ARTICLES 2 AND 2A AND INSOLVENCY LAW

CHAPTER FOUR ARTICLES 2 AND 2A AND INSOLVENCY LAW A. SCOPE OF ARTICLES 2 AND 2A Uniform Commercial Code (U.C.C.) Article 2 applies to transactions in goods. 2-102. 1 Although that phrase is both ambiguous and informed by much case law, the focus here is limited to a sale of goods. A sale involves the passage of title to movable property in return for a price. 2-106(1). In Article 2, the movable property is goods, which includes the unborn young of animals, growing crops, and certain other things related to realty, but not the money used to pay for the goods, information, the subject matter of foreign exchange transactions, investment securities, or things in action. 2-103(1)(k), 2-105(1), 2-107. 1 All references, unless otherwise denoted, refer to the current official text and comments to the Uniform Commercial Code. However, the current official text which amends Articles 2 and 2A has yet to be enacted in any state, therefore, the 2000 version of those Articles and its comments are referred to, with appropriate updates as relevant noted in italics. In addition, it must be recognized that amendments to Articles 1, 3 and 4, and 7 are not as yet enacted in all states. 141

142 The ABCs of the UCC: Related Insolvency Law Article 2A applies to a lease of goods. 2A-102. The definition of goods is essentially similar to the definition of the term in Article 2 ( 2A-103(1)(h); 2A-103(1)(n)), and a lease is defined as a transfer of the right to possession and use of goods for a term in return for consideration. 2A-103(1)(j); 2A-103(1)(p). B. RECLAMATION 1. RIGHT TO THE GOODS ON BREACH OR DEFAULT UNDER STATE LAW In a sale, the seller retains no interest in the delivered goods, and the remedy for nonpayment is an action for the purchase price. 2-709. In a lease, the lessor remains the owner and is also entitled to its residual interest ( 2A-103(1)(q); 2A-103(1)(w)), either in money ( 2A-532) or in kind ( 2A-525), if there is a default in payment of the rent. Alternatively, the lessor may pursue an action for the rent. 2A-529. Thus, if a lessee is insolvent, the lessor is in a different position than a seller would be. Although both the lessor and the seller are entitled to a monetary recovery, a monetary recovery is unlikely to be fully satisfactory for the lessor. The lessor has a right (subject to the Bankruptcy Code, as discussed infra), however, to get the property back, whereas a seller does not. Both, of course, also have a right to withhold or stop delivery ( 2A-525-526; 2-703(a); 2-703(2)(a), 2-705)), but the focus here is upon delivered goods. When goods have been delivered, and even though title to the goods has passed to the buyer, Article 2 gives the seller a limited right to reclaim goods received by the buyer in addition to the right to withhold or stop delivery of the goods or to refuse their delivery except for cash including payment in full for all goods previously delivered. 2-702. 2 This right to reclaim relates 2 A buyer s creditor has no greater rights than a buyer, so where the seller has not yet delivered, the seller s rights to the goods are superior to the security interest of the buyer s creditor. 2-702(3) and In re Kellstrom Indus., Inc., 282 B.R. 787 (Bankr. D. Del. 2002).

Chapter 4 Articles 2 and 2A and Insolvency Law 143 to a sale on credit; 2-507(2) gives a seller in a cash sale who is paid upon delivery (when the seller takes a bad check, for example) a similar right. A buyer has a similar but somewhat broader right under 2-502 to obtain goods that have been at least partially paid for, as does a lessee under 2A-522, although the lessee is in a much different position than the lessor. The time period to reclaim or obtain the goods is quite short in some circumstances: ten days (although a consumer buyer or lessee has no time limit if the seller or lessor has repudiated or failed to deliver, and a seller has a longer period if a misrepresentation of solvency has been made in a recent record). 3 The issue, then, is to what extent does the Bankruptcy Code (hereinafter Code ) recognize these rights to obtain the goods? 2. BANKRUPTCY LIMITATIONS IN CONNECTION WITH A LEASE Because a lease (as determined by law) may be treated in certain instances as a secured transaction, with the title retained by the ostensible lessor in fact only a security interest ( 1-203), an initial consideration should be whether the lease is actually a secured transaction. If so, the lessor s residual right to the goods may be lost because, although a secured party has a right similar to a lessor s right to obtain the goods upon default ( 2A-525, 9-609), that right can be avoided or subordinated by the trustee in bankruptcy if the security interest is unperfected as discussed supra in Chapters Two and Three. See 9-317(a)(2); Code 544. When is a lease considered to be a security interest? Under 1-203, the test is essentially whether the lessor retained a meaningful residual interest in light of the time the transaction was entered into. The following factors do not create a security interest: 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; 3 The amended version of 2-702 eliminates the longer period based on misrepresentation, and imposes instead a reasonable period to obtain the goods.

