Promissory Notes: Another Path to Perfection
By Steven N. Cohen, Karen B. Gelernt, and
Mr. Cohen and Ms.
Gelernt are partners and Mr.
Kalembka is an associate in the Banking and
Finance practice group of Cadwalader,
Wickersham & Taft. They may be reached at firstname.lastname@example.org email@example.com and firstname.lastname@example.org respectively.
This article explains how, under revised
Article 8 of the Uniform Commercial Code, lenders providing financing to
mortgage loan originators and consumer lenders can assure themselves of
having a perfected security interest in the underlying mortgage loans or
consumer loans in circumstances where, under traditional concepts under
Article 9 of the UCC, perfection could be challenged.
The use of
promissory notes as collateral
serves a vital function in providing prospective homeowners and other
consumers access to capital. For not only do
the promissory notes evidence the obligation of homeowners and
other consumers to repay their mortgage loans and other
consumer loans, the promissory notes can also serve as
collateral for the financing that a
home mortgage loan originator
or non-bank consumer lender typically requires to conduct its
At the same time, the requirement that the secured lender
(and not the mortgage loan originator
or consumer lender) have physical possession of a promissory note
for the secured lender’s security interest
to be perfected can pose
practical impediments to the financing of these promissory notes. These
problems are further compounded in circumstances where the underlying
promissory notes are lost or destroyed.
This article reviews
the legal underpinnings for traditional financing of
mortgage loan originators and consumer lenders and proposes
that, by taking advantage of the provisions of revised Article 8 of the
Uniform Commercial Code (the “UCC”), lenders providing financing
to mortgage loan originators and consumer lenders can assure
themselves of having a perfected security interest in the
underlying mortgage loans or consumer loans in circumstances
where, under traditional concepts under Article 9 of the UCC, perfection
could be challenged.
In a “mortgage warehouse”
transaction an institutional lender, such as a commercial bank,
insurance company, or investment bank (an “Institutional Lender”), will
lend to a mortgage bank or other “originator” (the
“Originator”), which will in turn use the proceeds of the loan to
fund loans by it to individual mortgagors.1 Institutional Lenders
also lend to Originators to fund consumer loans outside of the real
estate context, thus enhancing consumer access to credit generally.
for a loan from the
Originator, a promissory note (a “Note”) will be executed by the
mortgagor (a “Mortgage Note”) or consumer borrower (a “Consumer Note”)
in favor of the Originator, together, in the case of a loan
secured by real property, with a mortgage on the real property.
To secure its obligation to repay the Institutional Lender, the
Originator will grant a security interest in the Note in
favor of the Institutional Lender. In the case of a real estate loan,
the Institutional Lender may also obtain an assignment of the
mortgage, typically in blank, although it normally
will not have the assignment recorded in the relevant real property records.2
An Originator of mortgage loans may
use the proceeds derived
from the sale of such loans to repay its
borrowing from the Institutional Lender.
In connection with such a transaction, the Institutional Lender will
send the relevant loan files to the prospective investor,
together with a “bailee letter” that
instructs the investor that such investor is acting as the Institutional
Lender’s bailee for purposes of
maintaining the perfection of its security interest,3
and that such investor should wire any sales proceeds directly to the
and Perfection of Institutional Lender’s Security Interest
The UCC provides critical
advantages to an Institutional Lender that “perfects”
its security interest in the Notes. In particular,
a perfected security interest has priority over other creditors of, and
transferees from, the Originator,4 including
lien creditors and a bankruptcy trustee.5 A security interest is
perfected when it has “attached”6 and the mechanical step or steps
required to afford public notice of the security interest of the
creditor,7 e.g., filing a financing statement 8 or obtaining
possession of the collateral,9 have been taken.
i.e., validity, of a security
interest requires the satisfaction of
three conditions. First, the debtors
must have “rights”10 in
the collateral. Second, the creditor must give
“value,”11 which for UCC
purposes simply means “any
consideration sufficient to support a
contract.”12 Finally, unless the collateral is in the
possession of the secured party or is “investment
property”13 subject to its “control,”14 the parties must have
executed a written security agreement. (Of course, even if an exception
to the written agreement requirement applies, the prudent practice is to
enter into a written security agreement.)
In the case of “instruments,”15
such as the Notes,
perfection is accomplished by “possession.”16
Moreover, except for temporary perfection in limited circumstances,17
possession is the exclusive means for perfecting a security interest in
instruments. Possession is not a mere act, but a course of
conduct;18 possession, therefore, must be
“unequivocal” and “notorious.”19 The drafters of the UCC believed that a
rule requiring possession is consistent with long-established commercial
practices, and that permitting filing as an alternative would not
advance any significant interest.20 Possession by the secured
party, accordingly, is both necessary and sufficient,
since the debtor’s lack of possession alerts prospective creditors and
purchasers that the asset may be subject to a security interest.21
That being said, the
drafters did not include a definition of “possession,” leaving the
matter, for better or worse, to be determined on a case-by-case basis.22
Nevertheless, certain clear principles emerge. First, if an
Institutional Lender takes actual physical possession of the
Notes, its security interest is perfected.23
Conversely, the security interest
of the Institutional Lender in the Notes will not be perfected
if the Originator retains possession.
See, e.g., Ingersoll-Rand Financial Corporation v.
Nunley, 671 F.2d 842, 844-45 (4th Cir.
1982); Grant Gilmore, Security Interests in Personal Property, § 14.1
(noting the “antagonism to the secret lien” under the common
law). Likewise, the Institutional Lender cannot successfully
argue that the Originator acted as its agent for purposes of perfection
by possession, insofar as Official Comment 2 to Section 9-305 (“Comment
2”), declares that “it is of course clear . . . that the debtor .
. . cannot qualify as an agent for the secured party.”
Practical considerations may
necessitate that Consumer Notes be held by the Originator. Where the
Loans are subject to frequent modifications, or where the Notes are
numerous, possession by a Custodian may be impracticable.
