Robert A. Leflar Distinguished Professor

Transcription

1 Some Practical Advice About Taking Security Interests in Gemstones, Accompanied by a Theoretical Discussion of the Negotiability of Goods, New and Used Robert Laurence Robert A. Leflar Distinguished Professor A. Introduction. The theoretical difficulty with taking a security interest in gemstones lies in the emphasized words from 9-320(a) of the Uniform Commercial Code, which is, of course, Ark. Code Ann (a):... a buyer in the ordinary course of business... takes free of a security interest created by the buyer s seller, even if the security interest is perfected and the buyer knows of its existence. 1 The practical solution to this problem seems to be to ignore it, but I will return to that below. First some background. B. The Derivative Title Principle. Begin with the derivative title principle, found, with respect to goods, in Sect (1)(first sentence): A purchaser of goods acquires all title which his transferor had..., that is to say that a buyer s title derives from the title of his seller, hence the name of the principle. The same principle is found in with respect to negotiable paper: Transfer of an instrument... vests in the transferee any right of the transferor to enforce the instrument.... And in 9-201(a) with respect to encumbered goods: Except as otherwise provided..., a security agreement is effective according to its terms between the parties, against purchasers of the collateral and against creditors. One always begins with the proposition that if there is a claim against, an encumbrance upon, or a defect to, a person s title to goods, that encumbrance or defect remains against the purchaser of the goods. This is the beginning point, the general principle, to which there are many, many exceptions, discussed below. C. Negotiability. The concept of negotiability measures the extent to which circumstances allow a purchaser to defeat the derivative title principle. Sometimes a downstream purchaser of property takes free of upstream claims against, encumbrances upon and defects to the property, 1. I have omitted two clauses from the statute. First, there is an except as otherwise provided clause at the beginning of 9-320(a) with a cross reference to 9-320(e), dealing with the rare cases where the secured creditor is in possession of the collateral. And second, there is an exception for purchasers of farm products from a farmer. 75

2 ARKANSAS LAW NOTES 2004 and the various Articles of the U.C.C. protect those downstream purchasers in a variety of ways, and to extents greater or lesser. In every case, the purchaser must meet various standards in order to merit the given protection from the derivative title principle. Article Three, of course, contains negotiability at its heart; in fact Article Three is called Negotiable Instruments. If the paper purchased meets the definition of being a negotiable instrument, 2 and if a buyer of it meets the requirements of being a holder in due course, 3 then the buyer takes free of most, though not exactly all, upstream claims and defenses. Sections and contain the narrow exceptions to the rule of negotiation, for instance claims based on the infancy of the obligor on the instrument are enforceable against all downstream purchasers of the instrument, as are claims of fraud in the inducement. By and large, however, a holder in due course is very well protected against upstream claimants. As well it must be. Paper, of course, has no intrinsic value. In order to get people to deal commercially in paper a legal regime must be created to give them superior rights to the paper. This concept can be seen most clearly in the operation of the rules of Article Seven, with respect to negotiable warehouse receipts and bills of lading. Unlike Article Three paper, which represents an obligation or an order, Article Seven paper is a receipt, and represents goods in existence and either being stored, in the case of a warehouse receipt, or shipped, in the case of a bill of lading. Article Seven allows those goods to be bought and sold, numerous times in some instances, without leaving the possession of the warehouse or the carrier. This, of course, is an extremely efficient way to run a commercial set-up, but it will work only if buyers are willing to pay out actual cash money for a piece of paper that is not the goods themselves, but only represents access to the goods. And buyers will only do that, it is thought, if they are given legal protection against upstream claimants against the paper, or the goods themselves. Hence, negotiable documents of title, and the buyer of the paper, here called a holder through due negotiation, is given substantial protection against the derivative title principle by In fact, as is commonly said, paper trades more freely than goods. The negotiability of goods themselves is given by 2-403, whose first sentence, as we have seen, states the basic derivative title principle. With respect to stored, or bailed goods, a buyer in the ordinary course of business from a bailee who is in the business of selling goods of that kind gets the bailor