Non-assignable Rights Contracts and Leases as Collateral Under Revised Article 9

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Oct 2000

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The theme of the last two columns has been the expansion of the scope of Article 9 to enable creditors to
take security interests in assets that previously might have been difficult or impossible to obtain liens upon.
The most obvious bankruptcy implication of those changes is that there will likely be fewer unencumbered
assets available for the payment of general unsecured creditors.

This month's column follows up on that theme by analyzing the revised act's treatment of
non-assignable contracts, leases, franchises, software licenses and other rights. The revised act incorporates
a strong policy in favor of free assignability and overrides most restrictions on the assignment of intangible
property interests. Although not technically a "scope" provision, the elimination of anti-assignment rules
will have the practical effect of making these classes of assets available as collateral.

In the non-bankruptcy context, this will allow debtors to use such valuable non-assignable assets to
obtain credit. However, in the bankruptcy setting, the new rules will not only result in a decrease in
available unencumbered assets, but may also allow the secured creditor to capture the "reorganization
value" of the enterprise.

<h3>A Little Background</h3>

Under current law, there is some dispute about whether a security interest can be created in a
non-assignable, intangible asset. Since current §9-203(1)(c)<a href="#1" name="1a">1</a> requires that the debtor have "rights in the
collateral," the existence of an anti-assignment provision in the contract or under applicable law might
prevent the creation of a valid security interest.<a href="#2" name="2a">2</a>

Numerous cases have arisen in the context of Federal Communications Commission (FCC) broadcast
licenses. Early cases took the view that in light of the FCC's anti-assignment policy, no security interest
could be created in such a license. As a result, even if the license were assigned to a new owner with the
FCC's permission, the lender would have no security interest in the proceeds generated by the assignment.
In 1994, the FCC modified its position to clarify that no security interest could be created in a license
because that might interfere with the FCC's ability to regulate the licensee. However, a security interest
could be created in the proceeds of the assignment of a license to an FCC-approved third party if the
security interest in the proceeds did not interfere with FCC regulation of the licensee.<a href="#3" name="3a">3</a>

The revised act's treatment of security interests in non-assignable intangibles is similar to the current
treatment of FCC licenses. The revised act distinguishes between non-economic rights and the payment
rights and proceeds that might be generated by the intangible asset. The basic policy of free assignability
is tempered to the extent necessary to protect the other party to the contract, franchise, license, etc. from
most adverse effects arising from the granting of a security interest.

<h3>Payment Rights and the Anti-assignment Problem</h3>

With respect to payment obligations, the revised act expands the more limited free-assignability
provisions of current law. Current §9-318(4) renders "ineffective" contractual anti-assignment clauses in
accounts and in general intangibles for money due or to become due.<a href="#4" name="4a">4</a> Section 9-406 of the revised act
expands this provision in several significant respects.

First, and perhaps most significantly, new §9-406 covers a wider array of payment obligations than
§9-318(4). As noted in an earlier column, the definition of accounts has been expanded beyond merely
rights to payment arising from the provision of goods or services, and now includes such things as franchise
fees and intellectual property license fees. In addition to the expansion of the accounts category, the
free-assignability provisions of §9-406 now expressly apply to payment intangibles, chattel paper and
promissory notes. Thus, the new provision applies to virtually all types of payment obligations and prevents
anti-assignment provisions from interfering with their use as collateral.

Further, although current §9-318(4) only overrides contractual anti-assignment provisions, the revised
act goes further and renders ineffective both contractual anti-assignment provisions and any "rule of law,
statute or regulation" that restricts assignment of such payment rights. See §9-406(d & f). Note, however,
that since the UCC is state law, it cannot invalidate anti-assignment provisions of federal law. In addition,
the language of the new provision clarifies that it (1) applies to assignments and transfers as well as security
interests, (2) renders ineffective terms that merely restrict, rather than prohibit, assignment, and (3) renders
ineffective terms that trigger a default, termination or other penalty based on an assignment.

Section 9-406 expressly excludes from its coverage assignments health care insurance receivables, and
outright sales of payment intangibles and promissory notes. Those are dealt with in §9-408, discussed
below. Note, however, that §9-406 would apply to a security interest in a payment intangible or promissory
note.

<h3>Security Interests in the Underlying Non-assignable Rights</h3>

Although §9-406 represents a modest expansion of the current law's free-assignability policy, the more
significant expansion is found in §9-408.<a href="#5" name="5a">5</a> While §9-406 makes non-assignable rights to payment available
as collateral, §9-408 makes other non-assignable rights lienable.

Using language similar to §9-406, §9-408 broadly invalidates anti-assignment contractual provisions
and legal rules relating to promissory notes and payment intangibles, health care insurance receivables and
other general intangibles, including contracts, permits, licenses and franchises. However, §9-408 only
renders such terms ineffective to the extent that they "would impair the creation, attachment or perfection"
of a security interest. See §9-408(a)(1) & (c)(1).

Under this provision, it will be easy to create a valid, enforceable and perfected Article 9 security
interest in a debtor's non-assignable rights under its contracts, permits, licenses and franchise agreements.<a href="#6" name="6a">6</a>
Such a perfected security interest in the intangible right would also give the secured creditor a perfected
security interest in any "proceeds" of the intangible. See §9-315(a)(2) & (c). Since the revised act adopts
a broader "proceeds" definition than current law, such proceeds would include, inter alia, any sale proceeds
in the event that the debtor disposes of the intangible collateral, any license fees if the debtor is the licensor
of an intellectual property right, and any property collected on, or distributed on account of, the collateral.

See §9-102(64).

