Assignment 24: Relocation of Collateral or Debtor
Assignment 24 covers “choice of law” issues. Because Revised Article 9 has been adopted in all
50 states and because the law is now uniform throughout the states, you might well ask why
choice of law is even relevant, as the substantive law is the same everywhere.
What this material really covers is the issue of “where to file” a financing statement. In every
state, section 9-501 requires that most financing statements be filed in the office of the Secretary
of State. However, that does not answer the question: “which Secretary of State”? If Illinois law
governs the transaction, it will be the Illinois Secretary of State in Springfield; if Delaware law
governs the transaction, it will be the Delaware Secretary of State in Wilmington. So, the first
issue we will look at today is in what state’s filing system should an initial financing statement
be filed?
In addition, assuming that a financing statement is filed in the right state, what happens if the
debtor moves to another state or the collateral is moved to another state? Does that require the
secured party to file a new financing statement in that new jurisdiction?
Those are the two issues we will look at today.
In order to understand the provisions of revised Article 9, we have to look back to old Article 9
for a little bit. Old Article 9 (in effect prior to July 1, 2001) had a rule on where to file that was
known as the situs of the collateral test. Under that test, the physical location of the collateral at
the time of perfection determined the state in which the secured party was required to file a
financing statement to perfect a security interest in the collateral. Thus, for a corporation like
General Motors to borrow money using its assets as collateral could require a creditor filing
financing statements in all fifty states, as the collateral could be located in all of the states. This
also created terrible problems when collateral was moved from one state to another.
As a result of these problems, Revised Article 9 abandoned the “situs of the collateral”
rules in favor of a “location of the debtor” test for all security interests, other than those
perfected by possession, which remain subject to a situs of the collateral rule.
The most important section in revised Article 9 is section 9-301. It provides which state’s law
governs the enforceability of security interests. It provides in relevant part:
(1) Except as otherwise provided in this section, while a debtor is located in a
jurisdiction, the local law of that jurisdiction governs perfection, the effect of perfection
or nonperfection, and the priority of a security interest in collateral.
(2) While collateral is located in a jurisdiction, the local law of that jurisdiction governs
perfection, the effect of perfection or nonperfection, and the priority of a possessory
security interest in that collateral.
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Subsections (3) and (4) generally provide a “situs of the collateral” rule for timber to be cut, asextracted collateral, “fixture filings,” as well as possessory security interests in instruments,
money, and tangible chattel paper.
Therefore, we start with the premise that the debtor’s “location” governs issues of
perfection and priority of security interests in collateral, regardless of where the collateral
is located.
1. Where to File the Original Financing Statement?
Revised Section 9-307 spells out the rules for determining the “location” of the debtor. Where
does section 9-307(b)(1) say an “individual” debtor is “located”?
An individual is located at her “principal residence.” The term “principal residence” is
nowhere defined in Article 9, so you have to refer to other sources of law for guidance on
this issue.
Under section 9-307(b)(2) and (3), where is an “organization” located?
At its “place of business” if it has only one. If it has more than one, it is located at its
“chief executive office.”
“Place of business” is defined in section 9-307(a) as “where a debtor conducts its affairs.”
Is the term “chief executive office” defined anywhere in the Code?
No. Comment 2 to section 9-307 says it means “the place from which the debtor manages
the main part of its business operations or other affairs.”
The CB notes that in other contexts courts have used the “nerve center” test to determine the
“chief executive office” of a debtor. In some situations, it may not be easy to do that, but
Comment 2 says there will rarely be more than two possibilities and the prudent secured party
can always file in both places to protect itself.
Where does section 9-307(e) say a “registered organization” is “located”?
It is located in the state under whose law it is organized. Remember that this covers
corporations, limited partnerships, limited liability companies, or limited liability
partnerships.
Thus, in the case of debtors that are corporations (like General Motors), revised Article 9 greatly
simplifies the question of where to file the original financing statement.
2. Changes in Debtor’s Location
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Under Revised Article 9, in most cases if the collateral is moved from one state to another,
it has no effect on the perfection of the security interest. It is only a move by the debtor
from one state to another (a much less frequent occurrence) that requires the secured party
to take some additional action to continue the perfection of the security interest.
Of course, a debtor can change its “location” after the secured party perfects a security interest in
the collateral and section 9-316(a) provides the rules with respect to those changes of location. If
an “individual” debtor moves to a new state or if an “unregistered” organization changes its
place of business or chief executive office, what must the secured party do in order to continue
the perfection of a security interest in that debtor’s collateral?
Under subsections (a)(2) and (b), the secured party must file a new financing in the new
state within four months after the move.
A “registered organization” (such as a corporation) does not “move” from one state to another,
but it can do the same thing by one of two mechanisms, spelled out in the CB. They are:
(1) the corporation could merge into a corporation organized under the laws of another
state; or
(2) the corporation could transfer substantially all of its assets to a corporation organized
under the laws of another state.
If either of these things happen, what must the secured party do in order to maintain the perfected
status of its security interest?
Under section 9-316(a)(3) and section 9-316(b), the secured party has one year after the
transfer of the collateral to file a financing statement in the new state.
If the debtor relocates and the secured party does not do this, what happens to its security
interest?
It is unperfected as against everyone after the expiration of the four-month or one-year
period, whichever applies.
In addition, it is retroactively unperfected (that is, it is treated as if it had never been
perfected at all) “as against a purchaser of the collateral for value.” Section 9-316(b)
(second sentence). Keep in mind that “purchaser” includes a subsequent secured party,
but it does not include lien creditors. Thus, as to lien creditors, the security interest is
perfected as to them for a period of either four months or one year after the debtor moves
or the collateral is transferred.
For example, assume that Secured Party makes a loan to Dave Debtor, who operates “Dave’s
Barber Shop,” a sole proprietorship in Carbondale, Illinois. Secured Party takes a security
interest in all of Dave’s “equipment, inventory, and accounts, whether now owned or hereafter
acquired.” Secured Party files a proper financing statement with the Illinois Secretary of State on
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January 1. On March 1, Dave closes his Carbondale barber shop, moves to Cape Girardeau,
Missouri, and opens a new barber shop there. What does Secured Party have to do to maintain
the perfected status of its security interest?
It must file with the Missouri Secretary of State’s Office no later than July 1 (four months
for an individual’s change of principal residence).
Assume that Secured Party fails to file in Missouri by July 1. On June 1, Dave granted a security
interest in his “equipment, inventory, and accounts, whether now owned or hereafter acquired” to
First Missouri State Bank. As of August 1, who has priority on this collateral? [You should
assume, if you have not already guessed, that a perfected security interest always takes priority
over an unperfected security interest].
First Missouri Bank has priority. Under section 9-316(b) (last sentence), Secured Party’s
security interest is no longer perfected after July 1 and, as against purchasers of the
collateral for value, the security interest is “retroactively” unperfected. So, even though
there is a four-month period of automatic continuation of perfection after the debtor
leaves Illinois, and even though First Missouri Bank got its security interest at a time
when Secured Party was still perfected, its failure to file in the four-month window
“retroactively” strips it of perfected status.
Alternatively, what if Secured Party failed to file in Missouri by July 1. On June 1, Carl Creditor
got a Missouri state court judgment against Dave and had the sheriff seize Dave’s equipment and
inventory under a writ of execution. Now who has priority? See U.C.C. § 9-317(a)(2).
Carl is now a “lien creditor.” Secured Party still has priority. It was perfected for four months
after Dave moved to Missouri and that perfection is not “retroactively invalidated” for lien
creditors. Therefore, Carl’s lien is subordinate to Secured Party’s. Yet another example of the
hosing lien creditors get under Article 9.
Let’s turn to our Problem Set for today.
Problem 24.1:
24.1. Your client, Secured Lending Partners (SLP), has taken the security interests
described below. Where should it file a financing statement or other record to perfect in it?
a. A security interest in equipment used in operating a business in New York. Henrik
Durst, an individual who lives in New Jersey, owns the equipment and the business. U.C.C.
§§ 9-301(1), 9-307.
SLP should file in New Jersey because New Jersey is the debtor’s principal residence.
b. A security interest in fixtures used in the same business and owned by the same person.
U.C.C. § 9-301(3)(A).
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SLP should make a fixture filing in the real estate records of the county where the fixtures are
located.
c. A security interest in an automobile used as equipment in the same business and owned
by the same person.
SLP should perfect by notation on the certificate of title. That will require filing an application
with the Department of Motor Vehicles of the state that issued the certificate of title.
d. A security interest in equipment used in operating a business in New York. Sevan
Industries LLC, a Nevada limited liability company with its chief executive office in New
Jersey, owns the equipment and the business. U.C.C. § 9-307.
Sevan is a registered organization. SLP should file with the Nevada Secretary of State, because
Nevada is Sevan’s state of incorporation.
e. A security interest in a Boeing 747 aircraft owned by AirLeasing, Inc., a Delaware
corporation with its headquarters in California. The aircraft is based at an airport in New
York and regularly flies outside the United States. U.C.C. § 9-311(a).
SLP should file in the Federal Aviation Administration aircraft filing system in Oklahoma City,
Oklahoma, and also in the International Registry of Mobile Assets.
24.2. You have been assigned to file financing statements on behalf of your client,
Firstbank, in connection with a loan in the amount of $500,000 to Charles Tabb, an
inventor and professor of engineering. The collateral is the equipment, accounts, and
inventory of Tabb Engineering, a small business located in Tucson, Arizona, that Tabb
started before he began teaching. Tabb tells you he is the sole owner of the business. Tabb’s
ex-wife, Louise Godfrey, runs the business on a day-to-day basis in return for a salary and
a share of the profits, but Tabb himself makes all the big decisions. Tabb has a
“permanent,” tenured job at the University of Missouri in Kansas City. The school is in
Missouri, three miles from the Kansas-Missouri state line. Tabb lives in an apartment on
the Kansas side of the line but just moved there a few months ago and is hunting for a
house nearer the school — probably on the Missouri side of the line. During the summers,
Tabb returns to the home he owns just outside of Tucson, Arizona and spends his days
working on the business. A friend of yours who knows Tabb well says that Tabb intends to
quit teaching in a few years, move to Hawaii, and operate the business from there. U.C.C.
§§ 1-201(b)(25) and (27), 9-102(a)(28), 9-301, 9-307, 9-503(a)(4), 9-506(c), and Comment 2
to U.C.C. §9-307.
a. On the foregoing facts, who or what is, or might be, the debtor?
The person or persons who own the collateral are the debtors. U.C.C. § 9‐102(a)(28). We think
that could be (1) Charles Tabb, (2) a partnership between Charles Tabb and Louise Godfrey, and
(3) the business as an unincorporated organization. Comment 2 to U.C.C. § 9‐307 supports the
view that Tabb, not the business, is the debtor when it states that “An individual debtor is
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deemed to be located at the individual’s principal residence with respect to both personal and
business assets.” This suggests, but certainly does not prove, that the drafters intended to treat
sole proprietorships as individuals, not organizations. The reference to “business assets” could,
however, be read as a reference only to assets used in a business too small to be considered an
organization. The definitions of “organization” and “person” in U.C.C. § 1‐201(b)(25)
and (27) (formerly U.C.C. §1‐201(28) and (30)) supports this alternative view: Tabb Engineering
may be a “commercial entity” and so a “person” that is not an individual. U.C.C. §1‐201(b)(27)
ends with reference to “any other legal or commercial entity.” Addition of the term “commercial
entity” after “legal entity” seems to us a clear assertion that something need not be a legal entity
to be an “organization” as that term is used in Article 9. That could be Tabb Engineering. The
one court to so far face this issue and write about it ruled that a sole proprietor is not an
“organization” under former U.C.C. § 1‐201(28). In re Le Mieux, 362 F. Supp. 1040 (D. Minn.
1973).
Finally, it is possible, though not likely, that Louise is a partner in Tabb Engineering. Her receipt
of a percentage of the profits is not enough alone and the problem’s characterization of Tabb as
the “sole owner” suggests there is nothing else. If a partnership exists, the partnership is a
separate legal entity and possibly the owner of the collateral. If so, the filing should be against
the partnership.
We think it is reasonable to conclude that Tabb is the debtor. But there is an outside chance that
the business or a partnership is the debtor.
b. In what states should you file?
Filing against the individual. This filing should be in the state of Tabb’s principal residence.
