Fall 2002 final exam (Commercial Transactions)
Top student answers


Note: These were among the best answers received under examination conditions. They are not model answers, in that they all contain extraneous material as well as omitting useful information. Some even reach incorrect conclusions. However, they all provide intelligent, organized, approaches to the questions.


Question 1: Answer #1

FFB v. Zoe
Electronic Transfer

This is a situation that is governed by EFTA. It is therefore impossible to determine the actual outcome of this situation. However, the Comment to §4A-108 allows the application of appropriate principles by analogy. This is a payment that meets the obligations of §4A-202(a). This was an authorized payment by the company (under an agency principle); it was just for $600 more than usual. §4A-202(e) states that this applies to amendments as well. Since there is no definition of amendment, I would assume that Factor's action is an amendment. Therefore, this would be a proper electronic transfer of funds to Zoe. We could also look at this as a negotiable instrument situation.

Negotiable Instrument/Check

Zoe may have breached her warrantees under 3-416 & 3-417 because the check was altered, but this is unlikely. 3-407 says that alteration is an "unauthorized change". This seems to be a change after the instrument has been drafted so this doesn't seem to fit under the definition. Since this was the only warranty that Zoe could possibly have violated. She validly transferred the check.

Unjust Enrichment

It seems that FFB has no remedy against Zoe under the UCC. However, 1-103 allows for causes of action outside the code. FFB could sue for unjust enrichment. Zoe would argue detrimental reliance. However, from the facts she knew she had $600 more than she should and knew where it came from so she should lose.

FFB v. Lam Rotcaf

Checks 1&2

This is a fictitious payee situation. These checks are payable under 3-404(a). FFB is going to take the loss. The indorsements meet the requirements of 3-404(c)(i) and therefore, Bank Two became a holder when Factor transferred the checks and did not breach their presentment warranties under 3-4 17 to FFB. FFB may make the argument under 3-404(d) that Bank Two's contributory negligence contributed to FFB's loss. Bank Two must use ordinary care in accepting checks (3-103). It seems that Bank Two has exercised ordinary care, but it could be debatable. What is the policy for the acceptance to negotiated checks? This is most likely a losing argument for FFB.

Check 3

This is the same situation as above, the analysis hinges on whether the signature meets the requirements of 3-404(c)(i) (3-404(c)(ii) does not apply because this check was negotiated before deposit). The argument could be made that "Mal Factor" and "Lam Rotcaf are substantially similar, but this doesn't seem to be the case. Therefore, this is not a valid endorsement and Mal Factor breached his transfer warrantee (3-41 6(a)(2)) when he transferred to Sharkey. Sharkey is therefore, not a holder under 3-417(a)(1) and therefore, not entitled to enforce the instrument. His bank is therefore, not entitled to present the check to FFB. FFB can therefore, bounce the check back to Bank Three who can bounce it back to Sharkey who would have to take the loss.

FFB v. Kevin

FFB had until midnight on Thursday to return the check to Bank Three to avoid being  liable for the check (4-302(a)). FFB did not notify Bank Three until Friday that it was dishonoring the check because it was a counterfeit. However, by statutory definition the have honored the check and are liable for payment to Bank Three. Under 4-302(b) however, FFB may have a defense.

It does not seem that there was any breach of the presentment warranties. This was a forged instrument, which is valid as to holders. Kevin was the payee and therefore a valid holder and his endorsement is therefore authorized. Bank Three did not violate its presentment warranty (4-208). Bank Three also did not present the item "for the purpose of defrauding" FFB. It was the purpose of Kevin to defraud FFB, not the intention of Bank Three, as it did not know that the item was forged. Therefore, FFB is liable on the check.

 FFB. Lucky & Donald

§4A-202 requires a bank to have a commercially reasonable security procedure. The modification of their procedure by their employee most likely makes their security procedures no longer commercially reasonable. In general, the bank is going to have to bear the losses related to the wire transfer, but may be able to recover some sums. The $750,000 stolen by Factor is a loss the bank cannot recover unless FFB can find Factor.

