I. The Basic Checking Relationship and the Bank’s Right to Pay Checks a. General

i. The Basic Relationship 1. 3-103(a)(2), 4-104(a)(8), 4-105(3): Definition of “drawee” or “payor bank” 2. 3-103(a)(3), 3-105(c): Definition of “drawer” or “issuer” 3. 4-105(2): Definition of “depositary bank” 4. 4-105(4): Definition of “intermediary bank”

ii. Promulgation of Rules 1. Both Federal and State law makes rules. 4-103(b) acknowledges the preemptive

effect of rules that are promulgated by the federal rules over state rules iii. The UCC

1. Article I is general principles that apply to all substantive topics covered by the UCC

a. Definitions in 1-201(b) b. Obligation of Good Faith in 1-304

2. Article III is negotiable instruments 3. Article IV is Bank Deposits and Colllections

b. The Bank’s Right to Pay i. When is it proper for the Bank to Pay?

1. 4-401(a): A Bank can pay only when the check is “properly payable” a. It is properly payable if the “customer has authorized the payment.” 4-

401comment 1 2. If a check is given to an intermediary bank, then the intermediary becomes a

person entitled to enforce the check. 1-201(b)(25), (27) 3. If a check is stolen through no fault of the payee, the bank does not have the right

to pay the check. 4-401 comment 1, sentence 5-7. c. Overdrafts

i. The payor bank can charge the account, but (absent some specific agreement) it is also free to dishonor the check and refuse to pay it. 4-401(a), 4-402(a)

ii. McGuire v. Bank One, Louisiana, N.A. 1. Man representing himself as investment broker offers to sell woman bonds. She

writes him $200,000 check, says not to cash it until later date. He cashes right away, and money has not transferred from her investment account into another account, creating an overdraft of $188,000. He does not buy bonds with her money, but keeps it for himself (conversion). She believes bank failed to exercise ordinary care. Held, Bank had the right to cash the check. (1) The check was “properly payable” under 4-401. (2) 4-401 permits a bank to charge a properly payable check against a customers account even if an overdraft results. (3) Under 4-103 the bank must exercise ordinary care. (4) B/c the check was properly payable under 4-401(a), this is ordinary care under 4-103. (5) Case law has shown that it doesn’t matter how big of an overdraft that is caused, it does not affect ordinary care.

iii. Rationale for Overdraft Acceptance 1. Rule that required banks to pay overdraft would be unduly burdensome for banks

that would have to deal w/holding the bag if nobody reimbursed them

2. Rule that required banks not to pay overdrafts would be unduly burdensome on customers who would have bad credit and bounced checks

iv. Bank’s can agree to pay overdrafts, and thus become obliged to do so. 4-402(a) states that “a bank may dishonor an item that would create an overdraft unless it has agreed to pay the overdraft” and 4-103(a) states that “the effect of the provisions of this Article may be varied by agreement.

1. The UCC does not regulate how much banks can charge in overdraft fees. However, some state courts have found that a huge charge violates the banks obligation of good faith if charge was “not in the reasonable contractual obligations of the parties” and some courts have found them unconscionable.

v. Banks are allowed to pay checks in ANY order they choose. 4-303(b) d. Stopping Payment

i. Customer must give the payor bank timely and adequate notice of the stop payment. 4-403

ii. Bank cannot charge account over a stop payment order. 4-403 & Comment 7 iii. Three considerations limit the practicality of the customer’s right to stop payment:

1. The customer must act promptly to exercise the right. 4-403(a) a. “Received at a time and in a manner that affords the bank a reasonable

opportunity to act on it before any [final] action by the bank with respect to the item.”

i. Unlikely to work if stop payment comes more than a few days after check has been written

2. The duration of the stop payment order is six months, and can be revived by the payee after that. 4-403(b)

3. The underlying obligation for which the check was written. a. Payee has two separate rights on the check:

i. The right to enforce the check ii. The underlying obligation

b. To handle these two rights, UCC provides two rules: i. 3-310(b): UCC “suspends the payee’s right to pursue the customer

on the underlying transaction when the payee accepts the customer’s check.

ii. 3-310(b)(1): The statute provides that the suspension ends if the check is dishonored.

e. Remedies for Improper Payment. 4-401 i. Bank must reverse the improper transaction. B/c item was not properly payable, the bank

cannot sustain the charge on the customer’s account. Bank must thus recredit. 1. Statute also provides for consequential damages in cases which the charge to the

account leads the bank to dishonor other checks. Must pay damages to the customer for all things proximately caused. 4-402(b)

ii. 4-407 sharply limits the recredit issue. 4-407 “subrogates” the bank’s rights to the rights of the payee so that the bank can assert the payee’s rights against the drawer as a defense to the bank’s obligation to recredit the account.

1. Case: McIntyre v. Harris

II. The Bank’s Obligation to Pay Checks

a. When are funds available for payment i. The bank has the option to pay any item that is properly payable from the customer’s

account 1. When the account has funds “available” the bank has an affirmative duty to pay

the account ii. Two questions must be answered:

1. When is the determination made? 2. What is the balance in the account at that time?

b. Time of Evaluation i. The statute essentially chooses the moment that the payor bank evaluates the check as the

the point in time when the account must have sufficient funds ii. Under § 4-402(c), the bank is free to determine whether the account has sufficient funds

“at any time between the time the item is received by the payor bank and the time that the payor bank returns the item.”

1. Dishonor remains appropriate notwithstanding new credits to the account after the bank has evaluated the sufficiency of the funds in the account.

c. Availability of funds i. Reg CC establishes a framework of deadlines within which a depositary bank must

release funds that its customers deposit by check. 1. Unlike UCC § 4-215, those deadlines apply even if the depositary bank does not

determine by the deadline if the payor bank will honor the check in question. ii. First, distinguish among four separate dimensions:

1. General a. Customer deposited in the form of local check b. Customer deposited non-local check

i. Non local check is “any check drawn on a bank located outside the check-processing region of the bank at which the check is deposited

c. Customer wishes to use funds indirectly (writing checks against them) d. Customer wishes to use funds directly (withdrawing cash).

2. Noncash withdrawls from local checks a. The bank must make $100 available on the first business day after the

banking day on which the funds are deposited. b. The rest must be available for withdrawal no later than the second

business day 3. Noncash withdrawls from nonlocal checks

a. The bank has to make $100 available on the first business day after the banking day on which the funds are deposited.

b. The rest must be made available for withdrawal no later than the fifth business day after the . . .

4. Cash withdrawals from local checks a. The bank must make $100 available on the first business day after the

banking day of deposit b. Must make an additional $400 available the second business day

c. Must make remainder available on third day 5. Cash withdrawals from non-local checks

a. Must make $100 available on the first business day b. Must make additional $400 available on the fifth business day c. Must make remainder available on the sixth business day.

iii. Banking v. Business Day 1. Banking Day: Those business days on which the bank is open “for carrying on

substantially all of its banking functions 2. Business Day: All calendar days except Saturday, Sunday, and Federal Holidays

iv. Seven ways you can get all available funds the next day. However, you must be (a) the original payee of the instrument and (b) personally deposit the item (no ATM):

1. Cash Deposits 2. Checks drawn on a local branch of the bank where they are deposited 3. US Treasury Checks 4. USPS money orders 5. Checks drawn on a federal reserve bank or federal home loan bank 6. Checks drawn on a local governmental entity 7. Cashier’s Checks or similar items drawn on banks

v. Low-risk items that are not deposited with a teller in the payee’s own account: 1. A treasury check or Postal Service money order deposited by somebody other

than the original payee is treated as if it were a typical local check 2. If a Federal Reserve Check, local government check, or cashier’s check is

deposited by somebody other than the original payee, the check is processed under the standard rules, with the availability of funds depending on whether the check is a local or non-local check

vi. Low Risk items deposited in an ATM: 1. If Cash, Postal Service Money Order, Federal Reserve Checks, Local Government

Checks, or Cashier’s Checks are deposited at an ATM into an account owned by the payee of the check, the availability is deferred a single day, to the second business day.

a. So, customer can’t get shit until 2nd business day ($100 then) vii. Justification for prompt funds availability

1. First, Reg CC doesn’t unconditionally obligate the bank to release funds immediately

2. Second consideration is convenience 3. Third, the likely long-term effects of giving banks the risk of loss that they face if

deadlines force them to release funds without determining whether a check will clear

4. First National Bank v. Colonial Bank (Check Kiting Scheme/Risk of Loss) viii. Wrongful Dishonor: What happens in a bank refuses to pay

1. If a bank doesn’t pay a check it was obligated to pay, it has wrongfully dishonored the check

2. Customer is entitled to “all of the damages proximately caused by the wrongful dishonor.” UCC § 4-402(b)

a. Maryott v. First National Bank

III. Collection of Checks a. The Payor Bank’s Obligation to the Payee

i. Although the payor bank might be liable to the drawer for wrongful dishonor, the payee itself can usually do nothing to force the payor bank to pay the check

1. Illustration: Outdoor Technologies v. Allfirst Financial, Inc. a. H gave a $700g check to Outdoor for outstanding payments. The check

stated it was drawn on an account at FNB, but it was actually drawn on Omni Bank. Outdoor wanted to get the check cashed as quickly as possible because H was about to institute bankruptcy proceedings. Outdoor sent someone to drive to a branch of FNB to cash it. They said it was an Omni check, that Omni was owned by BankCorp. and to call the lawyer of Omni/BankCorp. Lawyer says neither bank has to cash it - however, he says that if the guy goes to the closest Omni branch and presents “proper authorization” they will cash it. When he got to the branch, the lawyer said a letter wasn’t “proper authorization,” that he needed board approval. He couldn’t get it in time, and H filed bankruptcy, freezing the accounts. (1) There is no fraud by the lawyer. (2) No negligent Misrepresentation.

ii. If the payee is concerned that the payor bank won’t pay, it can protect itself: 1. Payee could refuse to accept an ordinary check 2. Ask for a special check that offers an assurance the bank will pay it

a. Payee can ask for a certified check under 3-409(d) b. Ask for a cashier’s check or teller’s check. § 3-104(g), (h)

i. These require inconvenience to get b. The Process of Collection

i. Payee has two options to collect on a check: 1. Go directly to the payor bank and Obtain Payment Itself

a. Cash the check, by presenting it ”for immediate payment over the counter” 4-301(a)

i. If payor bank cashes, payment is final. 4-215(a)(2), comment 4 p 5 b. If payee has account at same bank as drawer

i. The bank sees this as an “on us” item ii. Will give the depositor a provisional credit on the day it receives

the item iii. As long as the payor bank provides that provisional settlement on

the day it receives the item, the payor bank has until its “midnight deadline” – midnight of the next banking day – to decide whether to honor the check. 4-301(a), (b).

1. If honored, it adds to payee’s account and deducts from drawer’s

2. If dishonored, notice is sent to payee/customer. a. Then, can charge back payee’s account

3. If bank does nothing by midnight deadline, it loses its right to dishonor the check. 4-214(c), 4-301(b).

2. Obtain payment through intermediaries: Two Steps a. Payee Depositary Bank

i. First, an agency relationship is set up between the bank and the customer. § 4-201.

1. Thus, the depositary bank becomes the “collecting bank” 2. Also, comes with a duty of ordinary care. 4-202(a)

ii. Second, bank gives provisional settlement, reserves its charge back right if the payor bank doesn’t honor the check. § 4-214

b. Depositary Bank Payor Bank i. Depositary Bank has broad discretion on how to collect

1. Must move quickly to meet funds availability rules ii. Typically, the check (paper) is transmitted to the payor bank, who

pays it 3. Methods of transmission

a. Clearinghouse Arrangements i. See p. 347 for a clearinghouse hypo

ii. Note: If bank doesn’t follow clearinghouse rules regarding a provisional settlement, it can lose its right to dishonor under the UCC

1. Can’t recover from depositary bank, clearinghouse, or payee after that

iii. See: Kimberly Allen Trust p. 348 iv. Trust deposited into its account with Lakewood a $110g check.

Lakewood presented to the payor bank the check the day after it was received, and placed a hold on trust account pending payment of the check. Lakewood received a provisional credit. After payor bank notified Lakewood the check had cleared, the hold was lifted from the account. Five days later, the payor bank said it was returning the check for insufficient funds, and Lakewood charged back the account and a fee. Trust filed action seeking its funds from Lakewood. (1) Under 4-214, a bank loses its right to charge back when payment becomes final. (2) Under 4-215(d), after payment becomes final, the bank is accountable to the customer for the item and any provisional credit when it becomes final. (3) 4-215(a) tells when something is “finally paid”. (4) Pursuant to 4-302, if an item is presented to and received by a payor bank, that bank is “accountable” for the amount of the demand item if it retains the item beyond midnight of the banking day of receipt without settling for it or, whether ot not it is also the depositary bank, does not pay or return the item, or send notice of dishonor until after its midnight deadline (midnight of the next banking day after receipt.

b. Bilateral Arrangements (Direct Send and correspondents clearing) i. A pair of banks that have a relationship – a lot of checks drawn on

them each day - will enter into this type of relationship – contractual, where they give provisional credits and then send the checks to the bank.

ii. Cheaper and Faster than the Federal Reserve method

c. Collection Through the Federal Reserve System i. System of last resort because it is most expensive and slower

ii. Send to Federal Reserve Bank, who sends it to Payor bank – must honor or notify by midnight deadline –

iii. If the payor wants to dishonor, go to Reg CC: 1. The Reg CC return deadline:

a. Payor bank must return the check in an “expeditious manner” in order to meet one of two deadlines”:

i. Two Day/Four Day Rule: ii. Requires the dishonoring payor bank to send

the check so that the check would normally be received by the depositary bank not later than 4pm on the deadline: the fourth business day for nonlocal checks; the second business day for local checks. CC 229.30(a)(2)

2. Reg CC and the UCC midnight deadline a. Whereas the UCC deadline requires the payor bank

to put it in the mail by midnight of the next banking day, Reg CC allows them to wait until the next day if they use a mode of delivery that results in a faster return than the midnight deadline

b. First extension, deadline is waived if you return the check to the transferor (Fed Reserve Bank) by the day after the midnight deadline

c. Second extension waives the midnight deadline if the payor bank uses a “highly expeditions meas of transportation, even if this means of transportation ordinarily would result in delivery after the receiving banks next banking day.”

3. Reg CC notice of non-payment deadline a. A payor bank that dishonors a check for $2500 or

more must get notice of its determination to the depositary bank by 4pm on the second business day after the banking day on which the payor bank received the check.

i. Whether non-local or not ii. Allows depositary to release funds the

second business day after the banking day d. Difference between failure to meet the Reg CC rules and failure to meet

the midnight deadline: i. Failure to meet the deadline affects the settlement process:

1. Payor bank becomes accountable for the item under § 4-302, payment becomes final under § 4-215, and depositary bank loses any right of charge back under § 4-214

ii. Failure to meet Reg CC:

1. Generally limited to damages CC § 229.38 e. Common Practice: Return notice over the Electronic Earns System(359)

Obligation Action Required Citations Midnight Deadline Send the item by midnight on

the next banking day unless Reg CC extends the deadline

UCC §§ 4-301(a), 4-104(a)(10), 1-201(38); Reg CC § 229.30(c)(1)

Reg CC return Return the Item to the depositary bank either by the two-day/four-day rule or by the forward collection rule

Reg CC § 229.30(a)

Reg CC notice If the item is for $2500 or more, give notice to the depositary bank by 4pm on the second business day

Reg CC § 229.33

IV. Risk of Loss in the checking System – The Basic Framework a. There are two tiers that address the issues of risk of loss in the Checking System

i. Tier One: A Basic Framework that distributes losses based on generalized assumptions about the relative abilities of parties to prevent certain types of losses

ii. Tier Two: Several situation-specific exceptions to the general first-tier rules b. Basic Tier One Problems

i. Nonpayment 1. General

a. Two fundamental elements of the system make nonpayment losses relatively common:

i. (1) The payee’s inability to know when it takes a check whether the payor bank will honor it

ii. (2) The relatively long delay between the time that the payee accepts the check and the time that the payee finds out whether the check will be honored

b. UCC 3-415 is the principal indorser liability statute 2. Endorsements

a. 3-204: Endorsement itself need be nothing more than a signature by the person selling the check

b. 3-205(b): This is a “blank indorsement” has the legal effect of making the check “bearer paper” so that the any party in possession of the check can enforce it

c. Or, endorsement can be a “special endorsement” payable to a specified person, entity, etc.

i. 3-205(a): This makes the check “order paper” which can be enforced only by the identified party

d. Or, the party can endorse the check “for deposit only” or “for collection.” i. 3-206: This is called “restrictive endorsements” which restrict the

right of later parties to transfer the check except in accordance with the endorsement.

3. UCC rules on indorsements and indorsement liability a. 3-415: each party that indorses a check makes an implied contract with

subsequent parties that acquire the check. That contract obligates the indorser to pay the check if the payor bank dishonors it.

b. The rule results in a chain of liability under which each party can pass a dishonored check back up the chain to the last person in the chain that is able to pay (the earliest indorser)

c. 3-414(b): Liability on the drawer of the insolvent check 4. Protecting the indorser from liability on stale obligations

a. 3-415(e): The indorser’s liability is conditioned on the check’s being deposited or presented within 30 days of the indorsement – or the indorser has no liability

b. 3-415(c): Any person seeking to enforce a claim of liability on an indorsement to give prompt notice of the dishonor to the indorser.

c. 3-503(c): If the person giving the notice is a collecting bank (both depository and intermediate banks (4-105(5)), it must give notice by

midnight of the banking day after it learns of the dishonor. In all other cases, the notice must come within 30 days.

