Fall 2001 final exam (Secured Transactions)
Top student answers
Note: These were among the best answers received under examination conditions. They are not model answers, in that they all contain extraneous material as well as omitting useful information. Some even reach incorrect conclusions. However, they all provide intelligent, organized, approaches to the questions.
Question 1: Answer #1
The first part of this advice will discuss which factors Second Bank should take into account when deciding whether to lend to Lemon at all. The second part will discuss which precautions Second Bank should take if it decides to lend.
A. To lend or not to lend.
a. The most important factor is Lemon's creditworthiness. Second Bank should analyse what the chances are that Lemon will eventually pay back the loan. Getting paid is always better than having to use the precautionary measures (like the foreclosure of security rights) discussed below. It appears that Lemon's creditworthiness depends largely on the outcome of the Chemtron litigation or settlement. It would be important for Second Bank to check Chemtron's creditworthiness, too. Are there any other claims against it that could lead to its bankruptcy? A huge claim against an insolvent debtor is not worth much.
b. In addition, Second Bank would be more willing to lend to Lemon if First Bank does not have a valid and perfected security interest in the Chemtron receivable, In that case, Second Bank could take a first priority security interest itself. This would reduce its risks vis-a-vis Lemon at the expense of First Bank.
At first glance, however, it seems that all requirements for attachment and perfection of a valid security right under Art. 9 have been satisfied: the partners and the firm signed security agreements, First bank filed a financing statement covering accounts receivable and proceeds and First Bank made a loan to the firm.
However, one could make the following arguments:
(i) the receivable is not an "account" within the meaning of Section 9-102(a)(2) and as mentioned in First Bank's financing statement. First, the receivable is contingent on a factor outside of the parties' control. The firm does not yet have rights (nor the power to transfer rights) in the collateral (9-203b)(2) and First Bank's security interested has not yet attached. The security agreement refers to "the fee receivable" and does not seem to contain an after-acquired-property clause, It is not entirely clear, therefore, that the security right will attach to the receivable once it comes into being.
(ii) The receivable may be an interest in a commercial tort claim (as defined in 9-102(13)). Commercial tort claims are excluded from the definition of accounts and in that case not covered by First Bank's financing statement. If Chemtron pays a part of the claim directly to Lemon this may indicate that the receivable is in fact an interest in a commercial tort claim.
(iii) The financing statement only mentions the firm as debtor (and not the individual partners). Pursuant to Section 503 (1) jo. Comment 2, this should be sufficient. However, one may argue that either LM&N as such no longer exists (particularly if it is dissolved), or that the name of the firm has changed since Lemon quit. In that case, Section 507 may help Second Bank. c. Another factor is the extent of Lemon's liability for LMN's obligations. Although I am not so familiar with US partnership law, it seems that — in addition to the firm- all partners are jointly and severally liable to First Bank for the entire loan and probably for all other partnership obligations.
If Lemon has to pay First Bank, she would be entitled to reimbursement by the other partners for their shares. Therefore, Second Bank should also consider M&N's creditworthiness because they are important potential debtors of Lemon.
d. Another factor is the outcome of the M&N litigation. Clients are free to choose their lawyer. The chances that a court would order Lemon to stop representing the clients are therefore small. Having said this, the clients may decide to leave Lemon and retain another lawyer if they please. M&N's claim to a full share of the Chemtron receivable has a higher chance of success (see below under B.).
e. If LMN is dissolved, Lemon would probably be entitled to 1/3 of the partnership assets. She may even claim that she is entitled to a part of the clients of the firm and outstanding receivables (to the extent not covered by First Bank's security interest) and the 50 K account balance. However, this balance is most likely subject to First Bank's general terms and conditions (if any) that would provide for a security interest therein or a right of set-off.
a. First of all, Second Bank should be aware that the measures mentioned herein have a cost to Lemon. If they ask too much, Lemon will probably go to another lender.
b. Second Bank may make its loan conditional upon Lemon settling her dispute with i...—~ M&N first. That will take away insecurity and will help Second Bank to assess the ~ risks. Furthermore, litigation is costly and time-consuming. In addition, Second Bank will thus avoid a potential tort claim for intentional interference with contractual relations, namely by benefiting from Lemon's breach of the negative pledge contained in the partnership contract.
c. Second Bank may want to get a security interest in (Lemon's stake) of the Chemtron receivable. If First Bank's security interest is valid and assuming there are no other security interests or liens on the receivable, this will be a second priority security interest. However, if the receivable turns out to be large enough, First Bank will be oversecured and the balance will be subject to Second Bank's security interest.
d. Second Bank could also negotiate a subordination agreement with First Bank to get first priority.
e. With a view to Lemon's creditworthiness and her liability for the obligations of the (soon to be dissolved) firm, Second Bank would want Lemon to represent what the firm's liabilities are. Second Bank would also want Lemon to covenant to maintain insurance for all old firm obligations and for any new claims. In addition, Second Bank could of course raise the interest rate to make up for any additional risks.
Question 1: Answer #2
As counsel for Second Bank (SB), I recommend that it lend to Lemon, provided that it takes adequate precautions.
