The last question in Problem 10.1 should bring to mind the discussion in Chapter 9 (The Specifics of Enforceability -- After-Acquired Property, Proceeds and Future Advances) of the difference between optional and obligatory future advance clauses.  In that discussion, the concept of an advance made "pursuant to commitment," as defined in new section 9-102(a)(68), was introduced.  Whether an advance has been made voluntarily or "pursuant to commitment," as defined in new section 9-102(a)(68), can be pivotal in resolving priority disputes involving future advances. However, the priority discussion is best deferred to Part VI.

There is another aspect of the definition of value in Article 1, section 1-204 that needs attention here and can be explored through the following problem.

 

Problem 10.2     (interactive)

Leslie Lender lends $10,000 to Donald Debtor on open (unsecured) credit.  Some weeks later Leslie demands and receives from Donald an interest in Donald's equipment to secure the loan. 

Has value been given sufficient to allow the security interest in the equipment to include the earlier loan?  Be sure to consult Article 1, section 1-204 before answering the question.

 

A note of caution is in order.  Even though securing or satisfying an antecedent debt is value for purposes of the enforceability (and attachment) of a security interest under new section 9-203(b)(1), there may be problems in bankruptcy.   As will be seen in Chapter 30 (Secured Party Versus Trustee in Bankruptcy), when value is given before a security interest is created the trustee may be able to avoid the security interest under BRA § 547 (the avoidable preference provision) leaving the creditor unsecured.  Moreover, securing or satisfying an antecedent debt is not considered "new value" as that concept is defined in new section 9-102(a)(57).  Certain priority rules considered in Part VI turn on whether new value has been given.

C. Debtor's Rights in the Collateral

Under former section 9-203(1)(c) a security interest was enforceable only if the debtor had rights in the collateral. New Article 9 section 9-203(b)(2) expands former section 9-203(1)(c) by requiring that the debtor have rights in the collateral "or the power to transfer rights in the collateral to a secured party."  At one level the requirement imposed by this section is straightforward and rather intuitive.  After all, you would not expect a debtor to be able to create an enforceable security interest in property in which the debtor has no rights.  But, there is more to the requirement than first meets the eye.

Early on courts looked to title to decide whether a debtor could create a security interest.  Title is an elusive concept and its role has been minimized in the UCC generally, see Article 2, section 2-401(1), and new Article 9, new section 9-202.  So, courts began to invoke property law doctrine under which a person ordinarily has the right to transfer only the interest that person has in the property, but under certain circumstances the person has the power to transfer more.  In particular, there was reference to the doctrine of "voidable title."

Reference to voidable title makes some sense because the classic instance of circumstances in which a transferor has power to transfer more rights than the transferor enjoys against the owner is that where a person who has voidable title transfers property to a bona fide purchaser for value (BFP).  Cf. Article 2, 2-403(1).  However, voidable title itself is not defined in the UCC and it has been left largely to the courts to decide when a person has voidable title and, hence, the power to transfer good title to a BFP.  Consequently, tying a conclusion that a debtor has sufficient rights in property under Article 9 to enable the debtor to create a security interest in the property to voidable title did little to give content to the requirement that a debtor have such rights.

The drafters of new Article 9 concluded that specific rules for dealing with particular disputes as to whether a debtor had sufficient rights to enable the debtor to create a security interest would work better than a scheme in which courts are required to fashion outcomes from principles that do not always mesh well with Article 9 rules. An important example is new section 9-319 dealing with the rights of creditors of and purchasers from consignees and which, according to Official Comment 2 to new section 9-319 “to a considerable extent reformulates the former law." However, as will be apparent from the discussion that follows, courts so far have not limited their inquiry to such specific rules.

In considering the question of whether a debtor has sufficient rights in the collateral it is useful to be sensitive to the reality that conclusions about which debtors have what rights or what power to create security interests frequently reflect beliefs as to when debtors should (or should not) have the right or power given what is at stake.  Normally what is at stake is whether a particular debtor in specific circumstances should be able to create a security interest that can subordinate the interests of competing parties, including those who might be thought to have stronger claims, at least in terms of historical conceptions of title.  Stated differently, decisions as to what is true often are decisions about what should be true.