 Lucky

FFB is entitled to recover via 4A-303(c) the amount of the wire transfer from Lucky.   However, the full amount received by Lucky is no longer available because FFB paid checks on Lucky's behalf with these funds. Can FFB get this money back? Yes, but it '. seems that there only remedy is against Lucky.

FFB has a right to restitution under 3-418(b) and can pursue those who were paid these sums. However, Comment 2 states that FFB has not right to restitution if the holder paid value in good faith and had no reason to know of the mistake. This seems to be the situation. Under 4-401 though, FFB has the right to charge these sums against Lucky's account and can attempt to get these sums from Lucky.

Donald

Donald should have an action for wrongful dishonor of the checks he wrote after the transfer. Under 4-402(b), bank should be liable for actual damages and possibly consequential damages proximately caused by this wrongful dishonor. There is a question as to whether damages should come under 4A (Comment 2), but we didn't deal with these kinds of damages, so I don't know what the consequence would be in this situation. 


Question 1: Answer #2

(1)  Article 4A does not apply to funds transfers that are governed by the Electronic Fund Transfer Act (EFTA). UCC § 4A-108. EFTA governs direct deposits of paychecks. 15 U.S.C. § 1693a(6), so Article 4A does not govern. As to whether a direct deposit is a negotiable instrument, § 3-104 defines a negotiable instrument as a "promise or order," defined in § 3-103 as a "written undertaking" and "written instruction" respectively; a direct deposit fits neither of these. Moreover, to the extent the EFTA does regulate liability in this area it would preempt the UCC as federal legislation. 

FFB's only recourse other than the EFTA would be common law remedies of unjust enrichment or restitution. Zoe's bank presumably would not even have constructive notice since appearances would have indicated Zoe merely got a raise, so only Zoe would be liable.

 (2)  With regard to the first two checks, under UCC § 3-304(b)(2), if the payee as written is a fictitious person as here, then "[a]ny indorsement. . . in the name of the payee stated in the instrument is effective as the indorsement of the payee in favor of a person who, in good faith, pays the instrument or takes it for value or collection." Id. This applies because Mal indorsed the first two checks using "Lam Rotcaf." As to whether Bank Two took the check for collection in good faith, we have no indication to that effect. Therefore, the checks were negotiated and Bank Two was a holder entitled to enforce according to § 3-301. Presumably, Bank Two presented the checks to FFB and is thus subject to the presentment warranties of § 3-4 17. Of these, only the third is implicated, that the bank has no knowledge that the draft is unauthorized, which would be hard to win for FFB. Bank Two may also be subject to liability for comparative negligence under § 3-404(d), which would require showing that it failed to exercise "ordinary care that contributed to the loss." Id. FFB would have to show that prevailing commercial standards were that banks require customers to show identification when depositing indorsed checks, which is unlikely since an indorsed check is payable to bearer.

 As to the third check, § 3-404(b) does not apply since it was not indorsed in the name of Rotcaf. Under § 1-201(20), Mal is not a holder, since the check was payable to Rotcaf and he is not Rotcaf. The key question is whether Sharkey became a person entitled to enforce the instrument. The check was transferred to Sharkey according to §3-203(a) since it was delivered for the purpose of giving Sharkey the right to enforce, and thus Mal's right to enforce was vested in Sharkey, § 3-203(b), but this right depended on Mal's becoming a holder by signing in the name of Lam Rotcaf, which he did not. Therefore, Sharkey was never entitled to enforce. By the same token, Bank Three is also not entitled to enforce. Thus Bank Three has breached the first presentment warranty, §3-417(a)(l). Sharkey is liable for breach of transfer warranties under § 3-416, specifically, that he is entitled to enforce the instrument and that all signatures are authentic and authorized, and his liability extends to subsequent transferees including FFB.

