Part IV Creating an Enforceable Article 9 Security Interest

Chapter 9 The Specifics of Enforceability - After-acquired Collateral, Future Advances, Transferred Collateral and Proceeds, and the New Debtor Problem

No treatment of enforceability would be complete without a discussion of security interests in after-acquired property, proceeds, and interests to secure future advances.  Often the collateral will change after the security agreement is executed. This happens when a debtor acquires more of the type of property of which the original collateral consists -- in which case there is after-acquired collateral -- and when a debtor disposes of collateral and receives something in its place -- in which case there are proceeds.  Both after-acquired property and proceeds obviously are important to a secured creditor.  Future advances security pertains to the amount of debt that is secured rather than what property may be claimed as collateral.

It can happen that the debtor transfers the collateral to another person who then becomes the debtor or a person becomes bound by a security agreement entered into by someone else.  In both cases there are new debtors and new Article 9 contains special rules for dealing with new debtor situations.  After-acquired property, proceeds, future advances and new debtor situations are the subjects of this chapter.

A. Security Interests in After-Acquired Property

Prior to adoption of Article 9 there were problems encumbering property that the debtor did not own at the time of the creation of the lien.  Subject to a limitation in the consumer setting that will be explored in Chapter 11 (Enforceability and Attachment of Security Interests in Consumer Transactions), former section 9-204(1) explicitly authorized a creditor to take an interest in after-acquired property.  In so doing, former Article 9 gave its blessing to the concept of a "floating (or continuing) lien," i.e., a security interest that floats over a debtor's assets generally and descends on whatever is available as collateral at the time of a default.  See Official Comment 2 to former 9-204.

New Article 9 continues former Article 9's treatment of security interests in after-acquired property in new section 9-204(a) by broadly authorizing the creation of security interests in after-acquired property.  This broad authorization prompts the question of how such collateral should be described in a security agreement.  Former Article 9 did not directly answer the question. Neither does new Article 9. Official Comment 3 to new section 9-108 states:

This comment implicitly accepts the fact that new section 9-204(a) is permissive (a security agreement may include after-acquired property), but it leaves the determination of whether after-acquired property has been adequately described to an interpretation of a security agreement.  There is no more effective way to express the intent that a security interest includes after-acquired property than to include a clause explicitly so providing.  Conversely, a security agreement that does not refer to after-acquired property does not cover later acquired original collateral.

It might be argued that there is no need to include a description of after-acquired property in the case of collateral such as inventory and accounts that by its very nature "turns over."  However, that argument does not apply to collateral that does not turn over and an after-acquired property clause is needed as to such collateral. For example, a security agreement covering equipment should say "equipment, existing and later-acquired."  Moreover, adding an "after-acquired " or "later-acquired" property clause to the collateral description is easy and painless and it is the most sensible course as to all collateral, even inventory and accounts.

The following problem illustrates the need for an adequate after-acquired property provision in a security agreement.

Problem 9.1    (interactive)

Exactly one year ago Danielle Debtor borrowed from Second Bank and signed a security agreement giving Second Bank an interest in Danielle's "crops growing on Debtor's farm in Pima County."  Danielle has come to Ready Lender seeking another loan and has offered to Ready Lender a security interest in Danielle's future crop.  The loan to Second Bank is still unpaid. 

Is Ready Lender at risk of being subordinated to Second Bank if it makes the requested loan?  (Assume that if Second Bank's security interest includes Danielle's current crop then Second Bank has first claim to the that crop.) 

If you had been representing Second Bank at the time of the loan made by Second Bank what description of collateral would you have advised Bank to use? 

If you had been representing Danielle, would you have agreed to such a description?

There is a non-obvious lesson to be learned from Problem 9.1. It is much better to structure a secured transaction correctly in the first place than be forced to come up with a solution when the deal breaks down.  Ask yourself what options Ready Lender or Danielle has for getting a determination of the scope of its security interest where the language creates some doubt.  A declaratory judgment action or even bankruptcy should come to mind.  These are not appealing options.  Of course, you cannot always be sure you have done it "right" in the first place.  However, secured financing practice is very much about planning and only secondarily, and much less desirably, about litigation.

It should be understood that after-acquired property clauses only do what they do.  They cannot be used to produce an enforceable security interest in something that is not covered by the description of the original collateral.  If a creditor has a security interest in debtor's "equipment, existing and hereafter acquired" the after-acquired clause does not give the creditor an enforceable interest in later-acquired consumer goods or inventory.  Less obviously, under new Article 9, describing collateral as "general intangibles" would not give the secured party an enforceable security interest in lottery winnings won after the security agreement was executed because, as noted in Chapter 5 (Classification of Collateral), lottery winnings fall within the definition of "account" in new section 9-102(a)(2).

Moreover, an after-acquired property clause will not always work even where the later-acquired property is within the basic description.  Thus, an adequately described after-acquired security interest can fail in bankruptcy.  There are several reasons for this and they will be explored more fully in Chapters 26 (Secured Party Versus Lien Creditor) and 30 (Secured Party Versus Trustee in Bankruptcy).

However, most pertinent here is Bankruptcy Reform Act (BRA) § 552.  Under BRA § 552, security interests created before bankruptcy, i.e., pre-petition, generally are not enforceable as to property acquired after a bankruptcy is filed, i.e., post-petition.  There is an exception for security interests in collateral acquired post-petition that qualifies as proceeds of collateral in existence pre-petition.  The proceeds point is considered in subpart C below.

