Perfecting Lease Payment Streams

CMC was in the business of originating commercial equipment leases. After obtaining a surety bond to guarantee payment under each lease, CMC would bundle all such leases and assign the payment streams under the equipment leases to third-party investors. CMC, despite being a sub-servicer under the surety agreements, assumed all of the duties and responsibilities associated with servicing the leases. In addition, CMC agreed to indemnify the surety.

During 1999 and 2000, NetBank invested in seven of these lease pools, paying more than $47 million for rights to payments under the leases. In addition to the lease payments, CMC assigned its rights in the surety bonds to NetBank. Under its agreement with CMC, NetBank received a fixed monthly payment including fixed payments of interest and principal. These payments accrued to NetBank regardless of whether payments were actually made pursuant to the underlying leases. NetBank did not file a UCC financing statement nor did it take possession of the original leases to perfect its interest in the payment streams under such leases.

In May 2002, CMC filed for bankruptcy protection and its trustee sought to avoid NetBank's interest in the lease payment streams. The bankruptcy court classified NetBank's interest in the lease payment streams as an interest in chattel paper, which would have required NetBank to file a UCC financing statement or take possession of the original leases in order to perfect its interest. The bankruptcy court also held that the transactions between CMC and NetBank were loans, thus precluding automatic perfection that would have been available if the court had otherwise classified the payment streams as payment intangibles rather than chattel paper and had determined that the transactions between NetBank and CMC were sales rather than loans. NetBank appealed to the appellate panel, which found that the payment streams were payment intangibles rather than chattel paper. However, the panel agreed with the bankruptcy court that the transactions constituted loans rather than sales. Therefore, since NetBank did not have the benefit of automatic perfection and since it did not file a financing statement against CMC, NetBank's interest was unperfected.

In order to understand the potential issues facing clients who deal with securitized lease payment streams, it is necessary to analyze the different ways in which courts might construe those interests under the UCC. This article will first examine the legal reasoning behind both the bankruptcy court's and the panel's decisions.

Chattel Paper vs. Payment Intangibles

The threshold issue in dealing with securitized assets in the post-CMC environment is whether the interest in such assets constitutes a payment intangible or chattel paper under the UCC. Chattel paper is defined under UCC '9-102(a)(11) (2001) as a record that evidences both a monetary obligation and a security interest in, or lease of, specific goods. In order to perfect a security interest in chattel paper, a holder must either file a financing statement under the UCC or take possession of the original lease. See, UCC ”9-102(a)(42), 9-102(a)(61) (2001). In contrast, the UCC defines 'payment intangible' as any personal property, other than chattel paper, under which the 'debtor's principal obligation is a monetary obligation.' Id. In a sale transaction, an interest in a payment intangible will be automatically perfected (UCC '9-309(3) (2001)); however, if the transaction is a loan, a holder must file a UCC financing statement in order to perfect its security interest under UCC ”9-310(a) (2001).

The bankruptcy court held that the lease payment streams were chattel paper because the underlying leases satisfied all the criteria of chattel paper under the UCC definition. In re Commercial Money Center, 2005 Bankr. LEXIS at *11. In so doing, the court did not view the payment streams as separate from the underlying equipment leases. In part, the court reasoned that characterizing the lease payment streams as payment intangibles would eliminate the monetary obligation requirement of chattel paper. Id. at *12. Under this analysis, NetBank's interests did not have priority over the CMC Trustee's interests because they were never perfected.

The appellate panel disagreed, however, distinguishing a 'monetary obligation evidenced by chattel paper [from] the chattel paper itself.' In re Commercial Money Center, 350 B.R. 465, 475. The court applied a strict statutory interpretation, reading 'evidenced' to be simply an adjective describing the records. Under this reasoning, written records must be present in order to characterize an interest as chattel paper under the UCC. Since the payment streams at issue were sold apart from the underlying equipment leases, the court determined that they fit more appropriately under the definition of payment intangibles. Under this analysis, NetBank would have priority in the context of a sale, since its interest would have been perfected automatically. The next issue that was addressed was whether the underlying transactions would be characterized as loans or sales.