Tabb lives in Kansas, but has no intention to stay. He does not yet even have a house in Missouri
or Hawaii, making both unlikely principal residences at present. But he does have a house in
Arizona and a longer term attachment to it than to his home in Kansas. On these facts we think
the filing should be in Kansas and Arizona and that the creditor might want to file in Missouri in
anticipation of the move. U.C.C. § 9‐502(d).
Filing against the business. If the business is an organization, filing will be at its chief executive
office. U.C.C. §9 ‐307(b)(3). If Firstbank bothers to file on this theory, we think the filing should
be in Missouri, because he apparently runs the business from there. But we would also file in
Arizona because a court could conceivably hold that the chief executive office is in Arizona.
Filing against the partnership. If Tabb Engineering is a general partnership it is a “person other
than an individual,” U.C.C. § 1‐201(b)(27) and so is an organization U.C.C. § 1‐201(b)(25).
Filing will be at its chief executive office. U.C.C. § 9‐307(b)(3). Again, the filing would be in
Missouri. Firstbank should also file in Arizona, in case a court should decide the chief executive
office is there.
c. What name or names should be listed on each of the filings?
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Filing against Charles Tabb. If the filing is against Charles Tabb, it should be in the name on his
Kansas driver’s license—provided his principal residence is in Kansas.
Filing against the business. Filing against an organization should be in the “organizational name
of the debtor.” U.C.C. § 9‐503(a)(6). We think that would be “Tabb Engineering.”
Filing against the partnership. The partnership is an organization, so, provided that the
organization has a name, filing should be in the organizational name. If the partnership doesn’t
have a name, filing should be in the names of the partners. U.C.C. § 9‐503(a)(6). If this is a
partnership, we think “Tabb Engineering” is its name. It is important to realize that this is not a
trade name. A trade name is a name other than one’s own. Here, Tabb Engineering is the
partnership’s own name.
d. You just learned that three years ago Tabb formed a Nevada corporation under the
name Tabb Engineering Products, Inc. Now where do you file?
Does the Nevada corporation own the collateral? It does if Tabb treats it as owning the collateral.
Does the Nevada corporation file income tax returns? Are the bank accounts from which the
business operates in the name of the corporation? If the Nevada corporation owns the collateral,
Nevada is the proper place to file. We ask how a lender is supposed to know whether the
corporation owns the collateral in a situation like this. We think the answer most often is that the
debtor has to prove who owns the collateral; if it can’t, the lender doesn’t make the loan.
e. As you are going through the papers provided by Tabb when he applied for the loan, you
find his most recent tax return where Tabb characterizes his business with Godfrey as a
“tenancy in common.” In what states should you file? What names should be listed on each
of the filings?
If Godfrey owns an interest in the business as a tenant in common, we think she is a debtor
because she is “a person having an interest . . . in the collateral.” U.C.C. § 9‐ 102(a)(28). Tabb is
also a debtor.
We reject the idea that the two together are an organization, because individuals are excluded
from the definition of organization. See U.C.C. § 1‐201(b)(25) and (27).
f. You just learned that some of the “equipment” might instead be fixtures. How does your
answer change? U.C.C. §9-301(3).
If the collateral includes fixtures, filing is in the real property records of the county where the
fixtures are located. U.C.C. § 9‐301(3)(A) and U.C.C. § 9‐501(a)(1).
24.3. a. What, if anything, should Firstbank do to monitor the location of the debtors in
Problem 24.2? U.C.C. §§ 9-316(a) and (b). Keep in mind that if Firstbank is lending at five
percentage points above its cost of borrowing, the gross profit on this loan will be $25,000 a
year.
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On such a small loan, we don’t think any out‐of‐pocket expenditures for monitoring the debtor’s
location would be cost effective. On the large majority of their loans, the debtors’ will pay, and
Firstbank will never have to look to its collateral. Of the small percentage where the debtor
defaults, most will be resolved through workouts. Among the tiny percentage that are not, only a
much tinier percentage will involve interstate moves that affect perfection. Of that much tinnier
percentage Firstbank can catch the large majority of moves simply by watching for obvious signs
such as a change in the debtor’s address on checks and envelopes and perhaps a check of the
debtor’s address on its website once a year.
b. How would your answer change if the loan were for $25 million?
On a $25 million loan, Firstbank can afford to do more. We think that would probably include a
periodic check, perhaps once a year, to see if the circumstances that determine place of filing
have changed.
c. What would be the advantages and disadvantages of a system that required filing against
individuals at their place of birth rather than at their principal residences? All states in the
United States keep birth records. In some states, they are public records; in others, they are
released only at the subject’s request. Filing against persons born outside the United States
would be in the District of Columbia.
You are not responsible for the answer to this question.
Assignment No. 26: Priority Under State Law
In our last few classes, we have looked at the concept of “perfection”—what steps does the
secured party have to take to make sure that her security interest in the collateral will be
enforceable against third parties. Today, we look at the concept of “priority”—when more than
one person has a lien on the collateral, who has the “first crack” at the proceeds of the sale of the
collateral? Issues of priority are very important, because by the time the debtor gets into default,
she will likely have many different creditors, some consensual and some nonconsensual, and she
will likely not have any property that is unencumbered. Therefore, more than one creditor will be
competing for the right to foreclose on the collateral and have the proceeds applied to reduce
their debts owing from the debtor.
We begin by looking at the concept of priority generally, and then we will look at the priority
rules under Article 9 with respect to priority in personal property. Much of the material for today
looks at the rules with respect to real property, but the concepts are the same as in Article 9.
1.
What does it mean to be a lienholder with “priority” over junior lienholders?
Usually, it is a matter of “first in time, first in right,” so that earlier-perfected lienholders have
priority over later-perfected lienholders, but there are many exceptions.
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The creditor who has priority is paid first out of the proceeds of foreclosure on the collateral
(after the payment of expenses of sale). Only if the senior lienholder is paid off in full are any of
the proceeds distributed to the other lienholder or any surplus paid to the debtor.
2.
When can a lienholder foreclose on collateral?
Generally, any time there has been a default with respect to the lienholder’s agreement with the
debtor. Generally, either a senior or a junior lienholder can foreclose on collateral after a default
under its agreement, regardless of whether the debtor is in default under any other agreement
with any other lienholder.
3.
What is the effect of foreclosure on the lien that is being foreclosed and on liens that are
subordinate (junior) to the lien being foreclosed?
Both the lien being foreclosed on and any junior liens are all wiped out by the foreclosure sale.
They are “discharged” by the sale. As to personal property, this is made clear by section 9617(a), subsections (2) and (3). The junior lienholder is entitled to get any proceeds of the
foreclosure sale left over after the senior lienholder’s debt is paid off (section 9-615(3)), but if
there is no surplus, the junior lienholder has lost all of her interest in the collateral. The junior
creditor still has the right to sue the debtor as an unsecured creditor, but as we have seen, that is
not an enviable position. Remember: a “lien” is not the same thing as a “debt.”
4.
What is the effect of foreclosure on liens that have priority over the lien being
foreclosed?
None. The senior lien still attaches to the property. The purchaser at the foreclosure sale buys the
property “subject to” the prior security interest. Of course, the purchaser is not personally liable
for the debt because the debt is a personal obligation of the debtor, but the property is subject to
the senior security interest. Remember: a “lien” is not the same thing as a “debt.”
In effect, the proceeds of sale are compensation for the loss of liens being discharged.
Because the senior lienholder is not losing its lien, it has no claim to the proceeds of the sale.
5.
What is the effect of a foreclosure sale on the debtor’s interest in the property?
The debtor’s interest is extinguished. § 9-617(a)(1).
It also cuts off the debtor’s right to redeem the property by paying the amount of the obligation
secured by the lien. § 9-623(c)(2).
6.
Is a lienholder ever compelled to foreclose its lien?
Usually, no. The secured party has the right not to exercise its rights after default.
7.
If a foreclosure sale is held on property subject to more than one lien, how are the
proceeds distributed?
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1.
2.
3.
4.
Expenses of sale.
Lien being foreclosed.
Junior liens that are wiped out by the foreclosure in the order of their priority.
Surplus to the debtor.
We’ve seen before that this is the rule under the Code. Section 9-615(a).
8.
What about the debtor’s unsecured creditors? Do they share in the proceeds of the
foreclosure sale?
No. They have no legal interest in the property being sold. Their remedy is to reduce their claim
to judgment and then execute on the proceeds of the sale that go to the debtor (if there are any,
which usually there aren’t).
In effect, the proceeds of a foreclosure sale are compensation for the loss of property
interests being discharged as a result of the sale. Because the unsecured creditor is not
losing any interest in the property (it doesn’t have one) as a result of the sale, it is not
entitled to any compensation out of the proceeds of the sale.
The system of priorities is complicated. Many claims are the subject of special state and federal
laws (such as priority for tax claims, etc.) that have to be read against the statutory rules for real
property or the Article 9 rules for personal property.
Let’s turn to our Problem Set for today.
Problem 26.1:
Your client, Katherine Kinski, has investigated an upcoming foreclosure sale for the
purpose of bidding at it. The sale is being conducted by the sheriff under a final judgment
of foreclosure in favor of John Gottlieb on a debt in the amount of $10,000. The judgment
specifically forecloses a subordinate mortgage in the amount of $29,000, but makes no
mention of a senior mortgage in the amount of $17,000. Kinski has examined the property
and concluded that she is willing to pay up to $25,000 to own the property free and clear of
all liens. The sheriff’s expenses in conducting the sale are $200. How much should Kinski
bid at the sale? Compare U.C.C. § 9-617(a).
She cannot buy the property free and clear, as there is a superior lien on the property that is in the
amount of $17,000. That lien will survive the sale, so she must deduct the amount of this lien
from the amount she would be willing to pay, so that gives a figure of $8,000. If she bids $8,000,
she will take the property free and clear of the $10,000 lien being foreclosed and the $29,000 lien
that is subordinate to the lien being foreclosed.
She can then pay off the senior mortgage for $17,000 and own the property free and clear.
If she bids $8,000 and is successful, how will the $8,000 in proceeds be distributed?
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$200 goes to the sheriff as his expenses.
$7,800 goes to the foreclosing lienholder, who now has a deficiency claim against the
debtor for the remaining $2,200 of his debt.
The subordinate mortgagee gets nothing from the sale.
The expenses of sale are not borne by the buyer at the sale. They come “off the top” of
the proceeds and reduce the amount to be distributed to the secured creditors.
What if the foreclosing mortgage (Gottlieb’s) had been only $5,000? How would the
proceeds be distributed?
$200 to the sheriff
$5,000 to the foreclosing mortgagee (Gottlieb).
$2,800 to the junior mortgagee.
Thus, in effect, the “expenses of sale” are economically borne by the junior-most creditor who
gets part of the sale proceeds.
Problem 26.2:
A 1990 Rolls Royce automobile worth $75,000 was seized by the sheriff under a writ of
execution on an $8,000 judgment. The car is subject to a first security interest in the
amount of $60,000 and a second in the amount of $30,000. Both secured creditors are
aware of the sale; neither has objected or demanded possession of the collateral. The
expenses of conducting the sale are estimated at $200. If all bidders understand the sale
procedure, what do you expect will be the highest bid at the sale? Compare U.C.C. § 9617(a).
First, the bidder at a foreclosure sale is usually buying the debtor’s equity in the property—that
is, the difference between the value of the property and the value of the liens on it which will
remain after the sale. What is the debtor’s equity here?
Zero. The car is worth only $75,000 and there are two liens on it, both of which are
senior to the lien being foreclosed on, so those liens, totaling $90,000, will survive the
sale. For a buyer to get title to the car free and clear, she will have to pay off these two
prior lienors and that will cost more than the car is worth.
So, is it true that no one can gain anything by bidding at the sale?
Not necessarily. Let’s think first about the foreclosing creditor. Here, you need to
understand that the foreclosing creditor must pay the sheriff’s expenses of sale,
$200, regardless of what happens at the sale. Knowing this fact, what might the
foreclosing creditor bid at the sale?
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It might bid $200 and thereby obtain the right to possess the car (or at least keep
the car from the debtor). If it’s going to have to spend $200 anyway, why not have
a Rolls Royce to tool around in for a few days.
This is probably especially true if the creditor thinks there is no prospect of
recovering any deficiency from the debtor—creditors might as well bid at least
the amount of the costs they will incur.
Would you be willing to bid $201 to acquire ownership of a $75,000 car that is subject to
$90,000 worth of liens against it?
