Secured Transactions, 2016

Table of contents :
1. Creation of an Article 9 Security Interest (Robert W. Glantz, Robert M. Fishman, David R. Doyle)
2. Perfecting Article 9 Security Interests Under Illinois Law (Jason M. Torf)
3. Priorities Among Article 9 Security Interests and Competing Rights (Richard J. Mason, Paul J. Catanese, Stephanie C. Gratton)
4. Rights and Remedies upon Default (Jeffrey E. Altshul)
5. Special Types of Collateral (Stephen A. Tagge, Gregory E. Moredock)
6. Equipment Leasing (Cynde H. Munzer, Howard J. Swibel)
7. Agricultural Financing in Illinois Under Article 9 (Timothy J. Howard, Thomas E. Howard)
8. Treatment of Secured Interests in Bankruptcy (Robert M. Fishman, Brian L. Shaw, Mark L. Radtke)
9. Subordination and Intercreditor Agreements (Frederick C. Fisher, Sean T. Scott)
10. Letters of Credit (Robert N. Sodikoff)
11. Avoidance of Security Interests as Fraudulent Transfers (Richard J. Mason, John F. Pollick)
12. Guaranties (Michael L. Weissman)
13. Lender Liability and Equitable Subordination (Robert W. Glantz, David R. Doyle)

Citation preview

SECURED TRANSACTIONS (IICLE®, 2016) This 2016 handbook replaces all previous editions and updates of this title. IICLE® thanks Robert M. Fishman, Richard J. Mason, and Jeffrey E. Altshul for their continued service as General Editors of this new edition. IICLE® also acknowledges with appreciation all those authors who contributed their time, knowledge, and insights gained from experience to this handbook. IICLE® is able to serve the bar and public only because of the contributions of its volunteer authors and speakers. Any tax information or written tax advice contained herein (including any forms or attachments) is not intended to be and cannot be used by any taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer. This notice has been affixed pursuant to U.S. Treasury Regulations governing tax practice. We would be interested in your comments on this handbook. Please address any comments to Director of Publishing, IICLE®, 3161 West White Oaks Drive, Suite 300, Springfield, IL 62704; call Amy McFadden at 800-252-8062, ext. 102; or e-mail comments to [email protected]. Call IICLE® Customer Representatives at 800-2528062 for information regarding other available and upcoming publications and courses.

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HOW TO CITE THIS BOOK This handbook may be cited as SECURED TRANSACTIONS (IICLE®, 2016).

Publication Date: March 31, 2016

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NOTICE RE: ACCESSING EDITABLE FORMS FILES FOR THIS PUBLICATION Thank you for purchasing SECURED TRANSACTIONS (IICLE®, 2016). In response to customer demand and technological advances, we are now offering a web link to deliver editable forms files that accompany IICLE® publications in lieu of a Forms CD. PLEASE NOTE: IICLE® FORMS ARE NOT INTENDED TO TAKE THE PLACE OF PROFESSIONAL JUDGMENT AS TO THE LEGAL SUFFICIENCY AND LEGAL ACCURACY OF ANY MATERIAL CONTAINED IN THE FORM. ALWAYS PERFORM INDEPENDENT RESEARCH TO VERIFY THE APPLICABILITY OF ANY FORM TO THE SPECIFIC FACTS AND CIRCUMSTANCES OF YOUR MATTER BEFORE USING AN IICLE® FORM. To access the Rich Text Format files for this book, please follow the instructions below: 1. Type this exact URL into the address bar of your Internet browser (e.g., Google Chrome, Internet Explorer, Firefox):

http://www.iicle.com/download/forms/sectrans16.zip *Please note that the “.zip” extension must be included in the URL for the download to work. Without it, you will receive an error message. 2. Once you have entered the link, a download notification will appear in your browser (the location of which varies depending on your browser of choice) and may prompt you to decide what to do with the file. In that event, please choose the “Save” or “Save As” option, give the file a name, and save it to your directory of choice. 3. Clicking on the zip file itself will automatically open a window displaying the files in your computer directory. The file name of the form corresponds to the section in the handbook where the form is found. Simply double-click the subfolder of the chapter of, then the particular file for, the form you are looking for. Once you click on the form file name, it will automatically open in your word processing program, where you may then edit the form to your specifications. Alternatively, you can access the forms by clicking on the “Start” button on your desktop. Choose the “Documents” option, and a window will open. Select the “Downloads” folder option on the left of the window. Within the “Downloads” folder, you will see the forms files and may select the particular file you wish to open by clicking on it. If you are unable to access the forms files using these instructions, please contact IICLE® for technical support, at 800-252-8062 between 8:30 a.m. and 4:30 p.m. CST.

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SECURED TRANSACTIONS 2016 Robert M. Fishman Richard J. Mason Jeffrey E. Altshul General Editors Chapter authors: Jeffrey E. Altshul Paul J. Catanese David R. Doyle Frederick C. Fisher Robert M. Fishman Robert W. Glantz Stephanie C. Gratton Thomas E. Howard Timothy J. Howard Richard J. Mason

Gregory E. Moredock Cynde H. Munzer John F. Pollick Mark L. Radtke Sean T. Scott Brian L. Shaw Robert N. Sodikoff Howard J. Swibel Stephen A. Tagge Jason M. Torf Michael L. Weissman

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This 2016 edition replaces the 2013 edition and all prior editions and updates of the same title. ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION 3161 West White Oaks Drive, Suite 300 Springfield, IL 62704 Owner: _______________________________________________________________

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Copyright 2016 by IICLE . All rights reserved. Except in the course of the professional practice of the purchaser, no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. ® IICLE encourages the adaptation and use of forms, checklists, and other similar documents printed in its publications in the professional practice of its customers.

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IICLE is a not-for-profit 501(c)(3) organization dedicated to supporting the professional development of Illinois attorneys through Illinois-focused practice guidance. ®

IICLE ’s publications and programs are intended to provide current and accurate information about the subject matter covered and are designed to help attorneys maintain their professional competence. ® Publications are distributed and oral programs presented with the understanding that neither IICLE nor the ® authors render any legal, accounting, or other professional service. Attorneys using IICLE publications or orally conveyed information in dealing with a specific client’s or their own legal matters should also research original and fully current sources of authority.

Printed in the United States of America. 16SECTRANS-R:3-16(486)CC PRD: 3-31-16 (1:CBP)

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TABLE OF CONTENTS

Table of Contents About the Authors ................................................................................................................ix 1. Creation of an Article 9 Security Interest ................................................................... 1 — 1 Robert W. Glantz Robert M. Fishman David R. Doyle 2. Perfecting Article 9 Security Interests Under Illinois Law ........................................ 2 — 1 Jason M. Torf 3. Priorities Among Article 9 Security Interests and Competing Rights ...................... 3 — 1 Richard J. Mason Paul J. Catanese Stephanie C. Gratton 4. Rights and Remedies upon Default .............................................................................. 4 — 1 Jeffrey E. Altshul 5. Special Types of Collateral............................................................................................ 5 — 1 Stephen A. Tagge Gregory E. Moredock 6. Equipment Leasing ........................................................................................................ 6 — 1 Cynde H. Munzer Howard J. Swibel 7. Agricultural Financing in Illinois Under Article 9 ..................................................... 7 — 1 Timothy J. Howard Thomas E. Howard 8. Treatment of Secured Interests in Bankruptcy........................................................... 8 — 1 Robert M. Fishman Brian L. Shaw Mark L. Radtke 9. Subordination and Intercreditor Agreements............................................................. 9 — 1 Frederick C. Fisher Sean T. Scott 10. Letters of Credit........................................................................................................... 10 — 1 Robert N. Sodikoff

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11. Avoidance of Security Interests as Fraudulent Transfers........................................ 11 — 1 Richard J. Mason John F. Pollick 12. Guaranties .................................................................................................................... 12 — 1 Michael L. Weissman 13. Lender Liability and Equitable Subordination......................................................... 13 — 1 Robert W. Glantz David R. Doyle Index ............................................................................................................................... a — 1

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ABOUT THE AUTHORS

About the Authors General Editors Robert M. Fishman is a Member of Shaw Fishman Glantz & Towbin LLC in Chicago, where he concentrates his practice in the areas of business bankruptcy and insolvency. Mr. Fishman has been an author and lecturer on a variety of business bankruptcy topics for numerous organizations, including the American Bankruptcy Institute, the American Institute of Certified Public Accountants, and the National Conference of Bankruptcy Judges. He is listed in the Guide to the World’s Leading Insolvency Lawyers, the Guide to Leading U.S. Insolvency Lawyers, and the Best Lawyers in America. He has also been selected as one of Illinois’ leading business bankruptcy attorneys by Leading Lawyers and Super Lawyers. Mr. Fishman is a member of the American Bankruptcy Institute (and former President and Chair of the Board and member of the Executive and Management Committees) and of the American Bar Association. A Fellow of the American College of Bankruptcy, Mr. Fishman received his B.A. from the University of Illinois and his J.D. from George Washington University Law School. Richard J. Mason is an Equity Partner at McGuireWoods LLP in Chicago, concentrating his practice in business insolvency and other business matters. He has written numerous articles for continuing legal education programs and law journals and has spoken at programs sponsored by, among others, the International Bar Association, the American Bankruptcy Institute, and the American Bar Association. Mr. Mason is former Chair of the American Bar Association Business Bankruptcy Committee on Use and Disposition of Property and is a longtime Fellow of the College of American Bankruptcy and the International Insolvency Institute, both invitation-only organizations. He is a member of the Illinois State and Chicago Bar Associations, the Commercial Law League of America, and the American Bankruptcy Institute. Mr. Mason received his B.A. with honors from the University of Illinois, his M.B.A. from the University of Chicago, and his J.D. from the University of Notre Dame Law School. Jeffrey E. Altshul practices at Carlson Dash, LLC, in Chicago, where he focuses on commercial finance, transactions, workouts, and bankruptcy. He is a member of the American Bankruptcy Institute, American Bar Association, and Wisconsin State Bar Association. Mr. Altshul received his undergraduate degree with honors from the University of Wisconsin-Milwaukee and his J.D. from Drake University Law School. Chapter Authors Paul J. Catanese is an associate at McGuireWoods LLP in Chicago, where he focuses his practice on restructuring and insolvency, commercial litigation, and financial services litigation. Following law school, he served as a law clerk for the Honorable Stephen C. St. John, U.S. Bankruptcy Judge for the Eastern District of Virginia. He is a member of the Chicago and Illinois State Bar Associations. Mr. Catanese received his B.A. from Boston College and his J.D. cum laude from the University of Richmond School of Law, where he was Lead Articles Editor of the University of Richmond Law Review.

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David R. Doyle is an associate at Shaw Fishman Glantz & Towbin LLC in Chicago, where he works with companies that are financially distressed or involved in financial or bankruptcy litigation. He represents both debtors and creditors. After law school, he completed a term clerkship for the Honorable Carol A. Doyle (no relation) during her tenure as Chief Judge for the U.S. Bankruptcy Court for the Northern District of Illinois. He is a member of the Chicago Bar Association, the Turnaround Management Association, and the American Bankruptcy Institute. Mr. Doyle received his B.A. from the University of Illinois and his J.D. cum laude at IIT Chicago-Kent College of Law. Frederick C. Fisher is a Partner at Mayer Brown LLP in Chicago, where he is a member of the Banking and Finance Practice, focusing on banking and finance, corporate and securities, and mergers and acquisitions. He was listed as an Emerging Lawyer by Leading Lawyers in 2015 and an Illinois Super Lawyer Rising Star in 2012 – 2015 and is a member of the Chicago Bar Association. Mr. Fisher received his B.S. from Miami University and his J.D. from Northwestern University School of Law. Robert W. Glantz is a Founding Member of Shaw Fishman Glantz & Towbin LLC in Chicago, where he concentrates his practice in all aspects of creditors’ rights, bankruptcy, and financing matters. A Certified Public Accountant, Mr. Glantz has been an adjunct professor of law at IIT Chicago-Kent College of Law and is a frequent lecturer for the National Business Institute and IICLE®. He has been listed as an Illinois Super Lawyer since 2007 and an Illinois Leading Lawyer since 2009. He is a member of the American Bankruptcy Institute, the American Bar Association, and the Turnaround Management Association. Mr. Glantz received his B.S. from the University of Illinois and his J.D. from the University of Illinois College of Law. Stephanie C. Gratton is an associate at McGuireWoods LLP in Chicago, where she handles restructuring and insolvency matters on behalf of creditors and lenders. Ms. Gratton received her B.A. with high honors from the University of Iowa and her J.D. from the University of Chicago Law School, during which time she interned for Prairie State Legal Services and for the Department of Homeland Security’s Transportation Security Administration. Thomas E. Howard is an associate at Howard & Howard Attorneys PLLC in Peoria, where he concentrates his practice in creditors’ rights, bankruptcy, and commercial litigation. He has been named both an Illinois Super Lawyer Rising Star and an Illinois Leading Lawyers Emerging Lawyer in 2015 and 2016. He is a member of the American, Illinois State (Standing Committee on Mental Health Law), and Peoria County Bar Associations. Mr. Howard received his B.A. from Illinois Wesleyan University and his J.D. from Marquette University Law School. Timothy J. Howard is a Member of Howard & Howard Attorneys PLLC in Peoria, where he concentrates his practice in business and commercial litigation, bankruptcy, real estate, and trust litigation. He has been named an Illinois Super Lawyer in 2007 – 2016 and an Illinois Leading Lawyer in 2003 – 2016. He is admitted to both the Illinois and Michigan Bars. He is a member of the Illinois State (Senior Lawyer Section Council Secretary 2015 – 2016) and Peoria County Bar Associations (President 2015 – 2016); a Fellow of the

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ABOUT THE AUTHORS

American Bar Foundation; and a member of the American Bar Association, the American Agricultural Law Association, and the American Bankruptcy Institute. Mr. Howard received his A.B. from Princeton University and his J.D. from the University of Notre Dame Law School. Gregory E. Moredock is an associate at Sorling Northrup in Springfield, where he concentrates his practice in family law and commercial litigation. He also practices in the fields of business advising and commercial transactions. Mr. Moredock received his B.S. cum laude from the University of Dayton as a John W. Berry Sr. Scholar and his J.D. magna cum laude from the University of Cincinnati College of Law, where he worked as a Fellow with the Ohio Innocence Project, was Senior Articles Editor of the Human Rights Quarterly, and served as an extern for the Honorable Judge Sandra Beckwith of the United States District Court for the Southern District of Ohio. Cynde H. Munzer is a Member of Aronberg Goldgehn Davis & Garmisa in Chicago, where she practices in the Banking and Finance and Business Law and Transactions areas, representing clients in business and transactional matters. She has been recognized as an Illinois Leading Lawyer in Closely & Privately Held Business Law by Leading Lawyers magazine since 2014 and was the recipient of the Anti-Defamation League’s Women of Achievement Award in 2003. She is a member of Vision 2020 (Illinois delegate), the Chicago Chapter of the American Technion Society, and the Chicago Chapter of the National Association of Women Business Owners. Ms. Munzer received her B.S. from the University of Illinois and her J.D. with high honors from IIT Chicago-Kent College of Law. John F. Pollick is a Member of Pollick & Schmahl, LLC, in Glenview, concentrating in corporate bankruptcy. He has spoken at programs on commercial lending and bankruptcy and has been an adjunct professor of bankruptcy law at IIT Chicago-Kent College of Law. Mr. Pollick received his B.A. from Yale University and his J.D. from the University of Michigan Law School. Mark L. Radtke is a Member of Shaw Fishman Glantz & Towbin LLC in Chicago, where he concentrates his practice in corporate reorganization, creditors’ rights, bankruptcy, and commercial litigation. He has spoken and written for numerous organizations, including IICLE® and the American Bankruptcy. He is a member of the American Bankruptcy Institute, currently serving on two advisory boards and recently completing a two-year term as the Cochair of the Young and New Members Committee. Mr. Radtke received his B.B.A. from the University of Iowa and his J.D. with high honors from IIT Chicago-Kent College of Law, where he was a member of the Order of the Coif and was the Executive Articles Editor of the Chicago-Kent Law Review. Sean T. Scott is a Partner at Mayer Brown LLP in Chicago, where he focuses his practice on energy restructuring; Latin America debt restructuring; banking and finance litigation; distressed real estate; and restructuring, bankruptcy, and insolvency. In 2008, he was named by Institutional Investor News as one of its ten “Rising Stars of Bankruptcy/Restructuring Law and Workouts.” More recently, he was recognized by Law 360, a leading newswire for

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business lawyers, as one of its “10 bankruptcy lawyers under 40 to watch” among all practitioners nationwide. Mr. Scott received his B.A. with honors, Phi Beta Kappa, from Washington University and his J.D. magna cum laude from the University of Notre Dame Law School, where he was Articles Editor of the Notre Dame Law Review. Brian L. Shaw is a Member of Shaw Fishman Glantz & Towbin LLC in Chicago, where he practices in all aspects of bankruptcy practice, regularly representing both debtors and creditors in a variety of reorganization and liquidation proceedings as well as in attendant litigation. He has authored and coauthored numerous articles in publications such as the American Bankruptcy Institute Journal, the Norton Bankruptcy Law Letter, and The Bankruptcy Strategist and previously served as a Contributing Editor of the American Bankruptcy Institute Journal. He has spoken on a variety of bankruptcy-related topics at regional and national conferences. Previously, he served as the President and the Vice President of Membership of the American Bankruptcy Institute as well as the Cochair of both the American Bankruptcy Institute’s Chicago Conference and its Inaugural Professional Development Program. He is also a Past Chair of the Chicago Bar Association’s Bankruptcy and Reorganization Section and served a three-year term on the University of Illinois College of Law Recent Alumni Advisory Board. Mr. Shaw received his B.A. cum laude from Tufts Unviersity and his J.D. magna cum laude from the University of Illinois College of Law. Robert N. Sodikoff is a Member of the Chicago firm Aronberg Goldgehn Davis & Garmisa, where he is Cochair of the Real Estate Group, focusing his practice on corporate and real estate law matters. He has taught courses on the Uniform Commercial Code and the introduction to law. He has been recognized as an Illinois Leading Lawyer in Banking and Financial Institutions Law since 2004 and has been named an Illinois Super Lawyer in Real Estate and Closely Held Business Law since 2006. He is a member of the American Bar Association and of the Real Estate Law Section of both the Illinois State and Chicago Bar Associations. Mr. Sodikoff received his B.A. with honors from the University of Illinois and his J.D. cum laude from Northwestern University School of Law. Howard J. Swibel is a Partner at Arnstein & Lehr LLP in Chicago, where he has developed substantial expertise in both the corporate transactional and litigation areas over a legal career spanning more than 30 years. He has spoken on a broad range of topics related to the corporate and litigation areas, including for the American and Chicago Bar Associations. He is active in a wide range of professional and civic activities. He has served for many years as an Illinois Commissioner to the National Conference of Commissioners on Uniform State Laws and as a trustee of the Uniform Law Foundation. In 2007, he completed his service as president of the National Conference of Commissioners on Uniform State Laws. He has served as an arbitrator for the National Association of Securities Dealers, hearing complex claims. He also serves as Chair of the Executive Committee of the Illinois Holocaust Museum and Education Center. Mr. Swibel received both his A.B. and his J.D. cum laude from Harvard University.

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ABOUT THE AUTHORS

Stephen A. Tagge is an attorney at Sorling Northrup in Springfield, where he concentrates his practice in transactions, banking, and bankruptcy (creditor). He has participated as a lecturer and author in continuing legal education courses in banking, secured transactions, mortgage foreclosure, creditors’ rights, and environmental duties of buyers and sellers of real estate for numerous organizations. He received his B.A. from Knox College and his J.D. from the University of Chicago Law School. Jason M. Torf is a Partner in Horwood Marcus & Berk Chartered, where he concentrates his practice in bankruptcy and creditors’ rights in the firm’s Litigation Group. He has authored materials and has been a speaker for numerous organizations, including IICLE® and the American Bar Association. He is a member of the American Bar Association Section of Business Law, Committee on Business Bankruptcy; the Chicago Bar Association; and the American Bankruptcy Institute. Mr. Torf received both his B.S. and his J.D. from the University of Illinois. Michael L. Weissman is Of Counsel to Levin Ginsburg in Chicago. He formerly served as executive vice president and general counsel of Bridgeview Bank Group. His practice is devoted to financial and business transactions, including the structuring of a wide variety of financing transactions. Mr. Weissman has also actively prosecuted civil and bankruptcy matters on behalf of financial institutions and defended them in lender liability lawsuits. He has a wealth of experience in the legal and business aspects of secured and unsecured lending for all types of credit facilities. He has represented most of the major banks and commercial lenders in the Chicago area. He has also frequently published articles in journals devoted to banking and commercial finance and has lectured for such diverse groups as the American Bar Association, the Association of Commercial Finance Attorneys, the Risk Management Association, the Commercial Finance Association, the Illinois Bankers Association, the Federal Reserve Bank of Chicago, the Illinois CPA Society, the Chicago-Midwest Credit Service Corporation, the Mississippi Law Institute, the Wyoming Bankers Association, the Chicago Association of Commerce and Industry, the Midwest Finance Conference, the Illinois Credit Union League, and IICLE®. Mr. Weissman has been a panelist for many seminars sponsored by the Lender’s Forum, the Banking Law Institute, the Bank Lending Institute, State of the Art Seminars, Infocast, Inc., the Lenders Educational Institute, the Bank Administration Institute, and Clarion Legal. He has been a member of the Committee on Commercial Financial Services of the ABA Section on Business Law and is a former Director of the Association of Commercial Finance Attorneys; a former Vice Chair of the Bank Counsel Committee of the Illinois Bankers Association; a Director, member of the Executive Committee, and Chair (2001 – 2002) of IICLE®; and former Chair of the Banking Group at the Union League Club of Chicago. He serves on ISBA’s Section Council on Commercial Banking, Collections, and he is the author of COMMERCIAL AND INDUSTRIAL LOAN DOCUMENTATION (IICLE® 2012). He is also the author of LENDER LIABILITY: HOW TO PROTECT YOURSELF AGAINST UNWARRANTED LAWSUITS and a contributor to THE BANKER’S GUIDE TO MULTI-BANK CREDITS AND LOAN PARTICIPATIONS, both published by Executive Enterprise Publications Co. and COMMERCIAL AND INDUSTRIAL LOAN DOCUMENTATION, published by IICLE®. He authors a column titled “The Legal Corner” for The RMA Journal. He is a member of the Editorial Board of a multi-chapter treatise on commercial damages and writes

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a monthly column on recent developments of interest to financial services attorneys with more than 1,200 subscribers for IICLE®’s FlashPoints at www.iicle.com. Mr. Weissman received his J.D. from Harvard Law School, was a Fulbright Scholar at the University of Sydney (Australia) Faculty of Law, received his M.B.A. from the Wharton Graduate Division of the University of Pennsylvania, and received his B.S. in Economics from Northwestern University. He is on the Roster of Fulbright Senior Specialists maintained by the Council for the International Exchange of Scholars. He was a Fulbright Senior Specialist at the School of Business Administration, Turiba, in Riga, Latvia, in 2006; a Fulbright Senior Specialist at the National University in Vientiane, Laos, in 2008; and an instructor in the American Bar Association’s International Senior Lawyers Project in Capetown, South Africa, in 2009, and taught for the African Centre for Legal Excellence in Zanzibar, Tanzania, and in Kampala, Uganda.

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BOARD OF DIRECTORS

IICLE® Board of Directors Chair Thomas A. Lilien, Office of the State Appellate Defender, Elgin* Vice Chair Robert Z. Slaughter, Avison Young, Chicago* Secretary Ben Neiburger, Generation Law, Ltd., Elmhurst* Treasurer Paul E. Bateman, Littler Mendelson P.C., Chicago* Immediate Past Chair William J. Anaya, Greensfelder, Hemker & Gale, P.C., Chicago* Mark Brittingham, SIU School of Law, Carbondale Bradley L. Cohn, Pattishall, McAuliffe, Newbury, Hilliard & Geraldson LLP, Chicago Jane N. Denes, Posegate & Denes, P.C., Springfield* LaVon M. Johns, Goldstein & McClintock LLLP, Chicago Michele M. Jochner, Schiller DuCanto & Fleck LLP, Chicago James M. Lestikow, Hinshaw & Culbertson LLP, Springfield Hal R. Morris, Arnstein & Lehr, LLP, Chicago Katherine Opel, Weinheimer Law Firm, PC, Edwardsville Stacy E. Singer, Northern Trust, Chicago Janine L. Spears, DePaul University, Chicago Hon. Ronald D. Spears, Taylorville Kathy H. Xie, Attorneys’ Title Guaranty Fund, Inc., Chicago *Executive Committee Members

IICLE® Board of Directors Past Chairs H. Ogden Brainard (1962 – 1969) John S. Pennell (1969 – 1971) William K. Stevens (1971 – 1972) J. Gordon Henry (1972 – 1973) Roger J. Fruin (1973 – 1974) Joseph J. Strasburger (1974 – 1975) William J. Voelker (1975 – 1976) Harold W. Sullivan (1976 – 1977) John J. Vassen (1977 – 1978) James M. (Mack) Trapp (1978 – 1979) Theodore A. Pasquesi (1979 – 1980) George W. Overton (1980 – 1981) Peter H. Lousberg (1981 – 1982) Kenneth C. Prince (1982 – 1983) Edward J. Kionka (1983 – 1984) Joseph L. Stone (1984 – 1985) Thomas S. Johnson (1985 – 1986) Richard William Austin (1986 – 1987) J. William Elwin, Jr. (1987 – 1988) Donald E. Weihl (1988 – 1989) Tomas M. Russell (1989 – 1990) John K. Notz, Jr. (1990 – 1991) Michael J. Rooney (1991 – 1992)

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Willis R. Tribler (1992 – 1993) Thomas Y. Mandler (1993 – 1994) Ralph T. Turner (1994 – 1995) Robert E. Bouma (1995 – 1996) Patrick B. Mathis (1996 – 1997) Michael H. Postilion (1997 – 1998) Robert V. Dewey, Jr. (1998 – 1999) Roma Jones Stewart (1999 – 2000) Hon. John A. Gorman (2000 – 2001) Michael L. Weissman (2001 – 2002) George W. Howard III (2002 – 2003) Robert E. Hamilton (2003 – 2004) Patricia A. Hoke (2004 – 2005) Thomas M. Hamilton, Jr. (2005 – 2006) Hon. Dale A. Cini (2006 – 2007) Susan T. Bart (2007 – 2008) Adrianne C. Mazura (2008 – 2009) George F. Mahoney, III (2009 – 2010) Robert G. Markoff (2010 – 2011) Hon. Leonard Murray (2011 – 2012) Donald P. Seberger (2012 – 2013) Lorraine K. Cavataio (2013 – 2014) William J. Anaya (2014 – 2015)

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SECURED TRANSACTIONS

IICLE® Staff Michael J. Rooney, Executive Director Amy L. McFadden, Director of Publications Megan K. Moore, Director of Programs

Publications Manny Banks, Publications Administrative Assistant Carole Chew, Executive Managing Editor Matthew Lund, Editor Angela Moody, Managing Editor Darryl Parr, Editor-in-Chief Sarah Payne, Subscriptions Coordinator Laura Reyman, Managing Editor Kim Rouland, Publications Compositor Courtney Smith, Managing Editor Megan Smith, Publications Marketing Associate Joy Wolfe, Managing Editor

Programs Konner Dudley, Programs Marketing Associate Stephanie Laffey, Online Project Coordinator Alonnah Madson, Programs Associate Christopher Noel, Volunteer Coordinator Tessa White, Programs and Partnership Development

Administrative Services Sarah Lawson, Assistant to Executive Director Business Office Dawn Bruce, Accounts Payable Jeff Kurmann, Human Resources/Accounting Associate Customer Support Diana Celano, Representative Information Technology Chris Hull, Information Technology Manager Dane Vincent, Information Technology Specialist

Readers may contact staff members via e-mail at [email protected] or [first initial][last name]@iicle.com (e.g., [email protected])

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SECURED TRANSACTIONS 2016 Edition Chapter 6: Equipment Leasing 6.65

Equipment Lease

Chapter 7: Agricultural Financing in Illinois Under Article 9 7.20 7.21

Agricultural Security Agreement Notice to Buyers of Farm Products

Chapter 9: Subordination and Intercreditor Agreements 9.12 9.13 9.14 9.17A 9.17B 9.34 9.36 9.37 9.38 9.40

Sample Provision: Bankruptcy Subordination Sample Provision: Default Subordination Sample Provision: Standstill Subordination Definitions of “Senior Indebtedness” and “Subordinated Debt” — Senior Lender’s Perspective Definition of “Senior Indebtedness” Additional Provision — Junior Creditor’s Perspective Sample Provision: Right To Purchase — Junior Creditor Sample Provision: Use of Cash Collateral Sample Provision: Disposition of Collateral Sample Provision: Adequate Protection Sample Provision: Contesting Liens of Other Creditors

Chapter 10: Letters of Credit 10.47

Sample Standby Letter of Credit

Chapter 12: Guaranties 12.5 12.11 12.20 12.22 12.25 12.27 12.28A 12.28B 12.29 12.39 12.45 12.46

Sample Language: Springing or Carveout Guaranty Sample Form: Guaranty Sample Language: Advising Guarantor of the Nature of the Risk Sample Language: Change of Terms Sample Language: Release of Coguarantor Sample Form: Reaffirmation of Guaranty Letter Sample Language: Waiver of Bank’s Duty To Pursue the Borrower Sample Language: Express Waiver of Sureties Act §1 Sample Language: Revocation by the Guarantor Sample Language: Successive Guaranties Sample Language: “Clawback” Clause Sample Form: Put (Alternative to a Guaranty)

Chapter 13: Lender Liability and Equitable Subordination 13.33

Jury Trial Waiver

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Creation of an Article 9 Security Interest

ROBERT W. GLANTZ ROBERT M. FISHMAN DAVID R. DOYLE Shaw Fishman Glantz & Towbin LLC Chicago

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©COPYRIGHT 2016 BY IICLE .

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I. [1.1] Introduction II. [1.2] History of Article 9 III. [1.3] Overview and Basic Terminology IV. Application of Article 9 A. [1.4] Transactions Included Under Article 9 B. [1.5] Transactions Excluded Under Article 9 V. Classification of Collateral A. B. C. D. E. F. G. H. I. J. K. L. M. N. O.

[1.6] [1.7] [1.8] [1.9] [1.10] [1.11] [1.12] [1.13] [1.14] [1.15] [1.16] [1.17] [1.18] [1.19] [1.20]

In General Goods, Equipment, and Inventory Accounts Instruments Promissory Notes Chattel Paper Letter-of-Credit Rights Supporting Obligations Healthcare Insurance Receivables General Intangibles Payment Intangibles Software Deposit Accounts Investment Property Commercial Tort Claims

VI. Security Interests A. [1.21] In General B. [1.22] “Security Interest” Defined C. [1.23] Attachment and Enforceability of Security Interests 1. [1.24] Debtor Must Have Obtained Rights or Power To Transfer Rights in Collateral 2. [1.25] Creditor Must Give Value 3. [1.26] Valid Authenticated Security Agreement or Possession or Control of Collateral 4. [1.27] Timing of Attachment D. [1.28] Attachment vs. Perfection

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CREATION OF AN ARTICLE 9 SECURITY INTEREST

VII. [1.29] Secured Creditor’s Rights in Proceeds of Collateral VIII. [1.30] After-Acquired Property and Future Advances IX. [1.31] Purchase-Money Security Interests X. Required Elements of Written Agreement A. B. C. D. E.

[1.32] [1.33] [1.34] [1.35] [1.36]

Requirement of a Written Agreement Necessity of a Writing Description of Collateral Description of Land in Certain Cases Description of Underlying Debt

XI. [1.37] Disposition of Collateral

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I. [1.1] INTRODUCTION The making of a loan or the extension of credit in exchange for the granting of a security interest in property is one of the fundamental concepts on which many commercial transactions and corresponding legal controversies are built. While the concept is fairly straightforward, the practical considerations underlying the concept can be quite complex and involved. The starting point for the consideration of security interests in personal property (this work does not cover mortgages and real estate interests) is the Uniform Commercial Code (UCC), 810 ILCS 5/1-101, et seq. The UCC has been adopted in every state (with limited variations) and generally governs the creation, validity, and enforcement of security interests in the United States. This chapter provides a historical overview of the security interest as it relates to personal property, coupled with a review of the central issues essential to an understanding of the same. The chapter then delves into the specific requirements of a security interest, reviewing certain variables that counsel for both the creditor and the debtor must take into account. Finally, this chapter considers the written document, the security agreement that evidences the understanding reached between the debtor and the creditor. This chapter also serves as a starting point for many of the more intricate secured transaction issues that are dealt with in greater detail in other chapters in this handbook.

II. [1.2] HISTORY OF ARTICLE 9 Prior to the adoption of the Uniform Commercial Code, there existed numerous differing security devices and diverse and sometimes conflicting bodies of law applicable to them. Individual states variously recognized pledges, conditional sales, chattel mortgages, trust receipts, and factors’ liens. A lender operating on a national or even regional basis would have to cope with forms, terminology, rules of possession, and formalities of execution that differed from state to state. Several uniform acts covering specific areas of endeavor had been promulgated, but only a few were widely adopted. In 1938, the Merchants Association of New York City called for a federal law governing interstate sales. In reaction, the National Conference of Commissioners on Uniform State Laws joined with the American Law Institute in 1940 to draft what was to become the UCC. The drafters established a Permanent Editorial Board, whose charter was and is to recommend from time to time changes to the UCC to reflect judicial interpretations and to take into account practical experience under the UCC and the development of new business practices. Some form of the UCC was ultimately adopted in all 50 states, the District of Columbia, and the Virgin Islands. Article 9 of the UCC, 810 ILCS 5/9-101, et seq., which governs the creation of almost all types of security interests in personal property, was revised in 1998 by the National Conference of Commissioners on Uniform State Laws, in conjunction with the American Law Institute. The revised form of Article 9 became effective July 1, 2001, and has since been adopted, with limited amendments, in all 50 states, the District of Columbia, and the Virgin Islands. Further amendments to the UCC were proposed and adopted by the National Conference of Commissioners on Uniform State Laws in 2010 and adopted in Illinois effective July 1, 2013. See P.A. 97-1034.

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The revised Article 9 embodies significant changes in scope, substantive rules, and procedures that were intended to simplify and clarify the rules regarding security interests and make Article 9 easier to use. Although the sections were substantially reorganized and renumbered, the revised Article 9 retained the general approach and much of the terminology of the former Article 9.

III. [1.3] OVERVIEW AND BASIC TERMINOLOGY Except for those matters expressly excluded, Article 9 of the Uniform Commercial Code, 810 ILCS 5/9-101, et seq., applies to the various forms of secured transactions common to the business world. A secured transaction involves any situation in which a creditor, in granting credit, obtains a property right to secure the debt. The creditor’s rights — the security interest — may be in specifically identified personal property, tangible or intangible, or in fixtures. Article 9 is the set of rules governing how those rights are created, extinguished, and reconciled with the competing rights of the debtor, the debtor’s other creditors, and other third parties who may also acquire or claim rights in the same property. There are two key concepts in the creation and operation of an Article 9 security interest: “attachment” and “perfection.” These two terms describe the key events in the creation of a security interest. Attachment occurs when the security interest is effective between the creditor and the debtor, which usually takes place when the agreement between the parties provides that it takes place. Perfection occurs when the creditor establishes its priority in relation to other creditors’ interests in the same collateral. In general, the creditor with priority over all other creditors is entitled to use the collateral to satisfy the debtor’s obligations when the debtor defaults, before other creditors subsequent in priority may do so. It is impossible to deal with Article 9 without mastering the basic and precise terms used in the statute. For example, there is a significant difference between the “attachment” of a security interest and the “perfection” of it. A dozen eggs may be “farm products” while being packed on the farm, “inventory” while sitting on the supermarket shelf, and “consumer goods” after they have made their way to your refrigerator. Section 9-102 sets out certain definitions and provides a cross-reference index to others that may be set out in the text of Article 9 or in other articles of the UCC. 810 ILCS 5/9-102. The fundamental definitions are summarized below for the limited purpose of facilitating the discussion in the balance of this chapter and not as a substitute for the specific and more comprehensive language set forth in the UCC itself, to which the practitioner is referred. Attachment: The situation in which all requirements have been met so that the security interest becomes enforceable against the debtor. 810 ILCS 5/9-203. Collateral: The property subject to a security interest, which may include “(A) proceeds to which a security interest attaches; (B) accounts, chattel paper, payment intangibles, and promissory notes that have been sold; and (C) goods that are the subject of a consignment.” 810 ILCS 5/9-102(a)(12).

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Debtor: “(A) [A] person having an interest, other than a security interest or other lien, in the collateral, whether or not the person is an obligor; (B) a seller of accounts, chattel paper, payment intangibles, or promissory notes; or (C) a consignee.” 810 ILCS 5/9-102(a)(28). Financing statement: “[A] record or records composed of an initial financing statement and any filed record relating to the initial financing statement.” 810 ILCS 5/9-102(a)(39). Perfection: The situation in which all requirements have been met to give a “perfected” security interest priority over an “unperfected” security interest. 810 ILCS 5/9-301 through 5/9-316. Proceeds: The following property: “(A) whatever is acquired upon the sale, lease, license, exchange, or other disposition of collateral; (B) whatever is collected on, or distributed on account of, collateral; (C) rights arising out of collateral; (D) to the extent of the value of collateral, claims arising out of the loss, nonconformity, or interference with the use of, defects or infringement of rights in, or damage to, the collateral; or (E) to the extent of the value of collateral and to the extent payable to the debtor or the secured party, insurance payable by reason of the loss or nonconformity of, defects or infringement of rights in, or damage to, the collateral.” 810 ILCS 5/9-102(a)(64). Secured party: “(A) [A] person in whose favor a security interest is created or provided for under a security agreement, whether or not any obligation to be secured is outstanding; (B) a person that holds an agricultural lien; (C) a consignor; (D) a person to which accounts, chattel paper, payment intangibles, or promissory notes have been sold; (E) a trustee, indenture trustee, agent, collateral agent, or other representative in whose favor a security interest or agricultural lien is created or provided for.” 810 ILCS 5/9-102(a)(73). Security agreement: The written agreement that “creates and provides for a security interest.” 810 ILCS 5/9-102(a)(74). Security interest: The “interest” in the personal property or fixtures that secures payment or performance of an obligation. 810 ILCS 5/1-201(b)(35).

IV. APPLICATION OF ARTICLE 9 A. [1.4] Transactions Included Under Article 9 Section 9-109 of the Uniform Commercial Code, entitled “Scope,” sets forth the broad range of transactions to which Article 9 applies and certain transactions that are specifically excluded. 810 ILCS 5/9-109. It includes any transaction, regardless of form, that creates a security interest in personal property or fixtures by contract, except for such transactions as are specifically excluded by UCC §§9-109(c) and 9-109(d). Without limitation, Article 9 applies to pledges, assignments, chattel mortgages, chattel trusts, trust deeds (non-real estate), factors’ liens, equipment trusts, conditional sales, trust receipts, any other lien or title retention contract, and any lease or consignment intended as security. Article 9 also applies to any sale of accounts, chattel

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paper, payment intangibles, or promissory notes, including the sale of a right in the receivable, such as a sale of a participation interest. Article 9 also applies to all types of consignment, defined by the UCC as a transaction, regardless of its form, in which a person delivers goods to a merchant for the purpose of sale and: (A) the merchant: (i) deals in goods of that kind under a name other than the name of the person making delivery; (ii) is not an auctioneer; and (iii) is not generally known by its creditors to be substantially engaged in selling the goods of others; (B) with respect to each delivery, the aggregate value of the goods is $1,000 or more at the time of delivery; (C) the goods are not consumer goods immediately before delivery; and (D) the transaction does not create a security interest that secures an obligation. 810 ILCS 5/9-102(a)(20). B. [1.5] Transactions Excluded Under Article 9 Sections 9-109(c) and 9-109(d) of the Uniform Commercial Code set forth certain circumstances and specific transactions to which Article 9 does not apply even though they are in the nature of secured transactions. Article 9 does not apply to 1. the extent that a statute, regulation, or treaty of the United States preempts Article 9 (810 ILCS 5/9-109(c)(1)); 2. the extent another statute of this state expressly governs the creation, perfection, priority, or enforcement of a security interest created by this state or a governmental unit of this state (810 ILCS 5/9-109(c)(2)); 3. the extent a statute of another state, a foreign country, or a governmental unit of another state or a foreign country, other than a statute generally applicable to security interests, expressly governs the creation, perfection, priority, or enforcement of a security interest created by the state, country, or governmental unit (810 ILCS 5/9-109(c)(3)); 4. the extent that the rights of a transferee beneficiary or nominated person under a letter of credit are independent and superior under 810 ILCS 5/5-114 (810 ILCS 5/9-109(c)(4));

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5. the extent that Article 9 is in conflict with the “Department of Agriculture Law of the Civil Administrative Code of Illinois” (810 ILCS 5/9-109(c)(5)), the “Grain Code” (810 ILCS 5/9-109(c)(5)), or the “Public Utilities Act” (810 ILCS 5/9-109(c)(6)); 6. a landlord’s lien (810 ILCS 5/9-109(d)(1)) or a lien other than an agricultural lien given by statute or other rule of law for services or materials (810 ILCS 5/9-109(d)(2)); 7. an assignment of a claim for wages, salary, or other compensation of an employee (810 ILCS 5/9-109(d)(3)); 8. a sale of accounts, chattel paper, payment intangibles, or promissory notes as part of a sale of the business out of which they arose (810 ILCS 5/9-109(d)(4)); 9. an assignment of accounts, chattel paper, payment intangibles, or promissory notes that is for the purpose of collection only (810 ILCS 5/9-109(d)(5)); 10. an assignment of a right to payment under a contract to an assignee that is also obligated to perform under the contract (810 ILCS 5/9-109(d)(6)); 11. an assignment of a single account, payment intangible, or promissory note to an assignee in full or partial satisfaction of a preexisting indebtedness (810 ILCS 5/9-109(d)(7)); 12. a transfer of an interest in or an assignment of a claim under a policy of insurance, other than an assignment by or to a healthcare provider of a healthcare insurance receivable and any subsequent assignment of the right to payment, although 810 ILCS 5/9-315 and 5/9-322 apply with respect to proceeds and priorities in proceeds (810 ILCS 5/9-109(d)(8)); 13. an assignment of a right represented by a judgment, other than a judgment taken on a right to payment that was collateral (810 ILCS 5/9-109(d)(9)); 14. a right of recoupment or setoff, but a. 810 ILCS 5/9-340 applies with respect to the effectiveness of rights of recoupment or setoff against a deposit account; and b. 810 ILCS 5/9-404 applies with respect to defenses or claims of an account debtor (810 ILCS 5/9-109(d)(10)); 15. the creation or transfer of an interest in or lien on real property, including a lease or rents thereunder, except to the extent that provision is made for a. liens on real property in 810 ILCS 5/9-203 and 5/9-308; b. fixtures in 810 ILCS 5/9-334;

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c. fixture filings in 810 ILCS 5/9-501, 5/9-502, 5/9-512, 5/9-516, and 5/9-519; and d. security agreements covering personal and real property in 810 ILCS 5/9-604 (810 ILCS 5/9-109(d)(11)); 16. an assignment of a claim arising in tort, other than a commercial tort claim, but 810 ILCS 5/9-315 and 5/9-322 apply with respect to proceeds and priorities in proceeds (810 ILCS 5/9-109(d)(12)); 17. a transfer by a government or governmental subdivision or agency (810 ILCS 5/9-109(d)(13)); 18. a claim or a right to receive compensation for injuries or sickness as described in 26 U.S.C. §104(a)(1) or §104(a)(2) (810 ILCS 5/9-109(d)(14)); or 19. a claim or right to receive benefits under a special-needs trust as described in 42 U.S.C. §1396(p)(d)(4) (810 ILCS 5/9-109(d)(15)).

V. CLASSIFICATION OF COLLATERAL A. [1.6] In General The manner in which the collateral subject to a security interest is classified is critical for several reasons. First, the proper place for filing or recording the financing statement may be affected by the classification of the collateral. Second, the rights of parties who purchase the collateral from the debtor are different for various classifications of collateral. Third, issues of priority between conflicting claims and the secured party’s rights after a default also can turn on the classification of the collateral. Without limitation, Article 9 of the Uniform Commercial Code applies to the following types of collateral: 1. goods; 2. equipment; 3. inventory; 4. accounts; 5. instruments; 6. promissory notes;

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7. chattel paper; 8. letter-of-credit rights; 9. supporting obligations; 10. healthcare insurance receivables; 11. general intangibles; 12. payment intangibles; 13. software; 14. deposit accounts; 15. investment property; and 16. commercial tort claims. B. [1.7] Goods, Equipment, and Inventory Article 9 of the Uniform Commercial Code defines “goods” as all things that are movable when a security interest attaches. The term includes (i) fixtures, (ii) standing timber that is to be cut and removed under a conveyance or contract for sale, (iii) the unborn young of animals, (iv) crops grown, growing, or to be grown, even if the crops are produced on trees, vines, or bushes, and (v) manufactured homes. The term also includes a computer program embedded in goods. 810 ILCS 5/9-102(a)(44). Specifically excluded from the term “goods” are accounts, chattel paper, commercial tort claims, deposit accounts, documents, general intangibles, instruments, investment property, letter-ofcredit rights, letters of credit, money, or oil, gas, or other minerals before extraction. Article 9 divides “goods” into the following four mutually exclusive types of collateral: Consumer goods: Goods “used or bought for use primarily for personal, family, or household purposes.” 810 ILCS 5/9-102(a)(23). Equipment: Goods “other than inventory, farm products, or consumer goods.” 810 ILCS 5/9102(a)(33).

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Farm products: Goods that are crops, livestock, and supplies used in farming operations, including the products of crops and livestock, such as milk and eggs, providing the debtor is engaged in a farming operation, as well as aquacultural products. 810 ILCS 5/9-102(a)(34). “Farming operation” means “raising, cultivating, propagating, fattening, grazing, or any other farming, livestock, or aquacultural operation.” 810 ILCS 5/9-102(a)(35). Inventory: Goods, other than farm products, that 1. are leased by a person as lessor; 2. are held by a person for sale or lease or to be furnished under a contract of service; 3. are furnished by a person under a contract of service; or 4. consist of raw materials, work in process, or materials used or consumed in a business. 810 ILCS 5/9-102(a)(48). The determination of the proper classification of goods is based on the primary use of the goods by the debtor. See, e.g., First Colorado Bank & Trust, N.A. v. Plantation Inn, Ltd., 767 P.2d 812 (Colo.App. 1988). A good can be in only one classification at any given time, but obviously the same good can change classifications depending on the nature of the debtor who holds possession of the good or the use to which it is put. C. [1.8] Accounts Section 9-102 of the Uniform Commercial Code defines an “account” as the right to payment of a monetary obligation arising from any of the following: 1. property that has been or is to be sold, leased, licensed, assigned, or otherwise disposed of; 2. services rendered or to be rendered; 3. a policy of insurance issued or to be issued; 4. a secondary obligation incurred or to be incurred; 5. energy provided or to be provided; 6. the use or hire of a vessel under a charter or other contract; 7. the use of a credit card or information contained on or for use with a credit card; or 8. winnings in a lottery or other game of chance operated or sponsored by a state, governmental unit of a state, or person licensed or authorized to operate the game by a state or governmental unit of a state. 810 ILCS 5/9-102(a)(2).

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Section 9-102(a)(2) specifically includes healthcare insurance receivables, but it specifically excludes the following: 1. rights to a payment evidenced by chattel paper or an instrument; 2. commercial tort claims; 3. deposit accounts; 4. investment property; 5. letters of credit; and 6. rights to payment for money or funds advanced or sold, other than rights arising out of the use of a credit card or information contained on or for use with the credit card. Id. D. [1.9] Instruments Section 9-102(a) of the Uniform Commercial Code defines an “instrument” as a negotiable instrument [as it is defined at 810 ILCS 5/3-104(a)] or any other writing that evidences a right to the payment of a monetary obligation, is not itself a security agreement or lease, and is of a type that in the ordinary course of business is transferred by delivery with any necessary indorsement or assignment. 810 ILCS 5/9-102(a)(47). Specifically excluded from the term “instrument” are (1) investment property, (2) letters of credit, (3) nonnegotiable certificates of deposit, (4) uncertificated certificates of deposit, (5) nontransferable certificates of deposit, and (6) writings that evidence a right to payment arising out of the use of a credit or charge card or information contained on or for use with the card. Id. E. [1.10] Promissory Notes Section 9-102 of the Uniform Commercial Code defines a “promissory note” as an instrument that evidences a promise to pay a monetary obligation, does not evidence an order to pay (e.g., checks), and does not contain an acknowledgment by a bank that the bank has received for deposit a sum of money or funds (e.g., a certificate of deposit). 810 ILCS 5/9-102(a)(65). F. [1.11] Chattel Paper Section 9-102 of the Uniform Commercial Code defines “chattel paper” as a monetary obligation together with a security interest in or a lease of specific goods if the obligation and security interest or lease are evidenced by a record or records. 810 ILCS 5/9-102(a)(11). Such records may be evidenced in a writing or writings (tangible chattel paper) or stored in an electronic medium (electronic chattel paper) including electrical, digital, magnetic, optical,

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electromagnetic, or any other current or similar technology. 810 ILCS 5/9-102(a)(31), 5/9-102(a)(79). For example, if a lessor of equipment borrowed money under a note and executed a collateral assignment of the equipment lease to secure repayment, the note, the collateral assignment, and the lease, taken together, would constitute chattel paper. G. [1.12] Letter-of-Credit Rights Section 9-102 of the Uniform Commercial Code defines a “letter-of-credit right” as a “right to payment or performance under a letter of credit, whether or not the beneficiary has demanded or is at the time entitled to demand payment or performance.” 810 ILCS 5/9-102(a)(51). The term, however, does not include a beneficiary’s right to demand payment or performance. (Transfer of such rights is governed by Article 5 of the UCC, 810 ILCS 5/5-101, et seq.) H. [1.13] Supporting Obligations Section 9-102 of the Uniform Commercial Code defines a “supporting obligation” as a “letter-of-credit right or secondary obligation that supports the payment or performance of an account, chattel paper, a document, a general intangible, an instrument, or investment property.” 810 ILCS 5/9-102(a)(78). Suretyship law determines whether an obligation is “secondary” for the purposes of this definition. I. [1.14] Healthcare Insurance Receivables A healthcare insurance receivable is a type of account defined by Uniform Commercial Code §9-102 as an “interest in or a claim under a policy of insurance which is a right to payment of a monetary obligation for health-care goods or services provided.” 810 ILCS 5/9-102(a)(46). All other insurance claims remain excluded from Article 9, other than as proceeds of collateral. 810 ILCS 5/9-109(d)(8). J. [1.15] General Intangibles Section 9-102 of the Uniform Commercial Code defines a “general intangible” as “any personal property, including things in action, other than accounts, chattel paper, commercial tort claims, deposit accounts, documents, goods, instruments, investment property, letter-of-credit rights, letters of credit, money, and oil, gas, or other minerals before extraction.” 810 ILCS 5/9-102(a)(42). The term also specifically includes “payment intangibles and software” (as defined in §§1.16 and 1.17 below). Id. As such, “general intangible” is a catchall of property rights that may be used to secure an obligation but that do not fit into any other classification of collateral. Examples of general intangibles are the goodwill or customer list of a business, the right to an income tax refund, the right to receive payment under a license agreement, and the right to receive a partial rebate of a purchase price because of a bulk discount. K. [1.16] Payment Intangibles A “payment intangible” is a subset of the definition of “general intangible” and is defined in Uniform Commercial Code §9-102 as a “general intangible under which the account debtor’s

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principal obligation is a monetary obligation.” 810 ILCS 5/9-102(a)(61). For example, an account debtor (promisor) under a particular agreement may owe several types of monetary obligations as well as other nonmonetary obligations. If the promisee’s right to payment of money is assigned separately, the right is either an account or a payment intangible, depending on how the promisor’s obligation arose. L. [1.17] Software “Software” is also a subset of the definition of “general intangible” and is defined in Uniform Commercial Code §9-102 as a “computer program and any supporting information provided in connection with a transaction relating to the program.” 810 ILCS 5/9-102(a)(76). The term does not include a computer program that is included in the definition of “goods.” M. [1.18] Deposit Accounts Section 9-102 of the Uniform Commercial Code defines a “deposit account” as a “demand, time, savings, passbook, nonnegotiable certificates of deposit, uncertificated certificates of deposit, nontransferable certificates of deposit, or similar account maintained with a bank.” 810 ILCS 5/9-102(a)(29). The term specifically excludes investment property or accounts evidenced by an instrument. Id. N. [1.19] Investment Property Section 9-102 of the Uniform Commercial Code defines an “investment property” as a “security, whether certificated or uncertificated, security entitlement, securities account, commodity contract, or commodity account.” 810 ILCS 5/9-102(a)(49). “Security,” “security entitlement,” and related terms are defined at 810 ILCS 5/8-102. O. [1.20] Commercial Tort Claims Article 9 applies only to commercial tort claims that are specifically described in a security agreement (i.e., “all commercial tort claims” is not acceptable). 810 ILCS 5/9-108(e)(1). See Helms v. Certified Packaging Corp. (In re Sarah Michaels, Inc.), 358 B.R. 366 (Bankr. N.D.Ill. 2007). Section 9-102 of the Uniform Commercial Code defines a “commercial tort claim” as a claim arising in tort with respect to which: (A) the claimant is an organization; or (B) the claimant is an individual and the claim: (i) arose in the course of the claimant’s business or profession; and (ii) does not include damages arising out of personal injury to or the death of an individual. 810 ILCS 5/9-102(a)(13). All other tort claims (e.g., personal injury tort claims) are excluded from Article 9.

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VI. SECURITY INTERESTS A. [1.21] In General The question of what is a security interest has two distinct but intimately intertwined aspects. First, there is the issue of what types of agreements have been construed as creating security interests. Second, there is the issue of when and under what circumstances a security interest will be enforceable. The first issue is addressed in §1.22 below. Sections 1.23 – 1.27 below address the closely related issue of the requirements for attachment and enforceability of security interests under Article 9. B. [1.22] “Security Interest” Defined Section 1-201 of the Uniform Commercial Code defines “security interest” as follows: “Security interest” means an interest in personal property or fixtures which secures payment or performance of an obligation. “Security interest” includes any interest of a consignor and a buyer of accounts, chattel paper, a payment intangible, or a promissory note in a transaction that is subject to Article 9. “Security interest” does not include the special property interest of a buyer of goods on identification of those goods to a contract for sale under Section 2-401, but a buyer may also acquire a “security interest” by complying with Article 9. Except as otherwise provided in Section 2-505, the right of a seller or lessor of goods under Article 2 or 2A to retain or acquire possession of the goods is not a “security interest”, but a seller or lessor may also acquire a “security interest” by complying with Article 9. The retention or reservation of title by a seller of goods notwithstanding shipment or delivery to the buyer under Section 2-401 is limited in effect to a reservation of a “security interest”. Whether a transaction in the form of a lease creates a “security interest” is determined pursuant to Section 1-203. 810 ILCS 5/1-201(b)(35). Structuring a transaction as a “lease” of personal property, rather than a traditional security interest, does not by itself exempt the transaction from Article 9. “Labeling an agreement a “lease” does not necessarily make it one.” In re Dena Corp., 312 B.R. 162, 169 (Bankr. N.D.Ill. 2004). Courts apply a four-part test, set forth in UCC §1-203, to determine whether the lease is in fact a “disguised” security interest. That section provides, in part, as follows: (b) A transaction in the form of a lease creates a security interest if the consideration that the lessee is to pay the lessor for the right to possession and use of the goods is an obligation for the term of the lease and is not subject to termination by the lessee, and: (1) the original term of the lease is equal to or greater than the remaining economic life of the goods; (2) the lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods;

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(3) the lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease agreement; or (4) the lessee has an option to become the owner of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease agreement. 810 ILCS 5/1-203(b) (quoted in Lyon Financial Services, Inc. v. Illinois Paper & Copier Co., No. 10 C 7064, 2016 WL 147654, *11 (N.D.Ill. Jan. 13, 2016)). “In other words, ‘a contract will be construed as a security interest as a matter of law if the lessee cannot terminate the agreement and any one of the four specified requirements is satisfied.’ ” 2016 WL 147654 at *12, quoting Mason v. Heller Financial Leasing, Inc. (In re JII Liquidating, Inc.), 341 B.R. 256, 268 (Bankr. N.D.Ill. 2006). Even if the transaction fails the four-part “per se” test set forth in §1-203(b), “the court must go on to analyze the facts particular to the case to decide whether the ‘economics of the transaction’ point to such a result.” Mason, supra, 341 B.R. at 268. The test is an objective one and does not focus on the parties’ intent. Id. Section 1-203(c) guides a court’s determination by identifying certain factors that, by themselves, fail to transform a lease into a security agreement: (c) A transaction in the form of a lease does not create a security interest merely because: (1) the present value of the consideration the lessee is obligated to pay the lessor for the right to possession and use of the goods is substantially equal to or is greater than the fair market value of the goods at the time the lease is entered into; (2) the lessee assumes risk of loss of the goods; (3) the lessee agrees to pay, with respect to the goods, taxes, insurance, filing, recording, or registration fees, or service or maintenance costs; (4) the lessee has an option to renew the lease or to become the owner of the goods; (5) the lessee has an option to renew the lease for a fixed rent that is equal to or greater than the reasonably predictable fair market rent for the use of the goods for the term of the renewal at the time the option is to be performed; or (6) the lessee has an option to become the owner of the goods for a fixed price that is equal to or greater than the reasonably predictable fair market value of the goods at the time the option is to be performed. 810 ILCS 5/1-203(c).

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C. [1.23] Attachment and Enforceability of Security Interests A security interest attaches to collateral when it becomes enforceable against the debtor unless an agreement expressly postpones the time of attachment. The enforceability of a security interest against a debtor’s collateral is governed by Uniform Commercial Code §9-203, which provides in relevant part: [A] security interest is enforceable against the debtor and third parties with respect to the collateral only if: (1) value has been given; (2) the debtor has rights in the collateral or the power to transfer rights in the collateral to a secured party; and (3) one of the following conditions is met: (A) the debtor has authenticated a security agreement that provides a description of the collateral and, if the security interest covers timber to be cut, a description of the land concerned; (B) the collateral is not a certificated security and is in the possession of the secured party under Section 9-313 [perfection by possession] pursuant to the debtor’s security agreement; (C) the collateral is a certificated security in registered form and the security certificate has been delivered to the secured party under Section 8-301 pursuant to the debtor’s security agreement; or (D) the collateral is deposit accounts, electronic chattel paper, investment property, or letter-of-credit rights, and the secured party has control under Section 7-106, 9-104, 9-105, 9-106, or 9-107 pursuant to the debtor’s security agreement. 810 ILCS 5/9-203(b). Once the above requirements are met, the security interest is “enforceable against the debtor with respect to the collateral” and is said to “attach.” See 810 ILCS 5/9-203(a). Consistent with the provisions of UCC §9-203, the court in Peterson v. Ziegler, 39 Ill.App.3d 379, 350 N.E.2d 356 (5th Dist. 1976), held that the requirements for attachment of a security interest are (1) that the debtor must have or acquire rights in the collateral, (2) that the creditor must give value, and (3) that the collateral must be in the possession of the creditor or there must be a written security agreement signed by the debtor that contains a description of the collateral. Each of these three requirements is addressed separately in §§1.24 – 1.26 below. There is caselaw that indicates that there is an exception to this process for obtaining a security interest in a limited liability company membership interest. In Heartland Bank & Trust Co. v. Covey (In re Lahood), Bankruptcy No. 07-81727, 2009 WL 2169879, *3 (Bankr. C.D.Ill.

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July 16, 2009), the court stated that “a charging order is the only way to obtain a lien on a distributional interest.” However, the lien to which the court referred was the creation of an involuntary postjudgment lien and not a consensual grant of a security interest. See First MidIllinois Bank & Trust, N.A. v. Parker, 403 Ill.App.3d 784, 933 N.E. 2d 1215, 342 Ill.Dec. 922 (5th Dist. 2010), for a better interpretation. 1. [1.24] Debtor Must Have Obtained Rights or Power To Transfer Rights in Collateral Formal passage of title is not required for the debtor to have rights in the collateral. Possession of the collateral by a purchaser is generally held to constitute effective passage of title from the seller to the purchaser, thus giving the purchaser sufficient rights in the collateral for Uniform Commercial Code §9-203 purposes. Andrews v. Mid America Bank & Trust Company of Fairview Heights, 152 Ill.App.3d 139, 503 N.E.2d 1120, 1123, 105 Ill.Dec. 114 (5th Dist. 1987). It has also been held, in situations in which the debtor had no actual interest in the collateral, that the owner of the collateral may be estopped from denying the validity of the secured party’s security interest if the owner misled the secured party into believing the debtor owned the collateral or otherwise had an interest in it. See, e.g., In re Pubs, Inc. of Champaign, 618 F.2d 432, 438 – 439 (7th Cir. 1980). However, in accordance with basic personal property conveyance principles, the general rule is that a security interest attaches only to whatever rights a debtor may have, broad or limited as those rights may be. The phrase “power to transfer rights” accommodates the exceptions to the general rule, and, in certain circumstances, a debtor may have the ability to grant a security interest in property that attaches to rights in the property that are greater than the rights the debtor has in the property. 2. [1.25] Creditor Must Give Value The term “value” is defined in §1-204 of the Uniform Commercial Code and may be “any consideration sufficient to support a contract.” 810 ILCS 5/1-204(4); In re Reliable Manufacturing Corp., 703 F.2d 996, 1000 (7th Cir. 1983). The value given by the creditor may be received either by the debtor or by some third party and still satisfy 810 ILCS 5/9-203. Reliable, supra, 703 F.2d at 1000. Typical examples of the requisite value are a sale on credit, a loan of money or binding commitment to loan, release of an existing security interest with consolidation of old and new debt, issuing a guarantee, or acting as an accommodation party. However, “value,” within the meaning of UCC §§1-204(4) and 9-203, is not limited to simple contract consideration. For example, a valid antecedent debt is expressly defined as “value” under UCC §1-204(3). One must, of course, consider the possible bankruptcy implications of accepting antecedent debt as consideration, especially if no “new” value is included. See Chapter 3 of this handbook for a discussion of priorities. 3. [1.26] Valid Authenticated Security Agreement or Possession or Control of Collateral In order for a security agreement to be valid (a) the debtor must have signed or otherwise authenticated a security agreement that contains a description of the collateral; (b) the collateral must be in the possession of the secured party by agreement with the debtor; or (c) if the

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§1.28

collateral is investment property, a deposit account, electronic chattel paper, or a letter-of-credit right, the secured party must have “control” of the collateral. The required elements for a valid written security agreement are addressed separately in §§1.32 – 1.36 below. It should be noted that a security agreement does not have to be signed but, alternatively, may be authenticated. Authentication allows for security agreements to be created through electronic commerce without handwritten execution. In addition, pursuant to Uniform Commercial Code §§9-108 and 9-203, the description of the collateral in the security agreement must reasonably identify the collateral. 810 ILCS 5/9-108(a), 5/9-203(b)(3)(A). Finally, when the security interest covers crops growing or timber to be cut, the security agreement must include a description of the land involved. In determining whether the collateral is reasonably described, the test is whether the description distinguishes the collateral from any other property with which it might otherwise be confused. Midkiff Implement Co. v. Worrall, 116 Ill.App.3d 546, 451 N.E.2d 623, 625, 71 Ill.Dec. 655 (4th Dist. 1983). Absent an authenticated security agreement, UCC §9-203 permits attachment of a security interest if the secured party is in possession (or, in some instances, control) of the collateral pursuant to an agreement of the parties. While possession may appear to be a clear indication that the parties have entered into such an agreement, situations have been known to arise in which there is a dispute as to whether possession was given for “security” or merely for safekeeping. See generally Yorkville National Bank v. Schaefer, 71 Ill.App.3d 137, 388 N.E.2d 1312, 27 Ill.Dec. 263 (2d Dist. 1979). In order to eliminate any ambiguity on this point, the better practice is always to use a written agreement that clearly sets forth the respective parties’ rights and limitations, even for so-called possessory security interests. This rule of thumb also applies to circumstances in which control of the collateral is required (e.g., investment property and deposit accounts); in such instances, a carefully drafted control agreement, whether the secured party or a third party has possession of the collateral, is always the better practice. 4. [1.27] Timing of Attachment Unless the agreement between the parties explicitly provides otherwise, attachment occurs automatically at the time all of the prerequisites identified in §§1.24 – 1.26 above have been met. 810 ILCS 5/9-203(a). Accordingly, delays in authenticating a security agreement when one is required will result in the postponement of the enforceability of the security interest until such time as the security agreement has been authenticated. See Mayor’s Jewelers of Ft. Lauderdale, Inc. v. Levinson, 39 Ill.App.3d 16, 349 N.E.2d 475, 477 (2d Dist. 1976). If circumstances require, the parties may agree that attachment is postponed to a later defined time. D. [1.28] Attachment vs. Perfection As discussed in §1.3 above, attachment of a security interest must be distinguished from perfection. The requirements for perfection are discussed in Chapter 2 of this handbook. Perfection addresses a secured party’s rights in the collateral with respect to other creditors of the debtor. Attachment fixes a secured party’s rights in the collateral with respect to the debtor. Thus, when a secured party fails to perfect a valid security interest that has attached to the debtor’s collateral, the secured party may prevail against the debtor but likely will not prevail against other creditors having perfected security interests in the collateral. See First Galesburg National Bank

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& Trust Co. v. Martin, 58 Ill.App.3d 113, 373 N.E.2d 1075, 1076, 15 Ill.Dec. 603 (3d Dist. 1978). See also Citizens State Bank of Lena v. Diemer, 144 Ill.App.3d 513, 494 N.E.2d 1224, 1227, 98 Ill.Dec. 897 (2d Dist. 1986) (failure to perfect lien on automobile did not invalidate lender’s security interest as against original borrower). With respect to a subsequent bankruptcy proceeding, remember that a trustee in bankruptcy, although the successor in interest to the debtor, enjoys the status of a hypothetical lien creditor. 11 U.S.C. §544(a). Hence, attachment, absent perfection, will not be effective against a trustee in bankruptcy. See In re Hillebrand Metal Works, Inc., 38 B.R. 956 (Bankr. N.D.Ill. 1984).

VII. [1.29] SECURED CREDITOR’S RIGHTS IN PROCEEDS OF COLLATERAL “Proceeds” are defined in Uniform Commercial Code §9-102 as (A) whatever is acquired upon the sale, lease, license, exchange, or other disposition of collateral; (B) whatever is collected on, or distributed on account of, collateral; (C) rights arising out of collateral; (D) to the extent of the value of collateral, claims arising out of the loss, nonconformity, or interference with the use of, defects or infringement of rights in, or damage to, the collateral; or (E) to the extent of the value of collateral and to the extent payable to the debtor or the secured party, insurance payable by reason of the loss or nonconformity of, defects or infringement of rights in, or damage to, the collateral. 810 ILCS 5/9102(a)(64). Money, checks, deposit accounts, and the like are “cash proceeds.” All other proceeds are “noncash proceeds.” Unless otherwise agreed, a secured party’s rights to proceeds are set forth in Uniform Commercial Code §9-315, which provides in relevant part that a creditor’s security interest “attaches to any identifiable proceeds of collateral.” 810 ILCS 5/9-315(a)(2). Section 9315 also addresses the questions of perfection of security interests in proceeds and priorities among creditors. Both of these topics are addressed in greater detail in Chapter 2 of this handbook. Section 9-203 of the UCC provides that attachment of a security interest to the collateral gives the secured party the rights to the proceeds defined in UCC §9-315; therefore, absent express exclusion, proceeds are automatically included within the coverage of a security interest. 810 ILCS 5/9-203(f). However, it is always prudent to specifically include “proceeds language” in the description of the collateral. If exclusion of proceeds is intended, clear and simple language such as “This security agreement does not extend to proceeds” should be used. As a drafter, never rely on proceeds coverage to obtain a security interest in accounts receivable and subsequent cash collections as proceeds of inventory.

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The critical element in dealing with a creditor’s rights in proceeds is whether the proceeds are sufficiently identifiable within the meaning of UCC §9-315 after commingling with other funds. See, e.g., Marquette National Bank v. B.J. Dodge Fiat, Inc., 131 Ill.App.3d 356, 475 N.E.2d 1057, 86 Ill.Dec. 678 (2d Dist. 1985) (finding secured creditor failed to come forward with sufficient evidence identifying funds in debtor’s account as cash proceeds from sale of collateral). For cash proceeds that have been commingled with other funds, Illinois has adopted a tracing rule commonly used in trust law and known as the “lowest intermediate balance” rule. C.O. Funk & Sons, Inc. v. Sullivan Equipment, Inc., 89 Ill.2d 27, 431 N.E.2d 370, 372, 59 Ill.Dec. 85 (1982). This rule provides that when the proceeds from the sale of collateral have been commingled with other funds in an account, the proceeds are “identifiable” provided that the account balance does not dip below the amount of such proceeds. 431 N.E.2d at 372 – 373. Under that rule, however, if at any time the account balance drops below the amount of proceeds deposited in the account, the security interest abates accordingly to an amount equal to the lowest balance and will not be increased if the debtor later increases the account balance by depositing additional funds unless the deposit was made in restitution. 431 N.E.2d at 372. In other words, the lowest intermediate balance rule “identifies” the proceeds from the sale of collateral by presuming that they remain in the account even if other funds are paid out as long as the account balance does not dip below the amount of such proceeds. In litigation involving a secured party’s rights in proceeds from the sale of collateral, the burden is on the secured party to show that it comes within the lowest intermediate balance rule. Thus, when a secured party failed to come forward with any evidence on the balance of a commingled account over the relevant time period, it was held that the secured party failed to identify proceeds, and a second creditor was given priority. Id. Accordingly, in this type of litigation, it is essential that the secured party produce evidence supporting the lowest intermediate balance. See also In re Lantz, 451 B.R. 843 (Bankr. N.D.Ill. 2011), in which Judge Barbosa decided that the bankruptcy court would employ the lowest intermediate balance rule to decide to what extent Chapter 7 debtors were entitled to the Illinois homestead exemption in a segregated account that they had established only after first depositing proceeds from sale of their Illinois homestead into a commingled account that had a balance of $884.26 at the time the homestead proceeds were deposited and into which the debtors deposited an additional $7,721.96 from other nonexempt sources before writing a check from the commingled account to fund the segregated account. When the commingling of trust funds cannot be traced, whether it be an express trust or a constructive trust imposed by a court (as a result of fraud or the breach of a duty related to the commingling), the funds may be distributed pro rata. One such example would be if the funds of multiple creditors were commingled in a trust account and then used to purchase assets of a different form. See, e.g., In re Possession & Control of Commissioner of Banks & Real Estate of Independent Trust Corp., 327 Ill.App.3d 441, 764 N.E.2d 66, 261 Ill.Dec. 775 (1st Dist. 2001) (finding that creditors could not trace commingled funds used to purchase noncash assets). “One can follow his money so long as it is not so mingled with other money or property that it can no longer be specifically separated.” 764 N.E.2d at 108. The burden then falls on the creditor to show sufficient grounds for seeking a preference over other creditors. See Sadacca v. Monhart, 128 Ill.App.3d 250, 470 N.E.2d 589, 594, 83 Ill.Dec. 463 (1st Dist. 1984) (burden on creditor seeking to impose constructive trust to show that funds she wished to impose trust on were not

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paid out of other creditors’ funds deposited in commingled account). Courts have concluded that, under such circumstances, all of the creditors who cannot identify their funds are similarly situated from an equitable perspective. See, e.g., Hatoff v. Lemons & Associates, Inc. (In re Lemons & Associates, Inc.), 67 B.R. 198, 213 (Bankr. D.Nev. 1986); Independent Trust, supra, 764 N.E.2d at 102. If the creditor cannot trace and identify the funds within the trust, such creditor, along with other similarly situated creditors, must share in any shortage on a pro rata basis. 764 N.E.2d at 109 – 110. See also First State Trust & Savings Bank of Springfield v. Therrell, 103 Fla. 1136, 138 So. 733, 738 (1932).

VIII. [1.30] AFTER-ACQUIRED PROPERTY AND FUTURE ADVANCES With certain exceptions noted below, a security agreement may provide that after-acquired property of the same description that is covered by the security agreement will constitute collateral under the security agreement. 810 ILCS 5/9-204(a). The “value” component of attachment required to support an after-acquired property clause is provided by the original value given at the time the security interest attaches, and, accordingly, no additional value is required. However, one must be cognizant of the special issues respecting after-acquired property clauses that arise in bankruptcy cases. See the discussion in Chapter 8 of this handbook. Caselaw generally indicates that for a security interest to cover after-acquired property, the security agreement must contain an explicit provision extending the security interest to the afteracquired property. See Filtercorp., Inc. v. Gateway Venture Partners III, L.P., 163 F.3d 570, 578 – 579 (9th Cir. 1998). See, e.g., In re Gary & Connie Jones Drugs, Inc., 35 B.R. 608 (Bankr. D.Kan. 1983). However, there is some authority to the contrary. See, e.g., Covey v. First National Bank in East Peoria (In re Balcain Equipment Co.), 80 B.R. 461 (Bankr. C.D.Ill. 1987). In the absence of definitive precedent, an explicit after-acquired property provision should always be included in a security agreement when the parties intend for the security interest to extend to after-acquired property. Drafters are cautioned to remember that an after-acquired property clause will still be limited by the collateral description in the relevant documents. Section 9-204(b)(1) of the UCC limits the use of after-acquired property clauses for consumer transactions. This section provides that only “consumer goods” (as defined at 810 ILCS 5/9-102) acquired by the debtor within ten days after the secured creditor gives value will be covered by an after-acquired property clause. Failure to disclose this ten-day limitation in the security agreement or use of an overly broad after-acquired property clause has been held to be violative of both federal and state truth-in-lending statutes. See Tinsman v. Moline Beneficial Finance Co., 531 F.2d 815, 818 – 819 (7th Cir. 1976) (overly broad after-acquired property clause and nondisclosure of ten-day limitation violated Truth in Lending Act, Pub.L. No. 90-321, Title I, 82 Stat. 146 (1968)); Holmes v. No. 2 Galesburg Crown Finance Corp., 77 Ill.App.3d 785, 396 N.E.2d 583, 585 – 586, 33 Ill.Dec. 194 (3d Dist. 1979) (overly broad after-acquired property clause violated Large Loan Act, Ill.Rev.Stat. (1977), c. 74, ¶66). Accordingly, after-acquired property clauses for consumer transactions should be narrowly drawn to come within the limits imposed by UCC §9-204(b), and the consumer should be adequately informed of both the existence and the limited scope of the after-acquired property provision.

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UCC §9-204(b)(2) provides that an after-acquired property clause in a security agreement does not reach future commercial tort claims. In order for a security interest in a tort claim to attach, the claim must be in existence when the security agreement is authenticated. In addition, the security agreement must describe the commercial tort claim with greater specificity than simply “all tort claims.” See Helms v. Certified Packaging Corp. (In re Sarah Michaels, Inc.), 358 B.R. 366 (Bankr. N.D.Ill. 2007). Pursuant to UCC §9-204(c), a security agreement may provide that future advances of the creditor will also be secured by the collateral. Such provisions, commonly referred to as “dragnet” clauses, were strictly scrutinized under the common law. See, e.g., National Acceptance Company of America v. Exchange National Bank of Chicago, 101 Ill.App.2d 396, 243 N.E.2d 264, 268 (1st Dist. 1968). However, clear and unambiguous security agreement clauses extending the security interest in the collateral to both past and future advances have been held valid (Stannish v. Community Bank of Homewood-Flossmoor, 24 B.R. 761, 763 (Bankr. N.D.Ill. 1982)) and are now fully acceptable elements of many secured loan transactions. Furthermore, the strict construction traditionally afforded dragnet clauses by Illinois courts has been soundly rejected by Article 9. Parties are now free to agree that a security interest secures any obligation whatsoever. The comments to UCC §9-204 suggest that the determination of the obligations secured by collateral is “solely a matter of construing the parties’ agreement under applicable law.” UCC Comment 5, 810 ILCS 5/9-204. Nevertheless, it is still good practice to state concisely in the security agreement that the debtor intends to presently grant a security interest in the collateral to secure “future advances” or use some other terminology clearly indicating the coverage of debts not currently in existence but intended to arise at some time in the future.

IX. [1.31] PURCHASE-MONEY SECURITY INTERESTS Section 9-103 of the Uniform Commercial Code provides that a security interest in goods is a “purchase-money security interest” (1) to the extent that the goods are purchase-money collateral with respect to that security interest; (2) if the security interest is in inventory that is or was purchase-money collateral, also to the extent that the security interest secures a purchase-money obligation incurred with respect to other inventory in which the secured party holds or held a purchase-money security interest; and (3) also to the extent that the security interest secures a purchase-money obligation incurred with respect to software in which the secured party holds or held a purchase-money security interest. 810 ILCS 5/9-103(b).

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Section 9-103 of the UCC provides that a security interest in software is a purchase-money security interest to the extent that the security interest also secures a purchase-money obligation incurred with respect to goods in which the secured party holds or held a purchase-money security interest if (1) the debtor acquired its interest in the software in an integrated transaction in which it acquired an interest in the goods; and (2) the debtor acquired its interest in the software for the principal purpose of using the software in the goods. 810 ILCS 5/9-103(c). “Purchase-money collateral” is defined in §9-103 as “goods or software that secures a purchase-money obligation incurred with respect to that collateral.” 810 ILCS 5/9-103(a)(1). “Purchase-money obligation” is defined §9-103 as “an obligation of an obligor incurred as all or part of the price of the collateral or for value given to enable the debtor to acquire rights in or the use of the collateral if the value is in fact so used.” 810 ILCS 5/9-103(a)(2). Purchase-money security interests are of particular importance because they frequently have priority over other interests. See, e.g., 810 ILCS 5/9-324; First National Bank of Vandalia v. Trail Ridge Farm, Inc., 143 Ill.App.3d 244, 492 N.E.2d 1030, 97 Ill.Dec. 371 (5th Dist. 1986) (priority over after-acquired property clauses). See also Chapter 3 of this handbook, in which the subject of priorities among competing claims of secured creditors is addressed at length. It should be noted that not all advances of purchase money will result in a purchase-money security interest. In DeKalb Bank v. Klotz, 151 Ill.App.3d 638, 502 N.E.2d 1256, 1259, 104 Ill.Dec. 596 (2d Dist. 1986), the court cited with approval the holding in North Platte State Bank v. Production Credit Association of North Platte, 189 Neb. 44, 200 N.W.2d 1, 6 (1972), in which the Supreme Court of Nebraska held that when a debtor had acquired both possession and title to collateral livestock two months before the financing bank loaned him the purchase-money funds, the financing bank did not acquire a purchase-money security interest. Such an advance failed to satisfy the requirement that the value given by the creditor enable the debtor to acquire rights in or use of the collateral because the debtor had already obtained both possession and title well before the funds were advanced. It is also important to note that Article 9 rejects the “transformation rule” that some courts applied under the former version of Article 9. The “transformation rule” provided that a purchasemoney security interest could lose its “purchase-money” status under certain circumstances, such as the refinancing of the purchase-money debt or the secured party having other collateral securing the purchase-money debt. Section 9-103 validates the “dual status” rule permitting collateral to have both purchase-money and non-purchase-money status. 810 ILCS 5/9-103(f).

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X. REQUIRED ELEMENTS OF WRITTEN AGREEMENT A. [1.32] Requirement of a Written Agreement Under Uniform Commercial Code §9-203, unless the secured party has possession or control of the collateral, a security interest can be created and enforced against the debtor only by a written agreement meeting certain requirements. 810 ILCS 5/9-203. See, e.g., Mayor’s Jewelers of Ft. Lauderdale, Inc. v. Levinson, 39 Ill.App.3d 16, 349 N.E.2d 475, 477 (2d Dist. 1976). These requirements are that (1) the agreement be authenticated (signed or otherwise) by the debtor and (2) the agreement must contain a sufficient description of the collateral. B. [1.33] Necessity of a Writing The security agreement can be evidenced by one or more writings construed together. The financing statement can be one of the writings, but the execution and filing of a financing statement alone have been held to be insufficient to create a security agreement. See, e.g., ITT Financial Services v. Gibson, 188 Ga.App. 188, 372 S.E.2d 468 (1988). C. [1.34] Description of Collateral Under the prior version of Article 9, the requirement that the collateral be adequately described engendered voluminous decisional law with seemingly endless combinations of factual situations. Revised Article 9 clarifies in §9-108(b) that the description of collateral by specific Article 9 types (see §§1.6 – 1.20 above regarding the different types of collateral) suffices to describe the collateral, except in certain consumer transactions and to secure an interest in commercial tort claims. 810 ILCS 5/9-108(b). If the collateral is a commercial tort claim, the description requires some specificity beyond the category type (e.g., “all claims arising out of the explosion occurring at the debtor’s Chicago Avenue warehouse in May 2002”). Unlike financing statements, as discussed in Chapter 2 of this handbook, Uniform Commercial Code §9-108(c) provides that a description of collateral in a security agreement may not use a “supergeneric” description of collateral like “all the debtor’s assets” or “all the debtor’s personal property.” 810 ILCS 5/9-108(c). D. [1.35] Description of Land in Certain Cases The security agreement must include a description of the real estate whenever the collateral is growing crops or timber. E. [1.36] Description of Underlying Debt Section 9-203 of the Uniform Commercial Code does not explicitly require that a security agreement describe the underlying debt. The only stated requirements are that (1) the debtor authenticate the agreement and (2) the agreement describe the collateral. See 810 ILCS 5/9203(b)(3)(A). However, §9-201 provides that a security agreement is “effective according to its terms between the parties, against purchasers of the collateral, and against creditors.” 810 ILCS 5/9-201(a). Citing this provision, in In re Duckworth, 776 F.3d 453, 461 – 462 (7th Cir. 2014)

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(holding that security agreement that referred to wrong date of promissory note was unenforceable, rendering bank unsecured in collateral), the Seventh Circuit overturned the bankruptcy and district courts and held that a security agreement that incorrectly described the underlying debt was unenforceable, at least as against a Chapter 7 bankruptcy trustee. It is not clear from the opinion whether the holding applies outside of bankruptcy cases. But to avoid the harsh consequences of the Seventh Circuit’s holding, drafters of security agreements should be careful to correctly describe the underlying debt. Additionally, the secured party may wish to include a “dragnet clause,” which provides that the collateral secures all existing and future indebtedness between the parties, not just a single specified debt. (The security agreement in Duckworth did not include a dragnet clause.)

XI. [1.37] DISPOSITION OF COLLATERAL Common-law decisions invalidating security interests because the debtor was permitted to use, sell, or dispose of the collateral were overruled by Uniform Commercial Code §9-205, which expressly allows a secured creditor and a debtor to agree that the debtor will have rights to use, dispose of, and/or transfer collateral, or the proceeds of it, without affecting the validity of the security interest. 810 ILCS 5/9-205. However, §9-205 is merely permissive, and the agreement between the parties will still control. For example, a security agreement may or may not require the debtor to account to the secured creditor or replace the collateral. Illinois adopted an additional provision regarding disposition of collateral by the debtor. Pursuant to 810 ILCS 5/9-205.1, a secured party may require that the security agreement include a list of persons or entities to whom the debtor is authorized to sell or transfer the collateral. Section 9-205.1 further provides that the debtor may sell the collateral to persons not so listed only upon seven days’ notice to the secured party of the debtor’s intention to sell. This provision is often used by parties lending to agricultural borrowers to ascertain and limit the places where the borrowers will be able to sell crops and/or livestock.

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2

Perfecting Article 9 Security Interests Under Illinois Law

JASON M. TORF Horwood Marcus & Berk Chartered Chicago

®

©COPYRIGHT 2016 BY IICLE .

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I. [2.1] Introduction II. Determining the Manner of Perfection A. [2.2] General Rules of Perfection B. Perfection by Possession 1. [2.3] What Constitutes Possession? 2. [2.4] When Is Possession Mandatory? 3. [2.5] When Is Possession Permissive? C. Perfection by Filing 1. Where Must the Filing Be Made? a. [2.6] Location of the Debtor (1) [2.7] Registered organizations (2) [2.8] Other debtors b. [2.9] Filing Office 2. [2.10] When Is Filing Mandatory? 3. [2.11] When Is Filing Permissive? 4. [2.12] When Is Filing Inadequate? 5. [2.13] When Is Filing Requirement Superseded by Other Statutes? D. [2.14] Perfection by Control 1. [2.15] When Is Control Mandatory? a. [2.16] Control of Deposit Account b. [2.17] Control of Letter-of-Credit Rights 2. [2.18] When Is Control Permissive? a. [2.19] Control of Electronic Chattel Paper b. [2.20] Control of Investment Property c. [2.21] Control of Collateral Assignments of Beneficial Interests in Illinois Land Trusts E. Automatic Perfection (By Attachment Alone) 1. [2.22] Under What Circumstances Is Perfection by Attachment Permanent? 2. [2.23] Under What Circumstances Is Temporary Perfection by Attachment Achieved? F. Special Types of Collateral 1. [2.24] Stock Option Contracts and Stock Warrants 2. [2.25] Partnership and LLC Interests 3. [2.26] Vehicles 4. [2.27] Boats and Vessels 5. [2.28] Aircraft

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G. Choice-of-Law Rules 1. [2.29] General Rule 2. [2.30] Agricultural Liens 3. [2.31] Goods Covered by a Certificate of Title 4. [2.32] Deposit Accounts 5. [2.33] Investment Property 6. [2.34] Letter-of-Credit Rights III. Elements of a Financing Statement A. [2.35] Contents 1. [2.36] Identification of Debtor and Secured Party a. [2.37] Identifying Correct Debtor b. [2.38] Effect of Errors or Omissions c. [2.39] New Debtor Becoming Bound by Security Agreement d. [2.40] Multiple Debtors and Secured Parties e. [2.41] Correctly Recording Debtor’s Name f. [2.42] Using Trade Names g. [2.43] Using Partnership Names h. [2.44] Change in Debtor’s Name i. [2.45] Change in Debtor’s Location 2. [2.46] Debtor’s Signature 3. [2.47] Addresses 4. [2.48] Description of Collateral 5. [2.49] Filing as to As-Extracted Collateral, Timber To Be Cut, or Fixtures B. [2.50] When To File C. [2.51] Special Bankruptcy Rule D. [2.52] How To File E. [2.53] Financing Statement Forms F. [2.54] How To Amend a Financing Statement G. [2.55] When Filing Office Can Reject Filings H. [2.56] Inaccurate or Wrongfully Filed Records I. [2.57] Filing Office Indexing Errors IV. [2.58] Continuation Statement V. [2.59] Statement of Release VI. [2.60] Termination Statement

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VII. [2.61] Statement of Assignment VIII. [2.62] Consignment/Lease Statement IX. [2.63] Requests for Information X. [2.64] Secretary of State’s Rules and Regulations XI. [2.65] Transition Rules for 2012 Amendments XII. Appendix A. [2.66] Information for State and County Filing B. [2.67] Perfection Chart

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§2.2

I. [2.1] INTRODUCTION This chapter is based on revised Article 9 of the Uniform Commercial Code (UCC), as drafted by the National Conference of Commissioners on Uniform State Laws and as adopted by the legislature of the State of Illinois at 810 ILCS 5/9-101, et seq. Revised Article 9, which replaces and supersedes the former version, took effect in Illinois on July 1, 2001. On August 17, 2012, the State of Illinois enacted additional uniform amendments (2012 Amendments) to Article 9, which were proposed and adopted by the National Conference of Commissioners on Uniform State Laws in 2010. The 2012 Amendments became effective July 1, 2013. This chapter discusses only the perfection of Article 9 security interests under revised Article 9, together with related changes introduced by the 2012 Amendments, and does not contain any substantive discussion of the law under the former Article 9. Because Article 9, as amended by the 2012 Amendments, applies to all transactions or liens within its scope, including those entered into or created prior to July 1, 2013 (810 ILCS 5/9-702(a)), reference to the transition rules contained at Part 7 of Article 9, 810 ILCS 5/9-701, et seq., with respect to transactions or liens entered into or created prior to July 1, 2001, and Part 8 of Article 9, 810 ILCS 5/9-801, et seq., with respect to transactions or liens entered into or created prior to July 1, 2013, is essential.

II. DETERMINING THE MANNER OF PERFECTION A. [2.2] General Rules of Perfection A security interest becomes perfected when it has attached and all applicable steps for perfection for the particular collateral in question have been taken. 810 ILCS 5/9-203, 5/9-308(a). The following procedures are four basic methods of perfecting a security interest under Article 9: 1. taking possession of the collateral (810 ILCS 5/9-313(a)); 2. filing a financing statement in a public office (810 ILCS 5/9-310(a)); 3. obtaining control of the collateral (810 ILCS 5/9-314(a)); and 4. accomplishing attachment alone (810 ILCS 5/9-309). An agricultural lien (which is defined at 810 ILCS 5/9-102(a)(5) as being certain interests in farm products) becomes perfected when it becomes effective and all applicable steps for perfection have been taken. 810 ILCS 5/9-308(b). A chart summarizing the methods of perfection for the principal collateral types under Article 9 (as well as the proceeds thereof) is included in §2.67 below.

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B. Perfection by Possession 1. [2.3] What Constitutes Possession? Article 9 does not define “possession.” To determine whether the secured party has possession, the rules of agency apply. UCC Comment 3, 810 ILCS 5/9-313. If the collateral is in the possession of someone who is clearly the secured party’s agent, then it is deemed to be in the possession of the secured party. For others who are not clearly the secured party’s agent, revised Article 9 presents two rules: Goods in the possession of a bailee that has issued a negotiable or nonnegotiable document covering the goods. If the document is negotiable, a security interest in the goods is perfected by perfecting a security interest in the document. This security interest has priority over any security interest that becomes perfected in the goods by another method during that time. 810 ILCS 5/9-312(c). If the document is nonnegotiable, a security interest in the goods may be perfected by issuance of a document in the name of the secured party, by the bailee’s receipt of notification of the secured party’s interest, or by filing a financing statement against the goods. 810 ILCS 5/9-312(d). The bailee is not required to acknowledge that it is holding on behalf of the secured party. Other collateral (except certificated securities). For other types of collateral, the secured party takes possession when the person in possession authenticates a record acknowledging that it holds possession of the collateral for the secured party’s benefit or a bailee takes possession of the collateral after having authenticated such a record. 810 ILCS 5/9-313(c). See, e.g., Maloney v. Stewart Title & Trust of Tucson (In re Nichols), 88 B.R. 871 (Bankr. C.D.Ill. 1988); First National Bank of Vandalia v. Trail Ridge Farm, Inc., 143 Ill.App.3d 244, 492 N.E.2d 1030, 97 Ill.Dec. 371 (5th Dist. 1986). Neither the debtor nor a lessee of the collateral from the debtor in the ordinary course of the debtor’s business qualifies as a bailee for purposes of perfection by possession. 810 ILCS 5/9-313(c). Perfection is concurrent with possession and continues only while possession continues. 810 ILCS 5/9-313(d). Perfection of a security interest in a certificated security in registered form perfected by delivery occurs upon delivery under UCC §8-301 and continues until the debtor obtains possession of the security certificate. 810 ILCS 5/9-313(e). A person in possession of collateral is not required to acknowledge that it holds on behalf of the secured party and by acknowledging does not assume any obligations to the secured party or any other person. 810 ILCS 5/9-313(f), 5/9-313(g). The acknowledgment is effective even if it violates the rights of the debtor. 810 ILCS 5/9-313(g)(1). 2. [2.4] When Is Possession Mandatory? Under Uniform Commercial Code §9-312(b)(3), a security interest in money can be perfected only by possession. 810 ILCS 5/9-312(b)(3).

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§2.8

3. [2.5] When Is Possession Permissive? Under Uniform Commercial Code §9-313(a), a security interest in goods, instruments (other than certificated securities and other goods covered by a certificate of title), negotiable documents, or tangible chattel paper may be permanently perfected by possession. 810 ILCS 5/9-313(a). C. Perfection by Filing 1. Where Must the Filing Be Made? a. [2.6] Location of the Debtor The location of the filing is determined generally by the debtor’s location, regardless of the type of collateral. 810 ILCS 5/9-301(1). (1)

[2.7] Registered organizations

The location of an entity created by a filing with a state (e.g., corporations, limited liability companies, registered business trusts, and limited partnerships) is the state where the filing is made. 810 ILCS 5/9-307(e). (2)

[2.8] Other debtors

The location of an entity other than a registered organization (e.g., a general partnership) is the location of its place of business or, if it has multiple places of business, then the location is its chief executive office. If the debtor is an individual, its location is the individual’s principal residence. 810 ILCS 5/9-307(b). The rules regarding the debtor’s location are subject to a number of qualifications. One such qualification states that the location rules apply only for debtors whose “residence, place of business, or chief executive office . . . is located in a jurisdiction whose law generally requires information concerning the existence of a nonpossessory security interest to be made generally available in a filing, recording, or registration system as a condition or result of the security interest’s obtaining priority over the rights of a lien creditor.” 810 ILCS 5/9-307(c). In other words, the rules in Uniform Commercial Code §9-307(b) for determining a debtor’s location do not apply when the debtor’s residence, place of business, or chief executive office is located in a jurisdiction that has not adopted Article 9 or some similar statute. This section, which is intended generally for non-U.S. debtors, provides for the District of Columbia to be the de facto location for debtors to which this section applies. The United States is also deemed to be located in the District of Columbia. 810 ILCS 5/9-307(h). In addition, UCC §9-307(f) specifies the location of a registered organization that is organized under the law of the United States. Deference is given to federal law to the extent that it determines, or allows the debtor to designate, the debtor’s state of location. The 2012 Amendments clarified that a designation of a home or main office also qualifies as a designation

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of a state of location. 810 ILCS 5/9-307(f)(2). Otherwise, the debtor’s location is deemed to be the District of Columbia. This section also determines the location of branches and agencies of banks that are not organized under the law of the United States or any individual state. 810 ILCS 5/9-307(f). However, under UCC §9-307(i), if all of the branches and agencies of the bank are licensed in only one state, then the debtor’s location is that state. 810 ILCS 5/9-307(i). UCC §9-307(j) applies to foreign air carriers. 810 ILCS 5/9-307(j). After the occurrence of certain events, the rules for determining a debtor’s location remain applicable. Under UCC §9-307(d), a person who ceases to exist, have a residence, or have a place of business continues to be located in the jurisdiction specified by the general rules of UCC §9-307(b) (or, if that section does not apply, the District of Columbia, as provided in UCC §9-307(c)). 810 ILCS 5/9-307(d). Under UCC §9-307(g), even the suspension, revocation, forfeiture, or lapse of a registered organization’s status or the dissolution, winding up, or cancellation of its existence does not alter its location, which continues to be dictated by UCC §9-307(e) or §9-307(f). 810 ILCS 5/9-307(g). b. [2.9] Filing Office In Illinois, the Office of the Secretary of State is the proper filing office. 810 ILCS 5/9-501(a)(2). This also applies when the debtor is a transmitting utility. 810 ILCS 5/9-501(b). Certain types of collateral require a local filing in the office where a mortgage on real estate would be filed or recorded, including 1. as-extracted collateral (defined at 810 ILCS 5/9-102(a)(6)); 2. timber to be cut (810 ILCS 5/9-501(a)(1)(A)); or 3. a financing statement filed as a fixture filing and concerning goods that are, or are about to become, fixtures (810 ILCS 5/9-501(a)(1)(B)). A mortgage on real estate is ordinarily filed with the recorder’s office in the county in which the real estate is located. 765 ILCS 5/28. 2. [2.10] When Is Filing Mandatory? Under Uniform Commercial Code §9-310(a), filing is the only manner of perfection for each of the following types of collateral: a. accounts; b. general intangibles; c. fixtures; and d. an assignment of a beneficial interest in a trust. 810 ILCS 5/9-310(a). Filing is also the only manner of perfection for agricultural liens. Id.

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§2.13

3. [2.11] When Is Filing Permissive? Article 9 of the Uniform Commercial Code permits the filing of a financing statement to perfect a security interest in various types of collateral. A security interest in the following types of collateral may be perfected by filing: a. chattel paper (tangible or electronic); b. negotiable documents; c. instruments; d. investment property; and e. in a nonstandard Illinois amendment that became effective January 1, 2002, collateral assignments of beneficial interests in Illinois land trusts. 810 ILCS 5/9-312(a). Note that certain specific rules apply to a financing statement for goods in the possession of a bailee. A financing statement for goods covered by a negotiable document must describe the negotiable document, while a financing statement for goods in the possession of a bailee that are covered by a nonnegotiable document must describe the goods. 810 ILCS 5/9-312(c), 5/9312(d)(3). Security interests in these types of collateral also may be perfected by control or possession. See §2.5 above and §§2.19 and 2.20 below. A security interest in these types of collateral perfected by filing is subordinate to security interests perfected by control or possession. Alternative methods of perfection achieve higher priority. 4. [2.12] When Is Filing Inadequate? Filing is not even an optional method of perfection for a. deposit accounts (except as proceeds), which may be perfected only by control; b. letter-of-credit rights (except as proceeds or supporting obligations), which may be perfected only by control; and c. money (except as proceeds), which may be perfected only by possession. 810 ILCS 5/9312(b). 5. [2.13] When Is Filing Requirement Superseded by Other Statutes? Transactions for which a system of filing has been established under federal law are exempted from the filing provisions. 810 ILCS 5/9-311(a)(1). In addition, transactions that are covered by state certificate-of-title statutes providing that a security interest must be indicated on the certificate as a condition or result of perfection (e.g., the Illinois Vehicle Code and the Boat Registration and Safety Act) are exempted from the filing provisions. 810 ILCS 5/9-311(a)(2), 5/9-311(a)(3). Compliance with the perfection requirements of such other statute, regulation, or

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treaty is sufficient to perfect a security interest under Article 9 and will have the same effect as a security interest that is perfected under Article 9. 810 ILCS 5/9-311(b). The time, duration, and continued effectiveness of perfection are governed by the statute, regulation, or treaty. 810 ILCS 5/9-311(c). While any such collateral is held as inventory for sale or lease and the holder is in the business of selling or leasing such goods, the certificate-of-title statute does not apply to a security interest created by the holder as debtor and perfection is achieved by filing. 810 ILCS 5/9-311(d). D. [2.14] Perfection by Control Under Uniform Commercial Code §9-314(a), a security interest in investment property, deposit accounts, electronic chattel paper, letter-of-credit rights, electronic documents, or beneficial interests in Illinois land trusts may be perfected by control of the collateral. 810 ILCS 5/9-314(a). “Control” is defined separately for each of these types of collateral. 1. [2.15] When Is Control Mandatory? Control is the only method of perfection of a security interest in deposit accounts or letter-of-credit rights. 810 ILCS 5/9-312(b)(1), 5/9-312(b)(2). a. [2.16] Control of Deposit Account Under Uniform Commercial Code §9-104(a), a secured party controls a deposit account in any of three ways: 1. if the secured party is the bank that maintains the deposit account; 2. if the secured party obtains the bank’s authenticated (see 810 ILCS 5/9-102(a)(7)) agreement that it will comply with the secured party’s instructions directing disposition of the funds in the deposit account without further consent by the debtor; or 3. if the secured party becomes the bank’s customer with respect to the deposit account. 810 ILCS 5/9-104(a). The debtor’s continued right to access the deposit account is not inconsistent with the secured party’s control. 810 ILCS 5/9-104(b). Both the secured party and the debtor may have access to the account. The security interest is perfected when the secured party obtains control. 810 ILCS 5/9-314(b). The security interest remains perfected only while the secured party retains control. Id. Banks are not required by law to enter into control agreements even if the customer so requests or directs. If a bank has entered into a control agreement, it is not obligated to confirm the existence of the agreement to another person unless requested to do so by its customer. 810 ILCS 5/9-342.

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§2.20

b. [2.17] Control of Letter-of-Credit Rights Under Uniform Commercial Code §9-107, a secured party obtains control of a letter-of-credit right if the issuer or nominated person (e.g., a confirmer or negotiating bank) consents to an assignment of the proceeds of the letter of credit. 810 ILCS 5/9-107. See also 810 ILCS 5/5-114(c). Perfection of a security interest in the original collateral also perfects a security interest in a letter-of-credit right as a supporting obligation. 810 ILCS 5/9-308(d). The secured party remains perfected only while the secured party retains control. 810 ILCS 5/9-314(b). Secured creditors should be cautioned that strict compliance with the control requirements of the UCC is critical for collateral where perfection by control is mandatory. In a case involving a judgment creditor’s claim against the judgment debtor’s deposit account, a secured creditor attempted to intervene, asserting that it had a prior perfected, priority security interest in the deposit account. Sign Builders Inc. v. SVI Themed Construction Solutions, Inc., 2015 IL App (1st) 142212, 30 N.E.3d 475, 391 Ill.Dec. 205. Despite the secured creditor’s agreement with the debtor stipulating that the creditor could only waive its rights to the debtor’s accounts through a written document, the court held that the secured creditor’s failure to satisfy any of the UCC’s requirements for control precluded from the requested intervention in the judgment creditor’s lawsuit. Id. The fact that the secured creditor was previously unaware of the existence of the deposit account did not alleviate it of its burden to satisfy the UCC’s requirements for control. Id. 2. [2.18] When Is Control Permissive? Control is available as a method to perfect a security interest in electronic chattel paper, investment property, or, in a nonstandard Illinois amendment that became effective January 1, 2002, collateral assignments of beneficial interests in Illinois land trusts. a. [2.19] Control of Electronic Chattel Paper For security interests in electronic chattel paper created before July 1, 2013, a secured party has control of electronic chattel paper if the record or records comprising the chattel paper are uniquely marked. 810 ILCS 5/9-105(1) (2012). For security interests in electronic chattel paper created after July 1, 2013, pursuant to the 2012 Amendments, a secured party has control of electronic chattel paper if the secured party’s receipt of the security interest is recorded under “a system employed for evidencing the transfer of interests in the chattel paper.” 810 ILCS 5/9-105(a). The statute does not define what constitutes a “system,” but a system is sufficient if the record or records comprising the chattel paper are uniquely marked. 810 ILCS 5/9-105(b)(1). b. [2.20] Control of Investment Property Under Uniform Commercial Code §9-106(a), a secured party has control of a certificated security, uncertificated security, or security entitlement as provided in UCC §8-106. 810 ILCS 5/9-106(a). Essentially, obtaining control of these types of investment properties means that the purchaser has taken the necessary steps, considering the manner in which the securities are held,

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§2.20

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to place itself in a position to have the securities sold without further action by the owner. Control of a commodity contract is obtained in a similar manner, as directed by UCC §9-106(b). Control over the account achieves control over the security entitlements or the commodity contracts held in the account. UCC Comment 4, 810 ILCS 5/9-106. The Article 8 rules on control of securities and security entitlements (810 ILCS 5/8-101, et seq) are as follows: 1. The secured party has “control” of a certificated security in bearer form if the security is delivered to the secured party. 810 ILCS 5/8-106(a). Delivery means the possession of the certificate by the secured party, another person on behalf of the secured party, or a securities intermediary acting on behalf of the secured party (but only if the certificate is in registered form and has been specially indorsed to the secured party by an effective indorsement). 810 ILCS 5/8301(a). 2. The secured party has control of a certificated security in registered form if the certificated security is delivered to the secured party and is indorsed to the secured party or in blank by an effective indorsement or is registered in the name of the secured party. 810 ILCS 5/8106(b). 3. The secured party has control of an uncertificated security if it is delivered to the secured party or if the issuer has agreed that it will comply with instructions originated by the secured party without further consent by the registered owner. 810 ILCS 5/8-106(c). Delivery occurs when the issuer registers the secured party or a person acting on behalf of the secured party as the registered owner. 810 ILCS 5/8-301(b)(1). Delivery also occurs if the registered owner acknowledges that it holds the security for the secured party. 810 ILCS 5/8-301(b)(2). 4. The secured party has control of a security entitlement if the secured party becomes the entitlement holder (i.e., becomes the broker’s customer) or the securities intermediary agrees that it will comply with entitlement orders originated by the secured party without further consent by the entitlement holder. 810 ILCS 5/8-106(d). A secured party has control if another person has control of the security entitlement on behalf of the secured party or, if the other person already had control of the security entitlement, the other person acknowledges that it has control on behalf of the secured party. 810 ILCS 5/8-106(d)(3). If the entitlement holder grants an interest in a security entitlement to its own securities intermediary, the securities intermediary automatically has control. 810 ILCS 5/8-106(e). A secured party may have control even though the original entitlement holder remains authorized to direct the securities intermediary to make trades and even to withdraw assets. UCC Comment 4, 810 ILCS 5/8-106. The secured party, however, must have the power to direct the securities intermediary to comply with the secured party’s entitlement orders with no further consent of the debtor. The secured party’s power to direct the securities intermediary may be conditional (e.g., it may arise only upon the debtor’s default). UCC Comment 7, 810 ILCS 5/8106.

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§2.21

A security interest perfected by control is perfected when the secured party obtains control and remains perfected until the secured party no longer has control and the debtor acquires the security certificate, becomes the registered owner of the uncertificated security, or becomes the entitlement holder. 810 ILCS 5/9-314(c). c. [2.21] Control of Collateral Assignments of Beneficial Interests in Illinois Land Trusts Illinois has enacted nonstandard provisions that took effect January 1, 2002, to preserve the former non-filing method of perfecting collateral assignments of beneficial interests (ABIs) in Illinois land trusts. Illinois land trusts are created for the principal purpose of holding title to Illinois land, and they give to the beneficiary a personal property interest called a “power of direction” or “beneficial interest.” The amendments recognize the potential, created by the inclusion of beneficial interests in revised Article 9 collateral that can be perfected by filing, of more perfected security interests in this type of personal property. Such security interests can arise under the uniform version of revised Article 9 merely by taking a security interest in all of the debtor’s general intangibles and filing a financing statement against “all assets” of the debtor in the location of the debtor. 810 ILCS 5/9-102(a)(42), 5/9-108, 5/9-504(2). Prior to the enactment of revised Article 9, conflicting caselaw in Illinois either required lodging an assignment of the beneficial interest with the land trustee or held that such interests were automatically perfected upon attachment. Compare St. Charles Savings & Loan Ass’n v. Estate of Sundberg, 150 Ill.App.3d 100, 501 N.E.2d 322, 103 Ill.Dec. 301 (2d Dist. 1986) (lodging and acceptance required), with In re Foos, No. 96 C 3982, 1996 WL 563503 (N.D.Ill. Sept. 23, 1996) (stating that weight of authority is that collateral ABI is perfected upon attachment). Rather than nullifying filing as a method of perfection (and thus creating a trap for the unwary secured party who relies on the uniform law’s specification of filing), the amendments adopt the “control” method of perfection as an additional, permissive method of perfection in the beneficial interest. 810 ILCS 5/9-107.1(a), 5/9-310(b)(8), 5/9-314(a). This approach also avoids the creation of a “secret lien” that is automatically perfected upon attachment of the ABI. Control is effected by lodging the collateral assignment with the land trustee and obtaining its acceptance by the trustee in an authenticated record. 810 ILCS 5/9-107.1(a). The secured party is in control even if the beneficiary retains the power of direction and the right to receive the rent income and profits thereof. 810 ILCS 5/9-107.1(b). Perfection by control gives the secured party a superpriority over other secured parties who perfected their ABIs by filing. This superpriority extends to beneficial interests and proceeds of beneficial interests consisting of cash proceeds or other beneficial interests in Illinois land trusts. If multiple parties perfect by control, the first to so perfect has priority. 810 ILCS 5/9-329.1. However, this is unlikely to become an issue since most assignments bar the trustee from accepting subsequent assignments without the consent of the secured party. The land trust amendments do not completely eliminate the need to identify the location of the beneficiary of a land trust and to file a financing statement there. First, a filing will ensure that the secured party receives notice of other secured parties’ foreclosures and hence provide an opportunity to intervene and assert the superpriority of perfection by control. Second, a precautionary filing avoids the prospect of litigation over choice of law if a beneficiary in a new

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§2.22

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deal is located outside Illinois. It will be less expensive to make a precautionary filing against a beneficiary than to litigate the issue. Bear in mind that the secured party who perfects by filing must be vigilant for location changes (particularly a change in the principal residence of an individual). Enforcement of a beneficial interest in an Illinois land trust may not be under Part 6 of revised Article 9, 810 ILCS 5/9-601, et seq. The Illinois Mortgage Foreclosure Law, 735 ILCS 5/15-1101, et seq., requires judicial foreclosure for ABIs in land trusts that were created at or in close proximity to the creation of the land trust pursuant to a requirement in the loan documents that the beneficial owner provide such security. 735 ILCS 5/15-1106(a)(3). Otherwise, a Uniform Commercial Code foreclosure is an optional remedy for other ABIs. 735 ILCS 5/15-1106(b). The Illinois Mortgage Foreclosure Law applies to all ABIs in land trusts created after its 1986 effective date. 735 ILCS 5/15-1106(a)(3). The amendments take special steps to ensure that local Illinois law will govern the perfection, the effect of perfection or non-perfection, and the priority of a collateral assignment of, or other security interest in, a beneficial interest in an Illinois land trust. 810 ILCS 5/9-306.1. An entire secured transaction involving a security interest in a beneficial interest in an Illinois land trust can be closed — and foreclosed — by a debtor and secured party located outside Illinois in a non-Illinois court. The special choice-of-law rule states that it implements the important interest of this State in matters associated with the administration of Illinois land trusts created for the principal purpose of owning an interest in Illinois land and the regulation of restrictions on the transfer of beneficial interests in, and of the power of appointments under, such trusts. Id. This language invokes §§223 and 278 of the RESTATEMENT (SECOND) OF CONFLICT OF LAWS that require disputes involving land to be governed by the local law of the situs of the land. This language also makes it unlikely that an Illinois court will enforce a foreign judgment that is based on non-Illinois law in conflict with this choice-of-law provision. E. Automatic Perfection (By Attachment Alone) 1. [2.22] Under What Circumstances Is Perfection by Attachment Permanent? Under Uniform Commercial Code §9-309 in each of the following circumstances, the security interest is perfected upon attachment without requiring the secured party to take possession of the collateral, obtain control of the collateral, or file a financing statement: a. Purchase-money security interests in consumer goods. However, if the consumer goods are fixtures, filing may be required under UCC §§9-310(a) and 9-502(b) (see Harney v. Spellman, 113 Ill.App.2d 463, 251 N.E.2d 265 (4th Dist. 1969)), or, if subject to a statute or treaty described in UCC §9-311(a) (see §2.13 above), then such statute or treaty governs perfection (UCC §9-311(b)). If there is no filing, transfers of the collateral to certain bona fide transferees will be free of the security interest. 810 ILCS 5/9-320(b).

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§2.22

b. Assignment of “insignificant” accounts, provided that the assignment “does not by itself or in conjunction with other assignments to the same assignee transfer a significant part of the assignor’s outstanding accounts or payment intangibles.” 810 ILCS 5/9-309(2). For insight into what might constitute a “significant part,” see City of Vermillion, South Dakota v. Stan Houston Equipment Co., 341 F.Supp. 707, 712 (D.S.D. 1972) (assignment was “significant” when it included entire proceeds of contractor’s sole construction contract), and E. Turgeon Construction Co. v. Elhatton Plumbing & Heating Co., 110 R.I. 303, 292 A.2d 230 (1972) (assignment of $10,000 retainage by plumbing subcontractor to equipment supplier was isolated event and did not constitute assignment of “significant part” of accounts receivable). c. Certain other security interests 1. arising from a sale of a payment intangible or promissory note (a sale of a participation interest in a promissory note is perfected automatically); 2. created by the assignment of a “health-care-insurance receivable” (defined at UCC §9-102(a)(46)) to the provider of the healthcare goods or services (a subsequent assignment from the healthcare provider to another is not automatically perfected); 3. arising under UCC §2-401, §2-505, §2-711(3), or §2A-508(5), until the debtor obtains possession of the collateral; 4. of a collecting bank in items, accompanying documents, and proceeds arising under UCC §4-210; 5. of an issuer or nominated person arising under UCC §5-118; 6. arising in the delivery of a financial asset under UCC §9-206(c) (i.e., when a broker credits a financial asset to the buyer’s account before payment); 7. in investment property created by a broker or securities intermediary or in a commodity contract or a commodity account created by a commodity intermediary; 8. arising from an assignment for the benefit of creditors of the transferor and subsequent transfers by the assignee; and 9. created by an assignment of a beneficial interest in a decedent’s estate. 810 ILCS 5/9-309. In addition, a security interest in a “supporting obligation” (defined at UCC §9-102(a)(78) as being a letter-of-credit right or secondary obligation that supports the payment or performance of certain types of collateral) is automatically perfected if a security interest in the collateral related to the supporting obligation is perfected. 810 ILCS 5/9-308(d).

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2. [2.23] Under What Circumstances Is Temporary Perfection by Attachment Achieved? A security interest in certificated securities, negotiable documents, or instruments is temporarily perfected under UCC §9-312(e) for a period of 20 days from the time of attachment, even if there has been no filing and the collateral remains in the possession of the debtor, as long as the secured party provided “new value” to the debtor. In addition, under UCC §9-312(f), a security interest that is already perfected with respect to a negotiable document or goods in the possession of a bailee (but not goods covered by a negotiable document) will remain temporarily perfected for 20 days without filing if the secured party makes the collateral available to the debtor for the purpose of ultimate sale or exchange or dealing with such collateral prior to sale or exchange in a manner consistent with such purpose. A perfected security interest in a certificated security or instrument also remains temporarily perfected, under UCC §9-312(g), for 20 days without filing if the secured party delivers such collateral to the debtor for the purpose of ultimate sale or exchange or presentation, collection, enforcement, renewal, or registration of transfer. After any 20-day period of temporary perfection expires, perfection will lapse unless such security interest is perfected in another manner directed by Article 9. See In re Schwinn Cycling & Fitness, Inc., 51 U.C.C.Rep.Serv.2d (CBC) 1224 (Bankr. D.Colo. 2003) (although plaintiff was temporarily perfected at petition date, plaintiff lost that status by failing to file financing statement within 20 days of parting with its collateral). If the collateral is sold, the interest in proceeds remains perfected only to the extent permitted under UCC §9-315(d). F. Special Types of Collateral 1. [2.24] Stock Option Contracts and Stock Warrants There is some uncertainty as to whether stock option contracts and stock warrants are securities and, thus, investment property, under the Uniform Commercial Code because of a split of authority as to whether stock options or warrants are included in the definition of “investment security.” See E.F. Hutton & Co. v. Manufacturers National Bank of Detroit, 259 F.Supp. 513, 517 (E.D.Mich. 1966) (stock warrants fall within definition of “investment security” under former version of Article 8); Art-Camera-Pix, Inc. v. Cinecom Corp., 64 Misc.2d 764, 315 N.Y.S.2d 991, 994 (1970) (transferable warrants evidencing rights to subscribe for shares in corporation will normally be “securities”); Cohn, Ivers & Co. v. Gross, 56 Misc.2d 491, 289 N.Y.S.2d 301, 305 (1968) (call option is not security, but rather “chose in action” concerning security). However, although cases discussing Article 8 may be instructive, these cases do not involve the treatment of securities under Article 9. Later caselaw suggests that stock options and warrants are likely general intangibles, which are perfected by filing, and not investment securities, which may be perfected by possession or filing. In re Larson, No. 90-05863, 1993 WL 367106 (Bankr. D.N.D. July 1, 1993) (creditor perfected its security interest in debtor’s general intangibles that included stock options); Cardillo v. Tech Prototype, Inc., Civil No. 92-235-SD, 1994 WL 264918, *3 (D.N.H. Mar. 17, 1994) (for purposes of summary judgment, stock options fail to meet Article 8 definition of “security”); United States v. Oncology Associates, P.C., 269 B.R. 139, 157 (D.Md. 2001), aff’d, 61 Fed.Appx. 860 (4th Cir. 2003) (stock option agreement falls within general intangibles under UCC).

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Moreover, at least two authors maintain that over-the-counter (OTC) derivatives would be deemed “general intangibles” and specifically “payment intangibles” under Article 9. These authors reached this conclusion based on authorities’ finding that certain option rights constituted “general intangibles.” Mark A. Guinn and William L. Harvey, Taking OTC Derivative Contracts as Collateral, 57 Bus.Law. 1127 (May 2002). Guinn and Harvey concluded that OTC options would not fall within the definition of “security” or “financial asset” under UCC §8-102 even though they are considered securities under federal statutes. While there is no clear answer to the question presented by stock options and warrants, it is important to consider this issue when security consists of stock options and/or warrants, and prudence may dictate perfection by both filing and possession. 2. [2.25] Partnership and LLC Interests Article 8 of the Uniform Commercial Code, 810 ILCS 5/8-101, et seq., contains special rules regarding partnership and LLC interests. The most critical is UCC §8-103(c), which states that an interest in a partnership or limited liability company is not a security unless it is dealt in or traded on securities exchanges or in securities markets, its terms expressly provide that it is a security governed by Article 8, or it is an investment company security. 810 ILCS 5/8-103(c). However, an interest in a partnership or limited liability company is a financial asset if it is held in a securities account. This definition controls over the more general definition of “security” in UCC §8-102 (which would, if applicable, likely lead to the conclusion that most partnership and LLC interests are securities). 810 ILCS 5/8-102(a)(15). Lenders involved in financing transactions involving security interests in partnership and LLC ownership interests must consider each portion of this definition: a. See if the ownership interests are publicly traded in the market. If they are, they are securities. If not, go to the next step. b. See if the partnership or LLC itself is a registered investment company. If it is, the interests are securities. If not, go to the next step. c. Look carefully at the partnership and LLC charter documents to see whether these documents “expressly provide” that the interests are securities. If not, and the first two tests were passed, then the interests are not securities. A partnership or LLC interest that is not a security will therefore be a “general intangible.” Security interests in such partnership or LLC interests may be perfected by filing a financing statement in the appropriate filing office or by other means. The last sentence of UCC §8-103(c) makes it clear that, whatever the status of the interest as a security or non-security, if held in a securities account, it is a financial asset and thus subject to perfection through control over the account itself. The secured party would be wise, however, to make sure that it has control, not just perfection through filing, if possible.

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In addition, the partnership and LLC interests may be certificated or uncertificated. If certificated, the prudent lender will require physical possession and control in that fashion as well as perfection through other means, whether or not the interests are securities. 3. [2.26] Vehicles Security interests in vehicles are subject to several unique rules. A “vehicle” is defined under the Illinois Vehicle Code as [e]very device, in, upon or by which any person or property is or may be transported or drawn upon a highway or requiring a certificate of title under Section 3-101(d) of this Code [625 ILCS 5/3-101(d)], except devices moved by human power, devices used exclusively upon stationary rails or tracks and snowmobiles as defined in the Snowmobile Registration and Safety Act [625 ILCS 40/1-1, et seq.]. 625 ILCS 5/1-217. A financing statement is not required to be filed to perfect a security interest in a vehicle and, if filed, is not effective. 810 ILCS 5/9-310(b)(3), 5/9-311(a)(2). Compliance with the motor vehicle lien statute is equivalent to filing a financing statement under Article 9, except that the time of perfection is determined by the Illinois Vehicle Code. 810 ILCS 5/9-311(b). A security interest in a vehicle is not valid against any creditor of the owner or any subsequent transferee of the owner or other secured party unless the security interest is perfected under the Illinois Vehicle Code. 625 ILCS 5/3-202(a). With one exception, a security interest in a vehicle may be perfected only by compliance with the Illinois Vehicle Code, and a security interest so perfected remains perfected even though use or possession of the vehicle is transferred. 810 ILCS 5/9-311(b); 625 ILCS 5/3-207. Perfection occurs by delivery to the Illinois Secretary of State of the existing certificate of title, if any, and an application for a new certificate of title containing the name and address of the secured party and the appropriate filing fee. 625 ILCS 5/3-202(b). In connection with the enactment of revised Article 9, the Illinois Vehicle Code was amended to deal with delays in the process of recovery of the certificate of title from the prior lienholder or the dealer. Under the amendment, the perfection date relates back to the time of the security interest’s creation if the delivery to the Secretary of State is completed within 30 days after the creation of the security interest or the new lienholder receives the certificate of title for the prior lienholder or dealer; otherwise, it is perfected as of the delivery date. Id. This should avoid bankruptcy attack in the event of an intervening bankruptcy of the owner. The local law of the jurisdiction that issues the certificate of title governs perfection, the effect of perfection or non-perfection, and the priority of a security interest in vehicles from the time the vehicle becomes covered by the certificate of title until it ceases to be covered. 810 ILCS 5/9-303(c). This law governs, even if there is no other relationship between the jurisdiction and the vehicle or the debtor. 810 ILCS 5/9-303(a). See In re Paige, 679 F.2d 601 (6th Cir. 1982); Hoffman v. Associates Commercial Corp. (In re Durette), 228 B.R. 70 (Bankr. D.Conn. 1998); Meeks v. Mercedes Benz Credit Corp., 257 F.3d 843 (8th Cir. 2001); In re Johnson, 407 B.R. 364 (Bankr. E.D.Ark. 2009).

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Goods become covered by a certificate of title when an application for a certificate of title and the appropriate fee are delivered to the appropriate authority. Goods cease to be covered at the earlier of the time the certificate of title becomes ineffective or the time the vehicle becomes covered by a certificate of title issued by another jurisdiction. 810 ILCS 5/9-303(b). Even though another state law governs perfection, the security interest remains perfected until it otherwise would have lapsed, subject to loss of perfection to purchasers of the vehicle for value described below in this section. 810 ILCS 5/9-316(d). A security interest in vehicle inventory held for sale or lease by a person in the business of selling or leasing goods of that kind is not perfected by notation on a certificate of title and must be perfected by filing a financing statement. 810 ILCS 5/9-311(d). Article 9 also requires perfection by filing against inventory in the case of title vehicles on lease (as opposed to merely held for lease). Id. Perfection of a security interest in inventory of a dealer is governed by the general perfection rules even though the vehicles will be covered by a certificate of title in the hands of a buyer. Under the former Uniform Commercial Code §9-302(3)(b), a secured party who financed a dealer would have filed a financing statement on the goods held for sale and would have complied with the certificate of title statute for goods held for lease. UCC Comment 4, 810 ILCS 5/9-311. Under revised Article 9, financers simply must file against the goods as inventory, whether the goods are held for sale or lease. If the debtor moves the vehicle to another jurisdiction and a new certificate of title is issued that does not show the security interest that was shown on the prior certificate, perfection continues until the security interest would have lapsed. 810 ILCS 5/9-316(d). However, perfection lapses as against a purchaser of the goods for value (including a secured party), and the security interest is deemed never to have been perfected against such purchaser if the lien is not noted on the new certificate of title within four months. 810 ILCS 5/9-316(e). A creditor who becomes aware that the vehicle has moved to another jurisdiction has four months to have its lien noted on the new state’s certificate of title or risk subordination to another secured party or buyer. Alternatively, the secured party may continue perfection by taking possession, or repossession, of the vehicle. 810 ILCS 5/9-313(b). Only in this circumstance does possession of the vehicle perfect. Id. 4. [2.27] Boats and Vessels Procedures governing perfection of security interests in boats depend on the size of the boat and the jurisdiction. If a boat weighs more than five tons and meets certain other requirements set forth in Chapter 121 of Title 46 of the U.S. Code, the boat may be federally “documented.” 46 U.S.C. §12102; 46 C.F.R. §67.5. A federal filing with the National Vessel Documentation Center (www.uscg.mil/hq/cg5/nvdc) is required in order to perfect an interest in a documented boat. 46 U.S.C. §31321. Generally, this federal filing takes the form of a “preferred mortgage,” which is given status and priority as a maritime lien. Id. For boats not covered under the federal documentation system that meet the definition of “motorboat” under 625 ILCS 45/1-2, “[a] security interest is perfected by the delivery to the Department of Natural Resources of the existing certificate of title, if any, an application for a

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certificate of title containing the name and address of the lienholder and the date of his security agreement and the required fee. It is perfected as of the time of its creation if the delivery is completed within 21 days thereafter, otherwise as of the time of the delivery.” 625 ILCS 45/3B-2(b). For all other “vessels” not included in the Illinois statutory definition of “motorboat,” perfection is governed by the same rules applicable to other goods, equipment, and/or inventory under Article 9. See 625 ILCS 45/1-2 (broadly defining “vessel” as “every description of watercraft used or capable of being used as a means of transportation on water, except a seaplane on the water, air mattress or similar device, and boats used for concession rides in artificial bodies of water designed and used exclusively for such concessions”). 5. [2.28] Aircraft If a federal statute, regulation, or treaty preempts Article 9’s rules with respect to when a secured party’s interest in collateral has priority over lien creditors, then the filing of a financing statement is neither necessary nor effective to perfect a security interest in that collateral. 810 ILCS 5/9-311(a)(1). Security interests in civil aircraft and their parts are subject to such federal statutes. UCC Comment 2, 810 ILCS 5/9-311; 49 U.S.C. §§44107 – 44111. See also Philko Aviation, Inc. v. Shacket, 462 U.S. 406, 76 L.Ed.2d 678, 103 S.Ct. 2476, 2479 (1983); In re AvCentral, Inc., 289 B.R. 170 (Bankr. D.Kan. 2003) (Federal Aviation Administration (FAA) controls perfection of security interest in aircraft); Aircraft Trading & Services, Inc. v Braniff, Inc., 819 F.2d 1227 (2d Cir. 1987); Travel Express Aviation Maintenance, Inc. v. Bridgeview Bank Group, 406 Ill.App.3d 1013, 942 N.E.2d 694, 697, 347 Ill.Dec. 491 (2d Dist. 2011). The distinct types of collateral that must be perfected under the Federal Aviation Act include (a) civil aircraft; (b) aircraft engines of 750 or more rated takeoff horsepower; (c) aircraft propellers capable of absorbing 750 or more rated takeoff shaft power; and (d) aircraft engines, propellers, appliances, and spare parts maintained by an air carrier certified under 49 U.S.C. §44705. 49 U.S.C. §44107(a). To perfect a security interest in aircraft, the instrument granting the security interest must be recorded with the Federal Aviation Administration Aircraft Registry. Form AFS-750-93, Information in Recording of Aircraft Ownership and Security Documents ¶2, www.faa.gov/licenses_certificates/aircraft_certification/aircraft_registry/media/AFS-750-93.pdf. The instrument must be signed by the debtor, who must be the registered owner, and must be notarized. 49 U.S.C. §44107. Additional requirements for properly recording security interests in civil aircraft and aircraft parts may be found in the Federal Aviation Administration regulations, 14 C.F.R. pt. 49, Recording of Aircraft Titles and Security Documents. A security interest that has been recorded with the FAA is perfected from the date of filing. 49 U.S.C. §44108. A security interest that has not been recorded with the FAA is enforceable only against the debtor, its heirs and devisees, and those who have actual notice of the interest. Id. Although federal law governs perfection of security interests in aircraft and major aircraft parts, priority of interests between interest holders in such collateral is still a matter governed by state law. See Braniff, supra, 819 F.2d at 1232; Northern Illinois Corp. v Bishop Distributing Co., 284 F.Supp. 121 (W.D.Mich. 1968) (applying rule that buyer in ordinary course from dealer takes free of security interest created by seller even if secured party filed under federal system). Note,

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however, that if there is any doubt as to whether perfection is governed by the federal scheme, it is advisable to file a financing statement. See Ahlbum v. Craig (In re Craig), 57 B.R. 63 (Bankr. D.S.C. 1985). G. Choice-of-Law Rules 1. [2.29] General Rule The law of the debtor’s location generally governs the perfection, the effect of perfection or non-perfection, and the priority of a security interest that is perfected by filing. 810 ILCS 5/9-301(1). However, if perfection is by possession, then the law of the state where the collateral is located governs perfection, the effect of perfection or non-perfection, and the priority of such security interest. 810 ILCS 5/9-301(2). In addition, with respect to tangible collateral (e.g., negotiable documents, goods, instruments, money, or tangible chattel paper) perfected by filing, the law of the jurisdiction where the collateral is located governs the effect of perfection. 810 ILCS 5/9-301(3)(C). 2. [2.30] Agricultural Liens The law of the jurisdiction where the farm products are located governs perfection, the effect of perfection or non-perfection, and the priority of an agricultural lien on farm products. 810 ILCS 5/9-302. 3. [2.31] Goods Covered by a Certificate of Title The law of the jurisdiction under whose certificate of title the goods are covered governs perfection and priority of a security interest in goods covered by a certificate of title. This rule applies only during the time the goods are actually covered by the certificate of title. 810 ILCS 5/9-303(c). 4. [2.32] Deposit Accounts The law of the bank’s jurisdiction with which the deposit account is maintained governs perfection and priority of a security interest in a deposit account. 810 ILCS 5/9-304(a). A bank’s jurisdiction is determined in accordance with the rules of 810 ILCS 5/9-304(b). 5. [2.33] Investment Property The law governing perfection and priority of a security interest in certificated securities is that of the jurisdiction where the security certificate is located. 810 ILCS 5/9-305(a)(1). With respect to uncertificated securities, the law of the jurisdiction where the issuer is located governs perfection and priority. 810 ILCS 5/9-305(a)(2). The law of the jurisdiction where the securities or commodity intermediary is located governs the effect of perfection of a security interest in security entitlements, commodity contracts, securities accounts, and commodity accounts. 810 ILCS 5/9-305(a)(3), 5/9-305(4). A commodity intermediary’s jurisdiction is determined in accordance with the rules of Uniform Commercial Code §9-305(b). 810 ILCS 5/9-305(b).

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6. [2.34] Letter-of-Credit Rights The law of the issuer’s or nominated person’s jurisdiction governs perfection and priority of a security interest in a letter-of-credit right. 810 ILCS 5/9-306(a). An issuer’s or nominated person’s jurisdiction is determined in accordance with the rules of 810 ILCS 5/9-306(b).

III. ELEMENTS OF A FINANCING STATEMENT A. [2.35] Contents Uniform Commercial Code §9-506(a) provides that a “financing statement substantially satisfying the requirements of this Part is effective, even if it has minor errors or omissions, unless the errors or omissions make the financing statement seriously misleading.” 810 ILCS 5/9-506(a). Nevertheless, to be effective, the financing statement must contain certain information. Subject to certain exceptions, a financing statement must state (1) the name of the debtor, (2) the name of the secured party or a representative of the secured party, and (3) the collateral covered by the financing statement. 810 ILCS 5/9-502(a). This information is discussed in §§2.36 – 2.49 below. The official forms (see §2.53 below) ask for certain additional information. Note also the requirements of the Secretary of State (see §2.64 below). 1. [2.36] Identification of Debtor and Secured Party Under former Article 9, courts were generally somewhat lenient about errors in the name of the secured creditor. For instance, courts rejected arguments that financing statements were defective when the creditor was identified by one of its divisional trade names (Clarke Floor Machine Division of Studebaker Corp. v. Gordon, 7 U.C.C.Rep.Serv. (CBC) 363 (Super.Ct.Md. 1970)), by a shortened version of its real name (Industrial National Bank of Rhode Island v. Quinn (In re Dwares), 6 B.R. 335 (Bankr. D.R.I. 1980)), when the secured creditor later changed its name or address (Steego Auto Parts Corp. v. Markey, 2 Ohio App.3d 200, 441 N.E.2d 279 (1981)), or when the name of the parent company of the secured party was used (In re Colorado Mercantile Co., 299 F.Supp. 55 (D.Colo. 1969)). Decisions under revised Article 9 should take a similar view. Further, a financing statement does not need to indicate the representative capacity of a secured party or the representative of a secured party to be sufficient. 810 ILCS 5/9-503(d). However, stricter rules regarding the debtor’s name have been promulgated because the filing officer uses the debtor’s name to index the security interest. a. [2.37] Identifying Correct Debtor Section 9-503(a) of the Uniform Commercial Code provides the requirements for naming the debtor on a financing statement: 1. For a registered organization, the financing statement must provide the name of the debtor indicated on the public record of the debtor’s jurisdiction of organization that shows the debtor to have been organized.

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2. For a decedent’s estate, the financing statement must provide the name of the decedent and indicate that the debtor is an estate. 3. For a trust or a trustee acting with respect to property held in trust, the financing statement must a. provide the name specified for the trust in its organic documents or, if no name is specified, provide the name of the settlor and additional information sufficient to distinguish the debtor from other trusts having one or more of the same settlors; and b. indicate that the debtor is a trust or is a trustee acting with respect to property held in trust. 4. In all other cases, a. if the debtor has a name, the financing statement must provide the individual or organizational name of the debtor; and b. if the debtor does not have a name, the financing statement must provide the names of the partners, members, associates, or other persons comprising the debtor. 810 ILCS 5/9-503(a). The 2012 Amendments, effective July 1, 2013, included several technical changes related to additional information that must be provided with respect to a decedent’s estate and certain trusts. With respect to a decedent’s estate, a financing statement must indicate that the collateral is being administered by a personal representative rather than that the debtor is a decedent’s estate. 810 ILCS 5/9-503(a)(2). The name of the decedent is sufficient if it is the same as the name of the decedent on the court order appointing the personal representative. 810 ILCS 5/9-503(f). Similarly, for a trust that is not a registered organization, the financing statement must provide (1) the name of the trust specified in the organic records of the trust, or if none is specified, the name of the settlor or testator, and (2) an indication that the collateral is held in trust. 810 ILCS 5/9-503(a)(3). b. [2.38] Effect of Errors or Omissions Under the general rule stated in Uniform Commercial Code §9-506(b), a financing statement that fails to sufficiently identify the debtor under UCC §9-503(a) is seriously misleading. 810 ILCS 5/9-506(b). However, if the financing statement would still be found using standard search methods (as described in UCC §9-506(c)), then the financing statement will not be considered seriously misleading. 810 ILCS 5/9-506(c). A financing statement that includes an incorrect address for the debtor is not seriously misleading. AG Venture Financial Services, Inc. v. Montagne (In re Montagne), 417 B.R. 214, 226 (Bankr. D.Vt. 2009) (“The courts have found that an incorrect address, serving only a minimal purpose in filing, does not constitute a seriously misleading error or omission.”), citing Hergert v. Bank of the West (In re Hergert), 275 B.R. 58, 68 (Bankr. D. Idaho 2002).

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c. [2.39] New Debtor Becoming Bound by Security Agreement In certain circumstances, such as when a change in business structure occurs, a new debtor may become bound by an existing security agreement. For example, if the original debtor to a security agreement is a sole proprietorship that becomes incorporated, a new debtor is bound. Also, the original debtor may be a corporation that merges into another corporation. UCC Comment 2, 810 ILCS 5/9-508. If a new debtor has or acquires rights in collateral for which a financing statement has already been filed, a security interest in that collateral remains perfected to the extent that the financing statement would have been effective had the original debtor acquired rights in the collateral. 810 ILCS 5/9-508(a). However, if the filing against the original debtor is seriously misleading (see §2.38 above) as to the new debtor, the filing is effective only as to collateral acquired by the new debtor before and within four months after becoming bound (see 810 ILCS 5/9-203(d) for the rule regarding how a new debtor becomes bound). 810 ILCS 5/9-508(b)(1). A financing statement that provides the name of the new debtor must be filed within four months of the new debtor’s becoming bound by the security agreement to perfect a security interest in collateral acquired by the new debtor more than four months after becoming bound. 810 ILCS 5/9-508(b)(2). See also §2.44 below. d. [2.40] Multiple Debtors and Secured Parties More than one debtor and secured party may be indicated on a financing statement. 810 ILCS 5/9-503(e). e. [2.41] Correctly Recording Debtor’s Name For an individual debtor, the financing statement must identify the debtor’s last name. 810 ILCS 5/9-516(b)(3)(C). Under the former Article 9, many cases found that a misspelling of an individual debtor’s last name is defective. Bank of North America v. Bank of Nutley, 94 N.J.Super. 220, 227 A.2d 535 (1967) (“Kaplas” instead of “Kaplan”); National Cash Register Co. v. Valley National Bank of Long Island, 5 U.C.C.Rep.Serv. (CBC) 396 (N.Y.Sup. 1968) (“Boywald” instead of “Borgwald”); In re Brawn, 6 U.C.C.Rep.Serv. (CBC) 1031 (Bankr. D.Me. 1969) (“Brown” instead of “Brawn” and reversal of first and last names). Similarly, one court has held that using the name “McGovern Auto Specialty, Inc.” was not effective against “McGovern Auto & Truck Parts, Inc.” Kay Automotive Warehouse, Inc. v. McGovern Auto Specialty, Inc. (In re McGovern Auto Specialty, Inc.), 51 B.R. 511 (Bankr. E.D.Pa. 1985). It is important to make sure that the financing statement actually refers to the correct debtor. See, e.g., River Valley Bank of Russellville, Arkansas v. Ace Sports Management, LLC (In re Ace Sports Management, LLC), 271 B.R. 134 (Bankr. E.D.Ark. 2001) (secured party incorrectly listed individual debtor’s corporation as debtor in financing statement instead of individual debtor).

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Prior to the 2012 Amendments, Article 9 did not provide any specific criteria in regard to the sufficiency of an individual’s name. What constitutes an individual debtor’s name should be determined by a review of the debtor’s driver’s license, social security card, birth certificate, or other official documents. Some doubt exists as to whether the use of an individual debtor’s nickname is sufficient. In Clark v. Deere & Co. (In re Kinderknecht), 308 B.R. 71 (B.A.P. 10th Cir. 2004), the Tenth Circuit Bankruptcy Appellate Panel held that the use of a debtor’s nickname (Terry) in a creditor’s financing statements rather than his legal name (Terrance) rendered the financing statement insufficient. This holding reversed the lower court and disavowed the result in In re Erwin, 50 U.C.C.Rep.Serv.2d (CBC) 933 (Bankr. D.Kan. 2003), in which the use of “Mike Erwin” as opposed to “Michael A. Erwin” did not render the financing statement seriously misleading because a reasonably diligent searcher not only would have run searches for “Michael A. Erwin,” but also for “Erwin” or “Erwin, M.” and would have found the financing statements. As Kinderknecht emphasizes, a secured party should make every effort to ensure the full legal name of an individual appears on a financing statement. Kinderknecht has engendered much discussion and controversy, and there are other questions left to be determined, such as the use of foreign names or how to resolve conflicts in the event that the debtor’s legal name shows up differently on the birth certificate, driver’s license, passport, etc. At least one court in Illinois has held that the name appearing on the debtor’s driver’s license is sufficient for purposes of §9-516(b)(3)(C), reversing a bankruptcy court opinion holding that the secured party must use the name on the debtor’s birth certificate when it conflicts with the name on his or her driver’s license. In re Miller, 78 U.C.C.Rep.Serv.2d (CBC) 496 (C.D.Ill. Aug. 17, 2012). The 2012 Amendments addressed this confusion by providing specific criteria for the sufficiency of an individual’s name. A financing statement sufficiently identifies an individual’s name only if it lists (1) the name indicated on the debtor’s most recent, state-issued, unexpired driver’s license; or (2) if the individual lacks a driver’s license, the individual’s surname and first personal name. 810 ILCS 5/9-503(a), 5/9-503(g). Accordingly, the 2012 Amendments adopted the view advanced in Miller, supra. In Pankratz Implement Co. v. Citizens National Bank, 33 Kan.App.2d 279, 102 P.3d 1165 (2004), the court concluded that a financing statement filed against “Roger House” instead of the debtor’s legal name, “Rodger House,” was seriously misleading because the financing statement would not be disclosed using the state’s standard search logic. The court held, in First Community Bank of East Tennessee v. Jones (In re Silver Dollar, LLC), 388 B.R. 317 (Bankr. E.D.Tenn. 2008), that, under Tennessee law, a filing in the trade name or assumed name of a debtor does not meet the “debtor’s name” filing requirement even if such name is registered with the state. Some courts have held that financing statements that fail to state an entity’s common organizational designations (such as “Inc.” or “LLC”) are seriously misleading. Official Committee of Unsecured Creditors for Tyringham Holdings, Inc. v. Suna Bros. (In re Tyringham Holdings, Inc.), 354 B.R. 363 (Bankr. E.D.Va. 2006). Under the Illinois business regulations regarding search requests, certain words and abbreviations at the end of the name that indicate the type of organization are disregarded as “Ending Noise Words.” 14 Ill.Admin. Code

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§2.42

SECURED TRANSACTIONS

§180.18(b)(4). Under the regulation, ending noise words include “Corp,” “Company,” “Inc,” and “LLC.” Id. However, because filing regulations change from time to time and searches vary from office to office, it is advisable to ensure that the exact legal name of the debtor (as registered with the secretary of state of the state of its incorporation) appears on the financing statement. A financing statement may provide the names of multiple debtors and multiple secured parties. 810 ILCS 5/9-503(e). f.

[2.42] Using Trade Names

A financing statement sufficiently shows the name of the debtor if it complies with the requirements of Uniform Commercial Code §9-503(a), whether or not it adds other trade names or names of partners. 810 ILCS 5/9-503(b). However, a financing statement that provides only the debtor’s trade name is insufficient. 810 ILCS 5/9-503(c). g. [2.43] Using Partnership Names Uniform Commercial Code §1-201(b)(25) defines the term “organization” very broadly, which includes partnerships of all kinds. 810 ILCS 5/1-201(b)(25). Therefore, the rules of UCC §9-503(a)(4), as described in §2.37 above, apply to partnerships. 810 ILCS 5/9-503(a)(4). If a partnership has a name, that name should be provided on the financing statement. Otherwise, the names of the individual partners should be provided. The 2012 Amendments clarified that the names of individual partners should be provided in a manner such that the financing statement would be sufficient if each individual partner were the debtor. h. [2.44] Change in Debtor’s Name In the event the debtor changes its name such that a filed financing statement becomes seriously misleading (see §2.38 above), that financing statement is effective to perfect a security interest in collateral acquired only before, or within four months after, the change. 810 ILCS 5/9-507(c)(1). In order to perfect a security interest in collateral acquired more than four months after the change, however, an amendment to the financing statement that renders it not seriously misleading must be filed within four months after the change. 810 ILCS 5/9-507(c)(2). i.

[2.45] Change in Debtor’s Location

If the debtor’s location changes, a financing statement must be filed in the jurisdiction of the debtor’s new location within four months of the change in order to maintain the continued perfection of a security interest in collateral that must be perfected by filing where the debtor is located. 810 ILCS 5/9-316(c)(2).

