PPSAthe price of certainty

Bob Dugan

Introduction. The Personal Property Security Act l999 [PPSA], enacted under urgency in the last session of Parliament, is the latest progency of Article 9 of the Uniform Commercial Code [UCC]. The PPSA will, we are told, drain the notorious quagmire of New Zealand’s chattel security law. However, Article 9 has been recently described as a dung heap [79 UMinnLRev 739] by Professor James White, one of the most respected authorities on the UCC. This article, which elaborates on the author’s contribution to the 1999 Spring Lecture Series at Victorial University, cautions the New Zealand business community not to expect too much from the PPSA. Most of the observations reflect experience and learning from the USA. See Symposium 79 UminnLRev (l995).

The key elements. The PPSA replaces the currently fragmented law of chattel security with a unitary regime having three principal features. First, the scope of the new regime is set by a broad definition of security interest which catches traditional security devices such as floating charges and Romalpa clauses as well as true leases, consignments and sales of intangibles. Secondly, the Act provides for registration of security interests. Thirdly, it contains an extensive set of priority rules, many of which are keyed to the registration requirement. As the principal rule, s 66(b) provides that, as between competing security interests, the one first registered one has priority.

Age. Two threshold caveats concern the age and rationale of the statute. While generally described as modern approach to chattel security, the PPSA embraces a regime which is, by now, a half century old. Article 9, part of the much larger UCC project, was finalised in l950, first enacted by Pennsylvania in 1953 and in all states except Louisiana by 1968. The Canadian personal property security statutes, the first of which was enacted by Ontario in l967, are largely copies of Article 9. The draft statute proposed by the Law Commission in l989 [Report no 8] closely followed the l988 British Columbia bill and the PPSA adheres to the 1993 Saskatchewan statute. The Saskatchewan statute like those in the other provinces adopts the same general features and most priority rules of the Article 9 model act. Accordingly, the PPSA is the product of an age without fax machines, photocopiers, computers, the Internet, credit cards and certificateless securities, derivatives and securitisation. It is contemporaneous with the Companies Act l955 and in vintage closer to the Chattel Transfer Act l921 than to the Companies Act l993 or FASTER.

Rationale. As for its rationale, Article 9 was the response to three problems facing the post-war banking system in the USA: a multiplicity of registration statutes, the lack of a reliable floating security and the increasingly interstate operation of borrowers and lenders. None of these factors exist in New Zealand. The floating charge has been well established here for almost a century. In relation to chattel security, registration is limited primarily to company charges and motor vehicles. While interstate transactions are not an issue in New Zealand, the enactment of the PPSA surely contravenes the spirit of CER, particularly in view of the cool reception of Article 9 in Australia. In any event, as illustrated most recently by the Companies Act l993, there are obvious dangers in adopting old overseas legislation designed for problems not present in the current domestic market.

Registration as the central feature. As a matter of both law and practice, registration is the central feature of the PPSA. As a legal matter, registration serves as the linchpin for the priority regime. As a practical matter, registration is the massively intrusive feature of legislation. It is probably safe to predict, in view of the predilection for debt and security, that most adults and personal property in New Zealand will become the subject of one or more registrations under the PPSA.

Direct costs. The PPSA was recommended to Parliament as a measure that would reduce the cost of lending. However, this is not intuitively obvious. For most transactions, the PPSA will, as compared with existing law, require as an additional step the filing of a financing statement. Afterwards, financing change statements must filed for renewals, amendments and discharge. Due to the role of registration in the PPSA priority regime, lenders will not advance credit, secured or unsecured, without first searching the PPSA register. Thus, a personal property security transaction will entail multiple trips to the register. In the USA, filing and search fees vary from one state to the next and range from $5 to $25 Even if the fees are set at the lower end of the range, the hundreds of thousands of transactions within the scope of the PPSA will add millions of dollars to the cost of lending. In the USA, it was estimated in 1995 that that Article 9 filing generated annual revenues of nearly one billion dollars. 79 UMinnLRev 725. Where the registration system is under the control of a single private or public sector provider, the opportunity for monopoly profits is obvious.

Indirect costs. The registration requirement also entails three kinds of secondary costs which will likely exceed the direct ones. First, as registration is web based, access to the register will often be through third party providers who will charge for their services. Secondly, the registration requirement will likely add to the costs of credit investigations as the information on the register must be processed in the due diligence exercise. Thirdly, registration will attract significant legal costs. Financing statements are legal documents affecting the rights of the parties to existing and proposed transactions. Accordingly, the statements will frequently be drafted and reviewed by lawyers. In the due diligence exercise, legal advice will be required to assess the validity and scope of outstanding securities. Undertakings will be requested, provided and billed at the usual rates. In the USA, the legal costs associated with the registration requirements under Article 9 are reported to comprise 5% to 10% of the total transaction costs incurred in eight figure loan transactions [79 UMinnLRev 691]. It is important to remember that these are just the costs associated with the registration requirement. There will be a very significant one-off expense for the review and revision of existing lending and security documentation for use under the PPSA.