You may test your understanding of the general rule embodied in BRA § 552 through the next problem.

Problem 9.2    (interactive)

Assume the facts of Problem 9.1.  Assume further, however, that

(a) the security agreement between Danielle and Second Bank described the collateral as "crops growing and to be grown on Debtor's farm in Pima County ";

(b) Danielle has filed bankruptcy; and

(c) the only crops "growing or to be grown" are those planted after bankruptcy was filed. 

Would Second Bank have an enforceable security interest in the crops outside of bankruptcy? 

Does Second Bank have an enforceable security interest in the crops in bankruptcy? 

What if the crops were planted before bankruptcy was filed but they did not begin "growing" until after bankruptcy was filed?

In Chapter 4 (Scope of Article 9) it was seen that former Article 9 covered security interests in tort claims only as proceeds but that the creation of a security interest in a commercial tort claim, as defined in new section 9-102(a)(13), as original collateral is within the scope of new Article 9.  However, new section 9-204(b)(2) provides that a security interest cannot attach to an after-acquired commercial tort claim.  Therefore, unless the commercial tort claim is in existence at the time the security agreement is authenticated a security interest in the claim is enforceable only if it constitutes proceeds.  See new section 9-102(a)(1) and Official Comment 4 to new 9-204 and subpart C below.

In Chapter 11 (Enforceability and Attachment of Security Interests in Consumer Transactions), we will see that under new section 9-204(b)(1), a security interest cannot attach to after-acquired consumer goods that are acquired more than ten days after a secured party gives value unless the goods are accessions.  "Accessions" are defined in new section 9-102(a)(1) to mean "goods that are physically united with other goods in such a manner that the identity of the original goods is not lost."  Examples of accessions include memory added to a computer and a compact disk player installed in an automobile.

Accessions are distinguishable from "commingled goods," defined in new section 9-336(a) to mean "goods that are physically united with other goods in such a manner that their identity is lost in a product or mass." [Emphasis added.]  Examples of commingled goods include flour used to bake a cake and, less obviously, ball bearings used in machinery.

It should be noted that from the perspective of a secured party who has a security interest in goods to which other goods are physically united so as to become accessions or commingled goods, the other goods are after-acquired in that a debtor acquires rights in them after the debtor has rights in the goods to which they become physically united.  However, a description of collateral that describes only the goods to which accessions are physically united is not sufficient to give a secured party an enforceable interest in the accessions.  The security agreement description must refer to accessions.

For example, if a secured party has a security interest in a tractor and the security agreement describes the collateral as the tractor, the secured party does not have an interest in a replacement engine unless the security agreement also refers to accessions.  Likewise, a party with a security interest in goods that become accessions has an interest in the goods with which the accessions are physically united only if the security agreement describes as the collateral the goods with which the goods are physically united.

By contrast, a party with a security interest in goods with which other goods are commingled has a security interest in the product or mass resulting from the commingling without referring to the goods that are commingled in the security agreement.  Thus, a party with a security interest in cakes described as such in a security agreement has a security interest in the cakes, including flour provided by another party and in which the other party has a security interest without the need to refer to flour in the security agreement covering the cakes. 

Moreover, unlike the accessions situation, the party supplying the flour has a security interest in the cakes without the need to describe the cakes.  This result might be reached by treating the cakes as proceeds, but new section 9-336(b) specifically provides that the security interest would attach to the cakes.  See Official Comment 3 to new 9-336.

The new Article 9 treatment of security interests in accessions considered in the next problem.

Problem 9.3    (interactive)

Second Bank lends to Donald Debtor who farms land in Pima County, Arizona. To secure the loan, Second Bank takes a security interest in collateral described as "Debtor's farm equipment." Subsequently, Donald replaces a John Deere tractor owned at the time the security interest was given to Second Bank with a new Ford tractor purchased from Selma Seller. 

Does Second Bank have a security interest in the Ford tractor? 

Suppose that the security agreement described the collateral as Debtors farm equipment, existing and after-acquired, but instead of replacing the John Deere tractor that Donald purchased a new motor from Selma and that Selma installed the motor in the tractor. 

Would Second Bank have a security interest in the motor? 

If Selma sold the motor on credit and took a security interest in the motor would Selma also have a security interest in the tractor?

B. Security Interests to Secure Future Advances

To this point the focus has been on what property secures a debt.  There is the further question of what indebtedness is secured by the collateral to which the security interest has attached.  Former section 9-204(3) provided that the obligations secured by a security interest could include future advances whether or not the advances were optional or binding. This section permited a creditor to take a security interest that secured not only an original extension of credit but later or future advances as well.  New section 9-204(c) similarly permits a security agreement to provide that collateral secures future advances or other value, whether or not the advances or value are given pursuant to commitment.

Given that the scheme is permissive, a creditor should be sure to include a future advance clause in the security agreement. The same advice was given as to after-acquired property in subpart A above. Moreover, decisions under former Article 9 regarding future advance clauses were consistent in reading former section 9-204(3) to mean that a later advance had to be of the same or similar type as the original advance if the later advance was to be secured by the security interest created at the time of the original advance.  In so reading former section 9-204(3) the courts took the view that what debt was included in a future advance clause was, as with the scope of an after-acquired property clause, a matter of the parties intent.

