Waive it Goodbye? Illinois Court Finds Implied Waiver of Security Interest Waive it Goodbye? Illinois Court Finds Implied Waiver of Security Interest

Waive it Goodbye? Illinois Court Finds Implied Waiver of Security Interest

Under the Uniform Commercial Code (“UCC”), it is possible for a secured party to waive its security interest by virtue of its conduct rather than by written agreement.  A recent Illinois appellate court case held that the secured party had implicitly waived its security interest due to “its inaction and failure to monitor” its borrower.  The holding in the case is troubling and ought to be of concern to lenders, particularly those in Illinois.

Background.  In Prairie State Bank & Trust v. Deere Park Associates,[1] an Illinois appellate court reviewed a case where the plaintiff, Prairie State Bank, had extended several loans to Just Sofas and Mattresses, LLC, and had perfected its security interest in all of Just Sofas’ inventory and its proceeds.  Unfortunately, the appellate court’s recitation of the facts of the case is lacking in detail, and there are many instances in the court’s reasoning that refer to facts that are not described in detail.

After the bank had perfected its security interest, Just Sofas entered into a consulting agreement with the defendant, Deere Park.  Under this agreement, Deere Park was to provide services in connection with liquidation sales of inventory at two Just Sofas stores, one of which was to be closed.  Deere Park also provided certain inventory to Just Sofas that Deere Park had obtained on its own credit.  Deere Park filed a UCC financing statement and sent a notice to the bank that Deere Park was claiming a purchase money security interest (“PMSI”) in the inventory it had provided to Just Sofas.[2]  Deere Park also made a “consultant’s advance” to Just Sofas (which was not used to purchase inventory).[3]

The consulting agreement provided for all proceeds of the liquidation sales to be deposited into a bank account administered by Deere Park.  The consulting agreement included a provision obligating both Deere Park and Just Sofas to keep their dealings confidential.

At some point while the liquidation sales were occurring, a bank officer became aware of an advertisement which indicated the store closing, but did not mention the involvement of Deere Park.  The bank then contacted Just Sofas, which confirmed the closing of the store, but indicated that the other store would remain open.  Neither Just Sofas nor Deere Park sought the bank’s consent or informed the bank of the sales or Deere Park’s role until the sales had been completed.  While the liquidation sales were ongoing, Just Sofas made several payments on the bank’s debt and the bank extended the maturity of two loans.  It is unclear whether the bank knew any details about the liquidation sales while they were occurring.

Deere Park used the proceeds of the sales to (i) pay itself commissions on the sales and a share of the sale profits, (ii) repay the consultant’s advance, (iii) pay an unsecured creditor at the behest of Just Sofas, (iv) retain an amount to use to defend litigation against the bank and (v) pay the balance to Just Sofas, which did not pay any such proceeds to the bank.  After the sales were completed, an auction house sold the remaining inventory.  The net proceeds of this auction were deposited with the bank.

After the inventory was sold, Just Sofas filed for bankruptcy.  The bank then sued Deere Park for conversion.  The trial court held that the bank had waived its security interest.  The trial court also found that Just Sofas was not in default of its loans from the bank at any point during the liquidation sales and that the liquidation sales were made in the ordinary course of business.

Analysis.  The court did not appear to analyze the issues before it under the UCC, which is unfortunate, for the UCC has provisions that are directly applicable.

A.    What would the Bank’s Position have been had there been no Waiver?

Before analyzing whether Prairie State had waived its security interest under the UCC, it is useful to consider what Prairie State’s rights would have been had there been no waiver of its security interest.  Under the facts of this case, the bank’s recourse in its collateral might have been quite limited.

Section 9-315(a) of the UCC sets forth a general rule providing that, subject to some exceptions, (1) a security interest in collateral that is disposed of will survive the disposition unless the secured party authorizes such disposition and (2) the secured party’s security interest will attach to any identifiable proceeds of the disposition.  Among the exceptions as to the continuation of the security interest in the collateral disposed of is UCC Section 9-320, which provides that a buyer in the ordinary course of business[4] of goods takes free of any security interest created by the seller (with an exception (discussed below) for a person buying farm products from a person engaged in farming operations).  In many cases the buyer will take free of the security interest and the secured party’s only right will be to proceeds.[5]

In the Prairie State case, it is likely that the purchasers of inventory took free of the bank’s security interest in the inventory, either due to the bank having consented to the sales in the security agreement or by virtue of such purchasers being buyers in the ordinary course of business.  If the bank had a security interest in the inventory, it would have had a security interest in the proceeds of sale.  If the bank did not take control of the proceeds of the sales (as appears was the case), it would only have been perfected in the proceeds temporarily (unless the proceeds were identifiable cash proceeds).  As to any proceeds paid to third parties, Section 9-332 of the UCC provides that persons that take funds from a deposit account or money take free of a security interest in such funds or money unless they act in collusion with the debtor in violating the rights of the secured party.  Thus, it would likely have been quite difficult to recover against persons that received payments from the sale proceeds.

