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Financial Services FLASHPOINTS December 2020

Michael L. Weissman, Levin Ginsburg, Chicago
312-368-0100 | E-mail Michael L. Weissman

Title Reserved in Grant of Security Interest

The Uniform Commercial Code (UCC) sometimes pops up in the most unusual cases. One such example is Raffel Systems, LLC v. Man Wah Holdings Ltd., Case No. 18-CV-1765 (E.D.Wis. June 15, 2020) (decision and order on defendant’s motion to dismiss plaintiff’s patent claims for lack of standing), a case brought for alleged patent infringement.

Man Wah Holdings Ltd., Inc. (the alleged patent infringer) moved to dismiss the case, alleging that Raffel Systems, LLC (the patent holder) didn’t have the requisite standing to initiate a lawsuit. Man Wah’s effort was rejected by the court.

First, a little bit about “standing,” i.e., whether a party is entitled to commence a lawsuit to rectify a wrong that was suffered. In patent law, said the judge, a party must satisfy two tests in order to sue for patent infringement. First, a party must have exclusionary rights in the patent, meaning the right to prevent other folks from making, using, selling, or offering to sell the patented item. Second, the party must establish status as a “patentee,” meaning the original inventor, or the patentee’s “successor in title.”

On December 7, 2016, Raffel executed an “Intellectual Property Security Agreement” with The PrivateBank and Trust Company, granting the bank a security interest in all Raffel’s intellectual property, whether then owned or subsequently acquired. The patents that were the subject of the litigation were listed as the collateral. PrivateBank filed a notice of its security interest with the United States Patent and Trademark Office (USPTO). (NOTE: This was an error. A UCC1 filing should have been made.) PrivateBank’s security interest was released on August 9, 2019. Four days later, Raffel entered into a new “Intellectual Property Security Agreement.” This time, it was with East West Bank. The same patents were listed as collateral. East West Bank also recorded its security interest with the USPTO. (NOTE: Same mistake. It should have been a UCC1 filing.)

Man Wah’s motion to dismiss the patent infringement case was premised on the argument that when Raffel filed the lawsuit, it no longer had title to the patents and therefore lacked the necessary standing to proceed with the case. Man Wah contended that Raffel lost title to the patents when it granted the security interests to PrivateBank and East West Bank and each of them recorded their respective security interests in the USPTO. The judge didn’t buy that argument.

The court first referred to Official Comment 2 to UCC §9-202, which explicitly rejects the importance of title: “The rights and duties of parties to a secured transaction and affected third parties are provided in this Article without reference to the location of ‘title’ to the collateral.” The UCC is clearly concerned with appropriately allocating risk rather than monitoring who has title.

Continuing its discussion, the court noted that the USPTO is not involved in the perfection of security interests. Its only function is to memorialize assignments of title, and that does not include recording security interests. This meant that the notices of security interest filed with the USPTO by the two banks were of no legal effect whatsoever. The court fortified that conclusion with a reference to the Copyright Act of 1976, Pub.L. No. 94-553, §101, 90 Stat. 2541, which specifically includes security interests as recordable documents. Implicit in this is that if Congress wanted to treat the Lanham Patent Act, ch. 451, 53 Stat. 1212 (1939), which does not include security interests as recordable documents, in the same fashion as the Copyright Act, which does, it would have done so.

The court’s conclusion was that Raffel had standing to bring the infringement action, saying:

In sum, because the Patent Act does not address perfection of security interests, the mere act of the banks recording their security interests in Raffel’s patents at the USPTO did not transfer title of the patents to the banks. Nothing in the Intellectual Property Security Agreements states that Raffel is assigning title of the patents to the banks; rather, the agreements specifically state that Raffel is granting a “security interest” in its intellectual property. . . . Raffel continues to hold title to the patents. [Citations omitted.]

What’s the point? Two conclusions can be drawn. First, that the grant of a security interest by a patent owner does not constitute an assignment of title (except for those very limited circumstances in which “title” is relevant). And second, to perfect a security interest in a patent, a UCC1 financing statement should be filed with the correct state’s filing office.

Actual Knowledge of Consignment Blocks Secured Priority Claim

Consignments have been a feature of American retailing for many years. As such, they are addressed in the UCC and arise in cases from time to time. One such case is TSA Stores, Inc. v. Performance Apparel Corp. (In re TSAWD Holdings, Inc.), 595 B.R. 676 (Bankr. D.Del. 2018).

The Sports Authority Holdings, Inc., and its affiliates (collectively “the debtors”) were national retailers of sporting goods and active apparel. The debtors developed a program for the sale of goods delivered to them on consignment. Under the program, once the goods delivered to the debtors on consignment were sold, the debtors would pay the vendors. This conforms to the UCC’s definition of a consignment as “a transaction, regardless of its form, in which a person delivers goods to a merchant for the purpose of sale and . . . the transaction does not create a security interest that secures an obligation.” 595 B.R. at 681, quoting UCC §9-102.

