In re Weiss: Sometimes It Pays to Be Too Careful

The United States Bankruptcy Court in the Eastern Division of the Northern District of Illinois recently handed down a disturbing, and, we hope, isolated decision in In re Weiss. While the opinion included a lengthy analysis of certain sections of the Bankruptcy Code and relevant state law, it failed to take into account applicable UCC provisions, which would have changed the outcome of the case. In re Weiss illustrates an important cautionary reminder that courts are fallible and sometimes decide cases incorrectly.

The issue decided in the case was whether two of the bankruptcy petitioner's creditors were secured creditors and entitled to relief from stay. The debtor, Weiss, had executed a promissory note and a pledge agreement to secure payment of notes to each of the creditors, R.C.M. and Marconi Trust. The central dispute was whether the security interests created by the pledge agreements were valid and enforceable.

The pledge agreements assigned all of Weiss' rights in a group of limited liability companies and partnerships, the Halyard Companies. The interests appear not to have been "securities" as defined in UCC Section 8-102, and thus were general intangibles under the definition in 9-102. The problem was that each of the companies had operating agreements that restricted Weiss' ability to transfer his interests in them. All of the operating agreements required Weiss to get consent from the other members, or partners, before assigning his interest. Weiss never obtained those consents and notified the creditors of this fact by expressly telling the creditors' counsel and by changing the language in the pledge agreement to reflect the fact that he did not have the power to assign his interest. Despite these warnings, the creditors went ahead with the loans and filed UCC-1 financing statements describing the collateral in the pledge agreement.

Three years after the promissory notes were issued, Weiss defaulted on both of the loans and subsequently filed for Chapter 11 bankruptcy, which led to the creditors petition for relief from stay on the collateral described in the pledge agreements.

The court analyzed the case under the requirements of Bankruptcy Code Section 362(d) and ultimately denied the motion for relief from stay. It held that the creditors failed to satisfy the requirements of 362(d)(1) because they could not establish that their debt was secured. Basing its conclusion on Illinois law, the court ruled that Weiss never actually acquired transferable rights in the property, and therefore, transferred nothing to the creditors. It interpreted the state law as requiring for proper assignment compliance with any agreement controlling the procedure for transfer of an interest. Because the Halyard operating agreements required consent to transfer interests and Weiss did not obtain that consent, the court ruled that he transferred no interest in the pledge agreement and the creditors were not secured.

While the court conducted a thorough analysis of the cases interpreting applicable Illinois law, its holding and the final outcome were incorrect because the court failed to take into account the effects of UCC Article 9 Section 408. UCC 9-408 provides that restrictions on assignments of certain general intangibles, which would include Weiss' rights in the Halyard Companies, are ineffective to impair or prevent the creation, attachment, or perfection of a security interest. If the court had included this UCC provision in its analysis, the restrictions on the transferability of Weiss' ownership interests would have been ineffective and his interests would have been transferred in the pledge agreement.

The court also erred when it held that Weiss had no rights in the collateral pledged in the pledge agreement. While discussing whether the pledge agreement was enforceable, the court seemed to confuse the issue of whether Weiss had rights in the collateral with the issue of whether he had power to assign those rights. The court mistakenly held that Weiss had no rights in the Halyard Companies due to the assignment restrictions in the operating agreements. It is clear from the facts of the case, however, that Weiss had rights in the Halyard Companies. The only disputed issue should have been whether Weiss had the ability to assign those rights.

Due to the court's failure to include applicable law in its analysis, In re Weiss was decided incorrectly. This case serves as an unfortunate, but important, example that sometimes courts render incorrect decisions. Hopefully, other courts will not follow this decision. In the meantime, in order to avoid the result in In re Weiss, the secured creditor could obtain the consent of the other members or partners — an unnecessary step under the correct interpretation of UCC Section 9-408.