Chapter 27 Secured Party Versus Buyers
A. Generally
Among the transferees who may compete with secured parties are buyers. We have often seen references to purchasers. A buyer is a particular kind of purchaser, namely, one who contracts to buy goods or other property. The most important of such buyers probably is a buyer in ordinary course (BIOC), defined in revised section 1-201(b)(9) to include most buyers of goods from a seller who is in the business of selling such goods. A BIOC generally takes free of a security interest created by the person from whom the buyer buys the goods even though that security interest has been properly and timely perfected.
The rule for a buyer not in ordinary course and a BIOC of farm products resembles that applicable to lien creditors in that priority generally depends on the timing of perfection of the security interest.
A special priority rule gives consumer buyers from consumer sellers priority over security interests of secured parties who have relied on automatic perfection rather than filing a financing statement.
Bear in mind that these special priority rules apply only if the secured party did not authorize a sale to be made free of the security interest. If you do not understand why this is so you should review Chapters 9 (The Specifics of Enforceability -- After-Acquired Property, Future Advances, Transferred Collateral and Proceeds, and the New Debtor Problem) and 16 (Perfecting Security Interests in Proceeds and Other Later Acquired Property).
B. BIOC Disputes
As was true under former section 9-307(1), under new section 9-320(a) a buyer in ordinary course (BIOC), other than a BIOC of farm products from a person engaged in a farming operation, takes free of a security interest created by the buyer's seller even though the security interest is perfected and even if the buyer knows of its existence.
It has generally been assumed that the BIOC rule stems from the historical notion of the market overt and is designed to protect the reasonable expectation of a buyer that the buyer will get good title to goods when buying from a person engaged in the business of selling such goods. See Kevins collaborative English law glossary, available online at http://www.kevinboone.com/lawglos_MarketOvert.html, last visited on October 1, 2008.
It has been suggested that the rule is intended to protect a creditor's security interest, see, e.g., Foy v. First National Bank of Elkhart, 868 F.2d 252 (7th Cir. 1989), but it is not clear that this can be so except to the extent that the definition of a BIOC in Article 1, section 1-201(b)(9) circumscribes who may qualify as a BIOC in ways other than buying from a seller engaged in the business of selling such goods.
The person seeking BIOC status, and the priority over a secured party that goes with it, has the burden of proving that the requirements of such status in Article 1, section 1-201(b)(9) (formerly section 1-201(9)) have been met. See, e.g., Agriliance, L.L.C. v. Runnells Grain Elevator, Inc., 272 F. Supp. 2d 800 (S.D. Iowa 2003); Matter of Gary Aircraft Corp., 681 F.2d 365 (5th Cir.). The essence of BIOC status is found in the first sentence of Article 1, section 1-201(b)(9), providing as follows:
Buyer in ordinary course of business means a person that buys goods in good faith, without knowledge that the sale violates the rights of another person in the goods, and in the ordinary course of business from a person, other than a pawnbroker, in the business of selling goods of that kind.
As for the requirement that a buyer have taken the goods without knowledge that the sale violates the rights of another, which in the Article 9 setting means violates a security interest held by another, it is important to note that it is not simply knowledge that a security interest exists but rather knowledge that the sale violates that security interest that is necessary to deny a buyer BIOC status.
A buyer is aided in establishing that the buyer is without knowledge that the sale violates anothers security interest by the fact that it is actual knowledge, and not simply knowledge of facts that could put the buyer on notice of a violation, that is material. See Article 1, section 1-202 (formerly Article 1, section 1-201(25)). It is unlikely that non-consumers and many merchants will actually know the sale violates the rights of the secured party (as distinguished from knowing about a security interest). However, a buyer who is experienced in the ways of commercial financing may well wish to examine any security agreements executed by its seller. Cf. Matter of Gary Aircraft Corp., 681 F.2d 365 (5th Cir.) (in which an experienced buyer did in fact examine a security agreement by which the seller created a security interest in the goods sold).
There is authority under former Article 9 indicating that the date of the sale controls as to whether the buyer has knowledge that could prevent the buyer from qualifying as a BIOC and knowledge acquired after that date is not relevant. Matter of Gary Aircraft Corp., supra. The language of section 1-201(b)(9) certainly supports such an interpretation and one would not expect decisions under new Article 9 to differ on this point.