The existing priority arrangement breaks down as follows. First Bank (FB) has a v perfected security interest in LMN's accounts. §9-102(a)(2)(ii) defines "account" to include rights to payment "for services rendered or to be rendered," which includes the fee receivables from the Chemtron case, and §9-310(a) permits perfection of a security interest in accounts by filing. Since FB's security agreement describes only the fee receivables from the Chemtron case as collateral, FB's security interest is limited to those receivables in particular, notwithstanding the broader description in the filing statement. FB also has a perfected security interest in LMN's $50,000 bank account at FB, It has control over this account under §9-104(a)(l) and thus has attached (§9-203) and perfected (§9-314(a)). Pursuant to §9-327, FB will have priority in this account over competing creditors.
It is important to note that LMN is a partnership. To the extent that each partner has an interest in FB's collateral — as a partnership or as individuals — each is liable. The fact that Lemon has left the partnership and created his own practice does not extinguish his liability on the $300,000 loan from FB. When he left the firm and took Chemtron with him, he took FB's collateral with him. Under §9-203(d)(1), even though a new "person" becomes bound as debtor, FB's security agreement is still effective. Under §9-508(b), the filing statement also remains effective. FB therefore has a perfected security interest in the fee receivables from Chemtron even after Lemon left the firm.
FB's perfection in the accounts gives it priority over subsequent security interests in the same collateral (§9-322(a)(1)). Unfortunately for SB, Lemon's most substantial at this point is the Chemtron account. The Chemtron fees have a potential value of anywhere from $0 to $4M, and a likely value of $1 M, If they end up being worth $1 M, SB would have no problem collecting: after $250,000 was paid off to FB, $750,000 would be left to secure SB's loan. Of course, the outcome of Lemon's litigation with M&N will affect the value of SB's security, To the extent Lemon converted partnership property or pledged it without consent, she did not have rights in that property, and any security interest of SB would not attach under §9-203(b)(2). The effect would be to subordinate SB's security interest to any amount of the Chemtron fee receivables that Lemon had to pay back to M&N. A bigger problem, finally, is that the collateral is potentially worth nothing. It is risky for SB to lend Lemon an additional $300,000 without further protection.
Because Lemon's practice is young and most likely growing, it makes good business sense to lend to her nonetheless. Lending to her at this time will likely build goodwill and loyalty on her part, providing a future source of business for SB. Thus, I would recommend that SB lend to Lemon, but take several additional steps to protect its investment.
First, SB should take a security interest in all Lemon's fee receivables and proceeds thereof. Even though this interest is still junior to FB and M&N's, there are several advantages. First, it protects SB in the event that the Chemtron litigation generates fees closer to $4M than $0. Second, if and when Lemon gets any other clients, SB has a senior claim to the fee receivables. For additional protection, SB may require that Lemon notify all her clients (including Chemtron) according to the terms of §9- 406(a) that payment is to be made directly to SB.
Second, SB should take a security interest in Lemon's deposit accounts pursuant to §9-104(a)(l), §9-203, and §9-314(a). SB should require Lemon to open a deposit account at SB and then transfer the $300,000 loan to that account. SB could place all fees paid to them pursuant to the §9-406 notification directly in that account. If fees are paid to Lemon instead of directly to SB, SB can require that she place all the fees that she receives in this account. §9-327 gives SB priority in these funds over competing creditors. That priority would trump FB's security interest in the fees from the Chemtron litigation. To prevent Lemon from withdrawing the $300,000 in one large chunk and SB losing its protection, SB could also require that it pre-approve any withdrawals over a minimal amount. An interest rate discount and Lemon's need for capital should give SB the leverage to demand such terms.
Finally, SB must ensure that its security interest in the Chemtron fees attaches. Since both M&N and Lemon want to avoid the costs of litigation, perhaps the best way would be to negotiate a subordination agreement as a part of the parties' settlement arrangement. Any settlement, for example, could include M&N renouncing all interest in the Chemtron litigation. M&N would agree that Lemon obtained sole rights to Chemtron when she left the firm. In return, Lemon would agree to pay them a portion of any Chemtron fees that she eventually receives. §9-3 32 will protect M&N from any claim FB might have to Lemon's settlement payment as proceeds. (M&N are receiving property for the disposition of their interest in the Chemtron fees, which may constitute "proceeds" under §9-102(64)). FB will try to show "collusion" between Lemon and M&N in violating its rights, but this will be difficult to prove (according to Comment 8 of §9-332, "collusion" is the "least stringent" of the various standards found within the UCC.) This deal is beneficial for both parties because SB's security interest is protected, while M&N is guaranteed a portion of any fees from the Chemtron case and is insulated from FB should none materialize. Furthermore, even though SB could still receive less than its full $300,000, the other security it has taken, the potential future benefits it will receive from Lemon, and the protections of this arrangement should help compensate it for the risk.
