Part VII Enforcing an Article 9 Security Interest
Chapter 37 Foreclosure as to Intangibles
A. Generally
Intangible collateral includes accounts, chattel paper and general intangibles. It also includes instruments. Such collateral consists essentially of promises by third parties to pay or perform certain other obligations. It is the promise of the third parties (account debtors as to accounts, chattel paper and general intangibles and obligors as to instruments) that is the primary security.
Accounts, chattel paper, general intangibles and instruments may secure debts, in which case there is a security transaction that is largely indistinguishable from a security interest in goods. See new section 9-109(a)(1). However, accounts, chattel paper, payment intangibles and promissory notes also may be sold and under new section 9-109(a)(3) such sales are within the scope of Article 9.
The primary difference between an interest in intangibles to secure an indebtedness and a sale of intangibles is that in sales transactions, under new section 9-608(b), the debtor is not entitled to any surplus and the obligor is not liable for a deficiency whereas in a security transaction, under new section 9-608(a)(4), the debtor is entitled to any surplus and the obligor is liable for any deficiency. However, these general rules may be altered by agreement and it is possible that there will be no right of charge back or right of recourse (no deficiency liability) in a security transaction and that there will be deficiency liability in a sales case.
Where the secured party is not required to account for any surplus or the debtor is not liable for any deficiency, the secured party assumes the risk that the account debtor or obligor will be unable or unwilling to pay and the debtor is off the hook. Where the secured party must account for a surplus or a debtor is liable for any deficiency, under new section 9-607(c), actions taken by the secured party must be commercially reasonable.
B. Foreclosure as to Assignments of Interests in Accounts and Chattel Paper to Secure Debts; Foreclosure as to Deposit Accounts
1. Satisfying Debts Out of Deposit Accounts
As has been noted in the past, sales of intangibles and security interests in intangibles may take many forms and generalizations are difficult. These materials will focus on assignments of interests in intangibles to secure debts and, more specifically, on security interests in accounts and chattel paper. But, first a word about satisfying debts that are secured by interests in deposit accounts, which are general bank accounts and are not accounts within the meaning of Article 9, is in order.
If a secured party has a security interest in a deposit account and the secured party is the bank in which the account is maintained, then the security interest is perfected by control under new section 9-104(a)(1). Under new section 9-607(a)(4) the bank/secured party is free to apply the balance in the deposit account to the obligation secured by the deposit account.
If a security interest in a deposit account is perfected by control under new section 9-104(a)(2) (the bank in which the account is maintained has agreed to follow the secured parties instructions without further assent by the debtor) or under new section 9-104(a)(3) (the secured party has become a customer on the deposit account) then, under new section 9-607(a)(5), the secured party may instruct the bank to pay the balance of the deposit account to or for the benefit of the secured party.
For completeness, it should be noted that a bank is not an account debtor, as defined in new section 9-102(a)(3), with respect to a deposit account or, more clearly, with respect to a negotiable instrument. That a bank is not an account debtor means that the rules governing assignments found in new sections 9-403, 9-404, 9-405 and 9-406, which are discussed below, do not apply. See Official Comments 5d and 5h to New 9-102.
2. Foreclosing on Accounts and Chattel Paper Assigned for Security
Assignments for security of accounts and chattel paper are three-party transactions. In such transactions the secured party/assignee, is taking an interest in the obligations owed by the account debtor on an account or chattel paper, typically a right to payment, to secure the debt owed by the debtor/assignor. Rules governing the extent to which an account debtor may continue to pay the debtor after an assignment and when defenses and claims against a debtor may be asserted by the account debtor against the secured party are necessary.
Under new section 9-406(a) an account debtor may discharge its obligation by paying the debtor (assignor) until the account debtor receives a notification, authenticated by the assignor or the assignee, that the amount due or to become due has been assigned and that payment is to be made to the secured party (assignee). However, also under new section 9-406(a), if an account debtor continues to pay the assignor after having received an authenticated notification then the debt is not discharged and the account debtor may incur double liability.
An account debtor may request reasonable proof of an assignment and if the secured party does not seasonably provide such proof the account debtor may continue to pay the debtor.
Under new section 9-209, once the obligation owed by the assignor/debtor has been paid, if there is no commitment by the assignee (secured party) to make further advances, the debtor may make an authenticated demand on the secured party to provide an authenticated record that releases the account debtor from any further obligation and the secured party must send such a release to the account debtor within ten days of receiving the demand.
