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1.) Larry London (LL) buys a computer with his new store credit card at Greatest Get (GG). GG immediately sells the right to receive monthly payments from LL to a finance company, Friendly Finance (FF). Unfortunately for LL, the computer stops working three months after he purchased it. As GG won’t return his calls regarding his broken PC, LL stops making payments. Long story short, all stakeholders (LL, GG, and FF) are fed up with each other’s behavior; they all lawyer up.
Pretend you are LL’s lawyer and, explain to your client all the possible issues you’ve learned in this week’s material that help and hurt his or her chances of winning a potential lawsuit. Remember to “keep your eye on the ball”. Limit your discussion to this week’s material. For example, you may want to consider whether the parties have a negotiable instrument. If so, what kind? What defenses might there be on that instrument?
2.) Marvin Mower (MM) is a college student trying to earn a few extra bucks. Marvin mows yards on the side, and he cuts the lawn for Ursula Unhappy (UU). UU writes MM a document for his work. The document acknowledges MM performed work, and that UU owed MM $50. MM doesn’t have time to get to the bank, so MM gives the document to Tommy Thirdparty (TT), who pays him $40 for it.
Predictably, before TT can try to recover $50, UU is unhappy with MM’s work, and refuses to pay TT.
Keeping your “eye on the ball” (limiting your post to this week’s material), discuss all the possible rights and responsibilities these three have to each other concerning the check and the yard.
Min 3 paragraphs each,. Use in text citations MLA. CHAPTER 15-16 ATTACHED
CHAPTER
15
NEGOTIABLE INSTRUMENTS
With graduation looming, Chaz needs to rent an apartment and buy a car. Responding to an online
ad, he finds the perfect place to rent. True, it is more expensive than he had planned, but he will
surely get a raise soon. With nervous hands, he writes out a big check for three month’s rent (first
month, last month, and security deposit). Then he goes to Trustie Car Lot to buy a used car. He
cannot afford the entire purchase price, so he makes a down payment and signs a promissory note
for the balance due.
With growing excitement, Chaz loads all his worldly possessions into his car and heads over
to his new apartment. When he arrives, though, his key does not work and a stranger answers his
knock. It turns out that someone else is living in his apartment. Chaz has been scammed—the
person he gave his check to had no right to the apartment. Stunned, Chaz goes to a friend’s place
where he can crash for a few days. But his car will not start. With his head in his hands, Chaz tries
to remember what he learned about negotiable instruments in his business law class.
When he arrives, his key does not work and a stranger answers his knock.
Let’s take the rent check first. When Chaz’s bank paid the scammer on the check, it became a
holder in due course. Chaz has no valid defenses against the bank. So that rent money is just gone,
unless Chaz can recover from the thief (not likely). But he has better luck with the car. Because
Trustie still holds the promissory note, it is not a holder in due course. If the car is defective, Chaz
will not have to pay back the full amount of the Trustie loan. What is the difference, you ask? Read
on to save yourself from Chaz’s mistakes.
15-1 NEGOTIABLE INSTRUMENTS
This chapter is about negotiable instruments, which are a type of commercial paper.
15-1a Commercial Paper
As Chaz learned, the law of commercial paper is important to anyone who writes checks or
borrows money. Historically speaking, however, commercial paper is a relatively new
development. In early human history, people lived on whatever they could hunt, grow, or make
for themselves. Imagine what your life would be like if you had to subsist only on what you could
make yourself. Over time, people improved their standard of living by bartering for goods and
services that other people could provide more efficiently. But traders needed a method for keeping
track of who owed how much to whom. That was the role of currency. Many items have been used
for currency over the years, including silver, gold, copper, and cowrie shells. These currencies
have two disadvantages—they are easy to steal and difficult to carry.
Paper currency weighs less than gold or silver, but it is even easier to steal. As a result, money
had to be kept in a safe place, and banks developed to meet that need. However, money in a vault
is not very useful unless it can be readily spent. Society needed a system for transferring paper
funds easily. Commercial paper is that system. If done right, it acts as a substitute for currency.
15-1b Types of Negotiable Instruments
There are two kinds of commercial paper: negotiable and non-negotiable instruments.
Article 3 of the Uniform Commercial Code (UCC) covers only negotiable instruments; nonnegotiable instruments are governed by ordinary contract law.
There are also two categories of negotiable instruments: notes and drafts. A note (also
called a promissory note) is your promise that you will pay money. A promissory note is used in
virtually every loan transaction, whether the borrower is paying for a multimillion-dollar company,
a television, or college tuition. When Krystal borrows money from the government to pay her
college tuition, she signs a note stating, “I promise to pay to the Department of Education all loan
amounts disbursed under the terms of this Promissory Note, plus interest and other charges and
fees that may become due as provided in this Promissory Note.” She is the maker because she is
the one who has made the promise. The Department of Education is called the payee because it
expects to be paid.
Note
The maker of the instrument promises to pay a specific amount of money. Also called a promissory note.
Maker
The issuer of a promissory note
Payee
Someone who is owed money under the terms of an instrument
A draft is an order directing someone else to pay money for you. A check is the most common
form of a draft—it is an order telling a bank to pay money. In a draft, three people are involved:
the drawer orders the drawee to pay money to the payee. Now before you slam the book shut in
despair, let us sort out the players. Suppose that Madison Keys wins the River Oaks Club Open.
River Oaks writes her a check for $500,000. This check is simply an order by River Oaks (the
drawer) to its bank (the drawee) to pay money to Keys (the payee). The terms make sense if you
remember that, when you take money out of your account, you draw it out. Therefore, when you
write a check, you are the drawer, and the bank is the drawee. The person to whom you make out
the check is being paid, so she is called the payee.
Draft
The drawer of this instrument orders someone else to pay money.
Check
The most common form of a draft; it is an order telling a bank to pay money.
Drawer
The person who issues a draft
Drawee
The person who pays a draft. In the case of a check, the bank is the drawee.
The following table illustrates the difference between notes and drafts. Even courts sometimes
confuse the terms drawer (the person who signs a check) and maker (someone who signs a
promissory note). Issuer is an all-purpose term that means both maker and drawer.
Issuer
The maker of a promissory note or the drawer of a draft
Who Pays
Who Plays
Note
You make a promise that you will pay.
Two people are involved: maker and payee.
Draft
You order someone else to pay.
Three people are involved: drawer, drawee, and payee.
15-1c Negotiation
Negotiable instruments are meant to act as a substitute for currency—that is, to be freely
transferable in the marketplace, just as currency is. To meet that goal, an instrument must comply
with this fundamental rule of commercial paper:
The possessor of a piece of commercial paper has an unconditional right to be paid, so long
as (1) the paper is negotiable, (2) it has been negotiated to the possessor, (3) the possessor is
a holder in due course, and (4) the issuer cannot claim a valid defense.
In the following sections, we explain all of these important terms.
Negotiable
In the opening scenario, Chaz has given a promissory note to Trustie Car Lot. So long as Trustie
keeps the note, Chaz’s obligation to pay is contingent upon the validity of the underlying contract.
If the car is defective, then Chaz is not liable to Trustie for the full amount of the note. However,
Trustie does not want to keep the note. It needs the cash now so that it can buy more cars to sell to
other customers. Reggie’s Finance Co. is happy to buy Chaz’s promissory note from Trustie, but
the price Reggie is willing to pay depends upon whether the note is negotiable.
The transferee of negotiable commercial paper has more rights than the person who
made the original contract. With negotiable commercial paper, the transferee’s rights
are unconditional: He is entitled to be paid the full amount of the note, regardless of the
relationship between the original parties. If the promissory note is a negotiable instrument, Chaz
must pay the full amount to its subsequent holders, no matter what complaints he might have
against Trustie.