In such circumstances, possession
under UCC Sections 9-304 and 9-305, obviously, is impossible.
In some circumstances, rather than
delivering the Notes directly to the Institutional Lender, it may be
more convenient and economical to leave the Notes with a custodian
that is a corporate affiliate of the Originator (an
“Affiliated Custodian”). As a preliminary matter, it is important to
recognize that affiliation may exist in circumstances beyond the
garden-variety parent-subsidiary and sister-sister relationships; for
example, an investment advisor is considered an affiliate under the
Investment Company Act of 1940 (the “1940 Act”)24
of the investment company it advises, and could be considered an
affiliate for commercial law purposes in connection with its custody
of Notes pledged by the investment company as borrower.
Despite the potential
administrative and cost advantages, leaving the Notes with the
Originator or an Affiliated Custodian creates risk for the
Institutional Lender regarding the perfection of its security interest.
The outcome for the Institutional
Lender in this case will depend on the precise nature of the
relationship between the Originator and the Affiliated Custodian
and, in some circumstances the relative degrees of control over the
Notes or the Affiliated Custodian exercisable by the Originator. See,
e.g., The Edibles Corporation v. West Ontario Street Limited
Partnership, 653. N.E. 2nd 45, 47 (Ill. App. 1995).
The lodestar of the analysis is
Official Comment 2 which provides that “it is of course clear . . . that
[an] agent [of the debtor] cannot qualify as an agent for the
Accordingly, where an Affiliated
Custodian is a wholly-owned subsidiary of the Originator, control of
the Affiliated Custodian by the Originator (and therefore,
control of the Notes by the Originator )
is plainly established, and the security interest
will almost certainly be unperfected.
Official Comment 2, however,
leaves many questions unanswered. Most importantly, it does not address
the situation in which the Originator is a subsidiary of the Affiliated
Custodian or in which the Originator and the Affiliated Custodian are
sisters or, considered affiliates under the 1940 Act. In these cases,
control is not as readily apparent because a subsidiary, sister or
investment company is not generally viewed as being “in control of” (as
distinguished from being “under common control with”) its corporate
parent or investment advisor.
Similar to the Comment, the case
law fails to articulate clear, easily applied rules regarding the
application of Section 9-305 in this context, but proceeds instead on a
case-by-case—indeed, sometimes contradictory—path.
Many cases adopt a conservative
approach, stating or implying that any close relationship between
the debtor and the custodian precludes perfection through
possession by a bailee. A leading example is
Heinicke Instruments Co. v.
Republic Corp., 543 F.2d 700 (9th Cir.1976), in which the debtor
pledged the stock of a company he had formerly served as president to
secure a personal loan. At the time the loan was made, certificates for
the stock had not been issued.
After the borrower defaulted, the
court held that a garnishee of the certificates had priority over the
lender because the lender had not perfected its security interest by
possession. In particular, the court found that the close relationship
between the issuer of the stock and the borrower precluded the issuer
from acting as agent for purposes of perfecting the lender’s security
interest.25 According to the court, it was “highly dubious” that the
issuer could act as agent for anyone except the person to whom the
shares were issued, i.e., the borrower.26
Moreover, the issuer’s
relationship to its former president “was too close . . . to provide any
effective notice of its agency status to third parties.”27
Another important holding was
rendered in McDonald v. National Bank (In re Hill), 7 B.R. 433 (Bankr.
W.D. Okla. 1980). In Hill, the debtor pledged an interest in his
motorboat as security for his promissory note.28 The
debtor filed for bankruptcy approximately two months later. During the
period between the debtor’s execution of the note and his bankruptcy
filing, the debtor stored the boat at the residence of his father (who
co-made the note).
Although the facts are somewhat
murky, the bank apparently contended that it possessed the boat within
the meaning of Section 9-305. The debtor did not have physical
possession of the boat, and the bank believed that the debtor’s father
was its de facto agent. The court rejected these contentions and found
that the bank’s security interest was not perfected by possession. “Mere
possession by the debtor or a person closely associated with him cannot
perfect the secured party’s interest.”29 In addition, the court noted
that “[t]he debtor could have removed the boat at any time had he so
wished. This was not the required unequivocal, absolute and notorious
notice to others.”30
in Rhode Island Hospital Trust National Bank v.
Monack (In re Lee), 28 B.R. 319 (Bankr.
D.R.I. 1983), the court found that the secured party had not perfected
its interest in a boat by possession where the collateral was held by a
relative of the debtor. The boat in question was sold to the debtor by
the seller, which retained a security interest in the boat. The boat
was in possession of the cousin of debtor’s wife, an arrangement
approved by the seller. The court concluded that “storing the boat on
the property of a relative of the debtor does not constitute ‘taking
possession of the collateral’ by an alleged secured party, within the
meaning of UCC 9-305.”31 It reasoned that the seller had failed to
demonstrate that the cousin of the debtor’s wife was not controlled by
the debtor or that the placing the boat on her property adequately
informed potential lenders of the possible existence of a security
Other courts have adopted a more
liberal stance. For example, in
Levey v. Burke, Wilson &
McIlvaine (In re Bragiel), 151
B.R. 186 (Bankr. N.D. Ill. 1993), the
debtor, a partner in a law firm, granted a security interest in his
shares of stock in the law firm to his bank lender. The firm held the
shares under a triparty agreement that
expressly acknowledged the pledge to the bank.33
Relying on the absence of any
indication that the debtor controlled, or even appeared to control, the
firm, the court concluded that the law firm was the creditor’s
bailee and that the possession by the firm
of the shares was adequate to place third parties on notice that
debtor’s control of shares was not unfettered. The court stated that the
existence of obligations to the debtor does not necessarily disqualify a
party from having the status of a bailee
under Section 9-305. 34
In a holding seemingly at odds
with Official Comment 2, the court in Clancy v. Kane (In re Bruce
Farley Corp.) held that the possession of two promissory notes by the
debtor’s wholly-owned subsidiary, putatively acting as agent for the
creditors, perfected the creditors’ security interest in the collateral.
