Spring 2007 final exam (Commercial Transactions)
Top student answers
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.
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Question 1, Answer 1
Does Lender have a perfected 51 in Music Mart's inventory and equipment?
Before Lender can have priority to the inventory and equipment, it must have perfected its SI. Music Mart granted Lender an SI in inventory and equipment. This description is adequate for a security agremeent because it lists items by type, so is not super generic. 9-108(c). There was a security agreement and I assume that Daniel Drazic signed it so it is authenticated under 9-203(b). Therefore, there was attachment because the SP, Lender, gave value, the loan. 9-203(b).
Lender has a perfected SI because it properly filed a financing statement. However the financing statement listed the debtor as Daniel Drazic, not Dan's Music Mart. It is unclear whether Dan's Music Mart is a registered organization. If it is, Dan's Music Mart should have been listed on the financing statement per 9-503. If it is not registered, which it probably isn't since the fact pattern says it is a trade name, then under 9-503(a)(4), Dan's name is sufficient. Furthermore, the lack of the tradename doesn't make the financing statement insufficient under 9-503(b)(1). The financing statement lists the collateral as "all business assets, including inventory." Presumably, all business assets includes the business' equipment and supergeneric terms for collateral are sufficient for financing statements, so Lender's interest is perfected.
Fender has priority in the factored accounts.
Fender purchased both sales contracts and the lease contracts, which are chattel paper. Chattel paper is defined in 9-102(11), and "means a record that evidences both a monetary obligation and a security interest in specific goods, ... [or] a lease of specific goods."
The chattel paper are also proceeds of Dan's sales, since a proceed is defined under 9-102(a)(64) as whatever is acquired upon disposition of collateral and whatever is collected or distributed on account of collateral. When the instruments (which Lester) has an insterest in are sold/leased, the CP are a proceed of that sale.
Under 9-330(a), Fender has priority over Lender (who has a SI in the CP as a proceeds), because there is no indication of bad faith, he is in the business of buying CP, the purchaser gave new value because he gave cash and also under 9-330(e) because this was a PMSI, Fender possessed the contracts, and the CP doesn't indicate that they had been assigned to anyone else.
A SI in cash proceeds only continues if the SP can identify the cash. 9-315(b). So Lester would have to be able to prove that the cash came from the same of inventory. If it can show that by tracing or the lowest intermediate balance (that the amount of cash in its accounts is equal to the value of the collateral disposed), then it will have priority to the cash.
Leased musical instruments
Lester would have priority in the leased musical instruments.
Lester would have an interest in the musical instruments because the instruments are the inventory of Music Mart, and Lester has a perfected SI in the leased equipment. They are inventory because they are leased as a person as a lessor, 9-102(AO(48). Since Lester is perfected, under 9-317(e), Lester has priority over the lessee.
The first question is whether the lease contracts were actually sales contracts. If they were sales, then they would be security interests, then it must be determined if Dan had a perfected SI in them. Under 1-203, a transaction termed a lease is a SI if the lessee cannot terminate the lease at any time and can become the owner for a nominal consideration. Here the lease contract is not terminable by lesee; they cannot just walk away from the lease, but rather they can only walk away by paying the remaining lease payments and 25% of the market value. Even if you did consider this terminable by the lessee, the payments they have to make are clearly not nominal, but actually penalizes them because they have to pay more, the 25% of market value. As such the leases are probably true leases, not security interests and are not subject to Art. 9.
Sold musical instruments
Dan or the buyers would have priority to these instruments.
Presumably, the buyers who bought the instruments are BlOC. To be a BlOC, under 1-201, the buyer bought goods in good faith wlo knowledge that the sale violated someone else's rights and they purchased from somone selling goods of that kind. There is no indication that buyer acted in bad faith or knowledge of violating someone else's rights, and Dan's Music does sell instruments as part of its business. As a result, the Buyers would take the instruments free of any security interest created by the buyer's seller. 9-320. Since Dan, the seller is the one that created the interest in the instrument, by giving an SI to Lender, Lender does not have claim to the instruments.
But under 9-317(e), Dan has priority over the D because it has a PMSI in the sold instruments (because they were sold under an installement sales contract) if Dan filed a financing statement.
For Fender to have priority under 9-330, it has to take possession of the chattel paper. Possession is not defined in Art 9. It would seem that under 9-330, Fender would no longer have priority in the CP (the factored accounts), but this depends on what was in the agreement between Fender and Music Mart. According to comment 4 to 9-330, the parties could agree that copies of the CP would be fine. In the case of fire, it would seem that this is evidence of bad faith, and so if CP has the scanned copies, this should be considered possession. However, in the situation of giving the contracts to a 3rd person, who is not a bailee, this should probably take away Fender's priority, unless Music Mart acted in bad faith by encouraging Fender to mistakenly give the accounts to someone else. Furthermore, in In Re Funding Systems Asset Mgmt, the court determined that if if duplicates are left in the possession of the debtor there was possession. These seems to suggest that the Creditor, here Fender, would have to have all copies of the leases in its possession at all times to have priority.
A. Default on loan agreement with Lester
1. Default and Perfected Security Interest
Default is not defined in part 6 of A9; thus parties are allowed under 1-208 to contract as to what determines whether the debtor is in default. This provision also allows for secured parties to include acceleration clauses which allow them to accelerate the due date of the debt not yet payable, so that the entire debt becomes payable immediately. As a preliminary issue, it is speculative as to whether Lester (L) in fact has a perfected security interest. There does not appear to be any issue with attachment (L gave value, D had rights in the collateral, and there appears to be an authenticated agreements). However, in the financing statement (FS) L listed the debtor by not using his full name. While under 5-503(b)(1) not listing the debtor's trade name does not render the financing statement ineffective, the name of the debtor must comply with 5-503(a). Here, "Dan" is not the debtor's first name and it is quite likely that under a standard search logic for the debtor's proper name, the financing statement would not be found. In addition, by not listing the debtor's full name the financing statement would likely be considered "seriously misleading" under 9-506(b); thus the FS is ineffective as a matter of law. However, despite not having a perfected security interest, Lester still has an unperfected security interest that could overcome other unsecured creditors, 9-201(a); however, Lester will not be able to benefit from any of the priority rules that come with a perfected security interest. Lester would however be vulnerable if this matter went into bankruptcy. In this matter, it does not appear that there are any other secured parties with relation to Dan's inventory; however, there is an issue with Dan's assets which include receivables. It is also worth noting that L does not have a purchase money security interest in Dan's inventory or equipment, as L simply granted D a variable line of credit. 9-103.