s title, not the bailee s, so goods are to some extent negotiable in and of themselves. But note that the protection given the buyer in the ordinary course of business in Article Two is less than that given the holder through due negotiation in Article Seven. The latter gains title to the goods by buying the paper, even when all the bailee is doing is holding the goods, not selling them. Article Two s protection typically would not protect a buyer of goods from a bailee who is storing them, unless the bailee is also in the business of selling goods as well. The typical Article Two case would be where the owner of a watch leaves it with a jewelry store that both sells and repairs watches. Under 2-403(2), the jewelry store has the power (though certainly not the right) to pass the owner s title to a buyer in the ordinary course of the jewelry store s business. Outside the situation of a bailment, goods are negotiable only through the concept of voidable title. As 2-403(1)(second sentence) says, 2. The definition of a negotiable instrument is found in The definition of a holder in due course is found in

3 SOME PRACTICAL ADVICE ABOUT GEMSTONES A person with voidable title has power to transfer a good title to a good faith purchaser for value. The term voidable title is a common law term, not defined with precision in the statute, though 2-403(1)(third sentence) gives four examples of when a seller has it. The point here is that the party with voidable title has no title at all against the true owner of the goods, but the goods have become negotiable and a good faith purchaser for value takes the goods free of the upstream claims of the true owner. At this point we have, then, that the concept of negotiability is found in Articles Two, Three and Seven of the U.C.C. The derivative title principle is foundational in each of those Articles, but each contains at least some measure of the concept of negotiability, with, as a general matter, paper being more negotiable than goods. It is unsurprising, then, to discover that negotiability also resides in Article Eight, dealing with investment securities, that is to say stocks and bonds. 4 The derivative title principle resides in that Article in 8-302, and protection of purchasers, here called protected purchasers, 5 is found in 8-303, providing that such purchasers take free of upstream claims. Which brings us to... D. Negotiability in Article Nine. As mentioned above, the derivative title principle in Article 9 resides in 9-201(a): Except as otherwise provided..., a security agreement is effective according to its terms between the parties, against purchasers of the collateral, and against creditors. It is entirely unsurprising, of course, that an agreement would be effective according to its terms between the parties who agree to it, so the emphatic part of that command regards the enforceability of the security agreement between the debtor and the creditor against third parties who were not privy to the agreement, in particular, third party purchasers or encumbrancers. For emphasis, the derivative title principle is restated with respect to purchasers in 9-315(a)(1): Except as otherwise provided... a security interest... continues in collateral notwithstanding sale... thereof.... The negotiability of Article 9 collateral, then, resides in the words except as otherwise provided, found in both 9-201(a) and 9-315(a)(1). Strictly speaking, 9-201(a) says [e]xcept as otherwise provided in the Uniform Commercial Code..., while 9-315(a)(1) says [e]xcept as otherwise provided in this article and in Section 2-403(2)..., so the search under the former is a bit broader than under the latter. Of course, Article 9 accepts the propriety of many kinds of collateral other than goods, but because my ultimate aim is the discussion of gemstones, and purchasers thereof, we may limit for present purposes our search for places where the statute provides otherwise to places involving goods. Because we ve already been there, the place to begin is with 2-403(2), the bailment or entrustment provision of Article 2, containing the rule regarding the negotiability of goods. Any entrusting of possession of goods to a merchant who deals in goods of that kind gives him power to transfer all rights of the entruster to a buyer in the ordinary course of business. How does that section become an exception to 9-315(1)(a) s derivative title principle? First, suppose that it is the debtor who entrusts goods encumbered by a security interest to a merchant who deals in goods of that kind: suppose a Rolex watch encumbered by the Bank of Fayetteville s security interest is placed for repair with Nonesuch Jewelry. Suppose Nonesuch sells the watch to a buyer in the ordinary course of business. Section 2-403(2) makes it clear that the buyer only gets 4. The definition of a security is found in 8-102(15). 5. The definition of a protected purchaser is found in

