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The Law of Tracing in Commercial Transactions by Raczynska, Magda (1st February 2018)

7 What Should a Default Proceeds Rule Be?

From: The Law of Tracing in Commercial Transactions

Magda Raczynska

Property and title and choice of law — Interests and terminology and transfer of title

(p. 233) What Should a Default Proceeds Rule Be?

7.1  Introduction

7.01  Previous chapters considered the complexity of the current English law governing the extent to which security interests and title-based interests can be asserted in fruits and substitutes. It also provided some insights into the way in which analogous issues are dealt with in other jurisdictions that have adopted the broad (functional) concept of security interests, which encompasses both security interests and title-based interests. One point, which ought by now to be clear is (p. 234) that there has been little consideration of the rationale behind the rules in this area, perhaps with the exception of the rules concerning ownership of products. This chapter seeks to fill this gap by identifying to what extent security interests and title-based interests should be asserted by default in proceeds, products, and fruits of the original asset. The key question is whether the secured creditor or a supplier should automatically have a proprietary interest in the proceeds, products, and fruits by virtue of the security interest or the title-based interest in the original asset.

7.02  There are two related issues. One is whether allowing or disallowing such an automatic extension should be a default or a mandatory rule, that is, whether the parties should be free to contract out of or into the extension of the security interest or the title-based interest to proceeds, products, or fruit of the original asset. Another is about the extent to which asserting interests in proceeds, products, or fruits should impact on the categorization of interests as security or title-based finance. The timing for asking these questions is apt because of the ongoing current debate about the shape of reform of the law of secured transactions in England and beyond. For that reason, this chapter begins with an outline of reform by way of context.

7.2  Reform of the English Law of Secured Transactions and Title-based Finance

7.03  A reform of the English law governing secured transactions and title-based finance has been considered for some time now. It has been driven by the desire to make the law simpler, more transparent, and the transactions more efficient. Three reports over the last four decades1 have recommended that English law should be reformed in a fundamental way and that it should follow the so-called functional approach based on Article 9 of the US Uniform Commercial Code (UCC), followed subsequently in Personal Property Security Acts in, for example, Canadian provinces,2 New Zealand,3 and Australia.4 The functional approach merges the conceptually separate streams of personal property. It involves application of a codified set of rules governing attachment, perfection, priorities, and enforcement to title-based interests, as well as to security interests on the basis (p. 235) that transactions should be treated in the same way as traditional forms of security interest (such as charges) based on their economic effect, which is to secure the performance of an obligation by providing an asset to which the party can resort.5

7.04  The first report on the reform of the law of secured transactions and title-based financing in England, the Crowther Report in 1971,6 criticized the system as incoherent and inefficient and recommended the adoption of a scheme essentially along the lines of Article 9 UCC. These recommendations were supported by two further reports: the Cork Report in 19827 and the Diamond Report in 1989.8 Although some proposals were eventually included in the Companies Act 1989, the relevant part of that Act did not come into force. A debate on a more fundamental reform emerged again as the Law Commission proposed a draft scheme based on the revised Article 9/PPSA model in its consultative report in 2004.9 This was not followed. However, the Companies Act 2006 included a power to amend the relevant part of that Act.10 In pursuance of the power, the Companies Act 2006 (Amendment of Part 25) Regulations 2013 were brought into force, introducing sections 859A–Q, which replace sections 860–92 of the Companies Act 2006. The 2013 reform was welcome but limited in scope.11 Thus, the debate about the need for and shape of reform continues through the work of the Secured Transactions Law Reform Project12 and the Financial Law Committee of the City of London Law Society.13 Both consider that the law of secured transactions could be simplified and made more transparent and accessible and that doing so would require a code (statute) although the precise way in which the law could be simplified continues to be debated. One of the issues is whether it would be desirable to include in (p. 236) the future statute provisions governing the secured creditors’ rights to proceeds.14 If so, the next question relates to how broad the scope of ‘proceeds’ rule ought to be, in particular whether it should include fruits. This work has shown that the current English law is complex and there are a number of unnecessary confusions and uncertainties. For example, it has already been seen that English law would benefit from clarification of the distinctions drawn between fruits and accretions, which are currently marred by the unhelpful rule that treats both the same.15

7.05  Inevitably, the consideration of the possible future statutory, or even refined common law rules governing proceeds and fruits ought to take into account interests of the stakeholders and their current practices. As part of those it is useful to look at some of the arguments that have developed in other jurisdictions as well as economic efficiency considerations. It is convenient to take the rules under Article 9 UCC16 as the primary point of reference for at least two reasons. First, since the enactment of the UCC in all fifty states of the USA and District of Columbia, the rules have been reformed, and it is useful to investigate the reasons for the reform. Second, in their current shape, the rules are very broad and extend security interest to both proceeds and fruits automatically, without the need for the creditor to provide for them in the security agreement, although there are additional registration requirements in certain cases in order to preserve perfection of the security interest in the new asset.17 In addition, the Law Commission Draft Regulations also recommended extending security interests automatically to proceeds but it is probably fair to say that it has never been very clear how widely the term ‘proceeds’ should be understood, in particular whether it should cover only substitutes or also fruits.18

7.3  Property Law Considerations in Shaping the Default Rules

7.06  The right to own private property is part and parcel of a market economy. Inherent in the ownership are a range of powers: to use an asset, to take benefits from that asset, to change its form and substance, and to transfer all or some of these to others.19 In a market economy resources are allocated by exercising the power to (p. 237) dispose of property, usually coupled with the power to enter into contract. Private property promotes market efficiency by providing incentives for the allocation of assets to those who place the highest value on their use.20

7.07  Given that security interests involve the alienation or transfer of property (like sales or debt repayments), granting a security interest in favour of a creditor is merely a way of exercising the freedom of contract aimed at transferring or alienating an interest in the property.21 This is referred to as the property-based theory of security interests.22 The same justifications based on promotion of market efficiency through incentivizing allocation of resources would appear to be true in relation to interests that are known under English law as title-based interests. Applying this theory to explain security and title-based interests in proceeds seems unhelpful for at least two reasons. One is that proceeds are future assets. The basic premise, on which the law of property dispositions is founded, is that no one can make a present transfer of something they do not presently own or otherwise have a power to dispose of. Allocation of resources is surely not enhanced through allocation of something that does not exist, and may not come into existence, so it is not clear why the law should incentivize the power to make dispositions of future assets, and therefore why it should allocate proceeds of disposition of an asset to the holder of a security interest. Another difficulty relevant to rights in proceeds, is to explain why a legal system should allow one asset to be substituted for another instead of making the creditor always follow the original asset and, where that fails, extinguish his interest.

7.08  However, it is possible to say that the law concerning proceeds or products is about protection of the individual autonomy to choose how to allocate resources: how to invest and how/what to produce. Investments require exercise of the power to dispose while creation of new products requires exercise of the power to make (to incorporate). When those powers are delegated to others, as is the case in transactions involving security and title-based interests, their exercise may lead to loss of proprietary interest in the initial asset. Where the exercise of such powers was authorized by the holder of the security interest or title-based interest, it can be said that the holder of the proprietary interest delegated her choice how to invest or how to produce on such terms as she consented. Thus, unless she delegated the power to dispose or power to incorporate subject to a right to proceeds or products generated in the exercise of that power, there is no reason she should (p. 238) have a right to those proceeds or products. On the other hand, if she did not authorize the exercise of the power to invest or to produce, she has not made the choice on how to dispose or produce. Since she had no opportunity to express her choice preferences, and the exercise of the power to dispose or produce has potential of resulting in the loss of her proprietary interest in the initial asset, it is fair enough to provide her with a proprietary interest in the proceeds or products as the outcomes of the exercise of the powers. The power to draw fruits does not seem to involve the same choice since ordinarily the exercise of the power to take fruit has no potential of resulting in the loss of proprietary interest in the income-generating asset. It would, therefore, not be necessary to protect her autonomy by way of a proprietary interest in the fruit unless she bargained for it.

