Knox v. Phoenix Leasing, Inc.
29 Cal. App. 4th 1357 (Cal. Ct. App. 1994)

POCHE, J.

    The issue presented is whether a secured creditor who obtains a defaulted debtor's property can be subject to restitution for the amount of the value of goods furnished the debtor by a third party. The answer is no: unless there are unusual circumstances the equitable remedy of restitution must defer to the rights given a secured creditor by the California Uniform Commercial Code (UCC).

BACKGROUND

    In March of 1990 as part of a concerted effort to expand the capacity of its plant in Sonoma County, Domaine Laurier Winery (Domaine) contracted with Mel Knox to purchase 200 seasoned oak wine barrels made in France. Four months later Domaine executed an agreement with Phoenix Leasing Incorporated (Phoenix) whereby Phoenix undertook to provide financing for the expansion. Phoenix was protected by (among other things) a security agreement covering all personal property, including "all equipment ... whether now owned or hereafter acquired" by Domaine.

    The wine barrels came in two shipments. Upon arrival of the first lot, Knox sent an invoice to Domaine; Domaine forwarded the invoice to Phoenix, which paid it in August of 1990. With the second lot, Knox sent the invoice for $33,011.37 directly to Phoenix. Domaine also requested Phoenix to pay Knox. Approximately two months after the second shipment was delivered, but before any payment for it, Phoenix declared Domaine in default of their agreement. The barrels were included in Phoenix's subsequent liquidation of Domaine's assets. n2

    By the time Knox's complaint came on for trial it had been reduced to a single cause of action for "Restitution--Unjust Enrichment" against Phoenix. The case was tried on the short cause calendar following denial of Phoenix's motion that, because it was a secured creditor while Knox was not, it was entitled to judgment on the pleadings. The trial did not produce a statement of decision, simply the court's announcement that Knox was entitled to judgment for $21,350 (70 percent of the original cost of the barrels which was essentially their undisputed resale value).

    Phoenix perfected this timely appeal from the ensuing judgment.

REVIEW

I

    According to the UCC, Domaine's execution of a security agreement describing the property covered gave Phoenix a security interest in that collateral [UCC citations omitted]. Phoenix perfected that security interest when it filed a financing statement with the Secretary of State [UCC citations omitted].  Phoenix thus acquired priority over other Domaine creditors [UCC citations omitted], including the right to take possession and sell the collateral if Domaine defaulted [UCC citations omitted]. It being undisputed that Phoenix complied with all of these steps, Phoenix maintains that it is immune to Knox's restitution claim.

    The opposing argument, which springs from the UCC's general directive that its provisions are to be supplemented by "principles of law and equity" (@ 1103), has divided courts considering whether restitution can be had from a code-protected secured creditor. On the one hand, a decided majority of jurisdictions have disallowed the equitable remedy of restitution (whether termed unjust enrichment, quantum meruit, contract implied in law, etc.). n4 They are willing to accept occasionally harsh results as the price to be paid for preserving the integrity of the UCC's scheme for secured transactions, encouraging compliance with the UCC, and thereby ensuring a predictable system of creditor priorities. [Citations omitted.] On the other hand, California and more recently Colorado, while conceding considerable soundness to the majority position, have permitted restitution from a secured creditor. [Citations omitted.] An examination of these decisions demonstrates that their disagreement with the majority position is one of degree and is not nearly so profound as appears at first glance. Recovery is clearly the exception, not the norm, and is subject to stern limitations.

    The first member of the minority camp--and the sole reported California decision in this area--is Producers Cotton Oil Co. v. Amstar Corp., supra, 197 Cal.App.3d 638 (Producers Cotton). The Producers Cotton firm held a security interest in the farm crops of its debtor. Amstar bought the crops and paid to have them harvested. Amstar knew of Producers' security interest, but neglected to obtain Producers' agreement to subordinate that interest. Amstar deducted the harvesting costs before remitting the sale proceeds of the crops to Producers. Producers sued Amstar and obtained a judgment on the theory that the deduction constituted conversion of its secured collateral.

    Amstar appealed, arguing that the UCC's article 9 governing secured transactions left room for the equitable principle of restitution. It relied on section 1103, which provides: "Unless displaced by the particular provisions of this code, the principles of law and equity, including the law merchant and the law relative to capacity to contract, principal and agent, estoppel, fraud, misrepresentation, duress, coercion, mistake, bankruptcy, or other validating or invalidating cause shall supplement its provisions." Producers responded that "... in order to give stability and predictability to commercial transactions, the priorities dictated by article 9 must prevail over equitable principles that might otherwise apply." Concluding that "... the facts present a classic case for establishing an implied in law contract, or quasi-contract," the Court of Appeal tersely concurred with Amstar: "We agree with the position of Amstar and hold that when a party possessing a security interest in a crop and its proceeds has knowledge of and acquiesces in expenditures made which are necessary to the development of the crop, and ultimately benefits from the expenditure, a party who, through mistake, pays such costs without first obtaining subordination, is entitled to recover." (Producers Cotton, supra, 197 Cal.App.3d at pp. 658, 660 [original italics].)