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PERFECTING ARTICLE 9 SECURITY INTERESTS UNDER ILLINOIS LAW

§2.48

2. [2.46] Debtor’s Signature Unlike under the former Article 9, a financing statement does not need to be signed by the debtor. See 810 ILCS 5/9-502(a). This requirement was eliminated to facilitate electronic filings. Although the debtor’s signature is not required, the debtor must generally authorize the filing of the financing statement. 810 ILCS 5/9-509(a)(1). The fact that a debtor authenticates or becomes bound by a security agreement constitutes authorization to file a financing statement. 810 ILCS 5/9-509(b). In addition, by acquiring collateral in which a security interest or agricultural lien continues after disposition of the collateral (see 810 ILCS 5/9-315(a)), a debtor authorizes the filing of a financing statement covering the collateral. 810 ILCS 5/9-509(c). The concept of authorization is not addressed by Article 9 but rather is left to judicial interpretation. See UCC Comment 2, 810 ILCS 5/9-509. A secured party is entitled to file a financing statement covering only collateral in which it holds an agricultural lien even without authorization by the debtor. 810 ILCS 5/9-509(a)(2). 3. [2.47] Addresses A filing office is required to reject a financing statement that fails to provide a mailing address for both the debtor and the secured party. 810 ILCS 5/9-516(b)(4), 5/9-516(b)(5), 5/9-520(a). Nevertheless, a filed financing statement that satisfies the requirements of Uniform Commercial Code §9-502(a) (which does not require that the address of either the secured party or the debtor appear on the financing statement) is effective, even if the filing office was required to refuse to accept it. 810 ILCS 5/9-520(c). In other words, if the filing office mistakenly accepts a financing statement for filing that it should refuse under UCC §9-520(a), as long as the financing statement provides all of the information required under UCC §9-502(a), it will be effective. Further, a financing statement that includes an incorrect address is effective. See AG Venture Financial Services, Inc. v. Montagne (In re Montagne), 417 B.R. 214, 225 – 226 (Bankr. D.Vt. 2009). 4. [2.48] Description of Collateral A financing statement must “indicate” the collateral that is covered. 810 ILCS 5/9-502(a)(3). The indication is sufficient if the description reasonably identifies what is described. 810 ILCS 5/9-504(1), 5/9-108(a). Collateral is reasonably identified by specific listing, category, type (as provided in Uniform Commercial Code §9-102), quantity, computational or allocational formula or procedure, or any other method, as long as the identity of the collateral is objectively determinable. 810 ILCS 5/9-108(b). AG Venture Financial Services, Inc. v. Montagne (In re Montagne), 417 B.R. 214 (Bankr. D.Vt. 2009) (financing statement is designed to include minimum information necessary to put creditors on notice that further investigation is required). Certain types of collateral (such as investment property, commercial tort claims, and, in consumer transactions, consumer goods, security entitlements, securities accounts, and commodities accounts) must be described according to more specific rules, however. See 810 ILCS 5/9-108(d), 5/9-108(e). In addition, an indication that the financing statement covers “all assets” or “all personal property” is sufficient. 810 ILCS 5/9-504(2). See also Grabowski v. Deere & Co. (In re Grabowski), 277 B.R. 388 (Bankr. S.D.Ill. 2002). Note, however, that such a description is not

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§2.49

SECURED TRANSACTIONS

sufficient for a security agreement. 810 ILCS 5/9-108(c). If the description of the collateral is insufficient, the creditor still has an enforceable security interest pursuant to the security agreement; however, the creditor will lose its priority status relative to other perfected secured creditors because the security interest was not properly perfected. See Sirazi v. General Mediterranean Holding, SA, No. 12 C 653, 2015 WL 1541087 (N.D.Ill. Apr. 1, 2015). The secured party must exercise care to ensure that the collateral description in the financing statement is at least as broad as that in the security agreement. Otherwise, the secured party will have a perfected security interest only in the narrower class of collateral. In re Keneco Financial Group, Inc., 131 B.R. 90, 93 (Bankr. N.D.Ill. 1991), citing Sweney v. Cardinal Doors, Inc. (In re Door Supply Center, Inc.), 3 B.R. 103 (Bankr. D. Idaho 1980). For instance, the term “tools” has been found to exclude equipment and machinery. Sweney, supra, 3 B.R. at 105 – 106. However, a Pennsylvania court held that a security interest was limited to the specific sizes and types of raw steel as listed in the security agreement, and once that material was incorporated into the finished product, that security interest was no longer valid, despite the broader language in the financing statement. Samuel Son & Co. v. Excalibur Machine Co. (In re Excalibur Machine Co.), 404 B.R. 834 (Bankr. W.D.Pa. 2009). Financing statements for purchase-money security interests do not require any special language. DeKalb Bank v. Klotz, 151 Ill.App.3d 638, 502 N.E.2d 1256, 104 Ill.Dec. 596 (2d Dist. 1986). An issue that is not addressed by Article 9 is whether a description in a security agreement includes after-acquired collateral if the agreement does not explicitly so provide. UCC Comment 3, 810 ILCS 5/9-108, states that no reference to descriptions of after-acquired collateral is included because this issue is a question of contract interpretation and is not subject to a statutory rule. With respect to a financing statement, however, because Article 9 now permits a description of “all assets” or “all personal property,” it would seem that after-acquired collateral would be included in such a broad description. UCC Comment 2, 810 ILCS 5/9-108. To ensure perfection, however, the prudent secured party should include reference to after-acquired property in the financing statement. See In re Middle Atlantic Stud Welding Co., 503 F.2d 1133 (3d Cir. 1974) (no security interest in after-acquired accounts receivable because security agreement and financing statement did not so provide); Schechter v. Nelson (In re Nightway Transportation Co.), 96 B.R. 854 (Bankr. N.D.Ill. 1989) (intent of parties, as manifested by security agreement, determines whether security interest includes after-acquired accounts). But see First Bank v. Eastern Livestock Co., 837 F.Supp. 792 (S.D.Miss. 1993) (issue is whether financing statement is adequate to warn prospective purchasers of preexisting security interest such that further inquiry would be prudent). 5. [2.49] Filing as to As-Extracted Collateral, Timber To Be Cut, or Fixtures In addition to satisfying the requirements of Uniform Commercial Code §9-502(a), a financing statement that covers as-extracted collateral or timber to be cut, or that is filed as a fixture filing and covers goods that are or are to become fixtures, must also a. indicate that it covers this type of collateral; b. indicate that it is to be filed in the real property records;

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§2.50

c. provide a description of the real property to which the collateral is related that would be adequate in a record of a mortgage of the real property in Illinois; and d. if the debtor does not have an interest of record in the real property, provide the name of a record owner. 810 ILCS 5/9-502(b). The description of the related real property must be sufficient to reasonably identify it. 810 ILCS 5/9-108(a). As stated in UCC Comment 5, 810 ILCS 5/9-502, the test for the adequacy of the description is whether the financing statement will fit into the real property search system and be found through a standard search. A recorded mortgage may also suffice as a financing statement with respect to as-extracted collateral, timber to be cut, or fixtures. In order to be effective as such, a. the mortgage must indicate the goods or accounts that it covers; b. the security interest must be in goods that are or are to become fixtures, as-extracted collateral, or timber to be cut that is related to the real property; c. the mortgage must satisfy the requirements of UCC §§9-502(a) and 9-502(b) other than an indication that it is to be filed in the real property records; and d. the mortgage must be recorded. 810 ILCS 5/9-502(c). B. [2.50] When To File “A financing statement may be filed before a security agreement is made or a security interest otherwise attaches.” 810 ILCS 5/9-502(d). Except for certain limited exceptions relating to a transmitting utility or a real estate mortgage used as a fixture filing (Uniform Commercial Code §§9-515(f), 9-515(g)), a financing statement is effective for a period of five years from the date of filing (UCC §9-515(a)) unless a continuation statement is filed within six months before the financing statement lapses (UCC §§9-515(c), 9-515(d)). 810 ILCS 5/9-515. If the debtor files a bankruptcy, the lapse of the financing statement is not tolled (unlike under the former Article 9), and the secured creditor must file a continuation statement, as provided above, in order to maintain continuous perfection of its security interest. See UCC Comment 4, 810 ILCS 5/9-515. This apparently can be done even without first obtaining relief from the automatic stay. 11 U.S.C. §362(b)(3). However, to the extent that the bankruptcy laws determine the rights of creditors only as of the date of the filing of the bankruptcy petition (11 U.S.C. §544(a)), there may be no practical effect if perfection lapses after the bankruptcy petition is filed (unless, for instance, the asset that is the collateral is abandoned from the bankruptcy estate and, thus, not administered therein or the asset is first acquired after the lapse).

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§2.51

SECURED TRANSACTIONS

C. [2.51] Special Bankruptcy Rule Under certain circumstances, a security interest that is perfected on or before 30 days after the debtor receives possession of the collateral is not avoidable as a preference. 11 U.S.C. §547(c)(3)(B). See also Fidelity Financial Services, Inc. v. Fink, 522 U.S. 211, 139 L.Ed.2d 571, 118 S.Ct. 651 (1998). Consequently, for preference purposes, the secured creditor is given a 30-day grace period to perfect from the time the debtor first acquires possession of the collateral. Courts have held that what constitutes “perfection” for purposes of the grace period depends on state law. Moser v. Toyota Motor Credit Corp. (In re Davis), No. 07-42789, 2009 WL 1033194 (Bankr. E.D.Tex. Mar. 24, 2009) (holding that lien on automobile was considered recorded when creditor submitted its application even though certificate of title was not issued until after grace period was over). D. [2.52] How To File Section 9-516(a) of the Uniform Commercial Code provides that “communication of a record to a filing office and tender of the filing fee or acceptance of the record by the filing office constitutes filing.” 810 ILCS 5/9-516(a). Consequently, it is extremely important to retain a time-stamped copy of all filings in the event of an error in the Secretary of State’s Office. The fact that the filing office fails to index a record correctly does not, however, alter its effectiveness. 810 ILCS 5/9-517. The language of UCC §9-516(a) is sufficiently broader than its corollary from the former Article 9 (former UCC §9-403(1)) to permit electronic filing. E. [2.53] Financing Statement Forms The Uniform Commercial Code Financing Statement (Form UCC1) is ordinarily used by secured parties who file with the Secretary of State’s Office and do not have to file in the real estate records. The UCC Financing Statement Addendum (Form UCC1AD) is ordinarily used by secured parties who file in the county, such as for perfecting security interests in timber to be cut, as-extracted collateral, or fixtures. The approved forms are contained in the official text of UCC §9-521 promulgated by the National Conference of Commissioners on Uniform State Laws and are available and fillable at www.cyberdriveillinois.com/publications/business_services/ucc.html. F. [2.54] How To Amend a Financing Statement An amendment must identify the initial financing statement by its file number, and, if the amendment relates to an initial financing statement that was filed in the office where a mortgage is filed, it must provide the date and time that the initial financing statement was filed as well as the information specified in Uniform Commercial Code §9-502(b), as described in §2.49 above. 810 ILCS 5/9-512(a). An amendment does not extend the period of effectiveness of the financing statement to which it relates. 810 ILCS 5/9-512(b). An amendment adding collateral or a debtor is effective as to the new collateral only from the date of filing the amendment. 810 ILCS 5/9-512(c), 5/9-512(d). An amendment that deletes all debtors or secured parties of record without providing any new names is ineffective. 810 ILCS 5/9-512(e). Note that separate

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§2.55

amendments are not necessary to effect multiple changes to a financing statement. A single amendment is sufficient to make multiple changes. See UCC Comment 2, 810 ILCS 5/9-512. The approved forms are contained in the official text of UCC §9-521(b) promulgated by the National Conference of Commissioners on Uniform State Laws and are available and fillable at www.cyberdriveillinois.com/publications/business_services/ucc.html. An amendment, other than one adding collateral or a debtor, may be filed only if the secured party of record authorizes the filing. 810 ILCS 5/9-509(d)(1). If the amendment is a termination statement (see §2.60 below), it may be filed only if the secured party of record has failed to file or send a termination statement when it is required to do so under UCC §9-513(a) or §9-513(c), the debtor authorizes the filing, and the termination statement so indicates. 810 ILCS 5/9-509(d)(2). If there is more than one secured party of record, any one of them may authorize the filing of an amendment under UCC §9-509(d). 810 ILCS 5/9-509(e). G. [2.55] When Filing Office Can Reject Filings A filing office that accepts written records may not refuse to accept a written initial financing statement, financing statement addendum, financing statement amendment, or financing statement amendment addendum in the proper format except for a reason set forth in Uniform Commercial Code §9-516(b). 810 ILCS 5/9-521. Even if the financing statement is sufficient (see §§2.35 – 2.49 above), filing offices are authorized and, in fact, required to reject filings that do not fulfill several additional requirements. 810 ILCS 5/9-520(a). A filing office may reject a filing only for these reasons, and if rejected for one of these reasons, the filing is ineffective. 810 ILCS 5/9-520(a), 5/9-516(b). To avoid rejection, an initial financing statement must fulfill the following requirements as well as the “sufficiency” requirements described in §§2.35 – 2.49 above: 1. It must be communicated by a method or medium authorized by the filing office. 810 ILCS 5/9-516(b)(1). 2. The filing fee and recordation tax (for fixture filings) must be tendered with the financing statement. 810 ILCS 5/9-516(b)(2). 3. If the debtor is an individual, the debtor’s last name must be clear. 810 ILCS 5/9-516(b)(3)(C). 4. A record to be filed in the real property records must give a sufficient description of the real property. 810 ILCS 5/9-516(b)(3)(D). 5. The secured party’s mailing address must be included. 810 ILCS 5/9-516(b)(4). 6. The debtor’s mailing address must be included. 810 ILCS 5/9-516(b)(5)(A). 7. The financing statement must state whether the debtor is an individual or an organization, and, for financing statements filed prior to July 1, 2013, if the debtor is an organization, the type

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§2.56

SECURED TRANSACTIONS

of organization, a jurisdiction of organization, and an organizational identification number (or state that the debtor has none). 810 ILCS 5/9-516(b)(5)(B), 5/9-516(b)(5)(C). Following July 1, 2013, as a result of the 2012 Amendments, a financing statement filed against an organization need not list the type of organization, jurisdiction of organization, or organization identification number, and a filing office may no longer reject a financing statement based on the failure to include that information. 810 ILCS 5/9-516. Filing offices may reject amendments that do not contain specified information. 810 ILCS 5/9-516(b). A continuation statement not filed within six months before the financing statement lapses may be rejected. 810 ILCS 5/9-516(b)(7). If the filing office is unable to read information in the financing statement, the statement is deemed not to include the information. 810 ILCS 5/9-516(c)(1). A financing statement that is rejected for a reason not specified in UCC §9-502 or §9-516 is effective as a filed financing statement, except against a purchaser of the collateral who gives value in reasonable reliance on the absence of the financing statement. If the filing office accepts a financing statement that it should have rejected, the financing statement is effective if it is “sufficient.” UCC Comment 3, 810 ILCS 5/9-520. If the filing office rejects a record, it must tell the person that presented the record that the record has been rejected, the reason for the rejection, and a date and time the record would have been filed. 810 ILCS 5/9-520(b). The communication must be made at the time and in the manner prescribed by filing office rule. Id. H. [2.56] Inaccurate or Wrongfully Filed Records If a financing statement is inaccurate or filed wrongfully, the debtor (or any person under whose name the record is indexed) may file a correction statement. 810 ILCS 5/9-518(a). Before July 1, 2013, this correction statement did not change the legal effect of the filed record. Former 810 ILCS 5/9-518(c). The correction statement must identify the record to which it relates by its file number or, if the correction statement relates to a real property records filing, the information required for statements filed in the real property records office; state that it is a correction statement; and give an explanation of why the debtor believes the record is inaccurate or wrongful and how the record should actually read. 810 ILCS 5/9-518(b). The 2012 Amendments made various minor changes with respect to correction statements and who may file them. First, “correction statements” were renamed “information statements” to more accurately reflect that the filing of the statement does not affect the effectiveness of the filed record. Second, the secured party of record will be authorized to file information statements with respect to records the secured party asserts were filed without authorization. 810 ILCS 5/9518(c). For example, if the debtor files an unauthorized termination statement, the secured party may file an information statement to put third parties on notice that the secured party did not authorize the filing of the termination statement with respect to its financing statement.

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§2.60

I. [2.57] Filing Office Indexing Errors The risk of a filing office indexing error is borne by searchers. Even if a record is indexed improperly so that it cannot be found through a search, it is effective. 810 ILCS 5/9-517.

IV. [2.58] CONTINUATION STATEMENT A continuation statement may be filed by the secured party within six months prior to the expiration of the original financing statement. 810 ILCS 5/9-515(d). Because a continuation statement is a type of amendment, the secured party must comply with the rules of Uniform Commercial Code §9-512(a) regarding amendments to a financing statement, as discussed in §2.54 above. 810 ILCS 5/9-512(a). The filing of a timely continuation statement extends the effectiveness of a financing statement for five years from the time the financing statement would have become ineffective. 810 ILCS 5/9-515(e). The UCC does not govern the duration and renewal of perfection of security interests perfected by compliance with a separate statutory regime. 810 ILCS 5/9-311(c). Thus, for example, a continuation statement is not required to continue the effectiveness of a security interest in an aircraft perfected by a filing with the Federal Aviation Administration because such an interest “is valid from the date of filing . . . without other recordation.” Travel Express Aviation Maintenance, Inc. v. Bridgeview Bank Group, 406 Ill.App.3d 1013, 942 N.E.2d 694, 698, 347 Ill.Dec. 491 (2d Dist. 2011), quoting 49 U.S.C. §44108(b).

V.

[2.59] STATEMENT OF RELEASE

In order to release all or part of any collateral described in a financing statement, a statement of release (which is a type of amendment) must comply with the rules of Uniform Commercial Code §9-512(a) regarding amendments to a financing statement, as discussed in §2.54 above. 810 ILCS 5/9-512(a).

VI. [2.60] TERMINATION STATEMENT When there is no outstanding secured obligation and no commitment to make advances, incur obligations, or otherwise give value, a secured party with a financing statement covering consumer goods must, within 20 days after receiving an authenticated demand, file a termination statement with the Secretary of State (Uniform Commercial Code §§9-513(a), 9-513(b)), and, for property other than consumer goods (with certain exceptions discussed below in this section), the secured party must, within 20 days after receiving an authenticated demand from a debtor, send a termination statement to the debtor (UCC §9-513(c)(1)). 810 ILCS 5/9-513(a) through 5/9-513(c)(1). (Even if there is no demand, a party with a security interest in consumer goods must file a termination statement within one month. 810 ILCS 5/9-513(b)(1).)

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§2.61

SECURED TRANSACTIONS

When a financing statement covers (a) accounts or chattel paper that has been sold but as to which the account debtor has discharged its obligation (UCC §9-513(c)(2)), or (b) goods that were the subject of a consignment to the debtor but that are no longer in the debtor’s possession (UCC §9-513(c)(3)), the secured party must send a termination statement to the debtor within 20 days of receiving an authenticated demand from the debtor. 810 ILCS 5/9-513(c)(2), 5/9-513(c)(3). A termination statement, which is a type of amendment, must comply with the rules of UCC §9-512(a) regarding amendments to a financing statement, as discussed in §2.54 above. Upon the filing of a termination statement, the financing statement to which it relates ceases to be effective. 810 ILCS 5/9-513(d).

VII. [2.61] STATEMENT OF ASSIGNMENT A financing statement itself may disclose an assignment of a security interest by providing the name and mailing address of the assignee as the name and address of the secured party. 810 ILCS 5/9-514(a). Alternatively, a secured party may assign all or part of its rights by filing an amendment that identifies the initial financing statement to which it relates by file number, provides the name of the assignor, and provides the name and mailing address of the assignee. 810 ILCS 5/9-514(b). Note, however, that mortgages filed as fixture filings can be assigned only under other applicable state law. 810 ILCS 5/9-514(c). After the assignee becomes the secured party of record, he or she alone has standing to sue to enforce the claim. Art Signs, Inc. v. Schaumburg State Bank, 162 Ill.App.3d 955, 516 N.E.2d 341, 114 Ill.Dec. 186 (1st Dist. 1987).

VIII. [2.62] CONSIGNMENT/LEASE STATEMENT Transactions, like consignments and leases, will sometimes be intended as security devices. 810 ILCS 5/9-103(d). Consequently, unless the resulting security interest is perfected, it may become subordinate to the rights of a bankruptcy trustee or competing lien or security interest holder. As a precautionary measure, parties like consignors and lessors may, under Uniform Commercial Code §9-505(a), file protective financing statements using the terms “consignor,” “consignee,” “lessor,” “lessee,” or the like instead of the terms “secured party” and “debtor.” 810 ILCS 5/9-505(a). The filing “is not of itself a factor in determining whether the collateral secures an obligation.” 810 ILCS 5/9-505(b). Under revised Article 9, a consignment as to inventory is treated in the same manner as a purchase-money security interest in inventory. 810 ILCS 5/9-103(d). The temporary perfection rule that permits a secured creditor to have its security interest in goods other than inventory or livestock relate back to the date the debtor received possession of the goods, so long as the creditor perfects its security interest within 20 days after receipt by the debtor, does not apply to inventory. 810 ILCS 5/9-324(a). As to inventory, a purchase-money security interest has priority over conflicting security interests in the same inventory only if

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§2.64

a. the purchase-money security interest is perfected when the debtor receives possession of the inventory; b. the purchase-money secured party sends an authenticated notification to the holder of the conflicting security interest; c. the holder of the conflicting security interest receives the notification within five years before the debtor receives possession of the inventory; and d. the notification states that the person sending the notification has or expects to acquire a purchase-money security interest in inventory of the debtor and describes the inventory (or expects to ship certain described inventory on consignment, as the case may be). 810 ILCS 5/9-324(b). Therefore, in order to avoid losing priority to a secured creditor with a conflicting security interest in a consignee’s inventory, a consignor of inventory should exercise caution by ensuring that both (a) a consignment financing statement is filed and (b) notification is sent to secured creditors with conflicting security interests in inventory prior to shipping the consigned inventory.

IX. [2.63] REQUESTS FOR INFORMATION Sections 9-523(a) and 9-523(b) of the Uniform Commercial Code provide methods for obtaining copies of filed documents. 810 ILCS 5/9-523(a), 5/9-523(b). Section 9-523(c) provides a method for obtaining reports of searches of filed documents. 810 ILCS 5/9-523(c).

X.

[2.64] SECRETARY OF STATE’S RULES AND REGULATIONS

The Illinois Secretary of State has promulgated rules consistent with revised Article 9 and in harmony with the rules and practices of filing offices in other states. 810 ILCS 5/9-526. The Secretary of State’s rules are found at 14 Ill.Admin. Code pt. 180. Besides creating some useful definitions, the rules provide key guidance regarding when tender of a record, such as a financing statement or amendment, is complete. Tender of such a record is complete at the time of personal delivery at the Office of the Secretary of State’s Uniform Commercial Code Division in Springfield. 14 Ill.Admin. Code §180.11(a)(1). In the case of records delivered by courier or postal service, however, the time of delivery is not the time of tender. Instead, tender is not complete until the next close of business following the time of delivery for financing statements. 14 Ill.Admin. Code §§180.11(a)(2), 180.11(a)(3). The rules make it clear that regardless of mode of delivery, the tender is complete even though the record may not have been accepted by the Secretary of State for filing and may be subsequently rejected. 14 Ill.Admin. Code §§180.11(a)(2), 180.11(a)(3).

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The rules confirm that the forms prescribed by UCC §9-521 are acceptable. 14 Ill.Admin. Code §180.12. These forms are available and fillable on the Secretary of State’s website at www.cyberdriveillinois.com/departments/business_services/uniform_commercial_code/ home.html. Online filing is available at www.cyberdriveillinois.com/departments/business_ services/uniform_commercial_code/ucc_instructions.html. However, the Secretary of State’s Office maintains some requirements for filings that must be followed, or the forms may be rejected: a. Names and addresses of the debtor and secured party “shall be in all capital or mixed case letters with a font size of at least 10 point Helvetica/Swiss style font.” 14 Ill.Admin. Code §180.12(a). b. Two paper copies of the record must be submitted along with a self-addressed stamped envelope if the remitter is to receive one copy as an acknowledgment. 14 Ill.Admin. Code §180.12(b). c. The record “must contain the full legal name and address of the debtor and indicate whether the debtor is an individual or an organization.” 14 Ill.Admin. Code §180.12(c). However, “disclosure on the records of the social security number or tax identification number of the debtor is non-required information and, due to the sensitive nature of the information, it will be redacted from the record.” Id. d. Filing fees are $20, and search fees are $10 per name, plus $1 per page of copies received. 14 Ill.Admin. Code §180.13(a). The rules confirm that the Secretary of State’s duties are ministerial in determining whether to accept or refuse a filing. The Secretary of State will not determine the legal sufficiency of a record, the existence of a security interest, or the accuracy of information or create any presumption that a record is correct in whole or in part. 14 Ill.Admin. Code §180.15(a). The Secretary of State will refuse a UCC financing statement if it contains more than one secured party or assignee name or address and some certain names or addresses are missing or illegible or no address is given in the applicable field, or if the filing fee has not been paid. 14 Ill.Admin. Code §§180.13(c), 180.15(b). Addresses should include street address, city, state, and postal code. 14 Ill.Admin. Code §180.15(b). The Secretary of State will return a rejected record along with the filing fee but undertakes no obligation to advise the remitter of defects. 14 Ill.Admin. Code §§180.15(c), 180.15(d). If it is later determined that the filing officer’s initial refusal to accept a record was in error, then the filing officer will file the record with the filing date and time when the actual filing occurs, but it will also file a statement stating that the effective date and time of filing was the date when the UCC record was originally tendered for filing. 14 Ill.Admin. Code §180.15(e). 14 Ill.Admin. Code §180.18 describes the rules followed by the Secretary of State for indexing names. As discussed in §2.41 above, the Secretary of State will ignore “ending noise words” on the list promulgated and adopted by the International Association of Corporation Administrators. This list includes common ending words such as “Corp,” “Corporation,” and “Co.” 14 Ill.Admin. Code §180.18(b)(4).

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The search rules make it essential that the full name of an individual or organization debtor appear on the record. Except for ending noise words, all other words are searchable and will restrict the results returned. For first and middle names of individuals, searches treat an initial as the logical equivalent of all names that begin with that initial. Thus, a search for “John A. Smith” would retrieve all filings against persons named “John Smith” with any middle name beginning with the letter “A” or with the middle initial “A.” If no middle initial is included in the request, “the search would retrieve all filings against individual debtors with ‘John’ or the initial ‘J’ as the first name, ‘Smith’ as the last name and with any name or initial or no name or initial in the middle name field.” 14 Ill.Admin. Code §180.18(b)(7). The rules bear close study with respect to the method used in the search logic of the Secretary of State’s Office. This is crucial. A record that is not disclosed by a search using the full name of the debtor will be ineffective because it is seriously misleading.

XI. [2.65] TRANSITION RULES FOR 2012 AMENDMENTS The 2012 Amendments apply to any transaction or lien within its scope, even if the transaction or lien was entered into or created before the July 1, 2013, effective date of the amendments. 810 ILCS 5/9-802(a). The 2012 Amendments do not apply in any bankruptcy cases or lawsuits commenced before July 1, 2013. To ease the transition to post-amendment Article 9, the Illinois legislature enacted various rules governing the continuing effectiveness of security interests created before July 1, 2013: a. Security interests that meet the requirements for attachment and perfection under both pre- and post-amendment Article 9 remain perfected after July 1, 2013, without any further action by the secured party. 810 ILCS 5/9-803(a). b. Security interests that meet the requirements for attachment and perfection under pre-amendment Article 9 but not post-amendment Article 9 remain perfected after July 1, 2013, as long as all of the attachment and perfection requirements under post-amendment Article 9 were satisfied before July 1, 2014. 810 ILCS 5/9-803(b) (as amended). Accordingly, secured creditors that did not take appropriate action to satisfy the post-amendment Article 9 perfection requirements prior to July 1, 2014, may need to evaluate the status of their perfection and priority. c. Security interests created but not properly perfected before July 1, 2013, under pre-amendment Article 9, but which otherwise satisfy all of the requirements for attachment and perfection under post-amendment Article 9, become perfected on July 1, 2013, or at the time the post-amendment Article 9 perfection requirements are met, whichever is later. 810 ILCS 5/9-804. d. A financing statement filed before July 1, 2013, that satisfies all of the requirements for perfection under post-amendment Article 9 is effective to perfect a security interest even though it was filed before the July 1, 2013 effective date of the 2012 Amendments. 810 ILCS 5/9-805(a). Such financing statements may be continued by the filing of a continuation statement. 810 ILCS 5/9-805(c).

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e. A financing statement filed before July 1, 2013, that was effective under pre-amendment Article 9 but would not be effective under post-amendment Article 9 is not rendered ineffective by the amendments but ceases to be effective at the time it would have otherwise lapsed under pre-amendment Article 9. 810 ILCS 5/9-805(b). Post-amendment Article 9 only governs the conflicting priority of security interests if one or more of the security interests were first perfected after July 1, 2013. If all of the conflicting security interests were perfected prior to July 1, 2013, then pre-amendment Article 9 governs priority. 810 ILCS 5/9-809.

XII. APPENDIX A. [2.66] Information for State and County Filing The Secretary of State’s website provides online filing (www.cyberdriveillinois.com/ departments/business_services/uniform_commercial_code/ucc_instructions.html), and the UCC forms may be filled and printed (www.cyberdriveillinois.com/departments/business_services/ uniform_commercial_code/ucc_instructions.html) and mailed to Secretary of State Uniform Commercial Code Division 501 South Second Street, Room 350 W Springfield, IL 62756 217-782-7518 For more information, call 217-782-7518 or 217-782-7519 (online filings). B. [2.67] Perfection Chart

Collateral Accounts — 810 ILCS 5/9-102(a)(2). Accounts and payment intangibles assigned — 810 ILCS 5/9-102(a)(2), 5/9-102(a)(61). Aircraft, engines, and propellers (over 750 hp).

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Perfection Method(s) Filing.

Proceeds Rule Filing collateral.

Automatic.*

Filing collateral.

*Cannot be a significant part of assignor’s accounts or payment intangibles.

Other statute — 49 U.S.C. §§44107, 44108; 14 C.F.R. pts. 47, 49.

Filing collateral.

File with Federal Aviation Administration in Oklahoma City. Also file overlapping UCC to perfect in-flight logs, records, and related equipment.

Comments General rule.

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Perfection Collateral Method(s) Aircraft parts of “certified Other statute — air carrier.” 49 U.S.C. §§44107, 44108, 44705. Assignment for benefit of Automatic. creditors. Beneficial interest in Automatic. decedent’s estate. Beneficial interest in Control or filing. Illinois land trust.

Proceeds Rule Filing collateral.

Certificated securities.

Possession.

Certificates of deposit — 810 ILCS 5/9-102(a)(29), 5/9-102(a)(49).

Control.

Non-filing collateral. Non-filing collateral.

Chattel paper, electronic — 810 ILCS 5/9-102(a)(11). Chattel paper, tangible — 810 ILCS 5/9-102(a)(11).

Control or filing. Possession or filing.

Non-filing collateral. Non-filing collateral.

Check.

Possession or filing.

Non-filing collateral.

Control or filing.

Consignments — 810 ILCS 5/9-102(a)(20).

Filing or possession.

Filing collateral. Non-filing collateral.

Non-filing collateral.

Automatic.*

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Comments File with FAA in Oklahoma City.

Filing collateral.

Automatic.*

Commodity contract or account — 810 ILCS 5/9-102(a)(14), 5/9-102(a)(15).

§2.67

Filing collateral.

Filing was mandatory until nonstandard amendment took effect January 1, 2002. Take “delivery” under 810 ILCS 5/8-301. Follow rules for “Investment property” (if applicable) or control agreement for “Deposit accounts.” 810 ILCS 5/9-105 describes special “control” methods. 810 ILCS 5/9-312(a), 5/9-313(a). Add legend to chattel paper to notify others of security interest. Type of “Instrument.” NOTE: Secured party also can be “holder in due course.” *Special rule for collecting bank’s security interest under 810 ILCS 5/4-210. Type of “Investment property.” *Security interest of commodity intermediary. Follows purchase-money security interest rules in 810 ILCS 5/9-317, 5/9-324.

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§2.67

Collateral Copyrights.

SECURED TRANSACTIONS

Perfection Method(s) Other statute — 17 U.S.C. §101, et seq.

Proceeds Rule Filing collateral.

Filing.*

Deposit accounts — 810 ILCS 5/9-102(a)(29).

Non-filing collateral.

*File precautionary UCC financing statement against any goods that incorporate the copyright. Control mandatory. *Automatic perfection by control for depository bank’s security interest — 810 ILCS 5/9-104(a)(1).

Control.*

Equipment — 810 ILCS 5/9-102(a)(33). Farm products — 810 ILCS 5/9-102(a)(34).

Filing.

Filing collateral.

Filing.

Filing collateral.

Fixtures — 810 ILCS 5/9-102(a)(41). General intangibles — 810 ILCS 5/9-102(a)(42). Goods — 810 ILCS 5/9-102(a)(44).

Filing.

Filing collateral.

Filing.

Filing collateral.

Filing or possession.*

Filing collateral.

Goods covered by negotiable documents — 810 ILCS 5/7-104.

Filing or possession.

Filing collateral.

Perfect against document.*

Comments File security agreement with U.S. Copyright Office.

Central filing with legal description — 810 ILCS 5/9-501, 5/9-502. Local filing with legal description. Catchall if not otherwise covered. *Perfection by bailee in possession requires authenticated acknowledgment by bailee — 810 ILCS 5/9-313(c).

General “goods” rule.

*Gives superproirity over secured party who files against goods or obtains possession thereof — 810 ILCS 5/9-312(c). NOTE: Secured party can be “holder” of negotiable document — 810 ILCS 5/7-301.

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Collateral Goods covered by nonnegotiable documents — 810 ILCS 5/7-104.

Perfection Method(s) Filing or possession.

Proceeds Rule Filing collateral.

Comments General “goods” rule.

Filing collateral.

*Issuance of nonnegotiable documents in name of secured party or bailee’s receipt of notice of secured party’s interest — 810 ILCS 5/9-312(d). Subset of “Accounts.”

Other.*

Healthcare insurance receivables — 810 ILCS 5/9-102(a)(46).

Filing.

Instruments — 810 ILCS 5/9-102(a)(47). Inventory — 810 ILCS 5/9-102(a)(48).

Possession or filing. Filing or possession.

Non-filing collateral. Filing collateral.

Investment property — 810 ILCS 5/9-102(a)(49).

Control or filing.

Non-filing collateral.

*Automatic only if assigned to healthcare provider.

Automatic.*

Automatic.*

Letter-of-credit documents.

Automatic.

Filing collateral.

Letter-of-credit rights — 810 ILCS 5/9-102(a)(51). Licenses of patents, trademarks, copyrights.

Control.

Non-filing collateral. Filing collateral.

Money.

Other statute.

Possession.

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§2.67

NOTE: Additional predelivery notice and perfection deadline for purchase-money security interest — 810 ILCS 5/9324(b). General rule — 810 ILCS 5/9-312(a), 5/9-314(a). *Automatic perfection of interest of broker or securities intermediary only. Security interest in favor of letter-of-credit issuer or nominated person. Control mandatory. File license agreement and assignment with appropriate U.S. agency. Precautionary UCC filing with U.S. Patent and Trademark Office or U.S. Copyright Office. 810 ILCS 5/9-312(b)(3).

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Collateral Negotiable documents.

Patents.

SECURED TRANSACTIONS

Perfection Method(s) Possession or filing.

Proceeds Rule Non-filing collateral.

Other statute — 35 U.S.C. §100, et seq.

Filing collateral.

Comments Possession primes security interests in documents or covered goods perfected by filing. File collateral patent assignment with U.S. Patent and Trademark Office. File precautionary UCC financing statement.

Payment intangibles sold — 810 ILCS 5/9-102(a)(61). Promissory notes sold — 810 ILCS 5/9-102(a)(65). Purchase-money security interest in consumer goods — 810 ILCS 5/9-102(a)(23). Purchase-money security interest in goods — 810 ILCS 5/9-102(a)(44), 5/9-103.

Automatic.

Filing collateral.

Automatic.

Filing collateral.

Automatic or filing.*

Filing collateral.

Filing.

Filing collateral.

Rail cars.

Other statute — 49 U.S.C. §11301, et seq. Possession or control.

Filing collateral.

Security interest arising from sale of financial assets — 810 ILCS 5/8-102(a)(9).

Securities account or entitlements. Ships.

Supporting obligations and liens.

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Non-filing collateral.

Automatic.*

Control. Other statute — 46 U.S.C. §31321, et seq. Automatic.

Non-filing collateral. Filing collateral.

Filing collateral.

*NOTE: Filing required to defeat a buyer of consumer goods — 810 ILCS 5/9320(b). NOTE: Additional predelivery notice and perfection for purchasemoney security interest in inventory collateral — 810 ILCS 5/9-324(b), 5/9324(c). File with U.S. Surface Transportation Board. See type of financial asset for general rules. *Security interest of securities intermediary or buyer of security. See type of financial asset for general rules. Control agreement with custodian of account. File with Secretary of Transportation. Perfected upon support of underlying collateral — 810 ILCS 5/9-308(d), 5/9-308(e).

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Collateral Timber and as-extracted collateral — 810 ILCS 5/9-102(a)(6). Title vehicles, boats, and goods.

Trademarks, trade names, service marks, etc., and licenses thereof.

Perfection Method(s) Filing.

Proceeds Rule Filing collateral.

Other state statutes.

Filing collateral.

§2.67

Comments Local filing with legal description. Secured party listed on title as owner or secured party (depends on title statute).

Possession.*

*Possession can perfect for title vehicles brought into new state until prior title lapses (e.g., by surrender of title and application to title agency in new state).

Filing.**

**Filing mandatory for inventory held for sale by dealer in that trade or held for lease or out on lease by such a dealer.

Filing. Other statute* — 15 U.S.C. §1051, et seq.

Filing collateral. *Also file assignment with U.S. Patent and Trademark Office. NOTE: Trademark assignment also must refer to debtor’s goodwill, and secured party should take security interest in equipment or formula associated with trademark to prevent loss due to separation of trademark.

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3

Priorities Among Article 9 Security Interests and Competing Rights

RICHARD J. MASON PAUL J. CATANESE STEPHANIE C. GRATTON McGuireWoods LLP Chicago

The contribution of John F. Pollick to previous editions of this chapter is gratefully acknowledged.

®

©COPYRIGHT 2016 BY IICLE .

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I. [3.1] Introduction II. Basic Rules of Priority for Holders of Article 9 Security Interests A. Law Governing Priority of Security Interests 1. [3.2] Perfection vs. Priority 2. [3.3] General Rules on Choice of Law 3. [3.4] Goods Covered by Certificates 4. [3.5] Deposit Accounts 5. [3.6] Investment Property 6. [3.7] Letter-of-Credit Rights 7. [3.8] Beneficial Interest in an Illinois Land Trust B. Persons with Priority over Unperfected Security Interests — Uniform Commercial Code §9-317 1. [3.9] Parties with Perfected Security Interests 2. [3.10] Prior Lien Creditors 3. [3.11] Certain Buyers, Lessees, and Licensees 4. [3.12] Parties with Rights Superior to Perfected Security Interests C. Priorities Among Conflicting Security Interests — Uniform Commercial Code §9-322 1. [3.13] Rule of First in Time 2. [3.14] Proceeds and Supporting Obligations 3. [3.15] Exceptions to “First in Time” Rule for Perfected Security Interests a. [3.16] Special Priming Security Interests — UCC §9-322(f) b. [3.17] Future Advances — UCC §9-323 c. [3.18] Security Interest in Collateral Transferred by Debtor — UCC §9-325 d. [3.19] Security Interest Created by New Debtor — UCC §§9-326 and 9-508 e. [3.20] Purchase-Money Security Interests — UCC §9-324 f. [3.21] Deposit Accounts — UCC §9-327 g. [3.22] Investment Property — UCC §9-328 h. [3.23] Letter-of-Credit Rights — UCC §9-329 i. [3.24] Beneficial Interest in an Illinois Land Trust — UCC §9-329.1 j. [3.25] Chattel Paper — UCC §9-330 k. [3.26] Instruments — UCC §9-330 l. [3.27] Documents and Securities — UCC §9-331 m. [3.28] Money — UCC §9-332 n. [3.29] Accessions and Fixtures — UCC §§9-335 and 9-334 o. [3.30] Commingled Goods — UCC §9-336 p. [3.31] Goods Covered by Certificate of Title — UCC §9-337 q. [3.32] Security Interest Perfected with Financing Statement Providing Certain Incorrect Information — UCC §9-338 r. [3.33] Proceeds — UCC §9-315

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4. [3.34] Effect of Subordination Agreement on Priority 5. [3.35] Priorities as to Security Interests Established Prior to Effective Date a. [3.36] Security Interest Perfected Before Effective Date — UCC §9-803 b. [3.37] Priority — UCC §9-809 III. [3.38] Non-Article 9 Rights Competing for Priority with Rights of Perfected Security Interests A. [3.39] Liens Relating to Possession of Goods for Services or Materials 1. [3.40] Artisans 2. [3.41] Warehouses 3. [3.42] Carriers 4. [3.43] Landlords and Other Potential “Possessors” B. [3.44] Rights of Owner or Encumbrancer of Real Estate with Fixtures C. [3.45] Rights of Reclaiming Seller D. [3.46] Rights of Judicial Lienholder E. [3.47] Rights of Buyers, Lessees, and Licensees F. [3.48] Rights of Lessor of Personalty G. [3.49] Rights of Bailor H. [3.50] Rights of Consignor I. [3.51] Rights of Setoff and Recoupment J. Various Competing Rights Arising from Federal Law 1. [3.52] Rights of Government Under Procurement Programs 2. [3.53] Federal Tax Liens 3. [3.54] Rights of Pension Benefit Guaranty Corporation 4. [3.55] Rights of Government Under Racketeer Influenced and Corrupt Organizations Act 5. [3.56] Rights of Sellers of Perishable Agricultural Commodities, Livestock, and Poultry 6. [3.57] Rights of Bankruptcy Estate 7. [3.58] Rights of Employees in Hot Goods 8. [3.59] Rights of Employees Under the Worker Adjustment and Retraining Notification Act

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I. [3.1] INTRODUCTION The purpose of this chapter is to provide an outline of the basic rules of priority for security interests created under the revised Illinois version of Article 9, 810 ILCS 5/9-101, et seq., of the Uniform Commercial Code (UCC). Revised Article 9 went into effect on July 1, 2013. See P.A. 97-1034. All citations to the UCC in this chapter are to the revised version unless otherwise noted. The rules of transition are set forth in UCC §§9-802 through 9-808. The chapter leaves a discussion of agricultural liens and related matters to other materials devoted to agricultural financing. Sections 3.2 – 3.37 below present an outline of the fundamental rules of priority among holders of Article 9 security interests. The discussion is not intended to cover all of the many exceptions to and nuances of the basic concepts. That will require reference to the precise text of Article 9 and to applicable caselaw. Sections 3.38 – 3.59 below focus on conflicts between a holder of a perfected security interest and a holder of some of the more common competing rights arising under state or federal law.

II. BASIC RULES OF PRIORITY FOR HOLDERS OF ARTICLE 9 SECURITY INTERESTS A. Law Governing Priority of Security Interests 1. [3.2] Perfection vs. Priority Uniform Commercial Code §§9-301 through 9-306.1 set forth a number of rules for determining the law governing the perfection and priority of security interests. 810 ILCS 5/9-301 through 5/9-306.1. Generally, the law of a single jurisdiction will govern both questions of perfection and priority. However, this may not always be the case when the debtor and the collateral are located in different jurisdictions. UCC Comment 7, 810 ILCS 5/9-301. The rules do not address choice of law for purposes other than perfection and priority, such as whether to characterize the transaction as a secured transaction. Id. 2. [3.3] General Rules on Choice of Law Except for special rules relating to priority of security interests in goods covered by certificates of title (Uniform Commercial Code §9-303), deposit accounts (UCC §9-304), investment property (such as securities) (UCC §9-305), and letter-of-credit rights (UCC §9-306), the general choice-of-law rule is that “while a debtor is located in a jurisdiction, the local law of that jurisdiction governs . . . the priority of a security interest in collateral.” 810 ILCS 5/9-301(1). Nevertheless, this general rule is modified by the following: a. “While collateral is located in a jurisdiction, the local law of that jurisdiction governs . . . the priority of a possessory security interest in that collateral.” 810 ILCS 5/9-301(2). b. Except for security interests in as-extracted collateral from wellheads or mineheads, “while tangible negotiable documents, goods, instruments, money, or tangible chattel paper is located in a jurisdiction, the local law of that jurisdiction governs . . . the priority of a nonpossessory security interest in the collateral.” 810 ILCS 5/9-301(3).

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§3.9

c. “The local law of the jurisdiction in which the wellhead or minehead is located governs . . . the priority of a security interest in as-extracted collateral.” 810 ILCS 5/9-301(4). 3. [3.4] Goods Covered by Certificates The local law of the jurisdiction under whose certificate of title the goods are covered governs the priority of a security interest in such goods from the time the goods become covered by the certificate of title until the goods cease to be covered by the certificate of title. 810 ILCS 5/9-303(c). 4. [3.5] Deposit Accounts The local law of a bank’s jurisdiction (as determined by Uniform Commercial Code §9-304(b)) governs the priority of a security interest in a deposit account maintained with that bank. 810 ILCS 5/9-304(a). 5. [3.6] Investment Property Section 9-305 of the Uniform Commercial Code sets forth a complex set of rules for ascertaining the local law governing the priority of a security interest in investment property, depending on whether the investment property is a certificated security, uncertificated security, security entitlement, securities account, commodity contract, or commodity account. 810 ILCS 5/9-305. 6. [3.7] Letter-of-Credit Rights Except in the case of certain security interests relating to supporting obligations under Uniform Commercial Code §9-308(d), “the local law of the issuer’s jurisdiction or a nominated person’s jurisdiction governs . . . the priority of a security interest in a letter-of-credit right if the issuer’s jurisdiction or nominated person’s jurisdiction is a State.” 810 ILCS 5/9-306(a). See UCC Comment 3, 810 ILCS 5/9-306, for a discussion of the role of a nominated person, such as a confirming bank. 7. [3.8] Beneficial Interest in an Illinois Land Trust “The local law of the State of Illinois governs perfection, the effect of perfection or nonperfection, and the priority of a collateral assignment of, or other security interest in, a beneficial interest in an Illinois land trust.” 810 ILCS 5/9-306.1. B. Persons with Priority over Unperfected Security Interests — Uniform Commercial Code §9-317 1. [3.9] Parties with Perfected Security Interests An unperfected security interest is subject to the rights of persons entitled to priority under Uniform Commercial Code §9-322 (such as holders of perfected security interests). 810 ILCS 5/9-317.

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2. [3.10] Prior Lien Creditors Subject to certain purchase-money security interests (as to which there is a 20-day grace period for perfection), a person who becomes a “lien creditor” as defined in 810 ILCS 5/9102(a)(52) (including bankruptcy trustees, assignees for the benefit of creditors, equity receivers, and creditors obtaining an attachment, levy, or the like) before a security interest is perfected or the security interest becomes enforceable under 810 ILCS 5/9-203(b)(3) and a financing statement covering the collateral is filed, has rights superior to the security interest. See Sign Builders, Inc. v. SVI Themed Construction Solutions, Inc., 2015 IL App (1st) 142212, 30 N.E.3d 475, 391 Ill.Dec. 205 (“If the lien attaches before the security interest is perfected, the lien creditor will prevail.”). See also Marquette National Bank v. B.J. Dodge Fiat, Inc., 131 Ill.App.3d 356, 475 N.E.2d 1057, 86 Ill.Dec. 678 (2d Dist. 1985) (prior perfected secured creditor defeats judgment lien creditor). 3. [3.11] Certain Buyers, Lessees, and Licensees Licensees of a general intangible or buyers that receive delivery of tangible chattel paper, tangible documents, goods, instruments, or a certificated security, and lessees of goods take free of an unperfected security interest if they give value and lack knowledge of the security interest. 810 ILCS 5/9-317(b) through 5/9-317(d). 4. [3.12] Parties with Rights Superior to Perfected Security Interests Parties whose rights are superior to the rights of holders of perfected security interests (identified in §§3.38 – 3.59) will also come ahead of holders of unperfected security interests. C. Priorities Among Conflicting Security Interests — Uniform Commercial Code §9-322 1. [3.13] Rule of First in Time Subject to various exceptions described in §§3.15 – 3.33 below, Article 9 of the Uniform Commercial Code sets forth the following three general rules derived from the basic rule of “first in time, first in right”: a. Conflicting perfected security interests rank according to priority in time of filing or perfection. Priority dates from the earlier of (1) the time of the first filing covering the collateral or (2) the time the security interest is first perfected if there is no lapse in filing or perfection. b. A perfected security interest has priority over a conflicting unperfected security interest. c. The first security interest to attach or become effective has priority if conflicting security interests are both unperfected. 810 ILCS 5/9-322(a).

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§3.18

2. [3.14] Proceeds and Supporting Obligations Subject to various special priority rules described in Uniform Commercial Code §§9-322(c) and 9-322(d), the first-in-time rules of §9-322(a) also apply to priorities concerning proceeds and supporting obligations (such as letter-of-credit rights and guarantees as set forth in UCC §9102(a)(78)). 810 ILCS 5/9-322(b). 3. [3.15] Exceptions to First-in-Time Rule for Perfected Security Interests There are certain exceptions to the first-in-time rule, which are discussed in §§3.16 – 3.33 below. a. [3.16] Special Priming Security Interests — UCC §9-322(f) Security interests in favor of collecting banks under Uniform Commercial Code §4-210, issuers or nominated persons under UCC §5-118, certain buyers and sellers of goods whose security interest arises under Article 2, and certain lessors and lessees of goods whose rights arise under Article 2A under UCC §9-110 take priority over certain prior perfected security interests. 810 ILCS 5/9-322(f). b. [3.17] Future Advances — UCC §9-323 A security agreement may provide that collateral secures future advances. Ordinarily, under the first-to-file-or-perfect rule of Uniform Commercial Code §9-322(b)(1), a security interest and lien creditor’s rights will be subordinate to future advances secured by a prior perfected security interest. However, as set forth in UCC §§9-323(a) and 9-323(b) (subject to certain modifications in UCC §§9-323(c) through 9-323(g)), there are two principal exceptions: 1. when the first security interest is perfected only automatically under UCC §9-309 or temporarily under UCC §9-312(e), §9-312(f) or §9-312(g) and the future advance is not made pursuant to a commitment entered into while the security interest was otherwise perfected; or 2. when the future advance is made more than 45 days after there is a “lien creditor” of the debtor unless the advance is made without knowledge of the lien or under a commitment entered into without knowledge. 810 ILCS 5/9-323 (a-b). c. [3.18] Security Interest in Collateral Transferred by Debtor — UCC §9-325 Occasionally, a debtor will grant a security interest in property that it acquired from another debtor who previously granted a security interest in the same property. Subject to certain limitations in Uniform Commercial Code §9-325(b), the first secured party will prevail as long as its security interest was perfected when the second debtor acquired the collateral and there is no lapse in perfection. 810 ILCS 5/9-325. See also 810 ILCS 5/9-507.

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d. [3.19] Security Interest Created by New Debtor — UCC §§9-326 and 9-508 A second debtor may become bound by the security interest of the first debtor, such as when the first debtor is merged into the second or the second purchases the collateral of the first and assumes its security agreement. If each debtor has its own secured creditor, conflicts could arise. Section 9-326 of the Uniform Commercial Code provides that a security interest created by the first debtor that is perfected by a financing statement that is effective solely under UCC §316(i)(1) or §9-508 will be subordinate to a security interest created by the new debtor in the same collateral that is perfected other than by a financing statement effective solely under UCC §316(i)(1) or §9-508. 810 ILCS 5/9-326. Otherwise, under UCC §9-326(b), in general, normal rules of priority will apply. Section 9-508 of the UCC provides essentially that a filing against the original debtor perfects a security interest in property that a new debtor has at the time it assumes the original debtor’s agreement as well as after-acquired property. 810 ILCS 5/9-508. However, if the filing against the original debtor becomes “seriously misleading” as to the debtor’s name under UCC §9-506, the filing will cover collateral of the new debtor for more than four months thereafter only if, during that period, an initial financing statement providing the name of the new debtor is filed. Section 9-316(i)(1) provides that when the new debtor is located in a separate jurisdiction from the jurisdiction in which the financing statement naming the original debtor was filed, it is effective to perfect the collateral before, and within four months after, the new debtor becomes bound if the financing statement would have perfected a security interest in the collateral had the collateral been acquired by the original debtor. e. [3.20] Purchase-Money Security Interests — UCC §9-324 Purchase-money security interests can be created only in goods and software. 810 ILCS 5/9103. In most cases, if the holder follows the procedures required by Uniform Commercial Code §9-324, perfected purchase-money security interests will be prior to a security interest acquired under an after-acquired property clause. UCC Comment 2, 810 ILCS 5/9-324. See, e.g., Litchfield National Bank v. Hart (In re Hart), 30 B.R. 14 (Bankr. C.D.Ill. 1983) (holder of perfected security interest in inventory did not have priority over holder of prior security interest when holder of subsequently perfected security interest in inventory did not send required notice due to its lack of diligence in searching for conflicting interests); DeKalb Bank v. Klotz, 151 Ill.App.3d 638, 502 N.E.2d 1256, 104 Ill.Dec. 596 (2d Dist. 1986) (purchase-money security interest had priority over after-acquired property clause of prior security interests); First National Bank of Vandalia v. Trail Ridge Farm, Inc., 143 Ill.App.3d 244, 492 N.E.2d 1030, 97 Ill.Dec. 371 (5th Dist. 1986) (holder of purchase-money security interest, which was perfected within required time frame, took priority over after-acquired property provision of prior security interest); Prairie State Bank & Trust v. Deere Park Associates, Inc., 2014 IL App (4th) 130819-U (holder of purchase-money security interest had priority over after-acquired property by giving written notice to existing creditor in addition to filing a financing statement). f.

[3.21] Deposit Accounts — UCC §9-327

A security interest perfected by “control” of a deposit account takes priority over security interests perfected otherwise. Sections 9-327(2) through 9-327(4) of the Uniform Commercial

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§3.27

Code describe the relative priorities of competing secured parties with control. Generally, the first-in-time, first-in-right rule prevails, though a bank in which the deposit account is maintained has priority over another secured party, and a security interest perfected by control under §9-104(a)(3) (the secured party is the bank’s customer with respect to the deposit account) prevails over such bank. 810 ILCS 5/9-327(2) through 5/9-327(4). g. [3.22] Investment Property — UCC §9-328 A security interest held by a secured party with control of investment property under Uniform Commercial Code §9-106 prevails over a security interest held by a secured creditor that does not have control. Sections 9-328(2) through 9-328(4) of the UCC address priorities by competing secured parties with control. 810 ILCS 5/9-328(2) through 5/9-328(4). h. [3.23] Letter-of-Credit Rights — UCC §9-329 A security interest perfected by control under Uniform Commercial Code §9-107 prevails over a competing security interest held by a secured party that does not have control. “Security interests perfected by control . . . rank according to priority in time of obtaining control.” 810 ILCS 5/9-329(2). i.

[3.24] Beneficial Interest in an Illinois Land Trust — UCC §9-329.1

A security interest in a beneficial interest in an Illinois land trust perfected by control under Uniform Commercial Code §9-107.1 prevails over a competing security interest held by a secured creditor without control. “Security interests perfected by control . . . rank according to priority in time of obtaining control.” 810 ILCS 5/9-329.1. j.

[3.25] Chattel Paper — UCC §9-330

Section 9-330 of the Uniform Commercial Code describes circumstances under which a good-faith purchaser of chattel paper for value, including a secured creditor (UCC Comment 2, 810 ILCS 5/9-330), can acquire an interest superior to an existing perfected security interest. 810 ILCS 5/9-330. k. [3.26] Instruments — UCC §9-330 Sections 9-330(d) and 9-331(a) of the Uniform Commercial Code describe the circumstances under which a good-faith purchaser of instruments for value, including a secured creditor (UCC Comment 2, 810 ILCS 5/9-330, 5/9-331), can prevail over the holder of a prior perfected security interest. 810 ILCS 5/9-330(d), 5/9-331(a). l.

[3.27] Documents and Securities — UCC §9-331

Section 9-331 of the Uniform Commercial Code describes circumstances under which holders in due course of a negotiable instrument (UCC §§3-305 and 3-306), holders to which a

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SECURED TRANSACTIONS

negotiable instrument of title has been duly negotiated (UCC §7-502), or protected purchasers of a security (UCC §8-303) may prevail over a prior perfected security interest. 810 ILCS 5/9-331. UCC Comment 2, 810 ILCS 5/9-331, indicates that subsequent holders of security interests may qualify for the protection afforded to purchasers under §9-331. m. [3.28] Money — UCC §9-332 A transferee of money, as opposed to a transfer of an interest in a deposit account, takes the money free of a security interest unless the transferee acts in collusion with the debtor in violating the rights of the secured party. 810 ILCS 5/9-332. n. [3.29] Accessions and Fixtures — UCC §§9-335 and 9-334 “Accessions” are “goods that are physically united with other goods in such a manner that the identity of the original goods is not lost.” 810 ILCS 5/9-102(a)(1). An example of an accession would be an engine installed in an automobile. If a security interest is perfected in goods when the goods become an accession, the security interest remains perfected, and its priority will be determined by the normal rules of priority unless the accessions are made part of a whole that is perfected under a certificate-of-title statute under Uniform Commercial Code §9-311(b). In such event, the security interest in the accession is subordinate. Note that a secured party that removes an accession must reimburse any owner or holder of a security interest of the whole, other than the debtor, for the cost of repair to the whole. 810 ILCS 5/9-335. “Fixtures” are discussed in §3.44 below with other non-Article 9 rights competing for priority with perfected security interests. o. [3.30] Commingled Goods — UCC §9-336 “Commingled goods” are “goods that are physically united with other goods in such a manner that their identity is lost in a product or mass.” 810 ILCS 5/9-336(a). If a security interest on goods is perfected when the goods become commingled, the perfected security interest extends to the product or mass. The normal rules of priority apply, except that (1) a perfected security interest extending into the product or mass has priority over any unperfected security interest at the time of the commingling; and (2) if there are multiple perfected security interests extending into the product or mass, they rank equally in proportion to the value of the collateral at the time of commingling. p. [3.31] Goods Covered by Certificate of Title — UCC §9-337 If the State of Illinois issues a certificate of title in certain goods requiring a certificate without indicating on the certificate the existence of any security interest or that there might be an undisclosed interest, then a purchaser who gives value and is without knowledge of any such security interest, other than a person in the business of selling goods of that kind, takes free of that security interest. Any prior security interest perfected under the law of another jurisdiction is subordinate to a security interest perfected under Uniform Commercial Code §9-311(b) by a secured party without knowledge of the earlier security interest. 810 ILCS 5/9-337.

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§3.33

q. [3.32] Security Interest Perfected with Financing Statement Providing Certain Incorrect Information — UCC §9-338 If a security interest is perfected with a financing statement that does not provide a mailing address of the debtor, indicate whether the debtor is an individual or organization, or specify certain particulars about a debtor organization, the security interest is subordinate to a later perfected security interest of a holder who gave value in reasonable reliance on the incorrect information. Such defects, however, do not appear to subordinate the security interest to a lien creditor. 810 ILCS 5/9-338. r. [3.33] Proceeds — UCC §9-315 “Proceeds” is defined in Uniform Commercial Code §9-102(a)(64) to include, among other things, “whatever is acquired upon the sale, lease, license, exchange, or other disposition of collateral.” 810 ILCS 5/9-102(a)(64). On occasion, one secured creditor will lay claim to property as “proceeds” while another will consider it original collateral. In other situations, competing security interests in original collateral will continue to compete in “proceeds.” Section 9-315 of the UCC begins with the proposition that except as otherwise provided in Article 9 (such as for certain purchases for value) and UCC §2-403(2) (relating to certain transfers of goods) and except when the secured party authorizes transfers of collateral free of its security interest, a perfected security interest will continue to be perfected in collateral disposed of by the debtor and in “any identifiable proceeds.” 810 ILCS 5/9-315. Commingled goods are “identifiable proceeds” to the extent provided in UCC §9-336. If the commingled proceeds are not goods, they are identifiable to the extent the secured creditor can trace them under equitable principles permitted by other applicable law. See, e.g., C.O. Funk & Sons, Inc. v. Sullivan Equipment, Inc., 89 Ill.2d 27, 431 N.E.2d 370, 373 – 374, 59 Ill.Dec. 85 (1982) (applying lowest intermediate balance rule whereby proceeds are presumed to remain in a bank account if account balance is equal to or greater than amount of proceeds deposited). A perfected security interest in “proceeds” becomes unperfected on the 21st day after the security interest attaches to the proceeds unless one of three conditions exists: 1. Subject to certain time limitations in UCC §9-315(e), a filed financing statement covers the collateral, the proceeds are collateral in which a security interest may be perfected by filing in the office in which the financing statement has been filed, and the proceeds are not acquired with cash proceeds. 2. The proceeds are identifiable cash proceeds. 3. The security interest in the proceeds is perfected other than through the automatic perfection within 20 days of attachment. 810 ILCS 5/9-315(d). “Except as otherwise provided by the Bankruptcy Code, the debtor’s entering into bankruptcy does not affect a secured party’s right to proceeds.” UCC Comment 8, 810 ILCS 5/9-315. The treatment of proceeds are covered under additional Article 9 provisions including UCC §§9-322(c) and 9-322(d), which set forth the rules of priority in proceeds when there are competing security interests in the original collateral. There are also special rules for the priority

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§3.34

SECURED TRANSACTIONS

of security interests in proceeds of purchase-money security interests (UCC §§9-324(d), 9-324(f)) and in chattel paper (UCC §§9-330(a), 9-330(c), 9-330(e)). 4. [3.34] Effect of Subordination Agreement on Priority Any party entitled to priority may freely contract to subordinate his or her security interest. 810 ILCS 5/9-339. 5. [3.35] Priorities as to Security Interests Established Prior to Effective Date In Illinois, revised Article 9 took effect on July 1, 2013. Section 9-801, et seq., of the Uniform Commercial Code set forth a complex set of rules governing the transition. 810 ILCS 5/9-801, et seq. There are, however, a few key general rules pertaining to priority of security interests perfected under the former law. a. [3.36] Security Interest Perfected Before Effective Date — UCC §9-803 Security interests that were already perfected (i.e., that were enforceable and enjoyed priority over a lien creditor) under the revised law prior to the effective date remain enforceable and perfected. Otherwise, the secured party had one year to perfect under the revised law. 810 ILCS 5/9-803. A security interest that was not perfected prior to the effective date will become perfected when the applicable requirements are satisfied. 810 ILCS 5/9-804. b. [3.37] Priority — UCC §9-809 Even though revised Article 9 will ordinarily govern the priority of conflicting security interests, under Uniform Commercial Code §9-809(a), if the “relative priorities” were “established” before the effective date, the former law determines priority. 810 ILCS 5/9-809.

III. [3.38] NON-ARTICLE 9 RIGHTS COMPETING FOR PRIORITY WITH RIGHTS OF PERFECTED SECURITY INTERESTS Various rights arising from federal or state law may compete for priority with the rights of the holder of a prior perfected Article 9 security interest. In some instances, the relative priorities have been established by statute or caselaw. In others, the law is still unclear. Some of the more commonly encountered competing rights are described in §§3.39 – 3.59 below. A. [3.39] Liens Relating to Possession of Goods for Services or Materials Section 9-333(b) of the Uniform Commercial Code provides that a “possessory lien” on goods has priority over a security interest in the goods unless the lien is created by a statute that expressly provides otherwise. Compare 810 ILCS 5/9-322(g) relating to agricultural liens.

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§3.41

Section 9-333(a) of the UCC defines a “possessory lien” as an interest, other than a security interest or an agricultural lien: (1) which secures payment or performance of an obligation for services or materials furnished with respect to goods by a person in the ordinary course of the person’s business; (2) which is created by statute or rule of law in favor of the person; and (3) whose effectiveness depends on the person’s possession of the goods. 810 ILCS 5/9-333(a). 1. [3.40] Artisans “The artisan’s possessory lien of the common law is recognized in Illinois. National Bank of Joliet v. Bergeron Cadillac, Inc., 66 Ill.2d 140, 361 N.E.2d 1116, 5 Ill.Dec. 588 (1977). And a creditor has a legal right to invoke lien provisions of the law to compel payment of a just debt.” Wheel Masters, Inc. v. Jiffy Metal Products Co., 955 F.2d 1126 (7th Cir. 1992). See also see Lake River Corp. v. Carborundum Co., 769 F.2d 1284 (7th Cir. 1985) (bagger and storer). The lien apparently has no provision for forfeiture and sale and is limited to the right to possession until payment is received. Navistar Financial Corp. v. Allen’s Corner Garage & Towing Service, Inc., 153 Ill.App.3d 574, 505 N.E.2d 1321, 106 Ill.Dec. 530 (2d Dist. 1987) (involving denial of lien for towing service). Furthermore, the artisan must add something of “intrinsic value” in order to be entitled to the lien. Id. (stating, for example, that towing of vehicle does not add intrinsic value). Compare related statutory liens for labor, material, or storage made explicitly subject to bona fide security interest. 770 ILCS 45/1, 45/4. 2. [3.41] Warehouses Section 7-209(a) of the Uniform Commercial Code creates the following warehouse lien: A warehouse has a lien against the bailor on the goods covered by a warehouse receipt or storage agreement or on the proceeds thereof in its possession for charges for storage or transportation, including demurrage and terminal charges, insurance, labor, or other charges, present or future, in relation to the goods, and for expenses necessary for preservation of the goods or reasonably incurred in their sale pursuant to law. If the person on whose account the goods are held is liable for similar charges or expenses in relation to other goods whenever deposited and it is stated in the warehouse receipt or storage agreement that a lien is claimed for charges and expenses in relation to other goods, the warehouse also has a lien against the goods covered by the warehouse receipt or storage agreement or on the proceeds thereof in its possession for those charges and expenses, whether or not the other goods have been delivered by the warehouse. However, as against a person to which a negotiable warehouse receipt is duly negotiated, a warehouse’s lien is

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§3.42

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limited to charges in an amount or at a rate specified in the warehouse receipt or, if no charges are so specified, to a reasonable charge for storage of the specific goods covered by the receipt subsequent to the date of the receipt. [Emphasis added.] 810 ILCS 5/7-209(a). Note, however, that the lien is lost as to any goods the warehouse “voluntarily delivers or unjustifiably refuses to deliver.” 810 ILCS 5/7-209(e). 3. [3.42] Carriers Section 7-307(a) of the Uniform Commercial Code creates the following lien for a common carrier: A carrier has a lien on the goods covered by a bill of lading or on the proceeds thereof in its possession for charges after the date of the carrier’s receipt of the goods for storage or transportation, including demurrage and terminal charges, and for expenses necessary for preservation of the goods incident to their transportation or reasonably incurred in their sale pursuant to law. However, against a purchaser for value of a negotiable bill of lading, a carrier’s lien is limited to charges stated in the bill or the applicable tariffs or, if no charges are stated, a reasonable charge. 810 ILCS 5/7-307(a). The lien is lost as to any goods the carrier “voluntarily delivers or unjustifiably refuses to deliver.” 810 ILCS 5/7-307(c). See also Gregg v. Illinois Cent. R., 147 Ill. 550, 35 N.E. 343 (1893); Navistar Financial Corp. v. Allen’s Corner Garage & Towing Service, Inc., 153 Ill.App.3d 574, 505 N.E.2d 1321, 106 Ill.Dec. 530 (2d Dist. 1987). 4. [3.43] Landlords and Other Potential “Possessors” Certain other Illinois liens may also arise from or relate to the possession of goods, but their “effectiveness” may or may not expressly “depend on the person’s possession of the goods” or may otherwise not strictly fall within the scope of Uniform Commercial Code §9-333. 810 ILCS 5/9-333(a). The priority of these liens will depend on whether the court determines either that such liens come within the scope of UCC §9-333 or that the Illinois legislature, in enacting revised Article 9, otherwise intended them to enjoy priority. In the case of landlords, for example, non-UCC law applies because a landlord’s lien on goods (other than crops) arises only when the landlord levies on the goods under a distress warrant and the UCC specifically states that non– UCC law should be applied to landlords. Thus, the common-law principle “first in time, first in right” places the prior security interest in front of the landlord. See also Southwest Bank of St. Louis v. Poulokefalos, 401 Ill.App.3d 884, 931 N.E.2d 285, 341 Ill.Dec. 677 (5th Dist. 2010) (applying non-UCC law to find that landlord’s lien had priority over bank’s non-perfected fixture lien). See also Peterson v. Ziegler, 39 Ill.App.3d 379, 350 N.E.2d 356 (5th Dist. 1976) (perfected security interest in house trailer took precedence over later landlord’s lien arising from judgment and levy for rent); First State Bank of Maple Park v. DeKalb Bank, 175 Ill.App.3d 812, 530 N.E.2d 544, 125 Ill.Dec. 386 (2d Dist. 1988). Compare 735 ILCS 5/9-316, a provision in the

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§3.44

Illinois Code of Civil Procedure, relating to a landlord’s lien on crops, and the express language therein giving the lien priority over conflicting security interests. To prevent landlords from attempting to interfere with a security interest on goods at the landlord’s premises, secured creditors will commonly seek acknowledgments of subordination prior to extending credit. B. [3.44] Rights of Owner or Encumbrancer of Real Estate with Fixtures Owners or holders of encumbrances on real property will sometimes claim a right in goods that are subject to a perfected security interest and have been affixed to the real property. Article 9 sets forth guidelines for determining the relative priority of the parties if the collateral is a fixture. “Fixtures” are defined as “goods that have become so related to particular real property that an interest in them arises under real property law.” 810 ILCS 5/9-102(a)(41). Courts look to non-Article 9 law when deciding whether something is a fixture and focus on factors such as the intent of the parties and the difficulty of removing the item in question from the related real estate. See, e.g., FirstMerit Bank, N.A., v. Antioch Bowling Lanes, Inc., 108 F.Supp.3d 618 (N.D.Ill. 2015) (holding that bowling lanes, gutters, and other bowling equipment are fixtures); Harrisburg Community Unit School Dist. No. 3 v. Steapleton, 195 Ill.App.3d, 553 N.E.2d 76, 142 Ill.Dec. 726 (5th Dist. 1990) (portable classroom was fixture of a school building); Landfield Finance Co. v. Feinerman, 3 Ill.App.3d 487, 279 N.E.2d 30 (1st Dist. 1972) (hotel/tavern furniture and equipment held not to be fixtures); Davis Store Fixtures, Inc. v. Cadillac Club, 60 Ill.App.2d 106, 207 N.E.2d 711 (2d Dist. 1965) (tavern equipment connected to plumbing lines and electrical wiring of building held not to be fixtures); In re Theodore A. Kochs Co., 120 F.2d 603 (7th Cir. 1941) (heavy machinery located in mortgaged plant was not fixture). Section 9-334(a) of the UCC specifically provides that Article 9 does not create security interests in “ordinary building materials incorporated into an improvement on land.” 810 ILCS 5/9-334(a). Thus, a party seeking to enforce rights in goods incorporated into a structure might have to rely on Illinois’ mechanics liens law. Ordinarily, creditors with security interests in assets that are or may eventually become “fixtures” will comply with the usual rules of perfecting a security interest in personalty and make a “fixture filing” (UCC §9-102(a)(40)) in the office required by UCC §9-501. Section 9-334 of the UCC provides that a security interest in fixtures will be subordinate to a conflicting interest or an encumbrancer or owner of the related real property other than the debtor unless the secured creditor takes certain steps to protect its interest as outlined under UCC §§9334(d) through 9-334(h). The rules vary depending on whether the security interest is a purchasemoney security interest in goods (UCC §9-334(d)), a security interest in certain readily removable goods such as factory and office machines (UCC §9-334(e)(2)), or a security interest in manufactured homes (UCC §9-334(e)(4)). There are also special rules for determining priority when the competing interest is a construction mortgagee (UCC §9-334(h)) or a judicial lien creditor (UCC §9-334(e)(3)).

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§3.45

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C. [3.45] Rights of Reclaiming Seller Under Uniform Commercial Code §2-702, in certain circumstances, an unpaid seller of goods on credit has a right of reclamation. 810 ILCS 5/2-702. See also 810 ILCS 5/2-403(1) for a similar result in a cash sale in which the payment instrument is dishonored. The rights of the reclaiming seller are, under UCC §2-702, subject to the rights of a “good faith purchaser.” In general, courts have tended to hold that a creditor with a floating security interest on inventory, as a good-faith purchaser, has rights that are superior to those of the reclaiming seller. See, e.g., American Saw & Mfg. Co. v. Bosler Supply Group (In re Bosler Supply Group), 74 B.R. 250 (N.D.Ill. 1987); Los Angeles Paper Bag Co. v. James Talcott, Inc., 604 F.2d 38 (9th Cir. 1979); In re Samuels & Co., 526 F.2d 1238 (5th Cir.), cert. denied, 97 S.Ct. 98 (1976); Harris Trust & Savings Bank v. Wathen’s Elevators, Inc. (In re Wathen’s Elevators, Inc.), 32 B.R. 912 (Bankr. W.D.Ky. 1983). However, if the secured creditor has not acted in good faith, its security interest may be subordinate. See also Monsanto Co. v. Walter E. Heller & Co., 114 Ill.App.3d 1078, 449 N.E.2d 993, 70 Ill.Dec. 646 (1st Dist. 1983). D. [3.46] Rights of Judicial Lienholder With certain exceptions, a security interest is subordinate to the rights of a person that has “acquired a lien on the property involved by attachment, levy, or the like” (810 ILCS 5/9102(a)(52)) to the extent that the security interest secures an “advance made more than 45 days after the person becomes a lien creditor unless the advance is made . . . without knowledge of the lien; or . . . pursuant to a commitment entered into without knowledge of the lien” (810 ILCS 5/9323(b)). The 45-day period seems to run from acquisition of the lien rather than knowledge of it. Liens acquired under execution and levy under 735 ILCS 5/12-111, by service of a citation to discover assets under 735 ILCS 5/2-1402(m), or by service of a nonwage garnishment under 735 ILCS 5/12-707 may qualify. E. [3.47] Rights of Buyers, Lessees, and Licensees Various provisions of Article 9 describe the circumstances under which a buyer, lessee, or licensee of collateral may take free of a perfected security interest with or without the secured creditor’s consent. The following is a list of Uniform Commercial Code sections and the categories of buyers, lessees, and licensees that they address: 1. buyers in the ordinary course of business (810 ILCS 5/9-320(a)); 2. buyers of consumer goods before the filing of a financing statement covering the goods (810 ILCS 5/9-320(b)); 3. buyers of oil, gas, or other minerals (810 ILCS 5/9-320(d));

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§3.50

4. licensees in the ordinary course of business of general intangibles (810 ILCS 5/9-321(b)); 5. lessees of goods in the ordinary course of business (810 ILCS 5/9-321(c)); 6. purchasers of goods covered by a certificate of title moving from one jurisdiction to another (810 ILCS 5/9-316(d)); 7. purchasers of chattel paper (810 ILCS 5/9-330); 8. purchasers of instruments (810 ILCS 5/9-330, 5/9-331); 9. purchasers of documents (810 ILCS 5/9-331); 10. purchasers of securities (810 ILCS 5/9-331); and 11. purchasers of collateral subject to a security interest perfected by a financing statement with incorrect information (810 ILCS 5/9-338(2)). F. [3.48] Rights of Lessor of Personalty A “true” lessor who leases property to the debtor should have an interest that is superior to the rights of any secured creditor of the debtor. See, e.g., In re Marhoefer Packing Co., 674 F.2d 1139 (7th Cir. 1982). However, a lessor under a lease intended as a security device (810 ILCS 5/9-109(a)(1)) (for example, to create, in essence, a conditional sale or installment sales contract) will be subject to the perfection requirements of Article 9, and, if prior perfection has not been accomplished, a secured creditor may acquire a superior interest in the “leased” assets. Id. See also In re Powers, 983 F.2d 88 (7th Cir. 1993); Mason v. Heller Financial Leasing, Inc. (In re JII liquidating, Inc.) 341 B.R. 256 (Bankr. N.D.Ill. 2006). G. [3.49] Rights of Bailor Whether a “bailment” or a “consignment” exists may be a disputed question of fact. (See the definition of “consignment” in 810 ILCS 5/9-102(a)(20).) Bailments, which do not qualify as “consignments” for the purpose of a sale, are not covered by Article 9, and thus the rights of the bailor should ordinarily prevail over the rights of a creditor with a security interest in the bailee’s assets. See, e.g., Wang Laboratories, Inc. v. Manufacturers Hanover Trust Co., Suffolk, N.A., 20 U.C.C.Rep.Serv. (CBC) 1035 (N.Y.Sup. 1976). H. [3.50] Rights of Consignor Consignments, defined in Uniform Commercial Code §9-102(a)(20), are within the scope of Article 9. 810 ILCS 5/9-109(a)(4). A consignor’s interest in consigned goods is treated like a purchase-money security interest. 810 ILCS 5/9-103(d). Consequently, if the consignor does not follow the procedures needed to protect the superiority of its purchase-money security interest, it should be subordinate to a perfected secured party with an after-acquired property clause.

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SECURED TRANSACTIONS

I. [3.51] Rights of Setoff and Recoupment Under Uniform Commercial Code §9-109(d)(10), rights of recoupment and setoff competing with a security interest are not governed by Article 9 except (1) as they relate to a bank’s right to set off or recoup a deposit account and (2) the right of an account debtor to assert a defense or a claim. 810 ILCS 5/9-109(d)(10). Section 9-340 of the UCC provides the general rule that a bank may set off or recoup a deposit account (other than one evidenced by a certificate of deposit) against a secured party. 810 ILCS 5/9-340. However, the bank may not set off (as opposed to recoup) a deposit account perfected by control under UCC §9-104(a)(3) if the setoff is based on a claim against the debtor. Subject to various exceptions relating to consumers and healthcare insurance receivables, UCC §9-404 enables account debtors to assert rights of recoupment and setoff against an assignee of the secured debt. 810 ILCS 5/9-404. Rights of setoff and recoupment not covered by UCC §9-104(a)(3) will, presumably, continue to be developed by the common law. J. Various Competing Rights Arising from Federal Law 1. [3.52] Rights of Government Under Procurement Programs Under United States v. Kimbell Foods, Inc., 440 U.S. 715, 59 L.Ed.2d 711, 99 S.Ct. 1448 (1979), the perfection and priority of consensual liens under federal lending programs, such as the Small Business Administration and the Farmers Home Administration, are controlled by state law in the absence of a federal statute setting priorities. However, “title-vesting” clauses in government procurement contracts may grant the federal government an interest superior to those of a holder of a perfected security interest even when the government has not recorded its interest. See In re American Pouch Foods, Inc., 769 F.2d 1190 (7th Cir. 1985), cert. denied, 106 S.Ct. 1459 (1986); 10 U.S.C. §2307(c). 2. [3.53] Federal Tax Liens Generally, federal tax liens will be subordinate to preexisting perfected security interests. 26 U.S.C. §6323(a). (26 U.S.C. §6323(f) and 770 ILCS 110/2 provide for the location of filing tax liens.) However, subject to some exceptions in 26 U.S.C. §§6323(b) and 6323(c), a federal tax lien will prevail over security interests arising after filing under an after-acquired property clause in a security agreement. An important exception under 26 U.S.C. §6323(c) is for certain security interests arising within 45 days of the tax lien filing. Thus, in most accounts receivable and inventory financing arrangements, the secured party, ordinarily, will have a period of 45 days from tax lien filing before the federal tax lien will jump ahead of the perfected security interest created under an after-acquired property clause. 3. [3.54] Rights of Pension Benefit Guaranty Corporation The Pension Benefit Guaranty Corporation (PBGC), under certain circumstances, may impose a lien on the assets of an employer who has not made required contributions to certain employee pension plans. 29 U.S.C. §1368. With certain modifications, the PBGC lien is accorded

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§3.56

the same priority as a federal tax lien. 29 U.S.C. §§1368(c)(1), 1368(c)(2); In re Kent Plastics, 183 B.R. 841 (Bankr. S.D.Ind. 1995); In re Divco Philadelphia Sales Corp., 64 B.R. 232 (Bankr. E.D.Pa.), modified, 72 B.R. 199 (E.D.Pa. 1986). See the discussion of federal tax liens in §3.53 above. 4. [3.55] Rights of Government Under Racketeer Influenced and Corrupt Organizations Act A criminal conviction under the Racketeer Influenced and Corrupt Organizations Act (RICO), 18 U.S.C. §1961, et seq., requires a forfeiture of all assets of the convicted party relating to the racketeering activity. United States v. Anderson, 782 F.2d 908, 918 (11th Cir. 1986), citing United States v. Cauble, 706 F.2d 1322, 1359 (5th Cir. 1983); United States v. Ginsburg, 773 F.2d 798 (7th Cir. 1985), cert. denied, 106 S.Ct. 1186 (1986). See 18 U.S.C. §1963(a). The forfeiture arises in favor of the United States on the date of the first act giving rise to the forfeiture, and any property transferred after the first violative act to third parties who had reason to know of the RICO violation may be subject to the forfeiture. 18 U.S.C. §1963(a)(3). In order to obtain a release of forfeited collateral, the secured party must, within 30 days of the earlier of receiving notice of a forfeiture order or the publishing of a forfeiture, establish by a preponderance of the evidence its superior right to the collateral. 18 U.S.C. §1963(6)(a). 5. [3.56] Rights of Sellers of Perishable Agricultural Commodities, Livestock, and Poultry The U.S. Code creates a trust in favor of certain suppliers of perishable agricultural commodities on certain commodities unless the suppliers have been paid in full or have failed to satisfy certain requirements of sending notice to the debtor and the Secretary of Agriculture. 7 U.S.C. §499e. See Midwest Marketing Co. v. Quality Produce Suppliers, Inc., 6 F.Supp.3d 843 (N.D.Ill. 2013); Continental Fruit Co. v. Thomas J. Gatziolis & Co., 774 F.Supp. 449 (N.D.Ill. 1991); In re Marvin Properties, Inc., 854 F.2d 1183 (9th Cir. 1988); Blair Merriam Fresh Fruit & Produce Co. v. Clark (In re D.K.M.B., Inc.), 95 B.R. 774 (Bankr. D.Colo. 1989); In re W.L. Bradley Co., 75 B.R. 505 (Bankr. E.D.Pa. 1987); In re Fresh Approach, Inc., 48 B.R. 926 (Bankr. N.D.Tex. 1985); The U.S. Code also creates a trust in favor of certain suppliers of livestock on certain livestock unless the suppliers have been paid in full or fail to satisfy certain requirements of sending notice to the debtor and the Secretary of Agriculture. 7 U.S.C. §196. See, e.g., In re Gotham Provision Co., 669 F.2d 1000 (5th Cir.), cert. denied, 103 S.Ct. 129 (1982); Weichman Pig Co. v. Jack-Rich, Inc. (In re Jack-Rich, Inc.), 176 B.R. 476 (Bankr. C.D.Ill. 1994); In re Frosty Morn Meats, Inc., 7 B.R. 988 (M.D.Tenn. 1980); Howard Wyman Co. v. Continental Illinois National Bank & Trust Company of Chicago, No. 85 C 989, 1985 WL 2401 (N.D.Ill. Aug. 27, 1985). The U.S. Code creates a trust in favor of certain suppliers of poultry on certain poultry unless the suppliers have been paid in full or fail to satisfy certain requirements of sending notice to the debtor and the Secretary of Agriculture. 7 U.S.C. §197. See Three “S” Farms, Inc. v. Plymouth Capital, Ltd. (In re Chi-Mar Foods, Inc.), 207 B.R. 594 (Bankr. N.D.Ill. 1997).

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SECURED TRANSACTIONS

6. [3.57] Rights of Bankruptcy Estate If the debtor becomes the subject of a voluntary or involuntary bankruptcy proceeding, the bankruptcy trustee (or the debtor-in-possession in a reorganization case) has a variety of powers that may impair the rights of a party with a perfected security interest. Under certain circumstances, the trustee may be able to avoid all or part of a security interest as a preference (11 U.S.C. §547), fraudulent transfer (11 U.S.C. §548), or transfer that is voidable by an actual creditor of the bankruptcy estate (11 U.S.C. §544(b)). Under 11 U.S.C. §552(b), the security creditor’s after-acquired property clause is cut off, and the security interest extends only to “proceeds, product, offspring, or profits” of collateral to the extent provided under the security agreement, “except to any extent that the court . . . orders otherwise.” Under 11 U.S.C. §362, §1201, or §1301, the secured party will be temporarily prohibited from enforcing its rights against the debtor or the collateral. Regardless of the validity of the security interest, the trustee “may recover from property securing an allowed secured claim the reasonable, necessary costs and expenses of preserving, or disposing of, such property to the extent of any benefit to the holder of such claim.” 11 U.S.C. §506(c). A trustee may also under certain circumstances obtain bankruptcy court authority to place a senior or equal lien on the secured party’s collateral during the administration of the bankruptcy case. See 11 U.S.C. §364(d). Finally, a trustee may modify the rights of a nonconsenting secured party under a reorganization or debt adjustment plan pursuant to 11 U.S.C. §1129, §1225, or §1325. 7. [3.58] Rights of Employees in Hot Goods Goods manufactured in violation of the minimum wage and/or overtime payment provisions (29 U.S.C. §§206, 207, 215) of the Fair Labor Standards Act of 1938 (FLSA) ch. 676, 52 Stat. 1060 (1938), are hot goods and may not be introduced into interstate commerce. See Citicorp Industrial Credit, Inc. v. Brock, 483 U.S. 27, 97 L.Ed.2d 23, 107 S.Ct. 2694 (1987). Although the United States Supreme Court has found that employees do not have a lien in hot goods, it has concluded that a secured creditor may not place repossessed hot goods in interstate commerce until the employees’ claims have been paid so that the Fair Labor Standards Act violation is remedied. Id. In Brock v. Rusco Industries, Inc., 842 F.2d 270 (11th Cir. 1988), the court indicated that, after the filing of a petition under the Bankruptcy Code, the proceeds of the sale of hot goods must first be paid to the underpaid workers, regardless of the automatic stay of 11 U.S.C. §362 and the priorities of distribution under the Bankruptcy Code. See also Martin v. Chambers, 154 B.R. 664 (E.D.Va. 1992) (action by the Secretary of Labor to enjoin debtordefendant from withholding minimum wage and overtime compensation due to any employee was not a violation of the automatic stay).

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§3.59

8. [3.59] Rights of Employees Under the Worker Adjustment and Retraining Notification Act Employers with at least 100 workers who close a facility, lay off a substantial number of employees, or undergo a major reduction of work hours must, except in extenuating circumstances, notify their employees and certain state and local governmental units at least 60 days before the event occurs. 29 U.S.C. §§2101, 2102. Failure to give this notice may result in civil damages being assessed against the employer, including payment of backpay and benefits to each employee for each day the employer is in violation of the law up to a maximum of 60 days. 29 U.S.C. §2104. At least one case has indicated that goods produced without compliance to the Worker Adjustment and Retraining Notification (WARN) Act, Pub.L. No. 100-379, 102 Stat. 890, will not be treated as “hot goods” as are goods produced without compliance to Fair Labor Standards Act. See In re Bluffton Casting Corp., 186 F.3d 857 (7th Cir. 1999) (employees were precluded from using Indiana mechanics liens law to establish priority of their claims for damages resulting from WARN Act violations over claims of secured creditors), overruled in part on other grounds by In re Bentz Metal Products Co., 253 F.3d 283 (7th Cir. 2001).

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4

Rights and Remedies upon Default

JEFFREY E. ALTSHUL Carlson Dash, LLC Chicago

®

©COPYRIGHT 2016 BY IICLE .

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I. [4.1] Scope of Chapter II. Default and Acceleration A. Default 1. [4.2] Defining Default 2. [4.3] Default Clause B. Acceleration 1. [4.4] Contractual Right of Acceleration 2. [4.5] Acceleration at Will C. [4.6] Consequences of Wrongful Acceleration III. Repossession of Collateral A. [4.7] Accounts, Contract Rights, Instruments, and Chattel Paper B. [4.8] Repossession of Goods C. [4.9] Peaceful Repossession IV. Disposition of Collateral A. B. C. D. E. F. G. H. I.

[4.10] [4.11] [4.12] [4.13] [4.14] [4.15] [4.16] [4.17] [4.18]

Overview Preservation of Collateral Notice of Proposed Disposition of Collateral Collateral Not Requiring Notice Prior to Disposition Notice of Public or Private Sale Form of Notice Parties Entitled To Receive Notice Contents of Notice Timing of Notice

V. Secured Creditor’s Obligations with Respect to Sale of Collateral A. [4.19] Overview B. [4.20] Sale of Collateral C. [4.21] Considerations Impacting Determination of Commercial Reasonableness VI. [4.22] Title Obtained by Purchaser VII. [4.23] Application of Sale Proceeds

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VIII. [4.24] Debtor’s Right of Redemption IX. [4.25] Strict Foreclosure: Accepting Collateral in Discharge of Indebtedness X. Sanctions Against a Secured Party for Failure To Comply with Part 6 of Article 9 A. [4.26] Damages B. [4.27] Recovery of Deficiency Against Principal Obligor or Guarantor XI. Replevin A. [4.28] Overview B. [4.29] Procedure XII. Attachment A. [4.30] Overview B. [4.31] Grounds for Attachment C. [4.32] Procedure

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§4.1

SECURED TRANSACTIONS

I. [4.1] SCOPE OF CHAPTER In 2001, Illinois — along with every other state — enacted extensive revisions to Article 9, 810 ILCS 5/9-101, et seq., of the Uniform Commercial Code (UCC), 810 ILCS 5/1-101, et seq. All citations to the UCC in this chapter are to the revised version unless otherwise noted. On August 17, 2012, the State of Illinois enacted uniform amendments to Article 9 and §2A103 of the UCC, which were proposed and adopted by the National Conference of Commissioners on Uniform State Laws in 2010. The 2012 Amendments became effective on July 1, 2013. See P.A. 97-1034. This chapter examines the rights and obligations of a secured party and borrower when the borrower defaults. The initial focus is on the concept of default and the rules under Part 6 (formerly Part 5), 810 ILCS 5/9-601, et seq., of Article 9 of the UCC, dealing with the repossession and disposition of collateral. Finally, non-UCC enforcement rights by which a secured party may obtain possession and dispose of collateral, such as replevin and attachment, are discussed.

II. DEFAULT AND ACCELERATION A. Default 1. [4.2] Defining Default The Uniform Commercial Code does not define the term “default” because the drafters of Article 9 recognized that what would constitute default would vary depending on the transaction and should be left to the secured party’s definition in the security agreement. A secured party should take pains to include in the security agreement a definition of default that eliminates disagreement over whether a certain act or failure to act constitutes a default. 2. [4.3] Default Clause While the various events of default included in a loan agreement or security agreement are tailored to reflect both the structure and risks of the particular transaction, the following are provisions typically included within the definition of default: a. failure to pay principal, interest, fees, or other expenses when due; b. failure by the borrower or others, such as guarantors, subsidiaries, or affiliates, to comply with the covenants in the agreement; c. misrepresentation or breach of warranty by the borrower or by others specified in the agreement; d. nonperformance (cross-default) under the terms and provisions of other related agreements;

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§4.5

e. bankruptcy, insolvency, failure to satisfy money judgments, or assignment for benefit of creditors of the borrower or other defined parties; and f.

the occurrence of a material adverse change in the financial or business condition of the borrower or other named parties (this can include death or incapacity of key individuals, loss of critical permits, licenses, or other rights, or breach or repudiation of credit supports or guaranties by third parties).

B. Acceleration 1. [4.4] Contractual Right of Acceleration If the borrower fails to pay the secured debt, the secured party will want the option to accelerate the debt. This right exists only when it is provided for in the promissory note and security agreement. See, e.g., General Electric Credit Corp. v. Castiglione, 142 N.J.Super. 90, 360 A.2d 418 (1976). A reference in the security agreement that in the event of default the secured party shall have “the rights and remedies provided” by law will not give a right to accelerate because acceleration is not one of the rights and remedies provided by Part 6 of Article 9 of the Uniform Commercial Code. Redding v. Rowe, 36 Wash.App. 822, 678 P.2d 337, 338 (1984). Illinois does not require that a secured party give notice to the debtor prior to accelerating the debt. However, if a secured party has accepted late payments from the debtor or has waived other defaults by the debtor, the secured party may be estopped from accelerating the debt unless the secured party has given the debtor notice that it no longer will accept late payments or that it will no longer waive other defaults. See, e.g., Westinghouse Credit Corp. v. Shelton, 645 F.2d 869 (10th Cir. 1981). 2. [4.5] Acceleration at Will Security agreements often provide that a secured party may accelerate “at will” or “when he or she deems himself or herself insecure.” Former §1-208 of the Uniform Commercial Code, now §1-309 (as added by P.A. 95-895, eff. Jan. 1, 2009), allows acceleration only when there is a good-faith belief that the prospect of payment or performance is impaired. Revised Article 9 for the first time explicitly requires satisfaction of both objective and subjective elements of good faith. “ ‘Good faith’ means honesty in fact and the observance of reasonable commercial standards of fair dealing.” 810 ILCS 5/9-102(43). See generally John C. Chobot, Objective Aspects of Good Faith in Insecurity Clause Debt Accelerations, 94 Com.L.J. 13 (1989). Under UCC §1-309, there is a presumption of good faith on the part of the secured party, and the burden of establishing a lack of good faith is on the party against whom the power has been exercised. Bartlett Bank & Trust Co. v. McJunkins, 147 Ill.App.3d 52, 497 N.E.2d 398, 100 Ill.Dec. 420 (1st Dist. 1986). Under prior law, some courts tested a secured party’s good faith by a subjective test of its honesty (see, e.g., Farmers Cooperative Elevator, Inc. v. State Bank, 236 N.W.2d 674 (Iowa 1975)), while others required the determination of insecurity to have been objectively reasonable under the circumstances (Smith v. Union State Bank, 452 N.E.2d 1059

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§4.6

SECURED TRANSACTIONS

(Ind.App. 1983)), and some commentators suggested that the standard lies somewhere between. See 4 James J. White and Robert S. Summers, UNIFORM COMMERCIAL CODE §34-3 (5th ed. 2002). See also Darlene M. Nowak, Standards for Insecurity Acceleration Under Section 1-208 of the Uniform Commercial Code: A Proposal for Reform, 13 U.Mich.J.L.Ref. 623 (1980). Illinois has used the subjective test rather than the objective test; however, even the Illinois test is not purely subjective. Watseka First National Bank v. Ruda, 135 Ill.2d 140, 552 N.E.2d 775, 142 Ill.Dec. 184 (1990) (creditor’s decision to accelerate must be based on more than mere whim). Given the clear language of UCC §9-102(a)(43), the earlier precedents must be used with caution: Illinois courts should require both a good-faith belief of insecurity and a reasonable basis for that belief. C. [4.6] Consequences of Wrongful Acceleration In Smith v. Union State Bank, 452 N.E.2d 1059 (Ind.App. 1983), it was held that even an erroneous determination of insecurity is not necessarily unreasonable or in bad faith. On the other hand, in Clayton v. Crossroads Equipment Co., 655 P.2d 1125 (Utah 1982), the Utah Supreme Court held that failure to accelerate in good faith can be a basis of an award of both actual and punitive damages against a secured party. A secured party’s actions will be measured against the UCC §1-304 obligation of good faith in the enforcement of contracts (810 ILCS 5/1-304), so secured parties must be cautious in their efforts to accelerate on the basis of a feeling of insecurity as opposed to the happening of a specific event of default.

III. REPOSSESSION OF COLLATERAL A. [4.7] Accounts, Contract Rights, Instruments, and Chattel Paper A secured party can assume control of this type of collateral by notifying the account debtor or the obligor on an instrument that subsequent payments must be made to the secured party. 810 ILCS 5/9-607(a). A holder of a security interest in a letter of credit cannot take action directly against the issuer of the letter of credit unless the secured party becomes a transferee beneficiary under Article 5 of the Uniform Commercial Code. 810 ILCS 5/5-114. A court should not enjoin the secured party from collecting the accounts of a debtor, even though the collection of accounts may impair the debtor’s conduct of a lawful business, absent a showing that the secured party is violating the terms of the loan agreement. Delcon Group, Inc. v. Northern Trust Corp., 159 Ill.App.3d 275, 512 N.E.2d 378, 111 Ill.Dec. 262 (2d Dist. 1987). At least one court held that a former UCC §9-504(3) notice of disposition of collateral is not required before a secured party may notify account debtors or initiate direct collection procedures. Western Decor & Furnishings Industries, Inc. v. Bank of America, 91 Cal.App.3d 293, 154 Cal.Rptr. 287 (1979). UCC §§9-611(b) and 9-611(d) appear to respond to this decision and provide that such notice is required to be sent to specified interested persons unless the

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§4.9

collateral is perishable or threatens to decline speedily in value and is of a type customarily sold on a recognized market. 810 ILCS 5/9-611(b), 5/9-611(d). The notice must be given in a reasonable time and manner and must contain reasonable content. 810 ILCS 5/9-612, 5/9-613. Often, however, secured parties seek the assistance of their debtors in the collection of the debtor’s accounts. This can result in less dilution of those accounts and reduce the likelihood of litigation with the debtor over the propriety of the secured party’s actions. Section 9-607(d) of the UCC provides that the secured party can deduct its expenses for collections made in a commercially reasonable manner. B. [4.8] Repossession of Goods Section §9-609(b) of the Uniform Commercial Code allows a secured party to take possession of its collateral if it can be accomplished without breach of the peace. 810 ILCS 5/9609(b). If peaceful repossession is not possible, the secured party must resort to judicial process such as replevin. The concept of peaceful repossession is discussed in §4.9 below. When the security agreement provides for it, the debtor may be required to assemble the collateral at a place designated by the secured party that is reasonably convenient to both parties. 810 ILCS 5/9-609(c). When the cost of moving the collateral is uneconomical, as might be the case with heavy machinery, UCC §9-609(a)(2) allows the secured party to render the collateral unusable or to sell it on the debtor’s premises. See, e.g., Elliot v. Villa Park Trust & Savings Bank, 63 Ill.App.3d 714, 380 N.E.2d 507, 20 Ill.Dec. 529 (2d Dist. 1978). The authorization to render equipment unusable or to dispose of collateral without removal from the debtor’s premises does not justify any unreasonable conduct by the secured party since UCC §9-610(b) requires that all of its actions in connection with disposition of collateral must be done in a commercially reasonable manner. 810 ILCS 5/9-610(b). C. [4.9] Peaceful Repossession Constitutional arguments against repossession efforts without notice to the debtor usually are rejected because no state action is found. See, e.g., Gibson v. Dixon, 579 F.2d 1071 (7th Cir. 1978). However, a fairly common issue faced when collateral is repossessed without the debtor’s consent is whether there was a breach of the peace. The UCC does not define “breach of the peace,” and courts look to non-UCC law for definitions. If the debtor unequivocally protests at the time of the repossession, however, the repossession may be found to be in breach of the peace. Dixon v. Ford Motor Credit Co., 72 Ill.App.3d 983, 391 N.E.2d 493, 497, 29 Ill.Dec. 230 (1st Dist. 1979). This right to prevent a repossession by protest extends to nondebtors who are in control of the secured party’s collateral. Census Federal Credit Union v. Wann, 403 N.E.2d 348 (Ind.App. 1980). When a secured party hires a repossessor who is an independent contractor, breach of the peace by the independent contractor should not give rise to a cause of action against the secured party for wrongful repossession. Kouba v. East Joliet Bank, 135 Ill.App.3d 264, 481 N.E.2d 325, 89 Ill.Dec. 774 (3d Dist. 1985). Kouba, however, was decided under agency law only. It is not

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SECURED TRANSACTIONS

clear whether courts in Illinois would recognize a cause of action for negligent choice of a repossessor in the context of a claim for wrongful repossession. Repossession accomplished by fraud or by trickery could generate liability for conversion. Ford Motor Co. v. Byrd, 351 So.2d 557 (Ala. 1977). Law enforcement agents, whether on or off duty, should not be solicited to effect a repossession. Stone Machinery Co. v. Kessler, 1 Wash.App. 750, 463 P.2d 651 (1970). If the secured party or its agents must enter a closed structure on the debtor’s property to obtain possession of the collateral, repossession will likely not be obtained without a breach of the peace. See Rogers v. Allis-Chalmers Credit Corp., 679 F.2d 138 (8th Cir. 1982); Laurel Coal Co. v. Walter E. Heller & Co., 539 F.Supp. 1006 (W.D.Pa. 1982). If a garage door must be forced open, this forced opening would constitute a breach of the peace, although one California court held that repossession from an open garage did not. Henderson v. Security National Bank, 72 Cal.App.3d 764, 140 Cal.Rptr. 388 (1977). One Illinois court has defined “breach of the peace” as conduct that incites or is likely to incite immediate public turbulence, or that leads to or is likely to lead to immediate loss of public order and tranquility. Chrysler Credit Corp. v. Koontz, 277 Ill.App.3d 1078, 661 N.E.2d 1171, 214 Ill.Dec. 726 (5th Dist. 1996). For example, a plaintiff who had filed an action against an agent of a secured party under 810 ILCS 5/9-609(b), which permits the repossession of collateral “without judicial process, if it proceeds without breach of the peace,” was held to have sufficiently pled a breach of the peace to survive a motion to dismiss by alleging that the agent had jumped the plaintiff’s fence, forced open a locked garage, and damaged the plaintiff’s property. Williams v. Precision Recovery, Inc., No. 03 C 7993, 2004 WL 769326 at *2 (N.D.Ill. Apr. 8, 2004). Interestingly, while the parties may determine by contract many of the standards respecting fulfillment of a secured creditor’s duties (810 ILCS 5/9-602, 5/9-603; §4.20 below), the parties may not define what constitutes a breach of the peace. 810 ILCS 5/9-603(b).

IV. DISPOSITION OF COLLATERAL A. [4.10] Overview Once a secured party has obtained possession of the collateral either by self-help or by judicial means, it may either dispose of the collateral under UCC §9-610 or accept the collateral in full or partial satisfaction of the debtor’s obligation under UCC §9-620. 810 ILCS 5/9-610, 5/9-620. Disposal of the collateral under UCC §9-610 includes the sale, lease, license, or other disposition of any or all of the collateral. Retention of the collateral and satisfaction of the debt, often referred to as “strict foreclosure,” are discussed in §4.25 below. When the secured party intends to dispose of the collateral, the overriding concept that it must respect is one of commercial reasonableness. 810 ILCS 5/9-610(b). Every aspect of the maintenance and disposition of the collateral must be done in a commercially reasonable manner

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§4.12

if the secured party is to avoid sanctions for failure to comply with the requirements of Part 6 of Article 9 of the Uniform Commercial Code, as discussed in §§4.26 and 4.27 below. B. [4.11] Preservation of Collateral A secured party must use reasonable care in the custody and preservation of collateral in its possession. First National Bank of Thomasboro v. Lachenmyer, 131 Ill.App.3d 914, 476 N.E.2d 755, 87 Ill.Dec. 53 (4th Dist. 1985). The collateral may be used or operated for the purpose of preserving it. See Bank Josephine v. Conn, 599 S.W.2d 773 (Ky.App. 1980). Violation of the secured party’s duty to use reasonable care in the custody and preservation of its collateral through its disposition may entitle the debtor to a setoff against the debt. See First National Bank of Thomasboro, supra. If the collateral is consumer goods and the debtor has paid 60 percent of the cash price or loan obligation, a secured party must dispose of the collateral. 810 ILCS 5/9-620(e). In this event, the secured party is required to dispose of the property pursuant to 810 ILCS 5/9-610. A debtor or guarantor may waive the right to require disposition of collateral only by an agreement to that effect entered into and authenticated after default. 810 ILCS 5/9-624(b). Pursuant to UCC §9-625, a secured party may be liable for damages, including the debtor’s ability to obtain, or the increased costs of, alternative financing. Statutory damages of $500 are, in certain circumstances, also provided to debtors. 810 ILCS 5/9-625. Article 9 of the UCC also gives courts the ability to fashion appropriate damages. Id. C. [4.12] Notice of Proposed Disposition of Collateral Former §9-504(3) of the Uniform Commercial Code required a secured party to give the debtor reasonable notification of the proposed disposition of the collateral. This is changed in UCC §9-611 to provide for authenticated notice of disposition and notice to any guarantor, “secondary obligor,” and other secured parties. 810 ILCS 5/9-611. The purpose of the notice requirement is to give these parties an opportunity to take whatever action is necessary to protect their interests in the collateral. Modern Auto Co. v. Bell, 678 S.W.2d 443 (Mo.App. 1984). Actions that are available include satisfying the underlying debt and redeeming the collateral, finding someone to assume the debt or to purchase the collateral, or taking some action that will minimize the possibility that the collateral will be sold for an amount substantially below the underlying debt. See Lake Shore National Bank v. McCann, 78 Ill.App.3d 580, 396 N.E.2d 1301, 33 Ill.Dec. 577 (1st Dist. 1979). Notice of the sale must be given in writing unless the collateral is perishable or threatens to decline speedily in value or is of a type customarily sold on a recognized market. 810 ILCS 5/9-611(d). See Stensel v. Stensel, 63 Ill.App.3d 639, 380 N.E.2d 526, 20 Ill.Dec. 548 (4th Dist. 1978).

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SECURED TRANSACTIONS

While a debtor may waive the right to receive notice, that waiver must be made after default. 810 ILCS 5/9-624(a). Generally, courts will not enforce provisions in the loan agreements purporting to waive notice. Borg-Warner Acceptance Corp. v. Watton, 215 Neb. 318, 338 N.W.2d 612 (1983). A debtor may sign a statement after default renouncing or modifying his or her right to notification of the sale, in which case no notice is required. 810 ILCS 5/9-624(a). The secured party also must conduct a search before the notice date at the proper recording office and then give notice to any other secured parties. 810 ILCS 5/9-611(b). Guarantors are also entitled to notice under UCC §9-611. National Acceptance Company of America v. Medlin, 538 F.Supp. 585 (N.D.Ill. 1982). Article 9 of the UCC provides that a secured party may dispose of collateral by license. 810 ILCS 5/9-610(a). D. [4.13] Collateral Not Requiring Notice Prior to Disposition Collateral that does not require notice because it is sold in a recognized market includes stocks, bonds, and commodities sold in markets without competitive bidding. See Washburn v. Union National Bank & Trust Company of Joliet, 151 Ill.App.3d 21, 502 N.E.2d 739, 104 Ill.Dec. 242 (3d Dist. 1986). Collateral typically not sold on a recognized market that requires notice includes vehicles (Maryland National Bank v. Wathen, 288 Md. 119, 414 A.2d 1261 (1980)), livestock (Wippert v. Blackfeet Tribe of Blackfeet Indian Reservation, 215 Mont. 85, 695 P.2d 461 (1985)), and copying machines (Hertz Commercial Leasing Corp. v. Dynatron, Inc., 37 Conn.Supp. 7, 427 A.2d 872 (1980)). In addition to foodstuffs, collateral that is perishable or threatens to decline speedily in value can include collateral that is seasonal in nature, such as Christmas toys and inventory of a retail store liquidated at the end of November. American City Bank of Tullahoma v. Western Auto Supply Co., 631 S.W.2d 410 (Tenn.App. 1981). E. [4.14] Notice of Public or Private Sale If collateral is to be sold at a public sale, the secured party must give the debtor “a reasonable authenticated notification of disposition” of the sale. 810 ILCS 5/9-611(b). In a commercial transaction, revised Article 9 of the Uniform Commercial Code specifies that ten days’ prior notice of disposition is reasonable. 810 ILCS 5/9-612(b). If the collateral is to be sold at a private sale, the secured party need only give the debtor reasonable notification of the time after which any private sale or other intended disposition is to be made. 810 ILCS 5/9-613(1)(E); Ford Motor Credit Co. v. Jackson, 126 Ill.App.3d 124, 466 N.E.2d 1330, 81 Ill.Dec. 528 (3d Dist. 1984). The UCC does not define the terms “public sale” and “private sale.” However, a UCC Comment states that “a ‘public disposition’ is one at which the price is determined after the public has had a meaningful opportunity for competitive bidding.” UCC Comment 7, 810 ILCS

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5/9-610. For a discussion of the distinctions between a public and private sale, see Annot., 60 A.L.R.4th 1012 (1988). See also Ford Motor Credit Co. v. Solway, 825 F.2d 1213 (7th Cir. 1987). A secured creditor cannot purchase at a private sale unless the collateral is of a type customarily sold in a recognized market or is of a type that is the subject of widely distributed standard price quotations. 810 ILCS 5/9-610(c). The burden may be on the secured party to prove that it gave adequate notice of the type of sale, particularly when there is confusion over whether the sale was intended to be public or private. See First Missouri Bank & Trust Company of Creve Coeur v. Newman, 680 S.W.2d 767 (Mo.App. 1984); Villella Enterprises, Inc. v. Young, 108 N.M. 33, 766 P.2d 293 (1988). F. [4.15] Form of Notice Notice should be given in writing. Butte State Bank v. Williamson, 215 Neb. 296, 338 N.W.2d 598 (1983). Section 9-611(b) of the Uniform Commercial Code requires that the secured party “send” the notice to the debtor. 810 ILCS 5/9-611(b). Section 1-201(b)(36) of the UCC defines the term “send” as meaning “to deposit in the mail or deliver for transmission by any other usual means of communication with postage or cost of transmission provided for and properly addressed.” 810 ILCS 5/1-201(b)(36). Pursuant to UCC §9-611(b), the secured creditor is required to send a “reasonable authenticated notification of disposition.” 810 ILCS 5/9-611. Section 9-613 of the UCC contains a suggested form of notification, which, when completed, provides sufficient information, but notes that a particular form of notice is not required. 810 ILCS 5/9-613. Section 9-614 of the UCC provides for a suggested form of notice for consumer transactions. 810 ILCS 5/9-614. The UCC does not require use of the mail, although a secured party may send notice by that means, including regular mail. Leasing Service Corp. v. Diamond Timber, Inc., 559 F.Supp. 972 (S.D.N.Y. 1983). While the use of certified or registered mail will provide a secured party with evidence of delivery or of the debtor’s refusal to accept notice (see, e.g., BancOhio National Bank v. Freeland, 13 Ohio App.3d 245, 468 N.E.2d 941 (1984)), there is a risk that the secured party may have actual notice that the debtor did not receive the notice if the notice is returned unclaimed without an indication that the debtor refused delivery. Use of regular as opposed to certified mail is acceptable. First National Bank & Trust Company of Lincoln v. Hermann, 205 Neb. 169, 286 N.W.2d 750 (1980). Some states, including Illinois, apply a second-try doctrine when the first notice of sale is returned unclaimed or undelivered. See, e.g., National Boulevard Bank of Chicago v. Jackson, 92 Ill.App.3d 928, 416 N.E.2d 358, 48 Ill.Dec. 327 (1st Dist. 1981); In re Carter, 511 F.2d 1203 (9th Cir. 1975). Secured parties should make every reasonable effort to locate the debtor because that is another aspect of the reasonableness of the secured party’s actions that may be examined by the court. Commercial Credit Corp. v. Cutshall, 28 U.C.C.Rep.Serv. (CBC) 277 (Tenn.App. 1979).

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SECURED TRANSACTIONS

G. [4.16] Parties Entitled To Receive Notice Prior to its revision, Article 9 of the Uniform Commercial Code required a secured creditor to give notice of sale to the debtor and to any other secured creditor who had filed with the secured creditor conducting the sale a written request for notice. If the other secured creditor did not file a request, it was not entitled to notice of the sale, although it could sue for damages under former §9-507(1) of the UCC alleging a failure to conduct a commercially reasonable sale. Louis Zahn Drug Co. v. Bank of Oak Brook Terrace, 95 Ill.App.3d 435, 420 N.E.2d 276, 50 Ill.Dec. 959 (2d Dist. 1981). The manner in which a junior creditor could give this notice was not specified, but at least one court had held that a senior secured creditor received “written notice of a claim of an interest in the collateral” within the meaning of unrevised UCC §9-504(3) when the junior secured creditor’s promissory note and security agreement were sent to the senior secured creditor. Luhellier v. Bolline Construction, Inc., 157 Mich.App. 131, 403 N.W.2d 522, 524, appeal denied, 428 Mich. 883 (1987). Under revised Article 9, the secured party must conduct a search, at least 20 days and not more than 30 days before the notice date, at the proper recording office and then provide notice to all lienholders. 810 ILCS 5/9-611(b), 5/9-611(c), 5/9-611(e). Good practice dictates that a separate notice should be sent to both debtors when they are husband and wife rather than a single notice addressed to “Mr. & Mrs. ____________.” Central Bank & Trust Co. v. Metcalfe, 663 S.W.2d 957, 959 (Ky.App. 1984). Most of the cases prior to the revisions to Article 9 held that a guarantor was a “debtor” within the meaning of former UCC §9-105(1)(d) and therefore was entitled to notice of the sale of collateral. The rationale was that the guarantor has an interest in the collateral as a subrogee upon payment of the secured claim. Pursuant to UCC §9-611(c), a guarantor is clearly entitled to notice of sale. A debtor or guarantor may waive the right to notification of disposition of collateral only by an agreement to that effect entered into and authenticated after default. 810 ILCS 5/9-624(a). A few courts under Article 9 held that a guarantor who did not own the collateral was not a “debtor” for purposes of notice of sale of the collateral. Brinson v. Commercial Bank, 138 Ga.App. 177, 225 S.E.2d 701 (1976), overruled by Barbree v. Allis-Chalmers Corp., 250 Ga. 409, 297 S.E.2d 465 (1982); United States v. Crispen, 622 F.Supp. 75 (N.D.Ill. 1985). However, UCC §9-611(c) requires notice be given to all guarantors and therefore overrules these cases. Bankruptcy trustees may be debtors entitled to notice of the sale of collateral. First National Bank & Trust Company of Tulsa v. Hutchins (In re Buttram), 2 B.R. 92 (Bankr. N.D.Okla. 1979). A recourse seller of chattel paper also should be given notice. First Galesburg National Bank & Trust Co. v. Joannides, 103 Ill.2d 294, 469 N.E.2d 180, 82 Ill.Dec. 646 (1984). UCC §9-611(c) provides a list of parties entitled to notice. When partners are involved, courts have held that notice to one is sufficient even though all partners did not receive notice since notice to one partner under state law may be deemed notice to all partners. American Fidelity Bank & Trust Co. v. McCoy, 41 U.C.C.Rep.Serv. (CBC) 1796 (Ky.App. 1985). Nevertheless, good practice would include notice to all partners when possible. When a corporate officer/guarantor executes instruments in both individual and representative capacities, notice should be sent twice, once in his or her corporate representative capacity and once in his or her individual capacity. Notice may be inadequate when it is not clear

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§4.18

in which capacity the notice has been sent. First National Bank & Trust Company of Fremont v. Hughes, 214 Neb. 42, 332 N.W.2d 674 (1983), superseded by statute as stated in Howard Kool Chevrolet, Inc. v. Blomstedt, 2 Neb.App. 493, 511 N.W.2d 222 (1994). But see Reeves v. Habersham Bank, 254 Ga. 615, 331 S.E.2d 589 (1985), overruled on other grounds by Emmons v. Burkett, 256 Ga. 855, 353 S.E.2d 908 (1987). When a federal tax lien has intervened, a secured creditor must give 25 days’ notice of the sale to the Internal Revenue Service. 26 U.S.C. §§7425(b), 7425(c). Failure to give this notice results in the tax lien surviving the sale. 26 U.S.C. §7425(b)(1). H. [4.17] Contents of Notice A notice must state the time and place of any public sale and the time on or after which any private sale or other intended disposition is to be made. 810 ILCS 5/9-613(1)(E). The notice also must describe the collateral and should state the name, address, and telephone number of the secured creditor. 810 ILCS 5/9-613. If there are special provisions of the terms of sale, they must be accurate and spelled out in the notice. Wilmington Trust Co. v. Conner, 415 A.2d 773 (Del. 1980); Travis v. Boulevard Bank, N.A., 880 F.Supp. 1226 (N.D.Ill. 1995). See also 810 ILCS 5/9613. It is not necessary that the notice contain information regarding the redemption rights of the debtor. Wilmington Trust Co. v. Addessi, 38 U.C.C.Rep.Serv. (CBC) 1416 (Del.Super. 1984). A particular phrasing of the notices is not required. 810 ILCS 5/9-613(4). However, UCC §9-613 contains a form of notice that should be sufficient when completed. I. [4.18] Timing of Notice Even if the secured party sends notice of the sale to the debtor, courts still may find the notice inadequate if the debtor does not have reasonable time to respond. See Fitzpatrick v. Bank of New York, 125 Misc.2d 1069, 480 N.Y.S.2d 864 (1984) (one day’s notice insufficient). The Uniform Commercial Code does not specify a length of time that notice must be given before a sale occurs, and courts have been reluctant to establish a “bright line” for a minimum number of days required. However, notices sent less than ten days prior to the sale date may be inadequate. See, e.g., Prairie Vista, Inc. v. Casella, 12 Ill.App.3d 34, 297 N.E.2d 385 (4th Dist. 1973). Note that UCC §9-612(b) provides that ten days’ prior notice of disposition is per se reasonable in nonconsumer transactions. 810 ILCS 5/9-612(b). However, under UCC §9-612(a), courts are free to determine the proper rules regarding reasonable time for notification in consumer good transactions. If there will be more than one sale of the collateral, successive notices are required. Spillers v. First National Bank of Arenzville, 81 Ill.App.3d 199, 400 N.E.2d 1057, 36 Ill.Dec. 477 (4th Dist. 1980); Connecticut Bank & Trust Company, N.A. v. Incendy, 207 Conn. 15, 540 A.2d 32 (1988). When the parties agree in the security agreement regarding the minimum length of notice and the means of giving notice, that agreement should be upheld by the court. Aetna Finance Co. v. Culpepper, 171 Ga.App. 315, 320 S.E.2d 228 (1984). However, Aetna involved a contractual

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§4.19

SECURED TRANSACTIONS

notice period of ten days, which most likely would be found to be reasonable. Very short contractual notice periods will not likely be recognized if the reviewing court believes they are unreasonable under the circumstances.

V. SECURED CREDITOR’S OBLIGATIONS WITH RESPECT TO SALE OF COLLATERAL A. [4.19] Overview Section 9-610(b) of the Uniform Commercial Code requires that disposition of the collateral, whether by public or private sale and in separate lots or in bulk, must be done in a commercially reasonable manner. 810 ILCS 5/9-610(b). The comments to the UCC emphasize that the only restriction placed on a secured party’s method of disposition is that of commercial reasonableness. UCC Comment 2, 810 ILCS 5/9-610. What is commercially reasonable is not defined in the UCC, although UCC §9-627 sets out certain safe harbors that are discussed below. 810 ILCS 5/9-627. In examining a secured party’s actions, the courts take into account a number of factors, including such things as (1) the relationship of a price obtained to the market price, (2) conformity with the standards of commercial reasonableness, (3) the presence or absence of a recognized market for the collateral and the secured party’s utilization of that market, and (4) the overall reasonableness of the methodology of disposition under the circumstances. See 810 ILCS 5/9-627(b). See, e.g., Swanson v. May, 40 Wash.App. 148, 697 P.2d 1013 (1985). When a secured party seeks to collect a deficiency following a sale, the burden will be on the secured party to establish that the sale was conducted in a commercially reasonable manner. See National Boulevard Bank of Chicago v. Jackson, 92 Ill.App.3d 928, 416 N.E.2d 358, 48 Ill.Dec. 327 (1st Dist. 1981); Federal Deposit Insurance Corp. v. Herald Square Fabrics Corp., 81 A.D.2d 168, 439 N.Y.S.2d 944 (1981). Under UCC §9-627(c), a conclusive presumption exists that the disposition was commercially reasonable if the disposition was approved in “a judicial proceeding” or “by a bona fide creditors’ committee” or “representative of creditors.” 810 ILCS 5/9-627(c). When a creditor seeks to obtain the benefits of UCC §9-627(c), however, it should take great pains to establish a complete record disclosing all terms of the sale and give all interested parties an opportunity to make an objection. Kolton v. K & L Furniture & Appliances, Inc., 82 Ill.App.3d 868, 403 N.E.2d 478, 38 Ill.Dec. 247 (1st Dist. 1979). See also Bryant v. American National Bank & Trust Company of Chicago, 407 F.Supp. 360 (N.D.Ill. 1976). Failure to obtain approval does not impact on the determination of commercial reasonableness that may be made in a later proceeding. 810 ILCS 5/9-627. If the secured party seeks to collect a deficiency from a consumer or if a consumer requests, the secured party in a consumer goods transaction has to provide the amount and calculation of any deficiency. 810 ILCS 5/9-616. B. [4.20] Sale of Collateral When collateral is perishable, a secured creditor may be obligated to dispose of the collateral promptly. Ruchaber v. Short, 53 Or.App. 58, 630 P.2d 915 (1981). Pursuant to UCC §9-611(d), notice of disposition need not be given if the goods are perishable. 810 ILCS 5/9-611(d).

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Former §9-504(1) of the Uniform Commercial Code allowed a secured creditor to sell the collateral in “its then condition” or following any commercially reasonable preparation. See UCC Comment 4, 810 ILCS 519-610. This standard has been read by some courts to obligate the secured creditor to make minimal repairs to collateral prior to sale. See, e.g., Weiss v. Northwest Acceptance Corp., 274 Or. 343, 546 P.2d 1065 (1976); Connex Press, Inc. v. International Airmotive, Inc., 436 F.Supp. 51 (D.D.C. 1977). Pursuant to UCC §9-610(a), a secured creditor may sell, lease, license, or otherwise dispose of collateral in its present condition or after any commercially reasonable preparation. 810 ILCS 5/9-610(a). The concept of commercial reasonableness also extends to the methods used to advertise the sale. See Boender v. Chicago North Clubhouse Association, Inc., 240 Ill.App.3d 622, 608 N.E.2d 207, 181 Ill.Dec. 134 (1st Dist. 1992), appeal denied, 151 Ill.2d 561 (1993). The advertising should have sufficient information to generate interest in the collateral. At a minimum, it should include a description of the collateral and the method, manner, time, place, and terms of the sale. See Liberty National Bank & Trust Company of Oklahoma City v. Acme Tool Division of Rucker Co., 540 F.2d 1375 (10th Cir. 1976). In determining whether a sale was conducted in a commercially reasonable fashion, most courts, following the language of unrevised UCC §9-507(2), focus on the procedures employed in the sale rather than on the price received at the sale. While a large discrepancy between the selling price and the actual value of the collateral will prompt a court to examine the reasonableness of the disposition (UCC Comment 2, 810 ILCS 5/9-627; Savage Construction, Inc. v. Challenge-Cook Bros., 102 Nev. 34, 714 P.2d 573 (1986)), mere inadequacy in price will not of itself, absent fraud or wrongdoing on the part of the secured party, make a sale commercially unreasonable. See 810 ILCS 5/9-627(a); Louis Zahn Drug Co. v. Bank of Oak Brook Terrace, 95 Ill.App.3d 435, 420 N.E.2d 276, 50 Ill.Dec. 959 (2d Dist. 1981). This will continue to be the standard under the similar language of UCC §9-627(a). A debtor cannot waive the requirement that the secured party dispose of the collateral in a commercially reasonable manner. 810 ILCS 5/9-602. However, the parties can establish by agreement the standard by which the performance of the commercially reasonable obligation will be measured (810 ILCS 5/9-602, 5/9-603), but only as long as such standards “are not manifestly unreasonable” (810 ILCS 5/9-603). C. [4.21] Considerations Impacting Determination of Commercial Reasonableness All aspects of the disposition of collateral will be measured against a commercially reasonable standard, including the decision of whether to hold a public or private sale. Old Colony Trust Co. v. Penrose Industries Corp., 280 F.Supp. 698 (E.D.Pa.), aff’d, 398 F.2d 310 (3d Cir. 1968). The comments encourage consideration of private sales on the assumption that they frequently result in higher realization on collateral. UCC Comment 2, 810 ILCS 5/9-610. The sale must be advertised in appropriate newspapers and trade journals and/or through the preparation of brochures and mailings to dealers and other potentially interested persons in such a way that they will solicit a broad interest. See Boender v. Chicago North Clubhouse Ass’n, 240 Ill.App.3d 622, 608 N.E.2d 207, 181 Ill.Dec. 134 (1st Dist. 1992), appeal denied, 151 Ill.2d 561

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SECURED TRANSACTIONS

(1993). Notice should be sent to the proper market (Poti Holding Co. v. Piggott, 15 Mass.App.Ct. 275, 444 N.E.2d 1311, appeal denied, 388 Mass. 1105 (1983)), and a secured creditor should prepare an affidavit of mailing and attach copies of evidence of mailing to establish written proof of compliance with the notice requirements of UCC §9-611 (see Leasing Associates, Inc. v. Slaughter & Son, Inc., 450 F.2d 174 (8th Cir. 1971)). Sufficient notice in advance of the sale should be given to the debtor and to all guarantors. Chrysler Capital Corp. v. Cotlar, 762 S.W.2d 859 (Mo.App. 1989). If possible, the debtor’s agreement or cooperation should be obtained regarding the method of sale. If the debtor participates in this decision regarding the conduct of the sale, he or she may be estopped to challenge a sale or may be deemed to have set the standards by which the secured creditor’s conduct will be measured. See, e.g., Ralston-Purina Co. v. Bertie, 541 F.2d 1363 (9th Cir. 1976); Becknell v. First National Bank in Little Rock, 740 F.2d 609 (8th Cir. 1984). The collateral may need to be prepared for sale and made available for inspection prior to sale. See UCC Comment 4, 810 ILCS 5/9-610. The sale should be held in a location that will maximize the attendance and the bidding at the sale. Gulf Homes, Inc. v. Goubeaux, 124 Ariz. 142, 602 P.2d 810 (1979). Good practice suggests that a secured creditor hire or consult an auctioneer or someone experienced in selling collateral of the type to be sold and prepare an inventory of the collateral. See United States ex rel. Small Business Administration v. Chatlin’s Department Store, Inc., 506 F.Supp. 108 (E.D.Pa. 1980). In Chatlin’s Department Store, the court even said that when a creditor decides to liquidate the assets of a primary obligor “it must act as the obligor’s fiduciary and make a sincere effort to obtain the full market value for the property.” 506 F.Supp. at 111. (With the “fiduciary” language, the Chatlin’s Department Store court goes further than most courts would; but if “sincere effort” means “good faith,” it is reasonably consistent with widespread application of the standards.) Sales may be conducted in lot or in bulk, with the property first being offered in bulk before a piecemeal sale (United States v. Champion Sprayer Co., 500 F.Supp. 708 (E.D.Mich. 1980)), and may be sold at wholesale rather than retail (Piper Acceptance Corp. v. Yarbrough, 702 F.2d 733 (8th Cir. 1983)). The better-reasoned cases hold that the determination of whether a sale at wholesale or retail is commercially reasonable depends on what markets are available to the secured creditor at the time. Spillers v. First National Bank of Arenzville, 109 Ill.App.3d 1100, 441 N.E.2d 872, 65 Ill.Dec. 557 (4th Dist. 1982).

VI. [4.22] TITLE OBTAINED BY PURCHASER A purchaser for value takes all of the debtor’s rights in the collateral and discharges the security interest under which it is made and any junior security interest or lien. 810 ILCS 5/9617(a). A purchaser for value defeats such rights even if the secured party has not complied with the requirements of Article 9 of the Uniform Commercial Code. 810 ILCS 5/9-617(b).

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A purchaser at a private sale is required to act in good faith. A secured creditor cannot bid at a private sale unless the collateral is either of a type customarily sold in a recognized market or of a type that is the subject of widely distributed standard price quotations. 810 ILCS 5/9-610(c). A purchaser at a public sale is under no duty to inquire into the circumstances of the sale, as long as the purchaser is acting in good faith. UCC Comment 4, 810 ILCS 5/9-610. A secured party automatically gives “title” warranties unless disclaimed. 810 ILCS 5/9610(d), 5/9-610(e). Section 9-610(f) of the UCC gives sample disclaimer language. 810 ILCS 5/9-610(f). At least one court has recognized that a former UCC §9-504 sale will not extinguish the right of other creditors to challenge a sale under common-law fraud theories or as a violation of the Uniform Fraudulent Conveyance Act (now Uniform Fraudulent Transfer Act). Sheffield Progressive, Inc. v. Kingston Tool Co., 10 Mass.App.Ct. 47, 405 N.E.2d 985 (1980). However, in BFP v. Resolution Trust Corp., 511 U.S. 531, 128 L.Ed.2d 556, 114 S.Ct. 1757 (1994), the U.S. Supreme Court held that a regularly conducted real property foreclosure sale was conclusively deemed to result in “reasonably equivalent value” for purposes of §548 of the Bankruptcy Code, 11 U.S.C. §548, the federal bankruptcy equivalent of the Uniform Fraudulent Transfer Act. At least two lower courts have declined to extend BFP’s holding to certain personal property sales. Case v. TBAC-Prince Gardner, Inc. (In re Prince Gardner, Inc.), 220 B.R. 63 (Bankr. E.D.Mo. 1998) (consensual foreclosure sale; good discussion of situations in which BFP is and is not applicable); Carter v. H & B Jewelry & Loan (In re Carter), 209 B.R. 732 (Bankr. D.Or. 1997) (“sale” of pawned articles to pawnshop in satisfaction of debt).

VII. [4.23] APPLICATION OF SALE PROCEEDS Section 9-615 of the Uniform Commercial Code establishes the order in which the proceeds of a sale of collateral must be applied: a. expenses relating to repossession and preparation for sale, including attorneys’ fees; b. satisfaction of the senior secured debt; and c. satisfaction of the subordinate debt. 810 ILCS 5/9-615. The secured party does not have to apply noncash proceeds to the debtor’s obligation unless it would be commercially unreasonable not to do so. 810 ILCS 5/9-615(c). The secured creditor also must account to the debtor for any surplus, and, unless otherwise agreed, the debtor is liable for any deficiency. 810 ILCS 5/9-615(d). The calculation of a deficiency following a commercially reasonable sale of collateral to the secured party, a person related to the secured party, or a guarantor at a price “significantly” below the range of prices that a commercially reasonable foreclosure disposition to a third party would have brought is based on the amount that would have been obtained had a third person purchased the collateral. 810 ILCS 5/9-615(f).

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§4.24

SECURED TRANSACTIONS

If the underlying transaction was a sale of accounts, chattel paper, payment intangibles, or promissory notes, the debtor is entitled to a surplus or is liable for a deficiency only if the security agreement so provides. 810 ILCS 5/9-615(e). Both former Article 9 and revised Article 9 of the UCC contemplate that the secured party recover the reasonable expenses associated with disposing of the collateral. These expenses could include amounts advanced by an agent for retaking, holding, and selling the collateral (Fedders Corp. v. Taylor, 473 F.Supp. 961 (D.Minn. 1979)); fees paid to a private detective to locate the collateral (Judd v. Heitman, 402 F.Supp. 929 (M.D.Tenn. 1975)); or insurance premiums providing coverage on the collateral pending the sale (Svestka v. First National Bank in Stuttgart, 269 Ark. 237, 602 S.W.2d 604 (1980)). When it is necessary for a secured party to repair the collateral, the repair costs can also be deemed expenses of the sale because the debtor will benefit from the increased sale price produced by repairing the collateral. Contrail Leasing Partners, Ltd. v. Consolidated Airways, Inc., 742 F.2d 1095 (7th Cir. 1984). It should be noted, however, that attorneys’ fees may be recovered only if such fees are allowed by the parties’ contract or are authorized by statute. UCC §9-615(a)(1) authorizes attorneys’ fees only “to the extent provided for by agreement and not prohibited by law.” 810 ILCS 5/9-615(a)(1). Thus, if there is no contractual authorization for the fees and no court allowance for them, attempts to collect attorneys’ fees as part of the expenses of recovering a deficiency claim may run afoul of the Fair Debt Collection Practices Act (FDCPA), 15 U.S.C. §1692, et seq. For example, in Lockett v. Freedman, No. 03 C 2992, 2004 WL 856516 (N.D.Ill. Apr. 21, 2004), a plaintiff sued a law firm for attempting to collect $350 in attorneys’ fees for a deficiency action, alleging that the contract the complaint sought to enforce did not authorize attorneys’ fees for such an action. In ruling on a motion to dismiss, the court held that the defendants may have violated the FDCPA by attempting to collect the attorneys’ fees as part of the plaintiff’s debt because there was no contractual or court authorization for the fees. 2004 WL 856516 at *3, citing Shula v. Lawent, 359 F.3d 489, 491 (7th Cir. 2004), and Veach v. Sheeks, 316 F.3d 690, 692 – 693 (7th Cir. 2003). Further, although many security agreements provide for attorneys’ fees based on a percentage of the obligation secured, most courts will examine the reasonableness of an attorney’s fee request based on the work done rather than the percentage spelled out in the agreement. See, e.g., Leasing Service Corp. v. Carbonex, Inc., 512 F.Supp. 253 (S.D.N.Y. 1981).

VIII. [4.24] DEBTOR’S RIGHT OF REDEMPTION Section 9-623 of the Uniform Commercial Code gives the debtor a limited right to redeem the collateral. The right must be exercised before a. the collateral has been collected under UCC §9-607; or b. the collateral has been disposed of; or c. the secured party has entered into a contract for disposition of the collateral; or d. the obligation has been discharged under UCC §9-622. 810 ILCS 5/9-623(c).

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§4.25

To redeem, a debtor must satisfy all secured obligations, plus all of the secured creditor’s reasonable fees, costs, and expenses. 810 ILCS 5/9-623(b). Junior creditors also have a right to redeem to protect their interests in the collateral. 810 ILCS 5/9-623(a). A debtor cannot waive a right of redemption prior to default. United States v. Marshall, 431 F.Supp. 888 (N.D.Ill. 1977). A debtor or guarantor may waive the right to redeem collateral only by agreement to that effect entered into and authenticated after default. 810 ILCS 5/9-624(c). Because a debtor must tender payment, inter alia, for “reasonable attorneys’ fees and legal expenses” to the extent provided for in the security agreement and not prohibited by law, a debtor will be entitled to a judicial hearing on the reasonableness of the attorneys’ fees and legal costs assessed against it by the secured party. Interstate Electric Supply Co. v. Contractors & Engineers, Inc., 161 Ill.App.3d 676, 515 N.E.2d 182, 189, 113 Ill.Dec. 373 (1st Dist. 1987).

IX. [4.25] STRICT FORECLOSURE: ACCEPTING COLLATERAL IN DISCHARGE OF INDEBTEDNESS Under former UCC §9-505, a secured party could choose to retain collateral in satisfaction of the indebtedness but only if the secured party already had possession of the collateral. Section 9620 of the Uniform Commercial Code now provides that the secured party may accept collateral in satisfaction of the debt even if the secured party does not have possession of the collateral. 810 ILCS 5/9-620. However, the secured party does have a duty to account under 810 ILCS 5/9-210. If the collateral is consumer goods and 60 percent of the cash price or 60 percent of the loan has been paid, strict foreclosure can be used only when the debtor agrees in writing after default to renounce its rights under UCC §9-620. 810 ILCS 5/9-602(10), 5/9-620(e). A secured party may not obtain the agreement of the debtor to a partial strict foreclosure. 810 ILCS 5/9-620(g). When the creditor proposes to retain the collateral in satisfaction of the obligation, written notice of the proposal must be sent to the debtor or to any other person whose interest is known to the secured party. 810 ILCS 5/9-621. In addition, when the creditor proposes to retain the collateral in partial satisfaction of the obligation, written notice must also be sent to any guarantor. 810 ILCS 5/9-621(b). The debtor and the other person then have 20 days in which to object in an authenticated notice to the proposed retention. 810 ILCS 5/9-620. At least one court has held that a secured creditor may sell a portion of the collateral and then propose to accept the balance of the collateral in discharge of the remaining indebtedness. American City Bank of Tullahoma v. Western Auto Supply Co., 631 S.W.2d 410 (Tenn.App. 1981). Collateral may be retained only in satisfaction of secured indebtedness. UCC §9-620, therefore, most likely is inapplicable when collateral is held in satisfaction of unsecured as well as secured indebtedness. Blackhawk Production Credit Ass’n v. Meridian Implement Co., 82 Ill.App.3d 93, 402 N.E.2d 277, 37 Ill.Dec. 387 (2d Dist. 1980). Because the comments to former UCC §9-505 speak in terms of discharging the obligation and abandoning any claim for a deficiency absent the written consent of the debtor, the secured

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§4.26

SECURED TRANSACTIONS

creditor could not retain collateral in partial satisfaction of the secured debt under the former UCC §9-505. Former UCC Comment 1, 810 ILCS 5/9-505 (2000). In contrast, UCC §9-620 provides that the secured party may accept collateral in partial satisfaction with the authenticated consent of the debtor in nonconsumer transactions. At least one court has held that when a secured party held collateral for an unreasonably long period after foreclosure without disposing of the collateral, a rebuttable presumption arose that the value of the collateral was equal to the amount of the debt and that the debt was discharged. Alamosa National Bank v. San Luis Valley Grain Growers, Inc., 756 P.2d 1022 (Colo.App. 1988). Thus, the creditor in effect had accepted the collateral in full satisfaction of the debt without following all the requirements of former UCC §9-505. The result was the same, however, and the right to pursue the deficiency was lost. The court also held that the debtor could recover damages if it were found that the secured party failed to act in a commercially reasonable manner. Id. Section §9-620(c) of the UCC rejects implied acceptance of collateral. Instead, the length of delay by a secured party goes to the question of the commercial reasonableness of the disposition. See UCC Comment 5, 810 ILCS 5/9-620. Note that this rule could have the indirect effect of resulting in “acceptance” in full in a state that chooses to apply the absolute-bar rule in consumer transactions and finds that a delay was commercially unreasonable.

X. SANCTIONS AGAINST A SECURED PARTY FOR FAILURE TO COMPLY WITH PART 6 OF ARTICLE 9 A. [4.26] Damages A secured party’s failure to live up to its obligations under Article 9 of the Uniform Commercial Code may result in either criminal or civil liability in addition to the penalties of Article 9. Its actions could violate state or federal statutes governing collection practices, trespass, or assault or could constitute intentional infliction of emotional distress. 4 James J. White and Robert S. Summers, UNIFORM COMMERCIAL CODE §34-14 (5th ed. 2002). Separate recoveries are allowed for violations of Article 9 and other statutes in the same transaction. Merchandise National Bank of Chicago v. Scanlon, 86 Ill.App.3d 719, 408 N.E.2d 248, 41 Ill.Dec. 826 (1st Dist. 1980). If a secured party is not proceeding in accordance with the provisions of Article 9, a court can restrain the proposed sale or impose conditions on that sale. 810 ILCS 5/9-625(a). Debtors and others entitled to notice may collect damages when the collateral has been disposed. 810 ILCS 5/9-625. Often, the damages are measured as the difference between the price actually obtained and the price that would have been obtained if the secured party had proceeded in a commercially reasonable manner. Ferrous Financial Services Co. v. Wagnon, 70 Or.App. 285, 689 P.2d 974 (1984). Under certain circumstances, damages may include lost profits. Hemken v. First National Bank of Litchfield, 76 Ill.App.3d 23, 394 N.E.2d 868, 31 Ill.Dec. 666 (4th Dist. 1979).

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§4.28

In Jackson v. Star Sprinkler Corporation of Florida, 575 F.2d 1223 (8th Cir. 1978), the court held that the secured creditor in possession of the collateral breached its “fiduciary” relationship with the creditors of the debtor by participating in a fraudulent conveyance. Similarly, wrongful or bad-faith actions on the part of the senior creditor may expose it to a fraudulent conveyance claim by junior creditors (Sheffield Progressive, Inc. v. Kingston Tool Co., 10 Mass.App.Ct. 47, 405 N.E.2d 985 (1980)) or to subordination of a senior creditor’s security interest (Limor Diamonds, Inc. v. D’Oro by Christopher Michael, Inc., 558 F.Supp. 709 (S.D.N.Y. 1983)). If a secured creditor is guilty of converting collateral, the measure of damages may be the amount equal to the value of the collateral at the time of the conversion less the amount of the debt owed. Mitchell v. Ford Motor Credit Co., 688 P.2d 42 (Okla. 1984). That case also allowed the award of punitive damages when the secured creditor acted with reckless disregard for the rights of the debtor. See also Davidson v. First National Bank & Trust Co., 609 P.2d 1259 (Okla. 1976), overruled on other grounds by Beneficial Finance Co. v. Young, 612 P.2d 1357 (Okla. 1980). B. [4.27] Recovery of Deficiency Against Principal Obligor or Guarantor Under UCC §9-626(4), if the secured creditor does not act in a commercially reasonable manner, in commercial transactions there is in effect a rebuttable presumption that the value of the collateral equals the secured indebtedness. In effect, then, the burden is on the creditor to show that a commercially reasonable disposition would still not have produced enough to satisfy the secured indebtedness. Prior to revised Article 9, a number of states disallowed the recovery of any deficiency when a secured creditor did not act in a commercially reasonable fashion. Article 9 of the Uniform Commercial Code does not address whether the court should apply the rebuttable presumption rule or the absolute-bar rule in consumer transactions. See UCC Comment 4, 810 ILCS 5/9-626.

XI. REPLEVIN A. [4.28] Overview Replevin is a statutory action to recover possession of property that has been wrongfully distrained, taken, or detained. See General Motors Acceptance Corp. v. Vaughn, 358 Ill. 541, 193 N.E. 483 (1934). A plaintiff must have a right of possession at the time the action is initiated. Gunn v. Sobucki, 216 Ill.2d 602, 837 N.E.2d 865, 297 Ill.Dec. 414 (2005). “An allegation that a defendant has constructive possession — i.e., ‘such a control over the property that he may deliver the possession of it to the plaintiff’ — is sufficient to meet the possession element of a replevin claim.” Evergreen Marine Corp. v. Division Sales, Inc., No. 01 C 4933, 2003 WL 1127905 at *5 (N.D.Ill. Mar. 12, 2003), quoting 66 AM.JUR.2d Replevin §19 (2001). The replevin statutes are set forth in Article XIX of the Code of Civil Procedure, 735 ILCS 5/19-101, et seq. As a statutory action, the provisions of the replevin statutes must be strictly followed. Novak Food Service Equipment, Inc. v. Moe’s Corned Beef Cellar, Inc., 121 Ill.App.3d 902, 460 N.E.2d 443, 77 Ill.Dec. 387 (1st Dist. 1984).

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B. [4.29] Procedure A replevin action is initiated as any civil action, and venue is appropriate in any county where the goods or chattels are located. 735 ILCS 5/19-103. Although service may be made as in other civil cases (735 ILCS 5/19-116), if the defendant has left the state, cannot be found, or is concealed within the state, notice can be given by publication (735 ILCS 5/19-118). The replevin statutes allow an order for replevin to be entered without notice to the defendant if the plaintiff will suffer impending harm from destruction, concealment, removal, or fraudulent transfer of the property. 735 ILCS 5/19-106. The procedure requires a verified complaint and a bond in double the value of the property to be seized. 735 ILCS 5/19-112. After a hearing on the issuance of a warrant of replevin, the plaintiff will be required to deliver the replevin complaint, bond, and certified copy of the court order to the sheriff. The sheriff then is directed to seize the property and return it to the plaintiff unless the defendant executes a bond in an amount double the value of the property. 735 ILCS 5/19-116. If the sheriff is unable to return some or all of the property, after trial the plaintiff may recover a judgment for possession or money damages for the value of the property not returned and damages for its wrongful detention. 735 ILCS 5/19-120. The doctrine of mitigation of damages applies and may affect the award of damages when the plaintiff fails to sue quickly. Culligan Rock River Water Conditioning Co. v. Gearhart, 111 Ill.App.3d 254, 443 N.E.2d 1065, 66 Ill.Dec. 902 (2d Dist. 1982). If the plaintiff wrongfully replevins property, the defendant may recover damages measured as the reasonable net rental value of the property. International Harvester Credit Corp. v. Helland, 151 Ill.App.3d 848, 503 N.E.2d 548, 104 Ill.Dec. 833 (2d Dist. 1986).

XII. ATTACHMENT A. [4.30] Overview The attachment statutes are set forth in Article IV of the Code of Civil Procedure, 735 ILCS 5/4-101, et seq. The attachment statutes authorize a creditor to attach the assets of an alleged debtor pending the outcome of the creditor’s lawsuit. Gale v. Transamerica Corp., 65 Ill.App.3d 553, 382 N.E.2d 412, 22 Ill.Dec. 92 (1st Dist. 1978). This can be a particularly helpful remedy when the debtor is concealing or threatening to transfer assets. B. [4.31] Grounds for Attachment The attachment statute details 11 grounds or causes for attachment. 735 ILCS 5/4-101. These relate primarily to instances in which the debtor is not a resident of the state, is avoiding service, or is concealing or about to remove property from the state.

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§4.32

C. [4.32] Procedure Section 4-104 of the Code of Civil Procedure details the procedures for initiation of an action. A verified affidavit meeting the statutory requirements (735 ILCS 5/4-104) and a bond in double the sum sworn to be due are required (735 ILCS 5/4-107). The provision for a bond is jurisdictional, and any attachment order issued without a bond and affidavit taken is void and shall be dismissed. Id. Section 4-107 of the Code of Civil Procedure further provides that a bond shall not be required of the State of Illinois, any department of the government thereof, or any state officer. A receiver, though an officer of the court, is not a “state officer” as contemplated by §4-107. Witters v. Hicks, 335 Ill.App.3d 435, 780 N.E.2d 713, 722, 269 Ill.Dec. 241 (5th Dist. 2002). Once an attachment order is entered and bond obtained, the sheriff is directed to attach the property in question. Persons holding the property subject to an order of attachment are treated as garnishees. 735 ILCS 5/4-126. The procedures governing sale of attached property are the same as other property levied upon for the enforcement of a judgment for the payment of money. Perishable property must be sold not more than 24 hours after the levy was made, with due notice to the defendant and to the public. 735 ILCS 5/4-125. Proceeds of disposition of attached property are given to the plaintiff or shared pro rata among all plaintiffs who have sued on attachments returnable the same day or within 30 days from the date of the first attachment. 735 ILCS 5/4-142. If one creditor has been responsible for preventing a fraudulent transfer, that creditor may be given a priority over other creditors. Id.

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5

Special Types of Collateral

STEPHEN A. TAGGE GREGORY E. MOREDOCK Sorling Northrup Springfield

®

©COPYRIGHT 2016 BY IICLE .

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I. [5.1] Introduction — Scope of Chapter II. [5.2] Modes of Transportation A. Aircraft 1. [5.3] Federal Aviation Act 2. [5.4] Recording of Security Documents a. [5.5] Form of Security Agreement b. [5.6] Future Assignments and Amendments c. [5.7] Releases 3. [5.8] Interplay with Uniform Commercial Code Article 9 B. [5.9] Motor Vehicles 1. Perfection of Security Interests in Motor Vehicles Under Illinois Law a. [5.10] Coverage of Illinois Vehicle Code b. [5.11] The Mechanics of Perfection c. [5.12] Subordinate Liens d. [5.13] Foreign Liens e. [5.14] Assignment f. [5.15] Release 2. [5.16] Commercial Vehicles Engaged in Interstate Commerce C. [5.17] Watercraft 1. Perfection of Security Interests in Watercraft Under Illinois Law a. [5.18] Coverage of Boat Registration and Safety Act b. [5.19] The Mechanics of Perfection c. [5.20] Subordinate Liens d. [5.21] Foreign Liens e. [5.22] Assignment f. [5.23] Release 2. Federally Documented Vessels a. [5.24] Vessels That Must Be Federally Documented b. [5.25] Filing with the U.S. Department of Transportation c. [5.26] Preferred Mortgages d. [5.27] Maritime Liens e. [5.28] Default f. [5.29] Discharge g. [5.30] Interplay with Uniform Commercial Code Article 9

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III. [5.31] Intellectual Property A. [5.32] Copyrights 1. [5.33] Recordation of Conveyances Involving Copyrights 2. [5.34] Effect of Recordation B. [5.35] Patents 1. [5.36] Recordation of an Assignment of Patent 2. [5.37] Effect of Recordation C. [5.38] Trademarks 1. [5.39] Recording Under the Federal Trademark Act 2. [5.40] Recording Under Illinois’ Trademark Registration and Protection Act IV. [5.41] Rights in Funds Held by Another A. [5.42] Insurance Policies B. [5.43] Wage Assignments C. [5.44] Judgments V. [5.45] Broadcasting Licenses

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I. [5.1] INTRODUCTION — SCOPE OF CHAPTER Illinois’ version of the Uniform Commercial Code (UCC), 810 ILCS 5/1-101, et seq., was extensively revised by P.A. 91-893 (eff. July 1, 2001) and subsequently by P.A. 95-895 (eff. Jan. 1, 2009). These Public Acts also made revisions to other sections. On August 17, 2012, the State of Illinois enacted uniform amendments to Article 9 and §2A-103 of the UCC, which were proposed and adopted by the National Conference of Commissioners on Uniform State Laws in 2010. The 2012 Amendments became effective on July 1, 2013. See P.A. 97-1034. The UCC Comment for §9-101 of the UCC asserts that Article 9 was designed to be a “comprehensive scheme for the regulation of security interests in personal property and fixtures.” UCC Comment, 810 ILCS 5/9-101. Chapters 1 – 3 of this handbook explain the procedures governing the creation, perfection, and priority of security interests that are governed by the comprehensive scheme the drafters of Article 9 envisioned. The drafters of Article 9, however, recognized that not all transactions fit neatly within the framework of Article 9. For transactions involving certain types of collateral, the attorney attempting to create or perfect a security interest must look beyond Article 9 and examine various provisions of federal and state statutes and caselaw. The purpose of this chapter is to alert the practitioner to those types of collateral that will require the practitioner to look beyond Article 9 in order to advise a client fully as to the steps necessary to create or perfect a security interest. As the scope of this chapter is broad, space limitations will not permit a comprehensive discussion of each of the topics discussed. The practitioner should, accordingly, thoroughly review the statutes, cases, and sources cited herein before attempting to render advice to clients.

