Ninth Circuit BAP Holds Lease Payment Streams Are Not Chattel Paper

The debtor filed a voluntary Chapter 11 petition on May 30, 2002. Pursuant to a stipulated order, the debtor resigned as sub-servicer and the surety was authorized to take possession of the leases in March 2002, which would be within 90 days of the petition date. According to NetBank, it was not clear if the leases were removed from the debtor's possession at an earlier date prior to the 90-day window. The case was later converted to Chapter 7. The trustee sought to avoid NetBank's interests using its strong-arm powers, because NetBank had not perfected its interests, and as a preference, because any perfection occurred within 90 days of the petition date.

The case presents three issues:

1) Were the payment streams 'chattel paper' within the meaning of Revised Article 9?

2) Was the transaction a 'loan' or a 'sale'?

3) Did the bank perfect by taking possession through a third-party agent?

Issue # 1: Were the payment streams 'chattel paper' within the meaning of Revised Article 9?

Section 9-309(3) of Revised Article 9 provides that a sale of a payment intangible is perfected when it attaches, ie, no filing or other step is required to perfect the sale. Therefore, if the transaction at issue involved both a 'sale' and a 'payment intangible,' NetBank would prevail even if it were unable to prove that it took possession of the leases prior to the 90-day preference period (there was no serious issue that the lender had failed to perfect by filing a financing statement). On the other hand, if the transaction was not a 'sale' or did not involve a 'payment intangible,' then NetBank would lose unless it could prove that it had perfected by taking possession prior to the 90-day preference period.

The UCC defines a 'payment intangible' as 'a general intangible under which the account debtor's principal obligation is a monetary obligation' (UCC 9-102(a)(61)), and defines 'chattel paper' as 'a record or records that evidence both a monetary obligation and a security interest in specific goods ' or a lease of specific goods ” (UCC 9-102(a)(11)). According to the court:

This language on its face defines chattel paper to mean the 'records' that 'evidence certain things, including monetary obligations. Payment streams stripped from the underlying leases are not records that evidence monetary obligations ' they are monetary obligations. Therefore, we agree with NetBank that the payment streams are not chattel paper. [Opinion at page 15].

The court then went on to conclude that if the payment streams are not chattel paper, they must fall within the payment intangible subset of the catch-all definition of general intangibles. (The payment streams are not 'accounts' because the definition of accounts excludes 'rights to payment evidenced by chattel paper.')

The court stated that the plain language of the statute is usually conclusive. It considered whether the plain meaning of the statute conflicted with the policies behind it ' to provide certainty in financial transactions and some means for third parties to discover competing interests in property. The court concluded that the plain meaning of the statute did not conflict with such policies, or if it did, the role of the court was not to rewrite the statute.

First, the court distinguished an earlier case, In re Commercial Management Svc., Inc., 127 B.R. 296 (Bankr. D.Mass. 1991). In that case, the assignee, who was assigned only the payment streams and not the underlying equipment leases, took possession of the leases. The Chapter 7 trustee argued that the payment streams were general intangibles and that the assignee had not perfected its interest in the payment streams because it had not filed any financing statements (under former Article 9, there was no automatic perfection upon a sale of payment intangibles). The Commercial Management court rejected this argument, holding that the assignee perfected its security interest in the payment streams by taking possession of the leases. The court assumed that Commercial Management was correct but distinguished it on the basis that in that case the leases were delivered to the lender. In the instant case, the parties disputed whether NetBank took possession of the leases. This conclusion seems inconsistent with the holding that the payment streams constituted payment intangibles. Obviously, one cannot perfect a security interest in payment streams by possession. Yet the court seems to be saying that possession of the chattel paper also perfects the 'stripped out' payment streams.

