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Copyright © International Chamber of Commerce (ICC). All rights reserved. ( Source of the document: ICC Digital Library )
by International Chamber of Commerce (ICC)
The United States, together with its common law cousins Australia, New Zealand and Canada (excepting Quebec), does not recognize the concept of “retention of title” as a means to allow a seller to recover sold goods in the event of a buyer’s insolvency or failure to pay. In contrast to the Late Payment Directive of the European Union (16 February 2011) and other EU regulations, the U.S. has taken the same path as other common law countries, recognizing a “retention of title” clause as creating only a “security interest” in the sold goods, which will be enforced as such.
A “security interest” in sold goods, properly registered and “perfected”, can provide a recovery remedy for a seller in the case of bankruptcy of the purchaser and in other situations, but the results will be far different than what the contract drafters intended.
There is no regulation of sales, and thus no regulation of RT, at the national level in the U.S. The U.S. Constitution reserves that area of law to the states, unless interstate commerce is involved. The law of sales in the United States is under the purview of the individual states, and any laws affecting RT or similar remedies will be found on the state level, in the state where the sale took place or under the law specified in the sales contract.
The Uniform Commercial Code (UCC) has become the basic law of sales and other commercial transactions in the United States since its proposal in 1963. The fifty U.S. states share a common legal heritage and their commercial laws have always been similar, but the differences among them led to problems in contracts and sales across state boundaries. After several unsuccessful attempts over the years to unify the law of sales, the result was the Uniform Commercial Code, a document covering sales and other topics, which was ultimately adopted by all fifty states and the District of Columbia.
The UCC has been amended several times since the two initial versions in 1963 and 1972: not all states have adopted the amendments or new versions, leading to minor disparities. The underlying platform, however, remains substantially the same from state to state. The jurisprudence of the fifty states interpreting and enforcing the provisions of the UCC also provides valuable guidance on how the UCC works in practice.
Under the UCC, an RT provision in a sales contract is not enforced as a means of retaking possession of goods which have been sold but not paid for pursuant to the contract of sale. The RT provision is instead considered to be a reservation of a “security interest” in the sold goods. The security interest, if “perfected” according to the UCC rules, can give the seller a priority right in litigation or bankruptcy proceedings over other creditors seeking to recover the goods, or the[Page231:]proceeds of the goods if already re-sold.
Parts of several different Articles of the UCC are involved in reaching this result. Article 2 of the UCC regulates Sales. Section 2-401 of Article 2, titled Passing of Title; Reservation for Security; Limited Application of This Section, contains the rules defining when title passes from seller to buyer in a sales transaction. Subsection 2-401(1) states the effect of an RT provision on the passage of title:
“Any retention or reservation by the seller of the title (property) in goods shipped or delivered to the buyer is limited in effect to a reservation of a security interest.”
The subsection goes on to expressly exclude the ability of the parties to contractually change the effect of an RT clause from what the UCC provides. While the seller and buyer have a broad range of authority to define between themselves how title to goods passes, such contractual provisions are made subject to the provisions of Subsection 2-401(1):
“Subject to these provisions and to the provisions of the Article on Secured Transactions (Article 9), title to goods passes from the seller to the buyer in any manner and on any conditions explicitly agreed on by the parties.”
[Emphasis supplied].
That conclusion is confirmed in another provision of the UCC, the General Definitions of the UCC found in Article 1. Section 1-201(35) defines a “security interest” as “an interest in personal property or fixtures which secures payment or performance of an obligation”. This statement appears able to include the interest of the seller in the property to secure payment by the buyer. However, Section I-201(35) goes on to state:
“The retention or reservation of title by a seller of goods notwithstanding shipment or delivery to the buyer under Section 2-401 is limited in effect to a reservation of a “security interest.”
It is not clear whether the language in the UCC in Articles 2-401(1) and I-201(35) automatically converts an RT provision into a security interest. The statutory language states that an RT provision is “limited in effect to the reservation of a security interest”: it does not say that a security interest has been created. The court would then look to see whether the RT provision met the requirements for the creation of a “security interest”.
