Which is the true statement about the rights of the debtor and the secured party after default?

Chapter 33 A Secured Party's Options On Default

A. Generally

As will be seen below, new Article 9 gives a secured party considerable flexibility with regard to satisfying a debt out of the collateral. However, as was stressed in Chapter 3 (The Nature of Secured Credit under Article 9), until a secured party has effectively foreclosed its security interest the debtor continues to be the owner of the collateral.  This reminder that a secured party has only a lien on property that is collateral for a debt is important to understanding the framework created by Article 9 for satisfying a debt out of the collateral.

Moreover, although the secured party’s options for foreclosing its security interest become available only after a default, the secured party must exercise its options to foreclose before the debtor ceases to be the owner of the collateral.  See, e.g., In re Cadiz Properties, Inc., 278 B.R. 744 (Bkcy N.D. Tex. 2002) (wherein the court rejected an argument by the creditor that an agreement according to which the debtor placed securities in escrow to secure a loan resulted in a transfer of ownership of the securities when the debtor defaulted on the loan).

What a secured party may or must do to satisfy a secured debt out of the collateral was governed primarily by Part 5 of former Article 9 and is governed by Part 6 of new Article 9.  The first choice to be made by an Article 9 secured party on default is whether to sue the debtor and go the route of a judgment and execution on non-exempt property or pursue Article 9 options for satisfying a debt out of the collateral.

New section 9-601(a) tracks former section 9-501(1) by providing that, after default, a secured party has the rights provided in Part 6, namely, to reduce a claim to judgment and enforce the claim by any available judicial procedure or, except as limited by new section 9-602, to proceed as provided for in the security agreement and exercise self help.  Ordinarily, a secured party will proceed under Article 9.  However, a secured party may choose to go the execution route where the collateral's value is such that a large deficiency is expected and there will have to be a lawsuit to collect what is owed anyway.  The execution route is governed by law outside Article 9.  Under new section 9-601(f), a secured party may purchase at an execution sale and thereafter holds the property free of any Article 9 requirements.  The downside of execution sales is that they bring notoriously low returns.  See B & S (cited in Chapter 3), Chs. 8 and 9.

By contrast, the Article 9 options for enforcing the security interest are intended to maximize the potential for recovery of the debt from the collateral and, correspondingly, to reduce the risk of large deficiencies.  In general terms, as is explained below and in the remainder of Part VII, the Article 9 options are to dispose of the collateral or to retain it in satisfaction of the debt.  What distinguishes these options from the execution route is that they may be pursued without judicial involvement, i.e., by exercising self help. 

Article 9 encourages freedom of contract.  Therefore, subject to certain limits discussed below, exactly what a secured party is permitted to do or must do may be spelled out in the security agreement.  See new 9-601(a), as discussed above.  Former Article 9 made the freedom of contract point through the repeated use of the phrase "unless otherwise agreed."  New Article 9 eschews this redundancy, but the ability to define rights and obligations, within certain limits, must be kept in mind.

Secured parties may not avoid by agreement the duties of good faith, diligence, reasonableness and care imposed at various points in Article 9 or other articles of the UCC.  This limitation on agreement is actually found in Article 1, 1-302(b) (formerly Article 1-102(3)).  New section 9-602 also limits the ability of a secured party to obtain a waiver or variance with respect to certain specified Article 9 duties and responsibilities.

Where rights and obligations may not be dispensed with by agreement, the parties are permitted to set the standards for determining whether rights have been honored or duties performed, so long as the standards agreed upon are not "manifestly unreasonable."  Although former Article 9 did not expressly so provide, parties could not change the obligation of a secured party to refrain from breaching the peace in the exercise of self help nor could they set standards as to what constituted a breach of the peace.  New section 9-603 makes these limitations explicit.

Under new Article 9, the restrictions on the ability of parties to alter Article 9 rights and obligations protect obligors as well as debtors. See new 9-602.  New Article 9 thereby resolves a question existing under former Article 9 whether parties such as guarantors are permitted to waive rights and protections that debtors may not.  It is important to distinguish "waivers" of rights or duties in a security agreement, which are subject to numerous limitations noted above, from agreements to waive certain Article 9 protections entered into after default, which by and large are enforceable.  See new 9-602 and 9-624.

