VT Industrial Development Auth. v. Setze

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                                 No. 89-28

Vermont Industrial Development Authority     Supreme Court

     v.                                      On Appeal from
                                             Washington Superior Court

Paul C. Setze, Patricia J. Setze,
Gordon D. Oxx, Jr., and Carol P. Oxx         March Term, 1991

James Morse, J.

Nancy J. Creswell and Emily B. Tartter of Paterson & Walke, P.C.,
  Montpelier, for plaintiff-appellee

Robert A. Gensburg of Gensburg Axelrod & Adler, St. Johnsbury, for
  defendants-appellants Setze

Michael J. Hertz of Hertz and Wesley, Brattleboro, for defendants-
  appellants Oxx

PRESENT:  Allen, C.J., Gibson, Dooley and Johnson, JJ., and Peck, J. (Ret.),
          Specially Assigned

     JOHNSON, J.    Defendants Paul and Patricia Setze appeal from a ruling
on a motion for summary judgment, holding them liable to the plaintiff,
Vermont Industrial Development Authority (VIDA), for the plaintiff's losses
on a contract insuring a commercial loan.  Defendants Gordon Oxx and Carol
Oxx settled with VIDA prior to argument and are no longer parties to this
appeal.  We affirm the trial court judgment with respect to the remaining
     The underlying facts are not in dispute.  In 1984, defendants created
Precision Technologies, Inc., (PTI) for the purpose of manufacturing and
selling ultra-precision surgical tools.  The venture was financed in part by
a loan from First Vermont Bank and Trust Company (Bank), which was secured
by an interest in PTI's machinery and equipment.  As an inducement to the
Bank to finance PTI's venture, VIDA agreed to insure the loan.  The
insurance agreement provided that, in the event of default by PTI, the Bank
would pursue its remedies under the security agreement, after first
obtaining written consent from VIDA, and apply any proceeds to the principal
outstanding on the loan.  VIDA would then indemnify the Bank for seventy-one
percent of the remaining principal.  Defendants, in a separate document,
entered into a Guaranty and Indemnity Agreement with VIDA, personally
agreeing to indemnify VIDA for any sums it paid to the Bank under the
insurance agreement, plus any expenses of collection, and to waive all
     PTI defaulted on the loan, and the Bank took control of the collateral
and sold it.  The collateral was valued at $543,590.  Initially, the Bank
notified interested parties that it would sell the collateral as a package
on a bid basis, setting the minimum bid at $550,000.  It sold the equipment
for $325,000 to a single bidder, VIDA's approval.  The sum was applied to
the principal due on the loan, and VIDA paid the Bank seventy-one percent of
the remaining principal.  VIDA then sued defendants on their guaranty,
seeking reimbursement for the sum paid to the Bank.
     On VIDA's motion for summary judgment the trial court held that the
Guaranty and Indemnity Agreement was an enforceable contract and that
defendants set forth no legally valid defenses to liability.  This appeal
     Defendants contend that the trial court erred in rejecting their
defenses, which were grounded on Article 9 of the Uniform Commercial Code.
They rely on two theories in an attempt to circumvent liability.  They argue
that in the overall financing scheme, VIDA was the real secured party and
that they are, therefore, the guarantors of a secured loan entitled to
certain protection under Article 9 of the Code.  Under Article 9, a secured
party must notify a guarantor of a secured loan of a sale of the collateral,
and the right to notice cannot be waived.  United States v. Lang, 621 F. Supp. 1182, 1184 (D. Vt. 1985); Vermont National Bank v. Hamilton, 149 Vt.
477, 484, 546 A.2d 1349, l353 (1988).  A secured party cannot recover any
deficiency from a guarantor in the absence of notice.  Vermont National
Bank, 149 Vt. at 481-82, 546 A.2d  at 1352.  Moreover, a secured party
seeking a deficiency from a guarantor must plead and prove a commercially
reasonable sale of the collateral.  Chittenden Trust Co. v. Maryanski, 138
Vt. 240, 246, 415 A.2d 206, 210 (1980).  VIDA, which takes the position that
it is not a secured party, did not notify defendants of the sale of the
collateral nor did it plead and prove a commercially reasonable sale.
     Defendants also contend that the Bank's sale of the collateral was
commercially unreasonable.  Therefore, they argue that VIDA was not legally
liable to the Bank under its insurance agreement, and they, as sureties of
the insurance agreement, are not liable to VIDA.
     On appeal from a grant of summary judgment, the moving party at trial
"must satisfy a two-part test.  It must establish that no genuine issue of
material fact exists, and that the motion rests on a valid legal theory that
entitles it to judgment as a matter of law."  Kelley v. Town of Barnard, ___
