Attorney Malpractice Liability for Failure to File UCC Financing Statement

by John C. Murray 2002. All rights reserved.

Introduction
The Malpractice Risk: Lory v. Parsoff
A recent New York case clearly illustrates the risks and consequences of a lawyer's failure to create a security
interest in the borrower's personal-property collateral. The New York Appellate Court, in Lory v. Parsoff,
745 N.Y.S.2d 218 (2002), affirmed the lower court's ruling that the plaintiff, a former client of the defendant
Parsoff and his law firm, was entitled to summary judgment against Parsoff and the firm because of their
failure to file a UCC-1 financing statement that would have perfected the plaintiff's security interest in the
assets of an electronics company sold by the plaintiff (which subsequently filed for bankruptcy).

A. The Trial Court Decision

In the legal malpractice action brought by the plaintiff, he alleged that the defendants (Parsoff and his
law firm) negligently failed to file a UCC-1 financing statement that would have perfected his security
interest in the assets of the company sold by plaintiff, Craftsman Sound and Security System
("Craftsman"), to Tony Amerigo and Paul Pettorino ("Purchasers"), the third-party defendants in this
lawsuit. The plaintiff further asserted that the defendants falsely represented that they had prepared and filed
the necessary documents to create a perfected security interest in Craftsman's assets.
The plaintiff originally retained Parsoff to represent him in the sale of his stock in Craftsman. The purchase
agreement for the sale of the stock ("Purchase Agreement") called for the Purchasers to deposit all shares of
Craftsman with Parsoff, who would act as escrow agent and return the shares to the plaintiff if the
Purchasers breached any of their contractual obligations under the Purchase Agreement. The Purchase
Agreement also stated that the plaintiff was entitled to a lien on all of Craftsman's assets if the Purchasers
breached the terms of the Purchase Agreement. The Purchasers subsequently defaulted, and the plaintiff
regained complete ownership of Craftsman. Meanwhile, the Purchasers filed a Chapter 7 bankruptcy
proceeding in an attempt to avoid their obligations under the Purchase Agreement, which bankruptcy action
was eventually dismissed. The plaintiff asserted that, based on the admission of Parsoff that he had no
documents evidencing that he had filed a UCC-1 financing statement in the county clerk's office in
Albany or Suffolk County, such negligent failure to file caused the plaintiff to be relegated to the
position of a creditor with an unsecured claim against Craftsman in its bankruptcy proceeding, when
Craftsman had properties to which a security interest would have attached.

[Note: New York had a "dual filing" system prior to passage of revised Article 9 of the UCC ("Revised
Article 9"), which became effective in New York and most other states on July 1, 2001; i.e., the
security interest was filed in the county (or counties) in which the personal property was located as
well as with the Secretary of State's office.

The general rule under Revised Article 9 is that the law applicable to the perfection of security interests is
the law of the debtor's location, which is generally the debtor's place of business (or, if the debtor is an
individual, the individual's principal residence) unless the debtor is a "registered entity," such as a
corporation, limited liability company, or limited partnership, in which case the location of the debtor is the
state in which it was organized.
Under Revised Article 9, most financing statements are filed in a single state-wide office, such as the
Secretary of State's office; there is no longer any need to file a financing statement in the local (county)
office for collateral that is not related to real estate].

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During the bankruptcy proceeding, the plaintiff accused the Purchasers of unlawfully removing office
equipment, records and logs. He also filed an action for civil and criminal contempt, which was later
withdrawn, to prevent the Purchasers from occupying Craftsman's corporate offices. Upon commencement
of plaintiff's legal malpractice action, the defendants brought a third-party action against the Purchasers
seeking contribution and asserting that they were required to indemnify the defendants if they were found
liable to pay damages to the plaintiff.