5. Avoiding indorsement liability a. 3-415(b): All the indorser must do to disclaim the liability is to add the

phrase “without recourse” to the indorsement. If an indorsement is made “without recourse,” subsequent owners of the check cannot sue the indorser even if the check is dishonored.

ii. Forged Signatures 1. General

a. Responses from the system i. The first response of the system is the obvious one that the

unauthorized signer – the thief – should be responsible for all losses caused by the forgery

ii. The difficult task is to determine who is liable in the event that the unauthorized signer cannot be located

b. Forged Drawers Signatures and the Rule of Price v. Neal i. The check is a complete forgery

ii. The allocation of losses from that kind of forgery depends on whether the payor bank (a) is duped into paying the check or (b) notices the forgery and dishonors the check

c. Payor Bank Pays the Forged Check i. Price v. Neal: Payor Bank bears the loss if it fails to notice the

forgery and honors the check (check was not properly payable because the drawer never authorized it)

ii. 4-401(a): payor bank has no right to charge the account if drawer doesn’t authorize it

d. Two exceptions that allow a shift in liability i. 3-418(a)(ii): payor bank can seek recover from “the person to

whom or for whose benefit payment was made.” ii. 3-418(c): Does not apply against a person that took the instrument

in good faith iii. 4-208: series of implied presentment warranties in favor of the

payor bank. If any of those warranties if false, the payor bank can recover from the party that presented the check to the payor bank or from any previous transferor in the chain of collection of the check

iv. 4-208(a)(3): Warranty liability if the transferor had knowledge that the signature of the drawer was unauthorized

1. 1-202: Distinguishing between “knowledge” and “notice” v. It makes some sense to leave the responsibility of loss with the

payor bank. A legal rule that puts the losses from forged checks on payor banks gives payor banks every incentive to work to develop institutions that limit losses from forged checks

e. Payor Bank Dishonors the Check i. If the payor bank notices the check is forged and dishonors it, then

the collecting bank is left holding the uncollectible check

ii. UCC contains two legal rules on which the presenting bank can rely:

1. (1) Creates a special set of warranties that limit claims about forged drawers’ signatures;

a. 3-417(a)(3) & 4-208(a)(3): Step 1 appears in the qualification of the warranty regarding the drawer’s signature that permits a payor bank to complain only if the warrantor had “knowledge that the drawers signature was unauthorized

b. 3-416(a)(2) & 4-207(a)(2): The analogous transfer warranty includes an absolute avowal of the authenticity of the drawer’s signature

2. (2) it limits payor banks to pursuing that limited set of warranties

a. 3-416(a) & 4-207(a): Step 2 appears in the rule that the parties that can pursue transfer warranties must be parties to whom an instrument has been transferred

b. Because an instrument is presented to the payor bank, not transferred to it, the payor bank cannot pursue the broader transfer warranties

f. One twist on the warranty rules is the interaction between articles 3 and 4 i. The article 4 transfer warranties provide liability only against

banks and their customers. Accordingly, a party seeking to pass liability to a party that handled the check before it got to a bank would have to rely on the Article 3 transfer warranties (3-416)

1. The only significant difference is the rule in 3-416(a) that Article 3 transfer warranties can be enforced by remote transferees only against entities that indorsed the check

iii. Forged Indorsements 1. General

a. The drawer actually signs the check in the first instance, but some other party subsequently forges an indorsement on the check

i. These rules are more favorable to the payor bank b. Generally, the payor bank can – even if honor was mistaken – pass the

loss back to the earliest solvent person in the chain after the forgery 2. Payor Bank Dishonors the Check Because of Forged Indorsement

a. The presenting bank is left with the bad check, but can recover its losses through transfer warranties.

b. 4-207(a)(1 & 2) or 3-416(a)(1 & 2): Because neither the forger nor any party after the forger in the process of collection is a person entitled to enfordce the instrument, and because the indorsement itself is forged, each of those parties has breached its transfer warranty under one of these statutes

3. Payor Bank pays the Check despite the forged indorsement

a. It is no more proper to charge the drawers account in this instance than in the forged signature area

i. 4-401(a) & comment 1: payor bank had no right to charge drawers account because they weren’t authorized to cash the check

b. 3-418: (payment by mistake) payor bank cannot recover under this theory either if the prior parties took the instrument in “good faith and for value”

c. 4-208(a)(1): payor bank can recover for a breach of presentment warranty – the presenting bank warrants that “it is a person entitled to enforce the draft” or is collecting the check on behalf of a person entitled to enforce the draft

i. 3-301: Absent a valid indorsement by the payee, nobody other than the payee can become a person entitle to enforce a check

ii. Therefore, payor bank can recover its loss from the presenting bank

iii. 4-207(a)(1 & 2): The presenting bank, in turn, would be entitled to pass the loss to parties earlier in the chain of collection b/c those earlier parties would have breached the transfer warranties in these statutes

d. The loss should pass to the earliest solvent person after the forger iv. Conversion

1. The payee of a stolen instrument is barred from enforcing the underlying obligation under 3-310(b)(4)

2. First, payee has a common law right to pursue the thief for conversion 3. 3-420(a): grants the victim a statutory action for conversion against parties that

purchase the check from the thief. The victim can pursue a bank that cashes the check for the thief or a payor bank that honors the check over the forged indorsement

a. However 3-420(a) is limited by 3-420(c) which prohibits any action against nondepositary “representatives” in the collection process. The comment 3 explains that the statute is designed to bar a suit against an intermediary bank that does nothing but process the check for collection as a representative of the depositary bank’s customer.

4. 4-407(2): The payor bank is protected by this subrogation provision, which allows the payor bank that pays the payee under 3-420(a) to charge the drawer’s account just as if the item had been properly payable.

v. Alterations 1. Two main types:

a. A change in some relevant aspect of the check as originally written i. Treat just like the treatment for forged indorsements

ii. If payor bank honors the check, it cannot charge the drawer’s account for the amount that it paid out on the check

iii. 3-407(c): Payor bank in this instance can enforce the check only “according to the original terms” of the check

iv. 4-208(a)(2): Payor bank can recover any loss by pursuing earlier parties in the chain of collection for a breach of the presentment warranty

v. 4-207(a)(3) & 3-416(a)(3): Any party against whom the payor bank recovers is entitled, in turn, to pursue earlier parties based on a breach of a similar transfer warranty

vi. Thus, the loss will rest with the earliest solvent party to handle the check after the alteration

b. An addition to an instrument that was incomplete when written i. 3-407, Comment 2: The payor bank can enforce the instrument as

completed, even if “the instrument was stolen from the issuer and completed after the theft.”

ii. 4-401(d)(2): The bank is entitled to charge the drawer for such an item

V. Risk of Loss in the Checking System – Special Rules a. Negligence

i. General 1. Loss is on the drawer if the drawer’s negligence substantially contributes to the

forgery. 3-406(a) a. Precludes a “party whose failure to exercise ordinary care substantially

contributes to . . . the making of a forged signature . . . from asserting the . . . forgery against a person who, in good faith, pays the instrument.”

2. Illustration: HSBC Bank USA v. F&M Bank Northern Virginia a. Written check had lots of blank, and someone inserted new numbers. (1) §

3-406 provides no claim if a thief who is not the payee indorses the check in the thief’s name rather than the payee’s name. (2) UCC also imposes ordinary care on banks – which means “general banking usage.” (3) If a bank can show that most banks have not yet adopted a new procedure that would have prevented a loss, then the bank’s potential liability if it keeps the old procedure is low. (4) Also, the UCC recognizes comparative negligence, under which any party should bear the portion of the loss attributable to its failure to exercise ordinary care. § 3-406(b).

b. Bank Statements i. General

1. Rests on the assumption that customers can stop forgery schemes if they would just look at their fucking bank statements!

2. When a drawer fails to discover a forgery evident from its monthly bank statements, the UCC normally transfers ensuing losses from the payor bank to the drawer by precluding the drawer from challenging the payor bank’s decision to honor future checks by the same forger. § 4-406(d)(2)

ii. The UCC does not make the bank wholly responsible for losses, but would call for each party to bear a portion of the loss based on the extent to which its shortcomings contributed to the loss. § 4-406(e)

1. Illustrative Case: Stowell v. Cloquety Co-op Credit Union a. Dude steals guys check and then steals his banks statement mail. Man did

not receive bank statement from December 92 to September 93, and he notified the bank in December 92 that he hadn’t received one. (1) The draft agreement with the bank defines “reasonable promptness” as that’s used under the UCC [under the UCC, you have 30 days from the mailing date of the statement to object to the check – 4-406(d)(2). (2) The man is at fault – the risk is on him to take measures – the bank can’t bear such a risk.

iii. Although 4-406(e) exposes the bank to a risk of responsibility for comparative negligence much like 3-406, 4-406(f) removes that risk if the customer fails to examine the statement sent by the bnak w/in one year.

c. Theft by employees i. General

1. Most common case is when an employee forges the employer’s indorsement on a check payable to the employer

2. In many cases, the general negligence rule or the bank statement rule will place this loss on employers

ii. When the loss is caused by a responsible employee, the UCC placesthe loss on the employer even if those more general rules don’t apply. § 3-405

iii. However, employer will try to shift the loss back to the bank: 1. First, under comparative negligence: Here, 3-405(b) 2. Second, a claim that a bank’s willingness to allow an employee to obtain funds

from an employers account amounts to participation in the employee’s breach of fiduciary duty: § 3-307

a. Illustrative Case: Cable Cast Magazine v. Premier Bank i. Employee had been stealing checks, was confronted, and admitted

it. Cable claims bank violated 3-307 by accepting checks with knowledge that employee was breaching fiduciary duty. Bank claims only employer liable under 3-405 and 3-406. Held, the bank is not liable. (1) The employer must bear the loss under 3-405 upon a showing that an employee with responsibility commits a fraudulent endorsement. However, Cable seeks to default 3-405 by asserting that Bank was not in good faith when it took the check from employee. 1-201(19) defines good faith as honesty in fact in the conduct or transaction concerned. (2) There is nothing here that indicates that the Bank knew the employee wasn’t the company, or was a fiduciary of the company. (3) Even so, Bank had to exercise reasonable care – here they did.

3. The employer may have no substantial claim b/c the check will not appear sufficiently unusual. The question then, is: can the employer pursue a claim directly against the depositary bank for losses the employer sustained from a scheme?

a. Illustrative Case: Gina Chin & Assoc. v. First National Bank i. Employee wrote checks to suppliers, forged the drawer’s signature,

then forged the payees signature for indorsement purposes. The sole cause of action is against drawee banks for charging her accounts in the amount of the forged checks. (1) 3-404 and 405 change the law by allowing comparative negligence. Court holds that these provisions ARE TRIGGERED IN A DOUBLE FORGERY SITUATION

d. Impostors i. General

1. Checks procured by impostors or payable to fictitious persons. 2. General rule is that the person victimized should bear the loss. 3-404

a. Illustrative Case: Meng v. Maywood State Bank i. Person has check made payable to himself and fictional person. (1)

The fictitious payee rule completely absolves a bank from any liability for payment over a forged endorsement. (2) It states in 3-404(b) that when something is made out to a fictitious payee, an indorsement in the name of the payee is effective as the indorsement of the payee.” (3) This rule is effective over the rule

that places the loss on the bank for payment of a forged indorsement. (4) As a matter of law, the designation of two payee’s on a cashier’s check is ambiguous where no directives are stated on the checks to determine the manner of payment (payment can be made to either of the named payees). (5) Here, P’s can’t demonstrate the bank failed to exercise ordinary care.

VI. Issuer-Cardholder Relationship a. Four Major Participants

i. Purchaser that holds the card ii. The issuer that issues the card

1. Agrees to pay the purchases that the cardholder makes in accordance with the agreement between the issuer and the cardholder

iii. Merchant that makes the sale iv. Acquirer who collects payment from the merchant

b. Universal Cards i. Visa and Mastercard, basically

c. Statutes i. No UCC generally applicable to credit cards

ii. Must use Federal Truth in Lending Act (TILA) & the Federal Reserves Regulation Z 1. TILA is limited to Consumer Transactions 2. Limited to Credit Cards extended to individuals

a. Exception: TILA § 104(1), Reg Z § 226.3(a)(2): b. Also does not apply to transactions of more than $25,000. TILA § 104(3)

d. Definitions i. Credit Cards: TILA § 103(k): “any card . . . or other credit device existing for the

purpose of obtaining money, property, lavor, or services on credit.” e. General Rules

i. Cannot issue credit cards without a request or application. TILA § 132, Z 226.12(a) ii. Must provide customer a “clear and conspicuous” written disclosure that summarizes the

applicable legal rules. Z 226.5(a)(1) 1. Closely resemble model disclosures provided by the Federal Reserve in

Appendix G of Reg Z. Can be enforced in federal court. f. Overview of System

i. Exactly the opposite of the checking relationship ii. Credit cards and Checkign accounts at same bank: Pursuant to agreement, Credit card

issuer can periodically deduct an amount from the funds to pay a prearranged portion of the charges. TILA 169(a), Z 226.12(d)(3)

iii. Because credit cards can’t invest funds as banks can, they make their money off of interest rates

iv. Convenience users are those people that pay their bills every month – and some issuers have responded to these people by imposing annual fees limited to convenience users

v. TILA § 169 deals with the ability of issuing bank to offset charges against other accounts (checking) of customer held at the bank

vi. Fraudulent transactions are judged by algorithms and such g. The mechanics of collection

i. Merchant has an agreement with a member of the applicable network (VISA, etc.), the acquiring bank

ii. Was once a ban on allowing merchants to offer discounts to people who pay cash. TILA § 167 now prohibits those agreements and leaves merchants free to offer any cash discounts they find appropriate. Z § 226.12(f)

iii. Merchant, after process, receives 95-98% of the amount charged; merchant bank gets about 2.5%; issuer gets about 1.5%; holder pays 100%

iv. Note, acquirers charge higher rates for people who make sales over the phone, b/c of bigger risk of fraud

h. Finality of payment i. Right to cancel payment by consumers is much greater than in other competing systems

ii. The issuing bank’s obligation to pay does not become final at the time of the initial payment to the acquirer.

1. TILA § 170(a) grants a cardholder the right to withhold payment on the basis of any defense that it could assert against the original merchant. Therefore, if you get bad goods, you have the right to assert a “goods don’t conform to contract” defense on the credit card people.

iii. Qualification on cardholders right to cancel payment: 1. TILA 170(a) is only a right to withhold payment from an issuer, it does not

include a right to seek a refund from the issuer or the merchant 2. Accordingly, the right dissipates as the cardholder pays off the credit card balance

generated by the transaction in question a. TILA § 170(b) and Z 126.12(c): limits challenge right to “the amount of

credit outstanding with respect to the transaction” 3. TILA § 170(a)(1): the cardholder must “make a good faith attempt to obtain

satisfactory resolution of the disagreement . . . from the merchant honoring the credit card.”

4. TILA § 170(a) prevents cardholders from withholding payment on transactions that occur outside the state where the cardholder resides and more than 100 miles from the cardholder’s billing address

a. Cases by telephone have had mixed results iv. Card issuing network has rules that pass risk back to the merchant

1. TILA § 170(a) the issuer can charge back the challenged credit slip to the acquirer

VII. Erroneous Charges a. General

i. First, cardholder has the right to withhold payment under TILA § 170 ii. TILA § 161 sets out detailed provisions of resolving alleged billing errors related to

credit cards. SEE Z 226.13 1. Under TILA § 161(a), the cardholder must provide written notice to the issuer

within 60 days after the date on which the creditor sent the relevant statement to the cardholder

a. “Billing Error” under 161(b) and Z 226.13(a) includes not only claims that the cardholder did not make the charge in question, but also claims that the merchant failed to deliver the goods and services covered by the charge in question, and eve requests for additional clarification about the charge.

2. The issuer must send a written statement of the notice within 30 days and must resolve the issue within two billing cycles

3. If the holder claims the merchant didn’t deliver goods, the issuer must “conduct a reasonable investigation and determine that the property or services were actually delivered.” Z 226.13(f) & TILA § 161(a)(B)(ii)

4. If the issuer doesn’t accept holder’s accusation, the issuer must give the cardholder a written statement of the issuer’s reason for not correcting the charge. Z 226.13(c)(2), (f) & TILA 161(a)

5. The creditor is barred from closing or restricting the cardholder’s account for failure to pay the disputed amount during the pendency of the investigation. TILA § 161(d), Z 226.13(d)

a. Issuer can accrue a finance charge against the disputed amount, which is due only if the dispute is resolved against the cardholder. Z 226.13(d)(1) n. 30 & Z 226.13(g)(1)

6. The statute provides only a $50 penalty against the creditor for failure to follow these procedures. TILA § 161(e)

7. Illustrative Case: Belmont v. Associates National Bank (Deleware) iii. If a charge is erroneous, it gets passed back to the acquirer, who in turn passes it back to

the merchant b. Unauthorized charges

i. Very strong cardholder protection 1. TILA § 133(a)(1)(B) limits the cardholder’s liability to $50, regardless of how

much is charged, even if no notice is sent. Z 226.12(b)(1) a. However, prompt notice can help a cardholder. Once notice is received by

the issuer, the cardholder is immune to all other charges. TILA § 133(a)(1)(E)

b. Also, VISA and MASTERCARD have provisions where, if you send notice within (2) business days following the theft of the card, you are immune from all liability

2. Although you are only charged $50 or less, the cardholder should be wary b/c some courts will say that your conduct was so negligent that you should have to pay beyond the $50 amount of TILA.

3. Illustrative Case: Minskoff v. American Express

ii. There is an unusual aspect of TILA that states the provisions that protect cardholders from paying unauthorized charges apply not only in consumer transactions, but also in business and commercial transactions

1. However, in the business context, the issuer and cardholder can contract out of the statutory allocation of loss from unauthorized charges.

2. TILA § 135 permits any business that issues credit cards to at least ten of its employees to accept liability for unauthorized charges without regard to the provisions of TILA § 133, so long as the business does not attempt to pass on to the individual employees any liability greater than the liability under § 133. Z 226.3(a) n.4, Z 226.12(b)(5) (explanation of TILA § 135).

iii. Liability 1. In face to face transactions, the issuer bears the loss from unauthorized charges as

long as the merchant followed the requisite procedures (verified the signature and obtained the appropriate authorization for the transaction).

2. In remote transactions (phone, internet) the risk of loss is left with the merchant. iv. Issues

1. Identity theft is an issue; also, never received cards that are stolen from a thief are an issue (this has been cut back because of phone verification)

VIII. General Debit Things a. Payment with a Debit Card

i. The primary difference between credit and debit is that a debit card always serves as an adjunct to a checking or savings account

ii. There is no reason why credit and debit features cannot be combined, and thus this has become common. Reg E, 12 CFR § 205.12

1. In this situation, it depends on whether customer pays with the credit or debit function

2. Debit functioned governed by debit rules, credit governed by TILA and Reg Z iii. The use of an impulse to obtain funds directly from an account qualifies it as an

electronic funds transfer, and is regulated by the Electronic Funds Transfer Act (ETFA) 1. Title IX of the Consumer Credit Protection Act (TILA is Title I)

iv. EFTA § 903(6): “ETFA applies to transfer of funds . . . initiated through an electronic terminal so as to order . . . a financial institution to debit . . . an account”

b. Establishing the Debit Card Relationship i. EFTA imposes two significant restrictions on banks ability to update its checking account

relationship with debit cards: 1. First, EFTA § 911 generally allows a bank to send an unsolicited debit card to a

customer only if the card is sent in an unvalidated condition. 2. Second, there are disclosure requirements that require the bank to provide the

consumer a detailed up-front disclosure of the terms and conditions that will govern use of the card. Reg E § 205.7(a)

a. Keep in mind nearly nobody will read this. c. Transferring funds with a debit card

i. Debit card allows a person to go to an electronic machine (ATM) and do any of the functions it could have done at a bank teller in person

ii. EFTA § 906 requires that a customer be given written documentation of each transaction that they inititate.

d. Collection by the Payee i. A merchant must enter into a contract, either directly with the bank that issued the card or

indirectly through a network that processes debit-card transactions for the card-issuing bank.

ii. Two major types of networks 1. Pin Based

a. Characterized by the requirement that the customer enter a PIN number b. Under the typical network rules, the payor bank’s obligation to pay

becomes final at the moment that it transmits the electronic message back to the merchant

c. The actual payment is usually made be a single daily deposit ot an account designated by the merchant, giving it credit for all of the days debit transactions

d. The payor bank becomes obligated to honor the payment request before the customer leaves the counter. Thus, risk to merchant is limited to payor bank insolvency or failure of the processing system

2. Pin Less a. This system does not clear and settle transactions immediately

i. Rather, there is an authorization transaction while the cardholder is at the terminal, which confirms the availability of funds in the account to cover the transaction

ii. Then, over the next few days, the merchant obtains funds from the transaction in the same way as it would obtain funds for a standard credit-card transaction

1. These are called “offline” debit; PIN based are called “online” debit

b. This system costs the merchant as much as standard credit-card transactions (1 – 2 %)

i. PIN based transactions cost the merchant must less (7 cents per transaction)

c. The key difference is finality; under the PIN less system, you have the rights of TILA in collection

iii. Error and Fraud in Debit Card Transactions 1. Erroneous Transactions

a. Two types (these have not caused significant losses) i. Improper withdrawal (withdrawal of the wrong account or of the

wrong amount) 1. If they charge the wrong account, they recredit the wrong

one and charge the other one ii. Could fail to make a withdrawal that it should have made

b. The system might fail in such a way that the merchant believes that it is receiving authorizations when it in fact is not communicating with the payor bank.

i. The POS network rules protect the merchant and pass the loss back to payor bank; they can mitigate losses from this easier

c. Insufficient Funds i. Bank can pay or not pay and pursue customer on overdraft

2. Fraudulent Transactions a. General

i. Several features of Debit minimize loss 1. The rules preventing unsolicited mailing of activated cards 2. Both the authorization request from the merchant to the

bank and the bank’s reply are encrypted ii. 99% of fraud on debit cards resulted from card usage by a close

acquaintance of the cardholder iii. Consumer faces much bigger problem with unauthorized

transactions on debit than on credit b. Who bears the loss between merchant who accepts stolen card and bank

on which the card draws? i. Network rules allocate the loss to the bank; much better position to

mitigate these losses c. Who bears loss between customer and bank?

i. Positive law provides an answer that protects the cardholder considerably even apart form the parties own agreements

ii. Federal law provides two separate protections related to unauthorized transactions, as well as a set of specified procedures for determining whether a particular transaction was authorized

1. First set of rules: establishes threshold requirement that a card have some minimal security feature (PIN, signature, picture, etc.). EFTA § 909(a)

a. In the absence of feature, no consumer liability 2. Other is 909(a) provisions, discussed next

3. Lost of Stolen Debit Card a. EFTA § 909(a) establishes a rule limiting customer’s loss from each

unauthorized transfer i. These rules apply to “any series of related unauthorized transfers.”