II. [5.2] MODES OF TRANSPORTATION Transactions in which a party desires to take a security interest in a mode of transportation, whether it be a car or small boat or something more exotic such as civil aircraft or an ocean liner, will require the practitioner to be familiar with certain provisions of Illinois and federal statutes in addition to Article 9 of the Uniform Commercial Code. The scope of the statutes that govern each particular mode of transportation is unique and, accordingly, discussed separately in §§5.3 – 5.30 below. A. Aircraft 1. [5.3] Federal Aviation Act Security interests in civil aircraft, certain aircraft engines, propellers, and spare parts are created pursuant to the provisions of Article 9 of the Uniform Commercial Code. Perfection of a security interest so created, however, can be achieved only by complying with the provisions of the Federal Aviation Act of 1958, Pub.L. No. 85-726, 72 Stat. 731 (codified generally at 49 U.S.C. §40101, et seq.). Section 503 of the Federal Aviation Act provides that the Administrator of the Federal Aviation Administration (FAA) is to establish a system for recording. 49 U.S.C. §44107.

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§5.4

The federal regulations promulgated to implement §503 make it clear that the Act only establishes a recordation system. When accepting a document for recordation, the U.S. Department of Transportation, acting through the FAA, explicitly disclaims any implication that the FAA has determined that the document actually affects title to or an interest in the aircraft or aircraft part that the filing purports to cover. 14 C.F.R. §49.17(c). Creation of security interests in civil aircraft and aircraft parts remains under the jurisdiction of state law and Article 9. The Federal Aviation Act directs the Secretary of Transportation to record the following instruments of conveyance: (1) conveyances that affect an interest in civil aircraft of the United States; (2) leases and instruments executed for security purposes, including conditional sales contracts, assignments, and amendments, that affect an interest in — (A) a specifically identified aircraft engine having at least 550 rated takeoff horsepower or its equivalent; (B) a specifically identified aircraft propeller capable of absorbing at least 750 rated takeoff shaft horsepower; (C) an aircraft engine, propeller, or appliance maintained for installation or use in an aircraft, aircraft engine, or propeller, by or for an air carrier holding a certificate issued under section 44705 of this title; and (D) spare parts maintained by or for an air carrier holding a certificate issued under section 44705 of this title; and (3) releases, cancellations, discharges, and satisfactions related to a conveyance, lease, or instrument recorded under paragraph (1) or (2). 49 U.S.C. §44107(a). Once recorded, each conveyance or other instrument described above will be deemed perfected against all persons. 49 U.S.C. §44108(b). However, filings with respect to spare parts maintained by an air carrier shall remain valid only for as long as the parts remain at the location designated in the recorded instrument. Id. With this statutory background in mind, in §§5.4 – 5.7 below, we turn to the mechanics of recording under the Federal Aviation Act. 2. [5.4] Recording of Security Documents Recordation of all documents required to be filed pursuant to the terms of the Federal Aviation Act occurs at the Federal Aviation Administration. The FAA assesses a modest recording fee for filing. See 14 C.F.R. §49.15. A conveyance is deemed filed as of the date and time it is received by the FAA Aircraft Registry. 14 C.F.R. §49.19. The FAA publishes a list of directions that provide useful information to the practitioner who seeks to record with the FAA. See Form AFS-750-94, Information To Aid in the Registration of

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U.S. Civil Aircraft, www.faa.gov/licenses_certificates/aircraft_certification/aircraft_registry/ media/afs-750-94.pdf. The rules governing the recording of security documents are codified at 14 C.F.R. pt. 49. Further information on this topic also is available at the FAA’s website at www.faa.gov/licenses_certificates/aircraft_certification/aircraft_registry. a. [5.5] Form of Security Agreement The security agreement recorded with the Federal Aviation Administration must describe the aircraft, engine, or propeller that it purports to cover by make and model, manufacturer’s serial number, and other details that make specific identification possible. 14 C.F.R. §§49.33(b), 49.43(a). Filings made to cover spare parts, however, only need describe generally the collateral to be covered. 14 C.F.R. §49.53(b). The security agreement must be signed by the debtor. 14 C.F.R. §49.17(d)(1). Cosigners and guarantors whose signatures appear on the security agreement must be specifically identified as having signed in their capacity of cosigner or guarantor. 14 C.F.R. §49.17(d)(2). Only the original security agreement is filed with the FAA. Should the filing party desire to have the original security agreement returned, the filing party must at the time of filing submit a copy of the original along with a certificate, signed by the filing party, that states that the copy has been compared to the original and that it is a true copy. 14 C.F.R. §49.21. Further suggestions for filing specific types of security agreements are contained in Form AFS-750-94, Information To Aid in the Registration of U.S. Civil Aircraft. See §5.4 above. b. [5.6] Future Assignments and Amendments Once recorded, a security agreement may be thereafter assigned or amended. The assignment or amendment must be signed by the assignor (or debtor in the case of an amendment) and must describe the conveyance already of record by stating the original conveyance’s date, the names of the parties, the date of Federal Aviation Administration recording, and the FAA-recorded conveyance number. 14 C.F.R. §49.17(d)(3). c. [5.7] Releases At the time of the recording of the security agreement, the Federal Aviation Administration will provide the filing party with the appropriate form necessary to record the release of the interest conveyed. The federal form created for releases is Form AC 8050-41, Part II — Release. 14 C.F.R. §49.17(d)(5). In general, if it releases all the collateral covered by the security agreement, then, in the case of spare parts, the release need not include a detailed description of the collateral or the location of the collateral. As with an assignment or amendment described in §5.6 above, however, the original conveyance must be identified by its date, the names of parties, the date of FAA recording, and the FAA-recorded conveyance number. Id.

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§5.10

3. [5.8] Interplay with Uniform Commercial Code Article 9 The leading Illinois case interpreting the interplay between the Federal Aviation Act and Article 9 of the Uniform Commercial Code is Bitzer-Croft Motors, Inc. v. Pioneer Bank & Trust Co., 82 Ill.App.3d 1, 401 N.E.2d 1340, 37 Ill.Dec. 247 (5th Dist. 1980). See In re Gary Aircraft Corp., 681 F.2d 365 (5th Cir. 1982). In Bitzer-Croft, a consumer purchased an aircraft from an aircraft dealer. The aircraft in question was covered by a chattel mortgage held by the dealer’s bank and properly recorded with the Federal Aviation Administration. The consumer also properly recorded its ownership interests in the aircraft with the FAA, but after the date and time of the recordation by the dealer’s bank. The dealer subsequently defaulted on its loan from its bank, Pioneer Bank & Trust. Pioneer claimed that since it recorded its interest in the aircraft prior to the purchaser’s recordation, Pioneer had a right to repossess the aircraft based on the provisions of the Federal Aviation Act. The purchaser, on the other hand, claimed that Article 9 governs questions of priority in properly perfected security interests, and that under Article 9 the purchaser was a buyer in the ordinary course of business entitled to retain possession of the aircraft. The Fifth District held that while the Federal Aviation Act preempted Article 9’s provisions regarding the perfection of security interests, the remaining provisions of Article 9, including those governing priority in collateral, must be applied by Illinois courts. The court found that Pioneer’s chattel mortgage specifically authorized sale of the aircraft in question to consumers, with the security interest of the bank to attach to the proceeds of this sale. Thus, the bank’s security interest in the aircraft vanished once the aircraft was sold to the consumer. A good discussion of cases from other jurisdictions involving the interplay between the Federal Aviation Act and Article 9 can be found in Barkley Clark, THE LAW OF SECURED TRANSACTIONS UNDER THE UNIFORM COMMERCIAL CODE §1.08(1)(b) (3d ed. 2011). Although a few cases from these other jurisdictions can be found that attempt to determine priorities without referring to Article 9, the majority of jurisdictions are in line with Bitzer-Croft, supra, and hold that questions of priority are governed by Article 9 and not the Federal Aviation Act. B. [5.9] Motor Vehicles Under the Illinois Vehicle Code, 625 ILCS 5/1-100, et seq., the Secretary of State retains jurisdiction over the perfection of security interests in most types of motor vehicles operated on Illinois highways. See 625 ILCS 5/3-201, et seq. The practitioner should also be familiar with the provisions of the federal motor vehicle lien statutes at 49 U.S.C. §14301, et seq., when the vehicle with which he or she is concerned is a large truck engaged in interstate commerce. 1. Perfection of Security Interests in Motor Vehicles Under Illinois Law a. [5.10] Coverage of Illinois Vehicle Code The Illinois Vehicle Code governs the perfection of a security interest in most types of motor vehicles. 625 ILCS 5/3-207; Arena Auto Auction, Inc. v. Mecum’s Countryside Motor Co., 251

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§5.11

SECURED TRANSACTIONS

Ill.App.3d 96, 621 N.E.2d 254, 190 Ill.Dec. 385 (2d Dist. 1993); Huber Pontiac, Inc. v. Wells, 59 Ill.App.3d 14, 375 N.E.2d 149, 16 Ill.Dec. 518 (4th Dist. 1978). A security interest in a vehicle is perfected “by the delivery to the Secretary of State of the existing certificate of title, if any, an application for a certificate of title containing the name and address of the lienholder and the required fee.” 625 ILCS 5/3-202(b). The Vehicle Code does not control the creation of a security interest in the vehicle or the legal ramifications flowing therefrom. McHenry State Bank v. Y & A Trucking, Inc., 117 Ill.App.3d 629, 454 N.E.2d 345, 73 Ill.Dec. 485 (2d Dist. 1983); South Division Credit Union v. Deluxe Motors, Inc., 42 Ill.App.3d 219, 355 N.E.2d 715 (1st Dist. 1976). Therefore, when the question is one of priority of claims, rather than whether the claims are perfected, it is governed by the Uniform Commercial Code, not the Vehicle Code. ITT Commercial Finance Corp. v. Unlimited Automotive, Inc., 166 B.R. 637, 642 (N.D.Ill. 1994). The situation in ITT Commercial Finance, supra, involved the interests of two creditors in a motor home purchased from Unlimited Automotive. The plaintiff creditor held a security interest in Unlimited Automotive’s inventory, and the defendant creditor was assigned a retail installment contract on the vehicle. The vehicle was returned to the dealership, and both parties claimed an interest. Although the primary issue centered on Unlimited Automotive’s dissolution, the case is also illustrative of the interplay with the Vehicle Code. The court held the interest of the retail installment contract was subordinate to that of the secured creditor and noted the fact that a consignor owns and holds legal title to a vehicle will not prevent qualifying secured creditors of its consignee from subjecting a vehicle to their claims if the consignor has not complied with the UCC requirement concerning notice of the consignment. The Vehicle Code states that no certificate of title need be obtained for a vehicle owned by the State of Illinois, a vehicle owned by the United States unless registered in Illinois, a vehicle owned by a manufacturer or dealer and held for sale, a vehicle used by a manufacturer solely for testing, a vehicle owned by a nonresident of the state, a vehicle regularly engaged in interstate transportation of persons or property for which a currently effective certificate of title has been issued in another state, a vehicle moved solely by animal power, an implement of husbandry, special mobile equipment, an apportionable trailer or semitrailer registered in Illinois prior to April 1, 1998, or a manufactured home for which an affidavit of affixation has been recorded pursuant to the Conveyance and Encumbrance of Manufactured Homes as Real Property and Severance Act, 765 ILCS 170/5-1, et seq., unless a recorded affidavit of severance has also been recorded pursuant to the aforementioned Act. 625 ILCS 5/3-102. The Vehicle Code does not apply to floor-plan financing arrangements. Crane v. Tambourine (In re Glenview Imports, Ltd.), 27 B.R. 496 (Bankr. N.D.Ill. 1983). The Vehicle Code specifically exempts from its coverage a security interest in a vehicle created by a manufacturer or dealer who holds a vehicle for sale. 625 ILCS 5/3-201(c). Instead, Article 9 provides that a financing statement filing is necessary when goods otherwise subject to certificate of title registration are held as inventory by a person in the business of selling goods of that kind. 810 ILCS 5/9-311(d). The Crane court found that a floor-plan financing arrangement met this definition. b. [5.11] The Mechanics of Perfection In order to perfect a security interest in a vehicle covered by the Illinois Vehicle Code, the attorney must deliver the following to the Secretary of State:

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§5.12

1. the vehicle’s existing certificate of title, if any; 2. an application for a certificate of title containing the name and address of the proposed lienholder; and 3. the required application fee. 625 ILCS 5/3-202(b). To help fill out the Secretary of State’s title application form (VSD 190, Application for Vehicle Transaction(s)), the Secretary of State has provided an application checklist (Form VSD 293, Vehicle Title and Registration: Tips for Properly Completing Your Application), available at www.cyberdriveillinois.com/publications/pdf_publications/vsd293.pdf. Form VSD 190 may be completed online and printed at www.cyberdriveillinois.com/departments/vehicles/title_ and_registration/pert.html. Form VSD 190, along with the required documentation and payment, must be presented to the local Secretary of State facility within seven days of the transaction. Upon receipt of the items listed above, the Secretary of State shall issue a new certificate of title containing the name and address of the lienholder. The newly issued certificate shall be mailed by the Secretary of State to the lienholder. 625 ILCS 5/3-203(d). A lienholder should strive to have the lien placed on the vehicle’s title immediately. The lienholder’s security interest will be deemed perfected as of the time of its creation if delivery by the lienholder of the certificate of title to the Secretary of State occurs within 30 days of the creation of the lien or within 30 days after receipt by a new lienholder of the existing certificate of title from the prior lienholder or licensed dealer. Deliveries occurring after 30 days, however, shall be deemed perfected as of the time of delivery. 625 ILCS 5/3-202(b). In Independence Land Title Corporation of Illinois v. National Bank & Trust Company of Sycamore (In re Independence Land Title Corporation of Illinois), 9 B.R. 394 (Bankr. N.D.Ill. 1981), a bank loaned money to a corporation and intended to take a security interest in a vehicle as collateral. The bank, however, was unable to deliver the vehicle’s certificate of title immediately to the Secretary of State. The debtor corporation filed for bankruptcy prior to the date that the bank delivered the certificate to the Secretary of State. As a result, the court found that the bank did not have a perfected security interest in the vehicle and awarded the vehicle to the bankrupt’s trustee. The importance of strictly complying with the protection provisions of the Vehicle Code cannot be overstressed. For an example of a creditor that failed to ensure that the Vehicle Code’s provisions were followed to the letter and thereafter had a court rule its security interest unperfected, the practitioner should review Boatmen’s Bank of Benton v. Wiggs (In re Wiggs), 87 B.R. 57 (Bankr. S.D.Ill. 1988). Cf. Williams v. Sears Consumer Financial Corp. (In re Tomer), 108 B.R. 204 (Bankr. S.D.Ill. 1989) (applying similar provision of Missouri law). c. [5.12] Subordinate Liens One wishing to perfect a subordinate lien on a vehicle covered by the Illinois Vehicle Code must first obtain temporary possession of the vehicle’s certificate of title. The Vehicle Code provides that the first lienholder must, upon request, deliver the existing certificate of title to the proposed subordinate lienholder or to the Secretary of State so that the proposed subordinate lienholder can comply with the steps outlined in §5.11 above. 625 ILCS 5/3-203(c). The Vehicle

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Code’s provisions guarantee that the delivery of the certificate of title by the first lienholder to the proposed subordinate lienholder will not affect the priority of the first lienholder’s rights. Id. The Secretary of State will deliver the newly issued certificate of title containing the name of the new lienholder to the first lienholder. 625 ILCS 5/3-203(d). d. [5.13] Foreign Liens The Illinois Vehicle Code addresses certain problems a potential lienholder faces when a vehicle was formerly possessed outside Illinois. In general, when a vehicle already subject to a security interest is brought into Illinois, the law of the jurisdiction where the vehicle was when the security interest attached will be used to determine whether the security interest remains attached in Illinois. 625 ILCS 5/3-202(c). Similarly, if a vehicle brought into Illinois is subject to a perfected security interest when brought into Illinois, the lienholder’s lien will remain perfected provided the lienholder’s lien is shown on the vehicle’s existing certificate of title. 625 ILCS 5/3202(c)2(A). In certain instances, however, Illinois law will control over the law of the foreign jurisdiction. If at the time the security interest attached to the vehicle the parties to the security agreement understood that the vehicle would be kept in Illinois and the vehicle was, in fact, brought into Illinois within 30 days thereafter for purposes other than transportation through Illinois, the validity of the security interest will be determined under Illinois law. 625 ILCS 5/3-202(c)1. In addition, if the perfected security interest created outside Illinois is not shown on the vehicle’s existing certificate of title when brought into Illinois, then the lienholder must re-perfect the interest in Illinois with priority dating only from the date of perfection in Illinois. 625 ILCS 5/3202(c)2(B). An attorney, therefore, must be particularly careful when he or she has knowledge that a vehicle purchased in one state may, in fact, be brought into and kept in another state. e. [5.14] Assignment The perfected lienholder may freely assign his or her interest without affecting the validity of the security interest. Although not required by the Illinois Vehicle Code, the assignee may obtain possession of the certificate of title and have his or her interest reflected thereon. Such a step is advisable since the Vehicle Code states that any person without notice of the assignment will be protected when dealing with the lienholder. The lienholder shall remain liable for any obligations as lienholder until the assignee is named as lienholder on the certificate. 625 ILCS 5/3-204. f.

[5.15] Release

Upon satisfaction of the security interest in the vehicle, the lienholder must execute a release of the security interest within 21 days and deliver the release to the vehicle’s owner. The release must be executed sooner if the owner pays by cash, cashier’s check, or certified check, in which event the release must be executed within 10 days of the payment. 625 ILCS 5/3-205.

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§5.18

2. [5.16] Commercial Vehicles Engaged in Interstate Commerce 49 U.S.C. §14301 addresses the perfection of a security interest in a motor vehicle owned or possessed by a carrier engaged in interstate commerce. A “motor vehicle” subject to the federal motor vehicle lien statute is defined as a truck of rated capacity (gross vehicle weight) of at least 10,000 pounds, a highway tractor of rated capacity (gross combination weight) of at least 10,000 pounds, a property-carrying trailer or semitrailer with at least one load-carrying axle of at least 10,000 pounds, or a motor bus with a seating capacity of at least 10 individuals. 49 U.S.C. §14301(a)(1). A security interest in such a motor vehicle will be considered to be perfected in all jurisdictions against all subsequent liens when the original security interest was properly perfected under the laws of the jurisdiction in which it was created. 49 U.S.C. §14301(b). Thus, a security interest created in Illinois when placed on the vehicle’s certificate of title will be deemed perfected and will be held prior to all subsequently created liens regardless of the law of the state in which the subsequently created lien arose. C. [5.17] Watercraft When an attorney receives a request from a client to take and to perfect a security interest in a watercraft, the attorney must first determine the nature and size of the watercraft at issue. Under the Boat Registration and Safety Act (BRSA), 625 ILCS 45/1-1, et seq., the Department of Natural Resources (DNR) has jurisdiction over the perfection of security interests in most types of watercraft operated on the waters within Illinois. 625 ILCS 45/3B-2. Federal law, however, preempts Illinois law for vessels weighing at least five net tons. 46 U.S.C. §12103. The taking of a security interest in vessels in this latter category is governed by 46 U.S.C. §31301, et seq. 1. Perfection of Security Interests in Watercraft Under Illinois Law a. [5.18] Coverage of Boat Registration and Safety Act The Boat Registration and Safety Act governs the perfection of a security interest in most types of watercraft in Illinois. Its provisions on security interests were modeled after similar provisions contained within the Illinois Vehicle Code. “Watercraft” is broadly defined by the BRSA as every description of watercraft used or capable of being used as a means of transportation on water, except a seaplane on the water, air mattress or similar device, and boats used for concession rides in artificial bodies of water designed and used exclusively for such concessions. 625 ILCS 45/1-2. The perfection of a security interest in certain types of watercraft, however, is not governed by the BRSA. One court has held that security interests in watercraft perfected pursuant to the provisions of the Uniform Commercial Code prior to the enactment of the BRSA were not

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§5.19

SECURED TRANSACTIONS

defeated by it. In re Moslander, 23 B.R. 407 (Bankr. C.D.Ill. 1982). In addition, the BRSA’s provisions on the perfection of security interests apply only to those types of watercraft for which a certificate of title is required. 625 ILCS 45/3B-2(a). A certificate of title in turn is required for all watercraft required to be numbered by the State of Illinois. 625 ILCS 45/3A-1. While the numbering provisions of the BRSA are quite broad, the practitioner is advised to consult the specific exemptions from the numbering provisions contained in 625 ILCS 45/3-12 to see whether the watercraft for which he or she seeks to perfect a security interest is exempt from the BRSA’s coverage. b. [5.19] The Mechanics of Perfection In order to perfect a security interest in a watercraft covered by the Boat Registration and Safety Act, the attorney must deliver the following to the Department of Natural Resources: 1. the watercraft’s existing certificate of title, if any; 2. an application for a certificate of title containing the name and address of the proposed lienholder and the date of the security agreement; and 3. the required application fee. 625 ILCS 45/3B-2(b). The DNR’s application form and form instructions are available at www.dnr.illinois.gov/ boating/pages/default.aspx. Upon receipt of the items listed above, the DNR shall either endorse the existing certificate or issue a new certificate containing the name and address of the lienholder. The endorsed or newly issued certificate shall be mailed by the DNR to the lienholder. 625 ILCS 45/3B-3(d). The lienholder’s security interest will be deemed perfected as of the time of its creation if delivery by the lienholder to the DNR occurs within 21 days of the creation of the lien. Deliveries occurring more than 21 days after creation shall be deemed perfected as of the time of the delivery. 625 ILCS 45/3B-2(b). c. [5.20] Subordinate Liens One wishing to perfect a subordinate lien on a watercraft covered by the Boat Registration and Safety Act must first obtain temporary possession of the vessel’s certificate of title. The BRSA provides that the first lienholder must, upon request, deliver the existing certificate of title to the proposed subordinate lienholder so that the proposed subordinate lienholder can comply with the steps outlined in §5.19 above. 625 ILCS 45/3B-3(c). The BRSA’s provisions guarantee that the delivery of the certificate of title by the first lienholder to the proposed subordinate lienholder will not affect the priority of the first lienholder’s rights. Id. The Department of Natural Resources will deliver the newly issued certificate of title containing the name of the new lienholder to the first lienholder. 625 ILCS 45/3B-3(d). d. [5.21] Foreign Liens The Boat Registration and Safety Act addresses the problems for a potential lienholder when the watercraft at issue was formerly possessed outside Illinois. In general, when a watercraft

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§5.23

already subject to a security interest is brought into Illinois, the law of the jurisdiction where the watercraft was when the security interest attached will be used to determine whether the security interest remains attached in Illinois. 625 ILCS 45/3B-2(c). Similarly, if a watercraft brought into Illinois is subject to a perfected security interest when brought into Illinois, the lienholder’s lien will remain perfected provided the lienholder’s lien is shown on the vessel’s existing certificate of title. 625 ILCS 45/3B-2(c)2(A). In certain instances, however, Illinois law will control over the law of the foreign jurisdiction. If at the time the security interest attached to the watercraft the parties to the security agreement understood that the watercraft would be kept in Illinois and the vessel was, in fact, brought into Illinois within 30 days thereafter for purposes other than transportation through Illinois, then the validity of the security interest will be determined under Illinois law. 625 ILCS 45/3B-2(c)1. In addition, if the perfected security interest created outside Illinois is not shown on the watercraft’s existing certificate of title when brought into Illinois, then the lienholder must re-perfect the interest in Illinois with priority dating only from the date of perfection in Illinois. 625 ILCS 5/3B2(c)2(B). An attorney, therefore, must be particularly careful when he or she has knowledge that a boat purchased in one state may, in fact, be brought into and kept in another state. e. [5.22] Assignment The perfected lienholder may freely assign the interest without affecting the validity of the security interest. Although not required by the Boat Registration and Safety Act, the assignee may obtain possession of the certificate of title and have the interest reflected thereon. Such a step is advisable since the BRSA goes on to state that any person without notice of the assignment will be protected when dealing with the lienholder. The lienholder shall remain liable for any obligations as lienholder until the assignee is named as lienholder on the certificate. 625 ILCS 45/3B-4. f.

[5.23] Release

Upon satisfaction of the security interest in the watercraft, the lienholder must execute a release of the security interest within 30 days and deliver the release to the watercraft’s owner. If the owner makes a written demand for the release, the release must be executed within 10 days of the demand. 625 ILCS 45/3B-5. Upon notification of the execution of the release of security interest, the holder of the certificate of title must forward the certificate to the next lienholder listed thereon or, if none, to the watercraft’s owner. The owner thereafter has a duty to return the certificate along with the release to be delivered to the Department of Natural Resources so that the satisfied lien may be deleted from the certificate. Id.

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§5.24

SECURED TRANSACTIONS

2. Federally Documented Vessels a. [5.24] Vessels That Must Be Federally Documented Federal law governs the perfection of a security interest in vessels documented with the U.S. Department of Transportation. See 46 U.S.C. §31301, et seq. A vessel must be documented by the Department of Transportation if it 1. weighs at least five net tons; 2. is not registered under the laws of a foreign country; and 3. is owned by a U.S. citizen (or other entity, the principals of which are U.S. citizens) or by the government of either the United States or an individual state. 46 U.S.C. §§12103(a), 12103(b). The Department of Transportation will issue a certificate of documentation to the owner of the vessel upon the completion of the documentation process. 46 U.S.C. §12105(a). However, the certificate of documentation shall not be deemed to be conclusive evidence of the vessel’s ownership in a proceeding in which ownership is contested. The Kitty C, 20 F.Supp. 173 (S.D.Fla. 1937). See also Compania Espanola de Navegacion Maritima, S.A. v. Navemar, 303 U.S. 68, 82 L.Ed. 667, 58 S.Ct. 432 (1938), superseded by statute on other grounds as stated in Odyssey Marine Exploration, Inc. v. Unidentified Shipwrecked Vessel, 657 F.3d 1159 (11th Cir. 2011); Swift & Co. Packers v. Compania Colombiana del Caribe, S.A., 175 F.2d 513, 519 (5th Cir. 1949), rev’d on other grounds, 70 S.Ct. 861 (1950). b. [5.25] Filing with the U.S. Department of Transportation All bills of sale, conveyances, mortgages, assignments, and other related instruments, in order to be valid against parties without actual notice of the existence of the instrument, must be filed with the Secretary of Transportation. 46 U.S.C. §31321(a)(1). The instrument in question, however, shall be deemed to be valid against the grantor, mortgagor, or assignor; the heir or devisee of the grantor, mortgagor, or assignor; or any other person having actual notice of the instrument regardless of whether the required filing is accomplished. Id. Six prerequisites must be satisfied by an instrument before it will be accepted for recording. The instrument must (1) identify the vessel; (2) state the name and address of each party to the instrument; (3) state, if a mortgage, the amount of the direct or contingent obligations . . . that is or may become secured by the mortgage, excluding interest, expenses, and fees;

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§5.27

(4) state the interest of the grantor, mortgagor, or assignor in the vessel; (5) state the interest sold, conveyed, mortgaged, or assigned; and (6) be signed and acknowledged. 46 U.S.C. §31321(b). “Acknowledge” is defined to include “notarization before a notary public or other official authorized . . . to take acknowledgments of deeds.” 46 U.S.C. §31301(1). All instruments filed with the Secretary of Transportation shall be “available for public inspection” and copying. 46 U.S.C. §31302(1). The Secretary is also directed to maintain “appropriate indexes” of all “instruments filed or recorded” for the use of the public. 46 U.S.C. §31321(e)(2). c. [5.26] Preferred Mortgages When investigating the taking of an interest in a federally documented vessel, the practitioner is urged to pay close attention to the provisions of the federal law pertaining to preferred mortgages. A “preferred mortgage” is defined as a mortgage that 1. includes the whole of a vessel; 2. is properly filed with the Secretary of Transportation; and 3. covers a documented vessel or a vessel for which documentation has been applied. 46 U.S.C. §31322(a). (See 46 U.S.C. §31322(a)(4)) for additional requirements that are needed for fishery endorsements 100 feet or greater in registered length.) The advantage to the lienholder in possessing a preferred mortgage is that if it becomes necessary to foreclose on the mortgage, the vessel may be sold free of any claim to the vessel existing on the date of sale. 46 U.S.C. §31326(a). In addition, the preferred mortgage lienholder has priority in the proceeds of the sale over all other claims to the vessel except for court costs and preferred maritime liens. 46 U.S.C. §31326(b). d. [5.27] Maritime Liens A person providing necessaries to a vessel pursuant to an order issued by an authorized person has a maritime lien on the vessel. 46 U.S.C. §31342(a). “Necessaries” are defined to include “repairs, supplies, towage, and the use of a dry dock or marine railway.” 46 U.S.C. §31301(4). The following persons shall be presumed to have authority to order the procurement of necessaries for a vessel: 1. the owner; 2. the master;

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§5.28

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3. the person entrusted with the management of the vessel at the port of supply; or 4. an officer or agent appointed by the owner, a charterer, an owner pro hac vice, or an agreed buyer in possession of the vessel. 46 U.S.C. §31341(a). A maritime lien arising before the filing of a preferred mortgage is deemed to be a preferred maritime lien. 46 U.S.C. §31301(5). As noted in §5.26 above, preferred maritime liens enjoy priority over preferred mortgages. Preferred maritime liens may also exist to cover damages arising out of a maritime tort, for wages of certain stevedores, for wages of the crew of the vessel, for general average, or for salvage. Id. A notice of a maritime lien may be recorded with the Secretary of Transportation. To be recordable, the notice must state the nature of the lien, the date the lien was established, the amount of the lien, and the name and address of the possessor of the lien, and it must be properly signed and acknowledged. 46 U.S.C. §31343(a). e. [5.28] Default Upon default, the holder of a preferred mortgage possesses three separate claims that may be enforced in U.S. district court. First, the mortgagee may proceed in rem against the documented vessel. 46 U.S.C. §31325(b)(1). Second, the mortgagee may file “against the mortgagor, maker, comaker, or guarantor,” in person or in admiralty, for the amount of the outstanding indebtedness. 46 U.S.C. §31325(b)(2)(A). Third, the mortgagee may proceed “against the mortgagor, maker, comaker, or guarantor” in a civil action for the amount of the outstanding indebtedness. 46 U.S.C. §31325(b)(2)(B). In addition, the mortgagee may exercise any other remedy (including an extrajudicial remedy) if the remedy is allowed under applicable law and the exercise of the remedy will not result in a violation of 46 U.S.C. §56101 or §56102. 46 U.S.C. §31325(b)(3). When proceeding in rem, notice of the civil action must be given to the master or individual in charge of the vessel, any person who has a recorded maritime lien on the vessel, and all other mortgagees of record. 46 U.S.C. §31325(d)(1). The failure to give notice to the above-named individuals does not negate the jurisdiction of the court but rather exposes the lienholder seeking to enforce the mortgage to damages to each of the individuals of record who do not receive notice. In addition to actual damages, interest holders may also receive their costs and attorneys’ fees. 46 U.S.C. §31325(d)(3). A diligent search for all lienholders of record, accordingly, will be necessary as a predicate to a foreclosure action. The statute, however, does not require the lienholder to search outside the boundaries of the United States for those who may hold liens on the vessel. 46 U.S.C. §31325(d)(2). Upon proof of default, the district court has the authority to order the sale of the vessel when the action brought was in rem. 46 U.S.C. §31326. f.

[5.29] Discharge

On full and final discharge of the indebtedness under a mortgage, preferred mortgage, or maritime lien, the owner or mortgagor may request the mortgagee or lienholder to forward a certificate of discharge to the Secretary of Transportation. The Secretary shall thereafter record the certificate to clear the lien from the Secretary’s records. 46 U.S.C. §§31321(f), 31321(h), 31343(c).

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§5.32

g. [5.30] Interplay with Uniform Commercial Code Article 9 Out-of-state cases seem to suggest that courts may look to Article 9 of the Uniform Commercial Code to fill in any gaps left open by the statutory lien-recording scheme for federally documented vessels. Compare Brown v. Baker, 688 P.2d 943 (Alaska 1984) (holding that state law governs), and Security Bank of Oregon v. Levens, 257 Or. 630, 480 P.2d 706 (1971) (holding that state law, not federal law, applies to non-preferred ship mortgages), with Mastan Co. v. Steinberg, 418 F.2d 177, 179 (3d Cir. 1969) (holding that federal law governs), cert. denied, 90 S.Ct. 1238 (1970), J. Ray McDermott & Co. v. Vessel Morning Star, 457 F.2d 815, 818 (5th Cir.) (same), cert. denied, 93 S.Ct. 292 (1972), and Maryland National Bank v. Darovec, 820 F.Supp. 1083 (N.D.Ill. 1993) (46 U.S.C. §31301, et seq., does not provide comprehensive and exclusive process for foreclosure that must be followed in all cases; mortgagee may use state law self-help methods to repossess vessels and may conduct private foreclosure sale). When a foreclosure against a vessel occurs under the jurisdiction and control of the federal district court, federal law would govern the rights of guarantors. Register v. Ford Motor Credit Co., 744 S.W.2d 301 (Tex.App. 1987) (decided under Ship Mortgage Act, 1920), writ granted (Oct. 15, 1988), writ withdrawn (May 24, 1989), writ dismissed by agreement (May 24, 1989). For example, the federal provisions found at 46 U.S.C. §31301, et seq., would appear to supplant UCC provisions regarding notice, and the only relevant question is whether there was compliance with the applicable federal law notice rules. No sale or mortgage that includes a vessel of the United States is valid against any person other than the grantor or mortgage owner and anyone with actual notice until the bill of sale or mortgage is recorded with the Coast Guard at the vessel’s home port. Maryland National Bank v. Vessel Madam Chapel, Official No. 924662, 46 F.3d 895 (9th Cir. 1995), citing former 46 U.S.C.App. §1012; 46 U.S.C. §31321(a)(1).

III. [5.31] INTELLECTUAL PROPERTY Federal law provides a system of recordation of conveyances of interests in copyrights, patents, and trademarks. Illinois law also provides a system of recordation of conveyances of interests in trademarks. Copyrights, patents, and trademarks also qualify as “general intangibles” as defined by 810 ILCS 5/9-102(a)(42). Conveyances of general intangibles are covered by the filing of a UCC1 Financing Statement. When a practitioner is asked to secure an interest in a copyright, patent, or trademark, he or she is thus faced with a dilemma of whether to file under federal law, state law, or both in order to ensure the perfection of the client’s security interest. Commentators in this area of the law universally agree that the practitioner should file under both the relevant federal law as well as a general intangible under Article 9 of the Uniform Commercial Code. Sections 5.32 – 5.40 below introduce the reader to the recordation systems established under the copyright, patent, and trademark laws. Perfection of general intangibles under Article 9 is discussed in Chapter 2 of this handbook. A. [5.32] Copyrights Copyright protection may be obtained to protect “original works of authorship fixed in any tangible medium of expression” that can be “perceived, reproduced, or otherwise communicated.”

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§5.33

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17 U.S.C. §102(a). Works of authorship eligible for protection include literary, musical, and dramatic works; pantomimes and choreographic works; pictorial, graphic, and sculptural works; motion pictures and other audiovisual works; sound recordings; and architectural works. Id. Ownership rights in a copyright have value and, accordingly, may be used to secure a transaction. 17 U.S.C. §201(d)(1) allows ownership of a copyright to be transferred in whole or in part by any means of conveyance. 1. [5.33] Recordation of Conveyances Involving Copyrights Conveyances of interests in copyrights are filed with the Copyright Office of the Library of Congress and must be accompanied by a sworn or official certification that it is a true copy of the original signed document. 17 U.S.C. §205(a). The document containing the conveyance must a. bear the actual signature of the person who executed it; b. be complete by its own terms; and c. be legible and capable of being reproduced in legible microfilm copies. 37 C.F.R. §201.4(c). A photocopy or facsimile may be submitted in lieu of the original document of conveyance if the reproduction is accompanied by a sworn or official certification that the reproduction is a true copy of the signed document. 37 C.F.R. §201.4(c)(1). A reference in the document submitted for recording to a schedule, exhibit, appendix, etc., that is not, in fact, attached to the document may render the document ineligible for recordation. 37 C.F.R. §201.4(c)(2). A document that merely identifies or incorporates by reference another document, however, will be accepted for recordation. Id. A filer may submit electronic lists setting forth the titles of the copyrighted works if the document submitted pertains to 100 or more titles of copyrighted works. The electronic list is not considered part of the recorded document and serves only as a means to index titles and other information associated with the recorded document. 37 C.F.R. §201.4(c)(4). The electronic list must be included in the same package as the paper document to be recorded. 37 C.F.R. §201.4(c)(4)(i). The electronic list of titles must consist of a table contained in an electronic file in Excel (.xls) or other similar format that has been approved by the Copyright Office, include only letters, numbers, and printable characters that appear in the ASCII 128 character set, include four columns entitled, from left to right “Article,” “Title,” “Authorship Information,” and “Registration Number(s),” list each title in a separate row, and include all information required by 37 C.F.R. §201.4(c)(4)(ii)(D). The electronic lists should be submitted “on a compact disc, flash drive, or other digital storage medium approved by the Copyright Office” and must be labeled with the following information: the name of the remitting party; the name of the first party listed in the paper document; the first title listed in the paper document; the number of titles included in the paper document; and the date the remitting party mailed or delivered the paper document. 37 U.S.C. §201.4(c)(4)(i). After recordation, the document will be returned to its filer. A certificate of record will also be sent to the document’s filer. 37 C.F.R. §201.4(e).

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§5.37

2. [5.34] Effect of Recordation A proper recordation of a conveyance of an interest in a copyright acts to give all persons constructive notice of the facts stated in the recorded document as long as the document specifically identifies the work to which the recordation pertains and registration has been made for the work. 17 U.S.C. §205(c). All copyrighted works are indexed by title and registration number of the work. Any conveyance of a copyright interest should, accordingly, make specific reference to the work’s title and registration number. A document is deemed recorded on the date the document and recording fee are received in the Copyright Office. 37 C.F.R. §201.4(e). The date of recordation, however, will relate back to the date of the document’s execution if the conveyance is recorded within one month after its execution in the United States or within two months after its execution outside the United States. 17 U.S.C. §205(d). When multiple interests in a copyright are conveyed, the first conveyance recorded will have priority over subsequently recorded conveyances as long as the holder of the conveyance first recorded possessed no actual knowledge of an earlier unrecorded conveyance. Id. B. [5.35] Patents The inventor or discoverer of “any new and useful process, machine, manufacture, or composition of matter, or any new and useful improvement thereof, may obtain a patent” to protect the rights in the same. 35 U.S.C. §101. Patents have the “attributes of personal property” and, accordingly, may be used as collateral. 35 U.S.C. §261. Interests in patents are specifically assignable in law by an instrument in writing. Id. 1. [5.36] Recordation of an Assignment of Patent An assignment of a patent is filed for recordation at the United States Patent and Trademark Office in Washington, DC. 37 C.F.R. §3.11. The assignment should identify the patent by its patent number and date. 37 C.F.R. §3.21. The name of the inventor and the title of the invention as stated in the patent should also be identified. The Patent and Trademark Office assesses a recording fee of $40 for each assignment not submitted electronically on or after January 1, 2014. 37 C.F.R. §1.21(h). Any appropriate recording fee must accompany the assignment. 37 C.F.R. §3.41. 2. [5.37] Effect of Recordation 35 U.S.C. §261 provides that an assignment “shall be void as against any subsequent purchaser . . . without notice, unless [the assignment] is recorded in the Patent and Trademark Office within three months from its date or prior to the date of such subsequent purchase.” Caselaw suggests, however, that a federal filing may not be necessary to protect a lienholder from a claim by a bankruptcy trustee since a bankruptcy trustee enjoys the status only of a lien creditor and not of a purchaser under federal patent law. In re Transportation Design & Technology, Inc., 48 B.R. 635 (Bankr. S.D.Cal. 1985). But see In re Peregrine Entertainment, Ltd., 116 B.R. 194, 203 – 204 (C.D.Cal. 1990) (holding that under UCC, security interests in patents need not be

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§5.38

SECURED TRANSACTIONS

recorded in United States Patent and Trademark Office to be perfected as against lien creditors because federal statute governing patent assignments does not specifically provide for liens). A later patent case, Chesapeake Fiber Packaging Corp. v. Sebro Packaging Corp., 143 B.R. 360 (D.Md. 1992), aff’d, 8 F.3d 817 (4th Cir. 1993), cites Transportation Design with approval and reiterates that a federal filing or recording is not necessary for a security interest to defeat a trustee in bankruptcy or other lien creditor. However, lienholders should always make the federal filing as a precautionary measure. The date of record is the date of the receipt of the assignment and the recording fee by the Patent and Trademark Office. 37 C.F.R. §3.51. C. [5.38] Trademarks Federal law and Illinois law each contain statutes purporting to cover the transfer of interests in trademarks. A “trademark” under the Trademark Act of 1946, ch. 540, 60 Stat. 427, means any word, name, symbol, or device, or any combination thereof — (1) used by a person, or (2) which a person has a bona fide intention to use in commerce and applies to register on the principal register established by this chapter, to identify and distinguish his or her goods, including a unique product, from those manufactured or sold by others and to indicate the source of the goods, even if that source is unknown. 15 U.S.C. §1127. The definition of “trademark” under the Trademark Registration and Protection Act, 765 ILCS 1036/1, et seq., is practically identical to the federal definition. 765 ILCS 1036/5(i). As its definition suggests, a trademark is only a symbol of the goodwill associated with the product of the manufacturer or merchant. Accordingly, when one speaks of transferring a trademark, he or she must necessarily contemplate a transfer of the goodwill with which it is connected. For this reason, a filing pursuant to the provisions of Article 9 of the Uniform Commercial Code is necessary to secure adequately an interest in a trademark since goodwill is an intangible asset. Creditors’ Committee of TR-3 Industries, Inc. v. Capital Bank (In re TR-3 Industries), 41 B.R. 128 (Bankr. C.D.Cal. 1984); In re Chattanooga Choo-Choo Co., 98 B.R. 792 (Bankr. E.D.Tenn. 1989). The federal and state trademark statutes do create a recording system for assignments, however, so each is briefly introduced in §§5.39 and 5.40 below. 1. [5.39] Recording Under the Federal Trademark Act 15 U.S.C. §1060 constitutes the federal law pertaining to the assignment of trademarks. Trademarks can be registered at the website of the United States Patent and Trademark Office at www.uspto.gov. A registered mark may be assigned along with its related goodwill if done in writing signed by the transferring party. Trademark assignments are recorded in the Patent and Trademark Office in Washington, DC. 37 C.F.R. §3.11(a). The assignment should identify the trademark’s certificate of registration by its number and date of registration and must be accompanied by the appropriate filing fee. 37 C.F.R. §§3.28, 3.41. In addition, the address of the

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§5.42

assignee should be recited in the assignment or given in a separate paper. 37 C.F.R. §3.31. The date of record for the assignment is the date that the Patent and Trademark Office receives the assignment and recording fee. 37 C.F.R. §3.51. As in the case of patents, “[a]n assignment shall be void against any subsequent purchaser” for value without notice unless recorded within three months or prior to such a subsequent purchase. 15 U.S.C. §1060(a)(4). 2. [5.40] Recording Under Illinois’ Trademark Registration and Protection Act The Trademark Registration and Protection Act largely tracks the federal law described in §5.39 above. Assignments are recorded with the Illinois Secretary of State’s Office. The Secretary of State assesses a $5 fee to record the assignment. Following the recordation of an assignment, the Secretary of State will issue a new certificate of registration to the assignee. The Act tracks federal law in providing that an assignment shall be void as against any subsequent purchaser for valuable consideration without notice unless recorded within three months of the assignment or prior to the subsequent purchase. 765 ILCS 1036/35.

IV. [5.41] RIGHTS IN FUNDS HELD BY ANOTHER While each type of collateral discussed in §§5.42 – 5.44 below — insurance policies, wages, and judgments — is an asset in and of itself, the actual money that gives these assets value as collateral to the lender is in the possession of a third party, whether it be an insurance company, employer, or defendant. However, each has individual qualities that necessitate a separate presentation. A. [5.42] Insurance Policies Article 9 of the Uniform Commercial Code does not apply to a transfer of an interest or claim in or under any policy of insurance other than an assignment by or to a healthcare provider of a healthcare insurance receivable. 810 ILCS 5/9-109(d)(8). Article 9 also does not apply to certain insurance policy proceeds. The UCC defines the term “proceeds” to include “to the extent of the value of collateral and to the extent payable to the debtor or the secured party, insurance payable by reason of the loss or nonconformity of, defects or infringement of rights in, or damage to, the collateral.” 810 ILCS 5/9-102(a)(64)(E). The concept of proceeds under §9-102(a)(64) is discussed in §1.29 of this handbook and is not repeated here. This discussion does not concern the proceeds received upon damage or destruction of a secured piece of collateral that are clearly covered by Article 9. See In re Reda, Inc., 54 B.R. 871 (Bankr. N.D.Ill. 1985). See In re Turnbull, 350 B.R. 429 (Bankr. N.D.Ill. 2006); General Star Indemnity Co. v. Hubbard Bowling Lanes, Inc., 92 A.F.T.R.2d (RIA) 2003-6331 (N.D.Ill. 2003). This discussion, rather, addresses the taking of the actual insurance policy as collateral. Given the exclusionary language of §9-109(d)(8) of the UCC, the question arises whether a policy of insurance can, in fact, be taken as collateral to secure the payment of a debt. The Northern District of Illinois addressed this question in In re Long Chevrolet, Inc., 79 B.R. 759 (N.D.Ill. 1987), and concluded that life insurance policies can be used as collateral. See also In re

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SECURED TRANSACTIONS

Tyson Metal Products, Inc., Tafco, 117 B.R. 181 (Bankr. W.D.Pa. 1990), citing Long Chevrolet, supra. The Long Chevrolet court found that the Illinois Insurance Code, 215 ILCS 5/1, et seq., allows the owner of any policy of life insurance to make an assignment of all or any part of his or her rights and privileges under the policy. See 215 ILCS 5/245.1. Inasmuch as a policy of insurance is a contract, the practitioner will need to thoroughly review the policy to be assigned to determine whether the particular insurance company that issued the policy has included within it any language pertaining to the assignment of the owner’s rights in the policy. In the absence of any language in the policy to the contrary, the validity of an assignment of an insurance policy will be determined under Illinois common law. Long Chevrolet, supra. In general, as the Long Chevrolet court explained, “[a]ny words that demonstrate the intent to transfer some identifiable property from the assignor to the assignee for valuable consideration are adequate to accomplish an assignment.” 79 B.R. at 767, quoting In re Estate of Martinek, 140 Ill.App.3d 621, 488 N.E.2d 1332, 1337, 94 Ill.Dec. 939 (2d Dist. 1986). An additional question raised in Long Chevrolet was whether identifying the collateral as “all policies and certificates” was too vague to render the subject matter of the assignment capable of identification. The language of an assignment, if it is to be valid, must identify the subject matter of the assignment. Hogan v. Dalziel, 40 Ill.App.2d 19, 188 N.E.2d 367 (2d Dist. 1963). The Long Chevrolet court held that the words “all policies and certificates” left no doubt as to what was being conveyed by the assignment. 79 B.R. at 768. The practitioner must act quickly when seeking to achieve an assignment of an insurance policy. The Illinois Insurance Code provides that an assignment is without prejudice to the insurance company on account of any payment it makes prior to receipt of notice of assignment. 215 ILCS 5/245.1. Thus, the insurance company must be provided with immediate written notice of the assignment in order to guard against the possibility of insurance benefits being paid to one other than the secured party. B. [5.43] Wage Assignments Article 9 of the Uniform Commercial Code does not apply to a transfer of a claim for wages, salary, or other compensation of an employee. 810 ILCS 5/9-109(d)(3). In Illinois, wage assignments are governed by the Illinois Wage Assignment Act, 740 ILCS 170/.01, et seq. As a preliminary matter, the practitioner must determine whether the individual offering an assignment of wages as collateral is an employee or is an independent contractor. Article 9’s exclusion extends only to the wages, salary, or other compensation of an employee. Payments to be received by an independent contractor for services rendered to those with whom he or she contracts are not wages but are, rather, accounts receivable to which Article 9 applies. See Massachusetts Mutual Life Insurance Co. v. Central Penn National Bank, 372 F.Supp. 1027 (E.D.Pa. 1974). If there is any doubt in the practitioner’s mind as to whether an individual is offering wages from employment or accounts receivable from independent contracts as collateral, the lender should file a financing statement.

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The Wage Assignment Act is a fairly detailed piece of legislation that must be closely examined by the practitioner in order to ensure that a valid wage assignment will be achieved. Section 1 of the Wage Assignment Act contains the conditions that must exist for a valid assignment of wages to occur: 1. The wage assignment must be signed by the wage earner in person. 2. The wage assignment must bear the date of its execution, the social security number of the wage earner, the name of the employer, the amount of the debt secured, the rate of interest to be applied, and the date on which payments are due. 3. The wage assignment must be given to secure an existing debt or one contracted by the wage earner simultaneously with its execution. 4. The words “Wage Assignment” must be printed or written in boldface letters not less than one-quarter inch in height both at the head of the wage assignment and one inch above or below the wage earner’s signature line. 5. The wage assignment must be in writing in a separate instrument complete in itself and not part of any other instrument. 740 ILCS 170/1. The wage earner cannot be an employee of the State of Illinois, any unit of local government, or a school district. 740 ILCS 170/9. An exact copy of the wage assignment must be furnished to the wage earner at the time the assignment is executed. 740 ILCS 170/1(3). After securing by wage assignment, the creditor must continue to monitor the employment status of the debtor. If the wage earner changes jobs, the creditor is protected only temporarily. The Wage Assignment Act provides: No assignment of wages shall become invalid by reason of cessation of employment but shall be valid and collectible against any future employer of the wage-earner within a period of 2 years from the date of its execution. 740 ILCS 170/3. In addition, since a wage assignment is valid for a period of only three years from the date of its execution, such a form of collateral will be advisable only for debts of a relatively short term. 740 ILCS 170/5. A creditor may seek to enforce a wage assignment only after certain statutory requirements regarding demand on the employer and notice to the employee are met. See 740 ILCS 170/2 – 170/2.2. Upon receiving notice, the employee has a chance to present any defenses he or she may have to the wage assignment. 740 ILCS 170/4.1, 170/4.2. The maximum amount that may be collected by a wage assignee for any workweek is the lesser of (1) 15 percent of the employee’s gross pay for that week, or (2) the amount by which the employee’s disposable earnings for the week exceed 45 times the federal minimum hourly wage in effect at the time the amounts are payable. 740 ILCS 170/4. A fee of $12 for each wage assignment shall be collected by and paid to the employer, and the amount so paid shall be credited against the amount of the wage earner’s

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outstanding debt. Wage assignments will be paid in the order in which the demands were served but may not exceed the limits described above. Id. Thus, a creditor does not want to be in a position of having a wage assignment that is superseded by a previously served wage assignment of another creditor. In general, as a review of the above suggests, wage assignment is not a very attractive way for the creditor to secure payment of a debtor’s debt. Practitioners are advised to seek other, more secure methods in which to protect a creditor’s position. C. [5.44] Judgments Article 9 of the Uniform Commercial Code does not apply to a right represented by a judgment. 810 ILCS 5/9-109(d)(9). However, Article 9 will apply to a judgment taken on a right to payment that was itself covered collateral. Id. Illinois caselaw governs the assignment of a judgment not covered by Article 9. Illinois courts will recognize an assignment of a judgment that is bona fide and made for valuable consideration. Stombaugh v. Morey, 388 Ill. 392, 58 N.E.2d 545 (1944); In re Hosier, 875 F.2d 128, 130 (7th Cir. 1989). The courts have set forth few rules governing the form the assignment must take. Any document that evidences an intent to transfer ownership of a judgment to an assignee will generally be held to be sufficient. Evangelical Slovak Women’s Union v. Papanek, 8 Ill.App.2d 298, 132 N.E.2d 20 (1st Dist. 1956). The judgment debtor should receive actual notice of the assignment. The Illinois Supreme Court has held that the filing of an assignment of judgment with the clerk of the court does not operate to give constructive notice to the judgment debtor. Schmidt v. Shaver, 196 Ill. 108, 63 N.E. 655 (1902). In the absence of notice, a judgment debtor will be entitled to receive a credit on any amount paid on the judgment to the judgment creditor. Chicago City Ry. v. Blanchard, 37 Ill.App. 391 (1st Dist. 1890).

V.

[5.45] BROADCASTING LICENSES

Suppose your client asks you to help secure a loan given to a television or radio station. Depending on the size of the loan, the practitioner may want to take a security interest in all of the station’s assets. While the taking of an interest in the station’s land and equipment should be relatively straightforward, the practitioner may have some concern over whether a security interest in the station’s Federal Communications Commission (FCC) broadcasting license can be taken. Such a concern would be well-founded. Federal law prohibits voluntary transfers of FCC licenses. A license is a personal privilege granted by law that is not transferable to another unless so allowed by law. Reith v. General Telephone Company of Illinois, 22 Ill.App.3d 337, 317 N.E.2d 369 (5th Dist. 1974). 47 U.S.C. §310(d) adopts similar language restricting transfers of broadcasting licenses: No . . . station license, or any rights thereunder, shall be transferred, assigned, or disposed of in any manner, voluntarily or involuntarily, directly or indirectly, or by

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transfer of control of any corporation holding such permit or license, to any person except upon application to the Commission and upon finding by the Commission that the public interest, convenience, and necessity will be served thereby. This language acts to prohibit voluntary transfers of broadcast licenses, including security interests. The best the practitioner can do for a client in such a situation is to secure the station’s land and equipment. Upon foreclosure, the secured party, since it would then possess all of the station’s assets, may make application with the FCC for the transfer of the debtor’s license to the secured party.

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6

Equipment Leasing

CYNDE H. MUNZER Aronberg Goldgehn Davis & Garmisa

HOWARD J. SWIBEL Arnstein & Lehr LLP Chicago

®

©COPYRIGHT 2016 BY IICLE .

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I. [6.1] Introduction — Scope of Chapter II. [6.2] Advantages of Equipment Leasing III. [6.3] True Lease vs. Lease Intended as Security (Pseudo-Lease) A. [6.4] Principles Applied by Courts B. [6.5] 810 ILCS 5/1-203 IV. Consequences of Distinction Between a True Lease and a Lease Intended as Security A. B. C. D. E.

[6.6] [6.7] [6.8] [6.9] [6.10]

Applicability of Article 2 Applicability of Article 9 Applicability of Article 2A Rights in Bankruptcy Applicability of Usury Laws

V. [6.11] Article 2A

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A. B. C. D. E.

[6.12] [6.13] [6.14] [6.15] [6.16]

F. G. H. I. J. K. L. M.

[6.17] [6.18] [6.19] [6.20] [6.21] [6.22] [6.23] [6.24]

N. O. P. Q. R. S.

[6.25] [6.26] [6.27] [6.28] [6.29] [6.30]

Scope of Article 2A Definitions of Lease, Consumer Lease, and Finance Lease Leases Subject to Other Statutes Goods Covered by Certificate of Title Limit on Power of Parties to Consumer Lease To Choose Applicable Law and Judicial Forum Unconscionability Option To Accelerate at Will Statute of Frauds Miscellaneous Lease Formation and Construction Rules Modification Lessee Under Finance Lease as Beneficiary of Supply Contract Express Warranties Warranties Against Interference and Infringement; Lessee’s Obligation Against Infringement Implied Warranties Exclusion or Modification of Warranties Third-Party Beneficiaries of Express and Implied Warranties Insurance and Proceeds Risk of Loss; Effect of Default on Risk of Loss; Casualty Enforceability of Lease Contract

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T. [6.31] Transfers and Assignments of Interests U. [6.32] Subsequent Lease of Goods by Lessor V. [6.33] Sale or Sublease of Goods by Lessee W. [6.34] Priority of Certain Liens Arising by Operation of Law X. [6.35] Priority of Certain Other Liens Y. [6.36] Special Rights of Creditors Z. [6.37] Rights of Lessor and Lessee When Goods Become Fixtures AA. [6.38] Accessions BB. [6.39] Performance of Lease Contract: Repudiated; Substituted; and Excused CC. [6.40] Default Procedure DD. [6.41] Notice After Default EE. [6.42] Modification or Impairment of Rights and Remedies FF. [6.43] Liquidation of Damages GG. [6.44] Statute of Limitations HH. [6.45] Default by Lessor — Lessee’s Remedies II. [6.46] Effect of Acceptance of Goods JJ. [6.47] Default by Lessee — Lessor’s Remedies VI. Typical Lease Provisions A. B. C. D. E. F. G. H. I. J. K. L. M. N.

[6.48] [6.49] [6.50] [6.51] [6.52] [6.53] [6.54] [6.55] [6.56] [6.57] [6.58] [6.59] [6.60] [6.61]

Description of Equipment Location and Care of Equipment Acceptance of Equipment Rental Payments Term of Lease Renewal Options Purchase Options Warranties and Disclaimers Indemnification Risk of Loss or Damage Insurance Assignment Return of Equipment Default and Remedies

VII. Other Issues Arising in Equipment Lease Transactions A. [6.62] Fraudulent Conveyance Issues in Sale-Leaseback Transactions B. [6.63] Equipment Leases as Collateral

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VIII. [6.64] Documents Used in Connection with Equipment Lease Transactions IX. [6.65] Sample Form of Equipment Lease

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§6.1

I. [6.1] INTRODUCTION — SCOPE OF CHAPTER Given the numerous benefits it affords, equipment leasing continues to grow in popularity among businesses of all sizes. Businesses in increasing numbers are leasing equipment ranging from computers to aircraft. This chapter begins with a brief description of the advantages provided by leasing rather than purchasing equipment. See §6.2 below. It is important to distinguish between a true lease and a lease intended as security. Sections 6.3 – 6.5 below discuss the principles applied by courts in differentiating between these two types of leases as well as §1-203 of the Uniform Commercial Code (UCC), 810 ILCS 5/1-101, et seq., which contains guidelines for determining whether a transaction creates a true lease or a lease intended as security. 810 ILCS 5/1-203. Sections 6.6 – 6.10 below discuss the significance of distinguishing between a true lease and a lease intended as security for purposes of the UCC and also discuss the Bankruptcy Code, 11 U.S.C. §101, et seq., and the applicability of usury laws. In recognition of the exponential growth in personal property lease transactions, Article 2A of the UCC, 810 ILCS 5/2A-101, et seq., dealing specifically with these transactions, was approved by the National Conference of Commissioners on Uniform State Laws (NCCUSL) in 1986 and by the American Law Institute (ALI) in 1987. P.A. 87-493, which adopted Article 2A in Illinois, became effective on January 1, 1992. Article 2A, which is modeled in large part on Article 2 of the UCC, pertaining to sales of goods, sets forth rules governing true leases of personal property. (Leases intended as security are not within the scope of Article 2A and instead are to be governed by Article 9 of the UCC, 810 ILCS 5/9-101, et seq.) Sections 6.11 – 6.47 below review and discuss the provisions of Article 2A. Sections 6.48 – 6.63 below discuss provisions that are typically included in equipment leases as well as fraudulent conveyance issues arising in sale-leaseback transactions and other issues that may arise when the equipment lease is given as collateral by the lessor. Section 6.64 below contains a checklist of documents often used in equipment lease transactions, and a sample form of an equipment lease is included in §6.65 below. Article 9 and other provisions of Illinois’ version of the UCC were revised by P.A. 91-893 (eff. July 1, 2001). The NCCUSL and the ALI approved a revision of Article 1 in August 2001. Significant structural changes were made to Article 1 with very few substantive changes. Illinois did not enact these changes until the passage of P.A. 95-895 (eff. Jan. 1, 2009). One important change included the removal of the factors utilized in the determination of a lease distinguished from a security interest from the definition of security interest in UCC §1-201 and the creation of a separate section, UCC §1-203, Lease Distinguished from Security Interest. The NCCUSL and the ALI approved a revised UCC Article 2 and Article 2A in 2004. The revisions to Article 2A were meant to harmonize Article 2A with the revised Article 2. The revised Article 2A recognizes new technologies, such as electronic signatures and the like, involved with leasing transactions and brings Article 2A up to date with the 2001 revision of Article 1. No state has adopted the revised Article 2 or Article 2A, although the Oklahoma legislature has made several attempts at enacting parts of it. All citations to the UCC in this chapter are to the current Illinois version unless otherwise noted.

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II. [6.2] ADVANTAGES OF EQUIPMENT LEASING In many instances, equipment leasing offers numerous benefits compared to purchasing the equipment, including the following: a. Leasing offers more convenience since it allows a business to procure equipment quickly, when the need arises, and only for the period of time that the equipment is needed. b. Particularly with respect to short-term leases, the rent payments may be significantly less than the cost of purchasing the equipment. c. Especially with short-term leasing, the risk of obsolescence created by changing technologies is borne to a greater extent by the lessor. d. Once it no longer has a need for the equipment, the lessee need not pay the costs incurred with the disposal or sale of the equipment if, upon termination of the lease, the lessor will regain possession of the equipment. e. Repair and maintenance work often can be furnished by the lessor, frequently at a cost less than if the lessee were to attempt this work itself. Of course, leasing also offers benefits from a tax standpoint. A business having substantial taxable income is usually able to avail itself of certain tax benefits (e.g., depreciation) and thereby reduce its tax liability by buying equipment and leasing it to a business that does not have sufficient taxable income to use these tax benefits. The lessor may pass on part of its tax savings to the lessee in the form of lower rent payments. These tax benefits for the lessor, however, are subject to certain limitations under the Internal Revenue Code; thus, the potential lessor should consult with its tax advisor before entering into a leasing arrangement. A more detailed discussion of the tax considerations and issues associated with leasing is beyond the scope of this chapter. The ability of the parties to a lease to share tax benefits has been a major factor in the growth of equipment leasing and has resulted in the formation of leasing companies, many of which are bank-related or leasing subsidiaries of equipment manufacturers. See Philip J. Glick, Equipment Leasing, BUSINESS LAW MONOGRAPHS (M. Bender, 1992). See also Bruce M. McAdam, Equipment Leasing: An Integral Part of Financial Services, 23 Bus.Econ., No. 3, 43 (July 1988); Peter W. Schroth, Financial Leasing of Equipment in the Law of the United States, 58 Am.J.Comp.L. 323 (2010). The Financial Accounting Standards Board released the new lease accounting standard in February, with an implementation year of 2019 for public companies — private companies will be allowed another year before transitioning is required. See FASB Accounting Standards Update, No. 2016-02 (Feb. 2016), www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176167 901010&acceptedDisclaimer=true (case sensitive). Although the new standard will change how leases are accounted for on corporate balance sheets, a white paper published in November 2015 by the Equipment Leasing and Financing Association (ELFA) emphasizes that most of the lease accounting changes are relatively neutral in their impact. See Changes in Lease Accounting: The

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§6.4

Benefits of Equipment Lease Financing Remain, www.elfaonline.org/issues/accounting/ec/ acctgwhitepaperleasingbenefits_final.pdf. Further, the paper reveals that the core benefits of leasing transactions will not go away under the new standard and that lessees will continue to enjoy a myriad of benefits, including: a. an immediate source of lower-cost capital; b. flexible terms and structures; c. payment plans aligned with cash-flow needs; and d. convenient and efficient execution.

III. [6.3] TRUE LEASE VS. LEASE INTENDED AS SECURITY (PSEUDOLEASE) The total rental payments for a piece of equipment may, in certain instances, be almost as much as, if not more than, the equipment’s original purchase price. As a result, the parties to a lease transaction may structure the transaction to permit the lessee to avail itself of the advantages of a true lease as well as obtain an equity interest in the equipment. These two goals, however, are inconsistent for purposes of the Uniform Commercial Code, the Bankruptcy Code, accounting treatment, and tax law, and efforts to permit the lessee to gain the benefits of both a rental and an equity acquisition in the same agreement have resulted in much litigation. See Albert F. Reisman et al., EQUIPMENT LEASING — LEVERAGED LEASING, p. 11 (3d ed. 1988). Consequently, it is important to distinguish between a true lease and a lease intended as security. Sections 6.4 and 6.5 below discuss (a) the principles applied by courts in distinguishing between a true lease and a lease intended as security and (b) the definition of a true lease contained in 810 ILCS 5/1-203. A. [6.4] Principles Applied by Courts Generally, true leases cover the temporary use of the equipment for a price and require that the leased items be returned to the lessor. Leases intended as security, however, are characterized by the obligation to pay the full purchase price because they are sales of equipment with a reservation of title to provide security to the lessor, who provided the initial funding to acquire the equipment. In re Loop Hospital Partnership, 35 B.R. 929, 932 (Bankr. N.D.Ill. 1983). The courts have made it clear that, although an agreement is denominated a lease, if its substantive provisions indicate that it is in fact a sale, it will be deemed a sale. The parties cannot change the legal effect of the agreement merely by dubbing it a “lease.” See Loop Hospital, supra. In determining whether a lease is a true lease or a lease intended as security, the courts rely on §1-203 of the Uniform Commercial Code. See Mason v. Heller Financial Leasing, Inc. (In re

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§6.4

SECURED TRANSACTIONS

JII Liquidating, Inc.), 341 B.R. 256, 260, 272 (Bankr. N.D.Ill. 2006), for the bankruptcy court’s application of 810 ILCS 5/1-203, in which the court found contractual agreements to be a “disguised security agreement rather than a ‘true lease’ ” when the lessee “could not terminate the Agreement and that the additional consideration required to purchase the Equipment at the end of the term is nominal.” Likewise, the court in Gangloff Industries, Inc. v. Generic Financing & Leasing, Corp., 907 N.E.2d 1059, 1065 (Ind.App. 2009), held that because the lessor alone had the option to terminate the agreement prior to the term fixed therein, the agreement met part one of the statutory test. In determining whether a transaction is a lease or security interest, the courts disregard the form of the agreement or the stated intent of the parties that the agreement be a lease and look to the agreement’s economic effect on the parties, sometimes referred to as the “economic realities.” Banterra Bank v. Subway Equipment Leasing Corp. (In re Taylor), 209 B.R. 482, 484 (Bankr. S.D.Ill. 1997); In re Homeplace Stores, Inc., 228 B.R. 88, 93 (Bankr. D.Del. 1998), quoting Hanes v. Vital Products Co. (In re Vital Products Co.), 210 B.R. 109, 112 (Bankr. N.D. Ohio 1997); In re Yarbrough, 211 B.R. 654, 657 (Bankr. W.D.Tenn. 1997). See also In re Owen, 221 B.R. 56, 62 (Bankr. N.D.N.Y. 1998). The most significant factor in determining whether a transaction is a lease or a sale and security interest is whether the lessor has retained a meaningful residual interest in the goods at the end of the lease term. In re Copeland, 238 B.R. 801, 804 (Bankr. E.D.Ark. 1999). If a lessor cannot reasonably expect to receive anything of value at the end of the lease term, then there is no residual value in the leased goods, and the transaction may be a sale and security interest. Id. See also Robert W. Ihne, Seeking a Meaning for “Meaningful Residual Value” and the Reality of “Economic Realities” — An Alternative Roadmap for Distinguishing True Leases from Security Interests, 62 Bus.Law. 1439 (Aug. 2007). In Borg-Warner Leasing, Inc. v. Bauer, 189 Ill.App.3d 102, 544 N.E.2d 1322, 136 Ill.Dec. 547 (5th Dist. 1989), the lessor sued for breach of a farm equipment lease. The trial court granted the lessor’s motion for summary judgment, and the lessee appealed. The lessee argued that “the notice of the sale and the sale of the [farm equipment] was unconscionable and in violation of” the UCC. 544 N.E.2d at 1324. The appellate court held that the lease was a true lease, not a lease intended as security. The court noted: The lease agreement provisions provided: (a) that defendant was to return the equipment to plaintiff at end of lease; (b) that defendant did not have an option to purchase the equipment; (c) that the equipment was the sole and exclusive property of plaintiff; (d) that only plaintiff could assign its rights under the lease. Id. At the time that Borg-Warner was decided, Article 2A had not been adopted in Illinois. However, the court’s holding and analysis of a true lease agreement are helpful. Since many cases involving equipment leases are under the United States Bankruptcy Court’s jurisdiction, the Bankruptcy Code sheds light on the issue. As one court noted, the Bankruptcy Code defines a security agreement as an “agreement that creates or provides for a security interest.” Lamar v. Mitsubishi Motors Credit of America, Inc. (In re Lamar), 249 B.R. 822, 825 (Bankr. S.D.Ga. 2000), quoting 11 U.S.C. §101(50). The court further observed that applicable state or local law will determine whether a consignment or a lease constitutes a security interest.

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B. [6.5] 810 ILCS 5/1-203 In an attempt to clarify the factors that are significant in distinguishing true leases from leases intended as security, a revised §1-201(37) of the Uniform Commercial Code was approved by the National Conference of Commissioners on Uniform State Laws in 1986 and the American Law Institute in 1987 and adopted in Illinois by P.A. 87-493 (eff. Jan. 1, 1992). The NCCUSL and the ALI subsequently approved a revised version of Article 1 in 2001, which was not adopted in Illinois until 2008 with the passage of P.A. 95-895 (eff. Jan. 1, 2009). Section 1-201(37) was replaced by 810 ILCS 5/1-203. 810 ILCS 5/1-203 provides, in pertinent part: (a) Whether a transaction in the form of a lease creates a lease or security interest is determined by the facts of each case. (b) A transaction in the form of a lease creates a security interest if the consideration that the lessee is to pay the lessor for the right to possession and use of the goods is an obligation for the term of the lease and is not subject to termination by the lessee; and (1) the original term of the lease is equal to or greater than the remaining economic life of the goods; (2) the lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods; (3) the lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease agreement; or (4) the lessee has an option to become the owner of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease agreement. Therefore, §1-203 sets forth a test for distinguishing between leases and security agreements that focuses on the economic reality of the transaction rather than on the intent of the parties. See UCC Comment 37, 810 ILCS 5/1-201 (2001). Simply put, the test to determine whether a transaction is a lease or security interest is whether the transaction creates a security interest. Williams v. Chartwell Financial Services, Ltd., 204 F.3d 748 (7th Cir. 2000); Mason v. Heller Financial Leasing, Inc. (In re JII Liquidating, Inc.), 341 B.R. 256 (Bankr. N.D.Ill. 2006). The new §1-203 as well as the previous §1-201(37) deletes any reference to the parties’ intention. In this regard, UCC Comment 37 to 810 ILCS 5/1-201 (2001) stated: Reference to the intent of the parties to create a lease or security interest has led to unfortunate results. In discovering intent, courts have relied upon factors that were thought to be more consistent with sales or loans than leases. Most of these criteria, however, are as applicable to true leases as to security interests. Examples include

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the typical net lease provisions, a purported lessor’s lack of storage facilities or its character as a financing party rather than a dealer in goods. Accordingly, amended Section 1-201(37) deletes all reference to the parties’ intent. The result of this change is to make the determination a much more objective one, based on the economic realities of the transaction rather than on the more obscure intent of the parties. Brankle Brokerage & Leasing, Inc. v. Volvo Financial Services (In re Brankle Brokerage & Leasing, Inc.), 394 B.R. 906, 911 (Bankr. N.D.Ind. 2008). Section 1-203(c) states that a transaction does not create a security interest merely because it provides that (1) the present value of the consideration the lessee is obligated to pay the lessor for the right to possession and use of the goods is substantially equal to or is greater than the fair market value of the goods at the time the lease is entered into; (2) the lessee assumes risk of loss of the goods, (3) the lessee agrees to pay, with respect to the goods, taxes, insurance, filing, recording, or registration fees, or service or maintenance costs; (4) the lessee has an option to renew the lease or to become the owner of the goods; (5) the lessee has an option to renew the lease for a fixed rent that is equal to or greater than the reasonably predictable fair market rent for the use of the goods for the term of the renewal at the time the option is to be performed; or (6) the lessee has an option to become the owner of the goods for a fixed price that is equal to or greater than the reasonably predictable fair market value of the goods at the time the option is to be performed. 810 ILCS 5/1-203(c). Section 1-203 also provides: (d) Additional consideration is nominal if it is less than the lessee’s reasonably predictable cost of performing under the lease agreement if the option is not exercised. Additional consideration is not nominal if: (1) when the option to renew the lease is granted to the lessee, the rent is stated to be the fair market rent for the use of the goods for the term of the renewal determined at the time the option is to be performed, or (2) when the option to become the owner of the goods is granted to the lessee, the price is stated to be the fair market value of the goods determined at the time the option is to be performed. 810 ILCS 5/1-203(d).

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Relying on §1-201(37), which has now been replaced in Illinois with §1-203, the Seventh Circuit Court of Appeals held that contracts under which a Chapter 13 debtor rented used household goods were true leases and not installment sales contracts, and, therefore, the rental company could repossess the goods from the debtor. In re Powers, 983 F.2d 88 (7th Cir. 1993). In Powers, the debtor could terminate the agreement at any time after the initial two-week rental period with no additional or nominal consideration, the initial rental period in each optional rental period was short in relation to the length of time that had to elapse before the lessee who did not exercise the yearly purchase option would own the goods, and the purchase price was much less than the total amount of the rental payment. Courts have observed that “nominality is merely a proxy for the questions: ‘Is the option price so low that the lessee will certainly exercise it and will, in all plausible circumstances, leave no meaningful reversion for the lessor?’ ” In re Gateway Ethanol, L.L.C., 415 B.R. 486, 500 (Bankr. D.Kan. 2009), quoting 4 James J. White and Robert S. Summers, UNIFORM COMMERCIAL CODE §30-3(e) (5th ed. 2002 & Supp. 2008). The bankruptcy court in Gateway Ethanol further explained that “[e]stablishing nominality where there is a purchase option price and cost associated with performance if the option is not exercised requires a comparison of the option purchase price with the reasonably predictable costs of performance under the lease if the purchase option is not exercised.” 415 B.R. at 500. The nominality determination must be made at the time of the agreement and based on the expectations of the parties upon entering into the transaction, rather than by considering the actual value at the conclusion of the term. 415 B.R. at 499 – 500. Under Illinois law, the purchaser of a Chapter 11 debtor’s assets in Gateway Ethanol failed to establish that a transaction whereby the debtor, the owner of an ethanol plant, acquired a thermal oxidizer boiler from a supplier was a disguised sale and not a true lease. Although the debtor in that case did not have an explicit right to terminate the lease agreement during its five-year term, the asset purchaser failed to show that the debtor had an option to become the owner of the boiler for no or only nominal additional consideration at the end of the lease term. The lease agreement provided that at the end of the lease’s term the debtor could either return the boiler to the supplier (with the debtor paying the cost of removal and shipment) or retain the boiler upon payment of a fixed option price of $600,000. The anticipated value of the boiler after five years was $600,000. Therefore, the court found that the consideration was nominal at best. The court also noted that the asset purchaser, who was not a party to the lease, was the only party that would benefit from a recharacterization of the transaction as a secured sale. Another court has held that a lease will be construed as a security interest as a matter of law if the debtor cannot terminate the lease and one of the enumerated requirements is satisfied. Banterra Bank v. Subway Equipment Leasing Corp. (In re Taylor), 209 B.R. 482 (Bankr. S.D.Ill. 1997). In Taylor, the court held that monthly buyout provisions in an equipment lease were not equivalent to the option to terminate for purposes of determining whether a transaction created a lease or security interest under Illinois law. The court reasoned that the option to terminate the lease differs from a buyout option in that under a termination clause, the lessee is free to cease performance under the contract without incurring further obligation.

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§6.6

SECURED TRANSACTIONS

In Taylor, the court found that a purchase option price representing 20 percent of restaurant equipment’s projected fair market value was not nominal for purposes of determining whether the purported equipment lease created a true lease or a security interest because it was not so economically compelling that the lessee would have no reasonable alternative but to exercise the option. The court found that the equipment lease was a security agreement and not a true lease, although the useful life of the property exceeded the length of the lease term, thereby favoring the finding of a lease. The court noted that the lessee did not have the right to terminate the lease at any time, the amount of rental payments exceeded the fair market value of equipment, and the lessee bore all costs of insurance, taxes, and maintenance for the equipment, as well as risk of loss, all suggesting a security agreement. Another court found that an automobile lease was a true lease and not a disguised security agreement under Illinois law when the debtor had the option of terminating the lease and could retain the automobile at the end of the lease term only by making payments that represented over 25 percent of the total payments under the lease. In re Lerch, 147 B.R. 455 (Bankr. C.D.Ill. 1992). The court in Lerch found that the mere fact that the debtor could terminate an arrangement was not determinative of whether the agreement is a true lease or a disguised security agreement. The court found that the fact that the debtor had assumed the risk of loss and needed to pay certain expenses associated with the vehicle did not preclude its finding that the motor vehicle lease was in fact a lease. In In re Hardy, 146 B.R. 206 (Bankr. N.D.Ill. 1992), the court found that lease agreements for beepers were true leases rather than disguised security agreements. The court found that even though the one-dollar-per-beeper purchase price at the end of the lease term was nominal, the debtor lessee’s rental payments were less than what the lessor paid for the beepers, and the agreement between the lessor and the debtor lessee did not cover the total useful life of the beepers. The court in Gangloff Industries, Inc. v. Generic Financing & Leasing, Corp., 907 N.E.2d 1059, 1065 (Ind.App. 2009), noted that “[h]owever the test is articulated, ‘the courts are clear upon one thing, which is that where the terms of the lease and option purchase are such that the only sensible course of action for the lessee at the end of the term is to exercise the option to purchase and become the owner of the goods, then the lease is one intended to create a security interest.’ ” Quoting United Leaseshares, Inc. v. Citizens Bank & Trust Co., 470 N.E.2d 1383, 1387 (Ind.App. 1984).

IV. CONSEQUENCES OF DISTINCTION BETWEEN A TRUE LEASE AND A LEASE INTENDED AS SECURITY A. [6.6] Applicability of Article 2 Leases intended as security are subject to Article 2 of the Uniform Commercial Code (Sales), while true leases are not. See, e.g., In re Loop Hospital Partnership, 35 B.R. 929 (Bankr. N.D.Ill. 1983). The express and implied warranties under Article 2 pertaining to sales of goods will be deemed to apply to a lease intended as security. Furthermore, it should be noted that Article 2A

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extends the Article 2 warranties to true leases. See 810 ILCS 5/2A-210 through 5/2A-216. Prior to the enactment of Article 2A, most states were able to apply the warranty provisions of Article 2 by analogy. See, e.g., Hornberger v. General Motors Corp., 929 F.Supp. 884, 887 (E.D.Pa. 1996) (noting that Article 2A did not become effective until after cause of action accrued, court held that lease transaction in question was substantially similar to sale of goods such that extension of warranty provisions of Article 2 would be justified). B. [6.7] Applicability of Article 9 Leases intended as security are subject to Article 9 of the Uniform Commercial Code. In re Loop Hospital Partnership, 35 B.R. 929 (Bankr. N.D.Ill. 1983). 810 ILCS 5/9-505 provides that the lessor may file a financing statement but that the filing is not of itself a factor in determining whether the collateral is security for an obligation. C. [6.8] Applicability of Article 2A Prior to the adoption of Article 2A of the Uniform Commercial Code, the courts began applying Article 2 of the UCC, by analogy, to equipment leasing issues. However, confusion still existed with respect to what law courts should apply when Article 2 provided no guidance. To address the confusion concerning the determination of which law to apply to leasing transactions, Article 2A was adopted by the National Conference of Commissioners on Uniform State Laws in 1986 and the American Law Institute in 1987. As noted in §6.1 above, P.A. 87-493, which adopted Article 2A in Illinois, became effective on January 1, 1992. Article 2A sets forth rules governing personal property lease transactions and carries over in large part the provisions of Article 2 pertaining to sales of goods. Article 2A is discussed in detail in §§6.11 – 6.47 below. It is important to note that Article 2A is applicable only to true leases. Leases intended as security are not within the scope of Article 2A and are to be governed by Article 9. UCC Comment, 810 ILCS 5/2A-101. 810 ILCS 5/2A-103(1)(j) defines “lease” as a “transfer of the right to possession and use of goods for a term in return for consideration.” A true lease may have non-leasing provisions. While Illinois courts have yet to address the hybrid lease/contract, one may assume that the courts will follow the dominant purpose test as they have with the application of Article 2 sales contracts. Therefore, if the predominant objective of the hybrid lease/contract is the lease of equipment, then Article 2A would presumably apply. The courts have held that although Article 2A was adopted, it does not apply retroactively to transactions that occurred prior to the effective date of its adoption in that jurisdiction. Hornberger v. General Motors Corp., 929 F.Supp. 884 (E.D.Pa. 1996); Stewart v. NationaLease of Kansas City, Inc., 920 F.Supp. 1188 (D.Kan. 1996). Although the courts decline to apply Article 2A to leases entered into prior to the effective date of its provisions, the courts tend to reference them for guidance in analyzing leases executed prior to the effective date of Article 2A, particularly in instances when the applicable provision was amended to clarify, rather than to change, the law in a substantive way. In re Bumgardner, 183 B.R. 224, 229 (D. Idaho 1995); Estep v. Fifth Third Bank of N.W. Ohio (In re Estep), 173 B.R. 126, 129 – 130 (Bankr. N.D. Ohio 1994).

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Practitioners should note that Article 2A is not applicable to guarantee agreements, except insofar as it controls the content of the lease subject to the guarantee. Ford Motor Credit Co. v. Moore, 663 A.2d 30 (Me. 1995); Innovative Office Systems, Inc. v. Johnson, 906 S.W.2d 940 (Tex.App. 1995) (upon joint motion of parties, Supreme Court of Texas granted application for writ of error without reference to merits, set aside judgments of court of appeals and trial court, and remanded case to trial court for entry of judgment in accordance with settlement agreement of parties). D. [6.9] Rights in Bankruptcy True leases are subject to §365 of the Bankruptcy Code, which permits the debtor-lessee to assume or reject the unexpired lease, subject to the court’s approval. 11 U.S.C. §365(a). While the trustee or debtor-in-possession decides whether to assume or reject the lease, the lessor may move to compel a prompt decision. Federal Rule of Bankruptcy Procedure 6006(b). If the debtor wants to assume the lease, the debtor is required to cure past defaults and provide adequate assurance of future performance. 11 U.S.C. §365(b). If, on the other hand, the lease is found to be a disguised security agreement, in order to obtain possession of the equipment, the lessor must bring a motion or complaint to modify the automatic stay under 11 U.S.C. §362. Consequently, if the lessor moves to compel the debtor promptly to assume or reject the lease, the lessee may attempt to claim that the lease was actually a security agreement. Having the lease reclassified as a security agreement will make it more difficult for the lessor to regain possession of the leased equipment. In addition, if the lease is deemed to be a security agreement, prepetition payments to the lessor may be recovered as a preference, assuming the lessor’s interest in the equipment is unperfected and the other factors indicative of a preference are demonstrated under 11 U.S.C. §547. This is particularly the case when a large arrearage is paid or reduced during the 90-day preference period. Finally, if the debtor-lessee is successful in its claim that the lease was actually a security agreement, it may also be able to avoid the lessor’s security interest under 11 U.S.C. §544(a) if the lessor’s interest was not properly perfected. Section 544(a) vests a trustee with certain strongarm powers designed to aid the trustee in recovering properties of the debtor’s estate for the eventual benefit of all creditors. See, e.g., Johnson v. First National Bank of Joliet (In re Johnson), 28 B.R. 292 (Bankr. N.D.Ill. 1983). Section 544(a) allows the trustee to succeed to the position of a hypothetical lien creditor and to avoid, among other interests, unperfected liens on property that the debtor appears to own on the date of the filing of the bankruptcy petition. The trustee, regardless of its personal knowledge or the knowledge of other creditors, acquires superior rights in all of the collateral and is entitled to priority. Furthermore, 11 U.S.C. §1107 gives the debtor-in-possession the rights of a trustee. As such, a debtor who becomes a debtor-in-possession takes on a new status as trustee acting on behalf of unsecured creditors and also can avoid unperfected liens pursuant to §544(a). Boatmen’s Bank of Benton v. Wiggs (In re Wiggs), 87 B.R. 57 (Bankr. S.D.Ill. 1988). Accordingly, the debtor-inpossession would be able to avoid any unperfected interest of the lessor with regard to the equipment.

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E. [6.10] Applicability of Usury Laws If the lease is actually a disguised security agreement, the transaction may be subject to usury and similar laws governing interest and finance charges. Usury laws generally are not applicable to true lease transactions, although it is advisable to check a particular state’s law to be safe.

V. [6.11] ARTICLE 2A In the 1970s, the courts began confronting the issue of what law would apply to equipment leases. At that time, there was no statutory or common-law set of rules that could be applied or that directly addressed personal property leasing transactions. Earlier courts attempted to apply Article 2 of the Uniform Commercial Code to equipment leases on the theory that an equipment lease is a “transaction in goods” under UCC §2-102. In re Vaillancourt, 7 UCC Rep.Serv. 748 (D.Me. 1970). See also Owens v. Patent Scaffolding Co., Division of Harsco Corp., 50 A.D.2d 866, 376 N.Y.S.2d 948, 950 (1975) (in reversing decision to apply UCC Article 2 rules regarding warranties to equipment lease, court held that “broadening application of such warranties to business transactions beyond those of sales per se . . . is irrelevant to the issue of [statutes of] limitation periods” [citation omitted]), rev’g 354 N.Y.S.2d 778 (1974). However, later courts rejected the idea of applying Article 2, in its entirety, to equipment lease issues. Walter E. Heller & Co. v. Convalescent Home of First Church of Deliverance, 49 Ill.App.3d 213, 365 N.E.2d 1285, 1289, 8 Ill.Dec. 823 (1st Dist. 1977) (“there are significant differences between a lease and a sale including the transfer of title, risk of loss, taxes, financial considerations, and bankruptcy proceedings”). See also Knox v. North American Car Corp., 80 Ill.App.3d 683, 399 N.E.2d 1355, 35 Ill.Dec. 827 (1st Dist. 1980), overruled on other grounds by Whitaker v. Lian Feng Machine Co., 156 Ill.App.3d 316, 509 N.E.2d 591, 108 Ill.Dec. 895 (1st Dist. 1987); Dillman & Associates, Inc. v. Capitol Leasing Co., 110 Ill.App.3d 335, 442 N.E.2d 311, 66 Ill.Dec. 39 (4th Dist. 1982). Essentially, equipment leasing transactions were treated by the courts as governed partly by common-law principles relating to personal property and real estate leases as well as by reference to UCC Article 2 (Sales) and UCC Article 9 (Secured Transactions). As recognized in the Foreword to Article 2A of the model UCC, the legal rules and concepts derived from these sources “imperfectly fit a transaction that involves personal property rather than realty, and a lease rather than either a sale or a security interest.” The drafting committee of Article 2A found that a lease is “closer in spirit and form to the sale of goods than to the creation of a security interest.” UCC Comment, 810 ILCS 5/2A-101. Therefore, the committee concluded that Article 2 was the appropriate statutory analogue for Article 2A, and many of the provisions and UCC comments of Article 2 are carried over in Article 2A. Id. The scope of Article 2A is limited solely to true leases. Leases intended as security are not covered by Article 2A since they are adequately dealt with in Article 9. See id.

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A. [6.12] Scope of Article 2A 810 ILCS 5/2A-102 provides that Article 2A of the Uniform Commercial Code applies to any lease transaction, regardless of form. “This article governs transactions as diverse as the lease of a hand tool to an individual for a few hours and the leveraged lease of a complex line of industrial equipment to a multi-national organization for a number of years.” UCC Comment, 810 ILCS 5/2A-102. The UCC Comment notes that despite the extensive regulatory scheme established by Article 2A, the drafters attempted to preserve freedom of contract and allow the parties to a lease to create private rules to govern the transaction. There are, however, special rules in Article 2A governing consumer leases that may restrict the freedom of contract regarding these leases. See, for example, the discussion of 810 ILCS 5/2A-106 in §6.16 below. B. [6.13] Definitions of Lease, Consumer Lease, and Finance Lease 810 ILCS 5/2A-103 sets forth the definitions applicable throughout Article 2A of the Uniform Commercial Code. Among other things, it defines “lease” as “a transfer of the right to possession and use of goods for a term in return for consideration” and specifically includes a sublease. 810 ILCS 5/2A-103(1)(j). Neither “a sale, including a sale on approval or a sale or return,” nor “retention or creation of a security interest” is a lease. Id. Also defined are the terms “consumer lease” and “finance lease” since Article 2A includes subsets of rules that specifically apply to these types of leases. 810 ILCS 5/2A-103(1)(e), 5/2A103(1)(g). The definition of a “consumer lease” is modeled after the definition in 15 U.S.C. §1667 and §1.301(14) of the former model Uniform Consumer Credit Code (see 7A U.L.A. 43 (1974)). UCC Comment (e), 810 ILCS 5/2A-103. A “consumer lease” is defined as “a lease that a lessor regularly engaged in the business of leasing or selling makes to a lessee who is an individual and who takes under the lease primarily for a personal, family, or household purpose, if the total payments to be made under the lease contract, excluding payments for options to renew or buy, do not exceed $40,000.” [Emphasis added.] 810 ILCS 5/2A-103(1)(e). A “finance lease” is defined as a lease with respect to which (i) the lessor does not select, manufacture, or supply the goods; (ii) the lessor acquires the goods or the right to possession and use of the goods in connection with the lease; and (iii) one of the following occurs: (A) the lessee receives a copy of the contract by which the lessor acquired the goods or the right to possession and use of the goods before signing the lease contract;

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(B) the lessee’s approval of the contract by which the lessor acquired the goods or the right to possession and use of the goods is a condition to effectiveness of the lease contract; (C) the lessee, before signing the lease contract, receives an accurate and complete statement designating the promises and warranties, and any disclaimers of warranties, limitations or modifications of remedies, or liquidated damages, including those of a third party, such as the manufacturer of the goods, provided to the lessor by the person supplying the goods in connection with or as part of the contract by which the lessor acquired the goods or the right to possession and use of the goods; or (D) if the lease is not a consumer lease, the lessor, before the lessee signs the lease contract, informs the lessee in writing (a) of the identity of the person supplying the goods to the lessor, unless the lessee has selected that person and directed the lessor to acquire the goods or the right to possession and use of the goods from that person, (b) that the lessee is entitled under this Article to the promises and warranties, including those of any third party, provided to the lessor by the person supplying the goods in connection with or as part of the contract by which the lessor acquired the goods or the right to possession and use of the goods, and (c) that the lessee may communicate with the person supplying the goods to the lessor and receive an accurate and complete statement of those promises and warranties, including any disclaimers and limitations of them or of remedies. 810 ILCS 5/2A-103(1)(g). As noted in UCC Comment (g) to §2A-103, the above definition focuses on the transaction rather than the status of the parties. It is important to note that, in other contexts such as tax and accounting, the term “finance lease” has been used to connote different types of lease transactions, including leases that are disguised secured transactions. However, for a lease to be deemed a “finance lease” under Article 2A, it must first qualify as a true lease rather than a lease intended as security. As such, unless the lessor is comfortable that its lease will qualify as a finance lease, the lease should contain provisions giving the lessor the benefits created by the subset of rules applicable to finance leases under Article 2A. It should also be noted that the above definition of a “finance lease” requires the lessor to remain outside the selection, manufacture, and supply of goods. In this regard, UCC Comment (g) to §2A-103 states: [T]hat is the rationale for releasing the lessor from most of its traditional liability. The lessor is not prohibited from possession, maintenance or operation of the goods, as policy does not require such prohibition. To insure the lessee’s reliance on the supplier, and not on the lessor, subsection (ii) requires that the goods (where the lessor is the buyer of the goods) or that the right to possession and use of the goods (where the lessor is the prime lessee and the sublessor of the goods) be acquired in connection with the lease (or sublease) to qualify as a finance lease. [Emphasis added.]

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The phrase “in connection with” is to be developed by the courts on a case-by-case basis. Id. UCC Comment (g) to §2A-103 also makes it clear that, absent fraud, duress, and the like, a lease that qualifies as a finance lease under Article 2A and is assigned by the lessor or the lessee to a third party does not lose its status as a finance lease under Article 2A. The following is a list of provisions or attributes that seem to be typical of a finance lease: 1. The lessor is in the business of financing leases. 2. The lease provides that the leased goods are acquired solely in connection with the lease. 3. The lease provides that the lessor does not select, manufacture, or supply the leased goods. 4. The lease provides that the leased goods are to be acquired or selected from a third party. 5. The lease disclaims warranty and promissory liability on the part of the lessor. 6. The lessee bears the risk of loss. 7. The lease contains a “hell or high water” clause. 8. The lease contains a non-cancellation clause. 9. The lease contains an accelerated payment clause. 10. The lease contains a late payment clause. 11. The lessee is obligated to pay all taxes as to the leased goods. 12. The lessee is obligated to procure and maintain insurance as to the leased goods. 13. The lessee is obligated to maintain the leased goods. 14. The lessee is obligated to pay all licensing and registration fees. 15. The lease contains a default provision (e.g., failure to pay rent, failure to maintain insurance, failure to pay taxes, and other similar provisions). 16. The lease contains provisions for the lessee’s payment of attorneys’ fees, costs, prejudgment interest, or repossession upon the lessee’s default. 17. The lessee is obligated to pay a non-substantial refundable security deposit.

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§6.13

18. The lessee is required to return the leased goods at the end of the lease term or is provided with the option to purchase the leased goods for consideration. 19. The lease provides that title to the equipment is to remain in the lessor. 20. The lessee is obligated to use markings supplied by the lessor stating that the equipment is the property of the lessor. 21. The lessee is prohibited from assigning the lease, subleasing the equipment, or pledging or otherwise disposing of the lease or the leased property or any interest therein. 22. The lessee is required to keep the leased equipment free and clear of all levies, liens, and encumbrances. E. Carolyn Hochstadter Dicker and John P. Campo, FF&E and the True Lease Question: Article 2A and Accompanying Amendments to UCC Section 1-201(37), 7 Am.Bankr.Inst.L.Rev. 517, 526 – 529 (1999). Dicker and Campo also note that while some of the above attributes have been found to be indicative of a transaction for security, the ultimate determination will depend on an analysis of §1-203 (formerly §1-201(37)). See §6.5 above. As noted above, a financing lease must first qualify as a lease. Therefore, in examining a transaction, one must ask the threshold question of whether the transaction qualifies as a lease under Article 2A. Financing for Science International, Inc. v. A.C. Trams, Inc., No. 94-3198, 1994 WL 705422 (D.N.J. Dec. 15, 1994); Colorado Interstate Corp. v. CIT Group/Equipment Financing, Inc., 993 F.2d 743, 749 (10th Cir. 1993). In AT&T Credit Corp. v. Zurich Data Corp., 37 F.Supp.2d 367 (D.N.J. 1999), the court held, among other things, that the agreement in question was a finance lease, as defined by Article 2A of the New Jersey UCC. The lessee had the right to reject the leased goods in a timely fashion if they did not conform to the lease agreement. A finance lessor is not usually subject to a products liability claim relating to leased goods unless it actively participates in the marketing or placing of those goods in the stream of commerce. Gonzalez v. Rutherford Corp., 881 F.Supp. 829 (E.D.N.Y. 1995) (applying New York law). Typically, warranties of merchantability and fitness are not applicable to finance lessors. However, if the finance lessor expressly takes on more than just a financing role by undertaking to perform express warranties or covenants, then the law will protect the lessee. Siemens Credit Corp. v. Newlands, 905 F.Supp. 757, 763 (N.D.Cal. 1994). The rationale for exempting finance lessors from implied warranties is that these lessors are in reality functioning as lenders. Finance lessors do not select or manufacture the goods and are not necessarily in a better position than the lessee to know of or have control over the underlying goods. The finance lessor would, however, be responsible for any express warranties made to the

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§6.14

SECURED TRANSACTIONS

lessee, as well as the warranty against interference. Regardless of whether the supply contract between the finance lessor and supplier names the lessee as an intended beneficiary, 810 ILCS 5/2A-209 makes the lessee of a finance lease the statutory beneficiary of the supplier’s/manufacturer’s warranties. Edwin E. Smith and Will Chou, Massachusetts Legislation Codifying the Law of Personal Property Leasing: Article 2A of the Uniform Commercial Code, 81 Mass.L.Rev. 143, 149 (1996); Newlands, supra (court found that commercial lease satisfied statutory requirements of finance lease, thereby obligating lessee to pay rent despite defective goods, and only allowing lessee to rely on warranties of supplier). In considering the issue of the finance lessor and the supplier being affiliated, the court in Newlands noted: “The fact that the prime lessor and the supplier may be affiliated companies does not eliminate the Lease’s status as a finance lease, and does not make the prime lessor’s disclaimer of warranties unenforceable.” 905 F.Supp. at 763. To the extent that a lease meets the definition of a finance lease as set forth in 810 ILCS 5/2A-103(1)(g), it would be deemed a finance lease irrespective of any affiliation between the finance lessor and supplier. Such an affiliation is insufficient to revoke the lessee’s obligation to pay the finance lessor. See UCC Comment (g), 810 ILCS 5/2A-103. In order to hold a finance lessor liable for a supplier’s alleged breach of warranty, even if that supplier is a subsidiary of the finance lessor, the lessee must establish facts that demonstrate that the finance lessor and the supplier were alter egos or otherwise disregard corporate form. Siemens Credit Corp. v. Kakos, No. 94 C 5365, 1995 WL 29618 (N.D.Ill. Jan. 24, 1995). C. [6.14] Leases Subject to Other Statutes 810 ILCS 5/2A-104 provides that leases are subject to certificate of title and consumer protection statutes of Illinois and other jurisdictions, as well as final consumer protection decisions of Illinois courts existing before Article 2A was enacted. Except for “certain limited exclusions,” in the event of a conflict between the provisions of Article 2A of the Uniform Commercial Code and such other statutes, the provisions of the other statute are to control. UCC Comment 3, 810 ILCS 5/2A-104. As such, if a conflict arises between Article 2A and a state consumer leasing statute, the latter law will prevail. See id. For an example of such a limited exception, see the discussion of sale-leaseback transactions in §6.62 below. D. [6.15] Goods Covered by Certificate of Title Generally, in cases in which goods are covered by a certificate of title, the lessor or creditor whose interest is indicated on the most recently issued certificate of title will prevail over interests shown on certificates issued previously by other jurisdictions. See UCC Comment, 810 ILCS 5/2A-105. Section 2A-105 reflects the policy that it is the burden of the lessor of goods covered by a certificate of title to police the goods when the goods are moved to another jurisdiction. As such, §2A-105 provides that the lessor will have “4 months after the goods are removed” to another jurisdiction to obtain a certificate of title issued by the new jurisdiction. 810 ILCS 5/2A-105.

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E. [6.16] Limit on Power of Parties to Consumer Lease To Choose Applicable Law and Judicial Forum Section 2A-106 of the Uniform Commercial Code recognizes the danger “that a lessor may induce a consumer lessee to agree that the applicable law will be a jurisdiction that has little effective consumer protection, or to agree that the applicable forum will be a forum that is inconvenient for the lessee in the event of litigation.” UCC Comment, 810 ILCS 5/2A-106. Consequently, the governing law chosen in a consumer lease will be unenforceable unless it is that of a jurisdiction (1) where “the lessee resides at the time the lease agreement becomes enforceable or within 30 days thereafter” or (2) where the “goods are to be used.” 810 ILCS 5/2A-106(1). Furthermore, if the judicial forum selected by the parties is a forum that would not otherwise have jurisdiction over the lease, “the choice is not enforceable.” 810 ILCS 5/2A106(2). In Demitropoulos v. Bank One Milwaukee, N.A., 953 F.Supp. 974 (N.D.Ill. 1997), the court confronted a choice-of-law issue involving an equipment lease. An automobile lease contained a clause providing that Wisconsin law would govern the parties’ disputes. In a motion to dismiss, the lessor had argued that the court should enforce the choice-of-law provision and use Wisconsin law to analyze the lessee’s consumer law claims. The court had agreed with the lessor and applied Wisconsin law to the case. Contrary to this stance, the lessor later asked the court to void the choice-of-law provision because §2A-106 forbids it. Specifically, the lessor pointed out that the parties chose a forum other than a jurisdiction in which the lessee resides. Since the lessees lived in Illinois, application of §2A-106 would render the choice-of-law provision unenforceable. The court declined to adopt the lessor’s argument, stating that §2A-106 was enacted to protect consumer lessees, not lessors. The court refused to apply the statute to subvert the very reasons for its enactment. The court, however, ignored the plain meaning of the provision by disregarding the fact that the statute does not differentiate which party is to benefit from a consumer lease. See Doe v. General Motors Acceptance Corp., 247 Wis.2d 564, 635 N.W.2d 7 (2001); Spina v. Toyota Motor Credit Corp., 301 Ill.App.3d 364, 703 N.E.2d 484, 234 Ill.Dec. 623 (1st Dist. 1998). Practitioners should note that, by using the term “judicial forum,” §2A-106 “does not limit selection of a nonjudicial forum, such as arbitration.” UCC Comment, 810 ILCS 5/2A-106. Moreover, §2A-106 does not affect “choice of forum clauses” contained in nonconsumer leases. Id. The UCC Comment to §2A-106 points out that the source for §2A-106 is §1.201(8) of the Uniform Consumer Credit Code (see 7A U.L.A. 36 (1974)), which Illinois has never adopted. F. [6.17] Unconscionability Section 2A-108 of the Uniform Commercial Code, which deals with unconscionability, borrows heavily from §2-302(1) and codifies existing law. 810 ILCS 5/2A-108. See, e.g., Dillman & Associates, Inc. v. Capitol Leasing Co., 110 Ill.App.3d 335, 442 N.E.2d 311, 66 Ill.Dec. 39 (4th Dist. 1982) (court declined to find unconscionability when businessmen of equal

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§6.18

SECURED TRANSACTIONS

sophistication entered into lease that contained provision disclaiming all responsibility for performance of leased equipment). Section 2A-108 allows a court to refuse to enforce a lease, in whole or in part, on the grounds of unconscionability. It also provides for the court to grant appropriate relief if it finds that (1) all or any portion of a consumer lease was “induced by unconscionable conduct” or that (2) “unconscionable conduct has occurred in the collection of a claim arising” from a consumer lease. [Emphasis added.] 810 ILCS 5/2A-108(2). The above provisions are not exclusive. Instead, they are in addition to remedies otherwise available for this conduct under other law (such as a tort action for abusive debt collection or another applicable state statute). UCC Comment, 810 ILCS 5/2A-108. Section 2A-108(b) also authorizes an award of reasonable attorneys’ fees if the court finds unconscionability with respect to a consumer lease. In deciding whether a lease is unconscionable, the central issue is whether the lease is so onesided and oppressive as to negate a meaningful choice on the part of the lessee. Trans Leasing International v. Schmer, 194 Ill.App.3d 70, 550 N.E.2d 1085, 141 Ill.Dec. 39 (1st Dist. 1990). In Trans Leasing, the lease provided that the “lessor makes no express or implied warranties as to the equipment and that defects in the equipment, or the unfitness of it, will not relieve the lessees from their obligation to make payments.” 550 N.E.2d at 1088. The court specifically noted that equipment leases that allow the lessee to choose the machine and supplier and obligate the lessee to bear the risk of defective equipment are in the nature of secured financing agreements. Thus, the court held, an equipment lease that requires the lessee to bear the risk of defective equipment is not unconscionable, provided that notice of this risk meets the conspicuousness requirements of the UCC. G. [6.18] Option To Accelerate at Will Section 2A-109(1) of the Uniform Commercial Code provides that a lease provision allowing a lessor to accelerate “at will” or “when he or she deems himself or herself insecure” will require that the lessor “in good faith believes that the prospect of payment or performance is impaired” before the lessor can accelerate. [Emphasis added.] 810 ILCS 5/2A-109(1). With regard to a consumer lease, “the burden of establishing good faith” is on the party who exercised the power. 810 ILCS 5/2A-109(2). In other leases, the burden is on the party against whom the power has been exercised. Id. As the UCC Comment to §2A-109 recognizes, a lease provision allowing the lessor to accelerate if it deems itself insecure is typically mandated by the lessor in a consumer lease and obviously is of critical importance to the lessee. Since its invocation depends not on specific criteria but on the discretion of the lessor, §2A-109 attempts to provide some regulation on its use in order to prevent abuse. The UCC Comment to §2A-109 notes that §2A-109, while borrowed from 810 ILCS 5/1-208, reflects a significant change from §1-208 by creating the above exception for consumer leases.

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H. [6.19] Statute of Frauds Section 2A-201 of the Uniform Commercial Code is modeled after 810 ILCS 5/2-201, setting forth a statute of frauds with respect to sales of goods. UCC Comment, 810 ILCS 5/2A-201. Section 2A-201(1) provides that a lease is enforceable if (a) the total payments . . . made under the lease . . . excluding payments for options to renew or buy, are less than $1,000; or (b) there is a writing, signed by the party against whom enforcement is sought or by that party’s . . . agent, sufficient to indicate that a lease contract has been made between the parties and to describe the goods leased and the lease term. [Emphasis added.] 810 ILCS 5/2A-201(1). A description of the leased goods or of the lease term is sufficient, regardless of whether it is specific, if it “reasonably identifies what is described.” 810 ILCS 5/2A-201(2). Section 2A-201(4) creates exceptions for transactions involving the following: 1. goods specifically manufactured or obtained for the lessee, for which the lessor has made a substantial beginning of their manufacture or commitments for their procurement, and that are not suitable for lease or sale to others in the ordinary course of the lessor’s business; 2. a judicial admission by the party against whom enforcement is sought that a lease contract is made; and 3. goods that have been received and accepted by the lessee. When, in the absence of a writing, the court finds an enforceable lease based on one of the exceptions set forth above, if no lease term is indicated, a “reasonable lease term” will be implied. 810 ILCS 5/2A-201(5)(c). It should be noted that, unlike §2-201, §2A-201 creates no exception for enforceability when payment has been made and accepted. According to the UCC Comment to §2A-201, the rationale for this departure is grounded in the distinction between sales and leases. Unlike a buyer in a sales transaction, the lessee does not tender payment in full for goods delivered, but only payment of rent for one or more months. The drafters decided that this act of payment is not a sufficient substitute for the required writing. I. [6.20] Miscellaneous Lease Formation and Construction Rules Sections 2A-202 through 2A-206 of the Uniform Commercial Code carry over rules of formation and construction from Article 2 pertaining to parol or extrinsic evidence (810 ILCS 5/2A-202), seals (810 ILCS 5/2A-203), formation in general (810 ILCS 5/2A-204), firm offers (810 ILCS 5/2A-205), and offer and acceptance in formation of the lease contract (810 ILCS 5/2A-206).

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§6.21

SECURED TRANSACTIONS

While the language of these Article 2A provisions is nearly identical to their Article 2 counterparts, there are several differences. Article 2A does not contain a “battle of the forms” provision as does Article 2. The UCC comments offer no guidance on the issue of “battle of the forms” confrontations in lease negotiations. Article 2A also does not contain any gap-filler provisions to supply missing terms to leases, but the courts are more likely to look to Article 2 by analogy for the gap fillers than for the battle of the forms provisions. J. [6.21] Modification Section 2A-208(1) of the Uniform Commercial Code provides that an agreement modifying a lease “needs no consideration to be binding.” 810 ILCS 5/2A-208(1). While §2A-208 borrows from §2-209(3), it does not incorporate a provision stating that the “requirements of the statute of frauds” be satisfied if the contract “as modified” is within its scope. 810 ILCS 5/2-209(3). This provision was not carried over because the drafters deemed it unfair to allow an oral modification, which may take the lease contract only a few dollars over the dollar limit, to make the entire contract unenforceable. However, the drafters also recognized that the problem could not be solved by providing that the lease contract would still be enforceable in its premodification state (assuming it then satisfied the statute of frauds) since, in certain cases, this might be worse than no enforcement at all. As such, the drafters opted to let the courts resolve this issue based on the facts of each case. See UCC Comment, 810 ILCS 5/2A-208. K. [6.22] Lessee Under Finance Lease as Beneficiary of Supply Contract Section 2A-209 of the Uniform Commercial Code recognizes that the function performed by the lessor in a finance lease is extremely limited and, therefore, the lessee looks to the supplier of the goods for warranties. See UCC Comment 1, 810 ILCS 5/2A-209. Accordingly, §2A-209 contains several provisions that protect the lessee as the beneficiary of a supply contract. First, §2A-209(1) provides that the benefit of the supplier’s promises and warranties, “whether express or implied . . . extends to the lessee” (subject to the supplier’s defenses). [Emphasis added.] 810 ILCS 5/2A-209(1). And of course, the lessees are also subject to those warranty terms and all defenses associated therewith. UCC Comment 1, 810 ILCS 5/2A-209. Section 2A-209(3) provides: Any modification or rescission of the supply contract by the supplier and the lessor is effective between the supplier and the lessee unless, before the modification or rescission, the supplier has received notice that the lessee has entered into a finance lease related to the supply contract. If the modification or rescission is effective between the supplier and the lessee, the lessor is deemed to have assumed, in addition to the obligations of the lessor to the lessee under the lease contract, promises of the supplier to the lessor and warranties that were so modified or rescinded as they existed and were available to the lessee before modification or rescission. 810 ILCS 5/2A-209(3).

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§6.24

UCC Comment 5 to §2A-209 indicates that the courts are to establish the parameters of causes of action by the supplier against the lessor based on the facts of each individual case. The comments further note that the benefit extended to the lessee by the above provisions is not without a price since 810 ILCS 5/2A-407(1) provides that in the case of a nonconsumer finance lease, the lessee’s promises to the lessor (e.g., promise to pay rent) under the lease become “irrevocable and independent” upon the lessee’s acceptance of the goods. UCC Comment 3, 810 ILCS 5/2A-209. Practitioners should note that §2A-209 is modeled in part on §9-404, which deals with defenses against an assignee in transactions in which accounts or general intangibles constitute the collateral. 810 ILCS 5/9-404 provides that any defense or claim of an account debtor arising from its contract with the assignor may be asserted by the account debtor against the assignee (unless the account debtor entered into an enforceable agreement to the contrary). L. [6.23] Express Warranties Section 2A-210 of the Uniform Commercial Code incorporates into Article 2A all of the express warranties found in Article 2, revised to take into account the differences between sales and leases. 810 ILCS 5/2A-210(1)(b). Like Article 2, §2A-210(1)(b) provides that “[a]ny description of the goods . . . creates an express warranty that the goods will conform to the description.” It is not necessary to the creation of an express warranty that the lessor use formal words, such as “warrant” or “guarantee” or that the “lessor have a specific intention to make a warranty.” 810 ILCS 5/2A-210(2). M. [6.24] Warranties Against Interference and Infringement; Lessee’s Obligation Against Infringement Section 2A-211 of the Uniform Commercial Code is modeled after 810 ILCS 5/2-312 with revisions to reflect the limited interest transferred to the lessee under a lease in contrast to the total interest transferred to a buyer in a sale. UCC Comment, 810 ILCS 5/2A-211. Section 2A211(1) provides that in each lease there is a warranty that, except for “infringement or the like,” no person holding a claim or interest that arose from an act or omission of the lessor will be able to interfere with the lessee’s use and enjoyment of the goods for the lease term. 810 ILCS 5/2A211(1). Except in a finance lease, a lease “by a lessor who is a merchant regularly dealing in goods of the kind [includes] a warranty that the goods are delivered free of the rightful claim of any person by way of infringement or the like.” [Emphasis added.] 810 ILCS 5/2A-211(2). Finance lessors are excluded from this warranty as with other implied warranties; the lessee under a finance lease is to look to the supplier for these warranties. UCC Comment, 810 ILCS 5/2A-211. Finally, under §2A-211(3), “[a] lessee who furnishes specifications to a lessor or a supplier shall hold the lessor and the supplier harmless against any claim by way of infringement or the like [arising] out of compliance with the specifications.” 810 ILCS 5/2A-211(3). This provision is derived from §2-312(3), which contains similar language applicable to a buyer of goods furnishing specifications.

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§6.25

SECURED TRANSACTIONS

N. [6.25] Implied Warranties 810 ILCS 5/2A-212 extends to leases the implied warranties of merchantability set forth in §2-314 of the Uniform Commercial Code, revised to take into account leasing practices and terminology. It also provides that additional implied warranties may arise from a course of dealing or trade usage. 810 ILCS 5/2A-213 extends the implied warranty of fitness for a particular purpose to leases, similar to §2-315 of the UCC, applicable to sales of goods. However, finance leases are excluded from the coverage of both §§2A-212 and 2A-213. O. [6.26] Exclusion or Modification of Warranties Similar to Article 2 of the Uniform Commercial Code regarding sales, implied warranties can be excluded or modified in lease transactions in two ways. The first is by a writing. For a writing to exclude or modify the warranty of merchantability, it must mention “merchantability” and “be conspicuous.” 810 ILCS 5/2A-214(2). For a writing properly to exclude or modify a warranty of fitness, it also must be conspicuous. For a writing to exclude or modify the implied warranty against interference or infringement, it must be specific and conspicuous. Id. Alternatively, all of these warranties may be excluded or modified by course of performance, course of dealing, or trade usage. 810 ILCS 5/2A-214(3)(c). Section 2A-214 does not address warranties made in a supply contract that may be related to a finance lease. It should be noted that §2A-214(4) provides that the “warranty against interference or against infringement” may be excluded or modified when circumstances “give the lessee reason to know that the goods are being leased subject to a claim or interest of any person.” 810 ILCS 5/2A214(4). This language borrows from 810 ILCS 5/2-312(2). Section 2A-214 provides a more unified treatment of disclaimers than in Article 2. The latter makes certain distinctions among the rules for disclaiming certain warranties. For example, Article 2 requires that the disclaimer of the implied warranty of fitness be in writing; there is no such requirement for the disclaimer of the implied warranty of merchantability to be in writing. See 810 ILCS 5/2-316(2). The drafters of Article 2A recognized that there is no policy regarding leases that would justify continuing certain distinctions found in Article 2 concerning the treatment of the disclaimer of the various warranties. See UCC Comment, 810 ILCS 5/2A-214. “ ‘[A] written disclaimer of an express warranty contained elsewhere in the same contract is generally inoperable.’. . . This general rule is subject to parol or extrinsic evidence ‘which would indicate that it is reasonable to construe the disclaimer as negating the express warranty.’ ” [Citations omitted.] AAR International, Inc. v. Vacances Heliades S.A., 202 F.Supp.2d 788, 795 (N.D.Ill. 2002), quoting Lake Bluff Heating & Air Conditioning Supply, Inc. v. Harris Trust & Savings Bank, 117 Ill.App.3d 284, 452 N.E.2d 1361, 1367, 72 Ill.Dec. 665 (2d Dist. 1983).

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P. [6.27] Third-Party Beneficiaries of Express and Implied Warranties As in §2-318 of the model Uniform Commercial Code governing sales of goods, §2A-216 of the model UCC sets forth three alternatives for extending express and implied warranties to thirdparty beneficiaries of leases. Each state can select its own alternative. Alternative A of §2A-216 of the model UCC extends the warranty “to any natural person who is in [lessee’s] family or household . . . or who is a guest in the lessee’s home if it is reasonable to expect that such person may use, consume, or be affected by the goods.” Alternative B extends the warranty “to any natural person who may reasonably be expected to use, consume, or be affected by the goods.” Alternative C extends the warranty “to any person who may reasonably be expected to use, consume, or be affected by the goods.” None of the three alternatives precludes the lessor from excluding or modifying warranties under the lease or from limiting the lessee’s rights and remedies. If the lease excludes or modifies warranties or limits remedies for breach with respect to the lessee, these provisions are enforceable against the beneficiary. See UCC Comment, 810 ILCS 5/2A-216. It should be noted, however, that all the alternatives forbid discrimination against the beneficiary. In other words, the lessor cannot exclude its liability to the beneficiary for any warranties that the lessor made to the lessee. Id. The Illinois General Assembly chose Alternative C, the broadest of the three alternatives. While the UCC Comment to §2A-216 recommends that the individual state legislatures adopt the alternative parallel to the choice made in §2-318, the Illinois General Assembly chose Alternative A, the narrowest of the alternatives, in 810 ILCS 5/2-318. The Illinois legislature has therefore “expanded the reach of privity in lease transactions in Illinois beyond what the common law allowed.” Illinois Code Comment, 810 ILCS 5/2A-216. Q. [6.28] Insurance and Proceeds Section 2A-218 of the Uniform Commercial Code, derived from 810 ILCS 5/2-501, pertains to insurable interests and proceeds and provides, in part, that a lessee obtains an insurable interest when existing goods are identified to the lease contract even though the identified goods are nonconforming and the lessee has an option to reject them. 810 ILCS 5/2A-218. However, notwithstanding the lessee’s insurable interest, the lessor retains an insurable interest until (1) the lessee has exercised an option to buy, and (2) the “risk of loss has passed to the lessee.” 810 ILCS 5/2A-218(3). Section 2A-218(5) also provides that the parties may by agreement obligate one or more parties to obtain and pay for insurance covering the goods and determine the beneficiary of the insurance proceeds. The exercise of the option to buy by the lessee is deemed exercised at the time that the transaction is closed, not at the time the lessee gives notice to the lessor. UCC Comment, 810 ILCS 5/2A-218.

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§6.29

SECURED TRANSACTIONS

R. [6.29] Risk of Loss; Effect of Default on Risk of Loss; Casualty Section 2A-219 of the Uniform Commercial Code contains rules regarding risk of loss and draws a distinction between finance and non-finance leases. 810 ILCS 5/2A-219. In a finance lease, the risk of loss passes to the lessee. In a non-finance lease, however, the lessor retains the risk of loss. 810 ILCS 5/2A-219(1). The parties may alter these provisions by express agreement. Illinois Code Comment, 810 ILCS 5/2A-219. The remainder of §2A-219 sets forth rules as to when the risk of loss is to pass if no time of passage is stated. These rules generally provide that the risk of loss passes to the lessee upon the lessee’s receipt of the goods if the lessor or, in the case of a finance lease, the supplier, is a merchant; otherwise, the risk of loss passes to the lessee on tender of delivery. Section 2A-219 states rules consistent with current practice in lease transactions but does not deal with responsibility for loss caused by the wrongful act of either the lessor or lessee. See UCC Comment, 810 ILCS 5/2A-219. The issue of negligent acts is left to the general law of property or other applicable law. See id. Section 2A-220 contains rules governing risk of loss in the event of a default by the lessor or lessee and again distinguishes between finance and non-finance leases. 810 ILCS 5/2A-220. In the case of a lessor’s default, §2A-220 does not prevent a lessee from treating the risk of loss as remaining with the supplier in a finance lease, although 810 ILCS 5/2A-517 limits the lessee’s opportunity to do so. UCC Comment, 810 ILCS 5/2A-220. In the case of a lessee’s default under a finance lease, the lessor or supplier may treat the risk of loss as having passed only “to the extent of any deficiency in [the] effective insurance coverage” of the lessor or supplier. 810 ILCS 5/2A-220(2). 810 ILCS 5/2A-221 sets forth rules regarding risk of loss in the event that the goods suffer casualty without the fault of the lessee, lessor, or supplier before delivery or before risk of loss passes to the lessee either under §2A-219 or pursuant to the lease agreement. Section 2A-221 also draws a distinction with respect to the treatment of finance leases. In Excel Auto & Truck Leasing, L.L.P. v. Alief Independent School District, 249 S.W.3d 46, 48 (Tex.App. 2007), school districts and taxing units brought an action against a motor vehicle leasing company seeking to collect delinquent taxes. The Texas appellate court held that because the leasing company’s agreement with its customers did not include a “hell or high water clause,” which provides that once the lessee accepts the leased item it must pay its rent in all events without regard for the proper function of the item or the conduct of the lessor, the company was the owner of the vehicles and therefore liable for the taxes. 249 S.W.3d at 51. S. [6.30] Enforceability of Lease Contract Section 2A-301 of the Uniform Commercial Code is of particular significance since it states that a lease contract is effective and enforceable according to its terms between the parties as well as “against purchasers of the goods and against creditors of the parties.” 810 ILCS 5/2A-301. The

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effectiveness or enforceability of the lease contract is not dependent on the lease contract or any financing statement being filed or recorded. See UCC Comment 2, 810 ILCS 5/2A-301. As discussed in §6.8 above, Article 2A applies only to true leases, not leases intended as security. As such, if the agreement is a true lease, §2A-301 provides that a financing statement is not necessary to protect the lessor’s interest. UCC Comment 2 to §2A-301 recognizes, however, that lessors who are concerned about whether the transaction creates a lease or a security interest will continue to file a protective financing statement. 810 ILCS 5/9-505, which permits a lessor to make such a protective filing, specifically provides that this filing shall not be used as evidence that the lease is intended as security. Lessors also typically file financing statements with their secretary of state’s office to give notice to the world of the lessor’s interest. This is especially important for a lessor when the leased property is used or stored with other non-leased property and may result in a third-party creditor being confused about which goods are in fact owned by the lessee. T. [6.31] Transfers and Assignments of Interests Section 2A-303 of the Uniform Commercial Code, which pertains to transfers and assignments of leases, is derived in part from 810 ILCS 5/2-210. 810 ILCS 5/2A-303. However, unlike §2-210, which deals only with voluntary transfers of interests under sales contracts, §2A303 deals with involuntary transfers as well as voluntary transfers. Section 2A-303 permits voluntary transfers of lease interests unless (1) the lease prohibits them; or (2), as is also the case for involuntary transfers, there is a material change in the duty of or a material increase in the burden or risk to the other party to the lease and the transferee fails to comply with certain conditions specified in §2A-303(2) within a reasonable time after a demand. Practitioners should note that to “prohibit the transfer of an interest of a party under the lease,” the language must be (1) specific, (2) written, and (3) conspicuous. 810 ILCS 5/2A303(7). This provision was included in recognition of the disfavor of the law regarding restrictions on lease transfers. See UCC Comment 8, 810 ILCS 5/2A-303. U. [6.32] Subsequent Lease of Goods by Lessor Section 2A-304(1) of the Uniform Commercial Code, which carries over the provisions of 810 ILCS 5/2-403, provides that “a subsequent lessee from a lessor of goods under an existing lease . . . obtains, to the extent of the . . . interest transferred, the leasehold interest in the goods that the lessor had or had power to transfer.” 810 ILCS 5/2A-304(1). As UCC Comment 4 to 810 ILCS 5/2A-304 notes, the subsequent lessee obtains all rights acquired under the law of agency, apparent agency, ownership, or estoppel. The subsequent lessee takes subject to the existing lease contract, including the existing lessee’s right thereunder. Id. Section 2A-304 should be read in conjunction with §2A-303 dealing with assignment of rights and delegation of duties. UCC Comment 1, 810 ILCS 5/2A-304.

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SECURED TRANSACTIONS

V. [6.33] Sale or Sublease of Goods by Lessee 810 ILCS 5/2A-305, which is modeled on 810 ILCS 5/2-403, provides that a buyer or sublessee from the lessee obtains, to the extent of the interest transferred, the leasehold interest in the goods that the lessee had or that the lessee had the power to transfer. W. [6.34] Priority of Certain Liens Arising by Operation of Law 810 ILCS 5/2A-306 provides that if a person furnishes services or materials with respect to leased goods, a lien given that person “by statute or rule of law” will take “priority over any interest of the lessor or lessee under the lease contract” or Article 2A unless this statute or law provides otherwise. However, the creation of such a lien may result in a default by the lessee under the lease agreement. The lessor should include a provision in the lease agreement that defines the creation of a third-party lien on the leased goods as an “event of default” and breach of the lease agreement. X. [6.35] Priority of Certain Other Liens Section 2A-307 of the Uniform Commercial Code sets forth priorities of leases and security interests in the leased goods. 810 ILCS 5/2A-307. “Except as otherwise provided in Sections 9317, 9-321 and 9-323, a lessee takes a leasehold interest subject to a security interest held by a creditor of the lessor.” 810 ILCS 5/2A-307(3). Y. [6.36] Special Rights of Creditors Section 2A-308(1) of the Uniform Commercial Code provides that if a lessor retains possession of the leased goods, a creditor of that lessor may treat the lease as void if, as against such creditor, the lessor’s retention of possession is fraudulent under any statute or rule of law. 810 ILCS 5/2A-308(1). Section 2A-308(1) states that the lessor’s retention of possession is not fraudulent if it is (1) in good faith, (2) in the current course of trade, and (3) for a commercially reasonable time after the lease becomes enforceable. Section 2A-308(3) states a rule with regard to sale-leaseback transactions (i.e., the seller sells goods to a buyer but retains possession pursuant to a lease between the buyer as lessor and seller as lessee). UCC Comment, 810 ILCS 5/2A-308. Notwithstanding any statute or rule of law that would treat this retention as fraud, whether per se, prima facie, or otherwise, the retention is not fraudulent if the buyer bought “for value” and “in good faith.” 810 ILCS 5/2A-308(3). The foregoing provision is apparently one of the “limited exclusions” referred to in UCC Comment 3 to 810 ILCS 5/2A-104, which states that, except for certain limited exclusions, in the event of a conflict between the provisions of Article 2A and other statutes, the provisions of the other statutes control. Under §2A-308, however, Article 2A controls with respect to the seller’s retention of possession in sale-leaseback transactions.

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It should also be noted that §2A-308 is modeled on 810 ILCS 5/2-402(2), dealing with the rights of the seller’s creditors against sold goods. Section 2A-308 overrides §2-402(2) to the extent that it would otherwise apply to a sale-leaseback transaction. See UCC Comment, 810 ILCS 5/2A-308. Z. [6.37] Rights of Lessor and Lessee When Goods Become Fixtures Section 2A-309 of the Uniform Commercial Code contains various priority rules with respect to fixtures and the filings that need to be made and is modeled on former UCC §9-313 (see now 810 ILCS 5/9-334). 810 ILCS 5/2A-309. Section 2A-309 requires the lessor to make a “fixture filing” in order to retain priority of its interest in a leased fixture. Certain exceptions, however, are carved out. For example, the “interest of a lessor of fixtures, whether or not perfected,” will retain priority over an encumbrancer or owner of the real estate if 1. the fixtures are “readily removable factory or office machines” or readily removable equipment “that is not primarily used or leased for use in the operation of the real estate”; 2. “the conflicting interest is a lien on the real estate obtained by legal or equitable proceedings after the lease contract is enforceable”; 3. “the encumbrancer or owner has consented in writing to the lease or has disclaimed an interest in the goods as fixtures”; or 4. “the lessee has a right to remove the goods as against the encumbrancer or owner.” 810 ILCS 5/2A-309(5). While §2A-309(5) covers “readily removable equipment,” it also adds the qualifier that this equipment not be “used or leased for use in the operation of the real estate.” Id. This “qualifier is intended to exclude from the expanded rule equipment integral to the operation of real estate, e.g., heating and air conditioning equipment.” UCC Comment 3, 810 ILCS 5/2A-309. Section 2A-309 is also more liberal than 810 ILCS 5/9-334 since it provides that issues of priority not otherwise resolved in §2A-309 are left for resolution “by the priority rules governing conflicting interests in real estate.” 810 ILCS 5/2A-309(7). This is in contrast to §9-334(c), providing for automatic subordination of the security interest in fixtures. Section 2A-309(9) provides that “[e]ven though the lease agreement does not create a security interest,” the lessor of fixtures may perfect its interest by filing a financing statement under Article 9. 810 ILCS 5/2A-309(9). Accordingly, §2A-309 provides a mechanism for perfection regarding fixtures. As UCC Comment 6 to 810 ILCS 5/2A-309 warns, the relevant provisions of Article 9 “must be interpreted permissively to give effect to this mechanism as it implicitly expands the scope” of perfection and priority provisions of Article 9 to govern transactions creating a lease of fixtures, “even though the lease agreement does not create a security interest.”

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In light of the foregoing, practitioners should make a fixture filing if the leased goods are fixtures. If there is any uncertainty as to whether the goods are fixtures, a filing should be made to be safe and protect the lessor’s interest in the leased goods. AA.

[6.38] Accessions

Section 2A-310 of the Uniform Commercial Code is derived from former UCC §9-314 (see now 810 ILCS 5/9-335) and addresses accessions (i.e., goods installed in or affixed to other goods). 810 ILCS 5/2A-310(1). The interest of a lessor or a lessee under a lease contract entered into before the goods become accessions is superior to all interests “in the whole” (810 ILCS 5/2A-310(2)) except 1. buyers and lessees “in the ordinary course of business of any interest in the whole acquired after the goods became accessions” (810 ILCS 5/2A-310(4)(a)); and 2. “a creditor with a security interest in the whole perfected before the lease contract was made to the extent that the creditor makes subsequent advances without knowledge of the lease contract” (810 ILCS 5/2A-310(4)(b)). Similar to §9-335(e), §2A-310 sets forth provisions for removal of accessions. If the lessor or lessee of accessions holds an interest “superior to all interests in the whole,” it may remove the goods, provided it reimburses any holder of an interest in the whole (other than the lessee) for the cost of repairing any damage caused by the removal. 810 ILCS 5/2A-310(5). The foregoing removal right may be exercised by the lessor or lessee either 1. upon “default, expiration, termination, or cancellation of the lease” by the other party; or 2. “if necessary to enforce [the] other rights and remedies” of the lessor or lessee under Article 2A. Id. Finally, a person entitled to reimbursement may refuse a party permission to remove until it receives adequate security for the performance of this obligation. Id. BB.

[6.39] Performance of Lease Contract: Repudiated; Substituted; and Excused

Part 4 of Article 2A of the Uniform Commercial Code, 810 ILCS 5/2A-401 through 5/2A407, addresses issues relating to the performance of the lease contract. Sections 2A-401 through 2A-407 generally track the provisions in Article 2 that pertain to performance of contracts for sales of goods but were revised to reflect leasing practices and terminology. Section 2A-401 deals with insecurity. Similar to 810 ILCS 5/2-609, §2A-401(2) provides that if “reasonable grounds for insecurity arise with respect to the performance of either party,” the insecure party may demand written assurance of due performance. 810 ILCS 5/2A-401(2). Until this assurance is received, the insecure party may suspend performance if commercially

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reasonable. The lease is repudiated if this assurance is not provided “within a reasonable time,” not to exceed 30 days after receipt of the demand for assurance. 810 ILCS 5/2A-401(3). Sections 2A-402 and 2A-403 concern anticipatory repudiation and are modeled after 810 ILCS 5/2-610 and 5/2-611, respectively. Section 2A-404, which deals with substituted performance and is modeled after 810 ILCS 5/2-614, provides for acceptance by the lessee of a “commercially reasonable substitute” under certain circumstances. Section 2A-405 sets forth rules to be complied with for excused performance (i.e., if delays in delivery or nondelivery in whole or in part are not to be deemed defaults under the lease). Section 2A-405 incorporates the provisions of 810 ILCS 5/2-615. Section 2A-406 is modeled on 810 ILCS 5/2-616 and deals with the procedure to be followed concerning an excused performance under §2A-405. Section 2A-406 provides that, in the event of such an excused performance, the lessee may either (1) terminate the lease or (2) modify the lease by accepting the available quota of goods. A nonconsumer finance lease, however, is excluded from the second alternative. Section 2A-407 of the UCC specifically addresses finance leases and is critical to the lessor. Section 2A-407(1) provides that, in a nonconsumer finance lease, the acceptance by the lessee of the goods causes the lease to become irrevocable. Once it becomes irrevocable, the lease “is not subject to cancellation, termination, modification, repudiation, excuse, or substitution” without the lessor’s consent. 810 ILCS 5/2A-407(2)(b). In AAR International, Inc. v. Vacances Heliades S.A., 202 F.Supp.2d 788 (N.D.Ill. 2002), the lessor of an aircraft sued the lessee for breach of lease and argued that the lessee’s acceptance of the aircraft, evidenced by a lease supplement, bars the lessee from exercising any rights or receiving any remedy under the lease agreement. The court held that “[a]cceptance does not itself impair any other remedy provided by [Article 2A] or the lease agreement for nonconformity.” 202 F.Supp.2d at 796, quoting 810 ILCS 5/2A-516(2). Section 2A-407 extends the benefits of the classic “hell or high water” clause to a nonconsumer finance lease and is designed to make covenants in a finance lease irrevocable and independent due to the limited function of the finance lessor in the three-party relationship — the lessee is looking to the supplier to perform the essential covenants and warranties. See UCC Comment 1, 810 ILCS 5/2A-407. As such, §2A-407 requires the lessee to perform even if the lessor’s acceptance is not in accordance with the lease. In these situations, the lessee, however, may pursue a cause of action against the lessor (e.g., for breach of certain limited warranties). 810 ILCS 5/2A-210, 5/2A-211(1). As UCC Comment 2 to 810 ILCS 5/2A-407 notes, this treatment is “appropriate” given that “the benefit of the supplier’s promises and warranties to the lessor under the supply contract . . . extend[s] to the lessee” under §2A-209. A hypothetical is given in the UCC comments to illustrate the impact of §2A-407. The hypothetical involves a five-year finance lease for equipment with A as the lessor, B as the lessee,

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§6.40

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and C as the manufacturer/supplier. Under the hypothetical, if the equipment malfunctions after delivery and acceptance, the following will apply: Under this Article, because the lease is a finance lease, no warranty of fitness or merchantability is extended by A to B. Sections 2A-212(1) and 2A-213. Absent an express provision in the lease agreement, application of Section 2A-210 or Section 2A-211(1), or application of the principles of law and equity, including the law with respect to fraud, duress, or the like (Sections 2A-103(4) and 1-103), B has no claim against A. B’s obligation to pay rent to A continues as the obligation became irrevocable and independent when B accepted the line of equipment (Section 2A407(1)). B has no right of set-off with respect to any part of the rent still due under the lease. Section 2A-508(6). However, B may have another remedy. Despite the lack of privity between B and C (the purchase order with C having been assigned by B to A), B may have a claim against C. Section 2A-209(1). UCC Comment 5, 810 ILCS 5/2A-407. CC.

[6.40] Default Procedure

Part 5 of Article 2A of the Uniform Commercial Code, 810 ILCS 5/2A-501 through 5/2A532, addresses issues arising in connection with defaults under a lease agreement. Section 2A-501 deals with default procedure and borrows from 810 ILCS 5/9-501. Section 2A-501(3) provides that if the lessor or lessee is in default, the party seeking enforcement may (1) “reduce the party’s claim to judgment” or (2) “otherwise enforce the lease . . . by self-help or any available judicial . . . or nonjudicial procedure,” including arbitration or the like. 810 ILCS 5/2A501(3). In effect, the scope of the above procedures is consistent with the procedures available to a foreclosing secured party. See UCC Comment 3, 810 ILCS 5/2A-501. However, §2A-501 represents a “departure” from Article 9 in certain respects. See UCC Comment 1, 810 ILCS 5/2A-501. For instance, §2A-501 recognizes the potential default of either party, a function of the bilateral nature of the obligations between the parties to a lease. Id. DD.

[6.41] Notice After Default

“Except as otherwise provided in [Article 2A] or the lease agreement, the lessor or lessee in default . . . is not entitled to notice of default or . . . enforcement from the other party.” 810 ILCS 5/2A-502. As the UCC Comment to §2A-502 recognizes, although Article 9 requires notice of disposition and strict foreclosure, the law regarding leases developed under common law and codified under Article 2A generally does not require notice of enforcement. Certain sections of Article 2A, however, do require notice. See, e.g., 810 ILCS 5/2A-517(4), regarding notice of a lessee’s revocation of acceptance. EE.

[6.42] Modification or Impairment of Rights and Remedies

Section 2A-503(1) of the Uniform Commercial Code provides that “the lease agreement may include rights and remedies for default in addition to or in substitution for those provided [under

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Article 2A] and may limit or alter the measure of damages recoverable under” Article 2A. 810 ILCS 5/2A-503(1). Section 2A-503, therefore, confirms the rights of the parties to a lease agreement to have the freedom to provide for rights and remedies in addition to or in substitution for those provided under Article 2A. Any limitation “of consequential damages” for personal injury “in the case of consumer goods is prima facie unconscionable,” but this limitation is not if the loss is commercial. 810 ILCS 5/2A-503(3). It should be noted that under §2A-503(2), if an exclusive remedy provision in a lease is held to be unconscionable, remedies under Article 2A are available. FF. [6.43] Liquidation of Damages Section 2A-504 of the Uniform Commercial Code addresses liquidation of damages. 810 ILCS 5/2A-504. Damages payable upon default of either party may be liquidated in the lease agreement at an amount or by a formula that “is reasonable in light of the then anticipated harm.” 810 ILCS 5/2A-504(1). It should be noted that §2A-504(1) specifically provides that lost tax benefits and loss of the lessor’s residual interest may be included as liquidated damages. GG. [6.44] Statute of Limitations Section 2A-506(1) of the Uniform Commercial Code provides that the statute of limitations with respect to lease contracts is four years “after the cause of action accrued,” but the parties to the lease may reduce this period to not less than one year. 810 ILCS 5/2A-506(1). An action for default accrues when the breach is or should have been discovered. 810 ILCS 5/2A-506(2). See also Imaging Financial Services, Inc. v. Graphic Arts Services, Inc., 172 F.R.D. 322, 329 n.6 (N.D.Ill. 1997), in which the court stated: “In Illinois, amendments to statutes of limitation are generally given retroactive effect. . . . Under [§2A-506(1)], ‘[a]n action for default under a lease contract, including breach of warranty or indemnity, must be commenced within 4 years after the cause of action accrued.’ ” HH. [6.45] Default by Lessor — Lessee’s Remedies Section 2A-508 of the Uniform Commercial Code addresses the remedies of the lessee in the event of the lessor’s default. 810 ILCS 5/2A-508. The lessee has the right to reject goods, cancel the lease contract, and recover damages and any payments made to the lessor. 810 ILCS 5/2A508(1). It should be noted that although §2A-508 gives no special treatment to finance leases, “in the case of most finance leases, following the lessee’s acceptance of the goods the lessee will have no rights or remedies against the lessor, because the lessor’s obligations to the lessee are minimal.” UCC Comment 10, 810 ILCS 5/2A-508. II. [6.46] Effect of Acceptance of Goods Section 2A-516(2) of the Uniform Commercial Code concerns the effect of acceptance of goods by the lessee and provides that this acceptance “precludes rejection of the goods accepted.” 810 ILCS 5/2A-516(2). In the case of a finance lease, if acceptance is made “with knowledge of a nonconformity,” it cannot be revoked. Id. In all other cases, “if made with knowledge of a

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nonconformity, acceptance cannot be revoked” unless the acceptance was on the “reasonable assumption that the nonconformity would be seasonably cured.” Id. Practitioners should note the above distinction for finance leases. The special rule for finance leases is “not inequitable” since the lessee has a direct claim against the supplier under 810 ILCS 5/2A-209(1). UCC Comment 1, 810 ILCS 5/2A-516. Revocation of acceptance of a finance lease is permitted if the lessee’s acceptance was “without discovery of the nonconformity” and “reasonably induced by the lessor’s assurances.” Id. JJ. [6.47] Default by Lessee — Lessor’s Remedies In the event that the lessee defaults under the lease, the lessor may 1. cancel the lease contract; 2. proceed respecting goods not identified to the lease contract; 3. withhold delivery of goods and take possession of goods already delivered; 4. stop delivery of the goods by any bailee; 5. dispose of the goods and recover damages or retain the goods and recover damages or, in a proper case, recover rent; or 6. pursue any other remedies as provided in the lease. 810 ILCS 5/2A-523(1). 810 ILCS 5/2A-505 and 5/2A-524 through 5/2A-529 discuss in detail the foregoing cumulative remedies triggered upon default. It should be noted that Article 2A rejects the doctrine of election of remedies. Whether, in a particular case, one remedy precludes another depends on whether the lessor has been put in as good a position as if the lessee had fully performed the lease contract. Uniform Commercial Code Comment 4, 810 ILCS 5/2A-523. The lessor may seek to sell the equipment following a default by the lessee in the lease agreement and set off the proceeds from the sale against the amounts due and owing by the lessee. This is especially so if the lessee is in poor financial condition and perhaps unable to pay a judgment that the lessor could obtain in court. Provided the lease agreement states that the lessee is liable for any deficiency between the sale price and the lessor’s damages, repossession and sale of the equipment may be the best alternative for the lessor. This common effort to mitigate the lessor’s damages is not without risk to the lessor. Although not a specific requirement in Article 2A (as opposed to Article 2), caselaw has held that any such sale must meet the commercial reasonableness requirements of the UCC. See Lyon Financial Services, Inc. v. Jude’s Medical Center, Ltd., No. 10 C 6957, 2011 WL 6029195, *4 (N.D.Ill. Dec. 5, 2011). But see VFS Leasing Co. v. J&L Trucking, Inc., No. 1:09-CV-2942, 2011 WL 3439525, **5 – 6 (N.D. Ohio Aug. 5, 2011) (holding that in true finance lease, as opposed to security interest, commercial reasonableness component of Article 9 is not applicable). Accordingly, a lessor seeking to sell the leased equipment should make sure that all aspects of the sale meet the minimum standards of commercial reasonableness to avoid possible scrutiny by a reviewing court.

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In addition, the lessor must make sure that the repossession of the goods is achieved without a breach of the peace. The lessee may seek to avoid a deficiency by filing a suit for damages against the lessor for violation of §2A-525. Section 2A-525 permits the lessor to take possession of the goods without judicial process, provided that the lessor can do so without a breach of the peace. The incentive for the lessor to retake possession of the leased goods without judicial process is clear: the lessor avoids the litigation costs and time delay associated with filing a suit for repossession. What constitutes a breach of the peace is determined on a case-by-case basis, although it is clear that breaking into the area in which the goods are located will likely be deemed a breach of the peace. See Pantoja-Cahue v. Ford Motor Credit Co., 375 Ill.App.3d 49, 872 N.E.2d 1039, 313 Ill.Dec. 650 (1st Dist. 2007).

VI. TYPICAL LEASE PROVISIONS A. [6.48] Description of Equipment The lease should describe in detail the equipment to be leased and include, if available, serial numbers. In many leases, the description of the equipment is contained in an exhibit or schedule to the lease. Often, in situations in which the lessee intends to lease several pieces of equipment from the lessor at different times, the parties initially will enter into a “master lease,” which sets forth the general terms of the lease transaction. Thereafter, when equipment is leased, the parties will execute a schedule to the master lease containing a description of the leased equipment as well as any provisions that will apply specifically to this equipment (e.g., the lease term, rent, and types and amounts of insurance required). The master lease should provide that the terms of any schedules are incorporated into and made part of the master lease. B. [6.49] Location and Care of Equipment The lease should designate the address or addresses at which the equipment is permitted to be kept and preclude removal therefrom without the lessor’s prior consent. The lease should also provide that the lessee shall not affix or attach the equipment to real estate so as to cause the equipment to be deemed a fixture. If the equipment will be attached to real estate, the lease should require waivers in favor of the lessor from the owner of the property, any mortgagee, and any other person having an interest in the property. See Albert F. Reisman et al., EQUIPMENT LEASING — LEVERAGED LEASING, p. 77 (3d ed. 1988). If the lease covers equipment that is mobile, it should provide that the equipment remain in a designated territory and require the lessor’s consent prior to moving the equipment out of that territory. Alternatively, rather than requiring the lessor’s consent, the lease could require that the lessor at least receive prior written notice regarding the movement of the equipment. See the discussion in §6.15 above regarding the need to obtain a certificate of title when equipment is moved to another jurisdiction.