Where the collateral consists of both personal property and real estate, a secured party may choose to enforce a security interest under real estate law as to both the real estate and personal property.  If a secured party chooses to proceed under real estate law the Article 9 provisions on foreclosure do not apply.  See new 9-604.  Under new Article 9 the option to proceed under real estate law extends to goods that are fixtures and decisions under former Article 9 holding that a secured party's only remedy as to fixtures was to remove them and pursue an Article 9 option are thereby rejected.  See Official Comment 3 to new 9-604.

Former Article 9 did not address the impact of "anti-deficiency" restrictions in real estate statutes, see B & S (cited in Chapter 3), Ch. 9, or rules against splitting causes of action against real estate and personal property.  New Article 9 also leaves these matters to the courts.  Cf. Official Comment 3 to new 9-604.

Former section 9-501(1) provided that "the rights and remedies referred to in this subpart are cumulative."  New section 9-601(c) provides that the rights with regard to enforceability are not only cumulative but may be exercised simultaneously.  New section 9-601(c) makes clear that a secured party is free to "mix and match" actions to enforce a security interest and no "election of remedies " results when a secured party proceeds initially through an exercise of self help, or vice versa.

Whether a secured party must sell all the collateral it has in its possession and whether a secured party who notices a sale of collateral securing more than one debt may proceed by judicial action as to the debts other than that specified in the notice are questions that remain to be conclusively answered.  On the other hand, a secured party who engages in conduct that constitutes abusive behavior or harassment risks liability under new Article 9, see Chapter 38 (Remedies for a Secured Party’s Failure to Comply with Article 9) or liability under non-UCC law, including tort liability.  See Official Comment 5 to new 9-601.

As noted in earlier chapters, under new section 9-102(a)(28) only a person having an interest in the collateral is a "debtor."  "Obligor" is separately defined in new section 9-102(a)(59) as the person who owes the debt. New section 9-601(d) indicates that both debtors and obligors have the rights provided for in Part 6 of new Article 9.  However, some care must be exercised in determining exactly what rights are enjoyed by which parties and what duties are owed to debtors or obligors, respectively.  The last is especially important insofar as the determination may impact the availability of a remedy for a failure of a secured party to comply with the requirements of Article 9.  See Official Comment 3 to new 9-625.

New Article 9 separately defines “secondary obligor” in new section 9-102(a)(71) as a person whose obligation is secondary or who has recourse against another, and many protections expressly run in favor of secondary obligors. However, according to Official Comment 2(a) to new section 9-102, the law of suretyship must be consulted to determine whether an obligation is secondary. The distinction could affect the ability of a party to assert suretyship defenses, such as impairment of the security, in an action for a deficiency. See Chapter 38 Remedies for a Secured Party’s Failure to Comply with Article 9).

New Article 9 explicitly provides in new section 9-605(1) that the duties owed by a secured party do not run to debtors or secondary obligors who are unknown to the secured party.  Thus, for example, a secured party has no duties as to a transferee of collateral from the debtor in a transaction as to which the security interest continues in the collateral unless the secured party is aware of the transfer.  Furthermore, under new section 9-605(2), a secured party has no duties to persons who become creditors of the transferee and take security interests in the collateral.

In Chapter 28 (Secured Party Versus Secured Party), it was pointed out that a secured party who has priority over another secured party under one or more of the Article 9 priority rules may agree to subordinate its security interest to a party as to which the agreeing party has priority.  A subordination agreement effectively alters the priority of the parties to the agreement that is dictated by the Article 9 priority rules.  However, an agreement to subordinate one’s priority does not affect the subordinated party’s ability to enforce its security interest under the rules explored in the remaining chapters of Part VII.  

A party who is junior to another party under the priority rules of Article 9 has the right to foreclose its security interest without regard to whether the senior party has done so.  The right of a junior party to do so exists even though its actions can complicate and even negatively affect the ability of a senior party to realize its debt out of the collateral.  See new section 9-615(g), as discussed in Chapter 35 (Disposing of Collateral to Satisfy a Secured Debt).  The same would be true of a party who is in a junior position because of a subordination agreement.