Reg E § 205.6 1. Thus, if thief used card 10 times before caught, the dollar

limits in § 909(a) describe the consumer’s exposure for the entire incident, not the individual transactions

b. This rule allows the bank to hold the consumer liable for up to $50 of unauthorized transfers that occur before the financial institution learns of the consumer’s loss of the card. “In no event . . .” EFTA § 909(a)

i. Applies w/o regard to fault or diligence on the part of the consumer c. Fault-based notice rule: allows the bank to charge the customer for losses

if the consumer does not promptly notify the bank after it discovers that the card has been stolen. “In addition . . .” EFTA § 909(a)

i. Operates on the assumption that customer should notify within two business days after he knows of the theft

ii. All charges after the two day limit can be charged to consumer, with maximum at $500.

1. This $500 includes the $50 that could have been charged the consumer from the first rule

d. Consumer has 60 days to review the statements of the bank. If consumer fails to report an unauthorized transaction within that 60 day period, the consumer bears responsibility for any subsequent unauthorized transactions that would have failed had the consumer identified the transaction on the statement. EFTA § 909(a); Reg E 205.6(b)(3)

4. Limiting Liability even futher a. States can limit the consumer’s share of the loss more narrowly. This is

allowed under EFTA § 919. b. The PIN less networks (VISA and MASTERCARD) have altered their

network rules to limit the consumer’s exposure to losses. i. Both networks voluntarily agreed that the banks issuing their cards

will limit customer liability for unauthorized transactions to $50, even if the consumer fails to notify the issuer of the theft of the card and fails to ID any fraudulent trasaction within the 60-day EFTA period.

5. Resolving Disputes about whether a transaction was authorized

a. Customer must give bank notice within 60 days after bank mails statement. EFTA § 908(a)

b. Bank must respond within 10 days or give customer a provisional credit. i. VISA and MASTERCARD lower this to 5 days

c. Then, bank proceeds with investigation, which it must complete within 90 days after receiving customer notice.

i. Federal court can impose treble damages on any bank that (a) fails to recredit an account within the 10-day period when required to do so o r (b) unreasonably rejects a customers claim of error. EFTA § 908; Reg E § 205.11(c)(3)

6. Illustrative Case: Heritage Bank v. Lovett

IX. Negotiable Instruments a. Negotiability and Liquidity

i. General 1. Liquidity refers to the ease at which an asset can be sold at a price that reflects its

proper economic value 2. The lack of a market makes sale difficult b/c it makes the seller expand its effort

to locate a buyer and educate the buyer about the value of the asset 3. Rules that relate to negotiability enhance liquidity:

a. First, negotiable instruments offer an easy way for verifying a party’s power to transfer an enforceable interest in the instrument (the info is on the instrument)

b. Second, there is a defense stripping rule that makes a negotiable instrument more valuable in the hands of a purchaserthan it was in the hands of the payee that sold it.

i. A person that becomes a “holder in due course” takes the instrument free from all “personal defenses”

ii. Basic Framework of Negotiable Instruments 1. A typical transaction

a. Bookseller in St. Louis is buying books from distributer in London. Businessman goes to his bank to purchase the draft. The draft somewhat says that it wants Barklay’s bank in London to pay this man for the books. Business gives to distributer, who can present the draft to Barclays bank or sell it to his own bank. American bank notifies Barclays of the draft so that it will recognize it when presented. Barclays, upon receiving the draft, deducts from an account the American Bank has at Barclays for such a purpose. If a person did a lot, the bank could give them software that allowed them to do the drafts, and notifies the bank when he does one, which in turn notifies Barclays.

2. The terms a. The party that directs the payment (American bank) is the “drawer” or the

“issuer” b. The person who caused the draft to be issued (the businessman) is called

the “remitter” c. The person to who the draft is being paid (the London guy) is the “payee” d. The person on whom the draft is drawn (Barclays Bank London) is the

“drawee” iii. The Two Stage Framework

Requirement Statutory References 1 The obligation must be a written promise

or order 3-104(a); 1-201(43); 3-103(a)(2), (3), (5), (6), (9); 3-104(e), (f), (g), (h)

2 The obligation must be unconditional 3-104(a); 3-106 3 The obligation must require the payment

of money 3-104(a); 1-201(24); 3-107

4 The amount of the obligation must be 3-104(a); 3-112(b)

fixed 5 The obligation must be payable to bearer

or order 3-104(a)(1) & (c); 3-109; 3-115 comment 2

6 The obligation must be payable on demand at a definite time

3-104(a)(2), 3-108

7 The obligation must not contain any extraneous undertakings

3-104(a)(3)

1. General Definition of Negotiable Instruments a. General

i. UCC § 3-104(a) ii. If an instrument misses any of the requirements, the rules of article

III don’t apply b. The Promise or Order Requirement

i. Order: 3-103(a)(6): An instruction by one person (the drawer) directing some other party to pay (the drawee)

1. An instrument that contains an order is called a “draft” 2. Three most common kinds of drafts:

a. A check – draft on a bank: 3-104(f) b. Cashier’s Check – drawer and drawee are the same

bank: 3-104(g) c. Teller’s Check – A draft by one bank on another

bank: 3-104(h) ii. Promise: 3-103(a)(9): A direct commitment to pay

1. The party that makes a promise is a “maker” 2. The instrument that contains the promise is a “note” 3.

iii. All negotiable instruments must be in writing c. The Unconditional Requirement

i. UCC 3-106 1. Limits negotiability to instruments that are absolute and

include on their face all of the terms of payment a. Can’t Include Conditional Payment Obligation

ii. Case: DBA Enterprises v. Findlay 1. Promissory note contained a statement that “Maker’s

obligation under this note is subject to the conditions recited in that Bill of Sale and Covenants not to Compete between the parties of even date.” (1) This makes the note non-negotiable.

iii. § 3-106(a)(ii) and (iii) states that a document is non-negotiable if it states that it is “subject to or governed by” another writing or if it states “that rights or obligations with respect to the document are stated in another writing.”

iv. Two Exceptions – 3-106(b): 1. In a note for which a maker gives collateral that includes

reference to other writings (security agreement, loan

agreement, mortgage) that describes rights related to the collateral and to the payee’s remedies upon default, these terms do not undermine negotiability. 3-106(b)(i)

2. If a document contains a statement that “payment is limited to a particular fund or source” this does not undermine negotiability. 3-106(b)(ii)

a. E.g. a “nonrecourse” real-estate note d. The Money Requirement

i. The promise or order must be for the payment of money 1. Includes domestic and foreign currency

e. The Fixed amount requirement i. The amount of the obligation must be FIXED

1. This does not exclude statements with interest or other charges

a. Also, interest can be variable or fixed 2. Just can’t be: “I’ll pay you half of what I get for the sale of

my books.” ii. Case: Nagel v. Cronebaugh

1. Note doesn’t contain a fixed amount, and thus isn’t negotiable – so you go to basic contract principals to interpret the note

f. The Payable to Bearer or Order Requirement i. § 3-104(a)(1)

ii. Must be payable to “bearer” or “order” iii. Bearer – two ways:

1. It must state: a. “Payable to Bearer” b. “Payable to the order of Bearer” c. Or, if it otherwise indicates that the person in

possession of the promise or order is entitled to payment. 3-109(a)(1)

2. Not payable to identified person: a. Doesn’t state a payee b. Made payable to “cash”

iv. Order – two ways: 1. Payable to an identifiable person

a. “Pay to the order of Dan Keating” 2. Payable to “an identifiable person or order”

a. Pay to Dan Keating or Order” b. Must include both “order” and “an identifiable

person” in the statement c. If misses one, it is not an instrument

v. Exception: 1. A check that fails the bearer-or-order requirement, but

satisfies all of the remaining negotiability requirements qualifies as an instrument

g. The Demand and Definite Time Requirement i. § 3-104(a)(2)

ii. Must be payable on demand or at a definite time iii. Can be payable “on demand” or at “no time” iv. Includes times that allow the holder to extend the time for payment v. Includes times that allow acceleration and prepayment

vi. The only obligation that would fail the rule would be a document giving the issuer either a completely unqualified option to extend or a qualified option to extend that did not state a date to which the extension would run

h. The No Extraneous Undertakings Requirement i. 3-104(a)(3): Forbids inclusion of a promise calling for something

other than the payment of money ii. Cannot be negotiable if it includes any non-monetary promises

1. To deliver wheat, etc. iii. Three exceptions:

1. An undertaking or power to give, maintain, or protect collateral to secure payment.

2. An authorization or power to the holder to confess judgment or realize on or dispose of collateral

3. Conditions in which the borrower waives laws intended for the benefit or protection of the borrower or obligor

a. Waivers of the Requirements of presentment, dishonor, notice of dishonor, and the like

X. Transferring a negotiable Instrument a. General

i. A transfer of a negotiable instrument never requires anything more than delivery of the instrument and a signature by the transferor

b. Negotiation and Status as a Holder i. Two concepts central to the transfer

1. “Holder” has a right to enforce the instrument. 3-301(i) a. No person can be a holder w/o possession of the instrument b. Bearer paper

i. If an instrument is bearer paper, possession is determinative. Any person isn possession of bearer paper is a holder. 1-201(b)(21) – even a thief

c. Order paper i. Order paper must be payable to some identifiable person. This is

the only person that is the holder. 1-201(b)(21) ii. Payable to more than one person

1. If “Husband or Wife” than either one; if “husband and wife” then both must be present

iii. Payable to account number 1. Holder of the account is the identified person

2. The act of “negotiation” by which it is transferred to a new holder a. “Negotiation” is any transfer of possession, even an involuntary one, by a

person other than the original issuer that causes the transferee to become holer. 3-201(a)

ii. Special and Blank Indorsements 1. To make the purchaser of an instrument the indentified person, the seller must

make an indorsement a. As simple as a signature,”unless the circumstances unambiguously

indicate that the signature was made for purpose other than indorsement.” 3-204(a)

b. Courts recognize signature in bottom right of instrument as the signature of the issuer. 3-204 comment 1 paragraph 2. Signature in any other place is treated as an indorsement

2. Special Indorsements a. Identifies the person to who the check is to be paid b. Transfers the identified person to the indorsement person. 3-205(a) c. If you have bearer paper, the special indorsement changes it to bearer

paper. 3-109(c), 3-205(a) 3. Blank Indorsement

a. Any indorsement made by a holder that does not indicate an indentified person

i. A blank indorsement transforms order paper to bearer paper, so that anyone in possession can enforce it. 3-109(c), 3-205(b)

ii. A blank indorsement on bearer paper has no effect on the character of the instrument, but it does create liability for the indorser under 3-415.

4. Bank rules that depart from abovementioned rules a. First, Article 4 generally dispenses with the requirement of indorsements

for transfers of checks in the check-collection system i. Depositary bank automatically becomes a holder of a check

deposited by its customer. 4-205(1) ii. Bank need not indorse a check when it transfers to another bank. 4-

206 b. Reg CC provides that no party other than a bank can become the holder of

a check once it has been indorsed by a bank i. The only way a different party can become the holder is if the bank

specially indorses the check to a nonblank party or returns the check to the depositor (dishonored checks). Reg CC and 4-201(b)

iii. Restrictive and Anomalous Indorsements 1. Restrictive Indorsements

a. Putting a condition other than “for deposit only” or “for collection” b. § 3-206(a), (b) invalidates almost all other restrictive indorsements c. If an instrument bears one of the allowable restrictive indorsements, a

party who pays or purchases the instrument commits conversion unless the proceeds of the instrument are received by the indorser or applied consistently with the indorsement. 3-206(c)

2. Anomolous Indorsements a. Indorsement made by a person that was not a holder at the time it made

the indorsement. 3-205(d) b. If a person who is not the holder signs order paper, it remains payable to

the person it is payable to. c. Article 3 assumes that these indorsements are made for “accommodation”

so that the anomalous indorser becomes a guarantor of the instrument. 3-419

c. Enforcement and Collection of Instruments i. The right to enforce an instrument

1. Any person that holds an instrument is a “person entitled to enforce the instrument” under 3-301(i)

2. You can sell an instrument, and than that person has all of your rights under the instrument. 3-203(b)

3. 3-203 also allows the purchaser a right to make a party sign the instrument after the sale

ii. Presentment and Dishonor 1. Two step approach:

a. Presentment i. A demand for payment made by a person entitled to enforce an

instrument. 3-501(a) 1. If a note, demand is made to the maker of the note. 2. If a draft, made to the drawee. 3-501(a)

b. The response of the party to whom presentment is made i. In most cases, the system assumes that a party intends to dishonor

the instrument if it does not take an affirmative action to honor it.

1. In most cases, it is considered dishonored if it is not paid at the time of presentment. 5-502(a)(1), (b)(2)

iii. Defenses to enforcement 1. As long as the person entitled to enforce the instrument is not a holder in due

course, Article III allows the obligor to impose a wide bariety of defenses, which include not only any defense cereated by Article III, but also any claim the obligor has against the payee with respect to the original transaction. 3-305(a)(2), (3)

2. Case: Turman v. Ward’s Home Improvement (failure ot provide the goods or services for which the instrument was given).

d. Liability on an instrument i. First, 3-401 articulates a general rule of exclusion. Except for the transfer and

presentment warranty liability, no party is liable on an instrument unless it has signed the instrument.

1. Two major problems: a. Some authorizing mark other than a signature: extremely broad definition

which includes markings in 3-401(b); see 1-201(b)(37) b. Individual acting as an agent or representative:

i. Signing party is the “representative” and the person they are agent for is the “represented person”

ii. Is represented person liable: 1. Bound by the same principles as contract and agency law.

3-402(a) iii. Representative liable:

1. Is not liable if (a) the signature shows unambiguously that he is signing on behalf of the represented person and (b) the instrument identifies the represented person. If either of these tests is failed, representative is liable unless he can prove that the original parties did not intend for him to be bound. 3-402(b)(1), (b)(2)

c. Determine the liability of the parties that have signed the instrument, there are four rules (TABLE 40.1, p. 647)

i. The party that issues the note is directly and unconditionally liable on the instrument. 3-412

ii. Drawee has no liability on a draft at the time it is issued. 3-408. If it accepts the draft (just a signature) the drawee is liable for the draft. 3-413

iii. Drawer of a draft is not liable on the draft unless it is dishonored. 3-414(b)

1. Drawers liability if discharged if the bank accepts the draft. 3-414(c)

iv. Indorser liable only if the instrument is dishonored. 3-415(a). The indorser’s liability is dishcharged if the bank accepts the instrument after it has been indorsed. 3-415(d). An indorser can limit its liability by indicating that it is signing the instrument “without recourse.” 3-414(e), 3-415(b)

e. The effect of the instrument on the underlying obligation i. General

1. When a party issues a negotiable instrument, it incurs liability that is completely separate from its liability on the underlying obligation

ii. 3-310 sets out the rules governing the relation between liability on the instrument and liability on the underlying obligation.

iii. Two Classes 1. Near-cash instruments. 3-310(a), (c)

a. Certified Checks, Cahier’s checks, and tellers checks. b. Cashiers and Tellers Checks are checks on which a bank is the drawer, so

the bank has liability under 3-412 and 3-414(b) respectively c. 3-310(a) and (c) provide that the underlying obligations is dischared when

the obligee takes one of the near-cash instruments 2. Ordinary Instruments. 3-310(b)

a. The statute does not immediately discharge the underlying obligation b. It is suspended, instead. 3-310(b)(1), (2).

i. In the instrument is paid, the underlying obligation is discharged. 3-310(b)(1), (2).

ii. If the instrument is dishonored, the suspension terminates, and the oblige has the option to enforce either the instrument or the underlying obligation. 3-310(b)(3). So, you can sue on the check, or on the obligation.

iv. A discharge of the underlying obligation under 3-310 is effective only to the extent of the amount of the instrument. 3-310(a), (b)

v. Resolving disputes, and “paid in full” clauses. 3-311 generally supports that use of instrument to resolve disputes

1. A paid in full clause will discharge an underlying obligation if (a) the instrument is tendered for full satisfaction of a disputed claim, or (b) the payor conspicuously notifies the payee that it intends the instrument to constitute full satisfaction of the claim, and (c) the payee successfully obtains payment of the instrument. 3-311(a), (b).

a. Illustrative Case: McMahon Corp. v. Burger Dairy Co. (Paid in Full Instruments)

XI. Holder in Due-Course Status a. General

i. Holder in due-course status implements the idea that enhancing the ability of transferees to enforce instruments increases the liquidity of negotiable instruments by making negotiable instruments more attractive investments

b. The requirements for holder in due-course status i. Must satisfy two sets of rules

1. First, it must obtain the instrument through the process of negotiation described in the previous section so that it becomes a holder

2. Second, there are special qualifications that must be satisfied to elevate an ordinary holder to a holder in due course

a. Set out in two stages: i. General definition: § 3-302(a)

ii. Section with definitions that describe the terms in 3-302(a) ii. Must satisfy three requirements:

1. Must take the instrument for value a. Ordinary payment qualifies as value, as does the release by the purchaser

of a pre-existing claim against the seller. § 3-303(a)(3) b. Promise of future performance DOES NOT count as value until

performance has occurred. 3-303(a)(1). 2. Must take the instrument in good faith. 3-302(a)(2)(ii)

a. Requires “honesty in fact” and “the observance of reasonable commercial standards of fair dealing. § 1-201(b)(20), § 3-103(a)(4)

i. Need not establish that potential holder acquired the instrument dishonestly, just failed to conform to reasonable standards of fair dealing.

b. Most common claims challenge long-term relationships between lenders purchasing negotiable instruments, on the one hand, and their clients, on the other. The issuers of those instruments have had considerable success arguing that their relationship with the client has become so close that the lender acts in bad faith when it tries to use holder-in-due-course status to insulate itself from defenses that would have been valid against its longtime client.