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§6.50

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Finally, the lease should require the lessee to (1) use the equipment in a careful and proper manner in the normal course of its business; and (2) comply with all laws, ordinances, and regulations that relate to the possession, use, or maintenance of the equipment. C. [6.50] Acceptance of Equipment The lease should provide that the lessee has a designated period of time in which to inspect the equipment (e.g., three days). Unless the lessee, within that period of time, gives the lessor written notice objecting to the equipment, the lease should provide that it shall be conclusively presumed that (1) the lessee has inspected the equipment, and (2) the lessee is satisfied with and has accepted the equipment. Finally, the lease should provide that, once acceptance is made, the lessee waives any right to revoke acceptance. The lessor should expect some resistance from the lessee with respect to such provisions, as the lessee will often seek a carveout for defects or issues that the lessee had no way of knowing about despite a diligent inspection. D. [6.51] Rental Payments Equipment leases commonly provide for fixed rental payments to be made in equal monthly or quarterly payments. Often, leases provide for adjustments to be made in the fixed rental payments upon the occurrence of certain specified events. For example, the lessee may be obligated to pay more rent if the lease is later found to be a lease intended as security rather than a true lease, thereby depriving the lessor of its anticipated tax benefits from the transaction. Similarly, a rental adjustment also could be triggered by any change in the tax laws that would affect the lessor’s expected economic return under the lease. Another example of an occurrence causing a rental adjustment is an increase in the interest rate assessed on the debt of a leveraged lease. It should be noted, however, that a court may find that a rental adjustment tied to an interest rate tends to show that the lease is actually a secured loan rather than a true lease. See Albert F. Reisman et al., EQUIPMENT LEASING — LEVERAGED LEASING, p. 58 (3d ed. 1988). If any rental adjustments are to be made, the lease should clearly specify how these adjustments are to be determined and the timing of the adjustments. Equipment leases also frequently provide for the lessee to pay “additional rent” to cover various expenses, such as licensing fees or sales and use taxes that certain states assess on the acquisition of the leased equipment and the collection of rentals. While the lessor usually is obligated to collect these taxes, the lease may provide for the lessee to pay these taxes as additional rent. The lease will require the lessee to pay the taxes either directly to the governmental entity levying the tax or to the lessor. Practitioners should check the applicable state’s law to determine the amount of the charges and the manner in which payment is to be made. Finally, equipment leases, similar to other types of leases, often contain provisions assessing late charges if the rental payments are not paid on the due date or during a designated grace period. The late charges could be a specified dollar amount or a percentage of the past-due amount. Alternatively, the past-due amount could be assessed a designated rate of interest (e.g.,

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two percent per month) until paid. Note that the lease should make it clear that the late charge applies not only to past-due rent but also to all fees and charges not paid when due under the lease. E. [6.52] Term of Lease The term of the lease can begin on a specified date or on the date of the occurrence of certain events such as (1) the date of delivery of the equipment to the lessee at a designated address or to a common carrier for delivery to the lessee, or (2) the date of the lessee’s acceptance of the equipment. Most leases provide that they cannot be canceled prior to the termination date. However, certain leases, particularly long-term leases, allow the lessee to cancel the lease upon payment of a fee. In the event the lessor chooses to give the lessee such a “buyout,” the lessor should require that the lessee give prior written notice to the lessor, i.e., 60 days, to give the lessor an opportunity to perhaps secure a new lessee for the equipment. In determining the term of the lease, practitioners concerned about a true lease should consider the test under 810 ILCS 5/1-203, which defines “security interest.” As discussed in greater detail in §6.5 above, §1-203 provides that if the original term of the lease is equal to or greater than the remaining economic life of the leased goods, then one prong of a two-prong test showing that the lease is actually a lease intended as security is satisfied. F. [6.53] Renewal Options The lessor may grant the lessee a renewal option either as part of the main lease agreement, in an addendum thereto, or in a separate side agreement between the lessor and lessee. If the renewal option is set forth in an addendum or side agreement, that document should make express reference to the main lease agreement and provide that the terms and conditions of the addendum or side agreement are incorporated into and made part of the lease. In addition, if there are any ancillary documents to the main lease, such as a guaranty, practitioners should make certain that these ancillary documents contain language ensuring that they will be applicable and in effect throughout any and all renewal periods of the lease. It is important that the lessee’s right to exercise any renewal option expressly be conditioned on the lessee’s not being in default of any term or provision of the lease. If the lease covers several pieces of equipment but the renewal option may be exercised only for certain pieces of equipment, this should be made clear in the lease. To avoid any misunderstandings or disputes, the lease should clearly set forth all of the terms and conditions on which it may be renewed, including 1. the advance notice required to be given by the lessee in order to exercise the renewal option (e.g., at least 90 days prior to the expiration of the original lease or any renewal thereof);

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2. the amount and due dates of rent payments (Instead of having a flat dollar amount for the rent, some leases provide that the rent for a renewal period shall be equal to a fair market rent to be agreed on between the lessor and lessee, if they are unable to agree on such rent, the lease should provide that the amount of rent will be determined by appraisers.); and 3. the duration of the renewal term and the number of successive renewal periods. The tax consequences of the renewal option should be reviewed. This option may affect the treatment of the lease for tax purposes. Reference should also be made to 810 ILCS 5/1-203, discussed in §6.5 above. Under §1203’s definition of “security interest,” a transaction does not create a security interest merely because it provides that the lessee has an option to (1) renew the lease or (2) renew the lease for a fixed rent that is equal to or greater than the reasonably predictable fair market rent for the use of the goods for the term of the renewal. However, §1-203 also provides in pertinent part that a transaction does create a security interest if the consideration that the lessee is to pay the lessor for the right to possession and use of the goods is an obligation for the term of the lease not subject to termination by the lessee and (1) the original term of the lease is equal to or greater than the remaining economic life of the goods, (2) the lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods, (3) the lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or for nominal consideration upon compliance with the lease, or (4) the lessee has an option to become the owner of the goods for no additional consideration or for nominal additional consideration upon compliance with the lease agreement. G. [6.54] Purchase Options A lease may give the lessee an option to purchase the leased equipment. The purchase option may be contained in the original lease agreement, in an addendum to the lease, or in a side agreement between the parties. If the purchase option is set forth in an addendum or side agreement, it should be made certain that the terms and conditions of the addendum or side agreement are incorporated into and made part of the main lease agreement. The lessee’s exercise of the purchase option should be conditioned on the lessee’s complete performance of all the terms and conditions of the original lease and any renewal thereof, including the payment of all rents. If the lease covers several pieces of equipment but not all of these pieces will be subject to the purchase option, the option should clearly identify which equipment may be purchased. If the lessee is required to exercise the purchase option for all of the equipment rather than certain pieces, this condition should be clearly spelled out. The notice that the lessee is required to give prior to exercising the option should be specified (e.g., written notice is to be given at least 120 days prior to the expiration of the original lease term or any renewal thereof). The lessor should disclaim all warranties in connection with the

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purchase of the equipment by the lessee. The purchase option should provide that the equipment will be conveyed to the lessee “as is,” without any representations or warranties. The purchase price for the equipment needs to be considered carefully. If the option may be exercised only for all of the leased equipment, the option should state the aggregate purchase price for the equipment as a whole. If, however, the lessee is entitled to purchase less than all of the pieces, the purchase price for each piece needs to be identified. Some leases provide that the option purchase price is to be a specified percentage of the lessor’s cost of the equipment, while other leases provide that the equipment may be purchased by the lessee for its fair market value. If the latter approach is used, the option provision should provide for an appraisal process in the event that the parties are unable to agree on the fair market value. As discussed in §6.5 above, 810 ILCS 5/1-203, which sets forth guidelines for distinguishing between a true lease and a lease intended as security, provides that an agreement is not deemed to be a lease intended as security merely because it provides that the lessee has an option to become 1. the owner of the goods; or 2. the owner of the goods for a fixed price that is equal to or greater than the “reasonably predictable” fair market value of the goods at the time the option is to be performed. See UCC Comment 2, 810 ILCS 5/1-203. The practitioner should refer to §6.5 above for a discussion as to what is deemed “nominal” under this definition. Leases normally require the lessee to pay any applicable sales, occupation, income, or use taxes in connection with the purchase of the equipment. Finally, practitioners should carefully review the tax consequences that the purchase option may have on the equipment lease. H. [6.55] Warranties and Disclaimers Many leases contain language to the effect that the lessor makes no warranties regarding the equipment. This is particularly the case with finance leases. It is possible that when warranties have not been properly disclaimed, the express and implied warranties of Article 2 will apply. As discussed more fully in §6.25 above, Article 2A extends the implied warranties of infringement, merchantability, and fitness for a particular purpose to leases other than finance leases. 810 ILCS 5/2A-212, 5/2A-213. Practitioners wanting to exclude these warranties should note that Article 2A sets forth rules for excluding or modifying implied warranties. To exclude or modify the implied warranty of merchantability, the language must mention “merchantability,” be written, and be conspicuous.

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810 ILCS 5/2A-214(2). See, e.g., Voelker v. Porsche Cars North America, Inc., 353 F.3d 516, 526 (7th Cir. 2003) (holding lessor did not breach warranty of merchantability when there was express written disclaimer on lease). To exclude or modify an implied warranty of fitness, the exclusion must be in writing and conspicuous. Id. To exclude the implied warranty of infringement, the language must be specific, written, and conspicuous. 810 ILCS 5/2A-214(4). Unless the circumstances indicate otherwise, all implied warranties are excluded by expressions such as “as is” or “with all faults.” 810 ILCS 5/2A-214(3)(a). It should be noted that 810 ILCS 5/2A-209 provides that under a finance lease, any promises and warranties made by the supplier to the lessor in a supply contract extend to the lessee. However, the supplier is not precluded under Article 2A from excluding or modifying an express or implied warranty under the supply contract. Any exclusion, modification, or limitation of any term of the supply contract would be effective against the lessee. See UCC Comment 1, 810 ILCS 5/2A-209. Accordingly, practitioners representing a lessee should attempt to procure a copy of the supply contract to ascertain what warranties, if any, have been excluded. Section 2A-209 is self-executing. Therefore, a provision in the finance lease specifically assigning to the lessee the supplier’s warranties is not necessary. Also, a finance lease should include language to the effect that the lessor is not familiar with the equipment and therefore bears no responsibility or liability to the lessee or any other person with respect to the operation, performance, or maintenance of the equipment. Finally, in addition to disclaiming the warranties discussed above in this section, the lessor should expressly disclaim any warranty concerning the lease’s treatment for tax or other purposes unless the parties have expressly agreed otherwise as part of their deal. I. [6.56] Indemnification To provide protection to the lessor, leases normally require the lessee “to indemnify and hold the lessor harmless from any and all claims, actions, proceedings, liabilities, damages, and costs (including reasonable attorneys’ fees) arising out of or resulting from the use, possession, operation, maintenance, or repair of the leased equipment by the lessee.” This indemnity language is especially crucial with respect to finance leases, in which the lessor is not the manufacturer or vendor of the equipment but is only supplying a financial service. J. [6.57] Risk of Loss or Damage Equipment leases usually require the lessee to assume the risk of loss of and damage to the leased equipment. It should be noted that Article 2A provides that, in the case of a finance lease, risk of loss automatically passes to the lessee. 810 ILCS 5/2A-219(1). As discussed in §6.29 above, §2A-219 sets forth rules as to when the risk of loss passes. The risk of loss provision should make it clear that the occurrence of any loss does not release the lessee from its obligations under the lease, including the payment of rent. The lease may also require that, in the event of damage to or loss of the leased equipment, the lessee, at the lessor’s option, shall

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1. promptly repair the equipment at the lessee’s own expense and to the lessor’s satisfaction; 2. replace the equipment; or 3. indemnify the lessor for the value of the equipment to the full extent of the lessor’s interest in the property, including any residual interest of the lessor in the equipment. The indemnification to be paid to the lessor under item 3 above can be determined by having the parties stipulate to a value or by an agreed-on formula set forth in the lease. For example, the lease could contain a schedule providing that the value will be a certain percentage of the equipment’s purchase price, depending on when the loss or damage occurs. The lease should provide that when and if the lessor receives indemnification for damage to or loss of any leased equipment, the lease will terminate with respect to that particular equipment. The lessor may want to have the option to terminate the lease with respect to all of the equipment, even if only some of the equipment is damaged or destroyed. If so, this should be made clear in the lease. K. [6.58] Insurance Most equipment leases require the lessee, at its own expense, to insure the equipment against loss, damage, or destruction. It should be noted that under the definition of a “security interest” in 810 ILCS 5/1-203, the fact that the lessee is obligated to pay for insurance does not in and of itself create a security interest. The insurance required to be maintained by the lessee should name the lessor and any assignees of the lessor as the loss payee, thereby enabling the lessor to receive the insurance proceeds directly from the insurer. The lessor, any assignee of the lessor, and the lessee should be named insureds. Some leases specify the types and amounts of insurance policies to be maintained by the lessee. Other leases do not contain this specification but instead require the lessee to keep the equipment insured for such risks and in such amounts as the lessor shall from time to time require. Whichever approach is used, the lease should require that the insurance be with an insurer and in such form as is reasonably satisfactory to the lessor. The lease should further require that the policies provide that they cannot be changed or canceled without the lessor’s receiving prior written notice (at least 30 days’ notice is desirable). To provide additional protection for the lessor, some leases require that (1) the policy provide that the lessor shall not be obligated to pay, but may at its option elect to pay, any premium that the lessee does not pay when due; and (2) the insurance coverage shall not be discontinued or suspended with respect to the lessor as a result of any default or breach of covenant or warranty by the lessee. The lessee should be required to deliver to the lessor written certificates of coverage to show that the required policies have been procured. In addition, the lease should require that, during the term of the lease, upon the lessor’s request from time to time, the lessee shall provide satisfactory evidence that these policies are still in effect.

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Finally, the lease should state that if the lessee fails at any time to maintain the required insurance, the lessee shall not use or operate or be entitled to possession of the equipment. L. [6.59] Assignment Leases typically provide that, without the prior written consent of the lessor, the lessee shall not 1. assign, transfer, pledge, or hypothecate the lease, the leased equipment, or any interest therein; 2. sublet or lend the equipment; or 3. permit the equipment to be used by anyone other than the lessee or its employees. The lease should provide that, in the event of any sublease, the sublease will be subordinated to the lease itself. This will permit the lessor to terminate the sublessee’s use of the equipment if the lessee should default. See Philip J. Glick, Equipment Leasing, BUSINESS LAW MONOGRAPHS (M. Bender, 1992). The lessor, on the other hand, usually is permitted to assign the lease or grant a security interest in the lease or the equipment, in whole or in part, without the prior consent of or notice to the lessee. Each assignee or secured party of the lessor may in turn reassign the lease or its security interest without giving the lessee prior notice. From the lessor’s standpoint, it is important to include language to the effect that 1. each assignee or secured party shall have all of the rights of the lessor under the lease; 2. the lessee will pay all rent and perform all other obligations under the lease directly to any assignee; and 3. the lessee acknowledges and agrees that the performance of such obligations, including the payment of rent, will not be subject to any defenses, claims, or setoff rights that the lessee may have against the lessor or any prior assignee of the lease or equipment (This provision will be of importance to any person providing financing to the lessor, as well as any other assignee. This type of agreement between the parties is specifically sanctioned under the Uniform Commercial Code (see UCC Comment 6, 810 ILCS 5/2A-303).). M. [6.60] Return of Equipment The lease should provide that, upon termination of the lease, the lessee shall return the equipment to the lessor, at the lessee’s sole expense and risk, in good condition and repair, excepting only ordinary wear and tear resulting from the lessee’s proper use of the equipment.

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N. [6.61] Default and Remedies Equipment leases normally provide for certain events of default, the occurrence of which will trigger various remedies. Examples of some events of default commonly appearing in equipment leases are 1. the failure of the lessee to pay rent or any other sum required under the lease by the due date; 2. the nonperformance by the lessee of any other term, covenant, or condition of the lease; 3. the lessee’s default in any obligation to the lessor independent of the lease; 4. any affirmative act of insolvency by the lessee, including but not limited to making an assignment for the benefit of creditors or the filing by the lessee of any petition under any bankruptcy, reorganization, insolvency, or moratorium law; 5. the filing of any involuntary petition under any bankruptcy statute against the lessee or the appointment of any receiver or trustee to take possession of the property of the lessee; 6. the subjection of any of the lessee’s property to any levy, seizure, assignment, application, or sale for or by any creditor or governmental agency; or 7. any material adverse change in the condition of the lessee. Note, however, that items 4 and 5 above are invalid under §365(e)(1) of the Bankruptcy Code, 11 U.S.C. §365(e)(1). In the event that there is a guarantor of the lease, each of the above events would also be applicable to the guarantor. An event of default would be triggered if any such event occurred with respect to the guarantor. Leases often contain a “cure” period for some events of default. The cure period may start running either on the date the lessor provides the lessee with notice of the event of default or on the date of the occurrence of the event of default. The lease should set forth the rights and remedies available to the lessor upon an event of default. Available remedies include the right by the lessor to 1. require the lessee to make the equipment available to the lessor; 2. enter the lessee’s premises where the leased equipment is located, without liability to the lessor, in order to repossess the equipment; 3. sell the equipment;

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4. lease the equipment; 5. accelerate all unpaid rental payments; or 6. recover damages. The damages to which the lessor may be entitled should be specified in the lease and may include 1. unpaid rental payments and other charges that accrued, including late charges; 2. future rental payments, discounted to their present value; 3. any tax benefits forfeited by the lessor as a result of the default; 4. compensation for the loss of the lessor’s residual interest; and 5. all costs and expenses incurred by the lessor in connection with the default, including the recovery, repair, storage, sale, or re-leasing of the equipment. As noted in §6.43 above, Article 2A specifically provides that lost tax benefits and loss of the lessor’s residual interest in the leased property may be included in liquidated damages. 810 ILCS 5/2A-504. The lease should indicate whether the lessee is entitled to deduct from the amount owed to the lessor any proceeds received by the lessor from selling or re-leasing the equipment. Note that the lease should make it clear that in the event of any sale or lease by the lessor of the equipment, the lessee will remain liable under the lease for damages and will not be released of any of its obligations thereunder.

VII. OTHER ISSUES ARISING IN EQUIPMENT LEASE TRANSACTIONS A. [6.62] Fraudulent Conveyance Issues in Sale-Leaseback Transactions Fraudulent conveyance problems may arise in sale-leaseback transactions. In these transactions, the seller sells the equipment to a buyer but retains possession under a lease between the buyer as lessor and the seller as lessee. The fact that title to the equipment changes without a change of possession may violate a state’s fraudulent conveyance statute, thereby allowing a creditor of the lessee to set aside the transaction as being a fraud on creditors. Illinois, along with almost every other state, has a statute governing fraudulent conveyances, the Uniform Fraudulent Transfer Act (UFTA), 740 ILCS 160/1, et seq. Section 5(a) of the UFTA carries over and expands on the above language:

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A transfer made or obligation incurred by a debtor is fraudulent as to a creditor, whether the creditor’s claim arose before or after the transfer was made or the obligation was incurred, if the debtor made the transfer or incurred the obligation: (1) with actual intent to hinder, delay, or defraud any creditor of the debtor; or (2) without receiving a reasonably equivalent value in exchange for a transfer or obligation, and the debtor: (A) was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or (B) intended to incur, or believed or reasonably should have believed that he would incur, debts beyond his ability to pay as they became due. [Emphasis added.] 740 ILCS 160/5(a). Note that §§5(a)(1) and 5(a)(2) of the UFTA are in the disjunctive; if either test is satisfied, the transfer is fraudulent and can be set aside. It should be noted that Article 2A contains a rule with respect to sale-leaseback transactions. 810 ILCS 5/2A-308 provides that, notwithstanding any statute or rule of law that would treat the seller’s retention of possession as fraudulent, the retention of possession pursuant to a lease is not fraudulent if the buyer bought 1. for value (see 810 ILCS 5/1-204); and 2. in good faith (see 810 ILCS 5/1-201(b)(20), 5/2-103(1)(b)). These provisions are consistent with existing fraudulent conveyance principles under Illinois law and the fraudulent conveyance provisions of the Bankruptcy Code. See 11 U.S.C. §548. B. [6.63] Equipment Leases as Collateral Equipment leases frequently are assigned as collateral for loans made to the lessor. Leases often permit these assignments without the prior consent of the lessee. Article 9 of the Uniform Commercial Code is applicable to pledges of equipment leases as collateral. In this regard, 810 ILCS 5/9-102(a)(11) defines “chattel paper” as a “record or records that evidence both a monetary obligation and a security interest in specific goods, a security interest in specific goods and software used in the goods, . . . a lease of specific goods, or a lease of specified goods and a license of software used in the goods.” Accordingly, the assignment of a lease falls under the definition of “chattel paper.” As such, even in true lease situations, in order to perfect its security interest, the assignee of the lease is required to file a financing statement. The assignment will be governed by Article 9, despite the fact that the lease transaction itself involves a true lease.

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As a precaution, the assignee may require that the lessor file financing statements against the lessee with regard to the leased equipment and that these financing statements in turn be assigned to the assignee. This action offers protection to the assignee in the event that the lease is subsequently found to be a lease intended as security rather than a true lease. See Albert F. Reisman et al., EQUIPMENT LEASING — LEVERAGED LEASING, p. 913 (3d ed. 1988). It should be noted that, as discussed in §6.31 above, 810 ILCS 5/2A-303 addresses assignments of leases. Section 2A-303 provides, among other things, that to prohibit the transfer of an interest of a party under a lease, the language must be specific, written, and conspicuous. In finance lease situations, the person providing financing may insist that such a provision be included in the lease.

VIII. [6.64] DOCUMENTS USED IN CONNECTION WITH EQUIPMENT LEASE TRANSACTIONS The following is a brief description of many of the documents often used in equipment lease transactions. For a more detailed discussion of documentation involved in equipment lease transactions, see Ronald M. Bayer, Equipment Lease Documentation, EQUIPMENT LEASING (1989). Proposal. The lessor may offer a proposal that sets forth a description of the equipment to be leased and other significant terms of the proposed lease, such as the lease term, rent, and terms of any purchase or renewal options. This type of proposal generally is not intended to bind the lessor and lessee; however, the nonbinding intent should be made clear in the proposal. Lease application. A lease application is sometimes used to procure a binding commitment from the lessee to lease the equipment. Some applications request the lessor to order the equipment from the supplier or manufacturer. The application should make it clear, however, that it does not obligate the lessor to lease the equipment in question. In addition to seeking personal information regarding the lessee’s officers, directors, partners, or guarantors, the application may also request bank references and trade references of the lessee. The lessor may require that the application be accompanied by a deposit that, if the lease is entered into, will be applied toward rent or other payments due. As is the case with other types of transactions, the application should provide that the deposit is nonrefundable if (a) the application is not approved because of the lessee’s credit, or (b) the lessee decides to “walk away” from the deal and does not enter into the lease. Purchase order. The purchase order is a request by the lessor to the vendor to purchase and deliver the equipment. Delivery is normally made directly to the lessee. The purchase order should contain an acknowledgment by the vendor as to the lessee’s right to inspect and reject the equipment upon delivery. Equipment lease/schedules. The lease may cover one or more specific pieces of equipment or be a master lease that will cover equipment leased in the future by the lessee. If the transaction

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involves a master lease, schedules describing the equipment to be leased and any provisions specifically applicable to the equipment (e.g., rent, lease term, insurance) will later be attached and should be executed by both the lessor and lessee. The master lease should make it clear that the terms of the schedules are incorporated into and made a part of the master lease. Purchase and renewal options. Rather than being included in the lease itself, purchase and/or renewal options relating to the leased equipment may be set forth in an addendum to the lease or in a separate side agreement between the parties. A discussion of these options is provided in §§6.53 and 6.54 above. Certificate or receipt of acceptance. The lessor should require the lessee to execute a certificate or receipt that confirms that the lessee has received the equipment in good condition and accepts the equipment in accordance with all of the terms and conditions of the lease. The certificate or receipt should contain an acknowledgment that the lessor has fully and satisfactorily performed all covenants and conditions to be performed by it under the lease. Landlord’s waiver and consent. If the equipment is to be attached to real property, the lessor should require that the landlord and anyone else having a claim with respect to the property execute a waiver in the lessor’s favor and consent to the attachment of the equipment to the real property. Uniform Commercial Code financing statements. If the lease is intended as security, financing statements must be filed to perfect the lessor’s interest in the equipment. Even though in “true lease” situations a financing statement need not be filed, a protective filing is usually made under 810 ILCS 5/9-505; in the event that the true lease is found to be a lease intended as security, the lessor’s interest will be protected. Section 9-505 provides that “the filing or compliance is not of itself a factor in determining whether the collateral secures an obligation. If it is determined for another reason that the collateral secures an obligation, a security interest held by the . . . lessor . . . which attaches to the collateral is perfected by the filing or compliance.” 810 ILCS 5/905(b). Evidence of insurance. The lessee should be required to provide a certificate of coverage or other evidence, in form and substance reasonably satisfactory to the lessor, showing that the insurance required under the lease has been procured. Guaranty. Particularly in lease transactions in which the lessee is a small, closely held corporation, the lessor will often require another person or corporation to guarantee the lessee’s obligations. The lessor should make sure that the guaranty will also be applicable to any renewal or purchase options with respect to the lease. Security agreement/trust deed. The lessee or any guarantor of the lessee’s obligations may be required to execute a security agreement or trust deed in order to grant the lessor a lien on its personal or real property as security for its obligations under the lease or any guaranty. Evidence of authorization. If the lessee is a corporation and the lease involves a substantial amount of money relative to the corporation’s assets, the lessor may require the lessee to provide

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a certified copy of corporate resolutions authorizing the lease transaction. If the lessee is a partnership or limited liability company, similar evidence of authorization may be required. If a guarantor is a corporation, partnership, or limited liability company, the lessor will often require resolutions or other evidence of authorization to make the guarantee. Legal opinion. The lessor may request that counsel for the lessee provide a legal opinion to the effect that, among other things, (a) the execution, delivery, and performance of the lease have been authorized by all necessary corporate or, if applicable, partnership or limited liability company action on the part of the lessee; and (b) the lease is a legally valid and binding obligation of the lessee and is enforceable against the lessee in accordance with its terms. The legal opinion should also cover any guaranty given for the lessee’s obligations.

IX. [6.65] SAMPLE FORM OF EQUIPMENT LEASE EQUIPMENT LEASE This Equipment Lease (Lease), dated as of the day of [date of lease], is entered into between [name of lessor] (Lessor) and [name of lessee] (Lessee). RECITALS: WHEREAS, Lessor desires to lease to Lessee, and Lessee desires to lease from Lessor, certain equipment described herein, all on the following terms and conditions: NOW, THEREFORE, in consideration of the foregoing, and of the covenants and agreements hereinafter contained, the parties agree: Section 1. Description of Equipment. Lessor hereby leases to Lessee, and Lessee hereby leases from Lessor, all of the equipment set forth in Schedule [A] hereto (Equipment). Section 2. Lease Term. The term of this Lease shall be for a period of [length of lease in months] months, commencing upon the earlier of the delivery of the Equipment to Lessee at Lessee’s address set forth in §27 hereof or to a common or other carrier for delivery to Lessee (Commencement Date). Section 3. Rent. In consideration of the leasing of the Equipment, during the term of this Lease, Lessee agrees to pay to Lessor rent in the amount of $[amount of rent], payable in advance on the [date rent due each month]. Any payment of rent or any other amounts due hereunder which are not paid when due shall bear interest at the lower of (i) [percentage rate of interest] per month or (ii) the highest rate allowed by law. Section 4. Security Deposit. In addition to the rent paid pursuant to §3 above, Lessee shall pay to Lessor as security for the performance of Lessee’s obligations hereunder the sum of $[amount of security deposit]. Lessor may, but shall not be required to, use the

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security deposit to pay all amounts that Lessee is required to pay under this lease but fails to do so. Upon termination of this Lease, Lessee shall receive any part of such deposit that has not been applied by Lessor in accordance with this Section, without interest. Section 5. Place of Payment. All rent and other payments made pursuant to this Lease shall be made at the address of Lessor indicated herein or at such other address as shall be designated from time to time by Lessor in writing to Lessee. Section 6. Lessee’s Acceptance of Equipment. Lessee’s receipt of the Equipment shall constitute acceptance thereof unless Lessee, within [number of days allowed after receipt of equipment to provide notice of defect] days after receipt of the Equipment, shall provide Lessor with written notice specifying any material defect therein. By acceptance of the Equipment, Lessee waives any defense, setoff, or counterclaim that it may have against Lessor relating to or arising out of the Equipment. Section 7. Location and Identification of the Equipment. Lessee shall not remove, nor permit the removal of, the Equipment from the address of delivery set forth herein without the prior express written consent of Lessor. Lessee shall not cause nor permit the Equipment to be affixed or attached to real estate so as to cause the Equipment to be deemed a fixture. In the event that Lessor, at any time during the term of this Lease, provides Lessee with any tags or other markers identifying Lessor as the owner or lessor of the Equipment, Lessee shall properly and promptly affix such tags or markers and prominently display them on the Equipment during the term of this Lease. Lessee shall not cover or remove any serial numbers, insignia, or other identification markings existing on the Equipment. Section 8. Lessee’s Care of the Equipment. Lessee agrees to (i) use the Equipment in a careful and prudent manner in the regular course of its business; and (ii) comply with all rules, regulations, laws, and ordinances and any and all insurance provisions applicable to Lessee’s use, maintenance, or possession of the Equipment. Lessee, without the prior written consent of Lessor, shall not make any modifications, additions, or alterations to the Equipment. Any and all such modifications, additions, and alterations shall belong to and become Lessor’s property and be subject to the provisions of this Lease. Section 9. Maintenance; Repair. Lessee, at its own cost and expense, shall (i) maintain the Equipment in good condition and working order as when delivered, ordinary and reasonable wear and tear excepted; and (ii) furnish any and all mechanisms and parts needed to maintain the Equipment in good working order. Any and all manuals and operating instructions provided by Lessor shall be carefully maintained by Lessee and returned to Lessor upon expiration or termination of this Lease. Section 10. Lessor’s Right To Inspect. Lessee shall permit and facilitate the inspection of the Equipment and Lessee’s records relating thereto at any reasonable time or times by Lessor.

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Section 11. Return of Equipment. Upon expiration or termination of this Lease, Lessee shall, at its own cost and expense, assemble and return the Equipment to Lessor at its address indicated herein or at such other address as Lessor may designate. The Equipment shall be returned in good repair, excepting ordinary wear and tear resulting from its proper use. Section 12. Renewal Option. Lessor hereby grants to Lessee the option to renew the Lease for [number and length of renewal terms]. Such right shall be exercisable by Lessee giving Lessor written notice of its intent to renew at least [number of days’ notice required to renew lease] days prior to the expiration of the original term of the Lease or any renewal term thereof. The right of Lessee to exercise the option under this Section shall be conditioned on Lessee’s complete performance of all of its obligations under this Lease or under any renewal of the Lease (if applicable) including, without limitation, the payment of rent in full as specified herein. The rent in effect during any renewal period shall be increased [percentage rate of rent increase] over the rent previously in effect. Section 13. Option To Purchase Equipment. Lessor hereby grants to Lessee the option to purchase the Equipment upon the expiration of the original lease term or any renewal term thereof. Such right shall be exercisable by Lessee giving Lessor written notice thereof at least [number of days’ notice required to purchase equipment] days prior to the expiration of the original lease term or any renewal term thereof. The purchase right shall be conditioned upon Lessee’s complete performance of all of its obligations under the lease including, without limitation, the payment of rent in full as specified herein. The option purchase price of the Equipment shall be $[purchase price of equipment], payable by certified or cashier’s check. Lessee shall be solely responsible for the payment of any and all sales, use, occupation, and income taxes applicable with respect to the sale of the Equipment. Upon payment of the option purchase price and all such applicable taxes, Lessor shall transfer to Lessee all of Lessor’s right, title, and interest in, to, and under the Equipment. Section 14. Loss and Damages. Lessee hereby assumes all risk of loss, theft, damage, or destruction to the Equipment from any cause whatsoever. No such loss, theft, damage, or destruction shall affect any obligation of Lessee under the Lease, which will continue in full force and effect, except as expressly provided below. In the event of any such loss, theft, damage, or destruction of the Equipment, Lessee shall immediately give Lessor written notice thereof and the facts relative thereto, and shall, at the sole option of Lessor, do the following: (i)

Promptly repair such Equipment;

(ii) Promptly replace such Equipment with like equipment in good repair and working order, which equipment shall become subject to the provisions of this Lease; or (iii) Promptly pay to Lessor the value of the Equipment to the full extent of Lessor’s interest in the Equipment, including any residual interest of Lessor in the Equipment.

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The value to be paid to Lessor pursuant to Subsection (iii) above shall be the value of such Equipment as is reasonably established by Lessor from time to time. Upon Lessor’s receipt of indemnification from Lessee pursuant to Subsection (iii) above, this Lease shall terminate with respect to the Equipment for which Lessor has received indemnification. Lessor may, at its option, terminate this Lease with respect to any remaining Equipment. Lessee agrees to provide Lessor with prompt written notice of the loss, theft, damage, or destruction of any Equipment, including, without limitation, all of the facts relevant thereto, and shall provide assistance to Lessor in investigating such loss, theft, damage, or destruction and in recovering damages from any and all third parties who may have any liability with respect thereto. Section 15. Insurance. Lessee, at its own cost and expense, shall maintain insurance for the Equipment in such amounts and to protect against such risks as Lessor shall from time to time require. Such insurance shall be maintained with a carrier or carriers acceptable to Lessor. All such insurance shall (i) name Lessor as an additional insured, (ii) contain a loss payable endorsement in favor of Lessor, (iii) be in a form acceptable to Lessor, and (iv) provide that it cannot be canceled or modified without at least [number of days’ notice required to cancel or modify insurance] days’ prior written notice to Lessor. All such Insurance shall provide that Lessor may at its option, but shall not be obligated to, pay any premium not paid by Lessee, and that the coverage with respect to Lessor shall not be forfeited or suspended as a result of any default or breach by Lessee with respect thereto. From time to time as requested by Lessor, Lessee shall deliver to Lessor evidence, satisfactory to Lessor, of the insurance required to be maintained hereunder. In the event that Lessee fails to maintain the insurance required hereunder, Lessee shall not be entitled to use or possess the Equipment. Section 16. Taxes and Fees. Lessee shall be responsible for payment of all sales, use, occupation, income, property, and other taxes, license fees, and other assessments imposed with respect to the Equipment, except for any taxes imposed with respect to the net income of Lessor. Lessee agrees that, without the prior express written consent of Lessor, it will not claim on behalf of Lessee or Lessor any immunity from taxation predicated on the taxexempt status, if any, of Lessee. Section 17. Ownership and Status of Equipment. The Equipment is, and shall at all times remain, the sole personal property of Lessor. Lessee shall hold or possess no right, title, or interest in, to, or under the Equipment except as specifically described in this Lease. Section 18. Liens. Lessee hereby agrees to keep the Equipment free and clear of all liens, claims, and encumbrances. Section 19. Indemnification by Lessee. Lessee hereby agrees to indemnify and hold harmless Lessor from and against any and all actions, claims, damages, judgments, costs, and expenses (including, without limitation, attorneys’ fees) resulting from or relating to Lessee’s use, possession, or maintenance of the Equipment or the breach by Lessee of any provision of this Lease.

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Section 20. Limitation of Warranties. Lessor has not made and does not make any representation or warranty, express or implied, with respect to the condition, quality, durability, suitability, or merchantability of the Equipment. Lessor shall not be liable for any liability, loss, or damage caused or alleged to be caused by the Equipment or any defect or inadequacy thereof. Section 21. Events of Default. For purposes of this Lease, the occurrence of any of the following shall constitute an “Event of Default” under this Lease: (i)

the failure of Lessee to pay rent or any other sum due under this Lease for a period of [number of days rent required to be delinquent to create default] days following the date such sum is due;

(ii) Lessee’s failure to perform any of its other obligations or covenants under this Lease, provided such failure is not cured within [number of days allowed to cure failure to perform obligation or covenant] days following Lessor’s written notice thereof; (iii) any affirmative act of insolvency by Lessee including, without limitation, the making of an assignment for the benefit of creditors or the filing by Lessee of any petition under any bankruptcy, insolvency, reorganization, or moratorium law; (iv) the filing of any involuntary petition against Lessee under any bankruptcy or insolvency law, or the appointment of any trustee or receiver with respect to Lessee or a substantial portion of Lessee’s property, provided such petition or appointment is consented to or acquiesced in by Lessee or remains undismissed for [number of days petition or appointment allowed to remain undismissed] days; or (v)

any material adverse change in the condition of Lessee.

Section 22. Remedies upon Default. Upon the occurrence of any one or more of the Events of Default, Lessor may, without notice to or demand on Lessee, do any of the following: (i)

Repossess the Equipment and re-lease all or any portion of the Equipment to any person or entity selected by Lessor;

(ii) Repossess the Equipment and sell all or any portion of the Equipment at a public or private sale; or (iii) Accelerate the payments due under this Lease and demand the total. In the event that Lessor takes the action in §22(i), §22(ii), or §22(iii) above, Lessee shall immediately pay Lessor the difference between (i) the aggregate rent to be received by Lessor from any third party for the balance of this Lease or the purchase price of the Equipment, as the case may be; and (ii) the total unpaid rent and other outstanding

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obligations of Lessee under this Lease (including accrued interest thereon calculated at the highest rate allowed by law), plus all costs and expenses incurred by Lessor in connection with Lessee’s default (including, without limitation, reasonable attorneys’ fees and other costs incurred by Lessor in repossessing, repairing, storing, re-leasing, and selling the Equipment). Section 23. Cumulative Remedies. All rights and remedies are cumulative, and the exercise of any right or remedy provided hereunder shall be without prejudice to the right to exercise any other right or remedy provided herein, by law or equity. Section 24. Waiver. No waiver of any default hereunder by a party shall operate as a waiver of any continuing or subsequent default. Any forbearance to act shall not be construed as a waiver of any right or remedy hereunder. To be effective, any and all waivers shall be in writing and specifically state what is being waived thereby. Section 25. Severability. The invalidity or unenforceability of any provision of this Lease shall not affect, impair, or render unenforceable any other provision hereof. It is intended that each provision herein that is invalid or unenforceable as written be valid and enforceable to the fullest extent possible. Section 26. Assignment. Lessee, without the prior written consent of Lessor, shall not do any of the following: (i) sell, transfer, assign, pledge, or hypothecate the Lease or any of the Equipment; (ii) allow any of the Equipment to be used by any person or entity other than Lessee or any of Lessee’s employees; or (iii) sublet any of the Equipment. Lessor may, without notice to Lessee, at any time assign this Lease or grant a security interest in this Lease or the Equipment. In such event, Lessor’s assignee or secured party shall have all of Lessor’s rights under this Lease and may reassign this Lease or its security interest without prior notice to Lessee. Subject to the above terms, the provisions of this Lease shall be binding on and inure to the benefit of the respective successors, assigns, and personal representatives of the parties hereto. Section 27. Notices. Each notice, consent, request, or other communication required or permitted by this Lease shall be in writing (unless otherwise specifically provided herein) and shall be deemed “given” to a party (i) when delivered by hand to such party; (ii) on the [3] day after deposit in the U.S. mail, postage prepaid and certified (return receipt requested), addressed to the party to which it is to be given at the address set forth below; (iii) on the date sent, if sent by telegram, telex, or facsimile transmission, provided confirmatory notice is sent by first-class mail, postage prepaid, to such party at the address set forth below; or (iv) on the [1] day after proper and timely deposit, freight prepaid, with a nationally recognized next-day delivery service providing next-day service to the location of the recipient, if sent to such party at the address set forth below: If to Lessor: [lessor’s address]

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If to Lessee: [lessee’s address] Any party at any time may change the address at which such party is to be given notice by giving notice of such party’s new address to the other party in the foregoing manner. Section 28. Captions. Captions are for convenience only and are not to be construed as substantive parts of this Lease. Section 29. Governing Law. This Lease shall be construed and governed in accordance with the laws of the State of Illinois, without regard to conflicts of laws principles. Section 30. Arbitration. Any dispute, claim, or controversy arising out of or relating to this Lease or the breach, termination, enforcement, interpretation, or validity thereof, including the determination of the scope or applicability of this agreement to arbitrate, shall be determined by binding arbitration in [city where arbitration is to be held], Illinois, before one arbitrator. The arbitration shall be administered by JAMS pursuant to its Comprehensive Arbitration Rules and Procedures and in accordance with the Expedited Procedures in those Rules. Judgment on the award may be entered in any court having jurisdiction. The foregoing shall not preclude the parties from seeking provisional remedies in aid of arbitration from a court of appropriate jurisdiction. Each party shall bear its own legal expenses in connection with any arbitration, subject to the right of the arbitrators to award legal fees and costs to the prevailing party in such proceeding. Section 31. Entire Agreement. This Lease, which includes any schedules or the like attached hereto, sets forth the entire agreement and understanding between the parties hereto with respect to the subject matter hereof. No party shall be bound by any amendment to this Lease unless any such amendment shall be signed by the party to be bound. Section 32. Counterparts; Electronic Transmission. This Lease and any schedules or other documents relating hereto may be executed in counterparts, each of which shall be deemed to be an original, but all of which shall together constitute but one and the same document. Receipt of an executed signature page by facsimile or other electronic transmission shall constitute effective delivery thereof. IN WITNESS WHEREOF, the parties have executed this Lease of the date first above written. LESSOR:

LESSEE:

[name of lessor]

[name of lessee]

By: _____________________________

By: ______________________________

Title: ___________________________

Title: _____________________________

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7

Agricultural Financing in Illinois Under Article 9

TIMOTHY J. HOWARD THOMAS E. HOWARD Howard & Howard Attorneys PLLC Peoria

®

©COPYRIGHT 2016 BY IICLE .

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I. [7.1] Agricultural Financing in the 21st Century II. The Agricultural Security Agreement A. B. C. D.

[7.2] [7.3] [7.4] [7.5]

The Fundamentals Description of the Collateral The Grant Important Representations

III. The Impact of Revised Article 9 A. B. C. D.

[7.6] [7.7] [7.8] [7.9]

Agricultural Liens Filing Financing Statements Priorities Purchase-Money Security Interests in Agricultural Products

IV. Other Issues Affecting Agricultural Transactions A. B. C. D. E. F. G. H. I.

[7.10] [7.11] [7.12] [7.13] [7.14] [7.15] [7.16] [7.17] [7.18]

Notice to Buyers of Farm Products Grain Code The Perishable Agricultural Commodities Act Government Payments Bankruptcy Financing Dealers of Patented Grain Products Limited Liability Companies Landlord’s Consent Is Marijuana a Farm Product?

V. [7.19] Conclusion VI. Appendix — Sample Forms A. [7.20] Agricultural Security Agreement B. [7.21] Notice to Buyers of Farm Products

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I. [7.1] AGRICULTURAL FINANCING IN THE 21ST CENTURY The use of computers and other new technologies have improved the business of farming. However, financing agricultural activities remains constant. Loans to farmers and ranchers continue to be divided into four categories: real estate loans (long term); capital acquisition loans for machinery or improvements (intermediate term); livestock loans (intermediate to short term); and crop loans (short term). The number and types of agricultural loan products are varied. For examples, see the 1st Farm Credit Services website at www.1stfarmcredit.com. The creation and perfection of a security interest in farm products and other personal property used in farming and ranching are governed by the Uniform Commercial Code (UCC), 810 ILCS 5/1-101, et seq. The purpose of this chapter is to provide counsel with a foundation on which to perfect an agricultural security interest to conform with revised Article 9 of the UCC, as amended by P.A. 91-893 (eff. July 1, 2001). All citations to the UCC in this chapter are to Illinois’ version. Real estate loans, including agricultural real estate, are covered in COMMERCIAL REAL ESTATE (IICLE®, 2011, Supp. 2013). The official comments to UCC Article 9 are very helpful, and the most recent edition of the model UCC may be purchased from the American Law Institute at its website, www.ali.org. The National Agricultural Law Center, on its website, has an agricultural law bibliography that includes transactional topics. See www.nationalaglawcenter.org/ag-law-bibliography. Finally, the best place to start with complex questions is Barkley Clark and Barbara Clark, THE LAW OF SECURED TRANSACTIONS UNDER THE UNIFORM COMMERCIAL CODE (rev. 3d ed. 2015).

II. THE AGRICULTURAL SECURITY AGREEMENT A. [7.2] The Fundamentals The Uniform Commercial Code defines “security agreement” to mean “an agreement that creates or provides for a security interest.” 810 ILCS 5/9-102(a)(74). Except as otherwise provided in the UCC, a security agreement is “effective according to its terms between the parties, against purchasers of the collateral, and against creditors.” 810 ILCS 5/9-201(a). In order for a security interest to be enforceable against the debtor and third parties with respect to the collateral described therein, 810 ILCS 5/9-203(b) requires that the following three conditions be met: 1. Value has been given. 2. The debtor has rights in the collateral or the power to transfer rights in the collateral to the secured party.

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3. One of the following conditions has been met: a. The debtor has authenticated (signed or otherwise executed) a security agreement that provides a description of the collateral and, if the security interest covers timber to be cut, a description of the land concerned. b. The collateral is not a certificated security and is in the possession of the secured party under 810 ILCS 5/9-313 pursuant to the debtor’s security agreement. c. The collateral is a certificated security in registered form, and the security’s certificate has been delivered to the secured party under 810 ILCS 5/8-301 pursuant to the debtor’s security agreement. d. The collateral is deposit accounts, electronic chattel paper, investment paper, or letter-of-credit rights, and the secured party has control pursuant to the debtor’s security agreement. These are the minimum requirements that must be satisfied to enforce a security interest. In re Duckworth, 776 F.3d 453, 462 (7th Cir. 2014). However, §9-203 does not provide a mechanism for rescuing a lender from mistakenly identifying the debt to be secured. In Duckworth, the court held that the mistaken identification of the debt cannot be corrected against the bankruptcy trustee by using parol evidence to show the intent of the parties to the original loan. Id. In Duckworth, the bank brought an action against the bankruptcy trustee and others asking the court to determine that the bank had a first priority security interest in proceeds from the sale of certain farm products, equipment, and crop insurance. After the farmer filed a Chapter 7 petition, the trustee was holding $22,284.27 in postpetition sales of farm equipment and $586,740.38 in crop proceeds. The debtor obtained a loan from the bank by a promissory note dated December 15, 2008, in the amount of $1.1 million. On page 2 of the 2008 note, in a paragraph headed “collateral,” it stated that the borrower acknowledged that the note was secured by a security agreement dated December 13, 2008. The debtor did sign an agriculture security agreement dated December 13, 2008, that described the collateral as all inventory, farm products, farm equipment, and crop insurance, among other property. In the definition of “note,” however, the principal amount was left blank and the note was referenced as being dated December 13, 2008. Unfortunately, there was no cross-collateralization clause. The trustee and another creditor argued that the security interest was invalid because the security agreement provided that its security debt was evidenced by a note dated December 13, 2008, which did not exist. The bank submitted the declaration of the loan officer who prepared the loan documents and personally closed the loan explaining that the discrepancy was a “clerical error.” Additionally, the bank maintained that the error was correctible by means of parol evidence, because Illinois adheres to the principle that documents executed as part of a single

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transaction are interpreted as one contractual agreement. The bankruptcy court agreed. So did the district court on appeal. However, the Seventh Circuit Court of Appeals reversed, declaring that bankruptcy trustees “are entitled to treat an unambiguously security agreement as meaning what it says, even if the original parties have made a mistake in expressing their intentions.” 776 F.3d at 463. The lesson learned in Duckworth is that special care must be taken to ensure that the security agreement contain a provision for securing future debts. Future advances or dragnet clauses are expressly permitted by the UCC. 810 ILCS 5/9-204(c). A future advances clause must be set forth in writing as part of the security agreement in order for the security interest to cover debts not expressly identified therein. See the sample form of an agricultural security agreement in §7.20 below. In the sample form of security agreement, the term “obligations” broadly encompasses all debts existing at the time of execution of the agreement and arising thereafter. B. [7.3] Description of the Collateral Most security agreements define “collateral,” and a mistake in the definition can be costly. Counsel should always use language covering after-acquired property for collateral even if counsel assumes that common sense would apply it to things like inventory. It is important to understand the meaning of terms under the Uniform Commercial Code. Some secured lenders define “accounts,” “inventory,” etc. This is not necessary if counsel is willing to rely on UCC terms. However, it must be noted that some UCC terms changed dramatically when Article 9 was amended in 2001. See §7.1 above. Counsel needs to be aware of the meanings of the revised UCC terms because including a provision that incorporates UCC terms can affect the entire agreement. 810 ILCS 5/9-102(a)(34) defines “farm products” to mean “goods, other than standing timber, with respect to which the debtor is engaged in a farming operation” and that are (A) crops grown, growing, or to be grown, including: (i) crops produced on trees, vines, and bushes; and (ii) aquatic goods produced in aquacultural operations; (B) livestock, born or unborn, including aquatic goods produced in aquacultural operations; (C) supplies used or produced in a farming operation; or (D) products of crops or livestock in their unmanufactured states. “Farming operation” is defined to mean “raising, cultivating, propagating, fattening, grazing, or any other farming, livestock, or aquacultural operation.” 810 ILCS 5/9-102(a)(35).

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The term “proceeds” is broadly defined to include whatever property or goods are received upon the sale, exchange, collection, or disposition of the collateral. 810 ILCS 5/9-102(a)(64). A security interest attaches to any identifiable proceeds of collateral. 810 ILCS 5/9-315(a)(2). Determining readily identifiable cash proceeds is a difficult endeavor. See C.O. Funk & Sons, Inc. v. Sullivan Equipment, Inc., 89 Ill.2d 27, 431 N.E.2d 370, 59 Ill.Dec. 85 (1982). The secured party has the burden of identifying its proceeds. Assumptions and speculation are insufficient to meet this burden. See Van Diest Supply Co. v. Shelby County State Bank, 425 F.3d 437 (7th Cir. 2005). C. [7.4] The Grant As amended in 2001, Article 9 of the Uniform Commercial Code maintains the same requirement as the prior version for language showing a grant of a security interest. The grant must describe the property and what it secures. 810 ILCS 5/9-203(b)(3). The failure to have a document explicitly granting a security interest is fatal. Covey v. Morton Community Bank (In re Sabol), 337 B.R. 195 (Bankr. C.D.Ill. 2006). While no particular words of grant or “magic words” are required to be included in the security agreement to create a security interest, no security interest will be recognized without a description of the collateral in a signed or authenticated document or in a separate document incorporated by reference into a signed or authenticated document. 377 B.R. at 202. D. [7.5] Important Representations Whether a secured party will have a priority depends on proper searches. Before making a loan, the lender must determine the following: 1. the debtor’s form of organization; 2. the debtor’s principal place of business; 3. the debtor’s predecessors; 4. all names utilized by the debtor; and 5. all locations used for goods. Once the lender receives representations regarding all of the foregoing, it must perform its own due diligence to verify these representations. Due diligence includes reviewing an entity’s articles of incorporation, articles of organization, or other organizational agreement and any other reports available to the lender to verify the locations of the collateral. The lender can confirm whether the borrower is a corporation or a limited liability company and in good standing at the website of the Illinois Secretary of State’s Department of Business Services at www.cyberdriveillinois.com/departments/business_services.

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The lender also must conduct an Uniform Commercial Code lien search using the precise name of the entity or person. The failure to get the name correct can be fatal. See, e.g., Corona Fruits & Veggies, Inc. v. Frozsun Foods, Inc., 143 Cal.App.4th 319, 48 Cal.Rptr.3d 868, 870 (2006) (financing statement that listed debtor’s name as “Armando Munoz” instead of his correct name of “Armando Munoz Juarez” was seriously misleading and thus invalid). On August 17, 2012, the District Court for the Central District of Illinois held that the use of a name on a driver’s license and social security card was sufficient for purposes of perfection by filing a financing statement for an individual. In re Miller, No. 12-CV-020522012 WL 3589426 (C.D.Ill. Aug. 17, 2012). As a result of this decision, the Illinois General Assembly adopted a nonuniform amendment to Article 9 to provide that the use of the name on a driver’s license for preparing a financing statement will result in the perfection of a lien by filing against the property of an individual. 810 ILCS 5/9-503(a)(4).

III. THE IMPACT OF REVISED ARTICLE 9 A. [7.6] Agricultural Liens The 2001 amendment of Article 9 of the Uniform Commercial Code by P.A. 91-893 (eff. July 1, 2001) brought agricultural liens within its scope. 810 ILCS 5/9-102(a)(5), as further amended by P.A. 92-819 (eff. Aug. 21, 2002), defines an “agricultural lien” to mean an interest, other than a security interest, in farm products (A) which secures payment or performance of an obligation for goods or services furnished in connection with a debtor’s farming operation; (B) which is created by statute in favor of a person that in the ordinary course of its business furnished goods or services to a debtor in connection with a debtor’s farming operation; and (C) whose effectiveness does not depend on the person’s possession of the personal property. There are at least three types of statutory liens in Illinois that involve agriculture: 1. agister’s lien; 2. thresherman’s lien; and 3. landlord’s crop lien.

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With regard to an agister’s lien, §50 of the Innkeepers Lien Act, 770 ILCS 40/0.01, et seq., provides: Agisters and persons keeping, yarding, feeding or pasturing domestic animals, shall have a lien upon the animals agistered, kept, yarded or fed, for the proper charges due for agisting, keeping, yarding or feeding thereof. 770 ILCS 40/50. Because the agister’s lien is a possessory lien extending to animals in the care and possession of the farmer or rancher, it does not fit the UCC definition of “agricultural lien.” Therefore, compliance with the filing requirements of Article 9 is not required. Regarding a thresherman’s lien, §50a of the Innkeepers Lien Act provides: Every person who, as owner or lessee of any threshing machine, clover huller, corn sheller or hay baler, threshes grain or seed, hulls clover, shells corn or presses hay or straw at the request of the owner, reputed owner, authorized agent of the owner or lawful possessor of such crops shall have a lien upon such crops, beginning at the date of the commencement of such threshing, hulling, shelling or baling, for the agreed contract price of the job, or, in the absence of a contract price, for the reasonable value of the services or labor furnished. Such lien shall run for a period of eight (8) months after the completion of such services or labor notwithstanding the fact that the possession of the crops has been surrendered to its owner or lawful possessor, provided that such lien shall not be valid and enforceable against a purchaser of said crops from the owner or lawful possessor thereof unless the lien holder shall, previous to or at the time of making final settlement for such crops by such purchaser, serve upon such purchaser a notice in writing of the existence of such lien. 770 ILCS 40/50a. Because the thresherman’s lien continues after possession of the crops has been surrendered, it fits the UCC definition of “agricultural lien.” Consequently, the rules for perfection, priority, and enforcement of this lien are provided by Article 9. Perfection is achieved by filing with the Secretary of State, and the priority rules of first to file apply. See 810 ILCS 5/9-310(a), 5/9-322. For a landlord’s crop lien in Illinois, §9-316 of the Code of Civil Procedure, 735 ILCS 5/1-101, et seq., provides in part: Every landlord shall have a lien upon the crops grown or growing upon the demised premises for the rent thereof, whether the same is payable wholly or in part in money or specific articles of property or products of the premises, or labor, and also for the faithful performance of the terms of the lease. Such lien shall continue for the period of 6 months after the expiration of the term for which the premises are demised, and may be enforced by distraint as provided in Part 3 of Article IX of this Act.

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A good faith purchaser shall, however, take such crops free of any landlord’s lien unless, within 6 months prior to the purchase, the landlord provides written notice of his lien to the purchaser by registered or certified mail. Such notice shall contain the names and addresses of the landlord and tenant, and clearly identify the leased property. A landlord may require that, prior to his tenant’s selling any crops grown on the demised premises, the tenant disclose the name of the person to whom the tenant intends to sell those crops. Where such a requirement has been imposed, the tenant shall not sell the crops to any person other than a person who has been disclosed to the landlord as a potential buyer of the crops. 735 ILCS 5/9-316. Historically, the landlord’s lien was beyond the scope of Article 9. The most common priority dispute was between a UCC lien creditor and a landlord claiming a crop lien. The landlord’s lien usually prevailed. See Dwyer v. Cooksville Grain Co., 117 Ill.App.3d 1001, 454 N.E.2d 357, 73 Ill.Dec. 497 (4th Dist. 1983); Farmers Grain & Supply Co. v. Skinner, 161 Ill.App.3d 201, 514 N.E.2d 216, 112 Ill.Dec. 750 (3d Dist. 1987). By P.A. 91-893, the General Assembly amended the landlord’s crop lien statute to fit within the Article 9 definition of “agricultural liens.” However, by P.A. 92-819, in 2002 the legislature added the following provision to the statutory crop lien: A lien arising under this Section shall have priority over any agricultural lien as defined in, and over any security interest arising under, provisions of Article 9 of the Uniform Commercial Code. 735 ILCS 5/9-316. Consequently, the landlord’s statutory lien for rent against crops grown on leased land continues to be superior to any consensual lien that the tenant may give on the crops, even those created under Article 9. Schweickert v. Ag Services of America, Inc., 355 Ill.App.3d 439, 823 N.E.2d 213, 215, 291 Ill.Dec. 203 (3d Dist. 2005) (“The 2002 amendment restored the original language of the statute as it was before the 2001 amendment.”). However, the landlord’s statutory lien for unpaid rent may be avoided under the Bankruptcy Code, 11 U.S.C. §101, et seq. 11 U.S.C. §§545(3), 545(4). See Marshall v. Aubuchon (In re Marshall), 239 B.R. 193 (Bankr. S.D.Ill. 1999); Pogge v. Powers (In re Smith), 302 B.R. 865 (Bankr. C.D.Ill. 2003). If a landlord wants to prevail over a trustee in bankruptcy on the crop lien, the landlord needs a consensual security interest and a properly filed UCC financing statement. If a landlord fails to perfect by filing a financing statement, the statutory crop lien once avoided will relegate the landlord to the status of an unsecured creditor. B. [7.7] Filing Financing Statements The 2001 amendment of Article 9 of the Uniform Commercial Code (see §7.1 above) made significant changes regarding financing statements. First, in all secured transactions involving a security agreement executed by the debtor, the debtor authorizes the secured party to file a

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SECURED TRANSACTIONS

financing statement describing the collateral. See 810 ILCS 5/9-509(a)(1). Article 9 also provides that a person holding an agricultural lien that arises by operation of law and requires no written agreement may file a financing statement without consent provided the financing statement covers “only collateral in which the person holds an agricultural lien.” 810 ILCS 5/9-509(a)(2). Second, the financing statement does not need to include the legal description of leased real estate as a condition of perfection because Article 9 requires this description only for “asextracted collateral or timber to be cut.” 810 ILCS 5/9-502(b). “As-extracted collateral” means oil, gas, or other minerals that are subject to a security interest that is created by a debtor having an interest in the minerals before extraction and attaches to the minerals as extracted. 810 ILCS 5/9-102(a)(6). Yet, a legal description may be appropriate as an indication of “the collateral covered by the financing statement.” 810 ILCS 5/9-502(a)(3). An example is the landlord’s lien on crops growing on specific acreage. When the debtor is a tenant farmer that does not have a record interest in the real estate, counsel also must provide the name of the record owner. 810 ILCS 5/9-502(b)(4). Prior to January 1, 1998, the filings for farm equipment, crops, and livestock were in the office of the county recorder in the county of the debtor’s residence. With a few exceptions, all financing statements are now required to be filed in the office of the Secretary of State. 810 ILCS 5/9-501(a). The law governing perfection of priority of security interests is generally determined by the location of the debtor. 810 ILCS 5/9-301. The law governing the priority of agricultural liens is the local law of the jurisdiction where the farm products are located. 810 ILCS 5/9-302. The debtor’s location depends on how the debtor is conducting the farm business. When a debtor is an individual, he or she is located at the individual’s principal residence. When the debtor is a non-registered organization, such as a general partnership, it is located at its place of business or its chief executive office if it has more than one place of business. 810 ILCS 5/9307(b). However, when the debtor is an organization that is organized under state law, such as a corporation or a limited liability company, it is located in the state where it is registered. 810 ILCS 5/9-307(e). The failure to file in the proper jurisdiction or to otherwise fail to satisfy the specific requirements for completing and filing the financing statement can be fatal. See, e.g., Duesterhaus Fertilizer, Inc. v. Capital Crossing Bank (In re Duesterhaus Fertilizer, Inc.), 347 B.R. 646 (Bankr. C.D.Ill. 2006). C. [7.8] Priorities Priority between conflicting security interests and agricultural liens in the same collateral generally dates from the earlier of the time the filing covering the collateral is first made or the security interest or agricultural lien is first perfected. See 810 ILCS 5/9-322, 5/9-338. A perfected security interest in growing crops has a priority over a conflicting interest of the owner or the mortgagee of the real property on which such crops are grown. 810 ILCS 5/9334(i)(1)(A). The same priority applies between an assignee of a beneficial interest in an Illinois land trust and the holder of a perfected security interest in crops. See 810 ILCS 5/9-334(i)(1)(B). Lenders financing farm real estate that also want to maintain priority in crops must comply with Article 9 of the Uniform Commercial Code.

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AGRICULTURAL FINANCING IN ILLINOIS UNDER ARTICLE 9

§7.9

D. [7.9] Purchase-Money Security Interests in Agricultural Products The 2001 amendment of Article 9 of the Uniform Commercial Code (see §7.1 above) eliminated the special priority for a purchase-money security interest (PMSI) in crops. See former UCC §9-312(2), 810 ILCS 5/9-312(2) (2000). Article 9 provides that a perfected PMSI in livestock that are farm products has priority over a conflicting security interest in the same livestock. 810 ILCS 5/9-324(d). This provision requires: 1. The PMSI must be perfected when the debtor receives possession of the livestock. 2. The PMSI secured party sends notification to the holder of the conflicting security interest. 3. The holder of the conflicting security interest receives notification within six months before the debtor receives possession of the livestock. 4. The notification states that the person sending it has or expects to acquire a PMSI in livestock and describes the livestock. The effective date of a PMSI lien depends on the date the secured party with the prior filed lien receives the notification from the PMSI lender and the date the debtor receives possession of the livestock. Since PMSI lenders rarely send PMSI notices months in advance of the delivery of possession of livestock, it is very important to document the date that the priority lender actually receives the required notice. In the event a bankruptcy is filed or a conflict arises with the holder of the blanket security interest in livestock, these dates will determine the priority of the PMSI lien. The content of the PMSI notice and the timing of its receipt were at issue in In re Leading Edge Pork, LLC, Bankruptcy No. 09-82789, 2010 WL 2926155 (Bankr. C.D.Ill. July 26, 2010). Leading Edge Pork, LLC, was a swine producer that purchased piglets from third-party sources and paid other third-party growers to raise them to market weight. The debtor retained ownership of the swine while in possession of the third-party growers. Lone Hollow LLC sold the debtor weaner pigs in 2009 on credit and took a PMSI in the pigs it sold. Lone Hollow perfected its security interest in the weaner pigs it sold by filing a UCC-1 Financing Statement on June 9, 2009. At issue in the case was whether the security interest was perfected as to the sale of pigs to the debtor on June 10th and 12th. At 6:34 p.m. on June 9th, Lone Hollow sent an e-mail to the bank via its website directed to an officer of the bank that stated in its entirety, Scott — Wayne Peugh gave me your contact information with regard to Purchase Money Security Interest for pigs delivered from Lone Hollow. 2010 WL 2926155 at *2. This e-mail was forwarded to the banker at 8:13 a.m. on June 10, 2009.

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§7.10

SECURED TRANSACTIONS

The second communication sent by Lone Hollow was mailed from Carthage, Illinois, on Friday, June 12, 2009, bearing the heading “NOTICE OF PURCHASE MONEY SECURITY INTEREST.” Id. The record contained no direct evidence as to the date or time the mail notice was delivered to the bank or when the debtor actually received the pigs sold on June 10th or 12th. On cross-motions for summary judgment, the bankruptcy court found that the e-mail notice was insufficient to satisfy the requirements of UCC §9-324(d)(4). It failed to identify Leading Edge Pork, LLC, as the bank’s borrower, nor did it state that Lone Hollow had or expected to acquire a PMSI. On the other hand, the court found that the letter dated June 12, 2009, did satisfy the content requirements of UCC §9-324(d)(4). Because there were genuine issues of material fact as to the timing of the receipt of the notification of the second letter by the bank and the receipt by the debtor of the pigs, the motions for summary judgment were denied. In order to prevail, Lone Hollow had to establish that the bank received the notification before the debtor received the pigs. Traditionally, PMSI suppliers sent their notices by certified or registered mail and retained the receipt or return card as evidence of the receipt of the notice in the event a conflict would subsequently arise. This remains the best practice. However, because this is the 21st century, some PMSI suppliers send their notices by e-mail. This can be acceptable provided the e-mail contain all of the information required by UCC §9-324(d)(4). By using e-mail or some other form of electronic communication, the PMSI lender should obtain confirmation from all lenders with the prior blanket security interests in livestock that the notice was received. The PMSI lender must retain these electronic records.

IV. OTHER ISSUES AFFECTING AGRICULTURAL TRANSACTIONS A. [7.10] Notice to Buyers of Farm Products The Food Security Act of 1985 (FSA), Pub.L. No. 99-198, §1324, 99 Stat. 1354, preempted the farm products rule in the Uniform Commercial Code that permitted a secured party to follow its lien into the hands of a buyer. 7 U.S.C. §1631. Buyers objected to the UCC rule and successfully lobbied for the enactment of this statute to permit buyers to take free of the UCC liens absent notice. See 7 U.S.C. §1631(h). As part of the 2001 amendment of Article 9 (see §7.1 above), Illinois enacted its own provision for notice to buyers of farm products of the interest of a secured party. 810 ILCS 5/9-320(f). The purpose of the notice is to protect the secured party and prohibit the buyer of farm products from paying the seller without including the secured party’s name on the check. In order to invoke this protection, the holder of the security interest is required to send notice to the potential buyers of farm products. The notice must contain: (I) the name and address of the secured party; (II) the name and address of the person indebted to the secured party;

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§7.10

(III) the social security number, or other approved unique identifier, of the debtor or, in the case of a debtor doing business other than as an individual, the Internal Revenue Service taxpayer identification number, or other approved unique identifier, of the debtor; and (IV) a description of the farm products subject to the security interest created by the debtor, including the amount of such products where applicable, crop year, and the name of each county or parish in which the farm products are produced or located. 7 U.S.C. §1631(e)(1)(A)(ii). A sample form of a notice to buyers of farm products is set forth in §7.21 below. The law also provides for fines and criminal penalties for selling to parties other than as disclosed to a secured party. 810 ILCS 5/9-315.02. Similarly, the FSA provides for penalties if the debtor violates the restriction on sale without paying the secured party. 7 U.S.C. §1631(h). Strict compliance with the notice provisions of §1631(e) is required for a secured party to obtain the protection provided by the FSA. State Bank of Cherry v. CGB Enterprises, Inc., 2013 IL 113836, 984 N.E.2d 449, 368 Ill.Dec. 503. In State Bank of Cherry, the bank claimed that CGB Enterprises, Inc., failed to protect the bank’s security interest in crops that CGB purchased from a farmer. CGB filed a motion to dismiss the bank’s complaint on the grounds the bank’s notices of security interest failed to strictly comply with §1631(e). On cross-motions for summary judgment, the circuit court entered judgment granting the bank’s motion for summary judgment and denying CGB’s motion. The farmer had executed a note in the bank’s favor using his crops as security. The farmer sold these crops to CGB. The bank alleged that it gave notice of the security interest in the crops to CGB pursuant to the FSA and that CGB failed to protect the bank’s security interest by making payment on the crops directly to the farmer without naming the bank on the check. CGB relied on Farm Credit Midsouth, PCA v. Farm Fresh Catfish Co., 371 F.3d 450 (8th Cir. 2004), which held that strict compliance with the §1631(e) notice provision is required for a party to recover for failing to protect a security interest in crops. The Eighth Circuit held that “the Act[ ] . . . does not contain language indicating the required contents of the written notice are merely permissive or can be satisfied through substantial compliance.” Farm Fresh Catfish, supra, 371 F.3d at 453. In State Bank of Cherry, supra, neither of the notices served on CGB included information regarding the names of the county where the farm products were produced or located. The appellate court adopted the construction of Farm Fresh Catfish that Congress intended strict compliance with the FSA, and the Supreme Court affirmed. As a result, CGB took free of the bank’s security interest even though CGB knew of its existence. 2013 IL 113836 at ¶67. However, the FSA protections for a grain buyer of corn and soybeans do not extend to the proceeds of those crops. CNH Capital America LLC v. Trainor Grain & Supply Co. (In re Printz), 478 B.R. 876 (Bankr. C.D.Ill. 2012). Therefore, the grain buyer cannot use the proceeds, in which the lender obtained a first priority security interest, to set off against the debts owed to it by the farmer.

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§7.11

SECURED TRANSACTIONS

Before filing a voluntary petition under Chapter 11 on December 31, 2010, the debtors, Mr. and Mrs. Robert Printz, entered into three line of credit and security agreements with CNH Capital America LLC. In addition to filing financing statements to perfect a security interest in the debtors’ crop proceeds and other personal property, CNH sent four separate letters to Trainor Grain and Supply Co., a potential purchaser of the crops, notifying Trainor of CNH’s lien on the crops. Separately from selling corn and soybeans to Trainor, the debtors also entered into a series of agreements whereby Trainor provided farming inputs to the debtors. Shortly before the filing of the voluntary petition, Trainor retained the sum of $362,443.49 from the crop proceeds due the debtors and applied the retained funds to the amounts the debtors owed it. After the bankruptcy case was filed, CNH responded by filing a complaint to determine the validity, priority, and extent of competing liens. One of the affirmative defenses raised was that CNH failed to satisfy the notification requirements under the FSA. First, the bankruptcy court found that CNH under Illinois law had a valid, perfected, first priority security interest in the debtors’ crops and proceeds from the sale of those crops by reason of the debtors’ execution of the security agreements and the filing of the financing statements that identified the lien on the debtors’ crops and proceeds. Second, Trainor argued that it was a buyer in the ordinary course of business under the FSA and that it took the corn and soybeans free and clear of CNH’s lien because the notice CNH gave Trainor was defective. Specifically, the notices all failed to include the debtors’ social security numbers and a proper description of the crops subject to the security interest. The bankruptcy court agreed that strict compliance is required for the FSA notice. Third, CNH, however, made no attempt to claim that its notices were sufficient under the FSA. Instead, CNH claimed that Trainor was not a buyer in the ordinary course because its intent in buying the crops was to use the sales proceeds to satisfy the debtors’ obligations for inputs. The bankruptcy court rejected this argument and found that Trainor did in fact purchase the corn and soybeans free and clear of CNH’s security interest. Finally, the court also found that the FSA did not support Trainor’s contention that it took both the grain and the proceeds free of CNH’s lien. The court found that the FSA does not include “proceeds” in providing for ordinary-course buyers of farm products to take farm products free from the security interests created by sellers engaged in farming operations. The purpose of the FSA is to protect buyers from liability to lien holders to which the debtors fail to remit the proceeds of products sold. Further, the court held that the FSA does not preempt state laws on the creation, perfection, and priority of security interests. The company, in setting off its preexisting debt against the proceeds of the debtors, was acting as a creditor and not as a buyer. B. [7.11] Grain Code The supremacy of the Grain Code, 240 ILCS 40/1-1, et seq., continues. Specifically, Article 9 of the Uniform Commercial Code does not apply to the extent that it is in conflict with the Grain Code. 810 ILCS 5/9-109(c)(5). The Grain Code is the legislature’s plan to regulate the Illinois grain industry. Its purpose is to protect producers in the event that licensed grain dealers or

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§7.12

warehousemen should fail financially. The Grain Code provides for margin requirements on certain contracts and sets forth the rules concerning delivery of grain, the insurance of warehouse receipts, etc. Lenders must become familiar with the terms of the Grain Code in order to engage in crop financing. Finally, a lender must be vigilant for a borrower who attempts to double-finance his or her crops. The farmer can deliver grain to an elevator and receive a negotiable warehouse receipt. The receipt can then be delivered to another lender. C. [7.12] The Perishable Agricultural Commodities Act The Perishable Agricultural Commodities Act, 1930 (PACA), 7 U.S.C. §499a, et seq., is a federally created statutory trust. The PACA trust is created for the benefit of persons who sell perishable agricultural commodities that are not paid. The statutory trust arises when the following occur: 1. The commodities sold are “perishable agricultural commodities.” 7 U.S.C. §499a(b)(4). A “perishable agricultural commodity” is defined as fresh fruits or vegetables of every kind and character (whether frozen or packed in ice) and cherries in brine. Id. 2. The purchaser of perishable agricultural commodities is one of the following: a. a commission merchant (7 U.S.C. §499a(b)(5)); b. a dealer (7 U.S.C. §499a(b)(6)); or c. a broker (7 U.S.C. §499a(b)(7)). 3. The transaction occurs in interstate or foreign commerce. 7 U.S.C. §499a(b)(8). 4. The suppliers, sellers, or agents have not received full payment on the transaction. 7 U.S.C. §499e(c). 5. The suppliers, sellers, or agents preserve their trust rights by giving written notice to the commission merchant, broker, or dealer within the time provided by law. Id. Under the PACA, the purchaser holds all perishable agricultural commodities, all products derived therefrom, and all receivables or proceeds from the sale of such perishables “in a floating trust” for the benefit of the unpaid suppliers, sellers, or agents. See, e.g., G&G Peppers, LLC v. Ebro Foods, Inc. (In re Ebro Foods, Inc.), 449 B.R. 759, 762 (N.D.Ill. 2011). An understanding of the application of the PACA is important in any agricultural lending. If the borrower is one of the suppliers, sellers, or agents whom the PACA benefits, the lender must know whether the borrower remains unpaid by the purchaser of perishable agricultural commodities. The lender also needs to ensure that its collateral description is broad enough to cover the right to payment of funds held in trust.

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§7.13

SECURED TRANSACTIONS

If the borrower is the purchaser, however, the lender is at greater risk. The rights of suppliers, sellers, or agents as trust beneficiaries in all inventory, receivables, or proceeds from the perishable agricultural commodities are statutorily superior to the rights of any other creditor, including a creditor of the purchaser who holds a perfected security interest in those inventories, receivables, or proceeds. A & J Produce Corp. v. Bronx Overall Economic Development Corp., 542 F.3d 54 (2d Cir. 2008). Consequently, lenders need to ensure that a purchaser-borrower has paid all of its suppliers. Finally, there is a parallel statutory scheme known as the Packers and Stockyards Act, 1921, 7 U.S.C. §181, et seq., that provides the same protection for livestock producers. See, e.g., Weichman Pig Co. v. Jack-Rich, Inc. (In re Jack-Rich, Inc.), 176 B.R. 476 (Bankr. C.D.Ill.1994). D. [7.13] Government Payments Government payments have provided fertile ground for litigation. Are they “proceeds” of crops or general intangibles? See In re Schmaling, 783 F.2d 680 (7th Cir. 1986) (“payment-inkind” payments did not constitute crop proceeds). Any security agreement limited to crops can avoid this issue by also taking a security interest either in all general intangibles or specifically in the various programs that a lender seeks as security. See In re Otto Farms, Inc., 247 B.R. 757, 760 (Bankr. C.D.Ill. 2000) (collateral description of “general intangibles, including government payments” was adequate to cover government loan deficiency payments). It is best to avoid litigation as to whether such a payment is “proceeds.” The Agricultural Act of 2014, Pub.L. No. 113-79, 128 Stat. 649, eliminated direct payments to producers while continuing crop insurance, rural development programs, and conservation programs. The lender must be aware that some programs prohibit or regulate assignments or security interests. Lenders must identify the program in which a borrower participates and review the regulations carefully with an attorney. For example, whether a bank has an enforceable security interest in crop insurance proceeds depends on whether proceeds have been distributed to the farmer. See In re Duckworth, Bankruptcy No. 10-83603, 2012 WL 986766 (Bankr. C.D.Ill. Mar. 22, 2012). In Duckworth, the bankruptcy court held that the Federal Crop Insurance Act preempted state law with respect to the method by which a lien on an insured’s right to crop insurance proceeds may be created. The court adopted the reasoning of In re Cook, 169 F.3d 271 (5th Cir. 1999), that the exclusive method by which a creditor can obtain a lien or security interest on undisbursed crop insurance proceeds is through the authorized assignment process. E. [7.14] Bankruptcy The greatest challenge to any secured transaction arises when a borrower files a proceeding under the Bankruptcy Code. Originally enacted in 1986, Chapter 12 of the Bankruptcy Code provides a procedure by which family farmers, as defined by the Code (see 11 U.S.C. §101(18)), can restructure debt. A permanent extension of Chapter 12 was enacted as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), Pub.L. No. 109-8, 119 Stat. 23. See Terrell Lee Sharp and Bentley J. Bender, Ch. 7, Chapter 12 Bankruptcy Tips and Procedures, CONSUMER BANKRUPTCY PRACTICE (IICLE®, 2011, Supp. 2013).

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AGRICULTURAL FINANCING IN ILLINOIS UNDER ARTICLE 9

§7.15

Whenever a dispute arises in a bankruptcy case as to the lien rights of a lender, an adversary proceeding will be filed to determine the validity, priority, or extent of a lien under Rule 7001(2) of the Federal Rules of Bankruptcy Procedure. Regardless of whether the adversary proceeding is brought by the lender, the debtor, or the trustee, the adversary proceeding provides the vehicle by which all legal and equitable theories may be tested. See, e.g., Illini Bank v. Clark (In re Snyder), 436 B.R. 81 (Bankr. C.D.Ill. 2010). At issue in Illini Bank was whether the equitable doctrine of marshaling should be applied to the benefit of Tri Ag, Inc., the holder of a junior lien against certain crop proceeds held by the Chapter 12 trustee. Illini Bank, as the assignee of the senior lienholder, wanted the funds for itself and opposed marshaling. In the debtors’ Chapter 12 petition and schedules, Mr. Snyder listed himself as a farmer and Mrs. Snyder listed herself as retired. However, the schedules for real property and personal property listed them as jointly owned. Tri Ag’s debt of $123,342 was the oldest. In February 2006, only Mr. Snyder signed a security agreement covering all crops grown on real estate located in Logan and Mason Counties. To perfect that security interest, a UCC financing statement naming him as the sole debtor was filed on April 7, 2006. Unfortunately for Tri Ag, AG-LAND loaned money to the debtors and, on February 27, 2006, filed a UCC financing statement naming both as debtors. AG-LAND was owed $130,897.05. Thus, AG-LAND had the prior security interest in all growing and harvested crops. In 2007, both debtors borrowed money from Illini Bank and granted it a security interest in crops, machinery, and equipment, among other property. After the bankruptcy case was filed, Illini Bank purchased AG-LAND’s position and thereby leapfrogged from third to first priority on the crop lien. Tri Ag and Illini Bank filed cross-motions for summary judgment on the issue of marshaling an application of the total crop proceeds of $100,520.88. The first issue the court decided was that the direct and circumstantial evidence supported the conclusion that Mrs. Snyder owned half of the crop proceeds. Consequently, because she failed to sign the Tri Ag security agreement, Tri Ag acquired and held a lien on only one half of the proceeds. Next, the court rejected Illini Bank’s argument that the doctrine of marshaling should fail. Instead, the court held that marshaling could be applied to protect the one-half interest held by Tri Ag. The court noted that if AG-LAND had not sold its claim to the bank, AG-LAND, because it held a first priority lien on crop proceeds and on machinery equipment, would have been substantially oversecured. As a result, Illini Bank took the assigned claims subject to the marshaling rights of Tri-Ag. F. [7.15] Financing Dealers of Patented Grain Products Agricultural lenders not only finance farmers; they also finance dealers that supply farmers with agricultural products, including fertilizers and seed. In doing so, these lenders typically take blanket liens on all personal property to secure existing and future indebtedness. Many lenders assume that if they have found no Uniform Commercial Code financing statement filed against a

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§7.15

SECURED TRANSACTIONS

dealer, they need be concerned only with subsequent lenders of purchase-money security interests in inventory. As to these PMSI lenders, the original lender will still retain priority in all other property assuming the lender was first to file. Unfortunately, the first lender that files a financing statement covering all property of a dealer in agricultural products may be lulled into a false sense of security. Lenders must be aware that an agricultural dealer’s inventory differs dramatically from the inventory of other commercial retailers. Lenders may believe that seed in the hands of a dealer is simply inventory. The supplier of the dealer, however, sees a patented product that only a licensed representative may sell. If the dealer has defaulted on its license, no one, including the lender in an UCC foreclosure sale, has authority to sell the seed. Consequently, the seed will have little value as collateral. In 2001, the United States Supreme Court upheld the right of seed manufacturers to obtain a utility patent on seed. In J.E.M. Ag Supply, Inc. v. Pioneer Hi-Bred International, Inc., 534 U.S. 124, 151 L.Ed.2d 508, 122 S.Ct. 593 (2001), Pioneer sued J.E.M. Ag Supply, doing business as Farm Advantage, for patent infringement. Farm Advantage purchased seed from Pioneer. However, Farm Advantage was not an authorized dealer of Pioneer, and when it resold the seed, Pioneer sued for patent infringement. The Supreme Court upheld Pioneer’s patent and the verdict for Pioneer on infringement. A utility patent grants the patent-holder the exclusive right to restrict the use, manufacture, or sale of the patented product. However, under the first-sale doctrine, once a product is first sold, typically the purchaser has a right of resale. This can lead lenders to believe that once a dealer purchases seed, the patent-holder’s rights have been exhausted, thus permitting the lender to foreclose on its security interest in the seed and resell it. Unfortunately, a lender cannot foreclose the patent-holder’s rights. The first-sale doctrine applies only if the sale is an unconditional sale. Seed patent-holders do not make unconditional sales to dealers. Rather, they license a dealer to sell a product that comes with a limited use label authorizing its use only as seed to grow grain. The result of these limited sales is that only licensed dealers may sell the seed. This method of restricting seed sales was upheld in Pioneer Hi-Bred International, Inc. v. Ottawa Plant Food, Inc., 283 F.Supp.2d 1018 (N.D. Iowa 2003), one of the cases related to a Farm Advantage resale of Pioneer seed. Ottawa Plant Food purchased seed from Farm Advantage and then sold the seed to farmers. Ottawa was not a licensed dealer. When Pioneer sued Ottawa for patent infringement, Ottawa based its defense on the first-sale doctrine, arguing that Pioneer’s patent rights were exhausted on its sale to Farm Advantage. The district court disagreed, finding that the label on the bags of seed corn authorized only the use of the seed and, thus, implicitly reserved all other patent rights. Thus, there was no unconditional sale of the seed, and the first-sale doctrine did not apply.

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§7.15

The impact of these cases on a lender with a security interest in a dealer’s inventory is severe. Although Article 9 of the UCC permits the creation of a security interest in the patented goods pursuant to 810 ILCS 5/9-408(a), the enforcement of the security interest is restricted under 810 ILCS 5/9-408(d). Section 9-408(a) renders ineffective restrictions on an assignment of a general intangible, which includes license rights, but only to the extent that these restrictions impair the creation and perfection of a security interest. A lender that perfects a security interest in inventory and general intangibles would appear to have a valid security interest in both the inventory (the seed) and the right to sell (the license held by an authorized dealer). However, having the security interest and being able to enforce it are two different matters. Section 9-408(d) precludes actual enforcement of a license if by its terms the license is not transferable. Thus, upon default, a secured party might take possession of the seed, but it will not be able to sell it without risking a suit for patent infringement. Article 9 is of limited help. Its only benefit is in a dealer bankruptcy case in which (1) the dealer’s license was not terminated prior to bankruptcy, (2) the dealer is able to assume the license, and (3) the dealer sells the seed in the ordinary course of its business as it reorganizes. In such a situation, the lender’s security interest will transfer to the proceeds of the lawful sales by the dealer. However, it is unlikely in most cases that the dealer will meet all of these criteria. A patent-holder that has not received royalties will usually move to terminate the dealer’s license. If this occurs prior to a bankruptcy filing, the patent-holder cannot be compelled to grant a license to the dealer-debtor in bankruptcy. The dealer will have no more authority to sell the seed. If the patent-holder does not manage to terminate the license prior to a bankruptcy filing, a dealer still may be restricted in selling the seed. If a dealer is behind in royalty payments, the dealer must cure these defaults in order to assume the license in bankruptcy. The result is that the patent-holder’s claim jumps to the head of the priority list even though the patent-holder does not hold a security interest. Finally, the debtor cannot solve the problem by a sale outside the ordinary course of business pursuant to §363 of the Bankruptcy Code. Section 363 permits sales free of an interest only in certain circumstances, specifically if the interest is a lien or is one for which applicable law will permit a sale in satisfaction of a money award. 11 U.S.C. §363. An intellectual property interest is not a lien, and applicable law does not permit a transfer without consent. See, e.g., In re CFLC, Inc., 89 F.3d 673 (9th Cir. 1996) (§363 sale cannot result in transfer of nonexclusive, nontransferable license over holder’s objection). This discussion demonstrates that a lender financing a dealer in patented seeds cannot rely on the inventory. To solve this problem, the lender might try to obtain some limited license from each of the manufacturers before lending. Whether any manufacturer will be receptive to granting such a license is unknown. Also, depending on the number of products (and thus licenses) involved, this may raise the cost of documenting the financing for a small dealer to a prohibitive amount.

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§7.16

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Another option is for the lender to consider lending only against a borrowing base. The base should include only accounts and inventory not subject to these licenses. The lender will have to perform occasional audits of the borrowing base to ensure that improper inventory is not included. The last option is for the lender to recognize that it is in reality partially unsecured and to use this knowledge in its underwriting. This knowledge may then lead the lender either to decline the loan as too risky or, alternatively, to price the loan through a higher interest rate due to the greater risk. G. [7.16] Limited Liability Companies Increasingly, farmers and ranchers are using limited liability companies (LLCs) to conduct their farm and livestock operations. When lending to LLCs, lenders must take care to review carefully and understand the terms of the operating agreements and determine whether the LLCs are member managed or manager managed. The type of operating agreement and management will determine the necessary documents for any secured transaction. First, a lender must determine whether there are any restrictions on the ability of an LLC borrower to grant a security interest in its assets to secure loans. For example, the operating agreement may prohibit any encumbrance on its assets without the approval or consent of all or a majority of the members. Typically, this requirement can be satisfied by having all members sign the note and the security agreement. Second, the lender also may take a pledge of the membership interest of an individual member. Most operating agreements prohibit such pledges without the prior consent of all members and satisfaction of the additional requirements contained in those agreements. For example, the other members may agree to consent but require that the lender give them a right of first refusal in the event that the lender decides to do an Uniform Commercial Code foreclosure of the pledged interest. Additionally, some operating agreements have an absolute prohibition against any pledge of a membership interest. It is imperative that the lender document the necessary consents or approvals in the manner required by the operating agreement. Failure to do so is fatal. See In re Weiss, 376 B.R. 867 (Bankr. N.D.Ill. 2007) (compliance with operating agreement controlling procedures for transfer of interest is required for proper assignment). In Weiss, the court provided a chart showing the provisions from the operating agreements of eight different LLCs that restricted, and in some cases absolutely prohibited, the transfer of a membership interest. The court also noted that the operating agreements required that the written consents be obtained “prior to” any transfer. 376 B.R. at 873. If the operating agreement contains an absolute prohibition, best practices dictate that the lender require that the agreement be amended to delete that prohibition or that all of the members affirmatively waive the prohibition. Third, it is equally imperative that the form of consent provide that the assignee, and any ultimate third party who acquires the interest once it is foreclosed on, be entitled to all of the economic and noneconomic (management) rights of the assignor. The Limited Liability Company

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Act, 805 ILCS 180/1-1, et seq., provides that a transferee of an interest in an LLC takes the interest “in accordance with authority described in the operating agreement or all other members consent.” 805 ILCS 180/30-10(a). See also Bobak Sausage Co. v. Bobak Orland Park, Inc., No. 06 C 4747, 2008 WL 4814693 (N.D.Ill. Nov. 3, 2008). Most operating agreements not only restrict assignments or pledges, but also limit the rights of any approved transferee to take only an economic interest (i.e., the right to monetary distributions from the LLC). The lender must demand that the interests transferred include all voting and management rights in order for the membership interest to have any real market value. The consent must be clear that the lender, as the collateral assignee, is not restricted and is affirmatively authorized and permitted to subsequently transfer the entire membership interest to any third party. A right of first refusal of any bona fide offer can be included in the consent. It is insufficient, however, for the remaining members to consent merely to the pledge or transfer of the interest to the lender without the right of subsequent transfer. No lending institution will want to bid at a UCC foreclosure sale to hold a membership interest as an investment. Instead, lenders will seek to transfer the membership interest once acquired to a third party to make a recovery on the loan. Provisions in an operating agreement purporting to place limitations or restrictions on a membership’s interest as a result of the member filing bankruptcy are unenforceable. LaHood v. Covey (In re LaHood), 437 B.R. 330, 336 (C.D.Ill. 2010). In conclusion, whether there is a security interest in the assets of the LLC or a collateral assignment of the membership interest in an LLC, a lender must exercise care to determine whether the security interest taken is valid and enforceable. H. [7.17] Landlord’s Consent Whether the collateral is equipment that is easily removable or fixtures in which the lender has a prior perfected security interest, it is imperative that the lender obtain a landlord’s consent if the collateral is located on property not owned by the debtor. In too many instances, lenders forget this important detail with unfortunate consequences. Obviously, the landlord’s consent is important to permit the lender to enter on the landlord’s real property to repossess and remove the personal property in which the lender has a security interest. This consent is even more important when the security agreement covers goods that are or will become fixtures. Section 9-604 of the Uniform Commercial Code provides the procedure by which a secured party can enforce its rights in fixtures. 810 ILCS 5/9-604. Section 9-604(c) permits the secured party that holds a security interest in fixtures and that has priority over all owners and other encumbrancers of the real property to remove the collateral from the real property upon default. This right of removal is subject to §9-604(d). Section 9-604(d) requires the secured party that removes collateral to reimburse any encumbrancers or the owners of the real property, other than the debtor, for the cost of repair of any physical injury caused by the removal. Moreover, “[a] person entitled to reimbursement may

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refuse permission to remove until the secured party gives adequate assurance for the performance of the obligation to reimburse.” 810 ILCS 5/9-604(d). Comment 3 to §9-604 further emphasizes that the right to reimbursement “gives the owner or encumbrancer a right to security or indemnity as a condition for giving permission to remove.” UCC Comment 3, 810 ILCS 5/9-604. I. [7.18] Is Marijuana a Farm Product? In November 2015, Illinois saw its first medical marijuana dispensaries open for business. Current federal law classifies all marijuana possession and sale as criminal. 21 U.S.C. §801, et seq. As a result, the marijuana industry must operate completely in cash even in states where it’s sold recreationally. Lending to marijuana businesses has created a volatile situation for the federal government. On February 14, 2014, the United States Department of Treasury Financial Crime Enforcement Network issued guidance regarding compliance with the Bank Secrecy Act and the requirements for filing suspicious activity reports by any financial institution insured by the Federal Deposit Insurance Corporation. See www.fincen.gov/statutes_regs/guidance/pdf/FIN2014-G001.pdf (case sensitive). However, when federal law changes, here are some issues to consider when financing marijuana businesses. How is marijuana to be categorized under the Uniform Commercial Code? While growing, or in a grown stage, marijuana is a “farm product.” 810 ILCS 5/9-102(a)(34)(A) (“crops grown, growing, or to be grown”). Products of crops in their unmanufactured state are also farm products. 810 ILCS 5/9-102(a)(34)(D). In Illinois, either a registered cultivation center or a registered dispensary may turn the marijuana farm products into inventory by manufacturing cannabis infused products. 410 ILCS 130/80(a). Marijuana available for sale is probably also considered inventory due to the extensive procedures required to prepare it. Once marijuana is harvested, the first step is to separate its valuable flowers from its other plant material. The marijuana plants are dried and cured after manicuring and trimming of the marijuana flowers. When the manicured marijuana is less than ten percent moisture, it is packaged and sold by the gram. The trimmings and other materials that shake free from the marijuana flowers are typically turned into extracts or edible products. This transformation of the marijuana farm products converts it into inventory under the UCC. Much like the federal restrictions placed on patented seed discussed in §7.15 above, Illinois law places restrictions on who may sell marijuana. A registered cultivation center may only sell its marijuana farm products or inventory to a state registered dispensary. 410 ILCS 130/105(e). In turn, an Illinois marijuana dispensary may only sell its inventory to registered qualifying patients. 410 ILCS 130/180(d). While the registered cultivation center or dispensary could grant a security interest in its farm products or inventory, it cannot grant a security interest in its state license to sell marijuana. Illinois law does not expressly prohibit granting security interests in the state licenses to sell marijuana, but the restrictions imposed by the state on the licensing issuance and renewal creates

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the presumption they cannot be used as collateral. 410 ILCS 130/85, 130/90, 130/115, 130/130. Generally state laws provide that no security interest may attach to a liquor license, explosive license, or patent license. Marijuana licenses will probably be treated the same. Obviously, no lender is licensed to possess or sell marijuana. Whether a cultivation center or a dispensary is a borrower, who may sell marijuana is strictly regulated. Therefore, upon default by the borrower the value of the marijuana farm product, or inventory, is nontransferable. If the borrower defaults, the lender can repossess and liquidate all the real estate and equipment of the marijuana business, but not the marijuana without state approval. The marijuana business entirely depends on its unique statutory rights to possess and sell marijuana. The most significant value of the borrower to the lender is its cash flow. Imagine if the marijuana business operates outside the state law and the Drug Enforcement Administration (DEA) seizes the marijuana inventory in a raid. With the marijuana taken as evidence, it cannot be liquidated. For this scenario, the bank financing the marijuana inventory should value it at zero. The bank could require the marijuana business to hold cash in a collateral pledge agreement at some percentage of the value of the marijuana inventory. When the DEA walks away with the marijuana inventory, the bank can declare a default and setoff the cash. Another option for the lender is the amount of interest charged for the extra risk of the marijuana business loan. The loan could be structured only on buildings and equipment, as if the inventory creating the cash flow could go up in smoke at any time. Lending to marijuana businesses is not yet allowed. While legalization may not be far in the future, one thing is clear. Marijuana businesses will continue to be strictly regulated like those selling alcohol, tobacco, or drugs. Valuing the marijuana inventory or farm products provides a new challenge to prospective commercial lenders. Through proper planning, a financial institution has several creative options available for collateralizing its loans.

V. [7.19] CONCLUSION Although a security agreement may deter litigation by the strength of its terms, litigation based on human frailty will arise without regard to the strength of the document. For example, if the lender fails to make sure that the notice to buyers of farm products is properly prepared and sent, the best security agreement in the world cannot protect the lender against losses suffered from missing collateral. More importantly, an agricultural lender must recognize a major difference from other commercial lending. In this area, it is possible for other parties that have not filed prior financing statements to hold a lender hostage. For example, the landlord’s statutory lien has priority over a lender that has filed against the crops grown on leased land. Additionally, a bank lender to a dealer in seed may find itself held hostage to the demands of a patent-holder for royalty payments.

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§7.20

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As a result, due diligence does not stop with checking for filed Uniform Commercial Code financing statements. A lender may need to obtain a subordination agreement with a landlord or review its debtor’s products and licenses and to adjust its decision to lend based on the restrictions contained in these licenses. An agricultural lender that fails to recognize the peculiar priorities and industry practices will suffer from this failure. Agricultural financing has its own special requirements. Lenders cannot approach the area as if it were like any other commercial or business loan.

VI. APPENDIX — SAMPLE FORMS A. [7.20] Agricultural Security Agreement AGRICULTURAL SECURITY AGREEMENT This Security Agreement, dated as of [date of security agreement] (Security Agreement), is made by [name of borrower] (Borrower), in favor of [name of bank], [city where bank located], Illinois, a state bank (Bank). RECITALS Whereas, pursuant to a Loan Agreement dated as of [date of loan agreement], by and between the Bank and the Borrower (Loan Agreement), the Bank has agreed to make available credit for the Borrower’s farming operations; and Whereas, it is a condition precedent to the obligation of the Bank to make the extensions of credit under the Loan Agreement that this Security Agreement be executed: AGREEMENTS Therefore, in order to induce the Bank to make extensions of credit under the Loan Agreement and for other good and valuable consideration, the parties hereby agree as follows: 1. Defined Terms. Unless otherwise defined herein, the terms defined in the Loan Agreement (whether or not such Loan Agreement remains in effect) are hereby incorporated by reference into this Security Agreement and shall have the meanings given to them in the Loan Agreement. 1.1 “Collateral.” The Collateral shall consist of all of the personal property of the Borrower, wherever located, and now owned or hereafter acquired, including: (i)

farm products, other than standing timber;

(ii) crops, including all growing and harvested crops, annual and perennial, and other plant products, now growing or hereafter to be planted or harvested;

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(iii) livestock, born or unborn, including all livestock, poultry, and fish, used or produced in farming operations; (iv) farm supplies, including but not limited to all seed, fertilizer, feed, medicines, harvested and stored grain, milk, and other supplies used or produced in farming operations; (v)

all payments, commodities, entitlements, certificates, or other rights under any government or other loan, reserve, disaster, diversion, deficiency, soil conservation, or other production control or price support program, now existing or hereafter enacted;

(vi) accounts; (vii) chattel paper; (viii) inventory; (ix) equipment; (x)

instruments, including promissory notes;

(xi) investment property; (xii) documents; (xiii) deposit accounts; (xiv) letter-of-credit rights; (xv) general intangibles; and (xvi) to the extent not listed above as original collateral, proceeds and products of the foregoing. 1.2 “Obligations.” This Security Agreement secures the following: (i)

the Borrower’s obligations under the Loan Agreement and any loans made thereunder, under any promissory note made by the Borrower, and under this Security Agreement;

(ii) all of the Borrower’s debts to the Bank whether now existing or hereafter arising, whether direct or indirect, whether absolute or contingent, howsoever evidenced;

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§7.20

SECURED TRANSACTIONS

(iii) the repayment of (a) any amounts that the Bank may advance or spend for the maintenance or preservation of the Collateral, and (b) any other expenditures that the Bank may make under the provisions of this Security Agreement or for the benefit of the Borrower; (iv) all amounts owed under any modifications, renewals, or extensions of any of the foregoing obligations; and (v)

all other amounts now or in the future owed by the Borrower to the Bank.

1.3 “UCC.” Any term used herein but not defined in this Security Agreement has the meaning given to such term in the Uniform Commercial Code (UCC) as enacted in the State of Illinois. 1.4 “Borrower’s Location.” (i)

if the Borrower is an individual, the location of his and/or her farming operations is the Borrower’s residence at [address of Borrower’s residence];

(ii) if the Borrower is a corporation, the location of its farming operations is the state of incorporation, which is Illinois. 2. Grant of Security Interest. The Borrower hereby grants a security interest in the Collateral to the Bank to secure the prompt payment and performance of the Obligations. 3. Perfection of Security Interests. 3.1 Filing of Financing Statement. (i)

the Borrower authorizes the Bank to file a financing statement (Financing Statement) describing the Collateral;

(ii) the Borrower authorizes the Bank to file a Financing Statement describing any statutory liens held by the Bank; and (iii) the Bank shall receive prior to the Closing an official lien search report from the Secretary of State for the State of Illinois, showing that the Bank’s security interest is prior to all other security interests or other interests reflected in the report. 3.2 Possession. (i)

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The Borrower shall have possession of the Collateral, except when expressly otherwise provided in this Security Agreement or when the Bank chooses to perfect its security interest by possession in addition to the filing of a financing statement.

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(ii) When Collateral is in the possession of a third party, the Borrower will join the Bank in notifying the third party of the Bank’s security interest and obtaining an acknowledgment from the third party that it is holding the Collateral for the benefit of the Bank. 3.3 Control. The Borrower will cooperate with the Bank in obtaining control with respect to Collateral consisting of: (i)

deposit accounts;

(ii) investment property; (iii) letter-of-credit rights; and (iv) electronic chattel paper. 3.4 Marking of Chattel Paper. The Borrower will not create any Chattel Paper without placing a legend on the Chattel Paper acceptable to the Bank indicating that the Bank has a security interest in the Chattel Paper. 3.5 Documents and Instruments. The Borrower shall immediately deliver all documents and instruments to the Bank endorsed as requested by the Bank. 4. Borrower’s Representations and Warranties. The Borrower warrants and represents the following: 4.1 Organization. The Borrower (i) is an organization duly organized, validly existing, and in good standing under the laws of the State of Illinois; (ii) has all requisite power and authority to own its properties and assets and to carry on its business as now conducted and as proposed to be conducted; (iii) is qualified to do business in every jurisdiction where such qualification is required, except where the failure to so qualify is not likely to have a material adverse effect on its business, operations, or finances; and (iv) has the corporate power and authority to execute, deliver, and perform its obligations hereunder and under the Loan Agreement. 4.2 Due Authorization. The execution, delivery, and performance of this Agreement have been duly authorized by all necessary corporate acts and do not violate the Borrower’s articles of incorporation or bylaws or any law or regulation applicable to the Borrower or its business, and this Agreement constitutes a duly valid and binding agreement of the Borrower enforceable against it according to its terms except as such terms may be limited by applicable bankruptcy or insolvency laws. 4.3 Predecessors. Except as described on Exhibit ____, there are no predecessors to the Borrower in existence during the past five years, and the Borrower has operated as a corporation or limited liability company as described in Section 4.1 for the past five years.

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4.4 Names. For the past five years, the Borrower has not used any other name, including trade names, except for those listed on Exhibit ____. 4.5 Title, No Other Liens. Except for the security interest granted pursuant to this Agreement, the Borrower owns each item of Collateral free and clear of any and all liens, security interests, encumbrances, or claims of any kind. No financing statements or other public notice with respect to all or any part of the Collateral is on file or of record in any public office, except such as have been filed in favor of the Bank or those that appear on Exhibit ____. 4.6 Location of Collateral. All of the Borrower’s fixtures, equipment, and inventory are now located and have been located during the past five years only at the locations listed on Exhibit ____. 5. Post-Closing Covenants and Rights Concerning the Collateral. 5.1 Maintenance of Security Interest. (i)

The Borrower shall maintain the security interest herein as a first priority security interest and shall defend such security interest against the claims and demands of all persons or entities.

(ii) At any time, upon written request of the Bank, the Borrower will promptly execute and deliver such further instruments and documents and take such further actions as the Bank may reasonably request for the purpose of obtaining or preserving the full benefits of this Agreement and of the rights and powers herein granted, including without limitation (a) the filing of any financing or continuation statements under the UCC in effect in any jurisdiction, and (b) in the case of Collateral as set forth in Section 3.3 hereof, take any action necessary to enable the Bank to obtain “control” within the meaning of the UCC. (iii) The Borrower shall keep current on all of its obligations to its landlord, and at the Bank’s request, the Borrower shall obtain from the landlord a letter addressed to the Bank stating it will notify the Bank of any defaults under the lease. 5.2 Changes in Name or Organization. The Borrower will not (unless in each case it shall have given the Bank at least 90 days’ prior written notice thereof of such change): (i)

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change its jurisdiction of organization from that specified in Section 4.1 hereof; or

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(ii) change its name, identity, or corporate structure to such an extent that any financing statement previously filed in favor of the Bank hereunder would become seriously misleading or otherwise become ineffective to maintain perfection of the Collateral. 5.3 Inspection. The parties to this Security Agreement may inspect any Collateral in the other party’s possession at any time upon reasonable notice. 5.4 Maintenance. The Borrower shall maintain the Equipment in good working condition and repair. 5.5 Insurance. The Borrower shall insure at its expense, and keep insured by solvent insurers, all Collateral in such amounts as similar goods are usually insured by companies similarly situated, against loss or damage of the kinds usually insured against by companies similarly situated, and upon the Bank’s request, the policies evidencing such insurance shall be duly endorsed in the Bank’s favor and certificates evidencing such insurance shall be provided to the Bank. If the Borrower defaults in this regard, the Bank shall have the right to insure and charge the cost to the Borrower. The Bank assumes no risk or responsibility in connection with the payment or nonpayment of losses, the only responsibility of the Bank being to credit the Borrower with any insurance payments received on account of losses. 5.6 No Disposition of Collateral. Except as otherwise provided herein, without the authorization of the Bank, the Borrower shall not: (i)

make any sales or leases of any of the Collateral;

(ii) license any of the Collateral; (iii) grant any other security interest in any of the Collateral; or (iv) deliver any Collateral to any grain elevator, warehouse, or other storage in exchange for any negotiable document without the Bank’s written consent and without delivery to the Bank of such negotiable document endorsed in accordance with the Bank’s instructions. 5.7 List of Purchasers. (i)

The Bank hereby requests from the Borrower a list of all purchasers, commission merchants, and selling agents to or through whom the Borrower desires to sell or otherwise intends to dispose of the Collateral. The UCC provides that the Borrower shall not sell or otherwise dispose of the Collateral to a commission merchant, or selling agent or other purchaser not included in this list, unless the Borrower has delivered to the Bank written notice of the Borrower’s desire to sell or otherwise dispose of the Collateral to such commission merchant or selling agent or other purchaser.

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(ii) The Borrower shall not sell or otherwise dispose of all or any portion of the Collateral unless and until the Borrower shall have disclosed to the Bank first the identity of the persons or entities to or through whom the Borrower desires to sell or otherwise dispose of the Collateral. (iii) The Borrower hereby acknowledges that the Bank, at its option, may send to those parties described below a notice setting forth certain information, including but not limited to the Bank’s security interest and identifying the Borrower and the Borrower’s social security or taxpayer identification number. The Borrower hereby authorizes the disclosure of such information by the Bank and further authorizes the disclosure of such information to additional parties not listed below when the Bank, in its sole discretion, deems such disclosure to be reasonably necessary to protect its security interest. (iv) Attached hereto as Exhibit ____ is a list of commission merchants, or selling agents or other purchasers, to or through whom the Borrower desires to sell or otherwise dispose of the Collateral. The Borrower represents that this information is correct. (v)

The Borrower hereby gives the Bank permission to (a) require any purchaser, commission merchant, or selling agent acquiring products covered by this Security Agreement to issue a check payable jointly to the Bank and the Borrower; (b) disclose to any purchaser, commission merchant, or selling agent identified by the Borrower all such information as is necessary for the Bank to obtain the benefits of the federal Food Security Act and 810 ILCS 5/9-320.1 and any regulations to any of the foregoing, including but not limited to the Borrower’s social security number or taxpayer identification number, as applicable, a description of the farm products subject to this Security Agreement, the crop year, the county, and a reasonable description of the property.

6. Borrower’s Covenants. Until the Obligations are paid in full, the Borrower agrees to the following: 6.1 Compliance with Environmental Laws. The Borrower shall comply with all applicable federal, state, and local laws, ordinances, rules, and regulations, including but not limited to all environmental laws, ordinances, rules, and regulations, and shall keep the Collateral free and clear of any liens imposed pursuant to such laws, ordinances, rules, and regulations. 6.2 Compliance with Employment Laws. The Borrower shall comply with all applicable federal, state, and local laws, ordinances, rules, and regulations concerning minimum wages, overtime, and payment of withholding taxes and deliver to the Bank such reports and information in form satisfactory to the Bank as the Bank may request from time to time to establish compliance with such laws.

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7. Events of Default. The occurrence of any of the following shall, at the option of the Bank (except for the occurrence of an event specified in Section 7.5, which shall be automatic), be an Event of Default: 7.1 Any default in payment or performance by the Borrower under the Loan Agreement, any notes, or any of the other Obligations; 7.2 The Borrower’s failure to comply with any of the provisions of, or the incorrectness of any representation or warranty contained in, this Security Agreement, any note, or any of the other Obligations; 7.3 Transfer or disposition of any of the Collateral, except as expressly permitted by this Security Agreement; 7.4 Attachment, execution, or levy on any of the Collateral; 7.5 The Borrower’s voluntarily or involuntarily becoming subject to any proceeding under (i) the Bankruptcy Code or (ii) any similar remedy under state statutory or common law; 7.6 The Borrower’s failing to comply with, or becoming subject to, any administrative or judicial proceeding under any federal, state, or local (i) hazardous waste or environmental law, (ii) asset forfeiture or similar law that can result in the forfeiture of property, or (iii) other law, when noncompliance may have any significant effect on the Collateral; or 7.7 The Bank receiving at any time following the Closing a lien search report indicating that the Bank’s security interest is not prior to all other security interests or other interests reflected in the report. 8. Remedies upon Default. 8.1 General. Upon any Event of Default, the Bank may pursue any remedy available at law (including those available under the provisions of the UCC) or in equity to collect, enforce, or satisfy any Obligations then owing, whether by acceleration or otherwise. 8.2 Cumulative Remedies. Upon any Event of Default, the Bank shall have the right to pursue any of its remedies separately, successively, or simultaneously, including without limitation the following: (i)

File suit and obtain judgment. In conjunction with any action, the Bank may seek any ancillary remedies provided by law, including levy of attachment and garnishment.

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(ii) Take possession of any Collateral if not already in its possession with demand and without legal process. Upon the Bank’s demand, the Borrower will assemble and make the Collateral available to the Bank as it directs. The Borrower grants to the Bank the right, for this purpose, to enter into or on any premises where Collateral may be located. (iii) Without taking possession, sell, lease, or otherwise dispose of the Collateral at public or private sale in accordance with the UCC. (iv) Set off any of the Borrower’s deposit balances with the Bank. 8.3 Recovery of Expenses. Should an Event of Default occur, the Borrower shall pay to the Bank all costs and expenses incurred by the Bank for the purpose of enforcing its rights hereunder, including: (i)

costs of foreclosure;

(ii) costs of obtaining money damages; and (iii) reasonable fees for the services of attorneys and other professionals employed by the Bank for any purpose related to this Security Agreement or the Obligations, including consultation, drafting documents, preparation of reports, and instituting, prosecuting, or defending litigation or arbitration. 9. Foreclosure Procedures. 9.1 No Waiver. No delay or omission by the Bank to exercise any right or remedy accruing upon any Event of Default shall (i) impair any right or remedy, (ii) waive any default or operate as an acquiescence to the Event of Default, or (iii) affect any subsequent default of the same or of a different nature. 9.2 Notices. The Bank shall give the Borrower such notice of any private or public sale as may be required by the UCC. Notification of disposition will be sent after default at least 10 days before the date of disposition. 9.3 Condition of Collateral. The Bank has no obligation to clean up or otherwise prepare the Collateral for sale. 9.4 No Obligation To Pursue Others. The Bank has no obligation to attempt to satisfy the Obligations by collecting them from any other person liable for them, and the Bank may release, modify, or waive any collateral provided by any other person to secure any of the Obligations, all without affecting the Bank’s rights against the Borrower. The Borrower waives any right it may have to require the Bank to pursue any third person for any of the Obligations.

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9.5 Compliance with Other Laws. The Bank may comply with any applicable state or federal law requirements in connection with a disposition of the Collateral, and compliance will not be considered adversely to affect the commercial reasonableness of any sale of the Collateral. 9.6 Warranties. The Bank may sell the Collateral without giving any warranties as to the Collateral. The Bank may specifically disclaim any warranties of title or the like. This procedure will not be considered adversely to affect the commercial reasonableness of any sale of the Collateral. 9.7 Purchases by Bank. In the event the Bank purchases any of the Collateral being sold, the Bank may pay for the Collateral by crediting some or all of the Obligations of the Borrower. 9.8 No Marshaling. The Bank has no obligation to marshal any assets in favor of the Borrower, or against or in payment of any note, any of the other Obligations, or any other obligation owed to the Bank or any other person. 10. Illinois Insurance Notice. Unless the Borrower provides the Bank with evidence of the insurance coverage required by the Borrower’s agreement with the Bank, the Bank may purchase insurance at the Borrower’s expense to protect the Bank’s interests in the collateral. This insurance may, but need not, protect the Borrower’s interests. The coverage that the Bank purchases may not pay any claim that the Borrower makes or any claim that is made against the Borrower in connection with the collateral. The Borrower may later cancel any insurance purchased by the Bank, but only after providing the Bank with evidence that the Borrower has obtained insurance as required by their agreement. If the Bank purchases insurance for the collateral, the Borrower will be responsible for the costs of that insurance, including interest and any other charges the Bank may impose in connection with the placement of the insurance, until the effective date of the cancellation or expiration of the insurance. The costs of the insurance may be added to the Borrower’s total outstanding balance or obligation. The costs of the insurance may be more than the cost of insurance the Borrower may be able to obtain on the Borrower’s own. 11. Miscellaneous. 11.1 Assignment. (i)

Binds Assignees. This Security Agreement shall bind and shall inure to the benefit of the heirs, legatees, executors, administrators, successors, and assigns of the Bank and shall bind all persons who become bound as a borrower to this Security Agreement.

(ii) No Assignments by Borrower. The Bank does not consent to any assignment by the Borrower except as expressly provided in this Security Agreement.

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(iii) Assignment by Bank. The Bank may assign its rights and interests under this Security Agreement. If an assignment is made, the Borrower shall render performance under this Security Agreement to the assignee. The Borrower waives and will not assert against any assignee any claims, defenses, or setoffs that the Borrower could assert against the Bank except for those defenses that cannot be waived. 11.2 Counterpart. This Security Agreement may be executed in two or more counterparts, each of which shall be deemed an original and all of which taken together shall constitute one and the same instrument. 11.3 Further Assurances. The Borrower agrees to execute any further documents, and to take any further actions, reasonably required by the Bank to evidence or perfect the security interest granted herein, to maintain the first priority of the security interests, or to effect the rights granted to the Bank herein. 11.4 Governing Law. This Security Agreement is being executed and delivered and is intended to be performed in the State of Illinois and shall be construed and enforced in accordance with the laws of the State of Illinois, except to the extent that the UCC provides for the application of other law. 11.5 Venue. If there is a lawsuit, the Borrower agrees upon the Lender’s request to submit to the jurisdiction of the state or federal courts located in [name of county], State of Illinois. 11.6 Jury Waiver. All parties to this Agreement hereby waive the right to any jury trial in any action, proceeding, or counterclaim brought by any party against the other party. 11.7 Headings. Section headings used in this Security Agreement are for convenience only. They are not a part of this Security Agreement and shall not be used in construing it. 11.8 Modifications. Any modification to this Security Agreement must be made in writing and signed by the party adversely affected. 11.9 Rules of Construction. (i)

no reference to “proceeds” in this Security Agreement authorizes any sale, transfer, or other disposition of the Collateral by the Borrower;

(ii) “includes” and “including” are not limiting; (iii) “or” is not exclusive; and (iv) “all” includes “any” and “any” includes “all.”

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§7.21

11.10

Severability. Should any provisions of this Security Agreement be found to be void, invalid, or unenforceable by a court or panel of arbitrators of competent jurisdiction, that finding shall affect only the provisions found to be void, invalid, or unenforceable and shall not affect the remaining provisions of this Security Agreement.

11.11

Notices. Any notices required by this Security Agreement shall be deemed to be delivered when a record has been (i) deposited in any United States postal box if postage is prepaid and the notice properly addressed to the recipient at the address set forth below, (ii) received by telecopy, (iii) received through the Internet, or (iv) personally delivered to a party.

The parties have signed this Security Agreement as of the day and year first written at [city where Security Agreement signed], Illinois. [name of borrower]

[name of bank]

______________________________

By: __________________________________ Its President

Address: [bank address]

Address: [borrower address] EXHIBITS

[The secured party must prepare and attach exhibits, including one setting forth the list of commission merchants, selling agents, and purchasers required by §5.7(iv).] B. [7.21] Notice to Buyers of Farm Products [on bank stationery] NOTICE TO BUYERS OF FARM PRODUCTS [via registered or certified mail] TO: [name of buyer] [address of buyer] Pursuant to §1324 of the Food Security Act of 1985 (7 U.S.C. §1631) and §§9-320 and 9320.1 of the Uniform Commercial Code (810 ILCS 5/9-320 and 5/9-320.1), notice of a security interest in farm products is hereby given as follows: 1. Name and Address of Secured Party: ____________ Bank ____________ ____________, Illinois

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2. Name and Address of Debtor: ____________ ____________ ____________, Illinois 3. Debtor’s Social Security Number(s) or Taxpayer I.D. Number(s): ___________________________________________________________________________ 4. Description of Farm Products covered by security interest: (a) Corn Amount of product (if applicable) Crop year County Description of property

_______________________________________ _______________________________________ _______________________________________ _______________________________________

(b) Soybeans Amount of product (if applicable) Crop year County Description of property

_______________________________________ _______________________________________ _______________________________________ _______________________________________

(c) Wheat Amount of product (if applicable) Crop year County Description of property

_______________________________________ _______________________________________ _______________________________________ _______________________________________

(d) Livestock Amount of product (if applicable) Crop year County Description of property

_______________________________________ _______________________________________ _______________________________________ _______________________________________

5. The following payment obligations are imposed on the Buyer of farm products by the Secured Party as conditions for waiver or release of the security interest: [Insert conditions, e.g., issuance of check that includes the secured party as the named payee.]

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8

Treatment of Secured Interests in Bankruptcy

ROBERT M. FISHMAN BRIAN L. SHAW MARK L. RADTKE Shaw Fishman Glantz & Towbin LLC Chicago

®

©COPYRIGHT 2016 BY IICLE .

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I. [8.1] Introduction II. Adequate Protection A. B. C. D. E.

[8.2] [8.3] [8.4] [8.5] [8.6]

What Is Adequate Protection? Chapter 12 What Is To Be Protected? Burden of Proof Valuation

III. The Automatic Stay and the Secured Creditor A. [8.7] Imposition of the Stay B. [8.8] Relief from the Automatic Stay Against Property IV. Use of Cash Collateral A. [8.9] What Is Cash Collateral? B. [8.10] In What Contexts Do Cash Collateral Issues Arise? C. [8.11] The Debtor-in-Possession’s Right To Use Cash Collateral 1. [8.12] Oversecured 2. [8.13] Fully Secured but with a Small Cushion 3. [8.14] Undersecured 4. [8.15] Interest and Costs V. [8.16] Obtaining Financing or Credit A. [8.17] Unsecured Credit Within the Ordinary Course of Business B. [8.18] Credit Outside the Ordinary Course of Business 1. [8.19] Court-Ordered Protection for Creditor 2. [8.20] Filing C. Special Postpetition Borrowing or Credit Problems 1. [8.21] Cross-Collateralization 2. [8.22] Debtor-in-Possession’s Independence 3. [8.23] Appeals VI. Trustee’s Strong-Arm Powers A. [8.24] What Are the Trustee’s Strong-Arm Powers and Why Do They Exist? B. [8.25] Limitations of the Trustee’s Strong-Arm Powers

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VII. Avoiding Preferential Transfers A. [8.26] What Is a Preference? B. [8.27] Defenses C. [8.28] Preferential Transfers to or for the Benefit of Insiders: Reaching Back One Year VIII. [8.29] The Avoidance of Certain Transfers as Fraudulent Conveyances A. B. C. D.

[8.30] [8.31] [8.32] [8.33]

General Procedural Rules Liability of Transferees Fraudulent Transfer Problems and the Secured Creditor Leveraged Buyouts

IX. [8.34] Postpetition Interest and Fees A. B. C. D. E.

[8.35] Oversecured Creditors Are Entitled to Postpetition Interest [8.36] Entitlement to Fees, Costs, and Expenses Tied to Contract Language [8.37] Timing of Payment [8.38] What Is the Proper Rate of Interest? [8.39] What Law Controls? 1. [8.40] Validity 2. [8.41] Standards F. [8.42] Late Charges G. [8.43] Proof of Claim and Distributions X. [8.44] Charges Against Secured Creditors’ Collateral — 11 U.S.C. §506(c) A. [8.45] Requirements for Bankruptcy Code §506(c) Claims B. [8.46] Standing Issue XI. Postpetition Effect of Security Interests A. B. C. D.

[8.47] [8.48] [8.49] [8.50]

After-Acquired Property Proceeds Exceptions Interplay with Other Bankruptcy Code Sections

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XII. [8.51] Confirmation of a Reorganization Plan A. [8.52] Disclosure Statement B. [8.53] The Reorganization Plan C. [8.54] Cramdown

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§8.2

I. [8.1] INTRODUCTION This chapter provides an overview of bankruptcy law as it relates to secured transactions. The ultimate test of a security instrument is whether it will survive a bankruptcy case. All too often, even with the optimism of all involved at the time a loan is made, the borrower finds itself in bankruptcy court. In such a setting, one can usually count on a thorough examination of all the loan and security documents, with an eye toward finding a defect that one party or another can turn to its benefit. Counsel for the secured creditor must remember that the statutory scheme that governs the bankruptcy process, the Bankruptcy Code, 11 U.S.C. §101, et seq., is designed to protect and weigh the competing interests of all parties — secured and unsecured creditors, the debtor, and equity security holders. This chapter identifies selected basic and recurring bankruptcy concepts and provides some practical recommendations on how to recognize and avoid certain potential problems.

II. ADEQUATE PROTECTION A. [8.2] What Is Adequate Protection? “Adequate protection” is not defined anywhere in the Bankruptcy Code, although it is of great and repeated importance in understanding both the use of cash collateral and the modification of the automatic stay, both discussed below in §§8.7 – 8.15. Three examples of adequate protection are found in §361 of the Bankruptcy Code. These examples include cash payments, replacement liens, and the “indubitable equivalent.” 11 U.S.C. §361. Cash payments to cover depreciation, depletion, or consumption of the collateral may be necessary in circumstances in which the collateral may lose value because of the wear and tear associated with normal usage or when it may be of a finite quantity or consumed in the ordinary course of business at a faster rate than it will be replaced. However, payment of current (postpetition) interest on the principal amount of the debt may be allowed only upon confirmation of a plan of reorganization. See the discussion in §§8.34 – 8.43 below. With respect to real estate collateral, payment of current real estate taxes may be considered, in addition to payment of insurance and maintenance costs. Replacement liens are often necessary simply to continue the status quo. Bankruptcy Code §552(a) cuts off the typical after-acquired property clause found in many security agreements. Section 552(b) provides certain exceptions to that rule, including the protection and extension of security interests in proceeds, products, offspring, profits, and rents acquired postpetition, as well as fees, charges, accounts, and other payments for the use of hotel rooms and other public facilities, to the extent that the underlying collateral was subject to a valid prepetition security interest that covered those same items. If the court is going to allow the debtor to consume assets that are subject to a security interest that is cut off by §552(a), then the secured creditor will want to obtain a court-approved replacement lien before the consumption occurs. Both the secured creditor and the court should be skeptical of replacement liens granted on assets of questionable or speculative value, such as a future crop of the debtor. 11 U.S.C. §552; In re Martin, 761 F.2d

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§8.3

SECURED TRANSACTIONS

472 (8th Cir. 1985); First Bank of Miller, Miller, South Dakota v. Wieseler, 45 B.R. 871 (Bankr. D.S.D. 1985); In re Berens, 41 B.R. 524 (Bankr. D.Minn. 1984); In re Serbus, 48 B.R. 5 (Bankr. D.Minn. 1984). But see In re Sauer, 223 B.R. 715 (Bankr. D.N.D. 1998); In re Westcamp, 78 B.R. 834 (Bankr. S.D. Ohio 1987). The final example of adequate protection, the “indubitable equivalent,” is the most nebulous of all. This concept had its genesis in Judge Learned Hand’s opinion in In re Murel Holding Corp., 75 F.2d 941 (2d Cir. 1935). This provision is the one that allows the court to fashion other forms of adequate protection as circumstances justify and allow. The statute does not define the indubitable equivalent, though. Further, the parties, subject to court approval in most instances, are free to fashion their own forms of adequate protection. See In re All-Way Services, Inc., 73 B.R. 556 (Bankr. E.D.Wis. 1987). In evaluating any proposed or contemplated form of adequate protection, it should be remembered that the mere granting of priority status under Bankruptcy Code §503(b)(1) is not a permissible form of adequate protection. 11 U.S.C. §361(3). B. [8.3] Chapter 12 Under Chapter 12 of the Bankruptcy Code, 11 U.S.C. §1201, et seq., §1205(a) specifically excludes §361 from applicability in Chapter 12 cases. 11 U.S.C. §1205(a). The legislative history makes it clear that adequate protection under Chapter 12 requires protecting the value of the collateral, not the interest of the creditor. For farmland, “reasonable rent” will be the typical form of adequate protection, to the extent that adequate protection will be necessary at all. 11 U.S.C. §1205(b)(3). Cash payments and replacement liens will generally be used to provide adequate protection respecting non-real estate assets. 11 U.S.C. §§1205(b)(1), 1205(b)(2). The indubitable equivalent alternative does not exist under Chapter 12. C. [8.4] What Is To Be Protected? The central theme of adequate protection is that the creditor is not to be unduly exposed to risk or loss without being provided with an appropriate form of protection. Just what is it that is to be adequately protected? The creditor is to be protected from a diminution in the value of its interest in the debtor’s property (injury). Injury can be caused by any of the following: the automatic stay imposed by Bankruptcy Code §362 (see §§8.7 – 8.8 below); the use, sale, or lease of property in which the creditor claims an interest under §363 (see §§8.9 – 8.15); or the granting of a lien under §364 (see §§8.16 – 8.23). 11 U.S.C. §§362 – 364. Several examples of potential injury are a decrease in the value of collateral through use or consumption; the accrual of postpetition interest, real estate taxes, or interest on a secured claim in the same property with a higher priority; the granting of relief to one party claiming an interest in collateral without granting the same relief to other parties claiming an interest; and the sale of property subject to a security interest without the sale proceeds being devoted to the payment of appropriate secured indebtedness.

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§8.7

D. [8.5] Burden of Proof The burden of proof on the issue of adequate protection is on the party seeking to establish the existence of adequate protection, who is almost always the trustee or debtor-in-possession. E. [8.6] Valuation Value of the collateral in question is almost always a key component of the analysis of adequate protection. What is the proper method of valuation for the purpose of considering adequate protection? If the method-of-valuation question arises in the context of the automatic stay preventing a creditor from enforcing its rights, then the amount the creditor could have realized in the absence of the bankruptcy case — or liquidation value — is probably the relevant standard. In re George Ruggiere Chrysler-Plymouth, Inc., 727 F.2d 1017 (11th Cir. 1984); United States v. Case (In re Case), 115 B.R. 666 (B.A.P. 9th Cir. 1990). For use of cash collateral purposes, the going-concern value may be the appropriate standard. In re American Kitchen Foods, Inc., 20 U.C.C. Rep.Serv. (CBC) 238 (D.Me. 1976). But see Sharon Steel Corp. v. Citibank, N.A. (In re Sharon Steel Corp.), 159 B.R. 165 (Bankr. W.D.Pa. 1993). Moreover, in a Chapter 7 case, 11 U.S.C. §701, et seq., in which liquidation is the objective, liquidation value is the relevant standard. Edgewater Medical Center v. Edgewater Property Co., (In re Edgewater Medical Center), 373 B.R. 845 (Bankr. N.D.Ill. 2007). In contrast, in a Chapter 11 case in which reorganization is a possibility, going-concern value is the relevant standard. EBC I, Inc. v. American Online, Inc., (In re EBC I, Inc.), 380 B.R. 348 (Bankr. D.Del. 2008). The quality and the thoroughness of the valuation evidence that the parties present to the court may well determine success or failure. What remedy, if any, is available to a secured creditor to whom the court grants adequate protection if the adequate protection proves to be inadequate and the creditor’s position is harmed? Such a claimant is entitled to a “superpriority” claim under §507(b) of the Bankruptcy Code. 11 U.S.C. §507(b); In re Blackwood Associates, L.P., 153 F.3d 61 (2d Cir. 1998); In re Greenwald, 205 B.R. 277 (Bankr. D.Colo. 1997); In re Cason, 190 B.R. 917 (Bankr. N.D.Ala. 1995). Superpriority claims are subordinate to domestic support obligations and certain administrative expenses of a trustee relating to domestic support obligations. 11 U.S.C. §507(a)(1).

III. THE AUTOMATIC STAY AND THE SECURED CREDITOR A. [8.7] Imposition of the Stay The filing of a bankruptcy case creates, by operation of law, an automatic stay of acts against almost all actions to enforce payment of debts incurred prior to the bankruptcy, including all acts against property of the bankruptcy estate. The stay is designed to allow the debtor time to reorganize its affairs in both a legal and a practical way. 11 U.S.C. §362(a). The stay is very broad in its application and remains in effect throughout the case unless terminated or modified by order of the court or by operation of law.

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SECURED TRANSACTIONS

The stay does not toll any applicable statutes of limitation for claims against the estate, except that action on claims for which the applicable statute of limitations had not expired upon the filing of the petition may be commenced within 30 days after notice of the termination of the stay. 11 U.S.C. §108(c)(2). B. [8.8] Relief from the Automatic Stay Against Property Secured creditors are primarily interested in the stay with respect to its effect on their ability to realize their rights in collateral. Relief from the stay may be obtained on several grounds, as discussed below in this section. 11 U.S.C. §362(d). Bankruptcy Code §362(d)(1) provides in pertinent part that relief from the stay may be granted “for cause, including the lack of adequate protection of an interest in property.” If a secured creditor requests, a court must grant relief from the stay unless the debtor meets its burden, either showing that cause does not exist or that the creditor is “adequately protected.” In re Dupell, 235 B.R. 783 (Bankr. E.D.Pa. 1999); In re Lilyerd, 49 B.R. 109 (Bankr. D.Minn. 1985). For a detailed discussion of adequate protection, see §§8.2 – 8.6 above. From the perspective of a secured creditor, the lack of adequate protection is usually the primary ground asserted in support of relief from the stay. However, the statutory causes are not exhaustive, and courts will, on a case-by-case basis, consider other reasons for granting relief. In re Mirant Corp., 440 F.3d 238 (5th Cir. 2006); In re Fernstrom Storage & Van Co., 938 F.2d 731 (7th Cir. 1991). For example, the debtor’s use of delay tactics, especially to avoid an inevitable foreclosure proceeding or sale, is a common form of “cause.” In re Canal Place Limited Partnership, 921 F.2d 569 (5th Cir. 1991); Trident Associates Limited Partnership v. Metropolitan Life Insurance Co. (In re Trident Associates Limited Partnership), 176 B.R. 16 (Bankr. E.D.Mich. 1993). The debtor’s lack of good faith in the filing or handling of the case is another. In re Reitnauer, 152 F.3d 341 (5th Cir. 1998); In re Kissinger, 72 F.3d 107 (9th Cir. 1995). If the debtor has no equity in the property subject to the interest of the secured creditor and the property in question is not necessary to an effective reorganization, then the stay should be terminated. 11 U.S.C. §362(d)(2). Unlike the lack of adequate protection analysis, all liens on the property in question should be taken into consideration in determining the equity issue. In re Indian Palms Associates, Ltd., 61 F.3d 197 (3d Cir. 1995). In those circumstances in which the value of the collateral exceeds the principal indebtedness, accrued interest and other allowable charges should also be taken into account. 11 U.S.C. §506(b). As to the question of “necessary to an effective reorganization” (11 U.S.C. §362(d)(2)(B)), the creditor seeking to terminate the stay may challenge the realistic or reasonable prospects of the debtor-in-possession’s confirming a plan within a reasonable period of time (Berkeley Federal Bank & Trust v. Sea Garden Motel & Apartments (In re Sea Garden Motel & Apartments), 195 B.R. 294 (D.N.J. 1996)) or may single out specific property as being unnecessary to an effective reorganization (In re Brian Wise Trucking, Inc., 386 B.R. 215 (Bankr. N.D. Ind. 2008)). In non-single-asset real estate cases, even a liquidating plan may constitute an “effective reorganization.” City of Martinsville v. Tultex Corp. (In re Tultex Corp.), 250 B.R. 560, 569

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§8.8

(Bankr. W.D.Va. 2000). In single-asset cases in which the estate has no equity in the property and liquidation is inevitable, courts have been divided over whether and when relief should be granted. See First American Bank of Virginia v. Monica Road Associates (In re Monica Road Associates), 147 B.R. 385 (Bankr. E.D.Va. 1992) (immediate relief); Homestead Savings & Loan Ass’n v. Associated Investors Joint Venture (In re Associated Investors Joint Venture), 91 B.R. 555 (Bankr. C.D.Cal. 1988) (delayed relief). Section 362 of the Bankruptcy Code provides that in a single-asset real estate case, a secured creditor is entitled to have the stay lifted upon request if, within 90 days of the entry of the order for relief (or, if later, 30 days after the court determines that the debtor is subject to §362(d)(3)), the debtor has neither (1) proposed a plan that has a reasonable chance of being confirmed or (2) commenced making monthly interest payments at the then applicable non-default contract rate of interest on the value of the creditor’s interest in the real estate. 11 U.S.C. §362(d)(3). In the debtor’s sole discretion, the monthly interest payments may be made from rents or other income generated from the property. Id. The 90-day time period may be extended for cause shown by court order entered within the 90-day period. Id. Additional bases for relief from the stay include the debtor’s transfer of ownership or interest in real property without consent of the secured creditor or court approval and multiple bankruptcy filings affecting real property. 11 U.S.C. §362(d)(4). For individual debtor cases, if a debtor’s case was dismissed within the one-year period preceding the current case, the stay as to certain actions automatically terminates on the 30th day following the petition date unless extended by the court (11 U.S.C. §362(c)(3)), and the stay is automatically terminated if the debtor fails to timely file his or her statement of intention with respect to the retention or surrender of personal property of the estate that serves as security for debts (11 U.S.C. §§362(h), 521(a)(2)). In addition, §362(e) of the Bankruptcy Code provides that in all bankruptcy cases, 30 days after a request for relief from the stay respecting acts against property of the bankruptcy estate, the stay is terminated unless the court, after notice and hearing, orders the continuation of the stay pending the conclusion of or as a result of a final hearing and determination under §362(d). 11 U.S.C. §362(e). A §362(e) hearing may be a preliminary hearing or may be consolidated with the final hearing under §362(d). The court may order the continuation of the stay pending a final hearing if it is determined the party opposing relief from the stay has a reasonable likelihood of prevailing at the final hearing. If the court characterizes the initial hearing as a §362(e) preliminary hearing, then the §362(d) final hearing must be concluded not later than 30 days after the conclusion of the preliminary hearing. For individual debtors, the stay terminates 60 days after a party makes a request for relief from the stay, unless the court renders a final decision during this 60-day period or the 60-day period is extended by agreement of all parties in interest or by the court for good cause. Id. The time periods in §362(e) are not to be taken lightly. While there may be circumstances under which additional time will be available, a failure to operate within the applicable time periods may be highly prejudicial to a party opposing a modification of the stay. A request for relief from the stay should be made by a motion filed pursuant to Federal Rules of Bankruptcy Procedure 4001(a) and 9014. Because the request for relief is made in the form of

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SECURED TRANSACTIONS

a motion rather than a complaint, a hearing on a motion to lift the stay is not the appropriate place for consideration of counterclaims, defenses, or offsets. Grella v. Salem Five Cent Savings Bank, 42 F.3d 26 (1st Cir. 1994). In hearings for relief from the stay, the party opposing the relief has the burden of proof on all issues except the debtor’s equity in the property; that burden falls on the party requesting relief. 11 U.S.C. §362(g); In re Boomgarden, 780 F.2d 657 (7th Cir. 1985); In re Arter & Hadden, L.L.P., 335 B.R. 666 (Bankr. N.D. Ohio 2005). Relief from the stay may sometimes be limited to certain issues or aspects of a controversy. In re Meehan, 46 B.R. 96 (Bankr. E.D.N.Y. 1985). To determine if cause exists for stay relief to continue litigation in another forum, courts may consider anywhere from 3 to 12 factors. In re Sonnax Industries, Inc., 907 F.2d 1280 (2d Cir. 1990); In re Nelson, 335 B.R. 740 (Bankr. D.Kan. 2004). For example, the court may allow a civil case against a debtor to proceed on the issue of liability but not damages. The court may also allow the case to proceed on damages but not the collection of them. In re Holtkamp, 669 F.2d 505 (7th Cir. 1982). A foreclosure proceeding may be allowed to proceed, but the actual foreclosure sale could not be conducted without further order of the court. The stay might be lifted and the creditor authorized to proceed against the debtor, but only to the extent of the debtor’s available insurance coverage.

IV. USE OF CASH COLLATERAL A. [8.9] What Is Cash Collateral? The definition of “cash collateral” is found in Bankruptcy Code §363(a) and includes cash, negotiable instruments, deposit accounts, and other cash equivalents, whenever acquired. 11 U.S.C. §363(a). An entity other than the debtor must have an interest in the cash collateral (usually a secured creditor but may be a bank asserting a right of setoff). Cash collateral also includes proceeds, etc., all as set forth in Bankruptcy Code §552(b). 11 U.S.C. §552(b). See §§8.47 – 8.50 below. Except to the extent that they are traceable proceeds, cash collateral does not include accounts, inventory, or equipment. Section 363(a) of the Bankruptcy Code expressly includes rents and hotel revenues under the definition of “cash collateral.” However, one must still have a perfected security interest in those rents for them to be considered cash collateral, and perfection is still controlled by state law. First, one must determine whether the mortgagee has a valid security interest in rents. Then one needs to establish the point at which the interest arose or became perfected. In Illinois, in addition to having a contractual assignment of rents as collateral, either actual possession or actual appointment of a receiver in a foreclosure suit is required to perfect such a security interest. West Bend Mutual Insurance Co. v. Belmont State Corp., 712 F.3d 1030 (7th Cir. 2013); Settlers’ Housing Service, Inc. v. Schaumburg Bank & Trust Company, N.A. (In re Settlers’ Housing Service, Inc.), 514 B.R. 258 (Bankr. N.D.Ill. 2014). However, applicable state law means the law where the real property is located, and some states’ laws may require only that an assignment of rents be recorded to perfect the interest. See In re KNM Roswell Limited Partnership, 126 B.R. 548 (Bankr. N.D.Ill. 1991) (holding that New Mexico law required only assignment of rents to be recorded to perfect security interest in rents).

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§8.10

The Bankruptcy Code provides, in pertinent part, that certain of the powers of a trustee and debtor-in-possession are subject to any generally applicable law that — (A) permits perfection of an interest in property to be effective against an entity that acquires rights in such property before the date of perfection; or (B) provides for the maintenance or continuation of perfection of an interest in property to be effective against an entity that acquires rights in such property before the date on which action is taken to effect such maintenance or continuation. (2) If — (A) a law described in paragraph (1) requires seizure of such property or commencement of an action to accomplish such perfection, or maintenance or continuation of perfection of an interest in property; and (B) such property has not been seized or such an action has not been commenced before the date of the filing of the petition; such interest in such property shall be perfected, or perfection of such interest shall be maintained or continued, by giving notice within the time fixed by such law for such seizure or such commencement. 11 U.S.C. §546(b). Under §546(b), after a bankruptcy is commenced, a mortgagor may perfect its security interest in rents, postpetition, by giving proper notice. In re Fullop, 6 F.3d 422 (7th Cir. 1993). Various courts around the country have found that the notice requirement can be satisfied by numerous steps, including sending a §546(b) notice, making a demand for the sequestration of rents, making a motion to prohibit the use of cash collateral (rents), and seeking a determination of secured status in rents under §506 of the Bankruptcy Code. B. [8.10] In What Contexts Do Cash Collateral Issues Arise? In most proceedings under Chapter 11 or Chapter 12 of the Bankruptcy Code, the debtor-inpossession or trustee will require the use of cash collateral in order to continue the business operations effectively. The secured creditor claiming an interest in the cash collateral will often oppose the use of cash collateral, believing that the debtor’s business operation will lose money and the dissipation of the cash collateral will ultimately prejudice the creditor’s ability to be repaid in full. As required under Bankruptcy Code §363(c)(4), the debtor-in-possession must keep cash collateral segregated and must account for it to the secured creditor claiming an interest in it. 11 U.S.C. §363(c)(4). See, e.g., In re Ag Service Centers, L.C., 239 B.R. 545 (Bankr. W.D.Mo. 1999); In re May, 169 B.R. 462 (Bankr. S.D.Ga. 1994). Cash collateral may be used by a debtor-in-possession only under limited circumstances. Its use requires either consent of the

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§8.11

SECURED TRANSACTIONS

applicable secured creditor(s) or, after notice and a hearing, a court order authorizing its use in accordance with the provisions of §363. The debtor-in-possession is, however, free to use noncash collateral in the ordinary course of business unless otherwise limited by court order. In order for the debtor-in-possession to use cash collateral over the objection of a party with an interest in that cash collateral, the court must find that the interested party is adequately protected. Examples of what may constitute adequate protection in a Chapter 11 case are found in Bankruptcy Code §361, though the list is not exhaustive. 11 U.S.C. §361. Temporary use may be granted if the court preliminarily determines there is a reasonable likelihood the secured creditor can be adequately protected. The burden of demonstrating adequate protection is on the debtor-in-possession or trustee. If the debtor makes a request to use cash collateral and a creditor with an interest in the cash collateral neither objects nor requests that it be provided with adequate protection, then the court may authorize the use without ordering that the creditor be provided adequate protection. If the creditor later requests protection, it will be too late with respect to any use that has already been authorized and that has already occurred. In re Robinson, 225 B.R. 228 (Bankr. N.D.Okla. 1998). Under Chapter 12, the §361 standards specifically do not apply. See §8.3 above. Adequate protection is being provided only to protect against a diminution in the creditor’s interest in the collateral due to its authorized use, not as additional collateral to which the creditor may look in general. C. [8.11] The Debtor-in-Possession’s Right To Use Cash Collateral The impact that the proposed use of cash collateral has on the value of the creditor’s interest in all of its collateral will be the measure of the need for adequate protection. 1. [8.12] Oversecured In some instances, a review of all the creditor’s collateral may result in the conclusion that the creditor is so oversecured (value of collateral exceeds amount of indebtedness) that the use of cash collateral poses no threat and requires no additional adequate protection. This concept is often referred to as “equity cushion.” The issue of the rate of dissipation of the equity cushion is important. In re Mendoza, 111 F.3d 1264, 1272 (5th Cir. 1997) (quoting Kost v. First Interstate Bank of Greybull (In re Kost), 102 B.R. 829, 831 (Bankr. D.Wyo. 1989)), seems to suggest that a 20-percent cushion should constitute adequate protection. A smaller cushion will probably not be considered adequate protection, especially if the cushion is likely to erode in any short period of time. Equitable Life Assurance Society of United States v. James River Associates (In re James River Associates), 148 B.R. 790 (E.D.Va. 1992). 2. [8.13] Fully Secured but with a Small Cushion If the creditor is fully secured and the debtor-in-possession is regenerating assets through its operations on roughly a break-even basis, then a replacement lien on after-acquired assets may be sufficient to provide adequate protection. Although the Bankruptcy Code allows interest to a fully

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secured creditor (11 U.S.C. §506(b)), it is unlikely that a court will authorize periodic cash payments to pay accruing postpetition interest. In re Delta Resources, Inc., 54 F.3d 722 (11th Cir. 1995). In order to assure that it remains fully secured, the creditor will want to monitor asset levels carefully. 3. [8.14] Undersecured An undersecured creditor (value of all collateral is less than the amount of indebtedness) is in a precarious position. It is now clear that there is no entitlement to interest (lost opportunity costs) on the secured portion of such a claim. United Savings Association of Texas v. Timbers of Inwood Forest Associates, Ltd., 484 U.S. 365, 98 L.Ed.2d 740, 108 S.Ct. 626 (1988). The accrual of interest on the claim of a senior lienholder during the pendency of a case can effectively turn a junior secured creditor into an unsecured or undersecured creditor. 4. [8.15] Interest and Costs Is the secured creditor entitled to accrue interest and assess its costs, including its reasonable attorneys’ fees, against the collateral? The Bankruptcy Code provides for interest and costs only if the creditor is fully secured and, with respect to costs and fees, if the underlying documents so provide. 11 U.S.C. §506(b); In re SW Hotel Venture, LLC, 460 B.R. 4 (Bankr. D.Mass 2011). See §§8.34 – 8.43 below. However, the language of §506(b) also stops when such accrual and/or assessment causes the secured creditor’s claim to equal the value of its collateral.

V. [8.16] OBTAINING FINANCING OR CREDIT In bankruptcy cases, particularly under Chapter 11, obtaining credit and/or borrowing funds may be accomplished under certain circumstances. In most instances, the source of credit will be existing suppliers and lenders. New parties, especially lenders, are usually not interested in getting involved in such a situation, although there are high-risk/high-return lenders who are actively seeking the “right” bankruptcy situation in which to get involved. The survival of the debtor may depend on the lender’s cooperation, and the lender’s ability to receive substantial repayment on prepetition debt may hinge on the debtor’s ability to reorganize and confirm a plan of reorganization. It is just this interdependence that makes the postpetition financing issue one that requires close scrutiny. A. [8.17] Unsecured Credit Within the Ordinary Course of Business The trustee or debtor-in-possession may obtain unsecured credit in the ordinary course of business without authority from the court. 11 U.S.C. §364(a). A claim arising from this credit is allowable as an administrative expense under §503(b)(1) of the Bankruptcy Code. Id. Examples of such unsecured credit are open account purchases of raw materials by a manufacturing company, purchases of inventory by a retailer, and purchases of seed, fertilizer, and chemicals by a farmer. The extent to which the debtor has obtained these goods on credit before may have a bearing on whether the activity is considered to be within the ordinary course of business. Remember that the court may enter an order limiting this form of credit.