As described above, there is no commercially equivalent form of security preserving a seller’s rights to the goods. However, the “security interest” which can emerge from an RT provision in a contract, can protect a seller in the case of insolvency or bankruptcy of a purchaser.
A “security interest” in goods or other property is created through a “security agreement”. A[Page232:]security agreement can be an express grant of a security interest, or it can arise indirectly if another document contains the required information. Here, another provision of the UCC enters the picture.
Article 9, Section 9-203(b), states the requirements for creation of a security interest enforceable against the buyer and third parties with respect to the goods being sold. At a minimum:
When these requirements are met, the security interest “attaches” and becomes enforceable.
Most credit sales contracts will meet these requirements. The first two requirements are usually met in a credit sales transaction, when the goods pass to the buyer and the buyer has rights to sell the goods. It is the last requirement that can be problematic: the sales documentation must describe the collateral with sufficient specificity, and the document must be “authenticated” by the debtor, i.e. signed in person or electronically.
A foreign seller seeking to include an RT provision in a contract for the sale of goods should make sure that the contract language includes a description of the collateral specific enough to allow third parties to know what the collateral is. The buyer must also have signed the document granting a security interest. The contract of sale can be sufficient to constitute a security agreement, but it is prudent to have an express statement from the buyer that “the buyer grants the seller a security interest in the collateral.”
Once the foreign seller has a “security interest” in the goods being sold, the question becomes what rights the foreign seller has to the goods or the proceeds from the goods under that “security interest”. Article 1, Section 1-201(35) states that a security interest is “an interest in personal property or fixtures which secures payment…”, but what does that mean in action?
The answer is found in Article 9 of the UCC, which governs Secured Transactions. Because the seller has an interest in the property to secure payment under Section 2-401(1), i.e. a security interest, the seller is considered to be a “secured party” under the Definitions section of Article 9, at Subsection (72) of Article 9-102. In simplest terms, a “secured party” is someone with a legal right to take possession of collateral in the event of a debtor’s failure to pay.
However, the security interest and the seller’s status as a “secured party” do not automatically entitle the seller to take position of the collateral at any time when the buyer does not pay. It is a good start, but that remedy only becomes available under certain circumstances involving the buyer, such as insolvency or bankruptcy. In addition, additional steps for “perfection” of the[Page233:]security interest, establishing priority over other claimants to the same assets, are also required before the seller’s rights under the security interest can be executed. These are described in Paragraph 5, below.
There is no relationship under U.S. law between RT and passage of risk, since RT is not a recognized concept under U.S. law. However, the creation of a security interest for the protection of the seller could be affected by the passage of risk.
The three requirements for creation of a security interest are:
The first requirement, that value have been given by the seller to the buyer, and the second requirement, that the buyer have rights to the goods, could be met if ownership changes at the same time that risk passes to the buyer. Under UCC § 2-401(2), title to goods passes at the time and place that the seller completes performance with respect to the physical delivery of the goods. If the goods are shipped by the seller to the buyer “Free Carrier”, then the seller has fulfilled its obligation to deliver the goods when they have been handed over and cleared for export, into the charge of the carrier named by the buyer at the named place or point. At that point, both ownership and risk of loss pass at the same time.
However, passage of risk is not always synonymous with transition of ownership rights. Passage of risk can, for example, be defined to specify which party is to carry the insurance for the shipment of the goods to the end destination, regardless of which party has title to the goods. In such cases, the passage of risk has no effect whatsoever on the creation of a security interest in the goods for the seller.
The third requirement, the authentication of a document by the buyer which describes the goods, depends on the contents of the document of sale and the authentication of that document by the buyer. It would not be affected by the passage of risk of loss of the goods.
A secured party has a claim to the goods which is effective against the buyer, against purchasers of the goods from the buyer, and against creditors for the purchase price of the goods. If the[Page234:]security agreement is properly drafted and perfected, the secured party will also have a claim to the proceeds resulting from the sale of the goods by the buyer.
