Article 9 applies to any transaction, regardless of the transaction’s form, in which personal property secures an obligation. Many transactions that are not structured as a secured loan—a lease of goods, a conditional sale, or a sale with an option or obligation to repurchase or resell—might nevertheless be a secured transaction. If the economics of the deal are such that the transaction is really a loan, then the transaction will be a secured transaction and will be governed by Article 9 (absent the application of some exception). Several consequences can flow from this recharacterization of the transaction. If the secured party fails to recognize that Article 9 applies, and because of that, fails to properly perfect its security interest, the secured party might end up losing priority in the collateral. More fundamentally, the recharacterization affects which party is the true owner of the property, which can matter if one of the parties petitions for bankruptcy relief, or one of them brings a claim predicated on ownership against a third party.
In NextEngine Inc. v. NextEngine, Inc., in connection with the restructuring of an earlier secured loan, the debtor “assigned” patents and trademarks to a holding company newly created by the debtor and the secured party. The holding company then granted back to the debtor an exclusive license to the patents and trademarks. The court ruled that the transaction was not a true assignment, and instead merely provided for a security interest, because the agreements referred to the intellectual property as “collateral,” prohibited the holding company from transferring the IP prior to default, required the lender to notify the debtor before any sale of the IP and give the debtor reasonable opportunity to purchase the IP at a higher bid, required that any proceeds of the sale be applied toward satisfaction of the debt, and provided that the holding company’s rights to the IP terminated upon full payment of the debt. Therefore, the holding company’s assignee did not have standing to bring an infringement claim against the debtor.
Article 9 applies to some transactions that are not loans, either in structure or economic substance. These include sales of accounts. Because Article 9 applies to both loans secured by accounts and to sales of accounts, whether a transaction involving accounts is a secured loan or a sale has no impact on the applicability of Article 9. However, the distinction between a secured loan and a sale can matter for other purposes. Perhaps chief among these is whether the transaction is subject to restrictions on usury.
Several cases last year dealt with a type of financing arrangement that appears to be proliferating: a purported sale of an interest in future receivables. Typically, these transactions involve a payment of a “purchase price” in return for a specified percentage of the seller’s future accounts receivable until the putative buyer receives a specified total return. The agreements also typically provide for the putative seller to pay the buyer—by automatic debit to its deposit account—a specified amount each day or each workday. The agreements might also contain a “reconciliation provision,” pursuant to which the amount of the daily payment can be adjusted more closely to match the amount equal to the specified percentage times the amount of receivables actually collected. In many of these transactions, the putative buyer’s rate of return is so high that the transaction would be usurious if it were deemed to be a loan, rather than a sale. Consequently, courts are frequently called upon to decide whether the transaction is a loan or a sale.
One such case, In re Shoot the Moon, LLC, involved eighteen transactions by which a financier, in return for immediate cash, purportedly purchased the debtors’ future receivables until the financier received a specified amount. The court ruled that the transactions were really secured loans. In doing so, the court relied on several factors: (i) the documents granted the financier a perfected security interest in virtually all of the debtors’ assets, not merely the receivables purchased, which is not typical of a sale of receivables; (ii) the filed financing statements identified each debtor as a “debtor,” rather than as a “seller”; (iii) the financier obtained a personal guaranty of the debtors’ payment and performance obligations and the guaranty contained a waiver of any requirement that the financier proceed against the “collateral” before demanding payment from the guarantor; (iv) the financier obtained an affidavit of confession of judgment “for a debt due”; (v) the parties discussed the transactions as “loans” with “terms” and “balances,” and rolled funds from one transaction to the next; and (vi) the financier retained a right of recourse against the debtors and the debtors’ commingled funds, containing both proceeds of the receivables allegedly sold and other funds. The court then ruled that the transactions, as secured loans, were usurious under Montana law, and that the financier was liable for twice the amount of interest charged.