7.4  Economic Efficiency Considerations

7.09  Costs associated with financing depend on the attitude to risk of the creditor (or financier) and on the assessment of the probability of repayment. Security interests and title-based interests reduce that risk by providing the interest holder with powers and rights to resort to the asset in priority to other creditors in insolvency of the borrower. Under English law assets subject to title-based interests or fixed security interests enable their holders to take the assets which are subject to those interests outside the liquidation regime, thus enabling the creditor to resort to the asset, typically by exercising the power of sale and applying the sale proceeds to the satisfaction of the obligation owed. Floating charge holders also enjoy an advantageous status in the chargor’s insolvency, at least compared to unsecured creditors.23 The proprietary protections operate to reduce credit risk by providing the creditor with the ability to resort to certain asset(s) and avoiding the prospect of the pari passu regime. This means that lenders and financiers are willing to provide the credit where otherwise they would not be or that they might offer it on better terms. The ability to create such proprietary protection is said to be economically efficient. For example, Jackson and Kronman noted that:

if the law denied debtors the power to prefer some creditors over others through a system of security agreements, a similar network of priority relationships could be expected to emerge by consensual arrangement between creditors. Permitting debtors to encumber their assets achieves the same result, but in a simpler and more economic fashion.24

(p. 239) 7.10  Nonetheless, economic efficiency of security interests has been extensively debated, particularly in the North American literature.25 Much less attention has been focused on the efficiency of the particular rules and the legal risks they create. Before considering whether particular default rules governing proceeds make finance more efficient, it is useful to explain what economic efficiency means in the context of secured financing in general. For clarity of analysis the references are made to security interests but analogous considerations apply to title-based interests unless otherwise specified.

7.4.1  Economic efficiency

7.11  A convenient way of measuring benefits to parties is to look at economic surplus parties receive.26 There is a limit to the amount that each borrower is willing to pay for a loan. The maximum price the borrower is willing to pay can be called his willingness to pay. It measures how much the borrower values the loan. Each borrower would want to obtain a loan at a price below its willingness to pay. To simplify the analysis, we assume that the price the borrower is willing to pay is the amount of interest rate charged over the duration of the loan. If the borrower can obtain the loan below the maximum amount she is willing to pay, the borrower receives a surplus.27 For example, if the borrower is willing to pay £1000 for a loan but pays only £800, the borrower receives a surplus of £200. Assuming that borrowers are rational, willingness to pay can serve as a measure of benefit to the borrower (as the debtor himself perceives it). Similarly, the benefit to creditors (creditor’s surplus) can be measured by the amount the creditor (financier or lender) is paid minus the cost to the creditor. If, for example, costs of finance amount to £700 but the creditor is paid £800, the surplus to the creditor is £100.28 Market equilibrium is reached at a point which indicates the price the borrower actually pays to the creditor. Resource allocation (including resource use) is efficient if the total surplus (p. 240) received by the creditor and the borrower is maximized. If surplus to the creditor and the surplus to the borrower are both maximized, the equilibrium is efficient. The surplus is at its highest when the amount that the borrower is willing to pay for the loan is as high as possible and the costs to creditor are as low as possible. If the benefit cannot be increased any more without making the creditor incur more costs and thereby making the creditor worse off, the equilibrium reached is efficient. If some gains from the financing are not being realized, for example because costs to the creditor can be reduced, financing is inefficient.

7.12  In order to see whether particular rules governing security and title-based interests make finance more efficient, it is necessary to understand the risks faced by the creditor. The greater the risk, the greater are the costs to the creditor and the greater is the price of the loan to the borrower. There are two main risks worth considering. One is that the market is not perfect and information is asymmetrically distributed.29 With the potential debtor seeking the lowest-cost transaction and the cost at least in part being determined by the level of default risk he presents, the debtor has an advantage to be gained from presenting himself as a lower risk. With imperfect knowledge of the debtor the creditor is faced with the challenge of determining both the overall risk level of the transaction (and therefore whether to enter into it at all) and determining an effective pricing mechanism.

7.13  A simple solution would be to price credit at a level that seems the worst-case scenario. However, this would not match the priorities of financiers working in a competitive market to reduce prices to ensure competitiveness. For borrowers, on the other hand, it is only worthwhile to borrow if the return on investment exceeds the cost of borrowing. The borrower is considered to have a better knowledge than his creditor to assess the return on investment and whether or not he will be willing and able to repay the loan at all. The creditor could try to assess repayment probability by looking at how high an interest rate or price the borrower is willing to pay, the assumption being the more the borrower is willing to pay, the more profitable the investment and so the greater the repayment probability.

7.14  Such reasoning would be flawed because while the willingness to pay higher price could reflect higher profitability of the undertaking, it could also indicate that the borrower is ready to take greater risk. Higher prices might, however, drive more trustworthy borrowers out of the market, making the ‘selection’ of borrowers (p. 241) ‘adverse’ from the viewpoint of the creditor.30 If the creditor cannot compensate for the increased risk of ‘bad borrowers’ by charging a higher price, the creditor will not lend at all to debtors even if they are willing to pay a higher interest rate. Security interests and title-based interest can both be thought to reduce the asymmetry of information between the creditor and the debtor and to overcome the adverse selection problems by providing a known and verifiable asset. The existence of an asset to which the creditor may resort enables the creditor to better inform herself of the creditworthiness of the borrower and the financial risk it poses and so eliminate the need for a higher price, thereby overcoming the adverse selection.31

7.15  The second risk is the so-called moral hazard problem. When describing the issue, economists refer to the context of agency when one person (the agent) is performing a task ‘on behalf of’ another (the principal) but it is worth noting this differs from agency in a legal sense. In economics, if the principal cannot perfectly monitor the agent’s behaviour, the agent may engage in dishonest or otherwise undesirable (‘immoral’) behaviour.32 Misbehaviour generates conflicts known as agency costs, which inflate the risks.33 Compensating the principal for its portfolio risk by increasing borrowing costs might increase moral hazard and inflate agency costs.34 In the context of finance, the agreement between the creditor and the borrower is concluded on the basis of the creditor’s assessment of the borrower’s repayment probability. After the agreement has been concluded, the creditor risks that the borrower’s behaviour may be inconsistent with that assessment. If the price was fixed, the borrower could try to reduce the real cost of credit by undertaking activity riskier than that envisaged by the creditor. The borrower might, for instance, engage in distributing corporate assets to shareholders in the form of excessive dividend payments.

7.16  One way to deal with moral hazard is to monitor the borrower, for example by asking for regular financial reports.35 The costs of such monitoring could quickly (p. 242) outweigh its benefits.36 Security interests (and title-based interests) are generally thought to reduce the need, as well as the cost of monitoring of the entirety of the debtor’s assets, to monitoring only the asset. This in turn overcomes moral hazard problems.37 The presence of collateral does not eliminate the risk of the debtor’s misbehaviour but the creditor is shielded from the consequences of such misbehaviour and cost of borrowing need not be inflated by agency costs.38

7.17  If credit is secured (asset-based) the probability of repayment depends not only on the factors mentioned above but also additional ones such as the value of the collateral on the market: that is, how much the market is willing to pay for the encumbered asset, at the time of enforcement of the security as well as on the continuing existence of an asset to resort to until the obligation is discharged and security is terminated. If the value of the asset falls, the creditor may not be paid in full. Neither the creditor nor the borrower can predict with certainty the future market value of the asset and this is usually outside of their control.39 In some cases, secured lending may itself fuel moral hazard when the lender places ungrounded reliance on the value of collateral, for example where the financier counts on the collateral improving in value.40 Similar problems arise where the security ceases to exist as the debtor withdraws assets from security or when encumbered goods are mixed with other goods. This creates a risk of losing security. If a security interest can no longer be asserted in the old asset, the problem of moral hazard is not overcome because without an asset subject to security the debtor will present a higher risk than the creditor originally agreed to finance. Thus, a legal system permitting withdrawal of assets from security without consent of the lender may fuel moral hazard where the debtor may, by its behaviour, cause assets to be withdrawn from security.

7.18  It is argued that a rule that automatically extends security interests to substitutes (whether proceeds or products) deals with this moral hazard problem and (p. 243) promotes efficiency of security interests. By contrast, it is argued, a rule that automatically extends security to fruits leads to inefficiency. The distinction between fruits and substitutes has been addressed in Chapter 3.

7.4.2  Promoting efficient credit market equilibrium: Substitutes

7.19  The problem of moral hazard posed by collateral can be overcome if the creditor contracts to take security in the substitute resulting from the debtor’s disposition of the old asset to a bona fide purchaser or mixing of the old asset to create a new one. Additional contracting means additional transaction costs, which can be avoided if the security interests extend to substitutes by operation of law. A rule that security automatically extends to substitutes (‘substitutes rule’) may be seen as preserving the bargain between the parties and avoiding additional transaction costs associated with contracting for this rule. A new asset acquired with the value represented in the old asset simply takes place of the old asset. The creditor still has a known and a verifiable asset, which preserves the reduced costs of monitoring of the debtor. It seems that whether the new asset is equivalent in value to the old asset is irrelevant at this stage because the creditor monitors a particular asset, not its value.

