Negotiating and Interpreting ‘Best Efforts,’ ‘Ordinary ...media.straffordpub.com/products/negotiating-and-interpreting-best...Negotiating and Interpreting ‘Best Efforts,’

Negotiating and Interpreting ‘Best Efforts,’

‘Ordinary Course of Business’ and Anti-Assignment

Provisions in Secured Lending Transactions Documenting Grant of Security Interest in Assets Subject

to Anti-Assignment Clause and Interpreting Complex Covenants

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THURSDAY, JULY 31, 2014

Presenting a live 90-minute webinar with interactive Q&A

Joerg H. Esdorn, Partner, Gibson Dunn, New York

Darius Mehraban, Partner, Gibson Dunn, New York

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<Presentation Title/Client Name>

Selected Topics in

Secured Lending Transactions Interpreting and Drafting “Ordinary Course of Business”

and “Best Efforts” Clauses, and

Addressing Anti-Assignment Provisions

Presented by: Joerg H. Esdorn and Darius Mehraban

Thursday, July 31, 2014


Interpretation of Certain Common Terms in Debt Agreements

• “Ordinary course of business” – Examples of common usage

– Legal guidance

– Recommendations

• “Best efforts,” “reasonable best efforts,” and “commercially reasonable efforts” – Examples of common usage

– Legal guidance

– Recommendations

6


“Ordinary Course of Business”: Examples of Common Usage

• Exceptions to asset sale covenant

– “Borrower may sell inventory in the ordinary course of business.”

– “Borrower may liquidate or otherwise dispose of obsolete, damaged,

expired, uneconomic, or worn-out property in the ordinary course of

business.”

• Exceptions to indebtedness covenant – “Indebtedness in respect of bid, performance or surety bonds or letters of

credit issued in the ordinary course of business, including letters of credit

supporting lease obligations or supporting (or in lieu of) such bid,

performance or surety bonds or in respect of workers’ compensation

claims.”

7


“Ordinary Course of Business”: Examples of Common Usage

• Exceptions to affiliate transactions covenant

– “Payments made and other transactions entered into in the ordinary course

of business with Affiliates upon fair and reasonable terms no less favorable

to the relevant Borrower than it would obtain in a comparable arm’s length

transaction with a Person that is not an Affiliate.”

8


“Ordinary Course of Business”: Legal Guidance

• Black’s Law Dictionary definition

– “Normal routine in managing a trade or business.”

• Contexts where term has been interpreted – Commercial contracts

• There is no case law interpreting “ordinary course of business” in the context of

debt agreements; however, there is case law interpreting this term in

commercial contracts, which may provide guidance when interpreting the term

in the context of debt agreements.

9



• Contexts where term has been interpreted (cont’d)

– U.C.C. “buyer in the ordinary course of business”

• U.C.C. § 9-320(a) – “[A] buyer in ordinary course of business . . . takes free of

a security interest created by the buyer’s seller, even if the security interest is

perfected and the buyer knows of its existence.”

• U.C.C. § 1-201(b)(9) – “A person buys goods in the ordinary course if the sale .

. . comports with the usual or customary practices in the kind of business in

which the seller is engaged or with the seller’s own usual or customary

practices.”

10



• Contexts where term has been interpreted (cont’d)

– Bankruptcy

• 11 U.S.C. § 363(c) – Limitations on transactions and use of property during

bankruptcy. Unless the court orders otherwise, the debtor may enter into

transactions, including the sale or lease of property of the estate, in the

“ordinary course of business,” without notice or a hearing, and may use

property of the estate in the “ordinary course of business” without notice or a

hearing.

• 11 U.S.C. § 547(c)(2) – The trustee may not avoid a preferential transfer to the

extent that such transfer was in payment of a debt incurred by the debtor in the

“ordinary course of business” of the debtor and the transferee, and such transfer

was made in the “ordinary course of business” of the debtor and the transferee.

11



• Contexts where term has been interpreted (cont’d) – Tax

• I.R.C. § 1221(a)(1) – Income from certain sales of goods is treated as ordinary

income rather than capital gains if it is derived from the sale of property held

for sale to customers in the “ordinary course of the business.”

12



• Various meanings in other areas of law – Previous conduct/past practice

• Unisys Corp. v. Hercules Inc. (N.Y. App. Div. 1996)1 – Under New York law, in a dispute over the interpretation of an agreement for the sale of a subsidiary, a New York intermediate appellate court stated that something done as a matter of “corporate historical practice” constitutes “ordinary course of business” as a matter of law.

• Preferred Care Partners Holding Corp. v. Humana, Inc. (S.D. Fla. 2009)2 – A federal district court in Florida, applying Florida law, interpreting a confidentiality agreement that prohibited contact with doctors who were part of plaintiff’s healthcare network except “in the ordinary course of business,” determined that defendant’s contract renegotiations with doctors who were both within defendant’s and plaintiff’s healthcare network were in the ordinary course of business since those negotiations were “normal” and “routine” compensation discussions with providers within defendant’s network.