4 ARKANSAS LAW NOTES 2004 the entruster s rights, that is to say the debtor s rights, which, of course, are encumbered by the bank s security interest. Section 2-403(2) s exception to the derivative title principle does not apply here, and the bank s security interest is enforceable against the buyer of the watch. But suppose instead that the Bank of Fayetteville takes possession of the Rolex and itself places the watch for repair at Nonesuch, who sells the watch to a buyer in the ordinary course of business. Now the buyer takes free of the security interest, and hence we have the exception of 9-315(a)(1) s derivative title principle. Of course, here the buyer does not take free of the debtor s claim to the watch, only to the entruster s claim. The cross-reference in 9-315(a)(1) to 2-403(2) provides only a very narrow occasion of negotiability. More important are three provisions of Article 9 itself: 9-317(b), 9-320(b) and 9-320(a). The third of these is the section of the Code where this discussion began and is by far the most important of the three, but let s dispose of the other two first. Section 9-317(b) provides that purchasers of goods for value, without notice and who take delivery of the goods, take free of unperfected security interests in the goods. This, you see, is an example of the negotiability of goods, for the purchaser is taking free of a claim that is perfectly valid against his transferor, perfection having nothing to do with the rights of the original debtor and creditor against each other. But, as you also see, this example of negotiability has no particularly wide import, except in those situations, almost always inadvertent, where the creditor fails to perfect. Well, ask a bankruptcy trustee: maybe those occasions are more common than we would like to think, and many unperfected security interests are rendered void in bankruptcy. Still and all, there is nothing particularly interesting about the rule of 9-317(b). And the negotiability found in 9-320(b) is very narrow, applying only to yard sales. Yard sales?! Yes. The rule of 9-320(b) applies only when both the seller and the buyer are consumers: [A] buyer of goods from a person who used or bought the goods for use primarily for personal, family, or household purposes, takes free of a security interest, even if perfected, if the buyer buys... primarily for the buyer s personal, family, or household purposes. There are additional requirements of purchasing without knowledge of the security interest and for value, and a filed financing statement will protect the security interest, but at base 9-320(b) is a complicated rule for yard sales. Enough said. Which brings us to 9-320(a) and the primary rule for the negotiability of goods under Article 9, already quoted above: [A] buyer in ordinary course of business... takes free of a security interest created by the buyer s seller, even if the security interest is perfected and the buyer knows of its existence, with exceptions not relevant here. It is plain from reading this rule that a buyer in the ordinary course of business does not take the goods purchased free of all security interests, only those created by her seller, but the impact of the rule is greatly expanded by the application of 2-403(1) s derivative title principle, here usually referred to as the shelter principle. To use my standard classroom example, imagine a grand piano, manufactured by the Baldwin Piano Company. Baldwin s principal creditor, say, is the Bank of New York, which has a perfected security interest in all of Baldwin s inventory. 6 Baldwin sells the piano in the ordinary course to Pianos West, a wholesaler of fine musical instruments. The principal creditor of Pianos West, say, is the Bank of Kansas City, which has a perfected security interest in all of Pianos West s inventory. 6. It would be very common, of course, for this security interest to describe the collateral as all of the debtor s inventory, now owned and hereafter acquired, thereby making it irrelevant at whatever time Baldwin made the piano. 78

5 SOME PRACTICAL ADVICE ABOUT GEMSTONES Pianos West sells the piano in the ordinary course to International Piano Gallery, a retailer of fine pianos. International s principal creditor is, say, the Bank of North Little Rock, which has a perfected security interest in all of International s inventory. International sells the piano in the ordinary course to Ella s Restaurant in Fayetteville. Now, which of the upstream security interests are enforceable against Ella s? The answer is none, even though 9-320(a) directly protects Ella s only against the security interest created by its seller, International, that is to say, the security interest of the Bank of North Little Rock. However, International was a buyer in the ordinary course from Pianos West and so it had 9-320(a) protection against the security interest created by its seller, that is the security interest of the Bank of Kansas City. And, because the Bank of Kansas City s security interest was not enforceable against International, then, under 2-403(1), Ella s acquired those rights by purchasing from International. So, International had 9-320(a) rights against the Bank of Kansas City, and Ella s can shelter itself under 2-403(1). Ella s has its own 9-320(a) rights against the Bank of North Little