If you were the high bidder, what would you get?
The keys to the car and a sheriff’s bill of sale (you won’t get the title, as that will
be in the possession of the senior secured party). You become the “owner” of the
car, “subject to” the prior security interests.
What can you do with this car?
You cannot resell it (practically) because you do not have the title. But,
you can tool around town in the car until the senior secured parties
exercise their rights to get the car. That would certainly impress your
classmates or your potential clients.
What if the secured parties immediately attempt to repossess the car? They
ask you to turn it over to them (or to their repossession man). What do you
do?
Tell them to bug off. There is nothing that says that you have to
turn over the collateral to the secured party. The secured party will
be entitled to possession of the car, under section 9-609, but it will
have to get a writ of replevin or some other court order and while
this is going on, you are cruising around St. Paul.
But what about the $90,000 debt? Are you liable for it?
No. Remember, debt is incurred by individuals, either consensually or through a court
order. You have not promised to pay the debt.
The security interest attaches to property—the Rolls Royce is subject to the liens, but
you, as the buyer of the collateral subject to the lien, only forfeit possession of the
property to the secured party—you are not personally liable to pay the debt the debtor
owed the secured party that was secured by the collateral.
Now, you might have to report to the Bar that you were the subject of a successful
replevin action and that might cause you enough difficulties so that you don’t want to
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spend the next few days checking out the ads in the paper for foreclosure sales on Rolls
Royces.
Problem 26.3:
You represent Diamond Head National Bank, which holds a first security interest against
some mobile equipment owned by Henry Walker, securing a debt in the amount of
$270,000. Walker is current in his payments. Diamond Head considers the loan very safe
because, even at a sheriff’s auction sale, they are confident the equipment would bring at
least $400,000. From friends at the Club, you have heard that Walker is in financial
difficulty and the holder of some kind of second lien is forcing a sale of the equipment.
a.
If this information is correct, is there any reason for Diamond Head to be
concerned? U.C.C. §§ 9-611(c)(3), 9-617(b), 9-625(b).
At first blush, it may appear that Diamond Head is okay. The foreclosure sale of the junior lien
will not extinguish Diamond Head’s lien and the buyer will take the goods “subject to” Diamond
Head’s security interest. So, legally, Diamond Head is o.k.
What about practicalities here? What might Diamond Head be worried about?
That the buyer may abscond with the collateral or will abuse it so as to lessen its value.
The Teacher’s Manual contains the following story about recent events in Miami, Florida:
Car thieves were attending the execution sales of heavily encumbered cars, giving false
names and addresses, buying the cars for nominal amounts of money, and taking them
directly to “chop shops,” where they were disassembled and the parts that could not be
traced (federal law now requires the VIN number to appear on some critical parts of the
car) were sold on the black market.
Most execution sales (as opposed to Article 9 sales) do not require notice to senior lienholders,
on the theory that these senior liens survive the sale.
Does this all explain to you why it is very common to put in security agreements a provision
prohibiting the debtor from further encumbering the collateral and making it an event of default
to do so?
b.
Can Diamond Head protect its position by purchasing the equipment at the sale?
U.C.C. § 9-615(a).
Diamond Head could purchase the collateral, but it cannot make a “credit bid” as we saw earlier.
It is not a foreclosing creditor and it has to come up with “hard cash” to pay the purchase price to
the foreclosing lienholder.
c.
Can Diamond Head prevent the sale? U.C.C. §§ 9-609(a), 9-401.
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Hard to say. The Intercity Investment case said the senior secured creditor was entitled to
damages against an executing creditor based on the theory that the senior secured creditor was
entitled to possession under section 9-609 because the debt was in default.
Here, however, the debt is not in default, unless Diamond Head’s security agreement contains a
provision preventing further encumbrances or a clause saying it is an event of default if the
debtor defaults on any security agreement with any other party (a cross-default clause).
d.
Assuming that the creditor forcing this sale was an Article 9 secured party, was
Diamond Head entitled to receive notice of this sale? U.C.C. § 9-611 and Comment 4 to that
section.
Yes, unless the collateral is “consumer goods.” If it is not consumer goods, then section 9611(c)(3) says that notice is required, if a search of the records ten days before the notification
date would have uncovered Diamond Head’s filing. Hence, under Article 9, a foreclosing
secured party needs to search the U.C.C. filing office records prior to selling the collateral.
Section 9-611(e) creates a “safe harbor” rule that a search done between twenty‒thirty days
before the “notification date” is sufficieint.
If the collateral here is “consumer goods,” then section 9-611(c)(3) says that there is no
requirement that the foreclosing secured party give any other secured party notice of the
foreclosure sale.
Why this distinction?
Most consumer/business distinctions are designed to protect the consumer, but I don’t see
how this protects the consumer at all.
Assignment 28: Lien Creditors v. Secured Creditors: The Basics
Our last four assignments are really the payoff for all the hard work we have done over the last
few weeks on attachment, perfection, maintaining perfection, and priority in general. Assuming
that a secured party has a perfected security interest in collateral, how does that security interest
stack up against other persons who might claim an interest in the collateral—in other words, how
do we determine the priority of a perfected security interest with respect to other claimants to the
collateral? We are looking at “competitions” between secured parties with perfected security
interests and others.
We will look at a number of different “competitions”— that is, we will see that the U.C.C. offers
different rules for priority among competing claimants based on the nature of the claimants. So,
the first step in your analysis is to classify the competing parties by type—is it a lien creditor v.
secured party, secured party v. another secured party, secured party v. PMSI secured party, etc.
Now, these priority disputes are usually a matter of time: the person who first takes the action
necessary to make her interest in the collateral valid as to third parties (other than the debtor) will
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likely have priority over persons who take the necessary action at a later time. This should come
as no surprise to you, for a widely followed rule of property law is “first in time, first in right.”
The problem, of course, is to understand what are the steps a party needs to take to make her
interest in the property valid as against third parties.
We are going to start by looking today at the rights of “lien creditors” and how their rights
compare to the rights of a secured party with a perfected security interest. Article 9 defines “lien
creditor” in section 9-102(52)(A). What is it?
a creditor that has acquired a lien on the property involved by attachment, levy, or the
like.
There is also a second subsection in this definition that is important. Section 9-102(a)(52)(C):
a trustee in bankruptcy from the date of the filing of the petition
In order to understand the priority of lien creditors, we have to understand the date when a
creditor “acquires” a lien under state law. State laws vary considerably on what the creditor
needs to do to “perfect” his lien. Four things are listed in the CB. What are they?
1.
Most common is the date of levy. This is the date on which the sheriff actually
takes possession of the property pursuant to the writ of execution (or attachment) issued
by the court issuing the judgment. This is the most common date on which a lien
creditor’s lien “attaches” to the property and the date it becomes valid as against third
parties.
2.
Next most common is the date of delivery of the writ to the sheriff. These writs (in
Illinois, a certified copy of the judgment) are issued by the clerk of the court or some
other administrative officer of the court at the request of the creditor who got the
judgment against the debtor. The writ (or copy of the judgment) is delivered to the sheriff
who enters it into a log the sheriff keeps. In some states, the time of the lien attachment
dates from this date, but only if the sheriff actually does later “levy” on the property by
taking possession of the property.
3.
Next most common is the date of service of a writ of garnishment. This is an
order served on a person who owes money to the debtor (typically a bank where the
debtor has an account or an employer of the debtor). These writs give the creditor an
interest in the debt dating from the date of service on the person who owes money to the
debtor (the “garnishee”). [This is a special rule for garnishments, because you cannot
take “possession” of a debt, which is an intangible].
4.
Finally, there is the date of recordation of the judgment. This is the date the
judgment is delivered to the filing or recording officer. This is the rule in most states
for when a lien becomes effective as to real property.
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In most states, a judgment creditor does not file a U.C.C.-1 financing statement, although it
would make terrific sense to allow this, as the California legislature has done. Unfortunately,
most states have not done this and continue to follow some archaic statutes about when a lien
creditor’s interest becomes a lien on the property.
Competitions Between Lien Creditors
As between lien creditors, the first to take the action required under state law prevails over a
later lien creditor who takes that action. This is the proverbial “race to the courthouse” or, more
accurately, race to the sheriff’s office.
Competitions Between a “Lien Creditor” and a Secured Party
In order to understand Revised Article 9, we have to understand the rule under old Article 9.
Under old Article 9 (section 9-301), the rule was that the first to perfect got priority. So, if the
secured party was perfected before the lien creditor “acquired” his lien, then the secured party
had priority. However, if the lien creditor “acquired” her lien before the secured party perfected,
then the lien creditor had priority.
It is important to note that, under both old and revised Article 9, “perfection” means more than
just filing a financing statement. Under Revised Section 9-308(a):
a security interest is perfected if it has attached and all of the applicable requirements for
perfection in sections 9-310 through 9-316 have been satisfied. A security interest is
perfected when it attaches if the applicable requirements are satisfied before the security
interest attaches.
Remember that “attachment” of the security interest under section 9-203(b) requires three things:
(1) the secured party gives value; (2) the debtor acquires an interest in the collateral; and (3) the
debtor has authenticated a security agreement (or the creditor has taken possession).
In other words, under Section 9-308(a), a security interest’s priority dates from the later of the
time the method of perfection is satisfied or the time it attaches. In most cases, perfection is by
filing. In many cases, the secured party will file her financing statement before the date she gives
value to the debtor or before the debtor has signed the security agreement. [This is because the
secured party wants to get his financing statement on file in time to do a search of the U.C.C.
records that will disclose her financing statement and the absence of other financing statements
filed before hers.] Because the security interest cannot “attach” until value is given and the
debtor has signed a security agreement, the security interest’s perfection would only occur later,
at the date of attachment. Under old Article 9, a lien creditor who acquired her lien before the
time the security interest attached would take priority over the subsequently attached security
interest of the secured party.
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However, consistent with the hosing that lien creditors generally get under Revised Article 9,
revised section 9-317(a)(2) relaxes the requirements under the old law for the secured party to
get priority. It provides:
A security interest . . . is subordinate to the rights of:
(2) except as otherwise provided in subsection (e), a person that becomes a lien creditor
before the earlier of the time:
(A) the security interest . . . is perfected [THIS THE SAME AS UNDER OLD
ARTICLE 9]; or
(B) one of the conditions specified in Section 9-203(b)(3) is met and a financing
statement covering the collateral is filed.
So, under revised section 9-317, if a proper financing statement has been filed and if the debtor
has authenticated a security agreement, the secured party’s security interest takes priority over a
lien creditor who acquired his lien on the collateral after those two things have happened.
THINK ABOUT WHAT THIS MEANS: Even though the security interest has not yet
“attached” (because the secured party has not given any value) and is not enforceable against the
debtor, the security interest is nonetheless enforceable, and has priority over, a competing lien
creditor who “acquires” his lien after the financing statement is filed and after the debtor has
authenticated a security agreement.
Of course, if the secured party never “gives value,” then the secured party won’t have any claim
as to the collateral, as there is no underlying debt to secure. However, if the secured party
advances money (gives value) later, then the secured party will take priority over the lien creditor
who acquired its lien after the financing statement was filed and the security agreement signed.
[As an aside, section 9-317(a) was controversial when Article 9 was revised and it was changed
TWICE after Revised Article 9 was first promulgated in 1998. In fact, the final version [adopted
in Minnesota and other states and the one in your Code book] was not arrived at until 2000.
Unperfected Security Interests: No Filing
However, if the secured party had not filed a financing statement at the time the lien creditor
“acquired” his lien, then the lien creditor has priority.
REMEMBER that this does not invalidate the secured party’s security interest—it is still
enforceable against the debtor, it is just subordinate to the lien creditor. For example, let’s
assume I loan you $500 and take a security interest in your lawn dog, which attaches under
section 9-203, but I fail to file to perfect it, because I fail to file a financing statement. A
subsequent lien creditor gets a judgment against you for $1,000 and levies on the lawn dog. If the
lawn dog brings $1,200 at the sale, $1,000 goes to the lien creditor, but I have a right to the
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remaining $200, because as between you and me, the security interest is enforceable, even if it is
subordinate to the interests of third parties.
The only exception to this is in bankruptcy—if the debtor files for bankruptcy, an unperfected
security interest is unenforceable, due to the federal statute giving the trustee the power to avoid
these security interests.
