Part VI Priority
Chapter 25 The How and Why of Priority
A. Generally
In Chapter 3 (The Nature and Scope of Secured Credit under Article 9), we explored the differences between secured and unsecured credit and the reasons why a secured creditor is likely to be much better off than an unsecured creditor both in and out of bankruptcy. We anticipated there the question that is the subject of Part VI and pointed out that the ultimate concern of a secured creditor is with priority over competing claimants to collateral, especially a trustee in bankruptcy. Having an enforceable security interest, a lien on particular property to secure a debt, is essential but it will do a creditor little good if there are conflicting claims to the property that are ahead of the creditor's security interest and the satisfaction of which will exhaust the value of the collateral.
The place to begin the discussion of priority is with the basic proposition that competing claims to the same property are possible. A legal regime in which the creation of a security interest precludes other claims to the collateral from even arising could exist. However, for the most part, Article 9 eschews such "inalienability" and debtors may voluntarily transfer interests in property to others despite the fact they already have created an Article 9 security interest in the property. Involuntary transfers resulting from legal process also are possible.
Under former section 9-311, the debtor's rights in collateral could be voluntarily or involuntarily transferred even if the debtor had agreed otherwise in the security agreement. The provision left open the possibility that law outside Article 9 could limit the effect of a transfer. It was understood that a transfer in violation of the security agreement could constitute a breach of the debtor's agreement and result in a default. It was standard practice to define default in a security agreement to include in the definition voluntary transfers made without the secured party's consent and involuntary transfers, such as sheriff's levies. New Article 9 deals with the matter of alienability somewhat differently than did former Article 9. The central provision is new section 9-401.
B. New Section 9-401(a) and the "General Rule"
We saw in Chapter 4 (Scope of Article 9) that certain transfers are entirely or largely outside the scope of Article 9 because these transfers are excluded from Article 9 coverage in new section 9-109(d). New section 9-401(a) states that, subject to certain specific identified exceptions, law outside Article 9 determines the extent to which a debtor may or may not transfer rights in collateral. According to Official Comment 4 to new section 9-401 even though a security interest in particular property is covered by new Article 9 under the general rule of new section 9-401(a) the security interest may be precluded or otherwise regulated by law outside Article 9.
Identifying laws outside Article 9 that are not somehow accounted for in Article 9 and which limit the ability of a debtor to transfer rights in collateral, especially those that deny a debtor the power to transfer an interest in property because the property is subject to a security interest, is not easy. However, under new section 9-401(a) any such laws are controlling and an attorney must be alert to their possible existence. As is explained more fully in the next subpart, the task is made more difficult by the possibility that other law may prevent something from even being property, in which case Article 9 would not apply because it governs only security interests in personal property.
C. New Section 9-401(a) and the Increased Availability of Certain Intangibles as Collateral
New section 9-401(a), by reference to new sections 9-406, 9-407, 9-408 and 9-409, increases the extent to which various intangibles may serve as collateral. It does so by generally rendering ineffective agreements that prohibit or restrict transfers for purposes of creating security interests in accounts, chattel paper, payment intangibles, general intangibles (including rights conferred by a computer software license), health-care-insurance receivables, promissory notes, letter-of-credit rights, and leases.
Under new section 9-408, most "no-assignment" clauses and even restrictions imposed by law do not render a security interest ineffective. According to the Official Comments, this provision will make it possible for creditors to take (and debtors to give) security interests in such increasingly valuable rights as those arising under a software license agreement. However, new section 9-408(d) qualifies the general rule of section 9-408 so completely that there is a serious question whether a security interest in a contract or license containing a no-assignment clause has any value, at least outside bankruptcy. Official Comment 2 to new section 9-408 uses the example of a security interest in a non-exclusive computer software license to illustrate the effect of the general rule and the limitations in new section 9-408(d).
According to the example, a no-assignment clause in such a software license would not prevent a security interest in the license from being effective. An assignment without the licensor/non-debtor's consent would be a default triggering a secured party's foreclosure rights. See new 9-401(b) and subpart D below. The commentary concludes, however, that
[Under] subsection (d), the secured party (absent the licensor's agreement) is not entitled to enforce the license, or to use, assign, or otherwise enjoy the benefits of the licensed software, and the licensor need not recognize (or pay attention to) the secured party. Even if the secured party takes possession of the computers on the debtor's default, the debtor would remain free to remove the software from the computer, and load it onto another computer, and continue to use it, if the license so permits. If the debtor does not remove the software, other law may require the secured party to remove it before disposing of the computer. Disposition of the software with the computer could violate an effective prohibition on enforcement of the security interest. See subsection (d).