In contrast, in Originclear Inc. v. GTR Source, LLC, the court ruled that a transaction by which a financier advanced a merchant $160,000 in return for $239,840 to be paid via automated daily withdrawals of $3,999—a transaction with an effective annual interest rate of 303.7 percent—was not a loan, and hence was not usurious in part because the agreement contained a reconciliation term which required the financier to adjust the amount of the daily payment to a stated percentage of the merchant’s receipts. Although the financier refused three requests for reconciliation by the merchant, and might therefore have breached the agreement, that did not, the court concluded, render the reconciliation term illusory.
In general, there are three requirements for a security interest to attach to collateral: (i) the debtor must authenticate a security agreement that describes the collateral; (ii) value must be given; and (iii) the debtor must have rights in the collateral or the power to transfer rights in the collateral. There were noteworthy cases on the first and third of these requirements last year.
The requirement of an authenticated security agreement is fairly easy to satisfy. The agreement must create or provide for a security interest. That is, the agreement must include language indicating that the debtor has given a secured party an interest in personal property to secure payment or performance of an obligation (or in connection with a sale covered by Article 9), and it must describe the collateral. No specific language is needed for the grant of the security interest, and the collateral description need not be specific or list every individual item; it need merely “reasonably identif[y]” the collateral. In other words, the security agreement must merely “make [it] possible” to identify the collateral. One case from last year demonstrates the relative ease with which this requirement can be satisfied.
In In re Ricca, a married couple signed a modification to two prior loan agreements. The modification provided that “[t]he Debt is partially guaranteed by a Security Interest in inheritance in the estate of [the man’s father].” The court ruled that this was sufficient to create a security interest in the man’s rights as a beneficiary under his deceased father’s will. The language adequately described the collateral and the parties agreed that the man’s intent was to pledge his inheritance.
For most types of property, a description by a type of collateral defined in the U.C.C. is sufficient. However, a description only by a defined type of collateral is an insufficient description of a commercial tort claim. Hence if the parties desire to encumber a commercial tort claim, their security agreement must describe the claim with greater specificity than simply by type. Two creditors ran into problems with this rule last year.
In Polk 33 Lending, LLC v. Schwartz, a credit agreement that included “all commercial tort claims (including D&O claims)” in the description of collateral was insufficiently specific to encumber commercial tort claims. Similarly, in In re Payroll Management, Inc., the court ruled that a security agreement describing the collateral as “all tangible and intangible property which is or may be used in the [debtor’s] business” did not cover the debtor’s claim for damages arising from the Deepwater Horizon oil spill, which was a commercial tort claim, because such claims must be described with greater particularity. The court then added that, even if the claim became a general intangible when a class action settlement became final, the security agreement still did not cover the resulting right to payment because the phrase “intangible property” does not adequately describe “general intangibles.”
There is an exception to the requirement of an authenticated security agreement when the secured party has possession of the collateral pursuant to an oral or unauthenticated security agreement. But that rule did not help the creditor in Miwel Inc. v. Kanzler. In that case, a commercial landlord claimed that a tenant orally granted the landlord a security interest in crushed rock and rock crushing equipment to secure past and future rent, and that landlord had “constructive possession” of the goods on the leased property. The court rejected the argument, concluding that actual possession, not constructive possession, is required when there is no authenticated security agreement.
A debtor cannot grant a security interest in property in which the debtor does not have rights or at least the power to convey rights. Because of that, prospective secured parties should generally take steps to confirm that the prospective debtor does indeed have property rights in the desired collateral. And, if an individual is to authenticate a security agreement on behalf of a business entity, it is incumbent on the secured party to make sure that the individual has the authority to do so. Two creditors encountered a problem with these basic requirements last year.
In First Dakota National Bank v. Gregg, a man who had contracted to feed cattle owned by his parents-in-law in return for payment based on the cattle’s weight represented to a bank that he was the owner of cattle. In a later dispute between the bank, which claimed a security interest in the cattle, and the parents-in-law, the bank acknowledged that its security interest “did not formally attach” to the cattle because the son-in-law did not have rights in the cattle. Nevertheless, the bank claimed that the parents-in‑law should be estopped from asserting that their son-in-law lacked rights in the collateral because they had allowed him to appear as the owner by giving him possession without filing a caretaker financing statement identifying their rights as bailors.