144 The ABCs of the UCC: Related Insolvency Law the lessee assumes the risk of loss of the goods; 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; 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 determined with reference to the facts and circumstances at the time the transaction is entered into; or 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, with the reasonably predictable fair market value being determined with reference to the facts and circumstances at the time the transaction is entered into. Id. 1-203 (this test was formerly incorporated into the definition of security interest at old 1-201(37) but was separated into the new 1-203 in the 2001 revision of the uniform text of U.C.C. Article 1). Moreover, regarding the last factor, a fixed price that is less than the reasonably predictable fair market value of the goods is not necessarily fatal. There is a set of purchase options, the fixed prices of which (1) are less than fair market value but greater than nominal and (2) must be evaluated by the facts of each case in order to ascertain whether the transaction that includes the option creates a lease or a security interest. 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, which is determined by reference to the facts and circumstances at the time the transaction is entered into. Additional consideration is not nominal if, when the option to become the owner of the goods is granted, the price 4 But see In re Bailey, 326 B.R. 156 (Bankr. W.D. Ark. 2005), where the fact the lessee was responsible for taxes, maintenance, and risk of loss, under all the circumstances there, weighed in the characterization of the transaction.

Chapter 4 Articles 2 and 2A and Insolvency Law 145 is stated to be the fair market value of the goods determined at the time the option will be performed. In re Marhoefer Packing Co., 674 F.2d 1139 (7th Cir. 1982), held that an option price amounting to 50% of fair market value is not nominal 5 and further recognized that, because the market can change, the comparison must be based upon what the parties contemplated at the transaction s inception and not upon the actual value at the time the option is exercised. The Marhoefer case also points out that, to create a security interest, the lessee must be obligated for the term of the lease. In that case, under an option to continue the lease, even though the lessee at the end of that continuation period may have been able to purchase the goods for an arguably nominal consideration, the lease was not a security interest because the lessee was not obligated to continue the lease or to exercise (and had not exercised) the option. 6 By the same token, a secured transaction exists if: the consideration 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; the original term of the lease is equal to or greater than the remaining economic life of the goods, determined by reference to the facts and circumstances at the time the transaction is entered into (see In re Pac. Express, Inc., 780 F.2d 1482 (9th Cir. 1986)); 5 See also In re Buehne Farms, Inc., 321 B.R. 239 (Bankr. S.D. Ill. 2005) (3 months rent nominal additional consideration). Compare In re Dynamic Tours & Transp., Inc., 56 U.C.C. Rep. Serv. 2d 514 (Bankr. M.D. Fla. 2004) (values at end of agreement ranged from some 25% to over 50%). 6 See also Buehne Farms case, supra. Compare the Dynamic Tours & Transp. case, supra, where there was an option to terminate. In In re Grubbs Construction Co., 319 B.R. 698 (Bankr. M.D. Fla. 2005), declined to follow by In re Shores, 332 B.R. 31 (M.D. Fla. 2005), the lessee could terminate early and buy the equipment. There was a TRAC clause where any excess value at lease end over an agreed value went to the lessee but the lessee also had to make up any shortfall. The court held the leases constituted security interests as the only rational choice on the facts was to exercise the early termination option.

146 The ABCs of the UCC: Related Insolvency Law 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; 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 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 lessee s obligations under the lease agreement (see C.F. Garcia Enters., Inc. v. Enter. Ford Tractor, Inc., 480 S.E.2d 497 (Va. 1997)). Under the above statutory criteria, a so-called rent-to-own lease, wherein the periods of obligation are week-to-week or month-to-month with an option to acquire the goods at the end of the last period for a nominal sum, is a true lease at inception because there is no obligation to continue the lease and, thus, to exercise the option. With each renewal of the lease, however, the facts and circumstances at the time of such renewal must be examined to determine whether the characterization that the lease is a true lease remains accurate because it is possible that a transaction that first creates a lease later will become a security interest. Id. Official Comment (j) to 2A-103. Note also that, although this analysis is appropriate, it may not always apply in the case of a consumer lease. See, e.g., 1974 Uniform Consumer Credit Code 1.301(35); Perez v. Rent-A-Center, 892 A.2d 1255 (N.J. 2006) (involving analysis subject to statute in many states). The Code s other major limitation upon the lessor s ability to recover the leased goods is discussed in Part B.3 of this chapter. The discussion also includes a lessee s right to obtain the goods under 2A-522 as well as the buyer s similar right. 3. BANKRUPTCY LIMITATIONS IN CONNECTION WITH A SALE A seller s or buyer s ability to obtain the goods that are the subject of a sale under 2-507, 2-702, or 2-502 may amount to a bankruptcy preference or a statutory lien for the seller or buyer as a