26 B.R. 164 (S.D. Cal. 1981). The debtors,
BFC, pledged the notes to the creditors, the
Clancys, to secure payment of two loans made by the
Clancys to the BFC. The notes initially were
held directly by the Clancys and later were
transferred to Seacoast Escrow Corporation, a wholly-owned subsidiary of
BFC (“Seacoast”) in order to initiate collection actions. The trustee in
bankruptcy claimed that the Clancys lost
their perfected security interest when they transferred the notes to
Seacoast because Seacoast could not act as agent for the
Clancys under Section 9-305. 35
Rejecting the contentions of the
trustee, the court held that Seacoast was clearly acting as the
creditors’ agent when it took possession of the collateral, and,
accordingly, the Farleys continued to have a
perfected security interest in the Notes.
Conspicuously absent is any effort
by the court to reconcile its holding with Official Comment 2. In fact,
the court seemed motivated more by considerations of equity than by
doctrine. Thus, the court referred to the Clancys’
complete unawareness of the subsidiary relationship of the creditor to
Seacoast. In light of the circumstances, “to allow the action taken by
the creditor intended to satisfy the debt [i.e., surrendering the
notes to Seacoast for purposes of collection] be
the action that renders the interest unperfected would be
inequitable.”36 The court held, therefore, that “whether the
interest remained perfected, the trustee in bankruptcy was
estopped from contesting the continuing
validity of the perfected security interest.”37
cases, therefore, do not offer clear guidance
as to what types of affiliation between debtor and custodian preclude
perfection under Section 9-305.
Nevertheless, certain factors have been emphasized by the courts.
Specifically, the existence and extent of control
maintained over the collateral by the debtor may drive a court’s
determination. This is the issue to which the discussion now
Control was central to the court’s
determination in Clarkson Co. Ltd. v. Shaheen,
533 F. Supp. 905 (S.D.N.Y. 1982). In Shaheen,
the principal (Shaheen) of several
corporations he controlled pledged his stock in such corporations as
collateral for his guarantee of debts owed by such corporations to
another corporation (MacMillan) controlled
by Shaheen.38 The relevant stock certificates were held by an attorney
appointed as escrowee.39
In a subsequent dispute between a
judgment creditor and MacMillan, the latter
claimed a perfected security interest in the shares prior to the
judgment lien. The fulcrum of the court’s analysis is the familiar
concept that perfection requires “actual and
exclusive possession” by the secured party,
which in turn has two components. First, that the “pledgor
surrender his dominion over the property, and . . . [second,
that] any semblance of ostensible ownership by the
be negated”.40 In this case, because the pledgor
controlled not only the actions and assets of the entities whose shares
he pledged, but also those of MacMillan, the
court concluded that the secured party lacked the required level of
possession.41 In fact, Shaheen was able “to
use the assets of MacMillan and all the
related companies as he chose at any time regardless of pledges,
escrows, public stockholders, or fellow directors.”42 At bottom, “MacMillan’s
possession was, in fact, Shaheen’s
possession.”43 The pledge was thus a sham and the security
holding in Merrill Lynch, Pierce, Fenner
& Smith v. Van Kylen (In re R. Van
Kylen), 98 B.R. 455 (Bankr.
W.D. Wis. 1989) also provides instruction regarding those powers,
which if retained by the debtor, will likely preclude
possessory perfection of the security
interest. In Van Kylen, the debtor had
pledged his interest in a cash management account (“CMA”) maintained
with his broker to Citizens State Bank. The governing agreement enabled
the debtor to control investments in the CMA and direct the broker to
deposit the funds therein into a checking account, thereby allowing the
debtor direct access to funds in the CMA at any time.
The court held that because the
debtor’s rights with respect to the CMA were “general intangibles”,44
the bank’s failure to file a financing
statement was fatal to its
claim of a perfected security interest.45 Further, even
assuming arguendo that the
assets held in the CMA were instruments, the bank’s assertion of
perfection through constructive possession would fail.
Specifically, because the debtor was not deprived of control
over the CMA, the bank could not have perfected its security interest by
possession. “Any control exercisable by
the debtor over the putative agent for the secured party defeats the
secured party’s claims to possession.
. . . 46 In sum, “[t]he degree of control the [debtor] possessed
over both the collateral and the putative agent render[ed] the
possession of the collateral by [the broker] inadequate to impart notice
to third parties . . .”.47
Another leading case examining the
issue of debtor control of collateral (although not instruments) is
Hassett v. Blue Cross and Blue
Shield (In re O.P.M. Leasing Services, Inc.), 46 B.R. 661 (Bankr.
S.D.N.Y. 1985). In O.P.M., the debtor’s
predecessor (the principals of which were also principals of the debtor)
deposited $100,000 with their attorneys as security for a contingent
obligation. The obligation and security was later assigned to the
debtor, which maintained the money with the same attorneys (which were
also the successor debtor’s attorneys).48 Under the terms of the escrow
arrangement the debtor was to receive any interest on the funds prior to
the release of the collateral to the secured party.49 The contingent
event occurred and the escrowed funds were released to the secured party
shortly before the debtor filed for bankruptcy.50
The bankruptcy trustee argued that
the secured party’s security interest in the escrowed funds was not
perfected by possession because the secured party could only take the
funds if the contingency (the debtor’s failure to pay certain amounts)
occurred. The court instead focused on the debtor’s lack of control of
the disposition of the collateral. Finding that the funds were not
within the control of the debtor since the debtor retained only a
contingent right to the funds,51 the court
held that the secured party maintained possession of the collateral.
