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On Perfected Security Interests, True Leases and Entrustment

Dispatches from the Trenches

This issue of Dispatches from the Trenches discusses the need for both a security agreement and a financing statement before a secured party has a validly perfected and enforceable security interest; true lease analysis under §1-201(37) of the Uniform Commercial Code; and the ability of a lessee who is a merchant dealing in goods of the kind being leased to convey to a purchaser greater rights than the lessee has under the lease.

In re: Outboard Marine Corp., 52 U.C.C. Rep. Serv.2d 488; 2003 Bankr. LEXIS 1356.

Outboard Marine Corporation (Debtor) filed a Chapter 11 petition and moved to sell all of its operating assets free and clear of all liens, claims, encumbrances and interests. Debtor's motion was objected to by Makino, which claimed a validly perfected security interest in certain pieces of manufacturing machinery it had sold to Debtor prior to the bankruptcy filing.

Makino, which requested partial summary judgment on this issue, contended that its purchase agreement with Debtor gave it an enforceable, properly perfected security interest in the machinery sold to Debtor and that it therefore was entitled to receive the proceeds of the sale of such machinery. The court determined that North Carolina state law applied to ascertain what property the debtor owned immediately preceding the time of bankruptcy, what liens existed on such property at that time, and the order of priority among the respective creditors holding such liens.

The court noted that Article 9 of the UCC requires two documents to create a perfected security interest in a debtor's collateral. First, there must be a signed security agreement adequately describing the collateral so that an "attachment" occurs. Second, the secured party must perfect its interest by filing a "financing statement" providing notice to other creditors that a security interest is claimed in the collateral.

The court initially found that Makino filed a financing statement in compliance with the UCC, but that it failed to execute a formal security agreement. However, Makino argued this financing statement, when read in combination with the language in the terms and conditions accompanying the invoices, constituted a sufficient basis to find that a security agreement was created.

The court noted that while most authorities conclude that a standard financing statement, in and of itself, does not create a security interest, courts uniformly hold that there are no "magic words" or precise formula necessary to create such an interest, as long as the formal requirements of the UCC are satisfied. The court considered the language of the preprinted invoice terms and conditions to reflect Makino's desire to create a security interest. However, the court determined the documents were silent as to Debtor's intent.

The court concluded that this uncertainty created a factual question that highlighted the need for further investigation. Since there was, in the court's opinion, a material factual dispute as to Debtor's intent to grant Makino a security interest, the court denied Makino's motion for partial summary judgment.

In re QDS Components, Inc., 292 B.R. 313, 50 U.C.C. Rep.Serv.2d 973 (Bankr. S.D. Ohio 2002).

In this case, the court undertook an extensive analysis of the Uniform Commercial Code test used to determine whether a transaction designated as a "lease" constitutes a "true lease" or a "disguised security interest." In its opinion, the court discussed true lease analysis under both the old and new version of § 1-201(37), which defines the term "Security Interest", including the Multiple Factor Approach, Percentage Test, The Option Price/FMV Test, the Economic Realities Test, and the new Bright-Line Test. The court detailed all of the tests and noted how different courts applied these tests, and the comments and criticisms of courts and commentators on each of these tests.

After its historical discussion, the court applied the Bright-Line Test. According to the court, this test contains two substantive prongs and satisfaction of these prongs would result in a transaction being characterized as a disguised security interest as a matter of law. Even if the Bright-Line Test was not satisfied, the court noted that the UCC then allows for a facts-and circumstances-test, which would result in a true lease only if, under the circumstances, the lessor still held some meaningful reversionary interest at the end of the lease term.

In this case the court held that the first prong of the Bright-Line Test was satisfied since the lessee could not terminate its obligation to make payments for the entire term. However, the court held that the party wishing to characterize the transaction as a disguised security interest did not satisfactorily prove the second prong of the Bright-Line Test since it did not present evidence of the reasonable expectations of the parties as to the cost of return or fair market value of the leased equipment at the end of the leases. The court also refused to apply other tests advanced to established that the option price was nominal.

In holding that the lessors maintained a meaningful reversionary interest the court again focused on the challenging party's failure to submit sufficient evidence. This lack of evidence led the court to conclude that the lease agreements were true leases under UCC § 1-201(37).

Mercedes-Benz Credit Corp. v. Johnson, 110 Cal. App. 4th 53, 1 Cal. Rptr. 3d 396, 51 UCC Rep.Serv.2d 168 (Cal. Ct. App. 2003).

An affiliate of Mercedes-Benz Credit named Calabasas Motor Cars (Lessor) leased a car to Hassan Marzban (Lessee). Although the terms of the lease only permitted Lessee to use the car, Lessee immediately sold it at his used car dealership to Terry Johnson (Purchaser). Lessee then stopped making payments on the car. Lessor filed a claim for breach of contract against Lessee and Purchaser, and alleged a superior interest in the vehicle.

Purchaser disputed this claim under §2A-305(b) of the Uniform Commercial Code, which states: "[a] buyer in the ordinary course of business or a sublessee in the ordinary course of business from a lessee who is a merchant dealing in goods of that kind to whom the goods were entrusted by the lessor obtains, to the extent of the interest transferred, all of the lessor's and lessee's rights to the goods, and takes free of the existing lease contract." Purchaser argued that this provision resulted in him having title to the car free and clear of any interest held by Lessor since he purchased it from a licensed used car dealer in the ordinary course of business.

Section 2A-305 provides a lessee who is a merchant dealing in goods of that kind with the ability to convey greater rights than the lessee has under the lease. As stated by one well-respected commentator: "if an owner leases goods to a dealer and the dealer is in the business of dealing in such goods both new and used, a sale by the dealer to a buyer in the ordinary course of business will cut off the owner's rights, and a lease to a lessee in the ordinary course of business will cut off the owner's rights to the extent of the lease." See Hawkland, Uniform Commercial Code Series, §2A-305:02.

In this particular case, the court analyzed the term "entrusting" and held the Lessor's leasing of goods to Lessee did not constitute the type of entrustment that would allow Lessee to pass clean title to Purchaser under §2A-305. However, anyone wishing to rely on this analysis should carefully review the UCC law in the applicable state since this case turns on a non-uniform definition of "entrustment" found in California's version of the UCC. Basically, the California Legislature had added language to the standard UCC definition of "entrustment" found in §2-403(3) so that delivery must have been provided to the merchant "for the purpose of sale, obtaining offers to purchase, locating a buyer, or the like." Jurisdictions following the uniform version of the UCC do not contain this additional language and define "entrustment" much more broadly.

Article appeared in the January, 2005 issue of the Monitor.
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