The New York Court of Appeals recently reversed the rulings of both the trial court and intermediate appellate court, and held that under Article 9 of the Uniform Commercial Code (UCC) a secured lender may collect the accounts receivables owed to the debtor by third parties.
A copy of the opinion is available at: Link to Opinion
The plaintiff lender entered into a promissory note and security agreement with a non-party subcontractor whereby the subcontractor could borrow up to $3 million dollars from the lender. The subcontractor granted the lender a security interest in its assets and the lender filed a UCC-1 financing statement.
More specifically, the collateral for the loan "constituted substantially all existing and future assets and properties of [the subcontractor], including, 'all right, title and interest of [the subcontractor] in and to its (a) accounts . . . .'", and the term "Accounts" included the accounts receivable arising from invoices the subcontractor issued to its customers.
The defendant contractor entered into a contract with the subcontractor. The plaintiff lender notified the contractor of its security interest and collateral assignment in the subcontractor's accounts.
The subcontractor defaulted and the lender demanded immediate repayment under the terms of the promissory note and security agreement. Ultimately, the subcontractor declared bankruptcy. The lender brought an action against the defendant contractor alleging that the lender was entitled to recover all amounts the contractor owed to the subcontractor after contractor received notice of the lender's assignment. The defendant contractor filed a motion to dismiss lender's complaint.
The trial court dismissed the lender's complaint holding that UCC § 9-607 "'does not determine whether an account debtor, bank, or other person obligated on collateral owes a duty to a secured party'"; (2) the agreement between the lender and the subcontractor was "a security interest and was not an assignment"; and (3) UCC § 9-607 applies to assignments, not security interests.
The lender appealed, and the intermediate appellate court affirmed the trial court, holding that the lender "did not have an independent cause of action against subcontractor pursuant to UCC § 9-607" because section 9-607(e) does not authorize a secured creditor, as distinct from an assignee, to recover from a nonparty debtor like the subcontractor.
The lender again appealed to the New York Court of Appeals.
The Court of Appeals analyzed the litigants' arguments under UCC § 9-406 and § 9-607. As you may recall, UCC § 9-607(a)(3), entitled "Collection and Enforcement by Secured Party," states as follows:
If so agreed, and in any event after default, a secured party. . . may enforce the obligations of an account debtor or other person obligated on collateral and exercise the rights of the debtor with respect to the obligation of the account debtor or other person obligated on collateral to make payment or otherwise render performance to the debtor, and with respect to any property that secures the obligations of the account debtor or other person obligated on the collateral.
The defendant contractor argued that, because the subcontractor advised the defendant contractor that there was a "dispute" between the subcontractor and contractor, the lender cannot rely on § 9-607(a)(3), which begins, "If so agreed." The Court of Appeals disagreed because the phrase "If so agreed" referred to the agreements relating to the security interest (here, the Promissory Note and Security Agreement between the lender and the subcontractor), and allowing a claimed dispute to nullify sections 9-607 and 9-406 would render the sections meaningless.
Instead, the Court of Appeals held that, because the lender was a "secured party", the lender had the authority to enforce the rights of its debtor (the subcontractor) to collect on the obligations of the account debtor (the defendant contractor), and that section 9-607 did not itself determine whether an account debtor owes a duty to a secured party.
The Court of Appeals also analyzed UCC § 9-406(a), which states:
An account debtor on an account, chattel paper, or a payment intangible may discharge its obligation by paying the assignor until, but not after, the account debtor receives a notification, authenticated by the assignor or the assignee, that the amount due or to become due has been assigned and that payment is to be made to the assignee. After receipt of the notification, the account debtor may discharge its obligation by paying the assignee and may not discharge the obligation by paying the assignor.
The defendant contractor argued that only assignors, not holders of security interests, could rely on the payment-redirection provisions contained in UCC § 9-406. The Court of Appeals disagreed because the UCC does not distinguish between a security interest and an assignment and there is no separate definition of "assignment," "assignor" or "assignee". The Court of Appeals also noted that New York state and federal case law concurred that treating assignments and security interests identically promotes efficient dealings between the parties.
The Court of Appeals further held that under UCC § 9-406, an account debtor who receives a secured creditor's notice asserting its right to receive payment directly can pay the secured creditor and receive a complete discharge or can seek proof from the secured creditor that it possesses a valid assignment and withhold payment in the interim.
Here, the Court of Appeals noted the differences in UCC §§ 9-406 and 9-607 and noted that section 9-607 addresses the rights of a secured party vis à vis the debtor to collect a specified payment right while section 9-406 addressed the secured party's rights against the account debtor to collect a specified payment right. The Court also noted that the Permanent Editorial Board for the Uniform Commercial Code rejected any rulings that interpreted "the term "assignment" as referring only to an outright assignment of ownership" as incorrect.
Therefore, the Court of Appeals held that nothing in UCC §§ 9-607 or 9-406 prohibited the lender and the subcontractor's contractual agreement. Instead, under Section 9-406, once the lender provided the requisite notification to the defendant contractor, the contractor could not discharge its obligation by paying the subcontractor, but must instead pay the lender or ask for proof of assignment from the lender.
Accordingly, the Court of Appeals reversed the lower courts' rulings dismissing the lender's complaint.
Ralph T. Wutscher
Maurice Wutscher LLP
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