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Assignment 8: Formalities for Attachment
Now, we have seen the general rights of both secured and unsecured creditors under state law
and how they can be affected by the debtor’s bankruptcy, so we look at the steps necessary for a
person to become a secured creditor. Generally, secured creditors are consensual creditors
—the
debtor agreed at one time to give the creditor a security interest in some of the debtor’s property.
Today, we look at how a creditor obtains a security interest in personal property under Article 9.
As the last part of the assignment notes, the law as it relates to real property is usually more
formal—every state has a series of detailed statutory requirements for obtaining an enforceable
mortgage on real property. We won’t spend any time on the real estate issues today.
There is a very, very, very important distinction in the law of personal property security interests
—the difference between a security interest attaching
and a security interest that is perfected
.
What does it mean when we say that a security interest has attached
to some personal property?
It means that the creditor can enforce the security interest against the debtor. If the
security interest has not attached, the creditor cannot enforce the security interest against
the debtor—in other words, the creditor is treated as an unsecured creditor.
What does it mean if the security interest is perfected
?
If it is perfected, it can be enforced, not only against the debtor, but also against third
parties (including other creditors) who might claim an interest in the collateral. The law
of “perfection” of security interests is covered in Part 3 of revised Article 9.
If a security interest is unperfected
, many people can acquire an interest in the collateral that is
superior to the interest of the secured party. We’ll talk about all this later in the semester.
It might be helpful to make an analogy to the law of real estate mortgages, where a similar issue
arises. Generally, a mortgagee has enforceable rights against the mortgagor in the property when
the mortgagor signs a mortgage granting the mortgagee a security interest in the property.
However, to make the mortgage enforceable as against others (purchasers, lienors, other
mortgagors, etc.), the mortgagee must record
the mortgage in the real estate records. That gives
notice
to third parties of the mortgagee’s interest in the property.
Likewise, a secured party has an enforceable security interest against the debtor when the
security interest attaches
under section 9-203, a section we will spend a lot of time with today.
However, just because the security interest attaches does not mean that the security interest is
enforceable with respect to third parties (purchasers, lienors, or other secured parties)—to make
it enforceable with respect to these third parties, the security interest must be perfected
—this is
the subject of later assignments, but right now it usually requires the filing of a document called
a financing statement
in a public office—usually the Secretary of State’s office. This public
filing gives notice
to third parties of the secured party’s interest in the collateral.
What does section 9-203(b) require for a security interest to attach?
1. value [defined in § 1-204] has been given [and everyone understands that this is “value
given by the secured party”]; 2. the debtor has rights in the collateral;
AND
3.a. the debtor has “authenticated” a security agreement that provides a description of the
collateral . . . ; OR
3.b. the collateral is collateral other than certificated securities and is in the possession of the
secured party pursuant to the debtor’s security agreement.
3.c. and d. there are also provisions about types of collateral known as “certificated
securities,” “investment property,” “deposit accounts,” “electronic chattel paper,” and “letter-of-
credit rights”—we will not deal with any Article 9 rules relating to those unusual types of
collateral—and you are not responsible for attachment of security interests with respect to those
unusual classes of property.
Section 9-203(a) says the security agreement is enforceable against the debtor with respect
to the collateral once it attaches and for attachment ALL THREE of those things must
occur.
Let’s think a little about attachment by possession. How common do you think this is?
Not very. Most debtors do not want to defer possession of the collateral until the
obligation secured by the security interest has been satisfied. For example, when you buy
a new car on credit, you want to be able to drive it before you pay it off. And, most
secured parties do not want possession of the collateral. For example, the bank would
rather not rent a secure parking facility to house all the cars it finances—it is happy for
you to use the car (as by going to work to make money to pay off the bank’s loan).
The overwhelming majority of secured creditors have their security interest attach by agreement.
What are the requirements for the “agreement” under section 9-203(b)(3)(A)?
1. Must be “authenticated” by the debtor—this effectively means it must be in a “record,”
which is either a writing or an electronic (digital) agreement.
“Authentication”—§ 9-102(a)(7)
“Record”—§ 9-102(a)(69)
2. It must “provide” a description of the collateral. We’ll talk about what descriptions are
“adequate” in class tomorrow.
This is not a hard requirement to meet, but it is amazing how many secured creditors screw this
up. For purposes of planning, you always require the debtor to sign a standard-form security
agreement and nothing else should be allowed. However, when your clients act without prior
legal advice, they frequently screw up, as did the creditor in the Ace Lumber
case who merely
had the debtor sign a UCC-1 financing statement
, not a security agreement. [Remember the
words of the great English Enlightenment poet, Alexander Pope, “A little learning is a dangerous
thing.”] The material in the text shows that courts have struggled with this requirement and many say a
security agreement can be found by reading a number of documents together, so long as one of
them is signed and so long as another of them contains a description of the collateral. This is
known as the composite document
rule.
So much for the first requirement (possession or writing).
Let’s turn to the second requirement, value having been given. When does a person give “value”
for a security interest?
“Value” is defined in section 1-204 very broadly. Anything that would be consideration
for an ordinary contract is value. So is an antecedent debt (in other words, “past
consideration” is “value”). So is a promise to extend credit or the extension of
immediately available credit. In fact, when an unsecured loan is in default, one of the
ways to work it out is for the debtor to provide some collateral to the lender as security
for the loan, thus converting the unsecured loan into a secured one.
“Value” is always given, although sometimes (as we will see later) the security interest
will attach only at the time that value is given and that may be important.
Let’s turn to the third requirement, the debtor has rights in the property. For our purposes right
now, we need to think about this requirement as a matter of timing
. For reasons we will see later,
most secured parties would prefer to have their security interests attach at the instant the debtor
acquires an interest in property. One way to do this is to have the debtor sign the security
agreement before she becomes the owner of property, so that as soon as she gets the interest in
the property, the secured party’s security interest attaches.
Let’s now turn to our Problem Set for today.
Problem 8.1:
8.1. a. Your client, First State Bank, loaned $150,000 to Coyote Laboratories, Inc. Coyote
fell on hard times and filed bankruptcy. R.K. Maroon, the bank’s president, told you that
the loan was to be secured by certain laboratory equipment, and the only documentation is
this email:
From: Coyote, Wile E., wecoyote@coyotelabs.com
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Sent: Thursday, February 12, 2015 4:35 PM
To: R.K. Maroon, President, First State Bank
Subject: Loan Collateral
Thank you for the delightful lunch today. As we discussed, I grant to First State Bank a first security interest in our laboratory equipment to secure the bank’s $150,000 loan.
You filed a secured proof of claim in the bankruptcy case, and attached a printed copy of the email. The bankruptcy trustee objected to your proof of claim, citing “the lack of an authenticated security agreement.” The case is likely to pay ten cents on the dollar to unsecured creditors. Maroon wants to know whether you think it is worth contesting this objection. What do you tell him? U.C.C. §§9-102(a)(7), (a)(70), (a)(74), 9-203(b).
We tell Maroon the Bank should contest this objection. We have a strong case, $135,000 is at
issue, and the procedure is easy – show up at the hearing on our claim and contest the objection.
The email contains language that clearly grants a security interest. The language is in the present
tense and indicates a present intent to to make the grant immediately. Although Coyote didn’t
sign the email, Coyote “authenticated” it under § 9‐102(a)(7). That provision says that in
addition to signing, a record is authenticated if “with present intent to adopt or accept a record, to
attach to or logically associate with the record an electronic sound, symbol, or process.” What’s
the thing that is logically associated? Well, ah . . . We don’t know, but there no doubt it is
something because the drafters intended to authorize email security agreements. Maybe it is
Coyote’s name in the “from” field? In the context of a contract for the sale of goods governed by
Article 2, a court has held an automatically generated signature block authenticates an email.
Princeton Indus. Prods. v. Precision Metals Corp.
, 120 F. Supp. 3d 812 (N.D. Ill. 2015).
b. If instead of sending the email, Coyote had called Maroon and told him exactly the same
thing, would First State have a security interest in the equipment?
We are confident that First State doesn’t have a security interest based on this oral grant. Section
9‐203(b) is a statute of frauds. The entire point of a statute of frauds is to distinguish between
oral and written agreements. (Oops! We aren’t supposed to say “written” anymore.)
c. What if Coyote had been unable to reach Maroon and left a voicemail message saying
exactly the same thing? Does it matter if Maroon deleted the voicemail message
immediately after listening to it?
We think First State has a security interest based on the voicemail message. That voicemail
message is probably on the same disk drive as the email message –how could anyone make a
principled distinction between them? When the bank president deletes the email message, that is
unfortunate from an evidentiary point of view. But what if the security agreement had been a
forty‐page signed and notarized writing and the secured party inadvertently burned it? You can’t
get out of your home mortgage by destroying all the copies. The law has rules for dealing with
this sort of thing. Proponents must furnish the “best evidence” of the written agreement. If that
best evidence is oral testimony, then the oral testimony is admissible. The legal issue is whether a
valid security interest was created, not whether it continued to exist after creation.
