Steven L. Schwarcz
The recent revisions of Article 9 of the Uniform Commercial Code ("UCC") are expected to have a significant impact on securitization-a type of financing that is perhaps the most rapidly growing segment of the U.S. credit markets and increasingly a major part of foreign credit markets. In its current form, Article 9 governs the sale of only certain types of assets that are involved in securitization transactions. Revised Article 9 attempts to broaden its coverage to virtually all securitized assets. I analyze how it does that and what it means for Article 9 to apply to these transactions, addressing issues of perfection and priority of asset transfers, commingling of proceeds, assignability of assets in the face of contractual restrictions, and the effect of negative pledge covenants. Finally, I show that the revisions of Article 9 do much to bring the commercial law setting for securitization into the twenty-first century.
Asset securitization is "by far the most rapidly growing segment of the U.S. credit markets" and increasingly is becoming a major part of foreign credit markets. In a typical securitization, a company (usually referred to as the "originator") sells rights in income-producing or financial assets-such as accounts, instruments, lease rentals, franchise and license fees, and other intangible rights to payment-to a special purpose vehicle ("SPV"). The SPV, in turn, issues securities to capital market investors and uses the proceeds of the issuance to pay for the assets. The investors, who are repaid from collections of the assets, buy the securities based on their assessment of the value of the assets. Because the SPV (and no longer the originator) owns the assets, their investment decision often can be made without concern for the originator's financial condition. Thus, viable companies that otherwise cannot obtain financing because of a weakened financial condition now can do so. Even companies that otherwise could obtain financing now will be able to obtain lower-cost capital market financing.
What does Article 9 of the Uniform Commercial Code have to do with securitization? In its current form, Article 9, which generally addresses only secured transactions, nonetheless governs the sale of certain types of financial assets-accounts and chattel paper-that are commonly involved in securitization transactions. The rationale for including sales of these assets in Article 9 was that "[c]ommercial financing on the basis of accounts and chattel paper is often so conducted that the distinction between a security transfer and a sale is blurred, and a sale of such property is therefore covered . . . whether intended for security or not." This same rationale, and the significant minimization of transaction costs that the rule achieves, holds equally true today.
What has changed today, however, is that, increasingly, many other types of financial assets are sold as part of commercial financing transactions. Whereas factoring was the only significant form of commercial financing to involve sales of financial assets (accounts and chattel paper) when the UCC originally was adopted, securitization-which involves the sale of a whole range of financial assets-has now become significant. Yet, Article 9 had not been amended to take securitization into account. Revised Article 9 is a bold and largely successful attempt to remedy that omission and to adapt the law governing secured transactions to the realities of modern commercial and financial transactions. It accomplishes these goals in several ways.
I. Revised Article 9 Brings the Sale of Most Types of Financial Assets Within Its Scope
As a threshold matter, Revised Article 9 brings within its scope the sale not only of accounts and chattel paper, as under current law, but also of "payment intangibles" and "promissory notes." Significantly for securitization, the definition of an account is expanded from current law to include not only credit card receivables and health-care-insurance receivables but also any "right to payment . . . for property that has been or is to be . . . licensed, assigned, or otherwise disposed of," thereby covering license and franchise fee receivables. Moreover, the term payment intangible is broadly defined as "a general intangible under which the account debtor's principal obligation is a monetary obligation." This definition appears intended to cover financial assets that are not already covered by the terms account, chattel paper, and promissory notes. For example, loan participations and commercial loans not evidenced by instruments would be payment intangibles.
Accordingly, Revised Article 9 will apply to securitization transactions so long as the financial assets being sold consist of accounts (including credit card, health-care-insurance, license, and franchise fee receivables), chattel paper, promissory notes, or payment intangibles. I will refer to these types of financial assets as "covered financial assets." The reader should note, however, that in some securitization transactions, financial assets are not sold but are merely transferred as security. Revised Article 9 then will apply, as does current Article 9, to virtually any financial asset so transferred.
