The following is a case update prepared by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, analyzing a recent decision of interest:
A California appellate court has held that a purchaser of conditional sales contracts was liable for the debts of two defaulting vehicle dealerships because the senior inventory lender retained the vehicles’ title certificates. [Ron Miller Enterprises, Inc., vs. Lobel Financial Corp., Inc., 2019 Westlaw 1199523 (Cal.App.).]
Facts: An inventory lender provided short-term loans to two automobile dealers. For each vehicle, the dealerships executed an agreement identifying that vehicle as collateral. The inventory lender took possession of each vehicle’s title certificate and filed UCC-1 financing statements against each dealer.
The dealers then sold the vehicles to consumers under conditional sales contracts. Those contracts were then sold to an assignee. Following the dealers’ default on their obligations to the inventory lender, the inventory lender brought suit against the assignee, on the theory that the assignee should have paid the inventory lender in order to acquire the title certificates. The trial court ruled in favor of the assignee, finding (1) that there was no intent on the part of the inventory lender to create a security interest in the vehicles and (2) that there was no obligation on the part of the assignee to pay the inventory lender.
Reasoning: The appellate court first held that the “collateral agreements” were tantamount to security agreements and that a security interest had been created in the vehicles:
[The inventory lender] and the dealerships did intend to create a security interest in the vehicles identified within the collateral agreements. That intent was especially shown by the collateral agreements themselves . . . . [W]hen each loan advance was made by [the inventory lender] to a dealership under its line of credit, the dealership signed a separate collateral agreement specifically identifying a particular vehicle, stating the loan advance was “for” that particular vehicle, and requiring repayment of the loan advance upon the sale of the same vehicle or by a certain date, whichever was first to occur. The collateral agreements further provided that “If, for any reason, the vehicle is returned . . . to [the inventory lender] for non-payment, [the dealership] will pay the deficiency balance when [the inventory lender] disposes of the vehicle.” These terms plainly establish the vehicles described in the collateral agreements were intended to serve as collateral for, or to effectively secure, the loan advances. The fact that [the inventory lender] would have a right to dispose of a vehicle if the dealership defaulted leaves no room for doubt that an actual security interest in the vehicles was intended.
The court also noted that the inventory lender took physical possession of the title certificates for the vehicles: “[T]his course of performance evidenced the nature of the parties’ agreement as constituting a security interest.” Similarly, the filing of the UCC-1 financing statements provided additional evidence of the parties’ overall intent to create a security interest.
The assignee next challenged the sufficiency of the collateral descriptions contained in the financing statements, but the court concluded that the descriptions, although broad, were adequate, and the inventory lender’s security interests were therefore properly perfected.
The court then held, however, that because the inventory lender’s security interest in the vehicles themselves terminated when those vehicles were sold to consumers, the inventory lender’s lien on the conditional sales contracts also terminated. Therefore, the inventory lender could not enforce its security interests against the assignee:
When [the assignee] purchased the conditional sales contracts from the dealerships, the security interests that had previously existed in the vehicles while they were in inventory no longer continued. Consequently, to the extent that [the inventory lender] is seeking relief against [the assignee] (i.e., payment for the title certificates) as a remedy for enforcement of the security interests as such, [the inventory lender’s] claim falls short and cannot prevail.
Nevertheless, citing Quartz of Southern California, Inc. v. Mullen Bros., Inc., 151 Cal.App.4th 901 (2007), the appellate court then held that the assignee was indeed liable to the inventory lender. The trial court had held that Quartz was distinguishable because that case involved the rights of a party that actually owned legal title to the vehicles in question, unlike the inventory lender in this case (which simply claimed a security interest in the vehicles). But the appellate court held that the assignee was liable for the dealers’ debts and that Quartz and the present case were congruent, even though Quartz did not involve Article 9 of UCC:
In both instances, the [assignee] was the party in the best position to prevent loss by obtaining the title certificates or making reasonable inquiry about the status and location of title prior to completing the purchase of the conditional sales contracts. . . . [The inventory lender] is in rightful possession of the title certificates and, under all the circumstances, [the assignee] is required to pay [the inventory lender] to obtain them.
Author’s Comment: With reference to the first issue (the existence of the inventory lender’s senior security interest), the court is clearly right. However, it would have been nice if the first lender had actually stated, in its “collateral agreements,” that it was taking a security interest in the vehicles and their proceeds, rather than having to force the court to cobble together the security agreement from a variety of documents and the parties’ course of dealing.