It also is important to note that the burden to prove a debtor has sufficient rights in the property to allow a security interest to attach is on the creditor asserting a security interest in the property in question.  In In re S.M. Acquisitions Co., 2004 WL 1151575 (N.D. Ill. 2004), for example, the federal district court reversed and remanded a determination by the bankruptcy court that a debtor had sufficient rights because of an absence of evidence indicating otherwise.  In so doing, the district court explicitly placed the burden of proof on the creditor.

As noted above, outright ownership cases are clear.   It also is true that an owner of property that is already subject to another lien has rights or power such as will allow a security interest to attach.  An outstanding lien generally does not bar the creation of a new one.  See new 9-401 and Chapter 25 (The Why and How of Priority).  At the other extreme are cases in which a person has no present or contingent right of ownership whatsoever and such persons do not have rights within the meaning of Article 9.  For example, a thief, pure and simple, has no rights or power to transfer such as will to allow a security interest to attach.

In between the extremes of ownership and a total absence of rights against the owner are all manner of cases as to which specific rules have been developed.  Thus, a person who as between that person and the owner of property has title that is voidable may have the power to transfer good title to a BFP.  Under Article 1, sections 1-201(b)(29) and (b)(30), a secured party is a purchaser.  Because an interest to secure an antecedent debt is value under new section 1-204(2) (replacing Article 1, section 1-201(44)(b)), a secured party also may be a BFP and thereby have a lien that subordinates the rights of the true owner. The fact that a secured party may be a BFP means that a debtor who gives the secured party a security interest in goods can have rights sufficient to allow the security interest to attach to the goods.  For example, a person who buys goods on credit (or with a bad check), leaving the seller unpaid, has sufficient rights in goods to allow a security interest that subordinates the unpaid seller's interest to attach.

In the case of In re S.M. Acquisitions Co., 2004 WL 1151575 (N.D. Ill. 2004), a federal district court applying Illinois law concluded that unless the true owner has consented to the debtor’s use of the property as collateral or is estopped to deny that the debtor has the power to do so, the debtor must have possession and title to the goods.  The court noted that constructive as well as actual possession will suffice and that the latter exists when the debtor has essentially complete control over the goods.  As for title, the court referred to Article 2, section 2-401, under which the parties to a contract for the sale of goods may agree when title passes and in the absence of such agreement title passes when the seller has completed performance with respect to the goods.

The insistence that the debtor have title is bothersome because passage of title has been given diminished importance under the UCC. Moreover, something less than the technical passage of title should suffice to allow a security interest to attach.  It has been held that a person who is in possession of property and has contingent rights of ownership, in the sense that the parties to the transfer contemplate that title to the property will pass to the person in possession, also has rights in the property sufficient to create an enforceable security interest.

The "possession with contingent rights of ownership" test has been employed to give secured parties priority over consignment sellers or other sellers for resale.  See General Electric Credit Corp. v. Town & Country Mobile Homes, Inc., 574 P.2d 50 (Ariz. App. 1977). See generally, Amfac Mortgage Corp. v. Arizona Mall of Tempe, Inc., 618 P.2d 240 (Ariz. App. 1980); In re County Green Limited Partnership, 438 F. Supp. 693 (D. Va. 1970).   However, in the final analysis, it appears that determinations as to whether a particular debtor has sufficient rights in property to allow a security interest to attach will be decided largely on a case-by-case basis.

The case of Arcadia Financial, Ltd v. Southwest-Tex Leasing Co., Inc., 47 UCC Rep. Serv. 2d 1371 (Tex. App. 2002), offers a good illustration of the difficulties courts may have in applying the foregoing concepts to determine whether or not a debtor has rights in collateral sufficient to allow a security interest to be created.  The facts of Arcadia Financial, as often is true, are complicated.  An auto leasing company (Southwest doing business as Advantage Rent-a-Car) sold used vehicles subject to a certificate of title law to a dealer, Lone Star, under an agreement whereby Lone Star would take possession of the vehicles for inspection and after accepting the vehicles Lone Star would pay for the vehicles and Advantage would provide Lone Star with the titles to the vehicles.