Chapter 4 Articles 2 and 2A and Insolvency Law 147 creditor, and preferences and statutory liens may be subject to avoidance in bankruptcy. Id. Code 547, 545; supra Chapter Two, Part E. Nonetheless, Bankruptcy Code 546(c) explicitly allows the seller s preference or lien as long as a 45-day limitation is met (a limited extension to twenty days exists if the 45-day period expires after the bankruptcy proceeding commences), as the seller s right is, in essence, a remedy for presumed fraud by the bankrupt buyer in acquiring the goods while insolvent shortly before bankruptcy. 7 Indeed, under 2-702, the seller may not base an alternative right to reclaim upon the buyer s fraudulent or innocent misrepresentations of solvency or intent to pay, and reclamation under the U.C.C. excludes all other remedies with respect to the goods. See, e.g., Kennett-Murray & Co. v. Pawnee Nat l. Bank, 598 P.2d 274 (Okla. Civ. App. 1979). It is unclear whether a statutory claim under Bankruptcy Code 546(c) is a separate remedy from 2-702, and whether it is the exclusive remedy of a seller attempting to reclaim goods from a bankruptcy trustee, or whether any other claim (e.g., under the U.C.C.) might prevail against the trustee s powers. See, e.g., In re Tucker, 329 B.R. 291 (Bankr. D. Ariz. 2005) (perhaps finding a right to reclaim in bankruptcy separate from the right under 2-702), and In re Contract Interiors, Inc., 14 B.R. 670 (Bankr. E.D. Mich. 1981); In re Rozel Industries, Inc., 74 B.R. 643 (Bankr. N.D. Ill. 1987); In re Julien Co., 44 F.3d 426 (6th Cir. 1995) (discussing minority and majority views on the issue; holding in conformity with the majority view that Code 546(c) is exclusive). See also In re Builders Capital & Serv., Inc., 317 B.R. 603 (Bankr. W.D.N.Y. 2004) (once seller establishes that it meets the requirements of 2-702, the seller must pursue reclamation through 546(c) of the Bankruptcy Code); Code 546(c)(2) and 503(b)(9) (establishing an administrative expense claim for the value of goods sold in ordinary course and received by the debtor 7 The right is subject under both 2-702(3) and 546(c) to rights of a perfected secured party. In re Nitram, Inc., 323 B.R.792 (Bankr. M.D. Fla. 2005); In re Tucker, 329 B.R. 291 (Bankr. D. Ariz. 2005).

148 The ABCs of the UCC: Related Insolvency Law within 20 days before bankruptcy). Both In re Georgetown Steel Co., 318 B.R. 336 (Bankr. D.S.C. 2004) and In re Waccamaw s HomePlace, 298 B.R. 233 (Bankr. D. Del. 2003), establish that a seller s claim is only to goods in the possession of the debtor at the time demand is made, or at the time the bankruptcy petition is filed where the seller took no action to prevent sales after the demand was made. See, infra, as to any claim to proceeds. Rights beyond the U.C.C. that may allow an unpaid seller in certain limited circumstances to obtain the goods sold or their proceeds are distinguishable. For example, under 7 U.S.C. 499e(c), a buyer of perishable agricultural commodities holds the produce, any related inventory, and accounts receivable in trust for the benefit of all of the buyer s unpaid sellers. Although such a right is, in essence, no less a preference or statutory lien than the right to reclaim under the U.C.C., the legislative history of Bankruptcy Code 541, which defines the property of the bankruptcy estate, provides that neither Bankruptcy Code 541 nor Bankruptcy Code 545 affect various statutory provisions that create a trust fund for the benefit of a debtor s creditor. This is another example of the Bankruptcy Code s deference to state property law. Id. supra Chapter One, Part A; Chapter Two, Part C; and Chapter Three, Part A. See also Bankruptcy Code 541(b)(8) relating to pawned personal property. Such trust fund statutes may have an equally deleterious effect upon a lender secured by the buyer s assets. Id. In re Richmond Produce Co., 112 B.R. 364 (Bankr. N.D. Cal. 1990). United States v. Westside Bank, 732 F.2d 1258 (5th Cir. 1984), addressed whether the reclamation right extends to proceeds of the sale of the goods, and, in a persuasive opinion, held that it did. But see In re Coast Trading Co., 744 F.2d 686 (9th Cir. 1984). Section 2-702, as amended, takes no position as to a claim to proceeds. Official Comment 2 to amended 2-702. There are other ambiguities, however. See, e.g., In re Marin Motor Oil, Inc., 740 F.2d 220 (3d Cir. 1984) (when demand under Bankr. Code 546(c) and 2-702(2) is timely and when the buyer receives the goods-adopting the time of dispatch (or mailbox rule ) in terms of the former issue).