2. Factored Accounts - including Leases and Installment Contracts
Both Dan's lease agreements and installment contracts are considered chattel paper under 9102(a)(11). L's security interest does attach to any identifiable proceeds, including these lease and installment contracts, 9-315(a); however, again there is an issue as to whether that security interest in indeed perfected. If he was perfected that would carry over the chattel paper under 9-315(d)(1). However, L's security interest may be primed by Fender under 9-330 regardless of whether the interest has perfected. L claims a security interest in the leases and installment contract merely as proceeds, and has not based his security interest on the proceeds (as language like "receivables" might otherwise suggest). Here, F is likely to achieve priority over the chattel paper pursuant to 3-330(a) - F took possession of the chattel paper paying new value as part of his business in good faith. Since F has possession of the chattel paper there is not need for him to file. F did not have any notice of other claims to the chattel paper, nor did he lack good faith in the amount he paid. While an argument could be made that between 80 to 90% of the value is not good faith, it is unlikely that such argument would prevail. In selling the chattel paper back to D for collection, L is likely to have a security interest in the proceeds of the chattel paper that were direct results of proceeds from the original collateral under 9-315. However, under 9-330(c) if the goods were repossessed the factor would have continued priority in the repossessed goods.
3. Cash Proceeds
As observed in part 1 supra, If there are other perfected security interests, Lester would be subordinated to them because of his unperfected security interest. However, if there are no other competing security interest, Lester would have priority with regards to the identifiable cash proceeds of the collateral, 9-203(f) and 9-315(a)(2). This security in the proceeds continues indefinitely, so long as they can be identified. 9-314(d)(2). However, if D uses the cash proceeds to buy new collateral, such as inventory or equipment, the security interest continues in the collateral for only 21 days unless the filing statement indicates the type of collateral purchased. 9-315(d).
4. Leased or Sold Instruments
Here there is an issue with leased or sold instruments. With the leased instruments, rights to these instruments are derivative of D. If F does not sell back the chattel paper, F would have priority to the proceeds of the chattel paper. With repossessed goods, a factor under 9-330(c) obtains priority to the proceeds of the chattel paper. However, if they are sold back to D then L may have an interest in the proceeds of the repossessed items.
In the installment sales contract, D's rights to the instruments will depend on whether they were bought for consumer or professional use. Under 9-309, if the goods were purchased for consumer purposes, then D has an automatic perfected security interest in the goods which L could derivatively have a security interest in it which could be available based on L's security interest in "assets." However, if the goods were purchased by professional musicians, D would have needed to file a filing statement within 20 days of the person receiving delivery to qualify for purchase money super priority. 9-317(e). Otherwise, D would have an unperfected purchase money security interest in the goods and that interest could be primed by the purchaser's other secured creditors.
In terms of the leased goods, an argument could be made that these leased goods were just a contract sale. In order to distinguish between a true lease and a contract sale, there needs to remain a meaningful residual value. Tests available for this include whether the option price is nominal and whether the lessee obtains equity in the property leased. 1-201(37). However, the payment structure here seems to suggest that it is a true lease because if the lessee wants to purchase the item he must pay the remaining value of the lease plus 25% - that amount would not likely be considered nominal. However, more information regarding the lease contract may help further establish whether it is a true lease or installment contract - like the terms of the lease and whether it is terminable at will, etc.
Again, the F likely has priority to both forms of chattel paper while in his possession; however, if he sells them back to Dan then L may be able to assert his security interest in the chattel paper as proceeds from the collateral.
If Fender mistakenly relinquished possession to the chattel paper, F may face certain risks to his priority. Under 3-330(a), F needs to maintain possession or control over the chattel paper. If F lacks possession, in order to maintain his priority he must have control, under 9-105. Here, it does not appear that the chattel paper is in electronic format since there is a hard copy. If F mistakenly gives the chattel paper back to D, F risks D selling the chattel paper to another factor who will have priority if they take the chattel paper in good faith for value as part of their business. If F gives the chattel paper to an agent that has not agreed to be an agent for F (by not creating an authenticated agreement to that effect), a party does not have possession under 9-313(c) for purposes of perfection; thus, D again could sell the chattel paper to another factor who would have priority if they took in good faith for value without knowledge. Fender could possibly avoid such outcomes by maintaining possession or include a legend or markings on the chatter paper reflecting his priority; these measures are important because of the nature of the instrument, without possession or a clear legend other factors are not on notice of the chattel paper's prior encumbrances.
If the documents were destroyed in a fire, L could possibly take advantage of 9-105 for purposes of possession, since the scanned copies are the single authoritative copy of the records. In addition, if the chattel paper were destroyed there is no further risk of them being sold to subsequent factors, so perhaps 9-105 would suffice.
The first issue Lester must be concerned with is the adequacy of the financing statement. There are two issues: the first is a factual issue related to whether Dan's Music Mart is the name of a registered organization that is the actual debtor. If it is, 9-503 requires Lester to put this name, and not Dan Drazic, on the financing statement. From the facts, it appears that Dan's Music Mart is a "d/b/a" name, so 9-503 makes providing the trade name insufficient and thus Lester has properly identified the actual debtor.
The second name issue is whether "Dan Drazic" is "sufficient" under 9-503. Since the debtor's full name is Daniel Drazic, Lester has left himself slightly vulnerable to a later searcher. However, I believe that given the uniqueness of the last name, Lester will probably be saved by the 9-506(c) exception for FS names that would come up using the standard search logic of the filing office. In addition, since 9-516 effectively requires Lester to provide some other information about the debtor, if he's fulfilled this requirement and searching "Dan Drazic" brings up the correct FS, the FS will have served its notice function.
