March 23, 2000
LENDER UPDATE: March 2000
Vermont Legal Issues for Banks and Other Lenders
This Lender Update will give you a report on some of the legal developments during 1999 that are significant for banks and other lenders doing business in Vermont. In this update, you will find a discussion of how recent changes to Vermont's partnership laws impacts lending practices, a report on class action litigation in the private mortgage insurance arena that could impact mortgage lending, discussions of recent court decisions in Vermont affecting foreclosure actions and deed-in-lieu of foreclosure transactions, and a discussion of the nuances of perfecting security interests in intellectual property assets.
PARTNERSHIP LAW UPDATES IMPACT LENDING PRACTICES
Effective January 1, 1999, the Vermont Legislature repealed the Uniform Partnership Act then in effect and replaced it with the Revised Uniform Partnership Act (the "Revised Act"). This modernization provides us with the opportunity to consider credit and collateral issues relevant to lenders, whether your borrower is a partner or the partnership itself.
If you are lending to the partnership, you should determine whether the partnership is a limited liability partnership ("LLP"). Under the Revised Act, general partners can now form as an LLP or even covert an existing general partnership into an LLP. This is accomplished by merely filing a certificate of qualification with the Vermont Secretary of State. The general partners in an LLP are not personally liable for the debts and obligations of the partnership. Thus, unlike the typical general partnership, a lender cannot automatically look to the assets of the general partners to support a loan to an LLP. To reach the general partners, lenders will now have to include the personal guarantees of the partners in the loan documentation.
If you are lending to a partner, as opposed to the partnership itself, you should consider (i) what interests in a partnership can serve as collateral for a loan, and (ii) how to perfect a security interest in these partnership interests.
The Revised Act provides that "the only transferable interest of a partner in the partnership is a partner's share of the profits and losses of the partnership and the partner's right to receive distributions." 11 V.S.A. § 3242. Further, a transfer of these economic rights does not authorize the transferee (such as a lender) to participate in the management or conduct of the partnership business, request access to information, or to inspect or copy the partnership books or records. These provisions are generally consistent with, albeit more clearly written than, the prior legislation. In short, a lender's security interest will continue to be limited to a (potential) revenue stream, and will not, upon foreclosure, confer any management or voting rights on the lender.
The Revised Act, consistent with prior law, deems these transferable partnership interests to be personal property. Thus, the Uniform Commercial Code will govern the perfection of a lender's security interest in this type of collateral.
If the partnership interest is dealt in or traded on securities exchanges or in securities markets, then the interest is a "security" within Article 8 of the UCC and special rules apply to perfecting a security interest in these investments. More typically in Vermont, the partnership interest is not a "security," and the lender must decide whether the interest constitutes an "instrument" or a "general intangible" within the UCC definitions of these terms.
An "instrument" is essentially defined to mean a negotiable instrument or any other writing which evidences a right to payment of money and is itself not a security agreement or lease. If the partnership interest in question is represented by a certificate, then it may constitute an instrument. If so, the act of perfection will be governed by the laws where the certificate is located, which may or may not be Vermont. If the instrument is located in Vermont, perfection is accomplished by physical possession. If the instrument is located outside of Vermont, the lender should request that the instrument be delivered to the lender in Vermont, in which case the Vermont UCC, and the possession rule, will apply.
If the partnership interest does not constitute an instrument, then it will fall within the "catch-all" category of "general intangibles." In such a case, the location of the partner will govern the act of perfection. If the partner is located in Vermont, then perfection is accomplished by filing a UCC-1 financing statement with the Vermont Secretary of State. If the partner is located outside of Vermont, then the UCC of the partner's jurisdiction must be consulted to determine the proper method of perfection.
David Sylvester is a director in the firm who represents lenders in commercial financings.
RESPA VIOLATIONS CLAIMED IN SUITS AGAINST PRIVATE MORTGAGE INSURERS
Class action lawsuits have been filed in federal court against four of the nation's largest private mortgage insurance companies, alleging violations of the anti-kickback provisions of the federal Real Estate Settlement Procedures Act, 12 U.S.C. § 2601 et seq. ("RESPA"). The suits were filed on December 17, 1999 in U.S. District Court for the Southern District of Georgia against Mortgage Guaranty Insurance Company, PMI Mortgage Insurance Company, Republic Mortgage Insurance Company and United Guaranty Corporation (collectively, the "MIs"). At issue is whether the MIs violated the anti-kickback provisions of Section 8 of RESPA, by providing excessive benefits to mortgage lenders through pool insurance arrangements and captive reinsurance on the private mortgage insurance policies the MIs issue to homeowners.