 Bank Two, Bank Three, and Sharkey might try to argue a defense of contributory negligence under § 3-406, but this is limited to negligence that caused the forgery (depending on the dubious assumption that the signature of a fictitious person can be forged), not negligence causing the issuing of the bogus checks.

(3) Presumably, FFB accepted and paid the counterfeit check. Under § 3-418(b), FFB may revoke acceptance or seek restitution from Bank Three as a person who benefited from the payment ("person" includes an organization, § 1-201(30)). However, Bank Three escapes this liability if it shows that it took the check in good faith and either gave value or changed position in reliance. § 3-418(c). Since Bank Three did allow Kevin to withdraw the funds, it did give value; it could also be argued that Bank Three changed position in reliance on FFB's paying the check. Bank Three is still subject to the presentment warranties of § 3-417; the question is whether Bank Three was entitled to enforce the check. This is probably satisfied under § 3-301: the check was presumably indorsed by Kevin (the record does not say) and so payable to bearer, thus Bank Three was a holder, § 1-201(20).

With regard to FFB's recovery, FFB is subject to the duties indicated in §§ 4-301, 302 to meet its midnight deadline for dishonoring, which it failed. FFB might be excused under § 4-109, under the provision "circumstances beyond the control of the bank," and FFB must also show that it exercised due diligence. The case law suggests that courts interpret this strictly, and Bank Three would argue that FFB was in control of its employees and failed its duty by not regularly checking for computer systems integrity.

 (4) With regard to liability of Lucky: Under § 4A-202, if the bank and customer have agreed to a procedure that is "a commercially reasonable method of providing security against unauthorized payment orders," and the bank proves good-faith compliance, then the payment order is effective. FFB is a receiving bank under the definition of§ 4A-103(4) because Omicron's instruction was sent to FFB. As such, FFB can recover from Lucky as beneficiary the amount of the erroneous payment order if it was transmitted pursuant to a security procedure for the detection of error." 4A-205(a)(2). This probably applies to the security procedure covering the transmission from Omicron to FFB. §4A-205 provides that the law of mistake and restitution applies, and here Lucky might raise a defense of estoppel, but this would require showing knowledge on the part of FFB. In sum, Lucky is likely to be liable to FFB for the entire $750,000.

There does not appear to be any basis for liability of Donald to FFB.


Question 2: Answer #1

 

Part 1, National Media Sales:

Assuming that NMS's demands are inflexible, VM's goals with regard to NMS are to pay the amount in arrears, to come up with the money to meet the 50% cash demand, and to eliminate bankruptcy vulnerability in the event of a BR petition.

·          Step I: Arrange cash financing with Merchants to take care of the missed payments and the 50% cash demand. See below for why Merchants will be willing to make the money available. NMS will likely not accept an arrangement based on making it a secured, rather than an unsecured, creditor because: (a) the combination of Merchant's blanket SI and the operation of §9-317 means that NMS will be subordinated under the first-to-file rule, and (b) whatever SI is granted would be ­avoidable as a preference in bankruptcy.

·          Step 2: Any payments made to NMS could potentially be avoided under §547 as preferences. To protect against §547 avoidance, any payments made to NMS must be made to fit within §547(c). These payments should be structured so that it is easy for NMS to prove that §547(c) applies since §547(g) gives NMS and VM the burden of proof.

 o            Protecting the payments of the amounts in arrears: Section 547(c)(4)'s further extension of credit exemption will apply because without this payment NMS was going to refuse further sales on 50% unsecured credit. Thus, payment is a precondition to the extension of further credit by NMS.

 o            Protecting the 50% cash payments: These payments will be protected from §547(c)(l)'s exemption for contemporaneous exchanges for new value. The payments should be structured to make clear the parties' intent that the payment is a contemporaneous exchange for new value and the exchange should in fact be contemporaneous.

 o            Protecting the 50% unsecured credit payments: These payments will be protected by §547(c)(2)'s exemption for ordinary course payments. The debt will be incurred in the ordinary course, the payments will be made in the ordinary course and the payment will be made according to ordinary business terms so long as this kind of arrangement is not way outside industry practice. See Matter of Tolona Pizza.