Priority in the factored accounts
It appears that the "factored accounts" purchased by Fender constitute chattel paper and proceeds of inventory. This implicates the 9-330 rule regarding priority between a purchaser of chattel paper and a secured party that claims a security interest in chattel paper "merely as proceeds." From the facts, it appears that Lester claims a SI in the chattel paper "merely as proceeds," as the relationship seems to be one of debtor-general inventory financier, and we have no idea as to whether the security agreement or loan contract provides that the relationship in any way hinges upon the creditor having priority in the chattel paper. Moreover, it appears that Fender would probably qualify for priority in the chattel paper even if Lester claimed the chattel paper other than merely as proceeds, as there is no indication that Fender knew the purchase violated lester's rights. It is clear that Fender gave new value, that this was the ordinary course of his business, and there is no indication that the CP had been marked with the requisite legend notifying purchasers that it has been assigned.
9-330(c) also gives Fender priority in the proceeds of the CP, which are any returned instruments (he also owns the stream of payments under the lease/sale contract). Lester will have priority in the cash paid by Fender to Music Mart, as these constitute "proceeds," of inventory in the sense that, since collateral is defined to include proceeds, thus the cash paid by Fender in exchange for chattel paper (both collateral and proceeds) will constitute proceeds. This should not bother Lester too much, since Fender has in effect agreed to bear the risk of nonpayment and collection in exchange for providing up-front cash infusions to the business in which Lester has a very strong priority position.
The general rule is that a SI continues in collateral when it is leased or sold (9-315); however, actual purchasers from Music Mart will take free of the perfected SI created by Music Mart in favor of Lester, because they qualify as BlOCs under 9-320, which is meant to apply in exactly this situation--purchasers of inventory. However, if, under the sale contract, a purchaser defaults on his payments, Fender will have priority in the repossessed instrument because this constitutes proceeds of chattel paper, which is now owned by Fender. When Fender sells back the CP to Music Mart in cases of default, they become subject to Lester's SI once again.
For instruments that are leased, Lester will retain priority in the actual instruments (but Lester owns the stream of lease payments as the purchaser of the lease). See Comment 10, 9-330. There is an issue here of distinguishing between true leases and sales with a reservation of a security interest. From the facts, we don't know whether the customers have a right to terminate the lease. There is some evidence that under the "lease" that Music Mart retains an economic interest in the instruments because it appears that the full lease payments do not equal the full value of the instruments (as evidenced by the 25% of estimated market value that must be paid, in addition to the lease payments, if the customer wants to purchase). Simply because it is called a lease does not make it so, and since the mandatory condition in 1-203 is not met, a court will look to the facts and circumstances of the deal.
Since chattel paper is a "pledgeable" form of collateral, possession is the best way to perfect a security interest (which includes a sale of CP) in CP. However, a SI in CP may be perfected by filing, and since Lester has filed against CP (as proceeds of inventory), Fender's giving up of possession is problematic for its claim to ownership. The problem is found in 9-318, which provides that, although a seller of chattel paper does not retain an interest in the CP, if the buyer's SI is unperfected, the seller retains rights and title in the CP. Since Fender has not filed against the CP and does not itself have possession, it might run into a problem if Music Mart were to resell the CP.
This analysis might change if Fender were to vest possession in Fender's agent. Fender cannot, however, give the CP back to Music Mart. 9-313(c) because a seller of chattel paper is a debtor, and a debtor cannot be an agent for purposes of the secured party's possession. Other agents may possess the CP for Fender, so long as these agents authenticate a record acknowledging that they hold possession for Fender's benefit.
There have been cases (their names are escaping me) where courts have held that only the original copies of the CP are effective; however, I believe that in the case of a fire there is a good reason to make an exception to this rule. The issue comes down to what it is to "possess" the CP, and whether or not the electronic copies are in Fender's possession. If they are on Fender's computer, I don't think that allowing Fender to maintain priority implicates any of the worries about notice to third party that the perfection and priority rules are meant to serve.
Orange Bank/Bosco - from the Bank's perspective
Orange Bank made a strategic error in failing to obtain a security interest on their loan, but this mistake can be corrected by refinancing, obtaining a non-insider guaranty, establishing firstlender exclusive priority, and transferring any bank accounts (at other banks) into depository accounts with OB. This memo will A) outline the parties current legal positions and potential liabilities; B) Discuss the legal effect of possible planning strategies; and C) Assess the various outcomes from Orange Bank's perspective.
A) Current Position and Potential Risks - Billie Bosco (BB) and Boscorp
Orange Bank has dangerously little information about BB and Boscorp's financial position at the moment. As a result, a thorough search of state financing-statement records should be undertaken immediately - to determine whether any other creditors have secured interests in any corporate or personal assets. OB should request access to Boscorp's books. Assuming that OB has not required BB and Boscorp to undertake mandatory reporting of its financial situation or accepting a negative pledge clause in the loan agreement, OB cannot assume that BB and Boscorp do not have large outstanding loans. Even with such a search, OB will not know (for certain) whether BB and Boscorp have any hidden obligations on promissory notes or guaranties. Assuming Boscorp approached OB about refinancing, this might suggest that its financial situation is not as rosy as OB would hope.
That said, based upon what we know now, Boscorp appears to be in a relatively safe financial situation. With a positive net value on its assets and net income sufficient to cover upcoming payments, Boscorp is not in imminent danger of collapse. With respect to BB himself, we know very little - but his personal loan does not appear to be in default or behind on payments, so his personal financial statement appears in better shape.
Under these circumstances, OB should be concerned about a number of potential scenarios. The greatest threat to OB would be if Boscorp owes a secured creditor a significant amount of money, and that creditor possesses better information and decides to accelerate Boscorp's debt under sec. 1-208. Such a move would render Bosco insolvent nearly immediately and place OB in quite a bind. A second threat is purchase-money lenders - who would obtain super priority via 9-324. A third threat is unsecured creditors - small-time vendors and the like that Boscorp may rely on for supplies. Even if none of Boscorp's assets are burdened by security interests, if Boscorp has enough unsecured liabilities, then it could plummet into insolvency very quickly - and in bankruptcy, no one would come out with a substantial share of Boscorp's assets.