13



• Various meanings in other areas of law (cont’d) – Previous conduct/past practice (cont’d)

• Grober v. Comm’r (T.C. 1972)3 – When U.S. Tax Court reviewed whether a sale of machinery and equipment was in ordinary course of business, court looked at “the taxpayer’s purpose in acquiring and in disposing of the property, the continuity of sales or sales-related activity over a period of time, the number and frequency of sales, the substantiality of sales and the overall history of the operation.”

14



• Various meanings in other areas of law (cont’d) – Infrequent conduct/first-time conduct

• Tanbro Fabrics Corp. v. Deering Milliken, Inc. (N.Y. 1976)4 – New York Court of Appeals deemed a company’s sale of excess fabric as within the ordinary course of business for purposes of U.C.C. § 9-307 even though the seller’s predominant business was dyeing unfinished fabric. The court pointed to the fact that the company had previously sold such goods and there was, in fact, a common practice in the industry, i.e., to be reasonably expected.

• Bontemps v. Bank of Babylon (N.Y. App. Div. 1983)5 – New York intermediate appellate court ruled a company’s sale of a car may still be part of ordinary course of business for purposes of U.C.C. § 9-307 even if it is infrequent or incidental to its predominant business of leasing cars.

15



• Various meanings in other areas of law (cont’d) – Infrequent conduct/first-time conduct (cont’d)

• Gosch v. Burns (6th Cir. 1990)6 – Transaction between the bank and borrower can be in the ordinary course for purposes of Section 547(c)(2) of the Bankruptcy Code even if it is the first such transaction taken by the customer because “obviously every borrower who does something in the ordinary course of affairs must, at some point, have done it for the first time.” This becomes fact-specific inquiry that looks to whether the transaction “would not be out of the ordinary for a person in the borrower’s position” in the same transaction.

16



• Various meanings in other areas of law (cont’d) – Creditor’s expectation test (Bankruptcy Code § 363)

• In re Lavigne (2d Cir. 1997)7 – The “creditor’s expectation test” or the “vertical test,” “‘views the disputed transaction from the vantage point of a hypothetical creditor and inquires whether the transaction subjects a creditor to economic risks of a nature different from those he accepted when he decided to’ enter into the contract with the debtor.”

– Industry-wide test (Bankruptcy Code § 363)

• In re Lavigne (2d Cir. 1997) – The industry-wide perspective, also called the horizontal test, determines “ordinary course of business” by looking at whether “the transaction is of a type that other similar businesses would engage in as ordinary business.”

17


“Ordinary Course of Business”: Recommendations

• Consistency and precision in usage – If the document switches between “ordinary course of business” and

“ordinary course of business consistent with past practices,” an inference

can be made that “ordinary course of business” is broader than past

practice.

– If consistency with past practice, or customary usage in the industry, is an

important point, expressly state this in the language.

18



• Define the scope of “ordinary course” in the agreement? – Example: “Ordinary Course of Business” – an action taken by a Person will be deemed to

have been taken in the Ordinary Course of Business only if that action: (a) is consistent in

nature, scope and magnitude with the past practices of such Person and is taken in the

ordinary course of the normal, day-to-day operations of such Person; (b) does not require

authorization by the board of directors or shareholders of such Person (or by any Person or

group of Persons exercising similar authority) and does not require any other separate or

special authorization of any nature; and (c) is similar in nature, scope and magnitude to

actions customarily taken, without any separate or special authorization, in the ordinary

course of the normal, day-to-day operations of other Persons that are in the same line of

business as such Person. COMMITTEE ON NEGOTIATED ACQUISITIONS, AMERICAN BAR

ASSOCIATION, MODEL ASSET PURCHASE AGREEMENT WITH COMMENTARY (2011).

19



• Flexibility of interpretation – If “ordinary course of business” is left undefined, there is more flexibility

for the borrower to interpret its meaning because the lender will have a

difficult time proving existence of a default.

– Most would say that a material incurrence of indebtedness would generally

not count as “ordinary course of business.”

– Also, actions requiring specific board approval would arguably not count

as “ordinary course of business.”

20


“Best Efforts,” “Reasonable Best Efforts,” and “Commercially Reasonable Efforts”:

Examples of Common Usage

• Syndication assistance in commitment letters – “You shall assist the Lead Arrangers in their syndication efforts, including

by making available your, and using commercially reasonable efforts to

cause the Target to make available the Target’s officers, representatives, and

advisors.”