Question 1: Answer #3
Security Interest of First Bank
Does Article 9 apply to this type of collateral, i.e. a contingent fee receivable? Under 9-109(d), Article 9 does not apply to an assignment of a right represented by a judgment and an assignment of a claim arising in tort, other than a commercial tort claim, It is probably safe to assume that the environmental claim does not fall within the definition of "commercial tort claim" under 9-102. However, the collateral between FB and LMN is not the underlying environmental claim but rather what LMN is entitled to at the end of litigation. Comment 15 notes that once a claim in tort has been settled and reduced to a contractual obligation to pay, the right to payment becomes a payment intangible and ceases to be a claim arising in tort. The collateral here is not simply the potential settlement or judgment but rather LMN's right to payment under the contingency agreement. One can therefore conclude that Article 9 covers a contingency fee receivable.
Next question is whether the collateral is correctly identified in FB's security agreement. Under 9-1 02(a)(2), "Account" includes a "right to payment of a monetary obligation for services rendered or to be rendered." The contingency fee seems to fall under this definition. The other possibility is that this is a payment intangible. 9-109, comment 15 indicates that a tort claim becomes a payment intangible once it is reduced to a contractual obligation to pay. A payment intangible is not an account. However, the contingency fee represents the value of the LMN's legal work rather than simply funds advanced or sold so it seems more accurate to classify this as an account. In any case, the inclusion of "other receivables" in the description of the collateral would most likely cover payment intangibles.
Therefore, the requirements of 9-203 seem to have been met. Value was given, LMN has power to transfer rights in the collateral, and the firm and each of the partners signed a security agreement. Filing is a permissible method of perfection for either accounts or payment intangibles and BF filed with the Secretary of State. Assuming the financing statement listed the FB as the secured party (9-502) and was filed in the state where LMN is located, FB is a secured creditor and would have first priority over any attorneys' fee in the environmental claim.
Security Interest of Second Bank
If SB made the loan to L, then what would be the collateral? Accepting the contingency fee receivable as collateral would be unwise for a couple of reasons. First, it is not clear that L has the right to transfer rights in the fee receivable. M&N argues that she does not. If L does not have the rights in the fee receivable or the power to transfer LMN's rights in the fee receivable, then SB's interest in the fee receivable would never attach under 9-203. This would leave SB in the position of being an unsecured creditor. Therefore if the only collateral for SB's loan is the contingency fee, this would be a pretty risky loan to make.
Second, even if SB does get a perfected secured interest in the fee receivable, it will be subordinate to FB and all other prior perfected secured creditors of LMN. Under 9-5 07, FB's security interest in the account would continue even if the case were taken over by L. So if the contingency fee ends up being worth less than whatever is due on FB's loan ($300K plus interest), then SB could end up with nothing.
One alternative for SB is to ask L to put up some other property as security, for example her home. Assuming that it is worth at least $300K and there are no other creditors (mortgages, etc.), SB would have a perfected secured interest in collateral sufficient to cover its loan. This would have an added advantage in that SB's interest would not be tied to the environmental litigation. L did sign a guarantee on the FB loan. Thus, there is the possibility that if LMN defaults on its loan, FB will go after L. However, FB did not file against L so it would be an unsecured creditor. Therefore, as long as SB perfects, it would have priority.
Forcing L to put up some of her own property would also create value in that it forces L to share in the downside risk of this loan. L is the least cost avoider in this case since she is the lawyer working on the environmental case. By putting some of her own property on the line, she signals her confidence in the environmental case and has an incentive to work harder to make sure she wins the case, or at least settles for enough so that SB will be fully paid back.
Another possibility is for SB to ask FB for a subordination agreement, as permitted by 9-339. Basically, SB would tell FB that it will not make the loan to L without a subordination agreement. FB faces a risk that its security interest in the contingency fee account will be worthless, or at least worth much less, if L stops working on the case. Since the environmental case is most likely worth $1M, meaning that there would be enough to cover both loans, FB may be willing to let SB get priority in order to preserve its interest in the contingency fee.
I would advise SB to either get a security interest in something other than
the contingency fee from the environmental case or a subordination agreement
from FB. If neither of those work, SB should require L to settle the partnership
litigation before it commits to the loan. M&N would probably be willing to
settle for enough to cover FB's loan, especially since they are guarantors, plus
a minimal profit. Based on L's interest in the contingency fee after the
settlement, SB would be in a better position to judge its credit risk.
Question 2: Answer #1
The first thing that needs to be sorted out is priority between Zippo and Commercial. Zippo's prior perfected security interest in Dragonfly's inventory and after- acquired property has priority over Commercial's security interest in the same inventory under §9-322(a)(1), To the extent that its loan financed Dragonfly's acquisition of inventory, Commercial would have priority under §9-324(b) but for the fact it failed to meet subsections (2)-(4). Accordingly, Zippo has first dibs to the new and used motorcycles on Dragonfly's lot. Assuming Dragonfly's breach of the negative pledge clause in its franchise agreement with Zippo constituted a default, Zippo has the right to —re-possess and re-sell this collateral in satisfaction of Dragonfly's debt, provided they stay within the parameters of §9-601 et seq. If that is what Zippo means by "terminating" ' Dragonfly's franchise, they are well within their rights as secured creditors.
Zippo is also perfected in Dragonfly's lease and installment credit contracts (ICCs) as proceeds of the inventory. The leases constitute chattel paper under §9-102(11). I do not know how ICCs work, but they may be similar to conditional sales contracts and thus are chattel paper under §9-102(11). If Dragonfly in fact maintains no security interest, the ICCs are likely instruments under §9-102(47) since they constitute writings that evidence a right to payment and appear to be transferred in the ordinary course of business. Chattel paper and instruments can be perfected by filing, so Zippo's security interest in these proceeds is perfected under §9-31 5(d)(1).