Chapter 4 Articles 2 and 2A and Insolvency Law 149 The Bankruptcy Code does not explicitly refer to the right of a buyer or a lessee under 2-502 or under 2A-522 to obtain the goods, and there is no direct equivalent for a lessor to the seller s right to reclaim under U.C.C. 2-702 and Bankruptcy Code 546(c) (but, of course, a lessor owns the goods; that right may be qualified in bankruptcy as discussed, infra). Accordingly, the trustee could argue that the buyer s or lessee s claim is a preference (i.e., getting the goods would be a transfer to the extent of satisfaction of the antecedent debt represented by any prepaid price or rent). The trustee could also possibly assert the priority of the trustee s hypothetical lien under Bankruptcy Code 544 (but the right of a lien creditor against an innocent purchaser may not be clear; a lien creditor generally only takes what remains after the buyer or lessee s claim). The trustee also might reject the contract in an appropriate case as executory under Bankruptcy Code 365, which might reduce the buyer or lessee s claim to damages as an unsecured creditor. See generally U.C.C. 2-403; Bankr. Code 365, 544, 547; supra Chapter Two; infra this Chapter, Part C. Other ambiguities also exist; for example, can the buyer or lessee assert a right to specific performance? See U.C.C. 2-716 and 2A-521 (2A-507A). In the case of Proyectos Electronicos, S.A. v. Alper, 37 B.R. 931 (Bankr. E.D. Pa. 1983), the answer given was yes. Yet again, this right to specific performance to obtain the goods may result in a preference under Bankruptcy Code 547. These considerations suggest that the buyer or lessee should seek expert legal advice. In re Adams Plywood, Inc., 48 B.R. 719 (Bankr. W.D. Tenn. 1985), is an instructive case, in which the buyer received defective goods and consequently rejected them under U.C.C. 2-601. The buyer then sought to recover the price paid in the seller s bankruptcy, asserting a right under Bankruptcy Code 546(c). The court applied Bankruptcy Code 546(c) literally and refused to extend it from sellers to buyers, pointing out that the buyer s remedy was under U.C.C. 2-711(3) ( 2A-508(5); 2A-508(4)), unless it had not returned the goods. Therefore, the buyer should have retained the goods in order to secure a claim to recover the purchase price.

150 The ABCs of the UCC: Related Insolvency Law C. EXECUTORY CONTRACTS AND UNEXPIRED LEASES As a general matter, Bankruptcy Code 365 allows the trustee in bankruptcy to assume or reject an executory contract or an unexpired lease. 8 Although a sales contract can be executory, this power is far more relevant with respect to leases. If the trustee assumes the lease, presumably because it is advantageous to the bankruptcy estate, any default must be cured or adequate assurance of cure must be provided, compensation for any actual pecuniary loss resulting from the default must be provided or assured, and adequate assurance of future performance must be given. Bankruptcy Code 365(b). 9 Bankruptcy Code 365(c) contains further restrictions upon assumption and there are timing requirements and duties in Bankruptcy Code 365(d). 10 A lessor s ability to prevent assumption or assignment because of a lease provision or because of state law basically is ineffective under Bankruptcy Code 365(e) and (f) unless the lessor cancelled before bankruptcy commenced, but is subject to Code 521(d). 8 Under Bankruptcy Code 365(p)(2)(A), a debtor who is an individual in a Chapter 7 case may notify the creditor that he or she desires to assume the lease. The creditor may agree and may condition the assumption on cure of default. If the lease is assumed, the liability under the lease is the debtor s and not that of the bankruptcy estate. Similar provisions exist for Chapter 11 and 13 cases under Code 365(p)(3) specifying the lease is considered rejected if not assumed in the plan confirmed. If a lease is involved in a Chapter 13 proceeding, the Chapter 13 debtor within sixty days of filing the petition must provide to the lessor evidence of insurance on the property, and must commence payments within thirty days of filing the petition and provide proof of payment to the trustee. Code 1326. 9 See also Bankruptcy Code 1110(a) and United Airlines, Inc. v. U.S. Bank, N.A., 406 F.3d 918 (7th Cir. 2005), reh g en banc den., 409 F.3d 812 (7th Cir. 2005), cert. dismissed, 126 S.Ct. 508 (U.S. 2005), applying, however, a special rule to promote financing to the airline industry. 10 Code 365 imposes on a trustee a duty to perform all lease obligations commencing on the 61st day after entry of an order for relief in a Chapter 11 case until a lease is assumed or rejected (except for a consumer lease), but does not provide a remedy if there is a failure to do so. The court in In re Midway Airlines Corp., 406 F.3d 229 (4th Cir. 2005) allowed rent, taxes, interest, late fees, and attorney s fees due under the lease as an administrative expense.