A court might well say that a personal loan is not intended to be secured by a security interest created to secure a business debt. The insistence of the drafters in Official Comment 5 to new section 9-204 that decisions comparing the kinds of credit involved as between the original advance and the future advance are rejected is curious at best, especially because the text of new section 9-204(c) does not differ substantively from that in former section 9-204(c).

For completeness it should be noted that insofar as a provision may operate to secure previously unsecured debts could raise an avoidable preference issue under BRA § 547.  See Chapter 30 (Secured Party Versus Trustee in Bankruptcy).

You may explore the treatment of future advances under new Article 9 in the next problem.

Problem 9.4    (interactive)

Danielle Debtor sells machine tools at retail.  Danielle just purchased a shipment of machine tools from All Tools, Inc. for $25,000.  All Tools, Inc. sells only for cash.  Danielle borrowed the $25,000 from Leslie Lender.  The loan agreement between Danielle and Leslie gives Leslie an interest in the shipment of machine tools from All Tools, Inc. to secure the loan.  The agreement further provides that "Lender shall have an interest in the machine tools to secure such advances as may be made from time to time by Lender to Debtor."  Two months later Danielle borrows $5,000 from Leslie to finance her son's wedding.

Is the $5,000 debt secured by the interest in the machine tools? 

How would you have drafted the agreement to try to avoid the question? 

There is another, more elusive, concern.  Note carefully the language used in the security agreement in Problem 9.4.  Was Leslie obligated to make the $5,000 loan?

As the last question in Problem 9.4 illustrates, future advance clauses may be optional or binding.  An optional clause provides that IF a later advance is made then the collateral that secures the original advance will also secure the later advance. But, subject to whatever limitations are imposed by an obligation of good faith that applies to all secured financing contracts under new Article 1, section 1-304 (formerly section 1-203), the decision whether or not to make a later advance belongs to the secured party.  Good faith is defined in Article 1, section 1-201(b)(20) and for states that have not adopted the proposed revised version of Article 1, section 1-201(b)(20) in new section 9-102(a)(43). A binding future advance clause is one that obligates the secured party to make a future advance whereas under an optional clause making a future advance is in the discretion of the secured party.

The distinction between a binding future advance clause and an optional clause is important both to the debtor and creditor's relationship and, as we will discover in Part VI, in resolving priority disputes with third parties.  When we discuss priority matters we will see that a binding future advance clause can produce an advance "pursuant to commitment," see new section 9-102(a)(68), and consider how such a characterization can affect priority.

You must be aware that the basic effect of a future advance clause can be achieved with a new security agreement.  Thus, whether or not the original agreement contains a future advance clause, the parties are free to negotiate a later extension of credit and enter into a new agreement to secure the later credit. Where the parties enter into a new security agreement exactly what collateral secures the new advance is a matter governed by the new security agreement.  How a new security agreement as opposed to a future advance clause affects priority is another matter for discussion in Part VI.  Of course if there is neither a future advance clause nor a new security agreement then the later advance is unsecured.

The next problem explores further the treatment of future advances by new Article 9.

Problem 9.5    (interactive)

Donald Debtor owes Ready Lender $10,000 which Donald borrowed to finance his business operations.  Ready Lender has a security interest in Debtor's inventory and accounts receivable.  Donald borrows another $10,000. 

What must be true if the second $10,000 loan is to be secured?

C. Security Interests in Transferred Collateral and Proceeds

1.  Transferred Collateral

Under former section 9-306(2) if a debtor made an unauthorized disposition of the original collateral then the security interest continued in the transferred collateral.  Whether a particular disposition was authorized is a matter of contract interpretation, but the Permanent Editorial Board of Article 9 (PEB) in P.E.B. Commentary No. 3 insisted that the security interest continued unless the secured party authorized the disposition free of the security interest.

New section 9-315(a)(1) adopts the position expressed in P.E.B. Commentary No. 3 by providing that a security interest or lien continues in original collateral unless the holder of the security interest or lien authorized the disposition "free of the security interest or lien."

The effect of the rule in new section 9-315(a)(1), that a security interest continues in collateral unless the secured party or lien holder authorized a disposition free of the security interest or lien, is to create a presumption that a transferee takes subject to the security interest or lien.  To overcome the presumption it must be shown that the holder of the security interest or lien not only authorized the disposition but that the holder further authorized that it be "free of the security interest or lien."  Whether there was the necessary authorization in a particular case will continue to be a question of the parties' intent, but the presumption will work in favor of secured parties.

Note that new section 9-315(a)(1) includes agricultural liens so that if collateral subject to an agricultural lien is transferred without required authorization then the lien continues in the original collateral.

New section 9-315(a)(1) further expands upon former section 9-306(2) by adding leases and licenses to the kinds of transfers that trigger the presumption that a security interest continues in transferred collateral. The inclusion of leases reflects the position taken by the PEB in P.E.B. Commentary No. 9 that transfers pursuant to a lease produce "proceeds. " The rationale of that commentary supports the inclusion of licenses as dispositions for the purposes of new section 9-315 as well.

You must understand that the ultimate decision as to who gets transferred collateral may involve a priority decision.  In other words, if the security interest does not continue that it does not would be dispositive of a dispute.  However, even where the security interest continues a particular transferee could prevail under the priority rules that are examined in Part VI.

The next problem explores the application of new section 9-315(a)(1).

