Throughout the shaded area, Farmers Tobacco made loans to the debtor. Although the original security agreement between the debtor and Farmers Tobacco contained no future advances clause, the later loans were evidenced by promissory notes stating that they were secured by the prior security agreement. The trial court, applying the first-to-file-or-perfect rule, awarded summary judgment to Farmers Tobacco, and the court of appeals affirmed. Although the appellate court’s conclusion was correct, its analysis was flawed.
Under the first-to-file-or-perfect rule, as long as: (i) perfection in the relevant collateral can be achieved by filing a financing statement; (ii) there is no period when there is neither filing nor perfection; and (iii) the later advances are in fact secured by the collateral—whether pursuant to a future advances clause in the original security agreement, a later amendment to that agreement, or a new, authenticated security agreement—the priority of the security interest securing the later advances is the same as the priority of the security interest securing the initial indebtedness. The Official Comments support this by noting that “[u]nder a proper reading of the first-to-file-or-perfect rule . . . , the time when an advance is made plays no role in determining priorities among conflicting security interests.” Unfortunately, the court of appeals based its analysis in part on the fact that Versailles Farms had not conducted due diligence by searching and requesting a copy of the security agreement between the debtor and Farmers Tobacco, and strongly suggested that its conclusion would have been different if Versailles Farms had made its secured loan to the debtor after examining the earlier security agreement and seeing that it lacked a future advances clause. That suggestion is incorrect.
B. Buyers of Goods
A buyer of goods takes free of an unperfected security interest in the goods if the buyer gives value and receives delivery without knowledge of the security interest. In contrast, a buyer of goods encumbered by a perfected security interest normally takes subject to that security interest. However, there are two notable exceptions: (i) if the secured party authorizes the sale free and clear; and (ii) if the debtor is in the business of selling goods of that kind and the buyer qualifies as a buyer in ordinary course of business. To be a buyer in ordinary course of business, the buyer must, among other things, buy goods: (i) in good faith; (ii) without knowledge that the transaction violates a third person’s rights in the goods; and (iii) in the ordinary course of business from a person engaged in the business of selling goods of that kind. A person that acquired goods through a transfer in bulk is not a buyer in ordinary course of business. There were two noteworthy cases last year dealing these exceptions.
In Nissan Motor Acceptance Corp. v. Sports Car Leasing LLC, a car wholesaler purchased seventy-nine new cars from three related dealers at about half the dealers’ cost. The court ruled that the wholesaler was a buyer in ordinary course of business that took free of the perfected security interest of the dealers’ floor plan financier. The court relied on the fact that the wholesaler had regularly bought cars, including new cars, from dealers who were trying to make a manufacturer’s sales quota, and that the sales comported with the dealers’ own practices because they had been selling cars to the wholesaler for two years.
A different result was reached in Bank of India v. Shrenuj USA, LLC. In that case, the debtor operated a business that supplied gemstones and jewelry to jewelers and jewelry retailers. After the debtor defaulted on the secured loan from its major lender, a buyer paid the debtor slightly more than $5 million for all the goods that the debtor had previously consigned to its major retail customer. Pursuant to the transaction, the buyer and debtor notified the consignee of the sale and instructed the consignee to make all further payments to the buyer. Shortly thereafter, the debtor went out of business.
The court ruled that the buyer was not a buyer in ordinary course of business and had not taken free of the lender’s perfected security interest because the dealer customarily sold to retailers but the buyer was not a retailer. Moreover, the buyer, which was formed for the purchase of buying the jewelry, was instead a purchaser in bulk. The court also ruled that the lender had not authorized the sale free and clear of its security interest because the security agreement authorized the dealer to sell only in the ordinary course of business.
C. Other Priority Issues
To protect the free flow of funds in commerce, section 9‑332 contains two rules. Subsection (a) provides that a transferee of money takes free of a perfected security interest unless the transferee acts in collusion with the debtor to violate the rights of the secured party. Subsection (b) provides that a transferee of “funds from a deposit account” takes free of a perfected security interest “in the deposit account” unless the transferee acts in collusion with the debtor to violate the rights of the secured party. In 2016, the United States Court of Appeals for the Fifth Circuit misconstrued the latter rule as applying only when the security interest in the deposit account is claimed as original collateral, rather than as proceeds. Two courts struggled with that precedent last year.