Second, the court considered the Trustee's argument that if Revised Article 9 permitted purchases of payment streams under leases to be automatically perfected, as the court held, this would permit secret interests. For example, an unscrupulous debtor could transfer interests in the same payment streams more than once. In general, the party who is the first to perfect will prevail (UCC 9-322(1)(a)). The more difficult example is if a secured party purchases an interest (and takes possession) of the chattel paper leases after the debtor has already sold the payment streams to someone else. Because these payment streams are automatically perfected, the second secured party may have no way of discovering the prior 'security interest.' It's an open question whether the second secured party would prevail under UCC 9-330(b) (and related UCC 9-330(c) and 9-322(c)), which provide that a purchaser (here, the second secured party) has priority over a security interest (here, the secret interest) in the chattel paper if the purchaser gives new value and takes possession of the chattel paper in good faith, in the ordinary course, and without knowledge that the purchase violates the rights of the holder of the prior but secret interest. This rule only applies to an interest 'in the chattel paper.' Under the holding, the payment streams stripped from the leases are not chattel paper, so arguably this special priority rule does not apply. On the other hand, under the holding of Commercial Management, it would seem that the second secured party should prevail. The court explicitly declined to resolve this issue. It was satisfied that the plain meaning of the chattel paper definition did not lead to a result that was demonstrably counter to the legislative intent.

Commentators have raised yet another issue, and one not considered by the court: the effect of UCC 9-318 on a priority dispute between a buyer of a payment stream under a lease and a subsequent purchaser of the chattel paper. Assuming the transaction with the buyer is a 'true sale,' then under UCC 9-318(a) the debtor/seller no longer retains any interest in the payment stream that was sold. Therefore, the subsequent purchaser would arguably have a security interest in chattel paper devoid of any payments. UCC 9-318(b) ' which provides that the debtor/seller is deemed to have rights in accounts or chattel paper that is sold where the buyer's security interest is unperfected ' will not save the subsequent purchaser because under UCC 9-309(3) and the holding of the case, the buyer's security interest is automatically perfected.

Issue # 2: Was the transaction a 'loan' or a 'sale'?

As noted above, in order for NetBank to prevail, it needed to prove not only that the lease payments were 'payment intangibles' but also that they were sold. The court assumed without deciding that the Trustee bore the burden of proof on this issue.

Whether a transaction is a sale or a loan is based on the intentions of the parties as determined from all the facts and circumstances surrounding the transaction. NetBank pointed to numerous alleged characteristics of sales in the documents, eg, the lack of typical loan provisions (such as guarantees and foreclosure rights), the assignment of the payment streams was 'without recourse,' and the fact that the debtor was permitted but not required to make servicer advances. On the other hand, the court found several strong indicia of a loan rather than a sale:

• Each month the debtor was required to pay NetBank a minimum fixed amount, regardless of what was paid by the lessees;
• The debtor bore all the costs of collection and received no servicing fees;
• If there was a shortfall at the end of the collection period, the debtor was required to make up the shortfall and pay ongoing 'interest' until all 'principal' was repaid in full;
• Any residual value in the transferred assets was returned to the debtor with no possibility that NetBank would receive more than repayment of the 'principal' and 'interest'; and
• The debtor was contractually obligated to indemnify the surety on the surety bond.

In other words, the bank had none of the potential benefits of ownership and was contractually allocated none of the risk of loss when the transactions were entered into. Accordingly, the court held that the transactions were loans, not sales, and NetBank's interest was not automatically perfected.

Issue # 3: Did the bank perfect by taking possession through a third-party agent?

NetBank conceded that it never took possession of the leases itself; instead, it argued that it had possession through the surety as a third-party agent or through the debtor as sub-servicer.

The court easily disposed of the second argument. The debtor cannot be NetBank's agent (UCC 9-313(3)). With respect to the first argument, the court agreed with NetBank that there was a genuine issue of material fact as to who had possession, when, and in what capacity. For example, the stipulated order under which the debtor resigned as sub-servicer dealt with documents and records 'not previously made available to the Sureties,' which suggested that the surety may have had possession of the leases before the date of the order.