The other major requirements for qualifying as a BIOC, namely, taking in good faith and in the ordinary course of business are relatively less straightforward and require fuller explanation. Courts under former Article 9 were in disagreement about the meaning of these requirements. See, e.g., Brashers Cascade Auto Auction v. Valley Auto Sales and Leasing, 15 Cal. Rptr. 3d 70 (Cal. App. 2004) (and the cases discussed therein). The disagreement was largely traceable to the fact that "in ordinary course," as used in what was then Article 1, section 1-201(9) (now Article 1, section 1-201(b)(9)), was not defined in Article 9 or elsewhere in the UCC and good faith was defined in various sections of the UCC in different ways.
Good faith was defined in Article 1, section 1-201(19) (now Article 1, section 1-201(b)(20)) to mean honesty in fact. Under this definition a person acted in good faith so long as the person did not actually know that something was amiss or did not act with an ulterior motive. More particularly, a person could be a BIOC, insofar as the requirement of good faith was concerned, even though the facts and circumstances were such as would lead a reasonable person to inquire further and in so doing discover the seller was acting improperly.
Not surprisingly, especially for those courts that believed a buyer should not benefit from blissful ignorance at the expense of a secured party whose security interest would be lost if the buyer qualified as a BIOC, the question was how to impose upon the buyer a degree of responsibility that took greater account of the fact that the ultimate need was to properly allocate the loss resulting from a seller's misdeeds between the buyer and the secured party who were, to a greater or lesser extent, innocent. See, e.g., Brashers Cascade Auto Auction v. Valley Auto Sales and Leasing, 15 Cal. Rptr. 3d 70 (Cal. App. 2004) (and the cases discussed therein); Foy v. First National Bank of Elkhart, 868 F.2d 252 (7th Cir. 1989).
A few courts were able to achieve the desired goal by importing into the Article 9 determination of when a buyer qualified for BIOC status the definition of good faith in Article 2, section 2-103(b)(1) (since replaced), that required a merchant buyer not only to act honestly in fact, but also "in the observance of reasonable commercial standards of fair dealing." See the review of such cases in Brashers Cascade Auto Auction v. Valley Auto Sales and Leasing, 15 Cal. Rptr. 3d 70 (Cal. App. 2004). Under this definition, good faith took on an objective dimension that could impose upon a buyer a duty to inquire whenever the facts and circumstances would lead a reasonable buyer to do so. Id.
Other courts were less inclined to read the Article 2 definition of good faith into Article 9, but were not disposed to allow a buyer to qualify as a BIOC provided only that the buyer acted honestly in fact and bought from a seller engaged in selling goods of the kind that were the subject of the sale. For these courts it was necessary to find in the "in ordinary course of business" language of the definition of a BIOC the objective element of reasonable behavior they deemed appropriate. See Brashers Cascade Auto Auction and Foy, supra.
Whatever the means by which a court was able to read the definition of a BIOC to impose an objective standard of reasonable behavior the net result, as are all determinations of reasonableness, was to require an inquiry into the particular facts and circumstances in each case. A further consequence of the demand for an inquiry into particular facts and circumstances was that the ultimate determination of BIOC status became a question of fact subject to the limited scope of review accorded to fact finders and to the variations in outcomes from case to case that necessarily result from such a process.
This lengthy dissertation on the meaning of BIOC status has focused on the state of affairs under former Article 9 and, therefore, serves only as a prelude to the discussion of BIOC status upon the adoption of new Article 9 and changes made to the definitions governing BIOC status made in conjunction with the adoption of new Article 9.
A major change, one that as will be seen in later chapters impacts matters other than BIOC status, is that made to the definition of good faith itself. Initially in new section 9-102(a)(43) and then in a proposed revision to Article 1, section 1-201(b)(20), the definition of good faith was expanded to include the observance of reasonable commercial standards of fair dealing.
The quoted language imparts to the meaning of good faith, and thence to the definition of a BIOC in Article 1, section 1-201(b)(9), the objective element and concomitant duty of reasonable inquiry that courts struggled to impose under former Article 9. Cf. Official Comment 20 to Article 1, section 1-201 (tracing the evolution of the definition of good faith).
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 when a buyer qualifies as a buyer in ordinary course.
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 controls. However, since 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 is adopted or the expanded definition of good faith contained in new section 9-102(a)(43) is held to control determinations of buyer in ordinary course status, decisions under former Article 9, in which courts required as a condition of qualifying as a BIOC that a buyer behave reasonably under all the circumstances, should inform determinations of BIOC status under new Article 9 and new section 9-320(a).