21




• Financing cooperation covenants in merger agreements – “The Purchaser shall, and shall cause its Affiliates to, use reasonable best

efforts to obtain the Debt Financing on the terms and conditions described

in the Debt Commitment Letter, including using reasonable best efforts to:

(i) enter into definitive agreements with respect to the Debt Financing

(including agreeing to any requested changes to the Debt Commitment

Letter by the committed lenders in accordance with the related flex

provisions); (ii) satisfy (or obtain a waiver) on a timely basis of all

conditions in such definitive agreements (within the Purchaser’s control);

and (iii) consummate the Debt Financing contemplated by the Debt

Commitment Letter at Closing.”

22




• Covenants regarding deliverables (e.g., certain financial statements, further assurances relating to collateral, insurance) – “The Borrower will use commercially reasonable efforts to obtain, on or

before 30 days after the date hereof, in the form agreed upon or otherwise in

a form and substance satisfactory to the Administrative Agent, an executed

Landlord Waiver, for each of the following locations. . . .”

23




• Covenants regarding regulatory approvals – “Borrower shall use its commercially reasonable efforts to assist in

obtaining from the FCC or such other Governmental Authority the

necessary consent, approval and authorization, if any, for the assignment

of or the direct or indirect transfer of control of such FCC Licenses.”

24



Legal Guidance

• How far must a party go to satisfy “best efforts”? – Bloor v. Falstaff Brewing Corp. (2d Cir. 1979)8 – Second Circuit

recognized a brewery on hard times could give “reasonable consideration

to its own interests” to satisfy a “best efforts” clause that required it to

promote another beer. In its discussion, the court affirmed the lower

court’s interpretation, which did not require the brewery “to bankrupt itself

. . . or even to sell those products at a substantial loss” to meet the standard.

25



Legal Guidance

• How far must a party go to satisfy “best efforts”? (cont’d) – Showtime Networks Inc. v. Comsat Video Enters. (N.Y. Sup. Ct. 1998)9 –

In applying New York law, a trial court in Manhattan stated that whether

“best efforts” or “reasonable business efforts” obligations were satisfied is

an issue of fact undeterminable on summary judgment; however, the court

went further to state that financial difficulty does not excuse performance

under either standard. The court distinguished Bloor on the grounds that

the defendant did not show that it met the Bloor test that performance

would be “financially disastrous.”

26



Legal Guidance

• Decisions suggest a blurred standard – Kroboth v. Brent (N.Y. App. Div. 1995)10 – Applying New York law, the

court stated that “‘best efforts’ requires more than ‘good faith,’ which is an

implied covenant in all contracts.” At the same time, the court inserted a

reasonableness standard into “best efforts” when it held that best efforts

“require[d] that plaintiffs pursue all reasonable methods.”

– Scott-Macon Secs., Inc. v. Zoltek Cos. (S.D.N.Y. 2005) 11 – When

evaluating whether a company had used “reasonable efforts,” a New York

federal court stated that “New York courts use the term ‘reasonable efforts’

interchangeably with ‘best efforts.’”

27



Legal Guidance

• Decisions suggest a blurred standard (cont’d) – But see LTV Aerospace & Defense Co. v. Thomson-CFF, S.A. (S.D.N.Y.

1996)12 – “The standard imposed by a ‘reasonable efforts’ clause . . . is

indisputably less stringent than that imposed by the ‘best efforts’ clauses

contained elsewhere in the Agreement.” Citing Bloor, the court stated:

“[t]herefore, in order to prevail upon its allegations that LTV did not exert

reasonable efforts to consummate the transaction, Thomson must

demonstrate that LTV’s actions were inconsistent with good faith business

judgments.”

28



Recommendations

• Use the variation you believe to be most appropriate, despite court decisions that blur the standards – Base this on the situation or your client’s interest.

• Define or limit the scope – Clarify by defining what constitutes “best efforts,” “reasonable best

efforts,” or “commercially reasonable efforts” or otherwise limiting the

scope of the obligation.

29



Recommendations

• Examples of definitions – Best Efforts means the efforts that a prudent Person desirous of achieving a

result would use in similar circumstances to ensure that such result is

achieved as expeditiously as possible on commercially reasonable terms.

– Commercially Reasonable Efforts means the efforts that a prudent Person

desirous of achieving a result would use in similar circumstances to

achieve that result as expeditiously as possible; provided, however, that a

Person required to use commercially reasonable efforts under this

Agreement will not be required to take actions that would result in a

material adverse change in the benefits to such Person of this Agreement

and the transactions contemplated hereby or to dispose of or make any

change to its business, expend any material funds or incur any other

material burden.

30



Recommendations

• Examples of specific limitations – Prior to any public offering of registrable securities, Company shall use

commercially reasonable efforts to cooperate with applicable Holders to

qualify the securities under state securities or blue sky laws; provided that

the Company shall not be required to (1) qualify as a foreign corporation,

(2) execute any general consent to service of process in any jurisdiction

where it would not otherwise be required to so qualify, or (3) subject itself

to taxation or service of process in any such jurisdiction.