Conclusion

The first holding ' that a payment stream stripped from chattel paper is a payment intangible ' is quite worrisome to chattel paper purchasers. If the transaction with the buyer of the payment stream is held to be a true sale, the buyer's security interest is automatically perfected under UCC 9-309(3). While a good argument can be made that the subsequent chattel paper purchaser who takes possession should prevail under UCC 9-330(b), the court itself acknowledged that this special priority rule may not apply. The court invited a legislative amendment, and perhaps one is in order. For example, UCC 9-309(3) could be amended to expressly exclude payment intangibles derived from chattel paper, and the language of UCC 9-318(b) and 9-330(b) could be amended to make clear that the subsequent chattel paper purchaser who takes possession would have priority over a buyer of the payment stream.

Barry A. Graynor is a special counsel in the San Francisco office of Cooley Godward Kronish LLP. He specializes in credit finance and equipment leasing, in particular shipping containers and other transportation equipment. He may be reached at 415-693-2136 or [email protected].

In August 2006 the U.S. Bankruptcy Appellate Panel of the Ninth Circuit rendered a decision in a case titled In Re: Commercial Money Center, Inc. (Netbank, FSB v. Kipperman), U.S. Bankruptcy Appellate Panel of the Ninth Circuit, BAP No. SC-05-1238-MoTB; Bk.No. 02-09721-H7; Adv. No. 03-90331-H7, holding that payment streams stripped from equipment leases are payment intangibles, not chattel paper, and thereby overturning the bankruptcy court decision. Accordingly, the assignment of the payment streams could be automatically perfected under '9-309(3) of Revised Article 9. Additionally, the court agreed with the bankruptcy court and held that the transactions in this case were loans, not sales, so there was no automatic perfection. Finally, the court held that there were unresolved factual and legal issues as to whether the lender had perfected its security interest in the leases by taking possession through a third-party agent, and therefore remanded the case for further proceedings.

The facts are relatively straightforward. The debtor, Commercial Money Center, leased equipment to lessees with sub-prime credit and assigned its contractual rights to future lease payments to NetBank. As part of the transaction, the debtor obtained a surety bond guaranteeing the payments and assigned its rights under the surety bond to NetBank. In addition, the debtor granted to NetBank a security interest in the underlying leases and other property. Each transaction involved a Sale and Servicing Agreement ('SSA') among NetBank, the debtor, and the surety.

Language in the SSA pointed to both a sale and a loan. For example, in one section of the SSA, the parties stated that they intend each assignment and transfer to constitute a sale and assignment outright, and not for security. On the other hand, another section of the SSA indicated that the parties structured the transaction with the intention that it qualify as indebtedness of the debtor secured by the leases for tax purposes. The SSA appointed the surety as 'servicer' and the debtor as 'sub-servicer.' NetBank was under no obligation to pay any servicing fee. Regardless of the amounts collected under the leases, the surety/debtor were required to pay a fixed monthly amount to NetBank including a final payment of any remaining 'Principal Balance' and 'Interest.' If a lessee fell behind, the surety/debtor could call on the surety bond or make a 'Servicer Advance' to NetBank to cover the shortfall. When all 'Principal' and 'Interest' payments were made, the SSA provided for any residual assets to be transferred back to the debtor. The governing law was that of Nevada. However, the court recognized that there were no material differences between the Nevada UCC and the uniform versions of the relevant provisions.

The debtor filed a voluntary Chapter 11 petition on May 30, 2002. Pursuant to a stipulated order, the debtor resigned as sub-servicer and the surety was authorized to take possession of the leases in March 2002, which would be within 90 days of the petition date. According to NetBank, it was not clear if the leases were removed from the debtor's possession at an earlier date prior to the 90-day window. The case was later converted to Chapter 7. The trustee sought to avoid NetBank's interests using its strong-arm powers, because NetBank had not perfected its interests, and as a preference, because any perfection occurred within 90 days of the petition date.

The case presents three issues:

1) Were the payment streams 'chattel paper' within the meaning of Revised Article 9?

2) Was the transaction a 'loan' or a 'sale'?

3) Did the bank perfect by taking possession through a third-party agent?