Under new section 9-109(a)(1) new Article 9 applies to a transaction that creates a security interest in personal property (or fixtures). According to Official Comment 3 to new section 9-408, “other law determines whether a debtor has a property interest (‘rights in collateral’) and the nature of that interest.” It follows that if the subject of a transaction is not even property then new Article 9 does not apply.
The court in In re Chris-Don, Inc., 367 F. Supp. 2d 696 (D. N.J. 2005), relied on this comment in holding that a New Jersey law providing that “under no circumstances, however shall a [liquor] license be deemed property . . .” was “other law” that prevented a security interest from attaching to a liquor license because it was not personal property. In so holding, the court rejected an argument that new section 9-408(c) overruled the New Jersey liquor license statute.
It may be that Chris-Don is a special case the decision in which was dictated by the express language of the non-UCC New Jersey law, but there are decisions under former Article 9 that reach similar outcomes based on the language of particular liquor license statutes. On the other hand, security interests in liquor licenses and other such intangibles, such as interests arising under franchise agreements, have been given effect in several jurisdictions despite the existence of restrictions on alienation that impact the value of such property as collateral or pose difficult issues of enforcement. See, e.g., Landon v. Stroud, 709 P.2d 565 (AZ App. 1985). See generally, Security Interests in Liquor Licenses, 56 A.L.R. 4th 1131 (1987).
These holdings seem more in line with the intent of the drafters of new Article 9 to expand the range of what may serve as collateral. Insofar as the language of a non-UCC law by its express language appears to require a decision that no Article 9 security interest can attach, as was the case with the New Jersey statute governing liquor licenses, a court might conclude, despite Official Comment 3 to new section 9-408, that new Article 9 has overruled the non-UCC law. Where such overruling by implication is not favored it may be necessary and desirable for a state legislature to avail itself of the invitation in new section 9-408(e) to list those laws that are inconsistent with the letter and intent of new Article 9 over which new Article 9 is to prevail. For example, the Arizona version of new section 9-408(e) provides that "[section 9-408] prevails over any inconsistent provisions in title 33, chapter 7" (dealing with certain statutory liens and available at http://www.azleg.state.az.us/ArizonaRevisedStatutes.asp?Title=33).
New section 9-407 renders ineffective a term in a lease agreement that prohibits or restricts the creation of a security interest, subject to certain exceptions unique to leases, such as a transfer by a lessee of its right to possession or a transfer that involves a delegation of material performance of either party. New section 9-406, making accounts and chattel paper readily available as collateral, and new sections 9-403 and 9-404, dealing with the effect of transfers on the rights of persons owing on accounts and chattel paper (account debtors), are considered in Part VII because they impact the foreclosure of security interests in such property.
D. New Section 9-401(b) – Restrictions on Transfer Versus Default
Under new section 9-401(b) an agreement between a debtor and secured party prohibiting a transfer of a debtor's rights in collateral or making the transfer a default does not prevent a voluntary or involuntary transfer from "taking effect". Official Comment 5 to new section 9-401 characterizes new section 9-401(b) as an exception to the general rule of new section 9-401(a) that makes clear that a debtor has rights in collateral that the debtor can transfer notwithstanding any agreement to the contrary.
Official Comment 5 adds that, by contrast to new section 9-406 (and new section 9-408 discussed in subpart C above), new section 9-401(b) does not render "ineffective" an agreement prohibiting transfer or making a transfer a default and "the debtor's breach [of such an agreement] may create a default." Consequently, a security agreement should define default to include specified voluntary and involuntary transfers (such as sheriff's levies). Default and its importance to foreclosure of a security interest will be discussed in Part VII.
E. The Essential Point for Part VI (Priority)
The essential point of the foregoing discussion is that under new section 9-401(a), except in the rare circumstance where a law outside Article 9 provides to the contrary, the existence of a security interest does not prevent a voluntary or involuntary transfer from being effective. Moreover, under new section 9-401(b), even an agreement by a debtor not to give security interests to other creditors or not to suffer judgments leading to a sheriff's levy will not prevent another secured party or a lien creditor from getting an interest in collateral.
