The Bankruptcy Appellate Panel for the Eighth Circuit recently held that a secured creditor obtained a valid lien on collateral because technical defects in the bill of sale did not invalidate a transfer of title to the collateral, and rejected the argument that the secured creditor should have inspected the bill of sale before advancing funds.

A copy of the opinion in In re Leonard is available at: Link to Opinion.

This was a dispute over the validity and priority of interest in collateral in goods. The seller sold the collateral to the debtor, a broker who delivered the collateral to another company for care and maintenance (“Care Company”). Care Company financed the debtor’s purchase of cattle through a line of credit it had with a lender and asserted a lien against the collateral.

But, the seller only received partial payment for the collateral because the debtor’s checks failed to clear. The seller then exercised his right to reclaim the collateral under the Uniform Commercial Code (UCC) for nonpayment. The problem for the seller was that the holder of a valid security interest takes priority over a reclaiming unsecured creditor.

Care Company argued that its security interest attached to the collateral the moment the debtor became the owner of the collateral, even if the debtor’s title was voidable due to the seller’s later assertion of reclamation rights. Thus, Care Company argued that its interest in the collateral took priority over the seller’s.

The seller alternatively argued that: (1) Care Company’s lien was not valid because title to the collateral did not properly transfer from the seller to the debtor due to defects in the bill of sale, and (2) even if title were transferred, Care Company did not exercise good faith as required to perfect a valid lien under the UCC.

The debtor filed a Chapter 11 bankruptcy case and the collateral was sold. The proceeds were held pending the outcome of the litigation. The Bankruptcy Court concluded on cross motions for summary judgment that Care Company’s lien and, in turn the lender’s lien, were both valid and that Care Company and the lender were entitled to the proceeds of the sale of the collateral. The seller appealed.

The first issue before the BAP was whether the seller transferred title to the debtor to allow Care Company’s lien to attach to the collateral.

The collateral consisted of cattle, and the seller surrendered possession of the cattle to the debtor in Colorado. Section 35-54-101 of the Colorado Revised Statues, commonly referred to as the “livestock bill of sale law,” required a bill of sale between the buyer and seller of livestock. A livestock bill of sale required, among other things, a bill of sale signed by both the seller and buyer, giving the post office address of each, in the presence of a witness who also signed his name and address. Colo. Rev. Stat. § 35-54-103.

In this case, the bill of sale was signed by the seller and a witness, but it was not signed by the debtor, and none of the parties’ post office addresses were given. Thus, the seller argued that title to the collateral was never transferred from the seller to the debtor, because the bill of sale was not in strict compliance with Colorado’s livestock bill of sale requirements. And, because the seller did not transfer ownership of the cattle to the debtor, the seller argued that the debtor could not have granted Care Company a security interest in the collateral. The BAP disagreed.

In a case involving similar facts, the Colorado appellate court held that title to cattle only passes if the transfer of possession is accompanied by a bill of sale in compliance with the livestock statutes. Cugnini v. Reynolds Cattle Co., 648 P.2d 159 (Colo. App. 1981) (“Cugnini I”), aff’d 687 P.2d 962 (Colo. 1984) (“Cugnini II”). However, in an attempt to harmonize the livestock bill of sale laws with the UCC, the Colorado appellate court in Cugnini I reversed the trial court and held that if neither party can claim valid title under the livestock bill of sale laws, the court may resort to the UCC to resolve the dispute. Id., at 164. Thus, the court in Cugnini I concluded that because the buyer took physical delivery of the cattle, and the seller transferred all of their rights to the buyer, the buyer had acquired title under the UCC and was therefore entitled to the proceeds of the sale. Id.

In Cugnini II, the Colorado Supreme Court affirmed the appellate court, and held that “noncompliance with the livestock bill of sale requirement [did] not necessarily prevent transfer of title.” Cugnini II, 687 P.2d at 965. In other words, transfer of title was not dependent on compliance with the livestock statutes. Because the livestock bill of sale statutes did not necessarily determine when valid title to cattle passes, the Colorado Supreme Court ruled that courts must look to other sources of the law, such as the UCC, to determine possession of valid title. Id

Relying on Cugnini, the BAP found that if the seller had valid title (which the seller insisted that it did), it could pass valid title to the debtor (who could then grant a lien to Care Company) without fully complying with the livestock bill of sale laws, if the UCC requirements for attachment were met.