Problem 8.2:
You are working as a law clerk for Judge Heather Clifford. Judge Clifford has given you
the exhibits from a recently completed bench trial and asked you “whether they meet the
authenticated security agreement requirement of U.C.C. §9-203(b)(3)(A).” The first is a
promissory note for $50,000 that was signed by the debtor but not by the secured party.
The note recites that it is “secured by collateral described in a security agreement bearing
the same date as this note.” The second is a financing statement that describes the collateral
as “all of the inventory and equipment of [the debtor’s] business.” Although the financing
statement was not signed, it was accompanied by another writing that was signed by the
debtor: an authorization for the secured party to file such financing statements and
amendments as the secured party may deem necessary or expedient to protect its existing
and future rights in collateral. The third is a letter from the debtor’s attorney to the
creditor that states, “Enclosed are the promissory note and financing statement which give
you a security interest in my client’s inventory and equipment.” No other writings were
introduced. What do you tell the judge? Is this a question that can be answered from the
documents alone, or do you need to read the testimony? U.C.C. §9-102(a)(7).
We think it is unclear whether the documents meet the authenticated security agreement
requirement. None of the documents alone meets the requirement, but together they might do so
in a jurisdiction that recognizes the composite document rule and doesn’t require that each
document be signed by the debtor to be considered.
The student needs to read the testimony to resolve uncertainty as to the meaning of the
documents and to determine whether the parties intended a security interest. Students usually
want to cite the composite document rule and jump to a solution without analysis. The trick here
is to get them to see that even though the elements of U.C.C. §9‐203(b) are vague, that is not a
license to ignore them.
We start by asking whether any of the documents, standing alone, might be a sufficient writing.
Does the lawyer’s letter alone create an enforceable security interest? First, the lawyer is not the
debtor but merely represents the debtor. Whether the lawyer’s signature is that of the debtor
depends on the lawyer’s actual and apparent authority, neither of which is clear merely from the
documents. Lawyers ordinarily do not execute security interests on behalf of their clients.
Second, the letter does not purport to be a security agreement; rather, it refers to the other two
documents.
The promissory note, like the letter, does not purport to be a security agreement; rather, it refers
either to the financing statement or to a document that apparently does not exist. The financing
statement has an adequate description of collateral and the debtor signed an authorization to file
it. But, financing statements don’t play very well as security agreements. In addition, the
signature is on the authorization to file the financing statement, not the financing statement itself.
Considered individually, none of these documents would seem to qualify as a security
agreement.
But under the composite document rule, the court can consider all of them together. Aside from
the problem of the lawyer’s authority, the facts given here are very similar to those in In re
Bollinger Corp.
, 614 F.2d 924, 926 (3d Cir. 1980), where the court found that the requirement of
a security agreement signed by the debtor was met. The Bollinger case was decided under the
pre‐1998 U.C.C. where the debtor also signed the financing statement. Here, the signed
authorization to file a financing statement could serve the same evidentiary purpose as a signed
financing statement as both provide an authenticated writing from the debtor.
Problem 8.3:
You recently joined the legal department at First National Bank and work under the direct
supervision of Scott Pryor. To begin your training, Friedman took you to the Kettering
closing. While you are driving back to the bank from the closing, Pryor asks you at
precisely what point in time First National Bank’s security interest attached to the
Fisherman’s Pier restaurant. What do you tell him? See
U.C.C. §§ 1-204, 9-203(b)(3)(A), 2-
501(1).
Let’s think back to the Kettering illustration. There were about six events that occurred there:
1. Kettering signs the note and security agreement;
2. Stella delivers the bill of sale, assignment of lease, and the keys;
3. Friedman delivered the First National check to Valley State Bank;
4. Valley State gives Friedman the termination statement;
5. Friedman delivered the check for the balance of the price to Stella; and
6. Kettering pays the balance of the purchase price to Stella with the cashier’s check.
What are the three requirements under section 9-203(b) for a security agreement to attach?
Written security agreement signed by the debtor and containing a description of the
collateral.
This was met when Kettering signed the written security agreement at
closing. This happened at [1] above.
Value.
Value was given no later than when Friedman delivered the first check at the
closing. [3] above. It may have been earlier if First National made a legally binding
promise to make the loan. Ordinarily, however, banks avoid making such “commitments”
in advance of the actual “closing” (signing and exchanging the documents).
Rights in the collateral.
Kettering certainly had rights in the collateral at the time Parker
delivered the bill of sale to the restaurant property. [2] above. Kettering may have had
rights in the collateral at an earlier time, as soon as he and Parker signed the agreement
for sale. Section 2-501(1) provides that “identification” of the goods occurs when the
contract is formed, with respect to goods that are identified and existing at the time the
contract is made and that such identification gives the buyer an insurable interest in the
goods. However, a security interest attaching at that time would only extend to the
interest he had then—a limited property interest and not title to the property.
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So, you could argue that the last of those events occurred when Friedman delivered the first
check to the Valley State Bank employee to pay off Parker’s existing loan. [3] above. However,
acts taken by one party at a closing are generally understood to be contingent on the acts to be
performed by the other parties, so none of the acts may have been intended to be final until the
last act, the delivery by Friedman of the last check to Parker.
Ultimately, with respect to Kettering and First National Bank, does it make any difference when
the security interest attached?
No. So long as it attached before a lawsuit was filed between the two of them, that’s all
that matters.
However, with respect to third parties (like competing creditors of Kettering who may
subsequently claim a security interest in the same property), the timing of the attachment may be
critical. We’ll defer consideration of these issues until the second half of the course.
Problem 8.4:
When you arrived at the Kettering closing, you pulled from your file the security
agreement you had prepared. The description of the collateral read: “The restaurant
equipment described on the attached list.” No list was attached. Ellen Bartell had promised
to bring the list of equipment to the closing, so it could be attached. But by the time you
arrived at the closing, both of you had forgotten. Without realizing the error, the parties
signed the security agreement without the list attached. The closing was completed and the
loan proceeds were disbursed. a. Did the bank, at that moment, have a security interest enforceable against
Kettering?
No. The debtor had not authenticated a security agreement “that provides a description of the
collateral.” § 9-203(b)(3)(A).
b. Two weeks later, Ellen Bartell remembered the list. She mailed it to Friedman with a
letter of apology. When he received it, he immediately stapled it to the security agreement.
He then asked you whether you thought the agreement was enforceable. What should your
reply have been?
The cases show a split in the courts. The courts in the Hewn
and Couch
cases say that the debtor
must sign the security agreement at the time that it contains a description of the collateral.
However, the courts in the Blundell
and Allen
cases hold that the description of the collateral
may be completed at a later time, finding that the “sequence of events is immaterial.” Allen
is a
federal case construing Illinois law.
c. Would it have made any difference if Bartell had discovered the omission two years
later and the parties did the same thing?
I don’t think so.
d.. What if she discovered it after Kettering filed for bankruptcy and the parties did the
same thing? See Bankr. Code § 362(a)(4) and (5).
Once bankruptcy is filed, the “automatic stay” is in effect. The “automatic stay” precludes a
creditor from doing any act to “create, perfect or enforce a” a lien against the estate. Because the
description of the collateral in the security agreement is necessary in order for the security
interest to attach, this description would be an act to “create” a lien.
Problem 8.5:
Early in the second year of solo practice, things seem to have gotten out of control.
Although the work is incredibly interesting and you’re making really good money, there
never seems to be enough time to get everything done. Several months ago, you represented
Porter Equipment on a deal for Porter to sell earthmoving equipment (essentially, a
bulldozer) to Winfield Construction Company. At the closing, Porter took $800,000 of the
purchase price in the form of a promissory note secured by an interest in the bulldozer. A
few weeks ago, Winfield filed for bankruptcy. Today, the trustee called and asked that you
forward a copy of the security agreement.
When you checked the file, you noted that the financing statement on file with the
Secretary of State describes the collateral as a “bulldozer,” but the description of the
collateral in the security agreement is simply blank. You noted the sick, breathless feeling
that seemed to come form the pit of your stomach, but which you had, since you began
practicing law, learned to recognize as an adrenaline-induced palpitation of the heart. By
rummaging around in your file you were able to jog your memory as to what had
happened. Katie Porter had promised you a description of the bulldozer a few days before
the closing, but she hadn’t sent it. At the closing, you had explained to the president of
Winfield that the description of the bulldozer was forthcoming. She signed the security
agreement with the description blank and orally authorized you to fill it in when you got
the description. Porter sent you the description when you were especially busy. You stuck
the description in the file, meaning to come back to it later, but it slipped your mind.