Out of the mist of Section 9-305
and cases thereunder, some signposts can be
detected to guide the Institutional Lender if the Notes are held by an
Affiliated Custodian that is not presumptively controlled by the
Originator. In particular, the likelihood that an Institutional
Lender’s security interest will be deemed to be perfected will increase
to the extent that (i) Originator controls
neither the activities of the Affiliated Custodian nor or the
disposition of the Notes, (ii) the name of the Affiliated Custodian
is readily distinguishable from that of the Originator and
(iii) the Affiliated Custodian takes measures, such as
segregating the Notes from other
proprietary and custodial assets, designed to provide notice of
the existence of the security interest.52
Nevertheless, given the
proclivity of judges (especially in insolvency proceedings) to set
aside security interests when afforded the opportunity, it is prudent to
assume for planning purposes that a court could avoid a security
interest when Notes are held by an Affiliated Custodian,
irrespective of the nature of the affiliation.
In light of the uncertainty, in
circumstances in which it is expedient to leave the Notes with the
Originator or an Affiliated Custodian, parties such as the Institutional
Lender may wish to avail themselves of the 1994 revisions to Article
8 of the UCC, discussed below.
An Institutional Lender also
confronts difficult perfection issues where the Notes have been lost or
destroyed (“Lost Notes”). A particularly vexatious problem may arise
if a Note, believed to be lost, is subsequently located at a time when
the Originator is in financial distress the Institutional Lender seeking
to exercise post-default remedies.53
Research has disclosed only
limited precedent relevant to the proper classification under Article 9
of the UCC of an asset such as a Lost Note or what rights, if any, a
secured party or other transferee, such as an Institutional Lender
acquires by an assignment of a Lost Note.
There are good arguments that a
Lost Note should be either an
“instrument” or a “general intangible”54 under the UCC, a
security interest in which, therefore, may be perfected
there is no precedent directly on point, the matter is
Under the definition of instrument
described in Section 9-105(1)(i) of the
UCC,55 a Lost Note will be an “instrument” if it (i)
is a “writing”, (ii) evidences a right to the payment of
and (iii) is transferred in the ordinary course of business by delivery.
The second requirement for a Lost
Note to be an instrument, i.e., that a Lost Note involves the
right to the payment of money, is plainly satisfied. It is less certain,
however, whether the other components of the definition are satisfied.
a copy or other reproduction of a Lost Note exists,
the writing requirement of the definition is obviously failed. Not
infrequently, however, reproductions of the Lost Notes in, e.g.,
microfiche form, will exist.
There is some support for the
proposition that a reproduction of an originally executed promissory
note is a writing, thereby
satisfying the first requirement. Under Section 1-201(46) of the UCC,
“writing” is defined to include “any intentional reduction to
tangible form.” Although the definition is not elucidated in the
relevant Official Uniform Comment, and research has found no case on
point, the “reduction” of a Lost Note to “tangible form” through the
medium of microfilm may cause such a Lost Note to satisfy the definition
of “writing.” As discussed below, there is some case law that supports
the proposition that a copy of an otherwise unavailable original
satisfies the requirement that a instrument
be reduced to writing.
The third requirement, that an
instrument be of a type which is in ordinary course of business
transferred by delivery with any necessary endorsement or assignment, is
most problematic. It does not appear that even a microfilmed copy of a
promissory note can be fairly said to be so transferred.
Nonetheless, the limited available case law does not rule out the
characterization of a Lost Note as an instrument.
A somewhat helpful holding
regarding the characterization of an asset such as a Lost Note as an
instrument is Bray v. Cadle Company,
880 S.W.2d 813 (Ct. App. Tex. 1994). In Bray, the borrower executed a
promissory note in favor of the lender, which note was secured by
another note that had previously been made in favor of the borrower (the
“Collateral Note”). Both notes were later assigned by the lender to the
appellee. Because the Collateral Note had
been lost, the appellee only received a
After the borrower defaulted on
its note and the lender sued for a deficiency judgment, the borrower
contended that because the original Collateral Note had been lost, the
lender, and therefore the appellee, lacked
an interest in the Collateral Note.57 The
court, however, apparently
treated the photographic copy of the Collateral Note as the functional
legal equivalent of the original.58
In particular, the court believed that since the original was lost, the
lender’s possession of the copy satisfied the “notice” function of a
possessory pledge.59 See also
General Elec. Co., Inc. v. Tracey Service Co., 729 F.2d 1446 (3d
Cir. 1984) (Table) (even though the stock certificate had been lost,
corporate stock was an “instrument”).60
Nevertheless, the Bray court’s
reasoning is not clear; it did not, for example, examine the
transferability characteristics incorporated in or even mention, the
definition of “instrument” in UCC Section 9-105(1)(i).
In addition to the problem of
characterization, it is not clear that the transfer of microfilmed
copies of the Lost Notes would perform the essential function served by
the possessory pledge of providing notice to
third parties that, because a creditor or its agent has physical
possession of property and the debtor therefore ostensibly has
surrendered possession, such property is subject to a security interest.
See, e.g., First Sav.
Bank of Virginia v. Barclays Bank, S.A., 618 A.2d 134 (D.C. App.
1992); In re Raiton, 139 B.R. 931 (Bankr.
9th Cir. 1992).61
Therefore, while it is possible,
it does not seem likely that a Lost Note, even if represented by a
reproduction, is an instrument.
If a court were to find that a
Lost Note is not an instrument, it could find that it is a “general
intangible.”62 This result is intuitively appealing. First, rights to
payment under various types of agreements, including swap receivables,
servicing rights and, indeed, uncertificated
loan participations, are understood to be general intangibles.
Although not directly on point,
Section 3-804 of the UCC is relevant to the analysis insofar as it
provides that the obligee of a Lost Note
retains a property right enforceable against its obligor. Under Section
3-804 of the UCC:
“The owner of an instrument which
is lost, whether by destruction, theft or otherwise, may maintain an
action in his own name and recover from any party liable thereon upon
due proof of his ownership, the facts which prevent his production of
the instrument and its terms.”