As a practical matter, however, the secured party will almost always be competing against other creditors who also have security interests in the assets of the defaulting buyer. The secured party will, in most cases, be negotiating rights to the property against a trustee in bankruptcy, who is in control of the buyer’s assets and the claims to those assets. For the seller’s claim to be enforceable before the buyer’s money is claimed by other creditors with claims, the secured party must have established its priority vis-à-vis the other creditors by “perfecting” the security interest as soon as possible after it was created.
The process of perfection varies somewhat from state to state, but in general, involves filing a “financing statement” with a designated state office in the state where the collateral (i.e. the sold goods) or the debtor is located. Such filings give notice to any other creditor or potential creditor of the buyer that the parties with perfected security interests have claims on the assets of the buyer, and that these parties have priority ahead of other potential creditors in claims for the buyer’s assets.
In some states, the seller can submit the financing statement to perfect the security interest without the signature of the debtor; in other states, the debtor must consent to the filing. In drafting the contract for the credit sale of goods, it is wise to include a simple statement that the debtor consents to the filing of the documents by the seller to perfect a security interest.
The process of perfection will change based on the nature of the goods that were sold. In most cases, a financing statement is required to be filed. However, where securities, chattel paper or similar documents are involved, perfection of a security interest is achieved when the secured party takes physical control of that property. In cases where ownership is established through possession of a title document, such as in the purchase of a car or a boat, it is sufficient if the secured party has possession of the title document. A seller should verify in each case in the state where the buyer is located, or where the goods will be located upon the sale, how the security interest for the collateral in question will be perfected.
By taking the steps required to “perfect” a security interest, the secured party can establish priority over other creditors who perfect security interests, based on the dates on which the competing security interests were perfected. Perfection also gives the secured party priority over all holders of security interests which are not perfected, as well as all “unsecured creditors” who do not have security interests at all.
Section 9-322 of the UCC sets out the relative priorities between perfected, unperfected, or mixed security interests. In general, the holders of perfected security interests have priority based on the date that their security interest was perfected. The holders of security interests which have not been perfected are next in line, assuming that any assets would remain to be distributed in an action against a debtor. Creditors without a security interests have no priority, and would only be able to recover any of the amounts owed them if assets were left after the claims of the perfected and unperfected security interests.[Page235:]
If yes, is there a possibility to transform the RT in case of a sale to a third party?
The effect of a sale of the contested goods to a third party depends on the statements in the security agreement, and in the related financing statement, assuming a properly perfected security interest exists. If the security interest is in the goods themselves, and only that, then the entitlement to collect the goods ends when the goods are sold, if the purchaser is a “buyer in good faith”, with no knowledge that the goods have not been paid for by the original buyer, or that a financing statement has been filed with the relevant authorities. If, however, the party purchasing the goods from the buyer knows, or should know, that the goods have not been paid for, then the purchaser is not a “buyer in good faith” and can be required to produce the goods for the seller.
The UCC also gives the secured party additional options in the collection of the amounts owed to it after the goods are sold. A security agreement or the financing statement will almost always state that the seller is entitled not only to the goods themselves, but to the “proceeds” of the goods, i.e. the monies received by the defaulting buyer when the buyer sells the goods to another purchaser — regardless of the new purchaser’s knowledge of the original transaction. If the buyer has the proceeds of the resale of the goods, the original seller is entitled to those proceeds, if “proceeds” are named in the security agreement and in the financing statement on file.
If the buyer of the goods defaults on the buyer’s obligation to pay for the goods, but does not file for bankruptcy, the seller can sue the debtor in a U.S. federal or state court, for the amount due plus any damages incurred because of the non-payment. In the U.S., attorneys’ fees are generally not paid by the loser of the litigation. Each party bears its own costs unless otherwise provided in the contract for the sale of the goods, or unless the judge finds grounds to require the loser to pay the fees for fairness or punitive reasons.