Performance Apparel Corp. (PAC) was one of the initial consignment sellers of goods to the debtors. It filed a UCC1 financing statement with respect to its consigned goods on August 29, 2009, and concurrently gave notice to the agent, Wilmington Savings Fund Society, FSB, for a group of term loan lenders. PAC failed to file continuation statements for its UCC filing, and it lapsed on its fifth anniversary in 2014.

On March 2, 2016, the debtors filed a voluntary petition for relief under Chapter 11 of the U.S. Bankruptcy Code, 11 U.S.C. §101, et seq. Prior to that, the debtors had borrowed $1.1 billion, which included a $650 million asset-based revolving credit facility and a $300 million term loan. Bank of America was the initial administrative agent for both loans. An amended and restated credit agreement was signed by the debtors and Bank of America on November 16, 2010. On December 31, 2015, Bank of America was replaced as administrative and collateral agent for the term loan lenders by Wilmington Savings Fund Society.

The term loan was secured by a first priority security interest on the debtors’ physical assets, intellectual property, and general intangibles and a second priority security interest on the debtors’ inventory and other assets that also served as collateral for the asset-based loan. The security for the term loan was the subject of a UCC filing in the correct states.

When the debtors sought bankruptcy relief, 11 to 12 percent of their inventory was goods held for sale on consignment. The bankruptcy judge permitted the debtors to continue selling the consigned merchandise as long as they complied with the terms of the consignment agreements and made payments to consignors such as PAC. The court order preserved the rights of the term loan agent to recover any payments the debtors made to consignors such as PAC if the court ultimately decided that Wilmington had a superior interest in them.

As of the date of the voluntary Chapter 11 filing, the estimated value of consigned goods from PAC in the possession of the debtors was $1,586,446. During the pendency of the case, those goods were sold, and the debtors paid PAC for them. As of July 2016, all of PAC’s consigned goods had been sold, and the proceeds of sale were paid to PAC as directed by the court.

Perhaps anticipating Wilmington’s strategy, the debtors made a preemptive strike. They filed a complaint against PAC challenging PAC’s claim to priority in the proceeds of the sale of the consigned goods. Not to be left on the sidelines, Wilmington joined the fray, seeking a ruling that its lien gave it priority over PAC in the contested funds.

Wilmington’s argument was that it had a perfected security interest that primed PAC’s security interest because PAC had allowed its security interest to lapse. In response, PAC argued that even though its security interest had lapsed, it was nonetheless first in priority to the contested funds because the term loan lenders had actual knowledge of PAC’s consignment arrangement with the debtors before the term loan was funded.

The court said that PAC had the better of the two arguments. It noted that, under the UCC, an arrangement like PAC’s is not subject to UCC priority rules if the consignor (PAC) can demonstrate that the consignee’s (the debtors’) other creditors (like Wilmington) knew that the consignee (the debtors) was substantially engaged in selling consigned goods. It also said there were numerous cases holding that Article 9’s priority rules should not apply with respect to other secured creditors of the consignee if those other secured creditors (like Wilmington) had actual knowledge that goods in the possession of the consignee were held on consignment.

To support its position, the court commended another court’s observation that if a creditor knows that goods in a debtor’s place of business are on consignment, that creditor is not misled by the presence of the consigned goods, and its lien should not extend to those goods. Applying that to the case before it, the court said, “If the Term Loan Lenders had actual knowledge of PAC’s consignment interests at the time the Term Loan was granted, they could not have been misled by any ‘hidden’ lien. Requiring PAC to give them ‘constructive’ notice [by a UCC filing], when they already had actual notice, would be to elevate form over substance and would not serve the purposes of the UCC.” 595 B.R. at 683.

The court went on to rule that the term loan lenders had actual knowledge of the consignment arrangement when the term loan was granted. The term loan credit agreement, which prohibited the debtors from incurring any other indebtedness, had an exception for permitted liens, and PAC was listed among them as having a permitted lien for inventory (consigned).

The court concluded: “[B]ecause the Term Loan Agent (and Lenders) actually knew of PAC’s interest in the consigned goods at the time the Term Loan was extended, the UCC does not determine their relative priority and the rights of [PAC] are paramount.” 595 B.R. at 685.

What’s the point? Consignment arrangements are common in retail. Lenders who extend credit based on collateral that includes inventory in an industry that often employs consignment arrangements need to go beyond a UCC search to determine whether their UCC filings will give them priority in case the borrower defaults and plan accordingly.

For more information about financial services, see COMMERCIAL AND INDUSTRIAL LOAN DOCUMENTATION (IICLE®, 2018). Online Library subscribers can view it for free by clicking here. If you don’t currently subscribe to the Online Library, visit www.iicle.com/subscriptions.

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