An April 1999 decision of the United States Court of Appeals for the Ninth Circuit indicates that a stock certificate which carries with it certain affirmative obligations may not be a "certificated security" under the pre-1994 amendments version of the UCC.1
Norman Turley (the "Debtor"), an Indy car racer and member of Championship Auto Racing Teams ("CART"), pledged one share of CART stock to Farmers and Merchants Bank of Long Beach (the "Bank"). The Bank attempted to perfect a security interest in the share and its proceeds under the pre-1994 amendments version of Article 8 of the UCC ("Old Article 8") by gaining possession of the share certificate. Thomas C. Thompson Sports ("Thompson Sports") held a perfected security interest in the Debtor's general intangibles under Article 9 of the UCC.
In order to participate in CART-organized Indy car races, one must become a CART franchise member. CART franchise members must comply with a number of strict membership requirements, including a commitment to participate in all Indy Car World Series events. If awarded a franchise membership, a member is required to purchase one share of CART stock. The non-transferable memberships are only valid for one season but may be renewed if the member is a "bona fide" participant in all racing events and is "otherwise eligible". If the membership terminates, the member must return the share of stock to CART in exchange for the sum of the share value and the franchise value, both as determined by the CART Board of Directors. According to CART by-laws, before a shareholder can sell, transfer, encumber or otherwise dispose of any share of CART stock, the shareholder must first deliver a written offer to sell to CART. The offer must contain the resignation of the shareholder's franchise membership and the prospective purchaser must be an existing CART shareholder. In response to the offer to sell, CART may either repurchase the share itself or allow the sale to proceed.
Shortly after entering into financing arrangements with both the Bank and Thompson Sports, the Debtor filed for Chapter 11 bankruptcy. After the petition, CART's Board of Directors voted to redeem the Debtor's share of stock for $220,000. The Bank argued that those funds were proceeds attributable to the redemption of the Debtor's CART share certificate which the Debtor had pledged to the Bank. Thompson Sports argued that it had priority to the funds because they represented proceeds from a franchise agreement (a general intangible) between the Debtor and CART. Both the district court and the bankruptcy court held that the Bank was entitled to the funds due to its prior, perfected security interest in the share certificate.
The Ninth Circuit's decision hinged on the question of whether the share certificate was a "certificated security" under Old Article 8. Since CART was a Michigan corporation, Old Article 8 provided that Michigan law governed the question of whether the share was a certificated security. At the time, under Michigan law, a certificated security was a "share, participation, or other interest in property of or an enterprise of the issuer or an obligation of the issuer" that was, among other things, of a type commonly dealt in on securities exchanges or markets or commonly recognized in any area in which it was issued or dealt in as a medium for investment. The UCC Comments provided that the purpose of this portion of the definition was to "cover such interests as the stock of closely-held corporations which, although not in fact dealt in on exchanges or markets, is 'of a type' that is."2
In its opinion, the Ninth Circuit rejected the Bank's argument that the CART share was a share in a close corporation and that the transfer restrictions were typical for such corporations. The Court of Appeals found instead that securities that were "of a type commonly dealt in on securities exchanges or markets or commonly recognized . . . as a medium for investment" did not carry with them affirmative obligations such as the CART shareholder's obligation to participate in races and to return the share certificate upon termination of franchise membership. The Court held that the Debtor's interest was not an Old Article 8 "certificated security" and was thus "caught by the 'general intangible' net in Article 9" of the UCC. Under Article 9, possession perfects a security interest in chattel paper, documents and instruments. Even though represented by a certificate, the CART share was not chattel paper, a document or an instrument. An Article 9 security interest in general intangibles may only be perfected by filing. Thus, the Court of Appeals concluded that despite having possession of the certificate, the Bank held nothing more than an unperfected security interest in the Debtor's CART share.
The draftsmen of the 1994 amendments to Article 8 of the UCC ("Revised Article 8") sought, in their definition of "certificated security", to evade the ambiguity of the "commonly dealt in on securities exchanges or markets" standard by establishing a rule that "a share or similar equity interest issued by a corporation . . . is a security."3 It would seem that this would be an end to the inquiry, and that under Revised Article 8, the court would have reached the contrary conclusion. However, the commentary to the Revised Article 8 provision states that this per se rule applies to "ordinary" corporate stock,4 and the Old Article 8 commentary, like the Revised Article 8 commentary, indicated the same intention to cover stock of closely-held corporations5 -- so perhaps it is not so clear that Revised Article 8 would mandate a different result. In any event, this case underscores how critical it is at the outset of a lending transaction to characterize accurately the collateral securing the loan. The case also demonstrates how, even where a characterization may seem obvious, on closer review a nonobvious characterization of the collateral may also be possible. When the character of a particular item of collateral is unclear, it is incumbent upon lender's counsel to protect its client's interests by perfecting the security interest with respect to each possible characterization of the collateral. Otherwise, a lender may discover that it has no perfected collateral interest in the property when it needs one the most.
In re Norman C. Turley, 172 F.3d 671 (9th Cir. 1999).
Endnotes
- The State of Michigan subsequently adopted the 1994 amendments to Article 8 of the UCC ("Revised Article 8"). Under Revised Article 8, it is likely that the case would have been decided differently. See discussion below.
- Revised Article 8 defines "certificated security" somewhat differently:
"Certificated security" is defined as "a security that is represented by a certificate" (Revised §8-102(a)(4)); and
"Security" is defined as "except as otherwise provided in Section 8-103, ... an obligation of an issuer or a share, participation, or other interest in an issuer or in property or an enterprise of an issuer:
(i) which is represented by a security certificate in bearer or registered form...;
(ii) which is one of a class or series or by its terms is divisible into a class or series of shares, participations, interests, or obligations; and
(iii) which:
(A) is, or is of a type, dealt in or traded on securities exchanges or securities markets; or
(B) is a medium for investment and by its terms expressly provides that it is a security governed by this Article." Revised §8-102(a)(15).
Section 8-103(a) of Revised Article 8 provides: "[a] share or similar equity interest issued by a corporation, business trust, joint stock company, or similar entity is a security." - Revised §8-103(a).
- Revised §8-103, official comment 2.
- Id.; Old §8-102, official comment 2.
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