In The Cortland Savings & Banking Co. v. Platinum Rapid Funding Group, Ltd., a buyer of the debtor’s future receivables received $869,250 through a series of wire transfers from the debtor’s deposit account, in which the depositary bank claimed a security interest as proceeds of other collateral. The trial court accepted the distinction drawn by the Fifth Circuit, ruled that the buyer/transferee had not taken free of the bank’s security interest in the “funds,” and held the buyer/transferee liable for conversion, impairment of security interest, and tortious interference with contract. On appeal, the Ohio Court of Appeals reversed. It expressly rejected the Fifth Circuit’s analysis and ruled that buyer/transferee took free of the security interest in the deposit account claimed by the depositary bank, whether as original collateral or as proceeds, unless the buyer/transferee acted in collusion with the seller to violate the bank’s rights.
The opposite conclusion was reached in HHH Farms, LLC v. Fannin Bank. In that case, the court ruled that a bank that received on deposit the cash proceeds of the debtor’s crops in which another lender had a security interest, and then accepted payment by checks drawn on that deposit account to pay off the bank’s loan to the debtor, converted the other lender’s property. Relying on Tusa-Expo, the court ruled that the bank was not protected by section 9‑332(b) as a transferee of funds from a deposit account because that rule applies only to a security interest in a deposit account, and the lender did not claim a security interest in a deposit account; it claimed a security interest in the crop proceeds deposited into the deposit account. A petition for review has been filed with the Texas Supreme Court.
V. Enforcement of a Security Interest
Article 9 gives secured parties various rights upon default, including the rights to repossess, collect, and dispose of the collateral. However, Article 9 does not define default. Instead, it leaves that to the parties’ agreement and other law. Consequently, unless some other law provides otherwise, parties are free to define default very broadly. In two notable cases from last year, the secured party took advantage of that latitude.
In Franklin Capital Funding LLC v. Viridis FSM Inc., the court concluded that the debtor had defaulted under its agreement with its secured lender in two respects. First, the debtor had failed to maintain all of its bank accounts with a bank that had entered into a control agreement with the lender, as the agreement required. Second, the debtor had terminated its relationship with one of its larger customers, and the lender determined that action had a “material adverse effect” on the debtor. The agreement expressly authorized the lender to determine, “in its sole discretion and judgment,” whether a material adverse effect had occurred, and such a term was enforceable.
In Frenkel v. NextGear Capital, Inc., an appellate court affirmed a lower court ruling that a floor plan financier of a car dealer acted within its rights by declaring a default and repossessing the collateral after the financier discovered that the debtor had sold several vehicles out of trust and used the proceeds for purposes other than paying the financier. Although the financier had sent the debtor a letter advising that the debtor had seven days to pay for several vehicles that the debtor had recently sold, that letter did not, the court ruled, estop the financier from declaring a default only five days later, when an audit revealed that the debtor had sold other vehicles out of trust. The financier was also not precluded from declaring a default due to prior course of dealing because the loan documents contained a non-waiver provision, which is generally enforceable under Indiana law, and the nature and extent of the default was unprecedented.
Article 9 permits a secured party to repossess collateral without judicial process, provided it can do so without causing a breach of the peace. This duty not to breach the peace is non-delegable; a secured party violates the rule even if an independent contractor causes a breach of the peace. Moreover, a breach of the peace can occur even if there is no violence. Consequently, a secured party and its agents must normally withdraw from a confrontation with the debtor or with third parties. The secured party must also not permit a uniformed police officer to assist in a repossession. That is because it is a false display of authority: the secured party has a contractual right to possession, but the debtor has a legal right to make the creditor go to court to enforce it. In three notable cases last year, secured parties and their agents found themselves liable or potentially liable for the manner in which collateral was repossessed.
In Noel v. PACCAR Finance Corp., the court ruled that debtors stated a cause of action against a secured party, a repossession company, and the repossession company’s subcontractor by alleging that the debtors had objected loudly during the subcontractor’s repossession of their dump truck. Not all courts agree that an oral protest is sufficient to render a repossession effort a breach of the peace.
In Bank v. Huizar, the court held that repossession agents breached the peace by entering the debtor’s unlocked vehicle, locking the door, and refusing to withdraw despite the debtor telling them to get off his property without taking the vehicle. Although the debtor eventually gave the repossession agents the keys to the car, that did not negate the breach of the peace that had already occurred.