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§8.18

SECURED TRANSACTIONS

B. [8.18] Credit Outside the Ordinary Course of Business Borrowing or credit outside the ordinary course of business, either secured or unsecured, will require notice and a hearing. 11 U.S.C. §§364(b) – 364(d). Such authorization from the court is discretionary and will depend on the circumstances of the case. If the court authorizes unsecured credit, a claim arising from granting the credit is allowable as an administrative expense under §503(b)(1). 11 U.S.C. §364(b). 1. [8.19] Court-Ordered Protection for Creditor Should the trustee or debtor-in-possession be unable to obtain unsecured credit allowable only under §503(b)(1) of the Bankruptcy Code, the court may grant further protection to the lender. See 11 U.S.C. §364(c). The court may grant the lender an allowable claim with priority over all other claims of the kind specified in §§503(b) and 507(b) of the Bankruptcy Code (a superpriority claim). The availability of this treatment may well act as an additional inducement to a secured creditor to participate voluntarily in the reorganization process. In the event of a subsequent conversion of the case to a Chapter 7 bankruptcy case, a superpriority claim will be subject to the administrative expenses arising from that Chapter 7 case. See 11 U.S.C. §726(b). The order granting a superpriority claim should be drafted very clearly and specifically. In re Flagstaff Foodservice Corp., 739 F.2d 73 (2d Cir. 1984). The court may also grant the postpetition lender a lien on any unencumbered property of the estate, or the court may grant a junior lien on property of the estate that is already encumbered. After notice and hearing, the court may authorize credit secured by a lien senior to or equal with an existing lien on property of the estate (commonly referred to as “priming” an existing lien). Before such a priming lien is granted, the court must determine that the trustee is unable to obtain credit otherwise and the existing lienholder’s interest in the property that is to become subject to the priming lien is otherwise adequately protected. In re Mosello, 195 B.R. 277 (Bankr. S.D.N.Y. 1996). Existing lienholders will seldom cooperate in this endeavor. The burden of proof on the issue of the adequate protection of the party whose lien is to be primed is on the trustee. 2. [8.20] Filing While often an order granting a postpetition security interest will recite that no filing or recording is necessary in order to perfect such an interest, it is probably a better practice to perfect the interest under applicable state law. C. Special Postpetition Borrowing or Credit Problems 1. [8.21] Cross-Collateralization When combining the use of current assets (such as cash collateral) with the extension of new, postpetition credit, difficult cross-collateralization issues arise. This practice is generally disfavored by the courts, although it is by no means rare. In re Cooper Commons, LLC, 430 F.3d 1215 (9th Cir. 2005); In re Ellingsen MacLean Oil Co., 834 F.2d 599 (6th Cir. 1987); In re Texlon Corp., 596 F.2d 1092 (2d Cir. 1979). On numerous occasions, courts have found that

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circumstances justified granting such relief. In re Vanguard Diversified, Inc., 31 B.R. 364 (Bankr. E.D.N.Y. 1983); In re Beker Industries Corp., 58 B.R. 725 (Bankr. S.D.N.Y. 1986); In re Flagstaff Foodservice Corp., 739 F.2d 73 (2d Cir. 1984). Prepetition lenders contemplating a postpetition loan to the debtor-in-possession will always think this is a good idea, especially when the prepetition loan is not strongly collateralized. However, at least one circuit court of appeals has stated that Bankruptcy Code §364(c) (11 U.S.C. §364(c)) does not permit the securing of prepetition debt with postpetition collateral as a means to obtain postpetition financing. In re Saybrook Manufacturing Co., 963 F.2d 1490 (11th Cir. 1992). Notice and a hearing regarding the granting of such a lien are mandatory. Local bankruptcy rules often require that any provision granting cross-collateralization to prepetition secured lenders be highlighted in any cash collateral or financing motion requesting such relief by reciting whether the proposed order, stipulation, or agreement contains such relief, identifying the location of any such provisions, and stating the justification for the relief requested. Northern District of Illinois Bankruptcy Rule 4001-2. 2. [8.22] Debtor-in-Possession’s Independence One of the major issues of controversy respecting a Bankruptcy Code §364 order is the likelihood that the debtor-in-possession is in no position, vis-à-vis the lender, to negotiate the terms of an order in an independent, evenhanded way. 11 U.S.C. §364. It is up to other parties in interest (creditors’ committee, other secured creditors) to review a proposed order closely and to bring to the court’s attention any issues respecting its fairness. 3. [8.23] Appeals Appeals from Bankruptcy Code §364 orders pose particularly difficult problems. A lender operating in good faith and in reliance on such an order is protected from the subsequent reversal of the order. See 11 U.S.C. §364(e); In re Ellingsen MacLean Oil Co., 65 B.R. 358 (W.D.Mich. 1986), aff’d, 834 F.2d 599 (6th. Cir. 1987); In re Fontainebleau Las Vegas Holdings, LLC, 434 B.R. 716 (S.D.Fla. 2010). While it may be difficult to obtain, it is imperative to seek a stay pending an appeal of an order under Bankruptcy Code §364 in order to preserve any chance for a successful appeal where a lender acted in good faith. One court held that a lender who was aware of the improper purpose of the postpetition loan was not protected by Bankruptcy Code §364(e). In re EDC Holding Co., 676 F.2d 945 (7th Cir. 1982).

VI. TRUSTEE’S STRONG-ARM POWERS A. [8.24] What Are the Trustee’s Strong-Arm Powers and Why Do They Exist? Section 544(a) of the Bankruptcy Code, which has been aptly termed the “strong-arm clause,” provides: The trustee shall have, as of the commencement of the case, and without regard to any knowledge of the trustee or of any creditor, the rights and powers of, or may

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§8.24

SECURED TRANSACTIONS

avoid any transfer of property of the debtor or any obligation incurred by the debtor that is voidable by — (1) a creditor that extends credit to the debtor at the time of the commencement of the case, and that obtains, at such time and with respect to such credit, a judicial lien on all property on which a creditor on a simple contract could have obtained such a judicial lien, whether or not such a creditor exists; (2) a creditor that extends credit to the debtor at the time of the commencement of the case, and obtains, at such time and with respect to such credit, an execution against the debtor that is returned unsatisfied at such time, whether or not such a creditor exists; or (3) a bona fide purchaser of real property, other than fixtures, from the debtor, against whom applicable law permits such transfer to be perfected, that obtains the status of a bona fide purchaser and has perfected such transfer at the time of the commencement of the case, whether or not such a purchaser exists. 11 U.S.C. §544(a). The Bankruptcy Code grants the trustee (or a debtor-in-possession) these strong-arm powers to cut off unperfected security interests, secret liens, and undisclosed prepetition claims against the debtor’s property as of the commencement of the case. In re Canney, 284 F.3d 362 (2d Cir. 2002). In other words, the trustee is granted the status of a hypothetical lien creditor as of the commencement of the bankruptcy case so that the trustee may recover for the benefit of the debtor’s bankruptcy estate any property that is not subject to a properly perfected lien under applicable nonbankruptcy law as of the debtor’s petition date. To create the same effect with respect to real property, the trustee has the rights and powers of a bona fide purchaser of real estate from the debtor. The strong-arm powers thus promote the Bankruptcy Code’s goals of equal distribution to similarly situated creditors by enabling a trustee to marshal or increase assets of the debtor’s estate. Mason v. Heller Financial Leasing, Inc. (In re JII Liquidating, Inc.), 341 B.R. 256 (Bankr. N.D.Ill. 2006). The key to avoiding an encounter with the trustee’s strong-arm powers is timely and proper perfection of a security interest under applicable law. Although a trustee’s strong-arm powers are conferred under the Bankruptcy Code, the extent of the trustee’s powers is determined under applicable nonbankruptcy law. Nickless v. Aaronson (In re Katz), 341 B.R. 123 (Bankr. D.Mass. 2006). For consensual liens that require the filing of a UCC1 Financing Statement with the Secretary of State for perfection, it is relatively easy to determine whether the creditor’s security interest was properly perfected under Article 9 of the Uniform Commercial Code, 810 ILCS 5/9-101, et seq. The determination, however, of the appropriate nonbankruptcy law to be applied in a given case not involving real property, when perfection is determined by the law of the jurisdiction where the real property is located, is not always so clear. Although the Court of Appeals for the Seventh Circuit has not yet decided the issue, other circuits had been divided as to the proper choice-of-law rules to apply in cases in which the court exercises federal question jurisdiction over claims that hinge on state law. See In re Jafari, 569 F.3d 644 (7th Cir. 2009); In re Gaston & Snow, 243 F.3d 599 (2d Cir. 2001)

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(discussing competing opinions between federal choice-of-law rules or conflicts rules of forum state). The majority of courts, however, now apply state choice-of-law rules to determine the appropriate law for disputes proceeding in bankruptcy courts. In re Dow Corning Corp., 778 F.3d 545 (6th Cir. 2015); In re Coudert Brothers LLP, 673 F.3d 180 (2d Cir. 2012). B. [8.25] Limitations of the Trustee’s Strong-Arm Powers The Bankruptcy Code limits a trustee’s strong-arm powers under §544(a) as follows: (1) The rights and powers of a trustee under sections 544, 545, and 549 of this title are subject to any generally applicable law that — (A) permits perfection of an interest in property to be effective against an entity that acquires rights in such property before the date of perfection; or (B) provides for the maintenance or continuation of perfection of an interest in property to be effective against an entity that acquires rights in such property before the date on which action is taken to effect such maintenance or continuation. (2) If — (A) a law described in paragraph (1) requires seizure of such property or commencement of an action to accomplish such perfection, or maintenance or continuation of perfection of an interest in property; and (B) such property has not been seized or such an action has not been commenced before the date of the filing of the petition; such interest in such property shall be perfected, or perfection of such interest shall be maintained or continued, by giving notice within the time fixed by such law for such seizure or such commencement. 11. U.S.C. §546(b). The purpose of limiting the trustee’s avoiding powers is to protect, despite the commencement of a bankruptcy case, creditors whom state law allows to perfect liens or interests by completing steps for perfection within a certain period of time after security interest attaches. 229 Main Street Limited Partnership v. Commonwealth of Massachusetts, Department of Environmental, 251 B.R. 186 (D.Mass. 2000), aff’d, 262 F.3d 1 (1st Cir. 2001). In conjunction with §362(b)(3), §546(b) is an exception to the automatic stay with respect only to the perfection or continuation of a lien, but not to the enforcement of a lien.

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§8.26

SECURED TRANSACTIONS

VII. AVOIDING PREFERENTIAL TRANSFERS A. [8.26] What Is a Preference? The Bankruptcy Code provides that the trustee may avoid a transfer of an interest of the debtor in property — (1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt owed by the debtor before such transfer was made; (3) made while the debtor was insolvent; (4) made — (A) on or within 90 days before the date of the filing of the petition; or (B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and (5) that enables such creditor to receive more than such creditor would receive if — (A) the case were a case under chapter 7 of this title; (B) the transfer had not been made; and (C) such creditor received payment of such debt to the extent provided by the provisions of this title. 11 U.S.C. §547(b). At the time a preferential transfer is made, there is nothing improper about it. It is only after a bankruptcy case is commenced when one looks over the applicable “preference period” that the transfer becomes potentially avoidable. In retrospect, a preference question arises any time a party receives a “timely” transfer of an interest of the debtor in property, made because of antecedent debt and while the debtor was insolvent. When is a secured creditor susceptible to the claim that it received an avoidable preferential transfer? For secured parties, the areas of greatest controversy regarding preferences usually involve the creation of new or additional security interests respecting problem loans, payments made on account of undersecured loans, or payments made to or for the benefit of insider guarantors. B. [8.27] Defenses Section 547(c) of the Bankruptcy Code provides a number of defenses to the general rule. Certain of these defenses are contemporaneous exchanges, the ordinary course of business,

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purchase-money security interests, and floating liens. Notwithstanding those defenses, if the aggregate value of transfers that a creditor receives during the preference period is less than $6,225, the transfers are not avoidable. 11 U.S.C. §547(c)(9). For cases commenced before April 1, 2013, the amount was $5,850 and less for cases commenced during earlier time periods. See 78 Fed.Reg. 12,089 (Feb. 21, 2013). One of the defenses to a preference claim arises with respect to “substantially contemporaneous” transfers for new value. The key issue here will usually involve the “intent” of the parties. Did they mean for the transfer to be a contemporaneous exchange? If the parties entered into a secured loan transaction but the secured creditor failed to obtain the debtor’s signature on a relevant loan document until sometime after the transfer of the money, the issue arises as to whether the transfer (the effective grant of the security interest) was on account of an antecedent debt. While certain courts have been willing to conclude that such an oversight, if corrected within a reasonable period of time, constitutes a substantially contemporaneous exchange, it is highly recommended that lenders never rely on the availability and success of such a defense. A secured creditor is often the recipient of a series of payments made pursuant to an installment note, all based on the previous transfer of consideration (the loan). Clearly, these installment payments are made because of antecedent debt. Bankruptcy Code §547(c)(2) provides that transfers made in the ordinary course of business of both the debtor and the creditor are not avoidable as preferences. If such payments were timely and according to the terms of the applicable documents, it is highly likely that the ordinary course of business defense will apply. Bankruptcy Code §547(c)(3) states that a trustee may not avoid a transfer as being preferential under §547 when the transfer creates a security interest in property acquired by the debtor — (A) to the extent such security interest secures new value that was — (i) given at or after the signing of a security agreement that contains a description of such property as collateral; (ii) given by or on behalf of the secured party under such agreement; (iii) given to enable the debtor to acquire such property; and (iv) in fact used by the debtor to acquire such property; and (B) that is perfected on or before 30 days after the debtor receives possession of such property. This provision of the Bankruptcy Code recognizes the “purchase-money security interest” concept that exists under the Uniform Commercial Code. See 810 ILCS 5/9-103. It allows a 30day grace period in which to perfect a security interest, during which the transfer will not be deemed to have been made because of antecedent debt.

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§8.28

SECURED TRANSACTIONS

Bankruptcy Code §547(c)(5) provides that a trustee may not avoid a transfer under this section that creates a perfected security interest in inventory or a receivable or the proceeds of either, except to the extent that the aggregate of all such transfers to the transferee caused a reduction, as of the date of the filing of the petition and to the prejudice of other creditors holding unsecured claims, of any amount by which the debt secured by such security interest exceeded the value of all security interests for such debt on the later of — (A)(i) with respect to a transfer to which subsection (b)(4)(A) of this section applies, 90 days before the date of the filing of the petition; or (ii) with respect to a transfer to which subsection (b)(4)(B) of this section applies, one year before the date of the filing of the petition; or (B) the date on which new value was first given under the security agreement creating such security interest. This subsection validates the widely used and accepted practice of “floating liens” on inventory and on accounts receivable. Absent this provision, the secured party would be exposed to the antecedent debt issue each time either new inventory was purchased or new receivables were generated and then became subject to the lender’s already existing security interest. (NOTE: Such “transfers” are still subject to the improvement of position aspect of Bankruptcy Code §547(c)(5).) C. [8.28] Preferential Transfers to or for the Benefit of Insiders: Reaching Back One Year Often, in the ordinary course of making a secured business loan, lenders will require that the principal insiders (officers, directors, or shareholders) give personal guarantees in connection with any loan made to the business entity. Several cases caused lenders to rethink this previously automatic requirement until Congress enacted the Bankruptcy Reform Act of 1994, Pub.L. No. 103-394, 108 Stat. 4106. In 1989, the Court of Appeals for the Seventh Court, in Levit v. Ingersoll Rand Financial Corp., 874 F.2d 1186 (7th Cir. 1989), held that when a creditor obtained the guarantee of a business debt from an officer or other insider of the debtor and subsequently payment on the underlying debt was made by the debtor, both the transferee-creditor and the guarantor were subject to the one-year preference period in Bankruptcy Code §547(b)(4)(B), 11 U.S.C. §547(b)(4)(B). The court reasoned that in such circumstances the insider would almost certainly know of the debtor’s financial troubles. The court concluded that if the same avoidance period applied to both guaranteed and unguaranteed debts of the debtor, the insider would have every incentive to “prefer” the guaranteed creditors from the minute financial difficulties commenced, hoping that a substantial paydown of the guaranteed debt could be accomplished before the commencement of the typical 90-day preference period. Subsequently, other circuit courts

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adopted the Levit extended reach-back period. However, in 1994, Congress added §550(c), providing that non-insider transferees are not liable for preferential transfers made for the benefit of insiders during the period between 90 days and one year prior to the filing of the petition. 11 U.S.C. §550(c). With that, the extended reach-back period set out in Levit was statutorily overruled.

VIII. [8.29] THE AVOIDANCE OF CERTAIN TRANSFERS AS FRAUDULENT CONVEYANCES What is a “fraudulent transfer” within the meaning of §548 of the Bankruptcy Code? Section 548(a)(1) provides: The trustee may avoid any transfer (including any transfer to or for the benefit of an insider under an employment contract) of an interest of the debtor in property, or any obligation (including any obligation to or for the benefit of an insider under an employment contract) incurred by the debtor, that was made or incurred on or within 2 years before the date of the filing of the petition, if the debtor voluntarily or involuntarily — (A) made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted; or (B)(i) received less than a reasonably equivalent value in exchange for such transfer or obligation; and (ii)(I) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation; (II) was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital; (III) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured; or (IV) made such transfer to or for the benefit of an insider, or incurred such obligation to or for the benefit of an insider, under an employment contract and not in the ordinary course of business. 11 U.S.C. §548(a)(1). This provision allows the trustee to recover for the estate’s benefit any property the debtor transferred under certain delineated circumstances for which the debtor did not receive appropriate consideration (reasonably equivalent value).

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Bankruptcy Code §101(54) defines “transfer” to include (A) the creation of a lien; (B) the retention of title as a security interest; (C) the foreclosure of a debtor’s equity of redemption; or (D) each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with — (i) property; or (ii) an interest in property. Thus, the Bankruptcy Code includes the following prebankruptcy property dispositions as transfers: (a) the absolute transfer of property, either by gift or sale; and (b) transfers for the purpose of creating or enforcing security interests, such as mortgages, pledges, or security agreements. See In re America West Airlines, Inc., 217 F.3d 1161 (9th Cir. 2000); Harry Turner & Associates, Inc. v. Shawnee County, Kansas (In re Harry Turner & Associates, Inc.), 153 B.R. 573 (Bankr. D.Kan. 1993). Under Bankruptcy Code §548(d)(1), a transfer is deemed made when it becomes valid against a subsequent bona fide purchaser under applicable state law. If the transfer is not perfected against a bona fide purchaser before commencement of the case, then the transfer is deemed to have occurred immediately before the date of the filing. 11 U.S.C. §548(d)(1). The Uniform Fraudulent Transfer Act, 740 ILCS 160/1, et seq., which is enacted in a number of states, applies the same rule. By contrast, other states have adopted the Uniform Fraudulent Conveyance Act, which does not have the “deemed” provision and follows the rule that the actual date of transfer will be determinative. “Insolvent” is defined in §101(32) of the Bankruptcy Code and is said to exist when “the sum of [an] entity’s debts is greater than all of such entity’s property, at fair valuation,” exclusive of fraudulently transferred and exempt property. 11 U.S.C. §101(32); In re Kaypro, 218 F.3d 1070 (9th Cir. 2000). Contingent rights, such as rights to contribution and subrogation, however, must be valued for purposes of determining solvency. In re Xonics Photochemical, Inc., 841 F.2d 198 (7th Cir. 1988). Contingent assets and liabilities must be valued for purposes of determining insolvency, and they must be discounted by the probability of occurrence. Paloian v. LaSalle Bank, N.A., 619 F.3d 688 (7th Cir. 2010); Covey v. Commercial National Bank of Peoria, 960 F.2d 657 (7th Cir. 1992); Official Committee of Asbestos Personal Injury Claimants v. Sealed Air Corp. (In re W.R. Grace & Co.), 281 B.R. 852 (Bankr. D.Del. 2002). The Bankruptcy Code provides that “ ‘value’ means property, or satisfaction or securing of a present antecedent debt of the debtor,” but the term does not include an unperformed promise to furnish support for the debtor or to a relative of the debtor. 11 U.S.C. §548(d)(2)(A); In re Bundles, 856 F.2d 815 (7th Cir. 1988). The debtor must actually receive a portion of the value promised to satisfy the reasonably equivalent value requirement. A benefit to the debtor may come indirectly through a benefit to a third party. See In re Image Worldwide, Ltd., 139 F.3d 574 (7th Cir. 1998). The threshold issue is whether the net effect of such a transaction results in value

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to the debtor’s estate. Id. Finally, the issue of reasonably equivalent value for a transfer is a question of fact. Id. Section 548(a)(1) of the Bankruptcy Code allows the trustee to avoid a transfer of the debtor’s property made (a) with actual intent to hinder, delay, or defraud any current or future creditor; or (b) with the result of constructive fraud during the two-year period preceding the bankruptcy filing. The three elements of actual fraudulent intent in Bankruptcy Code §548 must be read disjunctively. Consequently, if a debtor intends to delay its creditors only to gain more time to restore its affairs, it acts with fraudulent intent notwithstanding that it did not wish to deprive its creditors of payment. In re Roco Corp., 701 F.2d 978 (1st Cir. 1983); Hedback v. American Family Mutual Insurance Co. (In re Mathews), 207 B.R. 631 (Bankr. D.Minn. 1997). Whether a debtor actually intended to hinder, delay, or defraud its creditors by effecting a transfer is a question of fact to be determined by the circumstances of each case. King v. Ionization International, Inc., 825 F.2d 1180 (7th Cir. 1987). In King, the Seventh Circuit determined that the debtor acted with actual fraudulent intent when the main purpose of the transfer was to prevent a lawful creditor from collecting a debt. 825 F.2d at 1187. Moreover, the evidence should reflect a clear pattern of purposeful conduct. Silagy v. Gagnon (In re Gabor), 280 B.R. 149 (Bankr. N.D. Ohio 2002). Some courts have determined that actual intent to defraud can be determined as a matter of law. See In re Hinsley, 201 F.3d 638 (5th Cir. 2000); Merrill v. Abbott (In re Independent Clearing House Co.), 77 B.R. 843 (D. Utah 1987). A transfer may be deemed constructively fraudulent under §548 if a transfer is made for less than a reasonably equivalent value (a) while the debtor is insolvent, (b) while the debtor is engaged in business and will have unreasonably small capital to conduct its business after the transfer is made, (c) when the debtor is about to incur debts beyond its ability to pay as they mature, or (d) to an insider under an employment contract and outside the ordinary course of business. 11 U.S.C. §548(a)(1)(B). Insolvency need not result from such a transfer to make it fraudulent. Unreasonably small capital may be found under Bankruptcy Code §§548(a)(1)(B)(i) – 548(a)(1)(B)(ii)(II) even if the enterprise continues to operate at the same level for some period of time after the transfer. Boyer v. Crown Stock Distribution, Inc., 587 F.3d 787 (7th Cir. 2009); Moody v. Security Pacific Business Credit Inc., 127 B.R. 958 (W.D.Pa. 1991); In re Desert View Building Supplies, Inc., 633 F.2d 221 (9th Cir. 1980). A. [8.30] General Procedural Rules Generally, only the trustee or debtor-in-possession may sue to set aside a fraudulent transfer under Bankruptcy Code §548 or §544(b). 11 U.S.C. §§548, 544(b). Section 544(b) allows the trustee to avoid transfers that are avoidable under applicable law by a creditor holding an allowable unsecured claim, i.e., state law. Traina v. Whitney National Bank, 109 F.3d 244 (5th Cir. 1997). Under certain circumstances, however, courts have permitted creditors or creditors’ committees to bring such actions, particularly when the debtor’s estate lacks sufficient funds to bring the action itself or the trustee or debtor-in-possession refuses to do so. See In re Automated Business Systems, Inc., 642 F.2d 200 (6th Cir. 1981). Parties that are lineal descendants of the debtor’s statutory rights can bring avoidance actions. Mellon Bank, N.A. v. Dick Corp., 351 F.3d 290 (7th Cir. 2003). In Official Committee of

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Unsecured Creditors of Cybergenics Corp. v. Chinery, 330 F.3d 548 (3d Cir. 2003), the Third Circuit held that a creditors’ committee could pursue avoidance actions when a debtor-in-possession unreasonably refuses to do so. Other courts have followed suit. Gecker v. Marathon Financial Insurance Co. (In re Automotive Professionals Inc.), 389 B.R. 630 (Bankr. N.D.Ill. 2008). Many circuits have recognized the importance and difficulty of the derivative standing issue. In re MS55, Inc., 477 F.3d 1131 (10th Cir. 2007); In re Baltimore Emergency Services II, Corp., 432 F.3d 557 (4th Cir. 2005). The transferee and the debtor/transferor are usually necessary parties to a fraudulent transfer action. See Hamilton Nat. Bank of Boston v. Halsted, 9 N.Y.S. 852 (Gen. Term 1890), modified, 134 N.Y. 520 (1892). However, some courts have held that a debtor is not an indispensable party when, for example, the debtor no longer had an interest in the property transferred. See Moister v. Waters (In re Waters), 8 B.R. 163 (Bankr. N.D.Ga. 1981). Suits to determine, avoid, or recover preferential and fraudulent transfers are core proceedings. 28 U.S.C. §157(b)(2). Although the bankruptcy court has jurisdiction over such suits (28 U.S.C. §1334), the Supreme Court’s decision in Stern v. Marshall, ___ U.S. ___, 180 L.Ed.2d 475, 131 S.Ct. 2594 (2011), cast doubt on the bankruptcy court’s constitutional authority, as judges of Article III of the U.S. Constitution, to enter final judgments in avoidance actions. Specifically, the Court held that 28 U.S.C.§157(b)(2)(C), which provides that “counterclaims by the estate against persons filing claims against the estate” are “core” proceedings, is unconstitutional as applied to state law counterclaims that are not necessarily resolved in the process of allowing or disallowing the defendant’s claim. 131 S.Ct. at 2604; In re Ortiz, 665 F.3d 906, 912 (7th Cir. 2011). Courts were divided as to whether Stern, supra, should be applied broadly or narrowly and what they were and were not allowed to do in light of the opinion. Two subsequent Supreme Court decisions — Executive Benefits Insurance Agency v. Arkison, ___ U.S. ___, 189 L.Ed.2d 83, 134 S.Ct. 2165 (2014), and Wellness International Network, Ltd. v. Sharif, ___ U.S. ___, 191 L.Ed.2d 911, 135 S.Ct. 1932 (2015) — brought some much needed clarity. In Arkison, the Supreme Court concluded that Stern claims could be decided by bankruptcy courts in a manner consistent with the process established for the determination of non-core claims. In Wellness, the Supreme Court held that parties can consent to the bankruptcy court’s final adjudication of Stern claims and that such consent could be either express or implied as long as it is knowing and voluntary. The United States Supreme Court in Granfinanciera, S.A. v. Nordberg, 492 U.S. 33, 106 L.Ed.2d. 26, 109 S.Ct. 2782 (1989), held that an entity that has not submitted a claim against a bankruptcy estate has a constitutional right to a jury trial when sued by the trustee for the recovery of a fraudulent transfer of money. Justice Brennan, author of the plurality opinion, concluded that since a fraudulent conveyance action was normally heard in law (rather than equity) and money damages requested by the trustee were essentially a legal remedy, the Seventh Amendment afforded the defendants a right to a jury trial.

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B. [8.31] Liability of Transferees Under Bankruptcy Code §548(c), a transferee or obligee has a lien on the property transferred by the debtor or may enforce any obligation incurred by the debtor, to the extent that the transferee gave value, as long as the transferee or obligee took in good faith. 11 U.S.C. §548(c); In re FBN Food Services, Inc., 82 F.3d 1387 (7th Cir. 1996); For Your Ease Only, Inc. v. Calgon Carbon Corp., 560 F.3d 717 (7th Cir. 2009) (applying good-faith standards of Illinois Uniform Fraudulent Transfer Act and finding lack of good faith). Some courts focus on whether a transaction appears to have been at “arm’s length” to determine the good faith of the transferee. Other courts have defined “good faith” as a lack of knowledge of such facts as would put the reasonably prudent person on inquiry. In re M & L Business Machine Co., 84 F.3d 1330 (10th Cir. 1996). However, many courts are hesitant to define “good faith,” choosing instead to leave the concept to a more fluid know-it-when-you-see-it approach. In re Telesphere Communications, Inc., 179 B.R. 544 (Bankr. N.D.Ill. 1994). Bankruptcy Code §550(a)(2) may enable the trustee to recover the fraudulently transferred property from a subsequent transferee. Bankruptcy Code §550(d), however, provides that the “trustee is entitled to only a single satisfaction.” Under Bankruptcy Code §550(b), if an immediate or mediate transferee takes for value, in good faith and without knowledge of the voidability of the transfer, the trustee may not recover the property or its value from that transferee or from a subsequent good-faith transferee. The requirement of good faith is intended to prevent a transferee from transferring the recoverable property to an innocent transferee and later receiving a reconveyance of the property in question from the initial transferee. In re First Independence Capital Corp., 181 Fed.Appx. 524 (6th Cir. 2006). C. [8.32] Fraudulent Transfer Problems and the Secured Creditor Can the lawful, noncollusive exercise of rights by a secured creditor under an unavoidable mortgage really become an avoidable fraudulent transfer? Not anymore. In 1994, the Supreme Court of the United States decided BFP v. Resolution Trust Corp., 511 U.S. 531, 128 L.Ed.2d 556, 114 S.Ct. 1757 (1994), and held that the sale price received at a lawfully conducted mortgage foreclosure sale conclusively established reasonably equivalent value as long as the requirements of the applicable state’s foreclosure law were met. With this decision, the Supreme Court put to rest one of the major concerns of secured creditors enforcing their rights under a mortgage, as prior to 1994 some courts held that noncollusive foreclosure sales could be attacked under fraudulent conveyance law. See, e.g., In re Bundles, 856 F.2d 815 (7th Cir. 1988). D. [8.33] Leveraged Buyouts A very controversial area of fraudulent conveyance law involves attempts by trustees to avoid failed leveraged buyouts (LBOs). An LBO is a method of acquiring a company by which the acquiring company uses the assets of the acquired company to finance the acquisition. This area of the law is of great concern and interest to lenders who undertake the financing of these types of transactions. A central question that is regularly raised by defendants to such actions is whether

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these transactions are subject to avoidance under the constructive fraud provisions of the Bankruptcy Code. Several courts have considered this question. In both Credit Managers Association of Southern California v. Federal Co., 629 F.Supp. 175 (C.D.Cal. 1985), and Kupetz v. Continental Illinois National Bank & Trust Company of Chicago, 77 B.R. 754 (C.D.Cal. 1987), aff’d, 845 F.2d 842 (9th Cir. 1988), the court declined to apply the constructive fraud provisions of Bankruptcy Code §548 to LBOs, determining that the absence of actual fraud brought the transaction outside the reach of the Bankruptcy Code. Following the landmark decision in United States v. Tabor Court Realty Corp., 803 F.2d 1288 (3d Cir. 1986), aff’g United States v. Gleneagles Investment Co., 565 F.Supp. 556 (M.D.Pa. 1983), the district court in Wieboldt Stores, Inc. v. Schottenstein, 94 B.R. 488 (N.D.Ill. 1988), disagreed with the prior California decisions. The Wieboldt court held that fraudulent transfer law is generally applicable to LBOs although not all LBOs are subject to avoidance. Now the majority view is that bankruptcy and state fraudulent conveyance laws are generally applicable to LBOs. See Boyer v. Crown Stock Distribution, Inc., 587 F.3d 787 (7th Cir. 2009); MFS/Sun Life Trust — High Yield Series v. Van Dusen Airport Services Co., 910 F.Supp. 913 (S.D.N.Y. 1995); Mellon Bank, N.A. v. Metro Communications, Inc., 945 F.2d 635 (3d Cir. 1991). Despite the applicability of fraudulent conveyance laws to LBOs, many fraudulent transfer actions have been successfully defended as settlement payments under §546(e) of the Bankruptcy Code, which provides: Notwithstanding sections 544, . . . 548(a)(1)(B), and 548(b) of this title, the trustee may not avoid a transfer that is a . . . settlement payment, as defined in section 101 or 741 of this title, made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency . . . that is made before the commencement of the case, except under section 548(a)(1)(A) of this title. 11 U.S.C. §546(e). The application of §546(e) to shareholders receiving payments pursuant to LBO transactions involves complex issues of statutory interpretation. Some courts have held that the term “settlement payment” is broad and includes payments made under LBOs. See, e.g., In re Resorts International, Inc., 181 F.3d 505 (3d Cir. 1999). Under the Resorts reasoning, payments made to shareholders pursuant to LBOs are avoidable only if an actual intent to defraud exists pursuant to §548(a)(1)(A). Other courts, however, have held that the term “settlement payment” in §546(e) does not include payments for shares as part of private transactions, including an LBO. See, e.g., Official Committee of Unsecured Creditors of Norstan Apparel Shops, Inc. v. Lattman (In re Norstan Apparel Shops, Inc.), 367 B.R. 68 (Bankr. E.D.N.Y. 2007); Zahn v. Yucaipa Capital Fund, 218 B.R. 656 (D.R.I. 1998); Wieboldt Stores, Inc. v. Schottenstein, 131 B.R. 655 (N.D.Ill. 1991). Another circuit court has held that payments made to shareholders pursuant to LBOs are avoidable under §548(a)(1)(B) notwithstanding §546(e) because shareholders are the only transferees in such transactions, and they are not one of the protected entities enumerated in §546(e). In re Munford, Inc., 98 F.3d 604 (11th Cir. 1996). In the amendments to the Bankruptcy Code under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub.L. No. 109-8, 119 Stat. 23, Congress did not resolve the statutory ambiguity. Several circuit courts, however, have considered the issue and, contrary to the Munford court’s holding, have broadly applied the safe harbor under §546(e) and rejected limitations that would exclude transactions in

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privately held securities or transactions that do not involve financial intermediaries that take title to the securities during the course of the transaction. See, e.g., Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V., 651 F.3d 329 (2d Cir. 2011); In re Plassein International Corp., 590 F.3d 252 (3d Cir. 2009); In re QSI Holdings, Inc., 571 F.3d 545, 550 – 551 (6th Cir. 2009); Contemporary Industries Corp. v. Frost, 564 F.3d 981, 986 – 987 (8th Cir. 2009).

IX. [8.34] POSTPETITION INTEREST AND FEES The Bankruptcy Code provides: To the extent that an allowed secured claim is secured by property the value of which, after any recovery under subsection (c) of this section, is greater than the amount of such claim, there shall be allowed to the holder of such claim, interest on such claim, and any reasonable fees, costs, or charges provided for under the agreement or State statute under which such claim arose. 11 U.S.C. §506(b). Under §506(b), the holder of an allowed secured claim that is found to have collateral of a value greater than the amount of principal and prepetition interest on the claim is entitled to receive postpetition interest and may also be entitled to its reasonable costs, expenses, and attorneys’ fees. A. [8.35] Oversecured Creditors Are Entitled to Postpetition Interest Almost without exception, courts have allowed prepetition oversecured creditors to add postpetition interest to their secured claims, although many courts allow only the accrued postpetition interest to be paid at the completion of the case. In re Delta Resources, Inc., 54 F.3d 722 (11th Cir. 1995). While there had been some controversy about whether this treatment extended to both consensual and nonconsensual liens, the Supreme Court put that issue to rest in United States v. Ron Pair Enterprises, Inc., 489 U.S. 235, 103 L.Ed.2d 290, 109 S.Ct. 1026 (1989), holding that the United States was entitled to postpetition interest on its fully secured, nonconsensual tax claim. B. [8.36] Entitlement to Fees, Costs, and Expenses Tied to Contract Language Notwithstanding the existence of adequate collateral, the postpetition fees, costs, and charges are generally not allowable under Bankruptcy Code §506(b) in the absence of a contractual entitlement. 11 U.S.C. §506(b). See In re Gledhill, 164 F.3d 1338 (10th Cir. 1999). C. [8.37] Timing of Payment A second limitation on the entitlement to interest and fees involves Bankruptcy Code §506(b)’s proscription for “allowance” of postpetition interest as part of a secured claim while not requiring or even allowing the current payment of that amount until the completion of the case or sale of the underlying collateral. 11 U.S.C. §506(b). See In re Delta Resources, Inc., 54 F.3d 722 (11th Cir. 1995); In re SW Hotel Venture, LLC, 460 B.R. 4 (Bankr. D.Mass 2011). The

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determination of the allowability of postpetition interest often arises in the context of determining the amount of the secured claim for purposes of making distributions in Chapter 7 or Chapter 11 liquidations or for purposes of inclusion in a Chapter 11 or Chapter 13 plan of reorganization. Allowability of postpetition interest may arise in other contexts as well as, e.g., in the provision for adequate protection, although the Eleventh Circuit’s Delta Resources decision questions the propriety of that practice as most courts will not order adequate protection payments to be made on account of accruing postpetition interest. D. [8.38] What Is the Proper Rate of Interest? The grammatical structure of Bankruptcy Code §506(b) has confused an otherwise seemingly straightforward concept, creating an ambiguity in determining the proper rate of interest. The phrase “interest on such claim” is separated by a comma from the phrase “and any reasonable fees, costs, or charges provided for under the agreement or State statute under which such claim arose.” 11 U.S.C. §506(b). Consequently, some courts have engaged in a grammatical analysis of §506(b) in order to ascertain congressional intent. The Supreme Court’s opinion in United States v. Ron Pair Enterprises, Inc., 489 U.S. 235, 103 L.Ed.2d 290, 109 S.Ct. 1026, 1030 (1989), because of its clear statement that the phrase “provided for under the agreement” does not modify “interest on such claim” and the opinion’s failure to address the rate of interest question, may add to the confusion. Notwithstanding the misplaced comma, in the case of a contractual entitlement to interest, postpetition interest should be computed at the rate provided in the agreement under which the claim arose, and a majority of courts considering this issue have used the contract rate. In re Laymon, 958 F.2d 72 (5th Cir. 1992). Presumably, a statutory entitlement to interest should be computed at the rate provided in the state statute. E. [8.39] What Law Controls? The allowance of attorneys’ fees pursuant to Bankruptcy Code §506(b) has raised two questions over which courts have reached differing conclusions. The questions consider whether state or federal law is controlling on the issues of (1) the validity of provisions for payment of attorneys’ fees for purposes of 11 U.S.C. §506(b) and (2) the standards for determining reasonableness of such fees. 1. [8.40] Validity Regarding the validity issue, the majority of courts hold that federal law should be applied (see 1095 Commonwealth Corp. v. Citizens Bank of Massachusetts (In re 1095 Commonwealth Corp.), 236 B.R. 530 (D.Mass. 1999)), although some courts have held to the contrary (see Ferrari v. Barclays American/Business Credit, Inc. (In re Morse Tool, Inc.), 87 B.R. 745 (Bankr. D.Mass. 1988)). A review of the relevant legislative history supports the majority view. While H.R. 8200, 95th Cong., 1st Sess. (1977), and its version of 11 U.S.C. §506(b) would have applied state law to determine the validity of attorneys’ fees claims, the Senate version did not address the applicable

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law issue, and it was the Senate version of Bankruptcy Code §506(b) that was enacted. Pronouncements by the House and the Senate prior to the enactment of the Bankruptcy Code indicated clearly that federal law should determine the validity of attorneys’ fees issues. Accordingly, the better view is that federal law and not state law should control the issue of the validity of provisions allowing attorneys’ fees. 2. [8.41] Standards As it relates to the reasonableness of attorneys’ fees awards, the courts have generally held that reasonableness is to be determined in accordance with federal standards. In re Schriock Construction, Inc., 104 F.3d 200 (8th Cir. 1997); In re Hudson Shipbuilders, Inc., 794 F.2d 1051 (5th Cir. 1986). Any consideration of the allowance of attorneys’ fees will require the court to review the underlying documents that give rise to the entitlement, focusing on the scope of legal services covered by the attorneys’ fees provision. A court may (and probably should) require the party seeking an allowance of attorneys’ fees to demonstrate the reasonableness of the allowance by providing a detailed description of the services rendered and other evidence the party believes the court should consider. F. [8.42] Late Charges Late charges have also provoked controversy under Bankruptcy Code §506(b). Under the Bankruptcy Act of 1898, late charges were regarded as a penalty and, thus, were not enforceable in bankruptcy since bankruptcy courts were, and still are, essentially courts of equity. Section 506(b) requires that late charges, in order to be allowable, must (1) arise with respect to the claim of an oversecured creditor; (2) be provided for in the underlying documentation; (3) be reasonable; and (4) not be, in effect, a penalty, rendering the payments unenforceable. 11 U.S.C. §506(b). See In re LHD Realty Corp., 726 F.2d 327 (7th Cir. 1984); In re Dixon, 228 B.R. 166 (W.D.Va. 1998). G. [8.43] Proof of Claim and Distributions One issue that is often overlooked by secured creditors is whether to file a proof of claim. This is often the result of the fact that most courts agree that a properly perfected security interest will flow through and survive a bankruptcy case regardless of whether a proof of claim is filed. In re Macias, 195 B.R. 659 (Bankr. W.D.Tex. 1996). However, the decision to file or not to file does have some practical ramifications. The most notable one is that filing a proof of claim will be considered a submission to the jurisdiction of the bankruptcy court, which is a court of equity. The submission to jurisdiction, in turn, is treated as a waiver of the right to a jury trial in any lawsuit in which that right would traditionally exist (such as a fraudulent transfer suit). See Granfinanciera, S.A. v. Nordberg, 492 U.S. 33, 106 L.Ed 2d 26, 109 S.Ct. 2782 (1989). Moreover, liens can still be extinguished in Chapter 11 cases under Bankruptcy Code §1141(c), particularly if the secured creditor participates in the bankruptcy case. In re Northern New England Telephone Operations LLC, 795 F.3d 343 (2d Cir. 2015).

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There is some risk in not filing a proof of claim. The Court of Appeals for the Seventh Circuit has held that all creditors, including secured creditors, must timely file a proof of claim under Bankruptcy Rule 3002(c) in order to receive any distributions from a bankruptcy estate. In re Pajian, 785 F.3d 1161 (7th Cir. 2015). The Seventh Circuit’s logic in Pajian could also be applied to Chapter 11 cases. In any event, the bar date only affects the secured creditor’s ability to receive a distribution from the estate, and, therefore, the secured creditor may proceed against its security for payment of its claim even after the bankruptcy, as it retains its lien. In re Elmont Electric Co., 206 B.R. 41 (Bankr. E.D.N.Y. 1997).

X.

[8.44] CHARGES AGAINST SECURED CREDITORS’ COLLATERAL — 11 U.S.C. §506(c) The Bankruptcy Code provides: The trustee may recover from property securing an allowed secured claim the reasonable, necessary costs and expenses of preserving, or disposing of, such property to the extent of any benefit to the holder of such claim, including the payment of all ad valorem property taxes with respect to the property. 11 U.S.C. §506(c).

Section 506(c) is simply a codification of the caselaw before the enactment of the Bankruptcy Code, although there was no corresponding statutory provision under the prior Bankruptcy Act. As a general rule, administration costs of a bankruptcy estate are charged against the unencumbered assets of the estate and not against collateral held by, or for the benefit of, secured creditors. This is so because the trustee in bankruptcy acts as a representative of unsecured creditors, not secured creditors. In re Vitreous Steel Products Co., 911 F.2d 1223 (7th Cir. 1990). An exception to the general rule arises when the trustee incurs expenses primarily for the benefit of a secured creditor. The exception is limited in nature and is not designed to alter the time-honored premise that secured creditors are supposed to pass through bankruptcy cases with their rights intact. H.R.Rep. No. 595, 95th Cong., 1st Sess. (1977), reprinted in 1978 U.S.C.C.AN. 5963. The burden of proof that a certain expense is entitled to be surcharged under Bankruptcy Code §506(c) falls on the trustee or debtor-in-possession seeking treatment under §506(c). A. [8.45] Requirements for Bankruptcy Code §506(c) Claims Claims under Bankruptcy Code §506(c), to be approved, must satisfy the following requirements: (1) the expenditure was necessary; (2) the amount expended was reasonable; and (3) the secured creditor benefited from the expenses. 11 U.S.C. §506(c); In re K & L Lakeland, Inc., 128 F.3d 203 (4th Cir. 1997).

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First, the expenditure must be necessary to preserve or dispose of the secured creditor collateral. 11 U.S.C. §506(c). Common examples of such charges are appraisal fees, auctioneers’ fees, advertising costs, storage charges, payroll, marketing costs, and cleaning and repair bills. Less typical examples are rent, utility bills, insurance, and maintenance costs. An additional issue surrounding such expenditures is whether there has to be an actual expenditure rather than an incurred liability. However, the majority of courts have required that there be an actual expenditure to recover under §506(c). K & L, supra. Second, the cost or expense must have been reasonable. A key question may be, “Would the secured creditor have necessarily incurred the same expense?” Recovery may be limited to actual costs saved by the secured creditor. See, e.g., In re Combined Crofts Corp., 54 B.R. 294 (Bankr. W.D.Wis. 1985). A final requirement is that a cost or expense must have resulted in direct, quantifiable benefit to the secured creditor. This factor is difficult to quantify. Some courts have looked to a clearly defined separation or “cleavage date,” after which the trustee’s actions are deemed to have benefited the secured creditor. See, e.g., In re Trim-X, Inc., 695 F.2d 296 (7th Cir. 1982), in which the direct costs incurred in liquidating the collateral of a secured creditor were allowed under §506(c). See also In re C.S. Associates, 29 F.3d 903 (3d Cir. 1994) (finding payment of real estate taxes and water and sewer rent only indirectly benefited secured creditor and thus was not recoverable under §506(c)); In re Lunan Family Restaurants Limited Partnership, 192 B.R. 173 (Bankr. N.D.Ill. 1996) (allowing surcharge for utility payments, withholding tax payments, and health insurance arising from operation of restaurant). Another issue arising under §506(c) is whether the secured creditor consented to the expense. If the secured creditor caused or consented to the expense, the creditor may be liable for it, and court approval of the surcharge should be easier to obtain. However, a secured creditor’s acquiescence to a debtor-in-possession’s operation under Chapter 11 and cooperation with that operation does not constitute consent, nor is consent to be lightly inferred. In re Ferncrest Court Partners, Ltd., 66 F.3d 778 (6th Cir. 1995). It should be noted that consent is not required to obtain a surcharge under §506(c), but the existence of consent usually means the trustee or debtor-in-possession will have an easier time in court. B. [8.46] Standing Issue The statute clearly provides that the trustee may recover under §506(c) of the Bankruptcy Code. 11 U.S.C. §506(c). Section 1107 of the Bankruptcy Code provides that the debtor-inpossession shall have the rights and powers of a trustee. 11 U.S.C. §1107. What about third-party creditors who provide goods or services to the trustee or debtor-in-possession? In many instances, neither the trustee nor the debtor-in-possession has any impetus to pursue such claims on behalf of creditors. In the past, certain cases adopted a more expansive interpretation to §506(c), allowing such access to third-party creditors under several theories. See In re Wyckoff, 52 B.R. 164 (Bankr. W.D.Mich. 1985) (either trustee should bring action and pay third party out of recovery allowed or third party should bring action directly); In re Loop Hospital Partnership, 50 B.R. 565 (Bankr. N.D.Ill. 1985) (court sidestepped standing issue by concluding that, to extent standing was problem, award could alternatively be grounded on court’s equitable powers); In re

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Dakota Lay’d Eggs, 68 B.R. 975 (Bankr. D.N.D. 1987) (court refused to follow cases allowing creditors to assert §506(c) claims directly but suggested creditor could petition court to maintain §506(c) action in name of trustee); In re World Wines, Ltd., 77 B.R. 653 (Bankr. N.D.Ill. 1987) (better view was to allow landlord to assert his own §506(c) claim under circumstances of case); In re Reda, Inc., 54 B.R. 871 (Bankr. N.D.Ill. 1985) (court concluded §506(c) was available to parties other than trustee); Guy v. Grogan (In re Staunton Industries, Inc.), 74 B.R. 501 (Bankr. E.D.Mich. 1987) (contains detailed discussion of standing issue and concludes §506(c) should be available to third parties). In contrast, other courts adopted a strict construction of the statute and limited the availability of §506(c) to only the trustee or debtor-in-possession. In re Codesco, Inc., 18 B.R. 225 (Bankr. S.D.N.Y. 1982); In re New England Carpet Co., 28 B.R. 766 (Bankr. D.Vt.), aff’d, 38 B.R. 703 (D.Vt. 1983); In re Proto-Specialties, Inc., 43 B.R. 81 (Bankr. D.Ariz. 1984); In re J.R. Research, Inc., 65 B.R. 747 (Bankr. D. Utah 1986); In re Interstate Motor Freight Systems IMFS, Inc., 71 B.R. 741 (Bankr. W.D.Mich. 1987). However, in 2000, the Supreme Court in Hartford Underwriters Insurance Co. v. Union Planters Bank, N.A., 530 U.S. 1, 147 L.Ed. 2d 1, 120 S.Ct. 1942 (2000), held that only a trustee or debtor-in-possession could assert a claim under §506(c), thus resolving the standing issue once and for all. In making its decision, the Court stated that Congress says in a statute what it means and means in a statue what it says there.

XI. POSTPETITION EFFECT OF SECURITY INTERESTS A. [8.47] After-Acquired Property Generally, property acquired after the filing of a bankruptcy petition is not subject to a lien arising or resulting from any security agreement entered into by the debtor before the commencement of the case. 11 U.S.C. §552(a). This general rule, though, is subject to the exceptions in §552(b), which are discussed more fully in §8.49 below. Section 552(a) is directed to the “effect of such a prepetition security interest in postpetition property.” See S.Rep. No. 989, 95th Cong., 2d Sess. 91 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5877. In a hypothetical bankruptcy case, regardless of the §552(b) exceptions, the trustee or debtorin-possession may, in the ordinary course of business, sell, lease, or otherwise use the property that would, except for the bankruptcy case and §552(a), fall within the bounds of a typical afteracquired property clause contained in the prepetition security agreement of the secured creditor. In a normal manufacturing operation, the use of inventory to create a finished product, the sale of that finished product, and the collection and subsequent use of the accounts receivable generated by the sale will rapidly turn prepetition assets into postpetition assets. In the absence of a courtordered replacement lien granted to the prepetition secured creditor on postpetition assets of the same type, such a process will result in an estate full of postpetition property not subject to the prepetition lien and security interest of the prepetition secured creditor. This is precisely the concern, discussed in §8.19 above, that relates directly to the issue of adequate protection.

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§8.49

B. [8.48] Proceeds Under 11 U.S.C. §552(a), there is some confusion as to whether “proceeds” (discussed in Chapter 3 of this handbook) that are typically subject to the claim of the secured party are, in fact, “proceeds” as that term is generally understood in the nonbankruptcy world of secured creditors. Are proceeds instead simply after-acquired property that, under Bankruptcy Code §552(a), are no longer subject to the prepetition security interest of the secured party? The United States Supreme Court in Local Loan Co. v. Hunt, 292 U.S. 234, 78 L.Ed. 1230, 54 S.Ct. 695, 698 – 699 (1934), examined the distinction between after-acquired property and proceeds and determined that it is improper to recognize the creation of an enforceable lien upon a subject not existent when the bankruptcy became effective or even arising from, or connected with, preexisting property, but brought into being solely as the fruit of the subsequent labor of the bankrupt. Other courts have taken a somewhat different approach, focusing on Uniform Commercial Code §9-204, which validates after-acquired property clauses, and §9-306, which deals with proceeds. See, e.g., In re Bumper Sales, Inc., 907 F.2d 1430 (4th Cir. 1990). Still other courts have opted to try to pinpoint the creation of the collateral and trace its path into the proceeds. Under any of these approaches, however, the secured party clearly has the burden of proof on the issue of the survival of the lien postpetition. In re Cafeteria Operators, L.P., 299 B.R. 400 (Bankr. N.D.Tex. 2003); Exchange National Bank of Chicago v. Gotta (In re Gotta), 47 B.R. 198 (Bankr. W.D.Wis. 1985). C. [8.49] Exceptions The Bankruptcy Code provides as follows: Except as provided in sections 363, 506(c), 522, 544, 545, 547, and 548 of this title, if the debtor and an entity entered into a security agreement before the commencement of the case and if the security interest created by such security agreement extends to property of the debtor acquired before the commencement of the case and to proceeds, products, offspring, or profits of such property, then such security interest extends to such proceeds, products, offspring, or profits acquired by the estate after the commencement of the case to the extent provided by such security agreement and by applicable nonbankruptcy law, except to any extent that the court, after notice and a hearing and based on the equities of the case, orders otherwise. 11 U.S.C. §552(b)(1). Most security agreements contain boilerplate language that extends coverage to include proceeds, products, offspring, rents, or profit generated by the property subject to the security interest, as permitted by applicable nonbankruptcy law. Section 552(b)(1) preserves prepetition liens on postpetition proceeds of prepetition collateral “to the extent provided by such security agreement and by applicable nonbankruptcy law.” The “extent” language contained in §552(b) has been construed to mean the intent of the parties, as delineated in the security agreement or

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financing statement. In most instances it will be clear, under nonbankruptcy law and the relevant documents, that a particular security interest either does or does not extend to the asset that is now being characterized as “proceeds.” D. [8.50] Interplay with Other Bankruptcy Code Sections Section 552(b) of the Bankruptcy Code allows the court some flexibility in considering the equities of the case in limiting the postpetition effects of an otherwise valid and effective prepetition proceeds clause. 11 U.S.C. §552(b). In its evaluation, the court may consider any proceeds-related expenditures by the estate and any related improvements in the secured party’s position. The court’s flexibility exists, in part, due to the interplay of other Bankruptcy Code sections and §552(b). For examples of this interplay, one must consider the following Bankruptcy Code sections: §544 (involving the trustee’s hypothetical lien creditor and bona fide purchaser status); §547 (preferences); and §506(c) (involving the costs of the trustee’s preservation or disposition of collateral). A secured party’s right to proceeds, for instance, is subject to the trustee’s power under §547 to avoid the security interest, for the benefit of the estate, as a preferential transfer. The secured party has no rights in proceeds, product, offspring, rent, or profits under §552(b) if the security interest itself is avoided as a preference. If the security interest is avoided as a fraudulent transfer under §548, the secured party will lose any rights in proceeds under §552(b). Further, these avoided transfers are automatically preserved and can be asserted against proceeds for the benefit of the estate as against junior lienholders. See 11 U.S.C. §550(a). Because of the interplay of §§552(b) and 506(c), the secured party will not unduly benefit when the trustee uses the assets of the estate in a manner that enhances the value of the secured party’s collateral. For example, if the trustee uses inventory that is subject to a prepetition security interest to complete work in process, then the trustee may be able to recover his or her reasonable and necessary costs and expenses from the “proceeds” realized from the sale of the finished product pursuant to §506(c) (see §8.44 above), as well as a fair share of the profits for the benefit of the estate. In short, in applying §552(b), a court will make its decision according to the equities of the case. In addition, the court’s “equities” analysis may include any improvement or decline in value of the proceeds (whether the improvement or decline is caused by any party or is the result of cooperation or interference by the secured party), efficiencies or inefficiencies of the estate, or fluctuation in the market place. See, e.g., United States v. Hollie (In re Hollie), 42 B.R. 111 (Bankr. M.D.Ga. 1984); In re Trans-Texas Petroleum Corp., 33 B.R. 67 (Bankr. N.D.Tex. 1983). This flexible “equity” approach adopted by §552(b) allows the court to maintain a valid security interest in proceeds, rents, etc., while allowing the court to protect the interest of unsecured creditors and the estate. Following a court’s determination of the equities, profit or loss may inure to the estate or to the secured party or, if the court so determines, be apportioned between the estate and the secured party.

XII. [8.51] CONFIRMATION OF A REORGANIZATION PLAN The process of the confirmation of a plan of reorganization is a multistep one that can be both complex and time consuming. It is, of course, a narrower focus for the secured creditor than for

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§8.53

the plan proponent (usually the debtor-in-possession or trustee, but not always). The secured creditor is primarily focused on the treatment proposed for itself and other secured creditors, as well as on the overall feasibility of the plan. There are other issues of concern, but §§8.52 – 8.54 below concentrate on the plan treatment and feasibility, as well as certain of the basic confirmation steps. A. [8.52] Disclosure Statement Before either the court or the creditors consider a reorganization plan, the plan proponent must prepare, distribute, and gain approval of a disclosure statement. Parties are prohibited from formally soliciting acceptance of a plan until after approval of the disclosure statement has been accomplished. As set forth in §1125 of the Bankruptcy Code, a disclosure statement, before it can be approved by the court, must be found to contain “adequate information,” defined in §1125(a)(1) as information of a kind, and in sufficient detail, as far as is reasonably practicable in light of the nature and history of the debtor and the condition of the debtor’s books and records, including a discussion of the potential material Federal tax consequences of the plan to the debtor, any successor to the debtor, and a hypothetical investor typical of the holders of claims or interests in the case, that would enable such a hypothetical investor of the relevant class to make an informed judgment about the plan. 11 U.S.C. §1125(a)(1). Typically, a disclosure statement will provide a historical overview of the debtor and its financial condition, including the developments leading up to and resulting in the filing of the Chapter 11 case. It will then discuss the terms of the proposed plan and the relevant operational, financial, and/or managerial adjustments made to address the particular issues or problems of the debtor. Generally, certain financial projections for the debtor under the terms of the proposed plan will be included. Often, the debtor will also provide its view of the consequences of a liquidation of the debtor in an effort to demonstrate to the creditors and the court that the proposed plan is preferable to liquidation. The plan proponent drafts and files its proposed disclosure statement with the court. The statement is then transmitted to all creditors and parties in interest, who are given an opportunity to object to the statement. In determining the adequacy of a disclosure statement, the court must consider the complexity of the case, the benefit of additional information to creditors and other interested parties, and the cost of providing additional information. The court will conduct a hearing on the adequacy of the statement, consider any objections to it, require the proponent to make any amendments the court believes are appropriate, and ultimately either approve or refuse to approve the statement as containing adequate information. B. [8.53] The Reorganization Plan The debtor may propose a plan of reorganization at any time during a Chapter 11 case. 11 U.S.C. §1121(a). Any party in interest may propose a plan if a trustee has been appointed or if the debtor’s exclusive period in which to file a plan has expired. 11 U.S.C. §1121(c). The

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requirements for the contents of a plan of reorganization are detailed in §1123 of the Bankruptcy Code. 11 U.S.C. §1123. The plan shall designate classes of claims and interests, specify whether each class is impaired, specify the treatment to be accorded to each impaired class, treat each member of a class the same unless a particular class member agrees to different treatment, provide adequate means for the implementation of the plan, provide for the amendment of the corporate charter when applicable, and provide for an appropriate manner of selection of corporate officials and their successors. Once the plan has been drafted in accordance with §1123, it is filed with the court. The court directs that a copy of the proposed plan, along with a copy of the approved statement, a ballot, and a notice setting forth all of the pertinent dates, be transmitted to all creditors and parties in interest. Creditors and parties in interest now have the opportunity to accept or reject the proposed plan. In order for a plan to be confirmed, it must be accepted by the holders of at least two thirds in amount and more than one half in number of those voting in each class of impaired creditors and interests. 11 U.S.C. §§1126(c), 1126(d). Any class that is unimpaired under the terms of the plan is conclusively deemed to have accepted the plan and is not entitled to vote. 11 U.S.C. §1126(f). For the court to enter an order confirming a plan, it must determine that the plan meets the requirements of Bankruptcy Code §1129. Section 1129 provides that the court shall confirm a plan that complies with all of the applicable provisions of the Bankruptcy Code: the plan proponent complies with the Bankruptcy Code’s provisions; the plan is proposed in good faith and not by any means forbidden by law; all payments made or to be made for services, costs, or expenses in connection with the plan are or will be approved by the court as reasonable; and 1. the plan properly discloses (a) the identity and affiliations of all post-confirmation corporate officials and (b) the identity of any insider who will be employed or retained by the debtor and his or her compensation; 2. proper regulatory approval has been obtained, when applicable (each holder of a claim or interest in an impaired class has either (a) accepted the plan or (b) will receive at least what he or she would receive if the debtor were liquidated); 3. each class has either accepted the plan or is unimpaired under it, each class of administrative claims has been treated appropriately, and in the event there are any impaired classes under the plan, at least one impaired class has accepted the plan; 4. confirmation is not likely to be followed immediately by liquidation or the need for further reorganization, i.e., the plan must be feasible; and 5. all fees owing to the United States Trustee are properly provided for and the plan properly provides for the continuation of applicable retirement benefits. 11 U.S.C §1129(a).

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§8.54

C. [8.54] Cramdown An exception to the confirmation requirements discussed in §8.53 above is provided in Bankruptcy Code §1129(b), in that confirmation is possible without the acceptance of every class of impaired creditors and attendant satisfaction of Code §1129(a)(8). 11 U.S.C. §1129(b). Specific criteria are in §1129(b) respecting classes of secured creditors, unsecured creditors, and interests. This chapter considers only the issue with respect to secured creditors. In that regard, a class of secured creditors may be “crammed down” (forced to accept the treatment proposed in the plan) only if the proponent of the plan requests confirmation in spite of the rejection by an impaired class, at least one class of impaired creditors has accepted the plan (not counting the acceptances of insiders), the plan does not discriminate unfairly, and the plan is fair and equitable. Bank of America National Trust & Savings Ass’n v. 203 North LaSalle Street Partnership, 526 U.S. 434, 143 L.Ed.2d 607, 119 S.Ct. 1411 (1999). Impairment of claims and interests is treated at 11 U.S.C. §1124. In order for a claim to be unimpaired (and hence deemed to have accepted the plan), the plan must 1. leave unaltered the legal, equitable, and contractual rights to which its holder is entitled; 2. notwithstanding any legal or contractual rights of the claimant to accelerated payments, (a) cure all prepetition and postpetition defaults; (b) reinstate the maturity of the claim to its original term; (c) compensate the claim holder for any damages resulting from reasonable reliance on its legal or contractual rights; (d) compensate the claim holder for any actual pecuniary loss resulting from any failure to perform a nonmonetary obligation, other than a default arising from failure to operate a nonresidential real property lease; and (e) not otherwise alter the legal, equitable, or contractual rights to which the claimant is entitled; or 3. provide for payment, on the effective date, of cash equal to the claim. With respect to secured claims, a plan will impair a claim if it seeks to alter the terms and/or conditions of the maturity date, interest rate, dates of payments, collateral, prepayment penalties, or consent to the creation of junior interests in the collateral. The issue of unfair discrimination focuses on the classification and treatment of claims and interests. Because secured creditors are most often classified in a plan in separate, individual classes, the cramdown of a secured class usually does not involve an unfair discrimination controversy. A plan is fair and equitable with respect to the treatment proposed for a class of impaired rejecting secured creditors if it provides 1. that the secured creditor retains the lien(s) on the collateral in question and receives deferred cash payments totaling at least the allowed amount of its claim, of a value equal to at least the claimant’s interest in the estate’s interest in the collateral, as of the effective date of the plan;

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2. for the sale of the collateral subject to the lien, with the lien to attach to the proceeds of the sale, and the lien is treated consistently with items 1 and 3; or 3. for the realization by the secured creditor of the “indubitable equivalent” of its claim. In plain language, the secured creditor must receive cash payments totaling the allowed amount of the claim (without regard to the extent to which that claim may be undersecured) with a present value equal to the amount of the allowed secured claim. First, the court must determine the extent of the secured claim — what is the value of the collateral. Associates Commercial Corp. v. Rash, 520 U.S. 953, 138 L.Ed.2d 148, 117 S.Ct. 1879 (1997). In a Chapter 13 case, the Supreme Court has held value to be the price that a willing buyer in the debtor’s trade, business, or situation would pay to obtain like property from a willing seller. Id. Both before and after Rash, courts have generally utilized the fair market value standard if the debtor is an ongoing business concern. In re Mirant Corp., 334 B.R. 800 (Bankr. N.D.Tex. 2005); In re Davis, 14 B.R. 226 (Bankr. D.Me. 1981). Second, the court will need to determine an appropriate “discount rate” for the present value calculation of the stream of deferred payments. With respect to the selection of the appropriate cramdown interest rate, Bankruptcy Code §1129(b) does not provide any guidance, but the leading case, Till v. SCS Credit Corp., 541 U.S. 465, 158 L.Ed.2d 787, 124 S.Ct. 1951 (2004), provides some guidance. After Till, numerous courts have evaluated its impact and developed frameworks to determine the appropriate interest rate for the present value calculation under Bankruptcy Code §1129(b)(2)(A)(i). Market rate of interest is the most likely measure if the market is efficient. If evidence of a market rate is from an inefficient market, lacks precision, or is otherwise unreliable, courts will typically determine the appropriate rate using the “prime plus” approach explained in Till. For a fully secured creditor, the claim and the secured claim will be the same, and only the present value aspect of the test will be relevant. For the partially secured creditor, the plan must provide not only for a stream of deferred payments with the appropriate present value, but also for a long enough duration of payments to total the amount of the claim in its entirety. The greater the disparity between the amount of the claim and the secured claim, the more troublesome this requirement may become in certain cases. The indubitable equivalency test is the catchall standard for the fair-and-equitable test. The concept was introduced by Judge Learned Hand in his opinion in In re Murel Holding Corp., 75 F.2d 941 (2d Cir. 1935). It usually arises in the context of less typical treatment of a secured claim under a plan, such as the payment of stock, the abandonment to the secured creditor of its collateral (which will satisfy the test), or the granting of a replacement lien on other assets (valuation and stability of the assets are key). Metropolitan Life Insurance Co. v. San Felipe @ Voss, Ltd. (In re San Felipe @ Voss, Ltd.), 115 B.R. 526 (S.D.Tex. 1990); United States v. Arnold & Baker Farms (In re Arnold & Baker Farms), 177 B.R. 648 (B.A.P. 9th Cir. 1994). The question of whether a particular proposed treatment will satisfy the indubitable equivalent test will always come down to a question of fairness: Is the creditor getting something that is at least as valuable as and no more risky than what it previously had? See In re River East Plaza, LLC, 669 F.3d 826 (7th Cir. 2012).

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Some courts had allowed debtors to confirm plans under the indubitable equivalent test without allowing secured lenders to credit bid, but, in RadLAX Gateway Hotel, LLC v. Amalgamated Bank, ___ U.S. ___, 182 L.Ed.2d 967, 132 S.Ct. 2065 (2012), the Supreme Court held that a debtor may not obtain confirmation of a Chapter 11 cramdown plan that provides for the sale of collateral free and clear of a bank’s lien but prohibits credit bidding at the sale. Thus, a debtor may not confirm a plan over the objection of an impaired secured creditor pursuant to the indubitable equivalence prong of the statutory fair-and-equitable test unless the debtor proposes to treat the secured creditor in a way not contemplated by the first two prongs of the test. CenterPoint Properties Trust v. Olde Prairie Block Owner, LLC (In re Olde Prairie Block Owner, LLC), 460 B.R. 500 (N.D.Ill. 2011). From the perspective of the secured creditor, cramdown is the appropriate measuring stick for the treatment proposed under a plan. Aside from the give-and-take issues present in any negotiation, it sets the parameters for the secured creditor and its assessment of the plan. If the proposed treatment is capable (on a legal level) of being crammed down, then the secured creditor would be well advised to consider consenting to the treatment (accepting the plan). While courts have been somewhat resistant to holding secured creditors to this standard, “reasonableness” is often a criterion for allowing attorneys’ fees in bankruptcy cases, and opposition to a plan that proposes treatment that is clearly capable of satisfying the cramdown standards might well fail to meet that standard. On the other hand, there is no way that a plan proponent can force a secured creditor to accept proposed treatment except to the extent that the treatment qualifies under 11 U.S.C. §1129(b).

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9

Subordination and Intercreditor Agreements

FREDERICK C. FISHER SEAN T. SCOTT Mayer Brown LLP Chicago

The contribution of Donald P. Seberger to prior editions of this chapter is gratefully acknowledged.

®

©COPYRIGHT 2016 BY IICLE .

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I. [9.1] Introduction II. In General A. [9.2] Statutory Provisions 1. [9.3] The Uniform Commercial Code a. [9.4] 810 ILCS 5/1-310 b. [9.5] 810 ILCS 5/9-339 c. [9.6] 810 ILCS 5/9-340 2. [9.7] The Bankruptcy Code B. [9.8] Form of Contract C. [9.9] American Bar Association Model Agreement III. Subordination Agreements A. [9.10] Purposes and Uses of Subordinations B. [9.11] Types of Subordinations 1. [9.12] Bankruptcy Subordination 2. [9.13] Default Subordination 3. [9.14] Standstill Subordination C. [9.15] Major Substantive Issues 1. [9.16] Payment in Full 2. [9.17] Defining the Debt 3. [9.18] Default Provisions 4. [9.19] Standstill Period D. [9.20] Other Terms and Provisions 1. [9.21] Rights of Senior Lender 2. [9.22] Postpetition Interest 3. [9.23] Covenants of Junior Creditor 4. [9.24] Representations of Junior Creditor 5. [9.25] Subrogation Rights 6. [9.26] Trust Relationship 7. [9.27] Descriptive Legend 8. [9.28] Notices

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IV. Intercreditor Agreements A. [9.29] Purposes and Uses B. [9.30] Major Substantive Issues 1. [9.31] Defining the Collateral 2. [9.32] Allocation of Collateral and Products and Proceeds 3. [9.33] Default and Enforcement 4. [9.34] Right To Purchase C. [9.35] Bankruptcy and Insolvency Proceedings 1. [9.36] Use of Cash Collateral 2. [9.37] Disposition of Collateral 3. [9.38] Adequate Protection D. [9.39] Modifications E. [9.40] Other Terms and Provisions V. [9.41] Unitranche Facilities VI. [9.42] Conclusion

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I. [9.1] INTRODUCTION Subordination agreements are arrangements under which a creditor (the junior creditor) contractually undertakes to subordinate some or all of its rights against the borrower to the rights and interests of another creditor (the senior lender or senior creditor). Intercreditor agreements, which are a form of subordination agreement, usually denominate an arrangement between two or more secured creditors of a borrower who wish to establish and allocate between or among themselves lien priorities and rights in and to collateral. The varieties of subordination and intercreditor agreements are virtually limitless. Their specific provisions depend on a number of factors, including the nature of the transaction, the borrower’s business and property, the credit needs of the borrower, and the relative bargaining positions of the lenders or creditors of the borrower. This chapter is an introduction to subordination and intercreditor agreements in the context of commercial lending transactions. It describes the basic types of subordination and intercreditor agreements and identifies some of the most common issues that arise when documenting and negotiating such agreements. This chapter does not address subordinations in the context of real estate lending transactions or in the context of highly leveraged or corporate finance transactions and is meant to provide only a general overview and introduction.

II. IN GENERAL A. [9.2] Statutory Provisions Subordination agreements are recognized under both Illinois state law and federal law. Sections 1-310 (formerly §1-209) and 9-339 (formerly §9-316) of the Uniform Commercial Code (UCC), 810 ILCS 5/1-101, et seq., both expressly refer to the right of a creditor to subordinate its rights to those of another creditor. 810 ILCS 5/1-310, 5/9-339. See §§9.3 – 9.6 below. Likewise, §510(a) of the Bankruptcy Code, 11 U.S.C. §101, et seq., gives effect to subordination agreements. 11 U.S.C. §510(a). See §9.7 below. 1. [9.3] The Uniform Commercial Code Article 9 of the Uniform Commercial Code, 810 ILCS 5/9-101, et seq., establishes elaborate rules for determining the rights and priorities of competing creditors in and to a borrower’s property and assets. See Chapter 3 of this handbook. The UCC makes it clear that the rights and priorities of competing creditors may be altered by agreement between or among those creditors. Two sections of the UCC — 810 ILCS 5/1-310 and 5/9-339 — make specific reference to subordination agreements. See §§9.4 and 9.5 below. In addition, although 810 ILCS 5/9-340 does not mention subordination agreements, its effect is to place substantial importance on the use of subordination agreements by secured creditors who hold a security interest in a deposit account. See §9.6 below.

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§9.4

a. [9.4] 810 ILCS 5/1-310 Former §1-209 of the Uniform Commercial Code, added by the National Conference of Commissioners on Uniform State Laws in 1966, provided: An obligation may be issued as subordinated to payment of another obligation of the person obligated, or a creditor may subordinate his right to payment of an obligation by agreement with either the person obligated or another creditor of the person obligated. Such subordination does not create a security interest as against either the common debtor or a subordinated creditor. This section shall be construed as declaring the law as it existed prior to the enactment of this section and not as modifying it. Section 1-209 was an optional amendment. Professor Hawkland suggested that this section had its origin as a response to the decision in In re Wyse, 340 F.2d 719 (6th Cir. 1965). See 1 William D. Hawkland, HAWKLAND UNIFORM COMMERCIAL CODE SERIES §1-209:1 (2006). In Wyse, the court implied that a subordination provision in a guaranty created a security interest that, because it was not perfected, was avoided by the trustee of the bankruptcy debtor’s estate. Section 1-209 flatly rejected the idea that a subordination agreement is in the nature of a secured transaction. Section 1-310 of Revised Article 1 of the UCC, which replaces §1-209 and has been adopted in Illinois, does not make any substantive changes to §1-209. It provides: An obligation may be issued as subordinated to performance of another obligation of the person obligated, or a creditor may subordinate its right to performance of an obligation by agreement with either the person obligated or another creditor of the person obligated. Subordination does not create a security interest as against either the common debtor or a subordinated creditor. 810 ILCS 5/1-310. The final sentence of §1-209 has been deleted from §1-310. Revised Article 1 of the UCC, including §1-310, was passed as part of P.A. 95-895 and became effective January 1, 2009. See Revision of Uniform Commercial Code Article 1 — General Provisions (approved and adopted by the American Law Institute and the National Conference of Commissioners on Uniform State Laws in 2001), www.uniformlaws.org/shared/docs/ucc1/ucc1kitbundle.pdf. See also 1 William D. Hawkland, HAWKLAND UNIFORM COMMERCIAL CODE SERIES §1-310:1 (2012). In Strosberg v. Brauvin Realty Services, Inc., 295 Ill.App.3d 17, 691 N.E.2d 834, 229 Ill.Dec. 361 (1st Dist. 1998), the plaintiff initiated an action for breach of contract based on the failure of the defendant to make a payment under a promissory note. Following a jury trial, a verdict was entered in favor of the plaintiff, and the defendant appealed. In reversing the trial court verdict, the court of appeals held that the plaintiff could not properly recover amounts owing him under the promissory note because he had previously granted a security interest in the subject promissory note and subordinated his claims thereunder to the rights of the defendant’s bank. The court of appeals, citing former §1-209, stated: “While subordination agreements generally are not treated as security agreements giving security interests in the property of the subordinated creditor, such a result can occur if the parties to the subordination agreement intend to create a

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security interest.” [Footnote omitted.] 691 N.E.2d at 840 – 841. In this case, the court of appeals held that the clear language in the subordination agreement and the plaintiff’s endorsement and delivery of the promissory note to the defendant’s bank were sufficient to create a security interest. Id. b. [9.5] 810 ILCS 5/9-339 Section 9-339 of revised Article 9 of the Uniform Commercial Code states very simply: “This Article does not preclude subordination by agreement by a person entitled to priority.” 810 ILCS 5/9-339. Though the language of §9-339 differs slightly from its predecessor, former §9-316 (“Nothing in this Article prevents subordination by agreement by any person entitled to priority.”), the result is the same: Secured creditors may contractually modify the priorities of their security interests. As a general principle, Article 9 establishes priorities of security interests according to their sequence of filing or other perfection. Section 9-339 acknowledges and sanctions the contractual freedom of a secured creditor to alter the rules of priority established by Article 9. As is generally true in the law of contracts, and as the comments to §9-339 state, a subordination agreement cannot adversely affect a person that is not party to it. See UCC Comment 2, 810 ILCS 5/9-339. Thus, two secured creditors may contractually agree to reorder between them their relative rights, but they cannot affect the rights of another secured creditor that is not a party to the subordination agreement. Section 9-339 is silent as to whether a creditor may subordinate a portion of its rights and claims to those of another creditor. Because partial subordination is not expressly prohibited and the nature and the terms of subordination are subject to the rules governing contracts in general, it seems certain that partial subordinations are permissible. The parties, however, must make their intent known by clearly defining their relative rights and priorities. In Peoples National Bank of McLeansboro v. Karnes (In re Browning), 66 B.R. 79 (S.D.Ill. 1986), a bank held a perfected security interest in crops planted on its borrowers’ property. In 1984, at the request of another lender, the bank agreed to subordinate a portion of its collateral by drawing a distinction between crops planted in 1983 and those planted in 1984, retaining its priority position in the 1983 crops and subordinating its interest in the 1984 crops. c. [9.6] 810 ILCS 5/9-340 Though 810 ILCS 5/9-340 does not mention subordination agreements, its effect is to place substantial importance on the use of subordination agreements by secured creditors who hold a security interest in a deposit account. Prior to the adoption of §9-340 of the Uniform Commercial Code, a creditor with a perfected security interest in a deposit account generally defeated the setoff rights of the bank holding the deposit. However, §9-340(a) provides that a depository bank has priority setoff rights over a competing secured creditor unless the secured creditor has the deposit account placed in its own name. As a consequence, the prudent secured creditor taking a security interest in a deposit account will insist on obtaining from the depository bank a subordination agreement under which

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the bank expressly recognizes the priority rights of the secured creditor over the setoff rights of the bank (including by waiving any such rights). See generally Bruce A. Markell, From Property to Contract and Back: An Examination of Deposit Accounts and Revised Article 9, 74 Chi.-Kent L.Rev. 963, 1006 (1999). 2. [9.7] The Bankruptcy Code Like §§1-310 and 9-339 of the Uniform Commercial Code, 810 ILCS 5/1-310 and 5/9-339, §510(a) of the Bankruptcy Code recognizes and gives effect to subordination agreements. Section 510(a) provides: “A subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law.” 11 U.S.C. §510(a). See, e.g., Bank of America, National Ass’n v. North LaSalle Street Limited Partnership (In re 203 North LaSalle Street Partnership), 246 B.R. 325, 329 (Bankr. N.D.Ill. 2000) (holding, in applicable part, that subordination provision that does not violate Illinois law must be enforced in bankruptcy proceeding). See also In re Chicago, South Shore & South Bend R.R., 146 B.R. 421 (Bankr. N.D.Ill. 1992). As a consequence of the application of §510(a), unless the beneficiary of a subordination agreement has accepted a reorganization plan that waives its rights, it is entitled to receive distributions from the bankrupt estate until its claims are satisfied in full and before the holders of subordinated claims receive any distributions. See S.Rep. No. 989, 95th Cong., 2d Sess. (1978), reprinted in 1978 U.S.C.C.A.N. 5787; In re Bank of New England Corp., 364 F.3d 355 (1st Cir. 2004) (providing general discussion of subordination agreements and their enforceability under Bankruptcy Code). As noted in §9.5 above, 810 ILCS 5/9-339 permits subordination by agreement by the person entitled to priority. A subordination agreement cannot adversely affect a person that is not party to it. Consistent with this rule, it has been held that a trustee in bankruptcy cannot likewise obtain rights or benefits under a subordination agreement to which the debtor was not a party. In In re Bankruptcy of Kors, Inc., 819 F.2d 19 (2d Cir. 1987), the trustee successfully avoided the unperfected security interest of a creditor who was the beneficiary of a subordination by a senior secured and perfected lender. The trustee then asserted total priority for the estate based on the existence of the subordination agreement. The court rejected the trustee’s argument, holding that the trustee could not accede to the benefits of the subordination agreement because the debtor was not party to it. 819 F.2d at 24. See also Betta Products, Inc. v. DS-Max Management, Inc. (In re Betta Products, Inc.), No. 03-10925, 2003 WL 22945664 (Bankr. N.D.Cal. July 7, 2003) (holding that avoidance of lien does not entitle bankrupt estate to benefits of subordination agreement belonging to holder of avoided lien). B. [9.8] Form of Contract The Uniform Commercial Code sheds little light on what constitutes a subordination agreement. Section 1-201(b)(3) defines an “agreement” as “the bargain of the parties in fact, as found in their language or inferred from other circumstances, including course of performance, course of dealing, or usage of trade as provided in Section 1-303.” 810 ILCS 5/1-201(b)(3). Thus, in general, a subordination agreement can be formal or informal, oral or written. Indeed, courts have upheld and enforced oral subordination agreements, subordination agreements contained in letters, and those inferred from a course of dealing between parties. See, e.g., Louisiana National

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Bank of Baton Rouge v. Belello, 577 So.2d 1099 (La.Ct.App. 1991) (recognizing that subordination agreements may be oral but finding that plaintiffs had failed to establish oral subordination agreement); Williams v. First National Bank & Trust Company of Vinita, 482 P.2d 595 (Okla. 1971) (oral subordination agreement held effective); In re Smith, 77 B.R. 624 (Bankr. N.D. Ohio 1987) (subordination agreement found to exist in UCC3 financing statement and letter further detailing arrangement); AM International, Inc. v. Tennessee Valley Authority (In re AM International, Inc.), 46 B.R. 566 (Bankr. M.D.Tenn. 1985) (creditor’s consent to lockbox arrangement held to constitute agreement to subordinate its security interest). Notwithstanding, however, the language of §1-201(b)(3) that countenances agreements “inferred,” the rule in Illinois is that subordination agreements by implication are not recognized. In DuQuoin National Bank v. Vergennes Equipment, Inc., 234 Ill.App.3d 998, 599 N.E.2d 1367, 175 Ill.Dec. 353 (5th Dist. 1992), a bank brought a declaratory action against an agricultural equipment dealer seeking to establish the priority of competing security interests in the same collateral. In support of its contention that its security interest had priority, the equipment dealer asserted that a letter between it and the bank evidenced the bank’s intent to be subordinated. The trial court agreed and entered judgment in favor of the equipment dealer. On appeal, the decision of the trial court was reversed. The court of appeals held: “If a subordination agreement was intended, it must have been expressed in the agreement; a subordination agreement by implication is not recognized.” 599 N.E.2d at 1371. See also Western Bank v. Matherly, 106 N.M. 31, 738 P.2d 903, 906 (1987). It is also clear that a lender need not be a party to the subordination agreement in order to benefit from it. Section 1-310 expressly contemplates that a subordination agreement can be with “either the person obligated or another creditor of the person obligated.” 810 ILCS 5/1-310. Even though a subordination agreement need not be in writing to be enforceable, the prudent lender should always insist on a written agreement that clearly sets forth the relative rights of the borrower and the other creditors. This point is well illustrated in Peoples National Bank of McLeansboro v. Karnes (In re Browning), 66 B.R. 79 (S.D.Ill. 1986). In that case, a bank held a perfected security interest in crops planted on its borrowers’ property. In 1984, at the request of another lender, the bank agreed to subordinate to the other lender its security interest in the 1984 crops. The bank wrote a letter to the borrowers in which it affirmed its security interest in the 1983 crops and agreed to subordinate its security interest in the 1984 crops. The bank’s letter made no mention of years other than 1983 and 1984. Subsequently, the other lender made an additional loan to the borrowers. In 1985, the borrowers entered bankruptcy proceedings. During the course of the bankruptcy proceedings, the trustee filed a motion to compromise claims secured by the 1985 crops. Under the trustee’s proposal, the proceeds of the 1985 crops were to be allocated between the other lender and a local fertilizer company that financed those crops. The trustee determined, and the bankruptcy court subsequently agreed, that the bank had subordinated its claim in all crops of the borrowers other than those of 1983. On appeal of the order by the bank, the district court reversed the bankruptcy court, holding that the bank’s agreement to subordinate its security interest to that of the other lender was for 1984 only and did not apply to future years. The court noted that waivers, such as subordination

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agreements, will be enforced only when there is a clear and distinct manifestation of intent. The court then concluded, as a matter of law, that the bank’s letter was unambiguous and could not be read to apply to any years other than 1983 and 1984. Since the bank did not expressly subordinate its interest in the 1985 crops, its claim remained superior to that of the other lender. The lesson to be drawn from Browning is unmistakable. Creditors seeking to allocate or reallocate between or among themselves the priorities of claims or interests should do so only in a writing that is clear and unambiguous. See Marriott Family Restaurants, Inc. v. Lunan Family Restaurants (In re Lunan Family Restaurants), 194 B.R. 429 (Bankr. N.D.Ill. 1996). However, if an ambiguity exists, the court may consider evidence that is outside the four corners of the subordination agreement. See PMI Investment, Inc. v. Rose (In re Prime Motor Inns, Inc.), 167 B.R. 261 (Bankr. S.D.Fla. 1994) (after finding intercreditor agreement to be ambiguous, court considered surrounding facts and circumstances to determine intent of parties). C. [9.9] American Bar Association Model Agreement In 2006 the Syndications and Lender Relations Subcommittee of the Commercial Finance Committee of the American Bar Association’s Business Law Section formed a Model First Lien/Second Lien Intercreditor Agreement Task Force (ABA Task Force). The purpose of the ABA Task Force was to develop a “market-based” form of subordination and intercreditor agreement. On July 30, 2009, the ABA Task Force published its Draft Model Intercreditor Agreement with some accompanying commentary and alternate provisions. The ABA Model First Lien/Second Lien Intercreditor Agreement (ABA Model Intercreditor Agreement) was completed on January 15, 2010, and published in the May 2010 edition of The Business Lawyer with annotations. See Committee on Commercial Finance, ABA Section of Business Law, Report of the Model First Lien/Second Lien Intercreditor Agreement Task Force, 65 Bus.Law. 809 (2010). The annotated version of the agreement in both pdf and Word formats, as well as an unannotated Word version, can also be found at http://apps.americanbar.org/dch/ committee.cfm?com=cl190029. All references in this chapter to the ABA Model Intercreditor Agreement are to the annotated version.

III. SUBORDINATION AGREEMENTS A. [9.10] Purposes and Uses of Subordinations While other motives may exist from time to time in any given transaction, the primary motivation for most subordination agreements is to induce another creditor to advance new or additional funds to a borrower. For example, in a typical commercial financing transaction with a corporation, the senior lender (as new lender) may insist, as a condition to funding, that all intercompany loans between or among the borrower and the members of its corporate family be subordinated to the new loan by the senior lender. By doing so, the senior lender takes steps to prevent the borrower from dissipating its cash by transferring it to other corporate family members. Likewise, subordination agreements can be employed with respect to loans to the borrower from its principals. When used

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in this context, subordination agreements can have an effect similar to personal guaranties by giving the borrower’s principals incentive not to abandon the borrower should it encounter financial difficulties. In a transaction with multiple layers in the capital structure, a subordination agreement may also act to subordinate a junior debt capital provider’s rights against the borrower. If a senior lender does not seek subordination agreements as a condition to its initial loans to the borrower, it may seek them as a condition to either additional advances or a restructuring of the borrower’s current debt. In this context, subordination agreements can be an important bargaining chip for the senior lender. Another common use of subordination agreements is in acquisition financing. The seller of a business may agree to take a portion of the purchase price in the form of a promissory note, or the new owners of the acquired entity may make one or more loans or advances to the company. Likewise, a junior debt provider may also provide mezzanine or other subordinated junior debt to fund such acquisition. While these methods of financing can be beneficial to the acquired company, they raise concerns for the secured lender, which is typically providing the largest share of the acquisition financing. To protect the availability of the acquired company’s assets and cash flow to satisfy the obligations to the senior secured lender, the senior lender often will insist on a subordination agreement from the seller, the new owners, or other junior debt providers, as the case may be. B. [9.11] Types of Subordinations As noted in §9.1 above, because subordination agreements are “transaction specific,” there is a vast array of subordination agreements. On closer scrutiny, however, it is possible to group the various types of subordination agreements into one of three basic forms. These forms, ranging from the least stringent to the most stringent, are the so-called bankruptcy subordination, default subordination, and standstill subordination. See §§9.12 – 9.14 below. It is worth noting that many subordination agreements will fall somewhere between these forms and incorporate provisions from one form into another. 1. [9.12] Bankruptcy Subordination The bankruptcy subordination is the least restrictive type of subordination from the viewpoint of the borrower and its junior creditors and the least protective from the viewpoint of the senior lender. In essence, a bankruptcy subordination permits the borrower to make, and the junior creditors to receive, payments as long as no bankruptcy is initiated by or against the borrower or no other bankruptcy-related events have occurred. For example, the operative provision of a bankruptcy subordination typically provides: In the event of any receivership, insolvency, reorganization, or bankruptcy proceedings, any assignment for the benefit of creditors, or any proceeding initiated by or against the Borrower for any relief under any federal or state bankruptcy, reorganization, or insolvency law, or any other federal or state law relating to the relief of debtors,

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readjustment of indebtedness, reorganization, or composition or extension of indebtedness, (a) all Senior Indebtedness shall be paid in full in cash and commitments under the Senior Indebtedness shall have been terminated before any payment or distribution of any kind or character, whether in cash, property, or securities, howsoever arising or evidenced, is made to the Junior Creditor; and (b) the Junior Creditor shall not directly or indirectly take, set off, accept, or demand any payment for, or institute any legal action or proceedings for the collection of, all or any portion of the amounts owing to the Junior Creditor or take any other enforcement actions against the Borrower. All such payments or distributions that, but for the subordination provisions of this agreement, would otherwise be payable or deliverable to the Junior Creditor shall instead be paid and delivered to the Senior Lender until the Senior Indebtedness is paid in full. 2. [9.13] Default Subordination From the standpoint of the borrower and the junior creditor, the default subordination is more restrictive than the bankruptcy subordination but less restrictive than the standstill subordination. It is in effect a compromise position. In general, a default subordination permits payments to be made by the borrower to the junior creditor as long as there is no default under the financing agreement between the borrower and the senior lender. A default subordination agreement might provide: Upon the occurrence of an Event of Default, (a) all Senior Indebtedness shall be paid in full in cash and commitments under the Senior Indebtedness shall have been terminated before any payment or distribution of any kind or character, whether in cash, property, or securities, howsoever arising or evidenced, is made to the Junior Creditor; and (b) the Junior Creditor shall not directly or indirectly take, set off, accept, or demand any payment for, or institute any legal action or proceedings for the collection of, all or any portion of the amounts owing to the Junior Creditor or take any other enforcement actions against the Borrower. All such payments or distributions that, but for the subordination provisions of this agreement, would otherwise be payable or deliverable to the Junior Creditor shall instead be paid and delivered to the Senior Lender until the Senior Indebtedness is paid in full. The default subordination would also contain the same operative provision as the bankruptcy subordination, although presumably the occurrence of a bankruptcy or of bankruptcy-related events involving the borrower would also constitute an event of default under the agreement between the borrower and the senior lender. 3. [9.14] Standstill Subordination The standstill subordination is the most protective of the senior lender. As its name implies, under the standstill subordination, the junior creditor may not receive or accept any payment from the borrower and is obligated to stand still or stand by until all amounts (principal, interest, fees, costs, and other charges and expenses) owing to the senior lender are paid in full. A typical standstill subordination provides:

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§9.15

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As long as all or any portion of the Senior Indebtedness or commitments thereunder remains unpaid or outstanding, the Junior Creditor shall not directly or indirectly take, set off, demand, accept, or receive any payment for, or institute any legal action or proceedings for the collection of, all or any portion of the amounts owing to the Junior Creditor or take any other enforcement actions against the Borrower. All such payments or distributions that, but for the subordination provisions of this agreement, would otherwise be payable or deliverable to the Junior Creditor shall instead be paid and delivered to the Senior Lender until the Senior Indebtedness is paid in full. See §9.19 below. See also ABA Model First Lien/Second Lien Intercreditor Agreement §3.1 (2010), http://apps.americanbar.org/dch/committee.cfm?com=cl190029. C. [9.15] Major Substantive Issues Once the senior lender and the borrower agree generally on the type of the subordination, a number of additional and substantive issues that materially affect the scope of the subordination must be resolved. Among the most common are defining the indebtedness of both the senior lender and the junior creditor, qualifying the default provisions and remedies, and settling on the duration of any resulting standstill period. See §§9.16 – 9.19 below. There are, of course, numerous other issues that may arise and that are negotiated during the implementation of a subordination agreement. 1. [9.16] Payment in Full Regardless of the type of subordination, each limits or otherwise prohibits payments to a junior creditor until the senior lender is “paid in full.” The concept of “payment in full” often receives a great deal of attention by the senior lender. At a particular point in time, a senior lender may be paid in full, thereby freeing the borrower to make, and the junior creditor to receive, payments on the junior indebtedness. But what happens should all or a portion of the payments previously received by the senior lender be the subject of a recapture, such as an avoidable preference under §547 of the Bankruptcy Code, 11 U.S.C. §547, or some similar claim under other state or federal law? To protect themselves from such a risk, senior creditors typically characterize the required payment as “indefeasible,” require it to be paid in cash, and include a provision stating that the subordination will not terminate until the expiration of all applicable preference periods and is not subject to other recapture, repayment, or disgorgement under applicable law. 2. [9.17] Defining the Debt One of the most highly negotiated areas of any subordination involves defining the various debts. The senior lender will want the definitions of the amounts owing to it (senior indebtedness) and the amounts owing to the junior creditor (subordinated debt) to be as broad as possible. In addition, the senior lender will want to include as many persons as possible in the pool of junior creditors. This has the effect of elevating the greatest amount of senior indebtedness above the greatest amount of subordinated debt. From the senior lender’s perspective, the following definitions would be appropriate:

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“Senior Indebtedness” means (a) all obligations, liabilities, and indebtedness of the Borrower or any guarantor from time to time owed to Senior Lender under that certain Loan Agreement and related documents, including, without limitation, principal, interest, fees, charges, costs, or expenses; (b) all other obligations, liabilities, and indebtedness of the Borrower or any guarantor from time to time owed to the Senior Lender whether now existing or hereafter arising, however evidenced, direct or indirect, contingent or absolute, due or not due, including, without limitation, principal, interest, fees, charges, costs, or expenses; (c) those obligations, liabilities, and indebtedness of the Borrower acquired by the Senior Lender from other persons; and (d) all guaranties of the obligations, liabilities, and indebtedness described in (a) through (c) above. “Subordinated Debt” means (a) all obligations, liabilities, and indebtedness of the Borrower or any guarantor from time to time owed to the Junior Creditor under that certain Loan Agreement and related documents, including, without limitation, principal, interest, fees, charges, costs, or expenses; (b) all other obligations, liabilities, and indebtedness of the Borrower or any guarantor from time to time owed to the Junior Creditor, whether now existing or hereafter arising, however evidenced, direct or indirect, contingent or absolute, due or not due, including, without limitation, principal, interest, fees, charges, costs, or expenses; (c) those obligations, liabilities, and indebtedness of the Borrower acquired by the Junior Creditor from other persons; and (d) all guaranties of the obligations, liabilities, and indebtedness described in (a) through (c) above. Of course, the definitions of “senior indebtedness” and “subordinated debt” may be expanded further to include (or to cap in the case of such senior indebtedness) other more specific agreements or arrangements that might exist between the relevant parties, including, for example, lease transactions; letters of credit; currency swap agreements, futures contracts, option contracts, and other hedge agreements; and cash management agreements. See ABA Model First Lien/Second Lien Intercreditor Agreement §1.3 (2010), http://apps.americanbar.org/ dch/committee.cfm?com=cl190029. Conversely, the junior creditor will want both the senior indebtedness and the subordinated debt defined very narrowly in terms of specific transactions or amounts; e.g., if the junior creditor is also an equity holder, such creditor would not want its rights in such equity to be included within the definition of “subordinated debt” and thus subordinated. In addition, of particular concern to the junior creditor is the amount by which the senior indebtedness may be increased as a result of such things as additional loans or extensions of credit by the senior lender, overadvances, default interest, compounding interest, premiums, expenditures by the senior lender for taxes, insurance, and collection costs and attorneys’ fees. The junior creditor will want to see a cap or an upward limit on the amount of senior indebtedness. Similarly, the junior creditor likely will be concerned about renewals and extensions of the senior debt or any other action that might place the senior indebtedness ahead of it for an indefinite period of time. From the junior creditor’s perspective, the following provision added to the end of the definition of “Senior Indebtedness” would be appropriate: Provided, however, that in no event shall the aggregate amount of all Senior Indebtedness exceed $______________.

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§9.18

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The senior lender and the junior creditor may choose to negotiate much more sophisticated cap provisions. These may include specific caps on each component of the senior indebtedness, caps on principal amounts only (which caps may be based on a specified dollar amount or an availability formula set forth in the loan agreements), caps in the form of a percentage of the original senior indebtedness, caps on obligations under cash management and hedging agreements, caps on the availability of debtor-in-possession (DIP) financing that may be made available by a creditor to the borrower during an insolvency proceeding, or any number of other variations. See generally In re Tribune Co., 472 B.R. 223, 251 (Bankr. D.Del. 2012) (holding that definition of “senior indebtedness” in subordination provisions of indenture, as including interest accruing on preferred creditors’ claims, including any interest accruing after filing of bankruptcy petition by company, “but only to the extent allowed or permitted” [emphasis omitted] under bankruptcy law, meant that postpetition interest was not allowable to beneficiaries of subordination agreement, given general rule in bankruptcy that unsecured creditors are not entitled to recover postpetition interest, unless debtor is solvent), aff’d in relevant part, 2014 WL 2797042 (D.Del. June 18, 2014), rev’d on other grounds, 799 F.3d 272 (3d Cir. 2015). See also ABA Model Intercreditor Agreement §1.4. 3. [9.18] Default Provisions With respect to default subordinations, a number of issues arise, including the definition of “default” and the rights of the senior lender and junior creditor after a default occurs. The senior lender will typically insist that the definition of “default” under a default subordination parallel the definition of “default” under its loan agreement with the borrower. In addition to being a convenient point of reference for the senior lender, the definition of “default” in a loan agreement is always among those definitions that typically favor the senior lender. As a result, the senior lender will want a default under the loan agreement to trigger simultaneously the subordination of the junior debt, thereby depriving the junior creditor of further payments and enhancing the senior lender’s ability to receive payment from the borrower on the senior indebtedness. Moreover, because most loan agreements define “default” in terms of both an actual occurrence and an event that, with the passage of time or the giving of notice, could become a default, use of the definition of a default in the loan agreement in the subordination agreement can give the senior lender even greater control by triggering the subordination at the earliest possible time. To further protect its interest, the senior lender should also require the junior lender to limit the cross-default provisions in the junior lender’s loan agreement to those instances in which the senior lender actually accelerates the due date of any payment owed to it, as opposed to the occurrence of any “default” (i.e., a covenant default) as defined in the senior lender’s loan agreement. The junior creditor typically wants the definition to be narrower. Tying the triggering of the subordination to an expansive definition of “default” in the senior lender’s loan documents could have unintended and unwanted results. The junior creditor will not want every technical or de minimis breach by the borrower under the senior lender’s loan agreement to result in an event that triggers the suspension or cessation of payments under the subordinated debt. As a result, the junior creditor may wish to consider a materiality or similar standard (such as payment defaults or covenant defaults) for determining the existence of a default, but this approach should be carefully negotiated and thought through by the senior lender before accepting.

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All of this militates strongly in favor of a careful review by the junior creditor of not only the senior lender’s loan agreement but also related or ancillary documents and any other agreements between the senior lender and the borrower. The existence of often-used cross-default provisions in the senior lender’s loan documents requires the junior creditor to gain an understanding of the entire relationship between the senior lender and the borrower. In this regard, a broadly drafted cross-default provision could mean that a technical or de minimis default under the junior debt (even one waived or undeclared by the junior creditor) would result in a default under the senior indebtedness, thereby triggering a subordination of the junior debt. Another issue deserving particular attention by the parties involves waived defaults, cured defaults, and recurring defaults. Sophisticated loan agreements contain a myriad of representations, warranties, and covenants, the breach of which can result in a default. Assuming a nonmonetary default occurs, there are a number of possible outcomes short of acceleration of the underlying obligation. If the default is technical in nature or has no material effect on the credit, the senior lender often will not (or cannot) declare a default under its loan agreement. In this instance, a default has occurred, but the underlying obligation was not accelerated, and the senior lender was not deprived of any payments under the senior indebtedness. The junior creditor would undoubtedly assert that this situation should not constitute a basis for triggering suspension or cessation of the payment of the subordinated debt. Unless, however, the subordination agreement is carefully drafted, the junior creditor’s right to continued payment under the subordinated debt may be jeopardized. The junior creditor will want to negotiate the terms of the subordination agreement to make it clear that such defaults do not result in suspension or cessation of payments of the subordinated debt. The senior lender will want to retain as much flexibility as possible. The senior lender will not want to negotiate in advance its response to every possible default by the borrower. 4. [9.19] Standstill Period Following a default and the triggering of a default subordination, the junior creditor is typically precluded by the subordination agreement from taking any action to enforce collection or receive payment from the borrower or take any other enforcement actions under or in connection with the subordinated debt. During this so-called standstill period, the senior lender is often weighing its options, which range from foreclosure and liquidation to restructuring the senior indebtedness. While all of this is happening, several months may elapse. Sophisticated junior creditors, particularly those with some bargaining position, will insist on a cap on the standstill period (for example, 120 to 180 days) or a limitation on the number of standstill periods that can be instituted by the senior lender during the term of the subordination agreement. Moreover, the junior creditor will also seek a period of time following the standstill period during which the senior lender is precluded from commencing another standstill period based on a similar default. If the senior lender has not by the end of the standstill period either concluded a workout with the borrower or accelerated and commenced an enforcement action, the junior creditor will want the right to collect the amounts due to it under the subordinated debt or otherwise enforce its rights. Notwithstanding the existence of a standstill period, the junior lender will negotiate for, and typically will be allowed to take certain limited actions during, a standstill period, such as filing a proof of claim or statement of interest.

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§9.20

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D. [9.20] Other Terms and Provisions In addition to those provisions that revolve around the issues of the scope of the indebtedness, the meaning of default, and the effect of a default on the junior creditor and its ability to recover the subordinated debt discussed in §§9.15 – 9.19 above, there are numerous other important terms of a subordination agreement. These additional provisions address such matters as rights of the senior lender, representations and covenants of the junior creditor, and subrogation rights. See the discussion in §§9.21 – 9.28 below. 1. [9.21] Rights of Senior Lender Under the typical subordination agreement, the senior lender is vested with substantial rights. In addition to its right to receive payment for the senior indebtedness ahead of the subordinated debt, the senior lender will often seek to have the right to (a) demand, sue on, and collect the subordinated debt and enforce any security for it; (b) file a proof of claim or statement of interest, vote on a plan of reorganization, and make other filings, arguments, and motions in any bankruptcy proceedings of the borrower; and (c) require specific performance of and under the subordination agreement. In Bank of America, National Ass’n v. North LaSalle Street Limited Partnership (In re 203 North LaSalle Street Partnership), 246 B.R. 325, 328 (Bankr. N.D.Ill. 2000), the court considered a provision in a subordination agreement that afforded the senior lender the right to “vote or consent in any [Chapter 11] proceedings with respect to, any and all claims” relating to, the junior indebtedness. Prior to confirmation of the debtor’s plan of reorganization, the senior lender sought a declaratory judgment that it was entitled to vote the subordinated creditor’s claim in the confirmation. In finding for the subordinated creditor, the court opined that §1126(a) of the Bankruptcy Code, 11 U.S.C. §1126(a), and not the unambiguous language of the subordination agreement and §510(a) of the Bankruptcy Code, 11 U.S.C. §510(a), governs the determination of voting rights. Section 1126(a) of the Bankruptcy Code provides that “[t]he holder of a claim” may vote to accept or reject a plan under Chapter 11. 11 U.S.C. §1126(a). In reaching its decision, the court concluded that (a) the clear language of the subordination agreement did not provide a basis for ignoring the rights afforded a claim holder under §1126(a), (b) §510(a) does not allow for a waiver of the voting rights under §1126(a), and (c) absent an express agency relationship between the subordinated creditor and the senior creditor, Federal Rule of Bankruptcy Procedure 3018(c) does not allow a senior creditor to vote the claim of the subordinated creditor. 246 B.R. at 331. In Blue Ridge Investors, II, LP v. Wachovia Bank, N.A. (In re Aerosol Packaging LLC), 362 B.R. 43 (Bankr. N.D.Ga. 2006), the bankruptcy court reached the opposite conclusion from the court in North LaSalle Street, supra. In Aerosol Packaging, Blue Ridge Investors, a business investment fund, made an investment in Aerosol Packaging in the form of secured debt. Subsequently, Aerosol Packaging refinanced its working capital facility, and in connection with that refinancing, the new lender (a predecessor of Wachovia Bank) required Blue Ridge to enter into a subordination agreement pursuant to which, among other things, Blue Ridge granted to Wachovia Bank the right to vote Blue Ridge’s claim in any bankruptcy proceeding involving Aerosol Packaging. When Aerosol Packaging did indeed seek Chapter 11 protection and a plan of reorganization was presented to the creditors for approval, Wachovia Bank demanded that Blue

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Ridge deliver a ballot in favor of the plan of reorganization. Blue Ridge refused, and, pursuant to the subordination agreement, Wachovia Bank delivered a ballot on behalf of itself and Blue Ridge voting in favor of the plan of reorganization. Blue Ridge cast its own separate ballot voting against the plan of reorganization. In making its case before the bankruptcy court, Blue Ridge relied on North LaSalle Street. In rejecting Blue Ridge’s argument and its reliance on North LaSalle Street, the bankruptcy court held that (a) §1126 of the Bankruptcy Code does not prohibit voluntary delegation or assignment to vote, (b) there was no evidence that the subordination agreement was unenforceable under state law and therefore unenforceable under §510 of the Bankruptcy Code, and (c) Fed.R.Bankr.P. 9010 and 3018 expressly permit agents to cast ballots, and an agent is not always bound to comply with the directions of its principal. On appeal by Blue Ridge, the district court affirmed the decision of the bankruptcy court. Blue Ridge subsequently filed a notice of appeal, but it was later withdrawn with prejudice following a settlement. More recently, the Bankruptcy Court for the District of Massachusetts rejected the reasoning of Aerosol Packaging and instead followed and adopted the reasoning of North LaSalle Street in finding an assignment of voting rights in an intercreditor agreement to be unenforceable. See In re SW Boston Hotel Venture, LLC, 460 B.R. 38 (Bankr. D.Mass. 2011), vacated in part on other grounds, 2012 WL 4513869 (B.A.P. 1st Cir. 2012). 2. [9.22] Postpetition Interest It is common for subordination agreements to contain provisions applicable in the event of the bankruptcy of the borrower. Subordination agreements typically attempt to reorder the priority rights of the parties so that a distribution to a junior creditor is diverted to the senior lender until the borrower’s obligations to the senior lender are fully satisfied. Under ordinary circumstances, an unsecured creditor is not entitled to receive postpetition interest from the bankrupt estate. As a consequence, some courts were reluctant to enforce subordination agreements to allow senior creditors to obtain postpetition interest that would not have been recoverable but for the existence of the subordination agreement. Historically, the right of the senior creditor to receive postpetition interest has been dependent on the equity powers of the bankruptcy court. Since In re Time Sales Finance Corp., 491 F.2d 841 (3d Cir. 1974), bankruptcy courts have been willing to invoke their equitable powers to allow payment of postpetition interest to senior creditors as long as the subordination agreement was explicit as to the parties’ intent (known as the “rule of explicitness”). The rule of explicitness came about under the Bankruptcy Act and continued to survive following passage of the Bankruptcy Code in 1978. Unlike the Bankruptcy Act, which was silent on subordination agreements, the Bankruptcy Code contains §510(a), which provides that a “subordination agreement is enforceable . . . to the same extent that such agreement is enforceable under applicable nonbankruptcy law.” 11 U.S.C. §510(a). Until 1998, bankruptcy courts continued to recognize and apply the rule of explicitness even though §510(a) of the Bankruptcy Code limits enforceability to those agreements enforceable under “applicable nonbankruptcy law.” In In re Southeast Banking Corp., 156 F.3d 1114 (11th Cir. 1998), however, the court held that §510(a) abrogated the rule of explicitness in federal bankruptcy law on the basis that the rule of explicitness is a doctrine enunciated and applied by federal bankruptcy courts, and thus was not “nonbankruptcy law” under §510(a) of the

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§9.23

SECURED TRANSACTIONS

Bankruptcy Code. The court held that New York state law, and not federal common law, controlled the issue and certified the question to the New York Court of Appeals to determine what language had to be included in subordination agreements to afford senior creditors priority over junior creditors. Subsequently, the New York Court of Appeals adopted the rule of explicitness as a “guiding interpretive principle of State contract dispute resolution” in bankruptcy cases. In re Southeast Banking Corp., 93 N.Y.2d 178, 183, 710 N.E.2d 1083, 688 N.Y.S.2d 484 (1999). In 2004, the First Circuit Court of Appeals was asked to decide whether senior creditors were entitled to postpetition interest at the expense of junior creditors. See In re Bank of New England Corp., 364 F.3d 355 (1st Cir. 2004). It is clear that both parties assumed the rule of explicitness controlled, and therefore the issue before the court was whether the language in the subordination agreement was sufficiently clear to meet the requirements of the rule of explicitness. Like the Eleventh Circuit, the First Circuit concluded that the rule of explicitness was abrogated by §510(a) of the Bankruptcy Code. However, the First Circuit went two steps further and held that (a) “applicable nonbankruptcy law” means state law, and (b) state law may not adopt a rule consistent with the rule of explicitness that is solely applicable in a bankruptcy context because §510(a) “does not vest in the states any power to make bankruptcy-specific rules: the statute’s clear directive for the use of applicable nonbankruptcy law leaves no room for state legislatures or state courts to create special rules pertaining strictly and solely to bankruptcy matters.” [Emphasis in original.] 364 F.3d at 364, citing International Shoe Co. v. Pinkus, 278 U.S. 261, 73 L.Ed. 318, 49 S.Ct. 108 (1929) (holding that state may not enact bankruptcy-specific rules or otherwise provide additional or auxiliary regulation with respect to bankruptcy matters). On remand, the bankruptcy court found that the senior creditors were not entitled to postpetition interest. In re Bank of New England Corp., 404 B.R. 17 (Bankr. D.Mass. 2009). In its decision, the court considered whether, as a matter of contract interpretation, the parties intended to subordinate payment of the junior debt to the payment of postpetition interest on the senior debt. The court ultimately refused to require such subordination on the basis that had the drafter of the subordinated debentures wished to expand the subordination to include postpetition interest, he or she “would have added explicit language to accomplish that end.” 404 B.R. at 39. This decision was affirmed by the district court and the First Circuit (see HSBC Bank USA v. Bank of New York Trust Co. (In re Bank of New England Corp.), 426 B.R. 1 (D.Mass. 2010), aff’d, 646 F.3d 90 (1st Cir. 2011)), suggesting that parties may still be able, as a matter of contract, to provide for postpetition interest, but it will require courts to discern their intent. As a result, until such time as the rule of explicitness and the application of §510(a) of the Bankruptcy Code are fully and finally resolved, the prudent counsel for the senior creditor will continue to assume that the rule of explicitness still has life and include specific language in its subordination agreement permitting receipt of postpetition interest. 3. [9.23] Covenants of Junior Creditor The principal covenant or undertaking by a junior creditor in any subordination agreement is its waiver of the right to receive payment under or enforce any rights in the subordinated debt or any collateral for it, except to the extent permitted by the subordination agreement. Most

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subordination agreements contain other covenants of the junior creditor that are also very important to the senior lender. These include the agreement by the junior creditor that it will not, without the written consent of the senior lender and as long as the senior indebtedness is outstanding, (a) sell, transfer, assign, convey, pledge, or encumber the subordinated debt unless the transaction is expressly subject to the subordination agreement; (b) change the terms of the subordinated debt in a manner that will have an adverse effect on the rights of the senior lender under the subordination agreement; (c) accept additional collateral security for the subordinated debt or any other obligation owing to the junior creditor by the borrower; (d) discharge or cancel the subordinated debt or any portion of it; (e) subordinate any of the subordinated debt to any other obligation of the borrower; or (f) commence or join with any other creditor in any bankruptcy or similar proceeding against the borrower. Each of these covenants is designed to make sure the status quo among the borrower, senior lender, and junior creditor is maintained for the benefit of the senior lender. 4. [9.24] Representations of Junior Creditor Most subordination agreements contain some basic representations of the junior creditor. In addition to the standard representations on the junior creditor’s authority to enter into, and the validity and enforceability of, the subordination agreement, the junior creditor should represent and warrant (a) the then current amount of the subordinated debt; (b) the completeness and accuracy of the documents evidencing the subordinated debt; (c) the nonexistence of any other obligations of the borrower to the junior creditor; and (d) the nonexistence of any lien, claim, or encumbrance of the junior creditor on any property or assets of the borrower. These basic representations and warranties are designed to elicit information from the junior creditor that has a direct bearing on the junior creditor’s relationship with the borrower. 5. [9.25] Subrogation Rights The common-law right of subrogation permits a person who pays the debt of another to be subrogated to the rights of the person who received the payment. See, e.g., UnionBank v.Thrall, 374 Ill.App.3d 785, 872 N.E.2d 542, 313 Ill.Dec. 559 (2d Dist. 2007) (containing review and summation of principles and law of subrogation in Illinois). In the context of a subordination, a junior creditor would be subrogated to the rights of the senior lender to the extent the senior indebtedness was reduced as a result of proceeds of the junior debt delivered by the junior creditor to the senior lender. As a result, following any such payment from the proceeds of the junior debt, the junior creditor would be entitled to pursue the borrower immediately for an amount equal to that payment. Such a result would be inconsistent with the initial purpose of the subordination agreement and would in fact defeat the subordination. As a result, the senior lender must insist that the junior creditor agree not to assert its rights against the borrower until all of the senior indebtedness is paid in full in cash and all commitments to advance credit have been terminated.

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§9.26

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6. [9.26] Trust Relationship Despite best efforts to the contrary and the express provisions of the subordination agreement, sometimes payments due under the junior debt are improperly made or delivered to the junior creditor and not the senior lender. Subordination agreements typically contain an undertaking by the junior creditor to deliver such payments to the senior lender and, pending their delivery, to hold them in trust for the benefit of the senior lender. By expressly providing for a trust relationship under those circumstances, the senior lender is in a position to assert a claim for not only breach of contract but also breach of fiduciary duties if the junior creditor fails to comply with the payment terms of the subordination agreement. 7. [9.27] Descriptive Legend As noted in §9.17 above, it is important for both parties to clearly define the junior debt that is the subject of the subordination agreement. In addition to specifically describing or scheduling the junior debt, often the senior lender will require that the original of any document or instrument evidencing the subordinated debt be marked with a legend to indicate its subordinated nature. Such a legend not only defines the subordinated debt between the parties but also puts third-party purchasers or assignees on notice of the rights of the senior lender. 8. [9.28] Notices Because the junior creditor and the senior lender each have a separate contractual relationship with the borrower, there are times when one of them may come into possession of information about the borrower that is not known to the other. This is especially true in the context of the occurrence of an event of default by the borrower. An event of default under an agreement between the borrower and the junior creditor may also constitute an event of default under the borrower’s agreement with the senior lender. In turn, the event of default may trigger the rights of the senior lender under the subordination agreement with the junior creditor. See §9.18 above. It is important that the subordination agreement expressly provide those instances in which each of the parties is entitled to receive written notice from the other and, if appropriate, the content of the notice. In PPM Finance, Inc. v. Norandal USA, Inc., 392 F.3d 889 (7th Cir. 2004), the agent of the senior lender filed suit against the junior creditor alleging that the junior creditor failed to remit certain payments to the senior lender that had been made by the borrower, thereby breaching the obligations of the junior creditor under their subordination agreement. The district court granted summary judgment for the senior lender, and the junior creditor appealed. The thrust of the junior creditor’s argument was that the agent was required to notify the junior creditor of the borrower’s default, and the agent’s failure acted as a bar to recovering the money paid by the borrower to the junior creditor. In affirming the decision of the district court, the court of appeals noted that the subordination agreement contained no affirmative obligation on the part of the agent to provide notice. Indeed, the junior creditor admitted that it asked for a notice provision during contract negotiations and was rebuffed by the agent. Absent an affirmative written obligation, the court of appeals indicated an unwillingness to imply such an obligation under Illinois law.

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IV. INTERCREDITOR AGREEMENTS A. [9.29] Purposes and Uses Although often used interchangeably with subordination agreements, intercreditor agreements are typically contractual arrangements between two or more secured creditors of the borrower who desire to identify their lien priorities and rights in and to specific property of the borrower. As an illustration, assume that a borrower that is engaged in the manufacture and sale of heavy equipment has three secured lenders. One lender serves the working capital needs of the borrower by providing the borrower with an asset-based revolving line of credit. The second lender provided the borrower with a term credit, the proceeds of which were used to acquire fixed assets. Finally, the third lender financed the acquisition of the borrower’s real estate and improvements. Each of the first two credit facilities is secured by a perfected security interest in all of the borrower’s personal property and assets, including fixtures. The third lender’s loan is secured by the real estate and the improvements, including fixtures. Regardless of whether the credit facilities were entered into at the same or different times, each of the lenders will likely have a desire to agree in advance of any potential problems with the borrower how their respective interests in the same collateral will be treated. Of course, any number of other instances may arise in which a particular borrower may have more than one secured lender. Regardless of the structure of or reasons for the relationship, secured lenders are likely to want to address the same types of issues discussed in §§9.31 – 9.40 below. B. [9.30] Major Substantive Issues Unlike in the subordination agreements discussed in §§9.10 – 9.28 above, the primary focus in an intercreditor agreement is not on payment but rather on the security for the payment. As a result, the typical intercreditor agreement places substantial emphasis on defining and allocating the collateral and the products and proceeds of the collateral, quantifying the events of default, setting out the relative rights of the lenders in the collateral in the event of a default, and providing for the ultimate enforcement of those rights. See §§9.31 – 9.33 below. 1. [9.31] Defining the Collateral The primary purpose of any intercreditor agreement is to allocate among each of the participating lenders those properties and assets of the borrower that each lender will have the right to look to in the first instance to satisfy the borrower’s obligations to such lender. To effect this goal, it is necessary first to clearly describe and define the collateral. This is particularly important since each lender will have entered into its own form of security agreement with the borrower, and those forms may vary. Often, the allocations are made according to large classes of property, such as inventory, accounts, machinery, and general intangibles. If there is need to allocate individual items of a larger class of property (such as a particular piece of machinery from the class of equipment), the property should be specifically described and scheduled.

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2. [9.32] Allocation of Collateral and Products and Proceeds After having defined and described the collateral by either general class or specific items or both, the lenders will agree on its allocation among them. There is no one way in which the collateral is typically allocated. Each intercreditor agreement is different, and the allocations of the collateral depend on any number of factors, including the amounts and purposes of the loans, the quantity and quality of the borrower’s property and assets, and the bargaining power of each lender. In addition to allocating the collateral, the intercreditor agreement should also address the products and proceeds of that collateral. To illustrate further and to continue with the example set out in §9.29 above, it would be likely that the lender that provided the asset-based revolving line of credit would be accorded (a) a first priority security interest in all of the borrower’s inventory, accounts receivable, and general intangibles; and (b) a second position in all other personal property and assets. Likewise, the lender that provided the term financing for the fixed asset acquisitions would receive (a) a first priority security interest in machinery and equipment (or all other collateral not given first priority to the other lenders) and (b) a second position in all other personal property and assets. Finally, the mortgage lender would likely have only a first priority mortgage and security interest in the real estate, improvements, and fixtures. In this example, the first and second lenders would have to allocate between themselves the junior position in the fixtures. 3. [9.33] Default and Enforcement The provisions regarding default and, more importantly, what happens after a default are critical and constitute the core of the intercreditor agreement. Often, what constitutes a default under the intercreditor agreement is defined by the terms of the loan documents of the respective creditors. Each of the creditors should review the others’ documents to make sure there is general agreement on such things as the nature of the events that constitute a default and the existence of any applicable cure periods. The purpose of this review is to make sure that each of the creditors will have the right to proceed against the borrower and its respective collateral in the event of a default (noting that in certain cases the relationship between or among the various creditors may also be subject to subordination, which would limit the ability of junior creditors to take enforcement actions in certain instances). Generally, intercreditor agreements provide that the creditors give each other written notice before commencing any action to enforce their rights against the collateral. The prior consent of the other creditors to proceed with enforcement action usually is not required, although particular intercreditor arrangements in certain circumstances may possibly provide for it. Intercreditor agreements typically authorize each creditor to enforce its rights against that portion of the collateral in which it has the priority interest but not against any other collateral in which it may have only a junior interest. A properly drafted intercreditor agreement should always address the rights of each of the creditors to use the others’ portion of the collateral for a short period of time in order to maximize the value and/or foreclose on their collateral. While each of the blocks of the collateral may be

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easily allocated among the creditors, those blocks of collateral are interdependent and interrelated in the context of an operating business. The lender whose collateral is comprised of the inventory and accounts receivable will want to have access to and use of the machinery and equipment in order to convert raw materials, complete work in process, and ship the finished goods. The lender whose collateral consists primarily of the machinery and equipment will need to have continued use of the premises either to continue operations or merely to store the machinery and equipment pending sale and disposition. Finally, the mortgage lender may want to maximize the value of the real estate by marketing the premises while they are operational rather than totally vacant. For varying reasons, the creditors may agree among themselves to permit use of and access to each other’s collateral for a period of time to liquidate the collateral in an orderly way. Of course, the intercreditor agreement may provide for compensation to each other or, at the very least, indemnification for losses or damages resulting from this use. See ABA Model First Lien/Second Lien Intercreditor Agreement §§3.1 – 3.4 (2010), http://apps.americanbar.org/dch/ committee.cfm?com=cl190029. 4. [9.34] Right To Purchase Upon the occurrence of a default by the borrower under the credit agreement with the senior lender, the senior lender may elect to foreclose on the collateral and dispose of the collateral at a public or private sale under §9-610 of the UCC, 810 ILCS 5/9-610. If the senior lender is able to dispose of the collateral at a private sale for a price sufficient to repay the borrower’s obligations to the senior lender and the borrower’s obligations to the junior creditors, then the secured creditors will be made whole. However, if the senior lender is unable to effect a private sale that will realize a price sufficient to repay in full the obligations to the secured creditors, the senior lender might choose to conduct a public sale of the collateral and bid the amount of the senior lender’s debt. Unless the junior creditors outbid the senior lender at the public sale, the security interest of the junior creditors will be extinguished. To protect itself from the uncertainties of a public or private sale, the intercreditor agreement may provide the junior creditor the right to purchase at par the borrower’s obligations to the senior lender in the event of default and acceleration or the commencement of insolvency proceedings by or against the borrower. The senior lender will often insist on limitations to the time period during which the junior creditor may exercise its right to purchase the debt and may also require the debt purchase transaction to close within a specified number of days after the senior lender receives notice of the junior creditor’s intention to purchase. Junior creditors should consider the following provision: Upon (a) the occurrence of an Event of Default by the Borrower and acceleration of the Borrower’s obligations to the Senior Lender, and prior to the initiation of enforcement proceedings by the Senior Lender against the Borrower and/or the Collateral, or (b) the commencement by or against the Borrower of any insolvency or similar proceeding under federal or state law, the Junior Creditor may within [5] business days thereof purchase all, but not less than all, of the Borrower’s obligations to the Senior Lender for an amount equal to 100 percent of the then outstanding principal, accrued interest, fees, and expenses. During such [5]-business-day period, the Senior Lender shall not initiate any action or

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§9.35

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proceeding to enforce its rights against the Borrower. Upon consummation of such purchase and sale, the Senior Lender shall assign and negotiate to the Junior Creditor all loan agreements, security agreements, notes, instruments, and other documents evidencing or relating to the Borrower’s obligations to the Senior Lender. Some senior lenders will resist providing a right to purchase because the procedure limits the flexibility of the senior lender, slows the process (thus leading to a possible diminution in the value of the collateral), and potentially prejudices the rights of the senior lender if the junior creditor ultimately does not elect to exercise its purchase right. See also ABA Model First Lien/Second Lien Intercreditor Agreement §§5.1 – 5.7 (2010), http://apps.americanbar.org/ dch/committee.cfm?com=cl190029. C. [9.35] Bankruptcy and Insolvency Proceedings The integrity of subordination agreements can face its most severe tests in insolvency proceedings involving the borrower. Secured creditors are accorded numerous rights and protections under the Bankruptcy Code. In those cases in which there are multiple secured creditors with interests in common collateral and the value of the collateral is insufficient to satisfy the claims of all of the secured creditors, conflicts can and often do arise in matters affecting the use of cash collateral during the pendency of the bankruptcy proceeding, the granting of priming security interests in debtor-in-possession financing, or the sale or other disposition of the collateral free of all liens and security interests. Secured creditors have the right to consent or object to actions affecting the collateral that is the subject of their security interests. One of the purposes of the intercreditor agreement is to resolve in advance the competing interests of the secured creditors. 1. [9.36] Use of Cash Collateral Upon the filing of a Chapter 11 bankruptcy petition, the borrower-debtor will typically have immediate need for access to cash collateral. Section 363(a) of the Bankruptcy Code defines “cash collateral” as “cash, negotiable instruments, documents of title, securities, deposit accounts, or other cash equivalents” in which a creditor has a lien. 11 U.S.C. §363(a). It is very common for a borrower-debtor to seek to use the cash generated from a sale of its inventory or collection of accounts receivable to fund (at least in part) the continued operations of its business during the Chapter 11 proceeding. Proceeds from the sale of inventory or collection of accounts receivable constitute cash collateral. If the inventory or accounts and their proceeds are the subject of one or more security interests, that cash collateral may not be used by the borrower-debtor without the consent of the secured creditors or after providing “adequate protection” against diminution in the value of the collateral as contemplated in §361 of the Bankruptcy Code. 11 U.S.C. §361. Adequate protection may take the form of a cash payment or periodic cash payments, an additional or replacement lien, or such other relief as will result in the realization of the “indubitable equivalent” of a person’s interest in the collateral. 11 U.S.C. §361(3). In addition to having access to cash collateral, the borrower-debtor may well also have the need to obtain debtor-in-possession financing to provide additional liquidity for its operations during its reorganization efforts. Lenders of DIP financing typically demand so-called

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“superpriority” claims and liens in and to the borrower-debtor’s collateral. To avoid the imposition of superpriority claims and liens in and to the borrower-debtor’s collateral, the lenders of the prepetition secured debt may also be the providers of the DIP financing. As is the case with the borrower-debtor’s use of cash collateral, the obtaining of DIP financing and the granting of superpriority claims and liens require the consent of the secured creditors or the providing of adequate protection by the borrower-debtor, which often can make it difficult for a borrowerdebtor to obtain “superpriority” DIP financing from new money lenders. To avoid disputes between and among the senior lender and the junior creditors, the intercreditor agreement may contain provisions making it clear that the junior creditors will be deemed to consent to any use of cash collateral or DIP financing to which the senior lender grants its consent. The scope of the deemed consent may be subject to some limitations so as to not cede total control to the senior lender in all circumstances. Consider the following provision: Until such time as the obligations of the Borrower to the Senior Lender are paid in full in cash and satisfied, upon the commencement of an Insolvency Event by or against the Borrower, no Junior Creditor shall directly or indirectly object (or support any objection by another) to, and each shall be deemed for all purposes to have consented to, (a) any use, sale, or lease of “cash collateral” (as defined in Section 363(a) of the United States Bankruptcy Code), and (b) Borrower obtaining debtor-in-possession (DIP) financing, if the Senior Lender consents in writing to such use, sale, or lease or DIP financing. Notwithstanding the foregoing, it is agreed and understood that (i) each of the Junior Creditors retains security interest in and to the Collateral, and (ii) each of the Junior Creditors may seek adequate protection under and within the meaning of the United States Bankruptcy Code. See also ABA Model First Lien/Second Lien Intercreditor Agreement §6.1 (2010), http://apps.americanbar.org/dch/committee.cfm?com=cl190029. It should be noted that some courts have refrained from enforcing a creditor’s waiver of certain bankruptcy rights in a prebankruptcy intercreditor agreement on public policy grounds. See, e.g., Beatrice Foods Co. v. Hart Ski Mfg. Co. (In re Hart Ski Mfg. Co.), 5 B.R. 734 (Bankr. D.Minn. 1980) (finding subordination agreement to be effective, but not extinguishing junior creditor’s ability to assert claims or vote its claims); Bank of America, National Ass’n v. North LaSalle Street Limited Partnership (In re 203 North LaSalle Street Partnership), 246 B.R. 325 (Bankr. N.D.Ill. 2000) (finding intercreditor agreement unenforceable when it granted senior lienholder right to vote junior lienholder’s claim); In re SW Boston Hotel Venture, LLC, 460 B.R. 38 (Bankr. D.Mass. 2011), vacated in part on other grounds, 2012 WL 4513869 (B.A.P. 1st Cir. 2012) (finding assignment of voting rights in intercreditor agreement to be unenforceable). But see Blue Ridge Investors, II, LP v. Wachovia Bank, N.A. (In re Aerosol Packaging LLC), 362 B.R. 43 (Bankr. N.D.Ga. 2006) (enforcing contractual provisions of intercreditor agreement that granted senior lienholder right to vote claims of junior lienholder).

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§9.37

SECURED TRANSACTIONS

2. [9.37] Disposition of Collateral In the course of a bankruptcy proceeding involving a borrower, it may become necessary for the borrower-debtor to seek approval to sell some or all of its assets constituting collateral. Any such sale is subject to the consent of the holders of a security interest in the collateral subject to the sale. To avoid disputes between and among the senior lender and the junior creditors, the intercreditor agreement may, depending on the type of intercreditor arrangement, contain provisions making it clear that the junior creditors will be deemed to consent to any sale or other disposition of the collateral to which the senior lender grants its consent. The scope of the deemed consent may be subject to some limitations. Consider the following provision: In addition, no Junior Creditor shall directly or indirectly object (or support any objection by another) to, and each shall be deemed for all purposes to have consented to, the sale or disposition of the collateral, free and clear of all liens, claims, and encumbrances, under Section 363 of the United States Bankruptcy Code if the Senior Lender consents in writing to such sale or disposition, provided that (i) the proceeds of any such sale or disposition attach with the same priority and validity as the liens held by the Junior Creditors in and to the Collateral, (ii) the net cash proceeds are applied to reduce permanently the obligations of the Borrower to the Senior Lender, and (iii) the Junior Creditors shall not be deemed to have waived any right to bid in connection with such disposition subject to the priorities set forth in this Agreement. See also ABA Model First Lien/Second Lien Intercreditor Agreement §6.2 (2010), http://apps.americanbar.org/dch/committee.cfm?com=cl190029. 3. [9.38] Adequate Protection As discussed briefly in §9.36 above, in order for a borrower-debtor to use cash collateral or obtain debtor-in-possession financing, a borrower-debtor must either obtain the consent of all of the secured lenders or provide adequate protection. Situations can arise in which, by virtue of the value of the collateral and the relative amount of the borrower-debtor’s obligations to each of the secured lenders that the senior lender is over secured and the junior creditors are under secured. In those instances, the creditors will have differing views on whether, for example, replacement collateral is required to provide adequate protection. To address such potential disputes from a senior lender’s perspective, the following provision should be considered: No Junior Creditor shall directly or indirectly object (or support any objection by another) to (a) a request by the Senior Lender for “adequate protection” under the United States Bankruptcy Code, or (b) a motion, action, or proceeding in which the Senior Lender claims a lack of adequate protection under, or relief from the automatic stay imposed by, the United States Bankruptcy Code. Except without the prior written consent of the Senior Lender, no Junior Creditor shall seek or request adequate protection or relief from the automatic stay under the United States Bankruptcy Code.

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§9.40

See also ABA Model First Lien/Second Lien Intercreditor Agreement §6.4 (2010), http://apps.americanbar.org/dch/committee.cfm?com=cl190029. D. [9.39] Modifications For ease of administration of their respective relationships with the borrower, the senior lender and the junior creditor will each want to maintain the freedom to modify the terms of their respective agreements with, or refinance the debt to, the borrower without interference from the other. Of course, both the senior lender and the junior creditor will also want to make sure that the terms of any modification or refinancing by the other does not prejudice or alter their respective rights under their intercreditor agreement. Failure to address this issue adequately can have severe consequences, especially for a junior creditor. See, e.g., Buena Vista Home Entertainment, Inc. v. Wachovia Bank, N.A. (In re Musicland Holding Corp.), 374 B.R. 113, 118 – 119 (Bankr. S.D.N.Y. 2007) (holding that unambiguous provisions of intercreditor agreement allowed parties to amend senior lender’s credit agreement to incorporate new term loan, thereby extending senior lender’s lien priority granted under intercreditor agreement to that loan and “leapfrogging” junior creditors). The senior lender and the junior creditor will be especially interested in any modification or refinancing that increases the indebtedness above the caps (see §9.17 above), increases the interest rate, or extends the maturity. The degree to which modifications are limited or restricted will vary depending on the intercreditor arrangement and should be carefully negotiated. In addition, the parties may agree to permit the borrower to refinance without the other’s consent in those instances in which the refinancing lender expressly assumes, and agrees to be bound by the terms of, the intercreditor agreement. See also ABA Model First Lien/Second Lien Intercreditor Agreement §§2.1 – 2.4 (2010), http://apps.americanbar.org/dch/committee.cfm? com=cl190029. E. [9.40] Other Terms and Provisions In addition to the core provisions of the typical intercreditor agreement described in §§9.30 – 9.39 above, a number of other ancillary matters usually are addressed, including agency, contesting liens, financial covenant cushions, and marshaling assets. Perhaps most key among the additional provisions are those that address contesting the liens of the other creditors. The following is a typical provision: None of the Banks shall contest the validity, priority, enforceability, perfection, or nonperfection of any lien or security interest granted or purported to be granted to the other Banks, and each of the Banks agrees to cooperate in the defense of any action contesting the validity, priority, enforceability, perfection, or non-perfection of these liens or security interests. Without limiting the generality of the foregoing, no Bank shall contest the validity, priority, enforceability, perfection, or non-perfection of any lien or security interest granted to another Bank based on any allegation or claim of fraudulent conveyance, unlawful payment of distributions to equity holders, or other similar allegations or claims.

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§9.41

SECURED TRANSACTIONS

The decision in Ion Media Networks, Inc. v. Cyrus Select Opportunities Master Fund, Ltd. (In re Ion Media Networks, Inc., 419 B.R. 585 (Bankr. S.D.N.Y. 2009), sheds some light on the rights of a junior creditor to challenge the security interest of a senior lender. In Ion Media, the intercreditor agreement contained an express acknowledgment by the parties of the relative priorities as to the collateral and an agreement that those priorities would not be affected or impaired by “any nonperfection of any lien purportedly securing any of the Secured Obligations.” [Emphasis in original.] 419 B.R. at 594. The purchaser of the second lien obligations argued in a motion objecting to confirmation of the borrower’s plan of reorganization that certain Federal Communications Commission (FCC) licenses did not constitute “collateral” for purposes of the intercreditor agreement. While the first lien lender had a security interest in the proceeds of the FCC licenses, there was no security interest in the licenses themselves, and therefore there were no proceeds to which the lien could attach. Id. The court found that the use of the term “purportedly securing” in the intercreditor agreement to describe the security interest granted in the underlying security agreement “evidence[d] the intent of the Secured Parties to establish their relative legal rights [with respect to the FCC licenses themselves] vis a vis each other,” not only regardless of the ultimate validity of any lien therein granted by the debtors, but also regardless of whether a lien was even intended to be granted in the FCC licenses. Id. The parties to an intercreditor agreement will want to carefully craft any provision purporting to waive their rights to ensure that specific acts are adequately and clearly addressed. In In re Boston Generating, LLC, 440 B.R. 302 (Bankr. S.D.N.Y. 2010), the junior secured creditor objected to the bid procedures proffered by the senior secured creditor in connection with a sale of the assets under §363 of the Bankruptcy Code, 11 U.S.C. §363. The senior secured creditor asserted that the junior secured creditor had no standing to object because it had waived its rights to do so under the intercreditor agreement between them. The court ruled that the junior secured creditor had standing to object to the bid procedures, noting that “[t]he plain language of the Intercreditor Agreement says the [junior secured creditors] are silent in certain circumstances, but I do not read any express prohibition against objection to bidding procedures anywhere in the intercreditor agreement.” 440 B.R. at 317. The court also noted that the issue of standing to object the sale transaction could be taken up at a later date. Id. See also In re Erickson Retirement Communities, LLC, 425 B.R. 309 (Bankr. N.D.Tex. 2010) (holding that junior creditors, under subordination agreements that barred them from filing any actions or pursuing any remedies to collect their claims or enforce their rights until preferred indebtedness had been paid in full, had knowingly and intelligently waived any conflicting legal or statutory rights and therefore had no standing to file motion for appointment of examiner).

V. [9.41] UNITRANCHE FACILITIES In recent years, in an effort to reduce documentation burdens and increase simplicity in loan structures, some middle market borrowers have requested that each of its lenders enter into a single credit facility known as a “unitranche” facility. Barbara M. Goodstein, Unitranche Credit Facilities: An Untested Trend Gains Traction, 251 N.Y.L.J., No. 107 (June 5, 2014), www.mayerbrown.com/files/news/abb7689c-375e-489a-a6d9-a9192827c78 4/presentation/newsattachment/9cb64727-875c-481a-aa53-aa167a9959da/new%20york%20law% 20journal%206-5-14.pdf. Unlike a traditional senior/junior lender structure that is common in a

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§9.42

first lien/second lien or a senior/mezzanine transaction, a unitranche facility is usually documented in a single loan facility with one set of documents and is secured by a single lien on the collateral for the benefit of all lenders. Unitranche facilities have gained significant popularity and use in private-equity led leveraged buyouts. In order to account for the differing economics, enforcement rights, and lien priority between the various creditors (commonly referred to as “first-out” and “last-out” lenders), the unitranche facility is split into multiple tranches, with the first-out lender receiving priority in payment over the last-out lender. The document governing the relationship between the lenders is known as the agreement among lenders (or commonly referred to as the AAL) and retains many of the features of a traditional intercreditor and subordination agreement such as payment waterfalls, rights to purchase debt during a default, and bankruptcy provisions, but will also contain certain provisions that are more unique to a unitranche facility such as enforcement triggering rights (which determine which lender will lead enforcement actions) and highly tailored voting rights provisions (which determine which lender has the ability to vote or block certain amendments). Unlike a traditional intercreditor agreement, however, the borrower is usually not a party to the AAL and may be unaware of the rights, obligations, and priorities of the lenders who are parties to the agreement. Another of the defining characteristic of an AAL is the reallocation of interest rates among the first-out and last-out lenders based on their relative credit risks (placing the last-out lender at a higher interest rate than the first-out lender). Although unitranche facilities may be seen as a way to increase the efficiency of the loan documentation process, lenders and borrowers should be aware that bankruptcy courts have yet to significantly weigh in on the enforceability of many of the terms and provisions typical to an AAL. Goodstein, supra.

VI. [9.42] CONCLUSION A subordination agreement is a written promise by a junior creditor of a borrower not to receive payment after a designated time until the senior creditors of the borrower have been paid. All other features of the typical subordination agreement are derivative of this undertaking. An intercreditor agreement, which is a form of subordination, is an agreement among secured creditors of the same borrower in which their rights in and to specific property and assets of the borrower are allocated and their remedies set forth. While most subordination agreements and intercreditor agreements have a number of common provisions, each is dependent on the specific transaction. The drafter must have complete command of the facts in order to tailor the agreement to fit the parties and the circumstances.

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10

Letters of Credit

ROBERT N. SODIKOFF Aronberg Goldgehn Davis & Garmisa Chicago

®

©COPYRIGHT 2016 BY IICLE .

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SECURED TRANSACTIONS

I. Introduction A. [10.1] Governing Law B. [10.2] Independent Undertaking II. Classification A. [10.3] Categories of Letters of Credit 1. [10.4] Commercial (or Sales) Letters of Credit 2. [10.5] Standby Letters of Credit B. [10.6] Parties 1. [10.7] Applicant or Account Party 2. [10.8] Beneficiary 3. [10.9] Issuer or Issuing Bank 4. [10.10] Additional Parties a. [10.11] Advising or Notifying Bank b. [10.12] Confirming Bank c. [10.13] Negotiating Bank d. [10.14] Paying (or Nominated) Bank III. [10.15] Relationship of Parties A. [10.16] Contract Between Issuer and Applicant B. [10.17] Contract Between Issuer and Beneficiary C. [10.18] Contract Between Applicant and Beneficiary IV. General Principles Applicable to Letters of Credit A. B. C. D. E.

[10.19] [10.20] [10.21] [10.22] [10.23]

Formal Requirements Consideration Revocability Expiration Date Statute of Frauds

V. [10.24] Issuer’s Obligations Under Letter of Credit A. B. C. D.

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[10.25] [10.26] [10.27] [10.28]

Standard of Compliance Presentation Inspection of Documents upon Presentation Notice of Dishonor

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LETTERS OF CREDIT

E. F. G. H. I. J. K. L. M. N.

[10.29] [10.30] [10.31] [10.32] [10.33] [10.34] [10.35] [10.36] [10.37] [10.38]

Issuer Request for Applicant Waiver Disposition of Documents Timeliness of Presentation Identical Wording and Quotation Marks Partial Draws and Multiple Presentations Lost, Stolen, Mutilated, or Destroyed Standby Original, Copy, and Multiple Documents Formality Requirements for Documents To Be Presented Waiver Estoppel

VI. Fraud and Injunctive Relief A. [10.39] Fraud B. [10.40] Fraud in Transaction C. [10.41] Injunctive Relief VII. [10.42] Right to Reimbursement and Subrogation VIII. [10.43] Choice of Law IX. [10.44] Bankruptcy Issues X. Transfers of Letters of Credit; Assignment of Proceeds A. [10.45] Transfer of Letter of Credit B. [10.46] Assignment of Proceeds XI. [10.47] Sample Standby Letter of Credit

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§10.1

SECURED TRANSACTIONS

I. INTRODUCTION A. [10.1] Governing Law Letters of credit are generally governed by Article 5 of the Uniform Commercial Code (UCC) — Letters of Credit, 810 ILCS 5/5-101, et seq., and the International Chamber of Commerce’s ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600 (2006, rev. 2007) (UCP 600), which codifies custom. UCP 600 replaced the International Chamber of Commerce’s ICC Uniform Customs and Practice for Documentary Credits — Publication No. 500 (1993 ed.) (UCP 500). Because UCP 600 was not drafted for standby letters of credit, the International Chamber of Commerce promulgated a set of rules governing standby letters of credit, entitled the International Standby Practices — Publication No. 590 (1998) (ISP98). ISP98 is not intended for commercial letters of credit. The differences under the UCC, UCP 600, UCP 500, and ISP98 are discussed herein. B. [10.2] Independent Undertaking Letters of credit were originally devised to reduce the risk of nonpayment in international trade transactions. They provide a seller of goods a guaranteed means of payment from a reliable third party, generally a bank, in lieu of relying on the credit of the buyer. Thus, a typical letter-ofcredit transaction involves three separate and independent relationships: (1) an underlying sale of goods contract between the buyer and the seller; (2) an agreement between a bank and its customer (buyer/applicant) in which the bank undertakes to issue its letter of credit; and (3) the bank’s engagement to pay the beneficiary (seller) provided certain documents presented to the bank — the demand — conform with the terms and conditions of the credit issued on the customer’s behalf. See Voest-Alpine International Corp. v. Chase Manhattan Bank, N.A., 707 F.2d 680, 682 (2d Cir. 1983). Because a letter of credit is an independent undertaking by a bank, the bank must honor a presentation that complies on its face with the terms and conditions of the undertaking. Problems with the underlying transactions can then be sorted out between the seller and the buyer after honor by the bank. In the meantime, the seller (beneficiary) holds the proceeds from the draw pending resolution of any dispute relating to the underlying sale transaction. Uniform Commercial Code §5-103 provides an overview of an issuer’s commitment, as “[r]ights and obligations of an issuer to a beneficiary or a nominated person under a letter of credit are independent of the existence, performance, or nonperformance of a contract or arrangement out of which the letter of credit arises or which underlies it, including contracts or arrangements between the issuer and the applicant and between the applicant and the beneficiary.” 810 ILCS 5/5-103(d).

II. CLASSIFICATION A. [10.3] Categories of Letters of Credit Letters of credit are generally divided into two categories: commercial (or sales/documentary) letters of credit and standby letters of credit.

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§10.5

1. [10.4] Commercial (or Sales) Letters of Credit A commercial letter of credit is primarily used in international transactions in connection with the sale of goods. The transaction generally anticipates that the letter of credit will in fact be drawn on. It represents an undertaking to honor on the presentation of a complying document that represents the shipment or delivery of goods or services. It provides significant protection to both the seller and the buyer. It assures the seller that it will receive payment when shipment has been made according to agreement. It assures the buyer that the required transaction documents will be presented before payment is made. In addition to the beneficiary’s draft and invoice, the documents presented to the issuer will include documents prepared by third parties, such as warehouse receipts, a shipper’s bill of lading, and the like. The ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600 generally will apply to commercial letters of credit. 2. [10.5] Standby Letters of Credit International Standby Practices — Publication No. 590 Rule 1.06 identifies the primary characteristics of a standby letter of credit as irrevocable, independent, documentary, and binding when issued. A standby letter of credit assures payment or performance that is to become due. It resembles a guaranty. The letter of credit is issued to assure the beneficiary that it will receive the payment of money if the account party fails to pay or perform. If the account party complies with its obligations, no demand for payment will be made against the credit, and the letter of credit will expire. The transaction generally anticipates that the letter of credit will not be drawn on. A performance standby letter of credit supports an obligation to perform other than to pay money and may cover losses arising from an applicant’s failure to complete the underlying transaction. A performance standby letter of credit is often issued in favor of governmental units (the beneficiary) to ensure that a developer will perform necessary site development work. If the developer fails to do the required work for any reason, the governmental unit can draw on the letter of credit for the necessary funds to complete the work. See, e.g., Lochsa Falls L.L.C. v. State of Idaho, 147 Idaho 232, 207 P.3d 963 (2009), involving a letter of credit posted to secure the cost of constructing and installing a traffic signal. See also American Employers Insurance Co. v. Pioneer Bank & Trust Co., 538 F.Supp. 1354 (N.D.Ill. 1981), in which Jenkins Industries, Inc., posted a letter of credit from Pioneer Bank in favor of American Employers Insurance to support various performance bonds issued by American Employers Insurance to assure completion of construction by Jenkins Industries. A financial standby letter of credit supports an obligation to pay money and is also often used in lease transactions, particularly if the landlord provides the tenant with a significant build-out allowance. The letter of credit ensures the landlord that funds will be available for recovery if the tenant goes bankrupt or otherwise defaults under its lease obligations. See, e.g., Locke v. United States Trustee (In re Locke), 205 B.R. 592 (B.A.P. 9th Cir. 1996). It is also used to support an obligation to pay money, including an obligation to repay borrowed money. See, e.g., Colonial Bank, N.A. v. Taylor Morrison Services, Inc., 10 So.3d 653 (Fla.App. 2009), in which a letter of credit was issued to secure a loan to finance the construction of a townhome development.