Issue # 1: Were the payment streams 'chattel paper' within the meaning of Revised Article 9?

Section 9-309(3) of Revised Article 9 provides that a sale of a payment intangible is perfected when it attaches, ie, no filing or other step is required to perfect the sale. Therefore, if the transaction at issue involved both a 'sale' and a 'payment intangible,' NetBank would prevail even if it were unable to prove that it took possession of the leases prior to the 90-day preference period (there was no serious issue that the lender had failed to perfect by filing a financing statement). On the other hand, if the transaction was not a 'sale' or did not involve a 'payment intangible,' then NetBank would lose unless it could prove that it had perfected by taking possession prior to the 90-day preference period.

The UCC defines a 'payment intangible' as 'a general intangible under which the account debtor's principal obligation is a monetary obligation' (UCC 9-102(a)(61)), and defines 'chattel paper' as 'a record or records that evidence both a monetary obligation and a security interest in specific goods ' or a lease of specific goods ” (UCC 9-102(a)(11)). According to the court:

This language on its face defines chattel paper to mean the 'records' that 'evidence certain things, including monetary obligations. Payment streams stripped from the underlying leases are not records that evidence monetary obligations ' they are monetary obligations. Therefore, we agree with NetBank that the payment streams are not chattel paper. [Opinion at page 15].

The court then went on to conclude that if the payment streams are not chattel paper, they must fall within the payment intangible subset of the catch-all definition of general intangibles. (The payment streams are not 'accounts' because the definition of accounts excludes 'rights to payment evidenced by chattel paper.')

The court stated that the plain language of the statute is usually conclusive. It considered whether the plain meaning of the statute conflicted with the policies behind it ' to provide certainty in financial transactions and some means for third parties to discover competing interests in property. The court concluded that the plain meaning of the statute did not conflict with such policies, or if it did, the role of the court was not to rewrite the statute.

First, the court distinguished an earlier case, In re Commercial Management Svc., Inc., 127 B.R. 296 (Bankr. D.Mass. 1991). In that case, the assignee, who was assigned only the payment streams and not the underlying equipment leases, took possession of the leases. The Chapter 7 trustee argued that the payment streams were general intangibles and that the assignee had not perfected its interest in the payment streams because it had not filed any financing statements (under former Article 9, there was no automatic perfection upon a sale of payment intangibles). The Commercial Management court rejected this argument, holding that the assignee perfected its security interest in the payment streams by taking possession of the leases. The court assumed that Commercial Management was correct but distinguished it on the basis that in that case the leases were delivered to the lender. In the instant case, the parties disputed whether NetBank took possession of the leases. This conclusion seems inconsistent with the holding that the payment streams constituted payment intangibles. Obviously, one cannot perfect a security interest in payment streams by possession. Yet the court seems to be saying that possession of the chattel paper also perfects the 'stripped out' payment streams.

Second, the court considered the Trustee's argument that if Revised Article 9 permitted purchases of payment streams under leases to be automatically perfected, as the court held, this would permit secret interests. For example, an unscrupulous debtor could transfer interests in the same payment streams more than once. In general, the party who is the first to perfect will prevail (UCC 9-322(1)(a)). The more difficult example is if a secured party purchases an interest (and takes possession) of the chattel paper leases after the debtor has already sold the payment streams to someone else. Because these payment streams are automatically perfected, the second secured party may have no way of discovering the prior 'security interest.' It's an open question whether the second secured party would prevail under UCC 9-330(b) (and related UCC 9-330(c) and 9-322(c)), which provide that a purchaser (here, the second secured party) has priority over a security interest (here, the secret interest) in the chattel paper if the purchaser gives new value and takes possession of the chattel paper in good faith, in the ordinary course, and without knowledge that the purchase violates the rights of the holder of the prior but secret interest. This rule only applies to an interest 'in the chattel paper.' Under the holding, the payment streams stripped from the leases are not chattel paper, so arguably this special priority rule does not apply. On the other hand, under the holding of Commercial Management, it would seem that the second secured party should prevail. The court explicitly declined to resolve this issue. It was satisfied that the plain meaning of the chattel paper definition did not lead to a result that was demonstrably counter to the legislative intent.