7.20  Where there is a risk of the creditor’s security interest being defeated by a borrower’s disposition, a substitutes rule in a legal system is likely to promote the role of secured or asset-based finance. The creditor need not include the risk of losing security in the cost of borrowing. The likelihood of repayment is greater than if the creditor were to lose its proprietary interest in the original (disposed of) asset. This is true even if it may be difficult to estimate whether the likelihood of repayment differs depending on the type of asset encumbered: the asset which constitutes proceeds or product may be a different type of asset than the original collateral, which may in turn have an influence on the creditor’s ability to resort to that asset if the debtor defaults. Even if the likelihood of repayment is smaller when security shifts to a substitute compared to security in the original collateral (e.g. due to the smaller value of the substitute), it is still greater than not having security at all. While the creditor is better off by having a right to resort to proceeds or products (i.e. substitutes), the debtor is not worse off: the debtor surrenders security in one asset and substitutes it for another. Indeed, if security did not extend to proceeds and products automatically the creditor would likely be worse off (if he were unable to follow or claim the followed original asset) whilst the borrower would be better off as his assets would be free, for example, to be used to raise fresh secured finance. This would, therefore, be a less efficient outcome than one achieved if the substitutes rule applied.

7.21  In addition, the substitution of the original asset for proceeds or products does not generally change the position of the borrower’s other creditors, since the secured creditor would have a proprietary interest with respect to the new asset (p. 244) instead of the original collateral. A possible exception might arise where the new asset (the substitute) falls within the scope of another creditor’s security. The efficiency of the substitutes rule will have to take into account wider considerations such as the nature of both creditors’ interests; for example, whether either creditor’s finance enabled the borrower to acquire a new asset which otherwise the borrower would not have.

7.4.3  Inefficiency of automatic extension of interests to fruits

7.22  The rationale for extending security interests or title-based interest to fruits is different than in the case of substitutes. Fruits are generated beside, not instead of, the original asset. A rule automatically extending security and title-based interests to fruits (‘fruits rule’) would enlarge the subject matter of those interests. A question to ask is whether such a rule, similarly to the substitutes rule, would work to promote the efficiency of finance in relation to both security and title-based interests. In the process of generating fruits, unlike with proceeds or products, there is little risk of the creditor losing proprietary interest in the original asset by virtue of creation of the new asset. In the case of security interests, it is shown that the fruits rule causes inefficiency through oversecuritization of the creditor and a deadweight loss in the credit market. This is explained below. Essentially, the argument is that the borrower becomes worse off because as the new assets become automatically encumbered, the borrower receives no new value and is limited in making use of the new assets; for example, when seeking new credit the borrower cannot offer to the prospective new creditor a first-ranking security in the new asset (the fruit) because a security already exists in that asset.

7.4.3.A  Oversecuritization

7.23  It might be tempting to think that the creditor is better off with a right to fruits than he is without it because he has more assets to resort to (fruits as well as the original asset) in the event of the borrower’s default. The value of these assets may be much greater than the amount of the credit secured against them. It is important to remember, however, that a holder of a security interest can only resort to the assets up to the amount of the secured debt and that creditors generally take security in assets whose value is likely to cover the discharge of the secured debt where enforcement is necessary. Probability of repayment does not increase linearly with the increasing number of assets. The likelihood of repayment increases only incrementally, if at all, with extra assets being added. For example, if A lends £50 to B, who gives security over her watch worth £100, the likelihood of repayment of the loan by B will not increase substantially (if at all) just because B will add security over her computer worth £1000. The security over the watch already protects A because the sale proceeds of the watch are likely to comfortably suffice to discharge the secured obligation in case B defaults. The benefit of having (p. 245) security automatically extend to additional assets such as fruits is, therefore, likely to be marginal in a standard situation.

7.24  Extending security to fruits by operation of law would make the credit market equilibrium less efficient if one takes into account the interests of third parties. The difference between proceeds and products on one hand and fruits on the other is that the former are new assets that do not represent new wealth available to the creditor since they are substitutes of assets disposed of or mixed. Fruits are new assets that represent new wealth in the debtor’s estate. From the perspective of other creditors of the borrower, the fruits rule carves out a greater proportion of the borrower’s assets to the secured creditor, which is difficult to reconcile with interests of other creditors, thus making it further questionable from the perspective of maximizing the surplus to all those who might be affected by the transaction, in particular unsecured creditors. In the context of the wider economic efficiency debate security interests have been criticized for misallocating resources by imposing on unsecured creditors a bargain to which many, if not most, of them have given no meaningful consent.41

7.25  If this criticism has any grain of truth, the fruits rule becomes even less defensible from the perspective of the unsecured creditors, as the bargain concerning the resources (fruits) is, in effect, imposed not only upon the unsecured creditors but even on the parties to the secured transaction. While the unsecured creditors might become worse off, the creditor is in a position where he can resort to assets worth much more than the secured debt. The creditor is oversecuritized. Yet the creditor does not gain a benefit (or gains only a very small benefit) from the greater number of assets as collateral because the increase in the repayment probability is incremental. For that reason, it is preferable in a legal system not to provide that the security interests should automatically extend to fruits of the original asset. This should not, however, preclude the creditor from being able to agree with the grantor of security that security is to extend to fruits if desired, for example, where there is a risk that the original collateral might be insufficient to discharge the secured debt.

7.26  An analogous reasoning does not generally apply in the case of title-based interests. This is because holders of those interests when enforcing their interest are not limited by the amount of the outstanding price. They may take any surplus over and above the amount of the (functionally secured) payment obligation unless of course parties agreed that the holder of the title-based interest would pay the surplus to the borrower (buyer). Therefore, short of a contractual provision that (p. 246) surplus is to be made over the borrower, an automatic fruits rule benefits the title-interest holder.

7.4.3.B  The deadweight loss of the fruits rule

7.27  Another argument against an automatic extension of security to fruits is that such a rule would create a deadweight loss. In economic terms the rule extending security to fruits by operation of law would impede efficiency in a way analogous to deadweight loss in market equilibrium. A deadweight loss is the fall in total surplus that results from market distortion.42 A typical example is tax. In a market of goods when tax is imposed the price paid by the buyers rises but the sellers do not receive a greater price. This causes the supply and demand curve to shift.43 For example, if the tax is levied on sellers of widgets, the price of widgets goes up and the supply curve shifts: fewer widgets are sold at the given price. A tax on a widget causes the size of the market for the widget to shrink. It is argued that a rule that automatically extends security interests to fruits generates deadweight loss in a similar way as taxation does.

7.28  It was already said that the benefits to the lender from automatic extension of security to fruits rule are marginal. It can, therefore, be assumed that the lender is neither better off nor worse off with a fruits rule. The borrower, however, is worse off where the rule applies because the cost of borrowing rises for the borrowers. All assets, which the borrower can use to raise finance, present an investment opportunity to the borrower. The borrower can use the new assets to raise new finance. If the new assets are automatically subject to an interest in favour of the lender, the borrower loses that opportunity. What the borrower must give up is an opportunity cost.44 The borrower is worse off where the fruits rule applies because the costs of borrowing are enlarged by the opportunity cost. The borrower cannot offer the new assets as security to other lenders to gain fresh loans. He cannot borrow as much as he would be willing to. The market does not reach its efficient equilibrium because the surplus to both parties (i.e. the surplus of the borrower and the surplus of the creditor) is smaller than it would be without the rule. In addition, unlike, for example, tax, it is difficult to see that the deadweight loss of the fruits rule could be underpinned by public policy considerations.

7.29  A legal system could provide that parties can contract out of the fruits rule but this increases transaction costs, as they need to spend time and money to consider whether to exclude this rule. It is more efficient to let parties decide to ‘opt in’ rather than to ‘opt out’. Assuming that parties are rational, there is arguably no deadweight loss in a parties’ agreement to extend security to fruits (an ‘opt-in’) because parties would have considered why their relationship requires extension (p. 247) of security to fruits. For example, parties may decide to extend security to fruits because it is foreseen that the value of the original collateral will diminish on the market and so new assets will need to become subject to security.

7.30  The argument against the automatic extension to fruits based on deadweight loss is less clear-cut in relation to title-based interests. While in the context of security interests an automatic extension of security to fruits precludes the borrower from dealing with the asset unencumbered while not conferring any real advantage on to the creditor, it is not obvious that depriving the borrower of the ability to dispose freely of fruits generates an analogous opportunity cost in relation to title-based interests. The financier might, for example, have a right to dispose of the fruits free from the borrower’s interest.