Even if the contract for the sale of goods specifies another country’s laws as governing, the law of lex situs will often control a dispute which is in federal or state court. A 1992 federal case in the Western District of New York, The HongKong and Shanghai Banking Corp. v. HFHUSA Corp (805 F. Supp.133, 139 (W.D.N.Y. 1992)) involved a contract for the sale of goods which fell within the purview of Article 9 of the UCC. The contract stipulated that German law would apply, but the federal court declined to apply German law, in favour of New York law. The court stated that the parties’ choice of governing law “will not be regarded where it would operate to the detriment of strangers to the agreement, such as creditors or lienholders. ...” A party’s freedom to stipulate[Page236:]applicable law will be limited to allow parties who are “taking a security interest, or asked to extend credit which may be subject to a security interest [to] have sure ways to find out whether and where to file and where to look for possible existing filings. … Where the rights of third parties are implicated, the court should be governed by the ordinary rule that the federal district courts apply the choice of law rules of the state in which they sit.” (Id. at 140).
A 2002 federal court case, Usinor Industeel v. Leeco Steel Products, Inc. (209 F. Supp. 2d 880, 882 (N.D. Ill. 2002)), came to the same conclusion. The court found that the CISG, as treaty law, would have superseded any state or federal law on the formation of a contract, and the rights of the buyer and seller, if there were only a seller and a buyer. However, Art. 4 of the CISG excludes from the coverage of the CISG “(b) the effect which the contract may have on the property in the goods sold.” The rights of third parties, such as creditors, purchasers and other third parties are covered by domestic law. In the Usinor case, there was a third-party lender to the buyer, which had a property interest in the steel through a perfected security interest. The rights of the lender were not covered by the CISG, and would be adjudicated under domestic law. After deciding that U.S. rather than French law would apply, the court found that under the UCC, the third party’s claim to the steel took priority over Usinor because the third-party lender had perfected its security interest in the steel and Usinor had not.
The timeline of the proceedings is extremely variable, depending on the location of the controversy, whether the litigation will be in federal or state court, the complexity of the litigation and the amount in controversy. The duration could range from a few months to a few years.
There are alternative options for a seller to regain its goods under the UCC or common law.
One alternative is reclamation of goods under UCC Section § 2-702, which gives a seller the right to reclaim its goods within ten (10) business days of receipt by the buyer, if the seller discovers that the buyer is insolvent.
The second alternative under the UCC is Section 9-609, in Article 9 which governs secured transactions. Once the seller can be considered a “secured party” as discussed above, Section 9-609 provides that a secured party may simply go and get the collateral, if the secured party can do so without a breach of the peace. If a peaceful entry and taking is not possible, however, then the secured party would have to resort to judicial process to recover the collateral.
Replevin, a possessory action at common law, enables a person to get back personal property taken wrongfully or unlawfully, pending a final determination by a court of law, as well as compensation. Ironically, this remedy is not available if the seller has used an RT clause in a transaction where the UCC applies. In replevin, the seller must establish that it has title to the goods, and it would seem that an RT clause would accomplish exactly that. However, as described above, the seller’s RT clause will transform into a retention of a security interest under the UCC’s view of a credit sales contract. The seller will not have the required title to the goods in order to proceed with a replevin claim.[Page237:]
As discussed in Paragraph 5 above, the buyer has given the seller only a security interest in the property for which the buyer has not paid. The seller has not retained title to the goods.
When perfected, the security interest granted to the seller acquires a priority date on the day that the financing statement was filed. The seller then gets in line among any other creditors or lien holders to the asset in question. If the seller is the top priority date, then the seller can force a public sale of the property, keep its portion of the money raised in the sale, and allow the other debtors to allocate the remaining funds among themselves. If the seller is one of several creditors of the buyer, the ability to force a public sale may be limited or even worthless, if the asset being reclaimed is not sufficiently large to pay the seller after paying all other credits with superior priority to the seller’s claim.