Your first thought was self-loathing. How could you
, who always had it together better than
your law school classmates, have committed malpractice? Your thoughts turned darker yet
when you realized that even if Porter got most of his $800,000 out of your tight-fisted
malpractice carrier (more likely, she’d net about $200,000 to $300,000 after his attorney’s
fees—after all, he too was negligent, right?), you were going to be humiliated in the process,
he was never going to trust you again, and you would probably never be able to pay even
the balance of his loss. Eventually, your mind settled down to what really mattered. What
do you do now?
[Ethical rules omitted].
First of all, if this had occurred, prior to the debtor’s filing bankruptcy
, would there be a problem
with you stapling the description to the security agreement?
No. You still have the problem that, in some jurisdictions, the security interest does not
attach unless the debtor signed the security agreement at the time it contained a
description of the collateral
. If that is the case, there is nothing you could do. But in other
jurisdictions that say the authentication can occur before the description is added to the
security agreement, so long as adding the description was authorized, there would be no
problem.
Questions for the Prudes (who would inform the trustee of the problem)?
If you send the security agreement to the trustee, should you put the description of the collateral
in the same envelope? Could you put a paper clip on the two so they do not get separated? What
about stapling the two together?
Do you tell the trustee that they were not prepared at the same time or is the trustee’s job to ask?
Could you argue the “composite document” rule should protect them anyway?
Probably not because there is no “internal cross-reference.”
If the Prudes insist, have them call me (the client) and explain the situation:
Is this your decision to make?
You cannot reveal to the trustee that the description of the collateral was left blank
without your client’s consent. How are you going to obtain that?
Questions for the Sleazeballs (who would fill in the blanks on the theory that “no one will
ever know”)?
Would you say the same thing if the other side had forgotten to send you the description, but you
had enough information in your file to re-create it yourself? Could you draft up a description of
the collateral?
For those of you who think “someone might be able to prove this”—so, your sense of ethics is
dictated by what you think the odds are of your getting caught. Are you also willing to sign the debtor’s signature if you forgot to have her sign the security
agreement at closing?
What do you think the drafters of the Model Code wanted
you to do in this situation?
Possible Solution (from the Teacher’s Manual):
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You send the security agreement and description to the client. You explain the situation
fully to the client, including the client’s contract right to fill in the blanks, except that
bankruptcy is filed. You tell the client that you cannot send the completed agreement to
the trustee and that if ever called upon to do so, you would have to testify truthfully, but
you think the odds of being called to testify are about nil—the financing statement is fine,
the other side authorized you to complete the agreement, it is unlikely that the completed
agreement would ever be challenged, etc.
Does anyone have any problems with that?
Rule 8.4(c) that we discussed when we talked in Problem 3.2 about advising a client
about her rights to use misrepresentation to repossess collateral—it is professional
misconduct for a lawyer to “engage in conduct involving dishonesty, fraud, deceit, or
misrepresentation.”
Is telling your client exactly how to do something that you cannot ethically do consistent with this Model Rules?
Assignment No. 9: What Collateral and Obligations Are Covered?
We will look at two issues: (1) what property is covered by the security agreement? and (2) what
obligations are secured by the security interest in the collateral?
I hope that as you read the material for today, you learned something about the answer to the
question posed in the title of the assignment: the questions of what collateral and obligations are
covered by the security agreement are answered in almost all cases by referring to the agreement
of the parties, not Article 9 itself. Like all of the other articles of the U.C.C., the parties are
generally left free to determine their own rights and obligations and they do so by contract.
Hence, most of the litigation in this area focuses on general principles of contract interpretation
—what did the parties intend when they made their agreement?
First, let’s look at issues about what collateral is covered by the security agreement. We saw in
our last class that the security agreement the debtor signs must provide a “description of the
collateral” for the security interest to “attach” under section 9-203. We will look at those issues
first.
Here, we have an initial problem. Article 9 defines a number of “types” of personal property and,
as we will see later, has different rules about perfecting security interests based on the type of
collateral involved. Let’s go through the definitions of some of those different types of personal
property initially, although we deal with them in more detail later with respect to how a security
interest in various types of personal property can be “perfected.”
Remember that Article 9 applies to security interests in “personal property and fixtures.”
It is not, like Article 2, limited to “goods.” However, many security interests are taken in
the debtor’s “goods.” We need to look at some definitions of “goods” and the four sub-
categories of “goods.”
Section 9-102(a)(44) defines “goods” as:
all things that are movable when the security interest attaches
It includes “fixtures,” “standing timber that is to be cut and removed,” “the unborn young of
animals,” “crops growing, grown or to be grown,” and “manufactured homes.”
The last part of the definition says it does not
include:
accounts, chattel paper, commercial tort claims, deposit accounts, documents, general
intangibles, instruments, investment property, letter-of-credit rights, letters of credit,
money, or oil, gas, or other minerals before extraction. [This is a list of all Article 9
classifications of property other than “goods.”]
There are four categories of “goods” that we will look at: “consumer goods,” “equipment,” “farm
products,” and “inventory.” We will not cover “fixtures” and “manufactured homes” other than
incidentally.
We need to understand these four categories of “goods.” Everything that is a good has to be one
of these four things. Let’s try some examples:
1. Rex Appliance owns a new television set which it is holding for sale to its customers and
which it bought on credit from Sony. It gave Sony a security interest in the television set. What
category of goods is the television set?
It is “inventory” under section 9-102(a)(48). It is held “by a person for sale or lease or to
be furnished under a contract of service . . . .”
2. I buy the new television set for my home on credit and give the seller (Rex Appliance) a
security interest in it to secure my promise to pay the price. What is the television set?
It is “consumer goods” under section 9-102(a)(23) because it is “used or bought for use
primarily for personal, family, or household purposes.”
3. What if I own a sports bar and I bought the television set for use in the bar? I buy on
credit and give the seller a security interest to secure my promise to pay the price? What kind of
property is the television set?
It is now “equipment,” under section 9-102(a)(33). “Equipment” is the catchall category
of goods under Article 9. Here, the television is not “inventory, farm products, or
consumer goods,” hence it must be equipment.
For example, a racehorse is probably “equipment” as it does not fall within the
definitions of “inventory,” “consumer goods,” or “farm products.”
4. What if I am a farmer and I am raising chickens to create eggs which I then sell at a
roadside stand? What if I give a security interest in the chickens to a secured creditor?
The chickens are “farm products” under section 9-102(a)(34)(B)—“livestock, born or
unborn . . . .”
What if I give a security interest in the eggs to a secured creditor?
They are also farm products under section 9-102(a)(34)(D), as they are “products of . . .
livestock in their unmanufactured states . . . .”
What is the general Article 9 standard for the sufficiency of a description of collateral in the
security agreement? For example, could the security agreement define the collateral as “some of
the Debtor’s stuff”?
It is found in section 9-108: “. . . a description of personal or real property is sufficient,
whether or not it is specific, if it reasonably identifies what is described.” Section 9-108(b) creates a “safe harbor” rule with respect to when certain types of descriptions
“reasonably identify” what is described. Let’s think about how these “safe harbor” provisions
would work with respect to a debtor that is a computer store, granting a security interest in some
of its computer that it holds for sale.
1. Specific listing—“a Gateway 350 Solo notebook computer, serial no.
8793645194.
2. “Category”— “all Debtor’s laptop computers”
3. A Type of Collateral Defined in the U.C.C.— “all Debtor’s inventory”
Section 9-108 does say that a “super-generic” description of collateral (all Debtor’s personal
property) is not enough to reasonably identify the collateral IN THE SECURITY AGREEMENT.
LATER, WE SEE THAT THERE IS A DIFFERENT RULE WHEN IT COMES TO
IDENTIFYING COLLATERAL IN FINANCING STATEMENTS.
Frequently, the parties will want to cover after-acquired property
. What is “after-acquired”
property?
Property that the debtor acquires an interest in after the security agreement is executed.
Section 9-204 makes it clear that the security agreement can cover after-acquired property and it
rejects the old common law view that you cannot enforce a “floating lien”—that is, a lien that
floats from one specific item of property to another, different item of property. This is necessary
because frequently the collateral changes over time. Think about the retail seller of computers.
He gives a security interest in his “inventory” to a creditor. If the “inventory” consisted only of
the computers he had in his store on that date, in 60 or 90 days, all those computers would have
been sold and new ones purchased by the dealer for resale. If the security interest did not carry
over to this “after-acquired” property, the secured party and debtor would have to sign a new
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security agreement every time the dealer bought a new computer for resale. That would be
impractical. The security interest only covers “after-acquired property” if the security agreement says
so.
The usual way to do this is to say: “all of the debtor’s inventory, whether now owned or
hereafter acquired
.”
Now, the text notes that sometimes courts will uphold a collateral description that says “all”
inventory or “all”
accounts as including after-acquired inventory or accounts. The assumption
here is that inventory and accounts turn over so frequently that the parties must have intended to
cover “after-acquired” inventory or accounts when they said “all” accounts or inventory.
However, other types of property, like equipment, do not necessarily turn over, so courts usually
insist on the use of “after-acquired” language for collateral other than accounts or inventory.