B) Legal Effect of Possible Planning Strategies
OB's first priority is to minimize risk of Boscorp's insolvency. Several options present themselves: security interests, promissory notes, and guarantors.
The most obvious solution would be to take a security interest in Boscorp's unencumbered assets. However, this stategy brings with one great threat: the BT's ability to avoid preferences (via BC547). Under 547, once bankruptcy is declared, insolvency is presumed for a 90-day period
A second strategy would be to get BB to guaranty the loan - or sign as co-maker on a promissory note. This suffer from a similar threat: indirect preferences. The preference period is extended to 1 year for insiders (via 547(b)). Because BB is a director, he (and his family) count as insiders via 8C101(31). If Boscorp were to payoff the loan within the preference period, it would preference the guarantor (BB). As a result, a guaranty would extend the period in which we need to be concerned about bankruptcy. It's difficult to forecast one year ahead. A promissory note would raise the threat of it being classified as a fraudulent preference (as far back as 2 years) under 8C548/UFCA). However, the burden of proof for FC is pretty high (and OB has a good faith belief in BB and Boscorp's solvency), so FC is a lesser concern.
Third strategy: negative pledge clauses
2) BB's personal situation
BB's proposed cross-guaranty of his personal loan poses the same problem as the guaranty on Boscorp's loan - the danger of preference.
C) Proposed Solution for OB - refinancing
OB should take several aggressive measure to reduce its risks.
First, it should ask Bancorp and BB to open depository accounts at OB - and to transfer any assets at other banks to the OB account. OB should consider a minimum balance requirement . Although the right to setoff (via 9-340) can be treated as a security intereste (and therefore subject to the 90-day preference period), it would give OB early access to BB and Boscorp's assets pre-Bankruptcy, and even in the event of bankruptcy, it would establish a security interest that could survivie (if outside of the prference period).
Second, it should try to secure a guaranty from a non-insider - possibly a trusted friend or even investor in Bancorp. As long as the person is not a family member or officer, it will avoid the insider extended preference period .
Third, it should establish small security interest - to establish first-lender exclusive priority. If the financial situation improves, then OB can extend future advances on this collateral. Thisi s a minor component of protecting the bank - but important for establishing priority against other banks. Plus, default in 90 days is unlikely - but hard to say over the next year. If possible, OB should find a way to make this a "contemporaneous exchange of NEW value" (8C547(c)) - in which case it would avoid the preference period entire. BB would have to offer some additional consideration - perfecting the loan would not be enough on its own.
Fourth, to compensate the bank for higher risk, it should consider higher interest payments.
Sixth, to avoid the possibility of future secured interests in BB and Bosco's assets, OB should demand a negative pledge clause and restrictive covenants as part of the refinancing. A letter of credit would be a back-up option.
Fifth, as a desperation move, the Bank could accelerate the loan under 1-208. BUT, this option is not currently available - because we lack a GF belief in impairment.
Sixth, for BB's personal loan, OB should ask for a larger cash downpayment (via refinancing). A personal guaranty is unadviseable because of the concern about insider preferences. An accelleration clause would also be wise.
In the event that Boscorp. (Corp) becomes insolvent, Orange Bank (OB) faces the avoidance powers of the bankruptcy trustee (BT). BT can assert all property rights of Corp under 541. In addition, BT's strong-arm powers under 544(a) allows BT to avoid any transfer of property that could have been avoidable by a hypothetical lien creditor or BFP. In the event of insolvency, OB faces different risks if it uses new security interest to refinance versus using a form of guaranty. The potential legal risks are discussed below.
New Security Interest (SI)
In the event of Corp's bankruptcy, if OB takes a SI in some of Corp's assets, then OB faces risks of voidable preference under 547(b) for any payments received within 90 days of the bankruptcy filing. 547(b) preference first requires that the payment to OB is considered a transfer under 101. Clearly, any payments to OB is considered a transfer, and the transfer is for the benefit of creditor (OB). In fact, even if Corp pays off loan for the benefit of B, it may still be considered an indirect preference under 550(a)(1) and BT can recover the transferred property either from Corp or from B (since B was the person for whose benefit the transfer was made). Next, 547(b) requires that the transfer be made on account of an antecedent debt. Any payment to DB for the loan is payment for antecedent debt. These payments cannot be saved under 547(c)1 exception of contemporaneous exchange for new value. However, perhaps DB can argue for application of 547(c)(2) that this payment is in the ordinary course of business. But, this argument is weak if payment was made within 90 days of filing, particularly since Corp is technically already in default of its previous loan (and thus requires this refinancing scheme). Unlike paying a utility bill, paying off this loan to DB would not be considered ordinary course of business. Third, 547(b) requires that payment to DB be made while Corp was insolventinsolvency is presumed if payment was made within 90 days of filing. Fourth, the payment must give DB more than it would have received in a chap 7 liquidation. Payments received due to a grant of a new Sl would give DB more than it would have received under chap 7 liquidation. This is a question of fact and depends on how much Corp's assets are worth in liquidation. However, the facts suggest that much of corp's value stems from its long-term accounts receivable and of commercial goodwill. If Corp enters bankruptcy, goodwill value will decline and accounts receivables may also decline. The value DB may received from a chap 7 liquidation of Corp's assets is questionable and thus may likely be less than if Corp pays off DB's loan. Thus, payment to DB may likely be avoided by BT under 547.
DB also needs to worry about stripping down the value of the loan to the value of the collateral under 506. Given that we are not sure how much corp asset's are worth, if DB is undersecured, and corp files bankruptcy, then DB's loans may only be worth the stripped down vaule of the collateral. DB must then wait in line with other unsecured creditors and file a deficiency claim for remaining money owed.
DB does not need to worry much about 548 fraudulent conveyance (FC) since refinancing has no intent to defraud and refinancing (lower interest rates and extension of loan due date) is receiving reasonably equivalent value in exchange.