The rules are different for the transferee of non-negotiable commercial paper: His rights
are the same—no more, no less—as the person who made the original contract. That is to say,
they are conditional. If, for some reason, the original party loses his right to be paid, so does the
transferee. The value of non-negotiable commercial paper is greatly reduced because the transferee
cannot be absolutely sure what his rights are or whether he will be paid at all.
CHECKLIST
☑ Negotiable
☐ Negotiated
☐ Holder in Due Course
☐ No Valid Defenses
EXHIBIT 15.1
If Chaz’s promissory note is non-negotiable, Reggie gets exactly the same rights that Trustie
had. As the saying goes, Reggie steps into Trustie’s shoes. Other people’s shoes may not be a good
fit. Trustie lied about the car’s condition. As a result, it is worth only $6,000— not the $15,000
Chaz paid. Under contract law, Chaz owes Trustie only $6,000, so that is all he has to pay Reggie,
even though the note says $15,000.
Exhibit 15.1 illustrates the difference between negotiable and non-negotiable commercial
paper.
Because negotiable instruments are more valuable than non-negotiable ones, it is important
for buyers and sellers to be able to tell, easily and accurately, if an instrument is indeed
negotiable. To be negotiable:
1. The instrument must be in writing.
2. The instrument must be signed by the maker or drawer.
3. The instrument must contain an unconditional promise or order to pay. If Chaz’s
promissory note says, “I will pay $15,000 as long as the car is still in working order,” it is
not negotiable because it is making a conditional promise. The instrument must also contain
a promise or order to pay. It is not enough simply to say, “Chaz owes Trustie $15,000.” He
has to indicate that he owes the money and also that he intends to pay it. “Chaz promises to
pay Trustie $15,000” would work.
4. The instrument must state a def inite amount of money that is clear “within its four
corners.” “I promise to pay Trustie one-third of my income this year” would not work
because the amount is not definite. If Chaz’s note says, “I promise to pay $15,000 worth of
diamonds,” it is not negotiable because it does not state a definite amount of money.
5. The instrument must be payable on demand or at a def inite time. A demand instrument
is one that must be paid whenever the holder requests payment. If an instrument is undated,
it is treated as a demand instrument and is negotiable. An instrument can be negotiable even
if it will not be paid until sometime in the future, provided that the payment date can be
determined when the document is made. A prep school graduate wrote a generous check to
his alma mater, but for payment date he put, “The day the headmaster is fired.” This check
is not negotiable because it is payable neither on demand nor at a definite time.
6. The instrument must be payable to order or to bearer. Order paper must include the
words “Pay to the order of” someone. By including the word “order,” the maker is
indicating that the instrument is not limited to only one person. “Pay to the order of Trustie
Car Lot” means that the money will be paid to Trustie or to anyone Trustie designates. If
the note is made out “To bearer,” it is bearer paper and can be redeemed by any holder in
due course. Note that a check made out to “cash” is bearer paper.
Order
An instrument that includes the words “pay to the order of” or their equivalent
paper
Bearer
An instrument payable “to bearer”
paper
The rules for checks are different from those for other negotiable instruments. If properly filled
out, checks are negotiable. And sometimes they are negotiable even if not filled out correctly. Most
checks are pre-printed with the words “Pay to the order of,” but sometimes people inadvertently
cross out “order of.” Even so, the check is still negotiable. Checks are frequently received by
consumers who, sadly, have not completed a course on business law. The drafters of the UCC did
not think it fair to penalize them when the drawer of the check was the one who made the mistake.
EXAMStrategy
Question: Sam had a checking account at Piggy Bank. Piggy sent him special checks that he could
use to draw down a line of credit. When Sam used these checks, Piggy did not take money out of
his account; instead, the bank treated the checks as loans and charged him interest. The interest
rate was not apparent from the face of the check. When Sam wrote checks, Piggy sold them to
Wolfe. Were the checks negotiable instruments?
Strategy: When faced with a question about negotiability, begin by looking at the list of six
requirements. In this case, there is no reason to doubt that the checks are in writing, signed by the
issuer, and with an unconditional promise to pay to order at a definite time. But do the checks state
a definite amount of money? Can the holder “look at the four corners of the check” and determine
how much Sam owes?
Result: Sam was supposed to pay Piggy the face amount of the check plus interest. Wolfe does
not know the amount of the interest unless he reads the loan agreement. Therefore, the checks are
not negotiable.
Interpretation of Ambiguities. Perhaps you have noticed that people sometimes make mistakes.
Although the UCC establishes simple and precise rules for creating negotiable instruments, people
do not always follow these rules to the letter. It might be tempting simply to invalidate defective
documents (after all, money is at stake here). But instead, the UCC favors negotiability and has
rules to resolve uncertainty and supply missing terms.
Notice anything odd about the check pictured on the next page? Is it for $1,500 or
$15,000? When the terms in a negotiable instrument contradict each other, three rules apply:
1. Words beat numbers.
2. Handwritten terms prevail over typed and printed terms.
3. Typed terms win over printed terms.
According to these rules, Krystal’s check is for $15,000 because, in a conflict between words
and numbers, words win.
In the following case, the amount of the check was not completely clear. Was it a negotiable
instrument?
You Be the Judge
Blasco v. Money Services Center
352 B.R. 888
United States Bankruptcy Court for the Northern District of Alabama, 2006
Facts: Christina Blasco borrowed $500 from the Money Services Center (MSC). To repay the
loan, she gave MSC a check for $587.50, which it promised not to cash for two weeks. This kind
of transaction is called a “payday loan” because it is made to someone who needs money to tide
him over until the next paycheck. (Note that in this case, Blasco was paying 17.5 percent interest
for a two-week loan, which is an annual compounded interest rate of 6,500 percent. This is the
dark side of payday loans—interest rates are often exorbitant.)
Before MSC could cash the check, Blasco filed for bankruptcy protection. Although MSC
knew about Blasco’s filing, it deposited the check. It is illegal for creditors to collect debts after a
bankruptcy filing, except that creditors are entitled to payment on negotiable instruments.1
Ordinarily, checks are negotiable instruments, but only if they are for a definite amount. This
check had a wrinkle: The numerical amount of the check was $587.50, but the amount in words
was written as “five eighty-seven and 50/100 dollars.” Did the words mean “five hundred eightyseven” or “five thousand eighty-seven” or perhaps “five million eighty-seven”? Was the check
negotiable despite this ambiguity?
You Be the Judge: Was this check for a definite amount? Was it a negotiable instrument?
Argument for Blasco: For a check to be negotiable, two rules apply:
1. The check must state a definite amount of money, which is clear within its four corners.
2. If there is a contradiction between the words and numbers, words take precedence over
numbers.
Words prevail over numbers, which means that the check is for “five eighty-seven and 50/100
dollars.” This amount is not definite. A holder cannot be sure of the precise amount of the check.
Therefore, the check is not a negotiable instrument, and MSC had no right to submit it for payment.
Argument for MSC: Blasco is right about the two rules. However, she is wrong in their
interpretation. If there is a contradiction between the words and numbers, words take precedence
over numbers. In this case, there was no contradiction. The words were ambiguous, but they did
not contradict the numbers. If the words had said “five thousand eighty-seven,” that would have
been a contradiction. Instead, the numbers simply clarified the words. Even someone who was a
stranger to this transaction could safely figure out the amount of the check. Therefore, it is
negotiable and MSC is not liable.