Consequently, third parties may have claims to collateral that produce priority disputes between secured parties and third parties. This important reality was pointed out directly in Problem10.3, in Chapter 10 (The Need for Value and that the Debtor Have Rights in the Collateral), and was implicit in Problems 12.1 through 12.6, in Chapter 12 (Perfection Generally).
F. New 9-201 and the Rule that Secured Parties Prevail Except
There is another basic point to be made here. Despite the possibility that third parties can get interests in collateral and that conflicts between a secured party and third parties can and do arise, the "general rule" is that secured parties prevail in such conflicts. Under former section 9-201, "except as otherwise provided by this Act, " a security agreement was effective according to its terms against purchasers of the collateral and against creditors. New section 9-201(a)similarly states:
(a) Except as otherwise provided in [the Uniform Commercial Code], a security agreement is effective according to its terms between the parties, against purchasers of the collateral, and against creditors.* * *
The next two problems capture the essence of basic points made in this chapter.
Problem 25.1 (interactive)
Doris Debtor develops computer programs to assist law students to learn commercial law. Doris owns a high-powered computer that she purchased on credit from Doorway Computers, Inc. Doorway has an interest in the computer to secure its unpaid price. The security agreement that Doris signed provides that Doris may not transfer, voluntarily or involuntarily, any interest in the computer without Doorway’s consent and that any transfer in violation of the provision is void. The security agreement specifically provides that any creation of a security interest in favor of a party other than Doorway is prohibited. The security agreement further provides that the breach of any promise made by Doris in the security agreement is a default. Doris also licenses graphics software from Micromedia, Inc. that Doris uses in the development of computer learning programs. The license agreement contains a “no assignment” clause that prohibits Doris from assigning any interest in the licensed software. The license agreement allows Doris to use the software on any computer so long as she does not use it on more than one at a time. Without Doorway’s consent, Doris borrows from Southwest Bank and grants Southwest an interest in the computer to secure the loan. To further secure the loan, Southwest takes a security interest in the software licensed from Micromedia, Inc. Please indicate which of the following statements are true and which are false:
(a) The attempt to create a security interest in the computer in favor of Southwest Bank is ineffective and the security interest is void and of no effect.
(b) The creation of the security interest in favor of Southwest Bank would be a default on the part of Doris.
(c) If Doris were to suffer a judgment and the sheriff levied on the computer under a Writ of Execution the levy would be effective but would constitute a default on the part of Doris.
(d) The software licensed from Micromedia, Inc. by Doris constitutes goods.
(e) The “no assignment” clause in the license agreement denied Doris the power to create the security interest in the software in favor of Southwest Bank.
(f) In the event of a default by Doris of its security agreement with Southwest Bank, Southwest could enforce its security interest in the software without the cooperation of Micromedia, Inc.
(g) If, in the event of a default by Doris under its security agreement with Southwest Bank, Southwest sought to repossess and dispose of the computer to satisfy its debt, Doris could remove the software and use it on another computer.
Problem 25.2 (interactive)
Lisa Lender lends to Donald Debtor and takes a security interest in Donald's equipment to secure the loan. Subsequently, Donald gives a security interest in the same equipment to Friendly Finance Company and the sheriff levies on the equipment pursuant to a judgment against Donald obtained by Leon Lien Creditor.
Which of the following statements best describes the new Article 9 priority scheme?
(a) Lisa Lender has a claim to the equipment that is superior to any claim made by Donald Debtor, Friendly Finance or Leon Lien Creditor except as new Article 9 may provide otherwise.
(b) Lisa Lender has a claim to the equipment that is superior to any claim made by Donald Debtor and Friendly Finance but not a claim made by Leon Lien Creditor except as new Article 9 may provide otherwise.
(c) Lisa Lender has a claim to the equipment that is superior to any claim made by Donald Debtor and Leon Lien Creditor but not a claim made by Friendly Finance except as new Article 9 may provide otherwise.
(d) Lisa Lender has a claim to the equipment that is superior to any claim made by Donald Debtor but not a claim made by Friendly Finance or Leon Lien Creditor except as new Article 9 may provide otherwise.
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)
2011-08-22 update