Note: These were, in my judgment,
the best answers received under examination conditions. They should not
be taken as model answers, in that they all contain extraneous material
as well as omitting useful information. Some even reach incorrect
conclusions. However, they all take intelligent approaches to the
questions, are well organized and reasoned, and make sensitive use of
the facts.
Because answers were scanned from
originals to prepare this page, be aware that odd characters and typos
may have been unintentionally inserted into the text.
Question 1, Answer 1
1.
CURRENT LEGAL RISKS AND LIABILITIES
CHECK CASHING
I have inferred from the problem that
customers negotiate their paychecks to Cash24 by indorsement and
transfer for
value rendering Cash24 a holder in due course. (3-201, 3-302). The main
legal
risks stem from the difficulties in pursuing claims against Cash24' s
customers, especially for risk of flight and insolvency, along with the
inability to set off against a deposit account. Banks also retain a
defense for
negligence under 3-406.
If a customer presents a
forged instrument, Cash24 would be unable to enforce against the drawer
and
would be out the amount paid to customer, unless recovery from
customer. As no
one is entitled to enforce a fraudulent indorsement, due to lack of
proper
negotiation 3-201(b), Cash24 would breach the presentment warranty.
3-301,
3-417(a). Payor Bank could recover from Cash24 as the person who took
from the
forger unless Cash24 could assert a defense under 4-406, 4-301/4-215,
or 4-214(a).
b. Forged Checks
A forged check on the
other hand, does not breach the presentment warranty as a HDC is
entitled to
enforce against the forger. 3-403(a), 3-301. If the payor bank
dishonors the
check, liability goes up the chain to the first payee.
c. Altered Checks
If Cash24 accepts a check
from someone otherwise authorized to enforce, but who has raised the
amount,
Cash24 will be able to enforce only the amount of the original check
and will
lose the raised amount, unless recovery from customer.
d.
Dishonor
Although less risky than
the above as most employers will likely be able to cover employee
checks, if a
customer's employer dishonors a check, and neither payor bank nor
depositary
bank has breached its midnight deadline, 4-301/4-215, 4-214(a), Cash24
will be
forced to recover the amount of the check from the customer through
indorser's liability,
3-415(a), or if he/she is insolvent, from the employer, 3-414(b).
MONEY ORDERS
The only legal risks I see
associated with Cash24's money orders is a possible claim arising from
the
transaction between customers and their payees. For example if a payee
breached
a contractual duty and the customer wanted to get back the money it
paid for
the money order. This seems to be a very rare occurrence though as most
money
orders will be issued to pay for services, such as electricity, cable,
etc.,
that has already been received by the customer. In the
off-chance that
this isn't the case, I would suggest a money back guarantee in exchange
for the
money order. This would create goodwill without any significant burden,
depending of course on whether or not my assumptions on money order
usage are
correct and whether the administrative costs would be offset by
interest we
could collect before exchange. As long as Cash24 keeps enough money in
its deposit
account to cover the money orders, there should not be any other
problems.
PAYCHECK LOANS
Paycheck loans pose a
considerable risk as they are unsecured, however this risk is somewhat
mitigated by the low amounts and high interest rates. Cash24's ability
to
recall loans depends on a customer's solvency and the rights of other
secured
creditors, unsecured creditors and lien creditors if the customer goes
into
bankruptcy.
2. PROPOSED
CHANGES
Cash24 provides a much-needed
service to our customers, catering mainly to lowincome, unbanked
customers in
an area poorly served by ordinary banks with average fees similar to
low-balance accounts. These facts might allow us to deflect some
pressure to
reform our services. Depending on the intensity of the pressure, I
would
propose the following changes to alleviate risks and allow Cash24 to
lower
customer fees.
a. CHECK CASHING
As stated above, the main
problems associated with check cashing are due to the current
difficulties in
bringing suit against high risk customers. We can reduce our fees to
the extent
we are able to reduce risk.
i. Require information cards with signatures, current
address, etc
Although there would be
certain administrative costs, we could require each customer to fill
out an
information card with various data and create a record in a
computerized
database system. This would allow us to better monitor high risk
customers and
bring suit against those who break the law. The downside of course is
that this
would put an undue burden on good customers and unlikely reduce the
risk of bad
customers. If someone is willing to steal or commit fraud, they will
likely
give false information.
ii. Require
a verifiable permanent home address
This might alleviate the
fraud aspects in the previous paragraph, but would put an even greater
burden
on good customers.
iii. Require
employers to pre-authorize checks
Requiring
pre-authorization could greatly reduce risks with little burden on
customers
after an initial amount of administration, but would depend on the
diversity of
employers and their willingness to cooperate. Furthermore, it would
only work
with checks from employers.
iv. Maintain records of past
checks to prevent
unordinary amounts
Assuming most employees
receive a constant wage from month to month, and depending on the cost
of
maintaining a database system, we could keep a statistical record of
check
amounts to protect against aheration.
v. Link
check-cashing fees to a percentage of the check
We could change the
current flat fee to cash a check to a percentage fee based on the
amount of the
check. This would require "high-income" customers to subsidize
lower-income customers. It is not clear how this would alleviate risk
and would
possibly alienate "high-income" customers. Nevertheless business and
regulatory bodies might view it as a step towards alleviating the
burden on
low-income customers.
vi.