Something that is very important to remember here is that, when bankruptcy is filed, the
Bankruptcy Code in section 544(a) gives to the bankruptcy trustee (or the debtor in
possession in a Chapter 11 case) the status of a hypothetical lien creditor who obtained a
lien on all property of the debtor as of the date of the bankruptcy filing. This is very
important because, as we will see, if a secured party has perfected his security interest
prior to this date (or if the secured party has filed a financing statement and the bankrupt
debtor has authenticated a security agreement), the secured party’s interest will be prior to
that of the trustee. However, if the secured party has not perfected his security interest as
of that time (or failed to file a financing statement or the debtor has not authenticated a
security agreement), the bankruptcy trustee can “avoid” (invalidate) the secured party’s
security interest. Thus, in bankruptcy, a failure to perfect means that the secured party’s
security interest is completely unenforceable and the property thus becomes available for
distribution to the unsecured creditors, on whose behalf the trustee acts.
This is important because most priority issues involving lien creditors today involve
bankruptcy—the trustee gets this special status as a hypothetical lien creditor as of the date the
bankruptcy petition was filed. She then seeks to challenge security interests held by secured
parties, saying that they are invalid as against a lien creditor of his status. These are usually not
issues of timing—the security interest is always prior in time to the filing of bankruptcy (the
automatic stay would prohibit actions to perfect security interests post-petition)—the issue here
is whether the earlier secured party has taken the steps necessary to obtain priority over a lien
creditor. As we will see, if not perfected, then the security interest is not effective as to third
parties, such as lien creditors.
Hence, most of issues in this area involve questions of whether the security interest has been
perfected at all, not issues of timing.
PMSIs and Lien Creditors
There is an exception with respect to purchase money security interests (PMSIs) under section 9317(e). What does this section provide:
[I]f a person files a financing statement with respect to a purchase-money security
interest before or within 20 days after the debtor receives delivery of the collateral, the
security interest takes priority over the rights of a . . . lien creditor which arise between
the time the security interest attaches and the time of filing.
Hence, a PMSI that is filed within 20 days after the debtor gets possession of the collateral
“relates back” to the time of attachment. What is the purpose of this exception?
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To encourage and facilitate the credit sale of goods and make it easier for the debtor to
take immediate possession of goods. Otherwise, the credit seller would feel compelled to
hold onto the goods until he has filed.
Let’s turn to our Problem Set for today.
Problem 28.1:
Melinda Hu is in financial difficulty. Her friend, Phyllis Goldman, decides to lend her
$200,000, which is to be secured by scaffolding and construction equipment owned by
Melinda and located in Melinda’s construction yard. On March 7, Melinda signs a
financing statement [no longer required], security agreement, and promissory note. Phyllis
files the financing statement that same day. Phyllis does not disburse the money. On March
10, the sheriff levies on the equipment pursuant to a writ of execution in favor of Star
Plastering. On March 11, Phyllis receives from the filing officer the report of her expedited
search showing Phyllis’s interest to [be] the first filed against the equipment.
a.
As matters stand now, is Phyllis perfected? U.C.C. §§ 9-308(a), 9-203(b).
This is the “gap” lien creditor problem that the drafters wanted to avoid in Revised Article 9.
No. Although Phyllis has filed the financing statement, and filing is an effective method of
perfecting a security interest in equipment, under section 9-308(a), a security interest is not
perfected until it has “attached” and the necessary steps for perfection have been taken. Under
section 9-203, a security interest does not attach until three things happen:
a.
the debtor acquires an interest in the collateral (this is satisfied here);
b.
the debtor has authenticated a security agreement (this is satisfied here); and
c.
the secured party has given value (this has not happened here, as nearly as we can tell).
However, section 1-204 has a very broad definition of “value” and it is possible (but unlikely)
that Phyllis made some promise to Melinda in the security agreement that might constitute
“consideration.”
b.
If Phyllis makes the $20,000 loan despite the levy, will she have priority over Star in
the equipment? U.C.C. § 9-317(a).
This is an illustration of the basic rule of section 9-317(a)(2).
First of all, when did Star become a “lien creditor”?
Probably when it levied on the property if the state follows the majority rule—this would
be March 10. In some states, like Illinois, Star might have become a “lien creditor” even
earlier, such as when the certified copy of the judgment was served on the sheriff.
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As of March 10 (when Star levied), Melinda (the debtor) had signed the security agreement and a
financing statement was filed that same day. Hence, under section 9-317(a)(2)(B), Phyllis has
priority over Star.
Problem 28.2:
The local credit bureau reported today the entry of a judgment in the amount of $125,000
in favor of Sheng Electronics, an unsecured creditor of Conda Copper. Conda Copper also
owes a $50,000 unsecured obligation to one of your clients, RFT Enterprises. Billy
Williams, the owner of RFT, is concerned that by the entry of this judgment, Sheng will
obtain priority in Conda’s assets. “I have been patient with Conda, and they haven’t,” says
Williams. “Why should my account be subordinated to theirs?” Can you think of a way
that Williams could get priority over Sheng? U.C.C. §9-317(a) and 9-323(b).
First, has Sheng presently “acquired” a lien on any of Conda’s property?
No. A judgment against personal property only becomes a lien upon levy or service on
the sheriff of an order of execution or some such thing. As nearly as we can tell, Sheng
has not done that yet.
Second should RFT sue Conda Copper and try to get a judgment (the entry of a judgment in
favor of Sheng might be an event of default under the loan agreement with RFT)?
No. It would take forever to get the judgment and then get a lien based on the judgment.
By then, Sheng would have acquired a lien by levy or execution or whatever and would
be prior in time to RFT.
So, what can RFT do to make life difficult for Sheng in enforcing its judgment against Conda?
Enter into an agreement with Conda whereby Conda grants a security interest to RFT in
all its personal property, file a financing statement covering that collateral, and do this
before Sheng obtains a lien on Conda’s property.
If RFT does this, will RFT have a perfected security interest? Remember that under section 9308(a), a security interest cannot be perfected until it has attached. Has RFT given any “value”
so that its security interest would attach?
Yes. Remember that “value” as defined in section 1-204 includes an antecedent debt, so
that its earlier $50,000 unsecured loan to Conda would constitute “value.”
Of course, an Article 9 security interest has to be consensual—Conda has to agree. Why might
Conda agree to grant a security interest to RFT?
RFT has been more cooperative than Sheng.
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Maybe RFT can offer an extension of time for payment or some other inducement to Conda,
such as a restructuring of the debt.
Finally, if RFT has a prior security interest in Conda’s assets, it may be able to shield Conda’s
assets from foreclosure by Sheng under the Grocer’s Supply case.
If this fact pattern looks familiar, it is because it is the flip side of problem with Leonard
Drapkowski–owner of the lemon-yellow Firebird, five-speed, nicknamed “Honey,” where you
were asked to represent a judgment creditor who gets snookered at the last minute by a secured
party taking a security interest in the property.
Skip Problems 28.3, 28.4.
Problem 28.5:
Bonnie Brezhnev, who recently purchased Bonnie’s Boat World (BBW), calls to ask your
advice. Earlier in the day, BBW sold a $70,000 Bayliner Boat to Edith Jones. BBW ran an
“instant” credit check, which missed the fact that Edith’s former husband, Orville, held a
judgment against her in the amount of $80,000 for unpaid alimony and child support.
Edith paid $7,000 of the purchase price of the boat by check and signed a promissory note
for the balance. Along with the note she signed a security agreement in favor of BBW.
Edith immediately took possession of the boat and the documents landed in the in-basket of
BBW’s bookkeeper for processing.
As a result of some good detective work, Orville and a sheriff’s deputy were waiting a block
away when Edith rolled out of BBW’s yard with the boat in tow. Orville and the sheriff
followed her to the marina and as soon as she stopped, the sheriff levied on the boat and
took possession of it.
Bonnie has two questions. First, can she get the boat back from the sheriff today? (The
security agreement Edith signed provides that any levy on the collateral constitutes a
default.) Second, is there anything else she can do? See Grocers Supply Co. v. Intercity
Investment Properties, Inc. See also U.C.C. §§ 9-102(a)(23), 9-308(a), 9-309(1), 9-317(a) and
(e), 9-609.
Once again, assume that in this jurisdiction, a judgment creditor gets a lien on personal property
when the sheriff actually levies on it by taking possession.
One of the problems here is the recurring one of characterizing the collateral. First of all, let’s
assume that the boat is NOT a “motor vehicle required to be registered” under the laws of this
state.
Second, let’s assume that Edith bought the boat for personal use, so that it would “consumer
goods” under section 9-102(a)(23). What would be the result in that case?
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A purchase money security interest in consumer goods is automatically perfected without
the need for filing a financing statement or taking possession of it. Section 9-309.
If that is the case, then who has priority and the right to possession?
Because there has been a default, section 9-609(a) provides that the secured party
(Bonnie) is entitled to possession of the collateral. Bonnie as a secured party with a
perfected security interest takes priority over Orville, who did not become a lien creditor
until the sheriff took possession of the boat (assuming the hypothetical jurisdiction here
follows the majority rule that actual levy is required to get the lien—again, in Illinois, the
result would be different, as Orville would certainly have served the sheriff with a copy
of the judgment before Edith signed the security agreement).
Under the Grocer’s Supply case we read in our last class, the prior secured party is entitled to
possession as opposed to the lien creditor. All Bonnie’s has to do is to declare a default, because
the security agreement says levying on the property is an event of default.
Now, what if the boat is not “consumer goods”? Let’s assume that Edith was buying the boat to
use in her business. What would be the result?
Bonnie’s can still get priority if it acts quickly. Because this is a PMSI, Bonnie’s is given
20 days to file a U.C.C.-1 financing statement covering the boat under section 9-317(e).
If she does so, then the filing (which is required for perfection, remember) “relates back”
to the date of attachment, which would be just before the sheriff seized it. Therefore,
Bonnie’s would have priority. When the filing occurs, then Bonnie’s will have priority
and be entitled to possession under the Grocer’s Supply rationale. So, Bonnie’s had better
file within 20 days.
Problem 28.6:
Bonnie Brezhnev calls back with some bad news and some good news. The bad news is that
she checked the documents after her earlier conversation with you. Edith signed the
financing statement but not the security agreement. The space for the signature on the
security agreement is blank. The good news is that Edith is at this very moment sitting in
Bonnie’s office, willing to sign the security agreement if you say it is okay. “I’d rather you
got the boat than that #@$%&*,” Edith tells Bonnie. What do you tell Bonnie? U.C.C. § 9317(a).
This is not good news for BBW. What is the present state of affairs with respect to priority?
Orville has priority currently, because he became a lien creditor at a time when Bonnie’s
security interest was unperfected under section (2)(A) and before the debtor signed the
security agreement under section (2)(B).
Well, since this is a PMSI, cannot Bonnie’s just go ahead and have Edith sign the security
agreement, file the financing statement within 20 days, and get priority over Orville?
22
No. The special PMSI rule says that filing within the 20-day period only confers a
priority on PMSI secured parties with respect to the “rights of a . . . lien creditor which
arise between the time the security interest attaches and the time of filing.”
When will the security interest “attach” here under section 9-203?
Not until the debtor signs the security agreement.
When will that happen, relative to Orville’s becoming a lien creditor?
It will happen AFTER Orville became a lien creditor, so he will prevail under section 9317(a), because the special priority rules of section 9-317(e) will not apply.
Okay, now do you still want to get Edith to sign?
Sure. You’ll be second in line, but that is better than third in line or fourth in line. Orville
probably has other creditors waiting to glom on to his property.
What if Edith signs the security agreement an hour after Orville and the sheriff glom onto the
boat? Who is going to know those facts?
You, Bonnie’s, and Edith.
Are any of these persons interested in full disclosure of the true facts to Orville or Orville’s
attorney?
No.
So, what is the possibility here?
The security agreement is signed, you go wave it in front of the sheriff and act as if it
were signed before Orville levied (of course, you still got to get financing statement filed
in the 20-day period).
Is that ethical?
Of course not. You could not do it. That would violate Rule 4.1(a) and/or 4.1(b).
Could Bonnie’s do it?
How are going to advise Bonnie’s of that without running afoul of Rule 1.2(d) which
prohibits your counseling the client to engage in conduct that is fraudulent.
Or are you going to do that anyway?
