This post will further
examine Section 3-605 in preparation of next week’s post which present an
illustration of the Comprehensive Approach in dealing with Uniform Commercial
Code related matters. In the last post,
we looked at Sections 3-605(a)(b) which deal with releases and extensions of
obligations, on behalf of a principal obligor on an instrument, by a person entitled to enforce. The sections parallel one and other insofar
as no release or extension has any impact on obligations owed to a secondary
obligor by the principal obligor at the time of the extension. The release or extension impacts obligations
and rights which occur after the release or extension.
This basic scheme is
followed in Section 3-605(c) which deals with modifications other than a
release or extension of time. Section
3-605(c) reads as follows:
(c) If a person entitled to enforce an instrument agrees, with or
without consideration, to a modification
of the obligation of a principal obligor other than a complete or partial
release or an extension of the due date and another party to the instrument is
a secondary obligor with respect to the obligation of that principal obligor,
the following rules apply:
(1) Any
obligations of the principal obligor to the secondary obligor with respect to
any previous payment by the secondary obligor are not affected. The
modification correspondingly modifies any other duties owed to the secondary
obligor by the principal obligor under this article.
(2) The
secondary obligor is discharged from any unperformed portion of its obligation
to the extent that the modification would otherwise cause the secondary obligor
a loss.
(3) To
the extent that the secondary obligor is not discharged under paragraph (2),
the secondary obligor may satisfy its obligation on the instrument as if the
modification had not occurred, or treat its obligation on the instrument as
having been modified correspondingly.
Note at the outset, no consideration is required to make
the modification binding. Subsection (a)(1) states the basic rule stated. No modification affects the obligation of the
principal obligor to the secondary obligor for any payments made. However, the modification given by the person
entitled to enforce to the primary obligor ‘modifies any other duties owed to
the secondary obligor by the principal obligor under this article’.
As with
a release or extension, if the modification causes the secondary obligor a
loss, he or she is discharged to the extent of any loss caused to the secondary
obligor per Section 2-605(c)(2) If the
secondary obligor is not discharged under subsection (c)((2), Section
2-605(c)(3) gives the secondary obligor the option of accepting the
modification and proceeding accordingly, or ignoring the modification and
adhering to the terms of the original instrument.
The
final provision of Section 3-605 which deals with discharge of secondary
obligors on instruments is contained in section 3-605(d). Unlike the other sections discussed, this
particular provision has nothing to do with any contractual changes on the
note, but rather has to do with the collateral securing the note, which will
almost always be in play when there is a note.
Lenders want more protection than a signature; they want assets.
And this
is where you can clearly see the interrelationships between Articles. The law regarding promissory notes—
negotiable instruments—is governed by Article 3; secured transactions [reference
to collateral in Section 3-605] are governed by Article 9; both are directly
impacted by Article 1. This sets a basic
structure for the comprehensive analysis noted above which will be presented
next week.
Section 3-605(d) reads as follows:
(d) If the obligation of a principal obligor is
secured by an interest in collateral, another party to the
instrument is a secondary obligor with respect to that obligation, and a person
entitled to enforce the instrument impairs the value of the interest in
collateral, the obligation of the secondary obligor is discharged to the extent
of the impairment. The value of an interest in collateral is impaired to the
extent the value of the interest is reduced to an amount less than the amount
of the recourse of the secondary obligor, or the reduction in value of the
interest causes an increase in the amount by which the amount of the recourse
exceeds the value of the interest. For purposes of this subsection, impairing
the value of an interest in collateral includes failure to obtain or maintain
perfection or recordation of the interest in collateral, release of collateral
without substitution of collateral of equal value or equivalent reduction of
the underlying obligation, failure to perform a duty to preserve the value of
collateral owed, under Article 9 or other law, to a debtor or other person
secondarily liable, and failure to comply with applicable law in disposing of
or otherwise the interest in collateral.enforcing the interest in collateral.