Because Commercial has possession of the leases and ICCs, it has priority in them under §9-330 notwithstanding Zippo's perfected security interest. Because Zippo claims the leases "merely as proceeds," and assuming Commercial purchases chattel paper in the ordinary course of its lending business, §9-330(a) gives it priority in Dragonfly's leases. Commercial gave new value, there is no bad faith, and there is no legend on the chattel paper indicating that it was assigned to Zippo, If the ICCs are chattel paper, the same analysis applies, If they are instruments, Commercial has priority under §9-330(d) since they took possession in good faith and Zippo perfected its interest in a method other than possession. Accordingly, Commercial appears to have a right to both the leases and ICCs. [NOTE: if the ICCs are accounts ("rights to payment for property that has been disposed of (§9-102(2)), then Zippo would maintain perfection under §9-315(d)(l) and priority because Commercial has no security interest in Dragonfly's accounts. Again, I do not know the mechanics of ICCs and will assume that they are instruments for the remainder of the question.]
Commercial's possession of the title certificates does not affect Zippo's priority in the inventory. §9-311 Comment 4 holds that perfection of a security interest in inventory follows the normal perfection rules. An inventory lender may not follow §9-311, 50 Zippo maintains priority under §9-322(a)(1). Furthermore, Zippo's litigation threats against Commercial are largely empty. The negative covenant between Zippo and Dragonfly is a contractual provision and unenforceable against third parties. Commercial hardly seems to have committed a tort. There is no evidence of Commercial's having converted any of Zippo's property or intentionally interfered with their franchise agreement. However, Zippo may be able to undo Commercial's priority in the leases and ICCs by arguing that Commercial took them in knowing violation of Zippo's rights in the same collateral. Under §9-330(d), this would undo Commercial's priority in the ICCs. Under §9-330(a), the language in itself does not raise this exception; however, as a policy matter, this argument is particularly strong. §9-330(b) allows this exception, and it seems odd that the absence of a legend under §9-330(a) would give free reign to a subsequent purchaser of chattel paper to violate another's rights therein. The comments to §9-330 indicate that "violating the rights of a secured party" will require more than knowledge of Zippo's prior claim. However, proof that Commercial received Zippo's warnings before they took possession or that Dragonfly informed them of the negative pledge during negotiations may work. To properly advise Commercial on this point, I need more facts.
The "lease" to Gray Wolfpack (GW) could indeed be a true lease under § 1-201(37). While more facts are needed, an option to buy in itself does not create a security interest. Furthermore, given the laws of present value, the option to buy for 85% of the remaining lease payments is not necessarily less than GW's cost of performing under the lease (and therefore nominal under §1-201(37)(x)). Assuming GW has a lease, Commercial's failure to perfect its interest in the motorcycles becomes a problem. Under §9-330(a), Commercial has priority over Zippo with respect to the chattel paper, but not with respect to the residual interest in the motorcycles (See In re Leasing Consultants). Because Commercial perfected its reversionary interest (either under §9-311 or by filing) after Zippo, it loses priority in these "goods." Thus, if Zippo's security interest and filing is deemed to cover such a residual interest, it will have priority over Commercial in the reversionary interest.
If the "lease" is instead a security interest, GW, as a "buyer in ordinary course of business" under § 1-201(9), will take free of Zippo's security interest in the motorcycles pursuant to §9-320(a). Zippo will have to fight Commercial for the proceeds of this sale. Commercial, however, will be fully perfected in this case and will have priority over Zippo to the lease payments and reversionary interest from GW.
Whether GW has a lease or a security interest, once GW files for bankruptcy, Commercial will be stayed under §362 from collecting lease payments. Commercial could try to get this stay lifted under§362(d) — perhaps they can argue that GW has a silly business plan and will not be able to reorganize. But this is unlikely given that motorcycles are surely "necessary to an effective reorganization" under §362(d)(2)(B). Pursuant to §541(b)(2), however, GW's estate will include only its leasehold. The reversionary interest is not part of the estate, and whoever has priority in it may be able to recover the motorcycles nonetheless (see §365).
Question 2: Answer #2
Commercial Bank (CB) v. Zippo (Z)
It is clear from the facts that Z has a perfected security interest in Dragonfly's (D) inventory of motorcycles, including after acquired property. Presumably, it has met the requirements for creating an enforceable security agreement under 9-203 and it has met the requirements for perfecting under 9-3 10 and 9-3 12 (more below). Although perfection for security interests in collateral subject to certificate of title laws is generally not allowed by filing, section 9-311(d) makes an exception when the collateral is part of inventory as it is here. We can also assume from the lack of contradicting facts, that Z's financing statement met the requirements of 9-502 and 9-516 and was accepted. Lastly, it is also apparent that Z has a perfected security interest in the proceeds of inventory covered by his financing statement. Section 9-315 provides for continuing (as opposed to a temporary 20-day) perfection of a security interest in proceeds of inventory so long as (1) a filed financing statement covers the original collateral, (2) the proceeds are collateral in which a security interest may be perfected by filing in the office in which the financing statement has been filed, and (3) the proceeds are not acquired with cash proceeds. Conditions (1) and (3) are easily met in this case, and condition (2) is also met because the lease and installment contracts---both proceeds of inventory and both the subject of the present dispute---are chattel paper under 9-102(11) and therefore can be perfected by filing under 9-312(a). The inquiry does not end here, however.