The UCC was drafted with full knowledge that its provisions would be involved in bankruptcy or insolvency proceedings, particularly the outcome of sales transactions. Once bankruptcy is filed, the proceedings for repossession of the goods are primarily controlled by the trustee managing the bankruptcy, who must identify the assets and the claims against the bankrupt party. The trustee also has the right/obligation to recapture transfers made in the 90 days prior to the declaration of bankruptcy.
No assets can be removed from the bankruptcy estate without the approval of the trustee. Priority debts, such as domestic support obligations, wages/salaries, and taxes and penalties owed to government entities, are paid first. The security interests given by the buyer to the seller and which have been perfected have a high priority, following the statutory priorities described above.
The rights of the seller and buyer are influenced by the type of bankruptcy involved. Under U.S. law, there are several different types of bankruptcy. Under Chapter 13, a business which has no realistic chance of success is closed down, and all assets are liquidated by a trustee appointed by the bankruptcy court. Under Chapter 7, the business is reorganized, in the hopes of being able to continue to operate, also under a trustee that is appointed by the bankruptcy court. This reorganization is also referred to as a ‘receivership’, where the company itself or its management or shareholders request the court to name a receiver on its behalf. This form is usually used by a company struggling but still alive, which sees the potential for a return to successful operations. This process, also known as a “reorganization” of the existing business, usually involves new management and new business practices, with some existing obligations being cancelled and new procedures and management being put in place.
The security agreement and financing statement would have described the collateral in a way[Page238:]that the seller would be able to recognize the goods for repossession by the seller. However, the repossession would require time for the inventory of assets to be completed, and there could be a long wait before funds were paid out. Even then, payments would unlikely be payments in full of the amount owed.
The trustee has the ability to recapture transfers (including sales) made less than 90 days before the bankruptcy was declared. However, if the sale transaction has already occurred, generating income for the company, the incentive to rescind the transaction would be small. It is in these circumstances that the inclusion of “proceeds” becomes an important part of a security agreement. There would be no requirement to repossess the goods if the seller could simply file its claim for the proceeds of the sale.
All persons potentially affected by or involved in the bankruptcy are given a period of time to declare their claims against the bankruptcy estate. The duration for filing a “Proof of Claim” varies with the complexity of the bankruptcy proceeding, but some are filed within approximately 90 days.
The allocation of these charges would depend on the facts of the transaction.
NOTE: The following language is based on contractual provisions commonly seen in this country, but readers should always consult legal counsel before including a security interest provision in a contract, in lieu of an RT clause.
There is no specific RT clause that should be used for the U.S. market. RT is not recognized or enforced in the U.S., and there are unintended consequences which can arise from the use of an RT clause in a legal environment which does not recognize it.
A vendor selling into the U.S. would be well advised to include language in its sales contracts with U.S. purchasers that would constitute a “security agreement”. The security agreement would at least create a security interest on behalf of the vendor, and give the vendor the rights of a secured party upon perfection of the security interest. At a minimum, the required language can be a short paragraph included in the contract of sale, or in other sales or shipping documentation signed by the purchaser. That language could be along the following lines:
The Buyer [insert name] grants to the Seller [insert name] a security interest in the goods covered by[Page239:]this Agreement, as described in [state where the goods are described — which must include a general description of the type of goods involved, quantity, quality (if relevant), brand name if applicable, quality (if relevant), and number of units]. The Seller is authorized to complete, sign on Buyer’s behalf, and file with the relevant authorities at the place of destination, [state the place of destination], a security agreement/financing statement to perfect this security interest.
When large shipments are involved, the seller may require a longer and more detailed security agreement, with clauses restricting resale or transfer of the goods covered by the agreement, specifying the locations where the financing statements will be filed, and imposing other conditions on the buyer.
In any security agreement, it is critical to have the goods sufficiently described so that they can be identified by a third party. The arrival and storage location of the goods must also be noted, since that location determines where the financing statements will be filed. The security interest should be perfected as soon as possible after the buyer has possession of the goods, in order to give the seller the highest possible priority vis-à-vis other possible creditors.