Sales vs. Loans

While the courts in CMC disagreed about the classification of the payment streams under the equipment leases, both courts agreed that the underlying transactions constituted loans. Although the parties explicitly contracted for both a loan and a sale, varying by term, the courts emphasized the form of the transactions. In particular, the courts looked at the allocation of risk at the time of contracting, stating that 'for purposes of determining whether a transaction is a sale or a loan, a useful determining factor is who is economically at risk.' The transactions were relatively without risk for NetBank, since CMC assumed the risk of loss associated with servicing the leases. This de facto characterization is important to note, as the type of transaction will determine the availability of automatic perfection for payment intangibles if the underlying transaction is characterized as a sale rather than a loan.

Proposed UCC Amendments

The fundamental problem illustrated by the CMC decision is that since automatic perfection leaves no record that would put subsequent purchasers or lenders on notice of prior perfected interests, investors are unable to protect themselves against fraudulent transactions involving the duplicate sale of the payment intangibles to subsequent investors or lenders. The California Bar has suggested various amendments to the UCC that would explicitly link chattel paper and any related payment rights. These include amending the definition of 'chattel paper' in '9-102(a)(11) to include monetary obligations evidenced by related records, adding a provision that limits the definition of payment intangibles to exclude assignments of separate rights evidenced by chattel paper, and amending the UCC to give priority to subsequent purchasers who file or take possession of the chattel paper. See, California Bar Letter, pp. 7-8. The California Bar has also proposed eliminating automatic perfection altogether. Id. at 8-9.

Practitioners and legal scholars have also suggested amending the UCC. Some proposals include requiring purchasers of payment intangibles to either give notice or take possession of the underlying leases (Benjamin R. Norris, 'Lease Financing Transactions and 'In re Commercial Money Center Inc.,” 25 JOURNAL OF EQUIPMENT LEASE FINANCING 2, 4-5 (2007)), and either eliminating the automatic perfection rule or eliminating it in all transactions except those involving sales of loan participations between banks (Steven L. Schwarcz, 'Automatic Perfection of Sales of Payment Intangibles: A Trap for the Unwary,' 68 OHSLJ 273, 277-278 (2007)). While academics and practitioners struggle to address the new uncertainties left in the wake of CMC, it is important for attorneys to endeavor to protect their clients in these situations. While there is no foolproof method of protecting against prior, automatically perfected interests, attorneys should take certain precautions to limit their clients' exposure to risk.

Possible Protective Measures

CMC presents two main issues that an attorney must address to protect a client's security interests in chattel paper. First, how should an attorney determine the classification of a client's interest in payment streams in order to ensure proper perfection? Second, how may an attorney attempt to have the client's interest in payment intangibles protected against prior, automatically perfected interests in the same payment intangibles?

The general consensus is that prophylactic filing and taking possession of the underlying lease documents are both necessary to ensure proper perfection where the attorney is uncertain about whether a court would view the transaction as a loan or a true sale. See, Michael D. Sousa, 'Much Ado About Nothing?' 26-APR AM. BANKR. INST. J. 28, 83 (2007); see also Schwarcz, supra note 14 at 275-276. Alternatively, an investor can choose to take constructive possession by having possession of the original chattel paper transferred to a third party (other than the borrower or seller) acting as its agent. See, Prof. Dan Schechter, 'Outright Sale of Payment Intangibles May Be Automatically Perfected, but Sale That Allocates Credit Risk to Debtor May be Recharacterized as Disguised Loan,' 2006 COMM. FIN. NEWS. 68 (2006). Although some argue that these options undermine the intended benefit of an automatic perfection rule, it remains a necessary precaution in the post-CMC environment.

There are various precautionary measures that investors and their attorneys can undertake to protect against prior, automatically perfected interests. While none of these will completely eliminate the risk of duplicate transfers or fraudulent transactions, they may significantly reduce it. First, attorneys should perform a thorough due diligence review of the debtor/lessor. This may include spot-checking lessees in order to confirm that the debtor/lessor retains rights to the payment streams. It may also include a thorough due diligence review of the principals of the originator and any brokers involved in the transaction. See, Sousa, supra at 83. Second, attorneys should consider demanding representations by the lease originator, its principals, and guarantors attesting to the fact that the payment streams have not been assigned to any prior purchasers. See, Norris, supra at 5. Finally, investors in payment intangibles and their attorneys should consider legending the equipment lease agreements to clearly indicate their clients' interests. See, Prof. Dan Schechter, 'Outright Sale of Payment Intangibles May Be Automatically Perfected, but Sale That Allocates Credit Risk to Debtor May be Recharacterized as Disguised Loan,' 2006 Comm. Fin. News. 68 (2006). While investors should ideally legend the equipment lease agreements themselves, they may leave it to the debtor/lessor to do so, provided that they immediately verify that the leases have been properly legended.