7.5  Security in Proceeds under Article 9 UCC

7.31  Two notions of proceeds have emerged under Article 9 UCC: disposition-based and value-based concepts of proceeds. Disposition-based proceeds are distinguished on the grounds of passage of title while value-based proceeds focus on the occurrence of an event that exhausts or consumes the economic value of collateral or its productive capacity.45 The formulation of proceeds was expanded in the 2001 revision from the previous disposition-based definition46 to the value-based model of proceeds. The current definition in §9-102(a)(64) UCC therefore reads:

‘Proceeds’ means the following property:

  1. (A)  whatever is acquired upon the sale, lease [includes rents], license, exchange, or other disposition of collateral;

  2. (B)  whatever is collected on, or distributed on account of, collateral;

  3. (C)  rights arising out of collateral;

  4. (D)  to the extent of the value of the collateral, claims arising out of the loss, nonconformity, or interference with the use of, defects or infringement of rights in, or damage to, the collateral; or

  5. (p. 248) (E)  to the extent of the value of collateral and to the extent payable to the debtor or the secured party, insurance payable by reason of the loss or nonconformity of, defects or infringement of rights in, or damage to, the collateral.

§9-102(a)(64)(D) and (E) UCC concern tort claims47 and insurance proceeds respectively, whilst the remaining sections focus on different types of proceeds in the narrow sense (substitutes) and fruits. The expansion of the definition primarily concerned inclusion of the right to income and rents. It is therefore useful to examine what led to that extension of the definition to include fruits. In order to do so we will first look briefly at the historical approach of the US law to rents and we will then show examples of cases that were perceived as problematic prior to the change. Finally, we will investigate the rationale for the wide definition of proceeds and ask whether, based on the American experience, inclusion of a right to income and rents in the collateral would be a good solution in English law.

7.5.1  Historical development of security in rents and income

7.32  Historically, the question of fruits in the US, as in Roman law and English law, arose first in relation to mortgages over land. A mortgage has developed as an outright transfer (conveyance) of legal title, which involved a right to possess the land and to collect rents from the real property. The traditional approach has been to allow the mortgagee to collect proceeds, such as rents accruing on land, and to apply them to the discharge of debt, unless the mortgage document provided otherwise, even prior to default by the debtor. The right to collect rents was treated as a substitute for collecting interest, which was a violation of ecclesiastical and legal prohibitions on usury.48 This approach later changed. On the prevailing theory of the mortgage, the mortgagee does not implicitly have a right to collect rents arising from the mortgaged real property and to apply them towards the discharge of the debt. Another way of looking at the right to rents is to treat it as implicit in the right to possess. In some US states the mortgagee’s right to possession accrues immediately upon default by the mortgagor, even if foreclosure proceedings have not yet been instituted, which enables the mortgagee to collect rents.49 To ensure that the mortgage lenders have this right to collect rents the (p. 249) mortgagor is required to separately assign rent payments in the event of default50 but prior to the completion of foreclosure.51

7.33  As far as unaccrued rents were concerned common law traditionally treated such rents as an interest in land—an incorporeal hereditament,52 which required execution and delivery of an instrument conveying an interest in rents (an assignment of rents).53 This was problematic in the context of income received under licence agreements,54 for example, boat slip fees at marinas or hotel room charges. If a lender wanted to take security in such income, they needed to either obtain an assignment of that income as ‘rents’ in the land or create a security interest in the present and after-acquired accounts and perfect it by filing a financing statement covering ‘accounts’ under Article 9 UCC.55 A cautious lender needed to use the ‘belt and braces’ approach by both requiring the debtor (e.g. a marina owner) to execute an assignment of rents and filing a financing statement covering accounts in a relevant UCC filing office.56 Although this solved the issue of a perfected and enforceable security interest outside of bankruptcy, the question of classification of the lender’s interest was crucial in the US in the context of bankruptcy because a security agreement covering after-acquired property did not (and still does not) attach to property that falls in the bankruptcy estate post-petition.57 Characterization of income from licences as ‘rents’, ‘profits’, or ‘proceeds’ of land meant that the security interest in such newly accruing assets was enforceable after the bankruptcy proceedings commenced.58

7.5.2  Difference between ‘proceeds’ and after-acquired property in insolvency

7.34  After a petition for bankruptcy has been filed the interests of the secured creditor and the debtor with respect to accruing assets may diverge. The mortgagee (p. 250) is interested in preserving the post-petition rents so that they could be applied to the discharge of the mortgaged debt if necessary while the mortgagor is interested in applying the rents to fund its efforts to restructure the mortgage debt and to pay professional fees and expenses.59 The US Bankruptcy Code preserves any security interest acquired prior to bankruptcy so long as it is valid and perfected under state law.60 This applies to proceeds but not after-acquired property due to an express exclusion under § 552(a) of the US Bankruptcy Code, whereby a security agreement covering after-acquired property is not considered to create enforceable security in property acquired after the commencement of bankruptcy proceedings.

7.35  By contrast, a pre-petition security interest61 is valid and enforceable in post-petition property if the security agreement extends to ‘property of the debtor acquired before the commencement of the case and to proceeds, products, offspring, or profits of such property, then such security interest extends to such proceeds, products, offspring, or profits acquired by the estate after the commencement of the case’.62 There are exceptions to this. For example, the rule does not apply to the extent that the trustee or debtor in possession may use, sell, or lease proceeds, product, offspring, or profits.63 The provision also allows the court to consider the equities in individual cases, for example to take into account and evaluate any expenditures by the estate relating to proceeds and any related improvement in position of the secured party.

7.36  The difference in post-petition treatment of security in after-acquired property and security in proceeds and products has led to significant changes in the law in 2001, to which we now turn. It was driven to a large extent by the desire to count rents as ‘proceeds’ and not as ‘after-acquired property’. It is worth noting that the difference in treatment of security in after-acquired property and proceeds is not a matter of doctrinal logic but rather a policy-driven rule to enlarge the mass of assets available to unsecured creditors.

7.5.3  Value-based conception of proceeds: A practical convenience

7.37  It is interesting to note that the move towards the ‘value-based’ definition of proceeds, away from the ‘disposition-based’ conception (which is the reverse to the approach advocated here), was driven by the desire to avoid unfavourable (p. 251) provisions of US bankruptcy law rather than some deeper conviction about the inherent correctness of the value-based approach.

7.5.3.A  Rental and licence fees

7.38  Prior to 2001 case law suggested that rental and licence fees were not proceeds.64 Such assets were generated as a result of consumption, not disposition of the original collateral. ‘Disposition’ was interpreted as a transaction effecting a transfer of property65 or a ‘permanent transfer of possession’.66 For example, in the Value-Added case, coins for use of pay telephones were held not to be proceeds of telephones because use of telephones was not a ‘disposition’ within former §9-306UCC.67 Taking security in such rentals was only possible as security in after-acquired property, which was not valid post-petition.

7.5.3.B  Stock dividends as proceeds

7.39  The inability to grant security interests valid post-petition in assets not arising through disposition of the initial asset led to odd distinctions in relation to dividends generated on shares. Dividends generally were not considered as ‘proceeds’ under the disposition-based definition.68 They were seen as reflecting the productive capacity of shares, not being a result of their disposition. However, a distinction emerged between ordinary dividends (which were not proceeds under the pre-2001 UCC disposition-based definition) and liquidating cash dividends (which came to be seen as arising through a disposition of shares).