Allow electronic-benefit
customers to cash checks immediately
Depending on the cost of
implementing such a system, we could eliminate the need to print paper
checks
and allow customers to immediately cash electronic transfers. Customers
would
then cash all their electronic-benefit checks with us and we could cut
down on
paper costs.
b. MONEY ORDERS
Since risks associated
with money orders are low, we might offer lower rates or offer one for
free
after X number of checks have been cashed. As fees are based mainly on
administrative burdens, after overhead costs are covered, we could
reduce the
cost of money orders to our customers and gain goodwill with business
and
regulatory bodies.
c. PAYCHECK
LOANS
The risk from paycheck
loans arise from our unsecured standing.
i. Secure loans
First we could secure the
loans, but this is probably not worth the administrative costs on such
low
amounts. Also, customers might not have valuable collateral, or the
collateral
that they have might already be subject to prior secured creditors.
ii. Require guarantors
We could require all
customers to provide guarantors. However, the guarantors might not be
any more
solvent than high-risk customers.
iii. Do
not increase loan amount or issue additional
loans until the original amount has been paid
We could require
customers to pay prior loans in full before issuing new loans, but we
want to
take in as much interest as possible.
iv. Offer information and
customer service in multiple languages
Since a significant
number of our customers are immigrants and minorities we could keep the
loans
as they are and offer customer service and information in multiple
languages to
ensure customers fully understand what they are doing. However, this
would
require administrative cost.
^ TOP
Question 1, Answer 2
Check
Cashing
Cash24 faces three risks with respect to
its check-cashing business:
-
The
risk that the customer has forged the indorsement on the check
-
The
risk that the check itself is a forgery
-
The
risk that the drawer of the check does not have sufficient funds to
cover the
value of the check.
First, if the customer
forged the signature of the payee on the check, then Cash24 faces the
risk that
the check will either be dishonored, or that the check will be accepted
but
that the drawee bank will seek to recover the amount of the check from
Cash24
for breach of its presentment warranty under §3-417. In either
situation,
Cash24 is unlikely to be able to recover the amount of the check from
its
customer who has presumably absconded.
This is a difficult risk
to protect against. Naturally, Cash24 should demand identification from
customers cashing checks, require that checks be signed in its presence
and
compare signatures, but these are common procedures that it has
probably already
implemented. Accordingly, there are few opportunities for cost-saving
with respect
to this risk.
Second, if the check were
forged or the drawer had insufficient funds, Cash24 would face the same
risk of
having the check dishonored, in which case it would not be able to
recover the
disbursed money from its customer. [Though in either case, if the
drawee bank
paid the check, it would not be able to recover the amount from Cash24.
See §§3-418,
4-301.]
Ideally,
Cash24 would only pay customers for checks after the check had cleared
following deposit in Cash24's account with its depositary bank. It
could issue
the customer a promissory note for the amount of the negotiated check,
with
payment conditional upon the drawee bank's acceptance of the check.
Once the
check negotiated by the customer cleared, Cash24 could call the
customer and
inform them that they could come by and pick up their cash. This
arrangement
would be impossible to implement effectively, however. Many low-income
people
live from paycheck to paycheck (or benefit check to benefit check) and
would
not be able to wait until the check cleared. An acceptable compromise
would be
for Cash24 to pay its customer 50% of the face value of the
check
immediately in cash, and to pay the rest upon the check clearing. As
described above,
Cash24 could issue its customer a promissory note for 50% of
the check
for the interim period between negotiation of the check and final
acceptance by
the drawee bank.
This
wouldn't eliminate the risk to Cash24 of dishonor of the check, but it
would
reduce its exposure, and would permit it to provide its customer with
enough
cash to "tide them over" until the check cleared. This scheme would
likely reduce the number of payroll loans Cash24 could make, however.
If customers
don't have access to the full amount of their checks at the start of
the month,
they are less likely to spend it all in the first half of the month and
require
a payroll loan. While this may benefit some customers, others are
likely to
view this two-step arrangement as an inconvenience that would drive
them to
other service providers. Cash24 may be able to entice customers by
paying
nominal interest on its promissory note, a feature likely to assuage
the
concerns of some critics.
Finally, Cash24 could
implement a differentiated pricing scheme, charging less for checks
from
governmental entities, where the risk of dishonor is lower. (1) It could also charge
less for checks cashed by customers receiving electronic benefits
transfers
through Cash24. If any checks from such customers were dishonored,
Cash24 could
exercise its right of set-off before issuing checks for subsequent
electronic
transfers.
Converting
Electronic Benefits Transfers to Checks
Cash24 does not face any
substantial risks with respect to these transactions. It has received
the money
before it issues its check. There is a risk that the electronic
transfer was
sent by mistake, in which case the sender or the intermediary banks
might be
entitled to recover the amount of the transfer under the conunon law of
restitution, but since Cash24 will have disbursed the amount of the
transfer to
its customer, such parties cannot recover the funds from Cash24.
Money Orders
Cash24 may face some risk
in issuing money orders, depending on how its customer pays for the
order. It
will face the usual risks if its customer pays by check or credit card.
This is
unlikely to be the case, given that most of its customers are unbanked.
Nonetheless, Cash24 should only accept payment in cash to minimize
these risks.
It is unclear that Cash24 is
significantly overcharging for money orders. The United States Postal
Service
charges between $0.90 and $1.25 for money orders, (2) while WesternUnion
charges "around a dollar." (3) Nonetheless, Cash24's
charges may be more than 50% higher than its competitors.
While there
are few opportunities for cost saving, Cash24 may be able to lower its
fees in
light of its low risk exposure. Naturally, this would entail a loss of
revenue.
Payday
Loans
Cash24' s risk in such
transactions is simply stated: it faces the risk that the customer will
not
repay his/her loan when it becomes due. The simplest way for Cash24 to
minimize
this risk is to transfer it to another party. Cash24 may be able to buy
insurance against the risk of customer default. It is unclear whether
such
insurance is available, however. Moreover, purchasing such insurance
would
significantly reduce Cash24's profits on the loans and in any case
would make
it difficult to reduce the fees it charges its customers, as the
premiums would
likely be high. Given that Cash24 is charging $30 for a two-week loan,
however,
there may well be enough room for Cash24 to purchase insurance and
still
recognize a profit.
The most effective way
for Cash24 to transfer the risk to another party would be for it to
factor
these loans to a party specialized in this type of risk. By using the
secondary
market for such loans, Cash24 might still be able to recognize
significant
profits while increasing efficiency, thereby allowing it to lower the
fees it
charges.