In Chesapeake Investment Services v. Olive Group Corp., 2003 WL 369682 (Mass. Super. 2003), the court appeared to conclude to the contrary.  Of course, a subordination agreement may include a provision under which the subordinated party agrees not to enforce its security interest until the senior party has done so.  However, the failure of the subordinated party to honor its promise would result only in a breach of contract and the aggrieved secured party would be left to whatever remedies are available as to such a breach.

It is important to be aware that the essential precondition of any attempt to enforce a security interest against collateral is that there be a default.  The enforcement provisions beginning with new section 9-601 contain the explicit prefacing language "after default" (or words to that effect).  As will be explained further in subpart G, action taken to collect a debt in the absence of default can have disastrous consequences for a secured party.  As will also be seen in subpart G, what constitutes a default as to a security interest is a matter of contract and a determination of whether there has been a default can be as difficult to make as decisions as to whether a contract has been breached or who is the breaching party.

It should go without saying that a creditor may not seek to satisfy a secured debt out of property that is not subject to a security interest (or lien).  This point was made as early as Chapter 3 (The Nature of Secured Credit under Article 9) and driven home in subpart E of Chapter 9 (The Specifics of Enforceability – After-acquired Collateral, Future Advances, Transferred Collateral and Proceeds, and the New Debtor Problem).  However, the secured party in Automotive Finance Corp. v. Smart Auto Center, Inc., 334 F.3d 685 (7th Cir. 2003) attempted exactly what is not permitted by Article 9, namely, to satisfy the secured debt from vehicles not subject to the security interest, and opened itself up to liability for damages for conversion.

There are situations where some interference with property not subject to a security interest is unavoidable as a practical matter. For example, a vehicle repossessed from a consumer debtor may well contain items that are not subject to the security interest. Courts will allow secured parties some leeway here, but care should be taken not to exercise any more dominion over the non-collateral items than is necessary.  See Nevada National Bank v. Huff, 582 P.2d 364 (Nev. 1978).  It is good practice in such situations for the secured party to prepare an inventory of items that are not subject to the security interest and make them available to the debtor as soon as is practicable.

As was seen in Chapter 4 (Scope of Article 9), new Article 9 now covers agricultural liens as well as security interests.  Under new section 9-606, a default as to such a lien occurs when the secured party is entitled to enforce the lien under the statute creating the lien.

B. Getting Possession of the Collateral

For the most part, secured parties choosing to dispose of or retain collateral to enforce a security interest must first get possession of the collateral.  Under new section 9-609(b)(2), a secured party may get possession of collateral by the exercise of self help or "repossession."  However, the right to exercise self help recognized in new section 9-609 is limited in that there must be no breach of the peace and this limitation cannot be dispensed with in the security agreement.  See new 9-602(6).  If there is an actual or threatened breach of the peace the secured party must seek judicial assistance.  Most states, including Arizona, have provisional remedy statutes to facilitate seizure of collateral by judicial process.

In some cases physical possession of collateral by a secured party will not be practical.  New sections 9-609(a)(2) and 9-609(b) permit a creditor to use judicial process or to use self-help (subject to the breach of the peace limitation in new section 9-609(b)(2)), to render equipment unusable and dispose of collateral on the debtor's premises.  Under new section 9-609(c), to the extent provided for in the security agreement, and at any time after default, a debtor may be required to assemble collateral and make it available to the secured party at a place reasonably convenient to both the debtor and the secured party.

As we saw in Chapter 15 (Perfection by Possession (Including Documents of Title)), a secured party in possession, including repossession after default, has the rights and responsibilities provided for in new section 9-207.  In particular, the secured party must exercise due care with regard to holding and preserving the property which belongs to the debtor until after the debtor's ownership interest has been foreclosed. As noted earlier, under Article 1, section 1-302(b) (formerly Article 1, section 1-102(3)) the duty of care cannot be waived by the debtor in the security agreement.  In the case of Nevada National Bank v. Huff, 582 P.2d 364 (Nev. 1978), the secured party was liable for damages for breaching the duty of care as to repossessed property that was stored in an place that was not reasonably secure.

As we have seen, disputes can arise between competing claimants as to who has the superior right to possession of the collateral. Thus, a secured party may find the sheriff has seized the collateral under a writ of execution or another secured party may already have repossessed the collateral.  The ultimate resolution of such disputes is largely a matter of sorting out priorities as discussed in Part VI.  The details of the ways that a secured party can get possession of the collateral are the subject of Chapter 34 (Getting Possession of the Collateral).