7.5.3.B.a  Liquidating dividend

7.40  When shareholders of a company decide to dissolve the corporation, upon the dissolution the company pays its shareholders a liquidating dividend. Each shareholder exchanges its possession of a share certificate, if there ever was one, for a dividend. The transaction resembles a disposition—an exchange. The liquidating dividend derives its value from shares, but it is a functional equivalent of a ‘casualty that totally destroys stock’. Once the dividend is paid, the share certificate retains no value; it cannot be exchanged for anything else. A liquidating dividend was therefore considered as falling within the term ‘proceeds’ prior to the 2001 revision.69

(p. 252) 7.5.3.B.b  Ordinary cash dividend

7.41  Liquidating dividends were contrasted with ordinary cash dividends, as illustrated by Re Hastie.70 Hastie borrowed $750,000 from First National Bank in Oklahoma City, granting a security interest in 248 shares of stock of FirstBank. The security agreement provided that the secured party would have the right to receive from the issuer the share of dividends, profits, and other distributions to which the debtor would be entitled. Subsequently the Federal Deposit Insurance Corporation (FDIC) succeeded to the interest of First National Bank. FDIC took possession of the stock certificates and perfected the security interest in the stock under Oklahoma law but never asked FirstBank to register a change of stock ownership. Hastie, therefore, continued to be listed as a registered owner of the FirstBank stock.71 After Hastie filed for bankruptcy (a voluntary Chapter 11 petition) FirstBank paid cash dividends three times to Hastie. FDIC asserted a lien against those dividends under its security agreement but Hastie sought a declaration that FDIC had no perfected security interest in those dividends. The bankruptcy court agreed with Hastie that FDIC failed to perfect its security interest in the dividends. FDIC had the opportunity to cause the transfer of ownership of the FirstBank stock to be recorded, which would have ensured that it would receive notifications or dividends, to which the registered owner is normally entitled. The district court agreed. On appeal, FDIC tried a different argument. It submitted that its security interest in the dividends remained unaffected by Hastie’s bankruptcy filing because the dividends constituted proceeds of the stock under UCC §9-306(1), which meant that even if ‘proceeds, products, offspring, rents, or profits’ of collateral are acquired after the petition for bankruptcy is made, the security interest extends to them notwithstanding the bankruptcy.72 It was key then how the term ‘proceeds’ was to be understood in this context. The Tenth Circuit, in finding for Hastie, focused on the transactional nature of (then) §9-306(1) UCC. Brorby Circuit Judge held:

With respect to this definition, the term ‘sale’ may be defined generally as ‘[a] revenue transaction where goods or services are delivered to a customer in return for cash or a contractual obligation to pay. [The] [t]erm comprehends [a] transfer of property from one party to another for valuable recompense.’ Similarly, the term ‘exchange’ may be defined as ‘[the] [a]ct of giving or taking one thing for another,’ and the term ‘collect’ in the context of a debt or claim may be defined as ‘payment or liquidation of it.’ Lastly, the phrase ‘other disposition’ may be defined generally as the ‘[a]ct of disposing; [or] transferring to the care or possession of another; [or] [t]he parting with, alienation of, or giving up [of] property.’ Accordingly, each of the foregoing events describes an event whereby one asset is disposed of and another is acquired as its substitute.73

(p. 253) 7.42  With this characterization of proceeds as transaction-derived assets and in the absence of direct authority on whether dividends classed as proceeds,74 the Tenth Circuit court, concluded that:

The receipt of cash dividends by a registered owner of certificated securities bears no resemblance to the events specified in the definition of proceeds or to an act of disposition generally.75

For dividends to fall within the category of transaction-based proceeds the generation of dividends it was necessary to show a change in ownership or other disposition of the stock, and payment of ordinary dividends did not alter the ownership of the stock; it merely involved distribution of the issuing corporation’s surplus or retained earnings.76 Since dividends did not count as ‘proceeds’ of shares, perfection of security interest in shares did not lead to perfection of security interest in the dividends. A security interest in dividends had to be perfected separately. In the lack of acts leading to perfection of security interest in the dividends, FDIC’s security interest in the dividends was not perfected.

7.43  The decision was met with some criticism. Freyermuth, for example, argued that in some sense the payment of a dividend involved a disposition of the value represented by the issuer’s assets because ‘simple math demonstrates that the payment of a cash dividend has the effect of reducing [the shareholder’s] residual claim’.77 This does not seem to be right, however. If a shareholder wants to realize the value of its share prior to the issuer’s dissolution, they can only do so by selling the shares in a market transaction and the price of shares on the market is determined by a number of factors, least of which is whether dividends have just been distributed or not. In any case, Freyermuth’s criticism is itself based on a value-conception of proceeds; under a disposition-based approach to proceeds the fact that an asset is worth less after a certain event does not, by definition, mean there has been any disposition because the asset itself does not change, only its value.

7.5.3.C  Rents from leases

7.44  Where a secured party held a perfected security interest in equipment, it did not have a perfected interest in the lease of the equipment. Therefore, proceeds of the collateral referred only to sale of the equipment and not to rents forming the lease of the collateral.78 The seminal case in relation to proceeds of leased collateral is Re Cleary Brothers Construction Co.79 In that case Cleary granted a (p. 254) security interest to General Electric creditor Corp (GECC) in a crane. After filing for bankruptcy, without GECC’s permission, Cleary leased the crane to a third party for ten days for a specified rent. The court held that the rents paid on the lease of crane were not proceeds because no disposition of the subject matter of security—the crane—took place.

7.5.3.D  The non-existent collateral problem

7.45  Let us imagine that a company A manufactures and sells widgets to retailers. It has a £1m credit line with Bank X to finance its trading activity. X has a security on A’s accounts receivable. A’s competitor—company D—pays A £1m to stop manufacturing and selling widgets. A accepts the payment and closes the business. The question is whether Bank X can assert its security interest in the payment A obtained from D as proceeds of its collateral. The problem is that the original collateral—the accounts receivable—never came into existence.80 This is known as a non-existent collateral problem. It has emerged in the US case law in relation to government agricultural subsidy payments81 and proceeds of business interruption insurance.82 Some courts took the view that the lender had an opportunity to take a security interest in these assets.83 Arguments to the contrary were that (a) the debtor would not have received the subsidy or other payment but for the participation in the subsidy or insurance program; (b) if the debtor proceeded and manufactured widgets or planted crop, these assets would have been covered by the security interest; (c) the payment obtained was a substitute for widgets that would otherwise have been manufactured (or crops grown).

7.46  Prior to the 2001 amendment in the US such payments were not treated as proceeds as they did not fall within the term ‘disposition’. Freyermuth argued that the payments such as the subsidy paid for not growing the would-be covered crops, were proceeds of the collateral on the basis of the parties’ bargain. His argument was as follows. When the debtor and the secured party enter into a security agreement their mutual understanding might be that the debtor will, for example, grow the crops, to which the secured creditor’s interest will attach. (p. 255) If the debtor accepts the subsidy or other payment the debtor is depriving the secured creditor from its bargained-for collateral, which is comparable to the debtor, for example, growing crops and selling them for cash. Freyermuth’s argument is therefore that the lack of recognition of the collateral in such payments ‘frustrates the ex ante bargain of the parties and accords [d]ebtor a windfall’.84

7.47  If the rationale was to preserve the bargain between the parties, the problem of ‘non-existent collateral’ is that the bargain does not exist. Let us imagine that the farmer who creates security in crops finds a substitute use of his land and instead of growing crops hosts a rock concert.85 The question is whether the proceeds from renting the ground for such a purpose could be regarded as proceeds of crops. This would clearly be going exceedingly far, on the disposition-based conception of proceeds, since the security was agreed to extend to crops, not land itself, and ticket sales would be proceeds of land, not crops. Even if we were to follow Professor Smith’s analysis that rent counts as traceable proceeds of leased land because the right to rent arises on the basis of a separate agreement whereby the owner of land parts with a portion of his ownership, namely the use of land,86 we cannot say that ticket sales are proceeds of crops because they are generated on the basis of a different agreement of the owner to part with land use. Freyermuth himself admits that tickets sales would not be proceeds because the land-owner does not act as a farmer.87 Since farmers grow crops and do not host rock concerts it cannot be reasonably expected that a reasonable person in the position of the debtor and the secured party concluding a security agreement would have understood that the security over land extended to rents from rock concerts.

7.5.4  The rationale for a wide ‘proceeds rule’

7.48  As already mentioned, the revised Article 9 UCC was expanded to cover not only proceeds that the debtor received as replacements for the original collateral (as a result of a ‘disposition’) but also proceeds generated by or related to the original collateral.88 This enlarged concept of proceeds resolved the specific issues mentioned above by allowing classification of share dividends, rent collections, or royalties from licensing as proceeds. It is useful, however, to examine to what extent wider general reasons were raised.

(p. 256) 7.5.4.A  Arguments in favour of a wide definition of ‘proceeds’

7.49  There appear to be some reasons for the expansion of the definition of proceeds. First, reporters for Article 9 revision, Professors Steven Harris and Charles Mooney, argued that changes were needed to expand the lending base available to secured creditors, thereby increasing the debtor’s ability to obtain financing.89 This reason appears to be a generalization of the concerns with avoiding unfavourable bankruptcy provisions because creation of security in the assets, as after-after acquired assets, was possible, so the lending base was wide, but unfortunately unprotected in bankruptcy.