 

 Part 2, Channing:

 VM's goal here is to slash prices on Channing merchandise but avoid default and acceleration under the reasonable insecurity clause.

 ·          Step 1: Ascertain the amount owed Channing and secured by her PMSI in inventory and receivables.

 ·          Step 2: Cut prices on Channing merchandise so that the aggregate value of the Channing inventory and receivables is equal to the amount owed Channing and secured by her PMSI.

 ·          Step 3: When Channing declares VM in default under her "reasonable insecurity" clause litigate the issue arguing—

 o          She has reasonable security because the value of the outstanding debt is completely secured by the value of the inventory and receivables.

o          Calling the loan for discounting the merchandise is a violation of the duty of good faith implied in every default and acceleration at will clause by § 1-208. Cite K.M.C. for the proposition that there must be some objective basis upon which reasonable loan officer in the exercise of his discretion would have acted as Channing did.

 ·            Although this approach will alienate Channing, they are a sinking ship that VM can afford to abandon. Additionally, I'm sure that the FTC or the Antitrust Division would just love to hear about a supplier using its leverage to force retailers to maintain prices; Channing's threat is illegal. Finally, this approach has the advantage of forcing them to sue VM if they want any money.

 

Part 3, Merchants:

 VM's goal is to convince Merchants to provide further financing by giving it a SI with better priority, a way to cash in on VM's going concern value, and protection from the BR trustee.

 ·          Better Priority:

 o            Merchants already has a priority monopoly over future advances because of §9-322(a)'s first to file rule applied through §9-317(a); remind them of this.

 o          Use the debtor's §9-2 10 rights to show Merchants that there are no SI's with priority over its SI.

 o            Convert inventory covered by PMSI's into accounts by cutting prices to boost sales. This gives Merchants better priority because §9-324(b) leaves accounts out of the PMSI priority scheme.

o          Deposit all VM's cash into its account at Merchants so that §9-327(4) applies to give Merchants depositary bank priority over conflicting SI's.

·          Cashing in on Going Concern Value: VM could issue stock options to Merchants that will allow it to cash in on going concern value. VM can also remind Merchants that will be on the hook for 40% of Channing's contract if VM goes under. This carrot and stick approach should induce Merchants to extend further credit; especially credit to pay NMS since the business's success depends on advertising.

·            Bankruptcy Protection:

o          §362. the automatic stay: the nature of the blanket SI and the extent of VM's debt means that there will be a lack of adequate protection so that the automatic stay can be avoided.

o            §544(a), the hypothetical lien creditor: per §9-31 7(a)(2)(A), Merchants will have priority over the bankruptcy trustee because its SI has already been perfected under §9-308 and a petition has yet to be filed.

o            §544(b), actual unsecured creditors: to use §554(b) the BR trustee will have to find an unsecured creditor who can beat Merchants outside BR—this would have to be the victim of a fraudulent conveyance and such parties are unlikely to be found.

o          § 547, preferences: Section 547(b) does not present a problem. The loan payments will be in the ordinary course (§547(c)(2)) and there is no new SI so that there is no other transfer.

o          §548, fraudulent conveyances: even if the BR trustee could prove an actual intent to hinder, delay, or defraud creditors, §548(c)'s for value and in good faith rule would apply to protect Merchants.

 


Question 2: Answer #2

ValuMart's going value concern (protecting its asset value, including its trademark) and option value concern (possible economy up-turn and renewed profitability) incentivize staying in business and avoiding bankruptcy. Avoiding insolvency is in all creditors best interests (either through a sale or re-gaining profitability) to prevent bankruptcy trustee from controlling distribution of the estate's assets. Resolving ValuMart's financial predicament through mutual cooperation and re­negotiation is best.