Second, what obligations are secured?
Again, the answer is generally found in the security agreement itself.
Sometimes, it is a specific debt. For example, when I buy a new car, the security interest
in the car covers only the purchase money debt.
Sometimes, it is all the debts the debtor owes to the creditor. This is frequently the case
where the secured party is a bank and the debtor is a business. The business may have
several different loans (long-term financing of a building, revolving line of credit, short-
term working capital loans, etc.) with the bank, and the security agreement is written so
as to cover “all indebtedness of the debtor to the secured party.”
Finally, many obligations arise after
the security agreement is signed. This is always the case in
revolving credits or lines of credit, where the debtor borrows money (up to a predetermined
limit) then repays it in part, then borrows some more, etc. In order to secure this type of
obligation, section 9-204(c) says that the security agreement may include “future advances”
as
well as existing obligations. Again, it is important to spell out in the security agreement itself
whether future advances are covered or not. The typical way to do this is to say: “all
indebtedness, whether now existing, or hereafter arising, owing from debtor to secured party.”
Let’s turn to the Problem Set for today:
Problem 9.1:
What of the following is a sufficient description of collateral? U.C.C. § 9-108.
a.
“All equipment and inventory.” U.C.C. § 9-102(a)(33) and (48).
This is okay. U.C.C. § 9-108(b)(3).
b.
“All items purchased with the card in an agreement at the time the debtor obtained
a credit card from a department store.”
The majority rule is now that such a description is enforceable.
c.
“Restaurant equipment located at 123 Main Street. The debtor is a restaurant chain
that has a restaurant at that location.
This is okay. U.C.C. § 9-108(b)(2).
d.
“All of the debtor’s consumer goods.” The debtor signed the security agreement to
borrow $5,000 from Household Finance in order to purchase tickets on a cruise ship.
This is not okay. The credit cannot take a security interest in all of debtor’s consumer goods. See
c
e.
“All goods other than consumer goods.” U.C.C. § 9-102(a)(44).
This is okay. U.C.C. § 9-108(b)(3).
9.4
Robert and Mary Gillam have come to see you about their financial problems. For
the past seven years, they have made their living farming. When they started, they
borrowed $350,000 from the First National Bank of Frenville and granted a security
interest in “crops growing on the debtor’s farm in Osprey County, about 14 miles from
Tilanook” and most of their farm equipment. (The location information is correct and the
debtors own only a single farm.) The Gillams have paid that loan down to $190,000. It is
now the middle of the growing season and the Gillams don’t have enough cash to get them
through the harvest. They would like to borrow against their current crop, but First
National won’t lend them any more money. The second lender they approached,
Production Credit Association (PCA), told them that the current crop was unacceptable as
collateral because “First National already has it, and we don’t make crop loans in second
position.” This upset the Gillams because they had assumed that their current crop was not
covered by First National’s security interest. a. Who is right?
First, what is the ambiguity with respect to the term “crops growing on” the farm?
Does it cover “after-acquired” crops? Does it refer to crops “growing” at the time the
security agreement was signed, or does it cover crops “growing” at the present time? In
Charles v. Fidelity State Bank & Trust Co.
, 4 U.C.C. Rep. Serv. 2d 259 (D. Kan. 1987),
the court held that the description only related to crops growing at the time the security
agreement was made. The court said the usual way to cover “after-acquired” crops would
be “crops growing and to be grown” and that the absence of such language indicated an
intent to cover only growing crops as of the time the security agreement was executed.
This is just one example of how “sloppy draftsmanship” can really cause headaches.
Let’s assume that you are in a jurisdiction that would follow the Charles
case and say that the
Bank’s security interest only covers crops growing at the time the security agreement was signed.
b. What should the Gillams do? U.C.C. §§ 9 -108(a), (b), 9-203(b)(3)(A), 9-204.
A lawsuit (for disparagement or slander of title) would take too long to resolve. Threatening the
bank with the lawsuit might lead to a waiver—or it might not.
What will other lenders be unwilling to do?
They won’t be willing to lend against the crop so long as there is any possibility that the
lien of First National gets to the growing crops. The message here is that even an unenforceable description in a security agreement will deter
other lenders from lending against collateral arguably covered by the security agreement. Why
should the second lender (PCA) buy into a lawsuit over what the first lender covered in its
security agreement?
From the debtor’s point of view, the collateral description needs to be narrowly drawn and as
specific as possible—this is one area where debtor’s lawyers usually do not do a very good job—
they tend to just accept the secured party’s draft of the collateral description.
Problem 9.6:
Richard Cohen, a client of your firm, asked Sandra Bernhard, the partner for whom you
work, for an opinion on a “situation” in which he is involved. Because it is a very small
matter, Bernhard has asked you to look into it, tell her what the arguments will be on each
side, and evaluate them. You learned that Cohen lent $30,000 to Aircraft Video Marketing,
Inc. (AVMI) four years ago and entered into a security agreement that listed the collateral
as:
“All of Debtor’s equipment, including replacement parts, additions, repairs, and
accessories incorporated therein or affixed thereto. Without limitation the term
‘equipment’ includes all items used in recording, processing, playing back, or
broadcasting moving or still pictures, by whatever process.”
AVMI owned certain video equipment at the time the security agreement was signed and
acquired additional video equipment of a similar nature later. Like the original equipment,
the additional equipment was used in AVMI’s business for playing back motion pictures.
When AVMI defaulted, another creditor of AVMI’s, First National Bank of Omaha,
claimed the equipment. After Cohen established that his security interest predated First
National’s, they dropped their claim to the original equipment. But they continue to claim
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the equipment AVMI bought later, saying that it is not covered by the terms of Cohen’s
security agreement. What’s your assessment?
We have a problem of after-acquired property. If the lawyer who drafted the original agreement
had any brains, how would he have described the collateral in the security agreement?
“All of Debtor’s equipment, now owned or hereafter acquired
. . . .”
Of course, now we don’t have the option to rewrite the agreement. What language might give
Cohen a leg to stand on?
“All Debtor’s equipment”—Although some courts will say that “all” accounts
or
inventory
covers after-acquired accounts or inventory, most courts do not extend that
principle to other types of collateral, including equipment. So, “all equipment” probably
just means equipment the debtor owned at the time the Security Agreement was executed.
“including replacement parts, additions
, repairs and accessories . . . .”
What does “additions” generally mean?
Black’s Law Dictionary
defines it as: “extension, increase, augmentation.”
Usually, for example, if you owned a digital camera and later bought a zoom lens, the zoom lens
might be an “addition” because it is “added” to the original collateral. Is the same true for after-
acquired equipment?
No. The after-acquired equipment really is not an addition—it is a substitution
or a
replacement
.
In Graphic Resources v. Thiebauth
, 447 N.W.2d 28 (Neb. 1989), the court granted summary
judgment for the debtor on this one, finding that the dictionary definition, as well as the location
of the word along with “replacement parts,” “repairs,” etc., meant it referred only to additions to
the existing equipment, not to completely new equipment purchased as substitutes for the old
equipment.
Again, we have a problem where careful draftsmanship would have avoided the need for
litigation.
In our next class, Assignment 10, we will look at what happens if the collateral is sold or
otherwise disposed of by the debtor—when does the creditor have a security interest in items
received by the debtor in exchange for the collateral—and when does the creditor have the right
to trace the collateral into the hands of third parties.
Assignment 10: Proceeds, Products, and Other Value-Tracing Concepts
Common Problem
: What happens if the debtor sells or exchanges the collateral?
There are two problems that arise when a debtor disposes of collateral: (1) does the secured
party’s security interest attach to the property the debtor receives in exchange for the collateral?
and (2) does the secured party’s security interest continue in the original collateral,
notwithstanding that the debtor has disposed of it?
(
1) Does the secured party’s security interest attach to the property the debtor receives in
exchange for the collateral?
Two problems about whether the security interest covers the proceeds
: (1) does the secured party
get a security interest in the proceeds (“attachment” of the security interest to the proceeds); and
(2) how does the secured party’s security interest in the proceeds compare with claims to
proceeds by other persons (“perfection” of the security interest). Today, we will just look at the first of these problems—when does the secured party’s security
interest attach to “proceeds.”
You might ask, why don’t creditors just prohibit debtors from selling the collateral? There are
two reasons why this doesn’t happen:
A legal reason
: First, let’s look at section 9-401, which provides:
(a) Except as otherwise provided, . . . , whether a debtor’s rights in collateral may be
voluntarily or involuntarily transferred is governed by law other than this article.
(b) An agreement between the debtor and secured party which prohibits a transfer of the
debtor’s rights in collateral or makes the transfer a default does not prevent the transfer
from being effective.
In other words, the secured party cannot lawfully prevent the debtor from selling the debtor’s
rights in the collateral. This does not mean that the security interest in the collateral ends or that
the secured party has no remedy against either the debtor or the collateral—it just means that the
property is freely alienable by the debtor, notwithstanding any contrary provision in the security
agreement. This is consistent with the basic property law concept of free alienability
.