Taking the steps outlined above may serve to help protect the interests of clients who make investments in or lend against equipment lease payment streams.

Conclusion

It remains to be seen whether lawmakers will ultimately react to the CMC case with clarification to the UCC. What does exist for an unsuspecting lender, as assignee of a lease and the rental payments evidenced thereby, however, is the real possibility that such lender seemingly perfects its security interest in such lease and rental payments only to find that it actually has no right to receive such related rental payments due to the prior sale of such rental payments separate from the lease. By taking the precautionary measures described in this article and with the proper due diligence conducted by its legal counsel, a lender shall be best protected from the dangers posed by the appellate court's findings in the CMC case.

This article originally appeared in the New York Law Journal, a sister publication of this newsletter.

Alan M. Christenfeld is a partner in the New York office of Clifford Chance U.S. Shephard W. Melzer is a partner and Debra Goldberg is senior counsel in the New York office of Fulbright & Jaworski L.L.P. Stephanie DeGiacomo, a summer associate at Fulbright & Jaworski, also assisted in the preparation of this article.

In August 2006, the U.S. Bankruptcy Appellate panel of the Ninth Circuit Court of Appeals (the 'panel') decided In re Commercial Money Center, 2006 Bankr. LEXIS 1080, *11 (9th Cir. 2006) ('CMC'). The panel held that payment streams stripped from equipment leases constituted payment intangibles under the Uniform Commercial Code (the 'UCC'). By thus expanding the collateral classification 'payment intangibles' under the UCC, this decision raised significant questions of law related to secured transactions and increased the risk associated with the securitization of lease payment streams.

More specifically, the decision in the CMC case is significant for two reasons: 1) by misconstruing an interest as either chattel paper or a payment intangible, it is now possible for a holder to unassumingly fail to perfect its interest in such chattel paper or payment intangible; and 2) it is now much easier for subsequent purchasers of securitized lease payment streams or of the associated chattel paper, or lenders taking a security interest therein, to fall victim to duplicate fraudulent transactions involving such payment streams or associated chattel paper. Since the prior sale of securitized lease payment streams which are classified as payment intangibles will be perfected automatically (without filing a UCC financing statement or taking possession of the underlying lease documents)there will be no notice to subsequent purchasers or lenders of such prior automatically perfected interests in the same lease payment stream. While attorneys, business professionals, and scholars discuss possible responses to these problems, it is up to legal practitioners to protect their clients in the interim. This article reviews the CMC case and its practical implications, provides an overview of some proposed amendments to the UCC with respect to such problems, and discusses suggestions of how to protect clients in the post-CMC environment.

Facts and Holding of CMC

CMC was in the business of originating commercial equipment leases. After obtaining a surety bond to guarantee payment under each lease, CMC would bundle all such leases and assign the payment streams under the equipment leases to third-party investors. CMC, despite being a sub-servicer under the surety agreements, assumed all of the duties and responsibilities associated with servicing the leases. In addition, CMC agreed to indemnify the surety.

During 1999 and 2000, NetBank invested in seven of these lease pools, paying more than $47 million for rights to payments under the leases. In addition to the lease payments, CMC assigned its rights in the surety bonds to NetBank. Under its agreement with CMC, NetBank received a fixed monthly payment including fixed payments of interest and principal. These payments accrued to NetBank regardless of whether payments were actually made pursuant to the underlying leases. NetBank did not file a UCC financing statement nor did it take possession of the original leases to perfect its interest in the payment streams under such leases.

In May 2002, CMC filed for bankruptcy protection and its trustee sought to avoid NetBank's interest in the lease payment streams. The bankruptcy court classified NetBank's interest in the lease payment streams as an interest in chattel paper, which would have required NetBank to file a UCC financing statement or take possession of the original leases in order to perfect its interest. The bankruptcy court also held that the transactions between CMC and NetBank were loans, thus precluding automatic perfection that would have been available if the court had otherwise classified the payment streams as payment intangibles rather than chattel paper and had determined that the transactions between NetBank and CMC were sales rather than loans. NetBank appealed to the appellate panel, which found that the payment streams were payment intangibles rather than chattel paper. However, the panel agreed with the bankruptcy court that the transactions constituted loans rather than sales. Therefore, since NetBank did not have the benefit of automatic perfection and since it did not file a financing statement against CMC, NetBank's interest was unperfected.