Vt. ___, ___, 583 A.2d 614, 616 (1990).  The facts relevant to this appeal
are undisputed; thus, our inquiry is limited to analysis of the legal
theories underlying the grant of summary judgment. (FN1)
     The first issue is whether Article 9 of the U.C.C. applies to the Loan
and Guaranty Agreement between defendants and VIDA.  Article 9 applies to
"any transaction (regardless of its form) which is intended to create a
security interest in personal property or fixtures . . . ."  9A V.S.A. { 9-
102(1).  Under Article 1-201(37), a "security interest" is an "interest in
personal property or fixtures which secures payment or performance of an
obligation."  A secured party is "a lender, seller, or other person in whose
favor there is a security interest . . . ."  9A V.S.A. { 9-105(1)(i).  The
principal test for determining whether a transaction is covered by Article 9
is whether the transaction is intended to have effect as security.  9A
V.S.A. { 9-102, Uniform Laws Comments at 605.  Security interests under
Article 9 are consensual, and do not ordinarily arise by operation of law.
Cf. In re Bollinger Corp., 614 F.2d 924, 928 (3d Cir. 1980) (under Article
9, parties must intend to create a security interest in the collateral).
     To create a valid and enforceable security interest under Article 9,
there must be, at a minimum, a written security agreement that describes the
collateral and is signed by the debtor.  9A V.S.A. { 9-203.  Section 9-203
operates in the manner of a statute of frauds.  Its function is to minimize
disputes about the existence of an agreement.  J. White and R. Summers,
Uniform Commercial Code, Ch. 22, at 967-68 (1988).  Notwithstanding com-
pliance with { 9-203, a security interest will not attach, or actually come
into being, until the secured party gives value and the debtor acquires
rights in the collateral.  9A V.S.A. { 9-204. (FN2)
     There is a narrow exception to the rules outlined above, which is found
in 9A V.S.A. { 9-504(5).  Under that section, unsecured creditors with
rights in collateral may acquire the rights and obligations of secured
creditors if, in effect, they displace the secured creditor by receiving a
transfer of collateral or becoming subrogated to the secured party.
9A.V.S.A. { 9-504(5).
     The issue, then, is whether this transaction evidences an intent to
create a security interest in VIDA, or in the alternative, comes within the
scope of { 9-504(5).  The only express security interest in the various
documents that comprise the transaction is the Bank's security interest in
PTI's machinery and equipment.  Further, it was the Bank, not VIDA, which
gave value to the debtor, PTI, in exchange for the security interest.  Thus,
there was no agreement, no description of the collateral, and no value
given by VIDA to the debtors in exchange for a secured interest.  In short,
there was no compliance with any of the basic requirements necessary to
create a valid and enforceable security interest in the Guaranty and
Indemnity Agreement between defendants and VIDA.  {{ 9-203 and 204.
     Defendants urge us to consider the transaction as a whole, arguing that
VIDA should be considered the "true" secured party because it had the right,
pursuant to its insurance policy with the Bank, to control and approve the
disposition of the collateral, and because it directly benefited from its
sale.  Defendants' argument would require us to overlook all Article 9 docu-
mentation requirements and to look beyond the specific document creating the
obligation on which VIDA brought suit.  The hurdles that confront such an
approach are insurmountable.
     The right to control the collateral and to benefit from the proceeds of
its sale are not sufficient, in and of themselves, to create an Article 9
security interest.  {{ 9-203 and 204.  It is true that courts will sometimes
supply a missing element of { 9-203, such as a description of the collat-
eral, or a security agreement clause in a note or other evidence of indebt-
edness, if it is clear from evidence in addition to the documents that the
parties intended the transaction to be secured.  See In re Numeric Corp.,
485 F.2d 1328, 1331 (1st Cir. 1973) (combination of a financing statement
and a corporate director's resolution were sufficient to form a security
agreement).  But defendants have cited no cases in which courts have been
willing to overlook all of the documentation requirements of Article 9, and
to find an intent to create a security interest where those requirements are
wholly unsatisfied.  The cases cited by defendants are either factually
distinguishable, deal with matters not here at issue, or stand for
propositions that do not resolve this case.
     Moreover, this is not a case in which the documents raise any ambiguity
as to the nature and terms of the transaction.  The record contains at least
three documents pertinent to the transaction.  The preamble to the personal