A practical reason
: Second, in many cases, the secured party is happy to have the debtor sell the
collateral. Why? In order to understand this, let’s take an example: Dave Debtor owns a bookstore and needs to
get a loan. He goes to Secured Party and receives a $100,000 loan and Secured Party takes a
security interest in all of Debtor’s “inventory”— primarily, the books he offers for sale to his
customers. Why would Secured Party be agreeable to Dave’s selling that collateral?
Because that is how Dave generates profits in his business, profits he will use to pay off Secured
Party’s loan. Keep in mind that Secured Party is primarily interested in getting paid off, not on
taking possession of the collateral after Debtor’s default and selling the collateral.
In the case of inventory, it is easy to understand why the secured party would consent to the
debtor’s sale of the collateral. But what about other forms of collateral? For example, let’s
assume that Dave also gives Secured Party a security interest in Dave’s “equipment,” including
the computer system Dave uses to keep track of his inventory, sales, etc. What if Dave wants to
“trade in” this computer system (which would be Dave’s “selling” the old computer system as
part of the “price” of a newer one, section 2-304) that is now obsolete, for a newer and more
efficient system? Why would Secured Party be agreeable to Dave’s selling this collateral?
If Secured Party thinks its security interest will continue in the new computer system, it
will be more valuable than the old system and will also (everyone hopes) allow Dave’s
business to be more efficient and successful. Again, the ultimate goal of Secured Party is
to have Dave pay off the debt without the need to have recourse to the collateral.
So, because debtors frequently dispose of collateral, we need to address the issue of whether the
secured party’s security interest continues in the items the debtor receives when the debtor
disposes of the property. This is one form of what the casebook authors call “value tracing.”
There are a number of types of value-tracing concepts—proceeds, products, rents, profits, and
offspring. Each of these is different from the other, but each allows a secured party’s security
interest in collateral to attach to some value either produced by the collateral or received by the
debtor in exchange for a disposition of the collateral.
We will focus primarily on “proceeds”— the most common issue that arises. We will chat only
very briefly about products, rents, profits, and offspring.
What are “proceeds”? Section 9-102(a)(64):
a. “whatever is acquired upon the sale, lease, license, exchange, or other disposition of
collateral.”
So, if I own a computer and I trade it in for a new computer, the new computer is “proceeds” of
the old collateral. Keep in mind here that the definition of “collateral” in section 9-102(a)(12)(A)
includes “proceeds to which the security interest attaches.” This means that “the proceeds of
proceeds are proceeds.”
So, if I take my new computer (that I got in exchange for my old computer) and trade it in on an
even newer computer, the even newer computer is also “proceeds” of the original computer.
Later parts of section 9-102(a)(64) make it clear that “proceeds” can be broader than the first part
of the definition. Subsection (B) covers “whatever is collected on, or distributed on account of, collateral”
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This would cover the credits “collected on” checks as well as dividends “distributed on account
of” corporate stock.
Subsection (C) covers “rights arising out of the collateral.” As the casebook authors note no one
quite knows what that expansive language means. A couple of years ago, one of my students
asked what about a secured party who has a security interest in a debtor’s patent of a product. If
the debtor is engaged in the business of selling that patented product, virtually all of the debtor’s
property would be “proceeds” of the security interest because those would be “rights arising out
of the collateral.”
Subsection (D) covers “to the extent of the value of the collateral, claims arising out of the loss,
nonconformity, or interference with the use of, defects or infringement of rights in, or damage to,
the collateral.” So, if Secured Party has a security interest in my car, and Professor Dayton
negligently runs into my car, my claim for damages against Professor Dayton is “proceeds” of
the collateral.
Subsection (E) covers “to the extent of the value of collateral and to the extent payable to the
debtor or the secured party, insurance payable by reason of the loss or nonconformity of, defects
or infringement of rights in, or damage to, the collateral. So, if Professor Dayton’s insurer pays
me for the damage to my car, those are “proceeds” of the security interest as well.
It is important to note that Subsections (D) and (E) are the only aspects of “proceeds” that
are limited to the extent of the value of the collateral. All other aspects of proceeds do not
have that limitation. This means that, if I own a car worth $1,000 subject to a security
interest and I sell it to a buyer for $2,000, all
$2,000 is proceeds, to which the security
interest will attach.
When does a secured party’ security interest in collateral extend to proceeds of the collateral?
Under section 9-203(f), it says: “The attachment of a security interest in collateral gives
the secured party the rights to proceeds provided in Section 9-315 . . . .”
Section 9-315(a)(2) says: Except as otherwise provided . . . , (2) a security interest attaches to any identifiable
proceeds
of collateral.
In other words, as between the debtor and the secured party, the secured party’s security interest
in collateral continues to attach to “identifiable” proceeds of that collateral, whether the security
agreement so provides or not. Only if proceeds are expressly excluded under the security
agreement (which I have never seen) does the secured party’s security interest in proceeds not
attach.
In order for the security interest to attach to proceeds, they must be “identifiable.” We will spend
some time today looking at this requirement, and others as well.
(
2) Does the Secured Party’s Security Interest Continue in the Original Collateral,
Notwithstanding that the Debtor Has Disposed of It?
Let’s turn to section 9-315(a)(1):
(1) a security interest . . . continues in collateral notwithstanding sale, lease, license,
exchange, or other disposition thereof unless the secured party authorized the disposition
free of the security interest . . . .
As the book suggests, the result is like the old movie “The Blob”—the security interest attaches
to the original collateral and what is received in exchange for it. It can grow.
Let’s look at our Problem Set for today.
Problem 10.1:
Firstbank has a perfected security interest in all of the “equipment, inventory, and
accounts” of Polly Arthur, who is doing business as Polly’s Plumbing. The contract makes
no mention of proceeds, products, offspring, substitutions, additions, or replacements. Are
they included? U.C.C. §§ 9-102(64), 9-201(a), 9-203(f), 9-204(a).
First of all, what about “proceeds”? Are these covered, even though the security agreement does
not specify them?
Yes. Under section 9-203(f) and section 9-315(a)(2), “identifiable” proceeds are covered.
What about products, offspring, substitutions, additions, or replacements? Note that these terms
are not defined anywhere in the U.C.C. and the U.C.C. has no specific provisions about when, if
ever, a security interest attaches to these items.
I don’t think these are covered here. Now, some of value-tracing concepts are “rights arising out
of collateral” under section 9-102(64)(C) and therefore may be covered as “proceeds” under this
expanded definition. For example, “products” or “offspring” might be covered, but I don’t think
that we would ordinarily talk about “substitutions, additions, or replacements” as “arising out of
collateral.”
Now, if there was an “after-acquired property” clause in the Security Agreement, some
“products,” “offspring,” “substitutions,” “additions,” and “replacements” might fall into the
category of “after-acquired” property. Problem 10.2:
Which of the following are collateral of Firstbank under the security agreement described
in Problem 10.1 and why? U.C.C. §§ 9-102(a)(2) and (64), 9-315(a).
a. the money now in Polly’s bank account.
A bank account is not an “account” as defined in section 9-102(a)(2) because the last part of the
definitional section excludes “deposit accounts,” which are defined in section 9-102(a)(29) and
would cover this bank account.
Could the bank account be “proceeds” of Firstbank’s collateral?—It would be proceeds if it was
money “received upon . . . the disposition” of accounts that were collateral or “upon the sale” of
the inventory that was collateral under section 9-102(a)(64). If funds from the sale of the
inventory or the collection of accounts become “commingled” with other funds in the bank
account, then there would be an issue of exactly what parts of the bank account represent
“proceeds.” As noted in the text, courts generally apply the “lowest intermediate balance” test to
determine how much of the bank account represents proceeds and how much represents non-
proceeds. We will see how this test works in Problem 10.5.
b. a parrot that Polly took in payment of an overdue account.
The parrot would be covered because it is “whatever is received upon the sale . . . , exchange, or
other disposition of collateral or proceeds” [§ 9-102(64)(A)] or “whatever is collected on
collateral.” [§ 9-102(a)(64) (B)]. It is certainly “identifiable” under section 9-315(a)(2).
Remember: “proceeds” can be cash or property.
c. a new computer that Polly bought to replace the computer she owned at the time she
granted the security interest to Firstbank.
There are at least three issues here.
The old computer would have been covered in the security agreement as “equipment.”
First, this is a “replacement,” but recall from Problem 10.1 that replacements are not covered
unless specifically spelled out in the security agreement, unlike proceeds, which are covered
unless excluded.
Second, it could be that the new computer is the “proceeds” of the old one, if Polly sold the old
computer and used the funds to buy the new computer or if Polly traded in the old one as part of
the price of the new one (again, keep in mind that under section 2-304, a trade-in transaction
involves a “sale” of the old computer as part of the price of the new computer).