    A considerably more detailed discussion of the problem was developed in Ninth Dist. Prod. Credit v. Ed Duggan, supra, 821 P.2d 788 (Duggan). Like Producers Cotton, the context was agricultural. Duggan furnished feed grain to a livestock company whose accounts receivable and personal property were the subject of a perfected security interest held by a credit association. In accordance with its standard practice, the association financed the livestock company's operations by paying sight drafts given creditors by the livestock company. Duggan continued deliveries while an unsuccessful effort to sell the livestock company was overseen by the credit association. Cattle fed with Duggan's grain were sold and the proceeds paid to the credit association, which also received payment for feedlot services given cattle awaiting slaughter. When the livestock company became financially unable to pay Duggan, suit was brought against the association.

    The Colorado Supreme Court upheld the lower courts' determination that Duggan could obtain restitution from the credit association notwithstanding the latter's superior statutory priority as a secured creditor. It opened its analysis by noting that the central issue "... whether a creditor that holds a perfected security interest in collateral can be held liable to an unsecured creditor based on a theory of unjust enrichment for benefits that enhance the value of the collateral ... cannot be answered categorically." (Duggan, supra, 821 P.2d at p. 793.) Recognizing that this problem presented "obvious tension between the doctrine of unjust enrichment and the priority system established by Article 9," the court reviewed the relevant decisions and discerned that the "central point of distinction ... is the extent to which the secured creditor was involved in the transaction by which the unsecured creditor supplied goods or services that enhanced the value of the secured collateral." (Id. at pp. 795-797.) Acknowledging that the UCC's priority system "reflects the legislative judgment that the value of a predictable system of priorities ordinarily outweighs the disadvantage of the system's occasional inequities," the court formulated this rule: "In a situation where a secured creditor initiates or encourages transactions between the debtor and suppliers of goods or services, and benefits from the goods or services supplied to produce such debts, equitable principles require that the secured creditor compensate even an unsecured creditor to avoid being unjustly enriched. The equitable claim is at its strongest when the goods or services are necessary to preserve the security, as in Producers Cotton Oil." n6 (Id. at pp. 797-798.)

    Producers Cotton and Duggan have been subjected to critical comment, some of which is unusually hostile. n7 Were we the first California court to consider the issue, we might well agree with the strict position that allowing restitution claims would be incompatible with the UCC's priority system. The primary purpose and chief benefit of article 9 is the stability and certainty provided by those rules. (E.g., Duggan, supra, 821 P.2d at p. 797; 2 White & Summers, op. cit. supra, @ 26-20, p. 555.) These are significant policy considerations which should not be disregarded lightly. So weighty is their value that most courts and commentators agree that it is better to accept the occasional "harsh application of the law than to disrupt thousands of other transactions by injecting uncertainty and by encouraging swarms of potential litigants and their lawyers to challenge what would otherwise be clear and fair rules." (2 White & Summers, supra, at pp. 554-555; Peerless Packing Co. v. Malone & Hyde, supra, 376 S.E.2d at p. 164.) Any other approach threatens to "render the secured creditor status useless" (SMP Sales Management, Inc. v. Fleet Credit Corp., supra, 960 F.2d at p. 560) and thus badly impair the utility of the article 9 framework.

    But we do not come to this subject with a blank screen. As evidenced by Producers Cotton, California has opted to allow restitution claims against a secured creditor. When properly restricted to a very limited class of cases, this principle is sound.

    The reasons supporting the primacy of the article 9 scheme are unquestionably weighty. Article 9 has been in place for more than three decades. Its requirements are by now familiar and integrated into commercial practice. The corresponding benefit is the stability that is essential to a healthy business climate. Compliance with the obligations of article 9 should have a positive consequence.

    A secured creditor which has complied with all relevant UCC requirements to perfect its security interest, should therefore start with something like a presumption in its favor. The whole point of article 9 is to establish a comprehensive scheme affording maximum protection to the secured creditor who has followed its provisions. [Citations omitted.] This does not, of course, guarantee payment in full. Even a secured creditor which has perfected its security interest may be subordinated to another of like status which is chronologically senior, or to other specified classes of creditors, the most prominent of which are those having a purchase money security interest n8 (see @ 9312). But, having taken the trouble to satisfy all statutory requirements for protecting its interest, a secured creditor is entitled to a rebuttable preference for payment as against a creditor who has not demonstrated a similar compliance.