3. Must take the instrument w/o notice of certain problems with the instrument. 3-302(a)(2)(iii) – (vi)

a. Notice is when you have actual knowledge of a fact and when you have reason to know of the fact based on all the facts and circumstances known to you and the time. § 1-202(a)

b. It is not enough to prove that the holder had notice that something was wrong in the abstract with the instrument, the maker, or the payee. Rather, the maker must prove notice of one of the four problems listed in that clauses that close 3-302(a)(2)

i. The instrument is overdue (3-304), has been dishonored, or is in default. § 3-302(a)(2)(iii)

1. Demand instruments are overdue if not paid on the day after demand is made

2. checks automatically become overdue 90 days after their date

3. Instruments payable at a definite time become overdue upon any failure to make a scheduled payment of principal or upon any other event that results in acceleration of the date of maturity of the instrument

ii. The instrument has a forgery or alteration. 3-302(a)(1), 3-302(a)(2)(iv)

iii. A third party claims to own all or part of the instrument. 3-302(a)(2)(v)

iv. One of the obligors has a defense or claim that would limit or bar enforcement of the instrument by the original payee. 3-302(a)(2)(vi)

c. If notice does not fall in one of the four categories, the notice is relevant only if it is sufficiently damaging to undermine the holder’s good faith in acquiring the instrument.

d. Holder in due course status rests on the paradigm of an anonymous unknowing purchaser that knows nothing about the underlying transaction and thus cannot fairly be charged with problems in that transaction

c. Rights of the Holder in Due Course i. Free from most significant defenses to payment

1. Holder in due course is immune from most ordinary contract claims or defenses a. If thief stole bearer paper and sold instrument to Bank, Bank as holder in

due course is immune from any attempt by person who thief stole from to recover from bank. Person must go after thief. § 3-306

ii. Only defenses are the four “real” defenses in § 3-305(a)(1) 1. Infancy: cannot enforce an instrument issued by a minor with no capacity to sign

it. § 3-305(a)(1)(i) 2. Duress, Lack of legal capacity, and illegality: cannot enforce if original obligation

would have been void. § 3-305(a)(1)(ii) 3. Fraud that induced issuance of the instrument with neither knowledge nor

reasonable opportunity to learn of its character or essential terms. 3-305(a)(1)(iii). a. Courts interpret this narrowly

4. Discharge of the obligor in insolvency proceedings. § 3-305(a)(1)(iv) d. Payment and Discharge

i. Two step solution to the problem where one party discharges, and the holder-in-due course can still enforce the instrument:

1. First, the holder in due course status is not precluded by notice of payment of discharge. 3-302(b)

2. Second, any whole or partial discharge is effective against a person that takes w/o the notice of discharge. 3-302(b)

ii. A discharge is not binding on a holder in due course that takes w/o notice of the discharge. § 3-601(b)

1. This is a pain for obligor’s, who would have to keep paying after they are dishcharged by a previous holder. Several alternatives by the UCC:

a. The discharged party can make the discharge effective by acquiring the note and destroying it at the time of payment.

i. Holder must surrender when obligor makes payment. § 3-501(b)(2)(iii).

1. Doesn’t really work in practice b. If discharge is partial, the statute offers the maker the ability to protects

itself by forcing the holder to indicate on the instrument that the payment has been made. § 3-501(b)(2)(iii)

c. UCC is a bit of a pain b/c states that payment is only valid if it was made to a person entitled to enforce the instrument. § 3-602(a)(ii)

e. Transferees w/o holder in due-course status i. Position of a party without holder in due-course status isn’t so bad: the worst problem

such a holder faces is its exposure to defenses that would have been effective against the original payee of the instrument

ii. Two rules that make the position of the purchaser w/o holder in due course status better than the purchaser of a non-negotiable instrument

1. First rule applies only when purchaser failed to have it indorsed. 3-203(c) obligates the seller to sign the instrument at a later date

2. Second, the shelter rule. a. Purchaser that fails to obtain its own holder in due course status can assert

any holder in due course rights the seller had before the sale. 3-203(b)

XII. Remedies of Unsecured Creditors Under State Law a. Who is an Unsecured Creditor

i. Anyone owed a legal obligation that can be reduced to money judgment is a creditor of the party owing the obligation

ii. Unless a party contracts with the debtor for secured status or is ranted it by statute, the party is an unsecured creditor

1. These are general and ordinary creditors that populate state collection proceedings 2. Tort victims, incautious creditors, uninformed creditors, creditors who didn’t or

couldn’t negotiate for security iii. If the creditor has received a judgment, they are a judgment creditor, but this doesn’t

undermine their unsecured status. iv. These remedies are the minimum collection requirements owed to anyone who has an

obligation that can be reduced to a money judgment b. Unsecured Creditors Getting Paid

i. General Issues 1. Can’t do self-help seizure of the debtor’s property – this constitutes conversion

tort a. Additionally, they may be charged with larceny

2. Also, if you demand payment, you must do so in a reasonable manner to avoid wrongful collection practices

3. Case: Vitale v. Hotel California, Inc. a. Basically, you can levy on the property and get the sheriff to go collect it

i. Remedy is levy under writ of execution ii. Writ of garnishment: Requires the third party to pay the judgment

creditor rather than the debtor ii. Limitations on Compelling Payment

1. General a. It is the judgment creditors responsibility to use discovery to locate assets,

and only then will a sheriff go get it i. If you accidentally locate a third parties property:

1. Could be liable for damages 2. Could be liable for conversion

ii. Creditors can’t conduct fishing expeditions by showing up at a debtor’s place with an officer

b. Discovery i. Must find the debtor and have them sit through examination

1. If debtor lies: perjury ii. May not keep assets in predictable forms

iii. Sale to bonafide purchasers exempt the property iv. Can only enforce in the state the person is in

c. Debtors can preference one debtor over another as long as the payment to that debtor is fraudulent

2. Exemption Statutes a. Prevetn sheriff from seizing certain property under a writ of execution –

this property is exempt b. Wisconsin Statute – p. 707

i. A creditor can not seize: 1. Provisions for burial 2. Business and Farm Property, not to exceed $7500 in value 3. Consumer Goods, not to exceed $5000 in aggregate value 4. Motor Vehicles, not to exceed $1200 in aggregate value 5. 75% of debtor’s income in a one week pay period 6. Depositary accounts in the aggregate value of $1000

ii. Homestead Exemption 1. Home is exempt up to $40g, except certain liens 2. Home is building and land

c. Federal law exempts a minimum of 75% of debtors earnings from personal services

i. Some states exempt all earnings (Texas, Pennsylvania) iii. Is the Law Serious About Collecting Unsecured Debts?

1. Legal Mechanisms: a. Courts can order those subject to their jurisdiction to meet their legal

obligations and imprison them if they refuse to comply i. Do include obligations regarding:

1. Alimony or Child Support 2. Respecting the property of others by not trespassing or

stealing 3. Performing under a contract to sell real property

ii. Don’t include obligations regarding 1. Personal Injuries 2. The Wages of working people 3. Breaches of most kind of contracts

XIII. Security and Foreclosure a. The Nature of Security

i. The more effective collection right is known as a lien 1. “A charge against or an interest in property to secure payment of a debt or

performance of an obligation.” BC § 101 2. A relationship between particular property and a particular debt or obligation 3. The general nature of the relationship is that ifthe debt is not paid when due, the

creditor can compel the application of the value of the collateral to payment of the debt

a. This is foreclosure ii. There are two types of non-consensual liens:

1. liens obtained by statute, such as mechanic’s liens (statutory liens) 2. liens obtained by unsecured creditors through judicicial processs (judicial liens)

iii. The security interest has effect only in the event of a debtor’s default iv. Unsecured creditor’s get only what is left after provisions have been made for secured

creditors v. Why be an unsecured creditor

1. Can charge higher interest rates 2. Thrown into it without the opportunity to negotiate 3. Some agree to a contract that leaves them unsecured w/o realizing it

vi. Story of the History of Security 1. Parties who wish to do so can easily construct the security relationship using the

everyday conventions of sale and option to purchase 2. The story shows that in the hands of clever parties, or their clever lawyers,

existing legal forms can be employed in ways unanticipated by the lawmakers 3. Third, in determining which transactions are in the nature of security and must be

foreclosed, one can’t rely on the documents. a. A transaction is in the nature of security if the intent is to provide one

party with an interest in the property of another, which interest is contingent upon the non-payment of a debt. It is the substance of what is going on that matters, not the form.

i. Basile v. Erhal Holding Company: “The Supreme Court erred in declaring that the P waived her right of redemption in the demised premises. A deed conveying real property, although absolute on its face, will be considered a mortgage when the instrument is executed as security for debt.”

ii. The “intended as security” doctrine applies to personal property transactions as well as those involving real property. 9-109(a)(1)

1. Form does not matter b. Foreclosure Procedures

i. General 1. The procedure for real estate foreclosure differ widely from state to state 2. Article 9 provides a uniform procedure for personal property foreclosure that can

be very quick and easy, but it also permits secured parties to use judicial foreclosure methods of they prefer

ii. Judicial Foreclosure

1. A foreclosure process is judicial if it is accomplished by the entry of a court order. a. In most states, a creditor holding a mortgage or security interest typically:

i. Files a civil action against the debtor ii. In complaint, debtor details the terms of the loan and the nature of

default, and requests that the equity of redemption be “foreclosed” iii. The complaint is served on the debtor and any subordinate lien-

holder, who then have a period of time in which to raise defenses iv. Only after the P has established that it is entitled to foreclose will

the court enter a final judgment of foreclosure b. Foreclosure sale:

i. Usually by statute (conducted by sheriff or county clerk) 1. Usually a particular time of day in a particular place 2. Advertised (1-6 weeks in advance) 3. Upon receipt of money, sheriff certifies a person to be the

highest bidder 4. Foreclosure sale must be confirmed by the court

c. Deficiency: i. If the amount realized from the sale is less than the amount owed

the foreclosing creditor, the foreclosing creditor can request a judgment for the deficiency

ii. In many jurisdictions, anti-deficiency laws prohibit the granting of deficiency judgments in particular kinds of cases or give the court discretion to deny them

d. Possession after sale: i. Debtor usually remains on premises up to sale.

ii. If the debtor won’t surrender the premises, the purchaser is entitled to a writ of assistance, or a writ of possession, which will direct the sheriff to remove the debtor fro mthe premises and put the purchaser in possession.

2. Wisconsin Statute, p. 724 a. Foreclosure: you have to wait 12 months to put judgment on any house

that is foreclosed and owner occupied b. Foreclosure w/o Deficiency: Plaintiff has the right to waive a deficiency

judgment and consent that the mortgager can stay on the property, unless he or she abandons it, and remain entitled to all rents, etc. from the property until the confirmation of the sale by the court.

3. Cooperation from the debtor: a. If the debtor cooperates, and there are no other liens or interest in the

collateral, the debtor can simply transfer the property to the creditor by means of a deed in lieu of foreclosure.

b. Sometimes creditors do this by saying its better to lose the house now than lose it later and be liable for a deficiency

iii. Power of Sale Foreclosure 1. General

a. This is in about 25 states b. Include in the security agreement a power of sale

c. The security agreement might be in the form of a deed of trust i. The deed of trust states that the collateral will be held in trust by

the creditor or a third party such as a bank or title company. The borrower agrees that in the event of default, the trustee can sell the property and pay the loan from the proceeds of the sale.

2. Foreclosure can be accomplished w/o a lawsuit (E.g. California): a. California: Upon default under a mortgage or deed of trust containing a

power of sale, the creditor can record in the public records a notice setting forth the nature of the debtor’s default and the creditor’s election to sell the property. If the debtor doesn’t cure the default w/in 90 days, the creditor can set a time and place for sale, advertise it for 20 days, and then sell the property at an auction

b. Still, if debtor won’t leave, you’d have to sue for ejectment, unlawful detainer, or eviction.

i. If wrongful to foreclose, the debtor can bring a tort action for wrongful sale

c. UCC Foreclosure by Sale i. Personal Property

1. UCC Art 9 governs foreclosure for security interest in personal property. 2. After default, the secured party may sell, lease, license, or otherwise dispose of

any or all of the collateral. § 9-610 3. That sale or disposition itself forecloses the debtor’s right to redeem the property.

§ 9-623 4. It extinguishes the creditor’s security interes in the collateral and transfers to the

purchaser all of the debtor’s rights in the collateral. § 9-617(a) 5. Alternatively, if the creditor so chooses, it may foreclose by any available judicial

procedure. § 9-601(a)

XIV. The importance of possession pending foreclosure a. General

i. Why the secured creditor wants it 1. A debter may have little incentive to preserve and maintain the property 2. The use of the collateral between the time the right to foreclose accrues and the

time it becomes final may have substantial economic value. 3. If the debtor is in possession of the property in the period leading up to the sale, it

may be difficult or impossible for prospective purchasers to evaluate the property, thereby depressing the resale price

ii. Why the debtor wants it 1. Needs a place to live, sentimentality, functionality, etc.

iii. The creditor who can make a credible threat to dispossess the debtor has extraordinary leverage over the debtor

1. Interest, etc. iv. Many security Agreements provide that the creditor has the right to possession

immediately upon default, but such a provision is only the starting point of legal analysis b. The Debtor’s right to possession during foreclosure

i. General 1. Only the purchaser at the foreclosure sale is entitled to dispossess the mortgagee 2. By receiving a writ of assistance, or writ of possession after filing an ejection or

eviction action, the purchaser can have the sheriff on the scene in 10 to 20 days. c. Appointment of a receiver

i. Interested party can apply for the appointment of a receiver ii. Receiver is officer of the court with fiduciary obligations to all interested parties

iii. He has the right to collect the rents and use the money to maintain the building, as well as the authority to rent them out as necessary

iv. The receiver will retain any rents collected in excess of the amounts necessary to maintain the property, pending the outcome of the foreclosure action

v. Usefulness 1. Debtor and mortgager don’t get access to the cash flow 2. However, cash flow will be used to maintain the building, so it helps the

mortgager vi. Courts are reluctant to appoint receivers

1. Only in rare circumstances will the court appoint a receiver to take care of owner occupied real estate

2. a debtor can nearly always be sure he will retain possession of a family homestead 3. Receivers are appointed for owner-occupied commercial real estate more often,

but if someone’s business is being run out of it, this is unlikely vii. Check out the code provisions for appointment of receivers on 732

d. Assignment of Rents i. If the parties contemplate that the debtor will rent the collateral to others during the term

of the mortgage, the mortgage is likely to include a provision by which the debtor assigns the rents from the property to the mortgagee as additional security

ii. Because collecting the rents from mortgaged property that has been rented to third parties, like appointing a receiver, is functionally the equivalent of taking possession, some courts are reluctant to give effect to the assignment of rents clause

e. The right to possession pending foreclosure – Personal Property i. Article 9 governs nearly all security interests in personal property

ii. Article 9 favors the secured creditor in very strong terms iii. The secured party has a right to take possession immediately upon default. § 9-609 iv. Need not involve courts or officials if they can get possession without a breach of the

peace 1. If debtor resists repossession, the secured party must obtain a writ of replevin.

a. Does this by filing an action for replevin b. Any party entitled to possession of tangible personal property is entitled to

the writ c. Writ directs sheriff to take possession of the property

2. Immediately upon filing, the creditor can move for an order granting immediate possession pending the outcome of the case.

a. Typically takes no more than 10 days to accomplish 3. Most states require P to give notice of the hearing to the debtor 4. If the secured creditor proves it is likely to prevail in the action, the creditor gets

the writ of replevin a. Usually also has to post a bond in case the debtor wins in the action

5. The debtor can post a bond to retain the property 6. Typically, a creditor can get ahold of personal property through the court in a

matter of weeks f. The Article 9 right to self-help possession

i. The right is derived from § 9-609, providing that fafter default a secured party may take possession

ii. There are collection repossession agencies, etc. iii. § 9-609(2) gives the creditor the option to leave “equipment” temporarily in the

possession of the debtor but render it un-useable 1. Take the engine out, etc.

g. The Limits of self-help – breach of the peace i. § 9-609(b)(2) prevents the creditor from doing a breach of the peace

ii. For examples, look at cases on 742-744 h. Self-Help against accounts as collateral

i. This just means you collateral the persons incoming accounts 1. Examples of typical arrangements on 745

ii. In the event of default, § 9-607 and § 9-406 proved a self-help remedy to the party holding a security interest in the accounts

1. § 9-607 allows the secured creditor who knows the identity of the accocunt debtors to send them written notices to pay directly to the secured creditor

a. If they don’t, they can be sued, and this works

XV. Judicial Sale and Deficiency a. General

i. Keep in mind that Article 9 security interests can be foreclosed judicially. UCC § 9-601(a)(1).

b. Strict Foreclosures i. Strict foreclosures do not require a sale of the collateral

ii. Most common is the foreclosure of a contract for deed, or installment land contract 1. This is a contract for the sale of real property that provides for the payment of the

purchase price in installments over many years, with the deed to be delivered only after the last installment has been paid

iii. In most states, if the debtor does not pay the full purchase price in accord with the contract or at least by the end of a statutory grace period, the debtor’s interest in the property is forfeited and the the court confirms that the title remains with the seller.

c. Foreclosure sale procedures i. In most states, statutes specify

ii. The high bidder wins, must usually place a deposit, and pay the rest in a set amount of time (hours or days). If he doesn’t, he may lose his deposit and be liable for any damages in contract

iii. Sale Proceeds 1. The money goes first to reimburse the foreclosing creditor for the expenses of

sale. 2. Next, the proceeds are distributed to the foreclosing creditor up to the amount of

the debt secured by the foreclose lien 3. Any remaining surplus goes to the debtor

iv. While the foreclosure is in progress, the mortgage debtor has the right to redeem the property from the mortgage by paying the full amount due under the mortgage, including interest and attorney’s fees.

v. In more htna half the states, the debtor also has a statutory right to redeem the collateral from the buyer after the sale

vi. Statutory redeeming rights usually ranger from 6 months to 3 years, with one year being the most common

vii. Statutory rights of redemption are freely transferable. d. Problems with Foreclosure Sale Procedures

i. Sometimes the debtor is sufficiently outraged to bring a lawsuit asking the court to set aside the sale b/c of the inadequate sale price.

1. Armstrong v. Csurilla: Two instances when it can be set aside: (1)When the disparity is so great as to shock the court’s conscience; (2) When, in addition to the inadequate price, there are circumstances which would make it inequitable to allow the sale to stand. The judge in this case looks to a 10-40% of market value range

e. Advertising i. Forclosure sale advertising may be fixed by statute

1. See Wisconsin Statute on 758 and Advertisement on 759 for example ii. Advertising is usually in small circulation magazine in order to keep costs down

iii. The legal notices rarely attract buyers interested in owning the property. To the extent they bring in bidders at all, the bidders are usually professional bargain hunters who plan to resell the property at a profit.

f. Inspection i. The mortgage contract usually grants the foreclosing creditor the right to inspect the

collateral in preparation for bidding at the sale. Such a provision ordinarily will be specifically enforced.

ii. Others who wish to bid at the sale can observe the property from adjacent public places, but they have no right to enter the property to inspect.

iii. Buyers who want the property for their own use are unlikely to be willing to purchase without looking inside the building

g. Title and condition i. Buyers take subject to any defects in the title that they could have discovered through a

search of the public records or an inspection of the property. 1. Marino v. United Bank of Illinois: Guy buys property, has several outstanding

liens, he is screwed. “Generally the doctrine of caveat emptor applies in judicial sales, and the risk of a mistake or defect of title is to be borne by the purchaser unless there is fraud, misrepresentation, or mistake of fact.

h. Hostile Situations i. In foreclosure sales, often there is no one with either a motive or an obligation to furnish

information to prospective purchasers. ii. In fact, a debtor’s strategy for retaining its property often calls for preventing third parties

from obtaining the information they need to bid iii. Foreclosing creditors may not be able to furnish information b/c they don’t themselves

have access to it. iv. Typically the officer has no obligation or incentive to furnish information, but the officer

may have liability for furnishing incorrect information i. Antideficiency Statutes

i. Typical problem is that very low buying price reflects all the problems with foreclosure mentioned above, and then the debtor also has to pay the deficiency costs

ii. Antideficiency statutes either prohibit the court from granting deficiency judgments in particular circumstances, give the court the discretion to refuse to grant them, or limit the amount of the deficiencies to be granted

1. See good example on p. 765 2. California Antideficiency statute on 766

j. Credit Bidding at Judicial Sales i. The creditor will know of the sale even though it is poorly advertised, may be familiar

with the title and condition of the property already, and may have an enforceable contractual right to inspect it.

ii. The creditor can bid on credit up to the amount of the debt. Such a bid is called a credit bid.

