Memorandum

Date: May 24, 1999 
To: Secured Transactions students
From: Avery Katz
Re: Feedback on Spring 1999 exam

 

Here is an outline of how I thought the exam questions should have been approached. Attached to the hard copy version of this memo [available at the registrar's] are copies of the top two student answers to each question, along with a copy of the exam itself. What made these answers the best was their coverage of arguments, detail and sophistication in use of facts, and clarity in organization and explanation. If you drew different inferences from the given facts than I did or than the top answers did, you wouldn't have lost points, unless your inferences were unsupportable.

Your individual exams will be available for inspection at the registrar's office, though I have not made many marks on them; instead, I kept a score sheet for each exam containing my own notes. Attached to this memo is a key to the various markings I did use. If, after reading this memo and the top answers, you want to discuss your exam, please feel free to contact me.

It was a pleasure teaching the class and I wish you all well. Please keep in touch.



Question 1

In retrospect, I can see that this question should have been allocated more than 60 minutes; it contained many issues, and even the best answers did not discuss more than some of them. The analysis is most easily divided into two parts: first dealing with the various claims against Ethelred (E) and his guarantor Canute (C), and second dealing with the various claims against the dealer, Drucilla (D).

Claims against Ethelred and Canute

E, as a consumer, was a BIOC under 9-307, so when he bought his car he took free of GMAC's security interest in it. However, he did grant a SI in the car to D, which attached as soon as he got the car. We are not told whether D perfected by filing (the automatic-perfection rule of 9-302(1)(d) does not apply to motor vehicles subject to a registration statute) but in any event, when E returned the car, D gained possession and perfected at that point.

E's surrender of the car is a default. Even though he has not missed any payments and is backed up by a guarantor, it indicates a repudiation of the sales contract. Thus even under the good faith standard of 1-208, D is entitled to accelerate the loan and pursue remedies as a foreclosing creditor under Article 9, Part 5. Thus, she can hold a foreclosure sale, etc., subject to the standards set out in that Part. Because the value of the car is less than the outstanding amount on E's loan, D is further entitled to pursue a deficiency judgment against E, so long as she complies with all her Part 5 duties. Her attempt to contract out of the notice requirements of that Part, however, are invalid under 9-501 and 9-504, and under 1-102, she cannot contract out of the reasonableness requirement. (Conceivably a pro-debtor court might deny her the deficiency judgment because of her attempts to contract out of the notice requirement, but that would be a stretch since there has not yet been any failure of notice.)

D is also entitled to pursue these same claims against Canute (C), who guaranteed E's loan. C is also entitled to protections of notice, a reasonable sale, etc., notwithstanding his waiver of suretyship defenses. These cannot be waived under Part 5 and 1-102, whether in small or big print. The waiver of common-law suretyship defenses, however, may be all right, though this would depend on the local doctrines for interpreting and applying form contracts. In any event, such defenses are not obviously relevant on the facts. If C does make good on the guaranty, he will be subrogated to all of D's rights as a secured creditor, and can thus pursue them against E.

In addition, D's rights against E and C fall into her bankruptcy estate under 541, and so can be enforced by her bankruptcy trustee. Under 9-302(2), the rights could also be enforced by GMAC (G) or Megabank (M), who as D's secured creditors are entitled to take possession of and collect whatever accounts or chattel paper were promised to them as collateral. For the respective priorities of G, M, and the trustee, see below.

Claims against Drucilla and her transferees


GMAC holds a perfected purchase-money security interest in D's inventory. This SI carries over into E's sales contract (and into other accounts and chattel paper) as proceeds of inventory, and is probably still perfected under 9-306(3)(a) with regard to the proceeds. As observed above, however, the SI does not carry over into the car in E's hands, however, even though the sale to E was unauthorized under 9-306(2), because E was a BIOC. When E returned the car, however, it became part of D's inventory again and GMAC's SI in it re-attached under 9-306(5) [though if E returned the car after D's bankruptcy filing, 552 of the Bankruptcy Code would prevent GMAC's SI from re-attaching unless we can characterize the car as proceeds of E's contract with D.]
Megabank (M) holds a perfected security interest in D's sales contracts in its possession, which are chattel paper. M perfected after GMAC did, so under the first-in-time rule of 9-312(5), GMAC would have first claim on the contracts. But, assuming M is in the business of buying chattel paper and GMAC took only a proceeds interest in the contracts, M would have priority in them under 9-308(b). The same is true for the car that E returned, under 9-306(5). Presumably, uncertainty about whether all the elements of 9-308 had been met was the basis for the parties' subsequent subordination agreement. Given this agreement, M certainly has priority.