Under some conditions, section 9-324 allows a perfected purchase money security interest and an accompanying security interest in proceeds of the PMSI collateral to trump a preexisting security interest in inventory. Specifically, 9-324(b) allows a PMSI to trump a security interest in inventory provided that, inter alia, the purchase-money secured party sends an athenticated notification to the holder of the conflicting security interest. Because CB has not sent Z such a notice, it's PMSI does not trump Z's security interest in inventory. However, since CB has presumably met the requirements of 9-203 and 9-502 and other applicable attachment and perfection statutes, it does have a perfected security interest in the used motorcycles, albeit a security interest subordinated to Z's.
Although CB's PMSI does not take priority over Z's security interest in inventory, it likely does have priority with respect to proceeds under 9-330. Section 9-330 allows a purchaser of chattel paper to obtain priority over a security interest in the chattel paper which is claimed merely as proceeds of inventory subject to a security interest. However, the following statutory conditions must be met: (1) the purchaser must give new value and take possession of the chattel paper in good faith and the ordinary course of his business, and (2) the chattel paper cannot indicate that it has been assigned to an identified assignee other than the purchaser. These conditions appear to be met here. Z's only claim on the chattel paper is as proceeds of inventory subject to a security interest, and CB qualifies as a purchaser (1-201(32)) who gave new value and took possession by keeping the chattel paper in a lockbox. Specifically, he loaned D money to purchase the used motorcycles and in return received, inter alia, a property interest in the chattel paper in the form of a security interest in the proceeds of his collateral. Moreover, there is nothing in the facts to indicate that CB acted in anything other than good faith and ordinary course, nor is there anything to suggest the chattel paper indicated it had been assigned to an identified assignee other than the purchaser. Under 9-330 (which allowed CB to trump Z's security interest in the chattel paper) and 9-324 (which gave CB a perfected security interest), CB appears to have a perfected security interest in the lease and installment contracts and takes priority over Z's interest in those items.
CB v. Gray Wolfpack (GW)
The threshold question regarding GW's leases is whether they are true leases or financing leases. Section 1-201(37) lists a number of factors used to determine whether a lease passes the economic risks and benefits of ownership to lessee and should therefore be treated as a sale. On the limited facts, I would argue that economic ownership has passed because lessee has an option to purchase motorcycles for less than their presumed fair value under the lease. However, I would also want to know whether the lease was irrevocable and whether its length approximated the length of motorcycles' useful life. If no sale is found, then the motorcycles may be kept in the estate for the debtors use (see §363; §365) or returned to ensure adequate protection of lessor's interests (see §361). If a sale is found, it must be determined whether lessor has a perfected security interest.
During bankruptcy, the trustee assumes the powers of a hypothetical lien creditor dating from the time of filing (BC §544), and it can therefore defeat an unperfected security interest under 9-317. In order to determine whether lessor has such an interest, we must look at 9-311. To perfect an interest in non-inventory goods subject to certificate of title law, section 9-3 11 requires compliance with certificate of title laws for obtaining priority over a lien creditor. If lessor has complied with the relevant state certificate of title law (not given in this hypothetical) and therefore has a perfected security interest, the trustee cannot defeat it under 9-317. If, however, the lessor has not, trustee will defeat it and lessor will become an unsecured creditor.
CB's security interest in the leases and installment contracts likely has priority over Z's. Z is likely entitled to priority with respect to everything else. The effect of bankruptcy is unclear since certificate of title law is unknown. Depending on standards under state law, CB is potentially liable to Z for asserted claims with respect to all but the leases and installment contracts.
Question 2: Answer #3
Both Zippo and Commercial have a perfected security interest. Both attached (met 9-203 requirements) and perfected by filing (assuming financing statements met 9-502 requirements).
Zippo most likely has an Inventory PMSI as to the new motorcycles. The new motorcycles qualify as inventory under 9-1 02(a)(48). Zippo was the manufacturer and its loan was made to actually secure the purchase price — classic PMSI under 9-103. If the transaction meets the requirements of 9-324, then Zippo has a PMSI in the new motorcycles. Seems to be no conflicting security interest holders so no duty to notify. Also safe to assume that Zippo perfected its security interest before Dragonfly took possession. Even if for some reason Zippo could not establish PM status as to the new motorcycles, it would still have priority over Commercial as per 9-322 because it perfected first.
Under the terms of its security agreement, Zippo took a security interest in after acquired collateral, as permitted by 9-204. The priority of its interest in after acquired property would relate back to the original filing under 9-3 22, comment 5. However, the PM status of its security interest would not have carried over into the secondhand motorcycles (Raytheon).