 To address all creditors concerns, could find a buyer, possibly a competitor like Thrifty Mart, to purchase ValuMart, paying off all existing debts. Short of a sale, the following courses of action might satisfy creditors, keeping ValuMart out of bankruptcy:

 NMS:   NMS, an unsecured creditor, is least likely to receive payment in bankruptcy and has the strongest incentive to negotiate protection.

 ·          Could cut NMS out completely by buying advertising directly from media outlets. This would save ValuMart some money and would ease concerns that NMS will suspend service for non-payment. This is unattractive however, because ValuMart seems particularly dependent on NMS' services and might experience reputation damage for failing to timely pay outstanding bills.

 ·          Advise NMS that discontinuation of advertising services would likely result in bankruptcy NMS would receive nothing. All assets would go to pay off secured debt. NMS should be patient and allow ValuMart to turn itself around. This is an unattractive option because NMS doesn't want to get further in the hole than they already are.

·          Could bring NMS current (with cash on hand, by discounting Channing inventor~ or by borrowing from Merchants or another bank — See Sections 2/3 for discussion) and continue timely future payments to NMS. This is subject to §547 preference avoidance in bankruptcy if occurring within 90 days of the filing. NMS can argue however, that these were Ordinary Course payments excepted under §547(c). If this option is pursued, NMS should demand future payments up front each month. This avoids default and antecedent debt problems.

·          Provide NMS with individual/personal guarantees, Merchant bank's guarantee or Letter of Credit (bank did this for Channing and may have an incentive to guarantee NMS — see Section 3). A guarantee won't change NMS' bankruptcy priority status, but would allow recovery from third party guarantors.

·          Give NMS a Security Interest in existing assets. Because both Channing and Merchants already have superior security interests in ValuMart' s assets, without a subordination agreement, NMS would remain so under-secured that in bankruptcy, it wouldn't recover anything anyway. Additionally, could still fall victim to § 547 preference claims for SI in the antecedent debt (does protect its interest for new value services).

·          Give NMS super-priority by giving it possession of ValuMart's chattel paper. Although Channing and Merchants have security interests in the Chattel paper, possession trumps the perfected security interest of Channing and ValuMart under 9-330(b). Again this would be subject to the trustee's preference and fraudulent conveyance challenges.


Channing: ValuMart's should pay off Channing, discontinuing the Channing inventory due to disappointing sales, Channing's negative public perception and insolvency problems.

·          Since Channing is itself financially troubled, it may accept a "discounted" buy-out of the existing liability. If ValuMart pays off Channing (financed either by Merchants or a third party bank), it would be free to discount the inventory, getting a much-needed cash infusion (could use this infusion to pay NMS). This would also eliminate Channing's secured priority, allowing greater strength in Merchant's priority and NMS' (if also given a security interest). Convince Channing that because it's under-secured, in bankruptcy wouldn't get 4 million and a discounted buy-out would help them both.

·            Channing might not be interested in this because it has 40% guarantee from Merchants and a PMSI in the inventory and any cash proceeds (its has a SI subordinate to Merchants in non-cash/credit receivables (9-317)). However, can argue that PMSI is unperfected (no notice as required by 9-342(c)) therefore no super-priority (not clear in fact pattern if actual notice was given although, since Merchant's participated in negotiations, maybe notice is presumed).

Merchants: Merchants has the most invested in ValuMart therefore the most to lose and gain depending on the outcome It has a blanket security interest in all assets (fact pattern doesn't indicate whether a financing statement was filed however, given the sophistication of this lender, it is likely that it perfected its security interest and has priority over all other creditors (except Channing' s possible PMSI)) as the first to file per 9-322(a)(l).