1. Typically, the creditor has no incentive not to bid this high. a. Minimizes the likelihood that the sale will be set aside for inadequacy of

price. b. Minimizes the likelihood that debtor will exercise his right to redeem c. Avoids the undervalued purchase price problem

d. Doesn’t have to pay, just buys it on credit

XVI. Article 9 Sale and Deficiency a. General

i. As with real property foreclosures, the requirement that the collateral be offered for sale as part of the personal property foreclosure process cannot be waived or varied in the initial lending contract. § 9-602(10)

b. Strict Foreclosure under Article 9 i. After a default has occurred, the debtor can consent ot the secured party retaining the

collateral in full or partial satisfaction of the obligation. ii. § 9-620(c)(2) imples consent if the secured party sends the debtor a proposal for retention

of the collateral in full satisfaction of the debt and does not receive notification of the objection to the proposal within 20 days.

iii. Right to consent subject to three conditions: 1. There must be no objection from others holding liens against the collateral. § 9-

620(a)(2) 2. If the collateral is consumer goods, the debtor can consent, in writing or by

silence, to strict foreclosure only after repossession. § 9-620(a) 3. Strict foreclosure is not permitted if the debtor has paid 60% of the cashs price of

the consumer goods purchased on credit or 60% of the loan against other consumer goods. The debtor may waive this right after default, but this kind of waiver requires a writing. § 9-620(a)(4) and (e), 9-624(b)

a. The implicit assumption is that consumer who have paid less than 60 percent don’t have an equity, and anyone other than a consumer will be sophisticated enough to protect its equity by making the objection described in § 9-620(c).

c. Sale procedure under Article 9 i. § 9-610 governs the sale of collateral when Article 9 applies

ii. The secured creditor, and not a public official, conducts the sale and distributes the proceeds.

iii. The foreclosing creditor has a duty to the debtor to choose a procedure for sale that is commercially reasonable. “Every aspect of the disposition, including the method, manner, time, place and terms must be commercially reasonable.” § 9-610(b)

iv. § 9-611(c)(1) also requires that the creditor give the debtor prior notice of the sale 1. Purpose is to enable the debtor to observe the sale, participate in it, or otherwise

protect its rights v. § 9-623 incorporates the common law right to redeem. Redemption is accomplished by

paying the full amount of the debt, including the secured creditors’ attorney’s fees and expenses of sale.

1. No additional statutory right to redeem after the sale exists under the UCC vi. Debtors right to set aside a defective or irregular sale is more constructed under the UCC.

If the sale was commercially unreasonable, the debtors only right is often to sue the creditor for damages.

1. If, however, the collateral is consumer goods, the debtor has the right to recover a statutory penalty. § 9-625(c)(2)

2. The good faith purchaser at a UCC sale can buy with confidence that it will not lose its bargain b/c the sale is set aside. § 9-617(b)

vii. When collateral is sold for an insufficient price, the injury to the debtor may come in either of two forms.

1. Where the debtor has an equity in the collateral, the insufficient price may forfeit all of part of this equity.

2. There may also be an entry of a deficiency judgment in an amount larger than is appropriate.

d. Debtor’s defenses to deficiency judgments i. Failure to sell the collateral

1. § 9-610(a) provides that a secured party may sell the collateral after default, but there is not specific provision that says the creditor must sell the collateral.

2. If the secured creditor’s delay in selling is not commercially reasonable, the secured creditor’s deficiency will be limited to the amount that would have been left owing if the sale had been commercially reasonable. § 9-626(a)

ii. Requirement of Notice of Sale 1. § 9-611 requires that the secured party send notice to the debtor, guarantors, and

some lieners. 2. The failure to give this notice does not invalidate the sale. § 9-617, but it is a

defect that can have the effect of reducing the amount of the deficiency the secured party can recover.

3. Illustrative Case: FDIC v. Lanier a. Although the goods were sold at a private sale, the bank’s letter did not

indicate the type of sale at which the goods would be sold. This was not a fatal defect. For a private sale, the creditor only need provide notice “of the time after which any private sale or other intended disposition os to be made.” At a minimum it must be sent in such time that persons entitled to receive it will have sufficient time to take appropriate steps to protect their interests by taking part in the sale of after notice is sent, giving the debtor interests by taking part in the sale or other disposition if the so desire

iii. The Requirement of a Commercially Reasonable Sale 1. The reasonableness requirement of § 9-610(b) is purposefully vague. The

purpose is to bring the knowledge and ingenuity of the secured party to bear in determining a reasonable way to dispose of the particular kind of collateral.

2. Illustrative case: Chavers v. Frazier a. Failure to procure the best price for collateral does not in and of itself

make a sale commercially unreasonable. § 9-627(a). However, (1) the hasty sale for this type of equipment wasn’t reasonable, (2) The advertising was not adequate, (3) A distress sale auction was not reasonable, (4) Aircraft maintenance was not properly addressed prior to the sale, and (5) the purchase price was not reasonable.

3. Contrast Chaverz between judicial sale issues a. Chavers court says that sixty days was a grossly inadequate time ofr

advertising and marketing the aircraft, but judicial sale rarely allows that much time, even for complex collateral worth millions of dollars

b. Chavers court is disappointed in advertising that ran only briefly in the Wall Street Journal and Trade-a-Plane, but under judicial sale procedures,

the aircraft could have been sold in exactly the condition in which it was repossessed.

c. Chavers says that a “distress auction” was not reasonable, yet nearly every judicial sale is precisely that.

d. Chavers complains about the maintenance of the aircraft, but in a judicial sale, the aircraft could have been sold in exactly the condition in which it was repossessed.

e. Chavers court sets aside a sale for almost sixty percent of the fair market value, a price that would easily pass muster in most judicial sale procedures.

4. The appropriate remedy for failure to five notice of sale or failure to conduct the sale in a commercially reasonable manner

a. Majority hold that there is a a rebuttable presumption that the value of the collateral was at least equal to the amount of the debt, with the consequence that, if the consumer debtor objects, the court ends up determining what the sale price should have been.

b. Minority holds that any significant irregularity in the sale procedure is sufficient to deny the deficiency altogether – a view that relieves the court of the necessity to guess what the price would have been absent the defect.

i. If confused, see e.g. on 783

XVII. Bankruptcy and the Automatic Stay a. Filing a Bankruptcy Case

i. You file a form 1. Chapter 7 – liquidation 2. Chapter 11 – Reorganization 3. Chapter 12 – Reorganization only for owners of family farms 4. Chapter 13 – Reorganization for individuals

ii. Bankruptcy Clerk stamps it: Two things happen 1. A bankruptcy estate is created (all of the property of the debtor) 2. Stay against any collection activities is automatically imposed. BC § 362(a),

541(a) iii. Who is in control after the filing?

1. Under Chapter 7 a. The US Trustee appoints a trustee to administer the estate b. Trustee liquidates the estate c. If the debtor is an individual, he can exempt certain property from the

estate. Every individual debtor is entitled to keep the property of the bankruptcy estate that would have been exempt from creditors’ remedies on a judgment under state law. BC § 522(b)

d. After liquidation, trustee distributes money pro rata to general creditors i. If an individual, debts are discharged

ii. If a corporation, it is a corporate shell w/no assets that still owes its debts

2. Chapter 11, 12, or 13 a. Debtors are left in control of their own estates b. Trustees are appointed (don’t take possession of property) to examine the

debtors, review their repayment plans, receive payments from the debtors after their plans are confirmed by the court, distribute the money they receive to the appropriate creditors, and collect their fees.

c. Under Chapter 13 i. the debtor files a proposed budget, with a plan to devote all

“disposable income” to the payment of the debt for at least three years. BC § 1325(b).

ii. The plan must also promise to pay creditors at least as much as they would have received in a Chapter 7 liquidation. BC § 1325(a)(5)

iii. Trustee examines the budget and appears at the court hearing to consider the confirmation of the plan. BC § 1302

iv. If the plan is confirmed, the trustee receives the payments form the debtor and distributes them pro rata to the general creditors over the life of the plan. The plan lasts from 3 to 5 years, and the debtor is discharged from most remaining debt when the last payment is made. BC § 1328

d. Under Chapter 12 i. Basically the same pattern

e. Under Chapter 11

i. See p. 791 b. Stopping Creditor’s Collection Actions

i. Once the case is filed, the claims against the debtor are stayed, and you cannot violate the rules of a stay. You cannot pursue your debt.

ii. Court’s take stay violations VERY seriously. Thy usually hold deliberate violators in contempt of court and impose a fine sufficient to make them regret their transgression. In some circumstances, a party injured by the stay violation can sue for damages. BC § 362(h)

iii. While the stay is broad, it is not unlimited. 1. Only actions to collect pre-filing obligations are stayed. 2. Does not halt criminal proceedings against the debtor 3. Does not halt regulations from agencies

c. Lifting the stay for secured creditors i. Bankruptcy proceedings permit each secured creditor the right to participate individually

in the bankruptcy case rather tna forcing on them the collective treatment forced on the unsecured creditors.

ii. Grounds for lifting the stay are in BC § 362(d): 1. The stay must always be lifted if the trustee or the debtor does not provide the

creditor with adequate protection. BC § 362(d)(1) a. Adequate Protection is defined in § 361 b. A secured creditor’s interest is adequately protected when provisions that

the court considers adequate have been made to protect the secured creditor from loss as a result of a decline tin the value of the secured creditor’s collateral during the time the creditor is immobilized by the automatic stay.

c. The court recognizes that a cushion of equity of sufficient size may alone adequately protect the secured creditor against loss

i. How large, depends on: 1. The nature of the factors that might change the value of the

collateral 2. The volatitlity of the market in which the creditor might

have to sell it, and 3. The rate at which the secured debt is likely to increase in

amount 2. Or, the stay must be lifted if:

a. There is not equity in the collateral that the trustee or debtor might realize for unsecured creditors; and

b. The collateral is not necessary to an effective reorganization iii. Illustrative Case: In re Craddock-Terry Shoe Corp. iv. Motions to lift the stay receive high priority: the stay is automatically terminated, unless

within 30 days after a secured creditor moves to lift it, the court enters an order continuing it in effect. BC § 362(e)

XVIII. The treatment of Secured Creditors in Bankruptcy a. The vocabulary (the important ones at least)

i. Debts can be discharged in bankruptcy. A discharged debt still exists, but the discharge permanently enjoins the creditor from attempting to collect it. BC § 524(a)(2)

1. The discharged debt is then referred to as nonrecourse, meaning that it cannot be enforced against the debtor

2. Note the problems with not paying a nonrecourse secured debt on 807 ii. Under Article 9, Secured creditors have security interests, and unsecured creditors have

liens. People with realty have mortgages. iii. Bankruptcy Code groups Article 9 security interests together with real estate mortgages

and deeds of trust under the term security interest. Then, the Code lumps security interests together with all other secured statuses, including judicial and statutory liens, under the term lien. §101(51),(37)

iv. A creditor’s claim is the amount of the debt owed to the creditor under nonbankruptcy law at the time the bankruptcy case is filed. BC § 101(5) and (12)

1. It is nearly always the amount of the claim that is important during bankruptcy, and afterwards it is the amount of the debt that is important

b. The Claims Process i. General

1. The bankruptcy system determines the § 502 amounts of all creditors’ claims – the amounts those creditors were owed under non-bankruptcy law as of the date of bankruptcy

2. Chapter 7: amounts are determined by selling the assets 3. Chapter 11: determined by negotiations or by the court

ii. Early Process 1. Once bankruptcy is filed, the creditor files a proof of claim, describing the debt

and stating that it remains outstanding. If nobody objects to the claim, it is deemed “allowed”

a. Claim is for the full amount of debt and fees if allowed. They are accelerated as a result of the bankruptcy filing. BC § 502(b)(1)

2. Chapter 11: Debtor must file a list of its creditors with the amounts owing to each. If the debtor schedules the debt correctly and doesn’t dispute it, the creditor doesn’t even need to file a proof of claim.

3. If claim is questioned, it may go to dispute resolution process. If the ultimate resolution of a claim threatens to delay the bankruptcy case or distribution, the court can estimate the amount of a claim, allow it in the estimated amount, and proceed. BC § 502(c).

4. If the debtor outside bankruptcy had a legal defense to payment, the bankruptcy estate will have the same defense. BC § 558.

5. The BC gives some groups of unsecured creditor’s priority over others. SEE § 507(a).

iii. Calculating the amount of an unsecured claim 1. The amount of an unsecured claim in bankruptcy is essentially the amount owed

on the debt under nonbankruptcy law as of the moment the bankruptcy petition is filed. BC § 502(b)

a. If the creditor’s contract provides for the debtor to pay the attorney’s fees of the creditor or to reimburse for other fees, those amounts are included in § 502(b), provided that they were incurred prior to the time the bankruptcy was filed. § 502(b)(1).

2. Unsecured claims a. Do not grow with interest b. Traditionally, courts haven’t allowed unsecured creditorst to include

postpetition attorneys’ fees in the amounts of their claims. However, some recent cases have if the contract originally provided for it.

iv. Payment on Unsecured claims 1. The data from certain studies leads to two conclusions:

a. The fate of most unsecured creditors in bankruptcy is not a happy one. b. However, there are many cases in which unsecured creditors manage a

substantial if not full, recovery. c. Sometimes, debtors with substantial assets, an allowed claim can yield

substantial dividends. v. Calculating the Amount of Secured Claims

1. First, you must bifurcate the claim as require under BC § 506(a) a. The claim of a secured creditor can be a secured claim only to the extent

of the value of the collateral. The remainder of the creditor’s claim is an unsecured claim.

2. Second, you must determine whether the creditor is entitled to accrue postpetition interest, attorneys’ fees, or costs on its claim.

a. § 506 says that they creditor can do so if, and only if: i. Attorneys’ fees and costs must be reasonable

ii. Payment of the attorneys’ fees and costs by the debtor must be provided for under the agreement under which the claim arose

iii. Interest, attorneys’ fees, and costs can be accrued only to the extent that the value of the collateral exceeds the amount of the claim secured by it. (If the claim is oversecured)

vi. Selling the collateral 1. When the trustee liquidates the property of the estate, the trustee ordinarily sells

only debtors equity in property subject to a security interest, b/c that is all the state has succeeded to under the Bankruptcy Code § 541(a). Therefore, if there is a $10,000, the buyer takes the boat subject to the creditor’s lien

a. This terminates the automatic stay with respect to that item. 2. § 554(a) of the BC authorizes the trustee to abandon property of the estate that is

burdensome or of inconsequential value to the estate. When this happens, the property ceases to be property of the estate and reverts back to the debtor. This terminates the automatic stay with respect to this property

3. Finally, under some circumstances, the trustee can sell the collateral “free and clear of liens” under § 363(f).

vii. Who pays the expenses of sale by the trustee? 1. Bankruptcy Code § 506(c) authorisez a trustee who has incurred “reasonable,

necessary costs and expenses of preserving, or disposing of” property securing an allowed security claim to recover from the property.

2. The language limits the trustees right to deduct the proceeds “to the extent of any benefit to [the secured creditor.]” Thus, absent benefit to the secured creditor from the trustee’s expenditures, the trustee cannot deduct anything from the proceeds of sale.

3. The result is that a trustee’s sale of an under-secured creditor’s collateral will ordinarily benefit that creditor and be deducted from its recovery, but the trustee’s sale of property when the debt is sufficiently over-secured will not. Read 817-818.

c. Chapter 11 and 13 reorganizations i. The confirmation of a Chapter 11 plan discharges the old secured debts and payment

schedules and substitutes new ones. BC § 1141(d)(1)(A) 1. The plan must specify that the creditor retain its lien under BC §

1129(b)(2)(A)(i)(I), but after confirmation, the lien secures only the new debt. The confirmation plan to which the creditor has not agree is referred to as a cramdown

ii. The statutory standards of cramdown: 1. Practically the same under Chapter 11 and 13 (Compare § 1129(b)(2)(A) and §

1325(a)(5) 2. Unless the secured Creditor accepts (agrees to its treatment under) the plan, the

debtor must either: a. Surrender the collateral to the secured creditor in satisfaction of the

secured claim; or i. Most debtors want to avoid this

b. Distribute to the creditor, on account of the secured claim, property with a value as of the effective date of the plan that is not less than the amount of the allowed secured claim

i. Nearly always the property here is a promise of future payment iii. Valuing future payments

1. Think of the time value of money ($1 will not buy what it will today tomorrow) 2. So, establish the present value, and then add on the market rate of interest, which

must be determined (it is difficult, there are lots of markets). a. Illustrative Case: In Re E.I Parks (p. 821)

XIX. Creation of Security Interests a. Formalities for Attachment

i. A Prototypical Secured Transaction 1. See pages 827-829 2. Pablo signs a financing statement on the form set forth in UCC 9-521 3. Bank sent the financing statement to the Secretary of State for filing in the filing

system a. Provides Public Notice

4. Bank also ordered a search of the UCC filing system for other financing statements filed against the person Pablo’s buying from

a. The bank wanted a security interest in the assets prior to all others; only through such a search would the bank know whether there were already other security interests in those assets

5. At closing, previous owner delivered a bill of sale for the restaurant property, an assignment of her rights under the lease, and the keys to the restaurant

6. Bank walked to courthouse where it recorded the assignment of mortgage and checked the records to make sure Stella had not conveyed an interest in it to anyone else since the date of the bank’s title search.

ii. Formalities for Article 9 Security Interests 1. UCC 9-203(b) lists three formalities for the creation of a security interest

enforceable against the debtor: a. Either the collateral must be in the possession of the secured creditor or

the debtor must have “authenticated a security agreement which contains a description of the collateral”

b. Value must have been given c. The debtor must have rights in the collateral

2. Only when these are accomplished does the security interest “attach” to the collateral and become enforceable against the debtor. UCC 9-203(a) & (b)

iii. Possession or Authenticated Security Agreement 1. Article 9 ratifies two different kinds of security agreements

a. A Security agreement can be made effective by possession of the collateral

i. E.g. Pawnshops ii. However, the most common arrangement is to rely on a written

security arrangement and leave the debtor in possession of the collateral

b. Prototypical security transaction is based on a writing: i. Security Agreement, which contains:

1. Description of the Collateral 2. Description of the obligations secured 3. Provisions defining default 4. Specifying the rights of the secured creditor on default 5. Requires that the debtor care for the collateral and keep it

insured 6. Imposes other obligations on the debtor

ii. When the debtor has signed such an agreement, UCC 9-203(b)(3)(A) requirement of an authenticated security agreement is fulfilled. UCC 9-102(a)(7)

c. Neither oral or written arrangement can also fulfill the requirement of UCC 9-203(b)(3)

i. This must be inscribed on a tangible medium in which it can be stored and from which it can be retrieved