Commentators have raised yet another issue, and one not considered by the court: the effect of UCC 9-318 on a priority dispute between a buyer of a payment stream under a lease and a subsequent purchaser of the chattel paper. Assuming the transaction with the buyer is a 'true sale,' then under UCC 9-318(a) the debtor/seller no longer retains any interest in the payment stream that was sold. Therefore, the subsequent purchaser would arguably have a security interest in chattel paper devoid of any payments. UCC 9-318(b) ' which provides that the debtor/seller is deemed to have rights in accounts or chattel paper that is sold where the buyer's security interest is unperfected ' will not save the subsequent purchaser because under UCC 9-309(3) and the holding of the case, the buyer's security interest is automatically perfected.

Issue # 2: Was the transaction a 'loan' or a 'sale'?

As noted above, in order for NetBank to prevail, it needed to prove not only that the lease payments were 'payment intangibles' but also that they were sold. The court assumed without deciding that the Trustee bore the burden of proof on this issue.

Whether a transaction is a sale or a loan is based on the intentions of the parties as determined from all the facts and circumstances surrounding the transaction. NetBank pointed to numerous alleged characteristics of sales in the documents, eg, the lack of typical loan provisions (such as guarantees and foreclosure rights), the assignment of the payment streams was 'without recourse,' and the fact that the debtor was permitted but not required to make servicer advances. On the other hand, the court found several strong indicia of a loan rather than a sale:

• Each month the debtor was required to pay NetBank a minimum fixed amount, regardless of what was paid by the lessees;
• The debtor bore all the costs of collection and received no servicing fees;
• If there was a shortfall at the end of the collection period, the debtor was required to make up the shortfall and pay ongoing 'interest' until all 'principal' was repaid in full;
• Any residual value in the transferred assets was returned to the debtor with no possibility that NetBank would receive more than repayment of the 'principal' and 'interest'; and
• The debtor was contractually obligated to indemnify the surety on the surety bond.

In other words, the bank had none of the potential benefits of ownership and was contractually allocated none of the risk of loss when the transactions were entered into. Accordingly, the court held that the transactions were loans, not sales, and NetBank's interest was not automatically perfected.

Issue # 3: Did the bank perfect by taking possession through a third-party agent?

NetBank conceded that it never took possession of the leases itself; instead, it argued that it had possession through the surety as a third-party agent or through the debtor as sub-servicer.

The court easily disposed of the second argument. The debtor cannot be NetBank's agent (UCC 9-313(3)). With respect to the first argument, the court agreed with NetBank that there was a genuine issue of material fact as to who had possession, when, and in what capacity. For example, the stipulated order under which the debtor resigned as sub-servicer dealt with documents and records 'not previously made available to the Sureties,' which suggested that the surety may have had possession of the leases before the date of the order.

Conclusion

The first holding ' that a payment stream stripped from chattel paper is a payment intangible ' is quite worrisome to chattel paper purchasers. If the transaction with the buyer of the payment stream is held to be a true sale, the buyer's security interest is automatically perfected under UCC 9-309(3). While a good argument can be made that the subsequent chattel paper purchaser who takes possession should prevail under UCC 9-330(b), the court itself acknowledged that this special priority rule may not apply. The court invited a legislative amendment, and perhaps one is in order. For example, UCC 9-309(3) could be amended to expressly exclude payment intangibles derived from chattel paper, and the language of UCC 9-318(b) and 9-330(b) could be amended to make clear that the subsequent chattel paper purchaser who takes possession would have priority over a buyer of the payment stream.

Barry A. Graynor is a special counsel in the San Francisco office of Cooley Godward Kronish LLP. He specializes in credit finance and equipment leasing, in particular shipping containers and other transportation equipment. He may be reached at 415-693-2136 or [email protected].