However, beyond obtaining a bare "security interest" in the non-assignable intangible right and a right
to proceeds, the secured creditor receives few of the rights one normally associates with a security interest.
The secured party's right to "enforce" its security interest is noticeably absent from the §9-408(a) and (c)
override of anti-assignment provisions. This omission was intentional and was designed to strike a balance
that permitted the assignment of the debtor's rights without adversely affecting the interests of the
non-debtor party to the contract, permit, license, franchise, etc.<a href="#7" name="7a">7</a>

Section 9-408(d) explicitly states that the creation of a security interest in such a non-assignable right "does
not entitle the secured party to enforce the security interest in the...general intangible." See §9-408(d)(6). In
addition, the section spells out several of the specific limitations on the secured party's enforcement rights.
Using, as an example, a computer software license where the debtor is the licensee, the security agreement
(1) is not enforceable against the licensor, (2) imposes no duties or obligations on the licensor, (3) does not
require the licensor to recognize the security interest, pay or render performance to the secured party, or accept
payment or performance from the secured party, (4) does not entitle the secured party to use or assign the
debtor's rights, and (5) does not entitle the secured party to have access to any trade secrets or confidential
information of the licensor. As comment 2 to §9-408 states:

Even if the secured party takes possession of the computers on the debtor's default, the debtor would
remain free to remove the software from the computer, load it on another computer and continue
to use it, if the license so permits.

What is the value of such an interest? Outside of bankruptcy, it could have value if the licensor is
willing to recognize the security interest and consent to an assignment to the purchaser at the UCC
foreclosure sale. In addition, the right to proceeds may have value in some cases. Otherwise, in the absence
of the licensor's consent, the security interest may not generate any monies to satisfy the indebtedness in
the event of a default.

However, in bankruptcy, the security interest may suddenly have a great deal of value. First, the expanded
"proceeds" definition may make the interest very valuable. Section 552 of the Bankruptcy Code generally
limits the ability of pre-petition lenders to reach property created post-petition, unless the post-petition property
is the "proceeds" of the pre-petition collateral. The combined effect of a §9-408 security interest in a general
intangible and the revised act's expanded definition of proceeds may be that the secured creditor will now be
able to assert a lien on revenues generated post-petition by the intangible asset.

In addition, if the debtor's rights are assigned to a third party, the proceeds rule will allow the secured
creditor to claim a lien on the proceeds of the assignment. While this parallels the non-bankruptcy result in
cases where the licensor consents to the sale, it gives the secured creditor a bankruptcy windfall in those cases
where the licensor refuses to consent. Section 365 of the Bankruptcy Code invalidates certain contractual
anti-assignment clauses and permits the trustee or debtor-in-possession (DIP) to assume and assign otherwise
non-assignable contracts and leases in order to maximize the value of the estate. Section 9-408 may allow the
secured creditor to divert this value to the payment of its own secured claim.

Finally, in a reorganization context, §365 allows the DIP to override contractual ipso-facto and
anti-alienation clauses so that it may assume beneficial contracts and leases for use in its post-confirmation
operations. Under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Commercial Corp. v. Rash, 520 U.S. 953, 117 S.Ct. 1879 (1977)</a>, the value
of the secured creditor's collateral, and thus the amount of its allowed secured claim, turns on the use of
the collateral rather than its foreclosure sale value. Since the use value of intangible contract or lease rights
may be high in a reorganization context, the secured claim arising from a security interest in a
non-assignable intangible right may be very large, even though the collateral would be of no value to the
creditor outside of bankruptcy.

<h3>Enactment Update</h3>

The only enactment activity since the September column is that the revised act has now been signed
into law in the District of Columbia and North Carolina. Thus, a total of 27 states plus the District of Columbia have passed or enacted revision bills, and 12 additional states have pending bills.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> All citations are to the revised 1999 version of Article 9 of the Uniform Commercial Code, unless otherwise indicated. Citations to the currently applicable 1972 version of Article 9 are indicated by the term "current." <a href="#1a">Return to article</a>

<a name="2">2</a> See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Delgado, 967 F.2d 1466 (10th Cir. 1992)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Amereco Environmental Services Inc., 129
B.R. 197 (Bankr. W.D. Mo. 1991)</a> (hazardous waste operating permit); see, generally, 1 Clark, Barkley, The Law of Secured
Transactions Under the Uniform Commercial Code, ¶2.04[3] (2000). <a href="#2a">Return to article</a>

<a name="3">3</a> See Clark at 2-71. Following the FCC's lead, the Ninth Circuit drew a distinction between the license and its proceeds and
validated the lender's rights in the proceeds in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Investors L.P. v. Pacific Quadracasting Inc., 146 F.3d 746 (9th Cir.
1998), cert. denied, 525 U.S. 1121, 119 S.Ct. 903 (1999)</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> This category of general intangibles is similar to what the revised act calls "payment intangibles." <a href="#4a">Return to article</a>

<a name="5">5</a> The revision provides similar free-assignability rules for leases in §9-407 and for letter-of-credit rights in §9-409. <a href="#5a">Return to article</a>

<a name="6">6</a> Note that because of the supremacy of federal law, this change will have only a limited effect on federal law-based anti-assignment rules,
such as those involved in the FCC broadcast license cases. However, to the extent that refusal to recognize the security interest is based on the UCC "rights in collateral" requirement, §9-408 should change the result. <a href="#6a">Return to article</a>

<a name="7">7</a> For an excellent analysis of the revised act's application to intellectual property rights, see <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…, Steven O., "The Financing of
Intellectual Property Under Revised UCC Article 9," 74 Chi.-Kent L. Rev, 1077 (1999)</a>. <a href="#7a">Return to article</a>

Journal Authors

G. Ray Warner

Journal Date

Sunday, October 1, 2000 - 12:00