CSG Law Alert: New York Advances Secured Creditors' Rights to Recover Directly Against Account Debtors
Competing rights, obligations, and substantial dollars are often at stake when a company pledges receivables as collateral to secure a loan. The lender has a security interest in and lien on the receivables. This is memorialized by a security agreement between the lender and the company borrower. Under separate contracts, the company borrower has a right to receive payment from its account debtors. Account debtors are third parties, such as customers and clients, that contractually owe money (receivables) to a company borrower in the ordinary course of business. Finally, the account debtor has a right to discharge its obligation upon making payment of the amount due and owing. When receivables collateralize asset-based loans, Article 9 of the Uniform Commercial Code (“UCC”) governs the competing rights and obligations among the tripartite of lender, borrower, and account debtor. Like any statute, however, UCC Article 9 is subject to interpretation.
In a recent case from November 2022, the Court of Appeals of New York, the state’s highest court, considered the following questions: Is a security interest in a borrower’s existing and future receivables equivalent to a valid assignment conferring to a secured lender the right to recover directly from the account debtor bypassing the borrower? If so, does the account debtor discharge its obligation by paying the lender instead of the borrower? Should the account debtor pay the lender instead of the borrower even when the borrower disputes the alleged default that triggers the payment redirection?
The answer to each of these questions is yes, according to the Court of Appeals decision on November 22, 2022, in the case of Worthy Lending LLC v. New Style Contractors, Inc., No. 653406/2020, 2022 WL 17095585, 2022 N.Y. Slip Op. 06631 (N.Y. Nov. 22, 2022). According to the Worthy Lending case, a security interest is equivalent to an assignment for purposes of UCC sections 9-607 and 9-406. Because of this identity, a secured lender may obtain the value of receivables by directing account debtors to pay the secured lender, and discharge the obligation, rather than pay the borrower.
This client alert summarizes the factual background of the Worthy Lending case including the problematic decisions by the lower courts in favor of the account debtor (“New Style”). Next, this client alert discusses the correct decision by the Court of Appeals to reverse the lower courts and rule in favor of the secured lender (“Worthy”). Finally, this client alert examines the significant implications and key takeaways of the Court of Appeals decision. Lenders, borrowers, and account debtors should know this case when assessing competing payment rights and obligations on receivables. This is true even if New York law does not govern the security agreement at issue in a particular case. The Worthy Lending decision is consistent with UCC commentary that a majority of jurisdictions follow. In most cases, therefore, the Worthy Lending decision is either precedential or highly persuasive in determining the extent and enforceability of security interests in and liens on receivables.
I. The Factual Background
New Style engaged a company called Checkmate Communications LLC (“Checkmate”) as a subcontractor on two public construction projects in New York City. New Style, as an account debtor, owed $1.4 million to Checkmate based on receivables arising from invoices that Checkmate issued to New Style. Separately, Worthy made various loans to Checkmate of up to $3 million evidenced by a promissory note and security agreement among other loan documents. In exchange Checkmate granted Worthy a security interest in and lien upon existing and future assets of Checkmate, including receivables due from New Style. Worthy filed a UCC-1 financing statement to perfect its secured position in Checkmate’s accounts receivable and other assets.
At the time of Worthy’s loans to Checkmate, and before Checkmate defaulted on the loans, Worthy notified New Style in writing of the security interest and collateral assignment that Worthy acquired in the accounts that Checkmate had with New Style under separate contracts. Worthy’s notice directed New Style that “[a]ll remittances for Accounts shall be made payable only to Worthy.” Shortly thereafter, Checkmate defaulted on Worthy’s loans. Worthy accelerated the over $3 million debt. Checkmate subsequently filed for bankruptcy and never paid Worthy. New Style never paid Worthy either. Instead, New Style continued to pay Checkmate after receiving Worthy’s payment redirection notice.
II. The Problematic Decisions By The Lower Courts In Favor Of The Account Debtor New Style
Worthy sued New Style in New York state court under UCC section 9-607(a). Worthy sought to recover all amounts New Style owed to Checkmate after New Style’s receipt of Worthy’s payment redirection notice. New Style moved to dismiss Worthy’s complaint. The trial court granted New Style’s motion to dismiss. The intermediate appellate court unanimously affirmed. Both lower courts found that the security agreement between Worthy and Checkmate only granted Worthy a security interest but did not confer an actual assignment of all of Checkmate’s accounts. According to the reasoning of the lower courts, a secured party with a security interest in a borrower’s accounts is not the same as an assignee. The lower courts decided that Worthy could not sustain a cause of action against New Style under UCC sections 9-607 or 9-406 because: (i) New Style and Worthy had no contractual duty or other relationship to one another; (ii) Worthy was not an assignee of Checkmate and, therefore, Worthy could not impose upon New Style a separate obligation to repay Worthy the same amount New Style already paid to Checkmate; and, (iii) Checkmate’s claimed dispute of the alleged default barred Worthy from bringing an action against New Style.
III. The Court Of Appeals Reverses The Lower Courts By Correctly Deciding In Favor Of The Secured Creditor Worthy Lending
In reversing the decisions of the lower courts, the Court of Appeals decided that an “assignee”, under UCC section 9-406, includes a secured lender (Worthy) as the holder of a presently exercisable security interest in a borrower’s (Checkmate’s) receivables from an account debtor (New Style). The Court of Appeals interpreted the language of UCC Article 9 as treating assignments and security interests identically. As a result, a secured lender may enforce its security interest under UCC section 9-607 by notifying a borrower’s account debtors to redirect payments on receivables to the lender rather than to the borrower. The Court of Appeals further explained that a secured lender may provide a payment redirection notification to an account debtor before the occurrence of a borrower’s default (if the security agreement so provides) or after a borrower’s default, and notwithstanding a borrower’s claimed dispute about the existence or validity of an alleged default triggering the lender’s recovery efforts. Nothing in the statutory language of UCC sections 9-607 or 9-406 prohibits such actions by a lender. After an account debtor receives a payment redirection notification from a secured lender, an account debtor cannot discharge its obligations by paying the borrower instead of the secured lender. If an account debtor continues to pay the borrower after receiving such notice, then the burden and risk of loss of double payment falls on the account debtor. That is the statutory consequence of an account debtor failing to pay a secured creditor after receiving the required notice under UCC sections 9-607 or 9-406.
IV. The Key Takeaways
There are several important takeaways from the Worthy Lending decision. First, as mentioned above, the decision is consistent with UCC commentary that a majority of jurisdictions follow when interpreting and applying UCC sections 9-607 and 9-406. Second, the decision maintains predictability and promotes efficiency as among secured lenders, borrowers, and account debtors when receivables collateralize a loan. Treating assignments as identical to security interests reduces costs and mitigates risks because parties do not have to parse contractual language to try to determine whether the interest is an assignment or a security interest under UCC Article 9. Instead, consistent with UCC commentary, the term “assignment” refers to both an outright transfer of ownership and a transfer of an interest to secure an obligation. Consequently, payment rights and obligations on receivables are made clearer when there is no distinction between a security interest and assignment. Third, while a borrower may dispute whether a default exists, such dispute does not nullify sections 9-607 and 9-406. Otherwise, these provisions would be rendered meaningless by removing the secured creditor’s ability to obtain value of the security whenever the borrower claims that a dispute exists.
If you are a lender, borrower, or account debtor with concerns about your payment rights and obligations on receivables, please contact your CSG Law attorney or the author listed below.
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