Georgetown University Law Center
Examination in Commercial Law: Secured Transactions
(3 Hours)

Professor Avery Wiener Katz

Final Examination
May 7, 1999


1. This is an open book examination; any written materials may be consulted. You are encouraged to use your statute book.

2. There are three questions, each carrying equal weight in the grading. I recommend that you spend a significant portion of the suggested time for each question planning and organizing your answer. If you feel that any of your answers depend on facts not provided in the question, you should state clearly any additional assumptions you make.

3. Please begin your answer to Questions 2 and 3 in new examination books, as I will grade each question separately and independently.

4. Please write legibly; this will ensure that you receive due credit for your entire answer. If possible, please also write on alternate lines of the examination book, as this makes your answer much easier to read. I will make reasonable efforts to read material that appears on the scrap paper if you indicate in your examination book that you wish me to, but not otherwise. If you type or use Examsoft, please use reasonable line spacing, fonts, and margins.

5. Good luck on the exam; and for those of you graduating at the end of the term, best wishes. I will post grades on the class website as soon as they are ready, and will post a feedback memo as soon as possible after that.

This examination consists of 5 pages, including this cover page. Please be sure that your exam is complete.

Please do not turn the page until the proctor gives the signal.

Question 1 (60 minutes)

Drucilla operated a Cadillac dealership on Long Island. She took out a $3 million loan from GMAC to finance the inventory on her showroom floor, which she purchased for cash from General Motors' Cadillac division. GMAC took a security interest in her inventory, perfected it by filing, and arranged for a notation to appear on the dealer invoice for each car to that effect.

Drucilla's standard installment sales contract provided for a monthly schedule of payments, granted Drucilla a security interest in the car, and contained a term authorizing Drucilla to declare default and accelerate the loan whenever she deemed herself insecure. Ethelred bought a car under this contract, paying no money down, but getting his cousin, Canute, to co-sign the purchase contract as guarantor. Canute understood that he would be liable if Ethelred defaulted on the loan, but he did not read the fine print terms that waived all suretyship defenses and that purported to authorize Drucilla, in the event of default, to repossess and resell the car in any manner she deemed most convenient, without notice.

Drucilla took Ethelred's contract, along with others, and assigned them to Megabank for $500,000, without recourse. Megabank took possession of the sales contracts and of the dealer invoices for the cars covered by the contracts. Unfortunately, Drucilla failed to use this money either to repay GMAC or to purchase new inventory, as she was supposed to. GMAC's agreement with Drucilla made this behavior a default, and also prohibited her from selling any of her inventory while she is insolvent without written permission from GMAC.

In fact, Drucilla was insolvent when she engaged in these last transactions, and for the prior several months had sought to cover up that fact through an elaborate system of false invoices. Apparently she spent much of the $500,000 she received from Megabank on personal expenditures and gifts for friends and relatives. When her financial situation was at last revealed, she was forced to file for bankruptcy. At that point, Megabank and GMAC signed an agreement under which GMAC subordinated its rights in all chattel paper to Megabank, in exchange for a $150,000 cash payment.

Finally, after making two months' payments on his loan contract, Ethelred decided that a Cadillac was not for him after all, and returned his car to Drucilla's lot in the middle of the night and dropped the keys in the mail slot. The car has depreciated to the point where it is now worth less than the outstanding amount on his loan contract.

What are the various parties' rights and obligations?

Question 2 (60 minutes)

You are advising Radial Communications, Inc., a manufacturer of digital transmission equipment for telecommunications. Radial is engaged in negotiations to lease a radio transmission tower, together with associated software and hardware, to KPUT, an FM radio station that currently broadcasts using an analog signal, but wishes to convert to a digital format, which provides a clearer sound and would allow KPUT to reach a larger listening area. If the deal goes through, the radio tower will be erected on and affixed to a concrete base on real estate owned by KPUT's corporate parent, Bayshore Broadcasting. The contemplated contract provides for annual payments for a ten–year period, at which point KPUT (or its assignee) will have the right to buy the tower outright for $5000.