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§10.6

SECURED TRANSACTIONS

A commercial standby letter supports the applicant’s obligation to pay for goods or services. See, e.g., Michigan National Bank v. Metro Institutional Food Service, Inc., 198 Mich.App. 236, 497 N.W.2d 225 (1993). Basically, a standby letter can be used to support any credit when the ability of a party to perform or to pay is at issue. The required documentation under a standby letter of credit can range from a simple demand to a series of legal or technical documents. The classification of a standby as a performance, financial, or commercial standby only serves to identify the type of documentation that is typically required, but otherwise has no practical significance. One must look to the terms and conditions set forth in the standby to determine what documentation is required to be presented for payment. Although many standby letters of credit will specify that ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600 (or its predecessor ICC Uniform Customs and Practice for Documentary Credits — Publication No. 500) will apply, it is now increasingly common for standby letters of credit to specify ISP98 rather than UCP 600/500. Since ISP98 was designed specifically for standby letters of credit, its use likely will become more common. However, both UCP 600/500 and ISP98 work, and nothing in ISP98 requires language changes to the letter of credit that were not included in a typical letter of credit under UCP 600/500. B. [10.6] Parties There are generally three parties to a letter of credit: the applicant or account party; the beneficiary; and the issuer or issuing bank. ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600 art. 2; International Standby Practices — Publication No. 590 Rule 1.09. If the issuing bank nominates another bank to advise and confirm the standby, the other bank is the confirmer of the standby and adds its own undertaking to honor the standby. ISP98 Rules 1.09(a), 1.11(c), 2.04. 1. [10.7] Applicant or Account Party The applicant or account party is the party on whose behalf a letter of credit will be issued. The applicant requests that the issuer issue its letter of credit in favor of the beneficiary. Under the Uniform Commercial Code, unless otherwise agreed, the issuer is entitled to immediate reimbursement from the applicant, “in immediately available funds,” for payments made under the letter of credit. 810 ILCS 5/5-108(i)(1). 2. [10.8] Beneficiary The beneficiary is the party to whom the letter of credit is addressed and to whom payment is made. Generally, only the beneficiary can present documents and claim payment. International Standby Practices — Publication No. 590 Rule 1.09(a); ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600 art. 2.

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§10.11

3. [10.9] Issuer or Issuing Bank The issuer is the bank or other party that issues the letter of credit on behalf of its customer (the applicant or account party). A letter of credit is a separate contract independent of the underlying agreement between the account party and the beneficiary. It is construed in accordance with its terms without reference to any other documents. The issuer’s obligations to perform under the letter of credit are direct and primary and independent of the relationship between the applicant and the beneficiary. See 810 ILCS 5/5-103(d), 5/5-108(a), 5/5-108(f), 5/5108(g); ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600 art. 4; ICC Uniform Customs and Practice for Documentary Credits — Publication No. 500 arts. 3, 4, 14, 15; International Standby Practices — Publication No. 590 Rules 1.06, 1.07. Thus, it should be self-contained and include all necessary terms and conditions. It should clearly describe the documents that are to be presented by the beneficiary in order to receive payment. No other documents or agreements should be incorporated by reference, although reference to the UCP 600 or UCP 500 or ISP98, if applicable with regard to standby letters of credit, is acceptable. If conforming documents as specified in the letter of credit are presented, the issuer must make payment to the beneficiary regardless of whether the underlying agreement between the account party and the beneficiary has been satisfied. 4. [10.10] Additional Parties Additional parties may be involved in commercial letter-of-credit transactions. For the most part, the functions of these parties are beyond the scope of this chapter. However, for informational purposes, these parties generally are the advising or notifying bank, the confirming bank, the negotiating bank, and the paying (or nominated) bank. a. [10.11] Advising or Notifying Bank The advising or notifying bank transmits the terms and conditions of the letter of credit to the beneficiary. The bank does not assume liability on the letter of credit except for its accurate transmission. See 810 ILCS 5/5-102(a)(1); International Standby Practices — Publication No. 590 Rule 2.05(a)(i); ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600 art. 9; ICC Uniform Customs and Practice for Documentary Credits — Publication No. 500 art. 7A. Generally, the advising bank is in a locale accessible to the beneficiary and is used when the issuing bank is in a distant locale. UCP 600 Article 9 states that a credit and any amendment may be advised to a beneficiary through an advising bank. An advising bank that is not a confirming bank advises the credit and any amendment without any undertaking to honor or negotiate. By advising the credit or amendment the advising bank signifies that it has satisfied itself as to the apparent authenticity of the credit or amendment and that the advice accurately reflects the terms and conditions of the credit or amendment received. Similarly ISP98 Rule 2.05 provides that, unless an advice states otherwise, it signifies that the advisor has checked the apparent authenticity of the advised message and the advice accurately reflects what has been received.

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§10.12

SECURED TRANSACTIONS

b. [10.12] Confirming Bank The confirming bank holds itself out to the beneficiary as responsible under the terms of the letter of credit. It agrees to pay if the terms of the letter of credit are met regardless of whether the issuing bank pays. In effect, a confirming bank is a second issuer. A confirming bank is sometimes used if the issuer is geographically distant from the beneficiary or, in some cases, if the credit of the issuer is not sufficiently strong or well recognized. By the confirmation, the confirming bank agrees that it will honor the credit issued by the issuing bank and becomes directly obligated on the letter of credit to the extent of its confirmation. See 810 ILCS 5/5107(a); International Standby Practices — Publication No. 590; ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600. ISP98 Rule 1.09 provides that a “confirmer” “is a person who, upon the issuer’s nomination to do so, adds to the issuer’s undertaking its own undertaking to honor a standby.” See ISP98 Rule 1.11(c)(i). c. [10.13] Negotiating Bank With regard to commercial letters of credit, the negotiating bank purchases drafts under a negotiation letter of credit (one that does not restrict payment to a particular bank). When the negotiating bank (any bank in the locale of the beneficiary) has examined the documents and determined that they are in order, it will pay the beneficiary and claim reimbursement from the issuing bank. ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600 art. 2; ICC Uniform Customs and Practice for Documentary Credits — Publication No. 500 art. 10. d. [10.14] Paying (or Nominated) Bank The paying (or nominated bank) is usually in the beneficiary’s locale and is designated by the issuer as the bank that will receive a presentation, effect a transfer, confirm, pay, negotiate, or incur a deferred payment obligation, or accept a draft. The nominated bank (unless it is also a confirming bank) undertakes no liability under the letter of credit. ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600 Article 12 provides that, “[u]nless a nominated bank is the confirming bank, an authorization to honour or negotiate does not impose any obligation on that nominated bank to honour or negotiate, except when expressly agreed to by that nominated bank and so communicated to the beneficiary.” Additionally, UCP 600 Article 6d provides that the “place of the bank with which the credit is available is the place for presentation. The place for presentation under a credit available with any bank is that of any bank. A place for presentation other than that of the issuing bank is in addition to the place of the issuing bank.” Similarly, International Standby Practices — Publication No. 590 Rule 2.04 states that a “standby may nominate a person to advise, receive a presentation, effect a transfer, confirm, pay, negotiate, incur a deferred payment obligation, or accept a draft.” A “nomination does not obligate the nominated person to act except to the extent that the nominated person undertakes to act.” Id. Under ISP98 Rule 3.04, “[i]f no place of presentation to the issuer is indicated in the standby, presentation to the issuer must be made at the place of business from which the standby was issued.” UCP 600. See also 810 ILCS 5/5-107(b). Upon payment, the paying bank is entitled to reimbursement from the issuer.

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§10.19

III. [10.15] RELATIONSHIP OF PARTIES A letter-of-credit transaction involves three separate contracts and principal parties: between the issuer and the applicant; between the issuer and the beneficiary; and between the applicant and the beneficiary. A. [10.16] Contract Between Issuer and Applicant The first contract (the application and reimbursement agreement) is between the issuer and the applicant, who is generally a customer of the issuer. Pursuant to this agreement, the account party applies for the opening of the letter of credit and agrees to reimburse the issuer when it makes payment under the letter of credit. In a commercial letter-of-credit transaction, the application almost always includes a security agreement granting the issuer a security interest in the documents presented under the letter of credit and in the goods they cover. A standby letter of credit may be secured or unsecured, depending on the financial strength of the applicant at the time it applies for the letter of credit. B. [10.17] Contract Between Issuer and Beneficiary The second contract (which is technically an “engagement” (see 810 ILCS 5/5-103)) is the letter of credit itself. The letter of credit is the written undertaking of the issuer to accept or pay the draft or demand for payment of the beneficiary, provided that the beneficiary complies with the terms and conditions specified in the letter of credit. The letter of credit represents an independent obligation of the issuer. The issuer’s obligation is separate and apart from the underlying or related agreements that give rise to the issuer’s undertaking. Under the independence principle, defenses that may be asserted against the beneficiary that would be available to the applicant or the issuer under traditional contract law are generally not available. Fraud is the exception. C. [10.18] Contract Between Applicant and Beneficiary The third contract (the underlying transaction) is the business relationship between the applicant and the beneficiary. In a commercial letter-of-credit transaction, the beneficiary normally has sold goods or services to the account party, and the letter of credit provides for payment. In a standby letter-of-credit transaction, there will normally be an agreement between the applicant and the beneficiary, and the letter of credit assures the beneficiary that the applicant will perform its obligations or make the payment as and when required. In both commercial letter-of-credit and standby letter-of-credit transactions, the beneficiary is assured performance by the applicant. The assurance is given by substituting the creditworthiness of the issuer for that of the applicant.

IV. GENERAL PRINCIPLES APPLICABLE TO LETTERS OF CREDIT A. [10.19] Formal Requirements A letter of credit must be in writing and signed by the issuer, and a confirmation must be in writing and signed by the confirming bank. A telegram may be a sufficient signed writing if it

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§10.20

SECURED TRANSACTIONS

identifies its sender by an authorized authentication. See 810 ILCS 5/5-104. The letter of credit must be self-contained. No other documents or agreements should be incorporated by reference. To do so may convert the letter of credit into a guaranty. However, the letter of credit may expressly refer to ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600 or ICC Uniform Customs and Practice for Documentary Credits — Publication No. 500, and standby letters of credit may refer to the International Standby Practices — Publication No. 590, if it is wished that they be subject to them without violating this restriction. B. [10.20] Consideration No consideration is required to establish the letter of credit or to enlarge or otherwise modify its terms. 810 ILCS 5/5-105. C. [10.21] Revocability International Standby Practices — Publication No. 590 provides that a standby letter of credit “is an irrevocable, independent, documentary, and binding undertaking when issued and need not so state.” ISP98 Rule 1.06(a). Because a standby is irrevocable, it cannot be amended or canceled by the issuer except as provided in the standby or consented to by the beneficiary and any confirming bank. ISP98 Rule 2.03. Further, because a standby is independent, the enforceability of the issuer’s obligations does not depend on (1) the issuer’s ability to obtain reimbursement from the applicant, (2) the beneficiary’s right to obtain payment from the applicant, (3) a reference in the standby to any reimbursement agreement or underlying transaction, or (4) the issuer’s knowledge of preference or breach of any reimbursement agreement or underlying transaction. ISP98 Rule 1.06(c). Moreover, because the standby is documentary, the “issuer’s obligations depend on the presentation of documents and an examination of required documents on their face.” ISP98 Rule 1.06(d). And finally, because a standby is binding when issued, it is enforceable against the issuer whether the applicant authorized the issuance, the issuer received a fee, or the beneficiary received or relied on it or the amendment. ISP98 Rule 1.06(e). ICC Uniform Customs and Practice for Documentary Credits — Publication No. 500 provides that all letters of credit should clearly indicate whether they are revocable or irrevocable. Under UCP 500, in the absence of such indication, the credit is deemed to be irrevocable. See UCP 500 art. 6C. ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600 carries over the rule that credits are irrevocable. (UCP 600 art. 2 defines a “credit” as “any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a complying presentation.” [Emphasis added.]. UCP 600 further provides that a “credit is irrevocable even if there is no indication to that effect.” [Emphasis added.] UCP 600 art. 3.) The Uniform Commercial Code similarly provides that a letter of credit is revocable only if the letter of credit so provides. See 810 ILCS 5/5-106(a). In any event, the beneficiary should require that the letter of credit expressly state that it is irrevocable. An irrevocable credit can be modified or revoked only with the consent of the beneficiary. A revocable credit can be revoked by the issuer without notice to the account party or the beneficiary.

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§10.23

D. [10.22] Expiration Date The expiration date is the date after which the issuer need no longer honor the beneficiary’s drafts or demand for payment. The expiration date should be clearly identified in the letter of credit. Under the Uniform Commercial Code, if there is no stated expiration date or other provision that determines its duration, a letter of credit expires one year after its date of issuance. See 810 ILCS 5/5-106(c). Under International Standby Practices — Publication No. 590, the standby must contain an expiry date or permit the issuer to terminate the standby upon reasonable prior notice or payment. ISP98 Rule 9.01. ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600 Article 6 states that a credit must state an expiry date for presentation. An expiry date stated for honor or negotiation will be deemed to be an expiry date for presentation. A letter of credit that states that it is perpetual expires five years after the date of issuance. See 810 ILCS 5/5-106(d). A letter of credit may provide for automatic extension of the expiration date for another stated period. Most automatic extension clauses provide that the issuer must give notice to the beneficiary if the issuer elects not to extend sufficiently in advance of the expiration date to enable the beneficiary to get a new credit from the applicant or to draw on the existing letter of credit. The notice of non-extension must be “clear and unequivocal” to be effective. See 3Com Corp. v. Banco do Brasil, S.A., 171 F.3d 739 (2d Cir. 1999). When the expiry date or an installment demand deadline falls on a holiday or nonbanking day at the place of presentation, ISP98 Rule 3.13(a) provides that the expiration is extended to the first following business day. UCP 600 Article 29 provides that when the expiry date falls on a holiday or nonbanking day, expiration is extended to the first following banking day. However the UCP 600 extension applies only to expiry dates and would not apply to a non-expiry (installment) deadline. With respect to force majeure, under UCP 600 Article 36, a bank assumes no liability or responsibility for the consequences arising out of the interruption of its business by acts of God, riots, civil commotions, resurrections, war, acts of terrorism, strikes or lockouts, or any other causes beyond its control. A bank will not, upon resumption of business, honor or negotiate under a credit expired during such interruption of its business. Contrariwise, ISP98 Rule 3.14 states that if, on the last business day for presentation stated in the standby the bank is for any reason closed and presentation is not timely made because of the closure, then the last day for presentation is automatically extended to the day occurring 30 calendar days after the place for presentation reopens for business, unless the standby otherwise provides. E. [10.23] Statute of Frauds The letter of credit must be in writing (a form that is a record) and must be authenticated, generally by the signature of the issuer. So too must any amendment. See 810 ILCS 5/5-104.

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§10.24

SECURED TRANSACTIONS

V. [10.24] ISSUER’S OBLIGATIONS UNDER LETTER OF CREDIT Under its engagement with the beneficiary, the issuer must honor a draft or demand for payment that complies with the terms of the letter of credit regardless of whether there has been performance pursuant to the underlying transaction between the beneficiary and account party. Under ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600 Article 7 and International Standby Practices — Publication No. 590 Rule 2.01, the issuer’s obligation is to pay on the timely presentation of complying documents. Under Article 5 of the Uniform Commercial Code, upon making such payment, the issuer is entitled to reimbursement from the account party. However, if the issuer makes payment upon a presentation that does not conform to the requirements of the credit, it may lose its right to reimbursement from the applicant. UCP 600 and ICC Uniform Customs and Practice for Documentary Credits — Publication No. 500 omit any reimbursement obligation of the applicant. Accordingly, from the issuer’s perspective, it is important that the applicant execute a written reimbursement agreement in favor of the issue to clearly set forth the obligation and terms of reimbursement and the issuer’s rights and remedies, particularly if UCP 600 or UCP 500 may apply. The reimbursement agreement generally will provide that the issuer is entitled to reimbursement if it honors presentations under the letter of credit or documents that substantially comply with the terms of the letter of credit. Without such a provision, the issuer might lose its right to reimbursement if payment was made against a presentation that did not strictly conform to the requirements of the credit. UCC §5108(a) provides that “unless otherwise agreed with the applicant, an issuer shall dishonor a presentation that does not appear so to [strictly] comply [with the letter of credit].” 810 ILCS 5/5108(a). A. [10.25] Standard of Compliance In examining documents, the issuer’s obligations include good faith and the observance of general banking usage. Further, under the Uniform Commercial Code, an issuer must examine documents with care to ascertain that on their face they appear to comply with the terms of the credit but, unless otherwise agreed, assumes no liability or responsibility for the genuineness, falsification, or effect of any documents that appear upon such examination to be regular on their face. See 810 ILCS 5/5-109(a)(1), 5/5-109(a)(2). Generally, banks that regularly participate in the letter-of-credit market will honor the letter of credit except in the most extreme cases. Their concern is that if the market perceives that the bank does not honor its letter-of-credit obligations, the bank will get a reputation such that its letters of credit become unacceptable in the marketplace. Under International Standby Practices — Publication No. 590, the issuing bank is not responsible for (1) performance or breach of any underlying transaction (between the applicant and the beneficiary); (2) the accuracy, genuineness, or effect of any document presented under the standby; (3) the action or omission of others even if the other person is chosen by the issuer or nominated person; or (4) the observance of law or practice other than that chosen in the standby or applicable at the place of issuance. ISP98 Rule 1.08. Courts use two standards in determining whether there has been compliance with the drawing requirements of the letter of credit. Article 5 of the UCC adopts the standard of strict compliance,

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§10.27

subject to standard practices of financial institutions that regularly issue letters of credit. The reference to the standard of compliance is found in UCC §5-108(a), which provides that an issuer shall honor a presentation that, as determined by the standard practice referred to in subsection (e) [standard practice of financial institutions that regularly issue letters of credit], appears on its face to strictly comply with the terms and conditions of the letter of credit. 810 ILCS 5/5-108(a). ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600 and ICC Uniform Customs and Practice for Documentary Credits — Publication No. 500 do not state whether the standard for compliance is strict or substantial. Although the general rule is that the beneficiary must strictly comply with the terms and conditions of the letter of credit in order to be paid, a number of courts have held that insignificant variance between the letter-of-credit requirements and the documents submitted is permissible. See First Arlington National Bank v. Stathis, 90 Ill.App.3d 802, 413 N.E.2d 1288, 46 Ill.Dec. 175 (1st Dist. 1980). See also Integrated Measurement Systems, Inc. v. International Commercial Bank of China, 757 F.Supp. 938 (N.D.Ill. 1991). B. [10.26] Presentation The “standby should indicate the time, place and location within that place, person to whom, and medium in which presentation” is to be made. International Standby Practices — Publication No. 590 Rule 3.01. If the standby does not indicate a place for presentation, presentation should be made at the place of issuance. ISP98 Rule 3.04(b). If the standby is silent in regard to the specific location within the place of presentment, presentment may be made to the general post office address indicated in the standby, any location at the place of presentation to receive deliveries of mail, or any person at the place of presentation actually or apparently authorized to receive it. ISP98 Rule 3.04(d). ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600 does not contain a provision regarding the specifics of the location of presentation. Presentation means either the act of delivering documents for examination or the documents so delivered, as the context may require. ISP98 Rule 1.09. If the standby indicates time, place, person to whom, and medium in which presentation must be made, the presentation must be so made in order to be in compliance. ISP98 Rule 3.01. To the extent time, place, person, and medium are not specified, the compliance must be in accordance with the ISP98 Rules in order to be complying. ISP98 Rule 3.01. Most standbys require that all documents required under the standby be presented together and at the same time by the beneficiary. They also require that the demand for payment identify by number the letter of credit under which the documents are presented. This is consistent with ISP98 Rule 3.03, which provides that a presentation under a standby must identify the standby under which it is made. C. [10.27] Inspection of Documents upon Presentation The expiry date specified in the letter of credit is the last date on which the beneficiary can present conforming documents and make a complying presentation. International Standby

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§10.28

SECURED TRANSACTIONS

Practices — Publication No. 590 Rule 3.05. A presentation made after the close of business at the place of presentation is deemed to have been made on the next business day. ISP98 Rule 3.05(b). The documents must be presented in the medium indicated in the standby; when no medium is indicated, to comply, a document must be presented as a paper document, unless only a demand is required. ISP98 Rules 3.06(a), 3.06(b). If the standby calls for presentation of electronic documents, to comply, the document must be capable of being authenticated. ISP98 Rules 306, 1.09(c). The issuer may defer honor until the close of the seventh business day after receipt of the documents. See 810 ILCS 5/5-108(b). Under ICC Uniform Customs and Practice for Documentary Credits — Publication No. 500 Articles 13B and 14D(i), the issuer has a reasonable time not to exceed seven banking days after presentation to examine the documents and determine whether to take up or refuse the documents. Under ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600, a nominated bank acting on its nomination, a confirming bank, if any, and the issuing bank each have a maximum of five banking days following the day of presentation to determine if presentation is conforming. Under ISP98, notice of dishonor must be given within a time after presentation of documents that is not unreasonable. Notice given within three business days is deemed to be not unreasonable, and beyond seven business days is deemed to be unreasonable. The time for calculating when the notice of dishonor must be given begins on the business day following the business day of presentation. ISP98 Rule 5.01. This period is not curtailed or otherwise affected by the occurrence on or after the day of presentation of any expiry date or last day for presentation. See UCP 600 arts. 14(b), 16(d). The issuing bank honors a complying presentation made to it by paying the amount demanded of it at sight, unless the standby provides for honor by acceptance, deferred payment (in which event the issuer must make timely payment by paying the deferred amount on maturity), or negotiation. ISP98 Rule 2.01(b). D. [10.28] Notice of Dishonor Under International Standby Practices — Publication No. 590, notice of dishonor must state all discrepancies on which the dishonor is based. ISP98 Rule 5.02. Failure to give notice of the discrepancy precludes the assertion of that discrepancy in any document containing that discrepancy that is retained or re-presented but does not preclude assertion of that discrepancy in any different presentation under the same or separate standby. ISP98 Rule 5.03. However, a failure to give notice that a presentation was made after the expiration date does not preclude dishonor for that reason. ISP98 Rule 5.04. Under ISP98 Rule 5.01(a)(i), if notice of dishonor is given within three business days, it is deemed to be not unreasonable. Under UPC 600, notice must be given no later than the close of the fifth banking day following the day of presentation. E. [10.29] Issuer Request for Applicant Waiver If the issuer decides that a presentation does not comply and if the presenter does not otherwise instruct, the issuer may, in its sole discretion, request the applicant to waive noncompliance or otherwise authorize or honor within the time for giving notice of dishonor but without extending it. Obtaining the applicant’s waiver does not obligate the issuer to waive

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§10.31

noncompliance. International Standby Practices — Publication No. 590 Rule 5.05. If, after receipt of notice of dishonor the presenter requests that the presented documents be forwarded to the issuer or that the issuer seek the applicant’s waiver, the issuer is not required to do so. If it does, the presenter is then precluded from objecting to the discrepancies. ISP98 Rules 5.06(a), 5.06(b). F. [10.30] Disposition of Documents Dishonored documents must be returned, held, or disposed of as reasonably instructed by the presenter. International Standby Practices — Publication No. 590 Rule 5.07. G. [10.31] Timeliness of Presentation If the documentation is nonconforming, the beneficiary may cure or correct the defect and again present within the expiry date. If presentment is timely, payment will be made. However, if proper documents are not presented until after the expiry date, they are too late, and payment will not be made. But see Datapoint Corp. v. M & I Bank of Hilldale, 665 F.Supp. 722 (W.D.Wis. 1987), in which the court held that the issuer’s failure to timely notify the beneficiary of the defect estopped the bank from dishonoring the draft based on untimeliness. In Exxon Company, U.S.A. v. Banque de Paris et des Pays-Bas, 828 F.2d 1121 (5th Cir. 1987), the credit contained conditions that were incapable of performance. The credit by its terms expired on October 31. For payment, it required Exxon to certify that delivery from Houston Oil & Refining, Inc. (the account party), had not occurred between September and December. Houston Oil’s reimbursement obligation was secured by a hold placed against its accounts at Banque de Paris et des Pays-Bas (also known as Paribas). During November, Paribas released its interest in Houston Oil’s account. Thereafter, on November 30 and December 1, Exxon attempted to obtain payment by presenting documents to Paribas. Paribas rejected both presentations as untimely. The district court found a clash between the expiry date of the letter of credit and the dates specified for performance under the underlying contract. The court resolved the ambiguity by extending the expiry date. The appellate court reversed the district court by finding that the terms of the letter of credit were clear even though they made no commercial sense. The United States Supreme Court remanded the case for further consideration in light of Kerr Construction Co. v. Plains National Bank of Lubbock, 753 S.W.2d 181, 184 (Tex.App. 1987), which held that when there was an “irreconcilable conflict between provisions in an agreement, the provision which contributes most essentially to the agreement is entitled to the most consideration,” and that the provision in the letter of credit that stated when the account party had breached its contract was “condition precedent to the Bank’s liability and, as such . . . the most significant and essential provision” of the letter of credit. Exxon Company, U.S.A. v. Banque de Paris et des Pays-Bas, 488 U.S. 920, 102 L.Ed.2d 319, 109 S.Ct. 299 (1988). Accordingly, the circuit court in Exxon Company, U.S.A. v. Banque de Paris et des Pays-Bas, 889 F.2d 674, 678 (5th Cir. 1989), relying on Kerr, supra, affirmed the judgment of the district court and held that, under Texas law, the date fixed in the certification provision controlled over the expiration date.

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§10.32

SECURED TRANSACTIONS

To avoid problems like those presented in Exxon, supra, the beneficiary must make certain that all conditions specified in the letter of credit are capable of performance prior to the expiration date. H. [10.32] Identical Wording and Quotation Marks Under International Standby Practices — Publication No. 590, if the standby requires a statement without specifying precise wording in the document to be presented, then the wording in the document must appear to convey the same meaning as that required in the standby. ISP98 Rule 4.09(a). To avoid confusion, it is best to specify the wording required. If the standby requires “specific wording by the use of quotation marks, blocked wording, or an attached exhibit or form, then typographical errors in spelling, punctuation, spacing, or the like that are apparent when read in context are not required to be duplicated and blank lines or spaces for data may be completed in any manner not inconsistent with the standby.” ISP98 Rule 4.09(b). If, however, the standby specifies required wording “by use of quotation marks, blocked wording, or an attached exhibit or form, and also provides that the specified wording be ‘exact’ or ‘identical,’ then the wording in the documents presented must duplicate the specific wording, including typographical errors in spelling, punctuation, spacing and the like, as well as blank lines and spaces for data.” ISP98 Rule 4.09(c). I. [10.33] Partial Draws and Multiple Presentations ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600 and ICC Uniform Customs and Practice for Documentary Credits — Publication No. 500 provide that if any installment is not drawn within the period allowed for that credit, the credit ceases to be available for that and any subsequent installment, unless otherwise stipulated in the credit. UCP 600 art. 32; UCP 500 art. 41. Under International Standby Practices — Publication No. 590 Rules, each presentation is considered separately, and, unless the standby provides otherwise (i.e., the standby contains a statement that partial draws are prohibited), partial draws may be made. ISP98 Rules 3.07, 3.08. The issuer is not required to notify the applicant of a presentation under the standby. ISP98 Rule 3.10. If the standby provides that no partial drawings are allowed, the beneficiary may not draw less than 100 percent of the amount available. If the standby provides for no multiple drawings, there can be only one drawing, but it can be for an amount less than the amount available. ISP98 Rule 3.08(d). UCP 600 does not specifically address this situation. J. [10.34] Lost, Stolen, Mutilated, or Destroyed Standby If the original standby is lost, mutilated, or destroyed, the issuer is not required to replace it or waive any requirement for its presentation for payment under the credit. International Standby Practices — Publication No. 590 Rule 3.12. In effect, the beneficiary has no recourse against the issuer. The issuer can agree to replace the original or waive the requirement for presentation without affecting the applicant’s obligations to the issuer, but it is not required (and the issuer will likely not do so without the consent of the applicant). ISP98 Rule 3.12(b).

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K. [10.35] Original, Copy, and Multiple Documents All documents presented must be originals. Presentation of an electronic document, if permitted or required, is deemed to be an original. International Standby Practices — Publication No. 590 Rule 4.15. If the standby requires presentation of a “copy,” either the original or a copy is permitted, unless the standby states only a copy is permitted. ISP98 Rule 4.15(d). L. [10.36] Formality Requirements for Documents To Be Presented The following documents, when presented, must contain a signature: a demand for payment (International Standby Practices — Publication No. 590 Rule 4.16(b)(iv)); a statement of default (ISP98 Rule 4.17(c)); and legal documents (ISP98 Rule 4.19(iii)). Additionally ISP98 Rule 4.07(a) provides that a signature is required if it is custom or if the standby itself calls for it. Under ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600, there is no provision for a signature requirement except with respect to transport documents (Articles 19 – 25) and insurance documents (Article 28(a)). M. [10.37] Waiver If the beneficiary is unable to comply fully with the terms of the letter of credit, the issuer, with the consent of the account party, may waive the incomplete or defective performance. The issuer should obtain the waiver from the account party before waiving the deficiencies. Otherwise, the issuer may be required to pay the beneficiary but not have the right to reimbursement from the account party. Also, the issuer should notify the beneficiary in writing that it is accepting the nonconforming documents on the instructions of its customer (the account party) and that it is not waiving any future nonconformity. Further, an issuer is precluded from asserting as a basis for dishonor any discrepancy if timely notice is not given or any discrepancy not stated in the notice if timely notice is given. However, failure to give notice of discrepancy or to mention fraud, forgery, or expiration in the notice does not preclude the issuer from asserting, as a basis for dishonor, fraud or forgery under 810 ILCS 5/5-109(a) or expiration of the letter of credit before presentation. 810 ILCS 5/5-108(d). Under the International Standby Practices — Publication No. 590, the issuer (or confirming bank) may, in its sole discretion, waive the following rules and similar terms in the standby without notice to or consent of the applicant and without affecting the applicant’s obligations to the issuer, which are deemed to be for the issuer’s benefit or operational convenience: (1) treatment of documents received, at the request of the presenter, as having been presented at a later time (ISP98 Rule 3.02); (2) identification of the presentation to the standby letter under which it is presented (ISP98 Rule 3.03(a)); (3) where and to whom presentation is made (ISP98 Rules 3.04(b) – 3.04(d)), except the country of presentation stated in the standby; or (4) treatment of presentation made after the close of business as if it were made on the next business day (ISP98 Rule 3.05(b)). In addition, the issuer may, in its discretion, waive the following rules but not similar terms in the standby: (1) a required document dated after the date of its stated presentation (ISP98 Rule 4.06); or (2) the requirement that a document issued by the beneficiary be in the language of the standby (ISP98 Rule 4.04).

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§10.38

SECURED TRANSACTIONS

N. [10.38] Estoppel The issuer should give the reason for dishonor so the beneficiary has an opportunity to cure. If the issuer gives no reason, the issuer may be precluded or estopped from asserting the reason for dishonor. ICC Uniform Customs and Practice for Documentary Credits — Publication No. 500 specifically provides that the issuer must notify the beneficiary of the defects without delay. The timeliness of the notice of dishonor may be of crucial importance, particularly when the letter of credit is about to expire. UCP 500 art. 13. In Datapoint Corp. v. M & I Bank of Hilldale, 665 F.Supp. 722, 726 – 727 (W.D.Wis. 1987), the issuer sent notice of dishonor in the mail, rather than through telecommunications, even though it knew that by doing so the beneficiary would not receive the notice in time to cure. The court held that the issuer’s failure to act without delay by telecommunication or other expeditious means estopped it from asserting that the documents were nonconforming. The beneficiary should keep in mind, however, that under §5-108(b) of the Uniform Commercial Code, the issuer has seven days in which to give notice of dishonor (and five banking days under ICC Uniform Customs and Practice for Documentary Credits — Publication No. 600). 810 ILCS 5/5-108(b); UCP 600 art. 14(b). If the letter of credit is presented two days before expiring, the notice, if sent on the seventh day (pursuant to the UCC or UCP 500) or the fifth banking day (under UCP 600), would preclude a subsequent cure. The issuer should comply with all applicable notice requirements of the UCC and UCP 500 or UCP 600 even if the letter of credit expires during the interval, or it could be precluded from dishonoring for noncompliance under UCC Article 5, Article 14 or 15 of UCP 500, or Article 14(b) of UCP 600.

VI. FRAUD AND INJUNCTIVE RELIEF A. [10.39] Fraud If documents that on their face are in compliance with the letter of credit are presented to the issuer, the issuer is entitled to make payment even if it has received a claim of fraud from the account party with respect to the documents presented or the underlying transaction. Its duty is one of good faith and the observance of general banking usage. The issuer, however, is not required to make payment. If the issuer believes the documents to be forged, it can refuse payment and require the beneficiary to sue. This is more likely to happen in a standby letter-of-credit transaction in which there is no negotiating bank or holder of the draft or demand that has taken the draft or demand under circumstances that would make it a holder in due course. The issuer should require full indemnification, including defense costs, from its account party. Problems with respect to conformity of documents arise generally with respect to commercial letters of credit. As discussed above in this section, the issuer’s obligation is to verify that the documents on their face comply with the terms of the letter of credit. If they do, the issuer can rely on the genuineness of the documents despite notification from its customer of fraud, forgery, or other defects not apparent on the face of the documents. The customer can, however, seek to enjoin honor.

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§10.41

Article 5 of the Uniform Commercial Code makes clear that fraud must be found in the documents or must have been committed by the beneficiary on the issuer or applicant. According to UCC §5-109(a)(2), an issuer may honor its letter of credit in the face of the applicant’s claim of fraud. 810 ILCS 5/5-109(a)(2). This subsection also makes clear what was implied but not stated in former UCC §5-114 (810 ILCS 5/5-114 (1995)), that the issuer may dishonor and defend the dishonor by showing fraud or forgery of the kind stated in UCC §5-109(a). However, merely because the issuer has a right to dishonor and to defend the dishonor by showing forgery or material fraud does not mean that it has a duty to the applicant to dishonor. Many issuers will choose to honor despite an applicant’s claim in order to avoid being liable for wrongful dishonor if they are unable to prove forgery or material fraud. The applicant’s normal recourse is to procure an injunction. See 810 ILCS 5/5-109(b). If the applicant is unable to procure an injunction, it will have a claim against the issuer only in the rare case in which it can show that the issuer did not act in good faith. B. [10.40] Fraud in Transaction Former §5-114(2) (1995) of the Uniform Commercial Code also referred to “fraud in the transaction.” 810 ILCS 5/5-114(2) (1995). Unfortunately, the courts are not clear on whether “the transaction” refers to the underlying transaction or the letter-of-credit transaction. It probably means fraud in the letter-of-credit transaction. For example, if the letter of credit provides for payment upon presentation of a certificate from the beneficiary that the account party is in default (see the sample standby letter of credit in §10.45 below), and if the account party has in fact fully performed, the certificate, if given, would be fraudulent, and the account party may be able to enjoin payment. If, however, there is a dispute between the account party and the beneficiary regarding performance, the court should not intervene in the letter-of-credit transaction. The issuer should be allowed to pay the beneficiary, and the account party would then have a direct action against the beneficiary to resolve the dispute. See Recon/Optical, Inc. v. Government of Israel, 816 F.2d 854 (2d Cir. 1987). A letter of credit is designed to effect quick payment pending final settlement of a dispute. In effect, it allows the beneficiary to hold the money pending resolution of a good-faith dispute. However, its purpose is not served in permitting the beneficiary to commit fraud. C. [10.41] Injunctive Relief A party seeking an injunction must satisfy the traditional rules for injunctive relief, including irreparable injury and inadequacy of remedies at law. Section 5-109(b) of the Uniform Commercial Code expressly provides that a court of competent jurisdiction “may temporarily or permanently enjoin the issuer from honoring a presentation or grant similar relief against the issuer . . . only if the court finds that . . . all of the conditions to entitle a person to the relief under the laws of this State have been met.” 810 ILCS 5/5-109(b). The leading case, Sztejn v. J. Henry Schroder Banking Corp., 177 Misc. 719, 31 N.Y.S.2d 631 (1941), sets forth the principles under Article 5 of the UCC regarding when an injunction will issue in a commercial letter-of-credit transaction.

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§10.42

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In Sztejn, Schroder Banking Corporation issued an irrevocable letter of credit to Transea Traders, Ltd. The letter of credit provided that drafts drawn by Transea for the sales price of bristles would be paid by Schroder Bank upon shipment of the goods and presentation of an invoice and bill of lading showing shipment. Transea placed 50 cases of material on board a ship, procured an appropriate bill of lading, and prepared an appropriate invoice that described the goods shipped as “bristles” as called for in the letter of credit. These conforming documents were then presented to Schroder Bank, but before payment was made, Sztejn alleged that “Transea filled the fifty crates with cowhair, other worthless material and rubbish with intent to simulate genuine merchandise and defraud.” 31 N.Y.S.2d at 633. The court found that the complaint stated a cause of action and refused to dismiss, finding the following factors determinative: (1) the issuer was warned of the fraud prior to payment; (2) the letter of credit was not paid; (3) the party requesting payment was not a holder in due course; and (4), if the allegations were true, there was a clear fraud. In effect, Sztejn allows a court to order an issuer to do what it has discretion to do.

VII. [10.42] RIGHT TO REIMBURSEMENT AND SUBROGATION An issuer that has honored a presentation as permitted or required under the Uniform Commercial Code is entitled to be reimbursed by the applicant in immediately available funds. See 810 ILCS 5/5-108(i). The reimbursement agreement between the issuer and applicant can vary this, and often such agreements require that funds be deposited upon issuance of the letter of credit. Section 5-117 of the UCC also provides a potential right of subrogation to an issuer who has honored a letter of credit. 810 ILCS 5/5-117. Under International Standby Practices — Publication No. 590, the beneficiary must indemnify the issuer against all claims, obligations, and responsibilities (including attorneys’ fees) arising out of (a) the imposition of law or practice other than that chosen in the standby or applicable at the place of issuance; (b) the fraud, forgery, or illegal actions of others; or (c) the issuer’s performance of the obligations of a confirmer that wrongfully dishonors a confirmation. ISP98 Rule 8.01. This rule supplements any applicable agreement, course of dealing, practice, custom, or usage providing for reimbursement or indemnification on lesser or other grounds. ISP98 Rule 8.01(c).

VIII.

[10.43] CHOICE OF LAW

In an action for wrongful dishonor, the beneficiary is entitled to recover the amount recoverable under the letter of credit plus incidental damages, including interest. Jurisdiction is in the state where the issuer is located or doing business, not the location of the beneficiary or account party. See 810 ILCS 5/5-116. The letter of credit may provide for what law will govern. Absent such a provision, generally, the law of the issuing bank will apply.

IX. [10.44] BANKRUPTCY ISSUES Payments made by an issuer of a letter of credit to an unsecured beneficiary within the statutory period of §547 of the Bankruptcy Code (11 U.S.C. §547) may constitute a preference to the beneficiary. The preference will occur if the transfer is made within the preference period and

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relates to an antecedent debt. See In re Compton Corp., 831 F.2d 586 (1987), reh’g granted, 835 F.2d 584 (5th Cir. 1988). See also American Bank of Martin County v. Leasing Service Corp. (In re Air Conditioning, Inc. of Stuart), 55 B.R. 157 (Bankr. S.D.Fla. 1985), aff’d in part, rev’d in part on other grounds, 845 F.2d 293 (11th Cir.), cert. denied, 109 S.Ct. 557 (1988), which holds that a creditor cannot indirectly secure payment of an unsecured antecedent debt during the preference period through a letter-of-credit transaction when it could not do so directly through any other type of transaction. The issuer of the letter of credit can generally enforce its rights against the collateral of the bankrupt (account party) if, at the time the letter of credit was issued, the issuer took an appropriate security agreement and timely perfected or if the letter of credit was issued pursuant to a secured future advance obligation. Conversely, if the letter of credit is not secured and the issuer seeks reimbursement after a bankruptcy petition has been filed, the issuer is merely an unsecured creditor. One additional case bears mention at this time: Twist Cap, Inc. v. Southeast Bank of Tampa (In re Twist Cap, Inc.), 1 B.R. 284 (Bankr. M.D.Fla. 1979). Although this case has, for the most part, been discredited, it remains of interest as an example of how a court can wrongly determine the preference issue. In Twist Cap, the court found that letters of credit were the property of the debtor, and that a prior general security interest in the property of the debtor given to the issuer to secure payments made under the letters of credit to the beneficiary within the Bankruptcy Code §547 period were preferential. Therefore, the court enjoined payment. Twist Cap is generally regarded as wrong because both the issuance of the letters of credit to the beneficiary and the grant by the debtor of a security interest to the issuer took place outside the Bankruptcy Code §547 preference period. The court mistakenly looked to the payment date of the letters of credit as the date of the transfer. Section 362(a) of the Bankruptcy Code automatically stays an act to obtain property constituting part of the debtor’s estate. 11 U.S.C. §362(a). The cases generally hold that a letter of credit is not an asset of the bankrupt account party’s estate. Therefore, the beneficiary is generally not stayed from drawing on the letter of credit. However, the trustee may seek to recover the payment as a preference if the beneficiary received the benefit of the letter of credit in connection with an antecedent debt owed by the beneficiary. See Compton Corp., supra.

X. TRANSFERS OF LETTERS OF CREDIT; ASSIGNMENT OF PROCEEDS A. [10.45] Transfer of Letter of Credit Unless a letter of credit is expressly designated as transferable, the rights of the beneficiary under the letter of credit cannot be transferred. See 810 ILCS 5/5-112(a); International Standby Practices — Publication No. 590 Rule 6.02; ICC Uniform Customs and Practice for Documentary Credits — Publication No. 500 art. 48B. A standby that states that it is transferable without further provision means that the drawing rights (1) may be transferred in their entirety more than once, (2) may not be partially transferred, and (3) may not be transferred unless the issuer or confirmer agrees to and effects the transfer requested by the beneficiary. ISP98 Rules 6.02(b)(i) – 6.02(b)(iii). The issuer need not effect the transfer unless (1) it is satisfied as to the

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existence and authenticity of the original standby and (2) the beneficiary submits or fulfills (a) a request in a form acceptable to the issuer, including the effective date of the transfer and the name and address of the transferee; (b) the original standby; (c) verification of the signature and authority of the person signing for the beneficiary; (d) payment of a transfer fee; and (e) any other reasonable requirements. ISP98 Rule 6.03. If there is a transfer of drawing rights in their entirety (1) a draft or demand must be signed by the transferee, and (2) the transferee’s name may be used in place of the original beneficiary. ISP98 Rule 6.04. B. [10.46] Assignment of Proceeds There is a distinction between the transfer of the letter of credit itself and the assignment of the proceeds of the letter of credit. Although letters of credit themselves are not transferable, the proceeds may be assigned. See 810 ILCS 5/5-112; ICC Uniform Customs and Practice for Documentary Credits — Publication No. 500 art. 48B; International Standby Practices — Publication No. 590 Rule 6.06. Also, Article 5 of the Uniform Commercial Code permits a successor (through merger or consolidation), administrator, personal representative, trustee in bankruptcy, debtor in possession, liquidator, or receiver of a beneficiary to sign and present documents and receive payment in the name of the beneficiary. A successor’s status may be evidenced by presentation of a certificate of merger, a certificate of appointment as bankruptcy trustee, and the like. See 810 ILCS 5/5-113. However, even before the adoption of revised Article 5, it was generally held that a trustee or receiver was permitted to enforce its predecessor’s rights. For the assignment to be effective, the issuer must be given written notice of the assignment, signed by the beneficiary (assignor), identifying the letter of credit and containing a request to pay the assignee. See 810 ILCS 5/5-114(b). Unless applicable law otherwise requires, the issuer is not obligated to give effect to an assignment of proceeds that it has not acknowledged, and it is not obligated to acknowledge the assignment. ISP98 Rule 6.07. If the issuer does acknowledge the assignment, the acknowledgment confers no rights with respect to the standby to the assignee who is entitled only to the proceeds assigned and whose rights may be affected by amendment or cancellation and whose rights are subject to various third parties as set forth in ISP98 Rules 6.07(b)(i) and 6.07(b)(ii). The acknowledgment can be conditioned on receipt of the original standby letter of credit, verification of the signature and authority of the party signing on behalf of the beneficiary, and an irrevocable request signed by the beneficiary for an acknowledgment of the assignment. ISP98 Rule 6.08; 810 ILCS 5/5-114(c). See also 810 ILCS 5/9-312(b)(2) and 5/9314(a), regarding perfection of a security interest in the assignment of the proceeds of a letter of credit via control of the letter-of-credit rights. Accordingly, the assignee should obtain the issuer’s consent as a condition of accepting the assignment.

XI. [10.47] SAMPLE STANDBY LETTER OF CREDIT Model forms under International Standby Practices — Publication No. 590 are available at www.iiblp.org without charge.

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NOTE: The footnotes that appear in the form below are for explanatory purposes and are not part of the form. [name and address of issuing bank] Irrevocable Standby Letter of Credit No. ___ Date: [date of letter of credit] Expiry Date: [date letter of credit expires] Beneficiary [name and address] Ladies and Gentlemen: We hereby establish our irrevocable1 standby letter of credit No. ____________ in your favor for the account of [account party], for up to the aggregate amount of $____________. Partial draws are permitted, and this letter of credit shall be reduced by partial draws made hereunder.2 Payment under this letter of credit is available upon presentation of your sight draft or drafts drawn on us and accompanied by documents specified below: Documents required: (1) The original of this letter of credit;3 (2) Your letter certifying that [(account party) has defaulted on its obligation under (contract) (lease) dated (date of certifying letter) and has failed to cure said default within (ten) days after your written notice of such default and certifying the amount represented by the accompanying draft is due and owing to you] [you have received a Nonrenewal Notice (hereinafter described)]; and (3) [other — specify]. This letter of credit expires on [date letter of credit expires], and you must present all required documents by the expiry date. All drafts drawn under this letter of credit must be marked “Drawn under [name of bank] irrevocable letter of credit No. ____________, dated [date letter of credit expires].” [The expiry date and the last day to submit drawing documents shall automatically be extended by one year (but never beyond [outside expiration date] (the “Outside Expiration Date”)), unless on or before the date _____ days before any expiry date we have given you notice that the expiry date shall not be so extended (a “Nonrenewal Notice”).4] You may transfer this letter of credit in its entirety to any transferee (the “Transferee”) by presentation to us of the original letter of credit (including any amendments) and a Transfer Notice in the form of Exhibit B, completed and signed by you.5 Upon such transfer, all references to you shall automatically refer to such Transferee, who may then exercise all rights hereunder.

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SECURED TRANSACTIONS

We hereby engage with you that all drafts drawn under and in compliance with the terms of this credit will be duly honored if drawn and presented for payment at the office of [name and address of bank], on or before the expiration date of this credit. This credit is subject to [International Chamber of Commerce Publication No. 590 (ISP98)] [International Chamber of Commerce Uniform Customs and Practices for Documentary Credits — Publication No. 600 (2006, rev. 2007)] and, to the extent not inconsistent therewith, the laws of the State of Illinois. Sincerely yours, [authorized signature] EXHIBIT B FORM OF TRANSFER NOTICE [beneficiary letterhead] TO: [name and address of issuer] (Issuer) TRANSFER NOTICE The undersigned (the “Beneficiary”), Beneficiary under Issuer’s Letter of Credit No. ____________ dated [date of letter of credit] (as amended, the “Letter of Credit”), transfers the Letter of Credit to: [transferee name (the “transferee”) and address] Beneficiary encloses the original Letter of Credit, directs Issuer to reissue or amend the Letter of Credit in favor of Transferee, as beneficiary, and represents and warrants that Beneficiary has made no other assignment, encumbrance, or transfer of the Letter of Credit. [name and signature block with beneficiary’s signature and date] _______________ 1

UCP 600 Article 2 defines “credit” as “any arrangement, however named or described, that is irrevocable and thereby constitutes a definite undertaking of the issuing bank to honour a complying presentation.” ISP98 Rule 1.06(a) provides that a letter of credit is irrevocable. Nevertheless, it is currently customary for the letter of credit to specifically provide that it is irrevocable.

2

ISP98 Rule 3.08 provides that a presentation may be for less than the full amount available (partial drawing), and more than one presentation may be made. A statement “partial drawings prohibited” means that a presentation must be for the full amount available, and a statement “multiple drawings prohibited” means that only one presentation may be made and honored but that it may be for less than the full amount available. UCP 600 provides that partial drawings are allowed.

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3

Most issuers require that the original letter of credit be presented to draw on it. If the letter of credit is lost or destroyed, the beneficiary may be without remedy. ISP98 Rule 3.12(a) provides that if the original standby is lost, stolen, mutilated, or destroyed, the issuer need not replace it or waive any requirement that the original be presented under the standby. ISP98 Rule 3.12(b), however, allows an issuer to agree to replace the standby or to waive a requirement for its presentation.

4

This language allows the letter of credit to renew automatically each year unless the issuer gives notice of nonrenewal.

5

ISP98 Rule 6.02(a) provides that a standby letter of credit is not transferable unless it so states. A standby that states that it is transferable without further provisions means it (a) may be transferred in its entirety more than once, (b) may not be partially transferred (ISP98 Rule 6.02(b)), and (c) may not be transferred unless the issuer agrees to and effects the transfer requested by the beneficiary.

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11

Avoidance of Security Interests as Fraudulent Transfers

RICHARD J. MASON McGuireWoods LLP Chicago

JOHN F. POLLICK Pollick & Schmahl, LLC Glenview

®

©COPYRIGHT 2016 BY IICLE .

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SECURED TRANSACTIONS

I. [11.1] Overview II. [11.2] Fraudulent Transfer Law III. [11.3] Avoiding a Security Interest as a Constructively Fraudulent Transfer

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I. [11.1] OVERVIEW This chapter provides an overview of fraudulent transfer law, the circumstances under which the granting of a security interest might constitute a fraudulent transfer, and factors a lender will want to consider to eliminate or limit its exposure.

II. [11.2] FRAUDULENT TRANSFER LAW Both federal law and state law address and permit the avoidance of fraudulent transfers. The primary federal law on fraudulent transfers is §548 of the Bankruptcy Code, 11 U.S.C. §101, et seq. States have similar fraudulent transfer laws, primarily the Uniform Fraudulent Transfer Act (UFTA) and an amended version of the UFTA, known as the Uniform Voidable Transactions Act (UVTA), one or the other of which has been adopted in 44 states, the District of Columbia, and the U.S. Virgin Islands (in Illinois, as the Uniform Fraudulent Transfer Act, 740 ILCS 160/1, et seq.). State law generally provides a longer reach-back for avoiding fraudulent transfers, typically four years as opposed to the two-year reach-back period of 11 U.S.C. §548. Both §548 and state law recognize two types of fraudulent transfers: actual and constructive. Actual fraud exists when there is a transfer of an interest of the debtor in property or the incurring of an obligation by the debtor “with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted.” 11 U.S.C. §548(a)(1)(A). In general, a constructively fraudulent transfer is the transfer of an interest of the debtor in property, or the incurring of an obligation by the debtor, for which the debtor (i) received less than a reasonably equivalent value in exchange for such transfer or obligation; and (ii) (I) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation; (II) was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital; (III) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured; or (IV) made such transfer to or for the benefit of an insider, or incurred such obligation to or for the benefit of an insider, under an employment contract and not in the ordinary course of business.. 11 U.S.C. §548(a)(1)(B). Challenging the granting of a security interest as an “actual” fraudulent transfer is less common but not unknown. See Stoebner v. Ritchie Capital Management, L.L.C. (In re Polaroid Corp.), 472 B.R. 22 (Bankr. D.Minn. 2012) (actual intent to hinder, delay, or defraud will be

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§11.3

SECURED TRANSACTIONS

presumed when debtor was controlled by operator of Ponzi scheme); In re Sentinel Management Group, Inc., 728 F.3d 660 (7th Cir. 2013) (investment manager’s transfers of investors’ segregated funds into account used as collateral for its own loan exposed investors to risk of which they were unaware and thus established intent to hinder, delay, and defraud). The presence of actual fraud turns on the transferor’s intent. Much more common is a creditor (using state law) or a trustee or creditors’ committee (using §548 or state law, through 11 U.S.C. §544(b), or both) challenging the granting of a security interest as a “constructively” fraudulent transfer. Although the elements of a fraudulent transfer are very similar regardless of whether the challenge is made in a nonbankruptcy or bankruptcy forum, the remedies in the two settings are substantially different. In a nonbankruptcy forum, the complaining creditor generally seeks to avoid or recovers an obligation or transfer only to the extent necessary to cover its claim. 740 ILCS 160/8(a)(1). In a bankruptcy forum, the trustee or committee avoids or recovers the entire obligation or transfer for the benefit of all the debtor’s unsecured creditors. 11 U.S.C. §551.

III. [11.3] AVOIDING A SECURITY INTEREST AS A CONSTRUCTIVELY FRAUDULENT TRANSFER The basic elements of a constructively fraudulent transfer or obligation are that (a) the debtor transferred an interest in its property or incurred an obligation, (b) for which it received less than a reasonably equivalent value, and (c) at the time the transfer was made or obligation incurred, the debtor was insolvent, rendered insolvent, left with unreasonably small capital for its business, or intended to or believed it would incur debts beyond its ability to pay as they matured. If a financing involves affiliate guaranties, a leveraged buyout (LBO), or the payment of a dividend or distribution to equity holders of the debtor, the lender will want to be mindful of fraudulent transfer implications. In most cases, secured lenders have little reason to be concerned about constructively fraudulent transfers. A secured lender often lends money to a borrower who, in turn, grants the lender a security interest in its own property to secure repayment. In this situation, because the grant of the security interest covers only the loan the lender is making to the borrower and its time value (presumably, a fair market interest rate), a reasonable equivalence exists between what the borrower transferred and what it received. Accordingly, the “less than a reasonably equivalent value” element of a constructively fraudulent transfer is missing, and a fraudulent transfer cannot exist. In some cases, especially when the lender is financing an LBO or dividend payment, confirming the borrower’s use of the loan proceeds for its own benefit, its solvency both before and after the transaction, and its ability to timely pay its debts going forward gives a lender additional protection against fraudulent transfer liability. In situations in which a lender makes a loan to or for the benefit of one party but receives collateral from or the incurring of debt (such as a guaranty) by another party, fraudulent transfer issues will sometimes arise. These situations are not uncommon, especially among affiliated companies or parties. A parent may guaranty a debt or pledge collateral for a subsidiary (downstream guaranty or pledge), a subsidiary may do so for a parent (upstream), and a subsidiary may do so for a fellow subsidiary (sidestream). In these circumstances, a lender must carefully assess and try to minimize its fraudulent transfer risk. Its primary inquiries must be:

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a. What is the value of the party’s guaranty or pledge, and is the value received by that party in exchange for the obligation or transfer reasonably equivalent? b. What is the financial situation of the party at the time of the transaction, and what will it be after the transaction? Regarding value and reasonable equivalence, downstream guaranties and pledges generally do not pose a problem as long as the subsidiary debtor is not insolvent. If the subsidiary is not insolvent, each dollar that a wholly owning parent pays on a guaranty or pledge increases the parent’s equity in the subsidiary, and the parent’s value, by a like amount. Assessing value and reasonable equivalence for upstream and sidestream guaranties and pledges is more difficult. In the Seventh Circuit, value given by guarantors/pledgors may be measured by multiplying the probability that a guaranty or pledge will be called on by the amount of the overall liability. Covey v. Commercial National Bank of Peoria, 960 F.2d 657 (7th Cir. 1992). But see Rubin v. Manufacturers Hanover Trust Co., 661 F.2d 979, 990 – 991 (2d Cir. 1981) (value given equals full amount of outstanding guaranteed debt, even though liability remains contingent); Hemphill v. T & F Land Co. (In re Hemphill), 18 B.R. 38, 47 – 48 (Bankr. S.D. Iowa 1982) (note citations therein; value given is full amount of guaranteed obligation reduced by value of guarantor’s contribution, subrogation, and related rights). Also, in determining reasonable equivalence, the value received by guarantors/pledgors should include both indirect benefits (e.g., value received because of the strengthened finances of parent and affiliates) as well as direct benefits (the portion of the loan used for its direct benefit). See Rubin, supra, 661 F.2d at 991 – 992 (benefit to debtor “need not be direct; it may come indirectly through benefit to a third person”). The other necessary inquiry for constructive fraud relates to the financial condition of the guarantor/pledgor, both at the time of and after the transaction in question. 11 U.S.C. §548(a)(1)(B)(ii) requires that one of two forms of insolvency exist for constructive fraud: a. balance sheet insolvency, in which debts exceed assets, either at the time of or after making the transfer or incurring the obligation (11 U.S.C. §548(a)(1)(B)(ii)(I); see also 11 U.S.C. §101(32)(A)); or b. financial inadequacy, in which the debtor, at the time of or after making the transfer or incurring the obligation, is left with “unreasonably small capital” for its business or intends to or believes it will incur debts beyond its ability to pay as such debts matured (11 U.S.C. §§548(a)(1)(B)(ii)(II), 548(a)(1)(B)(ii)(III)). Thus, in large transactions, lenders may wish to obtain expert opinions from financial analysts establishing the solvency of the obligors. Fraudulent transfer challenges to a lender’s security interest may also arise in connection with the financing of an LBO or a guarantor/third-party pledgor.

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SECURED TRANSACTIONS

In an LBO, new shareholders buy out existing ones, paying for their purchase by borrowing against the assets of the company whose business they are buying. The net result can be that the company incurs a large debt to a lender and encumbers all of its assets to secure it but receives none of the loan proceeds, all of which go to the selling shareholders. LBOs, accordingly, can wreak havoc with a company’s balance sheet, render it insolvent, and greatly prejudice its unsecured creditors. When creditors of the company or its trustee in bankruptcy challenge an LBO, they generally seek to avoid both the payment of the loan proceeds to the selling shareholders and the granting of security interests to the lender as fraudulent transfers. Their basic argument is that the company did not receive reasonably equivalent value, or any value, for these transfers and was rendered insolvent by them. Although an LBO can be viewed as several discrete transactions — a secured loan to the company, a payment of a corporate dividend to a shareholder, a sale and purchase of stock — courts generally collapse these transactions and consider the company, the lender, and the buying and selling shareholders as parties to a single transaction. Viewed in this way, the selling shareholder and the secured lender are each seen as recipients of valuable company property who, in exchange, give nothing to the company. See, e.g., Wieboldt Stores, Inc. v. Schottenstein, 94 B.R. 488 (N.D.Ill. 1988); Bay Plastics, Inc. v. BT Commercial Corp. (In re Bay Plastics, Inc.), 187 B.R. 315 (Bankr. C.D.Cal. 1995). Responses and defenses commonly raised by lenders in LBO and other constructive fraud actions are that a. the debtor did receive reasonably equivalent value in exchange for the granting of its security interests or incurring of debt; b. the debtor was not insolvent or otherwise financially troubled at the time of or as a result of the transfer or the incurring of the debt; c. the “safe harbor” of 11 U.S.C. §546(e) applies; and d. the lender took the security interest “for value and in good faith” and, to the extent of the value given to the debtor, should receive, pursuant to 11 U.S.C. §548(c), a credit against any avoided transfer. Each of these responses and defenses poses difficulties for a lender. Reasonably equivalent value and insolvency are fact-intensive inquiries, with respect to which a lender should have done substantial due diligence prior to the transaction, precisely to prevent or defend against fraudulent transfer claims. See, e.g., In re Bundles, 856 F.2d 815 (7th Cir. 1988). The safe harbor of 11 U.S.C. §546(e) — which, among other things, exempts “settlement payments” from avoidance as a constructively fraudulent transfer — is subject to widely varying interpretations and application and should be relied on with caution. See, e.g., Lehman Brothers Holdings Inc. v. JPMorgan Chase Bank, N.A. (In re Lehman Brothers Holdings Inc.), 469 B.R. 415 (Bankr. S.D.N.Y. 2012); QSI Holdings, Inc. v. Alford, 382 B.R. 731 (W.D.Mich. 2007), aff’d, 571 F.3d 545 (6th Cir. 2009). Because §548(c) applies only after a transfer or obligation has been avoided (i.e., after lack of reasonably equivalent value and insolvency have been established), it is often difficult for a lender to show it acted “in good faith” and gave much, if any, value to the debtor. See, e.g., In re Sherman, 67 F.3d 1348, 1355 (8th Cir. 1995) (“[A] transferee does not act in good faith when

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he has sufficient knowledge to place him on inquiry notice of the debtor’s possible insolvency.”); In re Sentinel Management Group, Inc., 809 F.3d 958, 961 (7th Cir. 2016) (no good faith when transferee fails to act on “inquiry notice,” i.e., “awareness of suspicious facts that would have led a reasonable firm, acting diligently, to investigate further and by doing so discover wrongdoing.”) The dangers and risks to a secured lender of constructively fraudulent transfer liability from upstream guaranties are well illustrated by Official Committee of Unsecured Creditors of TOUSA, Inc. v. Citicorp North America, Inc. (In re TOUSA, Inc.), 422 B.R. 783 (Bankr. S.D.Fla. 2009), quashed, appeal dismissed in part, judgment entered sub nom. 3V Capital Master Fund Ltd. v. Official Committee of Unsecured Creditors of TOUSA, Inc. (In re TOUSA, Inc.), 444 B.R. 613 (S.D.Fla. 2011), rev’d, remanded sub nom. In re TOUSA, Inc., 680 F.3d 1298 (11th Cir. 2012). TOUSA was a large homebuilder that operated through various subsidiaries. In 2007, TOUSA agreed to settle a lawsuit against it by certain lenders for $421 million. To finance the settlement, TOUSA and several of its subsidiaries borrowed $500 million, secured primarily by assets of the subsidiaries. Agreements with the new lenders required that $421 million of the loan proceeds be used to pay the old lenders. Six months after the new loan proceeds were disbursed, TOUSA and the subsidiaries filed for bankruptcy. The creditors’ committee filed a constructively fraudulent transfer action against the old lenders for the settlement payment and against the new lenders to avoid their liens. The old and new lenders argued that the subsidiaries received reasonably equivalent value including, among other things, the economic value of avoiding bankruptcy. The bankruptcy court rejected their arguments and held that the subsidiaries did not receive reasonably equivalent value and, in addition, (a) were unable to pay their debts when due, (b) had unreasonably small capital, and (c) were insolvent both before and after the transaction. It avoided the liens to the new lenders and, holding that the loan transaction was “for the benefit of” the old lenders, ordered them to disgorge the payment they received. 422 B.R. at 785. It also rejected the “good faith” defense of both the old and new lenders, finding that they all had ample reason to know of the subsidiaries’ insolvency and that the subsidiaries were not receiving reasonably equivalent value from them. After reversal of the bankruptcy court decision by the district court, the Eleventh Circuit reversed again, upholding the bankruptcy court’s findings on reasonable equivalence and insolvency and its avoidance of the payment to the old lenders and the liens to the new lenders. As an aside, when the old lenders protested that the court’s ruling would impose on every creditor who received payment “ ‘extraordinary’ duties of due diligence,” the court responded: “[E]very creditor must exercise some diligence when receiving payment from a struggling debtor. It is far from a drastic obligation to expect some diligence from a creditor when it is being repaid hundreds of millions of dollars by someone other than its debtor.” In re TOUSA, supra, 680 F.3d at 1315. As TOUSA indicates, due diligence is critical to minimizing a lender’s risk of constructively fraudulent transfer liability. There is no substitute for thoroughly investigating the financial condition of a borrower and, especially, its guarantors and pledgors, determining how loan proceeds will be used, and honestly judging whether each obligor will receive reasonably equivalent value for its obligations and liens.

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12

Guaranties

MICHAEL L. WEISSMAN Of Counsel Levin Ginsburg Chicago

®

©COPYRIGHT 2016 BY IICLE .

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SECURED TRANSACTIONS

I. [12.1] Guaranties as Credit Enhancement II. [12.2] Types of Guaranties A. B. C. D. E. F. G. H. I. J.

[12.3] Conditional Guaranties [12.4] Restricted or Limited Guaranties [12.5] Springing Guaranties; Sample Language [12.6] Validity Guaranties [12.7] Guaranty and Remarketing Agreements [12.8] Collateralized Guaranties [12.9] Continuing Guaranties [12.10] Documentation and Execution Requirements [12.11] Sample Form of Guaranty Caselaw Highlights 1. [12.12] Guarantor Who Signs an Unconditional Guaranty Is Unconditionally Liable When Borrower Defaults 2. [12.13] Liability on a Springing Guaranty Can Be Generated by a Prohibited Act That Caused No Loss to the Lender 3. [12.14] Guaranty Applies to Both Original and Renewal Notes 4. [12.15] Transfer of Note Automatically Transfers the Guaranty 5. [12.16] Guarantor Cannot Prevent Enforcement of Guaranty Based on Alleged Oral Statements by Lender 6. [12.17] Statute of Frauds Prevents a Guarantor from Asserting an Alleged Oral Release of the Guaranty 7. [12.18] Guarantor May Not Raise Defenses to Enforcement of a Guaranty That Are Purely Derivative

III. [12.19] Discharging the Guarantor; Preserving Rights Against the Guarantor A. Pre-Default Discharge of the Guarantor by Conduct of the Bank 1. [12.20] Advising the Guarantor of the Nature of the Risk; Sample Language 2. [12.21] A Change in the Underlying Obligation a. [12.22] Change of Terms; Sample Language b. [12.23] Negating the Underlying Obligation: Extension or Novation c. [12.24] The Borrower Changes 3. [12.25] Release of Coguarantor; Sample Language 4. [12.26] Impairment of Collateral 5. [12.27] Failure To Perfect Is a Form of Impairment of Collateral; Sample Reaffirmation of Guaranty Letter 6. [12.28] Bank’s Duty To Pursue the Borrower; Sample Waiver Language

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B. Pre-Default Termination of the Guaranty 1. [12.29] Revocation by the Guarantor; Sample Language a. [12.30] Revocation by Notice b. [12.31] Revocation by Declination Not Effective 2. [12.32] Death 3. [12.33] Equal Credit Opportunity Act and Regulation B C. Post-Default Discharge of the Guarantor by Conduct of the Bank 1. [12.34] Grounds for Discharge a. [12.35] The Bank’s Duty To Give Notice of Disposition of Collateral b. [12.36] Waiver of Notice c. [12.37] Small Business Administration Guaranties 2. [12.38] Commercial Reasonableness and Other Purported Defenses IV. [12.39] Successive Guaranties; Sample Language V. [12.40] The Bank’s Duties to the Guarantor A. [12.41] Does the Bank Have an Implied Duty to a Guarantor To See to the Proper Application of the Loan Proceeds by the Borrower? B. [12.42] Does the Bank Have a Duty To Disclose to One Guarantor the Past Defaults of a Coguarantor? C. [12.43] Guarantor May Compel Arbitration Even If Guaranty Lacks Arbitration Clause If Underlying Note Has One VI. Guaranties and the Bankruptcy Code A. [12.44] Fraudulent Transfers B. [12.45] The “Clawback” Clause; Sample Language VII. [12.46] The “Put” — An Alternative to a Guaranty; Sample Put

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§12.1

SECURED TRANSACTIONS

I. [12.1] GUARANTIES AS CREDIT ENHANCEMENT A guaranty is a contract that involves three parties — the guarantor, the borrower, and the bank. The enforceability of the guaranty is determined in accordance with the general law of contracts. There must be consideration for the guarantor’s undertaking, but when a guaranty and other loan documents are executed concurrently, the documents are construed together and can be supported by the same consideration. Amato v. Creative Confections Concepts, Inc., 97 F.Supp.2d 949 (E.D.Wis. 2000). Because a guaranty is contractual, it can impose a greater liability on the guarantor than the obligation assumed by the borrower. Thus, a guarantor will remain liable for an unsatisfied indebtedness remaining after default and foreclosure, even though the primary obligation was nonrecourse as to the borrower, if the guaranty states quite clearly that the guarantor is to pay any unsatisfied indebtedness. And a guaranty of a mortgage debt is enforceable even if the foreclosure court fails to award a deficiency judgment against the guarantor in the foreclosure case. Inland Mortgage Capital Corp. v. Chivas Retail Partners, LLC, 740 F.3d 1146 (7th Cir. 2014). Further, a guaranty can be enforced even if the guaranteed debt cannot be because of evidentiary issues. City National Bank v. Tress, Civil Action No. 7:11-CV73, 2013 WL 3879689 (W.D.Va. July 26, 2013). In the same vein, discharge of the borrower in bankruptcy will not discharge the guarantor from liability on the guaranty. Typically, guaranties are thought of as collateral or contingent obligations rather than as primary obligations (i.e., a guaranty binds the guarantor to perform only in the event the borrower does not repay its debt or perform under a contract). For a guaranty to be legally effective, the statute of frauds requires that it be in writing. Although the guarantor must sign it to make it enforceable, it need not be signed by the guaranteed party. Grabill Cabinet Co. v. Sullivan, 919 N.E.2d 1162 (Ind.App. 2010). However, it has been held that an oral guaranty will be enforced if necessary to avoid a harsh injustice. Barrie-Chivian v. Lepler, 87 Mass.App. 683, 34 N.E.3d 769 (2015). A guaranty is an integral part of a package of loan documents and cannot be modified orally. Ringgold Capital IV, LLC v. Finley, 2013 IL App (1st) 121702, 993 N.E.2d 541, 373 Ill.Dec. 235.

II. [12.2] TYPES OF GUARANTIES The type of guaranty a lender uses depends on how it integrates into the underlying transaction. The absolute or unconditional guaranty is obvious. It is the kind of guaranty in which the bank does not have to pursue the borrower or liquidate the collateral (if any) before commencing action against the guarantor. Federal Deposit Insurance Corp. v. Indian Creek Warehouse, J.V., 974 F.Supp. 746 (E.D.Mo. 1997); In re Drexel Burnham Lambert Group Inc., 151 B.R. 674 (Bankr. S.D.N.Y. 1993). A sample form of guaranty of payment is set forth in §12.11 below. What other kinds of guaranties are there? A. [12.3] Conditional Guaranties As opposed to the absolute guaranty, in which the guarantor has unconditionally promised that it will perform those acts that the borrower fails to perform, the conditional guaranty requires

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§12.5

the happening of a condition precedent prior to the guarantor’s liability coming into existence. The condition precedent can be anything the guarantor and bank agree on, such as an exhaustion by the bank of all remedies available against the borrower. This latter type of conditional guaranty is known as a guaranty of collection. B. [12.4] Restricted or Limited Guaranties There are guaranties that are limited as to time or amount. If limited to a specified time period, the guarantor has no further obligation if the time limitation has passed without a triggering event having occurred. A guaranty limited as to amount requires that the guarantor pay an amount up to the limitation, notwithstanding the fact that the borrower has failed to pay a larger amount or the bank has suffered a larger loss. C. [12.5] Springing Guaranties; Sample Language The language of a springing or carveout guaranty reads as follows: Notwithstanding anything contained in this Continuing Guaranty Agreement or any other document or instrument related to the Loan to the contrary, but subject to the provision set forth below, Guarantor shall have no personal liability hereunder whatsoever; provided, however, that in the event that Lender attempts to exercise any of its rights and remedies as secured party pursuant to the provisions of a certain Loan and Security Agreement (Loan Agreement) with Debtor to be executed simultaneously herewith and in the pursuance thereof, and Guarantor fails to cooperate with Lender to the extent required pursuant to the provisions of this Continuing Guaranty Agreement, then, and in any such event, Guarantor shall have full personal liability hereunder. For the purposes hereof, the failure by Guarantor to “cooperate with Lender,” as set forth above, shall be limited to the failure by Guarantor to lawfully transfer control of Debtor, after the occurrence of an Event of Default under the Loan Agreement, to Lender or to its agent, designee, or nominee, or to a receiver appointed in an action by Lender to realize on its security interest granted under the Loan Agreement, or to execute and deliver any other instrument or document that Lender considers necessary or appropriate in connection with such court action, or the failure by Guarantor to take any action reasonably requested by Lender related to Lender’s realization on such security interest, but including, in any event without limitation, the failure to execute and deliver, or to cause Debtor to execute and deliver, or to observe or perform any of Guarantor’s, or cause Debtor to observe or perform any of Debtor’s, obligations under agreements with brokers relating to the sale of Debtor’s assets or agreements for the sale of such assets, or any other similar agreements arising from a joint effort by Debtor and Lender to find a buyer of such assets. Note that the guarantor has no obligation unless there is a failure on the part of the borrower or the guarantor to cooperate with the lender in a default/liquidation scenario. The enforceability of springing guaranties is well established. 172 Madison (N.Y.) LLC v. NMP-Group, LLC, 44 Misc.3d 1208(A), 977 N.Y.S.2d 668 (N.Y.Cty.Sup. 2013); Bank of America, N.A. v. Freed, 2012 IL App (1st) 113178, 971 N.E.2d 1087, 361 Ill.Dec. 565.

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§12.6

SECURED TRANSACTIONS

D. [12.6] Validity Guaranties The validity guaranty generally provides the lender with assurance that key officers of the borrower are personally committed to ensure that reports, information, and requests for funds are proper, in conformity with the loan documents, and free of fraudulent statements and omissions. Liability of such a guarantor is conditional on the lender’s suffering a loss as a result of the failure of the guarantor to assure compliance with the foregoing. E. [12.7] Guaranty and Remarketing Agreements The guaranty and remarketing agreement provides the guarantor with the opportunity to remarket the collateral for an amount that would reduce the guarantor’s obligation as a condition precedent to the guarantor’s liability. What happens if the beneficiary of the guaranty repossesses the collateral and sells it without providing the remarketing opportunity to the guarantor? What if the bank sells the collateral for more than a “commercially reasonable” amount but less than the amount guaranteed? F. [12.8] Collateralized Guaranties Guaranties may be secured solely by the credit of the guarantor, or by any combination of collateral and/or credit. When collateral is employed to secure a guaranty, the guaranty may remain a full recourse guaranty or be limited to the value of the collateral. G. [12.9] Continuing Guaranties A continuing guaranty is a divisible offer for a series of separate unilateral contracts. It contemplates a series of transactions between the guarantor and the bank, rather than a single debt. H. [12.10] Documentation and Execution Requirements • A guaranty should be executed concurrently with the disbursement of loan proceeds so that there is no question that consideration has been provided to the guarantor. • A guaranty should be signed in the presence of a bank official. A signature not signed in the presence of a bank official leaves open the questions of intent and genuineness because a bank official was not available to explain the purpose of the guaranty or to verify that the signature is not a forgery. An option would be to require a signature guaranty from the guarantor’s bank. •

A guaranty must be accompanied by the required identifications and authorizations.

•

A guaranty may be unsecured or secured by collateral.

See the sample form of guaranty in §12.11 below.

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I. [12.11] Sample Form of Guaranty GUARANTY THIS GUARANTY, dated as of [date], given by the undersigned, [name of guarantor] and [name of guarantor], jointly and severally (collectively, “Guarantor”), to [name of bank] (Bank), has reference to the following facts and circumstances: WHEREAS, Guarantor is financially interested, through some common ownership or control, in [name of corporation], a [corporate form] corporation (Borrower), which is indebted to the Bank, and Borrower has solicited Guarantor’s execution and delivery of this Guaranty to Bank; WHEREAS, Bank is unwilling to extend or continue to extend credit to Borrower unless it receives this Guaranty; furthermore, any and all loans or other financial accommodations made to Borrower by Bank are made with Bank’s full reliance on this Guaranty; and WHEREAS, by virtue of the foregoing, it will be to Guarantor’s direct interest and financial advantage to enable Borrower to obtain loans, advances, and other financial accommodations from Bank. NOW, THEREFORE, in consideration of the foregoing, Guarantor agrees as follows: 1. Definitions (a) “Borrower’s Liabilities” shall mean all obligations and liabilities of Borrower to Bank (including, without limitation all debts, claims, and indebtedness), whether primary, secondary, direct, contingent, fixed, or otherwise, heretofore, now, and/or from time to time hereafter owing, due, or payable, however evidenced, created, incurred, acquired, or owing and however arising, whether under the “Loan Agreements” (hereinafter defined), or by oral agreement or operation of law, or otherwise, and all terms, conditions, agreements, representations, warranties, undertakings, covenants, guaranties, and provisions to be performed, observed, or discharged by Borrower under the Loan Agreements. (b) “Guarantor’s Liabilities” shall mean all of Guarantor’s obligations and liabilities to Bank under this Guaranty. (c) “Loan Agreements” shall mean all agreements, instruments, and documents, including, without limitation, promissory notes, loan and security agreements, guaranties, letters of credit, mortgages, deeds of trust, environmental indemnity agreements, pledges, powers of attorney, consents, assignments, contracts, notices, leases, financing statements, and all other written matter heretofore, now, and/or from time to time hereafter executed by and/or on behalf of Borrower and delivered to Bank, including, without limitation, that certain Loan and Security Agreement dated as of the

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§12.11

SECURED TRANSACTIONS

date hereof, made by Borrower in favor of Bank (Loan Agreement), and any and all substitutions, replacements, renewals, and/or amendments to and of the aforementioned agreements, instruments, and documents. 2. Guaranty Guarantor unconditionally, absolutely, and continuingly guarantees to Bank the prompt performance and payment (in full) of all of Borrower’s Liabilities, when such performance or payment is due or declared due by Bank. In addition to the payment and performance of Borrower’s Liabilities specified in the preceding sentence, Guarantor shall additionally be liable for (a) all interest accruing on Borrower’s Liabilities outstanding from time to time; and (b) all of the costs and expenses incurred by Bank as identified in Section 9 of this Guaranty. If more than one person is executing this Guaranty, the undersigned’s liability under this Guaranty shall be joint and several. Bank may elect to enforce this Guaranty against all of the undersigned or any portion of the undersigned in its sole discretion. Guarantor agrees that Guarantor is directly and primarily liable, jointly and severally with Borrower, for Borrower’s Liabilities. Prior to enforcing its rights under this Guaranty, Bank is not required to (a) prosecute collection action or seek to enforce or resort to any remedies against Borrower or any other party liable to Bank on account of Borrower’s Liabilities or any Guaranty thereof; or (b) seek to enforce or resort to any remedies with respect to any security interests, liens, or encumbrances granted to Bank by Borrower or any other party to secure the repayment of Borrower’s Liabilities. Guarantor’s Liabilities shall in no way be impaired, affected, reduced, or released by reason of (a) Bank’s failure or delay to do or take any of the actions or things described in this Guaranty; (b) the invalidity or unenforceability of Borrower’s Liabilities or the Loan Agreements; (c) any loss of or change in priority or reduction in or loss of value of any security interest, lien, or encumbrances securing the repayment of Borrower’s Liabilities; (d) any discharge or release of Borrower from Borrower’s Liabilities. 3. Representations and Warranties Guarantor represents and warrants to Bank that: (a) The statements in the preamble to this Guaranty are true and correct. (b) This Guaranty, and Guarantor’s execution and delivery of the same to Bank, were solicited by Borrower and not by Bank. (c) Guarantor has the right, power, and capacity to enter into, execute, deliver, and perform this Guaranty.

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(d) This Guaranty, when duly executed and delivered, will constitute a legal, valid, and binding obligation of Guarantor, enforceable against Guarantor in accordance with its terms, subject to applicable bankruptcy laws or other laws affecting creditors’ rights generally or the equity powers of the courts. (e) The execution, delivery, and/or performance by Guarantor of this Guaranty shall not, by the lapse of time, the giving of notice, or otherwise, constitute a violation or breach of (1) any applicable law; or (2) any provision contained in any agreement or document to which Guarantor is now or hereafter a party or by which it is or may become bound. (f) Guarantor is now, and at all times hereafter shall be, solvent and generally able to pay its debts as such debts become due, and Guarantor now owns, and shall at all times hereafter own, property that, at a fair valuation, exceeds the sum of Guarantor’s debts. (g) Guarantor now has, and shall have at all times hereafter, capital sufficient to carry on all business transactions and all businesses and transactions in which Guarantor is about to engage. Guarantor does not intend to incur or believe that Guarantor will incur debts beyond Guarantor’s ability to pay as such debts mature. (h) There are no actions or proceedings that are pending or threatened against Guarantor that might result in any material and adverse change in Guarantor’s financial condition or materially affect Guarantor’s ability to perform Guarantor’s Liabilities. (i) Guarantor has reviewed independently the Loan Agreements, and Guarantor has made an independent determination as to the validity and enforceability thereof on the advice of Guarantor’s own counsel, and in executing and delivering the Guaranty to Bank, Guarantor is not in any manner relying on Bank as to the validity and/or enforceability of any security interests of any kind or nature by Borrower to Bank. (j) Upon written request from Bank, Guarantor agrees to furnish to Bank all pertinent facts relating to the ability of Borrower to pay and perform Borrower’s Liabilities, and all pertinent facts relating to Guarantor’s ability to pay and perform Guarantor’s Liabilities. Guarantor agrees to keep informed with respect to all such facts. Guarantor acknowledges and agrees that (1) Bank has relied and will continue to rely on the facts and information to be furnished to it by Guarantor; (2) in executing this Guaranty and at all times hereafter, Guarantor has relied and will continue to rely on Guarantor’s own investigation and on sources other than Bank for all information and facts relating to the ability of Borrower to pay and perform Borrower’s Liabilities, and Guarantor has not and will not hereafter rely on Bank for any such information or facts.

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§12.11

SECURED TRANSACTIONS

(k) Guarantor agrees to furnish to Bank, within [ninety (90)] days after the end of each year, Guarantor’s annual financial statements and state and federal tax returns for such fiscal year. The obligations of Guarantor set forth in this paragraph shall continue for the life of this Guaranty. 4. Waivers (a) Guarantor waives any and all right to assert against Bank any claims or defenses based on any failure of Bank to furnish to Guarantor any information or facts relating to the ability of Borrower to pay and perform Borrower’s Liabilities. (b) To the extent permitted by law, Guarantor waives all other defenses, counterclaims, and offsets of any kind or nature in connection with the validity and/or enforceability of this Guaranty, including, without limitation, (1) those arising directly or indirectly from the perfection, sufficiency, validity, and/or enforceability of any security interest granted by Borrower to Bank or acquired by Bank from Borrower; (2) those based on the failure or adequacy of consideration. (c) Guarantor waives any and all right to assert against Bank any claim or defense based on any election of remedies by Bank, which, in any manner, impairs, affects, reduces, releases, or extinguishes Guarantor’s subrogation rights or Guarantor’s right to proceed against Borrower for reimbursement, or any other rights of Guarantor against Borrower, or against any other person or security, including, without limitation, any defense based on an election of remedies by Bank under any provision or law or regulation of any state, governmental entity, or country. (d) Guarantor waives any right to assert against Bank as a defense, counterclaim, setoff, or cross-claim to the payment or performance of Guarantor’s Liabilities, any defense (legal or equitable), setoff, counterclaim, or claim that Guarantor may now or at any time hereafter have against Borrower or any other party liable to Bank in any way or manner. (e) Guarantor hereby waives notice of the following events or occurrences and agrees that Bank may do any or all of the following in such manner, on such terms, and at such times as Bank, in its sole and absolute discretion, deems advisable without in any way impairing, affecting, reducing, or releasing Guarantor from Guarantor’s Liabilities: (1) Bank’s acceptance of this Guaranty; (2) presentment, demand, notices of default, nonpayment, partial payment, and protest, and all other notices or formalities to which Guarantor may be entitled; (3) Borrower’s heretofore, now, or from time to time hereafter granting to Bank security interests, liens, or encumbrances in any of Borrower’s assets;

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(4) Bank’s heretofore, now, or from time to time hereafter doing any of the following: (i)

loaning moneys or extending credit to or for the benefit of Borrower, whether pursuant to the Loan Agreements or any amendments, modifications, additions, or substitutions thereto;

(ii) substituting for, releasing, waiving, or modifying any security interests, liens, or encumbrances in any of Borrower’s assets; (iii) obtaining, releasing, waiving, or modifying any other party’s Guaranty of Borrower’s Liabilities or any security interest, lien, or encumbrance in any other party’s assets given to Bank to secure such party’s Guaranty of Borrower’s Liabilities; (iv) obtaining, amending, substituting for, releasing, waiving, or modifying any of the Loan Agreements; (v)

granting to Borrower (and any other party liable to Bank on account of Borrower’s Liabilities) of any indulgences or extensions of time of payment of Borrower’s Liabilities; and

(vi) accepting from Borrower or any other party any partial payment or payments on account of Borrower’s Liabilities or any collateral securing the payment thereof or Bank’s settling, subordinating, compromising, discharging, or releasing the same. 5. Covenants and Agreements Guarantor covenants and agrees with Bank that: (a) All security interests, liens, and encumbrances heretofore, now, and at any time or times hereafter granted by Guarantor to Bank shall secure Guarantor’s Liabilities. (b) All indebtedness, liability, or liabilities now and at any time or times hereafter owing by Borrower to Guarantor are hereby subordinated to Borrower’s Liabilities. (c) All security interests, liens, and encumbrances that Guarantor now has and from time to time hereafter may have on any of Borrower’s assets are hereby subordinated to all security interests, liens, and encumbrances that Bank now has and from time to time hereafter may have thereon. (d) All indebtedness, liability, or liabilities now and at any time or times hereafter owing to Guarantor by any party liable to Bank by reason of any security interests, liens, or encumbrances granted by Borrower to Bank are hereby subordinated to all indebtedness, liability, or liabilities owed by such party to Bank. 6. Security

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§12.11

SECURED TRANSACTIONS

To secure the prompt payment to Bank of, and the prompt, full, and faithful performance of, Guarantor’s Liabilities, Guarantor grants to Bank a security interest in and lien on all of Guarantor’s now existing and/or owned and hereafter arising and/or acquired money, reserves, deposits, deposit accounts, and interest or dividends thereon, cash, cash equivalents, and other property now or at any time or times in possession or under the control of Bank or its bailee for any purpose (individually and collectively, “the Collateral”). Guarantor shall execute and/or deliver to Bank, at any time and from time to time hereafter at the request of Bank, all agreements, instruments, documents, and other written matter that Bank reasonably may request, in a form and substance acceptable to Bank, to perfect and maintain perfected Bank’s security interest in the Collateral or any other property pledged by Guarantor to secure Guarantor’s Liabilities. Bank shall have no obligation to protect, secure, or insure any of the foregoing security interests, liens, or encumbrances or the properties or interests in properties subject thereto. Guarantor warrants and represents to and covenants with Bank that (a) Guarantor has good, indefeasible, and merchantable title to the Collateral; (b) Bank’s security interest in and lien on the Collateral is now, and at all times hereafter shall be, valid and perfected, and shall have a first priority; (c) Guarantor shall not grant a security interest in or permit a lien, claim, or encumbrance on any of the Collateral in favor of any third party; (d) the addresses specified at the end of this Guaranty include and designate Guarantor’s principal residence and are Guarantor’s sole residences. Guarantor, by written notice delivered to Bank at least [thirty (30)] days prior thereto, shall advise Bank of Guarantor’s acquiring any new residence or selling any existing residence, and any new residence shall be within the continental United States of America. 7. Default The occurrence of any of the following events shall, at the election of Bank, be deemed a default by Guarantor (Event of Default) under this Guaranty: (a) if Guarantor fails to pay any of Guarantor’s Liabilities when due and payable or properly declared due and payable; (b) if Guarantor fails or neglects to perform, keep, or observe any term, provision, condition, covenant, warranty, or representation contained in this Guaranty, which is required to be performed, kept, or observed by Guarantor, and Guarantor shall fail to remedy such within [ten (10)] days of being served with written notice from Bank; (c) if the Collateral or any other of Guarantor’s assets are attached, seized, subjected to a writ of distress warrant, or levied upon, or become subject to any lien, or come within the possession of any receiver, conservator, trustee, custodian, or assignee for the benefit of creditors;

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(d) if Guarantor becomes insolvent or generally fails to pay, or admits its inability to pay, debts as they become due; (e) if a petition under Title 11 of the United States Code, or any similar law or regulation, shall be filed by Guarantor, or if Guarantor shall make an assignment for the benefit of its creditors, or if any case or proceeding is filed by Guarantor for its dissolution or liquidation; (f) if a petition under Title 11, United States Code, or any similar law or regulation shall be filed against Guarantor, or if a case or proceeding is filed against Guarantor for its dissolution or liquidation and such proceeding shall not be dismissed within [forty-five (45)] days of its filing, during which time Guarantor shall be diligently contesting such action or proceeding; (g) if Guarantor is enjoined, restrained, or in any way prevented by court order from conducting all or any material part of its business affairs, and such injunction or restraint shall not be voided, removed, or dismissed within [thirty (30)] days of the court’s order, during which time Guarantor shall be diligently contesting such action or proceeding; (h) if a notice of lien, levy, or assessment is filed of record or given to Guarantor with respect to all or any of Guarantor’s assets by any federal, state, or local government agency; (i) if Guarantor is in default in the payment or performance of any material obligation, indebtedness, or other liability to any third party, and such default is not cured within any cure period specified in any agreement or instrument governing the same; (j) if any material statement, report, or certificate made or delivered to Bank by Guarantor is not true and correct; (k) if any material adverse change in the financial condition, operations, business, or assets of Guarantor, and Guarantor shall fail to remedy such within [ten (10)] days of being served with written notice from Bank; (l) the occurrence of a default or Event of Default under any other agreement, instrument, and/or document executed and delivered by Guarantor to Bank, which is not cured by Borrower within any applicable cure period set forth in any such agreement, instrument, and/or document; (m) the occurrence of a default or event of default under the Loan Agreements; (n) the dissolution of Guarantor or if Guarantor attempts to cancel, revoke, or disclaim this Guaranty; or (o) the reasonable insecurity of Bank, and Guarantor shall fail to remedy such within [ten (10)] days of being served with written notice from Bank.

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SECURED TRANSACTIONS

8. Remedies Upon the occurrence of an Event of Default, without notice thereof to Guarantor, Guarantor’s Liabilities shall be due and payable and enforceable against Guarantor, forthwith, at Bank’s principal place of business, whether or not Borrower’s Liabilities are then due and payable, and Bank may, in its sole and absolute discretion, exercise any one or more of the following remedies that are cumulative and nonexclusive: (a) proceed to suit against Guarantor if Guarantor’s Liabilities are not immediately paid by Guarantor to Bank at Bank’s principal place of business; at Bank’s election, one or more successive or concurrent suits may be brought hereunder by Bank against Guarantor, whether suit has been commenced against Borrower, and in any such suit, Borrower may be joined (but need not be joined) as a party with Guarantor; and/or (b) reduce to cash or the like any of Guarantor’s assets of any kind or nature in the possession, control, or custody of Bank, and, without notice to Guarantor, apply the same in reduction or payment of Guarantor’s Liabilities; and/or (c) exercise any one or more of the rights and remedies accruing to Bank under the Loan Agreements, the Uniform Commercial Code of the relevant jurisdiction, and any other applicable law upon default by a debtor. Guarantor recognizes that in the event Guarantor fails to perform, observe, or discharge any of its obligations or liabilities under this Guaranty, no remedy at law will provide adequate relief to Bank, and agrees that Bank shall be entitled to temporary and permanent injunctive relief in any such case without the necessity of proving actual damage. 9. Costs, Fees, and Expenses If at any time or times hereafter Bank employs counsel for advice or other representation with respect to this Guaranty or to represent Bank in any litigation, contest, dispute, suit, or proceeding relating to this Guaranty or Bank’s rights thereunder, the reasonable costs, fees, and expenses incurred by Bank in any manner or way with respect to the foregoing shall be part of Guarantor’s Liabilities, payable by Guarantor to Bank, on demand. Without limiting the generality of the foregoing, such costs, fees, and expenses include reasonable (a) attorneys’ fees, costs, and expenses; (b) court costs and expenses; (c) court reporter fees, costs, and expenses; (d) long-distance telephone and facsimile charges; (e) expenses for travel, lodging, and food. Guarantor’s liability for all reasonable expenses and fees under this Section 9 shall also extend to the collection of any judgment that shall result from Bank’s enforcement of its rights and remedies hereunder. The obligation of Guarantor set forth in this agreement shall be continuing and shall not be merged into any judgment entered based on this Guaranty.

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§12.11

10. Miscellaneous All payments received by Bank from any source on account of Borrower’s Liabilities shall be applied by Bank in its sole discretion, and this Guaranty shall apply to and secure any ultimate balance that may be owed to Bank on account of Borrower’s Liabilities after Bank’s application. Bank’s determination as to how to apply moneys so received shall be conclusive on the undersigned. If any provision of this Guaranty or the application thereof to any party or circumstance is held invalid or unenforceable, the remainder of this Guaranty and the application of such provision to other parties or circumstances will not be affected thereby, the provisions of this Guaranty being severable in any such instance. This Guaranty shall be binding on Guarantor and inure to the benefit of Guarantor and Bank and their respective heirs, personal representatives, successors, and assigns. Whenever a notice is required or permitted to be given under this Guaranty, it shall be in writing and either delivered personally, or sent via certified mail, return receipt requested. Notice sent via certified mail shall be deemed given [two (2)] days after such notice is sent. Notice served by hand delivery shall be deemed served on the day delivered. Any written notice to Guarantor shall be to the address or addresses specified below. This Guaranty shall continue in full force and effect until Borrower’s Liabilities are fully paid, performed, and discharged and Bank gives Guarantor written notice thereof, such notice to be promptly sent by Bank after full performance of Borrower’s Liabilities. This Guaranty shall continue to be effective or be reinstated, as the case may be, if at any time payment of any of Guarantor’s Liabilities is rescinded or must otherwise be returned by Bank upon the insolvency, bankruptcy, or reorganization of Guarantor or otherwise, all as though such payment had not been made. This Guaranty is submitted to Bank at Bank’s principal place of business and shall be deemed to have been made thereat. This Guaranty shall be governed and controlled as to interpretation, enforcement, validity, construction, effect, and in all other respects by the laws, statutes, and decisions of the State of [name of governing state]. No modification, waiver, estoppel, amendment, discharge, or change of this Guaranty or any related instrument shall be valid unless the same is in writing and signed by the party against which the enforcement of such modification, waiver, estoppel, amendment, discharge, or change is sought. To the extent that Bank receives any payment on account of Borrower’s Liabilities, or any proceeds of Collateral are applied on account of Borrower’s Liabilities, and any such payment(s) and/or proceeds or any part thereof is subsequently invalidated, declared to be fraudulent or preferential, set aside, subordinated, and/or required to be repaid to a trustee, receiver, or any other party under any bankruptcy act, state or federal law, common law, or equitable cause, then, to the extent of such payment(s) or proceeds received, Borrower’s Liabilities or part thereof intended to be satisfied shall be revived and continue in full force

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§12.12

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and effect, as if such payment(s) and/or proceeds had not been received by Bank and applied on account of Borrower’s Liabilities. Guarantor agrees that Guarantor’s Liabilities hereunder shall be revived to the extent of such revival of Borrower’s Liabilities. Until expressly released in writing by Bank, this Guaranty shall be in addition to any other guaranties that Guarantor has previously given to Bank or that Guarantor may, from time to time, hereafter give to Bank relating to Borrower’s Liabilities. Guarantor warrants and represents to Bank that Guarantor has read this Guaranty and understands the contents hereof and that this Guaranty is enforceable against Guarantor in accordance with its terms. GUARANTOR AND BANK AGREE THAT ALL ACTIONS OR PROCEEDINGS ARISING DIRECTLY, INDIRECTLY, OR OTHERWISE IN CONNECTION WITH, OUT OF, RELATED TO, OR FROM THIS GUARANTY SHALL BE LITIGATED ONLY IN COURTS HAVING SITUS WITHIN THE COUNTY OF [name of county that is venue of litigation], STATE OF [name of state that is venue of litigation]. GUARANTOR AND BANK CONSENT AND SUBMIT TO THE JURISDICTION OF ANY LOCAL, STATE, OR FEDERAL COURT LOCATED WITHIN SAID COUNTY AND STATE. GUARANTOR HEREBY WAIVES ANY RIGHT GUARANTOR MAY HAVE TO TRANSFER OR CHANGE THE VENUE OF ANY LITIGATION BROUGHT AGAINST GUARANTOR IN ACCORDANCE WITH THIS PARAGRAPH. GUARANTOR AND BANK IRREVOCABLY WAIVE ANY RIGHT TO TRIAL BY JURY IN ANY ACTION OR PROCEEDING (A) TO ENFORCE OR DEFEND ANY RIGHTS UNDER OR IN CONNECTION WITH THIS GUARANTY OR ANY AGREEMENT DELIVERED OR THAT MAY IN THE FUTURE BE DELIVERED IN CONNECTION HEREWITH, OR (B) ARISING FROM ANY DISPUTE OR CONTROVERSY IN CONNECTION WITH OR RELATED TO THIS GUARANTY, OR ANY SUCH AGREEMENT, AND AGREE THAT ANY SUCH ACTION OR PROCEEDING SHALL BE TRIED BEFORE A COURT AND NOT BEFORE A JURY. [Signatures of Guarantors] J. Caselaw Highlights 1. [12.12] Guarantor Who Signs an Unconditional Guaranty Is Unconditionally Liable When Borrower Defaults Richard Kruse, a sophisticated businessman, executed a guaranty of a revolving credit loan of $500,000, made by the National Bank of Indianapolis to SignTec, LLC. Kruse v. National Bank of Indianapolis, 815 N.E.2d 137 (Ind.App. 2004). The guaranty stated that Kruse absolutely and unconditionally guaranteed SignTec’s obligations to the bank and that Kruse’s liability continued in full force and effect until the guaranty was revoked by written notice delivered to the bank. There was no limit on the amount of Kruse’s liability, which included all attorneys’ fees,

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§12.13

collection costs, and enforcement expenses. The guaranty expressly permitted the bank to extend or renew SignTec’s indebtedness without notice to Kruse. SignTec’s loan agreement with the bank identified Kruse as one of the three guarantors of SignTec’s debt to the bank. The three guarantors signed both the loan agreement and separate guaranties. When SignTec’s loan matured on March 28, 2002, the bank approved an extension to June 1, 2002. This first amendment was executed on behalf of SignTec and by the three guarantors. On June 1, 2002, a second amendment extending the maturity date to May 1, 2003, was signed on behalf of SignTec but not by the three guarantors. SignTec filed a petition for relief under Chapter 11 of the Bankruptcy Code in December 2002, and, shortly thereafter, the bank sent each guarantor a demand for payment of $499,165.35, plus per diem interest. In April 2003, the bank filed suit against the guarantors. Kruse contended he was not liable because the bank (1) failed to advise him of SignTec’s misconduct, (2) materially altered the underlying obligation without his consent, (3) impaired the collateral securing the debt, and (4) did not deal with him in good faith. But the court said none of these defenses were meritorious since the guaranty was absolute and unconditional. As to the first point, the court said Kruse was not entitled to notice of SignTec’s alleged misconduct (without identifying what the misconduct was) because the guaranty was absolute and because, under the terms of the guaranty, Kruse had waived all notice. On the second point, the bank’s alleged material alteration by allowing SignTec to borrow amounts in excess of the borrowing base, the court ruled that Kruse had agreed to guarantee SignTec’s debts in an unlimited amount so that even if the bank had made loans to SignTec in excess of the borrowing base, that was not a defense. Another point was Kruse’s contention that the bank had violated a fiduciary duty it owed to him and failed to deal with him fairly and in good faith. This contention was also held to be without merit. The court said there was no special relationship of trust and confidence that could give rise to a fiduciary relationship. It also said that this was not a case of unequal bargaining strength, nor was there any indication that the bank wrongfully abused a confidence placed with it by Kruse “so as to obtain an unconscionable advantage.” 815 N.E.2d at 148. On the matter of good faith, Kruse premised his position on an allegation that the bank stood idly by while the collateral for SignTec’s loan was dissipated. In response, the court said the facts of the case did not warrant a finding that the bank engaged in “a conscious doing of a wrong because of dishonest purpose or moral obliquity.” 815 N.E.2d at 149. Finally, the clause in the guaranty relating to attorneys’ fees and costs permitted the bank to recover the fees and expenses it incurred in defending against Kruse’s appeal, said the court. Guarantors tend to be creative in devising reasons why they should not respond to a demand to satisfy a defaulted obligation. Use of an absolute and unconditional guaranty with no limit as to amount and with appropriate waivers will generally permit the bank to overcome virtually every defense advanced by a guarantor. 2. [12.13] Liability on a Springing Guaranty Can Be Generated by a Prohibited Act That Caused No Loss to the Lender In CSFB 2001-CP-4 Princeton Park Corporate Center, LLC v. SB Rental I, LLC, 410 N.J.Super. 114, 980 A.2d 1 (2009), the lender made a $13.3 million mortgage loan, guaranteed by

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§12.14

SECURED TRANSACTIONS

the borrower’s principals. The loan and the guaranty were nonrecourse to the borrower and its principals, except upon the occurrence of certain events, including the imposition of subordinate financing on the mortgaged property. During the term of the loan, the borrower obtained $400,000 in subordinate financing secured by a junior mortgage on the property without obtaining the senior lender’s consent. The $400,000 junior mortgage was fully satisfied 7 months later. However, 18 months after the junior mortgage was repaid, the borrower stopped making payments on the first mortgage. This resulted in an uncontested foreclosure action and a sale of the property, leaving a deficiency due to the first mortgage lender. Following completion of the uncontested foreclosure action, the senior lender claimed that the junior mortgage financing triggered the full recourse provisions of the guaranties and sought recovery for its losses against the borrower’s principals. The principals argued that because the borrower cured the very breach that allegedly triggered their personal liability some 18 months prior to the default that led to foreclosure, the lender was not harmed. The court decided that it was unimportant that the junior financing was satisfied before the borrower’s default on the senior financing. The court focused on the fact that the borrower breached an obligation the parties had agreed posed a special risk to the senior lender. By granting the second mortgage lien, the principals’ action, according to the court, “had the potential to affect the viability and value of the collateral that secured the original loan.” 980 A.2d at 7. The court noted that the parties had agreed on the consequences for such an act — the springing of the full recourse provisions of the guaranty. The court concluded that the guarantors “may not now escape the consequences of their bargain” and imposed liability against them for the deficiency. Id. The court distinguished the imposition of this liability from damages that constitute a penalty on the grounds that the lender suffered a loss in a definite amount (i.e., the deficiency). Although the triggering event was not an intrinsically pernicious act, the court said that the burden of repaying the junior mortgage might have caused an eventual default on the first mortgage loan. In the final analysis, the particular reason for the departure from the nonrecourse standard was not relevant to the liability of the guarantors. The holding of the case is akin to a strict liability standard. To paraphrase the court, the parties’ bargain, once made, is unavoidable. Even though the result in this case seems harsh, it is based on the deal that the parties struck. And so long as a lender does no more than insist on compliance with the terms agreed on, guarantors have no valid basis for complaint. 3. [12.14] Guaranty Applies to Both Original and Renewal Notes TW General Contracting Services, Inc. v. First Farmers Bank & Trust, 904 N.E.2d 1285 (Ind.App. 2009), involved the interpretation of an absolute and unconditional guaranty of payment. In May 2005, TW executed two notes in favor of the bank — one for $110,000, and the other for $130,000. At the same time, Jack Taylor, Carolyn Taylor, Harland A. Wendorf, and Delores J. Wendorf executed unconditional guaranties of payment. TW’s notes were renewed in June 2006. Subsequently, in 2007, TW executed two other notes — one for $20,003, and the other for $341,000. By February 2008, TW was in default, and the bank sued the four guarantors on one of the two renewal notes, as well as both of the 2007 notes. The guarantors contended they were not liable because neither the renewal note nor the 2007 notes were specifically referenced in the guaranties. The court disagreed and ruled in favor of the bank.

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GUARANTIES

§12.16

Beginning its discussion, the court pointed out that a guaranty is a contract, and so the determination of liability depended on how the contract was to be interpreted. Looking at each document, the court noted that each was an absolute and unconditional guaranty that covered “every debt, liability and obligation of every type and description which Borrower may now or any time hereafter owe to Lender.” 904 N.E.2d at 1288. Each guaranty also stated that it “shall continue to be in force and be binding upon the Undersigned, whether or not all Indebtedness is paid in full, until this guaranty is revoked by written notice actually received by the Lender.” [Emphasis omitted.] 904 N.E.2d at 1289. The guarantors admitted they had never revoked their guaranties. The guarantors argued the guaranties were ambiguous and that the ambiguities should be construed against the bank as the creator of the documents. The court discerned no ambiguity in the documents. As to the contention that the guaranties did not specifically mention the notes that were in default and that precipitated the lawsuit, the court said the guaranties were global in scope since they covered each and every debt, liability, and obligation of every type and description that TW incurred or thereafter created in favor of the bank. A well-drafted guaranty is often a lender’s best friend. 4. [12.15] Transfer of Note Automatically Transfers the Guaranty American First Federal, Inc. v. Battlefield Center, L.P., 282 S.W.3d 1 (Mo.App. 2009), raised the question of the standing of the assignee of a note to enforce a guaranty of the note in the absence of any specific instrument of assignment. In February 2003, Battlefield Center executed three promissory notes in favor of Allegiant Bank. The notes were secured by three leasehold deeds of trust. Christopher J. Kersten executed a guaranty of payment of each of the notes to the bank and its assignees. Under an asset sale agreement dated December 10, 2004, the bank sold the notes to American First. The three deeds of trust were assigned to American First as part of the transaction. An allonge was attached to each note making each note payable to American First. The allonges did not mention Kersten’s guaranty. The asset sale agreement stated that the loans evidenced by the notes as well as all collateral documents, including all guaranties, were being sold by the bank and that the bank would execute and deliver a bill of sale to American First. The bill of sale was never delivered. Thus, lacking any specific instrument addressing the transfer of the guaranty, the question was whether American General acquired the guaranty by operation of law. Citing the general rule that the transfer of an obligation operates as an assignment of a guaranty even if there is no reference to the guaranty in the assignment, the court ruled for American First. To eliminate any possible confusion when purchasing debt obligations backed up by guaranties and collateral, the purchase agreement should specify in detail what is being purchased, and an instrument of transfer should be executed and delivered by the seller that specifically enumerates the items being assigned. 5. [12.16] Guarantor Cannot Prevent Enforcement of Guaranty Based on Alleged Oral Statements by Lender States other than Illinois have statutes designed to protect lenders against specious claims by borrowers and guarantors. Such a statute was invoked by a bank that was seeking to enforce a

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§12.17

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guaranty in Cowlitz Bank v. Leonard, 162 Wash.App. 250, 254 P.3d 194 (2011). Between 2006 and 2009, Tytan International, Inc., borrowed $660,000 from Cowlitz Bank. (On July 30, 2010 the Washington Department of Financial Institutions closed Cowlitz Bank, and the FDIC was appointed as receiver.) Mark Leonard guaranteed the debt. In October 2009, the bank declared the loan in default and demanded payment. No payment was made, and a lawsuit was filed against Tytan and Leonard. Leonard defended on the grounds that the bank had promised not to call the loan if he kept the banking relationship at Cowlitz. The court cited the Revised Code of Washington §19.36.110 which provides that “any prior or contemporaneous oral agreements between the parties are superseded by, merged into, and may not vary the credit agreement.” 254 P.3d at 195. In addition, the court noted that the loan agreements Leonard signed on behalf of Tytan all contained a caveat that oral agreements to forbear from enforcing repayment of a default are not enforceable in Washington. The court ruled for the bank and awarded attorneys’ fees and costs. This case demonstrates that protective statutes are in place in states other than Illinois and are extremely useful as a defense mechanism against claims that often are raised by borrowers and guarantors seeking to escape responsibility for their debts. 6. [12.17] Statute of Frauds Prevents a Guarantor from Asserting an Alleged Oral Release of the Guaranty Can a guarantor successfully assert that he was orally released from his guaranty? That was the issue before the court in FirstMerit Bank, N.A. v. Inks, 138 Ohio St. 3d 384, 7 N.E.3d 1150 (2014). On June 27, 2005, Ashland Lakes, L.L.C., borrowed $3.5 million from FirstMerit Bank, executing a promissory note secured by a mortgage on 130 acres of land in Ashland County, Ohio, and the personal guaranties of David and Deborah Inks and David and Jacqueline Slyman. The note and the guaranties contained confession of judgment clauses. In January 2009, the loan was in default, and the bank initiated foreclosure proceedings. The parties executed two successive written standstill agreements and a third written forbearance agreement to avoid foreclosure. Each contained a confession of judgment clause as well as a clause stating that there could be no change to the agreements unless it was in writing and signed by the parties. In January 2011, Inks and Slyman met with a senior officer of the bank regarding a release of the bank’s mortgage and possible deficiencies. They did not resolve their differences. Upon the expiration of the standstill agreements, a decree of foreclosure was entered with an auctioneer appointed to conduct a sale on May 9, 2011. The bank sent Inks and Slyman a term sheet on March 4, 2011, detailing the conditions for canceling the May 9, 2011, auction. FirstMerit stated it would cancel the auction and not exercise its remedies for 45 days if it received a $200,000 deposit and a $9,000 appraisal fee by March 7, 2011, along with an executed forbearance agreement. The bank also agreed to release its mortgage and the guarantors upon receipt of certain payments on certain dates. But there was to be no forbearance until the bank and the guarantors signed a written forbearance agreement. On March 7, 2011, Inks told a bank officer he could raise $150,000 for a deposit and asserted the bank officer said that was “doable.” 7 N.E.3d at 1152. The bank officer had a different

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§12.18

version. He asserted only that the bank “might consider” a lower deposit. Id. Following the conversation, the bank officer sent Inks a forbearance agreement calling for a $200,000 deposit. Inks responded with a letter objecting to the agreement and referring to $150,000 available the next day. On March 8, 2011, Inks and the bank officer spoke again with Inks ultimately being told it was too late to make the payment and that the property would be sold. The following day, March 9, 2011, the property was sold at auction. The sale resulted in a deficiency with the bank recovering a $3,337,467.15 judgment against the Inkses and the Slymans. Faced with the judgment, the Inkses and the Slymans moved for relief from the judgment, contending that an oral settlement agreement had been reached with the bank. The legal issue before the court was whether the settlement agreement the Inkses and the Slymans argued they had reached with the bank was enforceable in the face of the Ohio Statute of Frauds. The court held that it was not. The court said allowing defendants to employ an oral contract that fell within the statute of frauds as a defense would be enforcing the oral contract even though that same right is denied to the plaintiff, citing McGinnis v. Fernandes, 126 Ill. 228, 19 N.E. 44, 45 (1888). It also said: “Thus, we adhere to the well-established principle that the statute of frauds bars a party from enforcing an oral agreement falling within the statute in either the prosecution or defense of an action.” 7 N.E.3d at 1155. But did the agreement fall within the coverage of the Statute of Frauds? The court said that while a mortgage functions as security for a debt, “it also is a conveyance of property that passes the property conditionally to the mortgagee” and “an agreement to release lands from the effect of a mortgage is an agreement for the transfer of real property and thus falls within the Statute of Frauds.” 7 N.E.3d at 1155, quoting Casey v. Travelers Insurance Co., 585 So.2d 1361, 1363 (Ala. 1991). Lenders faced with an allegation that an oral settlement agreement calling for the release of a mortgage is enforceable can comfortably respond that enforcement is barred by the statute of frauds. 7. [12.18] Guarantor May Not Raise Defenses to Enforcement of a Guaranty That Are Purely Derivative In re Miller, No. 12-32487, 2013 WL 3445996 (Bankr. E.D.Wis. July 9, 2013), arose out of a Chapter 11 petition filed by Joseph G. Miller and an adversary proceeding initiated by Layton State Bank for a determination of nondischargeability of a guaranty Miller had signed on November 19, 2007. While the adversary proceeding was pending, the bank moved to dismiss certain defenses to enforcement of the guaranty that Miller had raised. The court granted the bank’s motion. Miller Ridge, LLC, entered into a construction loan agreement with the bank and signed a promissory note in favor of the bank, as well as a mortgage, assignment of rents, and commercial security agreement. Miller signed a continuing guaranty of payment and performance. Under the terms of the guaranty, Miller waived any rights or defenses based on suretyship or impairment of collateral and any claim to, at any time, deduct from the amount guaranteed any setoff, counterclaim, recoupment, or similar right whether the claim, demand, or right could be asserted by the borrower or the guarantor or both of them. In 2011, when Miller Ridge was in default under the note and mortgage and real estate taxes were past due, the bank exercised its rights under the assignment of rents. The bank entered into a

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§12.19

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rent collection and blocked account agreement, under which the bank would receive all rents and pay all operating expenses. But Miller claimed the bank failed to make full or timely payment of all the operating expenses. On October 21, 2011, a fire occurred at the building, causing damage of more than $100,000 and preventing occupancy of six units. Miller alleged the insurance coverage lapsed because the bank did not pay the premium, resulting in no funds to repair the damage or compensate for lost rental income. When the bank filed its adversary proceeding, Miller responded with counterclaims of breach of fiduciary duty, lender liability, equitable subordination, and breach of the duty of good faith. The court rejected all of Miller’s counterclaims. The court began its discussion by pointing out that Miller was not personally liable on any of the loan documents. His liability arose out of the guaranty he had signed. The court said: A guarantor can only sue (or defend) for direct harm to itself resulting from the contractual relationship to which it is a party, and [Miller] was not a party to the loan. The claims asserted by [Miller] based upon lender liability and breach of duty of good faith relating to acts allegedly taken by the bank following the default by Miller Ridge on the loans, are claims of the LLC, not the guarantor, Mr. Miller. Any harm to [Miller] is derivative of the alleged harm to Miller Ridge and, as such, any resulting claims must be brought by Miller Ridge. . . . Additionally, [Miller] specifically waived any right to bring a counterclaim pursuant to the terms of the Commercial Guaranty. [Citations omitted.] 2013 WL 3445996 at *3. The court also said: “Here, no independent acts against [Miller] alone are alleged; all alleged wrongs were to Miller Ridge, LLC, and thus are derivative as to [Miller].” 2013 WL 3445996 at *6. The court’s conclusion was that Miller lacked standing to raise defenses that belonged to the LLC and, further, that he had specifically waived all right to assert counterclaims. This decision emphasizes the rule that guarantors cannot attempt to defeat the enforcement rights of lenders by invoking defenses related to the lender’s conduct vis-à-vis the borrower.

III. [12.19] DISCHARGING THE GUARANTOR; PRESERVING RIGHTS AGAINST THE GUARANTOR Three areas of law pertaining to the preservation of rights under guaranties that warrant attention are a. pre-default discharge of the guarantor by the conduct of the bank; b. pre-default termination of the guaranty by the guarantor; and c. post-default discharge of the guarantor by the conduct of the bank.

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§12.21

A. Pre-Default Discharge of the Guarantor by Conduct of the Bank 1. [12.20] Advising the Guarantor of the Nature of the Risk; Sample Language A guarantor assumes a risk when the guaranty is executed. It is the risk set forth in the underlying loan agreement. If the risk changes, the guarantor must be advised. In American National Bank of San Francisco v. Donnellan, 170 Cal. 9, 148 P. 188 (1915), the court ruled that a guaranty could not be enforced by a bank because the guarantors were induced to execute a guaranty without disclosure of facts pertinent to the risk being assumed. The president of the bank had procured the guaranty to cover stock speculation losses previously incurred by the president’s son and an assistant bank cashier. The bank president, however, failed to reveal the real reason the guaranty was solicited and did not disclose the losses previously sustained. Obviously, knowledge of the risk is far more significant to an outsider guarantor than to an insider guarantor. A change in risk is usually well known to the insider guarantor, but a change in risk may not be known when the guarantor is an outsider. In either case, the guaranty should absolve the bank from this duty. The following is a drafting suggestion: Guarantor is presently informed of the financial condition of the Borrower and of all other circumstances that a diligent inquiry would reveal and that bear on the risk of nonpayment of the Obligations. Guarantor hereby covenants that it will continue to keep itself informed of Borrower’s financial condition, the status of other guarantors, if any, and of all other circumstances that bear on the risk of nonpayment. Absent a written request for such information by Guarantor to Bank, Guarantor hereby waives its right, if any, to require Bank to disclose to it any information that Bank may now or hereafter acquire, concerning such condition or circumstances including, but not limited to, the release of or revocation by any other guarantor. This is justifiable, particularly in the case of banks, given the number of borrowers whose indebtedness is guaranteed and the volatility of their respective businesses. 2. [12.21] A Change in the Underlying Obligation Because the underlying obligation is incorporated in the guaranty, a guarantor will not be held liable for a contract he or she did not agree to assume. A change in the underlying obligation, even one that benefits the borrower, will discharge the guarantor. Obviously, if the bank and the borrower agree to extend the time for payment or performance, the guarantor is discharged unless the guaranty specifically permits such extension. The guaranty might provide as follows: “The liability of the undersigned under this guaranty shall be unconditional irrespective of . . . any change in the time, manner, or place of payment.” The issue of whether a particular change so materially alters the original contract so as to discharge the guarantor arises frequently. The basic determination is whether the change modifies the risk the guarantor agreed to assume when the guaranty was signed.

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§12.22

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a. [12.22] Change of Terms; Sample Language Often, the issue is whether a change in the time for payment discharged the guarantor from its obligations. A change in timing of payment will materially alter the guarantor’s obligations. The guarantor will be discharged of all of its obligations under the guaranty. The guarantor should waive these kinds of defenses in order to prevent these problems. Suggested language might be the following: Guarantor hereby authorizes Bank, without notice or demand and without affecting its liability hereunder, from time to time to (a) renew, compromise, extend, accelerate, or otherwise change the time for payment or the terms of any of the Obligations, or any part thereof, including, without limitation, increasing or decreasing the rate of interest thereof; (b) take and hold security for the payment of the Obligations guaranteed hereby and exchange, enforce, waive, and release any such security; (c) apply such security and direct the order or manner of sale thereof as Bank in its discretion may determine; (d) release or substitute any one or more endorser(s) or guarantor(s); and (e) assign, without notice, this Guaranty in whole or in part and/or Bank’s rights hereunder to anyone at any time. Guarantor agrees that Bank may do any or all of the foregoing in such manner, on such terms, and at such times as Bank, in its discretion, deemed advisable, without, in any way or respect, impairing, affecting, reducing, or releasing Guarantor from its undertakings hereunder, and Guarantor hereby consents to each and all of the foregoing acts, events, and/or occurrences. Clauses such as these have been held to be valid. Failure to obtain a guarantor’s consent to modification of the guaranteed obligation creates a risk of discharging the guarantor. In Frost National Bank v. Burge, 29 S.W.3d 580 (Tex.App. 2000) (decided under Texas law), one of the key issues before the court was whether a guarantor had assented to the borrowers’ and lender’s changing the maturity date of the note by the language of a pledge agreement he had signed. Charles E. Burge and his wife sold a residence to H&H Building Interests, Inc., in August 1993 for $375,000. H&H wanted to tear down the existing structure and build a new home for sale on a speculative basis. Burge financed the entire purchase price by taking back two promissory notes — one for $175,000 and the other for $200,000. In December 1993, H&H obtained a construction loan from Frost National Bank, executing a note for $865,000 secured by a deed of trust and security agreement. But the bank wanted additional collateral. Burge agreed to give the bank the $200,000 he received when the construction loan was funded. He did so by purchasing a $200,000 certificate of deposit from the bank and signed a pledge agreement in favor of the bank. Burge apparently did not attend the execution of the construction loan documents and had the impression the construction loan had a two-year maturity. After the loan documents had been executed by H&H but before the bank signed them, a clerical error was noted. The note evidencing the construction loan showed the maturity date as December 28, 1995, rather than December 28, 1994, the correct date. The bank advised H&H that no funds would be advanced unless the date was corrected. H&H’s president

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§12.23

returned to the bank, struck out the incorrect year, inserted the correct maturity date, and initialed the correction. However, neither H&H nor the bank advised Burge of the change in the maturity date. On December 28, 1994, the bank advised Burge, both telephonically and by letter, that the note had matured. The bank subsequently granted H&H an extension until April 1995, but H&H did not satisfy the note. In June 1995, the bank served Burge with a formal notice of default. Burge did not respond, and the bank set off his certificate of deposit and credited the proceeds toward the unpaid balance of the note. The real estate was sold at auction for $600,000. A complex lawsuit followed, but attention is focused on Burge’s claim against the bank for having applied the certificate of deposit to the note. The first issue the Texas court had to decide was whether the note had been materially altered. If it had, Burge was discharged from liability. But the court did not hold there was a material alteration. It said the note had been changed simply to accurately reflect the parties’ original intentions. It noted that the note was signed concurrently with a deed of trust that referred to a 12-month note. This convinced the court that there was no material alteration. But the bank still was not out of the woods. Burge said that even if the date change was not material, he was discharged because the parties had not obtained his assent to the change. The bank’s response was that Burge had assented because the document he signed contained the following language: [The] undersigned [Burge] . . . authorizes [the Bank] . . . to renew or extend the time of payment, or grant any other indulgence concerning [the Note]. 29 S.W.3d at 591. The court read this language only to permit a renewal or extension of the maturity of the note but not a shortening of its maturity date. It adhered to the long-standing rule that, when in doubt, the language of the guaranty will be interpreted to favor the guarantor. Bankers should always obtain a reaffirmation from the guarantor whenever there is any question of whether a change in the underlying obligation might not be covered by the language of the guaranty. See §12.27 below for a sample reaffirmation of guaranty letter. b. [12.23] Negating the Underlying Obligation: Extension or Novation The elements of a novation are a prior valid obligation, a subsequent agreement by all of the parties to the new contract, the extinguishment of the old contract, and the validity of the new contract. The consolidation of separate indebtedness covered by separate guaranties into one obligation discharges the guarantor. Helene Burgess owned three Healthy Pleasures grocery stores, each separately incorporated and individually liable for its own debts. United Natural Foods, Inc. v. Burgess, 488 F.Supp.2d 384 (S.D.N.Y. 2007). United Natural Foods was a distributor of natural foods that supplied the stores. In May 1998, Burgess executed a credit application with United Natural that included a personal guaranty for two of the corporations, and in 2001, an application for the third corporation was signed on behalf of Burgess by her store manager. (The issue of whether the manager was authorized to sign on behalf of Burgess turned out to be a moot point.)

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§12.24

SECURED TRANSACTIONS

The separate guaranties obligated Burgess to pay the invoices that United Natural rendered to each store. United Natural provided food products to the stores from 1998 until 2003. By mid2003, the three stores collectively owed United Natural more than $2 million for products it had delivered. United Natural threatened a lawsuit, and discussions began about a debt extension. On November 5, 2003, Burgess sold her shares in the three corporations to Bashar Owar, one of the store managers. One of the stores was immediately closed. In December 2003, United Natural began shipping products on a COD basis. After further negotiations, a settlement agreement was negotiated that included a single promissory note. Under the settlement agreement, the debts of the three corporations were consolidated into one note making each corporation jointly and severally liable for the entire indebtedness. All note payments were to be first applied to the indebtedness of the store that was closed. The note payments were scheduled for a period of ten years. Burgess did not consent to the settlement agreement or the consolidated note. After only a small portion of the debt was satisfied, the two remaining stores closed, and United Natural sued Burgess on her guaranties. Burgess defended on the grounds that she had been discharged from liability on her guaranties by the execution of the settlement agreement and consolidated note. The court agreed. The court said that originally each corporation was invoiced separately and was responsible for only its own invoices. But the settlement agreement and note changed the obligation of the three corporations by making them jointly and severally liable for the consolidated debt of $2,259,272.47. That is, by the terms of the settlement agreement, each corporation was liable not only for its own debts, but also for the debts of the other two corporations. Furthermore, the settlement agreement called for note payments received from the two stores that remained open to first be applied to the debt of the closed store. The terms of payment were ten years rather than the thirty-day period called for in the original invoices. The court said the consolidated note replaced the invoices as the operative debt instrument and that Burgess’s guaranty did not survive the modifications of the original invoice debts. When modifying an indebtedness that is backed up by a guaranty, it is critical that the guarantor’s consent be obtained if the guarantor’s liability is to be preserved, unless the guaranty expressly permits such modification. c. [12.24] The Borrower Changes A change in the borrower will discharge the guarantor when the guarantor’s risk increases. Not every change, however, effects a discharge. For example, when the only deviation from the terms of the guaranty is a change in the borrower’s corporate name, no discharge occurs. 3. [12.25] Release of Coguarantor; Sample Language A compromise settlement made by one guarantor to induce a release will release all other noncontributing guarantors unless the settlement document contains a reservation of rights against the noncontributing guarantors. Connecticut National Bank v. Rehab Associates, 300 Conn. 314, 12 A.3d 995 (2011). A suggested drafting approach to avoid releasing the remaining guarantor(s) is the following:

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GUARANTIES

§12.26

The liability of the undersigned under this guaranty shall be unconditional irrespective of the acceptance of additional parties or the release of anyone primarily or secondarily liable on the indebtedness. But there are circumstances in which release of one guarantor will have no effect on the liability of other guarantors. The release of one guarantor did not release other coguarantors. In Private Bank & Trust Co. v. EMS Investors, LLC, 2015 IL App (1st) 141689, 33 N.E.3d 892, 393 Ill.Dec. 148, the court ruled that the bank’s release of one borrower did not release co-borrowers. Herbert Emmerman and Cheryl Bancroft created a limited liability company named EMS Investors, LLC, to convert a downtown Chicago apartment building into a condominium. They borrowed $1.62 million from Private Bank on a note with joint and several liability. Another entity Emmerman and Bancroft controlled, named Equity Marketing Services, Inc., guaranteed the loan. When the real estate market soured in 2008, the $1.62 million loan went into default. Bancroft filed for relief under Chapter 11 of the Bankruptcy Code and negotiated a settlement with Private Bank. The settlement was a full release from liability on the $1.62 million loan. The settlement agreement had a clause stating that it was not for the benefit of any third party. When the mortgage loan fell due, Private Bank sued Emmerman on the note and Equity Marketing on its guaranty. Emmerman contended that when Private Bank released Bancroft, the legal effect was to release him. The court did not agree. Emmerman based his defense to Private Bank’s claim on the absence of a reservation of rights clause in the Bancroft settlement agreement. The court began its discussion by noting that a joint and several obligation creates two separate causes of action because there are two separate contracts, one for several performance and another for joint performance. The court did admit that, in the case of joint and several liability, a release of one obligor may release another obligor. But it qualified that statement by also noting the result is different when “a contrary intent appears from the face of the document with the release.” 2015 IL App (1st) 141689 at ¶19. Forgoing an opportunity to pass on the thirdparty language in the Bancroft settlement, the court nonetheless ruled in favor of Private Bank. The court cited testimony of a bank officer that the settlement was not intended to affect Emmerman’s liability and Emmerman’s testimony that he knew the bank intended to collect from him. Thus, the court concluded that the surrounding circumstances made it clear that Private Bank had no intention of releasing Emmerman. Although the court ruled in favor of Private Bank, it is important that, when one of several co-borrowers or coguarantors negotiates a settlement and is released from liability, the agreement include a reservation of rights against other parties who are liable on the debt. 4. [12.26] Impairment of Collateral When the bank releases any of the collateral it holds for payment or performance by the borrower, the guarantor is discharged to the extent of the value of the collateral released unless the guaranty provides otherwise.

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§12.27

SECURED TRANSACTIONS

A guarantor remains liable on an unconditional guaranty even after the collateral securing the debt is released. The term “release” includes the failure to perfect a contemplated lien or security interest. It also includes the surrender of a fully perfected lien or security interest. In a New York case, Sklaroff v. Rosenberg, 125 F.Supp.2d 67, 69 (S.D.N.Y. 2000), the guarantors executed a guaranty that provided as follows: [the guarantors] hereby consent that from time to time, before or after any default by the borrower . . . with or without further notice to or assent from [the guarantors], any security at any time held by or available to [NHL] for any obligation of the Borrower . . . may be exchanged, surrendered or released and any obligation of the Borrower . . . may be changed, altered, renewed, extended, continued, surrendered, compromised, waived or released in whole or in part . . . and the [guarantors] shall remain bound under this guaranty notwithstanding any such exchange, surrender, release, change, alteration, renewal, extension, continuance, compromise, waiver, inaction, extension of further credit or other dealing. Subsequent to the execution and delivery of the guaranty, the defendant guarantors obtained the release of a mortgage that secured repayment of a $4.3 million debt in exchange for a cash payment of $885,000. When sued on their guaranty, the guarantors argued that the cash payment extinguished their liability, but the court disagreed, holding that the guarantors remained liable on their guaranty because the release of the mortgage had no effect on the guarantors in light of the specific language of the guaranty that anticipated a possible release of collateral. A well-drafted unconditional guaranty should provide, among other things, that the release of any security for the debt does not release the guarantor. 5. [12.27] Failure To Perfect Is a Form of Impairment of Collateral; Sample Reaffirmation of Guaranty Letter In First Bank & Trust Company, Palatine v. Post, 10 Ill.App.3d 127, 293 N.E.2d 907 (1st Dist. 1973), Palatine Welding Sales and Manufacturing, Inc., secured a loan from First Bank and Trust Company to purchase a lathe. The bank obtained a security interest in the lathe, the debtor having executed a note, security agreement, and Uniform Commercial Code (UCC) financing statement. Concurrently, the defendant guarantors executed a personal guaranty of the indebtedness. The bank failed to file the financing statement. Palatine Welding later went bankrupt. The trustee in bankruptcy sold the lathe, with the proceeds going into the estate. Suit was brought against the guarantors to enforce their guaranty; the guarantors’ defense was premised on the impairment of collateral rule. The court ruled in favor of the guarantors. To avoid the issue of an unintended release of a guarantor, the bank can and should have the guarantor execute a reaffirmation of guaranty, which would read as follows:

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GUARANTIES

§12.28

REAFFIRMATION OF GUARANTY TO:

[name of bank]

Dear ____________: The undersigned are financially interested in [name of corporation], a [corporate form] corporation (Borrower), and understand that you have agreed to amend the Loan and Security Agreement dated [date of security agreement] (as from time to time heretofore supplemented or amended, the “Loan Agreement”), by and between you and Borrower to extend the maturity date of the Revolving Credit Note and the Loan Agreement, with which the undersigned are familiar and to which the undersigned hereby consent. The undersigned have heretofore unconditionally guaranteed all indebtedness due you from Borrower. To induce you to execute and deliver such amendment to the Loan Agreement and accept the Note referred to herein, the undersigned hereby reaffirm all of the terms, covenants, and conditions of the Continuing Guaranty which the undersigned executed on [date of guaranty], in your favor. Dated: [date signed] [signatures of guarantors] 6. [12.28] Bank’s Duty To Pursue the Borrower; Sample Waiver Language There are statutes in a number of states that have established an important principle regarding the bank’s duty to pursue the borrower. These statutes provide that a guarantor, with proper notification, may require the bank to first proceed against the borrower. If the bank fails to comply, the guarantor is discharged to the extent of the damage caused by the failure to pursue the borrower. The doctrine is statutorily imposed in Alabama, Arizona, Arkansas, California, Georgia, Illinois, Indiana, Iowa, Kentucky, Mississippi, Missouri, Montana, North Carolina, North Dakota, Ohio, Oklahoma, Pennsylvania, South Dakota, Tennessee, Texas, Virginia, Washington, and West Virginia. An example of the language is found in the following Georgia statute: Any surety, guarantor, or endorser, at any time after the debt on which he or she is liable becomes due, may give notice in writing to the creditor, his or her agent, or any person having possession or control of the obligation, to proceed to collect the debt from the principal or any one of the several principals liable therefor; and, if the creditor or holder refuses or fails to commence an action for the space of three months after such notice (the principal being within the jurisdiction of this state), the endorser, guarantor, or surety giving the notice, as well as all subsequent endorsers and all cosureties, shall be discharged. To comply with the requirements of this Code section, the notice must specifically state that the creditor loses his or her rights to pursue the surety, guarantor, or endorser, as well as any cosureties,

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§12.28

SECURED TRANSACTIONS

coguarantors, or endorsers, if the creditor does not commence legal action within three months after receiving the notice. Further, any notice which does not state the county in which the principal resides shall not be considered to be in compliance with the requirements of this Code section. Ga. Code Ann. §10-7-24. The guaranty, therefore, should contain an express waiver of this right. Suggested language might read: As a condition to payment or performance by Guarantor under this Guaranty, Bank shall not be required to, and Guarantor hereby waives any and all rights to require Bank to, prosecute or seek to enforce any remedies against Borrower or any other party liable to Bank on account of the Obligations and/or to require Bank to seek to enforce or resort to any remedies with respect to any security interests, liens, or encumbrances granted to Bank by Borrower or any other party on account of the Obligations. The Illinois Supreme Court ruled that guarantors are not entitled to the protections of the Sureties Act. In a decision of great importance to lenders, the Illinois Supreme Court, on October 21, 2010, held that ordinary guarantors were not entitled to the statutory defenses available to sureties. So what is this all about? It is about the ability of lending institutions to enforce personal guaranties without having a series of roadblocks thrown in their path. First, the background. There is an Illinois statute that, with its predecessors, dates back to 1819. It is called the Sureties Act, 740 ILCS 155/0.01, et seq. In substance, it provides that if a surety believes that the primary debtor is likely to become insolvent or to leave the state, without paying a matured indebtedness, the surety can give notice in writing to the lender that the lender must pursue the debtor, and, if the lender does not exercise its remedies against the debtor with diligence (which includes getting a judgment and using postjudgment remedies), the surety has no liability to the lender. The question, however, is who is a “surety”? Does it include the ordinary guarantor of a bank loan? Those are the questions the Illinois Supreme Court answered in JPMorgan Chase Bank, N.A. v. Earth Foods, Inc., 238 Ill.2d 455, 939 N.E.2d 487, 345 Ill.Dec. 644 (2010). Earth Foods, Inc., obtained a loan in 2001 from JPMorgan Chase Bank. Leonard S. DeFranco guaranteed the loan with two other persons (guarantors). The loan was collateralized by the company’s inventory. Later, DeFranco sent the bank a letter stating that the company’s inventory was being depleted and demanded that the bank take action. Earth Foods stopped making payments to the bank in February 2004. On April 23, 2004, the bank delivered a notice of default to Earth Foods. Earth Foods made no payments after receiving the bank’s notice of default. When the assets of Earth Foods were transferred to a new corporation by a new controlling stockholder, the bank sued Earth Foods and the guarantors. DeFranco asserted a defense based on §1 of the Sureties Act, 740 ILCS 155/1. He claimed that the bank could not pursue him because he had given notice to the bank that Earth Foods was operating at a loss and that meant the bank had to pursue Earth Foods to final judgment and postjudgment before it could go after him. The bank argued the Act did not apply to guarantors, only to sureties. Therefore, whether the defenses available under the Sureties Act benefited guarantors like DeFranco was the issue before the highest state court in Illinois.

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§12.28

The Supreme Court began by stating that statutes had to be construed as they were intended to be construed at the time they were enacted. In this case, that meant in the year 1874, when the Sureties Act was modified to its present form. The court referred to a series of dictionaries and treatises dated in the early 1900s. These sources drew a distinction between sureties, whose liability is primary, and guarantors, whose liability is secondary. The court also quoted for that proposition its decision in Vermont Marble Co. v. Bayne, 356 Ill. 127, 190 N.E. 291, 294 (1934), in which the following language appears: The true distinction [between a surety and a guarantor] seems to be that a surety is in the first instance answerable for the debt for which he makes himself responsible, while a guarantor is only liable where default is made by the party whose undertaking is guaranteed. [Emphasis added by Earth Foods court.] 939 N.E.2d at 495. The Supreme Court concluded by stating: [W]e are compelled to conclude that our legislature meant to include only sureties, meaning those who are primarily and directly liable for a debt, not guarantors, those who are only liable when the principal defaults on the debt, in the Act’s protections. 939 N.E.2d at 497. Although most guaranties used by banks and other lenders provide that the guarantor waives the creditor’s due diligence in pursuing the primary obligor, in light of the above decision, it would be prudent not only to state that the guarantor has executed the guaranty as a guarantor and not as a surety but also to add an express waiver of §1 defenses to the text. For example: The undersigned, as a further inducement to the [bank] to extend credit to the [borrower], hereby waives any and all defenses otherwise available under §1 of the Illinois Sureties Act. In a Court of Appeals of Georgia case, REL Development, Inc. v. Branch Banking & Trust Co., 305 Ga.App. 429, 699 S.E.2d 779 (2010), the principal issue was whether a mortgagee could pursue its remedies against the borrower and guarantors without first consummating a foreclosure of its mortgages. The court had no difficulty in concluding that it could. REL Development, Inc., borrowed more than $3.5 million from Branch Banking & Trust Co. in December 2004 and an additional $562,500 in March 2005, with each loan secured by a separate parcel of real estate. The loans were guaranteed by REL Properties, Inc., and by Robert Lanier, who controlled both corporations. Another entity, I-20 East, Inc., borrowed $120,000 from Branch Banking that was secured by a mortgagee on a separate parcel of real estate and guaranteed by Lanier. In June 2008, all three loans were in default. Branch Banking sent written notice of acceleration to the borrowers and guarantors and began foreclosure proceedings. Lanier asked Branch Banking to cancel the foreclosures so that he could sell the properties, but no sales occurred. (This was the summer of 2008!) Rather than reinstating the foreclosures, Branch Banking pursued the borrowers and guarantors on the notes they had either signed or guaranteed. In response to the debtors’ and guarantors’ assertions that Branch Banking had failed to mitigate damages by declining to reinstate and proceed with the foreclosures, the court said: “The fatal flaw in this argument is that [Branch Banking] had no obligation to pursue foreclosure

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§12.29

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proceedings but was fully authorized by both the law and the debt instruments to pursue only lawsuits against the debtors and guarantors to recover the debts.” 699 S.E.2d at 781. The court observed that the promissory notes allowed Branch Banking to elect whatever remedy it decided to pursue. The mortgages stated Branch Banking could foreclose or “[e]xercise any and all rights accruing to a secured party under this Deed, the Code and any applicable law,” and that the mortgagees rights were “separate, distinct and cumulative of other powers and rights herein granted and of all other rights Grantee may have at law or in equity.” Id. The guaranties expressly stated that Branch Banking was not required to pursue foreclosure before instituting suit to collect the debts. On another point, the borrowers and guarantors argued that a judgment entered against them was improper because Branch Banking failed to reaccelerate the notes after canceling the foreclosures. In response, the court said a subsequent default had occurred and Branch Banking had not reaccelerated but, under the terms of the promissory notes, was not required to give notice of either the original acceleration or the reacceleration. Further, the court said that, even assuming notice of reacceleration was required, it was evidenced by the complaints served on the debtors and guarantors. This case aptly demonstrated that, with a few exceptions (California, Arizona, the “one action rule” states), language in notes, mortgages, and guaranties absolving the mortgagee of the requirement of foreclosing its liens as a precursor to suing the borrowers and guarantors will be enforced. B. Pre-Default Termination of the Guaranty 1. [12.29] Revocation by the Guarantor; Sample Language As a general rule, a guaranty can be revoked at any time, with proper notice, but revocation is restricted to transactions occurring subsequent to service of the notice. Consequently, a guaranty relating to a revolving credit agreement is revocable only for future transactions. The manner of revocation of a guaranty should be carefully spelled out in the instrument. With a carefully drafted instrument, transactions that have their origin prior to revocation, but that are modified, renewed, or amended subsequent to revocation, can be covered by the guaranty. Suggested language might read: This is a continuing guaranty that shall remain effective during the term of the Agreement and relates to any Obligations, including those that arise under successive transactions that shall either cause Borrower to incur new Obligations, continue the Obligations from time to time, or renew them after they have been satisfied, until this Guaranty has been expressly terminated. Such termination shall be applicable only to transactions having their inception after the effective date of termination and shall not affect any rights or Obligations arising out of transactions having their inception prior to such date, even if subsequent to such termination the Obligations are modified, renewed, compromised, extended, or otherwise

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GUARANTIES

§12.30

amended (including, but not limited to, an increase in the interest rate applicable to the Obligations). This Guaranty shall not apply to any Obligations created after receipt by Bank of written notice of its termination as to future transactions. a. [12.30] Revocation by Notice An example of how a court typically addresses the issue of whether a guaranty was revoked by proper notice is First Wisconsin Financial Corp. v. Yamaguchi, 812 F.2d 370 (7th Cir. 1987). In May 1979, Tomkenco, Inc., entered into a revolving credit arrangement with First Wisconsin Financial Corp., secured by all of Tomkenco’s assets. Tomkenco’s two principals gave personal guaranties to First Wisconsin. Later, it was discovered that one of the principals, Kuzmenko, fabricated documents to procure the loan. On January 31, 1981, the other principal, Yamaguchi, quit and sold his stock to Kuzmenko. It was not until June 1981 that First Wisconsin learned of the fraud. By that time, Kuzmenko had vanished, and First Wisconsin sued Yamaguchi on his guaranty. Yamaguchi contested liability by referring to a letter his attorney sent to First Wisconsin on April 2, 1981. The letter stated, inter alia, “[O]n behalf of Mr. Yamaguchi, I am requesting that you release Mr. Yamaguchi from all liabilities incurred . . . on or after January 31, 1981, the effective date of his resignation. This is, in effect, a revocation of the guaranty effective on January 31, 1981.” 812 F.2d at 372. Although the court recognized that the letter was not a model of clarity (since it sought to combine both a revocation and a release and used the modifier “in effect”), it nonetheless concluded that the April 2 letter was a revocation. The court stated that the “letter was designed to its purpose. It requested a release, a remedy not available unilaterally, and declared a revocation, a result within Yamaguchi’s sole control.” [Emphasis in original.] 812 F.2d at 374. Obviously, cases such as this are reflective of the guarantor’s favored status. Courts consistently state that a guarantor is a favorite of the law, and the terms of the guaranty will be construed strictly against the bank. Consequently, bankers are well advised to treat any correspondence that seems to speak in terms of revocation as a revocation and to make certain that the form of guaranty they use has a specific method for revocation. The value of such a provision and its enforceability is demonstrated by Bruno v. Wells Fargo Bank, N.A., 850 N.E.2d 940 (Ind.App. 2006). In Bruno, James Bruno guaranteed a bank loan and, when he suspected fraud, sought to revoke it. He was not successful because he did not revoke in the manner called for in the guaranty. In 2002, Patrick O’Brien induced Bruno to become a passive investor in a wholesale salvage company called Columbo Wholesale & Salvage, Inc. Thereafter, O’Brien negotiated a $100,000 revolving line of credit with Wells Fargo Bank, and both Bruno and O’Brien executed unlimited continuing guaranties of the line of credit as well as any other debt Columbo owed Wells Fargo. The guaranties stipulated that they could only be revoked by a written instrument served on Wells Fargo by certified mail. By July 2003, draws on the line of credit aggregated $73,000. About this time, Bruno learned that O’Brien had arranged for automatic debits on the line of credit to transfer funds directly into his (O’Brien’s) personal account. Bruno asked Wells Fargo to shut down the line of credit or cease granting credit to O’Brien. But the documentation on file at Wells Fargo authorized O’Brien to make withdrawals, and the loan was current as to

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SECURED TRANSACTIONS

both principal and interest. The bank also said it could not shut down the line of credit because O’Brien was a guarantor. In April 2004, Columbo was in default, and Wells Fargo sued Bruno on his guaranty. Bruno argued he had terminated his guaranty and, further, that the bank had violated a fiduciary duty it owed to him. The Indiana court rejected both contentions. First, the court said that no revocation of the guaranty had occurred. The guaranty called for revocation only by means of a written instrument delivered via certified mail, and that had not taken place. The court refused to treat Bruno’s complaints about O’Brien’s draws on the line of credit as the functional equivalent of written notice of revocation. Second, as to the alleged fiduciary obligation, the court said there was none. It found no evidence that Wells Fargo was in a position of superiority that allowed it to obtain an unconscionable advantage over Bruno. Bruno was said to be an experienced businessman who knew something was amiss as shown by the complaints he lodged with Wells Fargo over O’Brien’s withdrawals. The court also stated that the bank did not have a duty to advise Bruno about the technique required to remove O’Brien’s signatory authority on the Columbo account. Bankers can resist a claim of revocation of a guaranty if the guarantor fails to follow the procedure for revocation stipulated in the instrument of guaranty. Frontenac Bank v. T.R. Hughes, Inc., 404 S.W.3d 272 (Mo.App. 2012), raised two issues: (1) did the bank act in good faith in declaring a loan default based on an insecurity clause; and (2) did the bank violate the Equal Credit Opportunity Act when it required a spousal guaranty. This discussion deals with the second issue. In 2003, T.R. Hughes, Inc., and Summit Pointe, L.C., obtained financing from Frontenac Bank for the development and construction of two real estate projects in the greater St. Louis area. Summit made three loans, and T.R. made four loans. The borrowers executed seven promissory notes. The loans were secured by deeds of trust. Thomas Hughes and his wife, Carolyn, executed personal guaranties of each loan. The bank declared all the loans due and payable in 2009 due to the bank’s insecurity. In October 2009, the bank caused three foreclosures to be initiated, and the bank was the only purchaser at the foreclosure sales. On December 3, 2009, the bank sued Thomas and Carolyn to recover the outstanding balances on the defaulted notes. Thomas and Carolyn responded that Carolyn’s guaranty was void and unenforceable because the bank violated the Equal Credit Opportunity Act by requiring it. The trial court found that, although Thomas had submitted financial statements reflecting assets of both Thomas and Carolyn to the bank, Carolyn did not intend the joint financial statement to be an offer to provide a personal guaranty. But bank officers testified that the bank’s common practice was to deem a joint financial statement as a joint application for credit. On appeal, the Missouri appellate court pointed out that Regulation B provided, in pertinent part: “A creditor shall not deem the submission of a joint financial statement or other evidence of jointly held assets as an application for joint credit.” 404 S.W.3d at 289, quoting 12 C.F.R. §202.7(d)(1). The trial court also held that Carolyn did not offer to execute the guaranties but did so at the bank’s insistence. This finding was sustained on appeal even though the text of the guaranties contained the following language: “Guarantor represents and warrants to Lender that . . . (B) this Guaranty is executed at Borrower’s request and not at the request of Lender.” 404 S.W.3d at 287.