1. Computer disk. 2. This is referred to as a record. 9-102(a)(69)

ii. To constitute a security agreement of the third kind, that record must be “authenticated” by “processing it” with the intention to identify the authenticator and “adopt or accept” the record. 9-102(a)(7)(b)

2. In re Ace Lumber Supply, Inc. a. The debtor signed a financing statement to be filed in the public records to

put other creditors on notice, but the parties did not otherwise document the transaction. When the debtor later filed for bankruptcy, the secured creditor needed to prove that it had a valid security interest in order to have an allowed security claim. Held, under Montana Law the composite document rule is available to provide evidentiary support to create a security interest in collateral. That rule, however, does not allow only a financing statement signed by the debtor to satisfy 9-203(b)(3)(A)

3. Justification for the requirement of an authenticated security agreement: a. Preventing Fraud b. Minimizing Litigation c. Cautioning Debtors d. Channeling Transactions e. Discouraging Secured Credit

4. The competing policy is expressed in the doctrine of equitable mortgages. Under that doctrine, the courts can enforce an oral security agreements where to do so would be “equitable.”

a. This is impliedly repudiated in the text of 9-203(b)(3) 5. Cases in which the security agreement did not contain a description of the

collateral at the time it was authenticated have divided the courts. iv. Value has been given

1. The drafters of the UCC defined “value” in 1-201(44) so broadly that the requirement is virtually always met in a commercial transaction

2. The definition of “value” used in Article 9 not only encompasses all forms of consideration that would support an ordinary contract, it even includes one form of consideration that does not pass muster in common law contracts: past consideration.

a. 1-201(44)(b) provides that “a person gives value for rights if he acquires them . . . as security for . . . a pre-existing debt.”

v. Debtor has rights in the collateral 1. You can’t grant a security interest in someone else’s property. Three significant

subtexts:

a. First, it is read to mean that if the debtor owns a limited interest in property and grants a security interest in the property, the security interest will generally attach to only that limited interest.

b. Second, “owners” who acquired their rights in property by fraud have the power to transfer to bona fide purchasers ownership rights they themselves do not have.

c. Finally, you can transfer property to someone which you don’t have rights, and then if you eventually have rights in the collateral, then the security interest (only then) becomes enforceable.

vi. Formalities of Real Estate Mortgages 1. Differs from State to State

a. Most states require the mortgage be in writing and signed by the debtor in the presence of one or more witnesses

b. Some require acknowledgment as well, although most require that step only as a prerequisite to recording the mortgage

XX. Proceeds, Products, and other Value Tracing Concepts a. General

i. One way to assure that a security interest will follow the value is to include express language in the description of the collateral in the security agreement that covers all forms the value is likely to take

ii. A more practical solution is to employ value-tracing concepts – terms of art that indicate that in certain kinds of transformations of the collateral the security interest should follow from the value in prescribed ways.

b. Proceeds i. Definition

1. 9-102(a)(64): “Right arising out of the collateral are proceeds” a. Can be used to argue that virtually any property is proceeds

2. If the debtor sells the collateral, the security interest will attach to the price paid, whether it is in the form of an account, a promissory note, or cash. If the debtor leases the collateral, the security interest will attach to the rents received.

3. Courts will infer: a. When the parties have done a poor job of expressing their desire that the

security interest follow the value of the collateral, some courts are quick to infer it, even if the inference does violence to the definition of the terms used

b. Proceeds are “collateral” within the definition of collateral in 9-102(a)(12) 4. Proceeds are Automatic

a. Even if the security agreement makes no mention of proceeds, a security interest automatically covers them. § 9-203(f) and 9-315(a)

ii. Termination of Security Interest in the Collateral after Authorized Disposition 1. Secured creditors sometimes allow their debtors to dispose of collateral free of the

security interest a. Might be in security agreement – inventory of a store b. Might be given by creditor at a later time – car dealership c. Might be implied by the circumstances and conduct of the parties

2. In this instance, § 9-315(a)(1) gives effect to the authorization: the buyer takes free of the security interest and the secured creditor can look only to the debtor and the proceeds

iii. Continuation of Security interest In Collateral after Unauthorized Disposition 1. In some arrangements, the parties contemplate that the debtor will sell the

collateral only pursuant to further arrangement a. Often w/expensive items of collateral b. Allows the bank to pass on the nature and adequacy of the consideration

the dealer will receive for the sale 2. Some security agreements prohibit the sale of collateral

a. Such a clause doesn’t mean the buyer can’t sell the car at all b. When the debtor pays the debt, the interest terminates and the debtor can

sell 3. The way to handle a problem where three people are involved (Creditor, Debtor,

and Purchaser) is to arrange for a simulataneous exchange of the security interest, the car, and the money

a. Set up an escrow 4. Many states have enacted statutes making conduct. where a debtor sells the

collateral against a prohibition and doesn’t use the money to pay the debt, criminal

a. Illinois Statute (865): Can’t sell it and not account to the creditor b. New York Statute (865): Can’t sell it at ALL

5. Even if the security agreement expressly prohibits sale of the collateral, § 9-401 gives the debtor the power to transfer ownership to a buyer (may be a breach of the security agreement or a crime)

a. To understand 9-401, it must be read together with 9-315(a)(1): When a buyer purchases the collateral, the security interest is still there

i. Unless the secured party authorized the debtor to sell the collateral, free of the security interest, the security interest continuesin the original collateral and also in the proceeds

1. Is a windfall, but that’s the way it goes b. Creditors usually only bring these proceedings when their relationship

with a debtor sours (courts aren’t helpful to them) i. Also, the waiver cases (waiving your rights) usually occurs w/the

sale of livestock, where sales by debtors are pretty much continuous and the buyers are not protected by the UCC 9-320(a)

iv. Limitations on the Ssecured Creditor’s Ability to Trace Collateral 1. Security Interest encumbers proceeds so long as they are identifiable. 9-315(a)(2)

a. Commingling: Putting several pieces of collateral together; usually in a bank account

i. How to commingle. Think of oil and water. Use the “lowest intermediate balance rule”

1. Take the lowest balance between the time of the deposit of the proceeds and the present balance

b. The money in a commingled account: i. 9-322(b): a transferee of funds from a deposit account takes the

funds free of a security interest in the deposit account unless the transferee acts in collusion with debtor in violating the rights of the secured party

ii. However, anything the debtor purchased with that cash may be proceeds

1. You have to be able to trace the value with “specificity” 2. In re Oriental Rug Warehouse Club, Inc.

a. The secured party has the burden of proving with specificity – must have “arose directly from the sale or other disposition of the collateral and that these alleged proceeds can’t have arisen from any other source”

b. The intermediate balance rule assumes that a debtor who spends money from a commingled account spends first from his own funds. Once the balance fo the commingled account drops below the amount

of the deposited proceeds, then the secured creditor’s interest in the proceeds abates accordingly

c. Other value tracing concepts i. Product: What the collateral produces

1. Usually agriculture: wool is product of sheep, milk of cows, maple of trees a. These may also be proceeds, but we are unclear

ii. Profit: The excess of revenues of a business over the expenses where the business itself is the collateral

1. Under 9-315, applied to real-estate, a profit may not be proceeds: the former is a right ot remove; the latter typically is a thing received in exchange

iii. Rents: money paid for the temporary use of collateral iv. Offspring: what the animal produces – baby, etc. v. All of these are arguably proceeds b/c they are “rights arising out of collateral.

d. Non-Value tracing concepts i. Main types

1. After-acquired property 2. Replacements 3. Additions 4. Substitutions

ii. These are non-value tracing in the sense that they can pick up property acquired by the debtor with value not derived form the previously existing collateral

XXI. The prototypical Secured Transaction a. General

i. This part will break down a prototypical transaction. We will discuss the strategies and motivations of both sides. The legal doctrine governing secured credit is best understood in relation to those strategies and motivations

b. The Parties i. Deutsche Bank is a lender that specializes in floorplanning – buying the inventory that

people use on the showroom floor of businesses ii. Bonnie’s Boat World is a corporation that owns a spot near a lake on a commercial

highway c. Deutsche approves Bonnie’s loan

i. Bonnie goes and discusses with loan officer Paul Kaplan. She takes an application form, which asks for information about Bonnie and her business, including current balance sheets, income statements, and income tax returns for both herself and the corporation.

ii. Paul receives the application, and orders a credit check. After computer analysis and Paul’s own check, Paul decides to recommend authorization of the loan.

iii. He presents the loan to his branch manager. Branch manager approves the loan, and Paul calls Bonnie to let her know the transaction has been approved.

d. Deutsche and Bonnie document the loan i. Bonnie Presents to her lawyers the Security Agreement – Arbitration she will have to

sign, and then has a meeting with Deutsche. Prior to the meeting, Richard, a Deutsche employee, searches the Article 9 filing system to verify the name and address of the company. He goes to Bonnie’s Boat World and makes a list of all the boats currently in the company’s possession. While there, he examines the books and records of the company. Satisfied with what he has seen, he recommends to Paul that the loan is ready for closing.

ii. When Bonnie arrives at Paul’s office he presents four documents that are important to the transaction, which will be discussed in a moment:

1. Security Agreement 2. Sample form Statement of Transaction 3. Financing Statement 4. Personal Gaurantee

iii. Security agreement and Statement of Transaction 1. Security Agreement (full text) is highlighted on pp. 927-935 2. At the time she signs this agreement, Bonnie has not yet purchased any boats for

Deutsche to finance, Deutsche disburses no money at this “closing” and there is no Statement of Transaction for Bonnie to sign.

a. However, an example of a statement of transaction is presented on p. 935 iv. The Financing Statement

1. Bonnie also must sign a financing statement for filing in the UCC filing system of the state. The purpose of the financing statement is to give public notice that Deutsche claims a sexurity interest in Bonnie’s inventory

2. An example of a financing statement is on p. 936 v. The Personal Gaurantee

1. Although all of the loans go to the business, Deutsche requires bonnie to PERSONALLY guarantee all of the loans.

2. Rationale: a. First, if the borrower can’t repay the loan, the owners might. The

guarantee gives the lender the right to obtain a udgment against the owners and proceed against their assets just as though the owners were the ones that had borrowed the money. In addition, personal guarantees can be, and sometimes are, secured by interests in property owned by the guarantors.

b. Second, this assures, insofar as possible, that in the event of default, the lender will have the cooperation of the owners. When a corporate debtor becomes insolvent, the owners interest in the business often becomes worthless. Unless the owners are personally liable for debts of the business, they may not care how much of the debt is repaid. Even if the owners have all of their wealth in the corporation and the corporation is insolvent, if the owners are personally liable, they will continue to have an incentive to cooperate with the lenders that hold personal guarantees. In the event of competition for the assets of the corporation, the owners are likely to be on the side of the creditor to whom they have given their personal guarantee.

e. Bonnie Buy’s Some boats i. The Floorplan Agreement

1. The floorplan agreement provides that if Deutsche finances purchase of Shoreline Boats by deales such as Bonnie’s Boat World and then has to repossess those boats, Shoreline will buy them back and the full invoice price.

a. A copy of a floorplan agreement is on pp. 938-940 2. Advantage to Deutsche:

a. Shoreline buys all boats repossessed at full invoice price 3. Advantage to Shoreline:

a. With the Floorplan Agreement in place, Shoreline can offer qualified dealers nationwide 100 percent financing on the boats they buy from Shoreline, making the boats more attractive to dealers.

b. If Shoreline had to finance the boats itself, it would bear much of the risk of boats being lost, stolen, or destroyed through dealer fraud. Under the Floorplan Agreement, Deutsche bears these risks

4. Advantages to Bonnie: a. Because the repurchase agreement reduces Deutsche’s risk of loss on

resale after repossession, Deutsche can offer Bonnie a larger line of credit and finance a larger portion of each purchase than a bank typically could.

b. Bonnie’s may benefit from time to time from subsidies offered by Shoreline to Deutsche to provide dealers such as Bonnie’s with periods when little or no interest accrues.

ii. The Buy 1. Bonnie buys 5 boats from Shoreline, total: $55,000. 2. Shoreline contacts Deutsche to obtain approval of the purchase. 3. Deutsche verifies that both Bonnie’s and Shoreline are in compliance with their

agreements and that the purchase won’t overdraw Bonnie’s line of credit.

4. Deutsche gives Shoreline an approval number (like a visa number). Shoreline ships the five boats to Bonnie and sends the invoice to Deutsche.

5. Deutsche pays the $55,000 to Shoreline, recording it on their books as a loan to Bonnie’s.

f. Bonnie Sells a Boat i. Bonnie paid $15,566.58 for a boat from Shoreline. She is selling it to the Homer’s for

$20,000. Bonnie’s will have a gross profit of $4,333.32. ii. Bonnie has an arrangement with First State Bank in which it will finance 90% of

Bonnie’s customer’s purchases. The Homer’s qualify for the loan. iii. The Homer’s write Bonnie’s a check for $2,000 (10%), sings a security agreement and

financing statement for First State. iv. On receipt of the Security agreement and fiancing statement, First State gives Bonnie

$18,000. v. Because Bonnie financed with Deutsche bank on a pay as sold basis, Bonnie’s payment

for the boat is now due. In accord with this provision, Bonnie’s sends Deutsche a check for $15,566.68 that same day.

vi. At the beginning of the next month, Deutsche will bill Bonnie’s for the finance charges that accrued during the brief time this $15,566.68 was outstanding.

g. Monitoring the existence of the Collateral i. In case of fraud, Deutsche will continually monitor it’s collateral

ii. Duetsche will send a person, in this case Feynman, to Bonnie’s boat world every 30-45 days to verify the continuing existence of the collateral and check its condition

iii. Feynman has a list of all the boats Deutsche has security interests in, and he goes around and finds them based on their ID numbers on plates.

iv. When Feynman is finished, two boats are missing – he asks Bonnie about them. She tells him that one is out on the water, and one is sold yesterday. Feynman inspects the bookkeeping and verifies the truth of the second boat. When he returns to the bank, he will verify that check is received and the date it was postmarked. Bonnie tells him the other boat will be back in an hour. He demands to drive out and see the boat on the water. He verifies that it is the correct boat, and all is well.

v. The reason he verifies and checks all of the inventory at one time is b/c he wants to make sure that no fraudulent actions occurred, and none of the boats have had their name plate changed in his absence.

XXII. Personal Property Filing Systems a. What is priority?

i. A lien with a priority higher than another is referred to as the senior or prior lien and the other is referred to as the subordinate or junior lien.

ii. Regardless of social equity or principals of unjust enrichment, society feels comfortable with following the established filing system based on priority and secured v. unsecured creditors

1. See e.g. Peerless Packing Co. v. Malone and Hyde, Inc. b. How do creditors get priority?

i. Central to the system of lien priority is the idea that liens rank in the chronological order in which they were created

ii. Because the liens it will rank behind are already in existence, the prospective lender can obtain information about them and, if necessary, contract with the holder regarding their disposition.

iii. The taking of certain required steps is known as perfecting a lien. The steps that must be taken differ with the type of lien, but nearly all include acts in one of four categories.

1. Filing notice in a public records system established for that purpose 2. Taking possession of collateral 3. Taking control of collateral by means of the stake holder’s agreement to hold for

the secured creditor, or 4. Posting notice on the property or where it will be seen by persons dealing with the

property iv. The type of lien is unimportant. Except for the time of their perfection, one perfection is

the same as one another. c. The theory of the filing system

i. The filing system is the principal means used to communicate the possible existence of a lien from a creditor who has one to a creditor who is thinking of acquiring one.

ii. For an Article 9 security interest (which is a lien), one must file a financing statement, also known by its form number, a “UCC-1”

iii. Unsophisticated lenders often fail to discover a lien that is on the public record before they obtain their own; the result is that the lien they take will be subordinate to the lien already recorded.

d. Multiplicity of Filing Systems i. With a few exceptions, each county in the United States maintains a real estate recording

system in which not only real estate mortgages, but also Article 9 fixture filings are filed. § 9-501(a)(1).

ii. Many counties also maintain separate systems for property tax liens, local tax liens, and money judgments.

1. All but La. And Ga. Have these systems iii. Case: National Peregrine, Inc. v. Capital Federal Savings

1. Generall, whether a copyright has to be filed in the US Copyright office or in another system.

2. Held, the comprehensive scope of the federal Copyright’s Act recording provisions, along with the unique federal interests they implicate, support the view that federal law preempts state methods of perfecting security interest in copyrights and related accounts receivable.

3. Notes: a. Thus, when a federal statute provides for a national system of recordation

or specifies a place of filing different from that in Article 9, the methods of perfection specified in Article 9 are supplanted by that national system; compliance with a national system of recordation is equivalent to the filing of a financing statement under Article 9. UCC § 9-311(b).

iv. With regard to security interest in trademarks, however, one case specifies that a federal filing isn’t necessary to perfect, a state filing will do.

1. Joseph v. 1200 Valencia, Inc. e. Methods of Cost and Searching

i. In most searches, the lender pays two fees: that of the filing officer and that of the service company

ii. The typical fee for searching a single name is about $50. iii. Book suggests that the issue of where to search and file is one that requires both a

thorough knowledge of the law and the exercise of judgment in light of the likely cost and the amounts involved.

XXIII. The concept of Priority: State law a. General

i. First doesn’t necessary mean first in time. The holders of subordinate liens are often paid earlier in time than is the holder of the first lien.

ii. To say that one creditor hasd priority over another is to say that if the value of the collateral is insufficient ot pay only one of them, the law requires that value be used to pay the one who has priority.

b. Priority in foreclosure i. Two principals govern the timing of the enforcement of competing liens against the same

collateral: 1. First, absent an agreement to the contrary, any lien holder may foreclose while the

debtor is in default to that lien holder. a. The existence of a prior lien generally does not block the exercise of rights

of a subordinate one. 2. Second, no lien holder is compelled to foreclose.

a. Each has the option to extend the debtor’s time for payment or dimply forbear from exercising its remedy.

ii. See Hawaii statute on “how to apply proceeds” on p. 1076 iii. The procedure for foreclosing varies with the type of lien iv. The following principals govern most judicial or foreclosure sales.

1. The sale discharges from the collateral the lien under which the sale is held and all subordinate liens. It does not discharge prior liens. UCC 9-617(a)

2. The sale transfers the debtor’s interest in the collateral to the purchaser, subject to all prior liens. 9-617(a). the holder of the prior lien cannot enforce the debt against the person who purchases at the foreclosure sale. But the holder of the prior lien can enforce the lien against the purchaser. Unless the debt underlying the prior lien is paid by the purchaser or someone else, the holder of the prior lien can foreclose.

3. The proceeds of sale are applied foirst to the expeses of sale, then to payment of the lien under which the sale was held, then to payment of subordinate liens in the order of their priority. UCC 9-615(a). The remaining surplus, if any, is paid to the debtor. UCC 9-615(d)(1). Unsecured creditors do not share in the distribution; their remedy is to get paid by the debtor.

4. The debt underlying each lien is reduced by the amount paid to the lien holder from the sale, but the balance remains owing. The lien holder is then entitled to a judgment against the debtor for the deficiency, unless there is a statute providing otherwise. UCC 9-615(d)(2).