Similar to the solution
proposed for reducing Cash24's risks when cashing checks, Cash24 could
reduce
the fees it charges for payday loans where the customers receive
electronic
benefits transfers through Cash24. If a customer defaulted on his/her
paycheck
loan, Cash24 could exercise its right of set-off before issuing checks
for
subsequent electronic transfers.
Other protections would
be impractical. Cash24 could demand collateral for its loans, but its
customers
are unlikely to have collateral of significant value and Cash24 is
presumably
ill-equipped to take physical possession of and store collateral such
as a
television.
It might be possible for
Cash24 to take a security interest in its customer's next paycheck or
benefits
check, but if it has to pay a $20 filing fee in addition to search fees,
(4)
this would just make such loans more expensive. Moreover, if the
customer
enters bankruptcy, the customer probably won't have a job anymore and
probably
doesn't have any assets worth taking, so it is unlikely that taking a
security
interest would help Cash24.
====
Notes:
[Note 1: There may be other law prohibiting this scheme, but I am
unaware of it.]
(return ^)
[Note 2: See www.usps.gov.] (return
^)
[Note 3: Phone
inquiry on December 11, 2003.] (return ^)
[Note 4: f4 See, e.g.,
http://www.dos.state.ny.us/corp/uccfaq.html.] (return
^)
^ TOP
Question 1, Answer 3
Memorandum
To: Cash24
President
Re:
Legal Risks
Check Cashing
There are two primary
risks involved in our check cashing operation, liability from
dishonored checks
and liability from check fraud.
Dishonor
Threat
Check24 will almost
invariably suffer a loss upon the dishonor a check we have cashed. The
drawee
bank owes us no duty, so if it dishonors a check for lack of funds or
because
of a stop order, our only recourse is against the customer. Because we
have
only a temporary relationship with most of our customers, and because
many of
our customers have very few assets to begin with, our likelihood of any
substantial recovery is small.
Solutions
One potential solution to
this threat of dishonor is to hold a customer's check until we receive
notice
that it has cleared. Although this is option is open to us legally,
from a business
standpoint it would make little sense. Our customers are drawn to our
service
primarily because it provides them with instantaneous liquidity. If we
forced
customers to hand over their paychecks on Friday night, and did not
provide
cash until Saturday or later, they would most likely bring their
business to
one of our competitors.
A
compromise solution
could be to provide partial payment up-front for our customers
immediate needs,
but only provisional credit for the remainder, contingent of the check
clearing.
Even if the reduced risk could dramatically lower our fees, however, we
would likely
still lose business under this plan. Because our fee is already so low
($3.50)
in comparison to the cash we are providing, it is not likely that even
a
substantial reduction would compensate for the value our customers
place on
liquidity.
Another means of
risk
reduction would be to increase customer screening. The effect of
screening is
limited, however, because the primary risk of dishonor lies with the
drawer of
the check who is not present during the transaction. We should focus
our
efforts, therefore, on screening the checks themselves. First, we could
demand
different fees for different types of checks. Low-risk checks like
government
benefits or paychecks from large employers would incur a lower fee than
personal checks or small businesses checks. Although this would allow
us to
draw more low risk-checks from our competitors, the increased fee for
higher-risk checks could seriously harm business. A large percentage of
our
customers likely work for small companies or individuals, often on a
non-regular basis, and the loss of their business could be substantial.
It
might make more sense to keep all the fees the same and allow the
low-risk
checks to subsidize the higher risk customers. We could also increase
more
traditional screening processes like credit checks of payees or
background
research in to drawers.
Check
Fraud Threat
Our second major concern
with the check cashing operation is the threat of check fraud.
Generally, we
will not be liable for forged checks. When we forward a check to the
drawee
bank for payment, we do so under a presentment warranty under §3-4 17,
not
under a transfer warranty under §3-416, given the definition of
transfer under
§3-203. This presentment warranty makes us liable only if we had
knowledge of
the forged instrument, so in almost all cases the drawee bank is
required to
credit our account. Our only potential liability arises under §3-406 if
our
employees fail to exercise due care in accepting a forged check. By
properly
training our employees and ensuring minimal safeguards are in place, we
can
reduce the risk from forged checks to near zero.
Unfortunately,
this same
protection does not apply to checks with forged indorsements. Unlike a
forged
check, a forged indorsement never creates an entitlement to enforce
under
§3-301. Therefore, when we present a check to the drawee bank for
payment, we
breach the presentment warranty under §3-417. At that point, our only
recourse
is to go after the customer or previous transferees. As with dishonor,
however,
the nature of customers makes recovery in these situations unlikely.
Solutions
It is uncommon today for
individuals to personally give value for an indorsed check.
Consequently, the
chain of transferees is probably small, and it is likely that when a
customer
presents us with a forged indorsement, she is the forger herself or
closely involved
with her. It is critical, therefore, that we rigorously screen
customers for
risk of fraudulent indorsement. There are a number of ways to do this.
First, we should
instruct
employees to carefully check ID's and signatures, possibly requiring a
signature
test or answers to some background questions about the check's payee.
This
could be difficult, however, given the large number of customers who are
not
well established in the community and who may not have legal
identification.
Second, we could invest in technology to allow our employees to quickly
run a
criminal background check on all customers. Third, we could provide a
fee
discount to repeat customers. This would both encourage their loyalty
and
reduce the risk of forged identification. Finally, in the future when
it
becomes economically feasible, we could invest in high technology
anti-fraud
devices like electronic signature machines.
Wire
transfers
Our wire transfer
business probably poses the least risk. Because it is a direct transfer
of money,
primarily from a government source, there is little risk of dishonor or
fraud.
Money
orders
This is another very low
risk area for our company. There is a small potential risk of double
payment if
a customer, acting as a remitter, loses a money order and attempts to
receive
reimbursement. This threat can be minimized if we establish stringent
policies
towards lost instruments and hold funds in escrow until the threat has
been
reduced.
Paycheck Loans
This section of our
business is probably responsible for most of our negative image and
most of the
calls for public regulation. Because our customers are poor and the
credit
risks they present are high, we are forced to charge extremely high
rates.