Lone Star had entered into an agreement with Arcadia under which Arcadia would finance the sales of vehicles on credit to Lone Star’s customers and Lone Star would assign the contracts arising from the sales to Arcadia to secure the monies advanced to Lone Star.  According to the agreement between Arcadia and Lone Star, Arcadia was not obligated to advance any funds until Lone Star provided certificates of title to Arcadia that Arcadia could use to obtain new titles showing its security interest in the vehicles.

As will be explained in Chapter 17 (Perfection of Security Interests in Vehicles Subject to Certificate of Title Legislation), Arcadia’s security interest could be perfected only by having the security interest noted on the certificates of title covering the vehicles.  Lone Star sold four vehicles to customers who purchased on credit. Lone Star had never paid Advantage for the vehicles and, therefore, Lone Star had not received the certificates of title covering the vehicles from Advantage and could not tender the certificates to Arcadia.  Notwithstanding the requirement that Arcadia was not obligated to advance funds to Lone Star until the certificates of title were provided, Arcadia did in fact advance funds equaling the unpaid purchase prices of the vehicles sold by Lone Star.

Lone Star then went out of business and was unable to repurchase the sales contracts from Arcadia as provided for in their agreement.  Arcadia demanded that Advantage turn the certificates of title to the vehicles over to Arcadia.  Advantage refused and Arcadia sued Advantage for interfering with it contractual relations with Lone Star and the buyers from Lone Star and for conversion.

The lower court concluded that under the Texas Certificate of Title Law the sales by Advantage to Lone Star were void because the certificates of title were not transferred to Lone Star as required by the Certificate of Title Law.  It further concluded that Lone Star had nothing to sell to its customers and the contracts with these customers created no rights in the vehicles or in the obligations of the customers to pay the unpaid sales prices in favor of Arcadia.  In so doing, the trial court rejected Arcadia’s argument that the Uniform Commercial Code, Article 2, sections 2-401 and 2-403 should have been applied and under the UCC title to the vehicles would have passed to Lone Star and the buyers from Lone Star.

The appellate court held that there was no need to resolve any conflict between the Texas Certificate of Title Law and the UCC because under its interpretation of the UCC, the outcome would be the same.  The court then concluded that because passage of title to the vehicles was expressly conditioned on payment for them by Lone Star, under UCC Article 2, section 2-401, title never passed to Lone Star and Lone Star had nothing to sell to its customers.  The appellate court further concluded that, for the same reason, Lone Star did not have rights in the vehicles sufficient to allow a security interest in the vehicles or the contracts arising from the sale of the vehicles to attach in favor of Arcadia under new section 9-203(b).

It should be apparent that the appellate court’s analysis regarding the application of the UCC is erroneous.  Advantage had reserved title to the vehicles pending payment by Lone Star, but under Article 2, section 2-401(1), such a reservation of title operates only to create a security interest.  Further, although the sales by Advantage to Lone Star were voidable as between Advantage and Lone Star, under Article 2, section 2-403(1), a transferor with voidable title has the power to transfer title to a bona fide purchaser for value and, absent proof to the contrary, the buyers from Lone Star would take title to the vehicles free of Advantage’s claim to the vehicles.

As explained above, Lone Star’s voidable title would give Lone Star sufficient rights under new section 9-203(b) to allow the Arcadia’s security interest to attach.  Alternatively, Lone Star had possession of the vehicles with a contingent right of ownership that would give Lone Star rights sufficient to allow Arcadia’s security interest to attach.

The controlling question should have been whose security interest, that of Advantage, created by its reservation of title, or that of Arcadia, created by Lone Star in its agreement with Arcadia, should have priority.  The answer to this question turns on the application of priority rules that will be considered in Chapter 28 (Secured Party Versus Secured Party and Chapter 29 (Secured Party Versus Secured Party (Continued)).

Although the buyers from Lone Star appear not to have contested Advantage’s claims to the vehicles, as will be explained in Chapter 27 (Secured Party Versus Buyers), it would seem the buyers from Lone Star would qualify as buyers in ordinary course under revised Article 1, section 1-201(b)(9) and as buyers in ordinary course could well have had a claim to the vehicles superior to that of Advantage.

