FINANCIAL MANAGEMENT/Revised UCC article creates uncertainty

Article 9 of the Uniform Commercial Code (UCC) recently was revised, and the changes involve security interests that make it critical for local governments to update investors. First, cities and counties need to tell investors which version of Revised Art. 9 is in effect in their states. Also, they should inform investors of the steps they are taking to ensure that bondholders maintain the same security interest that existed at the time bonds were issued. The information should be sent to a Nationally Recognized Municipal Securities Information Repository (as designated by the Securities Exchange Commission) and should be included in offering documents for new bonds.

Revenue bond investors need to be certain about whether — and how much — they will be paid if a bond issuer goes bankrupt. Knowing what type of lien has been placed on pledged collateral creates that certainty and allows an investor to decide if it is willing to own the bond and the price at which it is willing to buy.

The revision could jeopardize pre-existing bondholder security interests. Most investors have not been informed of the changes, and those investors are now uncertain about what they own.

The prior version of Article 9 (Old Art. 9) specifically did not apply to “a transfer by a government or government subdivision or agency.” That meant a government could pledge its revenues and assets to revenue bondholders who were assured that the bonds would be repaid even in bankruptcy. Revised Art. 9, which became effective in most states on July 1, extends various security interest perfection requirements to bond issuers unless the adopting state has another statute that “expressly governs the creation, perfection, priority or enforcement of the security interest created” by the issuer.

Thus, Revised Art. 9 may be applicable to many governmental revenue bonds to which Old Art. 9 did not apply, including bonds issued for water and sewer projects. However, differing versions of the revision have been adopted by the various states.

Under the most commonly adopted revision language, security interest filings for new and previously issued bonds now may be required to assure bondholders that they will be paid in the event of a governmental bankruptcy. A cure period exists during which the security interest in bonds issued before July 1 can be re-perfected under Revised Art. 9.

Few issuers disclose to bondholders which version of Article 9 is in force in their state and whether bondholders have perfected security interests in the applicable collateral. Failure to disclose places the burden on investors to determine whether they continue to be secured parties in bankruptcy.

Under the most common version of Revised Art. 9:

• Security interests previously perfected could be in jeopardy because the revision applies retroactively. Unless a separate statute provides for perfection of a lien for bonds issued before the revision, or unless other steps are taken to perfect previously perfected liens, holders of bonds issued under Old Art. 9 may become unsecured creditors. That debt may end up being junior to subsequently issued parity debt.

• Even if a separate statute provides for perfection of the security interest, a UCC filing also could be necessary because statutes often define collateral differently than does the UCC.

• State law may require governmental control or possession of revenues and accounts, while the UCC requires that the secured party be in possession or control of pledged revenues. That would create a problem even in situations where the bonds are trusteed, and not all governmental bonds are trusteed.

• The author is a senior analyst with the Fixed Income Group of Vanguard Group, Valley Forge, Pa. She is a member of the National Federation of Municipal Analysts.