31



Recommendations

• Examples of specific limitations (cont’d) – Company agrees to use commercially reasonable efforts to obtain an

amendment, waiver or consent under its existing senior credit agreement to

permit the issuance of the Exchangeable Shares and related transactions,

but Company shall not be required to pay any fee to the lenders under the

existing senior credit agreement or to accept any pricing increase, or make

any other material concession relative to the existing terms of such credit

agreement, in order to obtain such amendment, waiver or consent.

32


Dealing with Contractual and Legal Restrictions on Assignment in the Context of Secured Lending

• Anti-assignment provisions – Overview

• Contractual restrictions on assignment

• Legal restrictions on assignment

• The U.C.C. “override” provisions

33


Anti-Assignment Provisions – Overview

• What is the effect of an anti-assignment provision on a security interest? – Anti-assignment provision may prevent attachment of a security interest, or

prohibit the enforcement of a security interest, or both. For a secured

creditor, it is important to analyze the provision to determine if it only

restricts outright assignments or whether it also restrict assignments for

security purposes (i.e., security interests).

• Is the anti-assignment provision subject to the U.C.C. override provisions? – The U.C.C. may override certain types of contractual and legal (i.e.,

statutory) anti-assignment provisions.

34



• What are the ramifications of breaching an anti-assignment provision? – Breach of an anti-assignment provision may subject the borrower to

damage claims for breach of contract or, depending on the language in the

anti-assignment provision, void the assignment, give the counterparty to

the agreement termination rights in case of material breach, or under

certain circumstances subject the lender to tort liability for tortious

interference with contractual relations.

35



• Certain examples – Borrower selling goods under buyer’s purchase order, and purchase order

has an anti-assignment provision governing the purchase order and the

resulting account.

– Borrower leases equipment under a lease with anti-assignment provisions.

– Borrower is the licensor of intellectual property pursuant to a licensing

agreement with anti-assignment provisions.

– Borrower holds a promissory note which requires the payor’s consent to an

assignment.

36


Contractual Restrictions on Assignment: Introduction

• The U.C.C. generally does not define “assignment” – Official comment 26 to U.C.C. § 9-102 states “[t]his article generally

follows common usage by using the terms ‘assignment’ and ‘assign’ to

refer to transfers of rights to payment, claim, and liens and other security

interests.” Furthermore, it may refer to “an assignment or transfer of an

outright ownership interest or the assignment or transfer of a limited

interest, such as a security interest.”

37


Contractual Restrictions on Assignment: Assignment v. Delegation

• Assignment of rights – Transfer of a right to performance to a third party. See RESTATEMENT

(SECOND) OF CONTRACTS § 317(1).

– It seems from comment 26 to U.C.C. § 9-102 that the grant of a security

interest may constitute an assignment of limited rights under the contract

(i.e., a conditional assignment).

• Delegation of duties – Appointment by one person of another to perform either a duty or a

condition to the other party’s performance. RESTATEMENT (SECOND) OF

CONTRACTS § 318(1).

– Depending on the circumstances, the enforcement of a security interest may

constitute a delegation of duties.

38


Contractual Restrictions on Assignment: Interpretation of Common Formulations

• “No party may assign this Agreement” – When a contractual provision simply prohibits “assignment of the contract,”

the limitation will only be construed to prohibit a delegation of duties under

the contract. See RESTATEMENT (SECOND) OF CONTRACTS § 322(1); U.C.C. §

2-210(3).

• “No party may assign any rights under this Agreement” – This has been construed to be a “personal covenant” of the assignor and a

violation of the covenant does not render the assignment ineffective. Rather,

it gives rise to damages against the assignor for the breach of such covenant.

RESTATEMENT (SECOND) OF CONTRACTS § 322(2)(b); see Pro Cardiaco

Pronto Socorro Cardiologica S.A. v. Trussell (S.D.N.Y. 1994).13

39


Contractual Restrictions on Assignment: Interpretation of Common Formulations

• “No party may assign any rights under this Agreement. Any purported Assignment is void.” – In addition to giving rise to damages, this provision will render a purported

assignment ineffective. See RESTATEMENT (SECOND) OF CONTRACTS §

322(2).

– Subject to the override provisions, the attachment of a security interest in

the contract may be void.

• “No party may delegate any obligations under this Agreement. Any purported delegation is void.” – In addition to giving rise to damages, this provision will render the

delegation void. See RESTATEMENT (SECOND) OF CONTRACTS § 322(2).

– Subject to the override provisions, even if a security interest in this contract

attaches, the anti-delegation language may limit enforcement.

40


Legal Restrictions on Assignment

• Federal Assignment of Claims Act, 31 U.S.C. § 3727 – FACA has no applicability to disputes between private parties.

– FACA allows enforcement of security interests on accounts receivable in

contracts with federal government if creditor is “financing institution.”