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§12.32

On appeal, the court credited the testimony of Thomas and Carolyn that the guaranties were not given voluntarily and emphasized that the bank’s officers testified the bank routinely required personal guaranties from wives on loans of similar size because otherwise the bank would question why they were not willing to “step up” if they wanted the money. 404 S.W.3d at 288. Although Frontenac argued that Thomas and Carolyn had submitted documentation to the Missouri Secretary of State indicating she was the treasurer of T.R. and a member of Summit, the trial court found that Carolyn was never a member or manager of Summit, and, although she had been listed as treasurer of T.R. on annual reports filed with Missouri Secretary of State, she had no involvement with the operations of T.R. The appeals court credited Carolyn’s testimony that she was not involved in the operations of T.R. Based on the foregoing and the fact that the loans satisfied the loan-to-value criteria in the bank’s written loan policy, the Missouri appeals court declared Carolyn’s guaranty unenforceable as it was in contravention of the Equal Credit Opportunity Act. The ruling did not affect Thomas’s guaranty. On the latter point, see also Chen v. Whitney National Bank, 65 So.3d 1170 (Fla.App. 2011). This case and others like it inform banks that they should not treat a joint financial statement as a joint application for credit, cannot rely on representations of voluntariness in printed forms of guaranty if the reality is quite different, should not have a standing policy that calls for a spousal guaranty whenever a loan is of a certain size, and cannot rely on a state filing that lists the spousal guarantor as a corporate officer if the reality is quite different. b. [12.31] Revocation by Declination Not Effective When a guarantor signed a guaranty of a loan to her corporation that covered all present and future indebtedness of the corporate borrower and stipulated that it remain in full force and effect until terminated by written notice of termination, and later, a new, larger loan was made to the corporation, and the guarantor was asked to sign a new guaranty with greater protections for the bank, but she declined to do so, and the loan was made nonetheless, she was not deemed to have revoked the guaranty. TruServ Corp. v. Flegles, Inc., 419 F.3d 584 (7th Cir. 2005). The guarantor’s declination to sign the later guaranty was not a revocation of the earlier guaranty. Noting that no written notice of termination had ever been served by the guarantor, the court held that her declination to sign the later guaranty was not the legal equivalent of the service of notice of termination. The guarantor was held to be liable on her guaranty. See also Federal Financial Co. v. Savage, 431 Mass. 814, 730 N.E.2d 853 (2000). 2. [12.32] Death When the guarantor is a natural person, his or her death will not revoke his or her liability for past advances but will do so for any future advances. The bank is entitled to pursue a claim against the decedent’s estate for the indebtedness incurred by the borrower prior to the guarantor’s death.

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Upon the death of a guarantor, it is good practice for the bank to file a claim against the guarantor’s estate. But will the claim against a decedent’s estate be allowed if no event has occurred that allows acceleration and demand by the creditor? The problem is solved by making the death of the guarantor an event of default, allowing the creditor to accelerate the debt and demand payment. 3. [12.33] Equal Credit Opportunity Act and Regulation B There have been a number of reported cases involving efforts to defend against enforcement of spousal guaranties based on purported violations of the Equal Credit Opportunity Act and Regulation B of the Federal Reserve System, 12 C.F.R. §202.2(e). See Silverman v. Eastrich Multiple Investor Fund, L.P., 51 F.3d 28 (3d Cir. 1995); IntegraBank/Pittsburgh v.Freeman, 839 F.Supp. 326 (E.D.Pa 1993); Bank of the West v. Kline, 782 N.W.2d 453 (Iowa 2010). That issue was finally resolved by the United States Supreme Court in a per curiam opinion dated March 22, 2016. In Hawkins v. Community Bank of Raymore, 761 F.3d 937 (8th Cir. 2014), aff’d by an equally divided Court, No. 14-520, 2016 WL 1092416 (Mar. 22, 2016), the United States Court of Appeals for the Eighth Circuit had held that a guarantor was not a loan applicant within the meaning of the Act. The Act defines a loan applicant as “any person who applies to a creditor directly for an extension, renewal, or continuation of credit.” 15 U.S.C. §1691a(b). The Eighth Circuit opined that, because guarantors do not participate in the loan application process, Congress did not intend that they fall within the coverage of the Act. That ruling was affirmed by a four-to-four vote of the Supreme Court. The Supreme Court’s decision clarifies an issue that has bedeviled lenders for quite some time. C. Post-Default Discharge of the Guarantor by Conduct of the Bank 1. [12.34] Grounds for Discharge If the borrower defaults, the bank has a choice of remedies. The bank may either sue the guarantor or defer suit until the collateral has been liquidated. If the bank, in lieu of instituting suit against the guarantor, elects to foreclose on the collateral securing the debt first, there is a risk of discharging the guarantor that is not present when suit is immediately brought against the guarantor. The risk is that the disposition of the collateral will not be deemed commercially reasonable, thereby preventing the bank from recovering a deficiency unless it is able to prove the disposition was commercially reasonable. City National Bank of Fort Smith, Arkansas v. Unique Structures, Inc., 49 F.3d 1330 (8th Cir. 1995). Although courts generally recognize waivers executed by guarantors, the same cannot be said in the context of the creditor’s disposition of collateral. a. [12.35] The Bank’s Duty To Give Notice of Disposition of Collateral The first issue the bank faces is whether the guarantor is to be given notice of a contemplated sale of the collateral. Whether a guarantor is entitled to notice of the intended disposition of collateral hinges on whether the guarantor is considered a “debtor” under Article 9 of the Uniform Commercial Code. It was almost unanimously agreed that a guarantor is a debtor for these purposes. Article 9 settles the issue once and for all by requiring notice. UCC §9-611(c)(2).

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The remaining question is how much notice. Once again, Article 9 of the UCC provides the answer by stipulating ten days’ notice of the intended disposition in a nonconsumer transaction. UCC §9-611(c)(3)(B). Service at the last known address of the guarantor is satisfactory. Sending the notice is all that is required. The bank does not have to make certain that it is received by the guarantor. McGrady v. Nissan Motor Acceptance Corp., 40 F.Supp.2d 1323 (M.D.Ala. 1998); Auto Credit of Nashville v. Wimmer, 231 S.W.3d 896 (Tenn. 2007). b. [12.36] Waiver of Notice If the guarantor is a debtor for these purposes, will his or her waiver of notice of disposition of collateral be given effect? Is the waiver enforceable? c. [12.37] Small Business Administration Guaranties In cases involving Small Business Administration (SBA) guaranties, courts demonstrate a marked propensity toward enforcing waivers executed by guarantors — but not in other contexts. If a bank fails to give notice in advance of a foreclosure sale, the guarantor may be off the hook for the deficiency. When the bank fails to give notice, the burden shifts to the bank to prove that its omission did not cause a loss to the guarantor. This is the “rebuttable presumption” rule. The bank’s right to a deficiency is compromised because of the bank’s failure to give notice prior to the foreclosure sale. What if the guaranty agreement expressly waives notice? Broad waivers of suretyship defenses have been upheld by the courts forever. A case from Texas, Rabinowitz v. Cadle Company II, Inc., 993 S.W.2d 796 (Tex.App. 1999), indicates how most courts are protecting guarantors on this issue. Rabinowitz guaranteed a $100,000 promissory note on behalf of Southern States Enterprises, Inc. Payment of the note was secured by certain collateral as well as Rabinowitz’s unconditional guaranty. The guaranty agreement included a broad waiver of suretyship defenses. When Southern States defaulted on the note, the bank took possession of the collateral and obtained from both Southern States and Rabinowitz a written waiver of “any right to written notice from [the bank] of the time after which any public sale, private sale or other intended disposition is to be made of the Collateral.” 993 S.W.2d at 798. The collateral was sold and the proceeds credited to the note. However, a large deficiency remained. Subsequently, the bank was declared insolvent, and the FDIC acquired the note and guaranty and sold it to the plaintiff, Cadle. Cadle made demand on Rabinowitz for the deficiency. Rabinowitz refused. Cadle sued on the guaranty, and Rabinowitz raised the defense that, although the collateral was sold and its proceeds credited to the note, there was no evidence of a “commercially reasonable” disposition of the collateral. The Texas court concluded that the rules of Article 9 of the Uniform Commercial Code should apply because the guaranty was part and parcel of the underlying secured transaction. Since a guarantor is liable for a deficiency just as clearly as the original borrower, the court felt that the two should be treated identically under Article 9. Under the UCC, the bank owes the debtor a duty to give advance notice of the sale and hold the sale in a commercially reasonable manner. Therefore, a guarantor has the same right as the principal borrower to challenge a sale. But some courts have held that, since the law of suretyship

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allows waivers of virtually everything, a guarantor should be able to waive creditor foreclosure misconduct. The Texas court rejected this argument on the ground that since the UCC prohibits pre-default waiver by the “debtor” of the bank’s duties during foreclosure, it should also apply to a guarantor. In short, the rule of Article 9 prohibiting waiver trumped the policy under general suretyship law of allowing broad waivers. On the key question of whether the sale was commercially reasonable, there was no evidence presented. However, the court concluded that the creditor seeking a deficiency has the burden of proof on this issue. Since the parties stipulated that there was no proof that the collateral in this case was disposed of in a commercially reasonable manner, the creditor lost its claim to a deficiency. A bank should not draft a guaranty that includes a waiver of notice of a sale by a guarantor prior to a foreclosure sale. 2. [12.38] Commercial Reasonableness and Other Purported Defenses A bank’s failure to hold a commercially reasonable foreclosure sale of collateral may discharge a guarantor from liability for a deficiency. Can the guarantor waive the requirement of commercial reasonableness? This question has been extensively litigated in the context of Small Business Administration guaranties, with varying results. In some cases, the waiver has been upheld, and in others, it has not. In cases that do not involve SBA guaranties, pre-default waivers by guarantors have not been upheld. Those cases do not allow waiver of the foreclosing lender’s duty of commercial reasonableness. In Tropical Jewelers, Inc. v. Nationsbank, N.A. (South), 781 So.2d 392 (Fla.App. 2000), Tropical Jewelers, Inc., obtained business loans from Intercontinental Bank, N.A., which merged into Nationsbank, N.A. The loans were secured by Tropical’s accounts, inventory, furniture, fixtures, and equipment. Personal guaranties were also provided. After Tropical defaulted, the bank sued Tropical and the guarantors. The collateral provided by Tropical was liquidated by the bank. Both Tropical and the guarantors contended that the collateral had not been liquidated in a commercially reasonable way. Finding that there were disputed issues of material fact concerning the commercial reasonableness of the sale, the bank’s request for judgment against Tropical was denied. But the real issue in the case arose because the guarantors had signed guaranties in which they waived the “right to object to the commercial reasonableness of any sale or disposition of collateral.” 781 So.2d at 394. The issue was whether this waiver precluded the guarantors from raising lack of commercial reasonableness as a defense. Citing the Uniform Commercial Code, the court held that the waiver was invalid and that, as a consequence, the guarantors could argue the collateral was not liquidated in a commercially reasonable fashion. The court flatly rejected the bank’s assertion that a guarantor is not a debtor for Article 9 purposes. Adhering to the overwhelming weight of authority (36 states deem a guarantor a “debtor” for Article 9 purposes), the court held that summary judgment against the guarantors was inappropriate because as debtors the guarantors could defend on the basis of a collateral liquidation that was not commercially reasonable.

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Bankers should be mindful of the fact that the statutory requirement of commercial reasonableness can only be waived after default, not before. UCC §9-624(a). When drafting guaranties, bankers should not include a pre-default waiver. A four-year delay in foreclosing on an apartment complex did not absolve a guarantor from liability on his guarantee in Pi’Ikea, LLC v. Williamson, 234 Ariz. 284, 321 P.3d 449 (App. 2014). In February 2004, TBM Equities, LLC, obtained a loan of $5.922 million from Irwin Union Bank, F.S.B., entered into a construction loan agreement, and executed and delivered a promissory note. The note was secured by a deed of trust, assignment of rents, security agreement, and financing statement on an apartment building in Tucson, Arizona. The defendant guarantors signed and delivered a continuing guarantee. TBM made all required note payments through October 1, 2008, but then ceased making payments. When the note matured on December 31, 2008, it was not paid. When the bank failed, an FDIC receivership was established, and the note was eventually assigned to Pi’Ikea in March 2012. Pi’Ikea filed suit against the defendant guarantors in August 2012. The defendants argued that Pi’Ikea, as successor in interest to the bank, was subject to all defenses that could be asserted against the bank and that the bank had failed to fulfill its duty to mitigate damages when it did not conduct a foreclosure in 2008 when a sale of the property would have paid off the note in full. Apparently, the property had been appraised for $10.2 million in June 2008. The guarantors also asserted that, after the note went into default, a foreclosure sale was scheduled for May 2009 but was delayed from time to time until the instant lawsuit against the guarantors was commenced. They argued that the failure to conduct a foreclosure sale allowed the debt to increase by $9.1 million. Their claim was that this was an “unconscionable extension of the guaranty.” 321 P.3d at 451. Although the court recognized Pi’Ikea’s duty to mitigate damages, it also said the duty can be waived by agreement of the parties. Reviewing the terms of the guaranty in question, the court concluded that the duty to mitigate damages had been waived by the guarantors. The guaranty stated that the lender “shall have no obligation to proceed against any collateral (including the Deed of Trust)” and that the guarantors waived any right to require the lender “to proceed against or exhaust any security held by Lender.” 321 P.3d at 452. Also cited by the court was the rule that, when guarantors waive the secured party’s duty to liquidate collateral, it necessarily grants to the secured party the right to select the time when the liquidation will occur. When a guaranty waives the secured party’s obligation to mitigate damages, it necessarily grants the secured party the right to select the time at which liquidation of collateral will occur, even if it doesn’t occur until four years after the default on the debt. Guarantors continue to advance reasons not to honor their guaranties. One of the latest cases is CSS Real Estate Development I, LLC v. State Bank & Trust Co., 324 Ga.App. 184, 749 S.E.2d 773 (2013).

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In February 2007, CSS Real Estate signed two loan agreements with the Buckhead Community Bank to facilitate the purchase of land and the construction of a hotel. Charles N. Crowder, Simon Ahn, and Samuel J. Park (original guarantors) guarantied repayment of the loans. CSS Real Estate sold the property to Enville, Inc., in October 2008. Enville’s owner, Thakorbhai D. Patel, also executed a guaranty of the indebtedness due Buckhead. On December 2, 2009, the loan was renewed, and the original guarantors and Patel executed new guaranties. Two days later, the bank failed, and the FDIC was appointed receiver. FDIC sold its interest to State Bank and Trust Co. On July 15, 2011, State Bank sent CSS a default notice, and on September 22, 2011, State Bank sued to collect the loans. The issue in the case, raised by all of the guarantors, was whether Buckhead had fraudulently induced them to renew the loan and sign new guaranties since Buckhead’s employees knew the bank was about to fail. The court rejected that contention, saying that, “Even if [Buckhead] knew it was failing at the time the loan and guaranties were renewed, [there was no] evidence that [CSS] would have acted differently had it known of [Buckhead’s] closure, or evidence of any damages that it sustained as a result of the closure.” 749 S.E.2d at 775. Flatly rejected were assertions by CSS that it could have negotiated with the FDIC or State Bank about the loans and guaranties if it had known Buckhead was doomed. The court, quoting Fuller v. Perry, 223 Ga.App. 129, 476 S.E.2d 793, 796 (1996), said that CSS’s statements regarding what might have occurred in regard to negotiations with the FDIC or State Bank “related entirely to future events involving a third party and consisted entirely of opinions, predictions, and conjectures, [and] they cannot form the basis of a claim for fraud.” 749 S.E.2d at 775. The point of this case is that a failing bank need not disclose its deteriorated financial position to its borrowers and their guarantors. The money was borrowed, and the borrower and guarantors agreed to pay it back, whether it was to the original lender or a successor in interest, such as the FDIC. JPMorgan Chase Bank, N.A., sued Arthur Wondrasek on his personal guaranty of the indebtedness of East-West Logistics, L.L.C., to the bank. JPMorgan Chase Bank v. East-West Logistics, L.L.C., 2014 IL App (1st) 121111, 9 N.E.3d 104, 380 Ill.Dec. 854. The $1 million loan was made in 2003 with Wondrasek concurrently executing a continuing, unconditional, unlimited guaranty. The guaranty would terminate only upon written notice from Wondrasek. He agreed the bank could renew, modify, compromise, extend, or accelerate the time of payment and/or increase or decrease the rate without releasing him from liability. He also waived all suretyship defenses and agreed to keep himself informed of the borrower’s financial condition. The loan to East-West fell due on February 24, 2008, and by November 17, 2008, the debt had increased to $1,627,339.46 plus the bank’s collection costs. Because East-West did not repay the loan, Wondrasek was sued on his guaranty. He filed an answer admitting he had signed the guaranty but also asserting affirmative defenses. After Wondrasek’s death, his estate was substituted as a defendant. The first affirmative defense the estate asserted was that the guaranty had been extinguished because loans were made to East-West when it was in default. The court rejected that argument because the guaranty stated the liability of the guaranty was both unconditional and unlimited.

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The second affirmative defense the estate advanced, that the bank had failed to notify Wondrasek of East-West’s defaults, was also rejected because Wondrasek had waived notice of any credit extensions to East-West and was responsible for keeping himself informed as to East-West’s financial condition. The estate also argued that it was entitled to assert that the bank had not acted in good faith. This assertion was based on the estate’s allegation that the bank continued to lend to East-West when it knew East-West could not repay the loans. Once again, the affirmative defense was rejected because the decedent had agreed to keep himself informed as to East-West’s financial status and the bank was absolved of any duty to do so. Moving on, the estate next argued that the integration clause in the 2005 East-West loan documents terminated Wondrasek’s 2003 guaranty. The integration provision said that the documents “supersede[d] all prior agreements and understandings relating to their [the Credit Facilities’] subject matter.” 2014 IL App (1st) 121111 at ¶59. The court said Wondrasek was not a party to the other loan documents and for that reason was not discharged by the integration clause. Finally, the court struck down the estate’s contention that the bank was guilty of common-law fraud. Once more, the court said the bank had no duty to provide information to Wondrasek and that Wondrasek had agreed to keep himself informed of East-West’s financial condition. The bank had no duty to communicate with him. A well-drafted guaranty will provide defenses to a bank against virtually every allegation a guarantor, or his or her estate, may make in an effort to avoid liability.

IV. [12.39] SUCCESSIVE GUARANTIES; SAMPLE LANGUAGE If the relationship with the borrower continues over an extended period of time and there are additional advances made to the borrower, the guarantor may be asked to execute a series of successive guaranties. In order to eliminate any confusion over whether the later guaranties supersede the earlier guaranties, the following language can be added to the guaranty: This Guaranty shall not be deemed to supersede or terminate any previous guaranty of Guarantor, but shall be construed as an additional or supplemental Guaranty unless otherwise expressly provided herein; and in the event that Guarantor has given to Lender a previous guaranty or guaranties, this Guaranty shall be construed to be an additional or supplemental guaranty and not to be in lieu thereof or to terminate such previous guaranty or guaranties unless expressly so provided herein.

V. [12.40] THE BANK’S DUTIES TO THE GUARANTOR From time to time, a guarantor will allege that the bank owes some special duty of disclosure to the guarantor. Generally speaking, courts have been disinclined to find any such duty of disclosure.

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A. [12.41] Does the Bank Have an Implied Duty to a Guarantor To See to the Proper Application of the Loan Proceeds by the Borrower? The Court of Appeals of North Carolina was called on to decide whether a lender had a duty to a guarantor of a loan to monitor the application of the loan proceeds. Carlson v. Branch Banking & Trust Co., 123 N.C.App. 306, 473 S.E.2d 631 (1996), review denied, 345 N.C. 340 (1997). Dr. and Mrs. Carlson were approached by a local stockbroker, David Schamens, who owned a company called Carolina First. Schamens wanted Carolina First to acquire another company called Ivy Management Company. The purchase price of $6.2 million was to be financed in part by bank loans secured by letters of credit. In return for providing a $500,000 letter of credit, the Carlsons were to receive 5,000 shares of Carolina First’s common stock. Branch Banking provided the acquisition loan partially secured by a letter of credit procured by the Carlsons from Southern National Bank, with Branch Banking as beneficiary. The Carlsons provided the letter of credit based on their understanding that the loan proceeds would be used for the Ivy acquisition. The loan to Carolina First was funded, but most of the loan proceeds were used for such things as a car for Schamens, construction at Schamens’s home, and expenses and reimbursements for Schamens’s stock brokerage company rather than the Ivy acquisition. Unbeknownst to either the Carlsons or Branch Banking, Carolina First’s contract to acquire Ivy had become void two months before the letter of credit was issued. Having funded the loan, Branch Banking drew on Southern National’s letter of credit, and the Carlsons were forced to fulfill their reimbursement obligation to Southern National. The Carlsons sued Branch Banking, asserting that it was negligent because it failed to see to the proper application of the loan proceeds. Was Branch Banking liable to the Carlsons? No, Branch Banking was not. The court said that once a lender disburses the loan proceeds to the borrower or as the borrower directs, the lender has fulfilled its obligation and it is not responsible for the ultimate application of the funds. B. [12.42] Does the Bank Have a Duty To Disclose to One Guarantor the Past Defaults of a Coguarantor? In Tranchitella v. Bank of Illinois in DuPage, 199 B.R. 658 (N.D.Ill. 1996), Sheri and Terry Tranchitella obtained financing from Bank of Illinois in DuPage on June 21, 1995. The loan documents (including a guaranty) they executed in favor of the bank imposed a lien on their jointly owned residence to secure the purchase money financing and to secure Terry’s debt to the bank under a note dated July 19, 1990, for $330,000, as well as other debt Terry had previously incurred to the bank. Unbeknownst to Sheri, Terry had been in default on a number of loans from the bank prior to July 19, 1990. Between July 19, 1990, and January 25, 1994, the bank made additional loans to Terry and rolled over some existing notes.

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The couple was subsequently in divorce proceedings and agreed to sell their home. When the sale occurred, the bank wanted to apply the proceeds of the sale to satisfy Terry’s debts. Sheri objected. Sheri contended that the bank had a duty to disclose to her that Terry was in default on loans from the bank granted before the guaranty was executed. The court held that the bank did not have an obligation to Sheri to disclose that Terry, her husband, was in default at the time the guaranty was signed. The court said that the bank could reasonably have assumed that because of their marital status Sheri would learn about the defaults. C. [12.43] Guarantor May Compel Arbitration Even If Guaranty Lacks Arbitration Clause If Underlying Note Has One Arbitration of the guarantor’s purported liability under a guaranty of a mortgage debt was at issue in Regions Bank v. Weber, 53 So.3d 1284 (La.App. 2010). In July 2007, Jordan River Estates, LLC, borrowed $4.42 million from Regions Bank, secured by a mortgage on real estate in Mississippi and the personal guaranties of Earl Weber, Jr., and Stephen J. Schmidt, members of the limited liability company. The promissory note executed in favor of the bank contained a clause under which the parties agreed to submit to arbitration all disputes, claims, and controversies and further that the Federal Arbitration Act, ch. 392, 61 Stat. 670 (1947), applied. The commercial guaranty executed by Schmidt and Weber referred to the note, stipulated that Louisiana law was controlling but did not contain an arbitration clause. When sued on the guaranty, Schmidt contended he was entitled to submit the matter of his alleged liability to arbitration even though he was not a signatory to the note. Regions opposed arbitration. The court noted that Louisiana law favored arbitration and, under Louisiana law, an arbitration clause in a written agreement is valid, irrevocable, and enforceable. It also noted that the controversy at issue fell within the coverage of the arbitration clause. The court ruled in favor of Schmidt, saying: The incorporation of an arbitration clause by reference to another written contract is a suitable method of evidencing the parties’ intent to arbitrate as long as the arbitration clause in the contract that is referred to has “a reasonably clear and ascertainable meaning.” . . . In the instant case, the Regions promissory note and commercial guaranty bear the same date of signing and the same loan number. Regions seeks to collect the debt evidenced by the promissory note from Mr. Schmidt. We find the promissory note and the Commercial Guaranty sufficiently intertwined to compel arbitration at the election of Mr. Schmidt. [Citations omitted.] 53 So.3d at 1290. In keeping with the legal maxim that “a guarantor is a favorite of the law,” the court exercised its judicial prerogative to find a clause in a guaranty that was not there.

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VI. GUARANTIES AND THE BANKRUPTCY CODE A. [12.44] Fraudulent Transfers The possibility that a guaranty may be avoided as a fraudulent conveyance arises in the context of intercorporate transactions, i.e., a “downstream” guaranty executed by a parent corporation on a loan made to a subsidiary, an “upstream” guaranty executed by a subsidiary on a loan made to its parent corporation, or a “cross-stream” guaranty executed by one subsidiary on a loan made to another subsidiary. A bankruptcy trustee can assert that intercorporate guaranties are voidable as fraudulent conveyances if the insolvent guarantor cannot demonstrate that it received “reasonably equivalent value” for the obligation incurred. The type of intercorporate guaranty will play a significant role in its enforceability. A parent guaranteeing the debt of its subsidiary can assert the existence of reasonably equivalent value on the basis of the ultimate financial benefit inuring to the parent that arises from the economic wellbeing of the subsidiary. The same economic gain is not evident if the guaranty is by a subsidiary for the debts of its parent or if the guarantor is merely under the common control of the parent. In re Tousa, Inc., 680 F.3d 1298 (11th Cir. 2012). Cross-corporate guaranties often generate fraudulent conveyance litigation when the guarantor ends up in bankruptcy. For example, in In re Image Worldwide, Ltd., 139 F.3d 574 (7th Cir. 1998), Image Marketing, Ltd. (IM), borrowed funds from Parkway Bank & Trust Co. When IM’s debts to trade creditors grew to several hundred thousand dollars, its sole shareholder created a new corporation called Image Worldwide, Ltd. (IW). When IM was liquidated, Parkway obtained a guaranty of IM’s debt by IW. IW made payments on IM’s debt to Parkway, but IW ended up in bankruptcy, too. The bankruptcy trustee for IW sought to recover the payments IW made to Parkway as fraudulent transfers since IW had not received “reasonably equivalent value” for them. Can the trustee recover the loan payments from Parkway? Parkway was ordered to return all loan payments it had received from IW since IW had not received reasonably equivalent value for the guaranty it provided. Although the court said it was not always necessary that the guarantor receive some of the loan proceeds in order for there to be reasonably equivalent value, it could find no value given to IW on the facts of the case. B. [12.45] The “Clawback” Clause; Sample Language A guaranty terminates upon full satisfaction of the obligations guaranteed. However, if the debtor subsequently goes bankrupt, the lender may have to repay amounts that constitute preferences or fraudulent conveyances. If bankruptcy does occur, the lender would want to have recourse against the guarantor, whose guaranty has been terminated on the basis of the guaranteed obligations having been paid. Therefore, it is customary to include a “clawback” clause in a guaranty. Suggested language might be as follows: If Bank receives any payment or payments on account of the liabilities guaranteed hereby, which payment or payments or any part thereof are subsequently invalidated, declared to be fraudulent or preferential, set aside, and/or required to be repaid to a trustee, receiver, or any other party under any bankruptcy act or code, state or federal law, common law, or

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equitable doctrine, then to the extent of any sum not finally retained by Bank, Guarantor’s obligations to Bank shall be reinstated, and this Guaranty, and any security therefor, [shall remain in full force and effect] [shall be reinstated] until payment shall have been made to Bank, which payment shall be due on demand. If any action or proceeding seeking such repayment is pending or, in Bank’s sole judgment, threatened, this Guaranty and any security interest therefor shall remain in full force and effect notwithstanding that Borrower may not then be obligated to Bank. The clause provides for the reinstatement of any security interest collateralizing the guaranty. However, the financing statements covering the collateral having been terminated, the lender may have irretrievably lost its priority position to an intervening secured creditor.

VII. [12.46] THE “PUT” — AN ALTERNATIVE TO A GUARANTY; SAMPLE PUT Occasionally, the bank will encounter an individual who refuses to execute an unconditional guaranty because he or she does not want to expose all of his or her assets to the claim of the bank. An alternative that can be used is a “put.” It is the functional equivalent of a limited guaranty. The party executing it agrees that, in case of a default by the borrower, he or she will purchase certain assets of the borrower at a stipulated price. Principals of a business may feel more comfortable with a put because they are acquiring assets with which they are familiar. A sample “put” follows: THE PUT [date of put] [Association Bank 222 S. Riverside Plaza Wilmington, IL] Re: [Community Distributors, LLC] (Borrower) Dear [name of bank representative]: The undersigned has requested that you provide financing aggregating [Five Million and no/100 Dollars ($5,000,000.00)] for the above-named Borrower. The undersigned has a substantial financial investment in Borrower and will be benefitted by the financing. You have asked the undersigned to provide a personal guaranty of the indebtedness of Borrower to you.

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The undersigned has declined to provide said personal guaranty but, in lieu thereof, has agreed as follows: 1. In the event there is a Monetary Default, with respect to Borrower, you may send notice thereof to the undersigned by certified mail postage prepaid, and the undersigned shall thereupon be immediately obligated to purchase the Eligible Inventory of Borrower, wherever located, from Borrower, with the proceeds of sale being directed to you. 2. The purchase shall be consummated within [number of days] days after the date of the notice referred to above at your offices in ____________, Illinois. 3. Payment will be by wire transfer to an account designated by you, or by cashier’s check payable to your order. 4. The purchase price to be paid will be the lesser of (a) the aggregate of advances against Eligible Inventory as shown on the Borrowing Base Report as of the date of the notice referred to in paragraph 1 above, or (b) $ [One Million Nine Hundred Thousand and no/100 Dollars ($1,900,000.00)]. 5. Upon consummation of the purchase referred to above, the undersigned may cause Borrower to deliver the items referred to above to such place or places as shall be designated by the undersigned and will cause Borrower to execute and deliver a Bill of Sale covering such items to the undersigned. 6. Upon consummation of the purchase referred to above, you will terminate your security interest in the items referred to above, provided, however, that nothing contained herein shall preclude you from exercising any and all remedies available to you upon the occurrence of an Event of Default by Borrower, excepting, however, the right to recover the items referred to above. 7. No delay on your part in serving the notice referred to in paragraph 1 above shall operate as a waiver thereof. No amendment or modification of this Agreement shall be effective unless the same shall be in writing and signed by the undersigned and approved by Borrower.

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Dated: [date signed] ___________________________________ [William A. Champion] AGREED: [COMMUNITY DISTRIBUTORS, LLC] By: ____________________________ Its: ____________________________ [ASSOCIATION BANK] By: ____________________________ Its: ____________________________

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13

Lender Liability and Equitable Subordination

ROBERT W. GLANTZ DAVID R. DOYLE Shaw Fishman Glantz & Towbin LLC Chicago

The contributions of Thomas J. Cunningham and William J. McKenna to prior editions of this chapter are gratefully acknowledged.

®

©COPYRIGHT 2016 BY IICLE .

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I. [13.1] Scope of Chapter II. [13.2] Contract Theories of Lender Liability A. [13.3] Oral Commitments B. [13.4] Written Commitments III. Tort Theories of Lender Liability A. [13.5] Control or “Alter-Ego” Liability B. [13.6] Fraud 1. [13.7] False Representation 2. [13.8] Failure To Disclose 3. [13.9] Consumer Fraud and Deceptive Business Practices Act C. [13.10] Negligent Misrepresentation D. [13.11] Breach of Fiduciary Duty/Constructive Fraud E. [13.12] Duress F. [13.13] Breach of Duty of Good Faith and Fair Dealing/Bad Faith 1. [13.14] Exercise of Discretion 2. [13.15] Independent Tort for Breach of Duty of Good Faith G. [13.16] Tortious Interference with Contract/Business Expectancy IV. [13.17] Statutory Theories of Lender Liability A. [13.18] Bank Holding Company Act Illegal Tying Provision B. Racketeer Influenced and Corrupt Organizations 1. [13.19] Introduction 2. [13.20] Requirement of RICO Predicate Acts 3. [13.21] Requirement of a Pattern 4. [13.22] Requirement of a RICO Enterprise 5. [13.23] Requirement That “Persons” Separate from Alleged RICO “Enterprise” Be Defendants 6. [13.24] Enhanced Emphasis on Proximate Causation of Claimed Injury by Racketeering Conduct V. [13.25] Equitable Subordination

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VI. [13.26] Strategies To Avoid Lender Liability A. Drafting Considerations 1. [13.27] Discretionary Advance Clauses 2. [13.28] No Oral Amendments Clause 3. [13.29] Notice of Requested Advances 4. [13.30] Acceleration Clauses 5. [13.31] Right To Terminate Lending Commitment 6. [13.32] Change of Management Covenant 7. [13.33] Jury Trial Waiver 8. [13.34] Choice of Law 9. [13.35] Choice of Forum 10. [13.36] Setoff Clauses B. [13.37] Drafting Considerations Relating to Written Loan Commitments C. [13.38] Creditor Control Issues D. [13.39] Sudden Changes in Position by Lender E. [13.40] Lender Personnel Training and Internal Procedures

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I. [13.1] SCOPE OF CHAPTER This chapter discusses lender liability claims under Illinois law. Both statutory and commonlaw theories of lender liability are addressed. The chapter also includes a discussion of the law regarding federal statutory liability imposed by the Racketeer Influenced and Corrupt Organizations Act (RICO), Pub.L. No. 91-452, Title IX, §901(a), 84 Stat. 941 (1970), and the Bank Holding Company Act of 1956, ch. 240, 70 Stat. 133, as well as equitable subordination in bankruptcy. The chapter includes practice pointers designed to help lenders avoid lender liability claims.

II. [13.2] CONTRACT THEORIES OF LENDER LIABILITY The most common type of lawsuit lenders face involves an allegation that the lender has breached a contractual obligation to its customer. In Illinois, the frequency of such actions decreased significantly with the enactment of the Credit Agreements Act, 815 ILCS 160/0.01, et seq. However, one Illinois appellate court expanded lenders’ potential exposure to claims based on the implied covenant of good faith and fair dealing. These developments are addressed in §§13.3 and 13.4 below. A. [13.3] Oral Commitments In 1987, the United States Court of Appeals for the Ninth Circuit affirmed one of the largest lender liability verdicts ever awarded. In Landes Construction Co. v. Royal Bank of Canada, 833 F.2d 1365 (9th Cir. 1987), the plaintiff was awarded $18.5 million based on a breach of an oral promise to lend $10 million to the plaintiff. Applying California law, the Ninth Circuit held that the essential terms of the financing had been agreed to and that the lender breached its promise. Illinois has not been receptive to such cases. In Delcon Group, Inc. v. Northern Trust Corp., 187 Ill.App.3d 635, 543 N.E.2d 595, 600, 135 Ill.Dec. 212 (2d Dist.), appeal denied, 128 Ill.2d 672 (1989), the appellate court held that a promise to lend was too indefinite to be enforced, despite the fact that such causes of action are generally recognized in Illinois caselaw. See also ISB Development Corp. v. Kopko, No. 09 C 3643, 2010 WL 2723181, *6 (N.D.Ill. July 1, 2010); Demos v. National Bank of Greece, 209 Ill.App.3d 655, 567 N.E.2d 1083, 1087 – 1088, 153 Ill.Dec. 856 (1st Dist. 1991); Champaign National Bank v. Landers Seed Co., 165 Ill.App.3d 1090, 519 N.E.2d 957, 116 Ill.Dec. 742 (4th Dist. 1988); Wait v. First Midwest Bank/Danville, 142 Ill.App.3d 703, 491 N.E.2d 795, 96 Ill.Dec. 516 (4th Dist. 1986); Bank of Lincolnwood v. Comdisco, Inc., 111 Ill.App.3d 822, 444 N.E.2d 657, 67 Ill.Dec. 421 (1st Dist. 1982). Concerns about the effect of large awards for lender liability such as the verdict in Landes Construction, supra, led lenders to pressure state legislatures to enact laws prohibiting the enforcement of oral agreements. Todd C. Pearson, Limiting Lender Liability: The Trend Toward Written Credit Agreement Statutes, 76 Minn.L.Rev. 295, 296 (1991). See also Univex International, Inc. v. Orix Credit Alliance, Inc., 914 P.2d 1355, 1358 (Colo. 1996) (en banc) (“The legislature enacted the statute of frauds applicable to credit agreements in an effort to discourage lender liability litigation and to promote certainty in credit agreements.”). In 1989, the

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American Bar Association proposed a Model Act that would bar actions based on oral promises to lend, and by the early 1990s, over 30 states had passed similar statutes. Michael L. Weissman, State Legislation Limiting Lender Liability: The Need for Uniformity, 108 Banking L.J. 136 (1991). The Credit Agreements Act was enacted in 1989 and became effective in September 1990. Generally, the Act prohibits actions based on an oral promise to lend or other oral statements by “creditors.” It provides: A debtor may not maintain an action on or in any way related to a credit agreement unless the credit agreement is in writing, expresses an agreement or commitment to lend money or extend credit or delay or forbear repayment of money, sets forth the relevant terms and conditions, and is signed by the creditor and the debtor. 815 ILCS 160/2. A “creditor” is a person who is “engaged in the business of lending money or extending credit.” 815 ILCS 160/1(2). This definition may create issues in certain cases in which a wholly owned subsidiary extends credit for a parent corporation not otherwise engaged in the business of making loans. The Credit Agreements Act defines a “credit agreement” broadly, including any “agreement or commitment . . . to lend money or extend credit.” 815 ILCS 160/1(1). Section 3(3) of the Credit Agreements Act further requires any modification of an existing credit agreement to be in writing to be enforceable. See Whirlpool Financial Corp. v. Sevaux, 96 F.3d 216, 224 (7th Cir. 1996) (Whirlpool III); Teachers Insurance & Annuity Association of America v. LaSalle National Bank, 295 Ill.App.3d 61, 691 N.E.2d 881, 888, 229 Ill.Dec. 408 (2d Dist.), appeal denied, 179 Ill.2d 621 (1998), cert. denied, 119 S.Ct. 1043 (1999). The only exclusions from the Credit Agreements Act’s broad reach are agreements “primarily for personal, family or household purposes” and those agreements made “in connection with the issuance of credit cards.” 815 ILCS 160/1(1). This exception is strictly construed. In Whirlpool Financial Corp. v. Sevaux, 874 F.Supp. 181 (N.D.Ill. 1994) (Whirlpool II), aff’d, 96 F.3d 216 (7th Cir. 1996), a guarantor unsuccessfully attempted to invoke the personal purposes exception to avoid liability on a personal guarantee based on oral representations of the lender. The underlying loan had been made for the benefit of the guarantor’s company, however, and not for his personal purposes. The Credit Agreements Act thus barred his defense based on an alleged oral representation. Illinois courts have broadly construed and applied the Credit Agreements Act, dismissing cases and rendering judgments in favor of lenders without hesitation. See, e.g., Westinghouse Electric Corp. v. McLean, 938 F.Supp. 487 (N.D.Ill. 1996); General Electric Business Financial Services, Inc. v. Galbut, No. 10 C 5010, 2011 WL 5373990 (N.D.Ill. Nov. 2, 2011); MB Financial Bank v. THG Restaurant Group, LLC, No. 10 C 5854, 2011 WL 1630131 (N.D.Ill. Apr. 28, 2011). Any cause of action that depends on an oral credit agreement is barred by the Credit Agreements Act, regardless of whether such an action sounds in contract or tort. LaSalle Bank Nat’l Assoc v. Paramont Properties, 588 F.Supp.2d 840, 853 – 854 (N.D.Ill. 2008); JF

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Corp. v. Cargill Financial Services, Inc., 45 A.D.3d 370, 846 N.Y.S.2d 27 (2007) (applying Illinois Credit Agreements Act); General Electric Capital Corp. v. Donogh Homes, Inc., No. 93 C 5614, 1993 WL 524814 (N.D.Ill. Dec. 15, 1993); Klem v. First National Bank of Chicago, 275 Ill.App.3d 64, 655 N.E.2d 1211, 211 Ill.Dec. 828 (2d Dist. 1995); McAloon v. Northwest Bancorp, Inc., 274 Ill.App.3d 758, 654 N.E.2d 1091, 211 Ill.Dec. 281 (2d Dist. 1995); First National Bank in Staunton v. McBride Chevrolet, Inc., 267 Ill.App.3d 367, 642 N.E.2d 138, 204 Ill.Dec. 676 (4th Dist. 1994), appeal denied, 159 Ill.2d 566 (1995). Actions such as fraud, tortious interference, and similar actions are all barred unless there is a written agreement. Whirlpool III, supra, 96 F.3d at 226 (fraud barred when based on false oral representation); First National Bank in Staunton, supra, 642 N.E.2d at 142 (tortious interference with business relations barred when based on oral statements and representations). See also U.S. Bank National Ass’n v. Canny, No. 4:10CV421 CDP, 2011 WL 226965 (E.D.Mo. Jan. 24, 2011) (applying Illinois Credit Agreements Act and dismissing borrower’s counterclaims based on unwritten promises). Moreover, an oral credit agreement will not support an action for breach of the implied covenant of good faith and fair dealing. Teachers Insurance & Annuity, supra, 691 N.E.2d at 890 – 891; Household Commercial Financial Services Inc. v. Suddarth, No. 01 C 4355, 2002 WL 31017608 (N.D.Ill. Sept. 9, 2002) (claim for breach of covenant of good faith and fair dealing barred by Credit Agreements Act). In McAloon, supra, the court held that a written proposal submitted by a putative borrower was not a written “credit agreement” even though the lender’s directors placed their initials on it, as it had not been signed by the putative borrower. 654 N.E.2d at 1094. In First National Bank in Staunton, supra, a bank officer’s promise to a bank customer that the customer could wait until a particular day to make a deposit to cover a check the customer had written was an “offer of credit” that was not enforceable as it was not in writing. 642 N.E.2d at 141. The Credit Agreements Act was applied to e-mail communications between a borrower and its lender in A.H. Employee Co. v. Fifth Third Bank, No. 11 C 4586, 2012 WL 686704 (N.D.Ill. Mar. 1, 2012). In A.H. Employee, the court held that an exchange of e-mails discussing a possible extension of a revolving loan did not satisfy the Act. Specifically, the court held that the plaintiffs had failed to show that the e-mails “expressed an agreement to extend the A.H. Note, that the emails set forth the relevant terms and conditions, or that they were signed by both parties.” 2012 WL 686704 at *11. The Act’s requirement of a “signature” would seem to make it difficult, if not impossible, for borrowers to rely on electronic exchanges of communication to establish an enforceable agreement. Even in situations in which the Credit Agreements Act yields harsh results, Illinois courts generally have not flinched in their application of the Act. One court has expressed concern about whether the Act may be too rigid. In Machinery Transports of Illinois v. Morton Community Bank, 293 Ill.App.3d 207, 687 N.E.2d 533, 227 Ill.Dec. 283 (3d Dist. 1997), a customer’s complaint was barred even though the customer alleged not only an oral agreement, but also that the customer had fully performed all of its obligations pursuant to that agreement. Although the court noted that “strict application of this statute can easily lead to disastrous consequences in the hands of unscrupulous lenders,” it nevertheless applied the Act and resisted the plaintiff’s plea that a “full performance” exception to the Act be created. 687 N.E.2d at 535 – 536. The court, in

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First National Bank in Staunton, supra, also explicitly recognized the potential for “hard cases” under the Credit Agreements Act: We recognize such an interpretation causes a harsh result for bank customers in some circumstances. The Act is very broadly worded, however, and dictates such a result. Bank customers do make oral agreements with their banks. Most often these agreements are honored by the banks and no problem results. However, if a bank for some reason chooses not to honor the agreement, the customer has no recourse in the law. There is no justifiable reliance on an oral credit agreement as a matter of law in Illinois. 642 N.E.2d at 142. Even traditional defenses to actions otherwise barred by a statute of frauds, such as equitable and promissory estoppel, are precluded by the Act. Whirlpool III, supra, 96 F.3d at 226; Teachers Insurance & Annuity, supra, 691 N.E.2d at 887; Klem, supra, 655 N.E.2d at 1213; McAloon, supra, 654 N.E.2d at 1094 – 1095. Cf. K. Miller Construction Co. v. McGinnis, 394 Ill.App.3d 248, 913 N.E.2d 1147, 1152, 332 Ill.Dec. 857 (1st Dist. 2009) (even if full performance would satisfy statute of frauds, it cannot avoid requirements of statute enacted separately from Frauds Act, 740 ILCS 80/0.01, et seq.), aff’d in part, rev’d in part, 238 Ill.2d 284 (2010). Illinois courts continue to strictly enforce the Credit Agreements Act, even when the results may be distressing and harsh. In Help at Home, Inc. v. Medical Capital, L.L.C., 260 F.3d 748 (7th Cir. 2001), the Seventh Circuit reaffirmed that the Act would be applied as written. The plaintiff was a nonmedical, home care provider who had entered into a contract with the defendant pursuant to which the defendant agreed to extend credit to the plaintiff. Only the plaintiff signed the agreement. The financing promised by the defendant never materialized, forcing the plaintiff to obtain credit elsewhere at a higher rate and under less favorable terms. The plaintiff sued for breach of contract, promissory estoppel, and breach of the implied duty of good faith and fair dealing. The defendant moved to dismiss, based primarily on the Credit Agreements Act. The district court granted the motion. On appeal, the Seventh Circuit first considered whether the parties’ agreement was covered by the Credit Agreements Act. The Seventh Circuit found that the proposed arrangements between the plaintiff and the defendant fell within the definition of a credit agreement under the Act even though the defendant did not actually extend any credit. However, the Act requires the written contract to bear the signatures of both parties, and the agreement between the plaintiff and the defendant did not. The plaintiff argued that under Bank One, Springfield v. Roscetti, 309 Ill.App.3d 1048, 723 N.E.2d 755, 243 Ill.Dec. 452 (4th Dist. 1999), appeal denied, 189 Ill.2d 655 (2000), a credit agreement need not consist of a single document. Because there were numerous writings between the plaintiff and the defendant in Help at Home, supra, some signed by the plaintiff and some signed by the defendant, the plaintiff argued this requirement was satisfied. However, the Seventh Circuit did not find Roscetti, supra, helpful in resolving the issue it faced. Ultimately, the court held that the documents signed by both parties or signed by the defendant “simply do not encompass the entire loan agreement.” 260 F.3d at 757. Accordingly, it held that all of the plaintiff’s claims were unenforceable. Id.

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In R & B Kapital Development, LLC v. North Shore Community Bank & Trust Co., 358 Ill.App.3d 912, 832 N.E.2d 246, 295 Ill.Dec. 95 (1st Dist. 2005), the court held that an escrow agreement was a credit agreement for the purposes of the Credit Agreements Act. The plaintiff obtained a construction loan from the defendant for the renovation of property it owned and entered into an escrow trust and disbursing agreement whereby part of the construction loan would be used to pay the project’s subcontractors. The subcontractors were never paid and, consequently, ceased work on the project. The plaintiff sued its lender for negligent misrepresentation based on (1) statements the defendant made during negotiation of the escrow agreement and (2) breach of fiduciary duty. The court found that the escrow agreement was an integral part of the construction loan, based on the broad language of the Credit Agreements Act and the line of cases interpreting the Act. Thus, the plaintiff’s claims for negligent misrepresentation and breach of fiduciary duty were barred by the Act because they were based on oral statements relating to a credit agreement. Another allegedly negligent misrepresentation in the context of a construction loan was at the heart of Paramont Properties, supra. In that case, the borrower alleged that the lender had negligently misrepresented that it would lend amounts above the amount set forth in the written commitment in order to cover certain cost overruns. 588 F.Supp.2d at 853. The court dismissed the negligent misrepresentation claim on the basis that any and all actions in any way related to a credit agreement were barred if not in writing. 588 F.Supp.2d at 854. In Westinghouse Electric, supra, the Northern District of Illinois held that guarantors’ claims of economic duress based on alleged fraudulent representations by a lender were barred by the Credit Agreements Act. 938 F.Supp. at 493. In Nordstrom v. Wauconda National Bank, 282 Ill.App.3d 142, 668 N.E.2d 586, 588 – 589, 218 Ill.Dec. 102 (2d Dist. 1996), the court held that a lender’s oral promise to procure insurance for certain equipment serving as collateral was “related to” a credit agreement and therefore not enforceable. In Whirlpool Financial Corp. v. Sevaux, 866 F.Supp. 1097 (N.D.Ill. 1994) (Whirlpool I), the plaintiff sought to recover on an unpaid $1 million note. The defendant argued that the plaintiff falsely represented that if he would sign a $1 million note, the plaintiff would invest $17.5 million into the defendant’s company and that the note could be converted into equity and would not need to be repaid. The plaintiff then failed to make the promised investment and sued to recover the amount loaned pursuant to the note. The plaintiff filed a motion to strike the affirmative defenses and counterclaims of the defendant, based primarily on the Credit Agreements Act. On the motion to strike and dismiss, the district court held that the affirmative defenses were not based on a “credit agreement” within the meaning of the Act. 866 F.Supp. at 1100. The court held that a promise to forgive or extinguish an obligation was not included as part of the definition of a “credit agreement” in the Act, and this was essentially what the plaintiff was arguing — that a promise to forgive or extinguish an obligation was barred by the Act. In an alternative argument, the plaintiff pointed out that part of the investment the defendant alleged the plaintiff had promised to make was to take the form of “debentures” (i.e., debt) and, therefore, a credit agreement. However, the defendant amended his affirmative defenses to remove any reference to “debentures,” and the district court held, on considering the motion to strike and dismiss, that this was sufficient to avoid dismissal of the case on the basis of the Act. The court specifically

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reserved the issue for later, however, noting in a footnote that if “debentures were, in fact, part of the investment agreement . . . the agreement may therefore be precluded by the Act.” 866 F.Supp. at 1100 n.2. After discovery had been conducted, the plaintiff in Whirlpool Financial Corp. filed a motion for summary judgment, which the district court granted. In granting the motion for summary judgment, the court held that the defendant’s affirmative defenses and counterclaims were barred by the Credit Agreements Act after all. Whirlpool II, supra. The court noted that at the time it had considered the motion to dismiss, it was required to accept the defendant’s allegations as true, and the defendant had alleged that the plaintiff breached an oral agreement “to invest $17.5 million, as opposed to an agreement to lend $17.5 million.” [Emphasis in original.] 874 F.Supp. at 185. Subsequent discovery, referred to and relied on by the plaintiff in its motion for summary judgment, indicated that some of the $17.5 million was to take the form of loans or credit, and therefore the Credit Agreements Act applied and barred the defense raised by the defendant. 874 F.Supp. at 187 – 188. The Seventh Circuit affirmed. Whirlpool III, 96 F.3d at 226. See also Teachers Insurance & Annuity, supra, 691 N.E.2d at 887 (rejecting defendants’ contention that Credit Agreements Act should not apply when defendants raise oral credit agreements as defense to lender’s claims, and rejecting authorities from Minnesota recognizing equitable exceptions from similar statute). The Credit Agreements Act has thus nearly obliterated actions based on the oral representations or statements of a lender, at least in a commercial context. Lenders are cautioned, however, that the Act should be viewed as a “safety net” rather than an invitation to speak to borrowers with reckless abandon. In W.E. Davis v. Merrill Lynch Business Financial Services, Inc., No. 03 C 2680, 2004 WL 406810 (N.D.Ill. Feb. 13, 2004), the court granted a lender’s motion to dismiss claims for fraudulent misrepresentation and breach of fiduciary duty because these claims were based on oral statements that the court held could not be actionable under the Credit Agreements Act. See also DaimlerChrysler Services North America, LLC v. North Chicago Marketing, Inc., No. 02 C 5633, 2004 WL 741740, *4 (N.D.Ill. Apr. 6, 2004) (claim of fraudulent inducement foreclosed by Credit Agreements Act even though result was “harsh and distressing”); LaSalle Business Credit, Inc. v. Lapides, No. 00 C 8145, 2003 WL 722237 (N.D.Ill. Mar. 3, 2003) (claims for economic duress and fraud based on oral statements were barred by Credit Agreements Act); Suddarth, supra (claims of fraudulent inducement and breach of covenant of good faith and fair dealing barred by Credit Agreements Act); Finova Capital Corp. v. Slyman, No. 01 C 6244, 2002 WL 318294 (N.D.Ill. Feb. 25, 2002) (holding that performance does not take oral agreement out of Credit Agreements Act, but finding that action for breach of implied covenant of good faith and fair dealing was not covered by Act). The court in W.E. Davis, supra, denied the lender’s motion to dismiss the claims of intentional interference with business relationship and willful and wanton misconduct on the basis of the Credit Agreements Act, but dismissed them for other reasons. Not only are claims based on oral statements barred by the Credit Agreements Act, but also claims based on omissions of statements are similarly barred. VR Holdings, Inc. v. LaSalle Business Credit, Inc., No. 01 C 3012, 2002 WL 356515 (N.D.Ill. Mar. 6, 2002). Interestingly, in VR Holdings, the court dismissed a claim for breach of a written contract based on allegations

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that a lender failed to disclose that it was reducing credit availability pursuant to the contract and was not including certain inventory in the borrowing base. The court held that such omissions were “related to a credit agreement” but were not part of the agreement itself and were, therefore, not actionable pursuant to the Credit Agreements Act. 2002 WL 356515 at *4. B. [13.4] Written Commitments Borrowers frequently sue lenders for breach of a written commitment to lend money. Occasionally, these written commitments take the form of letters of intent, which may or may not rise to the level of an enforceable contract. In addition, loan agreements and related documents are frequently modified in writing as time passes and circumstances change. Finally, lenders face potential liability to their borrowers for breach of the implied covenant of good faith and fair dealing. One Illinois appellate court expanded the scope of potential liability for breach of the implied covenant of good faith and fair dealing by finding that duty to exist independently of any written contract. That decision is analyzed below in this section. Lenders need to take special care in their preliminary relationships with potential borrowers. The issue of when a legally binding obligation arises can be a tricky question to answer. Illinois cases clearly require parties to any contract to reach mutual assent before they will be bound, but judging whether parties have reached mutual assent is not an exact science. Courts will determine whether parties intended to be bound by looking at facts and circumstances objectively. Midland Hotel Corp. v. Reuben H. Donnelley Corp., 118 Ill.2d 306, 515 N.E.2d 61, 65, 113 Ill.Dec. 252 (1987). Thus, a lender’s subjective belief that it has not committed to extend credit is irrelevant. The Illinois Supreme Court requires an agreement to be “so definite as to its material terms . . . that the promises and performances to be rendered by each party are reasonably certain.” (1 Williston, Contracts §§38 through 48 (3d ed. 1957); 1 Corbin, Contracts §§95 through 100 (1963). Academy Chicago Publishers v. Cheever, 144 Ill.2d 24, 578 N.E.2d 981, 983, 161 Ill.Dec. 335 (1991). In Runnemede Owners, Inc. v. Crest Mortgage Corp., 861 F.2d 1053 (7th Cir. 1988), the court held that a lender had not made an enforceable commitment to lend. The commitment letter in Runnemede Owners provided that the lender would make the loan only subject to a number of conditions, including completion of its pre-closing investigation. The Seventh Circuit found that the plaintiff failed to allege a binding contract to loan money and thus affirmed the district court’s dismissal of the plaintiff’s breach-of-contract action. 861 F.2d at 1058. It is possible, however, that a lender in a similar situation could be found to have contractually committed to make the loan, as long as the specified conditions were satisfied. See, e.g., Lester v. Resolution Trust Corp., 125 B.R. 528, 530 – 531 (N.D.Ill. 1991) (enforceable agreement to lend existed even though there were certain conditions); Osuji v. Countrywide Home Loans, Inc., No. 05C4758, 2006 WL 2425333, **3 – 4 (N.D.Ill. Aug. 17, 2006) (finding that affirmative and ambiguous language in loan application “wrap up sheet” created question of fact as to whether loan contract existed even when loan application unambiguously stated it was not commitment to lend). See also Purcell Tire & Rubber Co. v. MB Financial Bank, NA, No. 4:09CV00179 AGF, 2011 WL 1258299, *4

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(E.D.Mo. Mar. 31, 2011) (applying Illinois law and concluding that “under the facts of the present case, the Illinois Supreme Court would hold that the Commitment Letter constituted an enforceable contract”). Lenders should, therefore, always include the circumstances under which they may refuse to lend pursuant to a commitment letter. If final approval of a loan committee is required upon completion of the lender’s due diligence, that condition should be clearly stated in the commitment, with a warning that the loan committee may disapprove the proposed loan on final review. If there is no enforceable agreement, there is no implied covenant of good faith and fair dealing. Continental Bank N.A. v. Modansky, 997 F.2d 309, 312 (7th Cir. 1993) (no implied duty of good faith during contract negotiation); Pommier v. Peoples Bank Marycrest, 967 F.2d 1115, 1120 (7th Cir. 1992) (“before there can be an implied covenant, there first must be a contract between the parties that the covenant can be implied from”); Cobb-Alvarez v. Union Pacific Corp., 962 F.Supp. 1049, 1055 (N.D.Ill. 1997). However, once parties have reached agreement on the essential terms of an agreement, they are bound to negotiate the ancillary details in good faith. A/S Apothekernes Laboratorium for Specialpraeparater v. I.M.C. Chemical Group, Inc., 678 F.Supp. 193 (N.D.Ill. 1988), aff’d, 873 F.2d 155 (7th Cir. 1989); Borg-Warner Corp. v. Anchor Coupling Co., 16 Ill.2d 234, 156 N.E.2d 513, 517 (1958). See also First National Bank of Chicago v. Atlantic Tele-Network Co., 946 F.2d 516, 520 – 521 (7th Cir. 1991) (once bank issues commitment letter, it is bound by implied obligation of good faith to bargain in good faith over terms of agreement left open by commitment); Assaf v. Trinity Medical Center, No. 10-4021, 2011 WL 3563087, *9 (C.D.Ill. Aug. 15, 2011) (“The fact that some matters may have been left for future agreement does not necessarily preclude a finding of intent to contract during preliminary negotiations.”). If a lender extends a written commitment that is subject to a number of conditions, it is likely that the lender will be under an obligation to act in good faith in determining whether these conditions have been satisfied. Under such circumstances, a lender who arbitrarily or capriciously withholds final approval of a loan after any conditions described in the written commitment have been satisfied is likely to be held liable for breach of the implied covenant of good faith and fair dealing. Once the agreement has been reached and reduced to writing, however, a lender must still be vigilant, as the relationship with the borrower continues, to honor all agreements with the borrower. The more complex the relationship, the more difficult this task can be. In Nilsson v. NBD Bank of Illinois, 313 Ill.App.3d 751, 731 N.E.2d 774, 247 Ill.Dec. 1 (1st Dist. 1999), appeal denied, 191 Ill.2d 535 (2000), a borrower alleged that (among other things) his lender breached its obligation to renew a line of credit for a one-year period. He claimed $15 million in damages incurred when he was forced to sell stock in his company to repay the line of credit on the lender’s demand. Although the jury returned a verdict in favor of the borrower, it awarded him only $15,000. In a case involving breach of an agreement to lend money, the measure of damages recoverable by a successful plaintiff is the higher cost of alternative financing unless it was foreseeable that alternative financing would not be available. Lester, supra, 125 B.R. at 532. If it was foreseeable that alternative financing would not be available, the lender is responsible only for the foreseeable actual damages resulting from the breach. Id., citing Hill v. Ben Franklin Savings & Loan Ass’n, 177 Ill.App.3d 51, 531 N.E.2d 1089, 1095, 126 Ill.Dec. 462 (2d Dist. 1988); RESTATEMENT (SECOND) OF CONTRACTS §351, cmt. e (1981).

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III. TORT THEORIES OF LENDER LIABILITY A. [13.5] Control or “Alter-Ego” Liability The contractual theories of liability discussed in §§13.2 – 13.4 above and many of the theories of liability discussed in §§13.6 – 13.16 below relate to actions that a borrower might bring against a lender. Control or “alter-ego” liability, however, usually relates to liability that might be imposed on a lender by third parties as a result of unlawful behavior by a borrower. One author refers to this as “relational” liability, rather than “transactional” liability. Edward F. Mannino, LENDER LIABILITY AND BANKING LITIGATION §6.01, p. 6-3 (rev. ed. 2000). Excessive control of a borrower by its lender is not a tort per se. This type of liability results from actions related to the borrower’s conduct that give rise to actions pursuant to securities, environmental, tax, and racketeering statutes and common-law theories such as equitable subordination and the alter-ego doctrine. Statutory liability and equitable subordination are considered in §§13.17 – 13.25 below. Alter-ego theories are considered here. When a lender has exercised control over its customer, it may be held liable in lieu of, or in addition to, its customer. This kind of liability is occasionally referred to as “alter-ego” liability. Cases in which a lender’s control of its borrower has led to liability for actions of the borrower are rare. Section 14O of the RESTATEMENT (SECOND) OF AGENCY (1958) provides: A creditor who assumes control of his debtor’s business for the mutual benefit of himself and his debtor, may become a principal, with liability for the acts and transactions of the debtor in connection with the business. The comments to this section further provide that if a lender takes over the management of the debtor’s business either in person or through an agent, and directs what contacts may or may not be made, he becomes a principal, liable as any principal for the obligations incurred thereafter in the normal course of business by the debtor who has now become his general agent. The point at which the creditor becomes a principal is that at which he assumes de facto control over the conduct of his debtor, whatever the terms of the formal contract with his debtor may be. RESTATEMENT (SECOND) OF AGENCY §14O, cmt. a. The instrumentality or alter-ego doctrine may expose a lender to claims by the borrower that the lender’s control caused damage to the borrower, or it may expose the lender to claims by the borrower’s creditors, either for the debts of the borrower to those creditors or for equitable subordination. Most control cases turn on the issue of whether there is such a close relationship between the lender and borrower that the lender stands in a fiduciary relationship with the borrower. Ordinarily, no such relationship would exist between the lender and the borrower. Freibert v. Merrill Lynch Business Financial Services, 230 Fed.Appx. 531, 537 – 538 (6th Cir. 2007)

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(applying Illinois law); Northern Trust Co. v. Burlew, 171 Ill.App.3d 1000, 525 N.E.2d 1123, 1126, 121 Ill.Dec. 816 (1st Dist.), appeal denied, 123 Ill.2d 560 (1988); Samuel R. Miller and Angelo L. Calfo, The Fiduciary Duty of Lenders Through Excessive Involvement or Control Over Borrowers in Lender Liability Cases, LENDER LIABILITY LITIGATION 1988: RECENT DEVELOPMENTS, p. 187 (PLI Com. Law & Prac. Course Handbook Series No. 468, 1988). Liability based on a breach of fiduciary duty is considered fully in §13.11 below. However, the issue of fiduciary relationships specifically as they relate to alter-ego liability arose in two cases decided by federal courts in Illinois. In In re Prima Co., 98 F.2d 952 (7th Cir. 1938), cert. denied, 59 S.Ct. 357 (1939), the trial court found that a lender’s suggestion that its borrower hire a particular individual as a manager resulted in the borrower becoming an instrumentality of the lender. The borrower’s bankruptcy trustee sought to impose liability on the lender for foisting the individual on the borrower and for the damage caused by that individual’s mismanagement. The Seventh Circuit found no fiduciary relationship was created as a result of the lender’s suggestion and thus reversed the trial court’s decision. The court of appeals found it significant that the borrower had an opportunity to suggest its own manager but failed to do so and that there was no threat by the lender that forced the borrower to hire the individual in question. 98 F.2d at 964. Judge Schmetterer of the United States Bankruptcy Court for the Northern District of Illinois also determined that no fiduciary relationship existed between a lender and a borrower in Badger Freightways, Inc. v. Continental Illinois National Bank & Trust Company of Chicago (In re Badger Freightways, Inc.), 106 B.R. 971 (Bankr. N.D.Ill. 1989). In Badger, a trucking company alleged that its lender, Continental Bank, suggested the employment of a former Continental employee as the chief operating officer of Badger. 106 B.R. at 973, 978 – 979. The bank allegedly told Badger that it “should” let the new officer and another person selected by the bank run the business and that Badger’s current officers “should not” involve themselves in the day-today management of the business. 106 B.R. at 973. Badger sought equitable subordination of Continental’s claims in Badger’s subsequent bankruptcy case. This required Badger to first establish a fiduciary relationship. The court recognized that ordinarily no fiduciary relationship exists between a lender and a borrower. However, there is an exception when the lender controls its borrower. Judge Schmetterer wrote: An exception to this general rule exists when the lending institution exerts “dominion and control” over its customer. The rationale behind this exception is significant. If the lending institution usurps the power to make business decisions from the customer’s board of directors and officers, then it must also undertake the fiduciary obligation that the officers and directors owe the corporation (and its creditors). This reasoning also dictates the scope of the term “control.” What is required is operating control of the debtor’s business, because only in that situation does a creditor assume the fiduciary duty owed by the officers and directors. 106 B.R. at 977. Hiring a manager on the recommendation of the lender — even a manager with a close relationship to the lender — did not amount to control in Badger.

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Similarly, the bankruptcy court for the Northern District of Illinois rejected a borrower’s claim that its lender exercised undue control over the borrower in American Consolidated Transportation Cos. v. RBS Citizens, N.A. (In re American Consolidated Transportation Cos.), 433 B.R. 242 (Bankr. N.D.Ill. 2010). In this case, the court held that a forbearance agreement that required the borrower to hire a consultant did not amount to the “exercise of managerial discretion to such an extent that the lender usurps the power of the borrower’s directors and officers to make business decisions.” 433 B.R at 253. As examples of what might constitute “control” sufficient to expose a lender to liability, the court wrote that “a lender controls its borrower when it has a legal right to a controlling interest in the borrower’s stock, effectuates termination of all employees except those necessary to liquidate the business, contracts for a security force to guard the borrower, determines which of the borrower’s creditors are paid, and tells a corporate officer he can quit if he disapproves of the lender’s conduct.” 433 B.R at 254. Control cases do not occur frequently. Lenders should, nevertheless, be familiar with them and exercise restraint in the degree to which they involve themselves in the management of their borrowers’ businesses. B. [13.6] Fraud One of the most common theories of lender liability is fraud. Fraud may be premised on a false representation made by a lender or by a failure to disclose material information in derogation of a duty to disclose that information. 1. [13.7] False Representation Fraud based on a false representation has six elements: (a) a false statement of material fact; (b) the party making the statement knew or believed it to be false; (c) an actual and justified reliance on the statement or omission; (d) the statement was made with the intention of inducing the recipient to act; (e) an action by the recipient in reliance on the statement; and (f) a reliance on the false statement caused the recipient’s injury. See, e.g., Nilsson v. NBD Bank of Illinois, 313 Ill.App.3d 751, 731 N.E.2d 774, 783 – 784, 247 Ill.Dec. 1 (1st Dist. 1999), appeal denied, 191 Ill.2d 535 (2000); Frankel v. Otiswear, Inc., 216 Ill.App.3d 204, 576 N.E.2d 955, 160 Ill.Dec. 1 (1st Dist. 1991); Farm Credit Bank of St. Louis v. Isringhausen, 210 Ill.App.3d 724, 569 N.E.2d 235, 155 Ill.Dec. 235 (4th Dist. 1991); Commercial National Bank of Peoria v. Federal Deposit Insurance Corp., 131 Ill.App.3d 977, 476 N.E.2d 809, 87 Ill.Dec. 107 (3d Dist. 1985); Davis v. G.N. Mortgage Corp., 396 F.3d 869, 881 – 882 (7th Cir. 2005); New Freedom Mortgage Corp. v. C & R Mortgage Corp., No. 03 C 3027, 2004 WL 783206 (N.D.Ill. Jan. 15, 2004); Chow v. Aegis Mortgage Corp., 286 F.Supp.2d 956, 964 (N.D.Ill. 2003) (plaintiff must establish intent to deceive); Schrager v. North Community Bank, 328 Ill.App.3d 696, 767 N.E.2d 376, 262 Ill.Dec. 916 (1st Dist. 2002) (action for misrepresentation cannot be based on opinion, but question of fact precluded entry of summary judgment for lender). Today, in lender liability cases, one may add to the list that a statement to one with whom the lender has a credit agreement must be in writing or it will be barred by the Credit Agreements Act. DaimlerChrysler Services North America, LLC v. North Chicago Marketing, Inc., No. 02 C 5633, 2004 WL 741740 (N.D.Ill. Apr. 6, 2004) (claim of fraudulent inducement foreclosed by

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Credit Agreements Act even though result was harsh and distressing); W.E. Davis v. Merrill Lynch Business Financial Services, Inc., No. 03 C 2680, 2004 WL 406810 (N.D.Ill. Feb. 13, 2004) (claim for fraudulent misrepresentation dismissed on basis that oral misrepresentations are not actionable pursuant to Credit Agreements Act); LaSalle Business Credit, Inc. v. Lapides, No. 00 C 8145, 2003 WL 722237 (N.D.Ill. Mar. 3, 2003) (claim for fraud based on extra-contractual representation barred by Credit Agreements Act); Household Commercial Financial Services Inc. v. Suddarth, No. 01 C 4355, 2002 WL 31017608 (N.D.Ill. Sept. 9, 2002) (claim of fraudulent inducement to sign guaranty barred by Credit Agreements Act). See, e.g., Westinghouse Electric Corp. v. McLean, 938 F.Supp. 487, 493 (N.D.Ill. 1996) (“[d]efendants have not submitted any case law, nor can this court reason to a rule which requires that a fraud claim trumps or precludes application of the Credit [Agreements] Act”); McAloon v. Northwest Bancorp, Inc., 274 Ill.App.3d 758, 654 N.E.2d 1091, 1094 – 1096, 211 Ill.Dec. 281 (2d Dist. 1995) (barring claim based on fraud on basis of Credit Agreements Act); First National Bank in Staunton v. McBride Chevrolet, Inc., 267 Ill.App.3d 367, 642 N.E.2d 138, 140 – 142, 204 Ill.Dec. 676 (4th Dist. 1994), appeal denied, 159 Ill.2d 566 (1995). The Credit Agreements Act is limited in its application to actions brought by “debtors.” 815 ILCS 160/2. A “debtor” is “a person who obtains credit or seeks a credit agreement or claims the existence of a credit agreement with a creditor or who owes money to a creditor.” 815 ILCS 160/1(3). The Credit Agreements Act provides that a lender will not be liable to any person who is not in privity of contract with the creditor for civil damages arising out of a credit agreement, but specifically excludes actions brought by such persons based on alleged fraud by the creditor. 815 ILCS 160/3.1. Thus, another creditor who brings an action against a lender based on fraud will not be barred from maintaining that action by the Credit Agreements Act. There are relatively few Illinois cases discussing what facts are material in a lender liability context or cases involving an issue of intent. Certain cases do address the issue of whether a particular statement amounts to a statement of fact as opposed to an expression of opinion or a statement intended to create a certain impression without amounting to a statement of fact. Schrager, supra (action for misrepresentation cannot be based on opinion, but question of fact precluded entry of summary judgment for lender). In In re EDC, Inc., 930 F.2d 1275 (7th Cir. 1991), certain trade creditors alleged that a lender to their common borrower had engaged in fraud when it created the false impression that the borrower’s business was sound. In EDC, the lender was International Harvester Company, the seller of a subsidiary business, Wisconsin Steel. International Harvester accepted a $50 million note from Envirodyne Industries, the buyer of Wisconsin Steel. The trial court conducted a trial and determined that no fraud had occurred. On appeal, the Seventh Circuit rejected the contention that lending money to a shaky enterprise fraudulently creates an impression to trade creditors that the enterprise is solvent. 930 F.2d at 1281. This is an example of a cause of action that would not be barred by the Credit Agreements Act, as it was not an action brought by a debtor and, although the other trade creditors were not in privity of contract with the lender, the exception of 815 ILCS 160/3.1 applies and permits such actions. While statements that might create a certain false impression were sufficient to result in liability for fraud in the infamous Farah Manufacturing case in Texas (State National Bank of El Paso v. Farah Manufacturing Co., 678 S.W.2d 661 (Tex. 1984)), a statement must be factual in

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nature to be actionable in Illinois. See Continental Bank, N.A. v. Meyer, 10 F.3d 1293, 1298 – 1299 (7th Cir. 1993); Peterson Industries, Inc. v. Lake View Trust & Savings Bank, 584 F.2d 166, 169 (7th Cir. 1978). In Continental Bank, the lender allegedly made oral statements to investors in the borrower that the borrower’s business was “structured so as to make a profit,” that it was a “risk free investment,” that the borrower (a horse-breeding concern) “had highest quality horses,” and that the borrower “was managed by competent General Partners.” 10 F.3d at 1296. These statements were not actionable, according to the Seventh Circuit. 10 F.3d at 1299. Similarly, in Peterson Industries, supra, the lender had expressed confidence in the management of its borrower to its borrower’s trade creditors, who contended that they relied on the lender’s representations in extending credit to the borrower. When the borrower expired, one trade creditor sued the borrower’s lender for fraud, but the Seventh Circuit held that expressions of support for the borrower’s management and likely success were not actionable as fraud. 584 F.2d at 169. Both Continental Bank and Peterson Industries are also examples of cases that would not be barred by the Credit Agreements Act. Illinois cases far more frequently focus on the issue of justifiable reliance. This may be due to tension in the Illinois decisions regarding the circumstances under which a borrower might justifiably rely on a lender’s false statement. In 1960, the Illinois Supreme Court held in Schmidt v. Landfield, 20 Ill.2d 89, 169 N.E.2d 229, 232 (1960), that a party was not justified in relying on representations when that party had “ample opportunity to ascertain the truth of the representations” and failed to “avail himself of the means of knowledge open to him.” Three years later, the Illinois Supreme Court held in Eisenberg v. Goldstein, 29 Ill.2d 617, 195 N.E.2d 184, 186 (1963), cert. denied, 84 S.Ct. 1645 (1964), that if a party makes an intentionally false statement that is relied on by the other party, the speaker may not “charge the other with negligence in believing it.” Schrager, supra, 767 N.E.2d at 386 – 387 (denying motion for summary judgment on basis that genuine issue of material fact existed as to whether plaintiff’s reliance on lender’s alleged misrepresentation was justified). Dean Prosser endorses the Eisenberg holding over the Schmidt holding (William Lloyd Prosser, HANDBOOK OF THE LAW OF TORTS §108, p. 716 (4th ed. 1971)), yet the Illinois courts and the Seventh Circuit have almost uniformly held in favor of lenders by applying the Schmidt line of reasoning. “As a practical matter,” the Illinois appellate court said in Chicago Title & Trust Co. v. First Arlington National Bank, 118 Ill.App.3d 401, 454 N.E.2d 723, 729, 73 Ill.Dec. 626 (1st Dist. 1983), the “courts apply elements of both lines of authority, and all the relevant circumstances of the particular case must be considered in determining whether plaintiff’s reliance was justifiable.” In Runnemede Owners, Inc. v. Crest Mortgage Corp., 861 F.2d 1053 (7th Cir. 1988), the plaintiff unsuccessfully sought to impose liability on a lender for allegedly fraudulent representations made by the lender’s chairman. The lender made a written commitment to lend. Despite the fact that the commitment was conditional upon approval by the lender’s loan committee, the chairman allegedly told the borrower: “Don’t worry about the committee, I am the committee. What I say, goes. We have a deal.” 861 F.2d at 1055. The trial court held that these statements were insufficient as a matter of law to state a cause of action for fraud, and the Seventh Circuit agreed. The plaintiff was not justified in relying on these remarks, the court said, if the plaintiff relied at all. In considering whether reliance was justified, the Seventh Circuit took

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into account the parties’ relative knowledge of the facts available, their opportunity to investigate the facts, and their prior business experience. 861 F.3d at 1058, citing Luciani v. Bestor, 106 Ill.App.3d 878, 436 N.E.2d 251, 256, 62 Ill.Dec. 501 (3d Dist. 1982). The court held that when the plaintiff is an experienced businessperson, has an opportunity to learn the truth, and fails to conduct any investigation, the court will not likely find justifiable reliance. 861 F.3d at 1058 – 1059. Although the Seventh Circuit cited neither Schmidt nor Eisenberg, its consideration of the issue appears closer to the Schmidt analysis than the Eisenberg approach. Similarly, the appellate court reversed a verdict in favor of a borrower in Delcon Group, Inc. v. Northern Trust Corp., 187 Ill.App.3d 635, 543 N.E.2d 595, 600, 135 Ill.Dec. 212 (2d Dist.), appeal denied, 128 Ill.2d 672 (1989), after finding that the borrower could not have justifiably relied on the alleged misrepresentations of the lender. As the Seventh Circuit had earlier held in Runnemede Owners, supra, the Illinois appellate court held in Delcon Group that reliance is not justified if the party relying on the representations has the opportunity to ascertain the truth and fails to avail itself of that opportunity. 543 N.E.2d at 604, citing Schmidt, supra, 169 N.E.2d at 232. See also Nilsson, supra, 731 N.E.2d at 784 (affirming directed verdict for lender on fraud claim when plaintiff, experienced businessman, had full opportunity to learn facts and failed to do so and no evidence of reasonable reliance was presented). However, if a lender misstates the terms of the loan to induce the borrower to modify it, the lender could be liable for fraudulent misrepresentation. In Bank of America v. All About Drapes, Inc., 2015 IL App (1st) 142772-U, the borrower entered into a letter of credit with no set maturity date. The lender subsequently misrepresented to the borrower that the letter of credit was close to maturity and induced the borrower to sign a loan modification that, among other things, released all claims against the lender and set a new maturity date. The lender later sued under the modified loan, and the borrower raised the affirmative defense of fraudulent inducement and asserted a counterclaim of fraudulent misrepresentation. The appellate court reversed the trial court’s entry of summary judgment for the lender, finding that there existed a factual dispute as to whether the lender had fraudulently induced the borrower into signing a loan modification. Justice Delort dissented from that holding and argued that the borrower could not prove justifiable reliance, because the borrower had admitted that he did not believe the bank’s representations and thus “knew that [the lender] was lying, bluffing, or simply was incorrect.” 2015 IL App (1st) 142772U at ¶70. The Seventh Circuit also took into account the relative sophistication of guarantors in Brazell v. First National Bank & Trust Company of Rockford, 982 F.2d 206, 210 (7th Cir. 1992). In Brazell, the court of appeals overturned a jury’s verdict in favor of the guarantors, finding that there was no evidence the lender had engaged in fraud, much less evidence that would meet the required clear and convincing standard of proof. G.N. Mortgage, supra, 396 F.3d at 883 (affirming summary judgment for lender on fraud claim when plaintiffs had full opportunity to read and review loan documents that directly contradicted alleged oral statements made by lender and consequently could not justifiably rely on lender’s statements); Tammerello v. Ameriquest Mortgage Co., No. 05-CV-0466, 2006 WL 2860936 (N.D.Ill. Sept. 29, 2006) (granting motion for summary judgment on basis that reliance cannot be reasonable when plaintiff had only to look at contract before him to discover fraud); Reger Development, LLC v. National City Bank, No. 08

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C 6200, 2009 WL 1233898 (N.D.Ill. Apr. 28, 2009) (borrower could not reasonably rely on alleged oral representations that contradicted terms of written loan agreement), aff’d, 592 F.3d 759 (7th Cir. 2010). In Farmer City State Bank v. Guingrich, 139 Ill.App.3d 416, 487 N.E.2d 758, 94 Ill.Dec. 1 (4th Dist. 1985), the appellate court rejected a strict application of either the Schmidt or the Eisenberg approach and instead applied elements of each, as discussed in Chicago Title & Trust, supra. The Fourth District stated that “[a] false representation made by an experienced banker as to the nature of loan instruments is calculated to disarm a relatively inexperienced person.” 487 N.E.2d at 765. This might have “lulled” such a person into failing to investigate “the truth of the representation.” Id. Nevertheless, although the trial court had dismissed the borrower’s claim for actual fraud, it had permitted the borrower to introduce evidence of the lender’s alleged fraud at trial and at the conclusion of the trial had found that evidence insufficient. Thus, the appellate court found the trial court’s error in dismissing the claim harmless. In City National Bank of Hoopeston v. Russell, 246 Ill.App.3d 302, 615 N.E.2d 1308, 186 Ill.Dec. 251 (4th Dist. 1993), the appellate court reversed a trial court’s summary judgment for a lender. In City National Bank of Hoopeston, the lender had informed a guarantor that his guaranty needed to be increased from $60,000 to $90,000 and allegedly told the guarantor that the total due from the borrower at the time was $90,000. The guarantor, relying on this figure as the total amount due and believing the machinery and crops serving as collateral for the loan to have a value of approximately $70,000 (thus leaving his risk on the guaranty at approximately $20,000), agreed. In truth, the borrower owed over $130,000. When the lender sought to collect on the guaranty, the guarantor raised fraud as an affirmative defense. The lender contended that the guarantor could not establish justifiable reliance, as the guarantor could have discovered the actual amount due had he “been more cautious.” 615 N.E.2d at 1313. The court disagreed, finding that a “guarantor is entitled to rely on the representations of fact made by the bank.” Id. See also Durham v. Loan Store, Inc., No. 04 C 6627, 2006 WL 3422183, *6 (N.D.Ill. Nov. 27, 2006) (denying defendant’s motion for summary judgment on fraud claim when defendant may have “lulled the plaintiff into a false sense of security” even when plaintiff was aware of misrepresentations in her loan application). Commercial National Bank of Peoria, supra, also applied the approach of Chicago Title & Trust, supra, and, citing Eisenberg, supra, held that a correspondent bank’s reliance on certain representations of the defendant was justified. The court referred to the long relationship between the two banks (50 years) and in particular the length of the relationship between the two bank officers (13 years). Under these circumstances, the court did not feel that the plaintiff’s failure to ascertain the truth, even though there was an opportunity to do so, should preclude relief. 476 N.E.2d at 814. In Whirlpool Financial Corp. v. Sevaux, 866 F.Supp. 1097, 1102, later proceeding, 874 F.Supp. 181 (N.D.Ill. 1994), aff’d, 96 F.3d 1216 (7th Cir. 1996), the court denied the plaintiff’s motion to strike and dismiss certain affirmative defenses raised by the defendant. In Whirlpool, the plaintiff argued that the defendant’s reliance on an oral statement that a $1 million note would be converted into an equity interest and would never need to be repaid was unjustifiable. The court disagreed, noting that in Runnemede Owners, supra, and similar cases, the alleged oral

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statements were flatly inconsistent with the terms of written agreements. The court did not explain how a statement that the note would not need to be repaid was not flatly inconsistent with the terms of the note itself. Nevertheless, the court denied the plaintiff’s motion to strike and dismiss. Later, the court granted summary judgment in favor of the plaintiff on these affirmative defenses and counterclaims, and the Seventh Circuit affirmed on appeal. 2. [13.8] Failure To Disclose Fraud need not be premised on a false representation. A failure to disclose material information in the face of a duty to inform someone of those facts can also constitute fraud. “Fraud encompasses any act, omission, or concealment calculated to deceive, including silence, if accompanied by deceptive conduct or suppression of material facts constituting an act of concealment.” Farm Credit Bank of St. Louis v. Isringhausen, 210 Ill.App.3d 724, 569 N.E.2d 235, 237, 155 Ill.Dec. 235 (4th Dist. 1991). See also Emery v. American General Finance, Inc., 71 F.3d 1343 (7th Cir. 1995). Illinois cases tend to center on the question of whether a lender has a duty to disclose certain information. A duty to disclose arises when a lender owes its borrower a fiduciary duty, but such a duty does not ordinarily exist. Schrager v. North Community Bank, 328 Ill.App.3d 696, 767 N.E.2d 376, 385, 262 Ill.Dec. 916 (1st Dist. 2002). See also Mountain Funding, Inc. v. Frontier Insurance Co., No. 01 C 2785, 2003 WL 22175378 (N.D.Ill. Sept. 19, 2003). Illinois courts have held that in the absence of a fiduciary relationship, a borrower cannot establish an “intentional concealment of a material fact.” Hassan v. Yusuf, 408 Ill.App.3d 327, 944 N.E.2d 895, 912, 348 Ill.Dec. 654 (1st Dist. 2011). See also Janowiak v. Tiesi, 402 Ill.App.3d 997, 932 N.E.2d 569, 342 Ill.Dec. 442 (1st Dist. 2010). In Schrager, supra, the appellate court reversed entry of summary judgment for a lender, finding that genuine issues of material fact existed. In VR Holdings, Inc. v. LaSalle Business Credit, Inc., No. 01 C 3012, 2002 WL 356515 (N.D.Ill. Mar. 6, 2002), the borrower plaintiff alleged that the lender defendant failed to disclose that it was reducing credit availability under their agreement and that it was not including certain inventory in calculating the borrowing base. The court held that such omissions were not actionable because they were “related to a credit agreement” but were not written. 2002 WL 356515 at *3. Instead, they were omissions on the part of the lender. Accordingly, claims for breach of contract, fraud, and economic duress were all dismissed. The U.S. District Court for the Northern District of Illinois similarly rejected guarantors’ claims that they were fraudulently induced into signing their guaranties due to material omissions of fact by the plaintiff. The court held that “concealment may not be a passive omission of facts during a business transaction but must have been done with the intent to deceive under circumstances creating an opportunity and duty to speak.” Truserv Corp. v. Chaska Building Center, Inc., No. 02 C 1018, 2003 WL 924509, *17 (N.D.Ill. Mar. 6, 2003), quoting Isringhausen, supra, 569 N.E.2d at 240. In Commercial National Bank of Peoria v. Federal Deposit Insurance Corp., 131 Ill.App.3d 977, 476 N.E.2d 809, 87 Ill.Dec. 107 (3d Dist. 1985), a lender was held liable for defrauding its correspondent bank by representing that the correspondent bank would be paid back from

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receivables generated by the borrower. The lender failed to disclose to the correspondent bank that the borrower had laid off all of its employees, that the borrower had a sizeable overdraft, and that the generation of the receivables was very uncertain. Under these circumstances, the court found that the lender had a duty to disclose this information. 476 N.E.2d at 813. In most cases, however, the Illinois courts have not found a duty to disclose information. Fraud based on a failure to disclose material facts was at the heart of Northern Trust Co. v. VIII South Michigan Associates, 276 Ill.App.3d 355, 657 N.E.2d 1095, 212 Ill.Dec. 750 (1st Dist. 1995). In this case, guarantors of a $10 million credit facility argued that the lender failed to disclose that the lender had classified the loan as “troubled” and that the lender took into account in making credit decisions the fact that it had made other loans to one of the guarantors and his company and the status of those loans. The appellate court held that lenders have no duty to disclose such information and, therefore, the failure to disclose this information could not constitute fraud. 657 N.E.2d at 1102 – 1103. In First Midwest Bank, N.A. v. Sparks, 289 Ill.App.3d 252, 682 N.E.2d 373, 379, 224 Ill.Dec. 812 (2d Dist. 1997), the court held that there was no duty on the part of the lender to disclose information absent a “special or fiduciary relationship.” A guarantor argued that the lender engaged in fraud when it failed to disclose to the guarantor the extent of other loans the lender had made to the borrower. The trial court entered judgment in favor of the lender after a jury trial, finding no such relationship existed and therefore no duty on the lender’s part to provide the information to the guarantor about other loans made to the borrower. Incidentally, the guarantor also brought a claim against the lender based on the Consumer Fraud and Deceptive Business Practices Act (Consumer Fraud Act), 815 ILCS 505/1, et seq., which does not require that a plaintiff establish a common-law duty to disclose. In addition, the Consumer Fraud Act does not require proof of actual reliance. Despite the lower standard of the Consumer Fraud Act and the trial court’s application of a higher standard, the plaintiff was unsuccessful on appeal. The appellate court held that the trial court’s determination that the plaintiff guarantor had failed to support his claim with evidence of reliance was harmless error, as the lender was precluded from disclosing the extent of the borrower’s other loans from the lender pursuant to §48.1(c)(1) of the Illinois Banking Act, 205 ILCS 5/1, et seq. 682 N.E.2d at 378, citing 205 ILCS 5/48.1. That statute precludes banks from disclosing this type of information about bank customers without their consent. In Continental Bank N.A. v. Modansky, 997 F.2d 309, 313 (7th Cir. 1993), the Seventh Circuit held that a lender did not have a duty to inform guarantors of the risks associated with providing certain additional guarantees. In Continental Bank N.A. v. Everett, 760 F.Supp. 713, 717 – 718 (N.D.Ill. 1991), aff’d, 964 F.2d 701 (7th Cir.), cert. denied, 113 S.Ct. 816 (1992), the court found that while a creditor has a duty to act in good faith, and this duty might require the creditor to inform guarantors of facts that materially increase the guarantor’s risk (citing McHenry State Bank v. Y & A Trucking, Inc., 117 Ill.App.3d 629, 454 N.E.2d 345, 349, 73 Ill.Dec. 485 (2d Dist. 1983)), there is no breach of the duty when the increased risk is a matter of law equally available to the guarantors as to the creditor. Moreover, the court found that the lender had not actively concealed any information from the guarantors. 760 F.Supp. at 717 – 718.

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3. [13.9] Consumer Fraud and Deceptive Business Practices Act Borrowers occasionally turn to the Consumer Fraud and Deceptive Business Practices Act as an alternative to, or in addition to, an action based on common-law fraud. The Consumer Fraud Act provides: Unfair methods of competition and unfair or deceptive acts or practices, including but not limited to the use or employment of any deception, fraud, false pretense, false promise, misrepresentation or the concealment, suppression or omission of any material fact, with intent that others rely upon the concealment, suppression or omission of such material fact, or the use or employment of any practice described in Section 2 of the “Uniform Deceptive Trade Practices Act,” approved August 5, 1965, in the conduct of any trade or commerce are hereby declared unlawful whether any person has in fact been misled, deceived or damaged thereby. 815 ILCS 505/2. The Consumer Fraud Act has been held to apply to mortgage lenders. Perez v. Citicorp Mortgage, Inc., 301 Ill.App.3d 413, 703 N.E.2d 518, 523, 234 Ill.Dec. 657 (1st Dist. 1998), citing Mid-America National Bank of Chicago v. First Savings & Loan Association of South Holland, 161 Ill.App.3d 531, 515 N.E.2d 176, 113 Ill.Dec. 367 (1st Dist. 1987). To establish a claim pursuant to §2 of the Consumer Fraud Act, a plaintiff must prove a. a deceptive act or practice by the defendant; b. the defendant’s intent that the plaintiff rely on the deception; and c. the occurrence of the deception in the course of conduct involving trade and commerce. Perez, supra, citing Connick v. Suzuki Motor Co., 174 Ill.2d 482, 675 N.E.2d 584, 594, 221 Ill.Dec. 389 (1996), Elson v. State Farm Fire & Casualty Co., 295 Ill.App.3d 1, 691 N.E.2d 807, 816, 229 Ill.Dec. 334 (1st Dist. 1998), and First Midwest Bank, N.A. v. Sparks, 289 Ill.App.3d 252, 682 N.E.2d 373, 377, 379, 224 Ill.Dec. 812 (2d Dist. 1997). The Consumer Fraud Act is broader than common-law fraud, as it encompasses any deception or false promise. Bankier v. First Federal Savings & Loan Association of Champaign, 225 Ill.App.3d 864, 588 N.E.2d 391, 167 Ill.Dec. 750 (4th Dist.), appeal denied, 146 Ill.2d 622 (1992); Connor v. Merrill Lynch Realty, Inc., 220 Ill.App.3d 522, 581 N.E.2d 196, 163 Ill.Dec. 245 (1st Dist. 1991), appeal denied, 143 Ill.2d 636 (1992). Another significant difference between the Consumer Fraud Act and common-law fraud is the element of reliance. A plaintiff need not prove actual reliance on any statement, misrepresentation, or concealment in order to establish a claim pursuant to the Consumer Fraud Act. Perez, supra, 703 N.E.2d at 523, citing Siegel v. Levy Organization Development Co., 153 Ill.2d 534, 607 N.E.2d 194, 180 Ill.Dec. 300 (1992). See also O’Brien v. Landers, No. 1:10-CV-02765, 2011 WL 221865, *3 (N.D.Ill. Jan. 24, 2011); Wendorf v. Landers, 755 F.Supp.2d 972, 979 (N.D.Ill. 2010). The plaintiff is also not required to establish any common-law duty to disclose. “Concealment is actionable where it is employed as a device to mislead and the concealed fact must be such that had the other party been aware of it, he would have acted differently.” Sparks, supra, 682 N.E.2d at 378.

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If the plaintiff is not a consumer under the Consumer Fraud Act, it must allege a nexus between the defendant’s conduct and “general consumer protection concerns.” New Freedom Mortgage Corp. v. C & R Mortgage Corp., No. 03 C 3027, 2004 WL 783206, *10 (N.D.Ill. Jan. 15, 2004), citing Lake County Grading Company of Libertyville, Inc. v. Advance Mechanical Contractors, Inc., 275 Ill.App.3d 452, 654 N.E.2d 1109, 1116, 211 Ill.Dec. 299 (2d Dist. 1995). In New Freedom Mortgage, the court granted the defendant’s motion to dismiss on the basis that the plaintiff failed “to allege any public injury or injury to consumers in general.” 2004 WL 783206 at *10. Conduct by a lender that is unfair is actionable under the Consumer Fraud Act. In re Limberopoulos, No. 02 C 5008, 2004 WL 528005 (N.D.Ill. Mar. 16, 2004) (plaintiff must demonstrate deception to state claim pursuant to Consumer Fraud Act); Chow v. Aegis Mortgage Corp., 286 F.Supp.2d 956, 964 (N.D.Ill. 2003) (common-law fraud is more narrow than Consumer Fraud Act). What constitutes unfair conduct is determined on a case-by-case basis. Perez, supra, 703 N.E.2d at 523. See also Davis v. G.N. Mortgage Corp., 396 F.3d 869 (7th Cir. 2005) (plaintiff is not required to show actual reliance or diligence in ascertaining accuracy of misstatements). Courts consider “(1) whether the practice offends public policy; (2) whether it is oppressive; and (3) whether it causes the consumer substantial injury” in determining whether particular conduct is unfair. Saunders v. Michigan Avenue National Bank, 278 Ill.App.3d 307, 662 N.E.2d 602, 608, 214 Ill.Dec. 1036 (1st Dist.) (citing Federal Trade Commission v. Sperry & Hutchinson Co., 405 U.S. 233, 31 L.Ed.2d 170, 92 S.Ct. 898 (1972)), appeal denied, 167 Ill.2d 569 (1996). See also Limberopoulos, supra. Failure to disclose information is not actionable under the Consumer Fraud Act if federal law controls what disclosures are required and a bank or lender discloses the information required by federal law. Schulte v. Fifth Third Bank, 805 F.Supp.2d 560 (N.D.Ill. 2011); Hill v. St. Paul Federal Bank for Savings, 329 Ill.App.3d 705, 768 N.E.2d 322, 328, 263 Ill.Dec. 562 (1st Dist. 2002). In Perez, supra, the court held that a mortgage lender did not engage in unfair conduct by failing to disclose to its borrowers the terms and conditions on which private mortgage insurance (PMI) could be canceled. 703 N.E.2d at 523 – 524. The mortgage clearly required PMI until the obligation was paid in full, but the plaintiffs alleged that the defendant’s internal policy was to cancel PMI upon a borrower’s request once the borrower established a certain amount of equity in the mortgaged property. The plaintiffs alleged that it was unfair for the defendant to conceal or fail to disclose this policy to them. The court disagreed, holding that to impose such an obligation on the lender would be tantamount to rewriting the mortgage. 703 N.E.2d at 524. In Moore v. Fidelity Financial Services, Inc., 949 F.Supp. 673 (N.D.Ill. 1997), a borrower brought a claim against the finance company that financed the borrower’s purchase of a car. Although the court found that the borrower had not adequately pleaded a cause of action based on the Racketeer Influenced and Corrupt Organizations Act or common-law fraud, the court denied the defendant’s motion to dismiss the count based on the Consumer Fraud Act. In Nilsson v. NBD Bank of Illinois, 313 Ill.App.3d 751, 731 N.E.2d 774, 247 Ill.Dec. 1 (1st Dist. 1999), appeal denied, 191 Ill.2d 535 (2000), the appellate court affirmed a trial court’s

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directed verdict on the plaintiff’s claim against his lender based on the Consumer Fraud Act. The plaintiff offered evidence at trial that the lender committed a deceptive business practice by inserting a demand feature into the promissory note he signed. The trial court disagreed, holding that this was not a “deceptive lending practice” and furthermore finding that the plaintiff had not proved that the lender’s actions “proximately caused” any damages. 731 N.E.2d at 785. The appellate court affirmed. The appellate court characterized the dispute between the lender and borrower over what their true intentions were regarding whether the loan was to be a term or demand obligation as a “simple breach of contract.” Id. In Security First Network Bank v. C.A.P.S., Inc., No. 01 C 342, 2002 WL 485352 (N.D.Ill. Mar. 29, 2002), the court denied the plaintiff’s motion to dismiss the defendant’s claim pursuant to the Consumer Fraud Act. The defendant, a payroll service, alleged that its account at the plaintiff bank had been improperly debited as a result of fraudulent transactions of a third party. The defendant alleged that the plaintiff was aware that the third party had engaged in fraudulent transactions but failed to bring those transfers (or the possibility of additional fraudulent transactions) to its attention. The court held that such a claim could be sustained under the Consumer Fraud Act. C. [13.10] Negligent Misrepresentation Negligent misrepresentation was at one time a favorite cause of action for borrowers. A borrower must establish the following elements to state and prove a cause of action based on negligent misrepresentation: (1) a duty on the part of the lender to communicate accurate information; (2) a false statement of material fact; (3) the carelessness or negligence on the part of the lender in ascertaining the truth or falsity of the statement; (4) the lender’s intention to induce the plaintiff to act; (5) the plaintiff’s reliance on the false statement; and (6) the plaintiff’s damages resulting from that reliance. See Board of Education of City of Chicago v. A, C & S, Inc., 131 Ill.2d 428, 546 N.E.2d 580, 591, 137 Ill.Dec. 635 (1989), citing Soules v. General Motors Corp., 79 Ill.2d 282, 402 N.E.2d 599, 37 Ill.Dec. 597 (1980) (setting forth elements of negligent misrepresentation); New Freedom Mortgage Corp. v. C & R Mortgage Corp., No. 03 C 3027, 2004 WL 783206 (N.D.Ill. Jan. 15, 2004); Schrager v. North Community Bank, 328 Ill.App.3d 696, 767 N.E.2d 376, 262 Ill.Dec. 916 (1st Dist. 2002). The advent of the economic-loss doctrine, however, has all but abolished this cause of action in Illinois. The first element of negligent misrepresentation is proof of a duty. Duties can be seen as arising (1) as a matter of law or (2) as a matter of agreement. The law of torts generally controls duties that arise as a matter of law, while the law of contracts generally controls duties that arise as a matter of contract. The concept of the economic-loss doctrine is that when parties have reached an agreement that describes the duty one owes the other, any action between them should be controlled by that agreed-on duty, rather than a duty that would otherwise be imposed by law. Most duties that lenders owe their borrowers arise from a contract between the two parties. The Illinois Supreme Court adopted the economic-loss doctrine in 1982 in Moorman Manufacturing Co. v. National Tank Co., 91 Ill.2d 69, 435 N.E.2d 443, 61 Ill.Dec. 746 (1982). The court held in Moorman that purely economic losses arising out of contractual disputes are

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more appropriately recovered under contract law than under the law of torts. 435 N.E.2d at 447. The doctrine was later expanded to include disputes arising in a wide range of contexts in which parties had contractual relationships. In Anderson Electric, Inc. v. Ledbetter Erection Corp., 115 Ill.2d 146, 503 N.E.2d 246, 249, 104 Ill.Dec. 689 (1986), the court held that a “plaintiff seeking to recover purely economic losses” stemming from frustrated commercial expectations cannot recover in tort, “regardless of the plaintiff’s inability to recover under an action in contract.” There are exceptions to the general rule of the economic-loss doctrine. These exceptions include persons who have legal duties to others independent of their contracts and those defendants who are in the business of supplying information to others. Not long after it decided Moorman, supra, and Anderson Electric, supra, the Illinois Supreme Court, in Collins v. Reynard, 154 Ill.2d 48, 607 N.E.2d 1185, 1186, 180 Ill.Dec. 672 (1992), held that a lawyer can be sued in either contract or tort and that recovery could be sought in the alternative. Because attorneys owe their clients duties, regardless of the particular terms of their agreements with their clients, a plaintiff can bring an action in tort or in contract. The court wrote: Contract law applies to voluntary obligations freely entered into between parties. . . . Tort law, on the other hand, applies in situations where society recognizes a duty to exist wholly apart from any contractual undertaking. Tort obligations are general obligations that impose liability when a person negligently, carelessly or purposely causes injury to others. 607 N.E.2d at 1186. Both types of duties apply to attorneys. In Congregation of the Passion, Holy Cross Province v. Touche Ross & Co., 159 Ill.2d 137, 636 N.E.2d 503, 514, 201 Ill.Dec. 71, cert. denied, 115 S.Ct. 538 (1994), the Illinois Supreme Court stated: “The evolution of the economic loss doctrine shows that the doctrine is applicable to the service industry only where the duty of the party performing the service is defined by the contract that he executes with his clients.” In Congregation of the Passion, the court held that accountants — like lawyers (as the court recognized in Collins, supra) — have a duty to act reasonably and that the duty exists independently of any contract. Generally speaking, lenders (unlike attorneys and accountants) do not owe borrowers a duty beyond that established by their agreement. This is not always true, however. In Choi v. Chase Manhattan Mortgage Co., 63 F.Supp.2d 874, 885 (N.D.Ill. 1999), the Northern District of Illinois denied the defendant lender’s motion to dismiss the plaintiffs’ cause of action based on negligence as a result of the economic-loss doctrine. Instead, the court held that the lender owed an extra-contractual duty to the plaintiffs. In Choi, the plaintiffs lost their home when their mortgage lender bungled the payment of property tax and then further failed to file a petition to void the ensuing tax deed during the period of redemption. The defendants argued the plaintiffs’ effort to recover a purely economic loss using the tort theory of negligence was barred by the economic-loss doctrine. The court disagreed, stating: “Our review of the case law satisfies us that plaintiffs have adequately pled the existence of defendants’ duty to manage the escrow account

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and the accompanying tax obligations with professional competence and due care.” Id. Further, in Durham v. Loan Store, Inc., No. 04 C 6627, 2005 WL 2420389, *9 (N.D.Ill. Sept. 30, 2005), the court found that mortgage lenders fall within an exception to the Moorman doctrine. Mortgage contracts carry an “implied duty of professional competence” that arises “independently of contract.” Id., citing Ploog v. Homeside Lending, Inc., 209 F.Supp.2d 863, 875 (N.D.Ill. 2002). Indeed, the courts seem more likely to find an exception to the Moorman doctrine in cases involving consumers than those involving commercial borrowers. For example, in Bilek v. American Home Mortgage Servicing, No. 07 C 4147, 2010 WL 2836976 (N.D.Ill. July 15, 2010), consumer borrowers sued their mortgage loan servicer, claiming that the servicer negligently failed to properly service the loan. The defendant moved to dismiss based on the Moorman doctrine. The court denied the motion, however, holding that the servicer owed the plaintiffs a duty of care that they had adequately pled was not satisfied, and therefore was not barred by the economic-loss doctrine. The court agreed with the decision in Ploog, holding that “[m]ortgage contracts carry with them an implied duty of professional competence ‘analogous to the way the duty of good faith and fair dealing is imputed as a term of the contract.’ ” 2010 WL 2836976 at *3, quoting Ploog, supra, 209 F.Supp.2d at 875. However, the holdings in cases such as Ploog and Bilek were called into question by the Seventh Circuit’s decision in Wigod v. Wells Fargo Bank, N.A., 673 F.3d 547 (7th Cir. 2012). In Wigod, the court held that the plaintiff did not have a claim for negligent misrepresentation or negligent concealment against Wells Fargo based on an allegation that Wells Fargo misled her to believe it would modify her mortgage loan. Although the court found the borrower stated viable claims, it ruled that the “claims for negligent hiring or supervision and for negligent misrepresentation or concealment are . . . barred by Illinois’s economic loss doctrine because she alleges only economic harms arising from a contractual relationship.” 673 F.3d at 555. The Wigod decision is consistent with cases involving claims related to commercial loans. For example, in LaSalle Bank Nat’l Assoc v. Paramont Properties, 588 F.Supp.2d 840 (N.D.Ill. 2008), the district court dismissed a borrower’s negligence claim based on the lack of any common-law duty owed to a borrower by its lender. The defendant in Paramont Properties alleged that LaSalle was negligent in disregarding its own internal policies, making advances on the basis of flawed and incomplete budgets, and taking other actions the defendant contended were improper. The court stated that it “found no cases applying Illinois law which recognize (or refute) the existence of a general duty of care between lenders and borrowers.” 588 F.Supp.2d at 852. The court concluded that “Illinois does not, and would not, recognize a general duty of care owed by lenders to borrowers, especially not one that would create tort liability based on internal lending guidelines.” 588 F.Supp.2d at 853. Even if a lender has not undertaken the kind of obligations at issue in Choi, supra, it may nevertheless be liable for negligent misrepresentation if the borrower can convince the court that the lender is “in the business of supplying information for the guidance of others in their business transactions.” Moorman, supra, 435 N.E.2d at 452, citing Rozny v. Marnul, 43 Ill.2d 54, 250 N.E.2d 656, 660 – 661 (1969). Illinois courts recognize an exception to the economic-loss doctrine when this has been established. See also Orix Credit Alliance, Inc. v. Taylor Machine Works, Inc., 125 F.3d 468, 475 (7th Cir. 1997), citing Rankow v. First Chicago Corp., 870 F.2d

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356, 362 (7th Cir. 1989). Courts conduct a “case-by-case analysis to determine whether a party is in the business of supplying information.” 125 F.3d at 475, citing Rankow, 870 F.2d at 364. The focus is “on the nature of the information and its relation to the particular type of business conducted.” 125 F.3d at 475, quoting Coleman Cable Systems, Inc. v. Shell Oil Co., 847 F.Supp. 93, 95 (N.D.Ill. 1994). In a number of cases, courts in Illinois have held that lenders are in the business of supplying information. The Seventh Circuit’s opinion in Rankow, supra, is notable for its discussion of the history of the “in the business of supplying information” exception in Illinois. Although the case was brought against a bank and does address the question of whether First Chicago was in the business of supplying information to others, it did not involve a lender-borrower relationship. The bank provided information to participants in its dividend reinvestment and stock purchase plan related to the bank’s stock. Certain of those shareholders brought a lawsuit against the bank, alleging, among other things, that the bank had been negligent in making certain misrepresentations. The district court, relying on National Union Fire Insurance Company of Pittsburgh, PA. v. Continental Illinois Corp., 654 F.Supp. 316 (N.D.Ill. 1987), found that banks are not in the business of supplying information to others and dismissed the case. On appeal, the Seventh Circuit held that while the bank in National Union Fire Insurance had not been in the business of supplying information to others, that holding was not dispositive as to any negligent misrepresentation case a plaintiff might bring against a bank. Instead, “[a] precise, case-specific inquiry is required to determine whether a particular enterprise is ‘in the business of supplying information for the guidance of others in their business transactions.’ ” Rankow, supra, 870 F.2d at 361. While the court in Rankow easily found that the bank had provided information, “[t]he more difficult question,” the court wrote, was whether it was “in the business” of supplying that information. 870 F.2d at 363. In some cases, such as those involving termite inspectors, stockbrokers, and real estate brokers, that determination is easy: the “product” sold by those businesses is clearly information. Id. Other types of businesses clearly sell a tangible product, rather than information. Between these two extremes lie the more difficult cases, involving defendants whose business it is to provide both tangible goods (or other non-informational goods or services) and information. Financial services such as those provided by banks and stockbrokers present a particularly difficult problem, because there is a very thin line between an exchange of information about finances and actual financial transactions. See also Duchossois Indus. v. Stelloh, No. 87 C 4132 (N.D.Ill. Jan. 13, 1988) [1988 WL 2794]. That is why, as noted at the outset, it is particularly important in these settings to examine the particular information and transactions involved case by case. [Emphasis in original.] 870 F.2d at 364. The Seventh Circuit noted that in Citizens Savings & Loan Ass’n v. Fischer, 67 Ill.App.2d 315, 214 N.E.2d 612 (5th Dist. 1966), and Guaranty Bank & Trust Co. v. Reyna, 51 Ill.App.2d 412, 201 N.E.2d 144 (1st Dist. 1964), Illinois courts had found that banks could be liable for negligent misrepresentation. The court determined that the plaintiff had at least made a sufficient allegation that First Chicago was in the business of supplying information and that the claim should not have been dismissed. Rankow, supra, 870 F.2d at 366.

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In Rovell v. American National Bank (In re Rovell), 232 B.R. 381 (N.D.Ill. 1998), aff’d, 194 F.3d 867 (7th Cir. 1999), the plaintiff alleged that he relied on information negligently provided by his bank. He contended that he had written a check to pay a creditor and, after he sent the check, discovered that it was $10,000 more than was owed. His employee called the bank to determine whether the check had cleared and was told that the check had not yet cleared. It turned out the check had in fact cleared that day. Two days later, the plaintiff wrote another check to his creditor, this time for the correct amount. Both checks were cashed. In the plaintiff’s subsequent bankruptcy, the bank filed a proof of claim related to a line of credit provided to the plaintiff. The plaintiff objected to the bank’s claim and raised negligent misrepresentation as a basis for reducing the bank’s claim. The bankruptcy court held that the bank was not in the business of providing information regarding what checks had cleared and what checks had not cleared. On appeal, the district court found that the bank routinely provided information regarding what checks had cleared and what checks had not cleared for its customers to rely on in their business. Referring to Reyna, supra, Fischer, supra, DuQuoin State Bank v. Norris City State Bank, 230 Ill.App.3d 177, 595 N.E.2d 678, 172 Ill.Dec. 317 (5th Dist. 1992), and Rankow, supra, the court held that the bank was in the business of supplying information to others. Nevertheless, the court held that the plaintiff did not reasonably rely on the information provided by the bank and therefore affirmed the bankruptcy court decision. The Seventh Circuit affirmed the district court without discussion of the question of whether the bank was in the business of supplying information to others. In Marino v. United Bank of Illinois, N.A., 137 Ill.App.3d 523, 484 N.E.2d 935, 938, 92 Ill.Dec. 204 (2d Dist. 1985), the court held that the plaintiff had failed to plead or prove that the defendant was in the business of supplying information required to support a cause of action based on negligent misrepresentation. See also Continental Bank, N.A. v. Meyer, No. 88 C 8197, 1990 WL 147052 (N.D.Ill. Sept. 27, 1990) (defendant failed to allege that bank was in business of supplying information as required to support affirmative defense based on negligent misrepresentation). On the other hand, a bank’s motion to dismiss on the basis that it was not in the business of supplying information was denied in Bachmeier v. Bank of Ravenswood, 663 F.Supp. 1207, 1224 (N.D.Ill. 1987), in which the plaintiff at least pleaded that the bank met that standard. See also First Place Bank v. Skyline Funding, Inc., No. 10 CV 2044, 2011 WL 3273071 (N.D.Ill. July 27, 2011). In Instituto Nacional de Comercializacion Agricola (Indeca) v. Continental Illinois National Bank & Trust Co., 675 F.Supp. 1515, 1522 (N.D.Ill. 1987), the court stated that it would be an “impermissible stretch” to conclude the defendant’s business, “where it serves as confirming bank in the letter of credit area,” as being in “the business of supplying information for the guidance of others in their business transactions.” In DuQuoin State Bank, supra, the Illinois appellate court found that a bank was in the business of supplying information to others. The plaintiff bank alleged that the defendant bank had negligently supplied false information that the plaintiff relied on. The trial court found in favor of the plaintiff following a bench trial. The appellate court stated that there had “been no definitive analysis in the Illinois cases to date as to what principle should be applied in determining whether a party is ‘in the business of supplying information.’ ” 595 N.E.2d at 681 – 682. The court pointed to the testimony of the president of the defendant, who indicated that the bank was “in the business of loaning money to customers and in the course of its business

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would supply credit information about defendant’s customers to other financial institutions.” 595 N.E.2d at 682. The court held that this was enough: “Defendant was in the business of supplying information since it routinely gave out credit information to other banks.” 595 N.E.2d at 683. In an earlier case, the Illinois Appellate Court for the Second District held that a bank does not owe another creditor a duty to adequately investigate the creditworthiness of a common borrower. In Popp v. Dyslin, 149 Ill.App.3d 956, 500 N.E.2d 1039, 102 Ill.Dec. 938 (2d Dist. 1986), an owner of commercial property agreed to make certain improvements to the property and lease it to one of the defendants. In making this determination, the owner alleged that he relied on the fact that a codefendant bank had agreed to make a loan to the lessee. He alleged that the bank negligently investigated the creditworthiness of the lessee borrower, who paid neither one (the loan was insured by the Small Business Administration, however). While the court noted the issue of whether the bank was in the business of supplying information to others, it found that it was unnecessary to resolve that issue, as the bank did not owe any legal duty to the plaintiff. 500 N.E.2d at 1043. D. [13.11] Breach of Fiduciary Duty/Constructive Fraud Section 13.5 above explores a lender’s potential liability for controlling its borrower, which can, under some circumstances, result in a fiduciary relationship between the lender and its borrower. A fiduciary relationship may also result in certain situations in which the borrower places great trust and confidence in the lender. These situations are examined in this section below. As mentioned in §13.5 above, ordinarily no fiduciary relationship exists between a lender and its customer or a guarantor. Wigod v. Wells Fargo Bank, N.A., 673 F.3d 547 (7th Cir. 2012); Pendolino v. BAC Home Loans Servicing, LP, No. 10 C 5916, 2011 WL 3022265 (N.D.Ill. July 22, 2011); Jones v. Countrywide Home Loans, Inc., No. 09 C 4313, 2010 WL 551418 (N.D.Ill. Feb. 11, 2010); Tammerello v. Ameriquest Mortgage Co., No. 05 C 466, 2005 WL 1323559, *4 (N.D.Ill. June 2, 2005); Graham v. Midland Mortgage Co., 406 F.Supp.2d 948, 953 (N.D.Ill. 2005); Continental Bank, N.A. v. Modansky, 129 B.R. 159, 163 – 164 (N.D.Ill. 1991) (no fiduciary duty between lender and guarantor); Farmer City State Bank v. Guingrich, 139 Ill.App.3d 416, 487 N.E.2d 758, 763, 94 Ill.Dec. 1 (4th Dist. 1985). See also Teachers Insurance & Annuity Association of America v. LaSalle National Bank, 295 Ill.App.3d 61, 691 N.E.2d 881, 888, 229 Ill.Dec. 408 (2d Dist.) (“mortgagor-mortgagee relationship does not create a fiduciary relationship as a matter of law,” citing Northern Trust Co. v. Halas, 257 Ill.App.3d 565, 629 N.E.2d 158, 164, 195 Ill.Dec. 850 (1st Dist. 1993)), appeal denied, 179 Ill.2d 621 (1998), cert. denied, 119 S.Ct. 1043 (1999); Northern Trust Co. v. Burlew, 171 Ill.App.3d 1000, 525 N.E.2d 1123, 1126, 121 Ill.Dec. 816 (1st Dist.), appeal denied, 123 Ill.2d 560 (1988); LaSalle Bank Nat’l Assoc v. Paramont Properties, 588 F.Supp.2d 840, 853 n.1 (N.D.Ill. 2008). In certain circumstances, such as when the lender acts as an escrow agent, a lender may agree to act as a fiduciary for its customer. Vician v. Wells Fargo Home Mortgage, No. 2:05-CV-144, 2006 WL 694740 (N.D.Ind. Mar. 16, 2006) (applying Illinois law and finding fiduciary relationship between mortgagor and mortgagee when mortgagee managed mortgagor’s escrow fund). See, e.g., Choi v. Chase Manhattan Mortgage Co., 63 F.Supp.2d 874, 885 – 886 (N.D.Ill. 1999). A fiduciary relationship may also arise as a result of a special relationship between a lender and a

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borrower. Santa Claus Industries, Inc. v. First National Bank of Chicago, 216 Ill.App.3d 231, 576 N.E.2d 326, 330, 159 Ill.Dec. 657 (1st Dist. 1991); Paskas v. Illini Federal Savings & Loan Ass’n, 109 Ill.App.3d 24, 440 N.E.2d 194, 199, 64 Ill.Dec. 642 (5th Dist. 1982); Durham v. Loan Store, Inc., No. 04 C 6627, 2005 WL 2420389 (N.D.Ill. Sept. 30, 2005). In Pommier v. Peoples Bank Marycrest, 967 F.2d 1115 (7th Cir. 1992), the Seventh Circuit found inadequate evidence of a fiduciary relationship between a lender and a borrower. The court wrote: The essence of a fiduciary relationship is that one party is dominated by the other. Paskas, [supra,] 64 Ill.Dec. at 647, 440 N.E.2d at 199. The fact that one party trusts the other is insufficient. We trust most people with whom we choose to do business. Paskas, 64 Ill.Dec. at 647, 440 N.E.2d at 199, [DeWitt County Public Building Commission, Dewitt County, Illinois v. County of DeWitt, Illinois, 128 Ill.App.3d 11, 469 N.E.2d 689, 701, 83 Ill.Dec. 82 (4th Dist. 1984)] (quoting Southern Trust Co. v. Lucas, 245 F.2d 286, 288 (8th Cir. 1971)). The dominant party must accept the responsibility, accept the trust of the other party before a court can find a fiduciary relationship. DeWitt, 83 Ill.Dec. at 93, 469 N.E.2d at 700. “[A] slightly dominant business position . . . [does] not operate to turn a formal contractual relationship into a confidential or fiduciary relationship.” Mid-America [National Bank of Chicago v. First Savings & Loan Association of South Holland, 161 Ill.App.3d 531, 515 N.E.2d 176, 181, 113 Ill.Dec. 367 (1st Dist. 1987)]. See also, Burdett v. Miller, 957 F.2d 1375, 1381 (7th Cir. 1992) (“If a person solicits another to trust him in matters in which he represents himself to be expert as well as trustworthy and the other is not expert and accepts the offer and reposes complete trust in him, a fiduciary relation is established.”) Pommier must show that he placed trust and confidence in Peoples Bank, and that Peoples Bank gained influence and superiority over him. We are to look at factors such as: kinship, age disparity, health, mental condition, education, business experience, and the extent of reliance. Santa Claus, [supra,] 159 Ill.Dec. at 662, 576 N.E.2d at 331. [Emphasis in original.] 967 F.2d at 1119. See also BA Mortgage & International Realty Corp. v. American National Bank & Trust Company of Chicago, 706 F.Supp. 1364, 1372 (N.D.Ill. 1989); Kenneth M. Lodge and Thomas J. Cunningham, The Banker as Inadvertent Fiduciary: Beware a Borrower’s Special Trust and Confidence, 98 Com.L.J. 277 (1993). A fiduciary relationship must be established by clear and convincing evidence. Pommier, supra, 967 F.2d at 1119. A claim for breach of fiduciary duty survived a Federal Rule of Civil Procedure 12(b)(6) motion to dismiss in W.E. Davis v. Merrill Lynch Business Financial Services, Inc., No. 03 C 2680, 2004 WL 406810 (N.D.Ill. Feb. 13, 2004). Citing Pommier, supra, 967 F.2d at 1119, the court found that the lender had sought out the plaintiff to extend a line of credit. The court also found it relevant that (1) the principals of the borrower had executed personal guaranties, (2) the plaintiff relied on its line of credit to operate its business, and (3) the lender possessed financial statements of the borrower and knew the borrower relied on the line of credit. The court did not explain why these facts were relevant to the possibility that a fiduciary relationship existed between the borrower and the lender, other than to quote from Pommier that the essence of a

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fiduciary relationship was the exercise of dominion by one over another and the acceptance of the trust of the other. The court held that for purposes of a motion to dismiss pursuant to Fed.R.Civ.P. 12(b)(6), these allegations “show that particular circumstances may surround the relationship between [the lender] and [the borrower].” 2004 WL 406810 at *4. According to the court, the lender was “on notice of the claims [the borrower] is asserting for breach of fiduciary duty.” Id. Given the plaintiff’s allegations and the lender’s notice, the court refused to dismiss the borrower’s claims for breach of fiduciary duty. In Ploog v. Homeside Lending, Inc., 209 F.Supp.2d 863 (N.D.Ill. 2002), the U.S. District Court for the Northern District of Illinois held that a mortgagee who collects taxes from a mortgagor and holds them in escrow owes the mortgagor a fiduciary duty in connection with the funds collected. Alleged mismanagement of the escrowed funds, if established, would constitute a breach of fiduciary duty. 209 F.Supp.2d at 875. Moreover, damages for breach of such a duty are not barred by the economic-loss doctrine because they exist independent of the contract. Id. E. [13.12] Duress Although popular in some other jurisdictions, few borrowers in Illinois have attempted to advance a cause of action against lenders based on duress. In Dahl v. Federal Land Bank Assn. of Western Illinois, 213 Ill.App.3d 867, 572 N.E.2d 311, 157 Ill.Dec. 242 (3d Dist. 1991), the appellate court indicated that no independent cause of action based on duress is recognized in Illinois. The court said: As plaintiffs correctly point out, no Illinois court has to date recognized duress as an independent cause of action giving a right to affirmative relief as opposed to defensive relief. Duress has been available to avoid obligations, but not as an independent cause of action for damages. In the Introductory Note on Duress and Undue Influence to Sections 174 – 177 of the Restatement (Second) of Contracts the author of that commentary states: “Since duress and undue influence, unlike deceit, are not generally of themselves actionable torts, the victim of duress or undue influence is usually limited to avoidance and does not have an affirmative action for damages.” We decline to create a new cause of action urged upon us by plaintiffs. 572 N.E.2d at 314. See also Shields Enterprises, Inc. v. First Chicago Corp., 975 F.2d 1290, 1297 (7th Cir. 1992) (holding that Illinois does not recognize cause of action based on economic duress); Tibor Machine Products, Inc. v. Freudenberg-Nok General Partnership, No. 94 C 7635, 1996 WL 99896 (N.D.Ill. Feb. 29, 1996) (same). But see Holzman v. Barrett, 192 F.2d 113 (7th Cir. 1951) (assuming existence of such action without discussion). Two other Illinois cases have considered efforts by borrowers to establish an independent action for economic duress. See Lawless v. Central Production Credit Ass’n, 228 Ill.App.3d 500, 592 N.E.2d 1210, 1216 – 1219, 170

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Ill.Dec. 530 (4th Dist.), appeal denied, 146 Ill.2d 630 (1992); Butitta v. First Mortgage Corp., 218 Ill.App.3d 12, 578 N.E.2d 116, 120, 160 Ill.Dec. 937 (1st Dist.), appeal denied, 142 Ill.2d 652 (1991). Although neither Lawless nor Butitta expressly denied such a cause of action existed, in both cases the courts found the facts would not support a claim even if it did exist. In Westinghouse Electric Corp. v. McLean, 938 F.Supp. 487 (N.D.Ill. 1996), the court dismissed an affirmative defense and counterclaim of economic duress brought by a borrower against a lender. The court stated that “[e]conomic duress is present when (1) a wrongful act (2) induces a party to form a contract by depriving him of the exercise of free will.” 938 F.Supp. at 492 – 493, citing Resolution Trust Corp. v. Ruggiero, 977 F.2d 309, 313 (7th Cir. 1992), and Wallenius v. Sison, 243 Ill.App.3d 495, 611 N.E.2d 1096, 1101, 183 Ill.Dec. 448 (1st Dist. 1993). The borrower alleged that the lender made oral misrepresentations of its intention to enforce a note and some guarantees and that the lender wrongfully failed to disburse funds. The court held that any action based on oral misrepresentations was barred by the Credit Agreements Act and that the lender was under no obligation to disburse funds. As the lender had discretion with respect to disbursement of the funds, the court held that it owed the borrower a duty to act in good faith, but there was no evidence that the lender had acted arbitrarily or capriciously. 938 F.Supp. at 493 – 494. See also LaSalle Business Credit, Inc. v. Lapides, No. 00 C 8145, 2003 WL 722237 (N.D.Ill. Mar. 3, 2003) (claim for duress based on oral statements barred by Credit Agreements Act); VR Holdings, Inc. v. LaSalle Business Credit, Inc., No. 01 C 3012, 2002 WL 356515 (N.D.Ill. Mar. 6, 2002) (same). Economic duress is recognized in Illinois as an affirmative defense in certain circumstances, particularly when a party wishes to void a contractual obligation. The defense requires proof of wrongful conduct, however, and is rarely successful. In AM Credit Corp. v. Kitsos, No. 83 C 5344, 1985 WL 2228 (N.D.Ill. Aug. 2, 1985), two guarantors raised the defense of economic duress when a lender sued on their guaranties. They contended that the lender threatened that if they did not sign the guaranties, the lender would not extend credit. 1985 WL 2228 at *2. The court held that “[i]t is beyond doubt that a lender has the right to have documents signed before extending credit and that ‘the pressure of financial circumstances’ without more does not constitute duress.” 1985 WL 2228 at *3, citing Alexander v. Standard Oil Co., 97 Ill.App.3d 809, 423 N.E.2d 578, 582, 53 Ill.Dec. 194 (5th Dist. 1981). Moreover, the court held that the defendants’ ratified their guaranties by the “deliberate and continuous use of the line of credit for more than eighteen months.” 1985 WL 2228 at *3. In Northern Trust Co. v. Burlew, 171 Ill.App.3d 1000, 525 N.E.2d 1123, 121 Ill.Dec. 816 (1st Dist.), appeal denied, 123 Ill.2d 560 (1988), a borrower contended that his authorization of the sale of certain collateral was obtained by economic duress. The court stated that “duress is accomplished by a wrongful act or threat which induces another party to enter into a contract.” 525 N.E.2d at 1126, citing Kaplan v. Kaplan, 25 Ill.2d 181, 182 N.E.2d 706 (1962). After reviewing the record, the court held that the lender had not engaged in any wrongful conduct in obtaining the discretion to sell collateral and had not acted in bad faith in determining that selling the collateral was necessary. See also Kewanee Production Credit Ass’n v. G. Larson & Sons Farms, Inc., 146 Ill.App.3d 301, 496 N.E.2d 531, 533 – 534, 99 Ill.Dec. 838 (3d Dist. 1986) (reciting same elements and finding no evidence to support claim that judgment by confession had been obtained by economic duress).

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In Resolution Trust, supra, the court rejected a borrower’s defense based on economic duress. The defendant had prepared a letter describing the agreement between himself and the lender. In the letter, the defendant stated that the parties had mutually agreed that he would not be held personally responsible for the loan. The loan officer threatened to deny the loan unless that statement was stricken from the letter. As the defendant had to have the loan that day in order to avoid forfeiture of his interest in a business, he acceded to the lender’s demand. When the lender sought to hold the individual liable, he raised the defense of economic duress. He contended that but for his “precarious financial position” he would not have agreed to the lender’s demand. 977 F.2d at 313. The Seventh Circuit held, however, that “[d]uress is not shown by the fact that one was subjected to . . . a difficult bargaining position or the pressure of financial circumstances.” Id., citing Herget National Bank of Pekin v. Theede, 181 Ill.App.3d 1053, 537 N.E.2d 1109, 1112, 130 Ill.Dec. 780 (3d Dist. 1989), and Selmer Co. v. Blakeslee-Midwest Co., 704 F.2d 924, 928 (7th Cir. 1983). “[M]ere hard bargaining,” the court wrote, “is not enough.” 977 F.2d at 314, citing Federal Deposit Insurance Corp. v. Linn, 671 F.Supp. 547, 556, 559 (N.D.Ill. 1987). See also RIV VIL, Inc. v. Tucker, 979 F.Supp. 645, 655 – 656 (N.D.Ill. 1997); In re Olde Prairie Block Owner, LLC, 441 B.R. 298, 302 (Bankr. N.D.Ill. 2010). Threatening to take action that a lender is entitled to take does not constitute duress. See Bank of America, N.A. v. 108 N. State Retail LLC, 401 Ill.App.3d 158, 928 N.E.2d 42, 57, 340 Ill.Dec. 323 (1st Dist. 2010) (“where consent to an agreement is secured merely through a demand that is lawful or upon doing or threatening to do that which a party has a legal right to do, economic duress does not exist”). See also Novak v. Ocwen Federal Bank, FSB, No. 08 C 2528, 2010 WL 55654, *5 (N.D.Ill. Jan. 5, 2010) (granting summary judgment on borrowers’ economic duress claim, holding “Ocwen appears to have been simply doing its job of servicing the loan and to have given Novak considerable leeway”). In Butler v. Metz, Train, Olson & Youngren, Inc., 62 Ill.App.3d 424, 379 N.E.2d 1255, 20 Ill.Dec. 187 (2d Dist. 1978), a builder filed a lawsuit against an architect to determine the amount of fees due the architect and to set aside or void a security agreement given to the architect by the builder to secure the payment of fees. The builder contended that the security agreement had been obtained as a result of economic duress. The architect had filed a mechanics lien against the project being built by the builder. Thereafter, the architect demanded the security agreement in exchange for releasing the lien. The court held that the filing of the lien was lawful and therefore did not constitute duress. 379 N.E.2d at 1261. The fact that the builder was “financially vulnerable” at the time “carries no implication of duress.” 379 N.E.2d at 1262. Moreover, the court held that the builder had waived the defense of duress. “[W]e think the long delay in raising the issue of duress and the fact that it was raised for the first time as a defense to a counterclaim (and almost 6 years after the transaction in question) mitigates severely against recognizing it as a valid ground for avoiding the contract.” 379 N.E.2d at 1263. F. [13.13] Breach of Duty of Good Faith and Fair Dealing/Bad Faith The covenant of good faith and fair dealing is an implied term of every contract in the state of Illinois. Magna Bank of Madison County v. Jameson, 237 Ill.App.3d 614, 604 N.E.2d 541, 543 – 544, 178 Ill.Dec. 285 (5th Dist. 1992), appeal denied, 149 Ill.2d 651 (1993). See generally Jonathan C. Lipson, Governance in the Breach: Controlling Creditor Opportunism, 84 S.Cal.L.Rev. 1035 (2011); Seth William Goren, Looking for Law in all the Wrong Places:

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Problems in Applying the Implied Covenant of Good Faith Performance, 37 U.S.F.L.Rev. 257 (2003). Ordinarily, then, an action for a breach of the implied covenant of good faith and fair dealing would be part of a breach-of-contract action. The covenant is usually invoked as an aid to the construction of a contract by which one party is given broad discretion in performance. Perez v. Citicorp Mortgage, Inc., 301 Ill.App.3d 413, 703 N.E.2d 518, 524, 234 Ill.Dec. 657 (1st Dist. 1998); LaSalle Bank Nat’l Assoc v. Paramont Properties, 588 F.Supp.2d 840, 857 – 858 (N.D.Ill. 2008). In BA Mortgage & International Realty Corp. v. American National Bank & Trust Company of Chicago, 706 F.Supp. 1364, 1376 – 1377 (N.D.Ill. 1989), the Northern District of Illinois held that the implied covenant of good faith and fair dealing could not be waived. In Chemical Bank v. Paul, 244 Ill.App.3d 772, 614 N.E.2d 436, 185 Ill.Dec. 302 (1st Dist. 1993), the Illinois appellate court suggested the implied covenant of good faith might be waived, if done so expressly. The court said that “a covenant of good faith and fair dealing is implied into every contract, absent express disavowal.” [Emphasis added.] 614 N.E.2d at 442, citing Foster Enterprises, Inc. v. Germania Federal Savings & Loan Ass’n, 97 Ill.App.3d 22, 421 N.E.2d 1375, 52 Ill.Dec. 303 (3d Dist. 1981). The court in Chemical Bank held that a general waiver of defenses does not “expressly disavow” the implied covenant of good faith and fair dealing. Id. See also LaSalle Business Credit, Inc. v. Lapides, No. 00 C 8145, 2003 WL 722237 (N.D.Ill. Mar. 3, 2003) (guarantor cannot waive right to commercial reasonableness under Illinois law and lender does not act in bad faith when it refuses to disburse funds when forbearance agreement expires and it chooses not to renegotiate agreement). In Hill v. St. Paul Federal Bank for Savings, 329 Ill.App.3d 705, 768 N.E.2d 322, 263 Ill.Dec. 562 (1st Dist. 2002), the court rejected bank customers’ claims that the defendant breached the implied covenant of good faith and fair dealing by choosing a method of posting transactions to their accounts that potentially resulted in greater overdraft fees than if a different method had been chosen. The Uniform Commercial Code permits banks to choose whichever method they like to post checks to a customer’s account. 768 N.E.2d at 325. The court held that because the bank’s actions were consistent with the Uniform Commercial Code, it could not be held to have violated the implied duty of good faith and fair dealing. Similarly, in PPM Finance, Inc. v. Norandal USA, Inc., 297 F.Supp.2d 1072 (N.D.Ill. 2004), the court held that a senior creditor did not breach the implied covenant of good faith and fair dealing implied in a subordination agreement with a junior creditor when it failed to notify the junior creditor of their common debtor’s default on the debtor’s obligation to the senior creditor. The court held that the subordination agreement did not impose a duty to notify the junior creditor of any default by the debtor on its obligation to the senior creditor and that the implied duty of good faith would not impose a new term. Instead, the court held that the duty of good faith “simply guides the construction of explicit terms in the agreement.” 297 F.Supp.2d at 1095, citing Beraha v. Baxter Health Care Corp., 956 F.2d 1436, 1443 (7th Cir. 1992). See also ITQ Lata, LLC v. MB Financial Bank, N.A., 317 F.Supp.2d 844, 851 (N.D.Ill. 2004) (“implied duty of good faith and fair dealing is used as an aid to determine the intent of the parties”). 1. [13.14] Exercise of Discretion In Foster Enterprises, Inc. v. Germania Federal Savings & Loan Ass’n, 97 Ill.App.3d 22, 421 N.E.2d 1375, 52 Ill.Dec. 303 (3d Dist. 1981), the appellate court affirmed a jury’s verdict finding

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that a lender acted in bad faith when it rejected an appraisal arbitrarily. The lender had foreclosed and obtained a deed to the property in question. It then entered into a contract with the plaintiff that was to afford the plaintiff the option of purchasing the property for 80 percent of the market value as shown on an appraisal “acceptable to both parties.” 421 N.E.2d at 1380. When the plaintiff brought an appraisal to the defendant, it was rejected, and the defendant refused to sell the property for 80 percent of the market value shown on the appraisal. The court wrote: Good faith between contracting parties requires that a party vested with contractual discretion must exercise his discretion reasonably and may not do so arbitrarily or capriciously. . . . Where contractual discretion is exercised in bad faith, the contract is breached and it is incumbent on the courts to grant appropriate relief; however, bad faith is not synonymous with erroneous judgment. There can be no relief from an erroneous judgment exercised in good faith pursuant to a valid discretionary power. . . . We hold that [the defendant] impliedly promised to accept a reasonable market value appraisal. We hold that a failure to do so results in an actionable breach of contract. [Citations omitted.] 421 N.E.2d at 1381. At the conclusion of the resulting trial, the jury found that the evidence proved the lender had rejected the appraisal “not because it failed to fairly and accurately estimate the market value of the [property], but instead because it resulted in a sale price that was too low to permit the lending institution to bail out of a mortgage loan long since gone sour.” Id. The lender had thus breached its obligation to act in good faith. The court in Westinghouse Electric Corp. v. McLean, 938 F.Supp. 487, 493 – 494 (N.D.Ill. 1996), did not find that a lender acted arbitrarily or capriciously in exercising its discretion not to advance additional funds under an extension agreement. The court reached this result despite allegations by the borrower that the lender had orally promised to advance those funds. The court held such oral representations could not form the basis for any action by the borrower as a result of the Credit Agreements Act. 938 F.Supp. at 493. The lender defendant in VR Holdings, Inc. v. LaSalle Business Credit, Inc., No. 01 C 3012, 2002 WL 356515 (N.D.Ill. Mar. 6, 2002), sought dismissal of a claim based on an alleged breach of the duty of good faith and fair dealing. The lender argued that the operative credit agreement did not vest the lender with any discretion. Absent arbitrary or capricious actions pursuant to a contract, the lender argued that a claim for breach of the duty of good faith and fair dealing could not be maintained. The court denied the lender’s motion, simply stating that the defendant had “adequate notice” of the claim against it and that it was not convinced the plaintiff could prove no facts in support of its claim. 2002 WL 356515 at *4. But see Finova Capital Corp. v. Slyman, No. 01 C 6244, 2002 WL 318294 (N.D.Ill. Feb. 25, 2002) (granting lender’s motion to strike guarantors’ affirmative defenses for breach of implied covenant of good faith when lender did not exercise any discretion). 2. [13.15] Independent Tort for Breach of Duty of Good Faith Generally, there is no independent action for a breach of the implied covenant of good faith and fair dealing, with the sole exception of an action based on calling of a demand note. Osuji v.

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Countrywide Home Loans, Inc., No. 05C4758, 2006 WL 2425333, *6 (N.D.Ill. Aug. 17, 2006) (Illinois does not recognize independent tort for breach of duty of good faith and fair dealing); Tammerello v. Ameriquest Mortgage Co., No. 05 C 466, 2005 WL 1323559 (N.D.Ill. June 2, 2005) (same); APS Sports Collectibles, Inc. v. Sports Time, Inc., 299 F.3d 624 (7th Cir. 2002) (same); Truserv Corp. v. Chaska Building Center, Inc., No. 02 C 1018, 2003 WL 924509 (N.D.Ill. Mar. 6, 2003) (same); LaSalle National Bank Ass’n v. Gabayzedeh, No. 02 CV 734, 2003 WL 134997 (N.D.Ill. Jan. 17, 2003) (same); Johnstone v. Bank of America, N.A., 173 F.Supp.2d 809 (N.D.Ill. 2001) (same). See, e.g., Fernandes v. First Bank & Trust Company of Illinois, No. 93 C 2903, 1993 WL 339286 (N.D.Ill. Sept. 3, 1993); Home Savings Association of Kansas City, F.A. v. State Bank of Woodstock, 763 F.Supp. 292, 300 (N.D.Ill. 1991); N.W.I. International, Inc. v. Edgewood Bank, 291 Ill.App.3d 247, 684 N.E.2d 401, 225 Ill.Dec. 716 (1st Dist.), appeal denied, 175 Ill.2d 530 (1997). In 2001, however, the Illinois Supreme Court reversed a decision of the Illinois Appellate Court for the Second District that held a plaintiff may bring an independent action in tort for breach of the duty of good faith and fair dealing. Voyles v. Sandia Mortgage Corp., 311 Ill.App.3d 649, 724 N.E.2d 1276, 1281, 244 Ill.Dec. 192 (2d Dist. 2000), rev’d, 196 Ill.2d 288 (2001). See also Frederick v. Select Portfolio Servicing, Inc., No. 07 CV 7044, 2009 WL 230597, *7 (N.D.Ill. Jan. 30, 2009) (“Under Illinois law, claims of good faith and fair dealing are unavailable as independent tort claims against mortgagees where other remedies are available.”); LaSalle Bank Nat’l Assoc v. Paramont Properties, 588 F.Supp.2d 840, 853 (N.D.Ill. 2008) (“Illinois does not recognize an independent cause of action for breach of the implied duty of good faith and fair dealing.”). In Voyles, supra, the plaintiff owned a home in Springfield that was financed with a mortgage she gave to Citizen’s Savings & Loan. The plaintiff rented the home to a tenant, who agreed to make mortgage payments directly to Citizens. Citizens was aware that the tenant had no ownership interest and would be making the payments on the plaintiff’s behalf. The mortgage was later assigned to Sandia Mortgage Corporation, which did not understand the arrangement. Sandia incorrectly believed that the tenant had acquired an ownership interest in the property. In addition to a violation of the due-on-sale clause of the mortgage, the tax escrow was insufficient to pay the annual property tax, and Sandia was required to raise the monthly payments to cover the shortfall. Sandia failed to notify the plaintiff that it was increasing the payments, however, and this resulted in a default. Sandia then refused to accept payments tendered by the tenant, apparently both because it did not recognize any relationship with the tenant and because the mortgage was now in arrears due to the increase in the amount of the monthly payment. Finally, Sandia filed a foreclosure action. Later, the plaintiff filed a lawsuit of her own against Sandia. She alleged, among other things, that Sandia had breached its duty of good faith and fair dealing. Sandia, relying on Cramer v. Insurance Exchange Agency, 174 Ill.2d 513, 675 N.E.2d 897, 221 Ill.Dec. 473 (1996), contended that there was no independent tort to support an action based on the covenant of good faith and fair dealing. Cramer involved an attempt by an insured to recover against his insurance carrier for failing to pay insurance proceeds. The insured contended that the carrier had violated the implied covenant of good faith and fair dealing. The court in Cramer held, however, that the Illinois Insurance Code, 215 ILCS 5/1, et seq., provided the exclusive remedy under such circumstances. The court therefore did not pass on whether such an action might be available under other circumstances.