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Assignment 29: Lien Creditors Against Secured Creditors: Future Advances
In our last assignment, we saw the basic priority conflict resolution pattern between
nonconsensual, lien creditors holding a lien on property and the consensual, secured parties who
have a security interest in the collateral. The general rule is that the secured party has priority
over the lien creditor if one of two things happens before the lien creditor “acquires” her lien:
1.
if the secured party perfects its security interest; or
2.
if the secured party has filed a financing statement and the debtor has authenticated a
security agreement.
Today, we turn to a tricky problem: what happens if the holder of a security interest that would
otherwise have priority over the lien creditor under the general rule of section 9-317(a)(2) makes
advances to the debtor after the lien creditor “acquires” her lien. We’ll look first at the rules with
respect to personal property under Article 9 and then look to the rules of real estate law.
Remember from Assignment 9 that a security interest can attach to property that secures loans
from the secured party to the debtor that will occur in the future, called “future advances.”
First of all, keep in mind that under section 9-204(c), a security interest can secure future
advances, but only if the security agreement says so. In other words, there is no automatic
extension of a security interest to cover advances made at a later time—they are secured only if
the parties have agreed in the security agreement that the security interest extends to these
advances. However, Official Comment 7 to section 9-204 makes it clear that the financing
statement does not have to contain any reference to future advances.
So, a person searching the U.C.C. records would have no way of knowing whether a security
interest in collateral covers future advances or not.
The priority of future advances is set out its rule in section 9-323(b). What is that rule?
[Except for buyers of receivables]. a security interest is subordinate to the rights of a
person that becomes a lien creditor to the extent that the security interest secures an
advance made more than 45 days after the person becomes a lien creditor unless the
advance is made:
(1)
(2)
without knowledge of the lien; or
pursuant to a commitment entered into without knowledge of the lien.
Comment 4 to section 9-323 makes an important point. It says that the priority granted to future
advances under subsection (b) only applies in cases where the security interest would otherwise
have priority over a lien creditor’s rights under section 9-317(a). It says:
Subsection (b) does not elevate the priority of a security interest that is subordinate
to the rights of a lien creditor under Section 9-317(a)(2); it only subordinates.
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In other words, if the secured party has priority over the lien creditor under section 9-317(a)(2),
because it has either: (1) perfected its security interest; or (2) filed a financing statement and the
debtor has authenticated a security agreement before the lien creditor gets his lien, then the rules
of section 9-323 apply to any future advances the secured party might make that are secured by
that security interest.
However, if the lien creditor got her lien on the collateral before the secured party either: (1)
perfected his security interest; or (2) filed a financing statement and had the debtor sign the
security agreement, then the lien creditor has priority over all advances the secured party
makes, and the special rules of section 9-323 do not apply.
Now, this means that, notwithstanding that the lien attaches before advances are made, these
subsequent advances have priority over the lien creditor in three situations:
1.
in every case, any advance made within 45 days after the competitor becomes a lien
creditor takes priority over the lien, regardless of whether the secured party knows of the lien and
regardless of whether the secured party has a “commitment” to make these advances—think of
this as an “automatic priority” of future advances for 45 days after the lien attaches. Why is the
period of time 45 days?
Comment 4 to section 9-323 makes it clear that this is designed to give the secured party
maximum protection under the Federal Tax Lien Act of 1966.
2.
any advance made without knowledge of the lien takes priority over the lien, even if it
is made beyond the 45-day period and regardless of whether it was made “pursuant to a
commitment.”
Section 1-202(b) defines “knowledge” as “actual knowledge”—it is not the same thing as
“notice.”
3.
any advance made after 45 days and even though it is made with knowledge of the lien
still has priority over the lien if the advance is made “pursuant to a commitment made without
knowledge of the lien.”
The term “pursuant to a commitment” is defined in section 9-102(a)(68), which says:
“Pursuant to commitment” with respect to an advance made or other value given by a
secured party, means pursuant to the secured party’s obligation, whether a subsequent
event of default or other event not within the secured party’s control has relieved or may
relieve the secured party from its obligation.
So, even if the debtor is in default, and even if this would give the secured party the right not to
make the advance, if the secured party would have been obliged to make the advance (without
the default), then the advance is made “pursuant to a commitment.”
This is very bad news for a judgment lien creditor, who has gone to all the trouble to get a
judgment, execute on it, and locate and seize property of the debtor. It means that he can see the
25
value of the equity in the property disappear as a secured lender makes advances after the date of
his lien.
[THIS NOT ON EXAM OR THE QUIZ]. One of the issues that has come up is how to treat
what some courts call “non-advances”— these are typically costs the secured party expends after
the debtor’s default for the prosecution of a lawsuit against the debtor or to preserve the value of
the collateral. They include attorneys’ fees, costs of paying insurance on the property, and other
costs. Usually, the security agreement says these costs are added to the principal balance of the
debt and are secured by the collateral. What happens if these “non-advances” are made after a
lien creditor has obtained a lien on the collateral? Does the secured party have priority over the
lien creditor with respect to these costs?
The court in the Uni Imports case says that these expenditures in effect “relate back” to
the date of the security agreement and have priority over an intervening lien in favor of a
lien creditor.
Finally, the issue of future advances comes up in real estate transactions a lot. The typical
construction loan, for example, has the lender making advances to pay off the cost of
construction over a period of months or years. What if an intervening creditor of the debtor gets a
lien on the real property? How does that lien relate to the later-advanced monies?
The Schutze case shows the “modern” view that, so long as the mortgage contains a
“future advances” clause, it is effective to give future advances priority over the lien,
even if the later advances are made with actual knowledge of the intervening lien. Most
courts do not place a time limit or any other limit on this doctrine.
However, some courts make a distinction between “optional” advances and “obligatory”
advances and only give priority to “obligatory” advances.
Let’s turn to our Problem Set for today.
Problem 29.1:
A year ago, Lindsey Simon lent $1,000 to her friend, Henry Karwowski. Henry gave her a
security interest in his 32-foot Bayliner boat, and saw that her financing statement was
duly filed. Business Credit Associates (BCA) recently recovered a judgment against
Karwowski in the amount of $45,000. Yesterday, March 1, they levied on the boat. It now
sits in the Sheriff’s compound, behind an eight-foot cyclone fence that is topped with
Concertina wire.
Now Henry is back to ask another favor of Lindsey. What Henry wants is an additional
advance of $31,000. Henry’s lawyer, John Sung, says that the advance will protect the boat
from judicial sale. “Even if they go through with the sale, they won’t get anything,” he says.
Lindsey, who has been your client for years, asks whether this will work. What do you tell
her? U.C.C. § 9-323(b).
26
First of all, let’s assume that the original agreement between Lindsey and Henry contained
a “future advance” clause or a “dragnet” clause. If it did not, then there would be no basis
for claiming priority for the later advances over the judgment lien. Keep in mind that the
security agreement must spell out the obligations covered and the collateral. If the security
agreement just gave the secured party the right to the property as security for the $1,000
loan, then the secured party has no right to claim that the security interest even attached to
the property as security for any later advance.
Also assume that the value of the boat is $32,000.
Divide your answer into two parts: (1) what will happen if Lindsey does not make the
advance as requested? and (2) what will happen if Lindsey makes the advance and the
sheriff proceeds with the sale?
(1)
Lindsey Does Not Make the Advance:
If the bidders at the sale know this and if BCA goes ahead with the sale, then the bidders would
take the boat subject to Lindsey’s prior security interest securing a debt of $1,000. That means
that the bidders would bid no more than $31,000 for the boat. BCA could make a “credit bid” of
up to $31,000 and then become the owner of the boat, subject to Lindsey’s security interest.
BCA could then pay off the $1,000 debt and become the owner of the boat free and clear. If
someone else outbids them, BCA gets the amount of the bid, less the costs of the sale.
(2)
Lindsey Makes the Advance:
If she makes the $31,000 future advance to Henry and she makes it within 45 days after the
sheriff seizes the boat, then the $31,000 future advance will also have priority over the judgment
lien under section 9-323(b). Keep in mind that this is true even though Lindsey knows of the
security interest, even though she is under no legal obligation to make any future advance, and
even thought she is doing it with the intent to interfere with the sale.
[Now, there may be some fraudulent conveyance problems here unless Lindsey actually makes
the advance. For example, the Uniform Fraudulent Transfer Law invalidates any conveyance
made “with actual intent to hinder, delay, or defraud” a creditor. However, here the intent is
(arguably) to protect the boat as collateral. Note that lots of things may be done that have the
effect of hindering or delaying other creditors and the UFTA does not condemn them—creditors
do not owe a fiduciary duty to other creditors in most cases. Only actions done with this specific
intent violate the UFTA.]
If Lindsey makes the advance and the bidders at the sale are aware of this, how much would the
bidders be willing to bid?
Zero.
The bottom line here is that by making future advances to Henry, Lindsey can deny the lien
creditor any access to the collateral, thus in effect nullifying its lien.
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Now, does Lindsey have any real incentive to make the loan?
Other than bailing out a friend, I don’t think so. Friendship is important, but there are
very few friends I would lend $31,000 to, even if they offered me security for it.
Problem 29.2:
Assume that instead of representing Lindsey Simon, you represent BCA in its attempt to
collect the $45,000 judgment. You assess the value of the boat at $32,000. The sheriff’s sale
is set for March 29, just a few days from now. In preparation for bidding at the sale, you
conducted a U.C.C. search and discovered Lindsey Simon’s financing statement. Because
you believe that a deficiency judgment against Karwowski may be collectible, you don’t
want to bid higher than the value of Karwowski’s equity in the boat. But to know how
much that is, you need to know the amount secured by Simon’s interest.
When you called Simon, she said she would have to consult her attorney before giving you
that information. Although she said she would call you back, you have not heard from her.
a.
How do you plan to get the information? U.C.C. § 9-210.
BCA has the right to some discovery in the supplemental proceedings to effectuate its judgment
but if Lindsey delays making the future advance until just before the time of sale, BCA would
not be able to discover this.
Section 9-210 is not of much help here, as only the debtor has the right to this information. See
Comment 3.
b.
If you can’t get the information, what will be your bidding strategy at the sale?
U.C.C. § 9-323(b).
Probably the best thing to do is to go to the court and ask for some “equity” here to at least allow
the lien creditor to find out the amount of the prior security interest.
Alternatively, BCA can postpone the sale until the end of the 45-day period and then get the
debtor to swear under oath what the amount of the debt is in the supplementary proceedings.
I think the text and problems today indicate how existing Article 9 is really slanted against
judgment lien creditors and in favor of consensual secured parties. Let’s think for a moment
about the social consequences of this bias. Who tend to be secured parties?
Banks and other financial institutions.
Who tend to be judgment lien creditors?
28
Tort victims, divorced spouses or abandoned children, unsecured creditors (often small,
trade creditors with not enough clout to get a security interest to protect themselves, etc.).
So, the social result is to allocate the losses in business failures to the second class of
persons and there are increasing concerns about this. Is that a good thing, a bad thing, or
just an indifferent thing?
It could be argued that most consensual security interest transactions are part of
the process of wealth-creation. A business borrows money from the secured party
to develop its business, hire employees, etc.
However, most lien creditors are not engaged in wealth-producing activities—
they are merely seeking a transfer of wealth from one party to another.
Problem 29.3
This problem deals with future advances in real property law.
Mortgagor borrows $50,000 from mortgagee, and executes a note and mortgage which
state that future advances up to an additional $25,000 may be made by Mortgagee in the
future. However, Mortgagee has no obligation to make such advances. The mortgage also
states that it secures interest at 10 percent per annum and Mortgagee’s attorney’s fees in
any collection action. [LET’S ASSUME THE MORTGAGEE PROPERLY RECORDS
THE MORTGAGE.] Thereafter, J obtains a judgment for $100,000 against Mortgagor and
properly records it so as to impose a lien on Mortgagor’s real estate. Mortgagee has actual
knowledge of this lien. Then Mortgagee lends and Mortgagor accepts an additional $25,000
advance. Mortgagor defaults on the loan, owing the full balance [$75,000] and $10,000 in
interest. After default, Mortgagee incurs $5,000 of attorney’s fees that are recoverable
against Mortgagor under the terms of the mortgage. As between Mortgagee and J, who has
priority in the real property?
J is out of luck with respect to all the costs and advances made by Mortgagee. Of course,
the $50,000 already advanced would be entitled to priority under the general rules we
saw in our last class. Those advances were made before J became a lien creditor and his
lien is clearly subordinate to the lien of that $50,000 advance.
