to this transaction. That section, which came from old Article 9 and was reenacted in Kentucky in 2002, was designed to address the situation where a government entity is acting as the borrower, not where the government entity is acting as the lender. When the government entity is acting as borrower, subsequent creditors of the government are on notice that they are dealing with a special entity and can protect themselves accordingly. On the other hand, when the government entity is acting as lender and filing is not required, a prospective creditor of the government’s borrower has no way of determining that the government agency has a lien on the borrower’s property. In Delphi, the CCEDC argued that it had installed a little plaque on the equipment giving notice to all that it claimed ownership of the press. But the expense of such an inspection in every transaction is exactly what the filing system is designed to avoid in the interest of reducing financing costs generally. And there is no undue expense or inconvenience involved in requiring a government agency to pay $5 to file its own financing statement online, and in fact, most government entities that provide such financing do so.

The Supreme Court of Kentucky has heard argument on this issue. Hopefully, it will recognize that the statute is intended to deal only with government debtors, not government creditors, and act quickly to eliminate this class of “secret liens.”