The remainder of this article discusses what it means for Article 9 to apply to the securitization of financial assets. Most significantly, all sales of covered financial assets will be perfected, and the priority of the SPV as against creditors or a trustee in bankruptcy of the originator will be governed, by the rules of Article 9. Establishing clear and pragmatic rules for perfection and priority of the transfer of covered financial assets will minimize transaction costs for the reasons previously explained in the context of transferring accounts and chattel paper: parties to the securitization transaction will not have to make the difficult determination of whether each transfer of a covered financial asset is a secured transaction or a sale; filing for both types of transfers will forestall litigation attempting to second-guess that determination if the originator in the securitization transaction eventually goes bankrupt; and sales of covered financial assets no longer will have to be perfected under state common law procedures that often are costly and impractical.
But Revised Article 9 will apply to securitization in a myriad of other ways. In this article, I focus on the more significant impacts most likely to be encountered in a typical securitization transaction, such as mitigating the effect of commingling proceeds of financial assets and promoting assignability of financial assets, notwithstanding contractual restrictions to the contrary. The reader must recognize, however, that Revised Article 9 will have other impacts on securitization, some less significant, some that will be significant in only certain transactions, and some whose significance might not become obvious until transactions are actually done under the revised statute.
Of course, the fact that Revised Article 9 will apply to the sale of covered financial assets does not mean that Article 9 applies to those sales for all purposes. In interpreting Oklahoma's enactment of current Article 9, the Tenth Circuit Court of Appeals previously had concluded that Article 9's application to the sale of accounts-characterizing the buyer of accounts as a "secured party," the seller as a "debtor," and the sold accounts as "collateral"-means that accounts cannot be sold under Oklahoma law. Although that decision was much criticized, and the Permanent Editorial Board of the UCC issued a commentary stating that the case was incorrect and also amended comment 2 to current section 9-102 to clarify interpretation, those actions have not generally been approved by legislatures or courts and do not necessarily have the force of law. Revised Article 9, once approved by legislatures, is intended to drive the final nail into the Octagon coffin by providing not only that the question "whether a debtor's rights in collateral may be voluntarily or involuntarily transferred is governed by law other than this article ," but also that a "debtor that has sold an account, chattel paper, payment intangible, or promissory note does not retain a legal or equitable interest in the collateral sold." The latter point attempts to address the "rarified" argument that Octagon was correctly decided because certain limited property interests may remain with the originator after the sale of financial assets.
II. Revised Article 9 Establishes Clear and Pragmatic Rules for Perfection and Priority
Two of the essential goals of a commercial law statute are clarity and simplicity of implementation. In the context of the commercial law rules for perfection and priority, Revised Article 9 furthers both of these goals.
Perfection refers to the protection of a transferee's interest in transferred assets from creditors of the transferor and from the transferor's trustee in bankruptcy. Under current Article 9, perfection is generally achieved by filing financing statements in jurisdictions where the debtor (originator) or the collateral is located. The problem, however, is that it is often unclear where the debtor and the collateral are located and, in the latter case, the location may well change.
Revised Article 9 addresses this problem in two ways: by making the location of the debtor-as opposed to the location of the collateral-determine the jurisdiction whose law governs perfection in most cases; and by clarifying where a debtor is deemed to be located. The former point is less critical to securitization, which involves intangibles, than to other forms of secured financing where the assets are tangible items that can be moved around. But the latter point is quite significant to securitization. Section 9-307 of Revised Article 9 changes the rule of current section 9-103(3) to provide that registered organizations, such as corporations, organized under the law of a particular state are deemed to be located in that state. Thus, one would file financing statements against an originator incorporated under the laws of Delaware in Delaware, irrespective of where the originator's assets or business are located. Furthermore, where the originator is a foreign company not incorporated under state law, Revised Article 9 provides that its location is in the foreign jurisdiction where the originator has its chief executive office (or, if the originator has only one place of business, in the jurisdiction where that place is located), but only if that jurisdiction itself has a public filing system for perfection. If that jurisdiction does not have a public filing system, the originator is deemed to be located in the District of Columbia. Of course, whether filing in the District of Columbia will achieve perfection under the law of the foreign jurisdiction is also a question of that jurisdiction's law.