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The Second District held in Voyles, supra, that such a tort did exist. The court pointed out that in Citicorp Savings of Illinois v. Rucker, 295 Ill.App.3d 801, 692 N.E.2d 1319, 1324 – 1325, 230 Ill.Dec. 153 (1st Dist.), appeal denied, 179 Ill.2d 579 (1998), the court tacitly recognized the viability of such a claim. In Rucker, the court had found that a claim based on the breach of good faith and fair dealing could proceed in the face of a lender’s motion to dismiss when the allegations of the complaint raised issues of fact. Id. Not only did the Second District find that the tort exists, but it further found that Sandia had breached its duty of good faith when it failed to provide the plaintiff with notice that it was raising the amount of her monthly payment. Then, when the plaintiff tried to correct the problem caused by Sandia, Sandia refused to accept her payments. The court stated that “[b]ased on the narrow circumstances of this case, we hold that plaintiff proved her claim that defendant acted in bad faith and breached its duty of good faith and fair dealing.” Voyles, supra, 724 N.E.2d at 1281. The Illinois Supreme Court reversed, holding that Cramer, supra, was a poor analogy. An insurer’s duty to settle is not spelled out in the insurance policy, thereby justifying recognition of an independent tort in that circumstance. The Supreme Court held that it was “not persuaded” that there was any reason to expand the “limited cause of action” recognized in Cramer. Voyles v. Sandia Mortgage Corp., 196 Ill.2d 288, 751 N.E.2d 1126, 1132, 256 Ill.Dec. 289 (2001). In rejecting the plaintiff’s attempt to impose new duties on a lender in Voyles, the Illinois Supreme Court confirmed numerous consistent earlier appellate court decisions. See, e.g., Beraha v. Baxter Health Care Corp., 956 F.2d 1436, 1443 (7th Cir. 1992) (covenant of good faith and fair dealing has “never been an independent source of duties for the parties to a contract”); Bachmeier v. Bank of Ravenswood, 663 F.Supp. 1207, 1225 (N.D.Ill. 1987) (banking relationship alone does not impose duty of good faith and fair dealing independent of any contract); Gordon v. Matthew Bender & Co., 562 F.Supp. 1286, 1290 (N.D.Ill. 1983) (“It does not create an independent cause of action.”), citing Murphy v. American Home Products Corp., 58 N.Y.2d 293, 448 N.E.2d 86, 91, 461 N.Y.S.2d 232 (1983); Northern Trust Co. v. VIII South Michigan Associates, 276 Ill.App.3d 355, 657 N.E.2d 1095, 1104, 212 Ill.Dec. 750 (1st Dist. 1995) (“Although the covenant of good faith and fair dealing is used as an aid in construing a contract, it does not form the basis of an independent tort recognized in Illinois.”), citing Koehler v. First National Bank of Louisville, 232 Ill.App.3d 679, 597 N.E.2d 1261, 174 Ill.Dec. 49 (5th Dist. 1992), and Anderson v. Burton Associates, Ltd., 218 Ill.App.3d 261, 578 N.E.2d 199, 161 Ill.Dec. 72 (1st Dist. 1991). See also State National Bank v. Academia, Inc., 802 S.W.2d 282, 293 (Tex.App. 1990) (implied covenant of good faith and fair dealing does not create independent cause of action (applying Illinois law)). Those courts generally found that when a lender acts in a way that is approved by its contract, it cannot be held liable for bad faith. See Perez v. Citicorp Mortgage, Inc., 301 Ill.App.3d 413, 703 N.E.2d 518, 525, 234 Ill.Dec. 657 (1st Dist. 1998) (“[p]arties are entitled to enforce the terms of negotiated contracts to the letter without being mulcted for lack of good faith”), quoting Resolution Trust Corp. v. Holtzman, 248 Ill.App.3d 105, 618 N.E.2d 418, 424, 187 Ill.Dec. 827 (1st Dist. 1993). See also Coleman v. Madison Two Associates, 307 Ill.App.3d 570, 718 N.E.2d 668, 675, 241 Ill.Dec. 97 (1st Dist. 1999) (“implied covenant of good faith cannot override or modify the express terms of that contract”). For example, in Kham & Nate’s Shoes No. 2, Inc. v. First Bank of Whiting, 908 F.2d 1351, 1357 (7th Cir. 1990), the Seventh Circuit held that “[w]hen the contract is silent, principles of good faith . . . fill the gap. They do not block use of terms that actually appear in the contract.” In Bank One,

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Springfield v. Roscetti, 309 Ill.App.3d 1048, 723 N.E.2d 755, 764, 243 Ill.Dec. 452 (4th Dist. 1999), appeal denied, 189 Ill.2d 655 (2000), the court held that although the general covenant of good faith and fair dealing applies to lenders, “[t]he covenant of good faith and fair dealing does not enable a guarantor to read an obligation into a contract that does not exist.” The guarantor in Roscetti had argued that the lender breached its duty of good faith by failing to notify the guarantor of facts the lender knew would “materially increase the guarantor’s risk beyond that which the guarantor intends to assume and which the creditor may reasonably believe to be unknown to the guarantor.” 723 N.E.2d at 767. In Resolution Trust, supra, the court wrote: [N]othing in the mortgage documents requires a lender to soften its position or its heart. *** While we may entertain sympathy for the mortgagor desperately seeking to vary the terms of the security instruments, we should be tempered by remembering that lender and borrower enjoy the freedom of the marketplace to negotiate whatever they wisely or foolishly believe is in their best interests and a court is powerless to alter the clear terms of a mortgage contract. 618 N.E.2d at 423 – 424. In Washburn v. Union National Bank & Trust Company of Joliet, 151 Ill.App.3d 21, 502 N.E.2d 739, 104 Ill.Dec. 242 (3d Dist. 1986), the court held that no action existed for breach of the implied covenant of good faith adopted from common-law contract principles by the Uniform Commercial Code. The court in Washburn said: “We have been cited no cases holding that the obligation of good faith can alone be the basis for recovering money damages.” 502 N.E.2d at 743. In reaching this decision, the court distinguished the notorious lender liability cases Alaska Statebank v. Fairco, 674 P.2d 288, 291 (Alaska 1983), and K.M.C. Co. v. Irving Trust Co., 757 F.2d 752 (6th Cir. 1985). In 1999, the Illinois Appellate Court for the First District wrote that “notions of fair dealing and good faith by themselves do not form the basis for tort relief.” Coleman, supra, 718 N.E.2d at 674 – 675. In W.E. Davis v. Merrill Lynch Business Financial Services, Inc., No. 03 C 2680, 2004 WL 406810, *3 (N.D.Ill. Feb. 13, 2004), the court held that Illinois law does not recognize a tort independent of breach of contract for “willful and wanton misconduct.” In Carrico v. Delp, 141 Ill.App.3d 684, 490 N.E.2d 972, 95 Ill.Dec. 880 (4th Dist. 1986), a borrower sued a lender, alleging that the lender improperly terminated a line of credit agreement and refused to loan additional money to the borrower thereafter. Among other things, the borrower brought an action for malicious breach of contract, seeking the recovery of punitive damages. The plaintiffs contended this count amounted to an independent tort, which they likened to the tort of willful and wanton misconduct as approved in Morrow v. L.A. Goldschmidt Associates, Inc., 126 Ill.App.3d 1089, 468 N.E.2d 414, 82 Ill.Dec. 152 (1st Dist. 1984), rev’d, 112 Ill.2d 87 (1986). The appellate court rejected this effort, however, finding that Morrow applied only when there was “a conscious and deliberate disregard for the rights or safety of

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others.” 490 N.E.2d at 977, quoting Morrow, supra, 468 N.E.2d at 420. Morrow was reversed shortly thereafter. The court in Carrico wrote: While the law does not condone breach of contract, it does not consider it wrongful or tortious. If a party desires to breach a contract, he may do so purposely so long as he is willing to place the other party in the position he would have been absent the breach. (Album Graphics, Inc. v. Beatrice Foods Co. (1980) 87 Ill.App.3d 338, 42 Ill.Dec. 332, 408 N.E.2d 1041.) At most, the plaintiffs have alleged the bank acted in bad faith in breaching the contract. To sanction punitive damages on a bad faith theory would allow punitive damages whenever the breach was intentional. Thus, the exception would swallow up the general rule denying punitive damages for breach of contract. 490 N.E.2d at 977. In Carrico, the court did not explicitly find that there is no independent tort for bad faith. The court did say, however, that simply breaching a contract is not tortious. A breach of the implied covenant of good faith and fair dealing is nothing more than a breach of an implied contractual term and is not, therefore, tortious. In a 1997 article, William E. Deitrick and Jeffrey C.B. Levine soundly panned the Carrico decision, contending that it “essentially allows the court to re-write the parties’ agreement.” Contractual Good Faith: Let the Contract, Not the Courts, Define the Bargain, 85 Ill.B.J. 120, 121 (1997). Carrico (along with other Illinois decisions) held that while the implied covenant of good faith and fair dealing did not amount to a tort, it did require a lender to exercise discretion reasonably. The Seventh Circuit has rejected the notion that good faith requires reasonableness. In Original Great American Chocolate Chip Cookie Co. v. River Valley Cookies, Ltd., 970 F.2d 273, 280 (7th Cir. 1992), the Seventh Circuit said that “reasonableness” is not “the test of good faith.” The Illinois Supreme Court held in 1990 that if a lender acts honestly, it does not violate the implied covenant of good faith and fair dealing. In Watseka First National Bank v. Ruda, 135 Ill.2d 140, 552 N.E.2d 775, 779, 142 Ill.Dec. 184 (1990), the court held that a lender acted honestly in accelerating a debt, activating guaranties, and invoking an insecurity clause. In Ruda, a farmer had become insolvent when the lender accelerated the loan. The guarantors argued that the bank had not acted in good faith in accelerating and, therefore, they should not be held liable. The court disagreed, finding that the lender acted honestly, and that was enough to avoid any liability for breach of the implied covenant of good faith and fair dealing. 552 N.E.2d at 779 – 782. The Illinois Supreme Court did not impose an obligation on the lender to act reasonably. In choosing to look at the honesty of the lender’s conduct, rather than the reasonableness of the conduct, the Illinois Supreme Court created a subjective, rather than objective, means of evaluating whether a lender has acted in good faith. After Washburn, supra, and Ruda, supra, the Illinois appellate court decided Chemical Bank v. Paul, 244 Ill.App.3d 772, 614 N.E.2d 436, 185 Ill.Dec. 302 (1st Dist. 1993), and First National Bank of Cicero v. Sylvester, 196 Ill.App.3d 902, 554 N.E.2d 1063, 144 Ill.Dec. 24 (1st Dist.), appeal denied, 133 Ill.2d 555 (1990), both cases involving lenders accused of acting in bad faith.

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In Chemical Bank, the appellate court held that Chemical Bank “was required to act in good faith in enforcing the loan agreements at issue.” 614 N.E.2d at 442. The court thereupon affirmed a jury’s decision that Chemical Bank had not exercised good faith. This decision was based in part on the fact that Chemical Bank had exercised “considerable discretion in the use and application of the funds disbursed.” Id. In Sylvester, supra, the court reversed summary judgment for a lender by finding that the lender might not have acted in good faith in refusing an advance and terminating a credit line. The appellate court remanded, indicating the trier of fact should consider such questions as whether the borrower was in default at the time of the refusal and whether the project the funding related to would have been profitable. 554 N.E.2d at 1070, citing Champaign National Bank v. Landers Seed Co., 165 Ill.App.3d 1090, 519 N.E.2d 957, 962, 116 Ill.Dec. 742 (4th Dist. 1988). An outright lie was at the center of City National Bank of Hoopeston v. Russell, 246 Ill.App.3d 302, 615 N.E.2d 1308, 186 Ill.Dec. 251 (4th Dist. 1993), in which a guarantor alleged that the lender had misrepresented the amount the primary obligor had borrowed when the lender sought an increase in the amount of the guaranty. The guarantor relied on the statement of the amount due and the value of the collateral for the loan in calculating the amount that would be at risk if he signed the guaranty for an increased amount. While the lender argued that the guarantor could have been more diligent in learning the true balance due, the court stated: A bank has a duty of good faith in dealing with a guarantor . . . therefore, the guarantor is entitled to rely on the representations of fact made by the bank . . . especially the representations on how much money the bank has loaned to the person whose debts will be guaranteed. [Citations omitted.] 615 N.E.2d at 1313, citing Magna Bank of Madison County v. Jameson, 237 Ill.App.3d 614, 604 N.E.2d 541, 543, 178 Ill.Dec. 285 (5th Dist. 1992), appeal denied, 149 Ill.2d 651 (1993), Mt. Zion State Bank & Trust v. Weaver, 226 Ill.App.3d 783, 589 N.E.2d 983, 986, 168 Ill.Dec. 583 (4th Dist. 1992), Farmer City State Bank v. Guingrich, 139 Ill.App.3d 416, 487 N.E.2d 758, 765, 94 Ill.Dec. 1 (4th Dist. 1985), Dee v. Bank of Oakbrook Terrace, 84 Ill.App.3d 1022, 406 N.E.2d 195, 198, 40 Ill.Dec. 494 (1st Dist. 1980), and McHenry State Bank v. Y & A Trucking, Inc., 117 Ill.App.3d 629, 454 N.E.2d 345, 348, 73 Ill.Dec. 485 (2d Dist. 1983). Russell, supra, did not involve a cause of action based on bad faith, but the duty of good faith was used by a guarantor to persuade a court that he had justifiably relied on a lender’s representation and thereby avoid liability on his guaranty. In Continental Bank N.A. v. Everett, 760 F.Supp. 713, 717 – 718 (N.D.Ill. 1991), aff’d, 964 F.2d 701 (7th Cir.), cert. denied, 113 S.Ct. 816 (1992), the Northern District of Illinois found that a lender’s failure to disclose to guarantors the legal inability to perfect a security interest in an FCC license (thereby increasing the guarantors’ risk) was not something that the lender’s duty of good faith obligated it to disclose to the guarantors. The court held that guarantors have a duty to “make an inquiry into all circumstances that are relevant to their risk as guarantors.” 760 F.Supp. at 718, citing St. Charles National Bank v. Ford, 39 Ill.App.3d 291, 349 N.E.2d 430, 434 (2d Dist. 1976). On the other hand, the court specifically noted that the lender had not actively concealed this information from the guarantors. 760 F.Supp. at 717.

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Chemical Bank, supra, and Sylvester, supra, are representative of typical breach-of-thecovenant-of-good-faith cases. In these cases, the lender exercised its discretion (albeit pursuant to contractual authorization). When one party to a contract is permitted discretion, it must not exercise that discretion arbitrarily, capriciously, or in a manner inconsistent with the reasonable expectations of the parties. Perez, supra, 703 N.E.2d at 526 (“the express agreement between the parties clearly controls what expectations are reasonable”), citing Saunders v. Michigan Avenue National Bank, 278 Ill.App.3d 307, 662 N.E.2d 602, 609, 214 Ill.Dec. 1036 (1st Dist.), appeal denied, 167 Ill.2d 569 (1996). See also BA Mortgage & International Realty Corp. v. American National Bank & Trust Company of Chicago, 706 F.Supp. 1364, 1373 – 1374 (N.D.Ill. 1989) (mortgagee adequately pleaded that mortgagor acted in bad faith in rejecting leases). While one Illinois author has expressed the view that the implied covenant is underutilized, other Illinois authors clearly disagree. Compare Howard L. Fink, The Splintering of the Implied Covenant of Good Faith and Fair Dealing in Illinois Courts, 30 Loy.U.Chi.L.J. 247 (1999), with William E. Deitrick and Jeffrey C.B. Levine, Contractual Good Faith: Let the Contract, Not the Courts, Define the Bargain, 85 Ill.B.J. 120 (1997). Nevertheless, the trend in the 1990s was generally away from the bad-faith theories accepted in notorious lender liability cases such as K.M.C., supra, and Alaska Statebank, supra. The Illinois Supreme Court’s decision in Voyles, supra, makes it clear that no such independent tort exists in Illinois. G. [13.16] Tortious Interference with Contract/Business Expectancy Actions for tortious interference with contract or business expectancy arise when one person wrongfully induces another to breach a contract or otherwise frustrate a legitimate expectancy. Such cases are rarely seen in a lender liability context, but they do exist. To establish tortious interference with contract, a plaintiff must prove (1) the existence of an enforceable contract between the plaintiff and a third party, (2) the defendant’s awareness of the contract, (3) the defendant’s intentional and unjustified inducement of a breach of the contract, (4) the third party’s breach of the contract, and (5) injury to the plaintiff as a result. HPI Health Care Services, Inc. v. Mt. Vernon Hospital, Inc., 131 Ill.2d 145, 545 N.E.2d 672, 137 Ill.Dec. 19 (1989). If the contract is merely prospective in nature or when the agreement may not be fully enforceable (such as in employment-at-will relationships), a plaintiff must rely on tortious interference with a prospective business expectancy. This theory requires satisfaction of similar elements: (1) the reasonable expectation by the plaintiff of entering into a valid business relationship; (2) the defendant’s awareness of the plaintiff’s expectancy; (3) intentional interference by the defendant that prevents the expectancy from maturing into a valid business relationship; and (4) injury to the plaintiff as a result. Fellhauer v. City of Geneva, 142 Ill.2d 495, 568 N.E.2d 870, 154 Ill.Dec. 649 (1991). The most common defense to actions for intentional interference is justification. In 1994, in the seminal case Roy v. Coyne, 259 Ill.App.3d 269, 630 N.E.2d 1024, 196 Ill.Dec. 859 (1st Dist. 1994), the Illinois appellate court held that a plaintiff is not required to plead and prove lack of justification. Rather, justification is an affirmative defense that the defendant must establish. 630 N.E.2d at 1034.

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“ ‘[I]ntended but purely incidental interference resulting from the pursuit of the defendant’s own ends by proper means’ is not actionable.” Hayes & Griffith, Inc. v. GE Capital Corp., No. 88 C 10179, 1989 WL 135246, *9 (N.D.Ill. Oct. 24, 1989), quoting Bank Computer Network Corp. v. Continental Illinois National Bank & Trust Company of Chicago, 110 Ill.App.3d 492, 442 N.E.2d 586, 593, 66 Ill.Dec. 160 (1st Dist. 1982), quoting in turn William Lloyd Prosser, HANDBOOK OF THE LAW OF TORTS §130, p. 952 (4th ed. 1971). In Hayes & Griffith, the district court granted a motion to dismiss the plaintiff’s claim that a potential lender intentionally interfered with the plaintiff’s prospective business relations by knowingly misrepresenting its intention to complete a loan. The court found that there were insufficient allegations that the lender intended to interfere with the plaintiff’s business relationships. In Stofer v. First National Bank of Effingham, 212 Ill.App.3d 530, 571 N.E.2d 157, 156 Ill.Dec. 570 (5th Dist.), appeal denied, 141 Ill.2d 561 (1991), the owners of a car dealership alleged that their lender had tortiously interfered with their contract with General Motors and others. The dealership had gotten “out of trust” (i.e., it had sold vehicles subject to a floor planning agreement with the lender without remitting the proceeds from sale to the lender as required by the agreement), leading to a meeting with the dealership’s two lenders. The banks required the borrowers to put up additional collateral and agree to certain supervision. Thereafter, the plaintiffs negotiated for the sale of the dealership to a third party at the urging of the lenders. The resulting agreement included the transfer of real estate and stock and termination of the plaintiffs’ franchise agreement with General Motors. The court held that the plaintiffs failed to plead or prove that any third party actually breached a contract as a result of the alleged conduct of the defendants. The court further rejected the plaintiffs’ argument that pressure by the defendants exerted as a result of the defendants’ superior economic position resulting in modifications and changes in the plaintiffs’ contractual relationships with third parties was actionable. 571 N.E.2d at 166 – 167. In Amalgamated Financial Corp. v. Atlantis, Inc., 105 Ill.App.3d 379, 434 N.E.2d 417, 61 Ill.Dec. 264 (1st Dist. 1982), a mortgage broker brought an action based on tortious interference with contractual relations against a mortgage company for improperly interfering with the broker’s commission agreement with a developer. The finance company had indicated to the developer that the finance company would provide the requested financing, but only if the broker was limited to a one-percent commission, rather than the three or five percent indicated in the agreement between the broker and the developer. A jury returned a verdict for the broker. On appeal, the finance company argued that the jury’s determination that it had maliciously induced a breach of contract was not supported by the evidence. The appellate court disagreed, noting that “malice” in the context of tortious interference with contractual relations does not mean the “defendant acted with ill will, hostility or an intent to injure.” 434 N.E.2d at 419. Rather, the court found that “[i]t is only necessary to show that the defendant acted intentionally and without just cause.” Id. The evidence was clear that the defendant had acted intentionally, and there was no evidence to indicate justification beyond the fact that the interference was in the defendants’ self-interest, which the court held was not just cause. The jury’s verdict was therefore affirmed. A borrower claimed that its lender tortiously interfered with its business relationships in W.E. Davis v. Merrill Lynch Business Financial Services, Inc., No. 03 C 2680, 2004 WL 406810 (N.D.Ill. Feb. 13, 2004), when the lender allegedly wrongfully refused to honor requests for

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draws on a line of credit. The U.S. District Court for the Northern District of Illinois dismissed that claim, holding that under Illinois law the plaintiff must allege and prove that the defendant’s conduct was directed at the third parties “in the first instance.” 2004 WL 406810 at *3, quoting Krieger v. Adler, Kaplan & Begy, No. 94 C 7809, 1996 WL6540, *9 (N.D.Ill. Jan. 5, 1996), citing in turn Schuler v. Abbot Laboratories, 265 Ill.App.3d 991, 639 N.E.2d 144, 148, 203 Ill.Dec. 105 (1st Dist. 1993). See also Laser Industries, Ltd. v. Eder Instrument Co., 573 F.Supp. 987, 994 (N.D.Ill. 1983). Because the plaintiff in W.E. Davis alleged only that the lender’s actions were directed at the plaintiff and had a subsequent indirect effect on the plaintiff’s business relationships, rather than directed at those third parties in the first instance, the claim for tortious interference with business relationships could not be maintained. In LaSalle Business Credit, Inc. v. Lapides, No. 00 C 8145, 2003 WL 722237 (N.D.Ill. Mar. 3, 2003), the court held that a party cannot interfere with its own contract. In VR Holdings, Inc. v. LaSalle Business Credit, Inc., No. 01 C 3012, 2002 WL 356515, *4 (N.D.Ill. Mar. 6, 2002), the court denied a lender’s motion to dismiss a claim for tortious interference with contractual relations when the borrower alleged that the lender “improperly interfered in the [contractual relation] by taking actions which made it impossible for [the borrower] to complete the [contract].” On the basis of this allegation, the court held that it could not find that the plaintiff was unable to state a claim that would entitle it to relief for tortious interference. Id.

IV. [13.17] STATUTORY THEORIES OF LENDER LIABILITY In addition to potential contractual and tort liabilities, lenders face potential liability pursuant to a number of statutes, including securities, environmental, and tax statutes. For example, a lender who controls its borrower might be liable pursuant to federal securities laws for violations of those statutes by virtue of §15 of the Securities Act of 1933, ch. 38, Title I, 48 Stat. 74, or §20 of the Securities Exchange Act of 1934, ch. 404, 48 Stat. 881. 15 U.S.C. §§77o, 78t(a). The Seventh Circuit has held that as long as a lender does not actually control its borrower’s operations, it may monitor its loans, protect its collateral, influence management, and obtain financial reports without incurring potential liability for securities law violations of the borrower. Schlifke v. Seafirst Corp., 866 F.2d 935, 948 – 950 (7th Cir. 1989). Lenders also face potential claims based on the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA), Pub.L. No. 96-510, 94 Stat. 2767. Prior to 1996, some courts had imposed liability on lenders for managing a contaminated facility. In a widely discussed 1990 opinion, the Eleventh Circuit held that a lender could be liable pursuant to CERCLA when it was sufficiently involved in the management of a borrower so that it affected the “hazardous waste disposal decisions” of the borrower. United States v. Fleet Factors Corp, 901 F.2d 1550, 1558 (11th Cir. 1990), cert. denied, 111 S.Ct. 752 (1991). In 1992, following the controversy created by Fleet Factors, the United States Environmental Protection Agency (USEPA) promulgated a rule on lender liability pursuant to CERCLA designed to provide lenders with guidance and a safe harbor of activities that would not result in liability. 57 Fed.Reg. 18,344 (Apr. 29, 1992). This rule was vacated on the basis that the USEPA lacked statutory authority to

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restrict private rights of action provided by CERCLA. Kelley v. Environmental Protection Agency, 15 F.3d 1100 (D.C.Cir. 1994), cert. denied, 115 S.Ct. 900 (1995). The rule was then codified in the Asset Conservation, Lender Liability, and Deposit Insurance Protection Act of 1996, Pub.L. No. 104-208, 110 Stat. 3009-462. Tax statutes provide another potential pitfall for unwary lenders. A lender may be liable for withholding taxes on the wages of a borrower’s employees if the lender controls the borrower’s disbursements. United States v. Fred A. Arnold, Inc., 573 F.2d 605, 608 (9th Cir. 1978). Section 3505(b) of the Internal Revenue Code explicitly provides for lender liability when the lender supplies funds with the specific purpose of paying wages and has actual notice that the borrower either does not intend to pay withholding tax or will be unable to pay withholding tax. 26 U.S.C. §3505(b). Other statutes that lenders should pay particular attention to include (a) the Agricultural Credit Act of 1987, Pub.L. No. 100-233, 101 Stat. 1568 (1988), which provides farmers with certain protection from their lenders (see 12 U.S.C. §2001, et seq.; Saltzman v. Farm Credit Services of Mid-America, ACA, 950 F.2d 466 (7th Cir. 1991); Duncan v. Farm Credit Bank of St. Louis, 940 F.2d 1099 (7th Cir. 1991)); (b) the Truth in Lending Act, Pub.L. No. 90-321, 82 Stat. 146 (1968), along with the related Federal Reserve Regulation Z, 12 C.F.R. pt. 226; and (c) the Mortgage Act, 765 ILCS 905/0.01, et seq. Two statutes deserve special attention and treatment, as they involve significant amounts of lender liability litigation. The illegal tying provision of the Bank Holding Company Act and the Racketeer Influenced and Corrupt Organizations Act frequently result in trouble for lenders. See §§13.18 – 13.24 below. A. [13.18] Bank Holding Company Act Illegal Tying Provision Section 106(b) of the Bank Holding Company Act prohibits banks from engaging in anticompetitive practices that require borrowers to accept or provide other services or products or to refrain from dealing with other parties in order to obtain a loan or other service from the bank. 12 U.S.C. §1972(1)(C). This is referred to as “tying.” In McCoy v. Franklin Savings Ass’n, 636 F.2d 172 (7th Cir. 1980), the lender imposed a condition that certain improvements to the property be made before the loan would be extended and unilaterally altered the terms of the lender’s commitment letter. The trial court dismissed the illegal tying count for failure to state a claim, and the Seventh Circuit affirmed, holding that 12 U.S.C. §1972 was not concerned with issues of illegal modification, only with “the kind of conditions required, regardless of when they are imposed.” 636 F.2d at 175. The borrower in Exchange National Bank of Chicago v. Daniels, 768 F.2d 140 (7th Cir. 1985), unsuccessfully asserted that the bank had illegally tied one loan to another. The court emphasized the express language of the statute: a “bank shall not . . . extend credit . . . on the condition or requirement . . . that a customer shall obtain some additional credit, property, or service from such bank other than a loan.” [Emphasis in original.] 768 F.2d at 143. The court emphasized that the statute “does not prevent banks from making one in-house loan contingent on another” (768 F.2d at 143 – 144), and further noted that the statute “does not say that any actual loan in violation of its terms is unenforceable” (768 F.2d at 144).

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The remaining Seventh Circuit cases are equally unreceptive to borrowers’ assertions of anti-tying violations. In Davis v. First National Bank of Westville, 868 F.2d 206, 209 (7th Cir. 1989), cert. denied, 110 S.Ct. 68 (1989), the court found that a bank did not violate the anti-tying provisions by requiring that the borrowers agree to sell or liquidate their business by a date certain as a condition to additional financing. The court held that such an arrangement “is not anticompetitive and therefore not the concern of section 1972.” Id. Similarly, the requirement of a lockbox and blocked account in connection with an asset-based loan was not found to be an illegal tie-in. Mid-State Fertilizer Co. v. Exchange National Bank of Chicago, 877 F.2d 1333, 1337 – 1340 (7th Cir. 1989). Finally, in Graue Mill Development Corp. v. Colonial Bank & Trust Company of Chicago, 927 F.2d 988 (7th Cir. 1991), a bank conditioned extension of a credit line on the borrower’s use of a bank employee as construction manager. This action did not constitute an illegal tie-in, however, because under the applicable agreements, the borrower was not required to pay for these services except to the extent of savings on hard costs, which were never realized. The court interpreted the word “obtain” in the statute as requiring a customer to purchase the tied product. 927 F.2d at 991. The employee’s services were free, so the loan was tied only to the use, not the payment, of the employee. 927 F.2d at 992. Therefore, the plaintiff failed to state a claim under §1972. The court also noted the importance of proving an anticompetitive effect of the tying arrangement, stating that “[t]ying arrangements that ‘have no anticompetitive effect . . .’ do not violate §1972.” Id., quoting Davis, supra, 868 F.2d at 208. In Batten v. Bank One, N.A., No. 00 C 1837, 2000 WL 1364408 (N.D.Ill. Sept. 15, 2000), the plaintiff alleged a tying violation based on the bank’s practice of either charging a three-dollar fee or requiring that an account be opened before it would cash a payroll check drawn on it for a noncustomer. The court held that there was no illegal tying, under the Bank Holding Act, since neither the fee nor the requirement of opening a customer account to cash the plaintiff noncustomer’s checks was a tying product. The court further found that Bank One’s policy was designed to minimize its risk of loss in cashing payroll checks and qualified as a traditional banking practice not proscribed by §1972. Additionally, in Johnstone v. First Bank National Ass’n, No. 95 C 2008, 1998 WL 565193 (N.D.Ill. Aug. 31, 1998), the court granted First Bank summary judgment on a claim that certain extensions of credit were illegally tied to the purchase of delinquent notes owed the bank by a separate customer. The court found no showing that the bank’s challenged actions were designed to lessen competition. The possibility of a successful anti-tying claim against a lender certainly exists. The cases discussed above imply, however, that many of the typical conditions imposed by banks in lending or workout negotiations will not be deemed illegal tie-ins. But see Adelphia Recovery Trust v. Bank of America, N.A., 646 F.Supp.2d 489, 494 (S.D.N.Y. July 29, 2009) (holding that plaintiff recovery trust for debtor adequately pleaded Bank Holding Company Act claim when it alleged that the “extension of credit and/or provision of services, on the condition or requirement that [the debtor] also obtain some additional credit, property, and/or service from a subsidiary of the bank holding company of such bank” that aided in structuring of three allegedly fraudulently structured co-borrowing facilities and plaintiff attached to complaint internal e-mail from defendant bank corroborating coercive tying allegations).

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B. Racketeer Influenced and Corrupt Organizations 1. [13.19] Introduction The Racketeer Influenced and Corrupt Organizations Act makes it unlawful for a “person” who is “employed by or associated with any enterprise” from conducting or participating, “directly or indirectly, in the conduct of such enterprise’s affairs through a pattern of racketeering activity.” 18 U.S.C. §1962(c). A “person” is “any individual or entity capable of holding a legal or beneficial interest in property.” 18 U.S.C. §1961(3). An “enterprise” is “any individual, partnership, corporation, association, or other legal entity, and any union or group of individuals associated in fact although not a legal entity.” 18 U.S.C. §1961(4). Finally, a “pattern of racketeering activity” is “at least two acts of racketeering activity” committed within a ten-year period. 18 U.S.C. §1961(5). “Racketeering activity” consists of a list of enumerated crimes, including mail fraud, wire fraud, and bank fraud. 18 U.S.C. §1961(1). Although RICO is “primarily a criminal statute aimed specifically at curtailing the infiltration of business enterprises by organized crime” (Annot., 70 A.L.R.Fed. 538, §2 (1984)), it provides a civil cause of action to any person who has been injured as a result of a RICO violation. 18 U.S.C. §1964. RICO provides significant remedies. A person found to have violated RICO in a civil case will be held liable for treble damages, costs, and attorneys’ fees. 18 U.S.C. §1964(c). The proper scope of RICO has been the subject of much discussion. There is a large volume of caselaw considering nearly every potential issue that might arise in a RICO case. Not all of this authority is consistent. A full discussion of commercial RICO claims, even limited to such claims involving financial institutions, is beyond the scope of this chapter. However, because lender liability disputes frequently take the form of RICO claims, a summary of key RICO precedent involving lender liability type claims against financial institutions is included in §§13.20 – 13.24 below. A number of courts and commentators have indicated that RICO is being abused by plaintiffs who seek to impose RICO liability in garden-variety or run-of-the-mill fraud cases that should more properly be heard in state court. The Southern District of New York has stated, for example, in assessing a RICO claim: I surmise that every member of the federal bench has before him or her at least one — and possibly more — garden variety fraud or breach of contract cases that some Plaintiff has attempted to transform into a vehicle for treble damages by resort to what another respected jurist, Judge Allan Schwartz of this Court has referred to as “the litigation equivalent of a thermonuclear device” — a civil RICO suit. . . . All too frequently, these damning actions are commenced without the Plaintiff’s (or his lawyer’s) being aware of the most fundamental principles of the law that governs allegations of racketeering in a civil action. This case is more of the same. [Citations omitted.] Goldfine v. Sichenzia, 118 F.Supp.2d 392, 394 – 395 (S.D.N.Y. 2000).

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In a 1997 Seventh Circuit opinion, Judge Posner wrote: The prototypical RICO case is one in which a person bent on criminal activity seizes control of a previously legitimate firm and uses the firm’s resources, contacts, facilities, and appearance of legitimacy to perpetrate more, and less easily discovered, criminal acts than he could do in his own person, that is, without channeling his criminal activities through the enterprise that he has taken over. Fitzgerald v. Chrysler Corp., 116 F.3d 225, 227 (7th Cir. 1997), citing United States v. Turkette, 452 U.S. 576, 69 L.Ed.2d 246, 101 S.Ct. 2524, 2532 – 2533 (1981), Cenco, Inc. v. Seidman & Seidman, 686 F.2d 449, 457 (7th Cir. 1982), and United States v. Carson, 52 F.3d 1173, 1176 – 1177 (2d Cir. 1995). Cases that do not fit this mold are not necessarily illegitimate, but the plaintiffs in such cases face a healthy dose of skepticism from the courts. To state a valid RICO claim, a borrower must allege that its lender, “employed by or associated with” an enterprise affecting interstate or foreign commerce, conducted or participated in the conduct of this enterprise’s affairs “through a pattern of racketeering activity.” 18 U.S.C. §1962(c). See Beck v. Prupis, 529 U.S. 494, 146 L.Ed.2d 561, 120 S.Ct. 1608, 1112 (2000); Rao v. BP Products North America, Inc., 589 F.3d 389, 399 (7th Cir. 2009); MCM Partners, Inc. v. Andrews-Bartlett & Associates, Inc., 161 F.3d 443, 448 (7th Cir. 1998), cert. denied, 120 S.Ct. 43 (1999); S.Q.K.F.C. v. Bell Atlantic Tricon Leasing Corp., 84 F.3d 629, 633 (2d Cir. 1996). A borrower is furthermore required to plead and prove that the lender’s conduct proximately caused the borrower’s damage. Anza v. Ideal Steel Supply Corp., 547 U.S. 451, 164 L.Ed.2d 720, 126 S.Ct. 1991, 1997 – 1998 (2006); James Cape & Sons Co. v. PCC Construction Co., 453 F.3d 396 (7th Cir. 2006); Phoenix Bond & Indemnity Co. v. Bridge, 477 F.3d 928, 930 – 931 (7th Cir. 2007); Bastian v. Petren Resources Corp., 892 F.2d 680 (7th Cir.), cert. denied, 110 S.Ct. 2590 (1990); Ruiz v. Stewart Associates, Inc., 171 F.R.D. 238, 241 (N.D.Ill. 1997); Carnegie v. Household International, Inc., 220 F.R.D. 542, 546 (N.D.Ill. 2004); Red Ball Interior Demolition Corp. v. Palmadessa, 874 F.Supp. 576, 583 (S.D.N.Y. 1995) (citing Holmes v. Securities Investor Protection Corp., 503 U.S. 258, 117 L.Ed.2d 532, 112 S.Ct. 1311, 1316 – 1318 (1992), First Nationwide Bank v. Gelt Funding Corp., 27 F.3d 763, 769 (2d Cir. 1994), cert. denied, 115 S.Ct. 728 (1995), Standardbred Owners Ass’n v. Roosevelt Raceway Associates, L.P., 985 F.2d 102, 104 (2d Cir. 1993), and Hecht v. Commerce Clearing House, Inc., 897 F.2d 21, 23 – 25 (2d Cir. 1990)). The predicate acts amounting to “racketeering activity” must be the acts resulting in the damage. Holmes, supra, 112 S.Ct. at 1327. Although RICO is a criminal statute, in a civil case the elements need only be proved by a preponderance of the evidence. Mira v. Nuclear Measurements Corp., 107 F.3d 466, 473 (7th Cir. 1997); American Automotive Accessories, Inc. v. Fishman, 991 F.Supp. 987, 991 (N.D.Ill. 1998), aff’d, 175 F.3d 534 (7th Cir. 1999). Finally, RICO is to be construed broadly. LaSalle Bank Lake View v. Seguban, 937 F.Supp. 1309, 1321 (N.D.Ill. 1996); Daniels v. Bursey, 313 F.Supp.2d 790 (N.D.Ill. 2004). Joining the Eleventh Circuit, the United States Court of Appeals for the Fifth Circuit held in Rogers v. McDorman, 521 F.3d 381 (5th Cir. 2008), that the in pari delicto defense, in which a plaintiff’s own wrongful conduct can bar recovery, is a cognizable defense to a civil RICO action. Building off the Supreme Court’s application of the defense in Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 86 L.Ed.2d 215, 105 S.Ct. 2622 (1985), to the securities and antitrust statutory

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context, the Fifth Circuit held that the defense may succeed only when, “as a direct result of his own actions, the plaintiff bears at least substantially equal responsibility for the violations he seeks to redress.” Rogers, supra, 521 F.3d at 389 n.34, quoting Bateman Eichler, 105 S.Ct. at 2629. But see In re Le-Nature’s Inc., No. 2021, 2009 WL 3571331, *6 (W.D.Pa. Sept. 16, 2009) (rejecting defendant’s in pari delicto defense because debtor had “essentially rid itself of corrupt influence of certain corporate officers” prior to appointment of trustee and because, when trustee stepped into debtor’s shoes, debtor was no longer operating corruptly, so no wrongdoing could be imputed to trustee for purposes of in pari delicto defense). 2. [13.20] Requirement of RICO Predicate Acts A claimant must properly plead at least two separate predicate acts to state a claim under the Racketeer Influenced and Corrupt Organizations Act. Limestone Development Corp. v. Village of Lemont, Illinois, 520 F.3d 797, 801 – 802 (7th Cir. 2008); Emery v. American General Finance, Inc., 873 F.Supp. 1116 (N.D.Ill. 1994), aff’d in relevant part, 71 F.3d 1343 (7th Cir. 1995); 18 U.S.C. §1961(5). The claimant must also satisfy the “continuity plus relationship” test (i.e., “the predicate acts must be related to one another (the relationship prong) and pose a threat of continued criminal activity (the continuity prong)” [emphasis omitted]). Midwest Grinding Co. v. Spitz, 976 F.2d 1016, 1022 (7th Cir. 1992). Consistent with this test, the Seventh Circuit has stated that a “criminal enterprise, as distinct from a normal enterprise that gets into trouble with the law from time to time, is an enterprise that habitually resorts to illegal methods of doing business.” [Emphasis omitted.] Pizzo v. Bekin Van Lines Co., 258 F.3d 629, 633 (7th Cir. 2001). RICO, in defining what may be a predicate act, uses the phrase “any act which is indictable” demonstrating that criminal activity is required to support a predicate offense of mail or wire fraud. 18 U.S.C. §1961(1). Relevant authority makes clear that a borrower attempting to bring a RICO claim against its lender bears a heavy burden in trying to establish a mail or wire fraud claim for civil RICO purposes. As the Seventh Circuit noted in Emery v. American General Finance, Inc., 71 F.3d 1343, 1346 – 1347 (7th Cir. 1995): [R]ecent cases . . . make clear that all the statute punishes is deliberate fraud . . . where in order to get money or something else of monetizable value from someone you make a statement to him that you know to be false, or a half truth that you know to be misleading, expecting him to act upon it to your benefit and his detriment. *** Plenty of cases say that “merely failure to disclose” is not, without more, mail fraud . . . and we certainly have no quarrel with this proposition. [Citations omitted.] [Emphasis omitted.] When mail or wire fraud is the predicate act of a borrower’s RICO claim, each element necessary to show mail or wire fraud must be alleged with the particularity and specificity required by Fed.R.Civ.P. 9(b). Fujisawa Pharmaceutical Co. v. Kapoor, 814 F.Supp. 720 (N.D.Ill. 1993); Slaney v. International Amateur Athletic Federation, 244 F.3d 580, 599 (7th Cir.

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2001), cert. denied, 122 S.Ct. 69 (2001). As the Seventh Circuit stated in Spitz, supra, this means that “the complaint must, at minimum, describe the predicate acts with some specificity and ‘state the time, place, and content of the alleged communications perpetrating the fraud.’ ” 976 F.2d at 1020, quoting Graue Mill Development Corp. v. Colonial Bank & Trust Company of Chicago, 927 F.2d 988, 992 (7th Cir. 1991). The mail and wire fraud statutes first require a showing of a scheme to defraud. See Beverly Gravel, Inc. v. DiDomenico, 908 F.2d 223, 225 (7th Cir. 1990); Carpenter v. United States, 484 U.S. 19, 98 L.Ed.2d 275, 108 S.Ct. 316, 320 n.6 (1987) (mail and wire fraud statutes subject to same analysis). A plaintiff must also establish that, in perpetrating such a scheme, the defendant acted with specific intent. See United States v. Feldman, 711 F.2d 758 (7th Cir.), cert. denied, 104 S.Ct. 352 (1983); Meier v. Musberger, 588 F.Supp.2d 883, 909 (N.D.Ill. 2008); Barsky v. Metro Kitchen & Bath, Inc., 587 F.Supp.2d 976, 990 (N.D.Ill. 2008) (plaintiff must prove “specific intent to deceive or cheat”). Third, a borrower must properly allege that the wires or mails were used in furtherance of the scheme. Beverly Gravel, supra, 908 F.2d at 229; United States v. Rauhoff, 525 F.2d 1170, 1176 (7th Cir. 1975) (mailings must be made to promote, to reap benefits of, or to help conceal scheme); Barsky, supra, 587 F.Supp.2d at 990 (mailing not in furtherance when made after scheme “came to fruition” and was not intended to conceal scheme); Shiman v. Paradigm Venture Investors, L.L.C., No. 02 C 1320, 2002 WL 1793570 (N.D.Ill. Aug. 5, 2002). But see LaFlamboy v. Landek, 587 F.Supp.2d 914, 941 (N.D.Ill. 2008) (mailing need not contain false information to be in furtherance). Finally, a plaintiff must properly plead that the alleged misrepresentations were material. United States v. Regent Office Supply Co., 421 F.2d 1174, 1181 (2d Cir. 1970). In Bridge v. Phoenix Bond & Indemnity Co., 553 U.S. 639, 170 L.Ed.2d 1012, 128 S.Ct. 2131 (2008), the United States Supreme Court held that a plaintiff asserting a RICO claim predicated on mail or wire fraud need not show, either as an element of its claim or as a prerequisite to establishing proximate causation, that the plaintiff relied on the defendant’s alleged misrepresentations. The Court explained that the text of RICO does not contain any reliance requirement and that a person can be injured “by reason of” a pattern of mail fraud even if he or she has not relied on any misrepresentations. 128 S.Ct. at 2137. A borrower cannot adequately allege the required predicate acts by claiming that a lender merely enforced its contractual rights, albeit in bad faith. Moore v. Fidelity Financial Services, Inc., 949 F.Supp. 673, 677 (N.D.Ill. 1997) (finding no mail fraud when RICO defendant asserted colorable contract rights and explicitly told plaintiff it was doing so). Caselaw makes clear that when the conduct at issue is colorably authorized by a contract, there is no scheme to defraud. See Dresser Industries, Inc. v. Pyrrhus AG, 936 F.2d 921, 935 (7th Cir. 1991) (dismissing RICO claim based on predicate act of mail fraud because no scheme to defraud could exist when “Pyrrhus’ purported injury, continuing to perform services for Dresser, was required under the Contract at issue”). Nor, through artful pleading, should a plaintiff be able to turn an everyday contract dispute into a criminal mail fraud claim. See Carr v. Tillery, 591 F.3d 909, 918 (7th Cir. 2010) (“RICO is not a proper vehicle for levering a breach of contract suit between citizens of the same state into federal court”); Smith v.Grundy County National Bank, 635 F.Supp. 1071, 1076 n.8 (N.D.Ill.

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1986) (finding that plaintiffs’ allegations just showed contract dispute and that plaintiffs “tried to use pleading ‘hocus-pocus’ to turn a state law breach of contract and fiduciary duty case into a federal mail fraud and hence RICO case”); Serig v. South Cook County Service Corp., 581 F.Supp. 575, 580 (N.D.Ill. 1984) (“[m]ere breach of business contract disputes do not provide a basis for a RICO suit”); Grant v. Union Bank, 629 F.Supp. 570 (D. Utah 1986) (allegation that bank represented loan as almost guaranteed did not support specific intent to commit fraud; there was no allegation that bank advised as to what “prime” meant and no fact questions regarding bank’s awareness of misunderstanding). See also Dahlgren v. First National Bank of Holdrege, 533 F.3d 681 (8th Cir. 2008), granting summary judgment to the defendant bank against the plaintiff’s RICO claims when the defendant was alleged to have misled the plaintiff cattle investors into continuing to do business with a now-bankrupt cattle company by concealing the company’s increasing financial weaknesses in order to protect the bank’s interest in the company as its creditor. The court reasoned that the bank did not “conduct” or “participate, directly or indirectly, in the conduct” of the company’s affairs for purposes of 18 U.S.C. §1962(c) merely by conducting its own affairs as a creditor and taking actions consistent with its own interests as a creditor. 533 F.3d at 689 – 690. Rather, the Dahlgren court instructed, the bank, to be held liable, must take “additional steps as an outsider to direct the operation or management of its customer, the RICO enterprise.” 533 F.3d at 690. The court reasoned that a “bank’s financial assistance and professional services may assist a customer engaging in racketeering activities, but that alone does not satisfy the stringent ‘operation and management’ test” set forth by the Supreme Court in Reves v. Ernst & Young, 507 U.S. 170, 122 L.Ed.2d 525, 113 S.Ct. 1163 (1993). Id. In Grundy County National Bank, supra, the bank made a loan to the plaintiff at 3 percent over prime when it had allegedly promised, in a prior commitment letter, to make the loan at only 1.5 percent over prime. The court held that [n]o artifice, deceit, misrepresentation or material omission was used in charging the higher interest rate. . . . The Bank thought it had a right to charge the higher rate and plainly disclosed the rate. [Plaintiff] signed it knowingly, and simply disagrees that the Bank had such a right. This is the essence of contract, not fraud, cases. 635 F.Supp. at 1076. Likewise, in Union National Bank of Little Rock v. Federal National Mortgage Ass’n, 860 F.2d 847, 857 (8th Cir. 1988), the Eighth Circuit dismissed RICO extortion- and fraud-based claims arising out of a contract dispute between the parties. The plaintiff in Union National Bank of Little Rock alleged that the defendant made certain demands that constituted “economic terrorism” because they resulted from the defendant’s “superior bargaining position.” Id. The Union National Bank of Little Rock court, however, thought it clear that the defendant’s “demands on [plaintiff] were motivated by its interpretation of the [contract between the parties],” concluding that “whatever proves to be the proper interpretation of the parties’ agreement, [it would] decline to hold that [defendant] acted in an extortionate or fraudulent manner in making the demands that it did.” Id. See also Iden v. Adriana Buckhannon Bank, 661 F.Supp. 234 (N.D.W.Va. 1987) (bank didn’t engage in mail fraud in connection with restructuring loans, even though officer had embezzled money from borrowers; in fact, bank was equally deceived and credited borrowers with amount embezzled).

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3. [13.21] Requirement of a Pattern Any claim under the Racketeer Influenced and Corrupt Organizations Act by a borrower must show that the predicate acts were part of a pattern of racketeering activity on the part of the lender. See Olive Can Co. v. Martin, 906 F.2d 1147, 1150 (7th Cir. 1990) (“[m]erely alleging two predicate acts . . . does not satisfy the pattern requirement” for RICO). Courts do not look favorably on the allegation of a pattern based on claims of mail and wire fraud. See Midwest Grinding Co. v. Spitz, 976 F.2d 1016, 1025 (7th Cir. 1992); Wobble Light, Inc. v. McLain/Smigiel Partnership, 890 F.Supp. 721, 724 (N.D.Ill. 1995); Williams v. Aztar Indiana Gaming Corp., 351 F.3d 294, 298 (7th Cir. 2003). This holds true particularly when a RICO claim primarily depends on assertions of mail or wire fraud; even showing a large number of separate predicate acts may be insufficient to establish the requisite RICO pattern. See Kaye v. D’Amato, 357 Fed.Appx. 706, 715 (7th Cir. 2009) (“while a minimum of two predicate acts are required, two acts are normally not sufficient”); Ashland Oil, Inc. v. Arnett, 875 F.2d 1271 (7th Cir. 1989). The test for finding a pattern was articulated by the United States Supreme Court in Sedima, S.P.R.L. v. Imrex Co., 473 U.S. 479, 87 L.Ed.2d 346, 105 S.Ct. 3275, 3285 n.14 (1985): The target of [RICO] is thus not sporadic activity. The infiltration of legitimate business normally requires more than one “racketeering activity” and the threat of continuing activity to be effective. It is this factor of continuity plus relationship which combines to produce a pattern. [Emphasis in original.] The Supreme Court reaffirmed and expanded on Sedima’s continuity-plus-relationship test in H.J., Inc. v. Northwestern Bell Telephone Co., 492 U.S. 229, 106 L.Ed.2d 195, 109 S.Ct. 2893 (1989). As to relationship, the Court stated: [C]riminal conduct forms a pattern if it embraces criminal acts that have the same or similar purposes, results, participants, victims, or methods of commission, or otherwise are interrelated by distinguishing characteristics and are not isolated events. 109 S.Ct. at 2901, quoting 18 U.S.C. §3575(e). The Court defined “continuity” as both a closed- and open-ended concept, referring either to a closed period of repeated conduct, or to past conduct that by its nature projects into the future with a threat of repetition. 109 S.Ct. at 2902. A plaintiff may also demonstrate continuity by showing that the predicate acts are typical of a defendant’s “regular way of doing business.” Id. The continuity requirement can be either a closed-ended or open-ended concept, “referring either to a closed period of repeated conduct, or to past conduct that by its very nature projects into the future with a threat of future repetition.” Kaye, supra, 357 Fed.Appx. at 715, quoting H.J., Inc., supra, 109 S.Ct. at 2893. In employing the continuity-plus-relationship test mandated by Sedima, supra, and H.J., Inc., supra, the Seventh Circuit has emphasized four factors to consider in determining whether

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conduct constitutes a pattern for purposes of RICO. These factors include (a) the number and variety of predicate acts and the length of time over which they were committed, (b) the number of victims, (c) the presence of separate schemes, and (d) the occurrence of distinct injuries. Morgan v. Bank of Waukegan, 804 F.2d 970, 975 (7th Cir. 1986); ABN AMRO Mortgage Group, Inc. v. Maximum Mortgage, Inc., No. Civ. 1:04CV492, 2005 WL 1162889 (N.D.Ind. May 16, 2005); Guaranty Residential Lending, Inc. v. International Mortgage Center, Inc., 305 F.Supp.2d 846, 858 (N.D.Ill. 2004); Chen v. Mayflower Transit, Inc., 315 F.Supp.2d 886, 910 – 915 (N.D.Ill. 2004). The pattern requirement is an especially difficult hurdle for a RICO plaintiff to overcome. See Kaye, supra, 357 Fed.Appx. at 716 (“when a complaint presents a distinct and non-recurring scheme with a built-in end point and provides no indication that Defendants have engaged or will engage in similar misconduct, the complaint does not sufficiently allege continuity even if the purported scheme takes years to unfold, involves a variety of criminal acts, and targets more than one victim”). As the Seventh Circuit noted in J.D. Marshall International, Inc. v. Redstart, Inc., 935 F.2d 815, 820 (7th Cir. 1991), “[s]atisfying the pattern requirements — that there be continuity and relationship among the predicate acts — is not easy in practice.” See also Gamboa v. Velez, 457 F.3d 703, 709 (7th Cir. 2006) (rejecting RICO claims even when complaint satisfied all factors in relationship-plus-continuity test when “commonsense” indicated lack of continuity). Courts closely scrutinize the allegations that are said to form a pattern to see if these justify the treble damages available under RICO. United States Textiles, Inc. v. Anheuser-Busch Cos., 911 F.2d 1261, 1266 (7th Cir. 1990); McDonald v. Schencker, 18 F.3d 491, 498 (7th Cir. 1994); Williams, supra, 351 F.3d at 298. The Seventh Circuit has emphasized that the pattern requirement places an important check on the misuse of civil RICO. In Hunter v. J. Craig Construction Co., 51 F.3d 275 (7th Cir. 1995) (text available in Westlaw), the Seventh Circuit stated: The purpose of these requirements is to weed out garden variety fraud allegations and to prevent RICO from being misused as a tool wherewith a disgruntled party may exact disproportionate vengeance against his partners or associates when their business dealings turn sour. 4. [13.22] Requirement of a RICO Enterprise Under the Racketeer Influenced and Corrupt Organizations Act, a “RICO enterprise” is defined as “an ongoing ‘structure’ of persons associated through time, joined in purpose, and organized in a manner amenable to hierarchical or consensual decision-making.” Richmond v. Nationwide Cassel, L.P., 52 F.3d 640, 644 (7th Cir. 1995). See Baker v. IBP, Inc., 357 F.3d 685, 691 (7th Cir. 2004) (concluding lack of common purpose among entities in enterprise was “fatal problem”). But see also Williams v. Mohawk Industries, Inc., 465 F.3d 1277, 1285 – 1286 (11th Cir. 2006) (disagreeing with Baker, supra, and finding “[i]n our circuit, however, there has never been any requirement that the ‘common purpose’ of the enterprise be the sole purpose of each and every member of the enterprise”), cert. denied, 127 S.Ct. 1381 (2007). An enterprise must have “a structure and goals separate from the predicate acts themselves.” United States v. Masters, 924 F.2d 1362, 1367 (7th Cir.), cert. denied, 111 S.Ct. 2019 (1991). A plaintiff must include specific allegations regarding the structure of the alleged enterprise. See Limestone Development Corp. v.

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Village of Lemont, Illinois, 520 F.3d 797, 804 (7th Cir. 2008) (complaint insufficient when “no reference to a system of governance, an administrative hierarchy, a joint planning committee, a board, a manager, a staff, headquarters, personnel having differentiated functions, a budget, records, or any other indicator of a legal or illegal enterprise”). There must also be “a common purpose of engaging in a course of conduct.” Richmond, supra, 52 F.3d at 645. “Allegations that a defendant had a business relationship with the putative RICO enterprise or that a defendant performed services for that enterprise do not suffice.” Crichton v. Golden Rule Insurance Co., 576 F.3d 392, 399 (7th Cir. 2009). Some authorities have required that a RICO plaintiff allege facts that show more than a simple corporate relationship between a subsidiary and a parent to establish an enterprise. See Richmond, supra, 52 F.3d at 647 (quoting Brittingham v. Mobil Corp., 943 F.2d 297, 301 – 302 (3d Cir. 1991), for proposition that distinctiveness requirement is not met “by alleging enterprises that are merely combinations of individuals or entities affiliated with a defendant corporation”); Bachman v. Bear, Stearns & Co., 178 F.3d 930, 932 (7th Cir. 1999); Anael v. Interstate Brands Corp., No. 02 C 5192, 2003 WL 21995183, *6 (N.D.Ill. Aug. 18, 2003); Daniels v. Bursey, 313 F.Supp.2d 790 (N.D.Ill. 2004). As such, the fact that the other corporate entities are affiliated with a defendant is insufficient for purposes of RICO enterprise allegations. See Reves v. Ernst & Young, 507 U.S. 170, 122 L.Ed.2d 525, 113 S.Ct. 1163, 1173 (1993) (“liability depends on showing that the defendants conducted or participated in the conduct of the ‘enterprise’s affairs,’ not just their own affairs” [Emphasis omitted.]); Atkinson v. Anadarko Bank & Trust Co., 808 F.2d 438, 441 (5th Cir.), cert. denied, 107 S.Ct. 3276 (1987); Fitzgerald v. Chrysler Corp., 116 F.3d 225, 226 (7th Cir. 1997) (“plaintiffs carve up the medley of Chrysler entities into three different enterprises; but as none of the combinations of different members of the Chrysler family adds up to a RICO enterprise, it makes no difference how they are sorted”); Wooley v. Jackson Hewitt, Inc., 540 F.Supp.2d 964, 974 (N.D.Ill. 2008). But see General Accident Insurance Company of America v. Fidelity & Deposit Company of Maryland, 598 F.Supp. 1223 (E.D.Pa. 1984) (banks and other corporations can be individuals associated in fact for purposes of alleging existence of enterprise); Morosani v. First National Bank of Atlanta, 581 F.Supp. 945 (N.D.Ga. 1984) (bank and holding company were enterprise). In Cedric Kushner Promotions, Ltd. v. King, 533 U.S. 158, 150 L.Ed.2d 198, 121 S.Ct. 2087, 1290 – 1292 (2001), the Supreme Court held that an individual and a wholly owned corporation could be sufficiently distinct for RICO purposes. The Court concluded that the corporate owneremployee was distinct from the corporation because the corporation was “a legally different entity with different rights and responsibilities due to its different legal status,” and the Court could “find nothing in the statute that requires more ‘separateness’ than that.” 121 S.Ct. at 2091. The Court observed that, “[a]fter all, incorporation’s basic purpose is to create a distinct legal entity, with legal rights, obligations, powers, and privileges different from those of the natural individuals who created it, who own it, or whom it employs.” Id. In Boyle v. United States, 556 U.S. 938, 173 L.Ed.2d 1265, 129 S.Ct. 2237, 2244 – 2245 (2009), the United States Supreme Court attempted to clarify the “enterprise” requirement under RICO, holding that an association-in-fact enterprise must have an “ascertainable structure,” but rejecting the petitioner’s argument that the enterprise must contain additional structural features such as an identifiable hierarchy, a chain of command, or professionalism and sophistication of

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organization. Instead, the Court explained that in such an enterprise, “decisions may be made on an ad hoc basis and by any number of methods” and that “[m]embers of the group need not have fixed roles.” 129 S.Ct. at 2245. Accordingly, the Court upheld a district court instruction whereby jurors were charged that in order to find RICO liability, the prosecution had to prove that there was an “ongoing organization with some sort of framework, formal or informal, for carrying out its objectives” and that “the various members and associates of the organization function[ed] as a continuing unit to achieve a common purpose.” 129 S.Ct. at 2242 & n.1. In Bucklew v. Hawkins, Ash, Baptie & Co., 329 F.3d 923 (7th Cir. 2003), which was decided subsequent to Cedric Kushner Promotions, supra, the Seventh Circuit affirmed judgment in favor of the defendant on a RICO claim involving a parent corporation and its wholly owned subsidiaries. In deciding the issue, the court stated: A parent and its wholly owned subsidiaries no more have sufficient distinctness to trigger RICO liability than to trigger liability for conspiring in violation of the Sherman Act . . . unless the enterprise’s decision to operate through subsidiaries rather than divisions somehow facilitated its unlawful activity, which has not been shown here. [Citation omitted.] 329 F.3d at 934. Bucklew thus suggests that, although a parent corporation and its subsidiaries will generally not meet the distinctiveness requirement, they may be found distinct if the unlawful activity is facilitated by the enterprise’s decision to operate through subsidiaries. See also Bachman, supra, 178 F.3d at 932; Anael, supra, 2003 WL 21995183 at *2; Daniels v. Bursey, 313 F.Supp.2d 790 (N.D.Ill. 2004). In the multidistrict litigation stemming from Countrywide Financial Corporation’s alleged participation in the subprime mortgage crisis, the United States District Court for the Southern District of California held, in In re Countrywide Financial Corp. Mortgage Marketing & Sales Practices Litigation, 601 F.Supp.2d 1201 (S.D.Cal. 2009), that the class action plaintiffs stated a RICO claim for relief sufficient to survive a Fed.R.Civ.P. 12(b)(6) motion to dismiss when they alleged that the defendants engaged in a scheme to steer borrowers into subprime mortgages, which were then sold as investments on the secondary mortgage market, and contended that the defendants pushed borrowers into subprime loans irrespective of their ability to repay the loans. In so holding, the court followed the Seventh Circuit’s direction in Bucklew, supra, that a parent and its subsidiary are not sufficiently distinct, in and of themselves, to satisfy the requirement under 18 U.S.C. §1962(c) that the “person” must be a separate and distinct entity from the “enterprise.” Requiring a RICO plaintiff to show “something more” in order to indicate that the parent and subsidiary are distinct, the Countrywide court held that this “something more” test was satisfied by the plaintiffs’ pleadings that participation by the subsidiary defendants in the alleged enterprise “allow[ed] the enterprise to function more effectively” because it allowed “the normal checks and balances within the mortgage process to be eliminated, permitting Defendants to advance their scheme and conceal the fraudulent activity they have been engaging in.” 601 F.Supp.2d at 1214. The Countrywide court also joined the United States Court of Appeals for the Third Circuit, in Rolo v. City Investing Company Liquidating Trust, 155 F.3d 644 (3d Cir. 1998), in holding that there is no private right of action for aiding and abetting a RICO violation.

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5. [13.23]

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Requirement That “Persons” Separate from Alleged RICO “Enterprise” Be Defendants

Not only must there be an adequately alleged “enterprise” in an 18 U.S.C. §1962(c) claim, but controlling authority requires that that “enterprise” must be sufficiently distinct from the defendant “person.” Cedric Kushner Promotions, Ltd. v. King, 533 U.S. 158, 150 L.Ed.2d 198, 121 S.Ct. 2087, 1290 (2001); Crichton v. Golden Rule Insurance Co., 576 F.3d 392, 398 (7th Cir. 2009); Richmond v. Nationwide Cassel, L.P., 52 F.3d 640, 646 – 647 (7th Cir. 1995); Reves v. Ernst & Young, 507 U.S. 170, 122 L.Ed.2d 525, 113 S.Ct. 1163, 1173 (1993); Chamberlain Manufacturing Corp. v. Maremont Corp., 919 F.Supp. 1150, 1157 (N.D.Ill. 1996). A claim under the Racketeer Influenced and Corrupt Organizations Act must fail when it names the same party as both the RICO “enterprise” and “person.” Haroco, Inc. v. American National Bank & Trust Company of Chicago, 747 F.2d 384, 399 – 402 (7th Cir. 1984), aff’d, 105 S.Ct. 3291 (1985). Efforts by borrowers to avoid this rule by splitting their allegations about lenders and their affiliates have been unavailing. See, e.g., Rowe v. Bankers Life & Casualty Co., No. 09-CV00491, 2010 WL 3699928 (N.D.Ill. Sept. 13, 2010); Moore v. Fidelity Financial Services, Inc., 949 F.Supp. 673, 678 – 679 (N.D.Ill. 1997); Bennett v. United States Trust Company of New York, 770 F.2d 308 (2d Cir. 1985) (bank could not be both enterprise and culpable person in claim that it misrepresented that Federal Reserve margin rules did not apply to public utility stock purchased with loan proceeds and deposit as collateral), cert. denied, 106 S.Ct. 800 (1986); D & G Enterprises v. Continental Illinois National Bank & Trust Company of Chicago, 574 F.Supp. 263 (N.D.Ill. 1983). But see Nelson v. National Republic Bank of Chicago, Fed.Sec.L.Rep. (CCH) ¶91,481 (N.D.Ill. 1984) (allegation that bank, as culpable person, participated through associations with enterprises in securities fraud resulting in sale of worthless bonds stated viable RICO claim). Likewise, a bank cannot be both the culpable person and, in combination with its officers, the enterprise. Jay E. Hayden Foundation v. First Neighbor Bank, N.A., 610 F.3d 382, 389 (7th Cir. 2010) (no enterprise when plaintiff claimed bank was enterprise and also named it as defendant); Riverwoods Chappaqua Corp. v. Marine Midland Bank, N.A., 30 F.3d 339, 345 (2d Cir. 1994) (dismissing RICO claims against loan officers working for codefendant bank; cited approvingly in Fitzgerald v. Chrysler Corp., 116 F.3d 225, 226 (7th Cir. 1997)). But see Cedric Kushner Promotions, supra (president and sole owner of corporation can be culpable person, and, in combination with wholly owned corporation, enterprise under §1962(c)). The requirement that a RICO defendant has actually engaged in the enterprise’s affairs rather than just its own is another way courts have stressed the requirement that a RICO defendant be separate and distinct from the enterprise. For example, Stachon v. United Consumers Club, Inc., 229 F.3d 673, 676 n.3 (7th Cir. 2000), states that “the court has consistently insisted that the RICO defendant or ‘person’ be separate and distinct from the enterprise . . . because ‘liability depends on showing that the defendants conducted or participated in the conduct of the “enterprise’s affairs, not just their own affairs.” ’ ” [Citation omitted.] Similarly, in Atkinson v. Anadarko Bank & Trust Co., 808 F.2d 438, 441 (5th Cir.), cert. denied, 107 S.Ct. 3276 (1987), the court affirmed a district court’s decision to grant judgment notwithstanding the verdict in favor of a bank, finding that the alleged RICO violation (mailing of false loan statements) was solely an action by the bank, not the alleged criminal enterprise. The United States Court of Appeals for the District of Columbia Circuit in United States v. Philip Morris USA Inc., 566 F.3d 1095, 1105 (D.C.Cir. 2009),

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affirmed a district court judgment, finding the defendant cigarette manufacturers liable in a civil RICO action for “conducting the affairs of their joint enterprise through a pattern of mail and wire fraud in a scheme to deceive American consumers” regarding the health effects and addictiveness of smoking cigarettes, rejecting the defendants’ argument that an association-in-fact enterprise cannot be comprised of defendant corporations. Rather, the court held, 18 U.S.C. §1961(4)’s list of entities is non-exhaustive, and a RICO enterprise may be comprised of individuals, cigarette manufacturers, and trade organizations. 6. [13.24]

Enhanced Emphasis on Proximate Causation of Claimed Injury by Racketeering Conduct

In 2006, the Supreme Court reiterated that a civil claim under the Racketeer Influenced and Corrupt Organizations Act cannot survive unless the plaintiff properly alleges that the RICO violation was the proximate cause of its damages. Anza v. Ideal Steel Supply Corp., 547 U.S. 451, 164 L.Ed.2d 720, 126 S.Ct. 1991 (2006). In Anza, the plaintiff alleged that Ideal, its competitor in the steel supply business, engaged in a criminal scheme whereby it fraudulently failed to charge cash-paying customers for sales taxes. This practice allowed it to reduce its prices without affecting its profit margin. The plaintiff claimed damages based on its loss of significant business and market share to its cheating competitor. The Supreme Court held that the relevant inquiry in determining whether proximate cause has been properly alleged in a civil RICO claim is “whether the alleged violation led directly to the plaintiff’s injuries.” 126 S.Ct. at 1998. The court determined that in Anza’s case the direct victim of Ideal’s fraudulent scheme was the State of New York, which was cheated of its tax revenue. 126 S.Ct. at 1997. It further explained that civil RICO plaintiffs must show direct harm, lest RICO damages become too difficult to ascertain. The injury Ideal alleges is its own loss of sales resulting from National’s decreased prices for cash-paying customers. National, however, could have lowered its prices for any number of reasons unconnected to the asserted pattern of fraud. It may have received a cash inflow from some other source or concluded that the additional sales would justify a smaller profit margin. Its lowering of prices in no sense required it to defraud the state tax authority. Likewise, the fact that a company commits tax fraud does not mean the company will lower its prices; the additional cash could go anywhere from asset acquisition to research and development to dividend payouts. Id. In 2010, the Supreme Court again upheld the dismissal of a RICO claim when the plaintiff City of New York alleged that the defendant’s failure to submit legally required customer information to the state caused the city to be unable to pursue customers for unpaid taxes. Hemi Group, LLC v. City of New York, New York, 559 U.S. 1, 175 L.Ed.2d 943, 130 S.Ct. 983 (2010). The Court found that the plaintiff’s claim that “the defendant’s fraud on the third party (the State) has made it easier for a fourth party (the taxpayer) to cause harm to the plaintiff (the City)” failed to allege that the defendant proximately caused harm to the city. [Emphasis in original.] 130 S.Ct. at 990.

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The Seventh Circuit applied Anza, supra, in James Cape & Sons Co. v. PCC Construction Co., 453 F.3d 396 (7th Cir. 2006). There the defendants pleaded guilty to rigging bids for certain Wisconsin public highway jobs. The plaintiff was a competitor that alleged loss of construction contracts to the bid-rigging conspiracy. The court applied the holding in Anza in affirming dismissal of the RICO claims. It stated: This case poses similar concerns. A court could never be certain whether Cape would have won any of the contracts that were the subject of the conspiracy “for any number of reasons unconnected to the asserted pattern of fraud.” See Anza, 126 S.Ct. at 1997. It is entirely possible that Defendants would have won some bids absent the bid-rigging scheme, even if making less profits in the meantime. Furthermore, Cape cannot show what portion of its “lost market share” is attributable to the bids lost to the bid-rigging scheme. As the Court stated in Anza, “Businesses lose and gain customers for many reasons, and it would require a complex assessment to establish what portion of Ideal’s lost sales were the product of National’s decreased prices. . . . A RICO plaintiff cannot circumvent the proximate-cause requirement simply by claiming that the defendant’s aim was to increase market share at a competitor’s expense.” Anza, 126 S.Ct. at 1997-98. Also compelling is the Court’s holding that a direct causal connection is “especially warranted where the immediate victims of an alleged RICO violation can be expected to vindicate the laws by pursuing their own claims.” Id. at 1998. Here, WisDOT is fully capable of pursuing appropriate remedies, much like the State of New York in Anza. 453 F.3d at 403 – 404. See also Kaye v. D’Amato, 357 Fed.Appx. 706, 716 (7th Cir. 2009) (plaintiff could not state RICO claim when it could not show it would have been able to purchase property if defendant had not sold it to third party). Other courts have also begun to apply the enhanced emphasis on proximate cause stemming from Anza, supra. Williams v. Mohawk Industries, Inc., 465 F.3d 1277, 1290 – 1291 (11th Cir. 2006), (scrutinizing proximate cause at pleading stage as directed by Anza but concluding sufficient proximate cause was alleged), cert. denied, 127 S.Ct. 1381 (2007). See also RWB Services, LLC v. Hartford Computer Group, Inc., 539 F.3d 681, 688 (7th Cir. 2008) (holding plaintiff satisfied RICO’s proximate causation requirement when both plaintiff and third party were direct victims of alleged scheme, reasoning that “existence of multiple victims with different injuries does not foreclose a finding of proximate cause” and explaining that it was not dispositive that alleged scheme envisioned defrauding third party, who could also potentially bring RICO claim in response to scheme, because it is “not otherwise . . . grounds for denying a claim to a plaintiff directly injured by one predicate act in the hopes that a different one will emerge”).

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V. [13.25] EQUITABLE SUBORDINATION The doctrine of equitable subordination is not recognized under Illinois law, but is instead “a federal statutory creation available only in bankruptcy proceedings.” Paul H. Schwendener, Inc. v. Jupiter Electric Co., 358 Ill.App.3d 65, 829 N.E.2d 818, 826, 293 Ill.Dec. 893 (1st Dist. 2005). The Bankruptcy Code, 11 U.S.C. §101, et seq., provides: [A]fter notice and a hearing, the court may — (1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest; or (2) order that any lien securing such a subordinated claim be transferred to the estate. 11 U.S.C. §510(c). Modern equitable subordination as recognized in the Bankruptcy Code and recent bankruptcy cases has its roots in the forerunner to the Bankruptcy Code, the Bankruptcy Act of 1898. The traditional elements of equitable subordination under the Bankruptcy Act were (a) the claimant must have engaged in inequitable conduct, (b) the misconduct must have resulted in injury to the debtor’s creditors or conferred an unfair advantage on the claimant, and (c) equitable subordination of the claim must not otherwise be inconsistent with other provisions of bankruptcy law. In re Loop Hospital Partnership, 50 B.R. 565, 569 (Bankr. N.D.Ill. 1985), citing In re Mobile Steel Co., 563 F.2d 692, 700 (5th Cir. 1977). These elements, commonly known as the “Mobile Steel test,” have endured as the basic standard for equitable subordination under the Bankruptcy Code and in cases brought in state courts across the country. The Seventh Circuit formally adopted the Mobile Steel test in 2008 in In re Kreisler, 546 F.3d 863, 866 (7th Cir. 2008). See also United States v. Noland, 517 U.S. 535, 134 L.Ed.2d 748, 116 S.Ct. 1524, 1526 – 1527 (1996) (citing Mobile Steel test with approval). In the early and mid-1990s, prior to Kreisler, supra, the Seventh Circuit somewhat altered the traditional formulation of equitable subordination, particularly in the context of IRS tax penalty claims. In re Virtual Network Services Corp., 902 F.2d 1246 (7th Cir. 1990), involved subordination of an IRS claim rather than a claim of a financial institution. Virtual Network marked a departure from the traditional Mobile Steel formulation of the grounds for equitable subordination by not requiring an explicit finding that the claimant acted inequitably. Instead, the court considered that (a) the goal of equitable subordination is fairness to creditors, (b) punishing the debtor’s innocent creditors because of the debtor’s wrongful conduct served no purpose, and (c) the IRS priority claims at issue were punitive in nature. 902 F.2d at 1250. Therefore, the court subordinated the IRS penalty claims to those of the debtor’s general unsecured creditors. In Kham & Nate’s Shoes No. 2, Inc. v. First Bank of Whiting, 908 F.2d 1351, 1356 (7th Cir. 1990), the Seventh Circuit utilized Virtual Network as well as the traditional Mobile Steel test for equitable subordination to remedy the efforts of corporate insiders to convert equity or unsecured debt into secured debt in anticipation of bankruptcy. Kham & Nate’s, however, involved neither a penalty claim nor an insider. Under those circumstances, the court concluded that inequitable

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conduct was still a necessary element of equitable subordination. In the commercial context, inequitable conduct means a “breach plus some advantage-taking.” [Emphasis in original.] 908 F.2d at 1357. Accord Aluminum Mills Corp. v. Citicorp North America, Inc. (In re Aluminum Mills Corp.), 132 B.R. 869 (Bankr. N.D.Ill. 1991) (finding allegation that lender obtained release of possible fraudulent conveyance claims from debtor for no consideration three days prior to bankruptcy sufficient to survive motion to dismiss equitable subordination claim); Great American Insurance Co. v. Bailey (In re Cutty’s-Gurnee, Inc.), 133 B.R. 934 (Bankr. N.D.Ill. 1991) (subordinating secured claim of Great American to equitable lien of MorAmerica because Great American had required debtor to breach its contractual obligation to MorAmerica to give it second mortgage on certain real estate). The court in Kham & Nate’s concluded that no inequitable conduct had occurred since the lender, in abruptly terminating financing, was entitled to rely on a contract providing for entirely discretionary advances. Accord In re EDC, Inc., 930 F.2d 1275 (7th Cir. 1991). Another significant Seventh Circuit case on equitable subordination held that an individual unsecured creditor in a bankruptcy case has standing to seek equitable subordination of a secured creditor’s claim. In re Vitreous Steel Products Co., 911 F.2d 1223 (7th Cir. 1990). In In re Envirodyne Industries, Inc., 79 F.3d 579, 582 (7th Cir. 1996), the court applied its flexible approach, holding that courts “must look to the origin and nature of the unsecured claim and decide whether equity requires that it be subordinated,” to the claims of the acquired corporation’s stockholders who refused to exchange their shares for shares of the acquirer (thus converting their equity interest to debt). The court stated that although the claims were legally for debt, “they are in origin and nature claims based on equity interests.” 79 F.3d at 583. The 2008 opinion in Kreisler, supra, suggests the Seventh Circuit now follows the Mobile Steel test fairly closely, but the Seventh Circuit began moving back toward the traditional formulation in the late 1990s. In In re Lifschultz Fast Freight, 132 F.3d 339 (7th Cir. 1997), the Seventh Circuit further reined in the theory that inequitable conduct was no longer a required element for equitable subordination, reversing a lower court opinion that held that undercapitalization alone sufficed to order equitable subordination of debts owed the debtor’s shareholders. In Lifschultz, the court clarified that “mere undercapitalization does not . . . justify equitable subordination.” 132 F.3d at 345. The court dispensed with the trustee’s argument that, under Virtual Network, supra, equitable subordination no longer required inequitable conduct, stating: “The rule is that equitable subordination is predicated upon creditor misconduct; the exception of Virtual Network is for a class of tardy tax penalties.” 132 F.3d at 348. The court explained that Envirodyne, supra “simply establishes another exception to the general rule that equitable subordination requires inequitable conduct.” 132 F.3d at 349. The court also distinguished Envirodyne on the basis that the debt in that case was unsecured, noting that no case in the Seventh Circuit “has [ever] approved the equitable subordination of a secured claim absent inequitable conduct.” 132 F.3d at 349 n.11. See also In re A.G. Financial Service Center, Inc., 395 F.3d 410, 414 (7th Cir. 2005) (tax penalties may not be categorically disfavored by bankruptcy court, but case-by-case administration of Bankruptcy Code’s equitable subordination rules with respect to punitive awards against insolvent parties is appropriate); In re Friedman’s Inc., 356 B.R. 766, 775 (Bankr. S.D.Ga. 2006) (citing A.G. Financial, supra, in concluding that “[w]hile equitable subordination is generally triggered when there is some inequitable conduct on the part of the claimholder, that factor is neither a statutory nor mandatory prerequisite to the

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imposition of the doctrine”); Daley v. Chang (In re Joy Recovery Technology Corp.), 286 B.R. 54, 84 (Bankr. N.D.Ill. 2002) (rule mandating inequitable conduct before subordination is not absolute; “[t]hree categories of claims have been subordinated under the Mobile Steel test: ‘(1) when a fiduciary of the debtor misuses his position to the disadvantage of other creditors; (2) when a third party controls the debtor to the disadvantage of other creditors; and (3) when a third party actually defrauds other creditors’ ”), quoting In re United States Abatement Corp., 39 F.3d 556, 561 (5th Cir. 1994). But see In re Yellowstone Mountain Club, LLC, Bankruptcy No. 0861570-11, 2009 WL 3094930 (Bankr. D.Mont. May 12, 2009), in which it was held, after trial in a “Partial & Interim Order,” that the secured claim of Credit Suisse should be equitably subordinated to unsecured trade creditors, but not equity holders, due to Credit Suisse’s reckless actions in loaning substantial sums to a project that reasonable due diligence would have shown was doomed to failure. The dispute was later settled as part of a plan, and no final opinion was ever issued by the bankruptcy court on the equitable subordination issue. The Lifschultz, supra, opinion also addressed a concern over the continued validity of the earlier Virtual Network, supra, and Envirodyne, supra, rulings in light of two intervening Supreme Court decisions: Noland, supra, and United States v. Reorganized CF & I Fabricators of Utah, Inc., 518 U.S. 213, 135 L.Ed.2d 506, 116 S.Ct. 2106 (1996). The Lifschultz court noted that these cases “held that the bankruptcy court’s exercise of its power of equitable subordination must not have the ‘inevitable result’ of equitably subordinating ‘every tax penalty’ ” but also that “the Supreme Court found it unnecessary to ‘decide . . . whether a bankruptcy court must always find creditor misconduct before a claim must be equitably subordinated.’ ” 132 F.3d at 348 n.7. In Kreisler, supra, the Seventh Circuit confirmed that equitable subordination requires proof of creditor misbehavior. 546 F.3d at 866. The debtor had formed a corporation to purchase a secured claim against the debtor’s estate, and the bankruptcy court found the corporation’s conduct to be inequitable and equitably subordinated its claim. 546 F.3d at 865 – 866. The court reaffirmed its discussion in Lifschultz regarding the types of misbehavior that have been considered inequitable. 546 F.3d at 866. It found, nonetheless, that it did not need to address whether the bankruptcy court’s finding of inequitable conduct was correct. Id. Instead, it reversed the subordination of the corporation’s claim because there was no evidence that any of the corporation’s alleged misconduct harmed any of the other creditors, citing the Mobile Steel test. 546 F.3d at 867 – 868. Courts in other jurisdictions have refused to equitably subordinate claims without a showing that the creditor’s misconduct harmed other creditors. The Fifth Circuit, in In re SI Restructuring, Inc., 532 F.3d 355 (5th Cir. 2008), refused to equitably subordinate claims by the officers, directors, and largest shareholders of the debtor, Schlotzky, because of two loans made to the debtor corporation shortly before its bankruptcy. The court emphasized the requirement that “a claim should be subordinated only to the extent necessary to offset the harm which the debtor or its creditors have suffered as a result of the inequitable conduct.” 532 F.3d at 360 – 361. Since the court determined that the proceeds of the prebankruptcy loans by the insiders went to satisfy debt owed to current unsecured creditors, those creditors could not demonstrate harm to unsecured creditors as a class.

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Many other courts have also held plaintiffs to a higher standard when the alleged misconduct did not involve an insider of the debtor. Herzog v. Leighton Holdings, Ltd., 239 B.R. 497, 504 (N.D.Ill. 1999), determined that the Mobile Steel balancing test applies with differing force to insiders and other creditors. In Herzog, the district court approved a bankruptcy court holding that, when claimants are not insiders or fiduciaries of the debtor, the standard applicable for equitable subordination is “egregiousness and severe unfairness in relation to the other creditors.” Id. See also American Consolidated Transportation Cos. v. RBS Citizens, N.A. (In re American Consolidated Transportation Cos.), 433 B.R. 242, 253 (Bankr. N.D.Ill. 2010) (if creditor is not fiduciary of debtor, it must be “guilty of gross misconduct tantamount to fraud, overreaching or spoliation to the detriment of others”), quoting Pepper v. Litton, 308 U.S. 295, 84 L.Ed. 281, 60 S.Ct. 238, 245 (1939). In In re First Alliance Mortgage Co., 471 F.3d 977 (9th Cir. 2006), the Ninth Circuit also noted that the standard for a finding of inequitable conduct on the part of a non-insider was quite high. Despite a jury determination that Lehman was responsible for ten percent of the total fraud damages suffered in a separate class action on account of its aiding and abetting the fraud of the debtor, the Ninth Circuit affirmed judgments refusing to equitably subordinate Lehman’s claim in the bankruptcy estate. The case establishes that a non-insider lender’s conduct is rarely, if ever, sufficiently egregious to support a claim for equitable subordination. Finally, in an influential decision by the United States District Court for the Southern District of New York arising out of the Enron bankruptcy, the court addressed whether equitable subordination under §510(c) of the Bankruptcy Code could be applied to claims held by a transferee of debt. Enron Corp. v. Springfield Associates, L.L.C., (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007). The district court held that an innocent transferee of the claim of a lender whose conduct was challenged as having been inequitable was not subject to equitable subordination. The court specifically found that the remedy of equitable subordination under the Bankruptcy Code was not an attribute of a claim but was rather a “personal disability” of a claimant. 379 B.R. at 439.

VI. [13.26] STRATEGIES TO AVOID LENDER LIABILITY The risk of at least some lender liability claims can be reduced through careful drafting of loan documentation, avoiding certain high-risk creditor actions, and paying careful attention to internal lender policies and training. Sections 13.27 – 13.40 below outline suggested actions that may serve to minimize lender liability claims. A. Drafting Considerations 1. [13.27] Discretionary Advance Clauses Even when loan documents grant broad discretion to lenders with respect to further advances of revolving or other unfunded loan amounts, courts have imposed liability on lenders for failure to act in good faith. To address this risk, loan documents should include both a broad grant of discretionary authority to a lender with respect to future advances as well as an acknowledgment by the borrower that it is aware of and agrees to a broad degree of discretion in the lender with

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respect to such advances. Consideration should be given to an express waiver by the borrower in the loan documents of any claims in connection with a lender’s discretionary decision regarding loan advances arguing that the lender violated any obligation of good faith and fair dealing. Illinois law suggests that such a waiver would be enforceable if it explicitly made reference to the covenant of good faith and fair dealing. 2. [13.28] No Oral Amendments Clause Despite the favorable impact of the Credit Agreements Act, practitioners representing lenders should ensure that loan documents contain a clause prohibiting oral amendments or supplements to the parties’ agreements. This can provide a further defense, in addition to the Credit Agreements Act, in the event a borrower claims its lender orally committed to lend further funds on different terms or orally agreed to waive its rights related to the exercise of its default remedies. 3. [13.29] Notice of Requested Advances If loan documents provide a lender with discretion to advance further funds, the documents should also include a required specific notice a borrower must give before a requested advance will be made, if at all, by the lender. The lender can make use of this required notice period, before any advance will be due, to advise its borrower if it does not intend to make further advances. This will allow a borrower a time period to seek other sources of funds in the event it receives such a communication from the lender. It will minimize a borrower’s ability to argue that a bad-faith exercise by the lender of its right to refuse further advances put the borrower in a time bind and caused its business to suffer. 4. [13.30] Acceleration Clauses A lender must pay particular attention to acceleration clauses when drafting loan documents. A lender’s right to accelerate the due date of an indebtedness is almost always tied to monetary defaults, such as nonpayment of a required installment of interest or principal. A lender’s invocation of this type of monetary default has not figured heavily in lender liability type claims. Loan documents also frequently permit acceleration in the event of certain nonmonetary defaults such as defaults under an insecurity clause or a material adverse financial change clause. In these cases, the pursuit of post-default remedies is subject to borrower challenge. Before accelerating based on a nonmonetary insecurity clause default, a lender should take care that its actions satisfy both objective and subjective tests of insecurity. The lender must also ensure that any adverse financial changes being relied on can be documented. Acceleration and default clauses should be drafted clearly and specifically. In lieu of general insecurity or adverse material change clauses, it is suggested that preset declines in specific financial ratios be utilized as nonmonetary events of default that can trigger acceleration. 5. [13.31] Right To Terminate Lending Commitment A lender should ensure that termination dates are clear and specific. It is suggested that line of credit agreements contain a specific termination date. When they do not, but simply provide

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for advances to be made at a lender’s discretion, some Illinois courts have subjected the exercise of the right to terminate to a good-faith standard of reasonableness. 6. [13.32] Change of Management Covenant Avoid any covenant that permits a lender, in its discretion, to require a change of management upon default by a borrower. Similarly, provisions in loan documents that permit a lender to veto a particular management change proposed by a borrower present problems. Lender liability actions frequently stem from a lender’s alleged assumption of control over its borrower’s business operations. 7. [13.33] Jury Trial Waiver A lender should seriously consider including an express jury trial waiver provision in its loan documents. The waiver should be clear and conspicuous. Some courts have required that a jury trial waiver not be combined with other provisions, or that it be set forth immediately above a borrower’s signature line in boldfaced type. Alternatively, a borrower could be required to initial a jury trial waiver provision separately. An appropriate form of jury trial waiver is as follows: The Lender and Borrower each hereby irrevocably waives all right to trial by jury in any action, proceeding, or counterclaim arising out of or relating to any of the Loan Documents or the actions of the Lender in the enforcement thereof. 8. [13.34] Choice of Law Lenders should include in their loan documents a choice-of-law provision that provides for the application of the law of a particular jurisdiction. The jurisdiction should have some reasonable relationship to either the principal place of business of the lender or borrower or some location where a significant part of the loan transaction will be performed. 9. [13.35] Choice of Forum Lenders should consider a mandatory choice-of-forum clause consistent with the choice of law. Forum selection clauses are generally enforceable in commercial transactions. They should be clear and explicit. A chosen forum should also bear some reasonable relationship to the parties or the transaction. A forum selection clause should be drafted to require that any actions commenced by either borrower or lender relating to a particular loan be commenced in the state or federal courts of a particular jurisdiction. 10. [13.36] Setoff Clauses Lenders should consider including in their loan documentation a specific right to offset mutual obligations. The right should provide that a lender may set off regardless of whether a demand for repayment has already been made by the lender or whether a particular obligation owed by a borrower is yet unmatured. Such a clause will assist the lender in avoiding some of the limitations of the common-law right of a lender to setoff.

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B. [13.37] Drafting Considerations Relating to Written Loan Commitments Many of the same considerations apply to written loan commitments. They are discussed separately because lender liability litigation frequently arises out of disputes between borrowers and lenders with respect to the lender’s refusal to fund a loan commitment. The following specific suggestions are noted with respect to written loan commitments: 1. Define in clear and specific terms any preconditions to funding a written loan commitment. 2. Numerous claims have been made against lenders when a written loan commitment is conditioned on continued “good” financial performance by the borrower, as determined by the lender. Such claims can be avoided with careful drafting substituting specific financial ratios or benchmarks for acceptable performance as determined by the lender. 3. Require a written waiver of any unfulfilled preconditions prior to funding, to be signed by the lender. A number of lender liability claims have been based on the refusal to lend under circumstances in which the borrower claims a lender, by its conduct or oral statements, waived preconditions to funding. 4. Irrespective of the Credit Agreements Act, there is a risk of claims arising from alleged oral loan commitments. Avoid oral loan commitments. If engaged in extended negotiations relating to a commitment with a borrower, send the borrower a letter indicating that the lender commits to lend funds only pursuant to written loan commitments. Carefully document borrower meetings internally. 5. Lenders should avoid unilateral, undocumented changes in the conditions provided for in a written loan commitment. Claims frequently arise from a lender’s post-commitment unilateral change in fees or interest costs to reflect changes in perceived risk. 6. Do not continue to work informally with a borrower toward a closing date after the original expiration date of a loan commitment. Enter into a written amendment, if appropriate, to further extend the commitment date. C. [13.38] Creditor Control Issues Lender involvement in the management of a borrower’s business is extremely problematic. The leading case, State National Bank of El Paso v. Farah Manufacturing Co., 678 S.W.2d 661 (Tex. 1984), gives a good example of the problems that can arise from lender interference with the management of a borrower’s business. In Farah Manufacturing, an $18.9 million jury verdict was affirmed, based on evidence that a borrower’s lender had handpicked directors, forced resignation of other directors, and compelled the borrower to hire a “turnaround” consultant chosen by the lender.

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§13.39

SECURED TRANSACTIONS

Control issues can come in many forms. A listing of key control problems to be avoided is as follows: 1. the lender directing changes in borrower management; 2. the lender requiring the hiring of a particular “turnaround” consultant; 3. a representative of a lender sitting on the board of directors of the borrower; 4. the lender using its right to approve leases, sales, or other borrower transactions to adversely impact cash flow necessary to keep the loan current; 5. the lender persuading its borrower to acquire a business run by a different borrower of the lender that is itself in default or to assume or acquire at a reasonable price loans of another borrower; 6. the lender directing the borrower to sell particular assets; 7. the lender taking control of the company to liquidate assets in order to satisfy debts, but doing so in a way that ensures no money is left for competing creditors; and 8. the lender preparing a written business plan for the borrower designed to facilitate the repayment of loans. D. [13.39] Sudden Changes in Position by Lender Well-drafted loan documents permit a lender to pursue its post-default remedies expeditiously, in the case of some monetary defaults, without any required notice or opportunity to cure. Loan documents should also contain provisions establishing that one waiver of an event of default or one forbearance by a lender does not establish a pattern or in any fashion waive a lender’s right to pursue, at any other time, its post-default remedies. Despite such contractual provisions, lender liability claims frequently follow events that borrowers can successfully characterize as sudden changes in the lender’s position. Examples of such claims include the following: 1. After a lender worked conceptually with a borrower on a multiyear restructuring of the borrower’s operations and the lender orally promised to renew the borrower’s line of credit in order to implement the restructuring, thereby discouraging the borrower from seeking alternative financing, the lender suddenly refused to renew the borrower’s line of credit. A significant lender liability claim resulted. 2. When a loan officer orally agreed to make a post-default advance under a line of credit to avoid bouncing outstanding borrower checks, given that the lender was adequately collateralized to cover the advance, then changed his mind the next day and refused to make any advance, a significant lender liability claim resulted.

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LENDER LIABILITY AND EQUITABLE SUBORDINATION

§13.40

3. When a bank terminated a line of credit, in accordance with the language of the loan documents, but without adequate notice or an opportunity for the borrower to obtain an alternative source of financing, and under circumstances in which the borrower was not in default, a successful lender liability claim resulted. 4. When a bank suddenly terminated workout negotiations without notice to the borrower and joined other creditors in filing an involuntary bankruptcy petition against the borrower, a lender liability claim resulted. 5. When a borrower failed to make an interest payment on the date required under a workout agreement, a question of fact arose with respect to whether the lender was entitled to call the loan and accelerate the entire indebtedness one day after the interest payment was due, given that the borrower had ample funds on deposit with the lender to cover the late interest payment. E. [13.40] Lender Personnel Training and Internal Procedures Many lender liability claims based on the theories discussed in this chapter have been exacerbated by personality conflicts between a lender’s officers and the borrower or unfortunate internal memoranda discovered in the files of the lender by the borrower after litigation commenced. It is suggested that lenders wishing to avoid lender liability claims or minimize the seriousness of such claims consider the following internal policies or personnel training issues: 1. Internal memos in a lender’s credit file should be prepared with respect to all substantive meetings or telephone calls with a borrower. 2. The memos should be concise, accurate, and businesslike. 3. Such memos should avoid vulgarity, negative comments about the personality or character of the borrower’s principals, and hyperbole, either positive or negative, about a particular credit. 4. If the lender chooses to use form loan documents with its borrower, ensure that the lender’s personnel are adequately trained to use loan documents that fit the deal — e.g., do not use a demand note in connection with a term loan. 5. Have form loan documents reviewed and updated periodically to ensure that they conform with changes in the lender’s loan policies as well as developments in the law. 6. Have internal loan manuals and credit evaluation policies reviewed by outside counsel for conformity with current lending policies of a lender, developments in the law, and passages with potential for being used out of context in lender liability actions. 7. At the first sign of a personality conflict between officers of the lender and principals of the borrower, change administration of the loan. 8. Have an established practice of transferring troubled loans to an experienced workout specialist. Ensure that the timing of the transfer is set forth in the lender’s written policies and is

ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION

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§13.40

SECURED TRANSACTIONS

based on a well-defined milestone (e.g., appearance of the credit on an internal bank watch list for the first time, initial nonmonetary default, or initial downgrading by internal lender credit review department). 9. Ensure that all relevant records are contained within a single unified bank credit file. Avoid personal, working, or desk files kept by individual representatives of the lender. 10. Think twice before pursuing a small deficiency that results after a liquidation of collateral supporting a loan. Lender liability claims frequently emerge as counterclaims in this context.

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Index References in this index are to section number. Acceleration, at will, 4.5 equipment leases, 6.18 contractual right, 4.4 lender liability, drafting considerations, 13.30 wrongful acceleration, 4.6 Acceptance of goods, equipment leases, 6.46 Accessions, equipment leases, 6.38 “first in time” rule, 3.29 Accounts, as collateral, 1.8 repossession of collateral, 4.7 Adequate protection in bankruptcy, assets to be protected, 8.4 burden of proof, 8.5 Chapter 12, 8.3 defined, 8.2 valuation of assets, 8.6 After-acquired property, as collateral, 1.30 bankruptcy, postpetition effect of security interests, 8.47 Agricultural Act of 2014 (U.S.), agricultural financing and, 7.13

Agricultural commodities, priority of security interests, 3.56 Agricultural financing, bankruptcy and, 7.14 first-sale doctrine and, 7.15 government payments, 7.13 Grain Code and, 7.11 landlords, consent of, 7.17 LLCs and, 7.16 marijuana as farm product, 7.18 marshaling doctrine and, 7.14 notice to buyers of farm products, 7.10 form, 7.21 overview, 7.1, 7.19 patented grain product dealers, 7.15 Perishable Agricultural Commodities Act and, 7.12 Revised Article 9 and, agricultural liens, 7.6 financing statements, filing of, 7.7 priority of liens, 7.8 purchase-money security interests, 7.9 security agreements, collateral, description of, 7.3 form, 7.20 general provisions, 7.2 grants, 7.4 representations, 7.5

ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION

Agricultural liens, agricultural financing, 7.6 perfection of security interests, choice-of-law rules, 2.30 Aircraft, as collateral, Article 9, interplay with, 5.8 Federal Aviation Act, 5.3 perfection of security interests, 2.28 recording of security documents, 5.4 – 5.7 form of security agreement, 5.5 future assignments and amendments, 5.6 releases, 5.7 “Alter ego” liability, lender liability, 13.5 American Bar Association, Draft Model Intercreditor Agreement, 9.9 on lender liability, 13.3 American Law Institute, 1.2 see also specific Uniform Law Appeals, bankruptcy, special postpetition borrowing or credit problems, 8.23

a—1

ARB

Arbitration, guaranties, bank’s duties to guarantor, 12.43 Artisans, liens, priority of security interests, 3.40 As-extracted collateral, financing statements, contents of, 2.49 Asset Conservation, Lender Liability, and Deposit Insurance Protection Act of 1996 (U.S.), lender liability and, 13.17 Assignment, equipment leases, 6.31, 6.59 letters of credit, assignment of proceeds, 10.46 statements of assignment, 2.61 Attachment of security interests, creditor giving value required, 1.25 debtor having right or power to transfer rights in collateral required, 1.24 defined, 1.3 grounds for, 4.31 overview, 1.23, 4.30 perfection of security interests by, perfection versus, 1.28 permanent perfection, 2.22 temporary perfection, 2.23 possession or control of collateral required, 1.26 procedure, 4.32 time considerations, 1.27 valid authenticated security agreement required, 1.26 Attorneys’ fees, bankruptcy, 8.34 – 8.43 contract language, entitlement tied to, 8.36 debtors-in-possession, use of cash collateral by, 8.15 governing law, 8.39 – 8.41 standards, 8.41 validity, 8.40 time considerations, 8.37 equipment leases, 6.13, 6.17, 6.56 letters of credit, 10.42 RICO, 13.19 sale of collateral, 4.23 unconditional guaranties, 12.12

a—2

SECURED TRANSACTIONS

Automatic perfection of security interests, permanent perfection, 2.22 temporary perfection, 2.23 Automatic stay in bankruptcy, imposition of, 8.7 relief from, 8.8 Automobiles, see Motor vehicles Bad faith, lender liability, 13.13 – 13.15 exercise of discretion, 13.14 independent tort for breach of duty of good faith, 13.15 Bailment, priority of security interests, 3.49 Bank Holding Company Act (U.S.), lender liability and, 13.1, 13.18 Bank Secrecy Act (U.S.), agricultural financing, marijuana as farm product for purposes of, 7.18 Bankruptcy, adequate protection, assets to be protected, 8.4 burden of proof, 8.5 Chapter 12, 8.3 defined, 8.2 valuation of assets, 8.6 agricultural financing and, 7.14 automatic stay in, imposition of, 8.7 relief from, 8.8 cash collateral, use of, context of, 8.10 debtors-in-possession, 8.11 – 8.15 attorneys’ fees, 8.15 costs, 8.15 fully secured but with small cushion, 8.13 interest, 8.15 oversecured, 8.12 undersecured, 8.14 defined, 8.9 confirmation of reorganization plan, 8.51 – 8.54 cramdown, 8.54 disclosure statement, 8.52 requirements, 8.53

Bankruptcy (cont.), equipment leases, rights in bankruptcy, 6.9 financing or credit, obtaining, 8.16 – 8.23 credit outside ordinary course of business, 8.18 – 8.20 court-ordered protection for creditors, 8.19 filing, 8.20 special postpetition borrowing or credit problems, appeals, 8.23 cross-collateralization, 8.21 independence of debtorsin-possession, 8.22 unsecured credit within ordinary course of business, 8.17 financing statements and, 2.51 fraudulent transfers, avoiding, 8.29 – 8.33 leveraged buyouts, 8.33 liability of transferees, 8.31 procedural rules, 8.30 secured creditors and, 8.32 intercreditor agreements, 9.35 – 9.38 adequate protection, 9.38 disposition of collateral, 9.37 use of cash collateral, 9.36 letters of credit, 10.44 overview, 8.1 postpetition interest and fees, 8.34 – 8.43 contract language, entitlement tied to, 8.36 distributions, 8.43 governing law, 8.39 – 8.41 standards, 8.41 validity, 8.40 interest rate, 8.38 late charges, 8.42 oversecured creditors, 8.35 proof of claims, 8.43 time considerations, 8.37 preferential transfers, avoiding, defenses, 8.27 insiders, to or for benefit of, 8.28 one-year reach-back, 8.28 preference defined, 8.26 priority of security interests, 3.57 secured creditors’ collateral, charges against, 8.44 – 8.46 Bankruptcy Code §506(c) claims, 8.45 standing, 8.46

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INDEX

Bankruptcy (cont.), security interests, postpetition effect of, after-acquired property, 8.47 exceptions, 8.49 interplay with other Bankruptcy Code sections, 8.50 proceeds, 8.48 strong-arm powers of trustees, defined, 8.24 limitations on, 8.25 purpose of, 8.24 subordination agreements, 9.12 Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (U.S.), agricultural financing and, 7.14 leveraged buyouts and, 8.33 Bankruptcy Act of 1898 (U.S.), equitable subordination and, 13.25 late charges and, 8.42 Bankruptcy Act (U.S.), subordination agreements and, 9.22 Bankruptcy Code (U.S.) agricultural financing and, 7.6, 7.14 equipment leases and, 6.1, 6.3, 6.4, 6.9, 6.61, 6.62 equitable subordination and, 13.25 fraudulent transfers, avoidance of security interests as, 11.2 guaranties and, “clawback” clauses, 12.45 fraudulent transfers, 12.44 pre-default discharge of guarantor, release of coguarantor, 12.25 unconditional guaranties, liability upon default by borrower, 12.12 intercreditor agreements and, 9.2, 9.7, 9.35, 9.36 letters of credit and, 10.44 priority in security interests and, 3.58 sale of collateral and, 4.22 subordination agreements and, 9.2, 9.7, 9.16, 9.21, 9.22 see also Bankruptcy Bankruptcy Reform Act of 1984 (U.S.), preferential transfers, avoiding, 8.28

COL

Boat Registration and Safety Act (Illinois), watercraft as collateral, perfection of security interests, assignment, 5.22 coverage, 5.18 foreign liens, 5.21 mechanics of, 5.19 overview, 2.13, 5.17 subordinate liens, 5.20 Boats, see Watercraft Broadcasting licenses, as collateral, 5.45 intercreditor agreements, for purposes of, 5.45,9.40 Burden of proof, bankruptcy, adequate protection, 8.5 Business Services Department (Illinois), agricultural financing and, 7.5 Carriers, liens, priority of security interests, 3.42 Cash collateral, bankruptcy, use in, context of, 8.10 debtors-in-possession, 8.11 – 8.15 attorneys’ fees, 8.15 costs, 8.15 fully secured but with small cushion, 8.13 interest, 8.15 oversecured creditors, 8.12 undersecured creditors, 8.14 defined, 8.9 Certificates of title, equipment leases, 6.15 “first in time” rule, 3.31 perfection of security interests, choice-of-law rules, 2.31 priority of security interests, 3.4 Chattel paper, as collateral, 1.11 “first in time” rule, 3.25 perfection of security interests by control, 2.19 repossession of collateral, 4.7

ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION

Choice of forum, equipment leases, 6.16 lender liability, drafting considerations, 13.35 Choice of law, bankruptcy and, 8.24 equipment leases, 6.16 lender liability, drafting considerations, 13.34 letters of credit, 10.43 perfection of security interests, agricultural liens, 2.30 certificates of title, goods covered by, 2.31 deposit accounts, 2.32 general rule, 2.29 investment property, 2.33 letter-of-credit rights, 2.34 priority of security interests, 3.3 Civil Administrative Code (Illinois), excluded transactions, 1.5 “Clawback” clauses, guaranties, 12.45 Code of Civil Procedure (Illinois), attachment and, 4.30, 4.32 priority in security interests and, 3.43 replevin and, 4.28 Collateral, acceptance in discharge of indebtedness, 4.25 accounts as, 1.8 after-acquired property as, 1.30 agricultural financing, description in security agreements, 7.3 aircraft as, Article 9, interplay with, 5.8 Federal Aviation Act, 5.3 perfection of security interests, 2.28 recording of security documents, 5.4 – 5.7 form of security agreement, 5.5 future assignments and amendments, 5.6 releases, 5.7 as-extracted collateral, contents of financing statements, 2.49 attachment of security interests and, debtor having right or power to transfer rights in collateral required, 1.24 possession or control of collateral required, 1.26

a—3

COL

Collateral (cont.), bankruptcy, use of cash collateral in, context of, 8.10 debtors-in-possession, 8.11 – 8.15 attorneys’ fees, 8.15 costs, 8.15 fully secured but with small cushion, 8.13 interest, 8.15 oversecured creditors, 8.12 undersecured creditors, 8.14 defined, 8.9 broadcasting licenses as, 5.45 intercreditor agreements, for purposes of, 9.40 chattel paper as, 1.11 classification of, 1.6 – 1.20 commercial tort claims as, 1.20 consumer goods as, 1.7 copyrights as, 5.32 – 5.34 effect of recordation, 5.34 recordation of conveyance, 5.33 creditors’ rights in, charges against, 8.44 – 8.46 Bankruptcy Code §506(c) claims, 8.45 standing, 8.46 secured creditors, 1.29 defined, 1.3 deposit accounts as, 1.18 description of in financing statements, 2.48 disposition of, see Disposition of collateral equipment as, 1.7 equipment leases as, 6.63 farm products as, 1.7 “first in time” rule, collateral transferred by debtor, 3.18 funds held by others, rights in as, 5.41 – 5.44 insurance policies, 5.42 judgments, 5.44 wage assignments, 5.43 future advances as, 1.30 general intangibles as, 1.15 goods as, 1.7 health insurance receivables as, 1.14 impairment of, pre-default discharge of guarantor, 12.26 failure to perfect as, 12.27 instruments as, 1.9

a—4

SECURED TRANSACTIONS

Collateral (cont.), intellectual property as, 5.31 – 5.40 intercreditor agreements, allocation of collateral, 9.32 bankruptcy, disposition of collateral, 9.37 use of cash collateral, 9.36 defining collateral, 9.31 inventory as, 1.7 investment property as, 1.19 letter-of-credit rights as, 1.12 motor vehicles as, 5.9 – 5.16 commercial vehicles engaged in interstate commerce, 5.16 Illinois law, perfection of security interests under, assignment, 5.14 foreign liens, 5.13 mechanics of, 5.11 releases, 5.15 subordinate liens, 5.12 Vehicle Code, 5.10 overview, 5.1 patents as, 5.35 – 5.37 effect of recordation, 5.37 recordation of assignment, 5.36 payment intangibles as, 1.16 promissory notes as, 1.10 repossession of, accounts, 4.7 chattel paper, 4.7 contract rights, 4.7 goods, 4.8 instruments, 4.7 peaceful repossession, 4.9 sale of, 4.19 application of sale proceeds, 4.23 attorneys’ fees, 4.23 commercial reasonableness, determination of, 4.21 secured creditor’s obligations, 4.20 title obtained by purchaser, 4.22 secured creditors, charges against, 8.44 – 8.46 Bankruptcy Code §506(c) claims, 8.45 standing, 8.46 rights in, 1.29 software as, 1.17 supporting obligations as, 1.13

Collateral (cont.), trademarks as, 5.38 – 5.40 Trademark Act of 1946, recordation under, 5.39 Trademark Registration and Protection Act, recordation under, 5.40 transportation modes as, 5.2 – 5.30 watercraft as, see Watercraft Collateralized guaranties, 12.8 Commercial letters of credit, 10.4 Commercial tort claims, as collateral, 1.20 Commingled goods, “first in time” rule, 3.30 Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (U.S.), lender liability and, 13.17 Conditional guaranties, 12.3 Conflicting security interests, priority of security interests (UCC §9-322), established prior to effective date, 3.35 – 3.37 perfected prior to effective date, 3.36 priority, 3.37 “first in time” rule, see “First in time” rule proceeds, 3.14 subordination agreements, effect of, 3.34 supporting obligations, 3.14 Consideration, letters of credit, 10.20 Consignment, priority of security interests, 3.50 Consignment/lease statements, 2.62 Constitution (U.S.), bankruptcy, avoidance of preferential transfers, 8.30 Constructive fraud, lender liability, 13.11

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INDEX

Constructively fraudulent transfers, avoidance of security interests as, 11.3 Consumer Fraud and Deceptive Business Practices Act (Illinois), lender liability and, 13.8, 13.9 Consumer goods, as collateral, 1.7

DEF

Copyright Office (U.S.), copyrights as collateral, 5.33, 5.34 Copyrights, as collateral, 5.32 – 5.34 effect of recordation, 5.34 recordation of conveyance, 5.33

Continuing guaranties, 12.9

Costs, bankruptcy, use of cash collateral in by debtors-in-possession, 8.15 RICO, 13.19

“Continuity plus relationship” test, RICO, lender liability under, 13.20, 13.21

Cramdown, bankruptcy, confirmation of reorganization plan, 8.54

Contract law, lender liability, 13.2 – 13.4 oral commitments, 13.3 written commitments, 13.4 letters of credit, between applicant and beneficiary, 10.18 between issuer and account party, 10.16 between issuer and beneficiary, 10.17 repossession of collateral, contract rights, 4.7

Credit Agreements Act (Illinois), lender liability and, contract theories, 13.2, 13.3 duress, 13.12 fraud, 13.7 good faith and fair dealing, breach of duty of, 13.14 “no oral amendments” clauses, 13.28 written loan commitments, 13.37

Continuation statements, 2.58

Control, perfection of security interests by, 2.14 – 2.21 mandatory control, 2.15 – 2.17 deposit accounts, 2.16 letter-of-credit rights as, 2.17 permissive control, 2.18 – 2.21 electronic chattel paper, 2.19 investment property, 2.20 land trusts, collateral assignments of beneficial interests in, 2.21 Conveyance and Encumbrance of Manufactured Homes as Real Property and Severance Act (Illinois), motor vehicles as collateral, 5.10

Creditors’ rights, bankruptcy, avoiding fraudulent transfers in, 8.32 credit outside ordinary course of business, court-ordered protection for creditors, 8.19 collateral, charges against, 8.44 – 8.46 Bankruptcy Code §506(c) claims, 8.45 standing, 8.46 secured creditors, 1.29 equipment leases, 6.36 “lowest intermediate balance” rule, 1.29 Cross-collateralization, bankruptcy, special postpetition borrowing or credit problems, 8.21 Debtors, defined, 1.3

ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION

Debtors-in-possession, bankruptcy, special postpetition borrowing or credit problems, independence of debtors-inpossession, 8.22 use of cash collateral in, 8.11 – 8.15 attorneys’ fees, 8.15 costs, 8.15 fully secured but with small cushion, 8.13 interest, 8.15 oversecured creditors, 8.12 undersecured creditors, 8.14 Default, attachment, 4.30 grounds for, 4.31 procedure, 4.32 damages, 4.26 default clauses, 4.3 deficiency, recovery of, 4.27 defined, 4.2 discharge of indebtedness, acceptance of collateral in, 4.25 disposition of collateral, see Disposition of collateral equipment leases, 6.40 overview, 6.61 lessee’s remedies, 6.45 lessor’s remedies, 6.47 notice, 6.41 guaranties, see Guaranties intercreditor agreements, 9.33 overview, 4.1 redemption, debtor’s right of, 4.24 replevin, 4.28 procedure, 4.29 repossession of collateral, accounts, 4.7 chattel paper, 4.7 contract rights, 4.7 goods, 4.8 instruments, 4.7 peaceful repossession, 4.9 sale of collateral, 4.19 application of sale proceeds, 4.23 attorneys’ fees, 4.23 commercial reasonableness, determination of, 4.21 secured creditor’s obligations, 4.20 title obtained by purchaser, 4.22 subordination agreements, 9.13 default provisions, 9.18

a—5

DEF

Defenses, bankruptcy, avoiding preferential transfers in, 8.27 guaranties, derivative defenses precluded, 12.18 post-default discharge of guarantor, 12.38 Deficiency, recovery of, 4.27 Department of Agriculture Law (Illinois), excluded transactions, 1.5 Deposit accounts, as collateral, 1.18 “first in time” rule, 3.21 perfection of security interests, by control, 2.16 choice-of-law rules, 2.32 priority of security interests, 3.5 Description of collateral, financing statements, 2.48 Discharge, of guaranties, see Guaranties of indebtedness, acceptance of collateral in, 4.25 watercraft as collateral, perfection of security interests, 5.29 Disclaimers, equipment leases, 6.55 Disposition of collateral, notice, collateral not requiring notice, 4.13 contents of, 4.17 form of, 4.15 parties entitled to receive, 4.16 proposed disposition, 4.12 public or private sale, 4.14 time considerations, 4.18 overview, 1.37, 4.10 post-default discharge of guarantor, bank’s duty to give notice of disposition of collateral, 12.35 preservation of collateral, 4.11 Documents, “first in time” rule, 3.27

a—6

SECURED TRANSACTIONS

“Dragnet” clauses, after-acquired property, 1.30 underlying debt, description required, 1.36 Duress, lender liability, 13.12 Economic-loss doctrine, lender liability and, 13.10 Equal Credit Opportunity Act (U.S.), pre-default termination of guaranties, 12.30, 12.33 Equipment, as collateral, 1.7 Equipment leases, advantages of, 6.2 Article 2A, 6.11 – 6.47 acceleration at will, 6.18 acceptance of goods, 6.46 accessions, 6.38 assignment, 6.31 certificates of title, goods covered by, 6.15 choice of forum, 6.16 choice of law, 6.16 construction of lease, 6.20 creditors’ rights, 6.36 default, 6.40 overview, 6.61 lessee’s remedies, 6.45 lessor’s remedies, 6.47 notice, 6.41 definitions, 6.13 enforceability, 6.30 excused performance, 6.39 fixtures, rights when goods become, 6.37 formation of lease, 6.20 impairment of rights and remedies, 6.42 insurance, 6.28 liquidated damages, 6.43 modification of lease, 6.21 modification of rights and remedies, 6.42 other statutes, leases subject to, 6.14 priority of liens, arising by operation of law, 6.34 other liens, 6.35 repudiated performance, 6.39 risk of loss or damage, 6.29

Equipment leases (cont.), Article 2A (cont.), sale or sublease of goods by lessee, 6.33 scope of, 6.12 statute of frauds, 6.19 statutes of limitations, 6.44 subsequent lease by lessor, 6.32 substituted performance, 6.39 supply contract, lessee as beneficiary of, 6.22 transfers of interests, 6.31 true leases versus pseudoleases, 6.8 unconscionability, 6.17 warranties, exclusion or modification, 6.26 express warranties, 6.23 implied warranties, 6.25 interference and infringement, against, 6.24 third-party beneficiaries, 6.27 as collateral, 6.63 attorneys’ fees, 6.13, 6.17, 6.56 documents in connection with, 6.64 fraudulent transfers, 6.62 overview, 6.1 sample form, 6.65 true leases versus pseudo-leases, 6.3 – 6.5 Article 2, applicability of, 6.6 Article 2A, applicability of, 6.8 Article 9, applicability of, 6.7 bankruptcy, rights in, 6.9 principles applied by courts, 6.4 statutory provisions, 6.5 usury laws, applicability of, 6.10 typical provisions, acceptance of equipment, 6.50 assignment, 6.59 default, 6.61 description of equipment, 6.48 disclaimers, 6.55 indemnification, 6.56 insurance, 6.58 location and care of equipment, 6.49 purchase options, 6.54 remedies, 6.61 renewal of lease, 6.53

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INDEX

Equipment leases (cont.), typical provisions (cont.), rental payments, 6.51 return of equipment, 6.60 risk of loss or damage, 6.57 term of lease, 6.52 warranties, 6.55 Equipment Leasing and Financing Association, equipment leases and, 6.2 Equitable subordination, lender liability, 13.25 Estoppel, letters of credit, issuer’s obligations, 10.38 Excused performance, equipment leases, 6.39 Express warranties, equipment leases, 6.23 third-party beneficiaries, 6.27 Fair-and-equitable test, bankruptcy, cramdown, 8.54 Fair Debt Collection Practices Act (U.S.), sale of collateral and, 4.23 Fair Labor Standards Act of 1938 (U.S.), priority in security interests and, 3.58, 3.59 Farm products, as collateral, 1.7 Federal Arbitration Act (U.S.), guaranties, bank’s duties to guarantor, 12.43 Federal Aviation Act (U.S.), aircraft as collateral, Article 9, interplay with, 5.8 overview, 2.28, 5.3 recording of security documents, 5.4 Federal Communications Commission (U.S.), broadcasting licenses as collateral, 5.45 intercreditor agreements, for purposes of, 9.40

FIR

Federal Crop Insurance Act (U.S.), agricultural financing and, 7.13 Federal Rules of Bankruptcy Procedure (U.S.), agricultural financing and, 7.14 automatic stay, relief from, 8.8 equipment leases and, 6.9 subordination agreements and, 9.21 Federal Rules of Civil Procedure (U.S.), lender liability and, 13.11 Federal tax liens, priority of security interests, 3.53 Fiduciary duty, breach of, lender liability, 13.11 tortious interference with contract or business expectancy, 13.16 Filing, perfection of security interests by, filing office, 2.9 inadequate filing, 2.12 location of debtor, 2.6 – 2.8 other debtors, 2.8 registered organizations, 2.7 mandatory filing, 2.10 permissive filing, 2.11 superseded by statutes, 2.13 Financial Accounting Standards Board, equipment leases and, 6.2 Financial Crime Enforcement Network (U.S.), agricultural financing, marijuana as farm product for purposes of, 7.18 Financing statements, agricultural financing, 7.7 amendments, 2.54 bankruptcy and, 2.51 contents of, 2.35 – 2.49 addresses, 2.47 as-extracted collateral, 2.49 description of collateral, 2.48 fixtures, 2.49 identification of debtor and secured party, 2.36 – 2.45 signature of debtor, 2.46 timber, 2.49

ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION

Financing statements (cont.), defined, 1.3 filing, 2.52 “first in time” rule, financing statement containing incorrect information, 3.32 forms, 2.53 identification of debtor and secured party, 2.36 – 2.45 change of location, 2.45 change of name, 2.44 correct debtor, 2.37 correctly recording name, 2.41 errors or omissions, effect of, 2.38 multiple debtors and secured parties, 2.40 new debtor becoming bound by security agreement, 2.39 partnership names, 2.43 trade names, 2.42 indexing errors, correction of, 2.57 rejection of, 2.55 inaccurate records, 2.56 wrongfully filed records, 2.56 time for filing, 2.50 “First in time” rule, accessions, 3.29 certificates of title, goods covered by, 3.31 chattel paper, 3.25 collateral transferred by debtor, 3.18 commingled goods, 3.30 deposit accounts, 3.21 documents, 3.27 exceptions, 3.15 – 3.33 financing statement containing incorrect information, 3.32 fixtures, 3.29 future advances, 3.17 instruments, 3.26 investment property, 3.22 land trusts, beneficial interests in, 3.24 letter-of-credit rights, 3.23 money, 3.28 new debtor, 3.19 overview, 3.13 proceeds, 3.33 purchase-money security interests, 3.20 securities, 3.27 special priming security interests, 3.16

a—7

FIR

First-sale doctrine, agricultural financing and, 7.15 Fixtures, equipment leases, 6.37 financing statements, contents of, 2.49 “first in time” rule, 3.29 priority of security interests, 3.44 Food Security Act of 1985 (U.S.), agricultural financing and, 7.10 Foreclosure, strict foreclosure, 4.25 Fraud, lender liability, 13.6 – 13.9 constructive fraud, 13.11 Consumer Fraud and Deceptive Business Practices Act, 13.9 failure to disclose, 13.8 false representation, 13.7 letters of credit, 10.39 in transaction, 10.40 Fraudulent transfers, avoidance of security interests as, constructively fraudulent transfers, 11.3 overview, 11.1 statutory provisions, 11.2 bankruptcy, avoiding in, 8.29 – 8.33 leveraged buyouts, 8.33 liability of transferees, 8.31 procedural rules, 8.30 secured creditors and, 8.32 equipment leases, 6.62 guaranties and, 12.44 sale-leaseback transactions involving equipment, 6.62 Future advances, as collateral, 1.30 “first in time” rule, 3.17 General intangibles, as collateral, 1.15 Good faith and fair dealing, breach of duty, lender liability, 13.13 – 13.15 exercise of discretion, 13.14 independent tort for breach of duty of good faith, 13.15

a—8

SECURED TRANSACTIONS

Goods, acceptance of goods, equipment leases, 6.46 as collateral, 1.7 certificates of title, covered by, equipment leases, 6.15 “first in time” rule, 3.31 perfection of security interests, choice-of-law rules, 2.31 priority of security interests, 3.4 commingled goods, “first in time” rule, 3.30 liens relating to possession of goods for services or materials, priority of security interests, 3.39 – 3.43 artisans, 3.40 carriers, 3.42 landlords, 3.43 warehouses, 3.41 repossession of collateral, 4.8 Government procurement programs, priority of security interests, 3.52 Grain Code (Illinois), agricultural financing and, 7.11 excluded transactions, 1.5 Guaranties, as credit enhancement, 12.1 bank’s duties to guarantor, 12.40 – 12.43 arbitration, compelling, 12.43 disclosure of past defaults by coguarantor, 12.42 proper application of loan proceeds by borrower, implied duty, 12.41 “clawback” clauses, 12.45 collateralized guaranties, 12.8 conditional guaranties, 12.3 continuing guaranties, 12.9 documentation of, 12.10 enforcement of, derivative defenses precluded, 12.18 oral statements of lender, prevention of enforcement based on precluded, 12.16 execution of, 12.10 fraudulent transfers and, 12.44 guaranty and remarketing agreements, 12.7 limited guaranties, 12.4

Guaranties (cont.), original notes, applicability to, 12.14 post-default discharge of guarantor, commercial reasonableness defense, 12.38 defenses, 12.38 grounds for discharge, 12.34 – 12.37 bank’s duty to give notice of disposition of collateral, 12.35 SBA guaranties, 12.37 waiver of notice, 12.36 pre-default discharge of guarantor, 12.19 – 12.28 advising guarantor of nature of risk, 12.20 bank’s duty to pursue borrower, 12.28 change in underlying obligation, 12.21 – 12.24 change of borrower, 12.24 change of terms, 12.22 extension, 12.23 negation of underlying obligation, 12.23 novation, 12.23 impairment of collateral, 12.26 failure to perfect as, 12.27 reaffirmation of guaranty letter, 12.27 release of coguarantor, 12.25 pre-default termination of guaranty, death, 12.32 Equal Credit Opportunity Act, 12.30, 12.33 Regulation B, 12.33 revocation by guarantor, 12.29 – 12.31 by declination, 12.31 by notice, 12.30 puts as alternative to, 12.46 renewal notes, applicability to, 12.14 restricted guaranties, 12.4 sample form, 12.11 springing guaranties, 12.5 liability generated by prohibited act causing no loss to lender, 12.13 statute of frauds preventing assertion of oral release, 12.17 successive guaranties, 12.39 transfer of note automatically transferring guaranty, 12.15

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INDEX

Guaranties (cont.), types of, 12.2 – 12.18 unconditional guaranties, guarantor liable upon default of borrower, 12.12 validity guaranties, 12.6 Guaranty and remarketing agreements, 12.7 Health insurance receivables, as collateral, 1.14 “Hot goods,” priority of security interests, 3.58 Impairment of collateral, pre-default discharge of guarantor, 12.26 failure to perfect as, 12.27 Implied warranties, equipment leases, 6.24 third-party beneficiaries, 6.27 Indemnification, equipment leases, 6.56 Indubitable equivalency test, bankruptcy, cramdown, 8.54 Injunctions, letters of credit, 10.41 Innkeepers Lien Act (Illinois), agricultural financing and, 7.6 Instruments, as collateral, 1.9 “first in time” rule, 3.26 repossession of collateral, 4.7 Insurance, collateral, rights in funds held by others as, 5.42 equipment leases, 6.28, 6.58 Insurance Code (Illinois), collateral, rights in funds held by others as, 5.42 lender liability and, 13.15 Intellectual property, as collateral, 5.31 – 5.40 copyrights, 5.32 – 5.34 effect of recordation, 5.34 recordation of conveyance, 5.33

LEN

Intellectual property (cont.), as collateral (cont.), patents, 5.35 – 5.37 effect of recordation, 5.37 recordation of assignment, 5.36 trademarks, 5.38 – 5.40 Trademark Act of 1946, recordation under, 5.39 Trademark Registration and Protection Act, recordation under, 5.40 Intercreditor agreements, ABA Draft Model Intercreditor Agreement, 9.9 bankruptcy, 9.35 – 9.38 adequate protection, 9.38 disposition of collateral, 9.37 use of cash collateral, 9.36 contracts, form of, 9.8 modifications, 9.39 overview, 9.1, 9.42 purposes of, 9.29 statutory provisions, 9.2 – 9.7 Bankruptcy Code, 9.7 UCC, 9.3 – 9.6 810 ILCS 5/1-310, 9.4 810 ILCS 5/9-339, 9.5 810 ILCS 5/9-340, 9.6 substantive issues, 9.30 – 9.34 allocation of collateral, 9.32 default, 9.33 defining collateral, 9.31 enforcement, 9.33 right to purchase, 9.34 terms and provisions, 9.40 unitranche facilities, 9.41 uses of, 9.29 Interest, bankruptcy, 8.34 – 8.43 contract language, entitlement tied to, 8.36 debtors-in-possession, use of cash collateral by, 8.15 distributions, 8.43 governing law, 8.39 – 8.41 standards, 8.41 validity, 8.40 interest rate, 8.38 late charges, 8.42 oversecured creditors, 8.35 proof of claims, 8.43 time considerations, 8.37 subordination agreements, postpetition interest, 9.22

ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION

Internal Revenue Code (U.S.), lender liability and, 13.17 International Association of Corporation Administrators, perfection of security interests and, 2.64 International Chamber of Commerce, International Standby Practices — Publication No. 590, see Letters of credit Inventory, as collateral, 1.7 Investment property, as collateral, 1.19 “first in time” rule, 3.22 perfection of security interests, by control, 2.20 choice-of-law rules, 2.33 priority of security interests, 3.6 Judgments, collateral, rights in funds held by others as, 5.44 Judicial liens, priority of security interests, 3.46 Jury trial, lender liability, drafting considerations, waiver of, 13.33

Land trusts, “first in time” rule, 3.24 perfection of security interests by control, 2.21 priority of security interests, 3.8 Landlord and tenant, agricultural financing, consent of landlord, 7.17 liens, priority of security interests, 3.43 Large Loan Act (Illinois), after-acquired property and, 1.30 Lender liability, “alter ego” liability, 13.5 avoidance strategies, 13.26 – 13.40 creditor control issues, 13.38 drafting considerations, 13.27 – 13.36

a—9

LEN

Lender liability (cont.), avoidance strategies (cont.), internal procedures, 13.40 personnel training, 13.40 sudden changes in lender position, 13.39 bad faith, 13.13 – 13.15 exercise of discretion, 13.14 independent tort for breach of duty of good faith, 13.15 constructive fraud, 13.11 contract theories, 13.2 – 13.4 oral commitments, 13.3 written commitments, 13.4 control liability, 13.5 drafting considerations, acceleration clauses, 13.30 change of management covenant, 13.32 choice of forum, 13.35 choice of law, 13.34 discretionary advance clauses, 13.27 jury trial, waiver of, 13.33 “no oral amendments” clauses, 13.28 notice of requested advances, 13.29 right to terminate lending commitment, 13.31 setoff clauses, 13.36 written loan commitments, 13.37 duress, 13.12 economic-loss doctrine and, 13.10 equitable subordination, 13.25 fiduciary duty, breach of, 13.11 tortious interference with contract or business expectancy, 13.16 fraud, 13.6 – 13.9 constructive fraud, 13.11 Consumer Fraud and Deceptive Business Practices Act, 13.9 failure to disclose, 13.8 false representation, 13.7 good faith and fair dealing, breach of duty, 13.13 – 13.15 exercise of discretion, 13.14 independent tort for breach of duty of good faith, 13.15 negligent misrepresentation, 13.10 overview, 13.1

a — 10

SECURED TRANSACTIONS

Lender liability (cont.), RICO, enterprise, 13.22 overview, 13.19 pattern, 13.21 persons separate from enterprise as defendants, 13.23 predicate acts, 13.20 proximate cause, enhanced emphasis on, 13.24 statutory theories, 13.17 – 13.24 Bank Holding Company Act, 13.18 RICO, 13.19 – 13.24 Letters of credit, assignment of proceeds, 10.46 attorneys’ fees, 10.42 bankruptcy issues, 10.44 categories of, 10.3 – 10.5 commercial letters of credit, 10.4 sales letters of credit, 10.4 standby letters of credit, 10.5 sample, 10.47 choice of law, 10.43 collateral, rights in as, 1.12 consideration, 10.20 contracts, between applicant and beneficiary, 10.18 between issuer and account party, 10.16 between issuer and beneficiary, 10.17 expiration, 10.22 “first in time” rule, 3.23 formal requirements, 10.19 fraud, 10.39 in transaction, 10.40 governing law, 10.1 independent undertaking, 10.2 injunctions, 10.41 issuer’s obligations, 10.24 – 10.38 copies, 10.35 disposition of documents, 10.30 estoppel, 10.38 identical wording, 10.32 lost, stolen, mutilated, or destroyed documents, 10.34 multiple documents, 10.35 notice of dishonor, 10.28

Letters of credit (cont.), issuer’s obligations (cont.), original documents, 10.35 partial draws, 10.33 presentation, 10.26 formal requirements, 10.36 inspection of documents upon, 10.27 multiple presentations, 10.33 time considerations, 10.31 quotation marks, 10.32 request for applicant waiver, 10.29 standard of compliance, 10.25 waiver, 10.37 parties, 10.6 – 10.14 account party, 10.7 additional parties, 10.10 – 10.14 advising bank, 10.11 applicant, 10.7 beneficiary, 10.8 confirming bank, 10.12 contract between applicant and beneficiary, 10.18 contract between issuer and account party, 10.16 contract between issuer and beneficiary, 10.17 issuer, 10.9 issuing bank, 10.9 negotiating bank, 10.13 nominated bank, 10.14 notifying bank, 10.11 paying bank, 10.14 relationship of, 10.15 – 10.18 perfection of security interests, by control, 2.17 choice-of-law rules, 2.34 priority of security interests, 3.7 reimbursement, 10.42 revocability, 10.21 statute of frauds, 10.23 subrogation, 10.42 transfers of, 10.45 Leveraged buyouts, bankruptcy, avoiding fraudulent transfers in, 8.33 fraudulent transfers, avoidance of security interests as, 11.3

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INDEX

Liens, federal tax liens, priority of security interests, 3.53 judicial liens, priority of security interests, 3.46 motor vehicles as collateral, perfection of security interests, foreign liens, 5.13 subordinate liens, 5.13 priority of, agricultural financing, 7.8 equipment leases, arising by operation of law, 6.34 other liens, 6.35 priority of security interests, 3.39 – 3.43 artisans, 3.40 carriers, 3.42 landlords, 3.43 warehouses, 3.41 watercraft as collateral, perfection of security interests, foreign liens, 5.22 subordinate liens, 5.21 Limited guaranties, 12.4 Limited liability companies (LLCs), agricultural financing and, 7.16 perfection of security interests, 2.25 Limited Liability Company Act (Illinois), agricultural financing and, 7.16 Liquidated damages, equipment leases, 6.43 Livestock, priority of security interests, 3.56 “Lowest intermediate balance” rule, creditors’ rights, 1.29 Marijuana, agricultural financing, as farm product for purposes of, 7.18 Marshaling doctrine, agricultural financing and, 7.14 Money, “first in time” rule, 3.28

PER

Mortgage Foreclosure Law (Illinois), perfection of security interests by control and, 2.21 Motor vehicles, as collateral, 5.9 – 5.16 commercial vehicles engaged in interstate commerce, 5.16 Illinois law, perfection of security interests under, assignment, 5.14 foreign liens, 5.13 mechanics of, 5.11 overview, 2.26, 5.10 releases, 5.15 subordinate liens, 5.12 National Conference of Commissioners on Uniform State Laws, 1.2, see also specific Uniform Law Natural Resources Department (Illinois), watercraft as collateral, perfection of security interests, mechanics of, 2.27, 5.19 overview, 5.17 releases, 5.23 subordinate liens, 5.20 Negligent misrepresentation, lender liability, 13.10 New debtors, financing statements, new debtor becoming bound by security agreement, 2.39 “first in time” rule, 3.19 Northern District of Illinois Bankruptcy Rules (U.S.), cross-collateralization and, 8.21 Notice, agricultural financing, notice to buyers of farm products, 7.10 form, 7.21 disposition of collateral, collateral not requiring notice, 4.13 contents of, 4.17 form of, 4.15 parties entitled to receive, 4.16 proposed disposition, 4.12 public or private sale, 4.14 time considerations, 4.18

ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION

Notice (cont.), equipment leases, default, 6.41 lender liability, notice of requested advances, 13.29 letters of credit, notice of dishonor, 10.28 post-default discharge of guarantor, bank’s duty to give notice of disposition of collateral, 12.35 waiver of notice, 12.36 pre-default termination of guaranty, revocation by notice, 12.30 subordination agreements, 9.28 Novation, pre-default discharge of guarantor, 12.23 Packers and Stockyards Act (Illinois), agricultural financing and, 7.12 Parties, letters of credit, see Letters of credit Partnerships, financing statements, identification of debtor and secured party, 2.43 perfection of security interests, 2.25 Patent and Trademark Office (U.S.), patents as collateral, 5.36, 5.37 trademarks as collateral, 5.39 Patents, as collateral, 5.35 – 5.37 effect of recordation, 5.37 recordation of assignment, 5.36 Payment intangibles, as collateral, 1.16 Pension Benefit Guaranty Corporation (U.S.), priority of security interests and, 3.54 Perfection of security interests, aircraft as collateral, 2.28 attachment versus, 1.28

a — 11

PER

Perfection of security interests (cont.), automatic perfection, permanent perfection, 2.22 temporary perfection, 2.23 by attachment, permanent perfection, 2.22 temporary perfection, 2.23 by control, 2.14 – 2.21 mandatory control, 2.15 – 2.17 deposit accounts, 2.16 letter-of-credit rights, 2.17 permissive control, 2.18 – 2.21 electronic chattel paper, 2.19 investment property, 2.20 land trusts, collateral assignments of beneficial interests in, 2.21 by filing, filing office, 2.9 inadequate filing, 2.12 location of debtor, 2.6 – 2.8 other debtors, 2.8 registered organizations, 2.7 mandatory filing, 2.10 permissive filing, 2.11 superseded by statutes, 2.13 by possession, mandatory possession, 2.4 permissive possession, 2.5 what constitutes possession, 2.3 chart, 2.67 choice-of-law rules, agricultural liens, 2.30 certificates of title, goods covered by, 2.31 deposit accounts, 2.32 general rule, 2.29 investment property, 2.33 letter-of-credit rights, 2.34 consignment/lease statements, 2.62 continuation statements, 2.58 county filing information, 2.66 defined, 1.3 financing statements, see Financing statements general rules, 2.2 impairment of collateral, predefault discharge of guarantor, failure to perfect as, 12.27

a — 12

SECURED TRANSACTIONS

Perfection of security interests (cont.), LLC interests, 2.25 motor vehicles as collateral, assignment, 5.14 foreign liens, 5.13 mechanics of, 5.11 overview, 2.26 releases, 5.15 subordinate liens, 5.12 Vehicle Code, 5.10 overview, 2.1 partnership interests, 2.25 priority versus, 3.2 requests for information, 2.63 Secretary of State, rules and regulations, 2.64 state filing information, 2.66 statements of assignment, 2.61 statements of release, 2.59 stock option contracts, 2.24 stock warrants, 2.24 termination statements, 2.60 transitional rules, 2.65 watercraft as collateral, see Watercraft Perishable Agricultural Commodities Act (Illinois), agricultural financing and, 7.12 Personal property, leases, priority of security interests, 3.48 Possession, perfection of security interests by, mandatory possession, 2.4 permissive possession, 2.5 what constitutes possession, 2.3 Poultry, priority of security interests, 3.56 Preferential transfers, bankruptcy, avoiding in, defenses, 8.27 insiders, to or for benefit of, 8.28 one-year reach-back, 8.28 preference defined, 8.26 Presentation, letters of credit, 10.26 formal requirements, 10.36 inspection of documents upon, 10.27 multiple presentations, 10.33 time considerations, 10.31

Priority of liens, agricultural financing, 7.8 equipment leases, arising by operation of law, 6.34 other liens, 6.35 Priority of security interests, agricultural commodities, 3.56 bailment, 3.49 bankruptcy estate, 3.57 buyers, lessees, and licensees, 3.47 certificates of title, goods covered by, 3.4 choice of law, 3.3 conflicting security interests (UCC §9-322), established prior to effective date, 3.35 – 3.37 perfected prior to effective date, 3.36 priority, 3.37 “first in time” rule, see “First in time” rule proceeds, 3.14 subordination agreements, effect of, 3.34 supporting obligations, 3.14 consignment, 3.50 deposit accounts, 3.5 federal tax liens, 3.53 fixtures, real property with, 3.44 government procurement programs, 3.52 “hot goods,” 3.58 investment property, 3.6 judicial liens, 3.46 land trusts, beneficial interests in, 3.8 letter-of-credit rights, 3.7 liens relating to possession of goods for services or materials, 3.39 – 3.43 artisans, 3.40 carriers, 3.42 landlords, 3.43 warehouses, 3.41 livestock, 3.56 non-Article 9 rights, 3.38 – 3.59 overview, 3.1 Pension Benefit Guaranty Corporation, 3.54 perfection versus, 3.2 personal property leases, 3.48 poultry, 3.56 real property with fixtures, 3.44 reclaiming sellers, 3.45 recoupment, 3.51

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INDEX

Priority of security interests (cont.), RICO, 3.55 setoff, 3.51 unperfected security interests (UCC §9-317), buyers, lessees, and licensees, 3.11 parties with perfected security interests, 3.9 prior lien creditors, 3.10 rights superior to perfected security interests, 3.12 WARN Act, 3.59

SEC

Registered organizations, perfection of security interests by filing, 2.7 Regulation B (U.S.), pre-default termination of guaranties, 12.33

Purchase-money security interests, agricultural financing, 7.9 “first in time” rule, 3.20 overview, 1.31

Releases, collateral, aircraft as, recording of security documents, 5.7 motor vehicles as, perfection of security interests, 5.15 watercraft as, perfection of security interests, 5.23 guaranties, pre-default discharge of guarantor, release of coguarantor, 12.25 statute of frauds preventing assertion of oral release, 12.17 statements of release, 2.59

Puts, guaranties, as alternative to, 12.46

Remedies, equipment leases, 6.61

Racketeer Influenced and Corrupt Organizations Act (U.S.), lender liability and, enterprise, 13.22 overview, 13.1, 13.9, 13.19 pattern, 13.21 persons separate from enterprise as defendants, 13.23 predicate acts, 13.20 proximate cause, enhanced emphasis on, 13.24 priority of security interests and, 3.55

Rental payments, equipment leases, 6.51

Promissory notes, as collateral, 1.10 Public Utilities Act (Illinois), excluded transactions, 1.5

Reorganization, bankruptcy, confirmation of reorganization plan, 8.51 – 8.54 cramdown, 8.54 disclosure statement, 8.52 requirements, 8.53 Replevin, overview, 4.28 procedure, 4.29

Reclaiming sellers, priority of security interests, 3.45

Repossession of collateral, accounts, 4.7 chattel paper, 4.7 contract rights, 4.7 goods, 4.8 instruments, 4.7 peaceful repossession, 4.9

Recoupment, priority of security interests, 3.51

Repudiated performance, equipment leases, 6.39

Redemption, debtor’s right of, 4.24

RESTATEMENT (SECOND) OF AGENCY, lender liability and, 13.5

Real property, fixtures, priority of security interests, 3.44

ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION

RESTATEMENT (SECOND) OF CONFLICT OF LAWS, perfection of security interests by control and, 2.21 RESTATEMENT (SECOND) OF CONTRACTS, lender liability and, 13.4 Restricted guaranties, 12.4 RICO, see Racketeer Influenced and Corrupt Organizations Act (U.S.) Risk of loss or damage, equipment leases, 6.29, 6.57 Sale-leaseback transactions, equipment, fraudulent transfers, 6.62 Sale of collateral, application of sale proceeds, 4.23 attorneys’ fees, 4.23 commercial reasonableness, determination of, 4.21 overview, 4.19 secured creditor’s obligations, 4.20 title obtained by purchaser, 4.22 Sales letters of credit, 10.4 Sanctions, damages, 4.26 deficiency, recovery of, 4.27 Secretary of State (Illinois), agricultural financing and, 7.5 perfection of security interests and, filing with, 2.9 financing statements, 2.52, 2.53 motor vehicles as collateral, 2.26 rules and regulations, 2.64 termination statements, 2.60 trademarks as collateral, 5.40 Secured parties, defined, 1.3 Securities, “first in time” rule, 3.27

a — 13

SEC

Securities Act of 1933 (U.S.), lender liability and, 13.17 Securities Exchange Act of 1934 (U.S.), lender liability and, 13.17 Security agreements, agricultural financing, collateral, description of, 7.3 form, 7.20 general provisions, 7.2 grants, 7.4 representations, 7.5 attachment of security interests, valid authenticated security agreement required, 1.26 collateral, description required, 1.34 defined, 1.3 land, description required, 1.35 underlying debt, description required, 1.36 writing requirement, 1.32, 1.33 Security interests, attachment of, see Attachment of security interests bankruptcy, postpetition effect of, after-acquired property, 8.47 exceptions, 8.49 interplay with other Bankruptcy Code sections, 8.50 proceeds, 8.48 defined, 1.3, 1.22 enforcement of, 1.23 – 1.27 fraudulent transfers, avoidance as, constructively fraudulent transfers, 11.3 overview, 11.1 statutory provisions, 11.2 overview, 1.1, 1.21 perfection of, see Perfection of security interests priority of, see Priority of security interests purchase-money security interests, 1.31 agricultural financing, 7.9 “first in time” rule, 3.20 special priming security interests, “first in time” rule, 3.16

SECURED TRANSACTIONS

Setoff, lender liability, drafting considerations, 13.36 priority of security interests, 3.51

Strict foreclosure, 4.25 Seventh Amendment (U.S.), bankruptcy, avoidance of preferential transfers, 8.30 Ship Mortgage Act (U.S.), watercraft as collateral, perfection of security interests, 5.30 Signatures, financing statements, 2.46 Small Business Administration (U.S.), post-default discharge of guarantor and, 12.37 Software, as collateral, 1.17 Special priming security interests, “first in time” rule, 3.16 Springing guaranties, liability generated by prohibited act causing no loss to lender, 12.13 overview, 12.5 sample form, 12.5 Standby letters of credit, overview, 10.5 sample, 10.47 Standing, bankruptcy, charges against secured creditors’ collateral, 8.46 Standstill subordination, overview, 9.14 standstill period, 9.19 Statute of frauds (Illinois), equipment leases, 6.19 guaranties, preventing assertion of oral release, 12.17 letters of credit and, 10.23 Statutes of limitations, equipment leases, 6.44 Stock option contracts, perfection of security interests, 2.24

a — 14

Stock warrants, perfection of security interests, 2.24

Strong-arm powers, bankruptcy trustees, defined, 8.24 limitations on, 8.25 purpose of, 8.24 Subordination agreements, contracts, form of, 9.8 overview, 9.1, 9.42 purposes of, 9.10 statutory provisions, 9.2 – 9.7 Bankruptcy Code, 9.7 UCC, 9.3 – 9.6 810 ILCS 5/1-310, 9.4 810 ILCS 5/9-339, 9.5 810 ILCS 5/9-340, 9.6 substantive issues, 9.15 – 9.19 default provisions, 9.18 defining debt, 9.17 payment in full, 9.16 standstill period, 9.19 terms and provisions, 9.20 – 9.28 covenants of junior creditor, 9.23 descriptive legend, 9.27 notice, 9.28 postpetition interest, 9.22 representations of junior creditor, 9.24 rights of senior lender, 9.21 subrogation rights, 9.25 trust relationship, 9.26 types of, 9.11 – 9.14 bankruptcy subordination, 9.12 default subordination, 9.13 standstill subordination, 9.14 unitranche facilities, 9.41 uses of, 9.10 Subrogation, letters of credit, 10.42 subordination agreements, 9.25 Substituted performance, equipment leases, 6.39 Successive guaranties, 12.39 Supply contracts, equipment leases, lessee as beneficiary, 6.22

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INDEX

Supporting obligations, as collateral, 1.13 Sureties Act (Illinois), pre-default discharge of guarantor and, 12.28 Tax liens, priority of security interests, 3.53 Termination statements, 2.60 Third-party beneficiaries, equipment leases, warranties, 6.27 Timber, financing statements, contents of, 2.49 Time considerations, attachment of security interests, 1.27 disposition of collateral, notice of, 4.18 financing statements, 2.50 letters of credit, presentation, 10.31 Tort law, lender liability, see Lender liability Tortious interference with contract or business expectancy, lender liability, 13.16 Trade names, financing statements, identification of debtor and secured party, 2.42 Trademark Act of 1946 (U.S.), recordation under, 5.39 Trademark Registration and Protection Act (Illinois), recordation under, 5.40 Trademarks, as collateral, 5.38 – 5.40 Trademark Act of 1946, recordation under, 5.39 Trademark Registration and Protection Act, recordation under, 5.40

VEH

Transportation Department (U.S.), aircraft as collateral, filing requirements, 5.3 watercraft as collateral, filing requirements, 5.24, 5.25 Transportation modes, as collateral, 5.2 – 5.30 aircraft, see Aircraft motor vehicles, see Motor vehicles watercraft, see Watercraft Treasury Department (U.S.), agricultural financing, marijuana as farm product for purposes of, 7.18 Trustees in bankruptcy, strong-arm powers, defined, 8.24 limitations on, 8.25 purpose of, 8.24 Truth in Lending Act (U.S.), after-acquired property and, 1.30 lender liability and, 13.17 UCC, see specific topic Unconditional guaranties, guarantor liable upon default of borrower, 12.12 Unconscionability, equipment leases, 6.17 Uniform Commercial Code (Illinois), excluded transactions, 1.5 historical background, 1.2 included transactions, 1.4 intercreditor agreements and, 9.3 – 9.6 810 ILCS 5/1-310, 9.4 810 ILCS 5/9-339, 9.5 810 ILCS 5/9-340, 9.6 subordination agreements and, 9.3 – 9.6 810 ILCS 5/1-310, 9.4 810 ILCS 5/9-339, 9.5 810 ILCS 5/9-340, 9.6 see also specific topic

ILLINOIS INSTITUTE FOR CONTINUING LEGAL EDUCATION

Uniform Consumer Credit Code (former), equipment leases and, 6.13, 6.16 Uniform Fraudulent Conveyance Act (former), bankruptcy, avoiding fraudulent transfers, 8.29 sale of collateral and, 4.22 Uniform Fraudulent Transfer Act (Illinois), avoidance of security interests as fraudulent transfers, 11.2 bankruptcy, avoiding fraudulent transfers, 8.29, 8.31 equipment leases and, 6.62 sale of collateral and, 4.22 Uniform Voidable Transactions Act, fraudulent transfers, avoidance of security interests as, 11.2 Unitranche facilities, 9.41 Unperfected security interests, priority of security interests (UCC §9-317), buyers, lessees, and licensees, 3.11 parties with perfected security interests, 3.9 prior lien creditors, 3.10 rights superior to perfected security interests, 3.12 Usury, equipment leases, applicability of laws, 6.10 Validity guaranties, 12.6 Valuation of assets, bankruptcy, adequate protection, 8.6 Vehicle Code (Illinois), motor vehicles as collateral, perfection of security interests, assignment, 5.14 foreign liens, 5.13 mechanics of, 5.11 overview, 2.13, 2.26, 5.10 subordinate liens, 5.12

a — 15

VES

Vessels, see Watercraft Wage Assignment Act (Illinois), collateral, rights in funds held by others as, 5.43 Wage assignments, collateral, rights in funds held by others as, 5.43 Waiver, letters of credit, issuer’s obligations, 10.37 request for applicant waiver, 10.29 Warehouses, liens, priority of security interests, 3.41

SECURED TRANSACTIONS

Watercraft (cont.), Illinois law, perfection of security interests under, 5.18 – 5.23 assignment, 5.23 Boat Registration and Safety Act, 5.19 foreign liens, 5.22 mechanics of, 5.20 overview, 2.27 releases, 5.24 subordinate liens, 5.21 Worker Adjustment and Retraining Notification (WARN) Act (U.S.), priority of security interests and, 3.59 Wrongful acceleration, 4.6

Warranties, equipment leases, 6.55 exclusion or modification, 6.26 express warranties, 6.23 third-party beneficiaries, 6.27 implied warranties, 6.24 third-party beneficiaries, 6.27 interference and infringement, against, 6.24 third-party beneficiaries, 6.27 Watercraft, as collateral, 5.17 – 5.30 federal law, perfection of security interests under, Article 9, interplay with, 5.30 default, 5.28 discharge, 5.29 documentation requirements, 5.24 maritime liens, 5.27 preferred mortgages, 5.26 Transportation Department, filing requirements, 5.24, 5.25

a — 16

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