To the extent that Deere Park had a perfected PMSI in inventory, Deere Park would have had priority as to such inventory.  Prairie State would have had priority over Deere Park as to any inventory that Deere Park’s PMSI did not cover.

As a result, the bank’s recourse against its collateral might have been quite limited even if its security interest had not been waived.  However, the bank might have been able to sustain a conversion claim against Deere Park as to certain of the proceeds that Deere Park received.

B.     Implied Waiver by Course of Performance; Acquiescence.

Section 1-303(f) of the UCC provides that a course of performance is relevant to show a waiver or modification of an agreement that is inconsistent with the course of performance.  “Course of performance” is defined in the UCC to mean a situation where a party accepts or acquiesces in a repeated performance under an agreement by another party with knowledge of the nature of the performance and the opportunity to object. [6]

While not purporting to apply Section 1-303(f), the court found that the “actions and failures to act” of the bank were “more than enough to find implied waiver” of the bank’s “right to the inventory of Just Sofas and the proceeds from the sale of that inventory.”  The appellate court referred to a more general rule of waiver set forth in an Illinois Supreme Court case, Ryder v. Bank of Hickory Hills.[7]  The Ryder court defined waiver as “the intentional relinquishment of a known right” and also held that “waiver may be implied from the conduct of the party of the party who is alleged to have waived a right,” but that implied waiver “must be proved by a clear, unequivocal and decisive act of the party who is alleged to have committed waiver.”[8]  Implied waiver of a right may be found in Illinois if the conduct of the party holding the right is inconsistent with any other intention than to waive it.[9]

Due to the lack of detail in the appellate court’s recitation of the facts of the case, it is difficult to discern exactly what Prairie State did to support a finding that it had waived its security interest.  The appellate court only noted that there was evidence that “plaintiff was aware of the sale while it was going on and had notice of the consulting agreement between Just Sofas and [Deere Park] which gave [Deere Park] the authority to hold and distribute the proceeds of the sale.”  The court asserted that “[t]his put [Prairie State] on notice to inquire of [Deere Park] and [the Just Sofas president] as to its handling of inventory proceeds.  Instead, [Prairie State] made no inquiries of [Deere Park] until the sale proceeds had been paid out to other, inferior creditors.”

Under Section 1-303, in order for acquiescence to constitute a course of performance that would effect a waiver, the party against whom the waiver is asserted must have actual knowledge of the performance contrary to the contract, must have an opportunity to object and must acquiesce in such performance without objection.

While it is unclear from the court’s opinion what the bank actually knew, the court was sharply critical of the bank’s failure to inquire further after it became aware of certain facts.  This sort of “inquiry notice” is inconsistent with the actual knowledge required to establish a course of performance by acquiescence under the UCC.

The court also referred to several facts (again without much detail) that may have existed at the outset of the loan transactions:  the court referred to the bank making loans without having sufficient inventory collateral and to the bank not requiring the inventory proceeds to be deposited with the bank.  To the extent such facts existed at the outset, they would not be the result of a waiver, implied or otherwise, caused by course of performance.  The UCC and relevant caselaw suggest that the court was on firmer ground in examining whether a course of performance after the security agreement was entered into had constituted a waiver of the security interest, although the courts have been divided as to whether mere acquiescence in conduct by a debtor or junior creditor can constitute such a waiver.[10]

The trial court’s finding that Just Sofas was not in default of the loans while the liquidation sales were taking place is worth noting as well.  This finding necessarily includes a conclusion that the granting of the PMSI was not a default as well as that the sales themselves, and the application of the proceeds by Just Sofas to pay other creditors, was not a default.  If there were no default, it would be unclear whether Prairie State had a meaningful “opportunity for objection” to the sales (as is required by Section 1-303).  The bank did have several maturities which it extended during this period, however.

It is hard to see how the bank’s lending practices would have been evidence of the bank’s intention to waive its security interest, or been an action inconsistent with any intention other than to waive its security interest, under the Illinois precedent addressing implied waiver that the court relied on.  If the bank had acquiesced in anything, a plausible inference would be that it had acquiesced to the sales (and to the release of its security interest in the sold goods), but had intended to retain its security interest in the proceeds of sale.  However, determinations of waiver are findings of fact, and as such a trial court finding can be difficult to overcome on appeal.