– Contractor assigns right to payment as loan collateral rather than contract itself

or claims other than for payment arising under contract.

– Actual assignment must meet certain criteria and certain forms must be

delivered to governmental office administering contract.

– Secured creditor must file Form UCC-1 to perfect its security interest in

governmental receivables and compliance with FACA is not necessary for

perfection. See In re Altek Sys., Inc. (Bankr. N.D. Ill. 1981).14 However, if

secured creditor does not comply with FACA, it will not have a claim against

governmental agency that pays someone other than secured creditor after

creditor enforces its security interest in the contract.

41



• FCC licenses – Starting in 1994, the FCC allowed secured creditors to take a security interest in the

proceeds of a broadcast license. The rationale was that allowing a security interest

in the proceeds of a sale for the license would not threaten the FCC’s ability to

regulate transfer of the underlying license.

– In re Tracy Broadcasting Corp. (Bankr. D. Colo. 2010)15 – The court ruled on a

bank’s security interest in a radio station’s FCC license that since a secured party

could not place a lien on the underlying FCC license, Section 552 barred it from

placing a security interest in the proceeds. The Tenth Circuit overruled this case.

– In re Terrestar Networks, Inc. (Bankr. S.D.N.Y. 2011)16 – The court rejected the

reasoning in Tracy and ruled that secured creditors had an underlying lien on the

economic value of the FCC license. Following a Ninth Circuit opinion, it reasoned

that there is a distinction between the public right for the FCC to regulate exchange

of the license and the private right to grant liens on the economic value of the

license.

42



• FCC licenses – Recommendations – Secured creditors should obtain both a pledge in the equity interest in the

entity that holds the FCC license and an express pledge in such license and

the economic interests in such license. To further protect itself, a secured

creditor may request that the entity holding the FCC license be an SPV

with no other liabilities or liens.

43



• FCC licenses – Recommendations (cont’d) – The security agreement should be drafted in a way to avoid breaching FCC

regulations by including:

• Exclusion of a grant of security interest in the underlying license, to the extent

it is prohibited by applicable law.

• Express statement that prohibits transfer of the FCC license in any way that

violates FCC rules and requirements that any transfer be made in accordance

with FCC rules.

• Express covenant that requires the debtor to take any requested actions

necessary to transfer the FCC license upon an Event of Default.

44



• Government paid health-care-insurance receivables – The anti-assignment provisions of Medicare and Medicaid do not affect

debtors’ ability to perfect a security interest in health-care-insurance

receivables by filing a UCC-1.

– However, the anti-assignment provisions of Medicare and Medicaid prohibit

lenders from taking control of deposit accounts in which Medicare or

Medicaid health-care-insurance receivables are deposited.

• For the provisions governing Medicare Part A, see 42 U.S.C. § 1395g(c);

Part B, see 42 U.S.C. § 1395u(b)(6); and Medicaid, see 42 U.S.C.

§ 1396(a)(32).

45



• Government paid health-care-insurance receivables (cont’d) – Only a healthcare provider with a provider number can receive payments of

federal health-care insurance receivables. Accordingly, a secured creditor

will not have the ability to receive payments from the government directly

or direct the government to make payments to the secured creditor.

– For further detail, see DFS Secured Healthcare Receivables Trust v.

Caregivers Great Lakes, Inc. (7th Cir. 2004);17 In re Missionary Baptist

Foundation of America (5th Cir. 1986);18 and In re East Boston

Neighborhood Health Center Corp. (Bankr. D. Mass. 1999).19

46



• State gaming licensees – In many jurisdictions, including Nevada, lender generally cannot grant or

foreclose on a security interest in a gaming license, gaming equipment, or

the equity of a gaming licensee without first obtaining prior state gaming

authority approval or undergoing a suitability review, unless certain

exemptions apply.

• N.R.S. 463.300 – Unlawful transfer of ownership: “It is unlawful for any

person to sell, purchase, lease, hypothecate, borrow or loan money, or create a

voting trust agreement or any other agreement of any sort to or with any

licensee in connection with any gaming operation licensed under this chapter or

with respect to any portion of such gaming operation, except in accordance

with the regulations of the Commission.”

47



• State liquor licenses – In many jurisdictions, state law prohibits a secured creditor from taking or

enforcing on a security interest in a liquor license. The rationale behind

many of these statutes is that a liquor license is a privilege bestowed upon

the licensee, not a property right.

– In many states, it has been the practice of secured creditors to effectively

obtain a lien on the license by taking a pledge of the stock in the licensee.

48



• State liquor licenses (cont’d) – Concorde Equity II, LLC v. Bretz (Cal. Dist. Ct. App. 2011)20 – The

California Court of Appeal held the lender’s security interest could attach

to the proceeds of a liquor license sold by a court-appointed receiver

because it was an all-assets lien rather than an individual pledge of the

liquor license. Moreover, the court discussed that although one cannot take

a security interest in a liquor license, the sale of the license in this case did

not violate the underlying public policy to prevent transfers without

governmental approval because the transfer was by a court-appointed

receiver and the new buyer was approved by the relevant governmental

authority.