The court rejected the bank’s argument. It concluded that the doctrine of estoppel requires that there be a representation or concealment of material fact, and here there was neither. While the parents-in-law had not filed a financing statement, as they were authorized to do, there was no requirement to do so. Moreover, the parents-in-law had marked the cattle with their exclusive brand and attached to each left ear a separately numbered orange tag, and thus had done nothing to indicate that they were relinquishing ownership or control of the cattle.
In In re Lane, a woman signed a promissory note and security agreement as corporate secretary of a limited liability company. The court ruled that she had actual authority to do so because she was one of two managers of the company and the company’s operating agreement, which had been provided to the lender, stated that each manager had the authority to borrow money for the company and to encumber the company’s assets. Nevertheless, there was a problem. The court ruled that there was a genuine issue of fact as to whether the woman had acted outside the scope of her authority because the company alleged that the loan was not used for the company’s benefit. The court also ruled that there was a factual issue about whether the woman had apparent authority to execute the documents on behalf of the company because apparent authority requires due diligence by the third party, and an attorney’s opinion letter provided to the lender had red flags suggesting that it might not be a bona fide letter. Specifically, (i) the letter contained no opinions, only “representations”; (ii) the letter stated that the individual is authorized to execute loan documents on behalf of another entity but did not include a statement that she was authorized to execute the loan documents on behalf of the company, even though the letter names the company as one of the borrowers; (iii) the letter contained numerous typographical and grammatical errors, which are uncommon in letters prepared by law firms; (iv) the letter did not contain the customary components of an opinion letter, including a salutation, the name of the firm’s client, the scope of the investigation conducted, the assumptions made, a statement regarding the governing state law, or any qualifications or limitations; and (v) the letter included a representation that, according to the borrowers’ projected revenues, they will have the ability to repay the loan, which is highly unusual in attorney opinion letters.
When a debtor’s rights to transfer property are restricted by contract or law, the debtor might nevertheless be permitted to grant a security interest in that property. That is because Article 9 contains several rules that override many contractual and legal restrictions on assignment. However, these rules do not apply to shares of stock in a corporation. Consequently, if a debtor is restricted from encumbering shares of stock, no security interest can attach to the debtor’s shares. One secured party came up against this stark reality last year.
In McGowen, Hurst, Clark & Smith, P.C. v. Commerce Bank, a bank that made a personal loan to an individual shareholder in an Iowa professional corporation attempted to obtain a security interest in the individual’s shares to secure the debt. However, the borrower could not make a voluntary transfer of shares unless the transfer was authorized by the shareholders, which it was not, and the transfer was either to the corporation itself or to an individual licensed in Iowa to practice the same profession that the corporation is authorized to practice. Accordingly, the court ruled that the bank did not acquire a security interest in the shares. Although the individual executed an acknowledgment of the pledge on behalf of the corporation, he lacked actual or apparent authority to do so.
In general, a security interest can encumber after-acquired collateral—that is, personal property that the debtor acquires after authentication of the security agreement—simply by including a brief reference to after-acquired property in the security agreement. For example, in In re S-Tek 1, LLC, a security agreement covered “the following described property, whether now owned or hereafter acquired . . . All . . . Account Receivables [sic], . . . and other personal property owned by Debtor as of the Effective Date of this Agreement (emphasis added).” The court ruled that this was effective to encumber after-acquired accounts receivable. While the reference to property “owned by Debtor as of the Effective Date of this Agreement” might have been unnecessary, it did not render prior language covering “hereafter acquired” accounts either ineffective or ambiguous.
While encumbering after-acquired collateral requires a brief statement to that effect in the security agreement, encumbering proceeds of collateral is even easier. That is because a security interest automatically attaches to identifiable proceeds of the collateral. For this purpose, “proceeds” is defined broadly and includes, among other things, whatever is acquired upon the sale, lease, license, exchange, or other disposition of collateral. There is often significant overlap between after-acquired collateral and proceeds, but the concepts are distinct. This is perhaps most true in bankruptcy. Pursuant to section 552(a) of the Bankruptcy Code, property acquired by a bankruptcy debtor after the commencement of the bankruptcy case is not subject to a lien created by a security agreement entered into before the commencement of the case. In short, the Bankruptcy Code cuts off—as of the commencement of the bankruptcy case—the effectiveness of an after-acquired property clause in a prepetition security agreement. However, pursuant to section 552(b), a security interest will still attach to proceeds of collateral, even if the proceeds are acquired by the debtor post-petition. One creditor got tripped up by these rules last year.