With respect to the second issue (the duty of the assignee to pay the dealers’ debts to the senior inventory lender), this appears to be a case of “possibly right result, probably wrong measure of damages, and certainly wrong reason.” The issues are much more complicated than the court’s analysis would indicate.
First, the court is just wrong that the senior lender’s security interest terminated for all purposes when the cars were sold. Yes, the buyers of the cars took free of the lien. But the senior lien still followed the proceeds of the original collateral and attached to the conditional sales contracts, the chattel paper sold to the junior assignee. Under Cal. Comm. Code §9315(a)(2), “a security interest attaches to any identifiable proceeds of collateral.”
The conditional sales contracts were “chattel paper” under §9102(a)(11), and they were “proceeds” of the vehicles under §9102(a)(64)(A): “whatever is acquired upon the sale . . . or other disposition of collateral . . . .” To be more precise, they were “non-cash proceeds” under §9102(a)(58).
It is clear, therefore, that the inventory lender’s lien attached to the chattel paper. It is also clear that the sale of the chattel paper was a transaction within the scope of Article 9, even though it was an outright sale. See §9109(a)(3), and Comment 10(b) to §9330. Thus, under the usual rules of priority, the inventory lender would hold the senior interest, unless the assignee, the purchaser of the chattel paper, somehow took priority.
And maybe it did. See §9330:
(a) A purchaser of chattel paper has priority over a security interest in the chattel paper which is claimed merely as proceeds of inventory subject to a security interest if both of the following conditions are satisfied:
(1) In good faith and in the ordinary course of the purchaser’s business, the purchaser gives new value and takes possession of the chattel paper . . . .
(2) The chattel paper does not indicate that it has been assigned to an identified assignee other than the purchaser.
Given the sloppiness of the inventory lender’s documentation, we can safely assume that the chattel paper did not bear a “legend” indicating that it had been assigned. See Comment 5: “[S]ubsection (a) recognizes the common practice of placing a ‘legend’ on chattel paper to indicate that it has been assigned.” Therefore, the second of the two prongs of §9330(a) has probably been satisfied.
But what about the first prong? Let us assume that the assignee was acting in the ordinary course of its business when it took the assignment of the chattel paper. Was the assignee acting “in good faith,” given that the inventory lender had filed a financing statement?
The answer to that question is not obvious. Although the Commercial Code does not expressly say so, I am fairly sure that the mere existence of a prior UCC-1 would not be enough to poison the “good faith” of an assignee of chattel paper. I base that conclusion on Comment 6 to §9330:
In contrast to a junior secured party in accounts, who may be required in some special circumstances to undertake a search under the “good faith” requirement, . . . , a purchaser of chattel paper under this section is not required as a matter of good faith to make a search in order to determine the existence of prior security interests. There may be circumstances where the purchaser undertakes a search nevertheless, either on its own volition or because other considerations make it advisable to do so . . . . Without more, a purchaser of chattel paper who has seen a financing statement covering the chattel paper or who knows that the chattel paper is encumbered with a security interest, does not have knowledge that its purchase violates the secured party’s rights. However, if a purchaser sees a statement in a financing statement to the effect that a purchase of chattel paper from the debtor would violate the rights of the filed secured party, the purchaser would have such knowledge.
Note, however, that Comment 6 was drafted with reference to §9330(b), rather than §9330(a). And the focus of the comment is on whether the assignee of the chattel paper has “knowledge that the purchase violates the rights of the secured party,” rather than on the issue of “good faith” implicated under §9330(a)(1). Thus, although I conclude that the mere existence of a prior filing does not per se impeach the assignee’s “good faith,” I am not completely certain that I am right.
However, note that the title certificates to the vehicles were in the hands of the senior inventory lender at all times. The court in Quartz held (with little discussion) that this fact should have put the junior assignee on notice of the prior rights of the titleholder in that case:
[The assignee] is in the better position to prevent the loss caused by [the dealer] while minimizing the disruption of the efficient flow of used vehicles from dealers to consumers. The trial court found that [the assignee] did not act in a commercially reasonable manner when it failed to verify [the dealer’s] title before purchasing the sale contracts because a finance company could easily verify that a dealer had title, or it could ascertain who held the title and how much was owed to obtain it. [Id., 151 Cal.App.4th at 910-911.]