C. Disposing of or Retaining (Accepting) the Collateral in Complete or Partial Satisfaction of the Debt

After gaining possession a secured party may dispose of the collateral and apply the proceeds to the debt owed and to the expenses of foreclosure.  See new 9-615(a) and 9-610.  The rules governing dispositions are intended to maximize the return and minimize deficiencies, at least by contrast to execution sales.  Dispositions may be done without the assistance of a court and the rigid formalities associated with foreclosure sales of real estate or execution sales of both real estate and personal property do not apply to an Article 9 disposition.  Rather, under new sections 9-610(b) and 9-611(b), it is required only that reasonable notification be sent to persons entitled to such notification (or that the requirement of notification has been excused) and that a disposition be commercially reasonable.

Article 9 spells out how the proceeds of a disposition are to be applied.  See new 9-615(a).  It should be emphasized that under new section 9-615(a)(1), attorney's fees are chargeable against the proceeds only to the extent they are reasonable and are provided for in the security agreement.

Where a disposition does not bring enough to satisfy the debt and expenses, a secured party has the right to a deficiency but must account to the debtor for any surplus.  See new 9-615(d).  New Article 9 spells out the rules for calculating deficiencies and surpluses, requires that the calculation of a deficiency or surplus be explained to a consumer debtor, and sets forth procedures for resolving disputes regarding deficiencies and surpluses.  See new 9-615, 9-616 and 9-626.

Comparable rules govern the application of the proceeds to a foreclosure as to intangible collateral (such as accounts) and the right to a deficiency and the need to account for a surplus. See new section 9-608(a), Official Comment 2 to new 9-608 and Chapter 37 (Foreclosure as to Intangibles).

Under former section 9-505, in certain circumstances, a secured party could retain the collateral "in satisfaction of the debt."  Where a secured party retained under former section 9-505, the secured party could not seek a deficiency, but neither was the secured party obligated to account for any surplus.  The absence of any need to account for a surplus meant a debtor might have to "forfeit" accumulated equity and, hence, the procedure was referred to as "strict foreclosure."  Because consumers were thought to be peculiarly at risk in strict foreclosures situations, where the collateral was consumer goods and the debtor had paid sixty percent or more of the debt the secured party could not retain and had to dispose of the collateral.

New Article 9 continues to offer secured parties what amounts to an option to retain the collateral in satisfaction of the debt. However, the option is now referred to as "acceptance of collateral in satisfaction of the debt." New 9-620.  More importantly, except in consumer transactions (see new section 9-620(g)), collateral may be accepted in partial as well as complete satisfaction of the debt.  New 9-622.  The procedure for effecting an acceptance has been changed to shift the focus to consent to such action by the debtor, but parties who may be adversely affected still have the opportunity to prevent acceptance by a timely objection.  See new 9-620 and 9-621.

The bar to acceptance in consumer goods cases where the debtor has built up significant equity is continued.  Under new sections 9-620(e) and (f), in such cases the secured party must dispose of the collateral within 90 days or such longer period as the debtor and secondary obligors may agree to after default.

Responding to a split in court decisions under former Article 9, new section 9-620(b) provides that acceptance is at the option of the secured party and may not be forced upon the creditor by virtue of a delay in disposing of collateral.  The details of Article 9 dispositions and retentions or acceptances in partial or complete satisfaction of the debt are considered in Chapter 35 (Disposing of Collateral to Satisfy a Secured Debt).

D. Redemption of Collateral

Under new section 9-623, debtors, secondary obligors and other secured parties or lien holders may redeem the collateral from a secured party at any time before a contract for disposition of the collateral has been entered into or the process of effecting a full or partial acceptance of the collateral in satisfaction of the debt has been completed.  Although new section 9-623 generally tracks former section 9-506, it confers the right of redemption on holders of non-consensual liens.

As was true under former section 9-506, a party seeking to redeem must pay the debt owing to the secured party, including any amount owing as the result of an acceleration of the entire balance owing (as discussed in Part G below), plus the secured party's expenses.  See new 9-623 and Official Comment 2 to new 9-623.  Moreover, the debtor must tender full payment and the debtor’s promise to pay is not enough. See Automotive Finance Corp. v. Smart Auto Center, Inc., 334 F.3d 685 (7th Cir. 2003).

