Third Circuit Rejects Implied Waiver of Article 9 and Confirms What Constitutes a “Commercially Reasonable Search”

In September 2009, the Third Circuit issued a ruling in Wawel Savings Bank v. Jersey Tractor Trailer Training Inc. (In re Jersey Tractor Trailer Training Inc.), 580 F.3d 147 (3d Cir. 2009), that addressed significant issues that can arise in situations where competing claims to a debtor’s accounts receivable exist between a traditional lender and a factor. Although the court emphasized that it was rendering its decision based on the New Jersey version of the Uniform Commercial Code (UCC), its relatively broad holdings are generally applicable in the Circuit.

Jersey Tractor Trailer Training Inc. (JTTT) was a company that provided training and certification for truck drivers. In early 2002, JTTT borrowed approximately $315,000 from Wawel Savings Bank (Wawel) and, in exchange, granted Wawel a security interest in all of its assets, including its accounts receivable. Under Wawel’s loan documents, JTTT agreed not to settle any account for less than its full value without Wawel’s prior permission.

A little more than one year later, JTTT, apparently beginning to financially deteriorate, approached Yale Factors LLC (Yale) to finance its accounts receivable in order to increase its liquidity. Although JTTT’s loan agreement with Wawel required JTTT to obtain Wawel’s consent to the factoring arrangement, JTTT chose not to do so.

As part of its underwriting, Yale conducted a lien search for outstanding security interests in JTTT. Yale’s search was conducted on “Jersey Tractor Trailer Training.” Notably, the “Inc.” was specifically excluded from the search, based apparently on customary practice. For unknown reasons, Yale’s lien search did not disclose Wawel’s prior security interest—with the Third Circuit noting that it was at a loss as to why this was the case. Nevertheless, because Wawel’s prior lien was not uncovered, Yale entered into the factoring relationship under which JTTT granted Yale a first-priority security interest in the accounts receivable.

Between 2003 and 2005, Yale factored almost $1 million of JTTT’s accounts receivable through a process by which Yale advanced 70 percent of the receivables’ face value, less a fee, and sent the balance when Yale received payment from the customer. Yale wired the payments into JTTT’s bank accounts, first at another bank, and then eventually into a Wawel account that had been established at the Federal Home Loan Bank of New York (FHLB) to allow Wawel customers access to wire transfers.[1]

Toward the end of 2005, JTTT was experiencing significant financial difficulty, had little funds left in its bank accounts and, in addition to its loan with Wawel, owed Yale more than $600,000. Upon JTTT’s ultimate default, litigation ensued between Yale and Wawel in state court as to the parties’ rights to JTTT’s accounts. When JTTT filed for bankruptcy in April 2006, the issue as to who had priority to JTTT’s outstanding accounts receivable was litigated in the bankruptcy court.

Yale’s principal argument was that Wawel had implicitly waived its security interest in JTTT’s accounts receivable because it had knowledge of the factoring agreement and agreed to the lien by accepting the payments from Yale through the series of wire transfers to FHLB. The Third Circuit, however, rejected that argument, noting that even if Wawel knew of the arrangement, “there [was] a substantial difference between Wawel knowing of the sale of JTTT’s accounts receivable, and Wawel authorizing the sale ‘free of its security interest.’” Id. at 154. Interpreting §9-315 of the UCC, the Third Circuit held that because a secured party was not required to take action to preserve its security interest, “inaction alone may not lead to a finding of implied authorization.” Id. at 155.Rather, the Third Circuit concluded that acts of implied authorization must unequivocally demonstrate an intent to waive the security interest. Id.

All was not lost for Yale, however, as the Third Circuit also rejected the bankruptcy court’s finding that “Yale failed to observe reasonable commercial standards of fair dealing…when it conducted its series of UCC searches on…the incorrect corporate name.” Id. at 153. In addition to arguing Wawel’s implied waiver, Yale had also argued that it was a “holder in due course” or a “purchaser of instruments” that took free of Wawel’s security interest. In order to qualify for either status, the Third Circuit found that Yale needed to establish that it engaged in “reasonable commercial standards of fair dealing.” Id. at 156.Yale contended that it had done just that: It conducted a search under “Jersey Tractor Trailer Training” and did not uncover Wawel’s prior lien. The bankruptcy court disagreed, finding that Yale should have searched JTTT’s exact name, including the “Inc.”

Relying on §9-506(c) of the UCC, the Third Circuit held that “a commercially reasonable lien search is a ‘search of the records of the [relevant state or county] filing office, under the debtor’s correct name, using the filing office’s standard search logic.’ (emphasis added).” Id. at 158.In so holding, the court noted that the New Jersey Department of Treasury UCC Search Manual Rule instructed UCC-1 searchers to exclude “noise words,” including “Inc.,” from their search terms.
Lastly, the Third Circuit dismissed the bankruptcy court’s findings that Yale’s lien search, showing that JTTT had no significant bank debt at a time when the company was faced with liquidity issues necessitating the use of a factor, “should have raised red flags,” and “that Yale’s failure to heed those red flags was evidence of its ‘reckless[ness].’” Id. Although the Third Circuit agreed that a complete absence of secured debt may be an indication that the lien search was improperly conducted, the court concluded that the fact that Yale did not inquire further was, without more, insufficient support for the bankruptcy court’s conclusion that Yale failed to comport with reasonable commercial standards of fair dealing.