Negotiated
Remember the fundamental rule of commercial paper: The possessor of a piece of commercial
paper has an unconditional right to be paid, as long as (1) the paper is negotiable, (2) it has
been negotiated to the possessor, (3) the possessor is a holder in due course, and (4) the issuer
cannot claim a valid defense.
☐ Negotiable
☑ Negotiated
☐ Holder in Due Course
☐ No Valid Defenses
CHECKLIST
If the computer crashes and burns the first week, Jake has the right to refuse to pay
the note.
Negotiated means that an instrument has been transferred to the holder by someone other than
the issuer. If the issuer has transferred the instrument to the holder, then it has not been negotiated,
and the issuer can refuse to pay the holder if there was some flaw in the underlying contract. Thus,
if Jake gives Emerson a promissory note for $800 in payment for a new tablet computer, but the
tablet crashes and burns the first week, Jake has the right to refuse to pay the note. Jake was the
issuer, and the note was not negotiated. But if, before the tablet self-destructs, Emerson negotiates
the note to Kayla, then Jake is liable to Kayla for the full amount of the note, regardless of his
claims against Emerson.
Negotiated
An instrument has been transferred to the holder by someone other than the issuer
To be negotiated, order paper must first be indorsed and then delivered to the transferee.
Bearer paper must simply be delivered to the transferee; no indorsement is required.2
An indorsement is the signature of the payee. Tess writes a rent check for $600 to her
landlord, Larnell. If Larnell signs the back of the check and delivers it to Patty, he has met the two
requirements for negotiating order paper: indorsement and delivery. If Larnell delivers the check
to Patty but forgets to sign it, the check has not been indorsed and therefore cannot be negotiated—
it has no value to Patty.
Indorsement
The signature of the payee
EXAMStrategy
Question: Antonia makes a check out to cash and delivers it to Bart. Later, Bart writes on the
back, “Pay to the order of Charlotte.” He signs his name and gives the check to her. Is this check
bearer paper or order paper? Has it been negotiated?
Strategy: To be negotiated, order paper must be indorsed and delivered; bearer paper need only
be delivered, but in both cases by someone other than the issuer.
Result: This check changes back and forth between order and bearer paper, depending on what
the indorsement says. When Antonia makes out a check to cash, it is bearer paper. When she gives
it to Bart, it is not negotiated because she is the issuer. When Bart writes on the back “Pay to the
order of Charlotte,” and signs it, the check becomes order paper. When he gives it to Charlotte, it
is properly negotiated because he is not the issuer and he has both indorsed the check and
transferred it to her. If Charlotte signs it, the check becomes bearer paper. And so it could go on
forever.3
15-2 HOLDER IN DUE COURSE
The fundamental rule of commercial paper tells us that a holder in due course has an automatic
right to receive payment for a negotiable instrument (unless the issuer can claim a valid
defense). If the possessor of an instrument is just a holder, not a holder in due course, then his
right to payment is no better than the rights of the person from whom he obtained the instrument.
If, for example, the issuer has a valid claim against the payee, then the holder may also lose his
right to be paid, because he inherits whatever claims and defenses arise out of that contract.
Clearly, then, holder in due course status dramatically enhances the value of an instrument because
it increases the probability of being paid.
15-2a Requirements for Being a Holder in Due Course
A holder in due course is a holder who has given value for the instrument, in good
faith, without notice of outstanding claims or other defects. Let’s define these terms.
Holder
in
due
course
Someone who has given value for an instrument, in good faith, without notice of outstanding claims or
other defenses
Holder
For order paper, a holder is anyone in possession of the instrument if it is payable to or indorsed
to her. For bearer paper, a holder is anyone in possession. Tristesse gives Felix a check payable to
him. Because Felix owes his mother money, he indorses the check and delivers it to her. This is a
valid negotiation because Felix has both indorsed the check (which is order paper) and delivered
it. Therefore, Felix’s mother is a holder.
Holder
For order paper, anyone in possession of the instrument if it is payable to or indorsed to her; for bearer
paper, anyone in possession
Value
A holder in due course must give value for an instrument. Value means that the holder
has already done something in exchange for the instrument. Felix’s mother has already lent him
money, so she has given value.
Value
The holder has already done something in exchange for the instrument.
Good Faith
There are two tests to determine if a holder acquired an instrument in good faith. The holder must
meet both these tests:
1. Subjective test. Did the holder believe the transaction was honest in fact?
2. Objective test. Did the transaction appear to be commercially reasonable?
Felix persuades his neighbor, Faith, that he has invented a fabulous beauty cream guaranteed
to remove wrinkles. She gives him a $10,000 promissory note, payable in 90 days, in return for
exclusive sales rights in Pittsburgh. Felix sells the note to his old friend, Griffin, for $2,000. Felix
never delivers the sales samples to Faith. When Griffin presents the note to Faith, she refuses to
pay on the grounds that Griffin is not a holder in due course. She contends that he did not buy the
note in good faith.
Griffin fails both tests. Any friend of Felix knows he is not trustworthy, especially when
presenting a promissory note signed by a neighbor. Griffin did not believe the transaction was
honest in fact. Also, $10,000 notes are not usually discounted to $2,000; $9,500 would be more
normal. This transaction is not commercially reasonable, and Griffin should have realized
immediately that Felix was up to no good.
☐ Negotiable
☐ Negotiated
☑ Holder in Due Course
☐ No Valid Defenses
CHECKLIST
Notice of Outstanding Claims or Other Defects
A holder is on notice that an instrument has an outstanding claim or other defect if:
1. The instrument is overdue. An instrument is overdue the day after its due date. At that
point, the recipient ought to wonder why no one has bothered to collect the money owed.
A check is overdue 90 days after its date. Any other demand instrument is overdue (1) the
day after a request for payment is made or (2) a reasonable time after the instrument was
issued.
2. The instrument is dishonored. To dishonor an instrument is to refuse to pay it. For
example, once a check has been stamped “Insufficient Funds” by the bank, it has been
dishonored, and no one who obtains it afterward can be a holder in due course.
3. The instrument is altered, forged, or incomplete. Anyone who knows that an
instrument has been altered or forged cannot be a holder in due course. Suppose Joe
wrote a check to Tony for $200. While showing the check to Liza, Tony cackles to
himself and says, “Can you believe what that goof did? Look, he left the line blank after
the words ‘two hundred.’” Taking his pen out with a flourish, Tony changes the zeroes to
nines and adds the words “ninety-nine.” He then indorses the check over to Liza, who is
definitely not a holder in due course.
4. The holder has notice of certain claims or disputes. No one can qualify as a holder in
due course if she is on notice that (1) someone else has a claim to the instrument or (2)
there is a dispute between the original parties to the instrument. Matt hires Sheila to put
aluminum siding on his house. In payment, he gives her a $15,000 promissory note with
the due date left blank. They agree that the note will not be due until 60 days after
completion of the work. Despite the agreement, Sheila fills in the date immediately and
sells the note to Rupert at American Finance Corp., who has bought many similar notes
from Sheila. Rupert knows that the note is not supposed to be due until after the work is
finished. Usually, before he buys a note from her, he demands a signed document from
the homeowner certifying that the work is complete. Not only that, but he lives near Matt
and can see that Matt’s house is only half finished. Rupert is not a holder in due course
because he has reason to suspect there is a dispute between Sheila and Matt.
In the following case, the holder of the notes had reason to know that all was not well between
the parties to the original contract. But did the dentists’ claim have teeth?
In re Brican Am. LLC Equip. Lease Litig.
