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    August
    13
    2009

    Parties cannot contract away all debtor rights in security agreement, court of appeals says

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    Aug. 13, 2009 – Debtors and secured creditors may opt out of many – but not all – of the Uniform Commercial Code provisions when drafting a security agreement. In particular, the creditor’s obligations and the defaulting debtor’s rights in collateral are preserved.

    Parties cannot contract away all debtor rights in security agreement, court of appeals says

    By Alex De Grand, Legal Writer, State Bar of Wisconsin

    Aug. 13, 2009 – Parties may not completely opt out of the Uniform Commercial Code when drafting contract terms in a security agreement, specifically those that protect a debtor in default, the Wisconsin Court of Appeals held on Aug. 5 in Kraenzler v. Brace, 2008AP1709.

    The U.C.C. provides the basic framework for commercial transactions for businesses and individuals. Under Wis. Stat. § 401.102 (3), parties may opt out of many standard provisions, but that provision also allows for “an exception to the exception” shielding certain rights from waiver.

    A business loan

    Robert Brace loaned $14,103.78 to Werner Kraenzler for production of parts for 1932 Ford roadsters. The parties’ security agreement directed Kraenzler to pay Brace $2,000, deliver three sets of frame rails and boxing plates, and repay the principal. The stamping dies Kraenzler used to create the frame rails and boxing plates were the designated collateral to secure payment.

    If Kraenzler made every payment on time over a six-month period, he would pay Brace $4,460 in interest, amounting to nearly a 32 percent interest rate, the court noted.

    Kraenzler failed to make any of the monthly payments, incurring late penalties of $17,220. The court observed that this drove up the repayment total to $35,783.78. “These additional penalties resulted in Kraenzler having to pay almost 250 percent interest on the $14,103.78 six-month loan,” the court remarked.

    After the parties negotiated an extension of the deadline for repayment, Kraenzler paid Brace $2,000 and delivered three sets of frame rails and boxing plates. Kraenzler made no further payments and Brace sent a notice of default that went unanswered. Brace located the stamping dies and sold them to a third party for an undisclosed sum.

    Kraenzler sued Brace for violating his right as a debtor in default to require a commercially reasonable sale of collateral and the other rights provided by § 409.602. Brace counterclaimed for breach of contract and requested damages totaling $33,783.76.

    On Kraenzler’s motion for summary judgment, the circuit court ruled for Brace, holding that the provisions of Wis. Stat. ch. 409 could be varied by agreement so that Kraenzler and Brace’s contract was valid.

    ‘An exception to the exception’

    In an opinion authored by Chief Judge Richard Brown, the court dissected § 401.102 (3), which both parties cited.

    The first portion of the statute states that parties can opt out of all U.C.C. provisions by varying the terms in the contract, the court noted. But that language is immediately followed by the qualification “except as otherwise provided in chs. 401 to 411,” the court found.

    “Based on Kraenzler’s reading of § 401.102 (3), the unwaivable rights listed in Wis. Stat. § 409.602 are an exception to the exception that prohibits parties from waiving certain rights in a contract,” the court said. Section 409.602 details the creditor’s duties to the defaulting debtor, including the treatment of collateral.

    The court rejected Brace’s argument that the two clauses render § 401.102 (3) ambiguous. “Just because Brace refuses to fully read the statute and address the second clause does not mean the statute has more than one interpretation,” the court said.

    “Wisconsin Stat. § 401.102 (3) is silent as to which U.C.C. provisions qualify as exceptions to the exceptions,” the court continued. Accordingly, the court studied § 409.602, which instructs that “the debtor or obligor may not waive or vary the rules stated in the following listed sections.”

    “Once again, we are faced with an unambiguous rule,” the court concluded. “Section 409.602 is clearly an exception to the exception, and provides that Kraenzler cannot waive the rights listed within the statute.”

    The court listed these preserved rights as including:

    • require that the secured party may use the collateral only in the manner and extent agreed to by the debtor
    • request an accounting from the secured party regarding the collateral and any surplus from the sale of the collateral
    • require that the secured party proceed in a commercially reasonable manner when enforcing the obligation against the debtor
    • application of the proceeds from the collateral to the debtor’s obligation under the loan
    • receive timely notice upon disposition of the collateral by the secured party
    • a calculation and explanation of the surplus or deficiency on disposition of the collateral
    • redeem the collateral
    • remedies under Wis. Stat. §§ 409.625 and 409.626 when the secured party fails to comply with ch. 409, subsec. (13)

    “While the rights listed above can never be waived, the debtor is entitled to waive select rights, but only after the default occurs,” the court said. “This includes the right to consent to the acceptance of the collateral, in full, after default.”

    Precedent

    The court cited National Operating L.P. v. Mutual Life Ins. Co. of N.Y., 2001 WI 87, in which the creditor’s rights to enforce security agreement terms were limited by ch. 409. “Therefore, the debtor could not waive or vary his or her right to surplus equity on disposition of the collateral, or to contest the commercial reasonableness of the sale,” the court reported.

    “Lastly, the court [in National Operating] held that the debtor could waive his or her right to redeem the collateral, but only in writing, after default,” the court added.