According to the trial court, to establish a cause of action and damages for legal malpractice under New
York law a client must show that the attorney "failed to exercise that degree of care, skill, and diligence
commonly possessed by a member of the legal community, proximate cause, damages, and that the client
would have been successful in the action had the attorney exercised due care." The court also stated that
damages in a legal malpractice action "must be actual and ascertainable, resulting from the proximate cause
of an attorney's negligence." The court found that, under New York law, "[a]n attorney's failure to file
a financing statement in the manner required by law to perfect his client's security interest constitutes
negligence or malpractice as a matter of law." The court then stated that the plaintiff had established a
cause of action for summary judgment against defendants, even though the plaintiff regained ownership of
Craftsman and its assets. The court stated that, "failure to file the UCC-1 statement is negligence per se
and plaintiff is entitled to a determination as to what such negligence cost him in terms of damages."
The court ruled that the plaintiff had presented a prima facie case for damages because the defendants
acknowledged that there were no documents in their case file that indicated that the required UCC-1
financing statement was ever filed. The court therefore granted the plaintiff's motion for declaratory
relief and directed that an inquest/hearing be commenced to permit the plaintiff to prove any
damages he could establish as the result of the defendants' failure to file the UCC-1 financing
statement as to Craftsman. However, the court refused to approve the plaintiff's request for the recovery of
punitive damages, ruling that such damages were not warranted in this case because punitive damages are
not recoverable for an ordinary breach of contract and the defendants' conduct did not rise to the
level of moral turpitude and wanton dishonesty.
B. The Appellate Court Decision

On July 22, 2002, the Supreme Court of New York, Appellate Division, Second Department, upheld
the trial court's decision that the defendants' failure to file a UCC financing statement in the manner
necessary to perfect the client's security interest constituted malpractice as a matter of law.
The appellate court further held that the trial court properly granted summary judgment on the cause of
action by the plaintiff to recover an award of an attorney fee he incurred to retain alternative counsel as a
result of the defendants' malpractice. Additionally, the appellate court ruled that there was no merit to the
defendants' challenge to the plaintiff's claim for a refund of the legal fee paid to the attorney's law firm in
connection with the negligent representation.
Discussion
As demonstrated in Lory v. Parsoff, supra, the loss of lien perfection and priority because of the
failure to properly file a UCC financing statement can have catastrophic consequences and can expose
the offending attorney (and his or her law firm) to significant financial liability and professional
embarrassment.
According to James D. Prendergast, Vice President and Special UCC Counsel to the UCC Division of The
First American Corporation, "[i]n a commercial finance transaction . . . the greatest malpractice exposure
to a lender's counsel is not in the negotiation and drafting of the primary loan documents (services