The primary focus of the complaints is the "pool insurance" that lenders may purchase on a pool of loans sold to Fannie Mae or Freddie Mac. Lenders must pay a guaranty fee to compensate Fannie Mae or Freddie Mac for any loan losses not covered by primary mortgage insurance. The lender purchases insurance on such excess losses, which is commonly referred to as "pool insurance," in return for a reduction in the required guaranty fee. The MIs, it is alleged, have a practice of entering into agreements or understandings with lenders so that the lenders will refer primary mortgage insurance business to the MIs in return for pool policy coverage at below market prices.
The complaint also questions the validity of captive mortgage reinsurance arrangements, which have become increasingly common in an era of strong economic growth and low mortgage loan default rates. In these arrangements, a lender typically forms a wholly owned captive reinsurance company to reinsure a portion of the risk assumed by the MIs, in return for a portion of the premium the MIs receive from homeowners. In a 1997 ruling, the Commissioner of Housing and Urban Development examined captive mortgage reinsurance in the context of RESPA. He concluded that these arrangements are valid under RESPA, so long as a genuine reinsurance relationship exists and the premiums or other amounts paid by the MIs for reinsurance coverage do not exceed the value of the reinsurance.
The outcome of these suits could have a significant impact on MIs, lenders, and the mortgage reinsurance industry.
No quick resolution should be expected, however, as any decision on the merits of the claims most likely will come only after lengthy discovery and resolution of issues regarding certification of the plaintiff class.
Kevin Moriarty is an associate in the firm who practices in the areas of federal and state taxation, business structuring and insurance regulatory matters.
VERMONT STATUTE PERMITTING SUMMARY EVICTION OF TENANTS IN FORECLOSED PROPERTY HELD UNCONSTITUTIONAL
Vermont law has provided since at least 1972 that, as long as a foreclosing mortgage holder files a copy of a foreclosure complaint in the Town Clerk's office where the property is located, any party that acquires an interest in the property thereafter, including tenants, will be bound by the foreclosure decree, and is subject to summary eviction through Writ of Possession. Vermont statutes require no further notice or service on parties who acquire an interest in real estate during the pendency of a foreclosure action.
In 1999, several tenants who were summarily evicted under this procedure, through Vermont Tenants, Inc., challenged the constitutionality of this statutory procedure in federal court. These same parties also sought in a separate state court action a declaratory ruling that the Vermont Residential Rental Agreements Act prevents such summary evictions. The federal court ruled first, holding that the Vermont statute violated the due process rights of tenants who lease a unit in a property subject to foreclosure. The Vermont Supreme Court ruled several months later that the Vermont Residential Rental Agreements Act does not apply to evictions following strict foreclosure.
The effect of these decisions is to preserve the summary eviction process in strict foreclosure actions, subject to a heightened obligation on the part of the foreclosing party to give actual notice of the foreclosure action to tenants in possession. Unfortunately, no clear guidance can be found in the decisions as to the form or timing of notice that will satisfy due process requirements. For example, the decisions do not state whether a tenant must be made a party to the case, and given a right of redemption, if the foreclosing party learns about the tenancy prior to judgment being entered. Similarly, the decisions provide no guidance whether a tenant identified for the first time after judgment is entered, but before the redemption period expires, must be added as a party and given a right of redemption. Obviously, adding a tenant as a party in either scenario will delay completion of the foreclosure.
If a foreclosing party wishes to preserve the right to summary eviction via Writ of Possession, it will be necessary, at a minimum, to send an agent to the property to identify any tenants in possession, well in advance of the date the party plans to request a Writ of Possession. Any tenants in possession who are not named as defendants should be notified in writing that the foreclosure action is pending, the date the redemption period will expire, and the date it is expected that a Writ of Possession will issue if no redemption payment is made. If a tenant is given enough advance warning that the foreclosure will eliminate the tenants' right to possession, the due process requirement of notice and an opportunity to be heard should be satisfied. Whether due process requires that tenants be joined as parties to the foreclosure action is an unresolved issue that the Legislature will hopefully address in the near future.