Rock. And so on, upstream: Under 9-320(a), Pianos West took free of the Bank of New York s security interest, created as it was by its seller, Baldwin Piano Company. International has no power on its own to defeat the Bank of New York s security interest, but, under 2-403(1), it inherited that power from Pianos West. And Ella s inherited it from International. Thus we see that when Ella s Restaurant bought the piano in the ordinary course from a retailer who had bought it in the ordinary course from a wholesaler who had bought it in the ordinary course from the manufacturer, Ella s took the piano free from all upstream security interests, notwithstanding the restrictive language of 9-320(a). The conclusion to here is that inventory is quite negotiable under Article 9, and that buyers of inventory in the ordinary course take free of all upstream security interests. However, that conclusion only applies to new inventory, and to see why, return to our hypothetical, and suppose that Ella s Restaurant s principal creditor is the Bank of Springdale. Now, the piano is equipment to Ella s, not inventory as it had been to all of the businesses upstream from the restaurant, so suppose that the Bank of Springdale has a perfected security interest in all of Ella s equipment. After using the piano for two years, suppose that Ella s sells the piano to Ben Jack s New and Used Instruments. This transaction is quite ordinary to Ben Jack, but it is out of the ordinary to Ella s; Ella s business is to sell asparagus souffles, not pianos. Suppose that Ben Jack s principal creditor is the Bank of Siloam Springs, which has a perfected security interest in all of Ben Jack s inventory. And suppose that Ben Jack sells the piano in the ordinary course to the Shiloh Christian High School. Now, which of the security interests upstream from Shiloh Christian are enforceable against the school? Shiloh Christian, a buyer in the ordinary course of business, has 9-320(a) protection against the security interest created by its seller, Ben Jack, and so takes free of the security interest of the Bank of Siloam Springs. And, under 2-403(1), it acquires by its purchase from Ben Jack all of Ben Jack s rights. Ben Jack, as a purchaser from Ella s Restaurant, acquired all of Ella s rights, which, as we saw above, was to take the piano free of all the security interests upstream from Ella s. However, Ben Jack was not a buyer in the ordinary course of business from Ella s, because Ella s is not in the business of selling pianos, so, under 9-201(1) and 9-315(1)(a), Ben Jack took the piano subject to the security interest of the Bank of Springdale. Thus can we conclude that our ultimate purchaser, Shiloh Christian High School, takes the piano free of the upstream security interests of the Banks of New York, Kansas City, North 79

6 ARKANSAS LAW NOTES 2004 Little Rock and Siloam Springs, but subject to the security interest of the Bank of Springdale. More generally we can see that, through a combination of 9-320(a) and 2-403(1), a buyer in the ordinary course takes free of the upstream security interests that attached while the goods were inventory, but takes subject to security interests that attached while the goods were being used, either as equipment or as consumer goods. And even more generally we can see that new inventory trades more freely than used inventory. Under Article 9, new inventory is more negotiable than used inventory, a result that follows from the restrictive language of 9-320(a), and that is based, apparently, on the policy determination that it is less important to protect those who deal in used goods, rather than new. Which brings us at long last to... E. Gemstones. Change pianos to diamonds. We have just seen that when a buyer walks into Swift s Jewelry Store to buy a diamond in the ordinary course, he or she will, under 9-320(a), take the stone free of any security interest in favor of the Swift s inventory financers. And we have seen that he or she will, under 2-403(1), also take free of all upstream security interests that attached while the diamond was inventory, either in the hands of another retail store, a wholesale outlet, a production facility, or the famous diamond cartel. 7 But, as we have also seen, the buyer will take the stone subject to any security interest that attached to it while it was being used, most often, one supposes, as consumer goods. Hence, if the diamond had once been in a ring belonging to someone s rich aunt, and was inherited by the nephew, and encumbered by him with a security interest in favor of the Bank of Fayetteville, and then sold by him, eventually to find its way into the inventory of Swift s Jewelry Store, then a buyer in ordinary course from Swift s takes subordinate to the Bank of Fayetteville. Used inventory trades less freely than new inventory and here s the gemstone kicker with respect to gemstones it is virtually impossible to tell a new product from a used product. It was just this observation that was put to me, plaintively, by Brad Runyon, a member of the Class of 2005, a student in my Debtor- Creditor class, and a young man in the market for a gemstone. How, Mr. Runyon wanted to know, could a purchaser of a diamond ring ever be sure he wasn t buying subject to an enforceable upstream encumbrance that had attached when the gem was previously being used? The theory of the negotiability of goods, just related, is straightforward enough, but as Mr. Runyon and I talked our way through the problem, it became clear that neither of us knew enough about the financing of gemstone purchases at the retail level. Mr. Runyon, then, took on the project of sampling the local retail market, as well as other lenders against jewelry. 