The general rule of new section 9-404(a) is that an account debtor may assert against the secured party all claims and defenses the account debtor has against the debtor. However, under new section 9-403(b), in a commercial setting, the debtor (assignor) and the account debtor may agree that the account debtor will not assert claims and defenses against the secured party (assignee).
In Systran Financial Services Corp. v. Giant Cement Holding, Inc., 252 F. Supp. 2d 500 (N.D. Ohio 2003), the court held that an arbitration clause was enforceable by an account debtor against an assignee. In so holding, the court concluded that new section 9-404 governed a factoring arrangement (under which accounts were sold to the assignee at a discount) and that the Article 2 provisions that appeared to distinguish assignments of contracts and assignments for financing did not.
The court noted that the assignee (as with such assignees generally) could have required its assignor/debtor to agree not to include an arbitration clause in its contracts with its customers, but that the account debtor had not by its actions in resisting the claim waived the right to arbitration.
Of course, an agreement by an assignor not to include an arbitration clause in a contract would not be enforceable against the account debtor if the assignor entered into contracts providing for arbitration in violation of the agreement. The assignee could require that the assignor include in its contracts a provision under which the account debtor waived as against the assignee any claims or defenses it might have against the assignor.
Such “waiver of defense” clauses are expressly enforceable under the conditions spelled out in new section 9-403(b), namely, that the assignee have given value and taken the assignment without notice of a claim or defense. However, the assignee would have to establish a way to oversee the assignor’s contracts so as to assure that the waiver of defense clause was included in its contracts.
Under new section 9-403(d) "waiver of defenses" agreements are not effective against account debtors in consumer transactions (the debtor is an individual, the obligation is secured by an interest in consumer goods and the obligation was incurred for personal, family, or household purposes). New section 9-403(d) reinforces the protection given to consumers by the FTC Preservation of Consumer Defenses and Claims Rule, 16 CFR Part 433 (in the Selected Statutes).
It is important to point out that an account debtor, to which the foregoing rules apply, under new section 9-102(a)(3) means a person obligated on an account, chattel paper or general intangible. As explained in Chapter 5 (Classification of Collateral), general intangible, as defined in new section 9-102(a)(42), includes a payment intangible, as separately defined in new section 9-102(a)(61).
However, commercial tort claims, deposit accounts and letter of credit rights are excluded from the definition of general intangibles. The effect of the exclusion is that persons obligated as to such collateral, in particular, banks and tortfeasors, are not account debtors and the rules regarding assignments discussed here do not apply.
Moreover, the definition of account debtor in new section 9-102(a)(3) expressly excludes persons obligated on a negotiable instrument and a person so obligated, even where the negotiable instrument is chattel paper as defined in the last sentence of new section 9-102(a)(11), is not an account debtor to which the rules governing assignments apply. For the most part, Article 3 and not Article 9 governs negotiable instruments. See Official Comments 5d and 5h to new 9-102.
For convenience the discussion of the rules regarding assignments and foreclosure, more generally, has been narrowed to focus on transactions involving accounts and chattel paper (other than negotiable instruments).
There are essentially two kinds of assignments of accounts and chattel paper to secured debts. One is referred to as "notification" financing. In a notification situation the account debtor is notified at the time of the assignment to pay the secured party and not the debtor and under new section 9-406, as discussed above, the account debtor must cease paying the debtor and pay the secured party or risk incurring double liability.
In a sense the collateral in a notification financing situation is being foreclosed upon from the outset (from the time of the assignment for security) and the debt is satisfied by payments made by the account debtor directly to the secured party. However, even though the secured party has taken over collection from the account debtor or debtors, apart from an agreement to the contrary, the debtor continues to be responsible if the account debtor or debtors' payments do not satisfy the secured debt. See new section 9-608(a)(4).
Stated differently, the secured party has a right against the debtor for a deficiency. If the payments from the account debtor or debtors exceed the amount of the secured debt there is a surplus and new section 9-608(a)(4) further provides, subject to an agreement to the contrary, that the debtor is entitled to the surplus.
The other type of assignment is known as "non-notification " financing. In a non-notification situation the account debtor is not notified at the time of the assignment that it should pay the secured party at the time of the assignment and, under new section 9-406, the account debtor may continue to pay the debtor until notified otherwise. New section 9-607(a) provides the foreclosure options of a secured party in non-notification situations.
Under new section 9-607(a)(1), the secured party, on default by the debtor, may notify the account debtors to pay the secured party and the secured party more generally takes control of and may enforce the obligation owed to the debtor by the account debtor against the account debtor. Under new section 9-607(a)(2), the secured party could leave the debtor in charge of collecting the account debtors' promises to pay and take the proceeds of such payments, but doing so is not routine because the contractual relationship between the secured party and the debtor has broken down.