The other alternative is to avoid the cost to investigate for the presence of tenants while the case is progressing, and proceed with notice of lease termination and an eviction action, if necessary, once the foreclosure case is completed. This course of action could lead to significant delay, however, since 30-60 days advance notice of termination is required, depending on the circumstances, followed by an eviction action if the tenant refuses to vacate.
Andre Bouffard is a director of the firm who regularly represents lenders in loan workouts and foreclosure litigation.
MORTGAGEE EXTINGUISHES ITS INSURABLE INTEREST IN REAL PROPERTY WHEN IT ACCEPTS REAL PROPERTY IN SATISFACTION OF THE OUTSTANDING INDEBTEDNESS
A recent decision of the United States District Court for Vermont highlights one of the risks to a lender of accepting a deed in lieu of foreclosure in full satisfaction of the debt. In Harber and USA Properties, Inc. v. Underwriters at Lloyd's London, et al., decided in April 1999, Judge Murtha held that a mortgagee extinguishes its insurable interest in real property when it accepts damaged property in full satisfaction of an outstanding indebtedness.
The facts of the case are important in understanding how the Court reached this conclusion. The mortgagee asserting the insurance claim in this case acquired the mortgage through assignment from the original lender. After acquiring the note and the mortgage, and upon learning the property was not insured, the mortgagee purchased its own casualty insurance. After a fire destroyed a lumber mill on the property, the mortgagee commenced a foreclosure action. In order to settle the foreclosure action, the mortgagor conveyed the property to the mortgagee, in full satisfaction of the note. The mortgagee then presented an insurance claim to the insurer. The insurer denied coverage, contending that the claimant had no insurable interest in the property following its acceptance of a deed to the real estate in full satisfaction of the debt.
In the mortgagee's declaratory judgment suit against the insurer, the Court ruled there was no coverage. The Court noted there was no reported Vermont case which addressed the issue whether any insurable interest remains where a mortgagee has accepted a deed to the damaged property in full satisfaction of the debt. Relying on a 1971 decision of the New York Court of Appeals, the Court concluded that no insurable interest remains under these circumstances. The Court reasoned that an insurance policy designed to insure payment of the mortgage debt cannot provide coverage once the debt has been satisfied in full by transfer of the mortgaged property to the lender.
The Harber decision does not have binding precedential effect because it was recently reversed on appeal. The Court of Appeals for the Second Circuit ruled that there were disputed factual issues that needed to be resolved at trial before a judgment could be rendered. Because of some disputed facts under which Harber claimed to have equitable rights in the property apart from the mortgage, the case was remanded to the District Court for trial.
Nevertheless, the Harber decision makes clear that a lender risks losing insurance coverage for a pending claim if real estate collateral is accepted in full satisfaction of the mortgage debt. The existence of pending insurance claims should always be checked as part of the due diligence on a deed in lien transaction. To protect against loss of such a claim, a lender can delay transfer of the property until the claim has been paid, or make sure to preserve a deficiency claim in at least the amount of the insurance claim.
William Mason is an associate in the firm who regularly represents lenders in loan transactions.
PERFECTION OF SECURITY INTERESTS IN INTELLECTUAL PROPERTY
As the value of intellectual property as an asset class becomes more evident, lenders are examining more closely whether a borrower's intellectual property is included in the lender's collateral package. This article briefly describes the emerging law governing perfection of a security interest in patents, trademarks and copyrights.
Article 9 of the UCC governs secured transactions--consensual transactions involving the granting of credit secured by personal property. As a general matter, intellectual property falls within the scope of Article 9. The definition of "general intangibles" in section 9-106 was designed to include patents, trademarks and copyrights within its scope.
The UCC, however, does not apply to all secured transactions. In particular, it does not apply to security interests subject to a federal statute "to the extent that such statute governs the rights of parties to and third parties affected by transactions in particular types of property." Federal law contains recordation and priority rules governing the issuance or registration of patents, trademarks and copyrights. Unfortunately, the federal law is skeletal in nature, has not been updated to mesh with Article 9 and does not deal comprehensively with attachment, perfection and priority of security interests.