Revised Article 9 also brings a measure of pragmatism to the securitization of payment obligations evidenced by instruments. Under current law, a security interest in instruments can only be perfected by taking possession of the instrument. That may be impractical, however, where (as is common) a securitization transaction involves the transfer of large pools of instruments. The revision solves that problem by allowing a security interest in instruments to be perfected by filing. Nonetheless, holders in due course and certain other purchasers for value of instruments would have priority on the rationale that requiring them to check the filing system in connection with each purchase would impede those transactions, whereas there is only "a remote possibility that is not of serious concern" that an originator will voluntarily transfer instruments to third parties in breach of contractual restrictions.
One of the major controversies that arose during the Article 9 revision effort was how to perfect the sale of payment intangibles. Bankers were concerned that a perfection requirement of filing financing statements would subject them to costly new procedures when selling loan participations, a form of payment intangible. A somewhat practical solution was reached to mitigate this concern: the sale of payment intangibles would be deemed to be automatically perfected, without the need to file financing statements. This solution, however, is imperfect. Buyers of payment intangibles cannot search filing records to determine whether those intangibles previously have been sold to others. Thus, an SPV in a securitization transaction cannot ascertain the priority (discussed below) of the SPV's ownership rights, other than by relying on representations of the originator. Originators that are insufficiently capitalized to back up their representations therefore may find it difficult to securitize payment intangibles.
Priority refers to the ranking of multiple claims against a transferred asset. In a securitization context, it means that "the SPVs and investors' claims against the transferred financial assets are superior [in ranking] to any third-party claims," including that of the originator's trustee in bankruptcy. Under current Article 9, priority is generally accorded to the first secured creditor to file or perfect, under a rule usually referred to as "first in time, first in right." Revised Article 9 continues that rule.
There is, however, one exception under current Article 9 to first in time, first in right. A holder of a purchase money security interest ("PMSI") generally takes priority over an earlier perfected security interest in the same collateral. That exception, however, would create a significant problem for securitization and other forms of accounts receivable financing: because accounts are the proceeds of inventory, it would mean that a later perfected inventory financier with a PMSI would take priority over an earlier perfected SPV or accounts financier. To ensure that the PMSI exception does not discourage accounts receivable financing, current Article 9 has a special rule that favors accounts receivable financiers, including SPVs that purchase accounts, over purchase money financiers of inventory. Revised Article 9 continues that special rule.
III. Revised Article 9 Mitigates the Effect of Commingling of Proceeds
Commingling refers to the mixing of proceeds of collateral with assets of the originator. Under current Article 9, in an "insolvency proceeding" (such as bankruptcy), the secured party or SPV's interest in cash proceeds will be lost if the cash is commingled with other funds of the originator, except to the extent that an artificial formula preserves the security interest. However, this rule is unfair to secured parties because it can arbitrarily limit the amount of a perfected security interest in commingled cash proceeds and it allows an originator contemplating bankruptcy, in what has become a commonplace legal strategy for debtors, to intentionally commingle proceeds of a perfected security interest in advance of filing a bankruptcy petition in order to use the formula to defeat the perfected interest.
Revised Article 9 will remedy that unfairness. Rejecting the artificial formula, it returns to the common law principles of "tracing," under which a perfected security interest will continue in traceable cash proceeds of the original collateral. This would permit common law tracing rules such as the "lowest intermediate balance rule," in which it is presumed that funds remaining in an account after withdrawal by the debtor include the proceeds of collateral (or, put another way, that withdrawals from a deposit account following the deposit of proceeds are first made from non-proceeds).
Revised Article 9 also expands the definition of proceeds, which currently includes only what "is received upon the sale, exchange, collection or other disposition of collateral or proceeds." This relatively narrow definition had created confusion, for example, as to whether dividends of stock are proceeds. Under the expanded definition, stock dividends clearly would be included.