Because D is in default, either GMAC or M can take over the chattel paper and assert her rights under it, including her collection rights against E and C. Assuming the chattel paper and inventory is not enough to cover D's debts, furthermore, GMAC could bring a claim against D's estate for any deficiency. M could not bring a deficiency claim, however, because it took the chattel paper on a nonrecourse basis.

Of course, now that D is in bankruptcy, GMAC's and M's collection attempts will be stayed. M may be able to get the stay lifted, since the chattel paper is not obviously necessary to a successful reorganization, but it is unlikely that GMAC will be allowed to repossess the inventory, which is likely necessary. Because both GMAC and M are perfected, however, they will ultimately get priority over the unsecured creditors in the proceeds of the inventory and chattel paper, to the extent of their respective secured claims.

Finally, the trustee will be able to avoid D's gifts to friends and relatives as fraudulent conveyances. It may also be able to avoid GMAC's security interest in D's after-acquired inventory (including E's returned car) as preferential, though GMAC will have a good defense under 547 if it can prove that the turnover of inventory within the preference period did not increase the value of its SI. This is the only possible preference. M's SI in chattel paper was given in exchange for contemporaneous value, and the subordination agreement between M and GMAC did not transfer a property interest of the debtor.

Common errors: There were no especially common errors on this question, but the following points are worth noting. (1) Many of you spent unnecessary time and effort discussing whether GMAC was a purchase money creditor. In fact, GMAC does have PM status, but it makes no difference since there is no other creditor with a security interest in D's inventory. (2) Several of you argued that C's waiver of suretyship defenses was unconscionable. While there is an argument that the waiver is ineffective due to its appearance in fine print, such waivers are a standard term in guaranty clauses, and are routinely enforced, as in Pentax v Boyd. (3) The subordination agreement is not a preference for the reason stated above. Similarly it does not violate the stay because it is not an attempt to collect from or proceed against the debtor D.



Question 2

The first issue here is whether this transaction lies within the scope of Article 9. If it is a true lease, it is outside Article 9, but on the facts given (especially given the low price of the purchase option and the infeasibility of moving the tower to another location) it is likely a security interest disguised as a lease. More factual inquiry, however, would be needed to say for sure. If there is leeway for choice, then it may be better for Radial (R) to structure the transaction as a lease, because then R would have a superior position in the event of KPUT's bankruptcy. Specifically, as lessor it could retake the tower without regard to the automatic stay, while as secured creditor it would be subject to the stay and would be unable to foreclose if the tower were deemed necessary to a successful reorganization (a significant risk given the importance of a transmitting tower to a radio station.) For most other purposes relevant here, however, a lease and a security interest provide similar advantages if structured and carried out properly.

Similarly, because the tower will be affixed to realty, we must consider whether it might become a fixture under local real estate law. If it is, then any real estate claimants, including KPUT's parent company Bayshore (B), would have an interest in it; and it would be necessary to take additional precautions to protect R's interests against their claims.

Assuming the transaction is within Article 9, then, we need to make sure that R properly attaches, perfects, gets maximal priority over KPUT's and B's other creditors, and has effective rights upon default. Attachment is straightforward: under 9-203 there needs to be a signed writing adequately describing the tower as collateral. Value and rights in the collateral are inherent in the transaction.

Perfection is a little trickier: under 9-402, R needs to file a signed financing statement that properly gives KPUT's business name and address, R's own address, and adequately describes the collateral. In fact, even if the transaction appears to be a true lease, it is a good idea to make a precautionary filing under 9-408 just to be safe. Because the debtor is one of a number of affiliated corporations, however, it will be especially important to get the proper corporate information on the financing statement; additionally it will be necessary to monitor things to make sure that there are no subsequent changes in corporate structure that might invalidate the filing later on. As for place of filing, a central filing in the Secretary of State's office will perfect against a bankruptcy trustee, but to make sure to have priority against real estate claimants it will also be necessary to make a fixture filing in the local real estate records. A fixture filing would also have to comply with the requirements of 9-402(5), which include filing under the name of the landowner B, and providing a legally sufficient description of the underlying land.