49


The U.C.C. “Override” Provisions: Introduction

• U.C.C. § 9-102 – Introductory defined terms – “Accounts” generally means a right to payment of a monetary obligation.

• E.g., accounts receivable.

– “Account debtor” means a person obligated on an account, chattel paper, or

general intangible. The term does not include persons obligated to pay a

negotiable instrument, even if the instrument constitutes part of chattel

paper.

– “General intangible” is broadly defined to include any personal property,

including things in action, other than among other things, accounts,

instruments, and chattel paper. The term includes payment intangibles.

• E.g., intellectual property license.

• But see Section 9-109(d).

50



• U.C.C. § 9-102 – Introductory defined terms (cont’d) – “Payment intangible” is a subset of “general intangibles” under which the

account debtor’s principal obligation is a monetary obligation.

• E.g., rights to receive payment in a loan transaction that is not evidenced by a

promissory note or chattel paper.

– “Promissory note” means an instrument that evidences a promise to pay a

monetary obligation, does not evidence an order to pay, and does not

contain an acknowledgment by a bank that the bank has received for

deposit a sum of money or funds.

– “Chattel paper” generally means a record that evidences both a monetary

obligation and a security interest in or lease of specific goods.

• E.g., installment purchase contract relating to and secured by, or a lease of,

personal property.

51



• U.C.C. § 9-102 – Introductory defined terms (cont’d) – “Health-care-insurance receivable” is a subset of “accounts” and means an

interest in or claim under a policy of insurance which is a right to payment

of a monetary obligation for health-care goods or services provided.

• E.g., medical bill reimbursement claims of doctors against insurance

companies.

• U.C.C. § 9-109(a) – Introductory concept – The sale of an account, chattel paper, a promissory note, or payment

intangible constitutes a security interest for purposes of Article 9.

52


The U.C.C. “Override” Provisions: U.C.C. § 9-406

• Overview – Section 9-406 renders ineffective contractual or legal provisions relating to

certain receivables to the extent such provisions “prohibit, restrict or

require consent to the assignment or transfer of, or provide that the

creation, attachment, perfection or enforcement of the security interest

may give rise to a default, breach, right of recoupment, claim, defense,

termination, right of termination or remedy.”

• E.g., purchase order and account.

53



• Overview – Section 9-407 renders ineffective provisions in personal property leases to

the extent such provisions “prohibit, restrict or require consent to the

assignment or transfer of, or provide that the creation, attachment,

perfection or enforcement of the security interest may give rise to a

default, breach, right of recoupment, claim, defense, termination, right of

termination or remedy.”

• Section 9-407 applies to lease agreements but does not override remedy for

breach of transfer restrictions to the extent that there is a transfer of the lessee’s

right of possession or use of goods in violation of the lease agreement or there

is a delegation of a material performance of either party in violation of the lease

agreement.

– Override applies to transfer restrictions under lease contracts or governing a

lessor’s residual interest in goods.

54



• Overview – Section 9-408 renders ineffective contractual or legal provisions relating to

general intangibles and certain receivables to the extent such provisions

“impair the creation, attachment, or perfection of a security interest or

provide that assignment or transfer or the creation, attachment, or

perfection of the security interest may give rise to a default, breach, right of

recoupment, claim, defense, termination or remedy.”

• E.g., intellectual property licenses and cable franchise regulation.

• One key difference between Sections 9-406 and 9-408 is that Section 9-408

(unlike Section 9-406) does not override legal or contractual provisions in the

context of enforcement of a security interest.

55



• Overview (cont’d) • Further, Section 9-408(d) provides that to the extent a transfer restriction is

enforceable outside Article 9 but is partially overridden by override provisions

of Section 9-408, the security agreement (i) does not impose any duty or

obligation on the person in whose favor the restriction runs, (ii) does not

require that person to pay or render performance to the secured party, (iii) does

not entitle the secured party to use or assign any of the debtor’s rights in the

collateral, and (iv) does not entitle the secured party to any rights with respect

to trade secrets or confidential information of the person in whose favor the

restriction runs.

• Thus, if debtor is the licensee under a software license agreement containing an

anti-assignment provision, the security interest can attach to the debtor’s

interest under the license agreement but imposes no obligation on the licensor

and the secured party cannot use the license in the foreclosure or sell a

computer with the licensed software on it.

56



• Overview (cont’d) • Likewise, if debtor is the franchisee under a “non-assignable” municipal cable

franchise, the security interest attaches to the franchisee’s rights under the

franchise, but the secured party has no rights against the municipality and the

municipality needs to pay no attention to the security interest or the secured

party.