This expanded definition of proceeds can have major significance for securitization. Increasingly, the financial assets used in securitization transactions represent rights to payment that arise in the future ("future assets"). If, however, the originator goes bankrupt after the securitization transaction is entered into, section 552(a) of the Federal Bankruptcy Code may cut off the SPV's interest in future assets. While section 552(b)(1) generally would preserve the SPV's interest in future assets, that interest is only preserved to the extent that the future assets constitute "proceeds, product, offspring, or profit" of the SPV's prepetition assets. In this connection, courts interpret the term "proceeds" by reference to the UCC definition. Thus, Revised Article 9's expanded definition of proceeds will expand the universe of future assets that can be sold to SPVs without the fear of the SPVs' interest in those assets being cut off in the event of the originator's bankruptcy.
IV. Revised Article 9 Promotes Assignability Notwithstanding Contractual Restriction
Parties to contracts sometimes restrict the assignment of rights and obligations thereunder. These restrictions are often referred to as "anti-assignment clauses." In a securitization transaction, the parties to that contract are the originator and a third party obligated on the financial asset. Because the focus is on the originator's transfer of its rights in the financial asset to an SPV, we need only examine the obligor's ability to restrict that transfer.
Current Article 9 nullifies anti-assignment clauses that prohibit "assignment of an account or . . . creation of a security interest in a general intangible for money due or to become due." The rationale given is that the nullification of anti-assignment clauses "is widely recognized in the cases and . . . corresponds to current business practices." An implicit rationale, however, might be that the obligor on the account or general intangible is not prejudiced by its assignment, whereas enforcing the anti-assignment clause would impair the free alienability of property rights.
Revised Article 9 clarifies the rule of current Article 9. First, the revision eliminates any argument that a transfer of financial assets in violation of an invalidated anti-assignment clause nonetheless constitutes a breach as between the obligor and the originator. Second, the revision treats anti-assignment clauses in payment intangibles and promissory notes differently depending on whether the transfer in question is a sale or merely a transfer for security. Anti-assignment clauses would be ineffective in both cases from preventing perfection of the transfer of the right to payment, but they would be upheld to prevent an originator from selling its underlying business relationship. Thus, if the originator is a bank which has made a loan to a borrower, the bank could sell a participation in that loan-a loan participation being a payment intangible-to an SPV or other third party and could perfect that sale notwithstanding an anti-assignment clause in the underlying loan agreement; but the bank could not alter the underlying debtor-creditor relationship with its borrower. The buyer of the loan participation therefore would have no direct collection rights against the borrower.
V. Revised Article 9 Clarifies the Effect of a Negative Pledge Covenant
A negative pledge covenant is an agreement by a debtor in favor of a third party (typically, a creditor) in which the debtor agrees not to grant a security interest in or otherwise encumber its assets. In a securitization context, originators often make negative pledge covenants in favor of SPVs regarding transferred and to-be-transferred financial assets. If, of course, those financial assets already have been sold to the SPV and the originator retains no interest therein, the originator would have no power to grant a security interest and a negative pledge covenant then would be superfluous. But it is sometimes unclear whether the financial assets have been sold; and originators often do retain interests, such as interests in financial assets not yet sold, or undivided interests in financial assets that have been sold, or rights to surplus collections. In those cases, negative pledge covenants may be important.
Current Article 9 is unclear as to the enforceability of a negative pledge covenant. Revised Article 9 offers clarity by providing that while negative pledge covenants cannot restrict alienability, a transfer of financial assets in breach of a negative pledge covenant nonetheless constitutes a default by the originator. That default could entitle the SPV to exercise remedies against the originator and might also allow the SPV to sue the transferee, if it knew or should have known of the breached covenant, for tortious interference with contract.
The revision of Article 9 does much to bring the commercial law setting for securitization into the twenty-first century by embracing a broader range of financial assets, setting clear and pragmatic rules for perfection and priority of their transfer, clarifying inadvertent legal ambiguities, and reducing unnecessary transaction costs.