However, as is explored at some length in subpart G below, determining whether a debtor is in default and for how much is often less than straightforward.  Therefore, it could happen that a secured party and a debtor are able to negotiate the amount necessary to allow the debtor to recover repossessed collateral (and rectify an overdue balance) thereby producing what amounts to a redemption of the collateral.  Cf. Automotive Finance Corp. v. Smart Auto Center, Inc., 334 F.3d 685 (7th Cir. 2003).  Such a negotiated settlement that results in a de facto redemption might include a release by the debtor of any claims it might have for a wrongful repossession.  But, if the debtor tenders full payment, the secured party should not be allowed to condition a return of the collateral on the debtor’s willingness to forego any such claims.  See Automotive Finance Corp., supra.

As explained in Chapter 39 (Enforcing Security Interests in Bankruptcy), the right of redemption may bring repossessed collateral into the debtor’s estate in bankruptcy, in which case the secured party’s ability to satisfy the secured debt out of the collateral will be limited by the automatic stay.  Moreover, it has been held that a debtor in a Chapter 13 bankruptcy proceeding can effectively redeem collateral by making installment payments pursuant to a confirmed Chapter 13 plan.  See, e.g., In re Moffett, 288 B.R. 721 (Bkcy E.D. Va. 2002), affirmed 356 F.3d 518 (4th Cir. 2004); In re Rozier, 283 B.R. 810 (Bkcy M.D. Ga. 2002).  Further explanation of the latter point is beyond the scope of these materials.

It would seem to be important to know, both in and out of bankruptcy, when a debtor’s right of redemption has expired. Because Article 9 throughout carefully distinguishes between an ownership interest and a lien interest, one might reasonably assume that the right to redeem under new section 9-623 should continue until the debtor has been effectively divested of ownership.   Under this assumption, the right to redeem would end when title to the collateral passed to a purchaser at an Article 9 disposition or when the secured party had completed the requirements for accepting the collateral in complete or partial satisfaction of the debt.  However, under the UCC, the passage of title has been given greatly diminished significance. See Article 2, section 2-401 and Official Comment 1 to section 2-401.

More importantly, new section 9-623(c) literally provides that the right to redeem terminates not only when the secured party has disposed of the collateral but also when the secured party has entered into a contract for the disposition of the collateral. Although the parties to a contract can agree that title passes when the contract is made, in the absence of such an agreement, “title passes at the time and place at which the seller completes performance with respect to the goods.”  Article 2, section 2-401(2).  Consequently, it would appear that the right to redeem can end before title to the collateral has passed to a purchaser at a disposition.

Complicating matters even further, many Article 9 dispositions are by auction and auctions are governed by special rules found in Article 2, section 2-328.  Under section 2-328(2) a sale by auction is “complete” when the auctioneer so announces by the fall of the hammer.  However, the terms of the contract resulting from the acceptance of a bid may condition the sale on full payment.  See In re Atlantic Orient Corp., 290 B.R. 456 (Bkcy D. NH 2003).  It may reasonably be asked whether the debtor’s right to redeem where collateral is disposed of at an auction is terminated by an auction “contract” that the party making the highest bid fails to satisfy or whether the right continues until the contract is performed.

On the other hand, to conclude that a disposition at an auction or otherwise continues to be subject to the right of redemption until a contract for a disposition is completed could undermine the need for finality that has been deemed so important to commercial dealings generally.  In this regard, it is noteworthy that a disposition or an acceptance in satisfaction of the debt can be sufficiently final to force a party who is aggrieved by a failure of the secured party to comply with Article 9 to seek damages under new section 9-626 and deny such a party an ability to upset a disposition or acceptance.  See Chapter 35 (Disposing of Collateral to Satisfy a Secured Debt) and Chapter 38 (Remedies for a Secured Party’s Failure to Comply with Article 9).

In any event, in most cases a disposition or acceptance will proceed to completion and be effective and there will be no dispute about whether the right to redeem has terminated and there appears to be no reported case in which a conclusion that the right to redeem has ended has been challenged.  Of course, as the foregoing discussion should suggest a challenge is certainly possible.