Third, even if it is not “proceeds” (let’s assume that Polly simply junked the old computer and
bought a new one out of her unencumbered funds), the new computer is still “equipment” and
might fall within the literal meaning of the original collateral description in the security
agreement. What is the problem with this, however?
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It is “after-acquired” equipment. The collateral description we have does not include ‘after-
acquired” equipment. Unlike inventory and accounts, where courts will sometimes “imply” an
after-acquired clause, most courts will not do this with respect to equipment, as it is not
ordinarily the debtor’s practice to routinely sell off equipment.
Problem 10.4:
Joey Teigh contracted to buy Billie’s Toy Shop, including the leasehold, furniture, fixtures,
equipment, goodwill, accounts receivable, and trademarks. Joey hired you to represent her
in the closing. In preparing for the closing, you learned that Joey and Billie omitted the
inventory from the sale because Firstbank had a security interest in it. You’ve looked at
Firstbank’s security agreement and the description of collateral is just “inventory.” Is it
possible that security interest encumbers some of the accounts receivable? The other
property Joey is buying? (For now, don’t worry about whether the security interest could
be perfected; confine your inquiry to whether it could attach.)
To answer this Problem, you have to assume that Firstbank’s security interest covers after-
acquired inventory
.
Yes, even though Joey is not buying any “inventory” if he is buying the “accounts” some of those
accounts (and maybe all of them) will be the “proceeds” of inventory, as they are rights to
payment arising from the sale of the inventory. If they are “proceeds” of the inventory, they are
covered by the inventory lender’s security interest, whether they are mentioned in the security
agreement with the inventory lender. In fact, anything in the business bought with the proceeds of the sales of inventory (such as the
equipment, fixtures, etc.) would also be “proceeds” because they are received in exchange for the
disposition of the inventory or proceeds
.
Keep in mind that the “proceeds of proceeds are proceeds.” In fact, “the proceeds of proceeds of
proceeds are proceeds” ad infinitum
.
Problem 10.5:
a. ELP [Equipment Leasing Partners from Problem 10.3] consults you about a $35,000
loan to Golan Industries that was made for the express purpose of purchasing an XT-100
copier. Golan signed a security agreement granting ELP a security interest in the copier.
(The entire description of collateral reads “XT-100 copier, serial number XEX3088372.”).
Unfortunately, the copier was destroyed in a fire six months ago. Fortunately, the loss was
insured. At this point, what is ELP’s collateral? U.C.C. §§ 9-102(12)(A) and (64), 9-203(f).
First of all, are insurance payments received by the debtor for loss or destruction of the collateral
covered by “proceeds” under section 9-102(64)’s definition of “proceeds”?
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Yes. Section 9-102(64)(E) says: “to the extent of the value of collateral and to the extent
payable to the debtor or the secured party, insurance payable by reason of the loss or
nonconformity of, defects or infringement of rights in, or damage to, the collateral.”
b. Unfortunately, ELP was not named as a loss payee on the policy, so the insurance
company paid the $35,000 in insurance proceeds to Golan. Golan deposited the check to a
little-used bank account that contained $5,000 at the time. At this point, what is ELP’s
collateral?
Is the deposit account “proceeds”?
Yes. It is proceeds of the insurance check, which is proceeds of the copier. Again, the
proceeds of proceeds is proceeds.
Does the security interest extend to the entire deposit account?
The problem here is one of “commingling” and when proceeds are “identifiable.” When
proceeds are “cash proceeds” under section 9-102(9) (“money, checks, deposit accounts
and the like”) the problem becomes whether the proceeds are “identifiable” under section
9-315(a)(2). Remember that the attachment of a security interest to proceeds under
subsection (a)(2) only applies with respect to “identifiable” proceeds.
What does the text say is the test courts apply to determining whether money in a bank account
constitutes “identifiable” proceeds?
The test is called the “lowest intermediate balance” test. Section 9-315(b)(2) says that if
the proceeds are not goods, commingled proceeds can be identified by “methods of
tracing, including application of equitable principles, that is permitted under [other]
law . . . Comment 3 specifically identifies the “lowest intermediate balance test” as one
of these “methods.”
It is derived from the law of trusts and it premised on two assumptions: (1) the money
that flows out of the account first is the debtor’s own money, not the proceeds of any
collateral to which the security interest attaches; and (2) later additions to the account do
not
add to the proceeds. So, how does the “lowest intermediate balance” test work
generally?
It says that the amount of proceeds in the account is equal to the lowest balance in the
account after the date of deposit of the identifiable proceeds (the insurance check) and the
date the test is applied. So, we have to find the “lowest balance” of the account in this
problem. As of now, it would be $35,000.
c. From the account Golan wrote a check for $2,000 to rent another copier for the
month it would take to replace the XT-100, leaving $38,000 in the account. At this point,
what is ELP’s collateral?
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It is still the $35,000 in the deposit account. The first $2,000 that is removed is presumed to be
Golan’s own funds, not the proceeds.
d. Golan then wrote a check from the account for $32,000 to pay the IRS, leaving only
$6,000 remaining in the account. At this point, what is ELP’s collateral? U.C.C. §§ 9-315,
332.
Then, debtor writes a $32,000 check to the IRS. What is the balance of the account now?
$6,000.
So, what is the “lowest intermediate balance” of the account?
$6,000.
Let’s assume that five days later, the debtor deposited another $4,000 into the account. Now,
what is the “lowest intermediate balance”?
It is still the $6,000—remember it’s the “lowest” balance in the account after the time the
original, identifiable proceeds were deposited into the account, not necessarily the
“current” balance.
Remember, later additions to the account do not
add to the amount of proceeds.
What is the procedure that ELP could use to get at the $6,000 in the account?
A writ of garnishment
.
Assignment 13: Acceleration and Cure Under State Law
Today, we look at some very basic issues facing secured creditors, but that also apply to
unsecured creditors as well. Ordinarily, a secured party’s right to proceed against property that
constitutes collateral for its loan only arises when the debtor “defaults.” Recall that, under
section 9-601:
After default
, a secured party has the rights provided in this Part and . . . those provided
by the agreement of the parties.
When does a debtor “default” under a loan or security agreement?
Whenever the debtor does something that the loan or security agreement refers to as a
“default.” Under Article 9, there is no statutory definition of “default,” so we have to look
to the parties’ agreement in the first instance to determine what that is.
What is the most common form of “default”?
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The failure to pay money when due under a loan or security agreement. Ordinarily, so
long as the debtor is making the payments when due, the secured party is not worried
about other events that might constitute events of default under the security agreement,
but when the secured party does start to worry about the debtor’s missing payments, one
of the things the secured party does is look to the security agreement to see what else may
be an event of default.
Look at the material in the text—the excerpt from a standard default provision in a security
agreement. What are some of the events that constitute a “default” under this agreement and why
would they be of concern to the secured party?
a. A failure to pay. Note that this default provision does NOT contain any “grace period” for
making a payment late. Furthermore, it is a failure to pay under “any agreement” with Secured
Party. This is known as a “cross-default” provision. Typically, the debtor may have a number of
loans from the secured party, and provisions like this say that if the debtor misses a payment on
any of the loans, it is a default under all Loan Agreements.
b. A breach of warranty or other provision of the security agreement, note, or other
instrument or agreement between the parties. These promises are important—particularly ones
that relate to the financial condition of the debtor. It is common in loan agreements for the debtor
to promise to keep certain financial ratios (such as debt to net worth ratios, etc.) in her business.
Failure to meet those ratios may indicate a deteriorating business and the lender may want the
option of declaring a default (or really just to tell the debtor to pay off the loan and seek
financing elsewhere). In addition, the debtor promises to do a number of things to protect the
value of the collateral, such as maintaining insurance on the collateral, not moving it to another
jurisdiction, etc. Remember back to Problem 1.3, when Dr. Benning made the loan to the day
care center and the day care center made fundamental changes in how it did business, thus
decreasing its ability to repay the loan?
c. Debtor dies, becomes insolvent, or goes out of business. A good indication that payment
is not going to be made in the future.
d. If debtor gave secured party materially misleading financial information. Essentially, the
debtor has already committed a misrepresentation.
e. The collateral is lost or destroyed. The secured party’s security is now impaired. I think you get the message—”default” is defined by the parties’ agreement, and it is frequently
defined in the broadest possible terms—many debtors are in technical default almost from the
time the loan is made until it is paid in full.
The material in the text is a helpful description of various types of loans. You might note that in
the section on “lines of credit,” this type of loan is frequently called a “revolving line of credit”
or a “revolving loan” or (simply) a “revolver”—one where the borrower borrows and re-pays and
borrows and re-pays up to a specified limit over a fixed period of time, typically a year or two.
For example, the ordinary credit card transaction is “revolving credit”— the credit card issuer
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agrees to loan you money (up to your limit), which you can pay down in whole or in part, re-
borrow, re-pay, etc.