7.50  Second, the rationale for the proceeds rule was that it should ‘achieve efficiency of secured transactions by codifying the ex ante bargain of the hypothetical rationale debtor and secured party’.90 It is the presumed intention of the lender and the borrower that the security should extend to sums that reflect the economic value of the collateral.91 The law takes a paternalistic approach in inferring that intention. The UCC automatically gives the parties ‘a right to collateral (proceeds) that is usually bargained for even in those cases in which the parties have forgotten to implement their bargain by appropriate language in the security agreement’.92 This was meant to tie in with the UCC’s stated purpose, which is to simplify and clarify the law of commercial transactions through deterministic rules so as to decrease the transactional costs and increase predictability of the results of security interest disputes.93

7.5.4.B  Critique of a wide ‘proceeds’ definition

7.51  There are two assumptions made by the drafters of the UCC legislative provisions and it is not obvious whether they hold every time. One relates to codification of the parties’ bargain and the other to efficiency.

7.5.4.B.a  Codification of a bargain, which may not exist

7.52  The law sometimes codifies the perceived typical bargain of parties to a transaction. Providing a regulatory structure, which most parties would choose were they to bargain for these rules individually, reduces transaction costs and hence increases efficiency. The parties do not need to spend money on drafting rules from scratch because the law provides a set of default rules. In providing a set of default rules an assumption is made that the legislature is able to establish with a reasonable degree of (p. 257) certainty what parties usually bargain for. Such predictions as to parties’ behaviour are not unprecedented in commercial law. In the US, for example, under the Bankruptcy Code a bankrupt debtor cannot retain and use collateral unless the debtor has provided the secured party with adequate protection of its interest in the collateral:94 the debtor must at a minimum insure the collateral in order to provide the secured party with adequate protection. The rule is seen as a substitution for the need to include contractual clauses to that effect, which is what parties would normally do if the statutory provision did not exist. Naturally, the bargain envisaged by the law need not be a reflection of the true bargain between the parties. It rather reflects the usual bargain under the circumstances, which serves as a benchmark for legitimate expectations of the parties.

7.53  In relation to collateral extending automatically to proceeds that include fruits, it is questionable whether the legislature has not gone too far in inferring intention that would never have been there. Unless it can be shown that parties to a secured transaction would typically agree that security interest extends to fruits it cannot be said that there exists any bargain to codify. If the typical bargain does not exist, the legislature should not be imposing default rules on commercial parties only for the parties to have to contract out of them. There appears to be no evidence of any such pattern of behaviour of commercial parties and further, empirical research would be needed to prove this point.

7.5.4.B.b  Inefficiency of treating fruits as proceeds

7.54  If it is true that commercial parties usually bargain for disposition-based proceeds as well as fruits and income, then a legislative provision implementing what is usually bargained for into the general commercial law seems to be a cost-saving measure because the parties no longer need to spend time drafting proceeds clauses but can rely on a legislative provision. This argument rests on an assumption that parties typically bargain for security in widely understood proceeds. If parties do not normally extend security to fruits, it cannot be said that the legislative provision is a cost-saving measure. To the contrary, if parties do not typically want fruits to constitute collateral a legislative provision extending security to them would increase transaction costs because parties would have to incur cost in order to exclude the provision.

7.55  Furthermore, it was suggested earlier95 that extension of security interests to substitutes promotes this efficiency, because it reduces the risk of moral hazard and information asymmetry posed by the possibility of disappearance of the collateral. By contrast, extension of security interests automatically to fruits or income generated from collateral was shown to create a problem of deadweight loss,96 (p. 258) which means that the secured creditor’s encumbrance grows, the debtor’s lending base shrinks, and the debtor acquires no benefit from having her new assets (fruits, income) automatically subjected to security.

7.56  It is sometimes argued that a broad proceeds rule broadens the debtor’s lending base so she may use all her assets, as they come into being, to raise finance. This point about broadening of the lending base was rightly refuted by Warner, who argued that this purpose is fulfilled by broad validation of after-acquired property clauses under §9-201(a)UCC97 and that the expanded proceeds rule in fact does not lead to the achievement of the purpose because it captures ‘extra collateral’ in cases ‘where the parties did not care enough about the item to describe it in the security agreement’.98 Warner also argued that the broad expansion of security to proceeds violates bankruptcy rules (the deference rule) by diverting a wide pool of assets away from unsecured creditors, which is of particular importance in reorganization proceedings. Thus, it seems that not only is a rule extending security interests automatically to fruits inefficient but it also fails to advance the purpose of fair distribution of assets.

7.6  Should English Law Follow Article 9 UCC?

7.57  Bearing in mind that under current English law a secured creditor has no automatic right to proceeds and fruits arising by operation of law, a question arises whether English law should follow the path of Article 9 UCC extending security interests to proceeds widely understood, that is, including fruits and income.

7.58  There is little doubt that efficiency should be promoted by codifying parties’ bargain where possible. The legislator must, however, be very careful in inferring what the parties’ bargain is. It appears from anecdotal evidence that in commercial practice it is not expected that fruits (e.g. income, dividends) will fall within the scope of security.99 If the law imposes such a rule on commercial parties, it may well have the opposite effect to what is intended: instead of improving the efficiency of transactions, commercial parties will spend time and effort when dealing with the unexpected rule imposed by the legislator.

7.59  It seems that an automatic proceeds and products (substitutes) rule should be encouraged, but the rules should not extend to fruits. Even though fruits could (p. 259) be seen as traceable proceeds arising as a result of alienation of a limited interest in the original asset (alienation of use-value of the original collateral), it is important that fruits accrue alongside the existing collateral, not instead of it.100 When a security interest extends to a substitute asset, the creditor in principle obtains what was bargained for: a right to resort to an asset with priority to other creditors. An automatic right to proceeds that arise as a result of the grantor’s exercise of the power to dispose preserves the security interest, which otherwise would likely be defeated. The same may be said for an automatic right to products, which can be seen to be a result of the grantor’s exercise of the power to incorporate into a new product, although in relation to products the creditor may only be able to assert the interest in proportion to the contribution that the incorporated encumbered asset bears to the sum of the contributions. A well-balanced substitutes rule should, on the one hand, be broad enough to capture the necessary new assets in order to preserve the existence of security and, on the other hand, sufficiently narrow so as not to deprive the grantor unnecessarily of a lending base, which the creditor did not bargain for anyway. Except where there are context-specific considerations, extension of security to fruits and income should not be automatic but should be a matter that parties can provide for under an agreement.

7.7  Conclusion

7.60  It seems that introduction of a rule in English law automatically extending security interests to proceeds would likely promote efficiency of security interests and title-based interest. However, for the rule to achieve the economically efficient results, a right created in an initial asset should generally be automatically extended to proceeds and products (in the proportion that the original assets bears to the sum of the contributions) but not to fruits or income. Extending security interests to fruits or income by operation of law would be likely generate economic inefficiency as it is generally likely to make the grantor worse-off whilst providing incommensurately small benefit to the creditor.

7.61  While automatic extension of security interests to proceeds exists in the US under Article 9 UCC, the rule is based on a broad value-based conception of proceeds. It is strongly arguable that the adoption of the value-based approach, departing from the original idea of proceeds founded on disposition, has been motivated in the US by the desire to avoid unfavourable bankruptcy legislation, rather than any wider reasons. English insolvency law does not present the same pitfalls as in the US for those seeking to enforce security interests in after-acquired property (p. 260) once the insolvency proceedings have commenced. Since parties can, in principle, rely on the agreement to create security in future assets, there seems to be no comparable pressure to adopt a wider value-based conception of proceeds. For this reason, a possible future law reform of English law should not follow the example of Article 9 UCC, where security interests extend to proceeds, widely understood and comprising fruits.

7.62  A reform of the default rules regarding proceeds and products would have the advantage of clarifying some of the complexities associated with the law of tracing, and claims based on tracing, thus making it clearer for commercial parties when a proprietary remedy (a proprietary protection) is available, which in turn would promote certainty.


1  For a historical development of statutory framework of the law of security interest in personal property in England see J de Lacy, ‘The Evolution and Regulation of Security Interests over Personal Property in English Law’ in J de Lacy (ed), Personal Property Security Law Reform in the UK: Comparative Perspectives (Routledge-Cavendish 2012) 3–82; P Graham, ‘Registration of Company Charges’ [2014] Journal of Business Law 175, 179–82.

2  Personal Property Security Acts were adopted in the Canadian provinces mainly in the 1990s and early 2000.

3  Personal Property Securities Act 1999.

4  Personal Property Securities Act 2009 (Cth).

5  The functional approach is not without its critics, see eg M Bridge, R Macdonald, R Simmonds, and C Walsh, ‘Formalism, Functionalism and Understanding the Law of Secured Transactions’ (1999) 44 McGill LJ 567.