E. Enforcing Collateral Against Accounts and Other Collateral Involving Third Parties

Former Article 9 contained special rules for realizing a debt from collateral such as accounts and instruments as to which the interests of third parties (account debtors) who were obligors on the accounts and instruments were necessarily implicated.  New section 9-607 expands upon the treatment of such situations in former Article 9 and adds cases not addressed in former Article 9, such as enforcement of security interests in notes secured by deeds of trust and mortgages.  The situations and the rules governing them are discussed in Chapter 36 (Acceptance of Collateral in Full or Partial Satisfaction of the Debt).

F. Remedies for Failure of a Secured Party to Comply with the Enforcement Rules of Article 9

As was true under former Article 9, new Article 9 provides its own remedies for failures of a secured party to comply with Article 9, including provisions governing foreclosure.  See new 9-625.  New section 9-627 expands upon an attempt in former section 9-507(2) to give greater guidance with regard to the meaning of the commercially reasonable standard as it applies to dispositions and collections.

The basic remedy for an aggrieved party, as defined in new section 9-625(c)(1), is an action for actual damages under new section 9-625(b).  In a proper case, an aggrieved party entitled to relief may be able to get injunctive relief under new section 9-625(a) or statutory damages under new sections 9-625(c)(2), (e) and (f), and may be able to assert an estoppel under new section 9-625(g).

As will be explained in Chapter 38 (Remedies for a Secured Party's Failure to Comply with Article 9), under former Article 9, a secured party that failed to comply with Article 9 could be denied a deficiency.  New section 9-626 deals with the denial of a deficiency in other than consumer cases, leaving to the courts the question of when a deficiency should be denied in consumer cases.

In a proper case an aggrieved party also may seek damages under tort law, for example, for "wrongful repossession," and in such cases punitive damages are possible.  See Official Comment 3 to new 9-625.

The details of the remedies of a debtor or other aggrieved party for a failure of a secured party to comply with Article 9 are dealt with in Chapter 38 (Remedies for a Secured Party's Failure to Comply with Article 9).

You may test your understanding of the basic framework of rules governing enforcement of a security interest under new Article 9 in the next problem.

Problem 33.1    (interactive)

Sid Seller sells Donna Debtor a computer for $5,000 to be paid for in twelve equal monthly installments. Donna buys the computer for use in her office. Sid has a perfected security interest in the computer to secure the unpaid price. Donna defaults at a time when the debt owing is $2,000 and the computer is worth $3,000. There are no other parties with an interest in the computer.  Which of the following statements are true and which are false?

Sid Seller sells Donna Debtor a computer for $5,000 to be paid for in twelve equal monthly installments. Donna buys the computer for use in her office. Sid has a perfected security interest in the computer to secure the unpaid price. Donna defaults at a time when the debt owing is $2,000 and the computer is worth $3,000. There are no other parties with an interest in the computer.
Which of the following statements are true and which are false?

(a) So long as Donna does not resist, Sid may recover possession of the computer from Donna without judicial process.

(b) If Donna physically resisted Sid's attempt to repossess the computer then Sid would have to go to court to get possession of the computer.

(c) The limitation on self-help recovery of the computer cannot be dispensed with in the security agreement.

(d) Sid must exercise reasonable care as to the computer once Sid has taken possession of it unless Donna waived the duty of care in the security agreement.

And again, which of the following statements are true and which are false?

(a) After getting possession of the computer, Sid may resell it to another customer or, if Donna agrees, choose to keep the computer and treat the transaction as being at an end.

(b) If Donna had purchased the computer for use in her home then Sid could not keep the computer but would have to dispose of it within ninety days.

(c) If Sid resold the computer for $3,000 Sid would have to account to Donna for the difference between that amount and the $2,000 debt plus expenses.

(d) If the computer were worth only $500 at the time of the default and Sid resold the computer for that amount then Sid could sue Donna for $1,500 plus expenses or Sid could choose not to repossess the computer and sue Donna for the $2,000 owing on the contract.

(e) At any time prior to a disposition or a contract for disposition or acceptance of the computer in satisfaction of the debt, Donna may get the computer back from Sid by paying Sid $2,000 plus expenses incurred by Sid in enforcing its security interest.

