Even though Article 9 of the Commercial Code (Cal. Com. §§9101, et seq.) applies to both pledges and sales of promissory notes (§§9109(a)(1), (3)), the sale versus loan distinction can be important because Article 9 contains some sale distinguishing provisions – i.e., provisions that only apply if the transaction is a loan, not a true sale. Relevant here, the provisions addressing the secured party’s rights, obligations and remedies upon default (§§9601-9624) generally[1] only apply to loans, and not to sales of promissory notes (§9601(g)).
Despite these sales distinguishing provisions, the drafters of Article 9 elected not to expressly address whether a particular transaction is a “sale” or a “loan”, instead choosing to leave it “to the courts” (§9101, cm. 4). Nevertheless, certain provisions within Article 9 do provide guidance and insight in the sale versus loan analysis.
First, under Article 9 it is clear that substance prevails over form and that the labels chosen by the parties are not determinative in the analysis (§9109(a)(1)). The comments to §9109 provide that whether a security interest exists depends on the facts, “regardless of the form of the transaction or the name that parties have given to it.”
Second, §9318(a) provides that “A debtor that has sold an account, chattel paper, payment intangible, or promissory note does not retain a legal or equitable interest in the collateral sold.” The comments to §9318 elaborate saying that a seller “retains no interest whatsoever in the property to the extent it has been sold” (§9318, cm. 2). Thus, if the debtor retains a legal or equitable interest – or any interest whatsoever – the transaction is a secured loan, not a sale.
In addition to the guidance provided in Article 9, case law addressing whether a transaction is a “sale” or a “loan” has consistently found the presence of recourse to be the most important factor in the sale versus loan analysis. To the extent the risks of ownership remain with the purported seller, and not the purported buyer, courts are far more likely to find that the transaction involved is a loan. Major’s Furniture Mart, Inc. v. Castle Credit Corporation, Inc. (3d Cir. 1979) 602 F2d 538, is generally considered to be the seminal case in this regard.
In Major’s, the debtor (Major’s) purported to “sell” certain accounts receivable to Castle Credit (the secured party) together with an assignment of its rights. The purported sales were made at a discount, generally 15-18% below the face amount of the receivable, plus an additional 10% as a reserve for bad debts. At the time of trial, Castle has purchased loans with a face amount of $598,486 for $316,107.
In addition to the discount, “Major’s was required to ‘repurchase’ any account ‘sold’ to Castle which was in default for more than 60 days” (id. at 540). Major’s was also required to repurchase the receivables upon default or in the event of bankruptcy. The agreement further provided that it “could not be modified except in writing signed by all the parties” (id. at 541).
After Castle declared Major’s in default, Major’s brought suit in an attempt to reclassify the purported “sale” as a secured “loan” in order to recoup its equity in the receivables. The trial court found that notwithstanding its form, the transaction was a loan secured by the receivables, not a true sale of receivables. Castle appealed.
On appeal, Castle argued that the transaction was a sale because the parties had so labeled it a “sale.” This contention was quickly dismissed by the Third Circuit, reasoning that:
Courts will not be controlled by the nomenclature the parties apply to their relationship. In Smith-Faris Company v. Jameson Memorial Hospital Association, 313 Pa. 254, 260, 169 A. 233, 235, it was said: “ ‘Neither the form of a contract nor the name given it by the parties controls its interpretation. In determining the real character of a contract courts will always look to its purpose, rather than to the name given it by the parties. The proper construction of a contract is not dependent upon any name given it by the parties, or upon any one provision, but upon the entire body of the contract and its legal effect as a whole (id. at 543, citations omitted).
Having rejected Castle’s form over substance argument, the court reviewed a number of decisions, and summarized that “despite the express language of the agreements, the respective courts examined the parties' practices, objectives, business activities and relationships and determined whether the transaction was a sale or a secured loan only after analysis of the evidence as to the true nature of the transaction” (id. at 545).
Focusing on substance, not form, the court turned to “the extremely relevant factor of ‘recourse’ and to the risks allocated” in the sale versus loan analysis (id.). The court began by citing Professor Grant Gilmore, the primary drafter of Article 9, who wrote that:
If there is no right of charge-back or recourse with respect to uncollectible accounts and no right to claim for a deficiency, then the transaction should be held to be a sale, entirely outside the scope of Part 5 [current Chapter 6, Com. Code §§9601, et seq.]. If there is a right to charge back uncollectible accounts (a right, as s 9-502 [current §9607(c)] puts it, of “full or limited recourse”) or a right to claim a deficiency, then the transaction should be held to be for security and thus subject to Part 5 [current §§9601, et seq.] as well as the other Parts of the Article (id., fn. 12, quoting, Gilmore, Security Interests in Personal Property §44:4).
The court then quoted extensively from the district court’s opinion (at 545):
In the instant case the allocation of risks heavily favors Major's claim to be considered as an assignor with an interest in the collectibility of its accounts. It appears that Castle required Major's to retain all conceivable risks of uncollectibility of these accounts. It required warranties that retail account debtors e.g., Major's customers meet the criteria set forth by Castle, that Major's perform the credit check to verify that these criteria were satisfied, and that Major's warrant that the accounts were fully enforceable legally and were “fully and timely collectible.” It also imposed an obligation to indemnify Castle out of a reserve account for losses resulting from a customer's failure to pay, or for any breach of warranty, and an obligation to repurchase any account after the customer was in default for more than 60 days. Castle only assumed the risk that the assignor itself would be unable to fulfill its obligations. Guaranties of quality alone, or even guarantees of collectibility alone, might be consistent with a true sale, but Castle attempted to shift all risks to Major's, and incur none of the risks or obligations of ownership. It strains credulity to believe that this is the type of situation, referred to in Comment 4, in which “there may be a true sale of accounts . . . . although recourse exists.”