57


The U.C.C. “Override” Provisions: Comparing § 9-406 and § 9-408

Type of Collateral Legal Restriction Contractual Restriction

Accounts other than health-care-

insurance receivables Sale or transaction for security Sale or transaction for security

Chattel paper Sale or transaction for security Sale or transaction for security

Health-care-insurance receivables N/A N/A

Payment intangibles N/A Transactions for security

Promissory notes N/A Transactions for security

Other general intangibles N/A N/A

58

§ 9-406 – Total override for grant, perfection & enforcement of security interest


The U.C.C. “Override” Provisions: Comparing § 9-406 and § 9-408

Type of Collateral Legal Restriction Contractual Restriction

Accounts other than health-care-

insurance receivables N/A N/A

Chattel paper N/A N/A

Health-care-insurance receivables Sale or transaction for security Sale or transaction for security

Payment intangibles Sale or transaction for security Sales

Promissory notes Sale or transaction for security Sales

Other general intangibles Transaction for security Transaction for security

59

§ 9-408 – Limited override for grant/perfection of security interest only


The U.C.C. “Override” Provisions: What They Do Not Do

• Practical impairment of an assignment – Example: Buyer enters into an agreement with Seller to buy equipment that Seller

is to manufacture according to Buyer’s specifications. Buyer agrees to make a

series of prepayments during the construction process. In return, Seller agrees to set

aside the prepaid funds in a special account and to use the funds solely for the

manufacture of the designated equipment. Seller also agrees that it will not assign

any of its rights under the sale agreement with Buyer. Nevertheless, Seller grants to

secured creditor a security interest in its accounts. Seller’s anti-assignment

agreement is ineffective under Section 9-406(d); its agreement concerning the use of

prepaid funds, which is not a restriction or prohibition on assignment, is not

ineffective. Unless secured creditor releases the funds to Seller so that Seller can

comply with its use-of-funds covenant, Seller will be in breach of that covenant.

Official comment 5 to U.C.C. § 9-406.

60



• U.S. federal statute or regulation (i.e., preemption) – Federal Assignment of Claims Act

– FCC license-related issues

– Federal healthcare laws

• LP or LLC interests – To the extent that LP or LLC interests are Article 8 securities, they do not

constitute general intangibles and transfer restrictions governing such

securities are not subject to Sections 9-406 to 9-408.

61



• Account debtors who are individuals covered by consumer protection laws – U.C.C. § 9-406(h) – “This section is subject to law other than this article

which establishes a different rule for an account debtor who is an

individual and who incurred the obligation primarily for personal, family,

or household purposes.”

62


The U.C.C. “Override” Provisions: Important State Variations

• Delaware, Texas, Colorado, Kentucky, and Virginia – Override provisions in these states do not apply to LP or LLC interests.

See U.C.C. §§ 9-406(i)(5), 9-408(e)(4).

• Concern was that these interests may be “payment intangibles” and U.C.C. § 9-

406(d) may override provisions requiring the consent of other holders of

interests to approve a transfer of the interest resulting from a foreclosure sale.

• Draft PEB Commentary demonstrates that this is not a correct interpretation of

that section.

– In Kentucky and Colorado, the provision that the U.C.C. anti-assignment

overrides do not apply to LP or LLC interests is found in the business

organizations laws of those states, rather than in the U.C.C. See, e.g., Ky.

Rev. Stat. §275.255 (4)

63


The U.C.C. “Override” Provisions: Important State Variations

• New York – The New York anti-assignment override provisions do not apply to transfer

restrictions under laws or regulations. See N.Y. U.C.C. §§ 9-406,

9-408 (McKinney) (omitting §§ 9-406(f) and 9-408(c)).

• California – California has adopted all of the U.C.C. override provisions.

64


The U.C.C. “Override” Provisions: Documentation Considerations

• Choice of law – The U.C.C. provides explicit rules on governing law for perfection

purposes. However, other aspects of a secured transaction such as scope, attachment, and enforcement are determined by looking at the parties’ agreement or the application of the forum state’s conflict of law provisions.

– Can the secured party take advantage of these state-by-state variations by choosing a more favorable state law in the security agreement?

65



• Choice of law (cont’d) – Example: A debtor has an interest in a Delaware LLC that constitutes a

general intangible, and the LLC agreement for such entity restricts a

collateral assignment of such interests. If the debtor pledges that LLC

interest pursuant to a security agreement under New York law, would New

York law (override applies to LLC interests) or Delaware law (override not

applicable) govern?

– Official comment 3 to Section 9-401 states that “[t]his article does not

provide a specific answer to the question of which State’s law applies to

the restriction on assignment.” The comment then goes on to reference

non-U.C.C. choice of law principles and suggest that the entity’s

jurisdiction of formation is likely to govern.