If that passage from Quartz really means that one who purchases chattel paper from a vehicle dealer is acting in a commercially unreasonable fashion if it fails to verify title, then that means that the assignee in the Ron Miller case did not observe reasonable commercial standards. “Good faith” is defined in §9102(43) as “honesty in fact and the observance of reasonable commercial standards of fair dealing.” Recall that in order to prevail over a prior inventory lender, a purchaser of chattel paper derived from that inventory must act in “good faith,” under §9330 (a) (1). Thus, if I am reading Quartz correctly, the purchaser did not take priority over the inventory lender.
The irony is that although Quartz may have been relevant for purposes of the §9330 “good faith” analysis (which the court completely omitted), Quartz is completely irrelevant in determining the rights of two conflicting secured parties, i.e., the inventory lender vs. the purchaser of the chattel paper. Section 9330 occupies that field, and it would be strange if a chattel paper purchaser who took priority under §9330 were nevertheless somehow liable for the debts of the dealership under a broad reading of Quartz. Recall, too, that the prior titleholder in Quartz was not an Article 9 creditor; thus, the Article 9 priority rules were arguably irrelevant in that case.
Now that we have determined that the chattel paper purchaser took the chattel paper subject to the senior inventory lender’s lien, what are the consequences of that fact? Let us carefully distinguish between two different concepts: (1) the chattel paper purchaser’s liability for conversion of the senior inventory lender’s collateral, and (2) the chattel paper purchaser’s liability for the debts of the dealerships to the inventory lender. If Quartz is controlling (as the court held), then the junior secured party, the assignee, is indeed liable for the debts of the defaulting borrower. But there is no authority under Article 9, as far as I know, for that proposition.
Instead, if we assume that the chattel paper purchaser did not qualify for priority under §9330(a), that means that in an act of tortious conversion, the chattel paper purchaser wrongfully took possession of the chattel paper. The purchaser would have to give the chattel paper back to the senior inventory lender and presumably would be liable for the damage resulting from the conversion. See, e.g., Central Cal. Equip. Co. v. Dolk Tractor Co., 78 Cal.App.3d 855, 144 Cal.Rptr. 367 (1978).
But the amount of that damage may be far less than the amount owed by the dealerships to the senior inventory lender. After all, the chattel paper was only as valuable as the creditworthiness of the consumers who bought the vehicles. Thus, if they were not creditworthy (as seems likely, given the fact that these were used vehicles), the chattel paper was not worth very much, and the chattel paper purchaser’s total liability may be relatively small. I would conclude that this matter should have been remanded for trial on that narrow issue.
To the extent that this decision stands for the proposition that a purchaser of chattel paper is liable for the debts owed by a debtor to a senior lender, it is simply bad law. The sole issue is whether the purchaser of the chattel paper takes priority under §9330 or not. To hold that an assignee of chattel paper risks liability for the assignor’s debts is to invade the province of the Commercial Code, endangering the entire chattel paper industry. Worse yet, this decision converts a simple priority dispute into a messy inquiry of who knew what and when, inviting expensive and protracted litigation.
For discussions of other cases dealing with conversion by junior secured parties, see:
- 2012 Comm. Fin. News. 58, Third Secured Party Is Liable for Conversion of Second Lienholder’s Collateral Due to Failure to Properly Document Subordination of First Lien.
- 2006 Comm. Fin. News. 40, Despite Subordination Agreement, Junior Lienholder Who Receives Cash Proceeds from Debtor’s General Account Takes Free of Senior Security Interest, Even Though Money Was Not Received in Ordinary Course of Business.
- 2005 Comm. Fin. News. 50, Secured Party May Sue Purchaser of Collateral for Impairment of Security, As Alternative to Repossession or Conversion Claims.
- 2005 Comm. Fin. News. 45, Despite Subordination Agreement, Blanket Lender Is “Ordinary Course Payee” and Is Not Liable for Conversion of Inventory Lender’s Proceeds.
- 2005 Comm. Fin. News. 02, Secured Party Lacks Standing to Prosecute Bankrupt Borrower’s Customer for Conversion of Collateral.
- 2003 Comm. Fin. News. 28, Secured Creditor May Trace Commingled Proceeds; Subordinated Creditor Is Liable for Conversion When Funds Are Taken from Account.
- 2003 Comm. Fin. News. 16, Lender Is Not Liable for Conversion Following Allegedly-Unauthorized Sale of Corporate Assets, Unless Lender Was in Control of Corporation.
These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them. Thank you for your continued support of the Committee.