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requiring senior associate or partner attention), but rather in the ordering and review of existing
financing statements relating to personal property of the borrower."
James D. Prendergast, Guide to the Eagle 9TM UCC Insurance Program, 17 CEB Cal. Bus. L. Prac. 1, 4
(Winter 2002). Mr. Prendergast also observes that (as borne out in Lory v. Parsoff, supra), "there is a
probability of economic loss to a lender in the event of failure of lien priority as a result of inadequate
review of pre-existing filings, incorrect filings, documentation errors, or similar factors . . .. [R]e
classification of a lender from a secured creditor to an unsecured creditor in a bankruptcy proceeding could
have a significant impact on the lender's net income." Id. at 3. Mr. Prendergast further notes that, "the
secured party's only remedy for loss of perfection or priority . . . is a malpractice lawsuit against the
counsel who prepared the loan documentation . . . . This result is clearly untenable for the lender's
counsel, and may also be unsatisfactory for the lender if counsel's malpractice coverage is inadequate or
the issue is disputed in prolonged litigation." Id. at 9.
A Solution: The First American EAGLE 9TM Insurance Policy
As noted by Mr. Prendergast, the existing remedies available to lenders with personal- property collateral
security clearly have been inadequate in the circumstances described above. To address these concerns and
help avoid some of the negative consequences to lenders and lenders' counsel described above, First
American introduced the EAGLE 9TM UCC Insurance Policy ("EAGLE 9 Policy") in 2001.
The EAGLE 9 Policy provides indemnity insurance for the attachment, priority, and perfection of the
lender's security interest and transfers the risk of failing to properly create, perfect, or attain the desired
priority of, the lender's security interest to the insurer.
As pointed out by Mr. Prendergast, "[t]his is not a cost-replacement or cost-justification approach, but
rather reflects that the secured lender is not now getting what it needs to be secure in its lien position."
Id. As further noted by Mr. Prendergast, "the fundamental impetus of the product is that the EAGLE 9TM
UCC Insurance Program provides indemnity insurance for perfection and priority of the lender's security
interest . . .. This coverage is not otherwise available to lenders, although a lender may be deceiving itself by
thinking that the circular perfection opinion of borrower's counsel and the malpractice coverage of its own
counsel provide comparable protection to the lender. They do not, as was discovered in the real estate arena
long ago." Id. at 10.
For a single premium, the lender who purchases the EAGLE 9 Policy (and its counsel) obtains, in addition
to an insurance policy that provides full legal-defense costs, the benefit of systems and procedures
specifically designed to assure compliance with the Uniform Commercial Code (including legal and
procedural changes thereto, such as the recently enacted revisions to Article 9 that were enacted into law in
all 50 states in 2001). The knowledgeable and experienced personnel in First American's UCC Insurance
Division provide a "second set of eyes" and engage in a dialog with both the lender and the lender's counsel,
providing assistance and advice during every step of the transaction, from ordering the policy to filing the
required documentation in the proper location(s). The policy benefits include - at no additional cost - record
searches (with respect to a single search on a single debtor), document preparation, filing, follow-up, and
tracking (including timely notice of expiration dates) services. The EAGLE 9 Policy therefore provides
peace of mind to lenders and their counsel and may help to prevent the type of "horror story" evidenced by
the court's decision in Lory v. Parsoff, supra.
As noted above, First American developed the EAGLE 9 Policy (the first UCC insurance policy in the
industry) in 2000 to insure the attachment, perfection, and priority of personal property interests in loan
transactions (there also is a buyer's policy available). Part of the process is to work closely with lenders and
their counsel to make certain that the financing statements and related documents (including collateral
descriptions) are properly and accurately prepared and completed, and filed in the correct location(s).

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The Lory v. Parsoff case is a legal-malpractice case and would not, per se, invoke any of the insuring
clauses of the UCC insurance policy offered by First American. The lender's claim would be against its
attorney's malpractice insurer. However, part of the outsourcing services provided by a UCC insurance
provider such as First American is the review (or, as mentioned above, "second set of eyes") function
provided in connection with the EAGLE 9 Policy. The insurer will have reviewed the Security Agreement,
the UCC-1 financing statement and other related and relevant documents for attachment, sufficiency,
enforceability, and priority of the lender's security interest. For example, if the lender were engaged in a
mezzanine-financing lending transaction with an equity participant in the borrowing entity and desired to
have the borrowing entity elect to "opt in" to Article 8, the insurer would review the control agreement, and
perhaps even suggest (and perhaps provide) the proper form(s) (and discuss any other steps required) to
assure a successful opt-in. In those circumstances where the filing of a UCC-1 financing statement would be
required to perfect the lender's interest (for example, where the collateral was a "general intangible"), the
insurer would provide insurance that the filing was accomplished in the proper jurisdiction and maintained
the priority insured in the policy -- and perhaps most important, provide at the insurer's cost a defense
against any challenge (whether or not valid or justified) against the attachment, perfection, or priority of the
lender's security interest.
As soon as there was a valid claim under the UCC insurance policy, the insurer would be obligated to pay.
The fact that the lender might also have a claim against its attorney would be irrelevant and the insured
would not be obligated to first pursue any rights it had against the attorney. But the insurer normally would,
under its right of subrogation under the policy, have the right to pursue a claim against the negligent
attorney in an attempt to recoup its loss. However, the insurer often can be persuaded to waive, by
endorsement, any right of subrogation against the lender's attorney for indemnification for negligent acts by
the attorney.
Although the Lory v. Parsoff case does not in itself support security-interest perfection or priority insurance
-- but rather the avoidance of careless lawyers with respect to personal-property collateral -- a much more
significant case (which likely would invoke the insuring provisions of the EAGLE 9 Policy) is the recent 7th
Circuit case of Shelby County State Bank v. Van Diest Supply Company, 303 F.3d 832 (7th Cir., Sept. 17,
2002). This case held that a creditor's security agreement was ambiguous as to whether it covered after-
acquired inventory from other sellers, and was properly construed to limit the collateral to that creditor's
products by the bankruptcy court. The court found that the following collateral description covered only
purchase-money-security-interest inventory sold by the defendant to a Debtor and not all inventory from
whatever source:
[a]ll inventory, including but not limited to agricultural chemicals, fertilizers, and fertilizer materials sold to
Debtor by Van Diest Supply Co. whether now owned or hereafter acquired, including all replacements,
substitutions and additions thereto, and the accounts, notes, and any other proceeds there from.
With respect to the Shelby County case, the EAGLE 9 Policy would probably not (under a strict reading of
the policy) have covered the simple issue of what the parties intended as the security collateral (because of
the exclusion for matters "created, suffered, assumed or agreed to" by the insured). It would be up to the
lender (and its counsel) to correctly describe the collateral it intended to create a security interest against.
However, the insurer would not want to subject itself to a claim of bad-faith refusal to defend, or aggravate a
good customer (or, if can avoid it, agree to defend a claim with a "reservation of rights"), especially where it
is aware of the intent of the lender with respect to the collateral to be covered, and has reviewed the
collateral description and not "caught" any apparent discrepancies; under such circumstances the insurer
may well decide to provide a defense and indemnification for any loss suffered by the insured. Also, the
attachment (as well as the perfection and priority) of the security interest actually and accurately described
in the financing statement would be insured under the EAGLE 9 Policy in any event. The Shelby County