Radial is willing to enter into this transaction provided it can protect itself against the risk of non-payment. It knows its leverage over KPUT will be lessened after the tower is installed, since the costs of dismantling and removing the tower will make it much more valuable to KPUT than to any other potential buyer. Nonetheless, the salvage value of the tower is not insignificant; and more importantly, after KPUT converts to digital, it will be dependent on the tower to remain on the air.
Radial's directors have described to you two strategies they plan to use to minimize the risk of non-payment: one technical and one legal. The technical strategy is based on a secret module of source code, embedded in the tower's software operating system, that enables Radial to disable the tower simply by sending an electronic message from a remote location. This source code is written in machine language and invisible to anyone but a professional computer programmer, and Radial has not disclosed its existence and does not intend to. Radial reasons that if KPUT is shut down and forced to turn to Radial for technical assistance, it will have all the practical leverage it needs. To cover its legal bases as well, however, Radial has also proposed contractual terms that reserve the legal power to remove the tower in the event that KPUT defaults on its obligations, and that provide that Radial shall retain title in the tower and in all hardware and software over the ten-year life of the contract.

Radial asks you to advise it what exactly it needs to do to protect its rights to the fullest extent. You search the personal property records, looking under the names of both KPUT and its corporate parent Bayshore, and discover that Reliable Trust Co. has filed financing statements against both companies. Both financing statements describe the covered collateral as "equipment," but give no further information. You do not find any other financing statements or liens filed against either firm.

What is your advice?

Question 3 (60 minutes)

You are counseling a client who is owed $100,000 on an unsecured loan. The debtor, Fritz, appears to be insolvent; and the market value of his assets, consisting of equipment and inventory, is no more than $130,000. In addition, Fritz has granted two prior security interests in these assets. The first one, perfected by filing in April 1996, is held by Coastal Sales. It was granted as part of a revolving credit agreement that provided both that Coastal might make future advances to Fritz from time to time, and that any present or future obligations owed by Fritz to Coastal would be secured by after-acquired as well as by existing collateral. Fritz borrowed $50,000 from Coastal in accordance with this agreement, but he repaid all but $500 of this debt almost two years ago, and has not applied for additional advances since. The underlying credit agreement, however, is still in effect.

The second security interest, perfected by filing in December 1998, is held by Tidewater Finance. It was granted in connection with a $100,000 loan in exchange for which Fritz signed a valid security agreement covering equipment and inventory. This loan is still outstanding, and its unpaid principal plus accrued interest now amounts to $115,000.

You explain to your client that under the rules of Article 9 and the Bankruptcy Code, Coastal has first priority in Fritz's assets, and, with certain exceptions, this priority will extend to any advances it may subsequently make. Similarly, you explain that Tidewater has second priority. Thus Coastal and Tidewater will get repaid in full before unsecured creditors like your client get anything at all.

Your client responds: "Let me see if I understand. You're telling me that Coastal's financing statement gives them top priority in Fritz's assets, except it's only owed $500. This seems like a real waste of their priority position. Why don't we contact Coastal and see if we can get them to sell or assign their financing statement to me? Or I could sell my loan contract to them; since on your calculations it's worth less than 15K to me, and given their priority position, it would be worth full value to them. I'll bet that Fritz would be willing to go along with such an assignment, too. He needs my future business a lot more than he needs Tidewater's."

* * * * * *

1) Will the transaction proposed by your client work (i.e., is it really possible for Coastal to sell or assign its priority position, or to use it to shelter your client's loan)? If not, can you think of a substitute transaction that will achieve the same end?

2) Should it work (i.e., does it comport with the underlying policies of Article 9 or the Bankruptcy Code)?

[For extra credit: if you were Coastal, how much would you pay your client to take over her loan contract with Fritz?]