If, as Section 3-804 makes plain,
the obligee under a Lost Note has rights
thereunder enforceable against the obligor,
it would seem unreasonable to hold that such rights cannot be
effectively assigned. To hold otherwise would appear, among other
things, to contravene the UCC’s animating
purpose of “permit[ting] the continued
expansion of commercial practices through custom, usage and agreement of
There is one holding that,
although somewhat ambiguous, appears to support the characterization of
a Lost Note as a general intangible. In re
Southern, 32 B.R. 761 (Bankr. D.
Kan. 1983). In Southern, the debtors made a borrowing secured by a
promissory note and deed of trust arising from the sale of land to a
third party.64 After bankruptcy proceedings were initiated in respect of
the debtors, the lender was unable to find the collateral note.65 The
court indicated that, despite the lack of a
possessory pledge, the lender’s security interest would have been
properly perfected if it had filed a
Although it appears that the court therefore considered the lost
promissory note to constitute a general intangible, the court’s failure
to differentiate in this regard between the
contract for deed and the
note leaves the matter somewhat
Finally, although not concerned
with lost notes, the court’s holding in In
re Cambridge Biotech Corp., 25 UCC Rep. Serv.
2d 1076 (Bankr. D. Mass. 1995), is
consistent with the conclusion that assets such as the Lost Notes remain
personal property. In Cambridge, the issue before the court was
whether non-negotiable, non-transferable certificates of deposit were
instruments. In holding that they were instead general intangibles, the
court noted, significantly for purposes of the characterization of a
Lost Note as a general intangible, that because they were “personal
property . . . not excluded from the scope of Article 9 . . . [they]
must fall into the ‘catch-all’ category of ‘general intangibles’.”68
Under Revised Article 8
In 1994, the American Law Institute
and the National Conference of Commissioners on Uniform State Laws
approved a substantially revised version of Article 8 of the UCC
(“Revised Article 8”),69 which, as of
December 1, 2000, had been enacted in the District of Columbia and every
State except South Carolina. Most importantly for purposes of this
article, Revised Article 8 expanded the scope of its predecessor to
include not only traditional investment securities but the broader
concept of “investment property.”70 It is the elasticity of this concept
that enables parties such as an Institutional Lender in many
circumstances to perfect a security interest in Notes held by the
Originator or an Affiliated Custodian, Consumer Notes held by the
Originator, and in Lost Notes (or the functional equivalent of a
security interest therein).
The analysis proceeds as follows.
A security interest in “investment property”71 may be perfected
automatically,72 by “control”73 or, in most cases, by filing a UCC
financing statement.74 Perfection under Revised Article 8 is feasible
because the statute governs a broad range of investment property and
other “financial assets,”75 such as the Notes.
property” includes a
“security entitlement,”76 which arises when a “securities
intermediary” (i.e., a bank or broker that in the ordinary
course of business maintains securities accounts for others and is
acting in that capacity) credits a financial asset to a “securities
In addition to a security, a
“financial asset” includes any interest in property that “is, or
is of a type, dealt in or traded on financial markets or which is .
. . a medium for investment”78 and any property held by a
securities intermediary in a securities account if the securities
intermediary has expressly agreed to treat the property as a financial
asset.79 “Financial asset” also includes a “negotiable
As noted above, a security
interest in a security entitlement can be perfected automatically,81
by “control”82 or by filing a financing statement.83
“Control” of a security
entitlement is achieved in one of two ways. First, a secured party has
control if it becomes the entitlement holder 84 (i.e., has the
relevant financial assets credited to a securities account exclusively
in its name).85 Alternatively, a secured party has control over
financial assets that remain credited to the securities account of the
debtor (or an account whose name identifies both the ownership interest
of the debtor and the security interest of the secured party) if
the secured party obtains the agreement of the relevant securities
intermediary, with the consent of the debtor,
to comply with “entitlement orders”86 (i.e.,
directions) issued by the secured party without further consent of the
debtor. In a critical difference from the bailee-with-notice
context, ability of the debtor to withdraw or substitute collateral does
not impair the secured party’s “control” under Revised Article 8.
It appears that Notes, whether
Lost Notes, Mortgage Notes physically held by an Affiliated Custodian or
Consumer Notes held by the Originator, should satisfy the “functional”
text paraphrased above and thus qualify as financial assets. Even if
they did not, however, the parties may “opt into” Revised Article 8 by
obtaining the agreement of the relevant Custodian that
qualifies as a securities intermediary to treat the Notes as a
“financial asset.”87 A security entitlement to such a Note will
exist when the Custodian credits it to a securities account.88
Thus, as long as a Custodian
qualifies as a securities intermediary, an Institutional Lender
should be able to obtain a perfected security interest in Notes held by
an Affiliated Custodian or in Lost Notes if such Notes are
designated financial assets under Revised Article 8
and the Institutional Lender obtains control. Similarly,
if the Originator is holding Mortgage Notes or Consumer Notes and
qualifies as a securities intermediary, perfection by control should be
In addition, if the Originator is
not a broker or securities intermediary, the Institutional Lender can
perfect by filing an effective UCC-1 financing statement with respect to
In the case of Mortgage Notes held
by an Affiliated Custodian, concluding that the Lender is perfected may,
at first blush, seem contrary not only to Sections 9-304 and 9-305 of
the UCC, but to the ancient common law principles in which they are
rooted. Nevertheless, nothing in Revised Article 8 precludes an
institution that is a securities intermediary from acting as such with
respect to financial assets owned by its affiliates.