Problem 9.6    (interactive)

Donald Debtor is in the business of manufacturing automotive parts.  Ready Lender has a security interest in Donald's equipment.  The security agreement prohibits Donald from transferring any equipment without Lender's express written authorization.  Without written authorization Donald sells a drill press to Byron Buyer.  Ready Lender is aware that Donald has occasionally disposed of equipment and replaced it with newer equipment and has never objected to these dispositions. 

Does Ready Lender's security interest in the drill press continue? 

Suppose Ready Lender provided Donald with a document stating that "Lender authorizes the sale of the drill press to Buyer." 

Would Ready Lender's security interest in the drill press continue? 

When would Ready Lenders security interest in the drill press not continue?

For completeness note that new section 9-315(a)(1) refers to Article 2 section 2-403(2).   A brief comment about section 2-403(2) is in order.  When a person "entrusts" goods to a merchant in the business of selling goods of the kind entrusted there is a risk that the merchant will improperly transfer the goods to a buyer in ordinary course, as defined in revised section 1-201(b)(9) (essentially as a buyer who buys from a merchant who sells such goods without knowledge of the lack of authority on the part of the merchant to sell the goods).

For example, if the owner of a watch takes the watch to a jeweler for repairs and the jeweler not only repairs but sells watches and the jeweler wrongfully sells the watch to a retail customer (who most likely will meet the definition of a buyer in ordinary course) then the retail customer gets the owner's rights and in a dispute between the owner and the customer the customer would prevail.

In other words, section 2-403(2) shifts the risk of such improper transfers to the person who does the entrusting in the sense that the buyer from the merchant gets whatever rights the entrusting person had to the goods.  By virtue of the incorporation of section 2-403(2) into new section 9-315, a secured party who entrusts collateral that consists of goods to a merchant in business of selling goods of the kind confers on the merchant the power to transfer the secured party's rights to a buyer-in-ordinary-course of the goods.

As will be seen in Part VI, there is a priority rule that also protects buyers in ordinary course and it is not clear what the embellishment of new section 9-315 adds.

2.  Proceeds

Before Article 9 was enacted there were difficulties creating security interests in property that constituted proceeds of original collateral, meaning essentially property received when original collateral was disposed of.  To illustrate, when inventory is sold, as it is expected to be (certainly if the debtor's business is viable), the debtor will receive property that in a sense replaces the inventory. This property may be other inventory, for example, a "trade in, " or it may be cash or some cash equivalent or even a promise to pay for the inventory that is itself secured, or it may be some combination of the foregoing.  The trade in or cash equivalent or promise to pay or combination thereof, constitute proceeds.

Under the law prior to Article 9 there was no ready method to assure that a security interest would attach to proceeds.  Even when a security interest in proceeds was allowed, for example, as to accounts receivables, unless there was a strict accounting by the debtor for collections on the accounts the arrangement might be deemed to be a fraud on creditors. See Official Comment 2 to new 9-205.

Former Article 9 greatly enhanced the extent to which proceeds could serve as collateral. Thus, former section 9-306(2) simply bestowed on a creditor a security interest in identifiable proceeds.  Proceeds were identifiable when they could be traced to the original collateral.  To this extent the security interest in proceeds arose by operation of law. Under former section 9-203(3) there was no need even to refer to proceeds in a security agreement to make the interest enforceable.

"Proceeds" was defined in former section 9-306(1) to include "whatever is received upon the sale, exchange, collection or other disposition of collateral or proceeds." That same section distinguished "cash, " defined as "money, checks, deposit accounts and the like," from "non-cash" proceeds.  Cash proceeds could be difficult to trace sufficiently to make them "identifiable."  However, former section 9-205 abolished the risk of fraud where the debtor is allowed to make regular payments and does not have to turn over the proceeds themselves or otherwise make a strict accounting of proceeds (unless so required by the security agreement).

The basic proceeds scheme of new Article 9 parallels that in former Article 9. Thus, new section 9-315(a)(2) provides quite simply that a security interest attaches automatically to any identifiable proceeds of collateral.  There is no need for an agreement regarding proceeds and the interest is enforceable without the need to provide for a proceeds interest in the security agreement.  See new section 9-203(f).

New Article 9, section 9-205, echoes former section 9-205 by providing that a security arrangement that does not require a debtor to account to the secured party for proceeds (unless so required by the security agreement) is valid and is not fraudulent as against other creditors.  However, sound practice dictates that a creditor "monitor " or "police" collateral, including proceeds, to whatever extent is practicable.

An important point of clarification is in order.  Although Article 9 relaxes the rules regarding the extent to which a debtor must account to a secured party for proceeds and a secured party is essentially given an enforceable security interest in identifiable proceeds, the property claimed as proceeds must be traceable to the original collateral and the secured party bears the burden of proving that the property claimed as proceeds are traceable to the original collateral and, hence, identifiable.  See In re Quisenberry, 295 B.R. 855, 862 n. 3 (Bkcy N.D. Tex. 2003).

New Article 9 generally tracks former Article 9 on the matter of what constitutes proceeds.  The essential proceeds' definitions have been moved and appear in more complete form in the general definitional section of new Article 9. "Proceeds" is defined in new section 9-102(a)(64). The definition in new section 9-102(a)(64) continues former section 9-306(1)'s focus on what comes in (is acquired) when original collateral is disposed of.