2015 U.S. Dist. LEXIS 5923; 2015 WL 235409
United States District Court for the Southern District of Florida, 2015
CASE SUMMARY
Facts: Brican LLC was running a scam. The victims were dentists who wanted to lease multimedia
systems (called “Exhibeos”) for use in their waiting rooms. Each Exhibeo consisted of a computer
and a television which could, say, demonstrate proper flossing technique and show ads for
expensive cosmetic procedures.
The sales process worked this way: Brican would sell an Exhibeo to NCMIC Finance
Corporation, which would then lease the equipment to a dentist. Brican promised all the dentists
that another company, Viso Lasik, would buy enough advertising on the Exhibeos to cover the
monthly lease payments. Further, if Viso ever stopped its advertising, the dentists could cancel
their contracts. In short, Brican lured the dentists with the promise that the Exhibeos were
effectively free.
This plan not only sounded too good to be true, it was. Brican sold each Exhibeo to NCMIC
for $24,000. But Brican was also paying Viso for the ads it placed with the dentists, which
amounted to $29,000 over five years. In short, Brican was losing money on every Exhibeo it sold
but would pocket the $24,000 from NCMIC upfront and then worry later about the $29,000 it
owed in Viso ads. The only way this system could work, in the short run, was if Brican kept selling
more and more machines. In the long run—well, there was no chance of a long run.
NCMIC was attracted to the deal because dentists typically have a good credit rating, and were
agreeing to pay a high interest rate. It is possible that, at the beginning, NCMIC was unaware of
Brican’s scam. However, once NCMIC discovered the truth, it increased its lending tenfold.
Eventually, the inevitable happened. Brican sales declined, it ran out of cash, and then it
stopped paying for Viso ads on the Exhibeos. The dentists quit making their lease payments and
NCMIC sued them. Because the leases were legally the same as a promissory note, the dentists
alleged that NCMIC could not enforce the agreement because it was not a holder in due course it had not acted in good faith.
Issues: Had NCMIC acted in good faith? Was it a holder in due course?
Decision: NCMIC was not a holder in due course.
Reasoning: To be a holder in due course, the holder must have acquired an instrument in good
faith. Good faith requires not only that the holder believed the transaction was honest but that it
appeared to be commercially reasonable. A holder cannot ignore suspicious circumstances that cry
out for investigation.
NCMIC knew that Brican had promised the dentists that the Exhibeos were effectively free
(because the advertising fees would offset the lease payments) and that the dentists could cancel
their leases at any time. Once it had reason to be suspicious, NCMIC ignored its own procedures
for investigating fraud and, indeed, increased its lending tenfold. Any reasonable investigation
would have revealed Brican’s shaky financial position and that it was losing money on every
Exhibeo it sold. NCMIC could not prove that it acted in good faith. Therefore, it is not a holder in
due course.
15-2b Defenses against a Holder in Due Course
Negotiable instruments are meant to be a close substitute for currency, and, as a general rule,
holders expect to be paid. However, the issuer of a negotiable instrument is not required to
pay if:
•
•
•
•
•
•
His signature on the instrument was forged.
After signing the instrument, his debts were discharged in bankruptcy.
He was underage (typically younger than 18) at the time he signed the instrument.
The amount of the instrument was altered after he signed it. (However, if he left the instrument blank,
he is liable for any amounts later filled in.)
He signed the instrument under duress, while mentally incapacitated, or as part of an illegal
transaction.
He was tricked into signing the instrument without knowing what it was and without any reasonable
way to find out.
CHECKLIST
☐ Negotiable
☐ Negotiated
☐ Holder in Due Course
☑ No Valid Defenses
The following case illustrates the value of being a holder in due course. Remember that to be
a holder, you must be in possession of the instrument.
Creative Ventures, LLC v. Jim Ward & Associates
195 Cal. App. 4th 1430
California Court of Appeals, 2011
CASE SUMMARY
Facts: When Creative Ventures, LLC borrowed $3 million from defendant Jim Ward &
Associates, it signed promissory notes, payable to Ward. Thereafter, Ward sold this loan to 54
individual investors, but kept possession of the notes. When Creative made payments under the
loan to Ward, it paid the investors their share.
Under California law, the interest rate on a loan cannot be greater than 8 percent, except in
certain circumstances. Those circumstances include loans by a licensed real estate broker. Ward
claimed that it was such a broker, but it was not. When Creative discovered this lie, it sued Ward
and the investors to obtain a refund of all interest it had paid under the loan, as is permitted by
California law. The investors argued that they were entitled to keep the interest because, as holders
in due course, they had taken the note free of the claim against Ward.
Issues: Were the investors holders in due course? Were they entitled to keep the interest that
Creative had paid on the illegal loan?
Decision: The investors were not holders in due course and could not keep the interest Creative
had paid.
Reasoning: A holder in due course must, first of all, be a holder. A holder is someone in possession
of a negotiable instrument that is payable either to that person or to bearer. The promissory notes
in this case are payable to Ward, which is also in possession of the notes. Accordingly, Ward is
the holder.
Investors could have become holders if Ward had negotiated the notes by indorsing and
transferring possession to the investors. But there is no evidence that Ward did so.
15-2c Consumer Exception
The most common use for negotiable instruments is in consumer transactions. A consumer pays
for a refrigerator by giving the store a promissory note. The store promptly sells the note to a
finance company. Even if the refrigerator is defective, under Article 3 the consumer must pay full
value on the note because the finance company is a holder in due course. To solve this problem,
some states require promissory notes given by a consumer to carry the words “consumer paper.”
Notes with these words are non-negotiable and no one is a holder in due course.
Meanwhile, the Federal Trade Commission (FTC) has special rules for consumer credit
contracts. A consumer credit contract is one in which a consumer borrows money from a lender
to purchase goods and services from a seller who is affiliated with the lender. If Sears loans money
to Gerald to buy a 3-D television at Sears, that is a consumer credit contract. It is not a consumer
credit contract if Gerald borrows money from his cousin Vinnie to buy the television from Sears.
The FTC requires all promissory notes in consumer credit contracts to contain the following
language:
Consumer
credit
contract
A contract in which a consumer borrows money from a lender to purchase goods and services from a seller
who is affiliated with the lender
ANY HOLDER OF THIS CONSUMER CREDIT CONTRACT IS SUBJECT TO ALL
CLAIMS AND DEFENSES WHICH THE DEBTOR COULD ASSERT AGAINST THE
SELLER OF GOODS OR SERVICES OBTAINED WITH THE PROCEEDS HEREOF.
The UCC provides that no one can be a holder in due course of an instrument with this
language. If the language is omitted from a consumer note, it is possible to be a holder in due
course, but the seller is subject to a fine.
CHAPTER CONCLUSION
Commercial paper provides essential grease to the wheels of commerce. It is worth
remembering, however, that the terms of the UCC are precise and that failure to comply with these
exacting provisions can lead to unfortunate consequences.
CHAPTER
16
SECURED TRANSACTIONS
James is a secret agent. His mission? To capture the targets. His tactics? Fast and sneaky. His
equipment? State-of-the-art digital technology. His victims? Both shaken and stirred.
But James is not working for the government—he is employed by a bank. James is a modern
repo man, paid to recover vehicles from delinquent borrowers. Equipped with a digital camera, he
drives up and down highways and city streets capturing images of every passing license plate.
Instantaneously, his on-board computer matches these numbers to a database of “wanted” vehicles.
He knows who you are and where you live. Pay your car loan on time.
And a match means the chase is on. Armed with digital maps, he follows the target car. Once
it is parked, he swoops in and takes it away. Does this sound wrong? Everything James does is
legal. The moral of the story? He knows who you are and where you live. Pay your car loan on
time.