A critical difference between
attempting to perfect in a Note or other instrument held by a custodian
affiliated with the debtor under Section 9-305 and under Revised Article
8 is the difference between the Article 9 concept of
bailee and Revised Article 8 concept of
securities intermediary. The former is essentially relational; as
discussed above, it focuses on the relationship between the debtor and
the person or entity in possession of the collateral. The concept of
securities intermediary, in contrast, is functional; it is principally
concerned with the activities performed by such an entity in the
Moreover, since possession
by a nonaffiliated bailee has always
been available to perfect in an instrument, expanding the coverage of
the assets eligible for perfection through actions taken by a securities
intermediary under Revised Article 8 to include such financial assets as
promissory notes would be virtually pointless if the
bailee principle of
nonaffiliation were transplanted to the definition of securities
intermediary. Such a result would, in practice, not only conflict with
the plain language of the Revised Article 8, but would violate its
abiding purpose of modernizing the rules governing custody of financial
assets and providing more flexible means for perfecting security
The official commentary to Revised
Article 8 makes a decisive preemptive strike against any arguments that
the use of securities intermediaries should be shackled by common law
bailee precepts. In particular, such
commentary emphasizes that the “concept [of control] is not to be
interpreted by reference to similar concepts in other bodies of law.”91
Moreover, “the requirements for ‘possession’ derived from the common law
of pledge are not to be used as a basis for interpretation.”92
Accordingly, and crucially for purposes of the analysis, the control
provisions “are designed to supplant the concepts of ‘constructive
possession’ and the like.”93 Indeed, a “principal purpose” of including
the control provisions in Revised Article 8 was “to eliminate the
uncertainty and confusion”94 that the common law rules engender.
An interest in a Lost Note
likewise should be subject to perfection as a Revised Article 8
financial asset. The payment obligation represented thereby would appear
to satisfy the functional prong of the definition of financial
asset.95 Obtaining the agreement of the relevant
Custodian under UCC Section 8-102(a)(9)(iii)
to treat a Lost Note as a financial asset will eliminate any doubt
concerning its status in this regard.96 Perfection can thus be achieved
by implementing either of the control mechanisms described above.97
Accordingly, under Revised Article
8 the Institutional Lender will have a perfected security interest in a
security entitlement to Mortgage Notes or Lost Notes if
a Custodian that is a securities intermediary agrees to treat such Notes
as financial assets and either credits them to a securities account
exclusively in the name of the Institutional Lender or enters
into a “control agreement” with the Borrower and the Institutional
Lender respecting such Notes.
In the case of a Consumer Note or
a Mortgage Note held by the Originator that qualifies as a securities
intermediary, the same procedures can be implemented.
The agreements of the Custodian or
the Originator, as the case may be, in this regard need not be made in a
separate agreement, but may instead be incorporated in the
custodial or other agreement governing the relationship among
In addition, because a security
interest in investment property can also be perfected by filing a
financing statement,98 such a filing is a
useful precautionary measure.99 Such a filing should provide the
Institutional Lender with another basis for a first-priority security
interest in a security entitlement to the Notes. In the case of Mortgage
Notes, such a filing will also perfect a security interest in a Lost
Note to the extent it constitutes a general intangible.100
Finally, because a court could
conclude that a security interest in Mortgage Notes can in fact be
perfected by giving notice to an Affiliated Custodian under Article 9 of
the UCC, it is prudent formally to designate the Affiliated
Custodian as a bailee with notice of
the Institutional Lender’s security interest.
doubt concerning the
perfection of the Institutional Lender’s security interest in the Notes
may arise where the Notes must be held by an
Affiliated Custodian or where they have been, or are believed to
have been, lost. The Institutional
Lender may, therefore, find that its collateral is effectively worthless
precisely when the collateral is most needed–when the Originator is
insolvent or otherwise unable to perform its obligations.
financial asset and related control provisions of Revised Article 8
allow Institutional Lenders greatly to mitigate this risk, and do so in
a manner that is relatively easy to understand and document. As a
result, these provisions not only enhance the position of
Institutional Lenders, but should also increase the access
of Originators to credit.
1 In some cases, the insurance company or
investment bank may instead purchase the related mortgage loans
outright. In either case, bonds may subsequently be issued which are
backed by the future proceeds of the mortgages in a “securitization”
2 As a practical
matter, the Institutional Lender will likely conclude that under the
“mortgage-follows-the-note doctrine” the perfection of its security
interest in the Notes will perfect a security interest in the underlying
that this doctrine is codified in Sections 9-203(g) and 9-308(e) of the
revised version of Article 9 of the UCC that is scheduled to become
effective on July 1, 2001. Revised Article 9.
Secured Transactions (With Conforming Amendments to Articles 1, 2, 2a,
4, 5, 6, 7, and 8) (the “Revised UCC”).
See infra, “Perfection By Possession,”
and accompanying text.
Priorities between competing creditors are
determined under UCC § 9-312. In general, a perfected security
interest has priority over an unperfected security interest (UCC §
9-301(1)(a)). See note 5, infra,
and accompanying text.
5 UCC § 9-301(1)(b),
11 U.S.C. § 544.
6 UCC § 9-203.
7 UCC § 9-303.
8 UCC § 9-302(1).
9 UCC §§ 9-304,
10 UCC § 9-203(1)(c).
11 UCC § 9-203(1)(b).
12 UCC §
13 Defined in UCC
14 UCC §§ 9-203(1)(a),
8–106, 9-115(1)(e). The concepts of “investment property” and “control”
are discussed in detail, infra.
15 Defined in UCC
§ 9-105(1)(i) as
“a writing which evidences an obligation to pay money and is of a type
which is in ordinary course of business transferred by delivery with any
16 UCC §§ 9-304,
Possession is the
exclusive means of perfecting a security interest in the proceeds of a
letter of credit and money, and an alternative to filing in the case of
goods, documents, chattel paper and certificated securities. See
UCC §§ 5-116(a), 8-106(a), 8-301(a), 9-115(4)(a),
Note that the
Revised UCC provides that “control” is the exclusive means of protecting
a security interest in a “letter-of-credit right.” Revised UCC §§
9-102(a)(51), 9-107, 9-314(a).
a security interest in an instrument is automatically perfected for 21
days when granted in exchange for new value, and remains perfected for
21 days after possession is surrendered for purposes of ultimate sale or
collection. UCC § 9-304(4), (5).