Finally, in McLinn v. Thomas County Sheriff ’s Department, the court ruled that a debtor stated a cause of action under § 1983 against a police officer for aiding the repossession of the debtor’s truck without a court order by allegedly arriving with the repossessor, arranging for a backup officer to be present, ignoring the debtor’s demands that he and the repossessor leave his property, telling the debtor that the debtor had to allow the repossession to proceed, and physically imposing himself between the debtor and the truck. The debtor also stated causes of action against the repossession company for violation of § 1983, because the company allegedly coordinated its actions with the police, as well as for trespass and conversion.
C. Notification of Disposition
After default, a secured party may dispose of the collateral. Before most dispositions, the secured party must send reasonable notification of the disposition to the debtor and any secondary obligor. Such notification need not be received; it need merely be sent. However, because the duty is to send “reasonable” notification, a secured party might need to send a second notification if it learns that the first was not received.
In Potts v. KEL, LLC, a debtor sought a judgment notwithstanding the jury’s verdict on his claim that the secured party failed to provide reasonable notification of a disposition of shares of stock in a closely held business. The debtor did not receive the notification because he had separated from his wife and no longer lived at the address to which the notification was sent. The court ruled for the secured party because the evidence established that the secured party had sent the notification to the address that appeared on debtor’s K-1 form and on a company life insurance policy, and which the debtor had, prior to the notification, confirmed in his answer to a complaint the secured party had filed against him.
D. Collecting on Collateral
Section 9‑607 provides that, upon default, or when the debtor agrees otherwise, a secured party may instruct account debtors to make payment directly to the secured party. Section 9‑404 adds that the secured party’s right to collect against an account debtor is subject to all terms between the debtor and the account debtor and any unrelated claim that accrues before the account debtor receives notification of the secured party’s interest in the receivable.
In KR Enterprises, Inc. v. Zerteck Inc., a bank that had extended secured financing to an RV manufacturer tried, after the manufacturer went out of business, to collect from several RV dealers that had purchased—but not paid for—twenty-one RVs from the manufacturer. The principal owner of the manufacturer continued to prosecute the claims after paying off the bank and receiving an assignment of the bank’s rights. The dealers defended by claiming that the manufacturer was the first to breach their contracts by failing to pay promised rebates and warranty obligations relating to previously purchased RVs, that these breaches were material, and that the breaches therefore excused their obligation to pay for the later-purchased RVs. The court ruled, quite properly, that even though the manufacturer’s breach of the earlier contracts was material, that did not permit the dealers to pay nothing for the twenty-one RVs they later purchased. Instead, the dealers were entitled to set off from their obligations the amounts the manufacturer owed to them, because such claims arose before they received notification of the grant of the security interest. The court also ruled that dealers might have been entitled to setoff for the diminished value of the warranties made in connection with the twenty-one RVs, but they failed to prove the amount of that diminished value.
E. Accepting the Collateral
After default, a secured party may propose to accept some or all of the collateral in full or partial satisfaction of the secured obligation. To have an effective acceptance, the secured party must send the proposal to the debtor and not receive an objection from the debtor, anyone to whom the secured party was also required to send the proposal, or anyone else with an interest in the collateral subordinate to the secured party’s security interest. There was a notable case last year dealing with acceptance of collateral.
In 111 West 57th Investment LLC v. 111 W57 Mezz Investor LLC, the debtor was a limited liability company engaged in a joint venture to develop a $400 million luxury condominium through a subsidiary, and had granted a security interest in its equity interest in the subsidiary. After default, some insiders acquired the secured obligation and proposed to accept the collateral in satisfaction of a $25 million debt. A member of the debtor objected and brought a variety of claims against numerous parties.
The court ruled that the objecting member of the debtor LLC was not someone who was entitled to notification of the secured party’s proposal, and hence had no standing to object to the acceptance of the collateral. The member therefore also had no cause of action against the secured party for breach of Article 9. However, the court ruled that the member had stated a derivative cause of action for breach of the duty of good faith by alleging that the secured party suborned insiders to consent to the acceptance of collateral by promising that they would remain the construction managers. Moreover, this cause of action was not barred by the exculpatory clause in the parties’ agreement because liability for intentional bad acts are not subject to waiver, and it was not barred by the three-month limitation period provided for in the agreement because the defendant’s own actions precluded compliance with that limitation.
F. Other Enforcement Issues
In addition to expressly authorizing the post-default remedies of repossession, disposition, collection, and acceptance, Article 9 also provides that the secured party has the rights specified in the parties’ agreement. In short, the parties to a secured transaction are free to supplement the remedies available to a secured party. That freedom proved very important in one case last year.