As to the “future advances,” the Schutze case indicates that the later $25,000 advance
takes priority over J’s lien. Likewise the “non-advances” of attorney’s fees are
recoverable under the rationale of the Uni Imports decision.
In some states involving real estate mortgages and future advances, as noted in the CB, courts
distinguish between obligatory and optional advances, with obligatory advances taking priority,
but optional ones not taking priority. “Obligatory” means much like the U.C.C. term “pursuant to
a commitment.” Here, the mortgage says that the Mortgagee “may” make future advances and
this may mean that it is optional and not entitled to priority under states that follow this view.
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Problem 29.4:
Now we turn problems involving personal property under Article 9.
Debtor borrows $50,000 from Secured Party and executes a note and security agreement
that state that future advances up to an additional $25,000 may be made by secured party
in the future. However, Secured Party has no obligation to make such advances. The
security agreement also states that it secures interest at 10 percent per annum and Secured
Party’s attorney’s fees in any collection action. [Assume Secured Party properly perfected
the security interest by filing a financing statement.] Thereafter J obtains a judgment for
$100,000 against Debtor and becomes a lien creditor by levying on the collateral. Secured
Party has actual knowledge of the lien. Sixty days after the levy, Secured Party lends and
Debtor accepts an additional $25,000 advance. Debtor defaults on the loan, owing the full
balance [$75,000] and $10,000 in interest. Secured Party incurs $5,000 of attorney’s fees
that are recoverable against Debtor under the terms of the security agreement. As between
the Secured Party and J, who has priority in the personal property? U.C.C. § 9-323(b).
Here, we compare the rules about future advances in the U.C.C. to the rules about real estate,
which we saw in the prior problem.
First of all, the initial $50,000 advance from the secured party has priority over the judgment lien
of J. There is no future advance problem with that.
Next, what about the $25,000 advance? Do any of the exceptions in section 9-323(b) apply, so as
to give the secured party priority as to these advances that were made after the judgment lien
attached?
It was made after 45 days, so that exception does not apply.
It was made with knowledge of the lien, so that exception does not apply.
It was not made “pursuant to a commitment,” as the security agreement did not compel the
secured party to make an advance; it just gave the secured party this option.
So, the $100,000 lien would take priority over the $25,000 future advance, but it would still be
subject to the $50,000 in earlier advances.
Next, what about the interest?
Interest follows the principal. So, the interest accruing on the $50,000 advance has
priority over the judgment lien, but the interest on the $25,000 advance would be behind
the priority of the judgment lien.
What about the attorney’s fees?
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Under the Uni Imports case, these are “non-advances” which relate back to the date of the
original security agreement. The secured party has priority in them, but only to the extent
that they relate to past advances.
Might be hard to separate them between the two advances, but it might be possible to
assume that they were incurred in proportion to the amounts of the loans, so that 2/3
($50,000/$75,000) would be recoverable, but 1/3 ($25,000/$75,000) would not be
recoverable.
Assignment 32: Secured Creditors Against Secured Creditors: the Basics
Today, we turn away from competitions for collateral between secured parties and lien creditors
and examine a different problem–what happens if there are two competing secured parties who
claim security interests in the same collateral.
The Problem Set for today is long and the material complicated. As a result, I do not intend to
lecture very much. Today, I want you to understand the general rule of priority between
competing secured parties, spelled out in subsection 9-322(a) and a couple of special situations:
issues about priority as to future advances and issues relating to purchase money security
interests (PMSIs) in various types of collateral.
You are not responsible for the material on priority in commingled collateral or for
priority issues about accessions. Likewise, you are not responsible for the material on
purchase-money security interests in proceeds.
Before we turn to the problem set for today, we need to deal with two competitions between
secured parties that the Problems do not address.
1.
What result if you have a competition between two secured creditors, neither of whom
has perfected its security interest?
Section 9-322(a)(3) says the first to attach has priority.
Why will that situation never arise in the real world?
If you have two unperfected security interests, one of them will get perfected before a
lawsuit is filed.
2.
What happens if you have one secured party who has a perfected security interest in
collateral and another secured party who has an unperfected security interest in the same
collateral? Who takes priority?
The secured party who has perfected. Section 9-322(a)(2). This makes sense, doesn’t it,
because the meaning of having an “unperfected” security interest is that it is not
enforceable as against third persons other than the debtor.
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In the Problem Set for today, we’ll assume that all the secured parties are properly perfected.
Those are the difficult issues governed by section 9-322 and is subject to some special rules
about PMSIs in section 9-324. Let’s turn to our Problem Set for today.
Problem 32.1:
In late July, Dawgs and More Dawgs (Dawgs) applied to Bank One for a loan against its
inventory of lawn dogs. Without committing to make the loan, on August 1, Bank One filed
a financing statement against Dawgs showing the lawn dogs as collateral. Also in late July,
Dawgs applied for a similar loan from Bank Two. On August 5, Bank Two approved the
loan and filed a financing statement against Dawgs showing the inventory of lawn dogs as
collateral. Bank Two and Dawgs signed a security agreement on August 5 and Bank Two
advanced funds to Debtor. On August 7, C-Dogs, a supplier and judgment creditor of
Dawgs, became a lien creditor by levying on the inventory of lawn dogs. On August 10,
Bank One received the report of their U.C.C. search showing their financing statement to
be in first position. They approved the loan to Dawgs. Bank One and Dawgs signed a
security agreement, and Bank One advanced funds against the lawn dogs. As soon as the
check from Bank One cleared, the owner of Dawgs wired the Bank One loan proceeds to
Freeport in the Bahamas, where they paused only long enough to join the proceeds from
the Bank Two loan, and then continued on to places unknown. Who has priority in the
inventory of the lawn dogs? U.C.C. §§ 9-203(b), 9-308(a), 9-317(a), 9-322(a)(1).
This Problem is designed to illustrate the basic priority rule in competitions between secured
creditors and also how these rules apply in competitions between lien creditors and secured
parties.
Let’s begin by looking at priority issues between Bank One and Bank Two. Both are secured
parties and both have perfected their security interests in the lawn dogs (under section 9-308(a),
both Banks’ security interests have “attached” and both have complied with the filing
requirements of section 9-310). Disputes between two holders of perfected security interests are
governed by section 9-322(a)(1). What does that section provide?
Conflicting perfected security interests . . . rank according to priority in time of filing or
perfection. Priority dates from the earlier of the time a filing covering the collateral is
first made or the security interest . . . is first perfected, if there is no period thereafter
when there is neither filing nor perfection.
So, as between Bank One and Bank Two, who has priority here?
Bank One has priority. Even though Bank Two was the first to “perfect” because it filed
on August 5 and also its security interest “attached” on that date, the rule of section 9322(a)(1) is a “first to file or perfect” rule. Hence, even though Bank One did not
“perfect” until August 10, when its security agreement “attached,” it was the first to file,
and hence it has priority over Bank Two.
What is the justification for the “first to file or perfect” rule?
32
As the CB suggests, it is to protect the integrity of the filing system by allowing a secured
party to pre-file its financing statement, check the filing system to see that no one else has
filed ahead of her, and then lend the money to the debtor without the need to re-check the
filing system.
Why is the rule different in cases of competitions between two perfected secured parties (first to
file or perfect) and competitions between lien creditors and secured parties (lien creditor loses if
the secured party is the first to perfect or if the secured party has filed and the debtor has
authenticated a security agreement)?
Because where there are two secured creditors, the second secured creditor to file can
avoid any loss by not making a loan if its U.C.C. search shows an earlier-filed financing
statement filed by a competing secured party.
Here, for example, Bank Two could have refused to lend until it had the results of a U.C.C.
search. That would have shown Bank One’s prior filing and Bank Two could have avoided being
in a subordinate position.
However, a lien creditor has already suffered a loss (she has a judgment against the debtor) and
could not have avoided incurring that loss by searching the U.C.C. records.
Now let’s turn to the priority between C-Dogs and the Banks. Remember that C-Dogs is not a
secured party—it is a lien creditor. Here, we see the differences between the way Article 9 treats
priority issues in competitions between secured parties and competitions between secured parties
and lien creditors. What is the general rule (from Assignment 28) on when a lien creditor take
priority over a secured party under section 9-317(a)(2)?
The secured party has priority only if: (1) it was perfected when the lien creditor
“acquired” his lien; or (2) the secured party had filed and the debtor had authenticated a
security agreement.
So, what about the conflict between C-Dogs and Bank Two? Who has priority?
When did Bank Two “perfect” its security interest?
On August 5, when the security interest attached (security agreement, rights
acquired, and value given) and it filed its financing statement.
When did C-Dogs “become a lien creditor”?
On August 7.
So, Bank Two was perfected when C-Dogs became a lien creditor and therefore under the first
clause of section 9-317(a)(2)(A), Bank Two has priority over C-Dogs.
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Now, as between C-Dogs (the lien creditor) and Bank One, what is the priority?
(1)
Perfection. Even though Bank One “filed” first was that enough to make it
“perfected”?
No. A security interest cannot be perfected until it has “attached” under
section 9-308(a).
When did Bank One’s security interest “attach”?
Under section 9-203, it cannot attach until the debtor has authenticated the security
agreement, acquired rights in the collateral, and the secured party has given “value.”
These things did not occur until August 10.
On August 10, C-Dogs had already become a lien creditor, so it acquired its lien before Bank
One perfected.
(2)
Filing and Debtor Authenticated Security Agreement. In addition, even though it
had filed a financing statement prior to the time that C-Dogs became a lien
creditor, the debtor (Dawgs) had not authenticated a security agreement as of that
time.
So, as between Bank One and C-Dogs, C-Dogs has priority over Bank One.
So, Bank One has priority over Bank Two, Bank Two has priority over C-Dogs, but C-Dogs has
priority over Bank One. What’s up here?
This is known as the problem of “circularity” of priority. You can think of it as being like the
game “Rock, Scissors, Paper” where each item trumps one of the others but is trumped by
another one, so if all three show up at once, there is no way to choose who prevails.
How can something so stupid happen in a well-drafted Code?
It can’t, which leads us to the conclusion that Article 9 might not be very well-drafted in
this area.
The problem comes from using different rules of priority (first to file vs. first to perfect) to
determine different competitions for collateral. If there was a single rule (first to perfect, for
example) there could be no circularity problems.
In cases involving a circularity problem based on inconsistent priority rules, the Teacher’s
Manual says that courts have simply come up with no single, principled rationale for deciding
these cases. In the few cases that have arisen, some courts simply break the chain in favor of one
party who might be a “favorite” of the law or some other public policy. Typically, these
circularity problems arise in cases involving tax liens or other liens that, outside the U.C.C., are
given some form of “super-priority.”
34
In fact, a matter that should be of interest to you, is that the casebook authors say there are no
reported cases involving a circularity problem under the predecessors of sections 9-317 and 9322. So, the matter is almost entirely academic, which is fortunate for me because every time I
try to think about it, I get a headache.
Omit Problem 32.2.
Problem 32.3:
A year ago, George Sol Estes borrowed $75,000 from Octopus National Bank (ONB) to
purchase a computer for his dry cleaning business. The security agreement he signed at
that time provided that the collateral would consist of the computer and any “substitutions,
replacements, or accessions.” The security agreement contained no provision regarding
future advances, because none were contemplated at the time. ONB filed a financing
statement indicating that the collateral was “equipment.”
ONB has just approved a $400,000 line of credit for George, to be secured by the dry
cleaning equipment in his shop. Molly Parker, the loan officer at ONB, tells you that she
knows she must prepare a new security agreement, but wonders if she must also file a new
financing statement. U.C.C. §§ 9-322(a)(1), 9-502(d).
This is not a “future advance” matter because the first security agreement did not provide that the
security interest thereby created secured future advances. Nor is the dry cleaning covered by the
first security agreement’s reference to “substitutions, replacements, or accessions,” as the dry
cleaning equipment would not come within any of these terms. That is why there must be a
second security agreement—the security interest does not attach to the dry cleaning equipment
until Estes authenticates a new security agreement granting a security interest in the dry cleaning
equipment, ONB gives value, and Estes gets an interest in the dry cleaning equipment. That is
the notion of attachment.
But the financing statement serves a different function—it is the method of perfection of the
security interest. The description of the collateral in that financing statement–“equipment”—is
broad enough to cover the new collateral (the dry cleaning equipment). Hence, that financing
statement is an appropriate method of perfecting the security interest in the new collateral.
