A fundamental purpose of Article 9 of the Uniform Commercial Code is "to provide a simple and unified structure within which the immense variety of present-day secured financing transactions can go forward with less cost and with greater certainty." A recent decision by the bankruptcy appellate panel for the 9th U.S. Circuit Court of Appeals, however, has created a stir within the secured lending and financing community in connection with the current trend of fractionalizing assets and, more specifically, "stripping" payment streams from their underlying transactions.

In NetBank, FSB v. Kipperman (In re Commercial Money Center, Inc.), the bankruptcy appellate panel for the 9th Circuit held that payment streams separated from their underlying leases do not fall within the definition of "chattel paper" under the UCC. Rather, the panel held that the payment streams, i.e., the obligation to make rental payments under the leases, fell "within the payment intangible subset of the catch-all definition of general intangibles." More precisely, the panel concluded that these payment streams, stripped from their chattel paper, constitute "payment intangibles" under the UCC.

While fractionalizing collateral - or even separating payment streams from their respective chattel paper - is not a new concept, the panel's decision in Commercial Money Center to characterize the payment streams as payment intangibles under the UCC creates some degree of uncertainty in the perfection and priority rights in this type of collateral, particularly with respect to a later purchaser of the chattel paper or even a later purchaser of the monetary obligation. As even the bankruptcy appellate panel acknowledged in Commercial Money Center, its decision raises the specter of the creation of secret liens or other interests that could potentially trump even the interests of a bona fide purchaser for value or a purchase money secured lender.

The business of Commercial Money Center Inc. (CMC) consisted of originating commercial equipment leases. CMC leased the equipment on a national basis to lessees with sub-prime credit. CMC would then package these leases together into a "lease pool" and assign the payment streams due under the leases to third-party investors. NetBank, FSB invested in lease pools offered by CMC. As security for NetBank's receipt of the lease payments, CMC granted NetBank a security interest in the underlying leases. Significantly, CMC assigned NetBank both an interest in the payment streams and an interest in the underlying leases, but it bifurcated the two interests. Curiously, the agreements between the parties required CMC to perfect NetBank's security interests in the leased equipment.

Further, the agreements contemplated that CMC would list NetBank in the financing and lease documents as the assignee of these security interests and would deliver evidence of this to NetBank. Unfortunately, CMC failed to meet this end of its bargain with NetBank. Once CMC filed for bankruptcy, CMC's Chapter 7 trustee filed an adversary proceeding against NetBank, seeking a declaration, inter alia, that NetBank had failed to perfect its interests as required under the UCC. Because NetBank had allegedly not satisfied the requirements for perfecting its security interest in the payment streams, the Chapter 7 trustee sought to avoid NetBank's interests under sections 544(a), 550 and 551 of the Bankruptcy Code.

To remedy the glaring defect of potentially not having a perfected security interest, NetBank's counsel crafted a clever and intellectually appealing argument. NetBank urged that the equipment leases had not been sold to it by CMC, but rather, only the payment streams associated with each lease had been sold. If so, NetBank's interest would be "automatically" perfected under Section 9-309(3) of the UCC, a result that would forgive NetBank's failure to file a financing statement or take possession of the leases. In contrast, the Chapter 7 trustee argued that the payment streams flowing from the chattel paper (namely, the underlying equipment leases) also constituted chattel paper.

The lower court disagreed with the argument advanced by NetBank, in large part by virtue of the definition of "chattel paper" contained within Section 9-102(a)(11). The lower court reasoned that since the definition of "chattel paper" contains the three elements of a record that evidences both a monetary obligation and a security interest in a lease of specific goods, removing the "monetary obligation" element from the definition of "chattel paper" and characterizing it instead as a "payment intangible" does not follow from the plain language of the statutory definition of "chattel paper" and "would essentially delete the monetary obligation requirement from the definition." According to the lower court, then, a sale of chattel paper operates to transfer the monetary obligation embodied in the paper.

Because NetBank failed to perfect its interests in the payment streams (i.e., chattel paper) by either filing a financing statement or taking possession of the leases, the lower court held that the trustee could use its strong-arm powers to avoid NetBank's interests.

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights. He is a member of the American Bankruptcy Institute, the American Bar Association and its business law section, the Commercial Law League of America, the Pennsylvania Bar Association and the business law section of the Philadelphia Bar Association.

Michael D. Sousa practices in the area of bankruptcy law. Sousa served as judicial clerk to Rosemary Gambardella and to Donald H. Steckroth, both of the U.S. Bankruptcy Court for the District of New Jersey; to William J. Martini of the U.S. District Court for the District of New Jersey; and to John E. Wallace Jr., of the New Jersey Superior Court - Appellate Division. He is currently completing an LL.M. in bankruptcy from St. John's University School of Law, where he was named the American Bankruptcy Institute Scholar. He is also a regular author and contributing editor for several national bankruptcy publications, including the Journal of Bankruptcy Law and Practice and the American Bankruptcy Institute Journal.

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