6  Report of the Committee on Consumer Credit (Cmnd 4596, 1971).

7  Cork Report, Insolvency Law and Practice: Report of the Review Committee (1982, Cmnd 8558). Although it was concerned primarily with insolvency, the report made some proposals for far-reaching changes to security, including expressing broad support for the scheme proposed by the Crowther Committee.

8  Diamond, A Review of Security Interests in Property (1989).

9  Company Security Interests: A Consultative Report (Law Com Consultation Paper No 176, TSO 2004). See also Registration of Security Interests: Company Charges and Property other than Land (Law Com Consultation Paper No 164, TSO 2002). The time pressure did not permit carrying the wider-ranging recommendations into the Law Commission’s final report, Company Security Interests: Final Report (Law Com No 296, TSO 2005).

10  Companies Act 2006, s 894.

11  For full discussion see L Gullifer and M Raczynska, ‘The English Law of Personal Property Security: Under-reformed?’ in L Gullifer and O Akseli, Secured Transactions Law Reform. Principles, Policies and Practice (Hart 2016) ch 12.

14  See Secured Transactions Law Reform Project, Draft Policy Paper 2016, para 3.5, available at https://securedtransactionslawreformproject.org.

15  For discussion of the difficulties and a proposed solution, see Chapter 4.

16  UCC (2010), §§9-102, 9-315, and 9-336.

17  UCC (2010), §9-315(d)(e).

18  Law Commission Draft Regulations 2(1) defining term ‘proceeds’ juncto Draft Regulations 29: Law Commission, Company Security Interests: A Consultative Report (n 9), see also paras 3.182–3.187.

19  See T Honoré, ‘Ownership’ in T Honoré (ed), Making Law Bind. Essays Legal and Philosophical (Clarendon Press 1987) 161, 170 (arguing that power to alienate is one of the rudimentary incidents of the concept of liberal ownership).

20  S Harris and C Mooney, ‘A Property-Based Theory of Security Interests: Taking Debtor’s Choices Seriously’ (1994) 80 Va LR 2021, 2049; S Pejovic, The Economics of Property Rights: Towards a Theory of Comparative Systems (Springer 1990) 45–46 and 48; R Coase, ‘The Problem of Social Cost’ (1960) 3 J L & Econ 1.

22  For criticism of this theory, see A Schwartz, ‘Taking the Analysis of Security Seriously’ (1994) 80 Va LR 2073 (noting the inability of the theory to take into account market efficiency and costs that result from market externalities or asymmetric information).

23  For the order of satisfaction of claims in liquidation, see Re Nortel Companies; Bloom v Pensions Regulator [2013] UKSC 52 [39]–[40] (Lord Neuberger).

24  T Jackson and A Kronman, ‘Secured Financing and Priorities among Creditors’ (1979) 88 Yale LR 1143, 1157.

25  Much of the literature developed in response to the so-called ‘zero-sum game puzzle’ that in a perfect market the benefits derived from secured financing are offset by the cost of higher rates of interest charged by unsecured creditors, so the borrowers are no better off. The puzzle was posed originally by Jackson and Kronman, ‘Secured Financing and Priorities among Creditors’ (n 24). Alternatively, one could ask why unsecured creditors do not offset the debtor’s savings: see B Adler, ‘An Equity-Agency Solution to the Bankruptcy-Priority Puzzle’ (1993) 22 JLS 73, 74; P Shupack, ‘Solving the Puzzle of Secured Transactions’ (1989) 41 Rutgers LR 1067, 1091. The assumption that secured credit is cheaper than unsecured credit was questioned using empirical evidence, by R Mokal, ‘The Search for Someone to Save: A Defensive Case for the Priority of Secured Credit’ (2002) 22 OJLS 687, 710, citing J Franks and O Sussman, ‘The Cycle of Corporate Distress, Rescue and Dissolution: A Study of Small and Medium Size UK Companies’ on behalf of the Working Group on Company Rescue and Business Reconstruction Mechanisms, Institute of Finance and Accounting (London Business School), Working Paper 306-2000; see now also J Franks and O Sussman, ‘Financial Distress and Bank Restructuring of Small to Medium Size UK Companies’ (2005) 9 Review of Finance 65.

26  Cf N Mankiw and M Taylor, Economics (Thomson 2006) 132.

27  This is by analogy to buyer surplus, ibid, 132.

28  This is by analogy to producer surplus, ibid, 136–37.

29  See e.g. D Besanko and A Thakor, ‘Competitive Equilibrium in the Credit Market under Asymmetric Information’ (1987) 42 J Eco Theory 167; R Smith, ‘Money and Credit with Asymmetric Information’ (1994) 3 J Fin Intermediation 213; I Welch, ‘Why Is Bank Debt Senior? A Theory of Asymmetry and Claim Priority Based on Influence Costs’ (1997) 10 Rev Fin Stud 1203.

30  See G Akerlof, ‘The Market for “Lemons”: Quality Uncertainty and the Market Mechanism’ (1970) 84 Quarterly Journal of Economics 488; E Kieninger, ‘Introduction and Context’ in E Kieninger (ed), Security Rights in Movable Property in European Private Law (CUP 2004) 8.

31  H Bester, ‘Screening vs Rationing in Credit Markets with Imperfect Information’ (1985) 57 American Economic Review 850; Y Chan and G Kanatas, ‘Asymmetric Valuation and the Role of Collateral in Loan Agreements’ (1985) 17 Journal of Money, Credit and Banking 84, 85; Besanko and Thakor, ‘Competitive Equilibrium in the Credit Market’ (n 29); H Bester, ‘The Role of Collateral in Credit Markets with Imperfect Information’ (1987) 31 European Economic Review 887.

33  F Oditah, Legal Aspects of Receivables Financing (Sweet & Maxwell 1991) 16.

34  A Boot, A Thakor, and G Udell, ‘Secured Lending and Default Risk: Equilibrium Analysis, Policy Implications and Empirical Results’ (1991) 101 The Economic Journal 458.

35  Other ways include obtaining price protection by trading debts where possible, spreading risks by diversifying; cutting down repayment periods and using covenants in loan contracts: see V Finch, ‘Security, Insolvency and Risk: Who Pays the Price?’ (1999) 62 MLR 633, 642.

36  P Ali, The Law of Secured Finance (OUP 2002) para 2.63; Finch, ‘Security, Insolvency and Risk’ (n 35) 643.

37  Jackson and Kronman, ‘Secured Financing and Priorities among Creditors’ (n 24); J White, ‘Efficiency Justifications for Personal Property Security’ (1984) 37 Vand Law Rev 473; H Kripke, ‘Law and Economics: Measuring the Economic Efficiency of Commercial Law in a Vacuum of Fact’ (1985) 133 Univ of Penn Law Rev 929; Shupack, ‘Solving the Puzzle of Secured Transactions’ (n 25) 1075ff; Boot, Thakor, and Udell, ‘Secured Lending and Default Risk’ (n 34); but see A Schwartz, ‘Security Interests and Bankruptcy Priorities: A Review of the Current Theories’ (1981) 10 LS 1 (rejecting monitoring and signalling explanations of secured credit’s efficiency); A Schwartz, ‘The Continuing Puzzle of Secured Debts’ (1984) 37 Vanderbilt Law Rev 1051, 1066–67; T Jackson and A Schwartz, ‘Vacuum of Fact or Vacuous Theory: A Reply to Professor Kripke’ (1985) 133 U Pa LR 987, 994.

39  There may be exceptions. One is where the creditor has security over shares where the grantor of security has the right to issue shares. An exercise of the right would lead to the value of the creditor’s shareholding being diminished.

40  See J Niinimäki, ‘Does Collateral Fuel Moral Hazard in Banking?’ (2009) 33 Journal of Banking & Finance 514, 515 and literature cited there.

41  L LoPucki, ‘Unsecured Creditor’s Bargain’ (1994) 80 Virginia LR 1887, 1891 and at 1899: ‘security is an agreement between A and B that C take nothing’; supported generally by S Knippenberg, ‘The Unsecured Creditor’s Bargain: An Essay in Reply, Reprisal, or Support?’ (1994) Virginia LR 1967.