In order to understand the potential issues facing clients who deal with securitized lease payment streams, it is necessary to analyze the different ways in which courts might construe those interests under the UCC. This article will first examine the legal reasoning behind both the bankruptcy court's and the panel's decisions.

Chattel Paper vs. Payment Intangibles

The threshold issue in dealing with securitized assets in the post-CMC environment is whether the interest in such assets constitutes a payment intangible or chattel paper under the UCC. Chattel paper is defined under UCC '9-102(a)(11) (2001) as a record that evidences both a monetary obligation and a security interest in, or lease of, specific goods. In order to perfect a security interest in chattel paper, a holder must either file a financing statement under the UCC or take possession of the original lease. See, UCC ”9-102(a)(42), 9-102(a)(61) (2001). In contrast, the UCC defines 'payment intangible' as any personal property, other than chattel paper, under which the 'debtor's principal obligation is a monetary obligation.' Id. In a sale transaction, an interest in a payment intangible will be automatically perfected (UCC '9-309(3) (2001)); however, if the transaction is a loan, a holder must file a UCC financing statement in order to perfect its security interest under UCC ”9-310(a) (2001).

The bankruptcy court held that the lease payment streams were chattel paper because the underlying leases satisfied all the criteria of chattel paper under the UCC definition. In re Commercial Money Center, 2005 Bankr. LEXIS at *11. In so doing, the court did not view the payment streams as separate from the underlying equipment leases. In part, the court reasoned that characterizing the lease payment streams as payment intangibles would eliminate the monetary obligation requirement of chattel paper. Id. at *12. Under this analysis, NetBank's interests did not have priority over the CMC Trustee's interests because they were never perfected.

The appellate panel disagreed, however, distinguishing a 'monetary obligation evidenced by chattel paper [from] the chattel paper itself.' In re Commercial Money Center, 350 B.R. 465, 475. The court applied a strict statutory interpretation, reading 'evidenced' to be simply an adjective describing the records. Under this reasoning, written records must be present in order to characterize an interest as chattel paper under the UCC. Since the payment streams at issue were sold apart from the underlying equipment leases, the court determined that they fit more appropriately under the definition of payment intangibles. Under this analysis, NetBank would have priority in the context of a sale, since its interest would have been perfected automatically. The next issue that was addressed was whether the underlying transactions would be characterized as loans or sales.

Sales vs. Loans

While the courts in CMC disagreed about the classification of the payment streams under the equipment leases, both courts agreed that the underlying transactions constituted loans. Although the parties explicitly contracted for both a loan and a sale, varying by term, the courts emphasized the form of the transactions. In particular, the courts looked at the allocation of risk at the time of contracting, stating that 'for purposes of determining whether a transaction is a sale or a loan, a useful determining factor is who is economically at risk.' The transactions were relatively without risk for NetBank, since CMC assumed the risk of loss associated with servicing the leases. This de facto characterization is important to note, as the type of transaction will determine the availability of automatic perfection for payment intangibles if the underlying transaction is characterized as a sale rather than a loan.

Proposed UCC Amendments

The fundamental problem illustrated by the CMC decision is that since automatic perfection leaves no record that would put subsequent purchasers or lenders on notice of prior perfected interests, investors are unable to protect themselves against fraudulent transactions involving the duplicate sale of the payment intangibles to subsequent investors or lenders. The California Bar has suggested various amendments to the UCC that would explicitly link chattel paper and any related payment rights. These include amending the definition of 'chattel paper' in '9-102(a)(11) to include monetary obligations evidenced by related records, adding a provision that limits the definition of payment intangibles to exclude assignments of separate rights evidenced by chattel paper, and amending the UCC to give priority to subsequent purchasers who file or take possession of the chattel paper. See, California Bar Letter, pp. 7-8. The California Bar has also proposed eliminating automatic perfection altogether. Id. at 8-9.