16-1 ARTICLE 9: TERMS AND SCOPE
We can sympathize with the delinquent borrowers whom James stalks, but as we will see in this
chapter, the bank is within its rights because it had entered into secured transactions with the car
buyers. In a secured transaction, the lender gives money in return for the right to repossess items
of collateral if the debtor does not repay the loan. Whether a used-car lot sells an auto on credit for
$18,000 or a bank takes collateral for a $600 million corporate loan, the parties have created a
secured transaction.
Article 9 of the Uniform Commercial Code (UCC) governs secured transactions in
personal property. It is essential to understand the basics of this law because we live and work in
a world economy based on credit. Article 9 employs terms not used elsewhere, so we must lead
off with some definitions:
•
•
•
•
•
•
Fixtures are goods that have become attached to real estate. For example, elevators are goods when a
company manufactures them, but they become fixtures when installed in a building.
Security interest means an interest in personal property or fixtures that secures the performance of
some obligation. If an automobile dealer sells you a new car on credit and retains a security interest, it
means it is keeping legal rights in your car, including the right to drive it away if you fall behind in
your payments.
Secured party is the person or company that holds the security interest. The automobile dealer who
sells you a car on credit is the secured party.
Collateral is the property subject to a security interest. When a dealer sells you a new car and keeps a
security interest, the vehicle is the collateral.
Debtor, for our purposes, refers to a person who has some original ownership interest in the collateral.
If Alice borrows money from a bank and uses her Mercedes as collateral, she is the debtor because she
owns the car.
Security agreement is the contract in which the debtor gives a security interest to the secured party.
This agreement protects the secured party’s rights in the collateral.
•
•
•
•
•
Repossession occurs when the secured party takes back collateral because the debtor has defaulted
(failed to make payments when due).
Perfection is a series of steps the secured party must take to protect its rights in the collateral against
people other than the debtor.
Financing statement is a record intended to notify the general public that the secured party has a
security interest in the collateral.
Record refers to information written on paper or stored in an electronic or other medium.
Authenticate means to sign a document or to use any symbol or encryption method that identifies the
person and clearly indicates she is adopting the record as her own. You authenticate a security
agreement when you sign the papers at an auto dealership. A company may authenticate by using the
internet to transmit an electronic signature.
Here is an example using the terms just discussed. A medical equipment company
manufactures a CT scanner and sells it to a clinic for $2 million, taking $500,000 cash and the
clinic’s promise to pay the rest over five years. The clinic simultaneously authenticates a security
agreement, giving the manufacturer a security interest in the CT scanner. The manufacturer then
electronically files a financing statement in an appropriate state agency. This perfects the
manufacturer’s rights, meaning that its security interest in the CT scanner is now valid against all
the world. Exhibit 16.1 illustrates this transaction.
If the clinic goes bankrupt and many creditors try to seize its assets, the manufacturer has first
claim to the CT scanner. The clinic’s bankruptcy is of great importance. When a debtor has money
to pay all of its debts, there are no concerns about security interests. A creditor insists on a security
interest to protect itself in the event the debtor cannot pay all of its debts.
EXHIBIT 16.1
16-1a Scope of Article 9
Article 9 applies to any transaction intended to create a security interest in personal property or
fixtures.
Types of Collateral
The personal property that may be used as collateral includes:
•
•
•
•
•
Goods, which are things that are movable.
Inventory, meaning goods held by someone for sale or lease, such as all the beds and chairs in a
furniture store.
Instruments, such as drafts, checks, certificates of deposit, and notes.
Investment property, which refers primarily to securities and related rights.
Other property, including documents of title, accounts, general intangibles (copyrights, patents,
goodwill, and so forth), and chattel paper (for example, a sales document indicating that a retailer has a
security interest in goods sold to a consumer). Slightly different rules apply to some of these forms of
property, but the details are less important than the general principles on which we shall focus.
Article 9 applies any time the parties intended to create a security interest in any of the items
listed above.
16-2 ATTACHMENT OF A SECURITY INTEREST
Attachment is a vital step in a secured transaction. This means that the secured party has taken
three steps to create an enforceable security interest:
1. The two parties made a security agreement, and either the debtor has authenticated a security
agreement describing the collateral, or the secured party has obtained possession;
2. The secured party has given value to obtain the security agreement; and
3. The debtor has rights in the collateral.1
Attachment
A three-step process that creates an enforceable security interest
16-2a Agreement
Without an agreement, there can be no security interest. Generally, the agreement must be either
written on paper and signed by the debtor, or electronically recorded and authenticated by the
debtor. The agreement must reasonably identify the collateral. For example, a security agreement
may properly describe the collateral as “all equipment in the store at 123 Periwinkle Street.”
A security agreement at a minimum might:
•
State that Happy Homes, Inc., and Martha agree that Martha is buying an Arctic Co. refrigerator, and
identify the exact unit by its serial number;
•
•
Give the price, the down payment, the monthly payments, and interest rate;
State that because Happy Homes is selling Martha the refrigerator on credit, it has a security interest in
the refrigerator; and
Provide that if Martha defaults, Happy Homes is entitled to repossess the refrigerator.
•
16-2b Possession
In certain cases, the security agreement need not be in writing if the parties have an oral agreement
and the secured party has possession. For some kinds of collateral, for example stock certificates,
it is safer for the secured party actually to take the item than to rely upon a security agreement.
EXAMStrategy
Question: Hector needs money to keep his business afloat. He asks his uncle for a $1 million loan.
The uncle agrees, but he insists that his nephew grant him a security interest in Hector’s splendid
gold clarinet, worth over $2 million. Hector agrees. The uncle prepares a handwritten document
summarizing the agreement and asks his nephew to sign it. Hector hands the clarinet to his uncle
and receives his money, but he forgets to sign the document. Has a security agreement attached?
Strategy: Attachment occurs if the parties made a security agreement and there was authentication
or possession, the secured party has given value, and the debtor had rights in the collateral.
Result: Hector agreed to give his uncle a security interest in the instrument. He never authenticated
(signed) the agreement, but the uncle did take possession of the clarinet. The uncle gave Hector $1
million, and Hector owned the instrument. Yes, the security interest attached.
16-2c Value
For the security interest to attach, the secured party must give value. Usually, the value will be
apparent. If a bank loans $400 million to an airline, that money is the value, and the bank may
therefore obtain a security interest in the planes that the airline is buying.
16-2d Debtor Rights in the Collateral
The debtor can only grant a security interest in goods if he has some legal right to those goods
himself. Typically, the debtor owns the goods. But a debtor may also give a security interest if he
is leasing the goods or even if he is a bailee, meaning that he is lawfully holding them for someone
else.
Once the security interest has attached to the collateral, the secured party is protected against
the debtor. If the debtor fails to pay, the secured party may repossess the collateral, meaning take
it away.
16-2e Attachment to Future Property
After-acquired property refers to items that the debtor obtains after the parties have made their
security agreement. The parties may agree that the security interest attaches to after-acquired
property. Basil is starting a catering business but owns only a beat-up car. He borrows $55,000
from the Pesto Bank, which takes a security interest in the car. But Pesto also insists on an afteracquired clause. When Basil purchases a commercial stove, cooking equipment, and freezer,
Pesto’s security interest attaches to each item as Basil acquires it.