18 United States
v. Jones, 533 F.2d 1387, 1391 (6th Cir. 1976).
Equipment Co. v. County State Bank, 518 F.2d 377, 381 (10th Cir. 1975).
Official Uniform Comment 1 to Section 9-304.
See also First Sav.
Bank of Virginia v.
Barclays Bank, S.A.,
19 UCC Rep. Serv. 2d 1167, 618 A.2d 134
(D.C. App. 1992); In re Raiton, 17 UCC
Serv. 2d 962, 139 B.R. 931 (Bankr.
9th Cir. 1992).
however, that the Revised UCC will permit perfection of a
security interest in an instrument by filing (Revised UCC § 9-312(a)),
although such a security interest generally will be subordinate to a
competing security interest therein that is perfected by possession
(Revised UCC § 9-330(d)).
Transport Equipment, supra, note 19 (presence of agent of secured
party on debtor’s premises insufficient to give notice).
to two leading commentators, the
principle of notice
has: “shaped the law of security interests in personal property for four
hundred years: A party who wishes to acquire or retain a[n] . . .
interest in property that is effective against others must, as a general
matter, make it
possible for others to discover
Douglas G. Baird
and Thomas H. Jackson, Possession and Ownership: An Examination of the
Article 9, 35
L. Rev. 175, 178 (1983).
22 David A.
Ebroon, Possession by Possession
In Article 9: Challenging the Arcane but
Rule, 69 Ind. L.J.
1193 (1994) citing In re Automated Bookbinding Services Inc., 471
F.2d 546, 551-552
(4th Cir. 1972).
24 15 U.S.C. §
80a-1 et seq.
25 543 F.2d at
27 Id. at
28 Although this
case and Rhode Island Hospital, note 31, infra, involved
(coincidentally) boats, and therefore are not entirely on point, they
are relevant insofar as they deal with perfection issues arising when
possessory collateral is placed with a
person or entity having a pre-existing relationship with the debtor.
29 Id. at
30 Id. (citing
Transport Equipment, note 19, supra).
31 Id. at
32 Id.; see
also Gibson v. Resolution Trust Corp., 51 F.3d 1016 (11th Cir. 1995)
(possession of collateral by law firm acting as agent for bank did not
amount to constructive possession by officers and directors); Merchants
Nat. Bank of Cedar Rapids, Iowa v. Halberstadt,
425 N.W. 2d 429 (Iowa App.
appointed auctioneer agent of debtor, not secured party).
33 151 B.R. at
34 151 B.R. at
In re Allen,
134 B.R. 373 (Bankr. 9th Cir. 1991) (bailee
need not be under secured party’s exclusive control so long as it is not
under the debtor’s exclusive control); Norwest Bank v.
Berquist (In re Rolain),
823 F.2d 198 (8th Cir. 1997) (creditor had a “perfected security
interest in notes held by debtor’s attorney because debtor lacked
unfettered use of notes).
According to a
bailee-with-notice technique . . .
contemplates the collateral being held or controlled by someone aligned
(at least initially) with the debtor. The bailee
presumably already has some pre-existing relationship with the debtor,
and his receiving notification of the secured party’s interest merely
operates to transfer possession – albeit constructively – to the secured
Possessory Security Interests
§ 14.04[a][ii] at 14-48 (1976).
36 Id. at
entirely clear, it appears that Seacoast held the notes beyond the
provided by UCC § 9-304(5).
this transaction was effected to forestall enforcement action by the
Commission with respect to the creditor corporation.
533 F. Supp. at 911.
39 Id. at
40 Id. at
917 (quoting 4B Collier, Bankruptcy, ¶ 70.86 at 982 (14th
41 Id. at
42 Id. at
43 Id. at
44 98 B.R. at 464;
see also UCC § 9-106.
45 Id. at
464; see also UCC § 9-302(1).
46 Id. at
47 Id. at
48 46 B.R. at 664.
49 The court
noted, however, that accrued interest was not, in fact paid to the
debtor and was instead transferred to the secured party, together with
the principal. Id.
50 Id. at
51 Id. at
52 We note that
certain courts prior to the enactment of the UCC held that a secured
creditor had a perfected security interest in property stored at the
premises of the debtor under “field warehouse” arrangements.
See generally Union Trust Co. v. Wilson, 198
U.S. 530 (1905); Bostian v. Park National
Bank, 226 F.2d 753 (8th Cir. 1955).
procedures necessary to establish the transfer of possession from the
debtor to the custodian in such an instance are “not measured by any
fixed set of rules,” McCaffey
Canning Co. v. Bank of America, 109 Cal. App. 415, 435 (Cal. Dist.
Ct. App. 1930), “[i]t is the duty of the
pledgee to make such segregation and marks
as will indicate his possession to business men [sic] of ordinary
prudence . . .”. Western National Bank v. Chapman
(In re Spanish-American Cork Products Co.), 2 F.2d 203, 204 (4th Cir.
by courts that found a valid possessory
pledge include (i) locking the collateral in
an area in which the debtor was denied access, (ii) identifying the
warehouse premises as subject to the interest of the creditor, and (iii)
tagging the collateral to furnish notice of the pledge.
Union Trust Co., 198 U.S. at 537; Manufacturers &
Traders’ Bank v. Gilman, 7 F.2d 94 (1st Cir. 1925).
For example, the security interest
of the Institutional Lender would likely be subject to the “strong arm”
avoidance power of the bankruptcy trustee. 11 U.S.C.
54 UCC § 9-106.
note 15, supra.
