In response to the COVID-19 pandemic, the U.S. government offered COVID-19 Economic Injury Disaster Loans (“EIDL”) through the Small Business Administration (‘SBA”). The SBA stopped accepting new loan applications as of January 1, 2022.
Due to program design, the EIDL might cloud title without providing adequate public notice. This means that an EIDL loan could delay or prevent financing, re-financing, or sale. It could also mean an unintentional contractual breach of standard representations and warranties that speak to the absence of undisclosed encumbrances.
If you did not receive an EIDL loan (and your prurient interests are not aroused), you may stop reading here.
How? With apologies in advance for the complexity involved, this blog will involve two steps:
- A short trip through secured transactions, liens, and the Uniform Commercial Code (“UCC”), and, assuming you survive,
- An analysis of how the EIDL potentially clouds title and priority of security.
The UCC is involved when a transaction creates collateral. In more legalistic terms: in a secured transaction, a secured party takes a security interest (e.g., a lien) in an obligor’s real or personal property (i.e., tangibles, intangibles, quasi-intangibles, proceeds, etc.) for the purpose of securing payment or the performance of an obligation. (For more in-depth definitions, click here). These transactions rely on three overarching factors: (1) attachment; (2) perfection; and (3) priority.
Attachment occurs when a security interest “attaches” to the collateral. (While the process can be complicated, we’re really only talking about the valid creation of collateral.)
Perfection occurs when the secured party puts the world on notice that a creditor is claiming rights against a borrower’s property. Perfection is often achieved merely by filing the financing statements in the appropriate jurisdiction; real property filings for corporate entities are done at the “county” level of the state of incorporation. Unperfected rights can be challenged – and sometimes dismissed – in court (because it would be unfair to burden a bona fide innocent purchaser, e.g., with liens about which it could not have known).
Priority is the determination of superior and inferior security interests. Generally, a perfected security interest is superior to those that follow. How does that work? If a property is worth $100 but has two liens worth $80, somebody has got to lose. The loser has an inferior security interest.
EIDLs suffer from a perfection problem.
Assume a successful EIDL recipient receiving SBA funding. If the loan is greater than US$25,000, the SBA files the financing statement with the appropriate Secretary of State to record a security interest against the borrower’s “business assets”. This is normal for secured transactions—because financing statements are regularly filed at the state level.
Business assets would of course include real property. However, title searches for real estate transactions are regularly run only at the county level. In such transactions, a bona fide innocent purchaser or financing party would not discover the EIDL-generated security interest in the real property.
This leads to serious questions:
- Does the SBA have an enforceable security interest in real property?
- Does the SBA have priority over subsequent secured parties who filed at the county level against real property?
As of this publication, these questions remain unanswered. However, savvy secured parties will want to ensure clear title is not clouded:
- Bona fide purchasers, secured parties, and attorneys should search both county and state filing offices when conducting searches.
- Parties should work with title companies and other involved parties to provide disclosures and obtain waivers when an EIDL loan appears to create a security interest.
- If clouded title is discovered after the transaction, title policies could be activated.
If this already makes your head spin…you’re in luck! At The Wallenstein Law Group, we pride ourselves on our expertise and knowledge, leveraging that experience to thoughtfully guide client transactions to closure. Contact us today!