After-acquired
Items that the debtor obtains after the parties have made their security
property
A security agreement automatically applies to proceeds—whatever a debtor obtains who sells
the collateral or otherwise disposes of it. The secured party obtains a security interest in the
proceeds of the collateral unless the security agreement states otherwise.2
16-3 PERFECTION
Once the security interest has attached to the collateral, the secured party is protected against the
debtor. Pesto Bank loaned money to Basil and has a security interest in all of his property. If Basil
defaults on his loan, Pesto may insist he deliver the goods to the bank. If he fails to do that, the
bank can seize the collateral. But Pesto’s security interest is valid only against Basil; if a third
person claims some interest in the goods, the bank may never get them. For example, Basil might
have taken out another loan, from his friend Olive, and used the same property as collateral. Olive
knew nothing about the bank’s original loan. To protect itself against Olive, and all other parties,
the bank must perfect its interest.
There are several kinds of perfection, including:
•
•
•
Perfection by filing,
Perfection by possession, and
Perfection of consumer goods.
In some cases, the secured party will have a choice of which method to use; in other cases,
only one method works.
16-3a Perfection by Filing
The most common way to perfect is by filing a financing statement with the appropriate state
agency. A financing statement gives the names of all parties, describes the collateral, and outlines
the security interest, enabling any interested person to learn about it. Suppose the Pesto Bank
obtains a security interest in Basil’s catering equipment and then perfects by filing with the
secretary of state in the state capital. When Basil asks his friend Olive for a loan, she will check
the records to see if anyone has a security interest in the catering equipment. Olive’s search
uncovers Basil’s previous security agreement, and she realizes it would be unwise to make the
loan. If Basil were to default, the collateral would go straight to Pesto Bank, leaving Olive emptyhanded. See Exhibit 16.2.
Article 9 prescribes one form to be used nationwide for financing statements. Commonly
called UCC-1, the financing form is available online. Remember that the filing may be done on
paper or electronically.
The most common problems that arise in filing cases are (1) whether the financing statement
contained enough information to put other people on notice of the security interest and (2) whether
the secured party filed the papers in the right place.
EXHIBIT 16.2
Contents of the Financing Statement
A financing statement is sufficient if it provides the name of the debtor, the name of the
secured party, and an indication of the collateral.3 The name of the debtor is critical because
that is what an interested person will use to search among the millions of other financing statements
on file. Faulty descriptions of the debtor’s name have led to thousands of disputes and untold years
of litigation as subsequent creditors have failed to locate any record of an earlier claim on the
debtor’s property. In response, the UCC is now very precise about what name must be used. Most
states require that individuals use the same name on a financing statement that is on their driver’s
license or state ID card (for nondrivers).4 For organizations, the correct name is the one on the
“public organic record,” defined as any record available for public inspection, including its charter
or limited partnership agreement.5 Trade names alone are not sufficient.
Because misnamed debtors have created so much conflict, the Code offers a straightforward
test: A financing statement is effective if a computer search run under the debtor’s correct name
produces it. That is true even if the financing statement used the incorrect name. If the search does
not reveal the document, then the financing statement is ineffective as a matter of law. The burden
is on the secured party to file accurately, not on the searcher to seek out erroneous filings.6
The collateral must be described reasonably so that another party contemplating a loan to the
debtor will understand which property is already secured. A financing statement could properly
state that it applies to “all inventory in the debtor’s Houston warehouse.” If the debtor has given a
security interest in everything he owns, then it is sufficient to state simply that the financing
statement covers “all assets” or “all personal property.”
Place and Duration of Filing
Article 9 specifies where a secured party must file. These provisions may vary from state to state,
so it is essential to check local law. A misfiled record accomplishes nothing. Generally speaking,
a party must file in a central filing office located in the state where an individual debtor lives or
where an organization has its executive office.7
Once a financing statement has been filed, it is effective for five years (except for a
manufactured home, where it lasts 30 years). After five years, the statement will expire and leave
the secured party unprotected unless she files a continuation statement within six months prior to
expiration. The continuation statement is valid for an additional five years, and a secured party
may file such a statement periodically, forever.
A misfiled record accomplishes nothing.
16-3b Perfection by Possession
For most types of collateral, in addition to filing, a secured party generally may perfect by
possession. So if the collateral is a diamond brooch or 1,000 shares of stock, a bank may perfect
its security interest by holding the items until the loan is paid off. However, possession imposes
one important duty: A secured party must use reasonable care in the custody and
preservation of collateral in her possession.8 Reliable Bank holds 1,000 shares of stock as
collateral for a loan it made to Grady. Grady instructs the bank to sell the shares and use the
proceeds to pay off his debt in full. If Reliable neglects to sell the stock for five days and the share
price drops by 40 percent during that period, the bank will suffer the loss, not Grady.
16-3c Perfection of Consumer Goods
The UCC gives special treatment to security interests in most consumer goods. Merchants
cannot realistically file a financing statement for every bed, television, and stereo for which a
consumer owes money. To understand the UCC’s treatment of these transactions, we need to know
two terms. The first is consumer goods, which are those used primarily for personal, family, or
household purposes. The second term is purchase money security interest.
A purchase money security interest (PMSI) is one taken by the person who sells the
collateral or by the person who advances money so the debtor can buy the collateral.9 Assume the
Gobroke Home Center sells Marion a $5,000 stereo system. The sales document requires a
payment of $500 down and $50 per month for the next three centuries and gives Gobroke a security
interest in the system. Because the security interest was “taken by the seller,” the document is a
PMSI. It would also be a PMSI if a bank had loaned Marion the money to buy the system and the
document gave the bank a security interest. See Exhibit 16.3.
Purchase
money
security
interest
(PMSI)
An interest taken by the person who sells the collateral or advances money so the debtor can buy it
EXHIBIT 16.3
A purchase money security interest can arise in either of two ways. In the first example, a store
sells a stereo to a consumer on credit; the consumer in turn signs a PMSI, giving the store a security
interest in the stereo. In the second example, the consumer buys the stereo with money loaned
from a bank; the consumer signs a PMSI giving the bank a security interest in the stereo.
But aren’t all security interests PMSIs? No, many are not. Suppose a bank loans a retail
company $800,000 and takes a security interest in the store’s present inventory. That is not a PMSI,
since the store did not use the money to purchase the collateral.
What must Gobroke Home Center do to perfect its security interest? Nothing. A PMSI in
consumer goods perfects automatically, without filing.10 Marion’s new stereo is clearly
consumer goods because she will use it only in her home. Gobroke’s security interest is a PMSI,
so the interest has perfected automatically.
The Code provisions about perfecting generally do not apply to motor vehicles, trailers, mobile
homes, boats, or farm tractors. These types of secured interests are governed by state law, which
frequently require a security interest to be noted directly on the vehicle’s certificate of title.
EXAMStrategy
Question: Winona owns a tropical fish store. To buy a spectacular new aquarium, she borrows
$25,000 from her sister, Pauline, and signs an agreement giving Pauline a security interest in the
tank. Pauline never files the security agreement. Winona’s business goes belly up, and both Pauline
and other creditors angle to repossess the tank. Does Pauline have a perfected interest in the tank?
Strategy: Generally, a creditor obtains a perfected security interest by filing or possession.
However, a PMSI in consumer goods perfects automatically, without filing. Was Pauline’s security
agreement a PMSI? Was the fish tank a consumer good?
Result: A PMSI is one taken by the person who sells the collateral or advances money for its
purchase. Pauline advanced the money for Winona to buy the tank, so Pauline does have a PMSI.
Consumer goods are those used primarily for personal, family, or household purposes, so this
was not a consumer purchase. Pauline failed to perfect and is unprotected against other creditors.