·          Its long-standing relationship with ValuMart puts Merchants in the best position to evaluate the viability of ValuMart's survival. If survival or a turn-around is likely, it should loan additional funds, covered by blanket financing statement, conditioned on a Channing buy-out. This allows ValuMart to discount the Channing inventory, eliminates all Channing's security interests and gives ValuMart funds to pay off and continue business with NMS.

·            Merchants might hesitate to do this due to its under-collateralization and insolvency/bankruptcy concerns. However, granting the loan itself will keep Merchants in control. Can add loan term that prevents ValuMart from borrowing from anyone else, thus insuring Merchants secured priority status.

·          As further protection, Merchants can require all ValuMart funds be deposited with it, providing additional security via control over the depositor's accounts (9-327). It can also take possession of all chattel paper as it becomes available. Possession will provide further protection/security.

·          Finally, if Merchants doesn't want to extend additional credit to ValuMart, VM can shop for a third party loan. This will be difficult however, because loan would be subordinate to Channing & Merchants unless the lender gets subordination agreements (this is unlikely given Merchant's huge exposure). Loan could however be a re-consolidation requiring pay-off of Channing and Merchants.

The best options are re-consolidation of all debt through a third party lender OR more likely, borrowing more from Merchants to pay off Channing and come current with NMS. If none of this works, a final option is to file Chapter 11, get automatic stay protection and try to re-organize.


Question 3: Answer #1

 Part A

 Practical Problem: Tension exists between (a) provision of fair, equitable and organized distribution of assets to all creditors by maximizing the bankruptcy estate' value and (b) unjustly enriching the estate at the expense of secured creditors. The trustee can (per §361/362), keep collateral in the estate if necessary for an effective reorganization and the value of the collateral is adequately protected.

Allowing the trustee to keep a secured party's collateral in the estate without paying interest results in an "interest free" loan to the bankruptcy estate by the secured creditor. Otherwise, the creditor would have access to and use of the collateral's proceeds. The likely result is secured creditors' requiring "over­collateralization" when they extend loans OR secured creditors  repossessing/foreclosing on collateral at the first late payment or any other signs of default/insolvency problems.

Reform Arguments:

FOR REFORM: The plain language interpretation of "Adequate Protection" includes keeping secured creditors in the same position as if the debtor hadn't filed bankruptcy. If the creditor bargained for repossession/foreclosure rights upon default, adequate protection should include the resulting ability to liquidate the collateral, access the proceeds and compensate for the loss of use of those funds.

The trustee uses the collateral to confer a benefit on the estate, the estate should not be unjustly enriched. Payment of interest is equitable and comports with good faith requirements of the UCC and common law.

In addition, Timbers diminishes the value of getting a security interest and encourages creditors to "over-secure." This hinders economic and business market growth, making it hard for businesses to get loans if they don't have sufficient collateral. It will ultimately chill business development and the economy.

AGAINST REFORM: Secured creditors are only protected up to the bargained for value of the security. If creditors extend under-secured loans, they accept the risk of limited recovery. Creditors should only get interest if they have insured themselves against default/bankruptcy by over-securing. Lending is risky and secured creditors shouldn't get additional benefits at unsecured creditors' expense. As long as the collateral is "adequately protected" and they receive compensation for depreciation of the asset while it remains in the bankruptcy estate, they are getting what they bargained for and are not entitled to more.

Absent debtor's bankruptcy, the secured creditor would either get repayment of the loan by the debtor or repossession of the collateral, not interest. Unjust enrichment precludes recovery of interest.

Conclusion: Both positions have merit. We don't want to dis-incentivize lenders from extending secured loans. Similarly, we also don't want to further handicap disadvantaged unsecured creditors, who will only be receiving a pro-rata share of the estate.

A satisfactory compromise would allow the under-secured creditor to receive interest on its collateral kept in the bankruptcy estate however, the interest would be treated as unsecured debt. The creditor would get a pro-rata share of the interest, just like all other unsecured creditors. This recognizes the bargained for advantage/interest of the secured creditor while simultaneously prevents inequitable treatment of unsecured creditors.