To
mitigate the high risk
of default and reduce these rates, we could attempt to secure some kind
of
collateral from our customers. This seems a unworkable solution,
however, given
the financial situation and general lack of assets of our customers.
Furthermore, outside of opening a pawn shop (which would not present a
good
image for the company) there would be little economic way to foreclose
on
collateral given the small loan amounts involved.
The only
reasonable way
to reduce the credit risk of our customers is to improve screening.
Regular
credit checks will be of limited use since most of our customers can be
assumed
to have bad credit, but there are other options for reducing risk. We
could
reward repeat customers with lower rates to incentives them to pay and
increase
the number of reliable users in the future. We could also contact local
employers and make arrangements to receive payments directly from them
on
pay-day. Finally, we could work to build personal ties with our
customers in
order to exert social pressures towards repayment.
None of these
options are
perfect. But with a correct mix of risk reduction procedures we can
afford to
reduce fees, gain market share, and reduce regulatory pressure.
^ TOP
Question 2, Answer 1
General
Policy
As bankruptcy trustee I
first have a duty to ensure that E-buy regains solvency in order to
provide the
maximum benefit to creditors and its investors. Failing that, I have a
duty to
ensure that the creditors proceed in an orderly fashion and receive the
maximum
aggregate benefits upon liquidation.
Protecting
E-buy's
assets
There seems to be a
legitimate possibility that E-buy will survive bankruptcy proceedings
and
satisfy the demands of all its creditors. Its current insolvency could
potentially be a symptom of short-term cash-flow problems rather than a
systemic long-term failure of business structure. The going concern
value of
the company, therefore, is likely substantially greater than its value
upon
liquidation. Once the company can prove its potential, the existing
creditors
could be invited to a workout session to restructure debt. With the
relatively
small number of creditors involved, and the threat of holdouts low,
this is a
very real possibility. To reach this stage, there are a number of steps
I would
take as trustee.
First, and
most
importantly, I would attempt to halt Zyzyx's efforts to lift the
automatic stay
on its collateral under §362(d) of the Bankruptcy Code. Without the
ability to
sell inventory at retail prices during the holiday season, E-buy would
have
little chance of surviving.
Zyzyx could not
satisfy
the requirements of §362(d)(2) because the inventory is essential to
restructuring, and E-buy has substantial equity in the inventory under
the
cross collateralization plan. Zyzyx has a stronger argument that its
inventory
is not receiving adequate protection under §362(d)(1). After Timbers
of
Inwood Forest, Zyzyx could not lift the stay based solely on lost
opportunity costs in the collateral, but would need to show a tangible
loss.
Zyzyx would seem to have a strong argument in this regard, given the
demonstrated devaluation of outdated technology. Even if such a loss
could be
proven, since the inventory is critical to E-Buys survival, it might be
in the
company's interest to provide periodic cash payments to satisfy the
definition
of adequate protection under §361.
Another source of short
term capital for E-Buy would be access to the receivables held by the
credit
card companies under charge back disputes. Under the Truth in Lending
Act
(TILA) credit card customers have limited charge back rights. First, a
large
number of customers would seem to be disqualified because they are not
located
within 100 miles of E-buy. Courts have been increasingly willing to
disregard
the 100-mile requirement with internet transactions, however,
essentially
treating the merchant's location as the customer's computer. Even so,
many of E-Buy's
customers would still not have a valid claim because they may never
have had
rights against E-Buy. This issue would be resolved with contract law
and would
hinge on whether the consumers were given notice of the outdated
technology or
whether it was buried in fine print.
As trustee I
would fight
aggressively to protect Zyzyx's inventory and receive payment from the
credit
card companies. Even if the possibility of making E-buy solvent is low,
there
is still a strong option value for the owners. With very little to
lose, there
is no reason not to take a gamble and hope that the market turns
around. If
this gamble fails, as option-value gambles usually do, my next step
would be to
resolve conflicts between the competing creditors.
General
Investor's
(GI) Claims
Because GI has a valid
security interest in all of E-buy's assets perfected by an acceptably
broad
filing statement under §9-504(2), it will likely receive the
greatest
share of the bankruptcy estate. In fact, given the large amount that
the
investors loaned and the meager assets of the company on liquidation,
GI will
probably receive nearly all the company's assets at the expense of
other
creditors. There are a few potential exceptions, however.
First,
under the Uniform
Fraudulent Conveyance Act (UFTA), E-buy's creditors could bring a suit
against
GI for providing inadequate capital for the company. Under corporate
law, a
company's shareholders must abide by the "first in last out" rule and
receive dividends only out of a company's equity. There seems to be
evidence on
either side, but if the creditors could prove that the heavily
leveraged buyout
by GI was the cause of E-buys failure, they could recover any profits
that the
company's shareholders illegally received.
Second, any
recent
acquisitions of inventory could be considered a preferential transfer
for
purposes of §547. Because GI's position was improved on behalf of
antecedent
debt while the company was insolvent, the transfer could be avoided. To
determine the amount to set aside, the court would apply the two point
improvement test under §547(c)(5) and compare GI's aggregate
inventory
value 90 days before filing with GI's position today, setting aside any
gains
accrued.
Finally,
GI may have lost
perfection on some of E-buys inventory because of the company's name
change.
First, the name change would need to have rendered the financing
statement
seriously misleading. Under §9-503, this would depend on
whether it
could be found using the search logic of the filing office, which seems
likely
with a manual filing system given the similarity of the names. If the
name was
seriously misleading, GI would become unperfected after four months for
purposes of after acquired property under §9-507. Because 8
months
transpired after the name change before GI amended its financing
statement, any
property acquired during that four-month window would not receive
priority or
other secured creditors.
