Dragnet Clause Interpreted in a Manner Consistent with Revised Article 9
December 22, 2004
Michael Weissman - Chicago
In Pride Hyundai, Inc. v. Chrysler Financial, Inc., 369 F.3d 603 (1st Cir. 2004), a federal court was called upon to predict whether Massachusetts’ highest court would interpret UCC Section 9-204 consistent with the Official Comments to that section or with prior Massachusetts’ real estate decisions. Although Massachusetts did not adopt the Official Comments under Revised Article 9 (nor did most other states), the court opined that Massachusetts would indeed interpret UCC Section 9-204 in a manner consistent with the Official Comments.
The factual situation was as follows. Pride and four other related dealerships were under the ownership of Alfredo Dos Anjos (Anjos). In 1987, one of the Pride dealerships, Pride Chrysler-Plymouth, entered into a retail financing agreement with Chrysler Financial Corporation (CFC). The arrangement was designed to facilitate the financing of automobile purchases by Pride’s customers.
The CFC retail financing arrangement called for “charge-backs” to Pride if a customer paid off his or her financing early or defaulted. It also called for Pride to maintain with CFC a minimum reserve balance equal to the greater of $1,000 or 1.5 percent of the retail contracts purchased by CFC.
In 1994, CFC approached Anjos about wholesale (floor plan) financing. During 1995 and 1996, Anjos agreed to transfer both the retail and wholesale financing for all his dealerships to CFC.
The wholesale financing contracts required the dealerships to grant a security interest in their assets and were different from the retail contracts. They contained a dragnet clause that provided that the security granted pursuant to the wholesale financing contracts secured all debts of the dealerships. This meant that all of the dealerships’ obligations, under both the wholesale and retail contracts, were secured by the dealerships’ assets.
Later, when Anjos became disillusioned by his experience with CFC, he sought to replace CFC. He then learned that the dealerships’ retail charge-back obligations were secured by the assets of the dealerships as a result of the dragnet clause in the floor plan documents. He was told that CFC would not release its security interest unless he deposited $415,569 (1.5 percent of the outstanding retail contracts) with CFC. CFC had not previously enforced the 1.5 percent reserve requirement.
The relationship deteriorated further and Pride sued CFC claiming that CFC could not insist upon the 1.5 percent deposit because the dragnet clause did not secure any liability arising from charge-backs under the retail contracts.
Turning to the UCC section validating dragnet clauses, the court noted very little difference between the text of Old Article 9 and the text of Revised Article 9. The difference was in the Official Comments. The Official Comments rejected the view of some states (such as Wisconsin and Iowa), that a dragnet clause secured a future advance only if the future advance was of a similar type or class as the original advance. But as noted above, the Official Comments were not enacted into law in Massachusetts. Furthermore, all previous Massachusetts cases analyzing dragnet clauses arose in a real estate context and were of the view that a dragnet clause only secured debts that bore a close relationship to the original indebtedness.[1]
Nevertheless, the Court held that when confronted with the issue, the Massachusetts Supreme Judicial Court would adopt the approach in the Official Comments. It said that the parties to transactions involving dragnet clauses are usually quite sophisticated and understand the significance of the documents they are executing. Furthermore, said the court, a dragnet clause allows additional credit to be extended without the transaction costs attendant upon the execution of a new agreement for each advance.
What’s the point? The Court clearly discerned that while
dragnet clauses have a downside for an unsuspecting debtor, most debtors who
sign contracts with dragnet clauses are well aware of their consequences
including the possibility of seeking additional credit without incurring the
fees and expenses that generally arise in an initial financing transaction.
For more information e-mail Michael L. Weissman at
michael.weissman@hklaw.com or call toll free, 1-888-688-8500.
1. It is noteworthy that Massachusetts continues to adhere to the relatedness role for dragnet clauses in a real estate context. See NAB Asset Venture III, L.P. v. Brockton Credit Union, 62 Mass. App. 181, 815 N.E. 2d 606 (2004) where the Court said the narrow construction given to dragnet clauses is to prevent their “oppressive or fraudulent use.”