56 880 S.W.2d at
57 Id. at
59 Id. at
816-17; see also UCC §§ 9-304, 9-305.
60 The court in
In re Investors & Lenders, Ltd., 156 B.R.
145 (Bankr. D.N.J. 1993), held that because
the debtor maintained possession of the original promissory notes,
possession by the creditor of copies was insufficient to perfect its
security interest. The holding in Investors is distinguishable from the
facts assumed with respect to the Lost Notes, however.
61 At the same
time, the absence of originals of the Mortgage Notes eliminates a
critical risk otherwise addressed by the possessory
pledge, namely that the debtor will negotiate the paper to a third party
in violation of the rights of a creditor.
62 It is likely
that a Lost Note constitutes a “payment intangible”, and thus a “general
intangible,” under the Revised UCC, i.e., “a general intangible
under which the account debtor’s principal obligation is a monetary
obligation.” Revised UCC § 9-102(a)(61),
(42). A security interest therein will be
perfected by filing and a sale thereof will be automatically perfected
under the Revised UCC. Revised UCC §§ 9-310(a), 9-309(3).
It would not seem
that a Lost Note would fall into the other major category of intangible
payment rights under the UCC, i.e., “accounts,” since a Lost Note
does not constitute a “right to payment for goods sold or leased or for
services rendered.” UCC § 9-106.
enacted statute can be relevant to the interpretation of prior law.
See, e.g., red Lion Broadcasting Co. v.
Federal Communications Commission, 395 U.S. 367 (1969). Also,
the text of an approved, but not yet enacted, statute is relevant to the
interpretation of present law. See Carlson v.
Giacchetti, 21 UCC Rep. Serv. 2d
872 (Mass. App. 1993).
63 UCC § 1-102(2)(c).
64 32 B.R. at 763.
65 Id. at
It is not clear
whether, as in Bray, a copy of the
note existed and, if so, whether it was in the lender’s possession.
66 Id. at
67 To the extent
the Southern court found that the lost notes were general
intangibles, its holding is inconsistent with the holding in Bray
– underscoring the uncertainty in this area.
68 25 UCC Rep.
Serv. 2d at 1086.
8. Investment Securities (With Conforming and
Miscellaneous Amendments to Articles 1, 4, 5, 9, and 10).
70 Defined in UCC
71 UCC § 9-115(1)(f).
72 A security
interest in investment property granted by a “broker” (as defined in UCC
§ 8-102(a)(3)) or a “securities intermediary”
(as defined in UCC § 8-102(a)(14)) is automatically perfected when it
attaches UCC § 9-115(4)(c).
73 UCC §§ 9-115(1)(e),
74 UCC § 9-115(4)(b).
Note that filing is not an effective means of perfecting a security
interest in investment property where the debtor is a broker or
securities intermediary. UCC § 9-115(4)(c).
As noted above, a security interest in investment property granted by
such an entity is automatically perfected without further action. See
note 70, supra.
75 UCC § 8-102(a)(9).
76 UCC § 8-102(a)(17).
77 UCC § 8-501(a).
A “securities account” essentially is an account to which a financial
asset is credited by a securities intermediary for the owner or
78 UCC § 8-102(a)(9)(ii)
79 UCC § 8-102(a)(9)(iii).
UCC § 8-103(d).
instrument is negotiable if, among other things, it contains a promise
to pay a “sum certain” and is payable on demand or at a definite time.
UCC § 3-104.
See notes 72 and 74, supra.
82 See note
and accompanying text.
83 See note
74, supra, and accompanying text.
84 UCC § 8-106(d)(1).
85 UCC § 8-501(a).
86 UCC § 8-102(a)(8).
87 UCC § 8-102(a)(9)(iii).
88 A security
entitlement under the Revised UCC is not a specific property right in a
particular item. UCC § 8-503(b). Rather, it
is a bundle of contractual, statutory and property rights, the most
important of which involves the obligation imposed on a securities
intermediary to maintain sufficient interests in financial assets to
satisfy the claims of its entitlement holders. UCC §
89 Although the
security interest will be automatically perfected in this case, taking
the steps necessary to obtain control is advisable. For example, a
secured party with control in most instances takes free of any “adverse
claim” (as defined in UCC § 8°-102(a)(1)) to
the relevant investment property. UCC § 8-510.
Uniform Commercial Code - Investment Securities, Prefatory Note, 1.
Also, we note
that participants in the repurchase agreement (“repo”)
market have for some time been comfortable that an effective delivery
can occur with respect to, and a security interest perfected in,
securities subject to so-called “hold-in-custody”
repos, i.e., repos in which
the “seller”/borrower of funds does not deliver the securities to the
“buyer”/lender of funds.
appears to highlight the accommodation of traditional
bailee principles to commercial reality.
Uniform Comment 5 to Section 8-106.
95 See note
78, and accompanying text; see also UCC § 8-102(a)(9)(ii).
96 See note
79, and accompanying text.
notes 73, 81, 83 and 84, and accompanying text; see also UCC § 8-106(d)(1), (2).
98 But see
note 74, infra. As described in the text, in the case of an
Originator that is a securities intermediary, a filing will not be
effective. Instead, automatic perfection will apply. UCC § 9-115(4)(c).
99 Such a
financing statement should be filed in the jurisdiction in which the
Borrower maintains its chief executive office. UCC §§ 9-103(6)(d), 9-401.
note that under Revised Article 9, the proper jurisdiction to file a
financing statement with respect to a debtor that is a “registered
organization” (i.e., a corporation, limited partnership or
limited liability company) will change from the jurisdiction in which
the debtor’s place of business or chief executive office is located
to the jurisdiction under whose laws it is organized. Revised UCC
§§ 9-102(a)(70), 9-301, 9-307, 9-501(a).
100 Filing is an
alternative method of perfecting a security interest in an instrument
under the Revised UCC. See note 20, supra.