Zyzyx's
Claims
Zyzyx's could first claim
priority based on its purchase money security interest (PMSI). Although
a PMSI
will normally beat an earlier filed security interest, there are
special rules
for inventory under §9-324. In order to have priority over GI, Zyzyx
must have notified
GI when it took the interest (which there is no evidence of). Even with
notice,
Zyzyx will only be superior for cash proceeds received on or before
delivery
and would need to use E-Buy's records to trace cash proceeds back to
its
inventory.
The fact
that Zyzyx had
cross collateralized its inventory would not destroy its PMSI status.
Although
this would be an illegal arrangement in consumer transactions, under
§9-103,
this would likely be considered a reasonable agreement between the
parties.
Zyzyx would also
have
priority over the installment contracts that it received from E-Buy.
Because
these contracts merged a security interest with a monetary obligation
they
would be considered chattel paper under §9-102(a)(11). As such, Zyzyx
would
have a superior interest to GI under §9-330 since GI claims the paper
"merely as proceeds", so long as the paper was not marked by GI.
Alpha
and Beta
The court would almost
certainly refuse to recognize Alpha and Beta's security interest, but
would
instead consider it a preferential transfer under § 547(b). The
security
interest qualifies as a transfer under § 101(54), was made for
the
benefit of a creditor on account of antecedent debt, and enabled the
companies
to receive more than they would have as unsecured creditors. As long as
the
transaction took place 90 days before filling, the security interest
will be
set aside.
Destiny.
com
As a potential judicial
lien holder, Destiny.com would not have priority over any secured
parties and
would be unlikely to receive any payment.
^ TOP
Question 2, Answer 2
The
trustee has the following options:
1. General
Investors:
· Description of collateral
Even though the
description of collateral
in the financing statement complies with the requirement set forth by
§9-504(2), it is doubtful that the description of the collateral in the
security agreement satisfies §9-203(b)(3)(A). Certainly, §9-108(a)
provides
that a description of personal property is sufficient if it reasonably
identifies what is described.
The description
on the security agreement
is borderline. The question turns out into whether the description of
tangible
and intangible reasonably identifies what is the collateral subject to
the
security agreement. General Investors (GI) would argue that it is a
permissible
description by category, despite the generality, and that in any event
it
reasonably identifies the collateral. However, as trustee would let the
bankruptcy court decide this issue. There is no precedent on point and
the text
of the statute could favor us. There is enough at stake that it merits
the
court to define it. In addition to being extremely generic, the
description
does not perform the functions it was established for: it is difficult
for
creditor to identify the collateral and debtor cannot limit creditor's
rights
in the collateral.
· Change of name
If a change in
debtor's name is seriously
misleading §9-507(c) establishes that the filing ceases to be effective
as to
any new collateral acquired by the debtor after 4 months, unless a new
statement is filed. However, §9-506(c) provides that if a later search
under
the debtor's correct name, using the filing office's standard search
logic,
would disclose the financing statement, the mistaken name does not make
the financing
statement seriously misleading.
Either under a
manual or a computerized
search using the standard search logic—no capital letter matter-, the
name of
the E-Buy would come out right. So the change of name did not make the
financing statement seriously misleading.
(ii)
Fraudulent Conveyance
If the
bankruptcy court holds that
security agreement is valid, GI has a perfected security interest in
equipment,
inventory, cash, negotiable instruments —checks-, accounts —credit-card
receipts- chattel paper —installment contracts & security interest-
and
general intangibles —patent-. Nonetheless, the trustee would still have
a claim
against GI's security interest under §544 of Bankruptcy Code.
Certainly, §544
allows the trustee to avoid transfers that could have been avoided
under
non-bankruptcy law by actual unsecured creditor. Article 4 of the
Uniform
Fraudulent Conveyance Act —most likely adopted in our jurisdiction—
establishes
that a conveyance made by a person who is or will be rendered insolvent
thereby
is fraudulent as to creditors without regard to its actual intent if
the
conveyance is made without fair consideration.
There is
precedent on point. In a
leverage buyout (LBO) transaction, the court in US v. Gleneagles
Investment, invalidated a lender's security interest as a
fraudulent
transfer since the funds used "merely passed" through Target to Venture
and ultimately to the shareholders of Target. The court also held that
the note
given was worthless since Venture had no assets different than the
stock and it
constituted a gratuitous transfer. The Third Circuit upheld this
decision.
Even
though there are
differences in these cases, the trustee could make a plausible argument
that GI
was aware that E-Buy was being used by the venture capital fund to
transfer
funds to them and milk E-Buy leaving its creditors exposed. Knowing its
financial statements, it would be reasonable to conclude that GI was
aware that
incurring in such obligation would leave the company vulnerable to
insolvency.
This position would be backed by the opinion of some industry analyst
which
considered E-Buy's LBO as the source of current financial problems and
some
others who deemed that the price paid for the shares was too high.
Therefore,
GI's security interest could be avoided.
2. Zyzyx
(i) Security
Interest
In the Associated Sales
Contract ("Contract"), Zyzyx retained title of the goods pending full
payment by E-Buy. §1-201(37) establishes that the retention or
reservation of
title by seller of goods notwithstanding shipment or delivery creates a
security interest. Therefore, Zyzyx has a security interest over
inventory.
Nonetheless, it is unperfected since it did never file a financing
statement
-§9-308-. In consequence, the trustee is senior to Zyzyx -§9-31 7(a).
As to the chattel paper —installment
contracts & security interest-, Zyzyx has a perfected security
interest,
since it has taken possession of those contracts -§9-313(a) allows to
perfect
tangible chattel paper by possession-. Therefore, Zyzyx perfected
security interest
would be senior to bankruptcy trustee.
(ii) Preferences
Despite that it is a perfected
transaction, the trustee could avoid it as a preference under §547 of
the
Bankruptcy Code. However, we need more information to establish if it
constituted a transfer of an interest of D's property made w/in 90 days
prior
to filing for bankruptcy —all other requirements of §547(b) are met-,
or if
such prerogative was already established in the Contract v7
and
it was part of their ordinary course of business-§547(c)(2) exception-.