66



• Choice of law (cont’d) – Example: Debtor holds a cable franchise under applicable local law. The

local law provides that no rights under the franchise can be assigned

without consent of the municipality. If the N.Y. U.C.C. were to apply,

there would be no override under Section 9-408. Should the secured party

provide in the security agreement that the U.C.C. of the state in which the

municipality is located applies to the attachment and enforcement of the

security interest (assuming the U.C.C. of that state has adopted Section 9-

408(f))?

67



• Savings clause in security grant – Example: “provided, however, that notwithstanding any of the other provisions set forth in this Section 3 or any other

provision in this Agreement or any other Loan Document, the term Collateral and the terms set forth in this Section

defining the components of Collateral shall not include, and this Agreement shall not constitute a grant of a security

interest in, any of the following (the “Excluded Property”): (i) any property to the extent that such grant of a security

interest is prohibited by any Requirements of Law of a Governmental Authority, requires a consent not obtained of any

Governmental Authority pursuant to such Requirement of Law or is prohibited by, or constitutes a breach or default

under or results in the termination of or requires any consent not obtained under, any contract, license, agreement,

instrument or other document evidencing or giving rise to such property or, in the case of any Investment Property or

Pledged Collateral, any applicable shareholder or similar agreement, . . . . except to the extent that a term in such

contract, license, agreement, instrument or other document providing for such prohibition, breach, default or

termination or requiring such consent is ineffective and unenforceable against such Grantor under applicable law; . . . .

provided, however, that Excluded Property shall not include any Proceeds, substitutions or replacements of any

Excluded Property referred to above (unless such Proceeds, substitutions or replacements would constitute Excluded

Property referred to above).”

68


Case Law Cites

1. Unisys Corp. v. Hercules Inc., 224 A.D.2d 365 (N.Y. App. Div. 1996).

2. Preferred Care Partners v. Humana, No. 08-20424, 2009 WL 982433, at *8 (S.D. Fla. Apr. 9,

2009).

3. Grober v. Comm’r, 31 T.C.M. (CCH) 1179 (1972).

4. Tanbro Fabrics Corp. v. Deering Milliken, Inc., 39 N.Y.2d 632 (N.Y. 1976).

5. Bontemps v. Bank of Babylon, 96 A.D.2d 1025 (N.Y. App. Div. 1983).

6. Gosch v. Burns, 909 F.2d 903 (6th Cir. 1990).

7. Med. Malpractice Ins. Ass’n v. Hirsch (In re Lavigne), 114 F.3d 379 (2d Cir. 1997).

8. Bloor v. Falstaff Brewing Corp., 601 F. 2d 609 (2d Cir. 1979).

9. Showtime Networks Inc. v. Comsat Video Enter., 1998 N.Y. Misc. LEXIS 732 (N.Y. Sup. Ct.

June 29, 1998).

69


Case Law Cites

10. Kroboth v. Brent, 215 A.D.2d 813 (N.Y. App. Div. 1995).

11. Scott-Macon Secs., Inc. v. Zoltek Cos., 2005 WL 1138476 (S.D.N.Y. May 12, 2005).

12. LTV Aerospace & Def. Co. v. Thomson-CFF, S.A. (In re Chateaugay), 198 B.R. 848

(S.D.N.Y. 1996).

13. Pro Cardiaco Pronto Socorro Cardiologica S.A. v. Trussell, 868 F. Supp. 135 (S.D.N.Y.

1994).

14. Gen. Cable Co. v. Altek Sys., Inc. (In re Altek Sys., Inc.), 14 B.R. 144 (Bankr. N.D. Ill.

1981).

15. Spectrum Scan LLC v. Valley Bank & Trust Co. (In re Tracy Broadcasting Corp.), 438 B.R.

323 (Bankr. D. Colo. 2010), rev’d, 696 F.3d 1051 (10th Cir. 2012).

16. Sprint Nextel Corp. v. U.S. Bank Nat’l Ass’n (In re Terrestar Networks, Inc.), 457 B.R. 254

(Bankr. S.D.N.Y. 2011).

70


Case Law Cites

17. DFS Secured Healthcare Receivables Trust v. Caregivers Great Lakes, Inc., 384 F.3d 338 (7th

Cir. 2004).

18. Health Ctr. Corp. v. Chittenden Trust Co. (In re E. Bos. Neighborhood Health Ctr. Corp.), 242

B.R. 562 (Bankr. D. Mass. 1999).

19. Wilson v. First Nat’l Bank, Lubbock, Tx. (In re Missionary Baptist Found. of Am.), 796 F.2d

752 (5th Cir. 1986).

20. Concorde Equity II, LLC v. Bretz, 2011 WL 5056295 (Cal. Dist. Ct. App. Oct. 25, 2011).

71


Darius Mehraban

[email protected]

212.351.2428

72

Joerg H. Esdorn

[email protected]

212.351.3851

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