guaranty agreement specifically recognizes that, without mortgage insurance
issued by VIDA and defendants' personal guaranty to VIDA, there would have
been no bank financing for defendants' business venture. (FN3) The personal
guaranty, with a waiver of all defenses, was the quid pro quo for the trans-
action.  Given these express provisions in the agreement before us, VIDA's
rights in the collateral that derive from its insurance policy with the Bank
provide little support for the notion that the defendants' personal guaranty
to VIDA was intended to be secured.  Coupled with the lack of any compliance
with Article 9 documentation requirements, which must weigh heavily in
determinating the intent of the parties, we cannot conclude that the VIDA
was a secured party.
     Defendants' second contention is that VIDA assumed the rights and
obligations of a secured party under { 9-504(5).  It appears that VIDA was
"liable to a secured party under a guaranty, indorsement, repurchase agree-
ment or the like," which is the threshold requirement of { 9-504(5), but
would only acquire the secured party's "rights and duties" if it "receive[d]
a transfer of collateral from the secured party or . . . [was] subrogated to
his rights . . . ."  Id.  It is undisputed that, although VIDA had the right
to repurchase the note and therefore obtain the right to control the collat-
eral on default, VIDA did not exercise that right.  Therefore, it did not
receive a transfer of collateral from the Bank within the meaning of { 9-
504(5). (FN4)
     Further, by paying a portion of the amount owed to the Bank pursuant to
its insurance contract, VIDA did not become subrogated to the Bank. There-
fore, it did not assume the rights and duties of a secured party by subro-
gation.  "The right of a [party secondarily liable] to be subrogated . . .
does not attach unless all the principal obligations are discharged."
Walker Process Equipment Corp. v. Cooley Building Co., 129 Vt. 333, 340, 278 A.2d 714, 718 (1971); see International Underwriters v. Liao, 548 So. 2d 163, 164 (Ala. 1989) (an insurer has no right of subrogation "until the
insured has recovered an amount in excess of his or her loss"); Lombardi v.
Merchants Mutual Insurance Co., 429 A.2d 1290, 1291-92 (R.I. 1981) (same);
Couch on Insurance 2d (Rev. ed.) { 61:64 (1983).
     In two special circumstances, however, a party secondarily liable may
be subrogated even though the principal creditor has not recovered in full.
These are (a) where the principal creditor does not object to subrogation,
and (b) where a contract specifically provides that the party secondarily
liable will be allowed to subrogate to the extent he or she reimburses the
creditor.  Willard v. Automobile Underwriters, Inc., 407 N.E.2d 1192, 1193
(Ind. App. 1980); Couch on Insurance 2d { 61:66; see 4 Debtor-Creditor Law,
{ 19.03[C] at 19-13-14.
     VIDA's right to purchase the note in the event of default did not
constitute an agreement to subrogate.  Further, not only was there no
evidence from which the trial court could conclude that the Bank consented
to subrogation, logically, there was no reason for VIDA to become subro-
gated, since it had the right to proceed against defendants personally on
the guaranty and indemnity agreement.  Thus, VIDA did not acquire the obli-
gations of a secured party by subrogation.  Cases cited by defendants (FN5) 
are inapposite.
     Since VIDA was not a secured party, either by agreement or by operation
of 9A V.S.A. { 9-504(5), defendants were not guarantors of a secured trans-
action, and VIDA owed them no duties imposed by Article 9. (FN6) Our holding
does no violence to any public policy inherent in Article 9.  Article 9 does
not protect against unfair or incompetent dispositions of collateral under
all circumstances.  It protects only transactions that satisfy its
     Defendants' final contention is that they are not liable on their
personal guaranty agreement because VIDA was not, in fact, liable to the
Bank on the insurance agreement.  Their claim is that VIDA's insurance
contract was essentially a suretyship, which entitled it to assert the
defenses of its principal, PTI, against the Bank.  Thus, as surety, VIDA
should have asserted PTI's defense of a commercially unreasonable sale of
the collateral, and its failure to do so should bar VIDA's recovery on the
defendants' personal guaranty agreement.
     Defendants' surety argument ignores the plain and unambiguous terms of
the personal guaranty, in which defendants agreed to reimburse VIDA for any
sums VIDA paid to the Bank.  The agreement stated:
            Obligation:  The Guarantors, jointly and severally,
          guarantee to the Lender, its successors and assigns,
          that they will pay to the Bank any amount for which the
          Authority becomes liable to the Bank pursuant to the
          said Mortgage insurance Agreement and will indemnify the
          Bank pursuant to said agreement . . . .