In Stifano v. Slaga, a debtor had pledged his interest in a two-member limited liability company to secure a debt to the other member. The court ruled that the debtor was not entitled to any distributions after default but prior to the secured party’s acceptance of the collateral because the security agreement stated that, “[p]rovid[ed] that [the debtor] is not in default . . . , [he] shall be entitled to vote the Certificate and receive any distributions that may be declared respecting the Certificate.” The negative implication of that language was that the debtor was not entitled to distributions after default.
VI. Liability Issues
When the debtor in a secured transaction defaults, it is not uncommon for whoever stands to lose out—the debtor, a secondary obligor, the secured party, or other creditors of the debtor—to seek recompense from others involved. Those efforts might involve a claim based on an alleged failure to comply with Article 9 or a claim based on some other fount of law. There were a variety of interesting cases last year involving such attempts, most of which were unsuccessful.
In Odjaghian v. HHS Technology Group, LLC, two unpaid employees of the debtor sought to recover the amounts due to them from the newly formed entity that acquired the bulk of the debtor’s assets at a public disposition. Among the claims they asserted was one based on successor liability.
In general, a buyer of collateral at an Article 9 disposition acquires the debtor’s rights in the collateral but does not normally assume responsibility for the debtor’s obligations. However, the fact that the collateral is sold through an Article 9 disposition does not insulate the buyer from any of the four general bases of successor liability: (i) the buyer expressly or impliedly assumed the debtor’s liabilities; (ii) there was a de facto merger between the buyer and the debtor; (iii) the buyer was a mere continuation of the debtor; or (iv) the transaction was entered into fraudulently to escape liability. The employees in Odjaghian claimed that the buyer was a “mere continuation” of the debtor. But the trial court dismissed the claim and the court of appeals affirmed. Although the former employees claimed that the new entity conducted the same business with some of the same personnel, the debtor continued to exist and operate in several states. More important, there was no allegation that the employer and the buyer had common ownership and, according to the court, some common ownership is necessary under the mere continuation doctrine of successor liability.
In In re Karcredit, LLC, a bank that perfected a security interest in the debtor’s shares of stock in a corporation by taking possession of the stock certificate lost priority to a protected purchaser after the debtor falsely asserted he had lost the certificate, obtained a replacement certificate from the issuer in connection with the issuer’s merger, and then pledged the replacement to the protected purchaser. The bank then sued the issuer of the replacement certificate. The court held the issuer liable for breach of the merger agreement and breach of the certificate because the issuer failed to abide by its own restrictions on the exchange of shares when it transferred a new certificate to the debtor without surrender of the old certificate; only “holders” were entitled to receive new certificates in connection with the merger, and the bank, not the debtor, was the holder. The issuer’s liability was the lesser of the value of the shares or the amount of the debt those shares secured.
In two cases last year a secured party sought to impose liability on a lawyer for failure to perfect a security interest. In Juno Investments, LLC v. Miller, the debtor’s majority shareholder, which made subordinated secured loans to the debtor, brought negligence and breach-of-contract claims against the debtor’s counsel for failing to perfect the security interest by filing a financing statement in the wrong state. The court ruled that, even though counsel represented the debtor, not the shareholder, the shareholder stated a claim for negligence under the “alternative tort theory” because counsel did not advise the shareholder to obtain independent legal advice, their conduct was intended to directly affect the shareholder, it was foreseeable that the shareholder could be harmed by their failure to file the financing statement in the correct state, and their conduct was closely connected to the alleged injury. The court then ruled that the shareholder also stated a claim against counsel for breach of contract for two reasons. First, even though the engagement letter identified the debtor as the sole client, the letter was addressed to and signed by the managing director of the shareholder, making it plausible that the shareholder had an implied contractual relationship with the counsel. Second, the shareholder was plausibly a third-party beneficiary of counsel’s contract with the debtor.
The result in Lindner v. Wyrick was different. In that case, a secured party brought a breach-of-contract claim against his lawyer for filing a financing statement in the wrong state, leading to a loss of $671,000. The lawyer moved to dismiss, alleging that, under Pennsylvania’s “gist of the action,” the claim was really one for professional negligence, not breach of contract. The court agreed. The court interpreted the doctrine as both barring negligence claims that are truly breach-of-contract claims and barring contract claims if the true gravamen of the claim sounds in negligence. Because the secured party did not identify any promise that the lawyer failed to perform other than an implied promise to act in accordance with professional standards, the court ruled that the doctrine barred the secured party’s contract claim and dismissed the claim.