Curiously, the court discussed buyer in ordinary course status only as to Arcadia and seemingly failed to note that under Article 1, section 1-201(b)(9) only a buyer of goods can be a buyer in ordinary course.  Finally, to the extent that Arcadia had an enforceable security interest in the contracts of sale between Lone Star and its customers it is likely that Arcadia would be subject to the buyers’ defense that they had been forced to defend their title to the vehicles.  The question of the extent to which claims and defenses may be asserted by parties such as these buyers against assignees such as Arcadia are dealt with in Chapter 37 (Foreclosure as to Intangibles).

The important point made in this discussion of Arcadia Financial for purposes of the requirement that a security interest can attach only if the debtor has rights in the collateral sufficient to allow attachment is that, contrary to the court’s holding, a debtor such as Lone Star, does have rights with respect to the collateral sufficient to allow a security interest to attach because persons with voidable title have such rights as do persons in possession with contingent rights of ownership.

The foregoing must be qualified insofar as the UCC expressly denies a debtor sufficient rights to allow a security interest to attach at the expense of a seller.  Thus, new section 9-110 essentially makes a security interest arising under Article 2 (for example, by reserving title to goods) superior to that of a claim by a creditor of the buyer/debtor until the seller relinquishes possession of the goods. Moreover, although new section 9-110 apparently does not determine whether a seller may withhold delivery for non-payment under governing Article 2 sections, Official Comment 5 to new section 9-110 indicates that a buyer’s creditor has no greater rights as to the goods prior to the time the seller gives up possession and may not prevent the seller from withholding delivery and looking to new section 9-110 to give it priority of the buyer’s creditor.  See In re Kellstrom Industries, Inc., 282 B.R. 787 (Bkcy D. Del. 2002).

Thus, if Advantage in the Arcadia case had withheld delivery of the vehicles to Lone Star it could have relied on new section 9-110 to assure priority over Arcadia in the Arcadia case.  However, once the seller relinquishes possession then new section 9-110 ceases to apply and the earlier discussion of when the debtor has rights in the collateral sufficient to allow a security interest to attach once again comes into play.

Subject to the special rules governing various consignments, bailees generally do not have rights in or power with regard to bailed goods sufficient to allow a security interest to attach.  Likewise, lessees of goods in a true lease situation, see Article 1, section 1-201(b)(35) and Chapter 4 (Scope of Article 9), cannot create security interests that will subordinate the lessor's interest. An exception exists for a so-called "disguised conditional sale," that is, a security transaction parading as a lease. As to the differences between a true lease and a lease intended as security, see Article 1, section 1-203 (which now contains the discussion in former Article 1, section 1-201(37) dealing with the distinction).

Another type of bailment situation that has presented difficulties is that where goods have been sold on approval under Article 2, section 2-326.   According to section 2-326(1), a sale on approval is one in which goods are delivered primarily for use and the buyer may return the goods even if they conform to the contract.  Under section 2-326(2), goods sold on approval are not subject to the claims of creditors until the buyer has accepted the goods.  In the case of In re S.M. Acquisitions Co., 2004 WL 1151575 (N.D. Ill. 2004), the district court instructed the bankruptcy court on remand to determine, inter alia, whether goods asserted to be collateral had been sold on an acceptance basis and, if so, whether the debtor had accepted the goods.

On remand the bankruptcy court concluded that even if there was a sale on approval the debtor had accepted the goods.  See In re S.M. Acquisitions Co., 319 B.R. 55 (Bkcy N.D. Ill. 2005).  The court’s reasons for so concluding are less than entirely clear, but the decision seemed to turn on the totality of the circumstances.  The court might usefully have referred to Article 2, section 2-327(1)(b), according to which the use of goods sold under a sale or acceptance contract does not constitute acceptance, but a buyer who fails to seasonably notify the seller of an election to return the goods will be deemed to have accepted.