Chapter 4 Articles 2 and 2A and Insolvency Law 151 If the trustee rejects an unexpired lease for example, on behalf of the lessee (presumably because the lease terms are not advantageous) the rejection constitutes a breach under Bankruptcy Code 365(g) and can result in a claim by the lessor against the estate, which is unlikely to receive full payment but will, in most instances, enable the lessor to retrieve the goods. Under Bankruptcy Code 365(p)(1), rejection or untimely assumption releases the property as property of the estate, and terminates the automatic stay. As to other stay terminations with respect to leases, see Bankruptcy Code 362, 521 and 365(p)(3). In In re Stonebridge Technologies, Inc., 430 F.3d 260 (5th Cir. 2005), the trustee sued the lessor on the basis it had drawn prematurely on a letter of credit put up as security for the lease. The court held that once the lessee was in default, the lessor was entitled to its remedies, including drawing on the letter of credit, and even though the lessor had filed no proof of claim, the lease allowed acceleration and the lessor was then entitled to all accrued rent, plus rent for the remainder of the lease discounted to present value, less the fair rental value for the remainder of the term also discounted, as the measure of damages to which the lessor was entitled. The court also held that as no proof of claim had been filed, the cap on damages in Bankruptcy Code 502(b)(6) was inapplicable. This issue, although it relates only to leases of real property, came up again in In re Mayan Networks Corp., 306 B.R. 295 (B.A.P. 9th Cir. 2004), and that case should be consulted. If the lessor has filed bankruptcy, rejection might be viewed as requiring the lessee to relinquish the goods; however, the outcome here is unclear even though other comparable provisions allow real estate tenants to remain in possession if they continue their performance obligations. This problem is somewhat uncommon, as the lessor in bankruptcy likely needs the lessee s lease payments and therefore will probably reject the lease only if it is significantly under market rates. TKO Equipment Co. v. C & G Coal Co., 863 F.2d 541 (7th Cir. 1988), is an interesting, and questionable, case. The parties contract proclaimed that the contract was a lease (and it probably was),

152 The ABCs of the UCC: Related Insolvency Law but the lessor immediately filed a U.C.C. Article 9 financing statement (sometimes called a U.C.C.-1). Id. U.C.C. 9-505. The court surmised that the financing statement was filed because, while lessor status would allow the lessor to retrieve the property plus possible damages were the transaction to be rejected, failing that, secured status would at least allow recovery of the value of the property, how... much more comfy to be assured of receiving the property back, intact. TKO Equip., 863 F.2d, at 544. The court s point of view seems to suggest a degree of artfulness about the lessor s Article 9 filing when, in fact, the Article 9 filing was consistent with lessor status as a precaution in case the lease was recharacterized as a security interest. Id. 9-505. In any case, between these two parties, the court believed that a third party could have been misled by the lessor s after-the-fact attempt to recharacterize the lease as a secured sale and, therefore, held that the lessor was bound by its own characterization of the transaction as a lease. A second interesting case also involving U.C.C. Article 9 is In re Commercial Money Center, Inc., 56 U.C.C. Rep. Serv. 2d 54 (Bankr. S.D. Cal. 2005), rev d 2006 WL 2505205 (BAP 9th Cir. 2005), where a person bought the right to receive the payments under equipment leases. If the transaction was a purchase of a payment intangible, the buyer would be automatically perfected under U.C.C. 9-309(3) and defeat the bankruptcy trustee under Bankruptcy Code 544. If the transaction was a loan secured by payment intangibles, or if the property were chattel paper, the result would be different. The Bankruptcy court determined the property was chattel paper and the transaction was a loan. The U.C.C. does not decide how to characterize the type of transaction; here the seller would receive any excess collections and had to indemnify a guarantor, which perhaps suggests a loan. As to the characterization of the property, see Official Comment 5(d) to U.C.C. 9-102 if the right to payment is assigned separately, the right is an account or payment intangible depending on how the account debtor s obligation arose. The 9th Circuit BAP held the payment streams could be carved out and were payment intangibles but agreed the transaction was a loan and not automatically perfected, and remanded to determine if perfection did exist in some other way.