Benefits. It is elementary that legislation should not be enacted unless its benefits are demonstrably greater that its costs. There is little evidence of cost/benefit analysis in the decade of local discussion preceding adoption of the PPSA. This contrasts sharply with the intense cost/benefit debate surrounding the takeovers statute and draft takeovers code. The PPSA will palpably benefit those persons who provide services associated with the registration requirement. However, these benefits are the mirror image of the transaction costs identifed above and do not count in a cost/benefit analysis. Also certain is that the PPSA will favour some lenders over others. Inventory suppliers who presently rely on Romalpa clauses will find it more difficult to obtain security under the PPSA due to the signature and registration requirements. On the other hand, parties who rely on floating security will prosper from the first-to-file rule as well as the provisions for instant crystallisation and future advances. However, these effects are also in the nature of wealth transfers and not relevant in a cost/benefit analysis.

Increased certainty. The cost effectiveness of the PPSA turns, almost entirely, on its ability to deliver an increased level of certainty and transparency which, by reducing the risks facing lenders, will lower the cost of credit. The increased certainty and transparency presumably follow as a consequence of the registration-based priority system which validates security interests by means of a public event. The PPSA will be cost effective if the savings resulting from increased certainty exceed the costs of registration and if a comparable degree of certainty cannot be obtained by a less expensive measure. Even without regard to the substance of the PPSA, there is good reason to doubt whether either of these conditions for efficiency are satisfied. On the one hand, the expensive PPSA registration system embraces information which is, for the large part, already available in financial statements, in company records and at credit reporting agencies. On the other hand, secured financing is flourishing in jurisdictions which have rejected the Article 9 model in favour of registrationless regimes for personal property security.

Priority and registration. The case for cost effectiveness also suffers from the tenuous relationship between priority and registration under the PPSA. In contrast to registration under the Land Transfer Act l952, registration under the PPSA does not establish indefeasibility of title. It is neither a necessary nor sufficient condition for priority. Registration provides no or only limited protection against upstream defects in a debtor’s ownership rights, subsequent transfers to buyers or purchase money lenders, removal of the collateral from the jurisidiction, a change in name, or liens outside the act such as those in favour of bankers. The advance notice function of registration is perverted by the appearance of registration as a requirement in the super priority afforded to subsequent purchase money security interests. The limited and inconsistent role of registration in the priority regime qualifies the anticipated increase in certainty on the one hand and signficantly complicates the due diligence exercise on the other.

Alternative measures. Even if registration drove the priority rules toward net certainty, this would not establish its cost efficiency. The issue is whether a comparable degree of certainty can be attained by other less expensive measures. In this regard, the recently concluded revision of Article 9 clearly reflects the experience that registration is not a cost-effective priority referent in relation financial assets such as deposit accounts, certificateless securities and trading account balances. For such financial assets, which play an ever increasing role in financing transactions, the recent amendments to Article 9 establish control as a alternative and higher ranking form of perfection. It does not appear that these developments were considered by the drafters of the PPSA. Nor does it appear that serious consideration was given to the extent and operation of registrationless priority regimes.

Priority without registration. The priority regime in the PPSA can be largely duplicated without recourse to registration. Such a regime would comprise a first-in-time rule coupled with exceptions for buyers in ordinary course, purchase money security and intra-consumer sales except for motor vehicles. The special case of motor vehicles would be dealt with by an amendment to the present system for motor vehicle registration. The amendment would convert the registration document into a certificate of title with space for notation of liens. The result would replicate registrationless systems found in Germany and the Netherlands and, to a lesser extent, in the UK. As compared to the PPSA, this first-in-time regime would produce different results in relation to some secured parties, buyers not in ordinary course and execution creditors. However, on examination, the differences are either commercially trivial or warranted as a matter of policy.

Secured parties. As between competing security interests, s 66(b) of the PPSA awards priority to the first-registered interest. This rule expedites credit transactions in that it enables a prospective creditor to determine the priority of a proposed security by examining the register. Under a first-in time-rule, the creditor runs the risk that the proposed security will be trumped by earlier created one. However, the risk is a remote one. It will be realised only in the unlikely event that the debtor conceals the earlier encumbrance and the earlier transaction left no trace in the records of debtor or the credit reporting agencies. Debtor dishonesty is strongly deterred by civil and criminal sanctions. Today, credit transactions not coming to attention of credit agencies are largely confined to those with insiders, eg personal associates of the debtor, which are often vulnerable to challenge in the case of insolvency. The residual risk associated with concealed earlier securities can be further reduced by well-established lending practices. It is the author’s intuition that the expected losses associated with the residual risk, representing the possible gain from the certainty provided by a first-to-register regime, will fall far short of the costs of registration. In any event, the matter should not and need not be left to intuition. The incidence of debtor dishonesty, the content of credit reports, the available countermeasures and the costs of registration system are all known or potentially knowable facts.