Under former section 9-306(2) proceeds meant property received by the debtor when collateral was disposed of. New section 9-102(a)(64) eliminates any such requirement thereby making clear, for example, that when collateral is sold by a debtor to a buyer and the buyer also sells the collateral then what is received by the buyer constitutes proceeds.  For property to qualify as proceeds under new Article 9 it is necessary only that the property be traceable, directly or indirectly, to the original collateral.  See Official Comment 13d to new 9-102. 

New section 9-102(a)(64) omits a reference to "proceeds of proceeds" such as appeared in the definition of proceeds in former section 9-306(1).  However, it would make little sense for a security interest not to continue in proceeds (assuming the ability to identify).   Official Comment 13c to new section 9-102 states that "the idea of " proceeds of proceeds is captured in the revised definition of collateral and no change in meaning is intended.  "Collateral" is defined in new section 9-102(a)(12) to mean essentially the property subject to a security interest or agricultural lien, including proceeds to which a security interest attaches under new section 9-315(a)(2).

You may explore the basics of the treatment of proceeds under new Article 9 through the following problem.

Problem 9.7    (interactive)

Leslie Lender has a security interest in Danielle Debtor's "equipment, existing and after-acquired."  The security agreement makes no mention of proceeds.  The agreement does provide that Danielle is not to dispose of any equipment without the Leslie's express written consent.  Danielle sells a drill press to Byron Buyer without Leslies's express written consent.  Danielle receives cash in the amount of $1,000 and a check for $1,500.  Danielle uses the cash to purchase a newer and less expensive drill press.  She places the check in a cash drawer. 

Does Leslie have an enforceable security interest in the original drill press? 

Does Leslie have an enforceable interest in the new drill press as proceeds? 

Does Leslie have a security interest in the check in the cash drawer?

It is useful to understand that property that cannot be reached as proceeds, for example, because the property is not identifiable as proceeds, sometimes may be reached more directly.  The next problem illustrates how this is so.

Problem 9.8  (interactive)

Assume the facts of Problem 9.7.  Assume further, however, that Leslie Lender would be unable to show the new drill press is identifiable proceeds. 

Could Leslie still have an enforceable interest in that drill press?  If so, how?

As noted above, under new section 9-204(b)(2) a security interest cannot attach to a commercial tort claim, as defined in new section 9-102(a)(13), unless the tort claim is in existence at the time the security agreement is authenticated.  A security interest, however, could attach to a later arising commercial tort claim as proceeds under new section 9-315(a)(2) if the claim arises out of loss or damage to the original collateral.

For example, if the original drill press (or other equipment) in the Problems 9.7 and 9.8 had been lost as the result of tortuous behavior by a third person then the tort claim arising from that behavior could be proceeds of the drill press.

New section 9-102(a)(64)(E) includes as proceeds insurance payable to the debtor or the secured party by reason of loss or damage to the original collateral.  This inclusion is a carryover from a change made to former Article 9, section 9-306(1) in 1972 to reject court decisions holding that insurance proceeds were not proceeds within the meaning of Article 9 because the lost or damaged collateral had not been disposed of.

Former section 9-306(1) was amended in 1996 to specifically include within the definition of proceeds "payments or distributions made with respect to investment property."  This amendment was intended to reject the decision in Hastie v. FDIC, 2 F.3d 1042 (10^th Cir. 1993), holding that post-petition dividends on stock collateral are not proceeds under Article 9.

New section 9-102(a)(64) makes no specific reference to investment property.  However, new section 9-102(a)(64)(B) states that proceeds includes "whatever is collected on, or distributed on account of, collateral."  Official Comment 13a to new section 9-102 states that new section 9-102(a)(64)(B) "is broad enough to cover cash or stock dividends distributed on account of securities or other investment property" and reiterates that the section rejects the holding in Hastie v. FDIC, supra.

Of course, the quoted language of new section 9-102(a)(64)(B) is "broad enough" to cover income from collateral other than investment property.  The question arises just how much beyond the traditional concept of proceeds (what is received when collateral is disposed of) the drafters have intended to go or courts will be willing to accept.

Until the uncertainty has been removed it may be advisable to describe with specificity the particular items of income that are intended to be included as original collateral thereby giving a secured party an enforceable interest in the property as after-acquired original collateral.  As noted earlier, the use of specific descriptions generally is preferable wherever they are practicable.

A downside of the original collateral approach, considered in subpart A above, is that in bankruptcy a security interest created before bankruptcy is unenforceable under BRA § 552 as to property acquired after bankruptcy except where the property is proceeds.  Moreover, what constitutes proceeds in bankruptcy under BRA § 552 ultimately is a federal question and new section 9-102(a)(64) will not necessarily control.  Cf. Official Comment 13(a) to new section 9-102 (wherein the drafters make clear that new section 9-102(a)(64) rejects the Hastie decision only to the extent that decision relies on the Article 9 definition of proceeds).

However, describing particular property as original collateral does not preclude a claim to that property as proceeds.  If  proceeds is broadly interpreted and the claim is successful, so much the better for the secured party.  If the proceeds claim fails, the secured party has an enforceable security interest in property acquired before bankruptcy (or all such property if the debtor does not file bankruptcy).