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case clearly illustrates the importance of accurate and complete collateral descriptions and paying close
attention to such descriptions in security agreements and financing statements.

For the second straight year, bankruptcy filings have increased to an all-time record level. A record total of
1.5 million cases were filed in the year ended June 30, 2002. While the number of business bankruptcy
filings is declining slightly in 2002, the filings are much larger and have more significant implications for
the economy. A Price Waterhouse study estimates that nearly 11,000 companies will file for Chapter 11
protection in 2002. This is the highest number of bankruptcy filings since 1995 and an 8.8 percent increase
over 2001, when less than 10,000 private businesses filed Chapter 11. The goal of every bankruptcy trustee
is to obtain and preserve cash and assets, from all available sources, for the benefit of the estate and its
general creditors and to pay the expenses of administering the estate. The trustee therefore will pay a great
deal of attention to the sufficiency and validity of any security interest claimed against the debtor's
collateral, and will challenge the perfection and lien position of such interest wherever possible. For a lender
that is relying on the protection provided by its security interest in the debtor's collateral, a successful
challenge to the perfection or priority of such interest could have devastating "all or nothing" consequences
if its interest is reclassified as an unsecured claim. The lender's counsel also faces severe consequences if the
bankruptcy court determines that the lender's security interest is defective or ineffective - including
malpractice liability, damage to the lawyer's (and his or her law firm's) reputation, and loss of future clients
and income. Many attorneys concentrate their efforts for their lender-clients on the negotiation and drafting
of the legal documents that evidence and govern the financing of the debt secured by the debtor's collateral,
and delegate to lower-level associates and paralegals such mundane and "ministerial" (and less lucrative)
tasks as preparing, reviewing and filing UCC financing statements. However, the failure to correctly
perform these "minor" tasks (or, perhaps, the failure to perform such tasks at all) often results in the most
significant - and costly - malpractice exposure faced by attorneys in commercial financing transactions. The
unfortunate fact is that an attorney can delegate authority, but not responsibility, for such actions by
subordinates.