To decrease the risk of 547 preference, DB can try to make sure that Corp does not file bankruptcy within 90 days of payment of DB's loan. DB can try to prop-up Corp for 90 days after all, 547 dates from the date of the bankruptcy filing. DB can also make sure to file the FS immediately and then quickly work out the details of SA. This way, the refinancing agreement attaches and perfects sooner. After all, transfer is considered to take place at the moment of attachment, 547(e)(2), provided that perfoection occurs within 10 days. DB can also have installment payments, rather than one lump-sum payoff of the loan. This may help prop up Corp, giving it more flexibility and liquidity to avoid filing bankruptcy in the event it faces financial difficulty. It also give Corp more time to wait for its long-term accounts receviables to pay and perhaps its goodwill will allow it to rehabilitate its businesses. If Corp can pay an installment earlier, DB will receive some payments before the 90 days period. When DB files the FS, it should make sure that description meet the detailed S.A. requirements under 9-203. The financing statement can say "all personal assets" of Corp. Lastly, DB should explore the possibility of refinancing loan as purchase money loan with PMSI. This way, payments to DB can be considered proceeds of inventory purchased and money received from the purchases may allow DB to qualify under 547(c)(5) two-point test. May also allow DB to benefit from 547(c)(3) that saves PMSI's perfected within 20 days of possession.
Getting a guaranty from Billie (B) is a good idea. B is unlikely to file chap 7 since personal assets currently have positive net value. B is also an insider and have better info and monitoring abilities. If Corp is on the verge of bankruptcy, B may be unwiling to guaranty the loan.
B's guaranty also avoids 547 preferences and the avoidance powers of the BT under 544. If B pays the obligation of Corp, then it is not a transfer of an interest of Corp under 547b. It does not affect the estate or what other creditors would receive in bankruptcy. Thus, if Corp files chap 11, then OB can call on B to pay the loan.
B's guaranty also avoids 362 automatic stay (stay) if Corp files Chap 11 bankruptcy. The stay prevents creditors from calling their debts and requires that bankruptcy court approve motions to life the stay. OB would generally need to prove that the corporate assets are unnecessary to the reorganization of the Corp. If B guarantees the debt, then OB can avoid this and call on B to pay.
The question that does arise is whether B is accommodation party if he co-signs the promissory note. It can be argued that B gains no benefit from this refinanicing agreement. However, B is the sole owner of Corp and may potentially benefit. In addition, he freely exercised his right to contract and agrees to guaranty the loan.
Lastly, while the relationship between B and Corp is closely connected, Corp is a separate legal entity and unless B files for personal bankruptcy, a guaranty is a good idea.
The cross guaranty is interesting. It may raise 548 fraudulent conveyance (FC) issues. If Corp guarantees an old personal loan made to B, at the same time that B personally guaranteed a new loan made to B, it may raise questions of FC in that Corp is transferring property without receiving reasonably equivalent value in exchange. However, it would be hard to establish FC since 548(a)(1 )(B) requires that not only must Corp have received less than reasonably equivalent value, Corp must also have been insolvent on the date of transfer (and Corp is unlikely to be insolvent before refinancing agreement is negotiated) or Corp became insolvent as a result of such transfer (also unlikely since Corp is guarantying the loan and not making any payments).
Cross guarantying the loan may raise questions of insider status and may allow 547 preferences to extend to a 1-year period. Thus, not only would the above analysis on 547(b) apply, but it may potentially extend the BT's avoidance powers to 1 year within filing.
I will proceed by examining each of the proposed devices for how to structure this refinancing and the risks imposed by each in the event of insolvency by either Boscorp (Bos) or Bosco (B). In general, applicable to all of these options, Orange Bank (O) needs to find out with whether Bos is close to insolvency. The facts state that this answer turns on long-term assets and commercial goodwill which are hard to assess, and this indicates that Bos probably does not have a large amount of liquid assets, indicating that in terms of current liabilities, it may be close to insolvency. I think that first, O needs to find out the actual financial situation of Bos, perhaps getting permission to look at its accounting records, or have poermission to have someone monitor the assets periodically in excahnge for reductions in interest rates and the extension on the loan. In other words, depending on how close ti is to insolvency, this migth fall within the preference period if Bos files for bankrutcy, potentially placing O's interest at risk.
Security interest in Boscorp's assets
The highest risk in terms of gaining a security interest (SI), is if there is a senior secured party that would have priority over O with respect to these assets. First, O may search under the state filing system to see if anyone has a perfected SI in these assets. However, if the assets in question are accounts, or something that would auto-perfect under 9-309, there would not be a FS. Thsi would also be the case if the assets were inventory or equipment, the purchase of which was secured by a purchase money security interest. Under 9-210, O may ask Bos to get an accounting, a record authenticated by the debtor of what is covered. If Bos claims that some of these Sis have been fulfilled it can request a termination statement under 9-513c. Perhaps, 0 may enter an agreement with prior secured parties for them to subrogate their interest to O's, or have Bos pay them to do so.
In terms of bankruptcy, O must make sure it perfects or files immediately so the trustee may not avoid by stepping into the shoes of a lien creditor under 544a. In terms of valuation, O may wish to have an estimate of the worth of the assets in a foreclosure sale, in case this might be how the assets are valued under 506 (Which would be the amount that O could get toward its security interest before the reamining amount is added to the line of unsecured creditors). This security interest may also pose a problem with respect to bankruptcy if it falls in the preference period of 90 days with respect to fraudulent conveyances. Under 517b, if Bos is in fact insolvent at this time, granting a security interest in its assets so as to secure its previous loan from O may constitute a preference because it would entitle O to more than it would get under a chapter 7 liquidation in which O was unsecured .assurninq there are other creditors). I think, however that this may fall under an exception of a contemporaneous exchange for new value, because we are told that Bos is getting lower interest rates and an extension. If lower interest rates constitute value, this would not fall under a preference. Perhaps O could extend further credit to Bos in addition to the lower interest rates so as to insure that this would not be a preference, and would in fact fall within the exceptions. Furthermore, if Bos is actually insolvent, this might be a fraudulent conveyanceunder 548 because a security interest might constitute a a transfer in interest in property, becuase it is giving O a secured interest in its assets, because giving a lower interest rate or an extension on a previous loan may not constitute "reasonably equivalent value."