The case of In re Stallings, 290 B.R. 777 (Bkcy D Idaho 2003) offers a useful vehicle for exploring the points just made about proceeds and original collateral.  At issue in that case were payments made to a debtor under a federal program to compensate persons who had suffered farming setbacks as the result of a chemical sprayed by the U.S. Bureau of Land Management where both the federal program and the payments post-dated the filing of the petition in bankruptcy. The court concluded that the payments constituted at best an expectation on the part of the debtors and could not be reached either as original collateral described as general intangibles or payments under government programs or as proceeds.

The program payments could not be reached as original collateral in bankruptcy because they were collateral (other than proceeds) acquired after bankruptcy was filed and BRA § 552 bars enforcement of a security interest in such collateral.  The program payments could not be reached as proceeds because they did not stem from a loss or conversion of crops and rather were payments for crops not grown.

As for the expanded definition of proceeds in new Article 9 the court stated that "it is too much of an interpretive stretch to view the [program] payment, which can be seen as a gift from the government to effected [sic] farmers, as falling within the UCC definition of proceeds."  Stallings, at footnote 6.

Similar problems may arise as to other parts of new section 9-102(a)(64) to the extent they include as proceeds property that does not replace the original collateral.  Thus, under new section 9-102(a)(64)(D) claims arising out of the value of the loss, nonconformity, or interference with the use of, defects or infringement rights in, or damage to collateral constitute proceeds to the extent of the value of the collateral.

Once again, the Official Comments do not offer any guidance as to the scope of this provision. However, at least one court, in the case of In re Wiersma, 283 B.R. 294 (Bkcy D. Idaho 2002), applied the section quite literally in concluding that a breach of contract claim constitutes proceeds.

You may explore the foregoing discussion of the expansion of the concept of proceeds under new Article 9 in the next two problems.

Problem 9.9  (interactive)

Ready Lender has a security interest in Debtor's prize racing greyhound, Black Streak. The security agreement describes the collateral as "Debtor's racing greyhound, Black Streak." 

Why are Black Streaks winnings not proceeds in the historical sense of that term?  

What is the argument that Ready Lender has an enforceable interest in Black Streak's winnings? 

What is the argument that Black Streak's winnings are not proceeds under new Article 9? 

If you were drafting the security agreement for Ready Lender what would you do to try to assure that Black Streak's winnings are covered? 

Is there a downside to the original collateral approach?

Problem 9.10    (interactive)

Danielle Debtor operates a gambling casino.  Your client holds a security interest on Danielle's slot machines under a security agreement that describes the collateral as "Debtor's equipment, existing and hereafter acquired." 

Are the quarters and silver dollars placed in the slot machines after-acquired original collateral? 

Are the quarters and silver dollars covered by the security interest as proceeds? 

How could you have assured coverage of the coins with a proper description in the security agreement?

[This provision] indicates when proceeds commingled with other property are identifiable proceeds and permits the use of whatever methods of tracing other law permits with respect to the type of property involved. Among the "equitable principles " whose use other law may permit is the "lowest intermediate balance rule. " See Restatement (2d) Trusts § 202.

You may consider the treatment of deposit accounts as proceeds by new Article 9 in the next problem.

Problem 9.11   (interactive)

Assume the facts of Problem 9.7 (Leslie Lender has a security interest in Danielle's "equipment, existing and after-acquired."  The security agreement makes no mention of proceeds.  The agreement does provide that Danielle is not to dispose of any equipment without the Leslie's express written consent.  Danielle sells a drill press to Byron Buyer without Leslie's express written consent.  Danielle receives cash in the amount of $1,000 and a check for $1,500.   Danielle uses the cash to purchase a newer and less expensive drill press.  She places the check in a cash drawer.)  Assume further, however, these additional facts:

Danielle deposited the $1,500 check in a checking account in Second Bank;

At the time of the deposit the balance in the account is $4,000 all of which was from the deposit of non-proceeds;

Danielle defaulted owing Lender $2,000;

Leslie could not win in a priority dispute over the drill press with Byron Buyer (We will consider possible reasons in Part VI);

Before Leslie learned of the foregoing, Danielle withdrew $3,000 from the bank account;

Danielle took the cash and blew it at the dog track;

Just after the withdrawal there was an automatic deposit of $500 made by Second Bank to Danielle 's account to correct an earlier overcharge to the account;

There have been no other changes to the bank account balance.

How much of the bank account is subject to Leslie's security interest? 

Suppose Danielle had withdrawn $4500 instead of $3000 just before defaulting.  How much of the deposit account could Leslie reach now? 

Suppose the facts were as originally stated in Problem 9.10, except that none of the $1,500 found its way into the account.  How much of the deposit account could Leslie reach under this change in facts?

This Article deletes former Section 9-306(4), which dealt with proceeds in insolvency proceedings. Except as otherwise provided by the Bankruptcy Code, the debtor's entering into bankruptcy does not affect a secured party's right to proceeds.

* * *

It was noted above that BRA § 552's effect to render unenforceable security interests in collateral acquired after bankruptcy has been filed does not apply to proceeds.  The controlling provision as to proceeds is BRA § 552(b)(1).  Under it a security interest created pre-petition is enforceable as to proceeds acquired post petition is enforceable if the security agreement and the applicable nonbankruptcy law supports the claim.  The applicable nonbankruptcy law in this case is Article 9.  As you now know under that law a security interest attaches to identifiable proceeds and is enforceable without the need to provide for such an interest in the security agreement.

You may consider the treatment of property acquired after a bankruptcy petition has been filed in the next problem.