Keep in mind that section 9-502(d) makes it very clear that a secured party can file a financing
statement before the security interest attaches. In fact, that almost always happens in cases of
large loans—the secured party wants to make sure that its financing statement is filed, and only
then will it do a U.C.C. search, see its financing statement with no others earlier filed, and then
the secured party will make the loan and the security interest will attach.
Under the priority rules of section 9-322(a)(1), the date of the filing is the date for priority
purposes, even if the secured party’s security interest does not attach until some later time.
Would the result be the same here if the first financing statement had described the
collateral as “computers”?
35
No. The financing statement would not be effective to perfect the security interest in the
dry cleaning equipment because it would not contain a sufficient description of the
collateral.
These results make sense if you think about what a person who wanted to loan money to Estes
and take a security interest in the collateral would discover when it searched the U.C.C. records
and discovered ONB’s financing statement. If the financing statement covered “equipment,” the
searcher would have reason to think that it covered the dry cleaning equipment. However, if the
financing statement only covered “computers,” the searcher would believe that there was no
security interest in the dry cleaning equipment.
Problem 32.4:
a.
A year ago, Lindsey Simon lent $1,000 to her friend, Henry Karkowski. Henry gave
her a security interest in his 32-foot Bayliner boat and saw that her financing statement
was properly filed in accord with the law of the state. About a month later, Business Credit
Associates (BCA) lent Karkowski $45,000, taking a security interest in several items of
collateral, including the boat. BCA also filed an effective financing statement. Karkowski
fell behind in his payments to BCA and yesterday, March 1, BCA repossessed the boat. The
boat now sits in the repo agent’s compound, behind an eight-foot cyclone fence that is
topped with Concertina wire.
Now Henry is back to ask another favor of Lindsey. What Henry wants is an additional
advance of $31,000 “to protect the boat from sale by BCA and prevent BCA from
collecting.” Lindsey, who has been your client for years, asks whether this will work. What
do you tell her? U.C.C. §§ 9-322(a)(1), 9-609(a).
See also section 9-323, Comment 3 (first sentence).
Assume the boat is worth $32,000. Also assume that Lindsey’s security agreement said the
security interest secured future advances.
We now have a real “future advances” issue. This is very similar to Problem 29.3, which we
looked at in our last class. We saw in that Problem that the future advances would have priority
over the competing lien creditor. However, one difference here is that the competing creditor is
now a secured party with a perfected security interest, not a judgment lien creditor. Does this
make any difference here?
No. The future advance would still take priority over the intervening interest (in this
case, BCA’s security interest).
Section 9-322(a) contemplates that the date filing the financing statement fixes the date of
priority in all disputes between secured creditors, and this includes disputes involving “future
advances.”
36
Thus, in disputes between two secured creditors, the first to file has priority regardless of the
timing of advances it makes to the debtor.
Substitute Problem 32.5.a: [on the Canvas page]
Isabelle Inskster runs a printing business. In June 2001, she gives a security interest in all
of her equipment “now held or hereafter acquired” to Downtown Federal Bank and the
bank makes a proper filing to perfect this security interest. In May, 2003, Inkster is at a
trade show where she sees a new binding machine, the BindAll 2400, manufactured by
Bindy Manufacturing. She signs a sales order to purchase the BindAll 2400 for the price of
$13,595. On May 14, 2003, the Bindy salesman arrives at Inkster’s place of business with
the BindAll 2400, sets it up for her, and she pays the $1359 down payment and signs a note,
security agreement, and financing statement covering the BindAll 2400. Bindy files the
financing statement in the proper office on May 20, 2003. In July, Inkster defaults on both
obligations. Who has priority in the BindAll 2400? See U.C.C. §§ 9-103(a) and (b), 9-324(a).
If the usual rules of section 9-322(a) applied, then Downtown Federal Bank would have priority,
as it was the first to file its financing statement. However, Bindy’s security interest is a special
type of security interest. Here, what kind of security interest was Bindy getting?
A purchase money security interest, because under section 9-103 the security interest is
retained by the seller of goods.
This is a special rule about PMSIs and competitions with plain old security interests contained in
section 9-324(a).
Under subsection 9-324(a) what is required for the holder of a PMSI in goods other than
inventory (and this is equipment, not inventory) to get priority over a competing security
interest?
It gets priority over competing security interests so long as it is “perfected when the
debtor receives the collateral [this did not happen here, as the filing statement was not
filed until six days later] or within 20 days thereafter [this did happen here, as the
financing statement was filed six days after the debtor got possession].”
What does the casebook say about the purpose of this PMSI exception to the “first to file or
perfect” rule?
To make it easier to buy stuff on credit, so that the seller does not feel he has to delay the
sale in order to search the UCC filing system to see if he can get a security interest that
will be prior to other security interests.
It also increases the total value of the collateral subject to the first secured party’s
security interest without any additional money being put up by the first secured party.
Could do the same thing through the “straw man” method under section 9-325(a).
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Problem 32.6:
Sara Wisnewski has been manufacturing high quality speakers for audio systems since
1979. Her speakers are among the best available and her prices are reasonable. For the
past few years, orders have running in excess of her manufacturing capacity and she has
been unable to fill all she receives.
At the same time, she has been losing a considerable amount of money on bad debts. In
your initial conference, she told you about a case in which she sold $5,000 worth of
speakers to a new customer, who promptly filed bankruptcy. The customer still had most
of her speakers in stock when it closed its doors, but the bankruptcy court gave them to the
inventory lender. Sara literally ended up having to buy her own speakers back from the
bank to fill other orders. Her attorney in the bankruptcy case explained to her that “the
bank got the speakers because they had the first security interest.”
a.
Sara thinks she should have the first security interest and she’d like you to tell her
what she needs to do to get it. What do you tell her? U.C.C. §§ 9-102(48), 9-324(a) and (b).
Sara is thinking about taking a purchase money security interest (under section 9-103 the security
interest is “taken or retained by the seller of the collateral to secure all or a part of its price”). So,
can she take advantage of the priority preference given to PMSIs generally under section 9324(a)?
No. Her PMSI is a security interest in “inventory”—her customers hold the speakers for
sale to others–so the usual PMSI priority rule in section 9-324(a) does not apply.
Instead, the specialized rules relating to PMSIs in inventory in section 9-324(b) apply. In order
for Sara to get priority over a competing security agreement, what will she have to do?
(1) Has to perfect the interest at the time the debtor receives possession of the inventory
(in other words, Sara must file her financing statement in advance)—in other words, Sara
has no grace period in which to file her financing statement;
(2) Must give an authenticated notification to the holder of the conflicting interest (which
means Sarah will have to do a UCC search of her buyers’ records in the relevant filing
offices);
(3) This notification must be received within 5 years before the debtor receives
possession; and
(4) The notification must state that she has or expects to acquire a PMSI in inventory of
the debtor and describes the inventory.
Now, she can do all of these things. That is not the problem.
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b.
What problems do you foresee? What can she do about them?
What is the problem, according to the text?
The competing secured party will not make advances to the debtor on inventory covered
by the PMSI. More troubling is that the competing secured party will likely have a
provision in its security agreement making the debtor’s granting a security interest to any
other party an event of default, so the competing lender might shut down the debtor by
foreclosing on the inventory.
Why would the competing inventory lender be upset with this arrangement with Sara?
Because the competing inventory lender is lending money to the debtor on the
understanding that the debtor needs the loan to pay off the cost of acquiring the
inventory. In other words, the inventory lender assumes that the debtor is paying off Sara
with the proceeds of its loan.
If Sara is now claiming a purchase money security interest, that means she is selling the
inventory on credit to the debtor, so the debtor is, in effect, borrowing twice against the same
collateral.
So, what does Sara do?
If her speakers are so great and there are competing inventory lenders, have the buyer pay
COD or at least make a significant down payment with a very short period to pay the rest.
It will be easier for her to hold out for cash payment than it will be for her to get a prior
security interest in the inventory.
Omit Problems 32.7 32.8, and 32.9.
Assignment 36: Buyers Against Secured Creditors
In this, our last class of the semester, we turn to another set of competitions between
persons claiming competing interests in collateral—what are the rights of a secured party
compared to the rights of a buyer of the collateral from the debtor? In other words, does the
secured party’s security interest continue in collateral despite their sale, or do buyers of the
collateral take free of the security interest?
For comparative purposes, this Assignment begins by looking at the law of real
property—what is the general rule about when a buyer of real property takes subject to a preexisting mortgage on the property?
Usually, the buyer takes the property subject to the mortgage, so long as the mortgage
was prior in time. Hence, if I purchase property shortly before a mortgage is put on the
property, I take the property free of the mortgage. If, on the other hand, the mortgage was
prior to my purchase, then I take the property subject to the mortgage.
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Of course, the recording statutes in all jurisdictions affect the outcome. That is, in order
to be enforceable against the purchaser, the mortgage must be of record prior to the time
the buyer takes title to the property. Hence, usually, an unrecorded mortgage is not
enforceable against a purchaser, at least unless the purchaser had some other notice of it.
So, the real-property rule is first in time (or first to record).
What is the basic rule for personal property?
It is the same.
Section 9-201 provides:
Except as otherwise provided in [the Uniform Commercial Code] a security agreement is
effective according to its terms between the parties, against purchasers of the collateral
and against creditors.
Likewise, section 9-315(a)(1) provides:
(a) Except as otherwise provided in this article and in Section 2-403(2):
(1) a security interest . . . continues in collateral notwithstanding sale, lease,
license, exchange, or other disposition thereof unless the secured party
authorized
(2) the disposition free of the security interest . . . ;
Hence, unless there is an exception, a purchaser of collateral takes the collateral subject to a
security interest.
Does this mean that the buyer of goods subject to a security interest is personally liable to pay
the debt secured by the security interest?
No. The debt is the personal obligation of the debtor. However, the lien attaches to the
property that the buyer buys.
Unperfected Security Interests
Keep in mind that if the security interest is unperfected, then there is a special rule under section
9-317(b) about the rights of buyers. It provides:
(b) Except as otherwise provided in subsection (e) [giving a purchase money secured
party 20 days to file to perfect its security interest], a buyer, other than a secured party, of
tangible chattel paper, documents, goods, instruments, or a security certificate takes free
of a security interest . . . if the buyer gives value and receives delivery of the collateral
without knowledge of the security interest . . . and before it is perfected.
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Thus, with respect to most buyers of most tangible property, they take free of an unperfected
security interest if they give value and receive “delivery” of the collateral without knowledge of
the unperfected security interest.
Perfected Security Interests
Most of the book deals with when a buyer takes free of a perfected security interest. The book
suggests that there are four exceptions–four cases where the buyer of the collateral will take
them free of even a perfected security interest, although for our purposes, we will only worry
about three of them. What are these exceptions?
1.
If the secured party authorizes the disposition of the collateral. Section 9315(a)(1). This “authorization” to sell may be in the security agreement, but most courts
have found the authority to dispose of collateral as implicit in the circumstances as well,
as where the debtor has routinely disposed of collateral in the past without objection by
the secured party.
2.
A buyer in the ordinary course of business takes free of a security interest created
by his seller, even though he knows of the security interest. Section 9-320(a). This is
designed to protect buyers of “goods” (see § 1-201(9) which is limited to goods), who
buy from persons engaged in the business of selling goods of that type. There are a
number of complicated things about this exception:
a.
It is the “seller’s” course of business that must be ordinary. In other
words, a buyer buying an item he has never bought before and will never buy
again is still a buyer “in the ordinary course of business,” so long as his seller is
engaged in “in the business of selling goods of that kind.” See section 1-201(9).
b.
The buyer takes free of the security interest even if he knows about it, but
he cannot be a buyer in the ordinary course of business unless he acts “in good
faith and without knowledge that the sale to him is in violation of the ownership
right or security interest of a third party in the goods.” Hence, in order to be
disqualified from this status, a buyer must act in bad faith or know that the sale to
him is not allowed by the security agreement.
c.
The buyer only takes free of a security interest “created by the buyer’s
seller.” As the illustration at CB 1133 shows, if the security interest was created
by the seller’s seller and is one that continued in the goods notwithstanding the
sale from the seller’s seller to the seller, then the buyer would take the goods
subject to the security interest.
This is the most important of the exceptions—where the buyer takes the collateral free of
any security interest. Who is this designed to protect?