8 We and when I use the plural, I am almost always referring to Mr. Runyon, speaking to local business people on my behalf we spoke first to a local bank and discovered that this particular bank lends money against jewelry only when it was able to take possession of the collateral. This is a situation, plainly, more applicable to pledges of family heirlooms than engagement rings: Here s a picture of the ring, honey. You can wear it once it s paid for. 7. A Lexis or Google search will tell you more than you want to know about the DeBeers diamond cartel. See, e.g., Margaret Webb Pressler, DeBeers Pleads to Price-Fixing; Firm Pays $10 Million, Can Fully Reenter U.S., The Washington Post, July 14, 2004, p. E1.; Liz Stanton, Ten Reasons Why You Should Never Accept a Diamond Ring from Anyone, Under Any Circumstances, Even If They Really Want to Give You One, 8. These local Northwest Arkansas businesses generously answered our questions after our assurances of their privacy, so I will not be identifying them here by name. They know who they are, and we thank them for their help. 80

7 SOME PRACTICAL ADVICE ABOUT GEMSTONES Will you marry me? Such a proposal might occasionally appeal to the most clear-eyed, pragmatic of the betrothed, but, one suspects, not to most. That bank, though, had established a prudent, if conservative, policy. By taking possession of the collateral, a bank avoids the necessity of both a written security agreement, 9-203(b)(3)(B), and a filed financing statement, 9-313(a), although admittedly one would not expect such a prudent bank to take advantage of either of these protections. More to the point, by taking possession of the jewelry, the bank protects itself against the collateral s sale and disappearance. Furthermore, by being in possession of the collateral, the bank avoids application of 522(f) of the Bankruptcy Code. This provision, hated by all secured lenders, allows the debtor in bankruptcy to avoid an otherwise perfectly valid security interest in property that is exempt under 522(d), and which is also found on the 522(f) list. Jewelry is in both places. However, 522(f) does not allow the avoidance of possessory liens, and so the bank we interviewed is protected from this one (of several) of the Bankruptcy Code s lien avoidance provisions. But, as noted, most security interests in jewelry are not possessory. Usually the owner of the gemstone wishes to remain in possession, wearing the gem, while the note is being retired. 9 This is almost always the case with respect to purchase money loans. And, with our bank out of the picture, it is ordinarily the retailers themselves who advance the purchase price in one way or another. It is these retailers, then, who are at risk if, after using the gem for some time, the debtor sells it, and it ends up back in a retailer s inventory, to be sold again to a buyer in the ordinary course of business. As the discussion above shows, the theory of Article 9 is that the first retailer s security interest will survive and be enforceable against the second ordinary course buyer, but the realities of the gemstone trade seem to be that the first retailer knows that it will never, or almost never, be able to trace the gem to the second purchaser. Our research revealed a wide variety of financing plans used by Northwest Arkansas gemstone retailers. At least one jewelry story regularly retains title to the gems sold on credit, until payment in full is finally made. One suspects that the owners of this store think themselves to be acting conservatively, but many commercial lawyers would argue otherwise. Section 2-401(1)(second sentence) renders such an attempt to retain title ineffective to accomplish same, and the attempt is restricted in its effect to the retention of a security interest. The only time the retention of title accomplishes that result is in a true lease, which a gemstone transaction rarely is. Thus, notwithstanding the contract retaining title in the jewelry store, title in fact passes to the buyer and the store is merely a secured lender. If the owners of the store that attempts to retain title to the goods sold have sufficient legal savvy, they may know themselves to be secured parties in spite of what the contract says, and they may, as a result, file a UCC-1 form with the Secretary of State in Little Rock in order to perfect this secured status. 10 It would not be surprising, however, to discover that no filing was ever done the owners of the store, after all, think they are the owners of the gem until the final payment is made. 9. This puts aside the intriguing and occasionally litigated question of who owns the engagement ring: the one who wears it, or the one who buys it. While I ll admit that this question has been put to me by the occasional student, I m afraid the needed analysis is beyond the scope of the present discussion. Ask Miss Manners. 10. In order to file, the creditor must obtain the debtor s authorization to do so, 9-509(a)(1). This authorization ordinarily comes in the security agreement, but when the agreement purports to be a sale retaining title, the authorization may be problematic. 81