However, I think this falls outside of fraudulent conveyances because Bos is only liable for the actual extension of credit that it received from O, and not any more.
Personal Gurantee from Bosco on co-signed promissory note
In the case of a personal guarantee in the form of a co-signed promisory note, this would enable O to go after B as the guarantor if Bos went into bankruptcy. As a holder of the promissory note, O would be entitled to the payment of the note from B as a accomodating party under 3-419 and 3-116. B would probably be able to best monitor the funds of Bos as an insider of the corporation as its single owner. However, B can preserve suretyship defenses against O, perhpas if O fails to preserve a claim against Bos, for example, by selling the promissory note, and would not be able to go after B. However, O may wish to have B waive it suretyship defenses in the contract and, under Pentax, may wish to make this agreement clear so that this is no question that B is the guarantor and has waived his suretyship defenses. In addition, if B qoes bankrupt but Bos is not, as the holder of the promissory not O may still enforce it against B, si this method hedges O's bets all around
Furthermore, although B is considered an insider under 101 as a owner of the corporation for purposes of 547, this would not constitute a preference under 547b because a guarantor would not make any of the other creditors worse of, and this is not a transfer in the interest of Bos's property, it is of B's property.
This proposed device is perhaps the most risky for O. I think that first, if this is not "reasonably equivalent value," if the loans are not for an equal amount, then this could be a fraudulent conveyance under 548. This assumes that Bos is actually insolvent at the time. Furthermore, eVen if Bos was not insolvent at the time, this is risky because as an insider, discussed above, this loan may fall under the exception of 548(a)(B)(IV). Such a loan does not seem to be in the ordinary course of busienss, this is no indication that B does this regularly for Bos or is in the business of doing so. Therefore, if the loan is not for reasonably equivalent value, then this would be a fraudulent conveyance. Furthermore, if Bos were to go bankrupt, O would not compete with B as another creditor in the mix during bankruptcy, and there would potentially be fewer funds available for O. Overall, I would not recommend this provision, but I would recommend the previous two with the additional safeguards discussed above.
UCC style approach
The strongest argument for a UCC style approach, which incorporates a fairly complex framework for allocating and shifting the burden of fraud and loss is that intuitively, different parties to these types of transactions are better situated to guard against fraud. For example, person to person intermediaries and the like who conduct business online are better able to prevent loss do to intrusions by hackers who acquire customer information through security breaches in there software or hardware, etc. By imposing the burden for loss due to fraud and theft on the service providers, we can ensure that the programs will be as safe and secure as is technologically or economically feasible. We will also ensure continued advance and development within the industry to ensure greater safety as the technology develops and changes. If consumers bore the burden of loss, there would be a lot less incentive for providers to improve security (although they would have to worry about losing a critical mass of customers, who would we more wary of transacting will such services. The cost-benefit analysis, however, would be different).
As with the case of imposters, fictitious payees, and fraudulent indorsements by trusted employees, however, there may be certain situations in which it's best to impose to burden on the customer. These will be cases in which the customer's negligence leads to the loss, such as when they fail to inspect the bills they pay to make sure they are legitimate and that they actually made the purchase, or they fall for obvious phishing schemes, or use easily hackable passwords or write them down on pads alongside their computers, etc. The problem with this, of course, is distinguishing those cases in which the customer should be liable for negligence and those in which they should not. A password could be stolen in many different ways and it's not always clear how it was done. For example, the thief may have hacked the provider's database. Alternately, the user may have used a public terminal containing spyware that tracked key strokes. Or the password could have been stolen by a family member or visiter to one's home who found a list of passwords. So it's not clear how a strict liability regime for negligence would work here. A better approach might be to impose the burden on the provider unless the provider can prove negligence, as in 3-406.
The biggest drawback to a UCC-style approach here is that the systems to be regulated are used primarily by consumers who are unlikely to either understand or even be aware of its complexities. Even the UCC seems to acknowledge this fact when it subordinates itself to laws designed to protect consumers or permits courts to apply common law doctrines in consumer cases but not in commercial cases, e.g. the effect of cross-collateralization on PMSI's.
For this reason, it might be preferable to adopt the approach of something like the Truth in Lending Act, which is extremely generous to consumers.
TLA style approach
The chief benefit of the TLA style approach from the consumer's point of view is its simplicity and generosity. The consumer would be liable for only a nominal amount of any fraudulent transactions. This would have the benefit discussed above of forcing the industry to maintain the economically most efficient standard of protection, while protecting unwary consumers from the statutory subtleties and traps to be found in things like the UCC.
The are at least three problems here. First, it's difficult to say when fraud has taken place. This is because the customer gives the intermediary authority to charge its account, either contractually or through by implication. Any scheme designed to deal with this will have to find a way to ensure that the transactions are authorized. This might be done through electronic signatures or pins or maybe even electronic finger printing. It would probably be too costly to require telephone approval, except for perhaps large purchases. Perhaps the intermediaries could require users to have independent email addresses to which confirmation requests could be sent.
The other problem is the effect such a regime would have on this nascent industry. Visa and Mastercard and establshed entities that can afford to bear the cost (as evidenced by their decisions to do so voluntarily in the case of debit card fraud, for which consumers might otherwise be liable in their entirety if they wait long enough). Person to person intermediaries and the like, while profitable, may not be able to bear the costs to such liability or have to price themselves out of competition to absorb it. This is especially true of Internet transactions, where fraud is much more pervasive than in over the counter credit card transactions.
A final problem is the incentive such a regime might have on consumers. It would seem to encourgage negligence. Nor is the experience of the credit card industry wholly on point here. There are much greater opportunities for fraud with these types of transactions, which aren't face to face and don't require the physical possession of a card, etc. Limiting liability to some nominal amount may encourage consumers to ignore various schemes to defraud them of their user information and to fail to develop the sophistication to avoid them if they aren't going to cost them much.