Similar to the rules we looked at on “entrustment,” it is designed to protect buyers
who buy goods from dealers of goods of the type in involved. Unlike real
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property, where most buyers understand they need to check the status of title, it
would never occur to the buyer of groceries from Schnucks, or electronics from
R.J. Hobbies, or clothing from Famous Barr that it is necessary to check the status
of the seller’s title.
Remember that it is not limited to consumer buyers. For example, if Ford buys
1,000,000 tons of steel from U.S. Steel, Ford is a buyer in the ordinary course of
business and takes free of any security interests in the steel created by U.S. Steel.
3.
A consumer who buys consumer goods from another consumer takes free of a
security interest, unless it is perfected by filing. Section 9-320(b). Keep in mind that we
saw several days ago that purchase money security interests in consumer goods are
automatically perfected, with no need to file a financing statement under section 9309(1). If the seller has not filed a financing statement, then a consumer buyer of
consumer goods from another consumer takes free of the automatically perfected security
interest.
However, if the seller has filed a proper financing statement, then the consumer buyer
takes the goods subject to the security interest.
4.
Most buyers of tangible property not in the ordinary course of business
nevertheless take free of a perfected security interest to the extent it covers certain types
of future advances (section 9-323(d) and (e)). I will not have anything more to say about
these. The “future advances” exception almost never applies.
So, we have a system that presumptively continues the security interest in collateral even though
the collateral is sold or transferred, but subject to some numerous exceptions.
Let’s turn to our Problem Set for today.
Problem 36.1:
Alecia Card bought a used 2012 “Lindy Delux Housecar” (“The Lindy”) from the used car
lot of Sunrise R.V. She paid for the recreational vehicle with a $23,000 cashier’s check and
drove it home. The salesman at Sunrise assured her that she would receive title to the
Lindy directly from the Division of Motor Vehicles within two weeks. When the title did
not arrive as promised, Card complained to Sunrise.
Eventually, she learned the history of the Lindy. A man named Bruce Markell purchased it
from All Seasons R.V. over a year ago. Markell granted All Seasons a security interest in
the Lindy to secure a part of the purchase price. In the security agreement, Markell agreed
“not to transfer any interest in the vehicle.” A few weeks ago, Markell violated the security
agreement by trading the Lindy to Sunrise R.V. (Sunrise) for another recreational vehicle.
At the time he sold the Lindy to Sunrise, Markell still owed All Seasons $17,000 of the
purchase price. Sunrise bought the Lindy subject to that lien and agreed to pay it. Instead,
Sunrise deposited Card’s $23,000 to its operating account and spent the money on rent and
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other expenses. Card also learned that Markell did not notify All Seasons that he was
selling to Sunrise and did not obtain All Seasons’ permission to sell.
a.
Card wants to sue to remove All Seasons’ lien from the title to the Lindy. How good
is her case? U.C.C. §§ 9-315(a); 9-320(a).
See In re Sunrise R.V., Inc., 105 B.R. 587 (Bankr. E.D. Cal. 1989).
Card would be a buyer in the ordinary course of business under section 1-201(9)— she meets all
the elements of the definition.
As a buyer in the ordinary course of business, what security interests des she take free from
under section 9-320?
Security interests “created by the buyer’s seller.”
Who is Card’s “seller”?—Sunrise R.V.
Did Sunrise “create” this security interest?
No. Markell did.
So, even though Card is a buyer in the ordinary course of business, she does not take free of the
particular security interest in question here.
Would Markell’s sale to Sunrise have met the “buyer in the ordinary course of business”
exception so as to cut off all of All Season’s security interest?
No. Markell is not “in the business of selling goods of the kind” so All Seasons’s
security interest would have survived the sale from Markell to Sunrise.
What is the justification for this “created by the buyer’s seller” limitation?
Here, All Seasons and Card are both innocent. Card dealt with the bad guy (Sunrise) who
breached its promise to pay off Markell’s loan. As between two innocent people, maybe
the loss should fall on the person who dealt directly with the wrongdoer.
Of course, Markell is not free from fault here, either, so I’m not sure this is a particularly
persuasive argument.
Does she qualify under any other exception?
The sale was not “authorized” because the problem says that All Seasons had not agreed
to the sale, which was prohibited by the security agreement between it and Markell.
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The “consumer to consumer” exception does not apply because the seller is not a
consumer and the goods would have been “inventory” in Sunrise’s hands, not “consumer
goods.”
b.
If Alecia had insisted on seeing the certificate of title for the Lindy before she paid
her $23,000, what would she have learned? See U.C.C. § 9-311(d) and Comment 4 to that
section.
If All Seasons had any brains it would have the certificate of title itself.
Sunrise R.V.’s name would not be on the title. They prefer to transfer title only once for each car
they own—from their seller to their buyer. Comment 4 to section 9-311 alludes to the problem.
Instead, she would see the title in Markell’s name, with All Seasons listed as a lienor. Markell
will sign the back, but there will be no release of the lien. As its lien was not released, Alecia
might (if she were really shrewd) figure out that there might be a problem.
Of course, a dishonest seller would just make up some story about why it could not get the title
or tell her that it is in the process of getting All Season’s release of lien.
Nevertheless, if I were Alecia, I would not pay the price until I saw the All Seasons release.
Problem 36.2:
Alecia Card is back to see you for the fourth time since you represented her in All Seasons.
Though she is a bright, energetic, friendly person, she has been asking questions that seem,
. . . . well, a little too basic. Even before today, you had been suspecting that Alecia might be
showing signs of paranoia. In your meeting this morning, Alecia explained that she has
been shopping for a piano, has found a reconditioned one she likes for $10,000 at American
Piano Company in the Galleria Mall, and would like you to “represent her at the closing.”
Covering your surprise, you told her that most people who buy things in the mall just
represent themselves. “Yes,” she replied matter-of-factly, “but they haven’t been through
what you and I have.” You told her you’d think about it and give her a call this afternoon.
a.
Is there anything to her fears? U.C.C. § 9-320(a).
Sure. Even though she is a buyer in the ordinary course of business, there is some chance that
the seller of the piano to American had encumbered the piano and thus the ordinary course of
business exception in section 9-320(a) would not apply, as the security interest is not one
“created by her seller” (American).
b.
Can the problem be dealt with by a thorough search of the public records? U.C.C. §
9-507(a), including comment 3.
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With respect to the sale of the RV, we suggested that she could have waited to pay until her
seller produced a certificate of title. Can she get the same level of protection with respect to the
piano?
No. Pianos, like most personal property, is not subject to certificate of title laws.
So, to determine whether the status of the title to the piano, what could she do?
She could search the UCC filings against her seller.
Would this, necessarily, disclose the existence of all security interests that might be perfected in
the piano as collateral?
No. What if American Piano bought the piano from Bruce Markell who traded it in
violation of a security interest in his seller, All Seasons Piano Company?
You would be in the same boat as Alecia was in the earlier problem, but now you cannot even
demand to see a certificate of title.
If Alecia could learn the names of all the former owners of the piano, conceivably she could
conduct a search in all their names, but there is no document that will confirm who the owners
were and she would have to trust her seller (which did not get her very far in the preceding
problem).
c.
Should you recommend a psychiatrist or try to deal with this yourself? If you try to
deal with this yourself, what will you say to Alecia and what will you do to get ready for the
“closing.”
So, do you tell Alecia you will help her or what?
d.
Is this a problem that is unique to used goods, or could it occur with respect to new
goods as well?
It could occur with respect to new goods. If American bought the entire inventory of new pianos
from a defunct piano store (a sale in bulk, so that American would not qualify as a BIOCB) and
if that inventory was subject to a security interest in favor of the bulk seller, Alecia would not
qualify for the exception in section 9-320(a).
Problem 36.5:
Davis Department Store sold a combination TV-stereo-VCR-popcorn popper to Meredith
on credit for $1,925. Meredith paid no money down, but signed a promissory note, security
agreement, and financing statement. Davis filed the financing statement in the U.C.C.
records. The security agreement provided that Meredith “agrees not to sell the collateral.”
Six months later, Meredith lost his job at the meat processing plant and moved to
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Tennessee. Before leaving, she held a garage sale at which she sold the entertainment unit
to her friend, Cristina for $960. Cristina didn’t know about the security agreement with
Davis Department Store and (wouldn’t you know it?) made the mistake of paying by check.
Davis identified Cristina as the buyer from Meredith’ checking records.
a.
Davis asks whether they are entitled to repossess the entertainment unit from
Cristina
Cristina loses. None of the exceptions apply here:
a.
The sale was not authorized by the security agreement or otherwise.
b.
Cristina does not qualify as a buyer in the ordinary course of business, because
her seller, Meredith, was not “a person in the business of selling gods of that
kind.”
c.
The “not in the ordinary course of business” exceptions do not apply because
there are no future advances.
d.
The consumer to consumer exception does not apply because Davis filed a
financing statement covering the goods.
Does Cristina have a claim against somebody? See U.C.C. § 2-312.
Again, Cristina has a claim against Meredith for breach of the warranty of title under
section 2-312.
b. If so, do they have to refund his $960? U.C.C. §§ 1-201(9), 9-315(a), 9-320, 9-401(b).
No.
Problem 36.6a:
Your client, University City Bank (UCB), has a security interest in the inventory of Sound
City, Inc. Sound City sells sound systems at retail to consumers and businesses. The
security agreement between UCB and Sound City prohibited sales on credit and required
that “Debtor deposit all proceeds of sales of collateral to Debtor’s account #937284 at
University City Bank.” UCB perfected the security interest by filing a financing statement.
On October 20, Sound City, Inc. filed under Chapter 7 of the Bankruptcy Code. The
trustee abandoned the inventory, the debtor surrendered it to UCB, and UCB sold it and
applied the proceeds to its inventory loan. A deficiency of $36,000 remains owing to UCB
on the Sound City loan. Through discovery, you learned of the following transactions
which took place before the filing of the bankruptcy petition:
a.
Sound City sold a sound system to Rhonda Fried for $12,000. Rhonda paid $2,000
cash and signed a negotiable promissory note for the remaining $10,000. There is no
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evidence that she knew of the restrictive provisions of the security agreement. Sound City
deposited Rhonda’s check to an account with a bank other than UCB and used the money
to pay a utility bill. About a month later, Sound City sold the Rhonda note for $9200. UCB
has been unable to determine what Sound City did with the proceeds. Is UCB entitled to
repossess the sound system from Rhonda? U.C.C. §§ 9-315(a); 9-320; 9-323(d) and (e); 1201(9).
UCB is not entitled to repossess the sound system from Rhonda. Rhonda is the classic “buyer in
the ordinary course of business” under section 1-201(9). Her seller (Sound City) is “a person in
the business of selling goods of that kind.” She is certainly acting in “good faith and there is
nothing to indicate she knew anything about the security interest (but even if she did, it makes no
difference under section 9-320(a)) and she certainly had no “knowledge” that the sale to her was
in violation of the security interest of anyone. Furthermore, the fact that she bought on credit is
of no significance, as the third-to-last sentence of section 1-201(9) makes it clear that the sale
can be for cash or barter or on secured or unsecured credit. She also has possession of the goods.
b.
You may skip this part.
c.
George Paulos is a lawyer who has been representing Sound City for many years.
As of July 17, Sound City owed George $16,458 for legal services rendered in two
employment discrimination suits. George agreed to accept a $14,000 sound system as
partial payment and Sound City installed it in his home. Is UCB entitled to repossess the
sound system from George? U.C.C. §§ 9-306; 9-307; 1-201(9).
First, is George a “buyer in the ordinary course of business”?
He was apparently acting in good faith and without knowledge of any violation of UCB’s
rights. Certainly, his seller is a “person in the business of selling gods of that kind.”
Is he “buying” within the meaning of this definition?
No. “Buying” “does not include a transfer in bulk or as security for or in total or
partial satisfaction of a money debt.”
Hence, George is not eligible for this exception.
Are there any other exceptions that might protect George?
Alternatively, did UCB “authorize” this disposition?
It is not clear. It says that it prohibited sales on credit and required the debtor to
deposit all of the proceeds into an account, which is hard to apply to a cases
where the sale if in partial satisfaction of the earlier money debt. If it was
“authorized,” then George takes free of it. If it was not “authorized,” then George
would take subject to the security interest and UCB would have the right to
repossess. As the book notes courts have split on this issue (whether a sale is
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authorized if the debtor is required to pay the proceeds of the sale to the secured
party and does not) and revised Article 9 does not appear to have answered it.
See Comment 2 to section 9-315.
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