    This preference would be reinforced by the failure of the unsecured creditor to use various nonstatutory protections. As courts and commentators have noted, the unsecured creditor could have (1) demanded cash payment on delivery, (2) perfected a purchase money security interest (see fn. 8, ante), (3) checked with the appropriate governmental office to determine if the debtor had already granted a security interest posing a possible threat to repayment, or (4) obtained a secured creditor's agreement to subordinate its priority [citations omitted].

    But victory for a secured creditor is not an immutable law of nature. Fraud, for example, is expressly put beyond the pale. (See @ 1103; fn. 5, ante.) A code may strive for comprehensiveness, but exceptional situations will arise. Equity is ordinarily meant to operate in these situations [citation omitted], but its operation is subject to the principle that "equity follows the law." [citation omitted] This deference requires that equitable exceptions to statutory law be carefully limited to reduce any possible conflict with an express statutory command. [Citations omitted.] Producers Cotton and Duggan show how this may be accomplished.

    Those decisions begin with the premise that simply pointing to benefit realized by the secured creditor will not suffice. As Duggan notes, gain to the creditor is almost universally present. (Duggan, supra, 821 P.2d at p. 797.) Something more is required to displace the creditor's favored position. That something is either conduct by the secured creditor or the nature of the unsecured creditor's contribution to the collateral.

    What the Duggan court termed "the extent to which the secured creditor was involved in the transaction by which the unsecured creditor supplied goods or services" (Duggan, supra, 821 P.2d at p. 797) can take many forms. At one end of the scale is fraud, which in its myriad forms is "the very essence of wrong; conduct that has always been and always will be wrong, according to the common judgment of mankind; conduct that cannot be dressed up or manipulated or associated so as to invest it with any element of right." [Citation omitted.] The UCC gives it no sanction (@ 1103) and courts applying the UCC are equally stern. (See fn. 5, ante.)

     Harder to resolve are the less egregious situations "where a secured creditor initiates or encourages transactions between the debtor and suppliers of goods or services, and benefits from the goods or services supplied to produce such debts." (Duggan, supra, 821 P.2d at p. 798.) These situations present a fertile opportunity for trapping the unwary. If what the secured creditor did or failed to do can be reached by the doctrines of estoppel, misrepresentation not amounting to fraud, or mistake, the UCC allows redress to an innocent supplier (@ 1103). Just as contribution among tortfeasors is proportioned by fault [citation omitted], commercial loss allocation responds to the same impulse. If it had an active hand in promoting a transaction that goes bad, a secured creditor should not escape with a victimized supplier left behind holding an empty bag alone. In simple terms, the creditor should not be allowed to profit from the wrong of its own bad faith. (Cf. @ 1203; Civ. Code, @ 3517.)

    The most difficult factor is the secured creditor's acquiescence when an unsecured creditor provides goods or services to their common debtor. First raised in Producers Cotton, it was given a restrictive gloss by Duggan: "In Producers Cotton Oil the court held that the secured creditor's act of acquiescing in the harvesting of the secured collateral (crops) was a sufficient basis for holding the secured creditor liable on the theory of unjust enrichment. However, in that case, the harvesting was necessary to the actual preservation of the secured collateral.... Here, the delivery of corn was not essential to preserve the secured collateral, but instead served to augment or enhance its value. In such a case, more than mere acquiescence is required to hold a secured creditor liable on the basis of unjust enrichment." (Duggan, supra, 821 P.2d at p. 797, fn. 17 [original italics; citation omitted].) Subject to two reservations, we agree with this reasoning, which is sound and reflective of commercial realities.

    When an unsecured creditor provides goods or services that are necessary to preserve the collateral, this is an expense the secured creditor would ordinarily incur as part of the duty to use "reasonable care in the custody and preservation of collateral in his possession" (@ 9207, subd. (1) [9-207 in Revised Article 9]). This would be especially true in situations like Producers Cotton and Duggan, where the collateral is perishable. In such a case the unsecured status of the creditor appears less important than the fact that the secured creditor directly benefits from expenditures the creditor is spared having to make on its own behalf. Matters become less clear when the unsecured creditor's expenditures are not essential but merely useful, in the sense that the collateral available for liquidation is being increased.