16-4 PROTECTION OF BUYERS
Generally, once a security interest is perfected, it remains effective regardless of whether the
collateral is sold, exchanged, or transferred in some other way. Bubba’s Bus Co. needs money to
meet its payroll, so it borrows $150,000 from Francine’s Finance Co., which takes a security
interest in Bubba’s 180 buses and perfects its interest. Bubba, still short of cash, sells 30 of his
buses to Antelope Transit. But even that money is not enough to keep Bubba solvent: He defaults
on his loan to Francine and goes into bankruptcy. Francine pounces on Bubba’s buses. May she
repossess the 30 that Antelope now operates? Yes. The security interest continued in the buses
even after Antelope purchased them, and Francine can whisk them away.
But there are some exceptions to this rule. The UCC gives a few buyers special protection.
16-4a Buyers in Ordinary Course of Business
A buyer in ordinary course of business (BIOC) is someone who buys goods in good faith from
a seller who routinely deals in such goods. For example, Plato’s Garden Supply purchases 500
hemlocks from Socrates’ Farm, a grower. Plato is a BIOC: He is buying in good faith, and Socrates
routinely deals in hemlocks. This is an important status because a BIOC is generally not affected
by security interests in the goods. However, if Plato realized that the sale violated another party’s
rights in the goods, there would be no good faith. If Plato knew that Socrates was bankrupt and
had agreed with a creditor not to sell any of his inventory, Plato would not achieve BIOC status.
Buyer
in
ordinary
course
of
business
Someone who buys goods in good faith from a seller who routinely deals in such goods
(BIOC)
A BIOC takes the goods free of a security interest created by his seller, even though the
security interest is perfected.11 Suppose that, a month before Plato made his purchase, Socrates
borrowed $200,000 from the Athenian Bank. Athenian took a security interest in all of Socrates’
trees and perfected by filing. Then Plato purchased his 500 hemlocks. If Socrates defaults on the
loan, Athenian will have no right to repossess the 500 trees that are now at the Garden Supply.
Plato took them free and clear. (Of course, Athenian can still attempt to repossess other trees from
Socrates.) The BIOC exception is designed to encourage ordinary commerce. A buyer making
routine purchases should not be forced to perform a financing check before buying.
But the rule creates its own problems. A creditor may extend a large sum of money to a
merchant based on collateral, such as inventory, only to discover that by the time the merchant
defaults, the collateral has been sold. Because the BIOC exception undercuts the basic protection
given to a secured party, the courts interpret it narrowly. BIOC status is available only if the seller
created the security interest. Often, a buyer will purchase goods that have a security interest created
by someone other than the seller. If that happens, the buyer is not a BIOC. However, should that
rule be strictly enforced even when the results are harsh? You make the call.
You Be the Judge
Conseco Finance Servicing Corp. v. Lee
2004 WL 1243417; 2004 Tex. App. LEXIS 5035
Texas Court of Appeals, 2004
Facts: Lila Williams purchased a new Roadtrek 200 motor home from New World R.V., Inc. She
paid about $14,000 down and financed $63,000, giving a security interest to New World. The RV
company assigned its security interest to Conseco Finance, which perfected. Two years later,
Williams returned the vehicle to New World (the record does not indicate why), and New World
sold the RV to Robert and Ann Lee for $42,800. A year later, Williams defaulted on her payments
to Conseco.
The Lees sued Conseco, claiming to be BIOCs and asking for a court declaration that they had
sole title to the Roadtrek. Conseco counterclaimed, seeking title based on its perfected security
interest. The trial court ruled that the Lees were BIOCs, with full rights to the vehicle. Conseco
appealed.
You Be the Judge: Were the Lees BIOCs?
Argument for Conseco: Under the UCC, a BIOC takes free of a security interest created by the
buyer’s seller. The buyers were the Lees. The seller was New World. New World did not create
the security interest—Lila Williams did. There is no security interest created by New World. The
security interest held by Conseco was created by someone else (Williams) and is not affected by
the Lees’s status as BIOCs. The law is clear, and Conseco is entitled to the Roadtrek.
Argument for the Lees: Conseco weaves a clever argument, but let’s look at what they are really
saying. Two honest buyers, acting in perfect good faith, can walk into an RV dealership, spend
$42,000 for a used vehicle, and end up with—nothing. Conseco claims it is entitled to an RV that
the Lees paid for because someone that the Lees have never dealt with, never even heard of, gave
to this RV seller a security interest that the seller, years earlier, passed on to a finance company.
Conseco’s argument defies common sense and the goals of Article 9.
16-5 PRIORITIES AMONG CREDITORS
What happens when two creditors have a security interest in the same collateral? The party who
has priority in the collateral gets it. Typically, the debtor lacks assets to pay everyone, so all
creditors struggle to be the first in line. After the first creditor has repossessed the collateral, sold
it, and taken enough of the proceeds to pay off his debt, there may be nothing left for anyone else.
(There may not even be enough to pay the first creditor all that he is due, in which case that creditor
will sue for the deficiency.) Who gets priority? There are three principal rules.
Priority
The law sets out three rules to establish which creditors have better claims.
The first rule is easy: A party with a perfected security interest takes priority over a party with
an unperfected interest. This is the whole point of perfecting: to ensure that your security interest
gets priority over everyone else’s. On August 15, Meredith’s Market, an antique store, borrows
$100,000 from the Happy Bank, which takes a security interest in all of Meredith’s inventory.
Happy Bank does not perfect. On September 15, Meredith uses the same collateral to borrow
$50,000 from the Suspicion Bank, which files a financing statement the same day. On October 15,
as if on cue, Meredith files for bankruptcy and stops paying both creditors. Suspicion wins because
it holds a perfected interest, whereas the Happy Bank holds merely an unperfected interest.
The second rule: If neither secured party has perfected, the first interest to attach gets priority.
Suppose that Suspicion Bank and Happy Bank had both failed to perfect. In that case, Happy Bank
would have the first claim to Meredith’s inventory since Happy’s interest attached first.
And the third rule follows logically: Between perfected security interests, the first to file or
perfect wins. Diminishing Perspective, a railroad, borrows $75 million from the First Bank, which
takes a security interest in Diminishing’s rolling stock (railroad cars) and immediately perfects by
filing. Two months later, Diminishing borrows $100 million from Second Bank, which takes a
security interest in the same collateral and also files. When Diminishing arrives, on schedule, in
bankruptcy court, both banks will race to seize the rolling stock. First Bank gets the railcars
because it perfected first.
March 1
April 2
May 3
First Bank lends money and
perfects its security interest by
filing a financing statement.
Second Bank lends money and
Diminishing goes bankrupt, and
perfects its security interest by filing both banks attempt to take the
a financing statement.
rolling stock.
In the example above, it is easy to apply the rules. But sometimes courts must sort through
additional complications. We know that a perfected security interest takes priority over others. But
sometimes it is not clear exactly when the security interest was perfected.
In the following case, the creditor got in just under the wire.
In re Roser
613 F3d 1240
United States Court of Appeals for the Tenth Circuit, 2010
CASE SUMMARY
Facts: Robert Roser obtained a loan from Sovereign Bank, which he promptly used to buy a car.
Nineteen days later, Sovereign filed a lien with the state of Colorado. The bank expected that, with
a perfected interest, it would have priority over everyone else.
Unknown to Sovereign Bank, Roser had declared bankruptcy only 12 days after he purchased
the car. Later, the bankruptcy trustee argued that he had priority over Sovereign because the
bankruptcy filing happened before Sovereign perfected its security interest. When the court found
for the trustee, Sovereign Bank appealed.
Issue: Did Sovereign Bank, a PMSI holder, obtain priority over the bankruptcy trustee?
Decision: Yes, the PMSI holder obtained priority.