As you may recall, Section 2-401 of the UCC provides, in relevant part: (1) “title to goods passes from the seller to the buyer in any manner and on any conditions explicitly agreed on by the parties,” and (2) “[u]nless otherwise explicitly agreed title passes to the buyer at the time and place at which the seller completes performance with reference to the physical delivery of the goods, despite any reservation of a security interest and even though a document of title is to be delivered at a different time or place…”

Here, it was undisputed that (i) the seller surrendered possession of the cattle to the debtor in Colorado, (ii) the seller signed a bill of sale transferring title to the debtor, and (iii) the contract between the seller and the debtor contained no reservation of title or security interest.

Therefore, pursuant to Section 2-401, the BAP held that title passed from the seller to the debtor at the moment the collateral was transferred.

Next, the BAP turned to Care Company’s security interest in the cattle.

Section 2-403 of the UCC provides, in relevant part: “[a] person with voidable title has power to transfer a good title to a good faith purchase for value … [if] the delivery was in exchange for a check which is later dishonored, or the delivery was procedure through fraud.” Neb. Rev. Stat. U.C.C. § 2-403(1)(b), (d).

Under Section 2-403, the BAP determined that the debtor received title (albeit voidable title) from the seller at the time of transfer, and the debtor also received the power to transfer good title to a good faith purchaser for value.

On the question of whether Care Company was a good faith purchaser, the seller argued that the Bankruptcy Court used the wrong standard. Specifically, the seller asserted that the Bankruptcy Court should have found the debtor was a “merchant” under the UCC and applied the UCC’s higher standard of good faith for such merchants.

As you may recall, a “merchant” is defined in Article 2 of the UCC as “a person who deals in goods of the kind…” Neb. Rev. Stat. U.C.C. § 2-104(1). Livestock are “goods” under the UCC. Cugnini I, 648 P.2d at 163. “’Good faith’ in the case of a merchant means honesty and the observance of reasonable commercial standards of fair dealing in the trade.’” Neb. Rev. Stat. U.C.C. § 2-103(1)(b).

The seller argued that Care Company failed to observe reasonable commercial standards in releasing the funds to the debtor without first ascertaining that the debtor owned the cattle. More specifically, the seller argued that based on the summary judgment record, the Bankruptcy Court erroneously found that (i) cattlemen generally consider the bill of sale in this case to be valid documentation of ownership, and (ii) Care Company had seen the defective bill of sale prior to releasing the funds to the debtor.

The BAP rejected the seller’s argument for two main reasons. First, Care Company introduced affidavits from a number of individuals in the cattle and feedlot business who testified that the bill of sale at issue would be considered to be a valid bill of sale if it had been presented to them. And, the seller did not submit any affidavit to dispute Care Company’s evidence as to the documentation that cattlemen routinely require to transfer ownership.

In fact, according to the BAP, the statements in the affidavit were supported by both law and common sense. The technical defects in the bill of sale – itself governed by Nebraska law — did not affect the transfer of title because the seller owned the cattle and could therefore transfer title to the debtor under “any manner and on any condition explicitly agreed on by the parties.” Neb. Rev. Stat. U.C.C. § 2-401(1). Thus, when the seller gave a bill of sale signed by him, and witnessed by a state inspector, transferring ownership of the cattle to the debtor, along with possession of the cattle, cattlemen and their lenders would reasonably conclude that he had transferred ownership of such cattle to the debtor.

Second, the BAP rejected the seller’s argument that Care Company should have inspected the bill of sale before advancing funds to the debtor. In Cugnini II, the Colorado Supreme Court held that title could be transferred before or after payment. Cugnini II, 687 P.2d at 967 (“Some purchasers refuse to pay for cattle until after the brand certificate is received; however, others, on occasion will pay for cattle before the delivery of a brand inspection certificate and rely on getting it later.”)

Relying on Cugnini II, the BAP held that it was immaterial whether Care Company wired the funds before or after seeing the bill of sale because it did not affect the outcome of this case. In other words, whether Care Company saw the bill of sale before releasing the funds would only matter if the seller did not pass title to the debtor. Here, because the seller transferred title to the debtor, and due to Care Company’s line of credit arrangement with the debtor, the collateral became subject to Care Company’s lien the moment the debtor became their owner.

In sum, the BAP concluded that “[t]he purpose of Article 2 of the UCC is to facilitate the free flow of commerce. That purpose would not be served if lenders were obligated to ascertain that their borrowers have ownership and possession of collateral before funds are lent.”

Accordingly, the BAP affirmed the Bankruptcy Court’s orders holding that Care Company’s lien was superior to the seller’s rights as an unpaid seller.