Is Your Chattel Paper All Wet? An Even Deeper Dive Into the Super-Priority of Possession
by Kenneth P. Weinberg January/February 2017
In the second installment of a series on chattel paper, Attorney Ken Weinberg scuba dives into the two distinct super-priority rules relating to proceeds interest and non-proceeds interest.
The last edition of Dispatches from the Trenches explored certain aspects of the super-priority rule contained in Article 9 of the UCC relating to possession of chattel paper. As discussed, under certain circumstances, this rule allows a party that takes possession of chattel paper in connection with an outright or collateral assignment (possessor) to obtain a prior interest to another claimant who perfects its interest by filing (filer). During the last dive into this topic, we explored the new value and possession concepts carefully. In this edition, we dive almost as deep as the Mariana Trench into this issue, so take a big breath and watch out for frilled shark and giant squid!
The new value and possession components of the super-priority rule discussed in the last edition, and the good faith requirement briefly mentioned, apply anytime a possessor desires to take advantage of the rule. For this edition of Dispatches, we are assuming that the possessor can satisfy those elements and therefore focus solely on one additional element not discussed last time. It may surprise some to learn that this other element differs depending on the context. The result is two separate and distinct super-priority rules.
One of the rules is found in subsection (a) of 9-330 and applies to an interest in chattel paper claimed merely as proceeds of inventory. The other rule is found in subsection (b) of 9-330 and applies when the interest is claimed other than merely as proceeds of inventory. For ease of reference, this article will refer to the former as a proceeds interest and the latter as a non-proceeds interest.
A possessor claiming priority under the super-priority rule with respect to a proceeds interest will satisfy this component of the rule only if the chattel paper does not indicate that it has been assigned to an identified assignee other than the purchaser. In contrast, a possessor claiming priority under the super-priority rule with respect to a non-proceeds interest will satisfy this component of the rule only if it acquires its interest without knowledge that the purchase violates the rights of the secured party.
In other words, if the transaction involves a proceeds interest, the key inquiry to this component of the test is whether or not the chattel paper itself has been stamped or otherwise marked to show that it has been assigned to a different assignee. If the transaction involves a non-proceeds interest, the inquiry is much broader and focuses on the possessor’s knowledge.
The Proceeds Rule (Stamping)
The UCC makes clear that the special rule applicable to a proceeds interest is intended to be consistent with standard industry practice, noting:
[This Rule] eliminate[s] reference to what the purchaser knows. Instead, a purchaser who meets the possession or control, ordinary course and new value requirements takes priority over a competing security interest unless the chattel paper itself indicates that it has been assigned to an identified assignee other than the purchaser…This approach, under which the chattel paper purchaser who gives new value in ordinary course can rely on possession of unlegended, tangible chattel paper without any concern for other facts that it may know, comports with the expectations of both inventory and chattel paper financers.1
This rule provides a clear, bright line. The chattel paper in question is either stamped/legended or it isn’t.
The Non-Proceeds Rule (Knowledge)
In contrast, a possessor claiming a non-proceeds interest could lose even if the chattel paper were not stamped if there were other evidence that the possessor knew that the assignment violated the filer’s rights. For purposes of this rule, “knowledge” means actual knowledge.2 This standard is particularly important given that the good faith requirement does not require a search. The official comments to Article 9 provide:
A purchaser of chattel paper under this section is not required as a matter of good faith to make a search in order to determine the existence of prior security interests. There may be circumstances where the purchaser undertakes a search nevertheless, either on its own volition or because other considerations make it advisable to do so…Without more, a purchaser of chattel paper who has seen a financing statement covering the chattel paper or who knows that the chattel paper is encumbered with a security interest, does not have knowledge that its purchase violates the secured party’s rights.3
However, if there is a stamp/legend that the chattel paper has been assigned to an identified secured party, that automatically results in knowledge that the purchase violates that secured party’s rights.4
What Is a Proceeds Interest?