C.     Equitable Estoppel and Waiver.

The Prairie State court based its decision on the doctrine of implied waiver.  The doctrine of equitable estoppel may also be relevant to examinations of secured party acquiescence.  Unlike waiver, which focuses on the intent of a party to waive a contractual right (which may be implied by conduct), equitable estoppel may exist even when there is no intention on the part of the party estopped to relinquish any existing right.[11]

A secured party can be equitably estopped from asserting a conversion claim against a junior creditor by virtue of acquiescing in junior creditor conduct,[12] as was held in In re Joe Morgan, Inc.[13]  However, in that case, it was clear that the senior secured creditor had been told of the junior creditor’s activities at a meeting between the two creditors and that the two creditors were in frequent contact with each other regarding those activities, and there was evidence that the senior creditor had permitted the junior creditor to proceed.  In Illinois, a finding of equitable estoppel requires a knowing misrepresentation or concealment of material facts by the party to be estopped, as well as detrimental reliance by the party seeking the estoppel, and there is no recitation of any facts in the Prairie State court’s opinion that speak to such matters, or indeed of any contact between Deere Park and the bank other than the bank’s receipt of the PMSI notice.[14]

Professors White, Summers and Hillman argue that Section 1-303 of the UCC should apply only to the modification of rights and duties between the original parties to an agreement, and not to situations involving third parties not in privity to the agreement, such as situations involving a third party creditor.[15]  However, they point out that Section 1-103(b) of the UCC permits principles of equity to supplement the provisions of the UCC, and argue that a security interest may be equitably waived by the conduct of the secured party if the circumstances warrant.[16]

In the Prairie State case, equitable waiver was not necessary to protect the rights of the third party purchasers of the inventory, because such purchasers took free of the bank’s security interest.  Equity was also unnecessary to protect third party payees that had not acted in collusion with Just Sofas in violating the bank’s rights, because those parties took their payments free of the bank’s security interest pursuant to UCC Section 9-332.  The court did not inquire as to whether Deere Park was a party protected by Section 9-332; if it had colluded with Just Sofas in violating the bank’s rights, an equitable doctrine that is supplemental to the UCC should not have protected it. [17]

D.    Secured Party Conduct and Obligation to Act.

In addition to criticizing the bank for failure to make further inquiry after it became aware of the sales and the consulting agreement, the court also based its holding on other conduct of the bank, including what the court asserted were “failures to act with any degree of prudence or acumen in creating the loans, renewing the loans, monitoring the loans and monitoring the activities of Just Sofas or its president.”  The court held that the bank’s actions and failures to act were the “decisive acts” necessary to support a finding of implied waiver under Illinois caselaw.

By suggesting that the bank had to adhere to a standard of prudent conduct in order to avoid waiving its perfected security interest under the UCC, the court overstepped.  The trial court had cited with approval a quote in a bankruptcy court case that examined the sufficiency of a PMSI notice, In re Southern Vermont Supply, Inc.[18]  That case did not involve the waiver of a security interest.  Notwithstanding the tenuousness of this precedent, the Prairie State court sought to expand a statement therein concerning the failure of a prior filer to inquire as to the inventory covered by the PMSI notice beyond the narrow circumstances of PMSI notices into a broader duty on behalf of secured parties generally:

 . . . a secured floating lien creditor cannot simply rely on its status as a secured creditor to protect itself against inferior creditors.  Once it has knowledge of actions detrimental or potentially detrimental to its position, it needs to take action to protect itself and not rely on others to protect it or wait until all detrimental actions have occurred before trying to undo them.
While this may be prudent business advice – and the bank might have increased its recovery had it taken more positive steps (assuming it had the right to do so) -- a secured party is not obligated under the UCC “to take action to protect itself” in order to avoid waiving its security interest.  Article 9 of the UCC has a detailed scheme of perfection, enforcement rights and priorities which allocates rights and duties among multiple parties, and this scheme does not explicitly require a secured party to “protect itself” to prevent such a waiver.  As noted above, even if the bank’s security interest had not been waived, the bank would likely have been left with only a security interest in those proceeds that were paid to Just Sofas (and possibly Deere Park).  Further, the UCC specifically contemplates the possibility of conversion actions, which can be seen as “undoing” the effects of a prior enforcement action.

Final Observations.  The Prairie State decision was filed under Illinois Supreme Court Rule 23, which provides that the decision may not be cited as precedent except in very limited circumstances.  Because of the many issues raised by the court’s reasoning, that is a good thing for secured lenders.  Nevertheless, lenders should be mindful that acquiescence by a secured party in the conduct of a debtor or other creditor in some circumstances may be deemed a waiver of a security interest that was otherwise properly granted and perfected or otherwise lead to an equitable estoppel argument.

Some of the issues posed in the Prairie State case might have been avoided if the bank had stronger collateral restrictions in place at the outset of the deal, including a requirement that sales of inventory be deposited into an account over which the bank had control.