Because R is supplying the tower itself, this qualifies as a purchase money loan. Thus R will be able to get PM superpriority over the prior secured creditor Reliable Trust (RT). It will need to document the transaction properly, however, to be able to establish PM status later on. Reserving title should suffice in this regard. Additionally, in order to get superpriority, R will have to make sure to file its financing statement promptly, since 9-312(4) requires perfection within 10 days of the buyer's receipt of the collateral. Because the tower will be equipment in the hands of KPUT, R does not need to give RT any special notice, as required under 9-312(3) for PM interests in inventory. Similarly, a fixture filing within 10 days of the tower's becoming affixed to the realty will give R priority under 9-313(4)(a) over prior real estate claimants, except for construction mortgagees under 9-313(6). [If there are any such construction mortgagees, of whom we are not told, it will be necessary to negotiate with them specially for a subordination agreement under 9-313(5)(a.)]

If R follows all these steps, it will have the right to retake the tower upon default under 9-503, and to pursue other appropriate remedies under Article 9, Part 5. In particular, given the costs of physical repossession, it is worth noting that 9-503 also gives the creditor the right to render collateral unusable without removing it. This section on its face appears to validate R's plan of disabling the tower with a remote electronic signal. R needs to be careful, however, about how it implements this plan, since under 1-203 and 1-208 it is required to act in good faith when declaring default and pursuing remedies. Thus it is very important to define default carefully in the underlying lease/security agreement. If R disables the tower in circumstances where KPUT has not yet defaulted, it will itself be in breach of contract and will be liable for any resultant damages — a risky prospect given KPUT's reliance on the tower to remain in business. More significantly, concealing R's power to disable the tower within secret source code may itself be a breach of the duty of good faith (which under 1-201(19) requires "honesty in fact"). It may even be fraudulent, especially if R does not reveal the source code ex post, and instead allows KPUT to believe that the operating system has simply malfunctioned. [See, e.g., Werner et al v Lewis, 588 N.Y.S.2d 789 (N.Y. App. Div. 1990). ] Your advice should thus include warning KPUT against the legal risks of their "technical" strategy, even though they did not ask you about that.

Common errors: The most common errors on this question had to do with the relevance of fixture classification and fixture filing. First, classification as a fixture and classification as equipment are not mutually exclusive; in fact, most fixtures are equipment under the 9-109(2) definition. Second, a fixture filing is not required to perfect against a fixture. The relevance of a fixture filing is that it allows the secured creditor to gain priority over most (not all) real estate claimants under 9-313. Thus in this problem, a central filing would suffice to gain priority over RT, provided that all the necessary steps are taken to acquire purchase money status.
Several people also argued that KPUT would count as a "transmitting utility" under 9-105(n), which would mean somewhat different procedures for filing. This argument is incorrect; the reason it is incorrect, however, is not obvious on the face of the text, so I gave full credit for such answers. [The legislative history for this exception makes it clear that it is motivated by the special problems of debtors with extensive distributional systems: e.g., pipelines, telephone, cable, and electric companies, lines, railroads. For such debtors, it is not feasible to make a fixture filing everywhere that they may have property affixed to realty, so the code allows a fixture filing to be made centrally. This rationale, however, does not apply to a radio tower located at a fixed and single location.]



Question 3

This was a more open-ended question that called for a fair amount of creativity. In grading, I looked for answers that both attempted to apply material from the statutory text, and that also discussed larger policy concerns. Obviously, there is reason to be suspicious of a transaction that allows a unsecured creditor, who made no effort to obtain security when she lent and who probably received a higher interest rate as compensation for the associated risk, to jump to the head of the line at the expense of fellow unsecured creditors and of senior secured creditors such as Reliance Trust. On the other hand, Coastal did negotiate for top priority and the right to make secured future advances, and is entitled to exploit these rights to the fullest.

On the law. There is no provision of Article 9 (or of the UCC) that directly addresses the issue of whether a secured creditor can sell or assign its priority position. Sections 9-302(2) and 9-405(1) make it clear that one can assign or sell a security interest, and 9-405(2) allows assignment of "rights under a financing statement," but none of these sections indicates that the assigned interest can be used to secure a pre-existing debt that arose out of an entirely separate loan transaction. Similarly, while 9-312(7) states that future advances made while a security interest is perfected by filing relate back to and take the same priority as the original loan, it is questionable whether a separate and pre-existing unsecured loan, subsequently acquired by the secured party via assignment, should count as a "future advance," given that it does not involve any extension of new credit.