At the
outset, we see a major difference in the content of Section 3-605(d) and the
other subsections discussed. This
subsection, unlike the others, is not contingent upon a release, extension or
modification of the original note.
Rather, subsection (d) to Section 3-605 is focused on property which in
which an interest has been taken [collateral] which may be utilized by the
lender in the event the principal obligor fails to make payment as called for
by the note.
In order
for Section 3-605(d) to make sense, a brief introduction to Article 9 is
required. Article 9 is entitled Secured
Transactions and envisions a situation in which a loan is made by a lender
[secured party] to a borrower [debtor], with the loan being secured by certain
property [collateral] of the debtor. For
example, borrower wants a $100,000.00 loan from lender. Lender agrees to loan borrower the
$100,000.00 provided that borrower agrees to give lender a ‘security interest’
in his inventory to secure payment of the loan.
Although Secured Transactions are governed by Article 9, the definition
of a ‘security interest’ is contained in Article 1:
“Security interest” means an
interest in personal property or fixtures which secures payment or performance of an
obligation…. Section 1-201(b)(35)
The property is called collateral:
“Collateral” means the
property subject to a security interest…. Section 9-102(a)(12)
The agreement between the secured party and the debtor is
called a ‘security agreement’:
“Security agreement” means
an agreement that creates or provides for a security interest. Section 9-102(A)(72)
Placing
the foregoing discussion in the context of Section 3-605(d) we have the
following:
1. Secured
party loans debtor $!00,000.00;
2. Secured
party requires a secondary obligor to back debtor’s obligation;
3. Accommodation
maker signs the note as a secondary obligor;
4. The
note is further secured by a security interest in debtor’s inventory;
5. Action by lender impairs the value of the inventory.
Section 3-605(d) is
activated when the person entitled to enforce [typically the lender/secured
party] ‘impairs the value of the interest in the collateral’. Section 3-605(d) states that the value of
collateral is impaired:
1. “to
the extent the value of the interest is reduced to an amount less than the
amount of the recourse of the secondary obligor; or
2. “the
reduction in value of the interest causes an increase in the amount by which
the amount of the recourse exceeds the value of the interest.”
The section provides
examples of behaviors by a secured party which would constitute an impairment
of collateral:
1. Failure to obtain or maintain perfection or recordation of
the interest in collateral;
2.
Release of collateral without
substitution of collateral of equal value or equivalent reduction of the
underlying obligation;
3.
Failure to perform a duty to preserve
the value of collateral owed, under Article 9 or other law, to a debtor or other
person secondarily liable;
4. Failure to comply with applicable law in
disposing of or otherwise the interest in collateral.enforcing the interest in collateral.
These are illustrative only and therefore there are other
examples of impairment of value of collateral.
The comments to Section 3-605 state that this has been heavily litigated
which provides fertile ground for case law support for statutorily based
theories.
I think
it is safe to say that several more posts could be written on Section 3-605;
however, to keep pace with the flow of the posts and to move through as much
statutory material as possible, it is time to move on. The core concepts of Section 3-605 have been
articulated and can be refined to whatever extent is necessary in a particular
situation.
Section 3-605 will be
further discussed in the next post as part of the fact pattern presented in
connection with the comprehensive approach.
Below, I
have reproduced a brief excerpt from The
Uniform Commercial Code Made Easy which discusses some of the basics of
Article 9. This is not a book promotion,
but is presented to assist in understanding the basic Article 9 concepts which
intersect with Section 3-605(d).
Explanation Through Dialogue: Secured Transactions
“Remember,” responded Alan, “when we were at the bank and Fred
Luvick told you that the bank would need security of some sort before it would
fund the loan?”
Stephen nodded.
“Well,” continued Alan, “the legal vehicle by which it will get
the security in the property listed in paragraphs 1, 2, 3 and 4 is called a ‘security
interest’. It is defined in the Uniform Commercial Code in part as: “…an
interest in personal property…which secures payment…of an obligation.’ 3
“What is the obligation being referred to?” Stephen interrupted.