The court did not discuss whether the bank’s loan documents contained clauses providing that the parties’ rights under loan documents could be altered or waived only in writing or providing that failure or delays in exercising rights would not operate as waivers.  Section 1-302 of the UCC generally permits parties to contracts dealing with the subject matter of the UCC to vary UCC provisions by agreement.[19]  It is good practice to include such clauses.  The effectiveness of such clauses may vary by state; in Illinois, such clauses may themselves be waived by conduct.[20]

[1]  2014 WL 4557298 (Ill. App. 4th Dist., September 15, 2014).
[2]  See UCC §9-324.
[3] While the appellate court’s opinion did not say so, the PMSI notice had attached to it a copy of Deere Park’s UCC-1 financing statement, which contained two non-substantive references to the consulting agreement.
[4] See UCC §1-201(b)(9).
[5] See Official Comment 2 to UCC §9-315.
[6]  UCC §1-303(a) defines “course of performance” as follows: “A ‘course of performance’ is a sequence of conduct between the parties to a particular transaction that exists if: 
(1)  the agreement of the parties with respect to the transaction involves repeated occasions for performance by a party; and
(2)  the other party, with knowledge of the nature of the performance and opportunity for objection to it, accepts the performance or acquiesces in it without objection.”
Note that under UCC §1-202(b), “knowledge” is defined to mean “actual knowledge.”  By contrast, the definition of “notice” in UCC §1-202(a) imputes notice of a fact to a person if the person, based on facts and circumstances known to such person, has reason to know such fact exists.
A “course of dealing”  – distinguished from course of performance by relating solely to previous transactions between the parties to an agreement—would not support a waiver under UCC §1-303(f).  Official Comment 2 to UCC §1-303 states that “’Course of dealing,’ as defined in subsection (b), is restricted, literally, to a sequence of conduct between the parties previous to the agreement.  A sequence of conduct after or under the agreement, however, is a ‘course of performance.’”
See also Restatement (Second) Contracts §202(4) (“Where an agreement involves repeated occasions for performance by either party with knowledge of the nature of the performance and opportunity for objection to it by the other, any course of performance accepted or acquiesced in without objection is given great weight in the interpretation of the agreement.”).
[7]  585 N.E. 2d 46 (Ill. 1991).
[8]  Ryder, supra, citing Kane v. American National Bank & Trust Co., 316 N.E. 2d 177 (Ill. App. 3rd Dist. 1974).
[9] Ibid.
[10] Because of farm products exception to Section 9-315(a), there have been a number of cases examining whether secured parties holding security interests in farm products had implicitly waived their security interests by virtue of their conduct.  In these cases, the security agreements contained a prohibition against sale of the farm products without secured party consent, and there was a history of situations where the borrower sold the collateral without express consent, but used the proceeds to repay the debt until the borrower went into financial difficulty and then did not pay the debt with the sale proceeds.  These cases have been decided both ways, but in the cases where the secured party lost, the courts found either (i) evidence of implied waiver of the security interest (in which case the secured party had no claim to the sold collateral or the proceeds) or (ii) implied consent to the sale (but not loss of the security interest in the proceeds of the sale).  See, e.g., Farmers State Bank v. Farmland Foods, Inc., 402 N.W. 2d 277 (Neb. 1987);  State Bank, Palmer v. Scoular-Bishop Grain Co., 349 N.W. 2d 912 (Neb. 1984); Cox v. Bancoklahoma Agri-Service Corp., 641 S.W. 2d 400 (Ct. App. Tx. 1982); and Humboldt Trust & Savings Bank v. Entler, 349 N.W. 2d 778 (Ct. App. Iowa 1984).  See generally White, Summers & Hillman, Uniform Commercial Code §4.3.
[11] See Vaughn v. Speaker, 533 N.E.2d 885 (Ill. 1988).
[12] Conversion, like equitable estoppel and waiver, is one of the supplemental principles of law imported into the UCC by UCC §1-103(b).  Official Comment 2 to UCC §9-315 states that an action for conversion may be maintained “in an appropriate case” in connection with dispositions of collateral.
[13] 985 F. 2d 1554 (11th Cir. 1993).
[14] See Vaughn v. Speaker, supra.
[15] White, Summers & Hillman, Uniform Commercial Code §4.3.
[16] Ibid.
[17]  Official Comment 2 to UCC §1-103 indicates that “while principles of law and equity may supplement provisions of the Uniform Commercial Code, they may not be used to supplant its provisions, or the purposes and policies these provisions reflect, unless a specific provision of the Uniform Commercial Code provides otherwise” (emphasis in original).
[18] 58 B.R. 887 (Bankr. D. Vt. 1986).
[19] The parties may not vary obligations of good faith, diligence, reasonableness and care.  UCC Section 9-602 also specifies several rules that may not be varied in Article 9 transactions.
[20] See Chicago College of Osteopathic Medicine v. George A. Fuller Co., 776 F. 2d 198 (7th Cir. 1985) (applying Illinois law).

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances. 
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