If an assignment of an account or chattel paper is not for security and rather is an outright sale then there is no deficiency liability and no obligation to account for any surplus, unless the parties agree otherwise. However, we are focusing here on assignments for security and the rule as to such assignments is that the debtor is liable for any deficiency and is entitled to any surplus, except as the parties may agree otherwise. The rules regarding liability for a deficiency and the need to account for any surplus apply to both notification and non-notification financing.
The fact that a debtor is liable for any deficiency and is entitled to any surplus means that a secured party cannot with impunity act so as to reduce the amount collected on the accounts or chattel paper and thereby cause a deficiency (or increase a deficiency that would otherwise have resulted) or eliminate a surplus (or reduce the surplus that otherwise would have resulted).
It may happen that an account debtor is unable or unwilling to pay any or all of the face amount of an assigned account or chattel paper. The latter could happen if the account debtor asserts a claim or defense, such as for breach of warranty, that is good against the debtor and, hence, is also good against the secured party under new section 9-404(a), as discussed above. In either situation, the secured party may wish to settle the account debt for less than the face amount of the account.
A settlement for less than the face amount of the account could produce or increase a deficiency or eliminate or reduce a surplus. For this reason, new section 9-607(c) requires that a secured party proceed in a commercially reasonable manner. Just what is commercially reasonable with respect to particular actions, including especially settling disputed accounts, may be difficult to determine.
New sections 9-602 and 9-624 prohibit the parties from eliminating by agreement the secured party's obligation to proceed in a commercially reasonable manner and thereby avoid the problem, but new section 9-603(a) does allow the parties to set standards that are not manifestly unreasonable for testing the commercial reasonableness of a secured party's actions. A secured party would be well advised to spell out in the security agreement those actions that the debtor agrees will be commercially reasonable.
You may consider the new Article 9 rules governing foreclosure of an interest in an account or chattel paper to secure an indebtedness in the next problem.
Problem 37.1 (interactive)
Donald Debtor sells farming equipment to retailers of such equipment. Donald borrows from Northern Bank and assigns Donald's interest in contracts made with retailers as security for the loan. Under the security agreement between Northern and Donald assigning the contracts, Donald continues to collect on the contracts and the retailers are not advised of the assignment (i.e., this is "non-notification" financing). There is no provision in the agreement eliminating Bank's obligation to account for any surplus or Donald's liability for a deficiency. Donald defaults on the loan debt.
(a) May Northern enforce its security interest in the contracts by notifying the retailers (account debtors) to pay Northern and not pay Donald and otherwise taking control of collection (or by leaving the collection of the retailers' payments to Donald and taking the proceeds)?
(b) If a retailer continues to pay Donald after Donald's default and notification by Northern to pay it and not Donald is the retailer still obligated to pay Northern?
(c) Suppose that one or more of the retailers complain that Donald has not delivered the equipment as promised in the contracts between the retailers and Donald. May such claims by the retailers be asserted against Northern?
(d) If the retailers may assert the claims of breach of contract by Donald against Northern, to what extent may Northern "forgive" the indebtedness or otherwise settle the dispute? Why is there such a limitation on Northern's actions?
(e) Could Northern assign all the contracts to Friendly Finance Company "for collection"?
(f) Could Northern simply sell all the contracts to Friendly Finance Company at a discount and take itself out of the collection process?
(g) Could the terms of the security agreement assist Nothern (and you) in answering questions the answer to which turn on commercial reasonableness?
CASE COMMENTARY
Novartis Animal Health Us, Inc. v. Earle Palmer Brown, L.L.C., 424 F.Supp.2d 1358 (N.D. Ga.2006)
Orix Financial Services, Inc. v. Thunder Ridge Energy, Inc., 2006 WL 587483 (S.D.N.Y. 2006) (Slip Opinion)
Genesee Regional Bank v. Palumbo, 799 N.Y.S.2d 883 (N.Y. Supreme Court 2005)
Wells Fargo Bank Minnesota, National Association v. B.C.B.U, 143 Cal. App. 4th 493 (Cal. App. 2006)
IIG Capital, LLC v. Archipelago, L.L.C., 829 N.Y.S. 2d 10 (N.Y. App. Div. 2007)
Coffey v. Singer Asset Finance Co., L.L.C., 2007 WL 258962 (Tex. App. 2007)
Keybank National Association v. DPR Construction, Inc., 149 P.3d 233 (Or. App. 2006)
2011-08-22 update