Two useful examples of such decisions may be found in Brashers Cascade Auto Auction v. Valley Auto Sales and Leasing, 15 Cal. Rptr. 3d 70 (Cal. App. 2004) and Foy v. First National Bank of Elkhart, 868 F.2d 252 (7th Cir. 1989). In Foy the debtors inventory of vehicles was financed by a loan from a lender who took a security interest in the vehicles. The lender retained the certificates of title to the vehicles and would turn over a certificate only when the debtor paid for the vehicle it covered.
The debtor sold several vehicles to another dealer under an arrangement whereby the debtor would repurchase the vehicles from the buyer if the vehicles did not sell within some agreed upon period of time. The debtor told the buyer that it had the certificates of title for the vehicles and would make them available when a vehicle was resold. The debtors explanation for keeping the certificates of titles was that if a vehicle were repurchased the debtor would need the certificate of title. The debtor did not pay the loan debt from the sales of the vehicles and never obtained the certificates of title to the vehicles. When the debtor defaulted a dispute arose as to whether the buyer or the lender had prior claim to the vehicles.
The buyer argued that it had priority because as a BIOC it took free of the lenders security interest. The trial court held in favor of the buyer, essentially because it believed the buyers testimony that the buyer that it did not know that the debtor was failing to pay the lender and that there was nothing unusual about the fact that the debtor kept the certificates of title, both as a matter of local practice and because of the repurchase arrangement.
On appeal the trial court's decision was upheld. In its opinion, the court of appeals, without clearly specifying the source of the requirements, concluded that to be a BIOC a buyer had to have acted honestly in fact and also reasonably under all the circumstances, but whether the buyer satisfied the requirements were questions of fact and the court of appeals was obliged to defer to the trial courts answers to the questions.
The facts and the dispute in the Brashers case were quite similar to those in Foy. Once again, a debtor who sold vehicles to another dealer for resale failed to pay its lender when the vehicles were sold. Again, the buyer from the dealer did not receive certificates of title for the vehicles it bought. The trial court concluded that the buyer qualified as a BIOC who took free of the lenders security interest. In a very lengthy opinion, the appellate court reversed and remanded. It did so because the trial court had failed to apply legal standards that required a buyer to act in a commercially reasonable manner as well as honestly in fact.
As in Foy, the source of the commercially reasonable standard was not clearly identified, but the court expressed the belief that a sale, at least one to a merchant buyer, could not be in ordinary course unless the buyer acted in a commercially reasonable manner. Its belief was based very much on the court's assertion that such BIOC disputes are largely between two relatively innocent parties and that a rule that allocates the loss between the parties by looking to all the facts and circumstances is needed.
The court also was concerned that if a commercially reasonable standard were not imposed, there would be an inconsistency as between the Article 9 analysis of when a buyer qualified as a BIOC and the analysis under Article 2 of when a buyer was a BIOC for purposes of Article 2, section 2-403(2) (protecting a BIOC in an entrustment of goods situation).
Decisions as to BIOC status may also be informed by those made by courts inquiring into the meaning of good faith and notice as conditions on qualifying for holder in due course status and for the special priority given to certain purchasers of chattel paper and instruments under new sections 9-330 and 9-331(a). See, e.g., Agriliance, L.L.C. v. Runnells Grain Elevator, Inc., 272 F. Supp. 2d 800 (S.D. Iowa 2003). See generally, Chapter 29 (Secured Party Versus Secured Party (continued)). It should also be noted that decisions under former Article 9, see, e.g., Matter of Gary Aircraft Corp., 681 F.2d 365 (5th Cir. 1982), indicated that the good faith requirement did not impose on a person asserting BIOC status a duty of care and decisions thus far under new Article 9 appear to agree.
A possible expanded definition of good faith, either by virtue of adoption of the proposed revision to the Article 1 definition definition or adoption of the definition in new section 9-102(a)(43) containing the broader notion of good faith, is not the only change made in connection with adoption of new Article 9 that can affect BIOC status.
Article 1, section 1-201(b)(9) (revising an earlier version of Article 1, section 1-201(b)(9)), purports to define buying in ordinary course. See Official Comment 9 to Article 1, section 1-201(b)(9) (stating that "the second sentence [of the section] explains what it means to buy in ordinary course"). Thus, section 1-201(b)(9) provides that
A person buys in the ordinary course if the sale to the person comports with the usual or customary practices in the kind of business in which the seller is engaged or with the sellers own usual or customary practices. (Emphasis added.)