Problem with Commercial having a PMSI in the used motorcycles under 9-103 is that the security agreement lists the collateral as "inventory" and the used motorcycles qualify as inventory under 9-102(a)(48). 9-324(b) requires the PMSP to send authenticated notification to the holder of the conflicting security interest. The facts don't indicate that Commercial sent Zippo any notification. This means that Commercial loses its PM status and would instead have a secondary, albeit perfected, security interest in Dragonfly's inventory. Commercial may still be able to save its PMSI if Dragonfly had not bought all of the motorcycles yet, i.e. not received possession of the inventory. Then Commercial still has time to notify Zippo under 9-324(b)(3) and step ahead, at least as to the used motorcycles.
Better possibility is 9-330. Commercial has a security agreement and it has possession of ~ the lease and credit contracts and the title certificates. Assuming these qualify as "monetary obligations" as per 9-201(11), this would be chattel paper and Commercial could claim priority over Zippo's security interest under 9-330. 9-330(b) would apply if Zippo included the value of the chattel paper in determining the loan amount, otherwise (a). In any case both seem to be satisfied, assuming Commercial was unaware of the restrictions in Zippo's security agreement. Commercial gave new value, took possession, and none of the contracts indicated they had been assigned. So as long as Commercial took possession in good faith and in the ordinary course, Commercial can claim super-priority. Interesting because Commercial's possessory super-priority interest is running up against Zippo's PM super-priority interest.
Worth noting that the motorcycles are subject to state title certificate statutes but since Dragonfly is in the business of selling motorcycles, it falls under 9-311(d) which trumps (a). So perfection would be by filing.
Negative Pledge Clause and Exclusive Dealing Clause
Contractual clauses are both valid alternatives to security. However, they are governed by contract law and generally not enforceable against third parties, i.e. Commercial.
Under 9-201, a security agreement is generally effective according to its terms. Facts indicate that Commercial has the right to hold onto the title certificates and sales and lease contracts under its security agreement with Dragonfly. Assuming Commercial has priority under 9-330 or 9-324, as long as it is complying with its duty of care under 9-207, it is ok.
If, however, Commercial's security interest is junior to Zippo, it will have to turn over the certificates and contracts to Zippo. Dragonfly has defaulted under its agreement with Zippo, which gives Zippo the right to take possession under 9-609. 9-609, comment S says a junior creditor who refuses to relinquish possession of collateral upon demand of a superior SP would be liable in conversion.
Is this is a true lease or a sale? Casting a transaction as a lease is not conclusive (Lykes). What it actually is depends upon the facts and context. Under 1-201(37), a transaction does not create a security interest merely because the lessee has the option to become the owner of the goods. However, a transaction does create a security interest if the lessee does not have the right to terminate and the lessee has an option to become the owner for no additional or nominal additional consideration. It is not clear whether Wolfpack had the option to terminate but if it did not and 85% of the remaining lease payments is "nominal consideration," then under 1-201(37), this would actually be a security interest and not a lease. Under 1-201(37), additional consideration is nominal if it is less than the lessee' s reasonably predictable cost of performing under the lease. Since Wolfpack has the right to exercise its option at any time, presumably it could just choose to pay 85% of its final lease payment and become the owner. Wolfpack therefore is bound to become the owner so this more accurately characterized as a financing rather than a lease.
This means that since Dragonfly never perfected, it is an unsecured creditor and loses to the BT under BC544 and 9-317. Under BC362, it is stayed from perfected its interest, even though this is a PMSI, assuming more than 20 days have passed since Wolfpack took possession. If this were a lease, the fact that nothing was filed wouldn't matter. Dragonfly could retake possession of the motorcycles or recover the back lease payments from the trustee, as per BC 365.Commercial's security interest in collateral follows sale (9-315). However, trustee will argue that Wolfpack is a BIOC and therefore took free of Commercial's security interest under 9-320(a). Dragonfly is in the business of selling motorcycles, Wolfpack bought in good faith and without knowledge that the sale violated another party's rights. Wolfpack seems to qualify under 1-201(9). I don't think that holding title certificates would qualify as possession for purposes of 9-320(e).
Question 3: Answer #1
The trustee's strongest options are Dagwood's defenses and claims against VC for improper foreclosure and claims of preference and fraudulent conveyance in the transactions with Arnie. The trustee might claim that VC was unperfected, but this claim will probably fail.
Under Section 558 of the bankruptcy code, the estate inherits all of Dagwood' s claims and defenses against VC in connection with the foreclosure. Dagwood's failure to make timely loan payments is sufficient as a common-law default, and was probably listed as an event of default in the security agreement. It would also be difficult to argue that VC waived default considering its attempts to induce Dagwood to make payments. However, the trustee can make a strong argument that VC's repossession involved a "breach of peace" under 9-609(b).
Article 9 doesn't define breach of peace, so it is up to the courts to make this determination based on prior cases and in light of the policies behind Article 9. While there was no violence or threat of violence in this case, the repo team presented a document falsely purporting to be a court order under circumstances calculated to achieve maximum deception. Comment 3 to 9-609 mentions that a number of cases have held that a repossessing secured party's use of a (uniformed off-duty) law-enforcement officer without benefit of judicial process violated former 9-503. Given the overt use of fraud to obtain admission to the premises in this case, the courts are likely to be sympathetic to the trustee's argument that this constituted a breach of peace.