    One of the notable features of article 9 is its approval of the concept of the so-called "floating lien" generated by security interests extending to after-acquired debtor property. This measure of creditor protection is vital to the feasibility of long-term procedures such as inventory, accounts receivable, or agriculture crop financing. [Citations omitted.] Risk to other creditors is inherent in the operation of this mechanism (see Jackson & Kronman, Secured Financing and Priorities Among Creditors (1978) 88 Yale L.J. 1143, 1166), whose utility would be severely impaired if unsecured additions to the protected collateral could be excluded from its reach. Virtually every addition will augment or enhance the value of the pool of collateral already pledged to the secured creditor. Unless the unsecured creditor uses one of the means the UCC permits to ensure payment, the risk of loss must be deemed a cost of doing business (cf. @ 9207, subd. (2)(c)). This is the defining characteristic of a perfected security interest--"the degree to which it insulates the secured party from the claims of the debtor's other creditors." (Jackson & Kronman, supra, at p. 1143.) The mere fact of augmenting or enhancing the collateral's value is by itself insufficiently notable to justify special equitable protection from article 9's priority structure. If allowed, this exception would swallow the rule.

    The same is true concerning a secured creditor's acquiescence to such collateral pool augmentations. If acquiescence is to carry the risk of restitution liability, the secured creditor cannot afford silence. The creditor would be compelled to advise those who might deal with the debtor of the security arrangement and to disclaim responsibility for any obligation incurred by the debtor. n9 In order to know to whom these warnings must be given, the creditor would have to keep close tabs on the debtor's business dealings. Regardless of whether such a monitoring regime could overcome objections of cost, intrusiveness, and ineffectiveness, its conclusive flaw is that it would negate the utility of article 9's notice-filing system. One of the primary benefits of that system is that filing a financing statement relieves the now-secured creditor from the necessity of taking further action to protect its security interest; thereafter prospective creditors must watch out for themselves by checking the filings. Basing unjust enrichment liability on acquiescence would turn the filing system on its head, destroying existing creditors' reliance on that system and substituting a prospective creditor's duty to check with a new duty to warn and disclaim imposed on existing creditors. It would in plain effect reward ignorance and establish an incentive for ignoring the filing system. Acquiescence liability, because it would upend article 9's interlocking notice-filing and priority provisions, cannot be accepted.

    How does the evidence in this case measure up according to this legal template? Nothing in Phoenix's conduct amounted to fraud, actual or virtual (see fn. 5, ante), and Knox does not contend otherwise. The transaction between Knox and Domaine owed nothing to Phoenix in its inception. The contract for the barrels makes no reference to Phoenix, and was executed prior to Domaine's agreement with Phoenix. The barrels were ordered by Domaine, they were shipped to Domaine, and Knox initially looked to Domaine for payment. In light of Knox's testimony that he had no knowledge of Phoenix at the time he made the contract with Domaine, he could not have had any expectation of payment from Phoenix. The transaction between Knox and Domaine being in place and under way before Phoenix made any appearance, it is impossible to say that Phoenix initiated it. Similarly, the sole circumstance that Knox was paid for the first shipment with a check from Phoenix does not establish that Phoenix encouraged the deal; the course of performance under the Knox-Domaine contract owed nothing to anything said or done by Phoenix, or to the fact that Phoenix would be the true source of Domaine's payment to Knox. Phoenix never asked Knox to provide anything. (Cf. Earhart v. William Low Co. (1979) 25 Cal.3d 503, 511-515 [158 Cal.Rptr. 887, 600 P.2d 1344].)

    We have already determined that any acquiescence by Phoenix will not support restitution liability. Phoenix had no duty to overcome the failure of Knox, a merchant knowledgeable about article 9 procedures, n10 to acquaint himself with public information concerning the Phoenix- Domaine relationship.

    The barrels provided by Knox were not necessary to preserve the collateral covered by Phoenix's security interest in Domaine's "after acquired" property. The mere fact that the secured collateral was enhanced by the addition of the barrels does not support liability in these circumstances.

    The trial court's conclusion has an undeniable common sense allure--Knox provided barrels; Phoenix ended up with the barrels; Phoenix should therefore pay Knox for their value. Ordinarily this would be sound reasoning supporting an equitable result. Article 9, however, compels a different conclusion. Phoenix complied with statutory provisions intended to immunize secured creditors from such claims in all but the rarest of cases. As this is not that sort of case, the equitable impulse for restitution must yield to the Legislature's command. (Pacific Scene, Inc. v. Penasquitos, Inc., supra, 46 Cal.3d at p. 414; English v. Olympic Auditorium, Inc., supra, 217 Cal. at p. 641.)

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    The judgment is reversed.
Anderson, P. J., and Reardon, J., concurred.