Most
likely the priority of Zyzyx on chattel paper would be declared void as
a preference
and the exemption in §547(c)(2) would not be applicable.
Zyzyx is not a secured party, therefore,
it cannot ask for a lifting of the stay.
3. Alpha&Beta
Alpha and Beta would have a perfected
security interest in inventory —since they are suppliers, I assume it
was the
intention of the parties to grant security interest over it, it is not
clear
which is the collateral-. Alpha has actually disbursed funds and Beta
promised
to do so; hence, both of them have given value, and the collateral
attached.
Nevertheless, bankruptcy trustee could
avoid this transaction as a preference -§547(b)-. It is a transfer of
an
interest of debtor's property, to or for benefit of a creditor, on
account of
an antecedent debt, made while debtor was insolvent, made w/in 90 days
of
filing and it would give creditor more than it would get in liquidation.
The §547(c)(1) exemption does not apply
since it is not a contemporaneous exchange for new value given to the
debtor.
The security agreement is covering the new and the outstanding loans.
The
outstanding loan does not fit into contemporaneous exchange for new
value
substantially contemporaneous. Furthermore, recognizing the exemption
in this
case would contravene the purpose of the provision: don't favor one
creditor
over the other.
4. Disputed charges
Since E-Buy is already in bankruptcy
court, the claims about the credit card transaction could also be
disputed. E-buy
asserts that it provided its customer with the required information and
that it
disclose relevant information regarding the products it was selling,
therefore,
there is a high probability that it can be established that the claims
were
meritless.
In conclusion, it is difficult to
determine whether the company should continue in reorganization or go
to
liquidation. It depends on (i) how well positioned is the 11 company's
name and
how damage it is; E-Buy seems a pretty attractive name, however, the
extent of
the damage is unknown; (ii) the sales; and (iii) the success in
bankruptcy
proceeding.
I advice for fighting in the bankruptcy
court all the aforementioned claims, specially the one against GI, and
then
decide what is the best course.
^ TOP
Question 2, Answer 3
Maintain business
During the profitable
holiday shopping season F-Buy should maintain business. Reorganization
seems
useful for businesses that are solvent in cash flow terms, but not on
balance
sheet (eg firm mistakenly expanded long-term assets in response to
temporary
perceived demand, now needs to downscale).
The facts that forced
E-Buy into bankruptcy make a reorganization under chapter 11 seem
possible.
First of all, one of the main reasons that forced E-Buy into bankruptcy
was a
bank policy to increase fees and to delay credit card payments due to
frequent
credit card charge backs by consumers. These charge backs, based on
returned
consumer purchases, have no merit because sufficient disclosure of
relevant
specifications had been undertaken. Taking these factors into account,
as well
as the possibility for E-buy to reduce its overexpansion, there seems
to be a
realistic chance for E-Buy to continue its business after restructuring.
GI
Promissory note is
defined in 9-102(65) and perfected upon attachment. 9-309.
This is the
case because GI is major creditor and gave value (funding E-Buy's
startup
operations), it can be assumed that E-Buy has rights in collateral or
at least
power to transfer RIC, and the note was properly executed.
With regard to SI in
other assets the requirements for attachment under 9-203 are also
fulfilled.
Perfection follows 9-308.
In the process of filing
one has to observe 9-507c. Change in debtor's name is relevant when it
seriously misleading under 9-506. 9-506b refers to 9-503a requiring
that a
registered organization be identified by the name indicated on the
public
record. This is not the case. However, 9-506c provides another
exception by
referring to standard search method used to find a debtor. Modern
search logic
will probably find the name change, thus name change is not seriously
misleading. FS is effective despite minor errors. Amendment to FS is
still
possible. 9-512.
Scope of SI: The
description of collateral is not specific enough to meet the
requirements of a
FA under 9-108, but does suffice a FS under 9-504.
- Because
deposit account is a separate type
of collateral, SA covering general intangibles will not adequately
describe
deposit accounts. Rather, SA must reasonably identify deposit accounts
that are
the subject of a SI, eg by using the term deposit accounts. >
SI
is not effective for deposit account held by bank.
- 9-204b(2)
provides that an after-acquired
property clause in a SA does not reach future commercial tort claims.
In order for
SI to attach, the tort claim must be in existence when SA is
authenticated. In
addition, SA must describe tort claim with greater specificity than
simply
"all tort claims". 9-108(e)(1). Claim for patent infringement and
unfair competition against Destiny.com is commercial is not covered by
AAP-clause.
A, B
According to 547 BC
preference includes a transfer to or for the benefit of a creditor on
account
of an antecedent debt made while debtor was insolvent within 90 days of
filing
that gives C more than it would get under chapter 7. Signing security
agreement
covering outstanding unsecured loans counts as "transfer". The
outstanding loans are antecedent debt. E-Buy signed the security
agreement
covering outstanding debts "recently", thus it can be assumed that he
was insolvent (according to 547f BC insolvency presumed since July). A
and B
receive more than they would get under chapter 7 because now they are
secured.
However 547b BC refers to 547c: BT may not avoid transfer to the extent
that
such transfer was intended to be a contemporaneous exchange for new
value given
to the debtor and there was in fact a substantially contemporaneous
exchange. E-Buy
agreed to sign security agreement in exchange for additional credit, A
lent
funds under this arrangement, thus contemporaneous exchange was not
only
intended, but in fact given by A. In contrast, B has not given actual
exchange,
but B could fall under the exception of 547c(2) because the
transfer was
closely linked to the ordinary course of business. As a result, BT may
not
avoid the security agreement as a preferential transfer under 547 BC.
The case does not suggest
actual intent to defraud or hinder. 548a(1)(A) Neither is there a
fraudulent
transfer. 548a(1)(B)(i) because security agreement securing an
old debt
counts as receiving value, thus E-Buy received equivalent value when
signing
the security agreement.
The fact that A gave
E-Buy new funds does not create a PMSI since we are not told that E-Buy
actually used those funds to buy new goods. Furthermore, the SA only
covered
old outstanding loans.