The Winn
First Bank,
because it
perfected f
Reasoning: On the day that Roser entered bankruptcy, Sovereign Bank had not filed its financing
statement, which means that its security interest was not yet perfected. Ordinarily, a bankruptcy
trustee would take priority over all security interests that are unperfected on the day that a debtor
files a bankruptcy petition. However, there is an exception to this rule: If the creditor files a
financing statement for a PMSI within 20 days after the debtor receives the collateral, that security
interest is deemed to have been perfected as of the date of the debtor receives the collateral, not
the day on which the financing statement was filed. In this case, the bank filed within that 20-day
grace period, so its security interest took priority over the bankruptcy trustee.
Reversed and remanded.
16-6 DEFAULT AND TERMINATION
We have reached the end of the line. Either the debtor has defaulted, or it has performed its
obligations and may terminate the security agreement.
16-6a Default
The parties define “default” in their security agreement. Generally, a debtor defaults when he
fails to make payments due or enters bankruptcy proceedings. The parties can agree that other
acts will constitute default, such as the debtor’s failure to maintain insurance on the collateral.
When a debtor defaults, the secured party has two principal options: (1) It may take possession of
the collateral or (2) it may file suit against the debtor for the money owed. The secured party does
not have to choose between these two remedies; it may try one after the other, or both
simultaneously.
Taking Possession of the Collateral
When the debtor defaults, the secured party may take possession of the collateral.12 How does the
secured party do so? In either of two ways: The secured party can file suit against the debtor to
obtain a court order requiring the debtor to deliver the collateral. Otherwise, the secured party may
act on its own, without any court order, and simply take the collateral, provided this can be done
without a breach of the peace. A breach of the peace occurs when the repossession disturbs public
tranquility, such as through violent, threatening, or harassing acts.
Breach
of
Any action that disturbs public tranquility and order
the
peace
The repossession in the following case was a disaster, but was it a breach of the peace?
Chapa v. Traciers & Associates, Inc.
267 S.W.3d 386
Texas Court of Appeals, 2008
CASE SUMMARY
Facts: Marissa Chapa defaulted on her car loan, so Ford Motor Credit Corp. hired Traciers &
Associates to repossess her white Ford Expedition. Paul Chambers, Traciers’s field manager,
staked out the address on file, waiting for a chance to make his move.
One morning, Chambers saw a woman drive a white Expedition out of the driveway and leave
it running in the street while she ran back into the house. He made his move, quickly hooking up
the car to his tow truck and driving away. Chambers may have been fast, but he was wrong about
two things. First, he took the wrong car: This similar vehicle belonged to Marissa’s sister-in-law
Maria, who was not in default. Second, Maria’s two children were in the backseat.
When Maria realized that her car and her children had disappeared, she hysterically dialed
911. Within minutes, Chambers discovered the two Chapa children and immediately returned the
kids and the car to a frantic Maria.
Maria sued Ford, the repossession company, and the bank, claiming they had committed a
breach of the peace. The trial court dismissed the case and she appealed.
Issue: Did Chambers commit a breach of the peace in repossessing the car?
Decision: No, the repo man’s error was not a breach of the peace.
Reasoning: When a borrower defaults, a secured party may repossess the collateral without a court
order as long as it does not breach the peace. A “breach of the peace” is any conduct that disturbs
public order and tranquility, such as violent or forceful action or threats. If the borrower objects
during the repossession, then, to avoid confrontation, the secured party must immediately desist
and pursue its remedy in court.
Here, although Chambers made some mistakes, he did not breach the peace. He removed an
apparently unoccupied car from a public street without immediate confrontation, violence, threats,
or objection. Chambers returned the vehicle minutes later, as soon as he realized there were
children in the car. Chambers’s repossession, while very upsetting to Maria, was not a breach of
the peace.
Disposition of the Collateral
Once the secured party has obtained possession of the collateral, it has two choices. The secured
party may (1) dispose of the collateral or (2) retain the collateral as full satisfaction of the debt.
Notice that, until the secured party disposes of the collateral, the debtor has the right to redeem it,
that is, to pay the full value of the debt and retrieve her property.
A secured party may sell, lease, or otherwise dispose of the collateral in any commercially
reasonable manner.13 Typically, the secured party will sell the collateral in either a private or a
public sale. First, however, the debtor must receive reasonable notice of the time and place of the
sale so that she may bid on the collateral.
When the secured party has sold the collateral, it applies the proceeds of the sale: first, to its
expenses in repossessing and selling the collateral and, second, to the debt. Sometimes the sale
leaves a deficiency; that is, insufficient funds to pay off the debt. The debtor remains liable for the
deficiency, and the creditor will sue for it. On the other hand, the sale of the collateral may yield a
surplus; that is, a sum greater than the debt. The secured party must pay the surplus to the debtor.
16-6b Termination
When the debtor pays the full debt, the secured party must complete a termination statement, a
document indicating that it no longer claims a security interest in the collateral.14 These forms are
commonly called UCC-3 statements. Their goal is to notify all interested parties that the debt is
extinguished.
One important takeaway is that the law of secured transactions can be unforgiving. An
inconsistency on a UCC filing can be fatal to a creditor’s claim. The following case ends the
chapter with some drama. A lawyer made a $1.5 billion mistake—and no one was sympathetic.
In re Motors Liquidation Co.
2015 U.S. App 859
United States Court of Appeals for the Second Circuit, 2015
CASE SUMMARY
Facts: General Motors (GM) was the debtor on two unrelated loans: a $300 million loan (known
as the “Synthetic Lease”) and a $1.5 billion term loan (the “Term Loan”). JPMorgan Chase Bank
was the secured party on both transactions.
When GM decided to pay off the Synthetic Lease, it instructed its lawyers to prepare the
necessary termination statements for that loan. Unaware that the Term Loan was unrelated to the
Synthetic Loan, the lawyers mistakenly prepared the documentation to terminate the security
interests for them both and sent it to the parties for approval. None of the parties realized that the
termination statement for the Term Loan had been wrongly included. Indeed, JPMorgan’s attorney
responded, “Nice job on the documents.” Both UCC-3s were filed with Delaware’s secretary of
state.
When GM filed for bankruptcy the following year, JPMorgan discovered the error. Without a
security interest, the Term Loan was much less likely to be repaid. The bank asked that its security
interest in the Term Loan be reinstated because the UCC-3 filing had been a mistake. GM’s
unsecured creditors argued that the termination statement was valid and the Term Loan was now
unsecured.
According to Delaware law, a filing is valid if it is authorized by the secured party. Whether
or not the party intended or understood the filing’s consequences is irrelevant. The bankruptcy
court ruled that the UCC-3 was ineffective because JPMorgan did not authorize it. The unsecured
creditors appealed.
Issues: Was the termination statement valid? Is the Term Loan unsecured?
Decision: Yes, the termination statement is valid. The Term Loan is unsecured.
Reasoning: In determining the validity of a termination statement, the secured party’s intent is
irrelevant. Here, JPMorgan and its lawyers knew that GM’s lawyers were preparing the draft UCC3 termination statements, which would be filed upon their approval. They approved the UCC-3 for
the Term Loan, without expressing any concerns. JPMorgan and its lawyers then gave GM’s
lawyers the authority to act on its behalf in filing the approved UCC-3. Nothing more is needed to
terminate the security of the Term Loan.
UCC filings are the backbone of the law of secured transactions—and much depends on their
integrity. To protect the reliability of the system, the law will not excuse parties from the
consequences of their mistaken filings, no matter how severe.
CHAPTER CONCLUSION
Secured transactions are essential to modern commerce. Without them, many consumers
would never own a car or stereo, and many businesses would be unable to grow. But unless these
debts are repaid, the economy will falter. Secured transactions are one method for ensuring that
creditors are paid.