5. Example on 1076-77 c. Reconciling Inconsistent priorities

i. While the rules of the proceeding section are typical, they aren’t universal. ii. In some sale proceedings, a purchaser takes free of all liens against the property and

proceeds of sale are distributed first to the holder of the first lien. 1. Two reasons this is rare:

a. They deprive the holders of senior lines of their option not to foreclose.

b. A procedure that required payment of the first lien first would require some mechanism for identifying and giving notice to the holder of that lien so that the holder could protect its rights by bidding at the sale

iii. Rules governing priority between execution liens or security interests and federal tax liens are beyond the power of the state legislature altogether, b/c those rules are enacted by Congress as part of the Internal Revenue Code.

iv. Court fuse diverse sets of state and federal priority laws together to resolve conflicts 1. In the resulting system, all the schemes of foreclosure and distribution have one

feature in common: a. Those creditors whose liens are discharged by the sale share in the

proceeds of sale in the order in which liens have priority v. Mortgages usually have priority over judgment liens for the simple reason that when a

debtor has judgment liens against his or her property, no one will make a mortgage loan to the debtor.

vi. Case: Bank Leumi Trust Company v. Liggett 1. Liggett got a judgment; a year later, Bank Leumi took out a mortgage; then

Cosden got a judgment after Bank Leumi. Statute said that judgment creditors get paid first. Court disregards the statute and remands to consider as between the two. Likely, the court realized how the system was supposed to work.

d. The right to possession between lien holders i. General

1. Most courts require that the junior lien holders surrender possession to senior lien holders in the event that two foreclose at the same time

ii. The Grocers Supply Co. V. Intercity 1. Has to do with the fact that a subordinate creditor levied the property and didn’t

want to pay to he secured creditor the proceeds first 2. Notes

a. Florida court has held that UCC 9-401 does not exempt collateral from execution and that it may be seized and sold by the judgment creditor, subject to the secured party’s lien

i. Altec Lansing ii. First National Bank of Glendale v. Sheriff of Milwaukee County

b. Texas version of UCC provides that “unless otherwise agreed, a secured party has on default the right to take possession of the collateral.” UCC 9-609

c. With the exception of Wisconsin, other states considering the issue have consistently held that the right of a prior perfected creditor to take possession of its collateral is superior to any right of a judgment creditor and that the prior perfected secured creditor may regain possession of the collateral from an officer who has levied on the property at the direction of a judgment creditor.

d. Both the Oregon CofA and the Utah SC have held that a secured creditor whit a right of possession of the collateral after default may maintain an action for conversion against one who exercised unauthorized acts of dominion over the property to the exclusion of the creditor’s rights

iii. Issue with Grocers Supply is that if a junior leinholder can’t collect until a senior lienholder lets it, then the junior lien is worthless

1. CASE: Frierson v. United Farm Agency, Inc. a. Merchants cannot refuse to exercise its rights under the security

agreement, thereby maintaining UFA as a going concern, while it impairs the status of other creditors by preventing them from exercising valid liens. This would fly in the face of UCC 9-401

iv. UCC 9-401 doesn’t say that an unsecured creditor who has obtained a judgment against the debtor can levy on collateral encumbered by another creditor’s security interest, it just says that the issue “is governed by applicable law other than this article.”

v. Two ways to reconcile Grocer’s Supply and 9-401: 1. Reasoning in Frierson: The right of the senior to possession is not the right to

possession for the purpose of leaving the debtor in business and frustrating collection by junior line holders.

a. The senior lienholder must foreclose or stand aside so junior holders can do so.

2. The observation that Grocers Supply requires the junior lien holder to surrender possession to the senior, but it doesn’t bar the junior from continuing with the sale.

a. Under some sale procedures, property can be sold even though it isn’t physically present.

XXIV. Bankruptcy and Priority a. Three main difference in Bankruptcy

i. The secured creditor can’t foreclose until the stay is terminated. BC § 362(a) 1. Secured creditor can seek relief from the stay, but no saying whether it will be

granted. § 362(d) ii. The trustee or debtor in possession can sell the secured creditor’s collateral “free and

clear of liens,” effectively foreclosing the secured creditor’s lien on the trustee’s or debtor’s own timetable.

iii. The bankruptcy isn’t concerned with giving money immediately, it is concerned with maximizing the value of the estate for everyone, including the debtor.

b. Bankruptcy Sale Procedure i. Trustee or debtor in possession can sell the collateral

1. These sales may be judicial sales, pursuant to oa court order and confirmed afterward bythe court, or they may be nonudicial sales held pursuant ot the powers verted in the debtor’s in possession or trustees by statute. BC § 363(b)(1) and (c)(1).

ii. In bankruptcy sales the collateral may be sold subject to the liens of secured creditors. Once such a sale is complete, the collateral ceases to be property of the bankruptcy estate, the automatic stay expires, and, if the debt is in default, the secured creditor will be free to foreclose BC § 362(c)

iii. If the property is burdensome to the estate, b/c the liens encumber it so nobody is likely to buy it, then the estate will abandon it. BC § 554

1. Abandonment removes the property from the estate, revests the property in the debtor, terminates the automatic stay, and allows lienholders to foreclose.

iv. Bankruptcy law provides an alternative procedure under which a trustee or DIP can sell “free and clear” of the liens. BC § 363(f)

1. Works like the sale by the first lien holder in foreclosure. The buyer takes it unencumbered in title and presumably pays its full value of the purchase price. The liens are transferred to the purchase price, with the ultimate outcome that the proceeds are applied to the liens in the order of their priority.

v. CASE: In re Oneida Lake Development, Inc. 1. Debtor wins the right to sell collateral over a secured creditor’s objection. 2. § 363(f) authorizes a debtor to sell its property free and clear of liens and

encumbrances, so long as it can satisfy any one of the five subsections. a. Here, at issue is subsection (f)(3) and (f)(4)

3. (f)(3): sale by debtor free and clear of liens and encumbrances only when the sale price is “greater than the aggregate value of all liens on the property.”

a. Don’t look to face amount of lien, you look to the value of the creditor’s interest in the estate’s interest in such property.

vi. Notes 1. One circumstance in which the bankruptcy power to sell free and clear of liens

can achieve greater economic efficiency than the non-bankruptcy foreclosure sale procedure is where the amounts and priorities of competing liens against the collateral are in doubt and the collateral is depreciating in value

a. By selling free and clear, whatever their priority and amount, to the proceeds of sale, the debtor or trustee can prevent further losses.

2. In a bankruptcy case, a debtor or trustee can effect a sale free and clear of the two mortgages. § 363(f)(4).

3. Just as in non-bankruptcy sales, secured creditors in bankruptcy are allowed to bid into the amount of their liens. § 363(k)

c. The Power to Grant Senior Liens i. Under state law, liens often rank in priority in the order in which they are created and

perfected ii. In bankruptcy, the above first come priority doesn’t hold

iii. In limited circumstances, the trustee or DIP can borrow additional money from a post-petition lender, secured by a lien prior to existing liens. § 364(d)

1. Must notify the holder of the first lien before doing so. 2. If holder objects, court holds a hearing

a. Determine: b. (1) if the estate is unable to borrow money without granting the prior lien,

and i. May incur unsecured debt as an administrative expense with first

priority status under 11 USC § 507(a)(1) ii. It may acquire a loan that is either unsecured but senior to all

administrative expenses, secured by a lien on property that is not secured, or secured by a junior lien on property already secured. § 364

c. (2) there is adequate protection of the interest of the secured creditor whose lien is being displaced

i. If value is going to increase, this is probably sufficient 3. Rationale for this is on 453: business needs it to survive

iv. Why aren’t secured creditor’s happy about this? 1. Usually gets nothing from the transaction

a. Would have come out fine in a foreclosure 2. The adequate protection dispensed by the court is no guarantee against loss

a. If the property declines in value, and there isn’t enough to pay the claims, then the old lender’s unpaid claim turns into an unsecured debt, and while it has priority over other types of claims (§ 507(b)), it is still unsecured.

d. Protection of Subordinate Creditors i. Bankruptcy shifts what would be common in foreclosure, postiting essentially that the

collection efforts of senior line holders should be stayed if (1) the senior lien holders are adequately protected against loss, and (2) the stay is likely to facilitate the collection efforts of subordinate creditors

1. See analogy to medicine on 460

XXV. Lien Creditors v. Secured Creditors: The Basics a. General

i. This deals with three situations, all involving lien creditors: 1. Lien creditors v. lien creditors 2. lien creditors v. secured creditors 3. lien creditors v. mortgage creditors

b. How creditors become “lien creditors” i. Prototypical lien creditor: won a judgment, obtained a writ of execution, and then

obtained a lien by levying on specific debtor property. ii. § 9-102(a)(52) defines “lien creditor”

1. Any creditor who has acquired a lien on the property involved by attachment, levy or the like

iii. Attachement is a legal process in which the P in litigations obtains a writ and delivers it to a sheriff, marshal, or other law guy, who then levies on property of the debtor.

1. In a few jurisdictions, “attachment” is virtually a synonym for “execution.” 2. In most, the distinction between attachment and execution is that an attachment

occurs before judgment is entered, and an execution occurs after iv. Two other important lien types:

1. Garnishment: the process by which a judgment creitor in most states reaches debts owing from a third party to the debtor or property of the debtor that is in the hands of the third party.

a. In many jurisdictions, an unsecured creditor can garnish before obtaining a judgment in certain kinds of cases, subject to numerous statutory and constitutional restrictions. However, garnishment of wages held by an employer is prohibited prior to judgment in all states and even after judgment in a few.

2. Recordation of a judgment for money damages: a. In nearly all states, recordation of a mony judgment in the real property

recording system creates and perfects a lien against all real property owned by the debtor within the country

b. In a minority of states, the judgment creditor can record in the UCC filing system

c. See California Code on Real Property (1090-91) 3. A trustee in bankruptcy, including a debtor in possession under Chapter 11, has

the rights of a hypothetical ideal lien creditor – essentially a lien creditor with no debilitating history or knowledge – who obtained a lien on all property of the ebtor on the date of the filing of the bankruptcy case.

a. Even if none of the debtor’s creditors could prevail over an unrecorded mortgage b/c all knew about it, the debtor’s trustee, given its status, could. BC § 544(a).

c. Priority among lien creditors i. Governed by state statutes, usually on a first-come, first-served system.

ii. Laws generally award a lien priority on one of four dates: 1. Date of levy:

a. Some states honor only actual physical possession by the sheriff; others consider various kinds of symbolic or constructive possession adequate.

2. Date of delivery of the writ to the sheriff (after issued by court): a. In a large minority of states, writs of execution rank in the order in which

they are delivered to the sheriff w/ instructions for levy on the property in issue.

b. In all or nearly all of these states, the lien comes into existence only on levy and may then be said to “relate back” to the date of delivery to the sheriff.

i. Thus, only the one levied is a lien. If the second one is levied, it has priority b/c of relation back.

3. Date of Service of Writ of Garnishment a. This is the delivery of the writ by the sheriff to the garnishee, which is

typically a bank or an employer 4. Date of recordation of judgment:

a. This is the date the judgment is delivered to the filing or recording officer (in large majority, this only gives liens in real estate).

iii. In a competition between writs of execution, the majority rule gives priority to the first to levy on the particular property.

iv. The minority rule states that priority depends on the order in which writs were delivered to the sheriff.

d. Priority between lien creditors and secured creditors i. General

1. Priority between a lien creditor and a nonpurchase-money Article 9 secured creditor depends on whether the lien creditor “becomes a lien creditor: before the secured creditor does either of two things: (1)perfects its security interest or (2) files a financing statement and complies with UCC 9-203(b)(3).”

ii. Article 9 “Perfection” (9-308(a)): 1. Perfected only after it has been attached and the steps required for perfection are

met iii. Date on which lien creditor “becomes a lien creditor” § 9-317(a)(2).

1. Majority: at the time of levy 2. Minority: Delivery of writ to the sheriff

e. Priority amoung lien creditors and mortgage creditors i. Priority between liend and mortgage creditors is governed by real estate law.

ii. Real estate law generally gives priority to the first lien created, and then reverses the result only if the failure to perfect offends the state’s recording statute.

f. Purchase money priority i. When a second-in-time interest takes precedence over an earlier interest, the

congnoscenti describe the second secured creditor as “priming” the first. ii. Occurs often with purchase-money security interests (PMSI’s)

iii. Under the rule stated in UCC § 9-317(e), a PMSI can prime a lien creditor’s interest only if the PMSI comes into existence and attaches to the collateral before the creditor obtains its lien against that collateral

1. If the PMSI attaches first, the holder of the PMSI has a 20-day grace period in which it can perfect and thereby defeat a lien that came into existence between the dates of attachment and perfection of the PMSI.

2. The effect is that a PMSI secured creditor that went public later can defeat a lien creditor who went public up to 20 days earlier.

iv. Lien creditors who are concerned about he possibility of secure PMSI liens might choose to dealy their levies for 20 days after the debtor acquires new property to see if a PMSI shows up on the public record.

1. However, most will levy and wait to see if a PMSI files later. a. Lien creditor’s usually hurry to establish priority.

XXVI. Lien Creditors v. Secured Creditors: Future Advances a. Priority of Future advances: Personal Property

i. General 1. Secured creditors often continue to disburse money to their debtors after the initial

loan transaction. 2. Most of the secured parties who make these advances would be unwilling to do so

if their interest securing them might be subordinate to a lien creditor who levied on the collateral before the secured creditor made the advance.

a. Could protect itself by repeating its search for lien creditors before making each new advance and refusing to make the advance if one has intervened.

ii. Exceptions in favor of the secured creditor making advances 1. 9-323(b) gives several exceptions:

a. future advances have priority over the lien, provided the creditor making the advance does not have knowledge of the lien.

b. Every secured advance made within 45 days after the levy is entitled to priority over the lien, even if the secured creditor making the advance knows of the lien’s existence.

c. Every advance made “pursuant to a commitment entered into without knowledge of the lien” is similarly protected.

i. 9-323(b)(2) iii. Rationale for exceptions

1. Reason for giving the exception within 45 days, even with knowledge of the lien: a. Only by giving unconditional priority over lien creditors to secured

creditors future advances made during the 45-day period could the drafters qualify those future advances for the maximum priority over IRS tax liens available under the Tax Lien Act.

2. Reason for giving the exception after 45 day w/o knowledge of the lien: a. Debate on 1099-1100 (Should note rationales on both sides)

b. Priority of Nonadvances: Personal Property i. Question is whether the debtor’s contract fees, or nonadvances (attorney fees, costs of

collection, etc.) in the event of default qualify for priority over lien creditors under § 9-323(b)?

ii. Case: UNI Imports v. Exchange National Bank of Chicago 1. Facts: Exchange and Apracor entered security agreement on Apracor’s assets,

and revolving line of credit up to 7.2 million. After the note expired, Exchange continue to make advances. 1mo8days later, UNI obtained $66,000 judgment, had it enforced by marshal. Exchange refused to turn over the assets, saying they had priority. Exchange continued to advance money (2 million or so). They added to Aprocor’s balance credit collections, attorney fees, etc. DC granted UNI’s petition for the turn over of assets.

2. Issue: Whether other secured obligations such as interest and collection expenses qualify for priority under 9-323(b)?

3. Rationale: 4. 9-323(b) rests on the assumption that each advance gives rise to a new security

interest which arises when the creditor extends value. a. When this security interest is “perfected”

5. Only other case: Dick Warner Cargo says that those obligations are not treated as advances – those obligations give rise to their own security interests, at least some of which arose with the execution of the financing agreement.

a. Language: common use of “advance” are sums put at the disposal of the borrower – not expenditures made by the lender for its own benefit.

b. Court holds that creditor that perfects its interest with respect to such obligations is entitled to protection against subsequent lien creditors.

c. Therefore, as long as these are taken care of, they should be protected. d. Not plain language of 9-323(b), but any other result would be inconsistent

with drafter’s intent. 6. Dick Warner Cargo isn’t wholly convincing. 7. However, giving the holding of the 2nd Cir and the UCC Boards approval, “we

conclude that non-advances are not advances for purposes of 9-323(b).” 8. Must distinguish between nonadvances relating to advances made before the levy

(which have priority) and nonadvances relating to advances made after the levy (which have only the priority of the future advance).

iii. Drafters reworded 9-323(b) to endorse the UNI Imports holding. The rewording does not address the issue of non-advances relating to advances made after the lien.

iv. It is also worth noting that the accruing non-advances have priority even when the non-advances do not contribute value to the debtor’s estate and the secured creditor forbears from foreclosure until the debtor has predictably dissipated all value from which junior creditors might have recovered.

c. Priority of Future Advances and Non-advances: Real Property i. General

1. The law governing real estate transactions is even more tolerant of future advances made after a lien creditor perfects an interest in the collateral.

ii. Case: Shutze v. CreditThrift of America, Inc. 1. Facts: Beneficiary of first deed of trust is Deposit Gaurantee Mortgage on

property owned by Hobart Gentry. Lien was a conventional first mortgage. Gentry’s entered second mortgage for $23,500 with Creditthrift of America, and Gentry’s entered second deed of trust to Hendrix (trustee for Creditthrift), and this was duly recorded. The second deed of trust contains a future advance clause (1106). However, nothing in the advance clause obligated CreditThrift to make future advances.Shutze received a judgment on Sept 20, 1984 against Gentry for $4,500. It was enrolled in Forest county, and acquired the power of law. 11 months later, Gentry’s refinanced with CreditThrift for an additional $2,750 (CreditThrift regarded this as within their advance clause). Gentry’s bail out in 1988, and creditors resort to property to fulfill the obligations. CreditThrift and Shutze argue about CreditThrift’s $2750 lien.

2. Held: Our case law holds that future advances relate back to the original deed of trust, and although we find the UCC rule for personal property indistinguishable from real estate law, CreditThrift had no actual notice and thus would prevail under the UCC in any case.

3. Rationale: 4. Precedent consistently holds that Future Advance Clauses are perfectly fine; they

should be upheld according to Contract law, and subject to Contract defenses.

a. This is a convenience and accommodation to borrowers 5. All agree that creditThrift’s first lien comes before Shutze’s 1984 judgment lien.

We only consider the $2750 future advances of CreditThrift in 1985. 6. For priority purposes, the lien securing the future advance takes its date from the

recording of the original deed of trust and by operation of law reaches forward to secure the advance made after intervening rights became perfected.

a. Shutze had notice of such a clause. 7. The UCC as originally enacted treated this issue the same as our cases have –

they allow future advances to relate back to the original deed. 8. The new UCC stops at 45 days unless you didn’t know, but this 9-323(b) does not

reach real estate transactions. 9-109(a) and 9-109(d)(11). 9. Although it seems indistinguishable from personal property issues, if “we

important 9-323(b) into our law of real estate secured transactions, we would cut back the reach of the dragnet clause. We need not take that step today, for CreditThrift prevails under the UCC b/c they didn’t have notice of the lien.

iii. The usual means of obtaining a lien against personal property is for the sheriff to levy the property and take possession, thus everyone is on notice.

iv. The usual method for obtaining a judicial lien against real estate is for the creditor to record its judgment in the real estate records.

1. Unless the lien creditor thereafter conducts a search, he won’t know whether its lien attached to any property of the debtor.

2. Look at 1110 v. Not all court’s follow Shutze

1. Other jurisdictions refuse priority to such optional advances made by the mortgagee with knowledge of a subsequent lien, but give priority to obligatory advances.