The trustee can also make a very strong argument that the disposition of the collateral failed to meet the reasonableness requirement of 9-610 and that the notification was invalid under 9-611. Considering the specialized nature of the collateral, merely advertising in a local newspaper was clearly an insufficient means to reach the proper audience. In fact, a private sale may have been commercially unreasonable for this kind of collateral. While a paucity of bidders and a low sale price standing alone is insufficient to show that the sale was commercially unreasonable, the fact that VC was the only bidder and purchased the collateral for only $16,000 is highly persuasive. VC should have abandoned the sale when no other bidders showed up and started over using more appropriate means. The trustee can also argue that since no bidders showed up, VC was not authorized to purchase the collateral under 9-610(c). VC also failed to provide notification of the disposition under 9-611(b). Considering that VC sent its second letter to Dagwood's business address, it would be hard for VC to justify its conduct as "reasonably required to inform" Dagwood as required by 1-201(26).
VC's failure to comply with Part 6 of Article 9 in the above instances would make it liable for damages under 9-625(b). Since the equipment was essential to Dagwood's business, the trustee could potentially obtain damages for the loss of going concern value. Also, under 9-626(a), in pursuing a deficiency VC would have to overcome the presumption that compliance with the U.C.C. requirements would have yielded a sale price sufficient to satisfy the outstanding debt. Finally, if VC improperly purchased the collateral under 9-610(c), the trustee may be able to get the sale rescinded and recover the collateral.
Under Section 547 of the bankruptcy code, the trustee could challenge the payment of two months' rent to Arnie immediately prior to filing as a preference. Clearly all five of the requirements in 547(b) are met. Arnie might argue that the payment was permitted as an ordinary course transfer under 547(c)(2). However, considering that Dagwood made a lump sum payment for two months rent right before filing for bankruptcy, the payment probably didn't satisfy the requirements that the transfer be made in the ordinary course of business according to ordinary business terms (elements (B) and (C) of 547(c)(2)). Thus the trustee's preference claim against Arnie is strong.
The trustee might also try to argue that the foreclosure of the collateral by VC was a preference. Given that Dagwood was behind on loan, rent and tax payments the presumption that debtor was insolvent at the time of the transfer appears valid. However, since VC was a secured creditor, it would be difficult to argue that VC's position was improved by the foreclosure itself (i.e. without considering the bargain sale purchase of the collateral by VC). Thus a preference claim against VC is unlikely to succeed.
The trustee can use its powers under Section 548 of the bankruptcy code to challenge the sale of the trade name, along with the non-compete covenant, as a fraudulent conveyance. We don't have any information about whether $500 was "reasonably equivalent value" under 548(a)(1)(B). However, the fact that the transaction was suddenly initiated and completed on the eve of bankruptcy, and the purchaser was Dagwood's brother-in-law, strongly indicates an intent to defraud creditors under the alternative 548(a)(1)(A) test. Thus the trustee has a strong claim of fraudulent conveyance arising out the of the sale of the trade name to Arnie.
Perfection of VC's Security Interest
The trustee might try to use Section 544(a) and 9-317(a) to subordinate VC's security interest. The trustee could try to argue that CFC failed to perfect its security interest in the equipment when it filed its financing statement, but it is unlikely to succeed with this argument. The description of the collateral as "business equipment and inventory" clearly fits within 9-108(b)(3). Under 9-503(a)(4), the debtor's individual name Derwood Dagwood" would be sufficient, and the inclusion of a trade name following the individual name shouldn't matter.
Alternatively, the trustee could argue that the financing statement became seriously misleading, and thus ineffective under 9-506, when Dagwood moved or when CFC merged into Vulture. Even if the financing statement became seriously misleading as a result of these changes, 9-507(b) would protect it from being rendered ineffective under. Thus the trustee is unlikely to obtain any relief under 544(a).
Question 3: Answer #2
1.Claim: VC is unperfected.
If the trustee can prove that the financing statement is not properly filed, thus rendering security interest unperfected, trustee will be able to avoid the $16,000 recovery by VC as a preferential transfer (Bankruptcy Code 547(b)) (all five requirements will be satisfied if VC is unperfected); thus increasing the value of the bankruptcy estate.
Under 9-502(a)( 1), the debtor's name must be provided, In the present case, since the debtor's name was not filed as "Derwood P. Dagwood," the financing statement becomes seriously misleading (9-506(a)) and ineffective (9-520(c)). The exception of 9-506(c), which makes the financing statement not seriously misleading, if the financing statement nevertheless would be discovered in a search under debtor's correct name, using the filing office's standard search logic, does not apply here. Note that filing under trade name is insufficient (9-503(c)).
Although the secured party's name has changed from CFC to VC, this will not render the financing statement seriously misleading (Comment 2 to 9-506); only omission of the secured party will render the financing statement seriously misleading. Also, assuming that the address required under 9-51 6(b)(5)(A) is incorrect, it will not render the financing statement ineffective; it will only subordinate the security interest to a conflicting security interest to the some extent (9-338(a)).
2.Defense: VC did not comply with the procedures required in Part 6 of Article 9.