Having analyzed the substance of the transaction, the presence of recourse and the allocation of risks between the parties, the Third Circuit held that the purported sale was really a loan and that Major’s was entitled to any surplus from Castle.
The approach in Major’s is consistent with California law. In West Pico Furniture Co. v. Pacific Finance Loans (1970) 2 C3d 594, West Pico wanted a line of credit for its furniture business whereby Pacific would lend money secured by West Pico’s accounts receivable. Pacific’s attorneys rejected the proposed line of credit, but instead offered to finance West Pico’s operations pursuant to a master purchase agreement whereby West Pico would “sell” and Pacific would “buy” some of West Pico’s accounts receivables at a discount. West Pico agreed.
Under the terms of the master purchase agreement, West Pico was required to repurchase any receivable that was 60 days delinquent, but West Pico’s recourse liability in this respect was limited to 10% of the aggregated unpaid principal balances of the receivables. Alternatively, West Pico had the option to attempt to collect the receivable in lieu of repurchase. The transfer of each individual receivable was accompanied by an individually endorsed stated that it was “assigned, transferred and set over to Pacific for value received” (id. at 600). By the time of trial, West Pico had “sold” receivables with face values totaling $4,552,200 for $2,971,505 – a discount of roughly 65%.
The issue before the Supreme Court was whether the master purchase agreement was a sale or a loan. In discussing the difference between a sale and a loan the Court mirrored §9318(a) of the Commercial Code, noting that a true sale is the transfer of “the general or absolute interest as distinguished from a special property interest” (id. at 603, quoting, Milana v. Credit Discount Co. (1945) 27 C2d 335, 339).
Like the court in Major’s, the Supreme Court first noted that substance prevails over form, saying that “Whether a particular transaction is a usurious loan or a sale is a question of fact. In making such a determination, the trier of fact must look to the substance of the transaction rather than to its form” (id. at 603). The Court emphasized that the "negotiations, circumstances and conduct of the parties surrounding and connected with their contracts” controlled over the form of the agreement (id.). The Court further cautioned that the form of the agreement could not be used to cover up a “sham or subterfuge” (id.).
Addressing this, the Court first observed that West Pico initially sought a loan secured by the receivables because that is how it had traditionally financed its operations and would have coordinated with its accounting and tax procedures, but that “Pacific rejected these proposals” in favor of the a sale agreement coupled with an obligation to repurchase any 60 day delinquent account.
The court then turned to West Pico’s obligation to repurchase any 60 day delinquent accounts and held that:
the trial court was justified in concluding that at all times the risk of nonpayment of the conditional sales contracts was borne by West Pico and not by Pacific, and that the transactions instead of being sales represented loans of money to West Pico by Pacific for which the contracts were pledged as collateral.
The court was also persuaded by the fact West Pico made no attempt to verify the credit ratings of the account debtors and simply demanded repurchase whenever the accounts were 30-60 days delinquent (despite having the obligation to make “every effort” to collect from the account debtors).
Courts have also considered a host of other factors in making the loan versus sale distinction such as:
§ Whether the “buyer’s” ability to sell or pledge the property was subject to the “seller’s” interests. (See, In re Criimi Mae (Del. Bankr. 2000) 251 BR 796, 800-01[“The critical distinction [between a loan and a sale] is whether the transferor of the securities retained meaningful property interests inconsistent with an outright sale of the securities. One essential difference in the rights of a transferee under a true sale, as opposed to the transferee of a lien, is the right of the transferee to dispose of the securities and otherwise to deal with the securities as the absolute property of the transferee during the pendency of the repurchase/repayment obligation under the contract.”].)
§ Whether the “buyer” had no right to substitute collateral. (See, In re Criimi Mae, 251 BR at 804 [requirement to sell back the same collateral, as opposed to substitute collateral, is strong evidence of a loan because purported seller has right to repurchase the exact same property allegedly sold ]; Granite Partners, LP v. Bear Stearns & Co. Inc. (SDNY 1998) 17 FS2d 275, 298 [“Unlike a lender taking collateral for a secured loan, a repo buyer takes title to the securities received and can trade, sell or pledge them”].)
§ Whether the “seller” had a right to receive income from the property “sold.” (In re Criimi Mae, 251 BR at 803 [“Normally, reservation of the right to receive income from the property would be consistent with a reservation of an ownership right in the property.”].)
§ Whether the “buyer’s” interest was based on its investment. (In re Spring Mortg. Bankers Corp. (EDNY Bkrtcy. 1994) 164 BR 224, 229 [interest to “buyer” based on amount of buyer’s investment as opposed to amount of the underlying loan indicative of a loan].)
§ Whether the property was “purchased” at a significant discount. (In re Criimi Mae, 251 BR at 803 [“margin values over the amount of the repurchase obligation” and “loan to value requirements are most common in lending transactions”].)
§ The possibility of the “seller’s” forfeiture upon default. The existence of a substantial forfeiture is more indicative of a loan than a sale.
[1]
Section 9607(c) is an exception. It provides that the buyer of promissory notes must proceed in a commercially reasonable manner if the buyer seeks to enforce the notes against the account debtor.