The central issue in considering intellectual property collateral is whether the particular federal scheme at issue preempts the field and precludes application of Article 9 to the transaction. The subsections below briefly describe the interplay between Article 9 and the provisions of federal laws governing assignment of interests in copyrights, trademarks and patents.
a. Copyrights
The federal Copyright Act permits recording of any "transfer of copyright ownership" of a copyright in the Copyright Office. Ten years ago, a court in California held that this provision of the Copyright Act creates a broad system of record notice parallel to the state law scheme in Article 9. The court concluded that the Copyright Act is sufficiently comprehensive in scope to preempt the Article 9 filing scheme when a security interest in a copyright is involved. The court held that a creditor who had filed UCC-1s but failed to record its security interest at the Copyright Office was unperfected as to the debtor's copyrights in a library of films.
A further issue is whether a lender must make a federal filing to perfect a security interest in the proceeds of a copyright or copyright-related receivables. A security interest in a copyright licensor's right to receive payments under a copyright license (such as a software license) arguably requires recording in the Copyright Office.
To summarize, it is advisable to perfect a security interest in copyrights and their proceeds by recording in the Copyright Office. In addition, it would be prudent to file a financing statement under Article 9 because the courts have not ruled consistently on the question of whether the federal Copyright Act preempts Article 9.
b. Trademarks
A trademark is any device that serves to distinguish goods or services of one manufacturer, merchant or service provider from those of another. The federal trademark statute, the Lanham Act, permits assignments of trademarks together with the goodwill of the business in which the mark is used. The statute goes on to say that an assignment shall be void as against any subsequent purchaser without notice, unless the assignment is recorded in the Patent and Trademark Office within three months after the date of the transaction.
The emerging consensus from the courts is that the federal filing scheme does not preempt the field. Courts have held that a creditor's security interest in general intangibles was properly perfected as to federal trademarks merely by filing a UCC-1 financing statement.
Recently, a bankruptcy court held that a creditor who filed with the Patent and Trademark Office but failed to make a UCC filing was unperfected as to a bankruptcy trustee.
Note that a trademark should not be assigned without the goodwill associated with the mark. If a lender takes an assignment of a trademark without is associated goodwill, the assignment may be voided.
In sum, a number of courts have held that a creditor who perfects a security interest in a trademark by filing under the UCC has a perfected security interest in the mark and is not required to make a federal filing. Nonetheless, there is continuing uncertainty as to the means of perfecting a security interest in trademarks and the relative priorities of competing parties.
c. Patents
The federal law governing patents says: "An assignment, grant or conveyance [of a patent] shall be void as against any subsequent purchaser or mortgagee for a valuable consideration, without notice, unless it is recorded in the Patent and Trademark Office within three months from its date or prior to the date of such subsequent purchase or mortgage."
While this language might suggest that a federal filing is required to perfect a security interest in a patent, the limited case law in the area suggests that filing under Article 9 is sufficient to perfect a lender's security interest in a patent. In a case decided late last year, an influential court recognized that a security interest in a patent may be recorded with the Patent Office, but it found that the federal recording scheme did not preempt the field. Therefore, it held that a lender who had filed a UCC-1 financing statement had perfected its security interest as to lien creditors and therefore defeated the bankruptcy trustee.
Note, however, that the Patent Act's recording scheme appears to preempt Article 9 when a security interest is in competition with an assignee who has taken title to a patent under the federal scheme. A federal filing (patent mortgage or conditional assignment) is necessary to protect the secured creditor from a bona fide purchaser or mortgagee who properly records its interest with the Patent Office. Because the Patent Act has a three-month grace period for recording, a secured creditor appears to be vulnerable to a prior unrecorded assignment for a period of three months.
In short, to perfect a security interest in a patent, a lender should file a UCC-1 financing statement in the appropriate Article 9 filing office. The lender should also consider recording a conditional assignment with the Patent Office.
Paul H. Ode, a director in the firm, concentrates his practice in business transactions, commercial lending and creditor's rights.
All of the contributors to the Lender Update are members of Downs Rachlin Martin's Commercial Finance & Bankruptcy Group. The attorneys in this Group represent lenders in Loan Origination, Regulatory Matters, Loan Restructuring and Work-Outs, Collection and Foreclosure Litigation, Bankruptcy Matters, and Lender Liability Actions.
If you have any questions regarding the issues raised in this Lender Update, you may contact our Burlington office.
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