In In re JESCO Construction Corp., the debtor authenticated a security agreement purporting to grant a security interest in up to $600,000 of “net proceeds” of the debtor’s pending litigation against British Petroleum. The court ruled that the language did not create a security interest in the claim itself, merely in the net proceeds of the claim. In other words, the “net proceeds” of the claim were the original—albeit after-acquired—collateral. However, because the claim was settled after the debtor’s bankruptcy petition, and the net proceeds arose post-petition, section 552(a) of the Bankruptcy Code prevented the security interest from attaching to the net proceeds.
In general, perfection of a security interest is a necessary condition for the secured party to have priority over the rights of lien creditors, other secured parties, or later buyers, lessees, and licensees of the collateral. The method by which a secured party can perfect a security interest depends on the type of collateral and the nature of the transaction, but the dominant method of perfection is by filing a financing statement. One creditor last year was apparently caught unaware of the need to file a financing statement.
In In re Leaver, a creditor had a prepetition boarding lien on the debtor’s cattle. The boarding lien was a statutory lien perfected by possession. In the debtor’s Chapter 12 bankruptcy, pursuant to a stipulation approved by the bankruptcy court, the creditor released possession of the cattle to the debtor but retained its lien. Although clearly reluctant to nullify the intent of the stipulation, the court ruled that the creditor had replaced its statutory boarding lien with an Article 9 security interest. That interest was properly attached because the debtor had authenticated the stipulation which adequately described the collateral as “animals in [the creditor’s] possession owned by [the debtor].” However, the security interest was not perfected, the court ruled, because there was no basis for automatic perfection, no financing statement was filed, and nothing in the stipulation provided for perfection.
When a secured party does file a financing statement to perfect a security interest, the financing statement must provide the name of the debtor, provide the name of the secured party or a representative of the secured party, and indicate the collateral. Of these three requirements, using the correct name of the debtor is the most important. That is because financing statements are indexed by—and searches are conducted using—the debtor’s name. A filed financing statement that lists an incorrect name for the debtor is not effective to perfect unless the financing statement would be disclosed in response to a search under the debtor’s correct name, using the filing office’s standard search logic. These rules proved problematic for at least one secured party last year.
In In re Wynn, a creditor that financed the debtor’s purchase of a tractor filed a financing statement identifying the debtor as “Jerry W. Wynn.” At that time, the debtor had a valid Georgia driver’s license that listed his name as “Wilson Jerry Wynn.” In the debtor’s later bankruptcy, the court ruled that the financing statement, as originally filed, was ineffective to perfect the security interest because the debtor’s correct name was his name as it appeared on the driver’s license, and a search under the debtor’s correct name would not have produced the filed financing statement. It did not matter, the court concluded, that a “certified” search under the name “Wilson Wynn” would have produced the financing statement because such a search was not under the debtor’s correct name or conducted pursuant to the filing office’s standard search logic. Although the creditor later amended the financing statement to include the debtor’s correct name, and thereby perfected its security interest, the court correctly concluded that another secured party that had perfected in the interim had priority.
In general, when there are two perfected security interests in the same collateral, priority is determined under the first-to-file-or-perfect rule. The first security interest perfected or subject to an effective financing statement has priority, provided there was no period thereafter when there was neither filing nor perfection. This is often referred to as the first-to-file-or-perfect rule. One court struggled in applying this rule last year.
In Versailles Farm, Home & Garden LLC v. Haynes, two secured creditors, Farmers Tobacco Warehouse (“Farmers Tobacco”) and Versailles Farm, Home and Garden, LLC (“Versailles Farms”), claimed priority in the same collateral: tobacco crops and the proceeds thereof. A timeline of the facts looks as follows:
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.
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.
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.
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.
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.
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.
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.
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.
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.