Practitioners and legal scholars have also suggested amending the UCC. Some proposals include requiring purchasers of payment intangibles to either give notice or take possession of the underlying leases (Benjamin R. Norris, 'Lease Financing Transactions and 'In re Commercial Money Center Inc.,” 25 JOURNAL OF EQUIPMENT LEASE FINANCING 2, 4-5 (2007)), and either eliminating the automatic perfection rule or eliminating it in all transactions except those involving sales of loan participations between banks (Steven L. Schwarcz, 'Automatic Perfection of Sales of Payment Intangibles: A Trap for the Unwary,' 68 OHSLJ 273, 277-278 (2007)). While academics and practitioners struggle to address the new uncertainties left in the wake of CMC, it is important for attorneys to endeavor to protect their clients in these situations. While there is no foolproof method of protecting against prior, automatically perfected interests, attorneys should take certain precautions to limit their clients' exposure to risk.

Possible Protective Measures

CMC presents two main issues that an attorney must address to protect a client's security interests in chattel paper. First, how should an attorney determine the classification of a client's interest in payment streams in order to ensure proper perfection? Second, how may an attorney attempt to have the client's interest in payment intangibles protected against prior, automatically perfected interests in the same payment intangibles?

The general consensus is that prophylactic filing and taking possession of the underlying lease documents are both necessary to ensure proper perfection where the attorney is uncertain about whether a court would view the transaction as a loan or a true sale. See, Michael D. Sousa, 'Much Ado About Nothing?' 26-APR AM. BANKR. INST. J. 28, 83 (2007); see also Schwarcz, supra note 14 at 275-276. Alternatively, an investor can choose to take constructive possession by having possession of the original chattel paper transferred to a third party (other than the borrower or seller) acting as its agent. See, Prof. Dan Schechter, 'Outright Sale of Payment Intangibles May Be Automatically Perfected, but Sale That Allocates Credit Risk to Debtor May be Recharacterized as Disguised Loan,' 2006 COMM. FIN. NEWS. 68 (2006). Although some argue that these options undermine the intended benefit of an automatic perfection rule, it remains a necessary precaution in the post-CMC environment.

There are various precautionary measures that investors and their attorneys can undertake to protect against prior, automatically perfected interests. While none of these will completely eliminate the risk of duplicate transfers or fraudulent transactions, they may significantly reduce it. First, attorneys should perform a thorough due diligence review of the debtor/lessor. This may include spot-checking lessees in order to confirm that the debtor/lessor retains rights to the payment streams. It may also include a thorough due diligence review of the principals of the originator and any brokers involved in the transaction. See, Sousa, supra at 83. Second, attorneys should consider demanding representations by the lease originator, its principals, and guarantors attesting to the fact that the payment streams have not been assigned to any prior purchasers. See, Norris, supra at 5. Finally, investors in payment intangibles and their attorneys should consider legending the equipment lease agreements to clearly indicate their clients' interests. See, Prof. Dan Schechter, 'Outright Sale of Payment Intangibles May Be Automatically Perfected, but Sale That Allocates Credit Risk to Debtor May be Recharacterized as Disguised Loan,' 2006 Comm. Fin. News. 68 (2006). While investors should ideally legend the equipment lease agreements themselves, they may leave it to the debtor/lessor to do so, provided that they immediately verify that the leases have been properly legended.

Taking the steps outlined above may serve to help protect the interests of clients who make investments in or lend against equipment lease payment streams.

Conclusion

It remains to be seen whether lawmakers will ultimately react to the CMC case with clarification to the UCC. What does exist for an unsuspecting lender, as assignee of a lease and the rental payments evidenced thereby, however, is the real possibility that such lender seemingly perfects its security interest in such lease and rental payments only to find that it actually has no right to receive such related rental payments due to the prior sale of such rental payments separate from the lease. By taking the precautionary measures described in this article and with the proper due diligence conducted by its legal counsel, a lender shall be best protected from the dangers posed by the appellate court's findings in the CMC case.

This article originally appeared in the New York Law Journal, a sister publication of this newsletter.

Alan M. Christenfeld is a partner in the New York office of Clifford Chance U.S. Shephard W. Melzer is a partner and Debra Goldberg is senior counsel in the New York office of Fulbright & Jaworski L.L.P. Stephanie DeGiacomo, a summer associate at Fulbright & Jaworski, also assisted in the preparation of this article.