 Part B.

Practical Problem: Leases are advantageous to creditors because the default risks are lower (no repossession costs) and the administrative requirements for execution of a lease are less demanding than for secured transactions. Leases have lower monthly payments and are generally easier to qualify for than a secured purchase. Thus lessees have access to goods they would not necessarily have been able to afford otherwise. However, lessors, to insure themselves against the costs of depreciation and maximize their return, construct leases that sometimes closely resemble secured sales. The problem with this is twofold: it allows lessors to receive the bankruptcy benefits of lease priority (reclamation upon lessee's default is also easier); additionally allowing lessors to receive the benefits of secured sales (risk allocation on the lessee for care of the goods).

 Distinguishing leased goods from secured collateral is difficult and can lead to the mistaken conclusion by potential creditors that leased property is actually property of the estate and therefore subject to security. Debtors can give a false sense their assets/net worth by failing to disclose whether goods are leased or owned. This creates problems for subsequent lenders in calculating risk and also inhibits equitable distribution of assets in the event of bankruptcy.

 Reform Arguments:

 FOR:    Requiring lessor filing won't eliminate the advantages of the leaseholder (if in fact it is a true lease) in bankruptcy proceedings. Currently, optional filing provisions for leaseholders (9-505) protect the leaseholder from prejudice in the determination of the nature of the transaction (lease or sale).

The filing requirement would alert potential lenders about property that is not a debtor's assets, thereby providing important risk assessing information for the lender.

The filing requirement would also help ferret out disguised sales. This provides general protection for the debtor/lessee, potential lenders and the economy in general.

AGAINST: Lenders don't generally check the filing of financial statements so requiring lessors to file won't make a difference anyway. The filing requirement will however, create higher costs for lessors that will be passed on to lessees. This will in turn, minimize the economic incentive to grant leases rather than secured sales.

Therefore, the filing requirement won't necessarily uncover disguised sales or chameleon leases. If it's a lease of household goods, these probably don't add significant value to the consumer's estate and are likely not of concern to the lender for risk/security purposes. If the leased goods are more significant (car, boat etc.), the potential creditor can easily require the consumer to provide title to demonstrate proof of ownership.

Conclusion:

A filing requirement for leases of big-ticket personal property items, valued at $10,000 or more makes sense. This won't diminish the lessor's priority in bankruptcy but will give notice (assuming a potential creditor chooses to check) as to the debtor's assets and property status. Requiring filing on smaller ticket items would clog the system, be over-burdensome on lessors and would dis-incentivize the extension of leases on household goods. This would unnecessarily punish an already disadvantaged consumer population.


Question 3: Answer #2

Part A

Justice Scalia's typically textualist opinion in Timbers of Inwood Forest focused on statutory commands rather than on the policy debate underlying the weighty question he was resolving. The lack of a persuasive policy argument belies a volatile debate, and the statutory focus serves as a clear reminder that Congress may overturn the decision b3 statutory amendment. In question was whether an undersecured creditor, who was stayed under Bankruptcy Code § 362 from enforcing its security interest during the debtor's bankruptcy and consequently incurred lost opportunity costs, was entitled to postfiling interest as compensation. Predictably, creditors argued yes; debtors, no. The Court sided with the latter.

More forceful creditor arguments stem from the notion of "enforcing their bargain" and run to the very basis of secured credit itself. The secured creditor gave a presumably lower interest rate in exchange for the right to enforce a security interest in specified collateral; he contemplated taking the collateral if the loan was not repaid. For now, at least, he is left with neither. Further, one reason for taking secured credit was his ability to monitor the collateral and guard against the debtor's potential moral hazard. This ability, too, has been lost. Another reason for taking secured credit was the preference he would be given in bankruptcy; that preference is largely mitigated by a potentially lengthy uncompensated delay. Finally, creditors argue that giving bankrupt debtors an interest-free loan is simply not their duty -- and that by doing so, they are encouraging debtors to delay the process even further.