The material on “acceleration” and “cure” is important, particularly in “installment loans.” First,
what is an “installment” loan?
One where the debtor agrees to pay off the principal and interest in periodic installments,
usually monthly—like an ordinary mortgage loan on a residence.
What is an “acceleration” of a loan’s maturity?
If the loan or security agreement so provides, a loan that is payable in installments may,
after a default, be declared to be due and payable in its entirety by the lender, upon notice
to the debtor.
Why is acceleration important to a creditor who has made an installment loan to the debtor?
Because, otherwise, if a debtor misses some installment payments, the creditor can only
sue for the payments actually past due. Payments that would be due in the future are not
yet (technically) due as the payment date has not arrived.
Thus, creditors need a device to be able to declare the entire balance of the loan due after the
debtor defaults. The ‘acceleration” clause does this. If you represent a creditor in writing a loan
agreement and do not include an acceleration clause, you better make sure your malpractice
premium has been paid, because you are in for trouble.
What is “cure”?
A debtor who has defaulted by failing to make a payment when due has the right to make
all current and past due payments and, if she does so before
the creditor accelerates, the
breach has been “cured.” However, as the Old Republic
case shows, if the secured party has already accelerated the
debt, then it is too late to “cure” by making up past due installment payments. Instead, the
entire debt has to be tendered, because, after the acceleration, it is all due.
Let’s look at our Problem Set for today.
Problem 13.1:
Pat Roskoi, a plumbing subcontractor, consults you about a problem she is having with
Lincoln State Bank. Pat accidentally missed two $834 payments on her truck loan. Her
contract with the bank says that missing two payments is a default and that “upon default,
at the secured party’s option, the entire balance of the loan shall become due and payable.”
She noticed her omission before she received any kind of notice from the bank and
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promptly sent a check for the two overdue payments. The bank mailed her check back to
her with a note stating that the entire loan balance of $33,402 is due and payable. She called the bank, but the person she talked with told her that there was no mistake, and
she simply has to pay the entire balance of the loan. Pat says she doesn’t have the money
and that the loss of the truck would make it impossible for her to continue her business.
a.
Did Pat default?
Pat defaulted. The contract says missing two payments is a default and Pat missed two payments.
b.
Did Pat cure? If so, when?
The facts given are insufficient to determine whether Pat cured. Cure is possible only prior to acceleration. To tender, Pat must pay the arrearage in the manner established by the course of dealing between the parties. Presumably, Pat has been paying by mailing checks to Lincoln. So if
Lincoln received Pat’s check before Lincoln accelerated, Pat certainly tendered and cured. Pat may have tendered and cured if she merely mailed her check before Lincoln accelerated. Some courts apply the mailbox rule to installment payments if the parties have agreed to payment by mail or established a course of dealing by mail. Phillips Expl., Inc. v. Tomich, 2013 WL 3983643
(S.D. Ohio Aug. 1, 2013); Keller v. Delvalle, 1989 WL 516496 (Conn. Super. Ct. Jan. 13, 1989) (“This court is inclined to follow a line of Connecticut cases which apply the “mailbox rule” to the effect that tender occurs when the payment is deposited in the mail system.”).
The last paragraph of Old Republic Insurance Co. v. Lee explains the issue of timing. “[A] mortgagor, prior to the election of a right to accelerate by the mortgage holder upon the occurrence of a default, may tender the arrears due and thereby prevent the mortgage holder from
exercising his option to accelerate.” Comment 2 to U.C.C. § 9‐623 states that “if the entire balance of a secured obligation has been accelerated, it would be necessary to tender the entire balance” to redeem, but does not
c.
Did the bank accelerate? If so, when? U.C.C. § 1-202(f).
To accelerate Lincoln would have to have made a clear an unequivocal decision to accelerate. In addition, the court in In re Crystal Properties, Ltd.
, 268 F.3d 743 (9th Cir. 2001), held that a creditor like Lincoln “must take affirmative action to put the debtor on notice that it intends to accelerate” even where the contract allowed acceleration “without demand or notice.” Some authority exists for the proposition that Pat must receive the notice before acceleration occurs. For example, the court in Pici v. First Union National Bank
, 621 So. 2d 732 (Fla. Ct. App. 1993) ,stated that “debtor cured default under mortgage by tendering late payments and late charges before receiving notice of acceleration of debt.” Of course, Crystal Properties doesn’t say that, and we are not at all certain that the Ninth Circuit would reach that result.
d.
Pat asks you whether the bank “can get away with this.” What do you tell her? See
U.C.C. § 9-623, including Comment 2.
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If Pat asks “can they get away with this?” we don’t yet have the information we need to know whether have a good case – whether Lincoln received Pat’s check before Lincoln sent notice of acceleration. Because the evidence is in Lincoln’s control, many students may give up on the case. They will assume that Lincoln’s employees will lie. It helps to ask the students how they would gather evidence to prove when the check arrived. Prompt them to imagine the employee who declared the acceleration in a deposition. Would the student like to ask when the check arrived? Does the student think the employee would commit perjury when others at Lincoln probably also know the truth? Might Lincoln have records showing when the check arrived?
Lincoln has a lot to lose by resisting reinstatement – perhaps a judgment against them for wrongful repossession. They have little to gain – getting rid of a customer who has made all the payments to date. We expect that the Bank will back down if we write a threatening letter on Pat’s behalf. But there’s still the ugly problem of how Pat can afford to litigate if the bank doesn’t back down.
e.
What should we do?
We should call the bank’s lawyer to find out whether acceleration occurred before Pat tendered her cure. Students sometimes assume people will lie about facts solely under their control, but that is not always—or even usually—true. If the bank did not accelerate before Pat tendered, this matter could be cleared up with a telephone call.
Another way to attack the question of what to do is to ask the students to put themselves in the position of the bank’s lawyer. What would they do? They have a customer who missed only two payments and is willing to tender the past due payments. The bank is much better off with a performing loan than a repossessed truck it needs to sell. This isn’t a hill of beans for anyone but the nasty clerk that Pat dealt with. Even if acceleration has occurred, a discussion with the bank’s
lawyer may get the loan reinstated. The bank can always waive the acceleration, duly noting
Problem 13.2:
Your friend, Art Leff, is experiencing what he calls a “temporary
cash flow problem.” He
owes Lincoln State Savings a balance of about $460,000 on his house; his monthly payment
is $3,240. He did not make his mortgage payment on the due date last week (October 1) and
he is worried about what happens next. Of course, you refused to give any advice without
first reading the agreement; the relevant provisions were as follows:
Default.
Upon occurrence of any of the following events of default . . . (1) the Debtor
shall have outstanding an amount exceeding one full payment which has remained
unpaid for more than 10 days after the due dates . . . mortgagee shall have all of the
rights and remedies for default provided by applicable law and this Agreement,
including the right to declare the entire outstanding balance immediately due and
payable.
Art wants to delay making his house payments as long as he can and would like you to tell
him how long that will be.
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a.
Is Art in default? Under paragraph (g)(1) of the contract, Art is not in default at the present time.
b.
If Art makes no payments, when will he go into default? Art will be in default when his November payment is more than 10 days late. November 11 is only the tenth day after the due date. Accordingly, the borrower is safe at least until November 12. Furthermore, on November 12, arguably the debt has gone unpaid for only 10 days (November 2–11). We would advise a lender to wait at least until November 13, when the debt has been unpaid for a full 11 days after the due date.
c. If Art makes no payments, what will be the order of events? When is the last time he
can make this and subsequent payments without serious repercussions? What are
those repercussions? Art goes into default, Lincoln would have “the right to declare the entire outstanding balance immediately due and payable.” Lincoln then has to communicate that decision to Art. If Lincoln does so before Art cures, Art will owe $460,000 and no cure will be possible. Thus, the moment Art goes into default is the last moment Art can be sure he will be entitled to cure. When he receives notice of acceleration, it will already be too late. After declaring the acceleration, Lincoln would have to comply with state foreclosure law, either by filing a civil action seeking foreclosure or giving notice of sale pursuant to a power of sale statute. Either procedure ends in an auction sale of the house. Until the sale—or in some states until the judicial foreclosure sale is
confirmed by the court—Art could pay the entire balance owing on the loan and redeem the house.
d. What difference would it make if Art’s case were governed by the Illinois
reinstatement statute?
The Illinois statute (735 ILCS 5/15-1602) has the effect of extending the period of time during
which a debtor may cure her default merely by paying the amount of past-due indebtedness and
affiliated expenses. It basically says that, notwithstanding an acceleration of indebtedness, the
debtor can redeem within 90 after she is served with a summons in the foreclosure case. So, the
time would extend way beyond November 13.
Can only use this once in a five-year period.
Under the Illinois reinstatement statute, what is the amount that the debtor has to pay to redeem?