Even if VC has a perfected security interest, if the trustee steps into the shoes of Dagwood and claim that VC did not comply with the procedures provided in Part 6 of Article 9 (Bankruptcy Code 541). the trustee may collect damages caused by non-compliance from VC (9-625) or deviate the deficiencies claim of VC (9-626).
(1) Timing of default
Under 9-609(a) and 9-610(a), repossession or disposition of the collateral must be done after default. In the instant case, though it depends on the terms of the security agreement, it is
likely that failing to pay after series of reminder would have triggered default.
(2) Breach of peace
Under 9-609(b), VC must proceed repossession without breach of peace. Since Article 9 does not define what constitutes breach of peace, it is up to the court to decide whether the conduct of the repo team constructs breach of peace. However, absent of affirmative force, it can be argued that there was no breach of peace.
(3) Notification before disposition
The notification must be sent to the debtor and other secured creditors, if any, and it must be reasonable as to manner in which it is sent (9-611: authenticated notification), as to its timeliness (9-612(b): 10-days notice period), and as to its content (9-613). In the present case, the timeliness is adequate; the content, though details are not certain from the given facts (such as time and place of public disposition), is likely to be satisfied; the critical question is about the manner. Under 9-102(a)(74), "send" is defined as "deposit in the mail . . . by any other usual means of communication . . . addressed to any address reasonable under the circumstance." In the instant case, it could be argued in both ways; sending the notice to a former address is reasonable, placing burden on Dagwood to update the company record or take steps to transfer the mail to the new address; VC should have sent the notice to the business address as they did with respect to the second letter.
(4) Commercially reasonable disposition
Under 9-610(b), every aspect of a disposition of a collateral, including the method, manner. time, place, and other terms, must be commercially reasonable. In the instant case, there is no indication of an unreasonable disposition.
(5)Purchase by secured party
Under 9-610(c), a secured party may purchase the collateral at a public disposition. However, if the transferee of the disposition is the secured party, and if the amount of proceeds of the disposition is "significantly below the range" of the proceeds than if a party other than the ~ secured party would have bought, the deficiency will be recalculated to the amount that would have been realized in a disposition other than to the secured party. In the instant case, the fact that no one except VC's representative showed up at the foreclosure sale and that the bid was only 25% of the outstanding value of the loan, unless the collateral is not really valuable, it is highly likely that the deficiency will be recalculated.
3.Claim: Transactions with Arnie is voidable.
If the transaction with Arnie is a fraudulent transfer (Bankruptcy Code 548) or a preferential transfer (Bankruptcy Code 527(b)), the trustee may avoid the transfer and increase the value of the estate.
(1) Sale of trade name with covenant
Sale of the exclusive right to use the trade name, including covenant not to compete, may be avoided as a fraudulent transfer under 548(a)(l)(A) or (B). Under (A), the fact that the transaction occurred to an insider just before the date of filing of bankruptcy might be a strong jnference to prove "actual intent to hinder, delay, or defraud." Under (B), $500 may be "less a reasonable equivalent value, "and the fact that the transaction occurred just before the date filing of bankruptcy might be a strong inference to prove insolvency. Note that this transaction is not avoidable under 547(b), because it is not "for or on account of an antecedent debt."
(2) Payment of rent
Payment of the rent, if paid regularly, cannot be avoided, because it is an ordinary course payment (547(c)). Moreover, if the rent accrues, for example, at beginning of each month and is paid simultaneously, it is not a payment against an antecedent debt. However, in the instant case, unless the rent was to be paid once in two months or irregularly, Dagwood seems to be, at least, one month late on its payment. This is likely to make the payment out of the ordinary course, and render the two months' payment avoidable under 547(b).
Question 3: Answer #3
As the trustee the arguments that I would like to make are; ii) as against VC that the original financing statement was ineffective, ii) foreclosure process was invalid, and iii) transfer to Arnie was invalid per preference.
i) VC's financing statement:
Per 9-502's minimum requirement
Thus the claims and defenses related to the FS are not too strong for the estate.
ii) Foreclosure process invalid:
Claims related to the foreclosure are stronger than the FS related claims, especially the chances of prevailing on the disposition claim looks optimistic. The results would be in recovering any damages which is likely to be minimal and lessening the perfected security interest amount of VC.
iii) Preference as against Arnie
Pursuant to the Bankruptcy Code (BC) the trustee has two strong claims with good chance of prevailing, however, the payoffs are relatively small.
First, trustee can argue rights to the trade name and covenant not to compete sold to Arnie are not perfected (the collaterals in question are probably general intangibles and should be filed to be perfected, and the trade name should probably have to be registered per any relevant IP regulation) and therefore, per Bankruptcy Code 544 trustee may avoid the transfer.
Second, the two months' rent was given just prior to filing for bankruptcy and comes under the preferential period per BC 547 meeting all five criteria (payment was for the benefit of the creditor, for an antecedent debt while insolvent and lets the creditor get paid leaving him better off than if under liquidation). The exception provision (c)(2) for ordinary course of business looks unlikely to save Arnie since manner of paying two months rent just prior to filing bankruptcy is not normally ordinary manner of paying rent and here looks suspicious, hinting at something not normal.