Buyers not in ordinary course. The first-in-time regime would also relegate certain buyers not in ordinary course to a lower priority than they enjoy under the PPSA. The most significant group comprise purchasers of collateralised equipment from the debtor. Under s 52 of the PPSA, such a purchaser takes subject to the security interest only if it is perfected. This registration-based priority rule obviously expedites the purchase transaction in much the same manner as s 66(b) expedites credit transactions. Under a first in time rule, the purchaser faces the risk of being surpassed by an outstanding security interest. However, the risk is minimal and entirely manageable. Collateral will be held as equipment only by a business debtor. Purchasers will be generally be other merchants who can be expected to make the inquiries required to uncover evidence of the outstanding security, generally in the records held by the credit reporting agency. Further, a person unwilling to wear the residual risk has the option of acquiring such property a buyer in ordinary course from a dealer in used goods. While this requires removal of the given by the seller limitation in s 53, the absence of such a limitation in s 54 and s 58 indicates the limitation is dispensible. The secured party remains protected by recourse against the used goods dealer and any intermediary.

Execution creditors. As compared to the PPSA, the registrationless regime will also disadvantage some execution creditors. Section 103 provides an execution creditor priority over an unperfected security interest. In a first-in-time regime, the creditor will be subordinate to any earlier security interest. Ignoring the windfall potential of the rule, the most defensible rationale for s 103 focuses on the judgement creditor who relies on ostensible ownership in undertaking execution process only to discover at the last minute that the property is subject to a security interest. However, in most all cases, under a first-in-time regime, the judgement creditor will, before proceeding with execution, discover the existence of outstanding securities either through post-judgement discovery or from a credit report. As in the case of competing secured parties and buyers not in ordinary course, there remains a residual risk of reliance losses. However, given the availability of information, the expected extent of those losses falls again far short of the sums required to finance operation of the registration system.

Black letter law. There is also a perception in some quarters that increased certainty will result from the substitution of black letter priority rules for a century of common law. However, on casual inspection, the amount of chattel security litigation in New Zealand seems, if anything, less than that in the USA and Canada. Further, the claim can be easily verified by test driving the facts of a few leading cases through the rules of the PPSA. The result are pretty much what one might expect. When the PPSA takes effect, it will unsettle well-established priority configurations, fail to resolve unsettled ones and give rise to new priority questions.

Helby v Matthews [1895] A.C 471. This case established the priority between a vendor under a hire purchase contract and a subsequent purchaser of the collateral from the debtor. The outcome turns on whether the contract requires the purchaser to pay for the goods or merely gives them an option. Whilst one can argue with the approach as a matter of policy, the result comprises a clear and workable rule, a fact of paramount importance to the commercial community. Under the PPSA, the outcome is anything but certain. It turns whether an agreement along the lines of that in Helby creates a security interest; whether a pawnbroker qualifies as buyer or secured party; if the pawn is structured as secured transaction, whether the pawnbroker can invoke the rule in s 73; if the pawnbroker on-sells the goods, whether s 66 applies only to intra-consumer sales; and, if the vendor has not perfected its security interest, on resolution of the tensions between s 52 of the PPSA and s 27(2) of the Sale of Goods Act l908. The outcome will remain uncertain until these issues are resolved by litigation and/or amendments to the statute.

Len Vidgen [1986] 1 NZLR 349. This dispute between a Romalpa supplier and debenture holder focused on the recurrent issue whether an extended Romalpa clause constitutes a charge. Whilst s 74 of PPSA affords the title retention supplier priority over the earlier-registered floating security, it does not put to rest the underlying issue in Len Vidgen. Under the PPSA, the issue becomes how far can a title retention clause be extended without ceasing to qualify as purchase money security interest. In Southtrust Bank v Borg-Warner Acceptance Corp, 760 F. 2d 1240 (11th Cir l985), the Court held that an extended title retention clause did not qualify as a purchase money security interest as defined by a provision similar to that in the PPSA. It is certain that a receiver will, rather sooner than later, bring a similar challenge before the Court in New Zealand. The PPSA does not adopt the revisions to Article 9 which attempt to clarify the law in this area.

New Bullas [2000] 1 NZLR 223.. This case portends another type of uncertainty which is sure to eventuate once the PPSA takes effect. The PPSA largely obviates the distinction between fixed and floating charges which is at issue in the litigation. However, the PPSA also reverses current law in that ss 73 to 75 include proceeds generally in the super priority afforded the title retention creditor. This is a significant deviation from model version of Article 9 which limits the priority to cash proceeds. This local deviation will, of course, come as a surprise to those engaged in factoring book debts. After a careful perusal of the relevant provisions of the PPSA, advisors of factors and debenture holders will identify a number of possible strategies to circumvent the extension of the purchase money priority to book debts. These strategies will be the fodder for years of litigation in an area which would otherwise be settled by the forthcoming decision by the Privy Council.

Conclusion. On the whole, there is little reason to believe that the PPSA will lower the cost of credit. The registration requirement, as applied to hundreds of thousands of secured transactions, will increase out of pocket costs of lenders and borrowers by millions of dollars annually. As the PPSA does not significantly increase the amount of relevant credit information, it seems highly unlikely that the statute will make lending relationships more transparent. If North American experience is any guide, the PPSA will create a new quagmire for the next generation of lawyers. Instead of looking for solutions suited to current reporting practices and emerging forms of personal property, the New Zealand lawmaker has opted again for an overseas relic.