8 ARKANSAS LAW NOTES 2004 Failure to file is rarely a good idea, but one circumstance of the gemstone trade makes it less serious here. Surely most, if not all, security interests retained by jewelry stores inadvertently or not are purchase money security interests in consumer goods. These security interests, of course, perfect without filing, 9-309(1), so the creditor will be protected, for example, against the bankruptcy trustee seeking to avoid the lien under 544(b) s so-called strong-arm clause. Likewise, purchase money security interests are protected from avoidance under 522(f), discussed above. So, the conservative pessimist in me wants to advise the stores that attempt to retain title to gems sold to revise their forms to make them forthrightly into security interests, and to file a UCC-1 form. Filing s cheap. But, in the end, I concede, most retail jewelry stores will be protected by the statute without filing, and 2-401(1) presents no really important threat to them. At the other extreme from the stores that attempt to retain title to goods sold, was one family-owned store in Northwest Arkansas that apparently sells on unsecured credit. The store requires a customer to fill out a minuscule credit application, which contains a few details about interest rates and finance charges, and little else. We, of course, did not pursue a purchase to the end, so perhaps some additional paperwork containing a security agreement might have popped up along the way, but, taking the company at its word, here apparently we were faced with a long-established family business that was still comfortable doing business on a handshake basis, using those various intangibles to separate the bad borrowers from the good. More power to them, but really a formal security agreement and financing statement would seem at least to a commercial lawyer to be a minimal intrusion into the old ways of doing business. Between the extremes of the title retainers and the hand shakers, lie the chain stores. In our broad, but not complete canvas, all the chain stores used some form of credit card system in order to finance the purchase of gemstones. In one case, this was nothing more than a willingness to allow customers to use a standard Visa, Master Card, American Express or Discover card, thereby, for a service charge, passing the risk of non-payment on to the credit card company. More common, though, was the offering to the customer of an application for credit that essentially created a new credit card account, through such issuing entities as Citibank, Wells Fargo or G.E. Capital. One chain apparently issues and maintains these accounts internally, though of course they may assign the account to some other credit entity. Some, but not all, of these credit card agreements retain security interests in the goods sold. All contained binding arbitration clauses thought these days to be disadvantageous to consumers, and potentially unenforceable under the doctrine of Showmethemoney Check Cashers v. Williams 11 and its progeny. Most offered a very pricy insurance package as well. F. Conclusion. Back, finally, to the problem of negotiability. Given the difficulty of tracing and identifying gemstones, 12 it would appear that the retention of a security interest by the retail seller of gem Ark. 112, 27 S.W.3d 361 (2000). 12. We are told of a fairly recent attempt to introduce the use of lasers to micro-engrave serial numbers on diamonds to allow them to be traced. This would appear to be a new technology driven by the insurance industry, rather than the lending industry, and the jewelry expert who explained it to us saw, at present, too many difficulties with the system to offer much hope of tracing encumbered gems 82

9 SOME PRACTICAL ADVICE ABOUT GEMSTONES stones serves mostly to protect the seller against the defaulting buyer, and that buyer s bankruptcy trustee, rather than against downstream purchasers. Most sellers to whom we spoke seem to recognize that they will rarely, if ever, be able to follow a gemstone if it is cast, again, upon the sea of commerce. The risk of default by buyers who don t pay, one suspects, is covered by the handsome profit made on the sales to buyers who do pay, plus the equally handsome interest rates charged to those who need some time to pay. All of this shows, perhaps, that, in the end, there is more than a little sense, as well as considerable charm, in the business practices of the family that sells based on a look in the eye and a handshake. 83