At first glance, the phrase “merely as proceeds of inventory” would appear to refer to whether the possessor obtained a direct grant of a security interest in the chattel paper as original collateral. However, the Permanent Editorial Board (PEB) for the Uniform Commercial Code provides more insight. The board, composed of members from the American Law Institute and the Uniform Law Commission, prepares commentaries to help interpret the UCC and identify areas that need improvement.
According to PEB Commentary No. 8, an understanding of the types of financings commonly involving claims in chattel paper is needed in order to understand the distinction between a proceeds interest and a non-proceeds interest. The applicable PEB Commentary describes two types of financings, which it labels as Type A and Type B.
Type A: Proceeds Interest
Typically used for financing automobiles and large items of equipment, this type of inventory financing primarily focuses on discrete items. Each such item will secure a precise amount loaned against it, even though cross-collateralization may be present. In this type of financing, there will be a due-on-sale clause or other similar requirement that the associated inventory debt be paid off when the specific item is sold or after a maximum period (usually 90 days subject to renewal), whichever occurs first.
Type B: Non-Proceeds Interest
Used in situations involving smaller items of inventory which would be too burdensome to account for on an individual basis, this type of inventory financing is primarily accomplished pursuant to a general floating loan structure. Here, the advances are secured by inventory and receivables, sometimes called an availability loan under which the debtor is entitled to borrow from the secured party such amounts as the debtor may desire, subject to a maximum availability determined by a formula.
According to the Permanent Editorial Board, Type A financings result in chattel paper being claimed “merely as proceeds of inventory” unless the inventory financer takes the chattel paper out of the “mere proceeds” category by giving value against it in a new transaction, like discounting the specific chattel paper. The result is the same even if the security agreement and filing specifically claims chattel paper as original collateral rather than proceeds of inventory as defined under the UCC.
As the commentary states:
[If] the Type A inventory financer does not by some new transaction give value against specific chattel paper, the fact that the inventory debt is unpaid and that the security agreement specifically claims the chattel paper proceeds as additional collateral does not give the financer more than a mere proceeds interest. The courts have not always carefully reported the facts, but it is clear that in at least one of the cases, the security agreement did specifically claim an interest in chattel paper and the court did not treat that fact as significant.
Standard Equipment Leasing and Finance Transactions
Although the PEB Commentary discusses industry standards, these rules are primarily focused on inventory finance rather than the type of chattel paper transactions more common in the equipment leasing and finance industry.
A typical purchase of chattel paper from an originator does not fit into the Type A or Type B categories described above. However, it seems very clear that this type of transaction is not a Type A. Indeed, the purchasers/assignees are not focusing their interest on the leased or financed equipment and taking the chattel paper as only an ancillary right. Rather, the focus is squarely on the chattel paper itself. The purchaser/assignee gives value specifically for the chattel paper.
The result is, the possessor has a non-proceeds interest and must not have actual knowledge that the assignment violates the rights of the filer. If the chattel paper has been stamped to indicate the rights of the third party, the possessor is deemed to have such knowledge as a matter of law. Although it has no duty to search the UCC records, such a search may give rise to a claim that it had knowledge of the filer’s interest. Of course, other evidence can also be introduced under a facts and circumstances inquiry.
When a lessor/lender takes an interest in subleases/leases generated by its customer with respect to the rights in chattel paper generated by the leased or financed equipment, the other of the two rules should generally be applicable. In the vast majority of these transactions, the original lessee/borrower is the key credit, and the leased or financed equipment is the key collateral. In this respect, the transaction is much more like the Type A discussed above than the general floating loan structure of a Type B, where there is a borrowing base focusing on the value of the equipment and certain receivables generated by its lease or sublease.
The result is, the possessor’s knowledge is not relevant. The only inquiry is whether the chattel paper indicates that it has been assigned to an identified assignee other than the purchaser. As discussed in the last edition of Dispatches, remember to watch the new value issue carefully in this context. In particular, having a purchase money security interest is particularly helpful in this area.
The lesson is to proceed carefully when relying on the super-priority rule…errr, rules…afforded to a possessor of chattel paper. These rules can be complex, and deep exploration may yield both beautiful and scary results.