Debtor arguments, conversely, are based less on efficiency and more on distribution. Bankrupt estates are by definition cash-starved, and adding a requirement to pay substantial interest would be a "crushing burden." This burden would adversely affect all other (primarily unsecured) creditors, potentially including employees, tort claimants, or bondholders. Most importantly, it would affect the debtor itself. As Justice Scalia noted, to maintain the stay under § 362(d)(2), the debtor must have "an effective reorganization. . .in prospect." Where every dollar is precious, the possibility of a reorganization's success is vastly diminished when substantial interest must be paid. It is inefficient well as distributionally unfair to favor giving interest to a secured creditor, already favored in the bankruptcy process, over granting anything to unsecured creditors and over improving the debtor's chance to survive.

Because I find debtors' distributional and efficiency arguments more persuasive, I would not advise Congress to pass legislation that would reverse this decision.

 Part B

Despite the revisions to UCC § 1-201(37), characterizing deals as leases or secured transactions remains the one issue which induces the most litigation under Article 9. This is unsurprising; commentators have long noted that the law attempts a dividing line that might be ephemeral, and the line still remains devilishly fine and the determination inescapably fact-driven. Further, parties have strong incentives to skirt this line. For tax, accounting, financing, and bankruptcy reasons, they benefit from categorizing their deals as leases; thus clever attorneys who in fact intend to create security interests will intentionally blur the line, so they can later argue, if necessary, tin they were creating leases.

To avoid the mess of litigation, some have proposed amending Articles 9 and 2A to require lessors to file public financing statements in order to maintain priority over competing claimants. They argue that this will allow later comers the opportunity to avoid making claims for the same items; for instance, if creditors learn that a car is leased, they will avoid securing loans with that car as collateral. If notice is not given because no filing has been made, the blame lies with the lessor, and the loss of priority does as well. Similarly, bankruptcy trustees could assert priority over lessors who fail to file.

Opponents argue that this additional legal requirement is excessively burdensome. In most lease cases a filing is unnecessary, because there never would have been any litigation anyway -- either because the transaction was very clearly a lease, or because there never were competing creditors, or because later creditors were fully aware of the prior transaction. In these cases, public filing would be entirely redundant and would impose a burden both on lessors and on the already burdened public filing offices. Further, opponents argue, such a requirement could simply shift the costs and uncertainty elsewhere. For instance, if Lexis must file a financing statement on all cars that it lease to business executives, must Alamo file on all cars rented to tourists? Presumably so. If Alamo chose to file, this would result in much higher costs, which would be passed on to consumers. If it chose not to -- suspecting that the Mendenhall situation was rare enough -- it would still worry about every traveler avoiding bankruptcy during her trip, and this would create much uncertainty.

Presumably, proponents of lessor filing rely in part on the large improvements to the filing system in recent years. Filing is moving rapidly from local to centralized and from paper to electronic, the requirements have been mainstreamed (particularly under 9-521), and the backlog has been minimized. But that is not enough, I believe, to justify such a tremendous expansion of filing. Property and related collateral, important source of leases, are exempted from centralized filing. The enormity of new filings could return the backlog to its former levels. And the expense to repeated lessors, such as landlords afraid of tenants' bankruptcies, and consequently to consumers, is unjustified. Further, lessors who earnestly hope to avoid litigation can already file without prejudice under § 9-505.

Most of the arguments against requiring lessor filing, however, lose some force if consumer transactions are exempted. The weighty burden of filing and its lack of necessity in usual cases such as Alamo or landlords, would not be at issue. And most relevant litigation stems from commercial rather than consumer transactions anyway. I would thus recommend amending Articles 9 and 2A to require lessors to file -- but only if consumer transactions are exempted.