The final possibility is to leave these systems to a pure contract approach. This has the advantage of much needed flexibility particularly when it comes to emerging technologies with which even the legal experts responsible for drafting things like the UCC have little experience and whose future trajectories they cannot begin to predict. While the UCC leaves much to the design of private parties (witness 4-103, etc.), there is the risk that the default rules that set will influence the development of the technology for the worse. As in the common law approach, it is probably best to sit back and watch as private parties hash out the kinds of terms they want in such contracts and to reconsider codifying the law once some superior approach emerges from among its various alternatives.
The problem with this, however, is that the users, again, are consumers, who lack the bargaining power to get the terms they might want. If we leave the development of the law here to contracts between users and the intermediaries, we will almost certainly end up with lopsided agreements and adhesion contracts that invariably favor the providers.
It might be responded that the threat of legislation and competition for users may temper this possibility. If the providers do not give the users something, the government might step in an set terms like the TLA or competitors might start offering users better terms and the stingy provider will lose customers.
In all, however, I would probably recommend the second approach, given that the customers are consumers. Of course, such an approach might not be political popular and we may get something like the EFA.
In order to choose a regulatory framework as efficient as possible, two questions should guide the analysis: how can burdens be placed on the least cost-avoider? How to allocate benefits to the greatest benefit enjoyer? These questions should be answered while keeping in mind that certain conditions are necessary to allow these new payment systems to develop. The problems mentioned should of course be addressed and the regulatory framework chosen should give maximum incentives to reduce the risks of loss, error, fraud and general confusion, but related issues should be also be taken into account: to flourish, these new systems must enjoy a broad market penetration to increase liquidity as much as possible, which means that convenience and ease of use for the customer should be maximized. This goes beyond the mere desire to avoid fraud and errors. Additionally, finality of payment rules should be as clear as possible so that merchants are protected, which will also increase liquidity.
1) Legal framework similar to the current check regulations
The regulations addressing check fraud and mistakes are extremely detailed and try to identify the party most reponsible for the problem and allocate the loss to that party. This seems to be a very good system in terms of placing the burden on the least cost-avoider and the party better placed to avoid the fraud or loss, but it does not put much emphasis on giving the benefits to the greates benefit enjoyer: while the bank is usually the best party to amortize the loss, this system rules for example that customers should bear at least part of the loss if they contributed to it for example (cf. contributory negligence in 3-406).
In addition, an argument can be made that even though a party can sometimes looks like the better placed to avoid the fraud, this is not always the case in practice: the requirement that customers inspect their monthly statements and report unauthorized payments in a reasonable time but no more than 30 days seems sensible but runs against the fact that a significant number of customers do not read their statements.
This system can also be seen as irrational at times as some rules make fine distinctions based on unclear policy: 3-404 for example imposes negligence per se on the customer in case of impersonation, but it is not clear that the customer is the best party to avoid such an issue. The same goes about 3-416 and 3-417 which rule that a forged check breaches the transfer warranty but not the presentment warranty, and result in a situation where the payor bank must bear the loss if it fails to dishonor the check, but can pass it up to the first payee if it does disonor the check. Maybe such inconsistencies result from the fact that these rules are products of a long history and tried to codify a well-established common law tradition which developed on a case-by-case basis. There may be hope that a regulatory system designed from scratch for new payment systems may be better thought-out and more logical, but inconsistencies may be unintended, and only result from the fact that numerous and complicated rules will result in unintended consequences.This issue may be compounded by lobbying interests which may manage to influence the system in their favor, all the more because they may take advantage of the fact that the consequences of changing certain rules may not always be clear to the regulators.
In addition, this system would probably be seen as terribly unclear by customers which would be very warry of using it: this would do nothing to alleviate the current general confusion among customers and it would hurt the market penetration of these new systems. If all parties had centuries to learn the rules applying to checks, this would not be the case for a new regulatory system designed to cover new payment technologies.
Finality of payment is also uncertain when the customer has the right to stop a check and such a rule would not help to incite merchants to use the new systems, and would hurt liquidity.
2) Credit card framework
Such a system in based on bright-line rules which are very protective of both customers and merchants as the credit card company bears the loss when there is fraud, loss or unauthorized use. Provided that a clear system is devised so that customers know very clearly when they authorize a transaction, such a system provides maximum protection to customers and merchants and favors strongly market penetration and liquidity while giving powerful incentives to payment systems companies to take steps to reduce fraud and mistakes. These companies are often in the best position to do so as fraud can be due to defective/unsafe technological systems which should be fixed (made less confusing and safer), or to unauthorized acts of their employees. In addition, these companies are in a better position to go after the wrong-doers as they are better placed to indentify them and have more means and experience to litigate against them. An argument could also be made that payment companies should be responsible for payments authorized by customers when their payment systems contributed to confuse the customers and made them authorize payments when they did not intend to do so. This would provide a powerful incentive to the payment system companies to devise a better system.
Such a regulatory scheme may face resistance from the new payment systems because it was originally design to cover only credit transations and it would now apply to both credit and debit transactions, with a potentially much broader customer base and revenues based on completed transactions. It should be possible however to let payment systems companies decide to use credit only payment scheme when they think that this is necessary to protect their business model.
3) Freedom of contract framework
While an argument could be made that rational customers and payment system companies would agree on superior methods of allocating the risks between them, such an argument runs contrary to the fact that the payment system companies have powerful incentives to spend a lot of time and effort to design contracts in their favor while customers will not do so, and will also have a much lower understanding of the rules implemented. In addition, the protections offered to customers under unconscionability and mistake can be difficult to define as the string of cases litigated against banks for unconscionable fees show. The line between unconscionability and acceptable business practices can be blurry and this results in unclear rules because of litigations, which often lead to regulations to clarify the points in dispute, which defeats the purely contractual framework. Such a system would therefore be unlikely to lead to placing burdens on parties best able to address them, and giving benefits to parties most able to enjoy them. In addition, it would add to the general confusion and distrust of customers who would have to adjust to always changing rules which would differ from one provider to the other, and there is no guarantee that merchants would be able to enjoy a clear finality of payments.