XXVII. Trustees in Bankruptcy Against Secured Creditors: The Strong Arm Clause a. General

i. Unperfected security interests do not retain their priority when the debtor goes into bankruptcy. BC § 554(a)

ii. A bankruptcy trustee or DIP has the power to avoid most kinds of security interests that remain unperfected as of the time of filing of the bankruptcy case under § 554(a) – the Strong Arm Clause

1. In this situation, the creditor becomes unsecured. b. The purpose of § 554(a)

i. A policy against secret liens 1. If creditors haven’t perfected, they haven’t given public notice on their rights to

the collateral ii. Trustees will inspect security documents, check the secured creditors’ compliance with

filing requirements, and bring actions in bankruptcy court to avoid the security interests they discover are unperfected.

iii. If a trustee is successful in avoiding the security interest, the interest is “preserved for the benefit of the estate.” BC § 551.

c. The text of § 554(a) i. The complexity comes from the variance in state statutes relating to what it means to be

“perfected.” ii. Drafters invented three hypo persons, each of whom might compete with those holding

less than perfect liens; the trustee can step in to any of their shoes and defeat the liens - The ideal line creditor is the overall hypothetical: Federal law leaves it to the states to determine what rights these ideal lien creditors have against others.

d. The three hypothetical creditors: i. The judicial Lien Creditor of § 544(a)(1)

1. Def: “creditor that extends credit to the debtor at the time of the commencement of the case, and that obtains, at such time and with respect to such credit, a judicial lien on all property on which a creditor on a simple contract could have obtained such a judicial lien.”

a. This would be impossible for a real creditor b. Why did the drafters use this guy?

i. They wanted to test perfection as of the filing of the bankruptcy case.

ii. Giving the hypothetical lien creditor its lien only as of the commencement of the bankruptcy case prevents the trustee from challenging a security interest for being unperfected at some earlier time.

iii. Allowing the hypothetical lien creditor ot be other than a simple contract creditor would have done the same, b/c other kinds of creditors are sometimes accorded rights that relate back to some earlier time.

2. Lien on Motor Vehicle for Damages (Example) 3. In cases where the interest under attack is a lien on security interest, the only

characteristics of the hypo lien creditor that seem to make any difference are

a. That the hypo lien creditor obtains its rights through the exercise of judicial remedy such as execution, attachment, garnishment, levy, and the like; and

b. That the hypo lien creditor obtain its rights at the moment of the filing of the case.

4. When the competing claim is a security interest, the applicable state law will be §§ 9-317(a)(2) and 9-323(b).

a. Under it, ideal lien creditors defeat unperfected security interest for which no effective financing statement exist, but lose to other security interests.

ii. The creditor w/an Execution Returned Unsatisfied (§ 544(a)(2)) 1. Def: “Creditor that extends credit to the debtor at the time of the commencement

of the case, and obtains, at such time and with respect to such credit, an execution against the debtor that is returned unsatisfied at such time.”

a. § 544(a)(2) is beyond the scope of this book – prevents fraudulent transfers

iii. The Bona Fide Purchaser of Real Property ( 1. Must be real property other than fixtures 2. Def: Can step into the shoes of a purchaser who paid for the property(“perfected

such transfer”) at the time of the commencement of the bankruptcy case. a. Must be one “against whom applicable law permits such transfer (the lien

under attack) to be perfected.” b. Another way to see it: The trustee gets the rights of a bona finde purchaser

only in circumstances where the competing transfer was capable of perfection.

3. Courts allow the trustee to prevail: a. Where the competing creditor was supposed to do something to perfects

its lien and b. The competing creditor failed to do so.

e. The rights of a bona fide purchaser of real property are generally greater than those of a lien creditor

i. Midlantic National Bank v. Bridge 1. Bridge got first mortgaged. Then, got second for same amount and paid off the

first. The first was pronounced satisfied, but second, unbeknownst to the parties, remained unrecorded.

2. Trustees powers are limited to the law of the state where the property is held; 3. By operation of N.J. law, Midlantic retains an equitable lien although the lien

remained unrecorded – this would trump the strong arm powers of the trustee 4. N.J. law also shows that a bona fide purchaser of real property takes over a person

with an equitable lien 5. Therefore, Midlantic loses, b/c the trustee under § 544(a)(3) prevails

a. This might be different if it were personal property f. The implementation of § 544(a)

i. Does not require the trustee to avoid certain transactions (discretion to do so) ii. Exercise of discretion by Chapter 7 trustees

1. In Chapter 7, trustees are paid after secured creditors, and have an incentive to boost the pot – they are above unsecured creditors

2. Usually the trustee gets VERY LITTLE ($60) 3. If he can avoid some liens, then that money goes into the estate. § 541(a)(3) & (4)

iii. Secured creditors - proofs of claim in bankruptcy cases 1. The creditor doesn’t file a proof of claim

a. If the creditor ignores the bankruptcy and nobody comes after them, secured creditors’ liens “pass through bankruptcy unaffected.” The debtors obligation to pay the underlying debt is discharged, but the secured creditor can still foreclose on the lien.

2. The creditor does file a proof of claim: a. The creditor must attach evidence of his security interest b. The trustee is likely to examine this carefully and even conduct a search of

the public records to verify that the financing statement was filed. i. If no proof is filed, the trustee will demand it

3. The trustee has up to two years, § 546(a), to bring an action challenging the claim. iv. Exercise of discretion by Chapter 11 trustees

1. Ordinarily, no trustee, just a DIP – who exercises his discretion to bring or not bring actions

2. If DIP does bring claims and succeeds, he changes the debtors status from secured to unsecured

a. Will reduce creditors leverage in reorganization plan 3. Often, there are reasons (family, key supplier) not to avoid the liens in Chapter 11 4. The DIP is a fiduciary, and must exercise in the best interests of the estate.

a. If he won’t bring an action, several courts allow for the unsecured creditors committee to sue in place of the DIP

5. When converted to Chapter 7 case, the dynamic changes – as long as the conversion happens w/in 2 years of the filing of the Chapter 11 case, the trustee has plenty of time

g. Recognition of Grace Periods i. Grace periods allow for a creditor to have some time to perfect the lien thorugh public

filing. 1. E.g. 9-317(e) gives 20 days for PMSI’s to file 2. If the creditor files, it has priority over a lien creditor who becomes such between

the time of attachment and the time of filing 3. If the debtor goes into bankruptcy, it doesn’t matter – you still get the grace

period to file and then the trustee’s rights are subordinated to yours a. Result flows form a combination of § 362(a)(4), § 362(b)(3), and § 564(b).

ii. Resistance to BC § 544(a) 1. The changes to Article 9 that allow defectively filed security interests to prevail

over judgment lien creditors: a. 9-338 & 9-520(c): allow security interests perfected by the filing of

incorrect financing statements to prevail over lien creditors b. 9-515(c): a security interest that is no longer perfected b/c the financing

statement has lapsed can prevail over creditor that became a lien creditor while the security interest was perfected.

XXVIII. Secured Creditors against Secured Creditors a. The general rule

i. The basic rule: first to file or first to perfect 1. The basic rule is UCC § 9-322(a)(1): Between the holders of two security interest

in the same collateral, the first to file or perfect has priority 2. The holder who gains priority by first filing or perfecting retains it so long as the

holder remains continuously filed or perfected. § 9-322(a)(1) ii. The explanation is that the drafters sought by this rule to “protect the filing system.”

1. One problem is that it doesn’t necessarily reflect the first to file or perfect rule, b/c it is most likely a first to file rule. This changes if the creditor has it in his possession.

iii. The drafters intend that the first to file or perfect have priority even if the first knows that the debtor intended that another creditor have priority and even if the first believed itself to be subordinate at the time it filed or perfected.

iv. Exception to the rule: § 9-325 1. The security interests perfected against a transferee are subordinate to those

perfected against a transferor. a. Example on 1114

2. Works because article 9 security interests rank in order of perfection so that lenders can discover the security interests to which they will be subordinate.

b. Priority of Future Advances i. General rule

1. Provided only that the secured creditor’s financing statement “covers the collateral,” all advances made by the secured creditor to the debtor have priority as of the filing of the financing statement. Implicit in § 9-322(a)(1).

ii. Justification 1. The same given for the priority of future advances in real estate law. 2. Bank 1’s filing put Bank 2 on notice of the possible existence of security interest

that might secure future advances, so Bank2 should not be heard to complain if such advances are made.

3. The understanding is that one who takes a second security interest agrees to take subject to the amount outstanding under the first filing and any future advances the holder of the first may later make.

iii. Function 1. An important function is to relieve the lender who will make future advances

from the necessity to file and search in conjunction with each advance. The same is true w/the real estate system.

iv. Who would take a second security interest in a system in which the first can increase w/o limit?

1. Lenders who do not understand the future-advance rule; 2. Creditors who hope to benefit from their second interest but do not advance funds

in reliance on it; and 3. Lenders who protect themselves against future advances by contract with the

holder of the first interest. § 9-339. v. Can a single financing statement secure more than one such interest?

1. A single financing statement is adequate to perfect any number any number of security interests, to the limits of the description of collateral in the financing statement. § 9-322(a) and 9-502(d).

c. Priority in After-Acquired Property i. If the debtor later acquires property that fits the description in the security agreement, the

security agreement attaches. UCC § 9-203(b). ii. If the dexcription of collateral is broad enough to cover the after-acquired property, the

filing covers it. As against other Article 9 secured creditors of the debtor, the after-acquired lender’s priority dates from the time of its filing. § 9-322(a)(1).

iii. The most common commercial use of after-acquired property clauses is in inventory-secured financing.

1. The lender perfects its interes in both currently owned and after-acquired inventory by the filing of a singling financing statement.

2. See hypothetical on 1117. d. Priority of Purchase Money Security Interests (PMSI)

i. Generally 1. 9-324(a) - a PMSI in collateral other than inventory has priority over a

conflicting security interest in the same collateral if the PMSI is perfected not later than 20 days after the debtor receives possession of the collateral.

2. Justification a. PMSI is first in an important sense: it either supplied the collateral or

made advances “to enable to debtor to acquire the collateral.” 9-103(a) & (b)

b. Purchase-money priority can be understood as recognizing that, in the sense described here, the purchase-money lender has a relationship with the collateral beforethe after-acquired lender does.

c. It enables PMSI to sell and deliver immediately w/o having to check the public record. Provided the PMSI files w/in 20 days of the day the debtor receives possession, it will have priority over any earlier filings against the debtor that might exist.

3. Anyone lending against noninventory collateral in the possession of the debtor msut cfonsier the possibility that (1) the debtor obtained possession of the collateral in the past 20 days and (2) the holder of the one or more PMSI’s in the collateral has not yet filed a financing statement, but will before 20 days is up.

a. Searcher can remedy the problem is by verifying the debtor’s possession of the collateral and then wait 20 days beyond the basket period before searching.

ii. PMSI’s in inventory 1. The 20 day grace period for the filing of a PMSI in 9-324(a) does not apply when

the property sold will be inventory in the hands of the buyer. This exception is designed to accommodate the customs and practices in inventory financing.

a. See 1120 for this explanation 2. The inventory-secured lender may or may not require the debtor to use the loan

proceeds to pay for the inventory, but the understanding is that the debtor will grant no PMSI’s in it.

3. The special needs of inventory financiers are reflected in the special rules in 9-324(b): The rules permit purchase money priority in inventory only on these conditions

a. The purchase-money financier msut perfect no later than the time the debtor receives possession of the collateral, and

b. The purchase-money financier msut give advance notice t othe inventory lender that it expects to acquire a purchase-money security interest in inventory. To give this notice the purchase-money lender first searches the filing system for the names and addresses of all secured parties with a filing against inventory of the type it plans to sell. The lender then sends the notice, typically by certified mail, to each of the inventory lenders. Like a financing statement, the notice expires at the end o f five years. The purchase-money supplier can avoid expiration by repeating the notice at intervals of less than five years.

4. Most important, the protection comes without necessity for the inventory lender to search the filing system before each advance.

5. If the security agreement prohibits liens against inventory other than the lien of the inventory lender, a notification pursuant to § 9-324 is a notification to the inventory lender that the debtor is about to go into default. To avoid that, debtors typically refuse to grant purchase-money security interest to their suppliers.

e. Purchase Money Priority in Proceeds i. If a seller acquires purchase money priority in property of the debtor, and the debtor

exchanges the collateral for proceeds, the seller will have purchase money priority over a competing security interest perfected by an earlier filing against eh debtor naming those proceeds as original collateral.

1. Purchase money priority under § 9-324 extends to “collateral or its proceeds.” ii. The exception

1. § 9-324(b)” purchase-money status in inventory flows only into chattel paper, instruments, and cash proceeds.

a. Not accounts b. The flow through of purchase money status into chattel paper, instruments,

and cash deposits are themselves limited by the provisions of § 9-327 and 9-330. Those provisions protect purchasers of the chattel paper or instruments and secured parties with control of the deposit account into which the cash proceeds are deposited.

iii. Later purchase-money inventory lender can protect itself against the possibility of a priority account lender: the inventory lender would know of the account lender from the outset, b/c the account lender would have filed a financing statement before the inventory lender entered the picture. The inventory lender can refuse to lend unless the debtor arranges to pay the inventory lender upon sale of the inventory.

f. Priority in Commingled Collateral i. Two situations

1. Where the identity of the collateral is lost by commingling as the collateral becomes part of a product or mass.

a. The security interest “continues in the product or mass” § 9-336(c).

2. Where the identity is not lost, as where a replacement part is installed in a machine

a. The replacement part is an accession b. If the secured party has taken a security interest in only the replacement

part, 9-335 will apply: The secured party’s interest will continue to be perfected, and will have priority over later-perfected interests in the whole.

i. But the accession secured parties remedies may be severely impaired by 9-335(e).

1. Under that section, any secured party with priority over the accession-secured party is entitled to prevent removal of the accession from the whole

ii. If more than one security interest attaches to a product or mass as a result of commingling, the interests rank equally and share in the proportion that the cost of each party’s contribution bears to the total cost of the product or mass.

XXIX. Buyers against Secured Creditors a. Introduction

i. There are two common characteristics in all of these settings: 1. The secured creditor recognizes that the debtor has the right to sell the collateral.

Security does not interfere with the free alienability of property. 2. The secured creditor expects to be protected as to the value of its interest. The

protection may take the form of a lien on the proceeds the debtor receives from the buyer, a continuing lien on the collateral in the hands of the buyer, payment of the loan, or some combination of these protections.

b. Buyers of Real Property i. The general rule resolves the competition between buyer and mortgagee on the basis of

first in time. 1. If the mortgage was created before the debtor sold the property to the buyer, the

buyer takes subject to the mortgage. 2. If the sale takes place first, it will be free of a later mortgage granted by the

debtor-seller. ii. A recording statute may reverse either of the above results

1. One who buys in good faith, for value, without notice of an unrecorded mortgage may take free of it under the recording statute.

2. One who takes a mortgage, in good faith, for value, without notice of the recorded deed may have priority over the rights of the buyer pursuant to the recording statute.

iii. All purchasers of real property are expected to search the public record, are deemed to have notice (constructive) of duly recorded mortgages, and take subject to them.

iv. The applicable statute may be: 1. Race statute: first to file regardless of notice 2. Notice-race statute: first to file with notice of competing lien.

c. Buyers of Personal Property i. General

1. The general rule is that buyers take subject to encumbrances of record. a. 9-201: “A security agreement is effective . . . against subsequent

purchasers b. 9-315(a): “A security interest continues in collateral notwithstanding

sale.” ii. The authorized disposition exception: 9-315(a)(1)

1. General a. The security interest does not continue in the collateral if “the secured

party authorized the disposition free of the security interest.” 2. The exception doesn’t depend for its operation on equities in favor of the buyer.

a. It can apply in favor of a buyer who did or did not search the public record. It can apply in favor of a buyer who knows or does not know of the security interest or the secured creditor’s authorization to sell

3. The authorization to sell need not be express a. Many cases hold that a secured creditor who knew that the debtor was

making sales of collateral in violation of provisions of the security

agreement thereby waived the provisions and “authorized” the sale so that the buyer took free of the security interest.

4. The authorization must be to dispose of the collateral free of the security interest. This element can also be express or implied.

5. There is a split as to conditional authorization (you can sell it if you do this (pay me something, etc.))

a. Some treat the disposition as authorized b. Some do not c. Courts are more likely to treat the disposition as authorized if the buyer

knows of the condition, though this is not determinative. iii. The buyer in the ordinary course exception: 9-320(a)

1. The ordinary course of whose business? a. 1-201(9): Buyer in the ordinary course of business: Buying is in the

ordinary course of business only if it is from a person in the business of selling goods of that kind.

b. 9-320(a) is not limited to consumer buyers 2. The buyers knowledge

a. UCC 9-320(a) protects a buyer in the ordinary course of business “even though the buyer knows of the security interests existence.”

b. 1-201(9) seems to contradict this, b/c one cannot be a buyer in the ordinary course of business if “one knows that the sale to him is in violation of a . . . security interest of a third party.”

c. Comment 3 to 9-320(a) states: “Reading the definition together with the rule of law results in the buyer’s taking free if the buyer merely knows that a security interest covers the goods but taking subject if the buyer knows, in addition, that the sale violates a term in an agreement with a third party.”

d. Therefore, if the customer knowingly buys in violation of the condition, the customer takes subject to the bank’s security interest.

e. It is important to note that a buyer in the ordinary course of business ONLY takes free of the interest of her seller, not the interests of the seller’s predecessors in interest.

3. The farm products exception a. 9-320(a) affords no protection to people who buy farm products. b. However, the federal Food Security Act protects those buyers, so it is

really a worthless exception 4. When does a buyer become a buyer

a. There are people, at the moment a bankruptcy petition is filed, who have contracted to buy some of the collateral but have not yet completed their transaction.

b. If such a person is a “buyer” under 9-320(a), the person will take free of the inventory lender’s security agreement and be able to keep what was bought.

c. If the person has paid part, the person will get credit for that part, and owe the balance.

d. If the person is not yet a “buyer”, the person is merely an unsecured creditor of the seller for any part of the purchase price paid and for the benefit of the bargain the person has lost

e. Illustrative Case: Daniel v. Bank of Hayward i. Question is “When does a retail purchaser who makes a down

payment on a motor vehicle but does not take title to the vehicle become a buyer in the ordinary course of business to prevail over the security interest of the motive vehicle dealer’s floor plan financier?

ii. Answer: When the vehicle is identified in the contract. f. Daniel and a revision to UCC

i. After Daniel, the drafters revised § 1-201(9) to add that “only a buyer that takes possession of the goods or has a right to recover the goods from the seller under Article 2 may be a buyer in ordinary course of business

5. Sales of goods in the possession of the secured party a. Tanbro Fabrics v. Deering Milliken

i. Court holds that a buyer who purchases goods (just like the purchasers in Daniel) that are in the possession of the secured creditor, take free of security interest

b. This case IS OVERRULED by revision: i. 9-320(e): “Subsections (a) and (b) do not affect a security interest

in goods in possession of the secured party under 9-313.” ii. Comment 8: “rejects the holding of Tambro Fabrics . . . and,

together with § 9-317(b), prevents a buyer of collateral from taking free of a security interest if the collateral is in the possession of a secured party.”

iv. Buyer not in the ordinary course exception: 9-323(d) & (e) and 9-317(b) 1. Those who buy goods outside the ordinary course of business have no exemption

from the search-and-file game. a. They are expected to search and are charged with constructive notice

2. The buyer not in the ordinary course of business takes subject to any security interest that is perfected, but has priority over unperfected ones.

v. Consumer to Consumer Sale Exception: 9-320(b) 1. When a sale is outside the ordinary course of business, even consumer buyers are

expected to play the search-and-file game 2. We refer to the exception in 9-320(b) as the consumer to consumer sale exception

b/c the exception applies only if the goods are consumer goods in the hands of the seller before the sale and consumer goods in the hands of the buyer after the sale.

a. The requirement that the goods be held for personal, family, or household purposes of the seller prior to the sale is contained in the main part of section (b);

b. The requirement that they be held for personal, family, or household purposes of the buyer after the sale is contained in subsection (b)(3).

3. The buyer in a consumer-to-consumer sale is protected from an automatically perfected PMSI in consumer goods

a. Secured creditor can’t rely on PMSI protection in 9-309(1).