On July 2, 2010, the United States Court of Appeals for the Sixth Circuit ruled that, under Kentucky law, the “immunizing” effect of a purchase money security interest under Section 547(c)(3)[FN 1] was held in abeyance as a preference claim defense until the enabling loan security interest was “actually noted on the certificate of title.”  Brock v. Branch Banking and Trust Company (In re Johnson), — F.3d —-, 2010 WL 2629704 (6th Cir. 2010).  The holding had the practical effect of exposing the secured lender in that proceeding to the trustee’s claims for lien avoidance and recovery as a preferential transfer.

The Enabling Loan (Purchase Money Security Interest) Defense to a Bankruptcy Preference Claim

The creation of a security interest is considered a “transfer” (Section 101(54)(A)), and it is subject to avoidance and recovery as a preference under Section 547.  However, Section 547(c)(3) protects security interests in property acquired by the debtor with loan proceeds secured by a lien on the financed property.  The protection takes effect if the purchase money lender’s security interest “is perfected on or before 30 days[FN 2] after the debtor receives possession of” the collateral.

Motor Vehicle Lender’s Perfection of Its Purchase Money Security Interest Under Applicable State Law

The relevant facts and time table are:

  • February 8, 2005 (the “Closing Date”) –  Debtor purchased a motor vehicle from a dealership; Debtor executed an installment sales contract and security agreement with Branch Banking & Trust Co. (“BB & T”) to finance the purchase; and Debtor took possession of the truck.
  • February 17, 2005 (Closing Date plus 9 days) – Selling Dealership mailed a title lien statement, application for certificate of title, and required fees to the Letcher County, Kentucky clerk’s office by certified mail, return receipt requested.  Note: At this Point, the Process of Perfecting Lender’s Purchase Money Lien on Title Effectively Leaves Lender’s Control.
  • February 22, 2005 (Closing Date plus 14 days) – County clerk received the mailed documents and fees.
  • March 7, 2005 (Closing Date plus 29 days) – County clerk stamps the documents as received and uploads BB & T’s lien for recordation.
  • March 25, 2005 (Closing Date plus 47 days) –  Kentucky Transportation Cabinet issues certificate of title, reflecting notation of BB & T’s lien on March 7, 2005.
  • May 11, 2005 (Closing Date plus 93 days) – Debtor files voluntary petition for relief under Chapter 7 of the Bankruptcy Code.

The county clerk received BB & T’s application materials on February 22, 2005, which was within 20 days after the security interest attached. However, the county clerk did not process the application until March 7, 2005, outside the then applicable 20-day window for enabling loan protection. [FN 3]

Procedural History – A Long and Winding Road to Deciding When Perfection Occurs to Protect a Kentucky Motor Vehicle Security Interest from Avoidance

Following the bankruptcy filing, the Chapter 7 trustee brought an adversary proceeding to avoid, as preference, BB & T’s purchase money security interest in a motor vehicle owned by the Debtor.

The United States Bankruptcy Court for the Eastern District of Kentucky concluded that the perfection occurred on February 22, 2005, when the county clerk received the required paperwork and fee.

The trustee appealed the Bankruptcy court’s decision to the Sixth Circuit Bankruptcy Appellate Panel (“BAP”).  The BAP majority reversed, holding that perfection did not occur until March 7, 2005, when the county clerk actually processed BB & T’s security interest application and recorded the lien information in the Kentucky electronic recording system.

BB&T appealed the BAP decision to the Sixth Circuit Court of Appeals.  The Sixth Circuit certified the following question to the Kentucky Supreme Court:

In order to perfect a security interest on a motor vehicle in Kentucky, does the KRS require physical notation on the actual certificate of title as ultimately issued by the county clerk, or is perfection accomplished as and when the required paperwork and fee are submitted to the county clerk?[FN 4]

The Kentucky Supreme Court in a split decision (5 judges concurred and 2 dissented) concluded that

under Kentucky law, final perfection of a vehicle lien does not occur until physical notation is made on the title pursuant to KRS 186A.190, and accordingly, perfection is not accomplished as and when the required paperwork and fee are submitted to the county clerk. KRS 186A.195(5), on the other hand, while it does address initiation of the perfection process, is designed primarily as a timing mechanism for establishing priority among creditors. Compliance alone with the acts set forth therein does not accomplish perfection.

Johnson v. Branch Banking & Trust Co., — S.W.3d —-, 2010 WL 2470849, at *1 (Ky. June 17, 2010).