By this language the determination of when a sale is in ordinary course is made with reference to the usual and customary practices of sellers engaged in the same business or by reference to the particular sellers selling practices.
It may be that the requirement of ordinary course does little more than excluding sales that are outside ordinary course in the sense that they are made under terms that depart from the usual terms of sale, such as a fire or liquidation sale and sales that are made to a buyer to whom the seller customarily would not sell. So understood, the ordinary course requirement will be relatively easily satisfied in most cases.
It should be kept in mind that to be a BIOC under Article 1, section 1-201(b)(9), a buyer must buy in good faith and without knowledge that the sale violates a security interest held by another party and in ordinary course. Consequently, it seems that an independent inquiry must be made as to each of the conditions and a buyer could buy in ordinary course but still not qualify as a BIOC because the buyer did not buy in good faith or bought with knowledge that the sale violated the rights of a secured party.
There can be difficulties in applying new section 9-320(a) apart from the determination of whether a particular buyer qualifies as a BIOC. As indicated above, under new section 9-320(a) a BIOC takes free only of a security interest created by the seller from whom the buyer buys. There is no ready explanation for this limitation, but it must be kept in mind when applying the section.
Note, however, that a BIOC protected by new section 9-320(a) "takes free" of a security interest created by the buyer's seller. Therefore, a transferee from the BIOC acquires the goods free of that security interest. This result is traceable to the so-called "shelter principle" found in Article 2, section Article 2, section 2-403(1). Under that principle, a transferee by purchase of goods acquires all title that the transferee's transferor had or had power to transfer. See Official Comment 9 to former 9-301.
The fact that a transferee from a person who took free of a security interest also takes free of that security interest illustrates an important difference between taking free of a security interest and subordinating a security interest (as provided for in new section 9-317(a) (governing lien creditor disputes)). Additionally, it is possible for a secured party to "acquiesce" as to a particular sale and in so doing "entrust" the goods under Article 2, section 2-403(2). In such a case a buyer who is a BIOC can take free of a security interest even though the security interest was created by someone other than the seller from whom the BIOC buys.
Although decided under former Article 9, the case of Matter of Gary Aircraft Corp., 681 F.2d 365 (5th Cir.) offers what is perhaps the most complete explanation of the interaction between the buyers seller limitation in new section 9-320(a) and the shelter principle in Article 2, section 2-403(1). In Gary Aircraft, a dealer created a security interest in an airplane in favor of a lender who properly perfected its interest in the airplane by recording the interest with the FAA (see Chapter 19 (Perfection Pursuant to Federal Law)). Then, without the knowledge or consent of the lender, the dealer sold the airplane to a buyer who subsequently sold the airplane to another buyer.
It was held over the lenders objection that the buyer from the dealer met the burden of proof required for it to qualify as a BIOC and that although the second buyer could not take free of the lenders security interest under former section 9-307(1) the second buyer nonetheless was not subject to the lenders security interest because the second buyer took free of that security interest under the shelter principle of Article 1, section 2-403(1).
In the course of its opinion, the court dealt with the troublesome problem of the extent to which the Article 9 priority scheme could be altered by Article 2 provisions. It explained that the second buyer could not rely on the rule in Article 1, section 2-403(1), that a bona fide purchaser for value from a person who has voidable title gets good title because to do so would negate the buyers seller limitation in former section 9-307(1), but applying the shelter principle to protect the second buyer served only to give full effect to the taking free rule in former section 9-307(1) and the title acquired by the buyer from the dealer.
Although Gary Aircraft was decided under former Article 9, the courts reasoning in that case readily applies to the new Article 9 priority scheme created by new section 9-320(a) and Article 1, section 1-201(b)(9), and that priority remains subject to the shelter principle in Article 2, section 2-403(1). This is not to say that courts will always get it right.
Thus, in Leasing One Corp. v. Caterpillar Financial Services Corp., 776 N.E. 2d 408 (Ind. App. 2002), the court properly acknowledged the buyers seller limitation in new section 9-320(a), but seems not to have applied the shelter principle. That the shelter principle should have protected the subsequent buyer is not entirely clear because rather than a simple buyer from a buyer from a dealer situation, the case involved an assignee of a commercial lease through which a buyer had acquired equipment from a buyer from a dealer. The assignee of financing contracts situations poses the question of the extent to which a financer of a buyer who takes free of a security interest may stand in the shoes of the buyer as against the holder of that security interest and the answer to that question is unclear.