Bank
Bank has SI in deposit
account that is automatically perfected. 9-104. Bank's SI has priority
over all
other SI. 9-327. Bank can exercise recoupment or set-off. 9-340, 9-341.
Destiny
Based on the fact that
the counterclaim against E-Buy's claim for patent infringement and
unfair
competition is not likely to succeed, E-Buy might end up as a lien
creditor.
Priority
of SI
Under 9-327(3) Bank's SI
takes priority over all other conflicting SI in the deposit account.
9-327(4)
is not effective because there is no subordination agreement between
bank and
another creditor. Under 9-322a(1) GI has perfected SI in promissory
notes and
assets. Assuming that GI was the first creditor to file, GI has
priority over
Z' s perfected SI in installment contracts that are in his possession.
Insofar
as Z has an unperfected SI, his unperfected SI is also subject to GI's
SI which
are either perfected or at least earlier in time. 9-322(2), (3).
A and B have a perfected
SI, but were the last to file and are therefore subject to GI's and Z's
perfected SI. On the other hand, A and B's perfected SI has priority
over
unperfected SI GI or Z might have. In the event E-Buy wins its claim
against
Destiny.com, F-buy has a judicial lien which is subject to perfected
SI, but
has priority over unsecured SI. 9-317.
Petition for lifting
of stay
Relief from stay is
possible under 362d BC. Z is a "party in interest' because he is a
creditor and has a reasonable interest that the stay be lifted as soon
as
possible to prevent his goods from further depreciation. Z petitioned
lifting
of stay and has thus made a "request".
For lifting of a stay
under 362d(1) there must also be a cause, which includes "lack of
adequate
protection" (defined in 361 to include cash payments, replacements
liens
or other "indubitable equivalent"). Without such adequate protection
there is no cause to lift the present stay. Alternatively, a stay can
be lifted
under 362d(2), if the debtor has no equity in the property and such
property is
not necessary for reorganization. Since in the present case Z retained
title to
all goods sold to E-Buy, E-Buy has no equity in those goods (Z has
burden of
proof, 362g). However, assuming that the goods delivered by Z as main
supplier
of consumer electronic equipment are an essential part of the
bankruptcy estate
necessary for effective reorganization, Z's petition for relief can not
be
based on this ground.
BT
With regard to the assets
BT should try to sell off a significant amount of the equipment that is
not
needed to run the business on a smaller basis. Inventory — especially
older
items — should be sold off, if necessary even with small profit margins
as long
as there is any value left. Cash should be left on deposit and checks
deposited
with bank as well to ensure necessary cash flow. Same with credit card
receiveables. Value of receiveables on computer installment sales
program might
be distributed among creditors. Patent on business model and computer
algorithm
should be maintained if business keeps going. Claim for patent
infringement and
unfair competition is unsure and should not be distributed, but kept on
reserve.
^ TOP
Question 3, Answer 1
THE PROBLEM — SECURED
CREDITORS
VS. INVOLUNTARY TORT CLAIMANTS
I suggest the
subcommittee focus its attention on an aspect of the UCC based entirely
on
unsound justifications: the priority given to secured creditors over
involuntary tort claimants arising later in time. Currently as
Article 9
stands, secured creditors (SCs) have an extremely strong position that
allows
them to win disputes involving conflicting claims to a debtor's assets
even
against involuntary tort claimants (ITCs). 9-201, 9-3 17. If a
tortfeasor has
enough assets to pay back all secured creditors with a sufficient
amount left
to settle tort claims, this should not present much of a problem.
However, this
is often not the case, and after secured creditors, who willingly
entered into
contractual relationships with debtors, have taken their share, little
remains
for innocent parties subjected to significant harm due to a debtor's
breach of
duty.
The definition of a lien
creditor found in 9-102(52) has substantially the same meaning as the
old
definition in pre-revision 9-301. See comment 20 to 9-102.
This shows
that despite ample academic criticism, little has been done to improve
this
situation. Perhaps the lack of a solidified lobby has stalled effort
towards
reform. As no ITC knows ex ante that she will become a victim, there is
little
incentive to advocate for her prospective rights. This problem is
further
exacerbated by the fact that ITCs are often very diverse from each
other making
collective action and resource pooling near impossible. Additionally,
SCs,
already monitoring debtors to a certain extent to protect against
default,
etc., are in a much better position than ITCs to monitor against a
debtor's
hazardous behavior.
PROPOSED
CHANGES
I would propose the following
changes:
Carve out a definition
of involuntary tort claimants from 9-102(52)
There is substantial
difference between ITCS and other lien creditors to have distinct
definitions.
Option 1 - Tort
claimants always have priority
Depending on the willingness
of SCs to lend if they know they will be subordinate to ITCs the UCC
might
provide absolute priority to ITCs.
Option 2 — SCs
have priority, but become liable to TCs
Perhaps a compromise
would be to allow SCs priority so that they could continue to collect
payments
and interest during lengthy judicial proceedings, but then allow ITCs
to
recover from SCs as well as debtors. Of course SCs would be extremely
wary of
this, but it would probably incentivize monitoring of debtor's behavior.
Option 3 — 1 to
1 disbursement of funds
Neither SCs nor ITCs have
priority, but take as equals with disbursement of payments on a 1 to 1
basis.
Option 4 —2 to 1, etc.
disbursement
Alternatively, allow SCs
to take payments at a higher rate than ITCs, e.g. 2 to 1, etc.
Option
5- SC priority over ITC does not apply to AAP
Allow
SCs to keep a priority in initial assets, but allow ITCs to have
priority in
any after-acquired property.
EMPIRICAL
DATA
Empirical Data that would
help to determine whether or not this issue requires legislative reform
might
include:
1. The frequency of tort
claims that recover
nothing due to prior SCs
a. Judicial
records
2. The actual ability of
SCs to monitor
hazardous behavior.
a. The
subcommittee could survey typical secured creditors, task research
groups to
measure what is needed to monitor and whether or not SCs have such
resources,
etc.