The credit card framework seems therefore the most apt to reach the goals defined above: place the burden to avoid the issues of errors, confusion and fraud on the party best able to address them, the payment system providers, while protecting and giving benefits to the parties who will the best take advantage of them, the customers and the merchants, who will be very protected and will enjoy clear rules applicable across the board. However, adopting such a regulatory scheme would probably have a major impact on the kinds of payment systems being developed and offered as payment systems providers may try to screen their customers and maybe favor credit versus debit payments
Question 3, Answer 3 (532)
The following memo addresses fraud, foregery and mistake complications for Internet payment transactions and direct debit trasactions, proposing three models of reform to consder. One important factor to consdier is that such models developed over time and in specific response to those systems of payment. For Internet trasactions, it may be premature to adopt a comprehensive regulatory framework, as the market is currently in disequilibrium and it is unlear whether popular systems today like PayPal will dominate the market in the future or whether consumers will continue to provide bank account information. Thus, it is important to retain some flexibility in whatever regulatory scheme is adopted.
Advantages and Disadvantages of reform
1. UCC Article 3 & 4 Model Reforms
Articles 3 and 4 provide extensive protetions and risk allocation system for foregered instruments and fraud. They are often consumer friendly, which is something that would please your contingency greatly. For example, the rules regarding forged insdorsements would work particularly well. Under 3-403 an unauthorized signature is generally ineffective. If we required systems such as PayPal to have online signatures/authorizations, for example via a special code, then any atempt to use an electronic payment that did not have such a signature would be invalid. Similarly, an authorization rule would not alienate the business constituency if we also included a negligence principle similar to 4-406. That section provides that a person whose failure to exercise ordinary care contributes to an alteration/forged signature, is precluded from asserting an alteration against a BFP. In the context of direct debit transactions, consumers who left their bank pin codes out and availalbe, or used "remember my password" functions on public or office computers, then would be subject to the negligence principle of 4-406. Articles 3 and 4 also protect the financial sintutituions through presentment warranties. If similar rules are adopted for PayPal and direct debit transactions, then we would be including protections for the payment system.
There are several key disadvantages to adopting this model. The Article 3 and 4 models were designed with banks in mind. Banks were under extensive federal regulation already, and are centralized entities with a specialization in dealing with large accounts. By contrast, PayPal and other electronic payment systems are fairly new and decentralized. Much of the fraud in such electronic systems occurs not at PayPal itself, but by interception of electronic transmittal or by direct solicitation of information from consumers using "imposter" software, commonly known as "phising." Thus, even if consumers are careful with their passwords, a sophisticated hacker could create an email webpage similar to a PTPI and prompt a consumer for his or her sensitive login information. In such cases, we would need to develop alternative means of protecting consumers beyond the protections that Articles 3 and 4 currently offer.
2. Credit Card Model
The credit card model presents an attractive option also. Sections 1643 and 1666 of TILA chargeback provisions are advantageous to consumers, as they allow a cardholder to avoid liability in excess of $50 and to chargeback payments, subject to certain restrictions. The model also has protections for the merchant and credit card companies, as cardholder negligence can offset liability and cardholders are required to engage in monitoring of their charges to receive the benefits of TILA protections.
The disadvantge of such a regime is its vagueness. In particular 1666 chargeback rights provide that a cusomter can only charge back if they buy from somebody whose place of business is within the same state or within 100 miles of the consumer's residence. Because we are dealing with Internet payments, the georgraphic location of the transaction is unclear - it could either be the buyer's living room laptop or the seller living in American Samoa. One remedy may be to eliminate the geographic restriction and allow charge back as long as the other requirements (goodfaith oblgiation, in excess of $50, etc) are met.
3. Freedom of Contract Model
This model may be more attractive to the Internet merchants using direct debit and PTPI systems than to the individual consumers, whose interests prompted this subcommittee investigation in the first place. The freedom of contract model does forward the policy goals of autonomy and freedom. By agreeing to engage in purchases over the Internet, which is notoriously subject to intrusions of privacy and fraud, a consumer could considered to bear the risk by sending their information out over a public network. Consumers who purchase over the Internet are arguably more sophisticated than the genreal population, and can and should be on notice of potential fraud. There are also several existing mechanisms to put consumers on notice of the security of a website for purchase: the size and popularity of the business, the web address "https" versus "http" and the general professional appearance of the website.
Moreover, If such a model were adopted, we would be able to accomodate the differences within the consumer constitutency. Some consumers frequently purchase over the Internet and may want to bargain for a long-term relationship with a service for direct debit, with an online grocery delivery service FreshDirect. On the other hand, other consumers may be willing to accept a boilerplate contract if they do not contemplate purchasing over the Internet frequently.
However, a freedom of contract model has several disadvantages and it may create traps for the unwary consumer. In such sales, the contract would ostensibly be drafted by the payment provider for a mass market and the consumer would only have two options: accept or reject. In anonymous transactions, there is a limited possibility that the consumer would be able to renegotiate for better terms with a payment provider or that they would even want to, as one of the major reasons consumers even do Internet purchases is for convenience and speed. In such situations, we may also become concerned about the risk fo the merchant or PTPI taking advantage of the consumer through procedurally or substantively unconscionable provisions. We would also have to be concerned about employee fraud, especially in the context of direct debit trsanctions, where the merchants or their employees could potentially have access to large bank accounts.
Furthermore, the advanages of the freedom of contract model would not be lost if we were to begin with a requlatory framework or default rules and then allow sophisticated parties to alter the rules to their needs. The UCC already provides such a system, as it allows the parties to vary rules by agreement under 1-102. Especially because such transactions occur on a wide scale, it may reduce transaction costs to have default rules ex ante, rather than to resolve disputes ex post thorugh litigation over the specifics in each different contract.
Before adopting one of the above models, or a combination of them, it is necessary to determine which constiuency is the most important. Some of the reforms benefit consumers and other merchants or PTPIs. In some cases, merchants and consumers may overlap, in the case of eBay, so what ever system is chosen must balance the needs of the parties and avoid creating disincentives for th econtinued use of such payment processes.