TITLE 18 > PART I > CHAPTER 63 > 1341

1341. Frauds and swindles
How Current is This?
Whoever, having devised or intending to devise any scheme or artifice to defraud, or for obtaining money or
property by means of false or fraudulent pretenses, representations, or promises, or to sell, dispose of, loan,
exchange, alter, give away, distribute, supply, or furnish or procure for unlawful use any counterfeit or
spurious coin, obligation, security, or other article, or anything represented to be or intimated or held out to
be such counterfeit or spurious article, for the purpose of executing such scheme or artifice or attempting so
to do, places in any post office or authorized depository for mail matter, any matter or thing whatever to be
sent or delivered by the Postal Service, or deposits or causes to be deposited any matter or thing whatever to
be sent or delivered by any private or commercial interstate carrier, or takes or receives there from, any such
matter or thing, or knowingly causes to be delivered by mail or such carrier according to the direction
thereon, or at the place at which it is directed to be delivered by the person to whom it is addressed, any
such matter or thing, shall be fined under this title or imprisoned not more than 20 years, or both. If the
violation occurs in relation to, or involving any benefit authorized, transported, transmitted, transferred,
disbursed, or paid in connection with, a presidentially declared major disaster or emergency (as those terms
are defined in section 102 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act (42

5
U.S.C. 5122)), or affects a financial institution, such person shall be fined not more than $1,000,000 or
imprisoned not more than 30 years, or both.

False imprisonment often involves the use of physical force, but such force is not required. The threat of
force or arrest, or a belief on the part of the person being restrained that force will be used, is sufficient. The
restraint can also be imposed by physical barriers or through unreasonable duress imposed on the person
being restrained. For example, suppose a shopper is in a room with a security guard, who is questioning her
about items she may have taken from the store. If the guard makes statements leading the shopper to believe
that she could face arrest if she attempts to leave, the shopper may have a reasonable belief that she is being
restrained from leaving, even if no actual force or physical barriers are being used to restrain her. The
shopper, depending on the other facts of the case, may therefore have a claim for false imprisonment. False
imprisonment has thus sometimes been found in situations where a storekeeper detained an individual to
investigate whether the individual shoplifted merchandise. Owing to increasing concerns over shoplifting,
many states have adopted laws that allow store personnel to detain a customer suspected of shoplifting for
the purpose of investigating the situation. California law, for example, provides that "[a] merchant may
detain a person for a reasonable time for the purpose of conducting an investigation whenever the
merchant has probable cause to believe the person is attempting to unlawfully take or has unlawfully
taken merchandise" (Cal. Penal Code 490.5 [West 1996]).
False arrest is a type of false imprisonment in which the individual being held mistakenly believes that the
individual restraining him or her possesses the legal authority to do so. A law enforcement officer will not be
liable for false arrest where he or she has probable cause for an arrest. The arresting officer bears the burden
of showing that his or her actions were supported by probable cause. Probable cause exists when the facts
and the circumstances known by the officer at the time of arrest lead the officer to reasonably believe that a
crime has been committed and that the person arrested committed the crime. Thus, suppose that a police
officer has learned that a man in his forties with a red beard and a baseball cap has stolen a car. The officer
sees a man matching this description on the street and detains him for questioning about the theft. The
officer will not be liable for false arrest, even if it is later determined that the man she stopped did not steal
the car, since she had probable cause to detain him.
An individual alleging false imprisonment may sue for damages for the interference with her or his right to
move freely. An individual who has suffered no actual damages as a result of an illegal confinement may be
awarded nominal damages in recognition of the invasion of rights caused by the defendant's wrongful
conduct. A plaintiff who has suffered injuries and can offer proof of them can be compensated for physical
injuries, mental suffering, loss of earnings, and attorneys' fees. If the confinement involved malice or
extreme or needless violence, a plaintiff may also be awarded punitive damages.
An individual whose conduct constitutes the tort of false imprisonment might also be charged with
committing the crime of kidnapping, since the same pattern of conduct may provide grounds for both.
However, kidnapping may require that other facts be shown, such as the removal of the victim from one
place to another.
False imprisonment may constitute a criminal offense in most jurisdictions, with the law providing that a
fine or imprisonment, or both, be imposed upon conviction.
Further Readings
Bedau, Hugo Adam. 2002. "Causes and Consequences of Wrongful Convictions: An Essay-Review."
Judicature 86 (September-October): 11520.
Hare, Jamie. 1997. The Fight for Innocence. Portsmouth, Va. P.O. Box 3492, Portsmouth 23701-0492).
Scheck, Barry C., and Peter J. Neufeld. 2002. "Toward the Formation of 'Innocence Commissions' in
America." Judicature 86 (September-October): 98105.