Other Code provisions cast doubt on transactions that disadvantage third parties such as Reliance. Section 9-316 allows a secured creditor to subordinate a security interest to a junior creditor, but the comment to this section states that such a subordination agreement cannot adversely affect the rights of a third party. More generally, while 1-102(3) states that freedom of contract is a general principle of the Code, comment 2 to that section indicates that this freedom does not empower the contracting parties to alter the rights of third parties, and specifically refers in this regard to the priority system of Article 9.

On the other hand, it is straightforward under Article 9 to design a transaction that achieves the desired result of converting the client's loan into a secured debt with senior priority. All that is needed is for Coastal, the senior secured creditor, to lend Fritz another $100K for the purpose of debt reconsolidation. Fritz can then take the $100K and use it to pay off its debt to the client, who gets reimbursed in full. Coastal then will hold a fully secured claim for $100,500, which takes senior priority over Reliance under 9-312(7).

This transaction, however, would certainly be voidable as a preference under 547 of the Bankruptcy Code if it took place within 90 days of bankruptcy. (Specifically, it would not be a preference for Coastal to increase its security interest by 100K, since this would be in exchange for an simultaneous infusion of 100K of new value. The preference would be in using the 100K to pay off the loan to the client.) Additionally, it might be voidable as a fraudulent conveyance, either under 548 of the Bankruptcy Code, or under state fraudulent conveyance law, if the parties were deemed to have the actual intent of hindering or defrauding other creditors such as Reliance. If so, the trustee could under 550 recover the 100K either from your client, or from Coastal.

Admittedly, the transaction could be saved from attack as a preference by propping up Fritz for 91 days before filing for bankruptcy. To save the transaction under 548, however, it would be necessary to prop Fritz up for a year, and under state fraudulent conveyance law, until the statute of limitations had run.
[One might wonder whether there is any way to structure the transaction so that it counts as a future advance under Article 9, and does not count as a preference under 547. Here is a possibility: Coastal agrees to guaranty Fritz's loan to the client; then the client calls on Coastal to pay the guaranty. This transaction would not be a preference because (at least in form) it would not involve a transfer of any property interest of the debtor Fritz. The amount paid by Coastal under the guaranty would then arguably count as a future advance under Article 9. Of course this arrangement is probably too clever to pass muster in bankruptcy, and it does not take care of the fraudulent conveyance problem.]

In terms of overall statutory policy.
It seems clear that this last transaction would violate the spirit of Bankruptcy Code 547, and probably the Bankruptcy Code as a whole. Whether it violates the spirit of Article 9, however, is a more difficult question. Coastal did negotiate for top priority and the right to make secured future advances, and is entitled to exploit these rights to the fullest. Similarly, Reliance knew (or should have known) about Coastal's position when it lent. One might argue that Reliance could have reasonably expected that the future advance clause would only be used to secure new amounts lent by Coastal, not to cover pre-existing loans made to other creditors, but it is foreseeable that future advances might be extended for the purpose of debt reconsolidation. Such reconsolidations are standard and useful transactions in the commercial world, and as such, section 1-102(2) suggests that the UCC should be read to facilitate them.
But on the other hand, 1-103 provides that we must read the UCC in light of general principles of law and equity, and these principles include the law of fraud and fraudulent conveyances. Of course, if one believes that such reconsolidations are ordinary and reasonable business transactions, then one would presumably conclude that they should not be regarded as fraudulent.

For a sampling of scholarly views on this problem, see Spencer Neth, "The First to File Priority in Article 9: Can You Sell Your Place in Line?," 31 U.C.C.L.J. 64 (1998) [with response by Morris Shanker]; and Steven Walt, "Revisiting Neth's ‘The First to File Priority in Article 9: Can You Sell Your Place in Line?' and Shanker's Response," 31 U.C.C.L.J. 217 (1998).



Key to symbols used to mark exams:

v good point or argument
! excellent point or argument
~ fair point, or incompletely or unclearly expressed
– weak point
… point needs elaboration
" point already made, repetitive
? unclear
?? very unclear, confused, mixing together separate points
x mistake of law, misstatement of fact, misuse of term
x? point appears mistaken
# irrelevant or tangential point
#? point's relevance unclear
ns non sequitur: conclusion does not follow
ff fighting facts: contradicting stated facts or making assumptions inconsistent with them
ll laundry list: throwing in relevant and irrelevant arguments alike, without distinction