“Your obligation to repay the bank per the payment schedule you
ultimately agree upon,” responded Alan.
“What interest in the property will the bank have?” Stephen asked.
“Its interest will be comprised of certain legal rights it will
have in the listed property,” responded Alan, “which it can exercise in the
event you fail to perform your obligations to it under the terms of the
Security Agreement or Loan Agreement.”
“If for example, you
failed to meet your obligations to the bank under the Loan Agreement by not
meeting your payment schedule, the bank could, under certain circumstances,
take possession of your inventory and sell it to recover the money you owe it.”
“By the way,” Alan said, “this property is called ’collateral’
under the Code.” 4
Alan could see that
Stephen was having some trouble grasping the concept, “Stephen,” he said, “Let
me give you an example which can help clear this up for you. Let’s assume that
instead of borrowing money from the bank for the boat business, you are
borrowing $750 from a pawnbroker. As you know, he won’t give you the money
unless you give him some property. And of course the property must be worth at
least as much as the loan or he probably won’t lend. Anyway, let’s assume that
he takes your watch worth $1200 and you agree that if you don’t pay him back
within, say, 60 days, he can keep the watch. In Article 9 language, he would
have a ‘security interest’ in the watch.
“That is, the pawnbroker
would have ‘an interest in personal property’ i.e. the rights you and he
agree that he shall have in the watch, which secures payment of an obligation:
your obligation to repay the money you borrow from him.
“Your situation with the bank,” Alan continued, “is basically the
same, except, of course, that bank won’t have physical possession of the boats.
First, the bank, like the pawnbroker, won’t lend money without security. In the
pawnbroker situation, the security is the watch, in the bank situation, it will
primarily be the boats. Failure to make your payments to the bank will give the
bank similar rights with the boats and other property listed that the
pawnbroker would have with the watch. For example, subject to certain rules, it
can sell the boats to recover money you owe if you don’t meet your obligations
to it. Thus, the interest which the bank has in the collateral, i.e., the security
interest, like the pawnbrokers interest in the watch, secures payment of your
obligations to it to repay the money borrowed.
As you can see, the loan agreement is specifically referred to in
the Security Agreement in the last paragraph before the default provisions. As
you notice, the bank is under an obligation to lend you additional money in the
amount of $400,000 upon your securing either the Crown or Marina account. This
obligation on the part of the bank is sort of like the after acquired property
clause we discussed this morning. This particular clause is called a “future
advance clause”. It, like the after acquired property clause, was
looked upon with disfavor in earlier case law. It has now been validated by
§9-204 of the Uniform Commercial Code.
“The Uniform Commercial Code gives special names to the parties in
such a transaction. Since the bank would be a lender in whose favor you would
be creating the security interest, the bank would be called the ‘secured
party’. 5 Since you have an interest in the collateral, you will be called
the ‘debtor’. 6 As you can see, this
agreement is titled “Security Agreement”. The reason is because
it is an agreement which creates a security interest.” 7
___________________________
___________________________
5 “Secured party” means
a person in whose favor a security interest is created or provided for under a
security agreement. . . Section
9-102(a)(72)(A)
6 Debtor” means a
person having an interest, other than a security interest or other lien, in the
collateral, whether or not the person is an obligor; Section 9-102(a)(28)(A)
7 “Security agreement”
means an agreement which creates or provides for a security interest. Section 9-102(a)(73)
The general validity of a security agreement is set forth in §9-201:
The general validity of a security agreement is set forth in §9-201:
Except as otherwise provided in [the Uniform
Commercial Code] a security agreement is effective according to its terms
between the parties, against
purchasers of the collateral, and against creditors. Section 9-201(a)
There are exceptions to the basic rule noted
above which are contained in subsections (b), (c) and (d). Most notable
among these exceptions is subsection (b) which deals with “any applicable
rule of law which establishes a different rule for consumers. . . .”
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