1. Willingness of SCs to
lend if ITCs have
priority?
a. Again
a survey of SCs or perhaps a test state before proposing enactment
nationwide.
2. Average tort
settlement/judicial award
a. Canvass
recent tortfeasors to determine amounts paid. Search judicial records.
^ TOP
Question 3, Answer 2
In UCC §
1-103 and the accompanying comments, the drafters state their
intent of
making the UCC a flexible document that is adaptive to changing times
without
the need of frequent amending. This is accomplished partially through
the structure
of the document and partially through the twin fall back safety nets of
liberal
judicial interpretation consistent with this goal and partially by
permitting
the use of pplemental legal principles to support the UCC's purposes.
Flexibility, of course, is not a goal in itself but has value only if
it
contributes to the promotion of some useful value, e.g. (a) efficiency
and(b)
an opportunity for equitable negotiations among commercial actors. Is
the UCC
efficient in the way it allocates information or monitoring costs, and
does it
create circumstances where parties can bargain fairly? If so, then
presumably
they can create value through Pareto-improving transactions and then
negotiate
for the gains from efficiency in an equitable manner.
While the
UCC is admirable in its structure, there is one tradeoff which seems
both
inequitable and inefficient, and that is the fact that judicial liens
are
subordinate to perfected security interests. If we assume that one of
the goals
of tort law is to force actors to intemalize the costs of their
actions,
promoting efficient decision making (i.e. decision making that
accurately
includes the costs of a particular course of action) will promote the
efficient
use of resources and, ultimately, cultivate the fruits that tantalized
the UCC.
Under 9-317(a), however, a judicial lien is simply another security
interest,
one which may have no value if all of an actor's assets are already
covered by
a previous security interest. This scheme, while promoting certainty,
carries
with it a kind of perverse incentive: the cost to the debtor (for
example, a
corporation) of engaging in potentially harmful behavior is reduced,
possibly
substantially, and when the price of something drops, all else being
equal, the
rational actor consumes more of that thing. Other schemes have been
suggested
such as, for example, privileging tort victims. If the UCC elevated the
priority of a judicial lien, this might encourage the commercial actor
to be
extra careful in his business. Of course, he or she might purchase too
much
safety, at the cost of capital to grow his or her business.
It might be useful first to see if this is really a
problem. Is tort protection really a reason for granting security
interests in
one's property? The price elasticity of demand for reckless behavior is
observable,
at least indirectly, through the response of similar businesses in
different
regions to different kinds of insurance, and that might be one way to
determine
whether businesses, if they did engage in this behavior, would
overreact or
simply behave more safely. Regardless, this priority rule sticks out
among the
other rules as one that might warrant closer scrutiny for future
revision.
It might also be interesting to have a scheme where
priority was determined among similarly secured creditors randomly. In
this
way, arms-length dealers could bargain for the risk of leaping to the
back of
the queue if the debtor became insolvent while judicial lien holders
would have
a chance of being first in line but neither party would have much
incentive to
behave opportunistically since any effort spent would be lost, but the
outcome
of such behavior would be uncertain.
^ TOP
Question 3, Answer 3
The drafters of
the
recent amendments to Article 9 chose to maintain minimal filing
requirements
under §9-502, requiring only the names of the parties and an
indication
of collateral. Furthermore, §9-504(2) sets such a lenient
standard for
indication of collateral that almost any generic description is enough.
The PBB needs to examine these filling requirements to determine
whether they provide the most efficient level of information.
Comment 2 to
§9-502
states the general policy for adopting such a lenient filing
requirement. It
states that the section only seeks to provide "notice filing" to
creditors, at which point they would need to inquire further to learn
what
goods of the debtor are covered.
There are number
of
potential problems with the idea of notice filing. First, it can be
extremely
costly for creditors to find out the needed information, especially in
complicated situations involving numerous secured creditors. Second,
the code
provides little assistance to creditors seeking information. In order
to gain a
detailed account of the collateral, a creditor can seek information
from
secured creditors directly, but these creditors will likely be
unwilling to
provide assistance, both for lack of time and because they have an
interest in
junior creditors providing capital to their debtor. A creditor's only
other
option is to ask the debtor herself to request information from the
creditor
under §9-2 10. This is not much help either. A debtor in a desperate
situation
could simply lie about her security agreement, or if the party
seeking
information holds a judicial lien and is not a potential creditor, the
debtor
might refuse to act at all.
Because the
process of
finding information is so costly even after a creditor has been put on
notice,
there is anecdotal evidence that many creditors have simply stopped
using the
filing system. I propose the PEB devise a study to determine how often
creditors actually search the filing system.
If it turns out
that use
is very low, one option would be to eliminate the filing requirement
altogether. This would eliminate much of the litigation arising from
disputes
about filing, and would substantially reduce the administration costs.
Creditors would need to simply ask potential debtors about any superior
security interests, which would not present much more risk than relying
on
debtors to provide information under §9-2 10.
A second option
to combat
low use of the filing system would be to increase the information
required at
filling. PEB should commission a second test to determine whether an
increase
financing statement information would have an effect on creditors'
willingness
to search. Since convenience and speed would likely be factors, this
study
could be combined with the new technology allowances under 9-516(a) and
9-102(a)(69). Researches could poll relevant creditors to see
how
receptive they would be to a searchable electronic database with full
information in the filing statement. Furthermore, an empirical test
could be
provided on a limited scale in a willing state.
Finally,
even if
creditors were more likely to use a system with more information, the
overall
costs and benefits of the plan would need to be studied. Increased
information
would have a number of apparent benefits. First, creditors could lend
at lower
interest rates since they could be assured of accurate information
about prior
security interests. Second, the market as a whole will be better able
to gauge
a company's financial status.
These benefits would need
to be weighed against substantial costs. Not only would the
infrastructure and
maintenance costs be high for the state, but each creditor would need
to provide
substantially more information upfront and constantly update the filing
with
any changes.
^ TOP