The facts of Leasing One also raised the question of whether the transaction between the transferor and the transferee of the equipment was a true lease or a lease intended as security. The court concluded that it was unnecessary to decide the question because in its view the outcome would be the same whether the transaction was a true lease or a lease intended as security. However, to the extent that an outcome turns on the application of new section 9-320(a) the answer to the question does matter because that section applies only if the transaction creates a security interest within the scope of Article 9. See Chapter 4 (Scope of Article 9).
In Arcadia Financial, Ltd v. Southwest-Tex Leasing Co., Inc., 47 UCC Rep. Serv. 2d 1371 (Tex. App. 2002), the court appears not to have understood that under the UCC, Article 1, section 2-401(1) (see Chapter 4 (Scope of Article 9)), conditioning a transfer of title to goods on payment operates only to create a security interest, and consequently failed to consider the distinct possibility that the buyers of vehicles at retail in that case would qualify as BIOCs and would take free of the security interest of the creditor from whom the dealer obtained the vehicles.
Curiously, the court did discuss Article 1, section 1-201(b)(9) in considering whether an assignee from the dealer of contracts arising from the sale of the vehicles could qualify as a BIOC. It concluded that the assignee was not a BIOC because it had knowledge that the terms of the agreement between the dealer and the creditor from whom the vehicles had been obtained had been violated.
Insofar as the assignment was considered independently of the sales giving rise to the contracts that were assigned, a shorter, more accurate, explanation would seem to be that only buyers in ordinary course of goods qualify for BIOC status under Article 1, section 1-201(b)(9). However, there would remain the question suggested above of whether the assignee of the contracts could stand in the shoes of a buyer who takes free of a security interest and knowledge of the assignee regarding a violation of the terms of a security agreement should not be attributed to the buyer so as to deny the buyer BIOC status.
On the other hand, as alluded to in Chapter 17 (Perfection as to Goods Subject to Certificate of Title Legislation), some certificate of title statutes provide that a transfer of a vehicle covered by a title issued under such a statute is not effective unless the certificate of title is transferred and where such a statute applies, unless the statute is expressly subject to Article 9, where a certificate is not transferred there may be no transfer of the vehicle such as would allow a buyer in ordinary course to take free of a security interest under new section 9-320(a). Cf., Vibbert v. PAR, Inc., 224 S.W.3d 317 (Tex. App. 2006).
As noted above, under new section 9-320(a), a buyer in ordinary course of farm products from a person engaged in a farming operation does not take free of a security interest created by the buyers seller. The reason for the farm products exclusion very simply is that agricultural lenders were able to get an exception. Application of the exclusion obviously requires knowing when goods are farm products. See Chapter 5 (Classification of Collateral). A BIOC of farm products gets some protection against unperfected security interests in new section 9-317(b), discussed below.
More importantly, Congress stepped in to confer protection of a BIOC of farm products in Food Security Act (FSA) of 1985, 7 U.S.C. § 1631. Under subsection (d) of act except as provided in (e) of this section and notwithstanding any other provision of Federal, State, or local law, a buyer who in ordinary course of business buys a farm product from a seller engaged in farming operations shall take free of a security interest created by the seller, even though the security interest is perfected; and even though the buyer knows of the existence of the such interest.
Thus, the FSA substitutes a federal law scheme for determining when a BIOC of farm products takes free of a security interest for the Article 9 rule. Subsection (e), to which the general rule of the FSA is subject, provides that if a states filing system has been certified by the Secretary of Agriculture as meeting the requirements of the FSA then a secured party who has filed an effective financing statement may give notification, the contents of which are spelled out in the act, to potential buyers of farm products that will prevent the buyers from taking free under subsection (d) of the act. See, e.g., Agriliance, L.L.C. v. Runnells Grain Elevator, Inc., 272 F. Supp. 2d 800 (S.D. Iowa 2003) (discussing the operation of the FSA).
It must be stressed that the notification scheme of the FSA is applicable only to the extent that the Secretary of Agriculture has certified that a states filing system satisfies the requirements of the act. In states whose filing systems have not been certified, the rule of subsection (d) of the act applies and BIOCs take free of security interest essentially on an equal footing with BIOCs of other than farm products under new section 9-320(a). Of course, even in a state whose filing system has been certified and in which the notification scheme is applicable, if a secured party fails to give the required notification then the BIOC takes free of the security interest.
The rule of new section 9-320(a) is subject to an exception found in new section 9-320(e). That section provides: