Consumer Avoidance of Non-purchase-money Security Interests Under Revised Article 9

From a consumer bankruptcy perspective, few of the changes made by revised Article
9 are significant. Indeed, the revised act largely ignores most of the significant
consumer issues. This is because consumer groups and the financial services industry
were unable to reach a consensus as to the proper approach to take on most consumer
issues.² As a result, the uniform version of the revision does not even attempt
to supply a rule for many of the difficult consumer issues. For example, in
non-consumer transactions, the revision clearly rejects the "absolute bar" rule that
deprives a secured creditor of its right to a deficiency when its UCC sale violates
the Article 9 rules.³ However, the revision expressly provides no rule for consumer
transactions, leaving "to the court the determination of the proper rules in consumer
transactions."⁴

Refinancing and Lien Avoidance

One important area where the Article 9 rules traditionally have affected consumer
bankruptcy practice is in the area of purchase-money security interests. In general,
a purchase-money security interest is a security interest in an item that secures its
own purchase price or the loan that enabled the debtor to acquire the item.⁵ For
Article 9 purposes, the determination of whether a security interest in consumer
goods is a "purchase-money" security interest or a "non-purchase-money" security
interest is of little significance to the debtor. The primary importance of that
distinction in the consumer-goods context is to determine the appropriate method that
the secured creditor must use in order to perfect its security interest. Article 9
provides automatic perfection to purchase-money security interests in consumer goods.⁶
In contrast, if the security interest is a non-purchase-money security interest,
the secured creditor generally must file a UCC financing statement in order to
perfect its lien.⁷

However, when a bankruptcy is filed, the distinction becomes very important. If the
collateral is property that could otherwise be exempted as household goods, tools of
the trade or professionally prescribed health aids, then §522(f) of the
Bankruptcy Code allows the debtor to avoid a security interest in those items if the
security interest is a non-possessory, non-purchase-money security interest.⁸ Since
the Code does not define the term "purchase-money security interest," the courts have
uniformly held that the relevant state's Article 9 definition prevails.⁹

Several important interpretive questions arose under the former Article 9's definition
of purchase-money security interest and its intersection with the §522(f) lien
avoidance provisions. The principal issue was whether the purchase-money character of
a security interest was destroyed if the lien secured any debt beyond the purchase
price of the collateral.¹⁰

The courts split into two camps. One group of opinions followed the
"transformation" rule and held that the purchase-money status of the security interest
was lost if it secured any non-purchase-money obligations.¹¹ The other group followed
the "dual-status" rule and held that a security interest could be partly purchase-money
and partly non-purchase-money.¹² Under this view, an allocation formula was needed
in order to determine the extent to which the security interest was a purchase-money
security interest. However, where the contract failed to contain an allocation
formula, courts applying the dual-status rule frequently looked to state law or applied
a judicially created "first in-first out" formula.¹³

The difference between these approaches becomes significant when the original
purchase-money obligation is either refinanced or consolidated with some other obligation,
which may also have originally been a purchase-money obligation. In jurisdictions
applying the "transformation" rule, the refinancing or consolidation of the debt destroys
the purchase-money character of the security interest.¹⁴ Outside of bankruptcy, the
only effect of this is that the secured creditor must file a financing statement in
order to perfect its security interest in the refinancing or loan consolidation
transaction. However, if the debtor subsequently files bankruptcy, the lien can be
avoided entirely under §522(f) even if perfected because it is a
"non-purchase-money" security interest.¹⁵

"Purchase-money" Definition Expanded

The revised act firmly rejects the "transformation" rule. Revised Article 9 both
adopts the dual-status rule and provides a statutory allocation formula—at least for
non-consumer transactions.¹⁶ Section 9-103(f) provides that a purchase-money
security interest does not lose its status as such even if it secures both
purchase-money and non-purchase-money obligations.¹⁷ Further, the provision expressly
states that purchase-money status is not lost when the purchase-money obligation is
renewed, refinanced, consolidated or restructured.¹⁸ In addition, the revision makes
clear that the purchase-money obligation is not limited to the cash price of the
collateral, but also includes other expenses incurred in connection with the
purchase.¹⁹

Since the dual-status rule requires an allocation formula in those cases where
non-purchase-money obligations are consolidated with purchase-money obligations, revised
Article 9 also provides a mechanism for determining how much of the new obligation
qualifies as a purchase-money obligation.²⁰ Under the revision, payments must be
applied in accordance with any "reasonable method" agreed to by the parties. In the
absence of such an agreement, payments must be applied in accordance with the
directions of the debtor given at or before the time of payment. If there is neither
an agreement nor timely direction from the debtor, then payments are applied first to
any obligations that are not secured. If there are multiple purchase-money secured
obligations, then payments are applied in the order in which the obligations were
incurred. In general, these rules favor the secured creditor by maximizing the extent
to which the security interest will be treated as a purchase-money security interest.

Lien Avoidance Under the Revision

By changing the underlying state law definition of a purchase-money security
interest, the revision would appear to reverse those decisions that permitted
§522(f) lien avoidance of refinanced or consolidated purchase-money security
interests. However, that result is not clear because of the unusual compromise that
was struck on consumer issues. Although the section clearly adopts the dual-status
rule for non-consumer transactions, §9-103(h) provides that the limitation of the
dual-status rule to non-consumer transactions "is intended to leave to the court the
determination of the proper rules in consumer-goods transactions."

What is not addressed is the source of the law that the courts are expected to
apply. The Official Comment states that the new provisions are not intended to affect
or influence purchase-money characterizations under other statutes, and it mentions
§522(f) as an example.²¹ It then asserts that since the Code is federal law,
the Article 9 definition "does not, and could not, determine" the federal law
question of whether §522(f) permits lien avoidance.

What the comment overlooks is the fact that the federal cases decided under
§522(f) have consistently deferred to the Article 9 state law definition of a
purchase-money security interest. Those opinions were based on the courts' interpretations
of former §9-107. Now that former §9-107 has been repealed, the underpinnings
of cases like Manual and Freeman are gone. Can the courts look to the new
non-consumer rules for guidance? According to the express language of the revision,
they may not. Section 9-103(h) states that "the court may not infer from [the
non-consumer rule] the nature of the proper rule in consumer-goods transactions and may
continue to apply established approaches."

This language clearly authorizes the courts to continue to apply existing case
authority in those jurisdictions with applicable old-Act precedent, even though the
statutory basis for those cases has been repealed. It does not, however, require
that the courts in those jurisdictions continue to apply old-Act case law. Indeed,
if courts follow the Official Comment, the question of how §522(f) applies to
refinancing and loan consolidation transactions is open to re-examination. The comment
suggests that courts should not look to the Uniform Commercial Code (UCC), but
instead should create a federal definition of purchase-money security interest that
reflects the bankruptcy policies embodied in §522.

Footnotes

¹ The views expressed herein are Prof. Warner's and do not necessarily reflect the views of the University of Missouri or the law
firm of Greenberg Traurig P.C. Return to article

² See, generally, Benfield Jr., Marion W., "Consumer Provisions in Revised Article 9," 74 Chi.-Kent L. Rev. 1255,
1255-59 (1999). Return to article

³ §9-626(a). All citations are to the revised 1999 version of Article 9 of the Uniform Commercial Code unless otherwise
indicated. Citations to the prior version of Article 9 are indicated by the term "former." Return to article

⁴ See §9-626(b). Since the consumer provisions are a likely target for non-uniform amendments, practitioners should consult the
locally enacted version of revised Article 9 to determine whether the uniform version of the act applies. Return to article

⁵ See §9-103(a)(2) and former §9-107. Return to article

⁶ §9-309(1). Return to article

⁷ See §9-310(a). Return to article

⁸ 11 U.S.C. §522(f)(1)(B). Return to article

⁹ See, e.g., In re Freeman, 956 F.2d 252, 254 (11th Cir. 1992); In re Billings, 838 F.2d 405,
406 (10th Cir. 1988); Southtrust Bank v. Borg-Warner Acceptance Corp., 760 F.2d 1240, 1241 (11th Cir.
1985); Pristas v. Landaus of Plymouth Inc., 742 F.2d 797, 800 (3d Cir. 1984); In re Matthews, 724 F.2d
798, 800 (9th Cir. 1984). Return to article

¹⁰ Courts also disagreed as to whether the purchase price was limited to the item's cash price or it also included other charges
incidental to the purchase, such as sales taxes and finance charges. Compare Pristas, 742 F.2d at 800 (price includes taxes and
finance charges), with Freeman, 956 F.2d at 255 (taxes and interest not part of purchase price). Return to article

¹¹ See In re Manuel, 507 F.2d 990 (5th Cir. 1975); see, also, Southtrust Bank, 760 F.2d at 1241;
Matthews, 724 F.2d at 800. Return to article

¹² See, e.g., Billings, 838 F.2d at 408-09; Pristas, 742 F.2d at 800. Return to article

¹³ See Pristas, 742 F.2d at 800. Some of the cases cited as applying the "transformation" rule can be read as merely requiring
that the loan contract or some applicable statute provide an explicit allocation formula. See, e.g., Southtrust, 760 F.2d at 1243

(noting that neither the contract nor applicable law provided an allocation method). Return to article

¹⁴ See, e.g., Freeman, 956 F.2d at 255 (consolidation), and Matthews, 724 F.2d at 800 (refinancing). In
addition, in a refinancing transaction, the credit is not used "to acquire rights" in the collateral as required by former §9-107.

Matthews, 724 F.2d at 800-01. Return to article

¹⁵ In addition, if the secured creditor fails to file a financing statement to perfect the refinancing or loan consolidation transaction,
the security interest would be unperfected and subject to avoidance under the §544 "strong-arm" power. See 11 U.S.C. 544(a)(1). Return to article

¹⁶ §9-103, cmt. 7(a) and (b); see, also, In re McAllister, 2001 WL 1149068 (Bankr. N.D. Iowa 2001)
(dicta discussing revised Article 9). Return to article

¹⁷ §9-103(f)(1). Return to article

¹⁸ §9-103(f)(3). Return to article

¹⁹ The list of examples in Official Comment 3 to §9-103 goes beyond those expenses that are incidental to the original acquisition
of the collateral. The comment states that the following items would be included in the purchase-money obligation: "sales taxes, duties, finance
charges, interest, freight charges, costs of storage in transit, demurrage, administrative charges, expenses of collection and enforcement,
attorney's fees and other similar charges." Return to article

²⁰ See §9-103(e). Return to article

²¹ See §9-103, cmt. 8. Return to article