42  Mankiw and Taylor, Economics (n 26) 150–51.

43  Ibid, 150–51.

44  Ibid, 151.

45  In correspondence on the issue of proceeds prior to the expansion to value-based concept of proceeds, one author stated ‘[i]t seems to me the “exchange” idea has the benefit of fairness; it allows the secured party to make up what the secured party has lost’ F Miller, ‘Letter to Professor C Mooney’ (1990) Permanent Editorial Board for Uniform Commercil Code, PEB Study Group Uniform Commercial Code Article 9 (Oct 11, 1990), Document Nos 3–5.

46  Under previous UCC §9-306(1): ‘proceeds’ included anything received upon the ‘sale, exchange, collection or other disposition of’ the collateral; under UCC §9-306(2) (1990): ‘Except where this Article otherwise provides, a security interest continues in collateral notwithstanding sale, exchange or other disposition thereof unless the disposition was authorized by the secured party in the security agreement or otherwise, and also continues in any identifiable proceeds including collections received by the debtor.’

47  Prior to the revision collateral did not extend to tort claims: Bank of New York v Margiotta 416 NY S 2d 493 (Sup Ct 1979); but see McConigle v Combs 968 F 2d 810, (9th Cir 1992), cert dismissed 113 S Ct 399 (1992).

48  The passage that follows is based on G Nelson and D Whitman, Nelson and Whitman’s Real Estate Finance Law (4th edn, Practitioner Treatise Series 2001) §1.2, 7, cited in RW Freyermuth, ‘Modernizing Security in Rents: The New Uniform Assignment of Rents Act’ (2006) 71 Missouri LR 1, 6.

49  Freyermuth cites Maryland, New Jersey, Pennsylvania, and Vermont: RW Freyermuth, ‘Modernizing Security in Rents’(n 48) 6.

50  Article 9 UCC does not apply to mortgages over land and individual states have not enacted the relevant legislation dealing away with that requirement.

51  When the process of foreclosure sale is completed the purchaser can collect rents as an incident of its ownership of the land.

52  In the US law see Independence Tube Corp v Levine (In re Tavern Motor Inn Inc) 80 BR 659, 661–62 (Bankr D Vt 1987); R Freyermuth, ‘Of Hotel Revenues, Rents, and Formalism in the Bankruptcy Courts: Implications for Reforming Commercial Real Estate Finance’ (1993) 40 UCLA L Rev 1461, 1481.

54  In the US it seems to be common to treat as licences the relationship between certain categories of occupiers and owners, e.g. marinas, nursing homes, parking garages, golf courses, student dormitories, and hotels, see ibid, 9–10 and cases cited there.

55  Ibid, 10.

56  Ibid, 11, 21.

57  Title 11 of the United States Code (hereinafter referred to as 11 USC) §552(a). These provisions are discussed in more detail at paras 7.34–7.36 below.

58  For problems in the US see R Freyermuth, ‘The Circus Continues—Security Interests in Rents, Congress, the Bankruptcy Courts, and The “Rents Are Subsumed in the Land” Hypothesis’ (1997) 6 J Bankr L & Prac 115; Freyermuth, ‘Of Hotel Revenues, Rents, and Formalism’ (n 52).

59  Commerce Bank v Mountain View Village Inc 5 F 3d 34 (3rd Cir 1993); In re Jason Realty LP 29 F 3d 423 (3rd Cir 1995); Sovereign Bank v Schwab 414 F 3d 450 (3rd Cir 2005); Freyermuth, ‘Modernizing Security in Rents (n 48) 1, 7, and 32–33.

60  11 USC §544(a).

61  Security interests are defined separately in 11 USC §101(51) as a ‘lien created by an agreement’ and applies not only to Article 9 UCC security interest.

62  11 USC §552(b).

63  11 USC §363.

64  In re Value-Added Communications Inc 139 F 3d 543 (5th Cir 1998) (coins inserted in a pay phone); Gen Elec Credit Corp v Cleary Bros Constr Co (In re Cleary Bros Const Co) 9BR 40, 41 (Bankr DS Fla 1980) (holding that rental equipment does not generate proceeds).

65  Weisbart & Co v First National Bank 568 F 2d 391, 395 (5th Cir 1978).

66  Mechanics National Bank v Gaucher 386 NE 2d 1052, 1055 (Mass App Ct 1979).

67  In re Value-Added Communications Inc 139 F 3d 543 (5th Cir 1998).

68  UCC §9-102(a)(64)(B). The former UCC §9-306(1) originally only included collections but not ‘whatever … is distributed on account of’. It was amended in 1994 to include ‘payments or distributions made with respect to investment property’. The revised version of Article 9 does not limit ‘distribution’ to investment property collateral.

69  Under §9-306(1); see Aycock v Texas Commerce Bank NA 127 BR 17 (Bankr South Distr Tex 1991).

70  In re Hastie (1993) 2 F 3d 1042 (10th Cir) 1043–44.

71  Ibid, 1044.

72  11 USC §552(b). Note that the present formulation of that section has slightly changed.

73  In re Hastie (1993) 2 F 3d 1042 (10th Cir) 1045 (references to Black’s Law Dictionary (5th edn West Publishing Co 1979) 1200, omitted here).

74  The present definition is wider, §9-102(a)(64) and encompasses dividends.

75  In re Hastie (1993) 2 F 3d 1042 (10th Cir) 1045.

76  Ibid, 1046.

77  RW Freyermuth, ‘Rethinking Proceeds: The History, Misinterpretation and Revision of UCC Section 9-306’ (1995) 69 Tulane LR 645, 671.

78  Gen Elec Credit Corp v Cleary Bros Constr Co (In re Cleary Bros Const Co) 9BR 40 (Bankr DS Fla 1980) 41.

79  Ibid. See other cases cited in Freyermuth, ‘Rethinking Proceeds’ (n 77) 661, fn 72.

81  Farmers could agree with the government not to plant certain designated crops on a certain percentage of their acreage in return for a payment (in kind or in certificates) for the foregone crop. See In re Schmidt 38 UCC Rep Sev (Callaghan) 589, 590 (Bankr DND 1984).

82  Re Kroehler Cabinet Co 129 BR 191 (Bankr WD Missouri 1991) (stating that the proceeds from a business interruption insurance policy were not insurance proceeds resulting from the destruction of the collateral but were paid as a result of the actual loss of business income, which was not subject to the security interest), reversed sub nom MNC Commercial Corp v Rouse 1992 WL 674733 (WD Mo 1992), cited in Freyermuth, ‘Rethinking Proceeds’ (n 77) 691.

83  Re Schmaling 783 F 2d 680, 684 (7th Cir 1986) (in relation to federal payment-in-kind agricultural subsidy program received by the debtor who had granted security to a bank over all ‘crops grown or growing … together with all property of a similar nature or kind … which may be hereafter acquired’ (at 681)).

84  Freyermuth, ‘Rethinking Proceeds’ (n 77) 683, citing some state court decisions which—unlike the federal court ones—recognized classification of agricultural subsidy as proceeds, e.g. Sweetwater Production Credit Association v O’Briant 764 SW 2d 230, 232 (Supreme Crt of Texas 1988).

85  Argument made in Re Schmaling 783 F 2d 680, 684 (7th Cir 1986).

86  L Smith, The Law of Tracing (OUP 1997) 22.

88  UCC §9-102(a)(64), cf former UCC §9-306(1).

89  S Harris and C Mooney, ‘Revised Article 9 Meets the Bankruptcy Code: Policy and Impact’ (2001) 9 Am Bankr Inst LR 85, 96.

91  Ibid, 59–66, 692–700; Freyermuth, ‘Of Hotel Revenues, Rents, and Formalism’ (n 52) 1524–35.

92  W Hawkland, ‘The Proposed Amendments to Article 9 of the UCC Part II. Proceeds’ (1972) 77 Com LJ 12, 16.

93  A Kaunders, ‘Substitution of Proceeds Theory for UCC § 9-306(5), or, the Expansive Life and Times of a Proceeds Security Interest’ (1994) 80 Va Law Rev 787, 806–07.

94  11 USC §§361(1)–(3), 362(d)(1), 363(e).

95  See earlier, paras 7.19–7.21.

96  See earlier, paras 7.22–7.30.

97  G Warner, ‘The Anti-Bankruptcy Act: Revised Article 9 and Bankruptcy’ (2001) 9 Am Bankr Inst L Rev 3, 51–61.

98  G Warner, ‘Article 9’s Bankrupt Proceeds Rule: Amending Bankruptcy Code Section 552 through the UCC “Proceeds” Definition’ (2011) 46 Gonzaga Law Rev 521, 523.

99  Based on discussions of Working Group A of Secured Transactions Law Reform Project, Meeting 2.

100  See discussion of the conception of fruits in Chapter 3.