Problem 9.12    (interactive)

Donald Debtor manufactures automobile parts.  Second Bank has a security interest in Donald's inventory of automobile parts, existing and after-acquired, and the interest has been timely perfected.  Donald has filed bankruptcy.  Of the $30,000 inventory of automobile parts subject to Second Bank's security interest on hand, $10,000 of it was in existence prior to bankruptcy, $5,000 was acquired with proceeds from the sale of inventory in existence pre-petition and $15,000 was acquired post-petition with non-proceeds. 

In which automobile parts does Second Bank have an enforceable security interest?

New section 9-315(a)(2) does not cover proceeds from property subject to an agricultural lien. Official Comment 9 to new section 9-315 indicates that whether an agricultural lien extends to proceeds of property subject to such a lien is not determined by Article 9 but is left to other law, specifically the statute creating the agricultural lien.  The comment adds that if the proceeds are themselves farm products that would be subject to an agricultural lien then an agricultural lien could attach to the proceeds not as proceeds but by operation of the statute creating the agricultural lien.  The difference is not unlike that between a security interest in property as proceeds or in property as after-acquired property. Recall Problem 9.8.

Many states, including Arizona, have liens that could qualify as agricultural liens. For example, ARS 33-901 creates a farm services lien for furnishing labor or machinery upon agricultural land.  ARS 33-362 creates a landlord's lien that also could fall within new section 9-102(a)(5)'s definition of an agricultural lien.  See United States v. Globe Corp., 546 P.2d 11 (Ariz. 1976) and B & S (cited in Chapter 3), Ch. 25. It would be necessary to examine such statutes to discover whether proceeds are covered.

You may consider how proceeds of property subject to an agricultural lien are treated under new Article 9 in the next problem.

Problem 9.13    (interactive)

Assume again the facts of Problem 9.1 (Exactly one year ago Danielle Debtor borrowed from Second Bank and signed a security agreement giving Second Bank an interest in Danielle's "crops growing on Debtor's farm in Pima County."  Danielle has come to Ready Lender seeking another loan and has offered to Ready Lender a security interest in Danielle's current crop.  The loan to Second Bank is still unpaid.) 

Is the following statement true or false? 

Second Bank has a security interest in the crops growing at the time of the loan and also in any monies generated by a sale of the crops growing at the time of the loan that are identifiable as monies generated by the sale of the crops growing at the time of the loan.  Suppose Second Bank had no security interest but a local statute gave Second Bank a lien on Danielle's crops. 

Would the monies generated by a sale of the crops be covered by Second Bank's lien? 

Suppose Danielle put the monies into growing a new crop.  Would Second Bank have an agricultural lien on the new crop?

D.  The New Debtor Problem

As we saw in subpart C, under new section 9-315(a)(1) a security interest continues in transferred collateral unless the secured party authorized transfer of the collateral free of the security interest.  Where there has been no such authorization the transferee takes the collateral subject to the security interest and the security interest is enforceable to the same extent as it was against the transferor unless, as is explored in Part VI, the transferee takes free of the security interest or otherwise has priority over the secured party under some special Article 9 rule governing such conflicts.

Under new section 9-102(a)(28), "debtor" is defined as "a person having an interest in the collateral . . . whether or not the person is the obligor."   According to new section 9-102(a)(59), an "obligor" is a person that owes an obligation secured by a security interest.  By these definitions, when collateral is transferred the transferee becomes the debtor and the transferor ceases to be the debtor but continues as the obligor. 

Consequently, a transferee is a new debtor, but not as that term is used in new Article 9.  Under new section 9-102(a)(56), a "new debtor" is a person who becomes bound under new section 9-203(d) on a security agreement entered into by someone else (who in the new Article 9 scheme, under new section 9-102(a)(60), is the "original debtor").  It is new debtors in this technical sense that is the subject of this subpart.

Under new section 9-203(d)(1), a person becomes bound as a debtor by a security agreement entered into by another person (the original debtor) and, hence, becomes a new debtor) if by operation of law other than of Article 9 or by contract the security agreement becomes effective to create a security interest in that person's property.  Under new section 9-203(d)(2), a person becomes bound by a security agreement entered into by another person (the original debtor) and becomes a new debtor, if by operation of law other than Article 9 or by contract the person becomes generally obligated on the obligations of the original debtor, including the obligation secured under the security agreement, and the person acquires or succeeds to all or substantially all the assets of the original debtor.

Among the more important cases of a person becoming a new debtor by operation of law outside new Article 9 or by contract (or both) are those where a debtor changes from a sole proprietorship to a corporation or a corporate debtor is taken over by or merges with another corporation.

Under new section 9-203(e), the security interest created by the security agreement entered into by original debtor is enforceable against the new debtor without the need for any other agreement or authentication of the security agreement by the new debtor, as otherwise would be required by new section 9-203(b)(3)(A).

"New debtor" problems arose under former Article 9, but former Article 9 did not contain the rules explicitly provided by new Article 9 for dealing with the problems.  Understanding the new Article 9 scheme for determining when persons become new debtors is essential to applying the new Article 9 rules governing perfection of security interests in the collateral of new debtors (Part V) and also the rules for resolving priority disputes between the creditors of original debtors and the creditors of new debtors (Part VI).

To explore the basics of the new Article 9 new debtor scheme, especially to the extent that new debtors are distinguished from transferees, consider the following problems.

