Most of us think of the Uniform Commercial Code (UCC) as being relevant only to creating, perfecting and enforcing security interests in connection with loans secured in whole or in part by personal property. However, sales of certain assets also are covered by the UCC.

The good news: the UCC requirements do not apply to sales of real or tangible personal property, securities, intellectual property or most contractual obligations. However, the UCC applies to sales of certain payment obligations (e.g., sales of loan portfolios), and it will apply if a transaction that the parties called a sale is recharacterized as a secured loan. The UCC also is relevant in determining whether purchases of other types of assets are “free and clear” of the claims of lenders and other third parties.

Purchases of Loan Portfolios—How to Document and Perfect

The UCC applies to sales of accounts (think most accounts receivable), chattel paper (think equipment leases and loans), promissory notes and payment intangibles (think payment obligations for loans that are not represented by a note and under swaps and other derivatives)—we’ll call these types of assets “payment rights.” While there are exceptions (such as purchasing payment rights as part of the sale of the business out of which they arose), they generally will not apply to the purchase of a portfolio of payment rights, and there may be difficulties in being sure of the relevant facts to know that any of the exceptions apply. As a result, the diligence and documentation process for a purchase of payment rights needs to satisfy UCC requirements.

These requirements are not particularly burdensome in a commercial transaction. The purchase contract needs to be a signed writing (or its electronic equivalent) and must reasonably identify the purchased payment rights, and the transaction needs to be perfected. “Perfection” is the label the UCC puts on the steps that a purchaser needs to take to successfully transfer the assets away from the seller. The applicable method of perfection depends on what type of payment right is being sold. For accounts, a UCC filing is the only available method of perfection; for chattel paper, either filing or control (possession of tangible chattel paper and the electronic equivalent for electronic chattel paper); and, for payment intangibles and promissory notes, perfection is automatic (when the parties close their transaction under an appropriately drafted agreement).

What Can Go Wrong?

So far, the UCC hoops look simple—sign a contract and follow the perfection steps, right? But there are two pitfalls—a court may not agree that there is a sale, or a court may disagree as to which category of payment rights is involved. Since either of these determinations can change the perfection steps, they are an important part of evaluating a transaction.

If the transaction is recharacterized by a court as a secured loan, and not a sale, then while the perfection steps for accounts and chattel paper are unchanged, the perfection steps for payment intangibles and promissory notes are different—namely, automatic perfection is no longer available. For a collateral assignment of payment intangibles to be perfected, a UCC filing is required, while perfection of a collateral assignment of promissory notes requires either filing or possession.

Courts also have disagreed with the parties’ characterization of the payment rights, which may affect the perfection steps applicable even if the purchaser (and its counsel) are quite certain that the transaction will be treated as a sale. If what the purchaser thought was a payment intangible or promissory note (i.e., automatically perfected transfer) is instead an account or chattel paper, then the applicable perfection steps (filing or possession, as described above) must be taken.

What’s the safest course? Make a UCC filing (the cost is minimal compared to the expense of litigating the issues of sale versus collateral assignment and type of payment right, or of losing the assets) and, in the case of chattel paper and promissory notes, take possession of the assets. While filing is effective to perfect a transfer of chattel paper or promissory notes, there are some third parties who can acquire these types of assets free and clear of the purchaser’s interest if the assets are left in the seller’s hands.

Diligence Issues

Because most sales of assets are not free and clear of existing UCC security interests, a buyer of assets should go through the same diligence process as would a lender. That means ordering appropriate UCC and other lien searches against the seller of the assets. In designing these searches, diligence may require searching prior names used by the seller or prior owners of the collateral, to make sure existing liens are identified and transfers to the seller have been perfected where required.

The search, however, may not turn up important information, because filing is not the sole method of perfection for many types of assets. As noted above, perfection is automatic with respect to sales of payment intangibles and promissory notes, so a search may not disclose that the seller has (negligently or fraudulently) sold the assets to a prior buyer, and has nothing to transfer to the current buyer. Perfection may be by possession as to many types of assets, including chattel paper and tangible personal property such as equipment, but simply asking the seller to turn over the purchased property usually will uncover any problems with these types of assets. Perfection may be by control as to other types of assets, and, again, asking for a turnover of purchased property will usually reveal any prior transfers or existing security interests. To some extent, however, unlike real property, where title insurance is available, the buyer will be dependent on the honesty of its seller and the accuracy of the information obtained through representations and warranties in the purchase contract and through public records searches and other diligence.

For one type of assets—securities—the picture is slightly brighter. A buyer of securities who meets the UCC’s requirements to be a “protected purchaser” takes free and clear of adverse claims to the securities that it purchases; in effect, it will get better title than its seller had. The protected purchaser requirements should be reviewed with counsel to see if they are met, but they generally are not difficult. And here is an added bonus—although limited liability company and partnership interests normally are not securities for UCC purposes, by adding (prior to the sale) a few magic words in the limited liability company or partnership agreement to indicate that the purchased membership or partnership interest is intended to be a security under Article 8 of the UCC, the buyer may make those interests securities, and thus put itself within reach of protected purchaser status.

Conclusion

Buying and selling portfolios of loans and other assets promises to be an important part of the process by which liquidity is restored to the credit markets. Knowledge of UCC perfection requirements, and related purchaser diligence issues, will lead to properly documented transactions and fewer post-closing headaches.