It is worth noting, as discussed earlier, that the district court felt constrained by Illinois law to require that title have passed before the debtor could have rights sufficient to create an enforceable security interest but it did not explain the connection between acceptance and passage of title.  That connection can be found in Article 2, section 2-327(1)(a), providing that in the absence of express agreement, title passes upon acceptance.

In ways that cannot be understood without referring to the specific provisions and comments thereto the expansion of the scope of Article 9 under new section 9-408 can impact a determination of when a debtor has rights in collateral.  New section 9-408 is discussed in Chapter 4 (Scope of Article 9).

You may explore the foregoing discussion of when a debtor has sufficient rights in collateral to create a security interest in the following problems.

 

Problem 10.3     (interactive)

Danielle Debtor owns a computer subject to a security interest held by Second Bank. 

Does Danielle have rights in the computer sufficient to give Ready Lender an enforceable security interest in the computer?

 

Problem 10.4     (interactive)

Cora Crook steals a computer from Owen Owner.  Cora borrows from Second Bank.  Second Bank takes a security interest in the computer.  Assuming the other requisites of new section 9-203(b) are satisfied, is Bank's security interest enforceable?

 

Problem 10.5    (interactive)

Leroy Lessor leases a computer to Lisa Lessee.  Under Article 1, section 1-201(b)(35) and 1-203 the lease is not intended for security.

Does Lisa have sufficient rights in or power to transfer the computer to allow Ready Lender to take a security interest in the computer that could subordinate Leroy's rights? 

Would your answer be different if the lease was a "disguised conditional sale"?

 

Problem 10.6      (interactive)

Donald Debtor manufactures custom window awnings on a special order basis.  Byron Buyer provides the raw materials needed by Donald to manufacture window awnings for Byron.  The agreement between Donald and Byron provides, among other things, that Donald has possession of the raw materials only for the purpose of manufacturing the window awnings for Byron and that Donald has no rights in or title to the raw materials, contingent or otherwise.  Donald borrows from Second Bank and gives Bank a security interest in the raw materials supplied by Byron. 

Does Bank have an enforceable security interest in the raw materials?

 

Problem 10.7    (interactive)

Bertram Buyer has entered into a contract to purchase tools used in Bertram’s business from Easy Sale, Inc. Under the terms of the agreement entered into between Bertram and Easy Sale, Bertram may take possession of and use the tools without becoming obligated to pay for the tools until Bertram indicates he is satisfied with the tools (or Bertram fails to notify Easy Sale that he is returning the tools within a reasonable time).  

Does Bertram have sufficient rights in the tools to create an enforceable security interest in favor of Northern Bank?  

If not, at what point would Bertram have such rights?  

Would your answers to these questions be different if Bertram were a reseller of tools such as acquired from Easy Sale and the tools were delivered to Bertram under an agreement providing that if Bertram sold the tools to third parties he would remit some portion of the proceeds to Easy Sale, but if Bertram did not sell the tools he would return them?  Explain your answer.

 

Problem 10.8    (interactive)

John borrows money from Second Bank.  With Mary's permission, John signs a security agreement giving Bank an interest in a Jaguar owned by Mary to secure the debt. 

Does Bank have an enforceable security interest in the Jaguar? 

How can Bank best assure that it will have an enforceable security interest in the Jaguar?

 

CASE COMMENTARY

In re Lexington Healthcare Group, Inc., 335 B.R. 570 (Bkcy D. Del. 2005)

Wells Fargo Bank v. Robex, Inc., 711 N.W.2d 732 (Iowa App. 2006) (Unpublished opinion)

Integrity Bank Plus v. Talking Sales, Inc., 2006 WL 212193 (D. Minn. 2006)

ACG Credit Co., LLC v. Gill, 876 A.2d 188 (N.H. 2005)

Mackela v. Bentley, 614 S.E.2d 648 (S.C. App. 2005)

In re Jeans, 326 B.R. 722 (Bkcy W.D. Tenn. June 28, 2006)

Vibbert v.PAR, Inc, 224 S.W.3d 317 (Tex. App. March 23, 2006)

Coffey v. Singer Asset Finance Co., L.L.C., 2007 WL 258962 (Tex. App. 2007)

 

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2011-08-22 update 

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