G. The Need for a Default

As noted above, the essential pre-condition of attempts by a secured party to collect a debt from the collateral is that there be a default.  Under new section 9-606, a default as to an agricultural lien occurs at the time the secured party becomes entitled to enforce the lien in accordance with the statute under which it was created. Former Article 9 did not define the very important event of default as to a security interest and neither does new Article 9.  Rather, default is a matter left to the security agreement.

The parallels to breach of contract should be apparent.  You should recall from contracts class how difficult it can be at times to decide whether there has been a breach of contract or who is the breaching party.  These same difficulties may arise in an Article 9 transaction.

Certain defaults are relatively clear. For example, a security agreement will almost certainly make a failure to pay as agreed a default. However, in many situations it is unclear whether there is a default that will support the actions taken by the secured party.  Even failure to pay situations can get complicated because of the possibility of a modification or even a waiver of the payment terms.  In a secured sales transaction, Article 2, section 2-209, could apply. Under section 2-209(1), an agreement to modify a contract within Article 2 needs no consideration to be binding.

To protect against a modification where none was intended, a secured party is permitted by section 2-209(2) to include in the security agreement a provision that a modification is not effective unless it is in a signed record.  However, according to the same subsection, to be enforceable against a non-merchant, such a requirement must be separately signed by the non-merchant party.  Under Article 2, section 2-209(3), the requirements of Article 2, section 2-201, containing a statute of frauds, must be satisfied if the contract as modified is within its terms.

Under Article 2, sections 2-209(4) and 2-209(5), actions that do not produce an effective modification may nevertheless result in a waiver.  In particular, if a secured party regularly accepts late payments, it could happen that the secured party will be held to have waived the payment date, thereby precluding it from relying on a payment made after the date provided for in the security agreement to support foreclosure.

There appears to be some difference of opinion as to whether a so-called “anti-waiver” provision in a security agreement will be effective. According to Official Comment 3 to new section 9-601, Article 9 takes no position on the issue and leaves the question to the law outside Article 9. However, under Article 2, section 2-209(5), a secured party may retract a waiver by notifying the debtor that the waived term is being reinstated, unless the retraction would be unjust because of a material change of position in reliance on the waiver.

As Official Comment 2 to Article 2, section 2-209, emphasizes, modifications are subject to the obligation of good faith imposed in Article 1, section 1-304, formerly Article 1, section 1-2 03.  The meaning of good faith is considered further below.

Although the foregoing discussion of modification and waiver focuses on Article 2 and secured sales, modification and waiver issues can arise in lending transactions as well.  More generally, under Article 1, section 1-103(b), “unless displaced by the particular provisions of [the Uniform Commercial Code], the principles of law and equity, including the law merchant and the law relative to capacity to contract, principal and agent, estoppel, fraud, misrepresentation, duress, coercion, mistake, bankruptcy, and other validating or invalidating cause supplement its provisions.”  The doctrines of modification and waiver clearly are applicable through this provision.  

Insofar as default is concerned, a secured party should use care to avoid acting so as to give rise to a claim that it has waived a default, or modified the agreement so as to preclude the occurrence of a default or should be estopped to assert a default.  As to each, the case law in the jurisdiction whose law governs a transaction must be consulted.  See, e.g., Automotive Finance Corp. v. Smart Auto Center, Inc., 334 F.3d 685 (7th Cir. 2003) (concluding that the debtor had failed to satisfy the elements of an equitable estoppel under Indiana law).  See also, Agriliance, L.L.C. v. Runnells Grain Elevator, Inc., 272 F. Supp. 2d 800 (S.D. Iowa 2003).

Under general contract law a party often will have what amounts to a right to "cure" a breach.  The ability to cure arguably would apply to a security agreement as well except for the fact that security agreements routinely contain an "acceleration clause." Such clauses permit a creditor to accelerate the debt in the event of any default.  The result, for example, that if a debtor misses a single monthly installment the creditor may demand the entire outstanding balance.

The power of a creditor to accelerate a debt is in fact greater than the foregoing suggests. Thus, under Article 1, section 1-309 (formerly Article 1, section 1-208), a creditor may accelerate a debt "at will" or "when he deems himself insecure." The only limitation on such acceleration is that the secured party must act in "good faith." However, the burden of establishing a lack of good faith is on the debtor. Under former Article 9, the debtor's burden was compounded by the fact that "good faith" was defined in former Article 1, section 1-201(19) to mean "honesty in fact" and there is no element of commercial reasonableness associated with good faith as so defined.