Defendants also agreed to ratify any "settlement or compromise" between VIDA
and the Bank, and "waived[d] all defenses, counterclaims, or offsets" they
might have had.  In light of these provisions, it is not necessary to
resolve the issue of suretyship.  That, and any other defense defendants may
otherwise have had, were waived.

                                   FOR THE COURT:

                                   Associate Justice

FN1.    Whether or not the Bank's sale of the collateral was commercially
reasonable remains a disputed issue of fact; however, it is not necessary to
resolve it in view of our disposition on the legal issues.

FN2.  9A { 9-204 states, in part:  A security interest cannot attach until
there is agreement . . . that it attach and value is given and the debtor
has rights in the collateral.  It attaches as soon as all of the events in
the preceding sentence have taken place unless explicit agreement postpones
the time of attaching.

FN3.    See 10 V.S.A. { 221(c)(10)(A) (VIDA may issue mortgage insurance if
mortgagor is unable to secure financing on reasonable terms.)

FN4.    The Code does not define "transfer of collateral," but cases  imply
that there must be a transfer of title before an assignee acquires the
rights and obligations of the secured party.  See Western National Bank of
Casper v. Harrison, 577 P.2d 635, 639 (Wyo. 1978) (no transfer of collateral
occurred where bank had not repossessed property, did not have title to
property, and attempted no transfer of collateral to guarantor); CIT
Financial Services v. Herb's Indoor RV Center, Inc., 795 P.2d 890, 896
(Idaho Ct. App. 1990) (B118 Idaho 185, 191, urnett, J., dissenting)
(physical placement of collateral with guarantor, unaccompanied by title,
did not constitute transfer).

FN5.    Mid-States Insurance Co. v. American Fidelity & Casualty Co. 234 F.2d 721, 731 (9th Cir. 1956) (subrogation found although the entire loan
principal not discharged because principal creditor failed to object and
would recover the entire sum loaned); Tucker v. Scarborough, 596 S.W.2d 4,
7 (Ark. App. 1980) (debtor had no standing to object to subrogation of
guarantor since principal creditor did not object).

FN6.    Defendants argued in the alternative that Article 9 applied to the
transaction because the Bank was VIDA's agent in disposing of the collat-
eral.  As discussed infra, VIDA's right to approve the sale of the collat-
eral did not impose any Article 9 obligation on it, unless it met the
narrow terms of { 9-504(5), which it did not.