Kentucky Supreme Court: “You Pick a Date – Pick any Date… Wait, not that One!”

In answering the question certified to it, the Kentucky Supreme Court did not specify the date on which perfection occurred as to the Johnson vehicle.  A description of the event constituting “perfection”, however, was clearly identified by the Kentucky Supreme Court:

[P]erfection cannot be said to occur until notation, though when notation does occur, the perfection may then be deemed to have occurred at an earlier date.  In this vein, if the title is never issued, or if the title is erroneously issued without notation, perfection does not occur, which is a further reason why our interpretation is compelled. [Emphasis Added]

The only date possible under this holding is the date of physical issuance of the certificate of title, which did not occur until March 25, 2005, when the Kentucky Transportation Cabinet finally issued the certificate of title with BB & T’s security interest notation.

The Sixth Circuit seems to have disregarded the Kentucky Supreme Court’s emphasis on actual, physical issuance of the certificate of title.  Instead, the Sixth Circuit picked March 7, 2005, the date when the county clerk finally fed the BB & T lien notation materials into the electronic recording system.  The Sixth Circuit, based on the Kentucky Supreme Court’s response to the certified question, concluded:

With this answer in mind, we uphold the BAP’s conclusion that perfection of BB & T’s lien did not occur until March 7, 2005, when the security interest was actually noted on the certificate of title.

How Big a Problem is This Anyway

Ever since the United States Supreme Court decision in Fidelity Financial Services, Inc. v. Fink, 522 U.S. 211, 118 S.Ct. 651, 139 L.Ed.2d 571 (1998), lenders engaged in the financing of motor vehicles have had to deal with the reality that state titling laws providing for retroactive perfection would not be given effect under Section 547(c)(3)(B).  Under Fink, if the steps necessary for perfection were not completed in the perfection period of Section 547(c)(3)(B), then no state law perfection retroactivity provision could come to the rescue.

Congress mitigated the effects of Fink by lengthening the perfection period (which at the time of the Fink decision was 20 days) to 30 days.  Additionally, the issue would only come into play where both some glitch in the titling process pushes completion of perfection outside a 30 day period after financing and the vehicle purchaser files bankruptcy within 90 days after the grant of the security interest.  However, as we noted in our recent article on the possibility of recovery of a monetary preference award against lenders whose security interests are avoided, trustees and other preference claimants may now have a monetary incentive to carefully scrutinize their perfected motor vehicle security interests for exposure to avoidance actions.

Despite the narrow factual circumstances in which it might come into play, the decision in Johnson is of concern because it potentially broadens the line of attack by trustees and other preference claimants on the enabling loan defense.  The Johnson case encourages preference claimants to focus on the existence of any theoretically possible event that might prevent the last necessary act in the perfection process.

In should be noted that some states’ titling laws, define “perfection” as the point of submission of the necessary paperwork to the appropriate titling agency.  Even in these jurisdictions, the Johnson decision will put pressure on secured parties to maintain proof of date of lien application submission along with evidence that the submission was in conformity with lien notation requirements.

For automotive lenders in states like Kentucky, where perfection only occurs upon physical notation of the issued certificate of title, the uncertainly illuminated in Johnson will be antithetical to increased availability of motor vehicle financing, and for a few secured parties might actually present concerns for monetary preference liability.


[FN 1]  All Section references are to the United States Bankruptcy Code unless otherwise identified.

[FN 2]  Prior to October 17, 2005, the perfection period in Subparagraph (B) was only 20 days.  The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) extended the 20-day period to 30 days.  Because the Johnson bankruptcy case was filed before October 17, 2005, the Sixth Circuit addressed the pre-BAPCPA version of the Bankruptcy Code.

[FN 3]  Under Kentucky law, the county clerk is required to enter the information required for notation of the security interest in the electronic recording system before 3:00 p.m. on the next business day following tender. Ky.Rev.Stat. Ann. §§ 186A.195(1); 186A.165. For some undisclosed reason, this mandate was not followed and the delays outlined above ensued.

[FN 4]  The wording of the question is surprising.  The Sixth Circuit stated that the actual question before it was “whether the submission by a secured creditor of the required documents and fee to the county clerk necessary to have its lien noted on the certificate of title prevents a creditor on a simple contract from acquiring a judicial lien superior to that of the secured creditor during the period between the secured creditor’s submission and the actual issuance of the certificate of title with the lien noted on it.”  380 B.R. at 476