New Article 9 leaves the acceleration scheme of former Article 9 intact with one significant change. Following the lead of numerous court decisions, a definition of "good faith" was added to Article 9, in new section 9-102(a)(43), that required not only honesty in fact but that the creditor observe "commercially reasonable standards of fair dealing." In its most recent form, the definition of "good faith" has been moved back to Article 1 and Article 1, section 1-201(b)(20) now incorporates the "reasonable standards of fair dealing" requirement.

One result of the change from an entirely subjective test of good faith to one that has an important objective dimension of commercially reasonable behavior is that a debtor may more readily meet its burden of proving that a creditor lacked the good faith required by Article 1, section 1-309 in accelerating a debt.

Unfortunately, insofar as giving meaning to the requirement of good faith is concerned, not all states have adopted the proposed revision of the definition of good faith in Article 1. Several states have retained the more limited, honesty in fact, definition. A review of which states have adopted the expanded definition and which states have retained the narrower definition may be found at: http://www.law.unlv.edu/faculty/rowley/ra1_updates.htm.

To make matters worse, a state retaining the narrower definition in Article 1 may nonetheless have adopted and have retained new section 9-102(a)(43) containing the expanded definition of good faith. Arizona is one such state. In states that have adopted the narrower "honesty in fact" definition of good faith in Article 1 but the broader "honesty in fact" and "the observance of reasonable commercial standards of fair dealing" in Article 9, the question arises as to which definition governs determinations of good faith in the context of applying an Article 1 provision to an Article 9 dispute.

Thus, it was noted in Chapter 27 (Secured Party Versus Buyer) that where buyer in ordinary of course status is material in resolving priority disputes according to the Article 9 rules such as that contained in new section 9-320(a) it would seem that the broader Article 9 definition of good faith should control, but that because buyer in ordinary course is defined in Article 1, section 1-201(b)(9), it might be argued that the narrower definition applies.

To the extent that the proposed change to the definition of good faith in Article 1 is adopted or the expanded definition of good faith contained in new section 9-102(a)(43) is held to control determinations of good faith in applying Article 1, section 1-309 (formerly Article 1, section 1-208) to an Article 9 transaction a debtor may more readily meet its burden of proving that a creditor lacked the good faith required by Article 1, section 1-309 in accelerating a debt.

It is worth noting that the right to accelerate is not conferred as a matter of law and the security agreement should contain an acceleration clause and some articulation of when acceleration is permitted.  Moreover, acceleration clauses, even those that provide that acceleration is at the option of the secured party, are not likely to be interpreted as being "self executing" or automatically accelerating the balance owing on any default without some notification to a debtor that the debt is being accelerated.

The change in the definition of good faith impacts another provision governing enforcement of a security interest.  Under new Article 1, section 1-304 (formerly section 1-203), "every contract or duty within the Uniform Commercial Code imposes an obligation of good faith in its performance or enforcement."  Official Comment 19 to new section 9-102 indicates that the revised definition of good faith should be employed when applying section 1-203 in the Article 9 context.  There is an ongoing debate as to whether section 1-203 supports an independent action for breach of the duty of good faith that is not resolved by the change in the definition of good faith.

It is customary and desirable to define default in a security agreement to include any and all events that a creditor wishes to trigger the creditor's ability to attempt to satisfy the debt from the collateral.  Among the more common events included in a standard definition of default are suffering a judgment or levy, transferring the collateral without consent, failure to keep the collateral properly insured, and failure to maintain the collateral in reasonably sound condition.

You may explore the complexities of the need for a default as an indispensable prerequisite to collecting a debt from collateral in the next problem.

Problem 33.2   (interactive)

Donald Debtor is a computer graphics designer.  Donald has borrowed from Western Bank and given Western a security interest in Donald's equipment.  The security agreement contains the following provision:

What are the rights of the secured party and the rights of the debtor after default?

What legal recourse does a secured party have upon default?

When two perfected secured creditors have rights to the same collateral which party takes priority?

When a debt is secured by property as collateral and the debtor defaults The creditor may?