Problem 9.14   (interactive)

Jane Smith is a sole proprietor doing business as "Jane's Desert Treasures."  Ready Lender has a security interest in Jane's inventory of jewelry, existing and after-acquired. 

In which jewelry currently owned and later acquired does or will Ready Lender have an enforceable security interest?

Problem 9.15    (interactive)

Without Ready Lender's authorization, Jane Smith in Problem 9.14 transfers an item of jewelry to John Doe who also is in the business of selling jewelry.  John Doe also acquires an item of jewelry from Harold Brown. 

Putting aside the possible impact of priority rules to be considered in Part VI, is the item of jewelry acquired by John Doe from Jane Smith subject to Ready Lender's security interest? 

On what does a complete answer depend? 

Does Ready Lender have a security interest in the item of jewelry acquired by John Doe from Harold Brown and added to Johns inventory? 

What additional facts would be necessary to give Ready Lender a security interest in the item of jewelry acquired by John Doe from Harold Brown?

Problem 9.16    (interactive)

Assume that Jane Smith in Problem 9.14 sells her business to John Doe and in connection with the sale Jane transfers all of her business assets, including all of her jewelry inventory, to John Doe and John Doe assumes all of Jane's obligations, including Jane's obligation to Lender. 

Does Ready Lender now have an enforceable security interest in the item of jewelry that John Doe acquired from Harold Brown? 

Suppose that instead of a sale to John Doe, Jane Smith had incorporated her sole proprietorship business under the name "Jane's Desert Treasures, Inc." and it was the corporation that acquired an item of jewelry from Harold Brown.  Would Ready Lender have a security interest in the item of jewelry acquired from Harold Brown? 

For completeness, ask yourself this question: Does Ready Lender has a security interest in jewelry transferred by Jane to the corporation?

E. Some Parting Thoughts about the Enforceability and Attachment of Security Interests

It is useful to note here that the foregoing discussion of attachment and enforceability of security interests may be collapsed into two basic questions: (1) To exactly what property does an otherwise enforceable security interest attach? and (2) Exactly what debt may be satisfied from the property to which a security interest has attached?  In making these inquiries recall what is at stake in the enforceability inquiry.  What is the impact on a creditor if a court concludes that the requirements for enforceability have been met?  If the requirements have not been met?  How does a putative secured creditor stand relative to other creditors and a trustee in bankruptcy depending on whether a security interest is enforceable or not?

You may explore these closing questions in the next problem.

Problem 9.17   (interactive)

Leslie Lender lends Donald Debtor $10,000.  There is an authenticated security agreement that describes the collateral as "All of Donald's equipment located at Donald's place of business."  Donald's equipment located at its place of business is worth $20,000. 

In what property does Leslie have an enforceable security interest? 

Suppose instead of all its equipment, Donald had given Leslie a security interest in a drill press, serial number XYZ123, worth $10,000, and the security agreement so described the collateral. 

In what property would Leslie have an enforceable security interest now? 

Assume again that Donald gave Leslie a security interest in the drill press with the serial number XYZ123.  Suppose Donald owned three drill presses, including a drill press with the serial number XYZ123.  Suppose further that the drill press with that serial number XYZ123 was stolen and the loss was not insured. 

Can Leslie simply take one of the other two drill presses to satisfy the debt? 

Who would care if Leslie did take a substitute drill press? Suppose in the case where Leslie Lender has a security interest only in the drill press with serial number XYZ123 and that drill press was stolen, Donald had an insurance policy covering any losses of Donald 's equipment and on which Donald is the named insured. 

Does Leslie have a claim to the insurance proceeds covering the loss of the drill press serial number XYZ123? 

Would your analyses or your answers to the questions posed in this problem change if the parties were doing business electronically and there was an enforceable security agreement satisfying the requirements of new section 9-203(b)?

CASE COMMENTARY

Planned Furniture Promotions, Inc. v. Benjamin S. Youngblood, Inc., 374 F. Supp. 2d 1227 (M.D. Ga. 2005)

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

The Epicentre Strategic Corporation-Michigan v. Perrysburg Exempted Village School District, 2005 WL 3060104 (N.D. Ohio 2005)

In re Clayson, 341 B.R. 137 (Bkcy W.D.N.Y March 24, 2006)

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

In re Watson, 286 B.R. 594 (Bkcy D. N.J. 2002)

First National Bank of Izard County v. Garner, 86 Ark. App. 213, 167 S.W.3d 664 (Ark. App. 2004)

Counseller v. Ecenbarger, Inc., 834 N.E.2d 1018 (Ind. App. 2005)

Ronald V. Odette Family Limited Partnership v. Agco Finance, LLC, 129 P.3d 95 (Kan. App. 2005)

Missouri State Credit Union v. Wilson, 176 S.W.3d 182 (Mo. App. 2005)

Borley Storage and Transfer Co., Inc. v. Whitted, 271 Neb. 84, 710 N.W.2d 71 (Neb. 2006)

Madisonville State Bank v. Citizens Bank, 184 S.W.3d 835 (Tex. App. 2006)

Madisonville State Bank v. Canterbury, Stuber, Elder, Gooch & Surratt, P.C., 209 S.W.3d 254 (Tex. App. 2006)

Stockman Bank of Montana v. AGSCO, Inc., 727 N.W.2d 742 (N.D. 2007)

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2011-08-22 update