It is not the full accelerated debt. It is the past due debt (including past due interest) plus “all
costs and expenses required by the mortgage to be paid in the event of [default] . . . .” Those
costs and expenses can be very significant. If the mortgage calls for payment of attorney’s fees,
those fees are payable. Likewise, the cost of filing the foreclosure action, and maybe fees
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regarding maintenance of the property (like insurance, etc.) if the debtor has not paid them.
Those can be large, but are still a great deal cheaper than the full amount of the accelerated debt.
Keep in mind that this statute is in addition to the debtor’s common-law “equity of redemption,”
which would require the debtor to pay off all of the debt (the accelerated amount) before
foreclosure in order to discharge the mortgage.
Problem 13.6:
You represent Angie Littwin and her company, Littwin Mortgage. Two years ago, Littwin
lent $600,000 to Lance’s Landscaping, Inc. (Lance), repayable in equal monthly payments
over seven years. The loan is secured by an interest in all of Lance’s equipment; the default
provisions in the agreement are those set forth in the Standard Default Provisions in section
A of this assignment. Angie has come to see you today because she wants to call the Lance’s
loan. When you asked why, Angie told you it was because Lance had failed for two
consecutive years to provide Littwin with proof of liability insurance, as required by the
terms of the security agreement. But in response to your questions, Angie admitted that
Lance is a strong debtor that has made every payment on time and that the real reason she
wants to call the loan is that Littwin itself is in financial difficulty and desperately needs the
cash. (“When you need cash,” Angie explains, “You don’t get it by calling your bad
loans.”)
Angie can’t get his cash out by selling the loan, because the loan carries such a low rate of
interest.
The last due date for proof of insurance was 23 days ago. Littwin doesn’t know if Lance has
the insurance or not. There has never been any discussion of the contract provision
requiring it. “Do I or don’t I have the right to call this loan?” Angie asks. What is the
answer to Angie’s question? U.C.C. §§ 1-201(b)(20), 1-304, including Comment 2, 1-309, 9-
102(43), and 9-601(a).
a.
How do you answer Angie’s question? U.C.C. §§ 1-201(b)(20), 1-304 including
Comment 1, 1-309, and 9-601(a).
We don’t think Littwin has the right to call this loan, but we think Littwin will get away with it. Lance breached the contract by failing to furnish proof of insurance. That breach is a default under § 11(b) of the security agreement. There is no standard of fair dealing in the lending industry that prevents a lender from calling a loan for such a breach, so Lance won’t be able to prove bad faith. There probably is a standard that prevents a lender from calling a loan merely because the lender needs money. That was the basis for the $105 million verdict against Continental Bank mentioned in the text below the spider ad. But the odds are slim that Lance would be able to discover that Angie called the loan solely because she needed the money.
What if Lance actually has the liability insurance, but has simply failed to furnish proof? On a literal reading of the contract, it would appear that a breach is a breach. (“Debtor breaches any
. . . provision hereof . . .”) If failure to furnish proof of insurance did not put Lance in default, debtors like Lance would be able to ignore with impunity the requirement that they furnish proof of insurance.
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b.
What do you think of the argument that by its failure to demand proof of insurance
last year, Littwin waived Lance’s obligation to furnish proof of insurance this year?
Littwin hasn’t waived this year’s default by not asking for proof of insurance last year. Paragraph
13 of the contract provides that waiver of a particular default does not waive later defaults of the same kind. Such provisions are routinely enforced. Could Littwin’s failure to object to the lack of
proof of insurance this year waive this year’s proof? There has been only 23 days of silence; the court in JR Hale
Contracting did not think 23 days amounted to waiver. But they also said that mere silence can effect a waiver by estoppel if it has misled the borrower and induced reliance. Perhaps Littwin is “stand[ing] mute when [it] has the duty to speak.” On the other hand, Littwin has not been in touch with the debtor as had the bank in JR Hale Contracting
. To say that Littwin
has to ask for the proof of insurance is virtually to
nullify the contract provision requiring Lance to furnish it without request. Yet many
courts will be reluctant to enforce acceleration for what seems to be so petty a breach.
c.
If Littwin calls the loan in bad faith, resulting in the demise of Lance’s business, can
Lance sue for damages?
To the extent we expect a court to follow the comment to U.C.C. §1‐304 (formerly § 1‐203), the answer is “no.” Lance’s remedy is to fight the loan call, using lack of good faith as a defense. That comment is based on a Permanent Editorial Board opinion and was in Article 9 prior to the 1998 revision. Of course, there is nothing in the text of Article 9 that even remotely suggests the sword‐shield distinction.
d.
Are you willing to continue representing Angie?
Of course, we have such high standards of ethics and morality that we would not be caught dead representing the likes of Angie Littwin (except for two of us who realize that they probably would if they needed the money badly).
e.
If you had to continue, what would you advise?
One of the authors is too ethical to even consider the case hypothetically. The others, who believes in freedom of thought (at least in cases where it is not acted upon) hypothetically would advise sending an immediate notice of acceleration before Lance can send the proof of insurance and following up with a replevin before Lance can arrange alternative financing. These authors point out that even though Lance would have a strong case in front of a jury, under the comment to U.C.C. §1‐304 (formerly § 1‐203), Lance has no right to sue at all. Even if he did, the matter is
unlikely to ever get to a jury. Lance will be facing the imminent extinction of a sound business
through replevin. In fact, if this case is in a jurisdiction that permits ex parte replevin, Lance’s day in court probably won’t come until after the business has been extinguished. Under Supreme Court precedent, Lance is entitled to a prompt postseizure hearing. That typically comes about ten days after the sheriff seizes the assets of the business—and shuts the business down. (Angie will need to strike without warning, so Lance’s lawyer can’t be ready in time for an earlier hearing if the court should choose to grant one.) If Angie is both ruthless and relentless, she should be able to force a settlement on terms that will give Lance the time they need to find new
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financing. Angie will get the cash that she needs and the Release of Liability for Wrongful Acceleration that Angie and her lawyer will both need to sleep at night. Lance will lose the benefit of his interest rate bargain, but hey, that’s life in the jungle. P.S. If Angie needs to call this
loan, it’s not a good idea to ask the debtor for proof of insurance. Lance probably will furnish it, thus curing before Angie can accelerate.
1.
Malachy’s Dog Show prize money; - Yes
2.
The remaining 3 Pekingese puppies; - Yes
3.
The puppy insurance money; - Yes
4.
The Vegas gambling money; - yes 5.
David’s Lexus GX; Depends 6.
David’s new West Highland Terrier; Depends 7.
David’s savings account. – Proceeds What do you tell them? What is The Garner Group’s collateral?
The Garner Group took a security interest in Malachy and “all proceeds, products, and profits
therefrom.”
Read the definition of “proceeds” in UCC §9-102(a)(64). Under this definition, a security interest will follow the value of collateral through some transformations but not others. If the debtor sells the collateral, the security interest will attach to the price paid, whether it is in the form of an account, a promissory note, or cash. If the debtor leases the collateral, the security interest will attach to the rents received. If the debtor merely uses the collateral in its business, the revenues of the business are not proceeds.
UCC §9-102(a)(64)
“Proceeds” are “collateral” within the definition of the latter term in UCC §9-102(a)(12)
To illustrate, assume ZBank has a security interest in the inventory of Billie’s Toy Shop. Billie’s Toy Shop sells some toys to Marjorie Venutti and Venutti writes a check for the $250 purchase price. We already know that the check is proceeds. Now assume that Billie’s Toy Shop deposits the check to its bank account and the check is collected. The money in the account is now proceeds of the toys because it was received in exchange for proceeds of the toys. If Billie’s Toy Shop uses the money to buy more toys, the new toys will be the proceeds of the old toys.
“after-acquired property,”
UCC §9-315(a).
CC §9-315(b) provides that the secured party can prevail by identifying the funds remaining in the bank account as its collateral by “a method of tracing, including application of equitable principles”
the lowest intermediate balance rule. That rule provides that the amount of the secured creditor’s collateral remaining in a bank account after the deposit of proceeds and subsequent transactions is the lowest balance of all funds in the account from the time of the deposit to the completion of the transactions. To put it another way, in calculating
the amount of proceeds remaining in the account, the debtor is presumed to spend first from the debtor’s own funds; whatever remains is proceeds.
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Section [9-102(a)(64)] of the UCC defines the term “proceeds” to include “whatever is received upon the sale, exchange, collection or other disposition of collateral or proceeds.” [UCC §9-102(a)(64)]. Section [9-315(a)], in turn, provides that, upon the sale of collateral, a security interest in that collateral “continues in any identifiable proceeds including collections received by the debtor.” [UCC §9-315(a)] (emphasis added). The secured party has the burden of establishing that something constitutes identifiable proceeds from the sale or disposition of the secured party’s collateral. To do this, the secured party must “trace” the claimed proceeds back to the original collateral; in other
words, the secured party must establish that the alleged proceeds arose directly from the sale or other disposition of the collateral and that these alleged proceeds cannot have arisen from any other source.
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