7th Circuit Prevents Lender From Enforcing Promissory Notes Held By Third Parties
July 03, 2019
Lesson. Lenders must always prove that they are entitled to enforce their promissory notes under the applicable UCC provisions. Normally, this is a simple excercise, but creative financing like that in the Tissue v. TAK case can complicate the issue.
Case cite. Tissue v. TAK 907 F.3d 1001 (7th Cir. 2018)
Legal issue. Whether the plaintiff, which was not in possession of the originals, was nevertheless entitled to enforce the subject promissory notes against the defendant.
Vital facts. The Tissue case involved an unconventional and fairly complicated transaction. The Plaintiff entered into an agreement to sell a tissue mill located in Wisconsin to an affiliate of the Defendant. A piece of the financing fell through, rendering Plaintiff unable to pay off certain secured creditors of the mill. This obstacle prevented Plaintiff from being in a position to deliver clean title to the buyer.
To bridge the gap, the parties entered into a kind of seller financing, whereby the Defendant (as a de facto borrower, as well as the purchaser of the property) issued four promissory notes payable to the Plaintiff (as a de facto lender, as well as the seller of the mill) totaling $16MM over three years. Plaintiff, in turn, delivered the promissory notes to the secured creditors as substitute security. With the original notes in hand, pledged as security to replace their liens in the mill, the creditors released their security interests, and the transaction closed. My reading of the opinion is that, in a contemporaneous side deal, the Plaintiff itself promised to pay the debts owed to the secured creditors as documented by the notes. The Court summed things up as follows: “this meant that the [creditors] who released their security in the tissue mill had the credit of both the [Plaintiff] and the [Defendant] behind the notes’ promises.”
Of course, everything fell through, and the Plaintiff sued the Defendant to, among other things, collect on the four promissory notes. As a consequence of the failed transaction between the Plaintiff and the Defendant, the money owed to the prior lienholders had not been paid by either party, and those creditors had not returned the original promissory notes to either the Defendant or the Plaintiff. Therefore, Plaintiff did not possess any of the original notes at the time it filed suit against the Defendant. Please read the opinion for more detail on the facts and background, as well as other legal issues relevant to the outcome.
Procedural history. Tissue is an opinion from the Seventh Circuit Court of Appeals arising out of a judgment entered by the United States District Court for the Eastern District of Wisconsin. Despite the fact that Wisconsin law controlled, the pertinent Uniform Commercial Code sections of Wisconsin and Indiana are similar. Plus, Indiana is in the 7th Circuit, so the decision affects parties doing business in Indiana.
Key rules. The key statute was Wis. Stat. 403.301 dealing with negotiable instruments. Here is Indiana’s version: Ind. Code 26-1-3.1-301:
"Person entitled to enforce" an instrument means:
(1) the holder of the instrument;
(2) a nonholder in possession of the instrument who has the rights of a holder; or
(3) a person not in possession of the instrument who is entitled to enforce the instrument under IC 26-1-3.1-309 or IC 26-1-3.1-418(d).
A person may be a person entitled to enforce the instrument even though the person is not the owner of the instrument or is in wrongful possession of the instrument.
Holding. The 7th Circuit affirmed the district court and concluded that, since the Plaintiff was not the holder of the notes, it was not entitled to enforce them against the Defendant.
Policy/rationale. The Plaintiff “was not entitled to enforce the notes because it is not their holder, is not in possession of them, and is not entitled to enforce them [under the statutory exceptions.]" The notes had not been lost, stolen or destroyed. The notes had not been paid by mistake by anyone. In the end, only the holders, or nonholders in possession, could enforce the notes – which the Plaintiff was neither.
Further, because the notes replaced liens against the tissue mill, the creditors needed the notes as security until the debts were repaid. If the Plaintiff “had paid the notes as promised, and thus retired the loans, then it would recover the notes from the [creditors] and be able to enforce them” under the UCC.
As a side note, the Plaintiff tried to make hay out of the fact that the creditors could not enforce the notes either because the Plaintiff did not endorse the notes before delivering them in pledge as collateral. The Court reasoned that “this may well be true,” but that fact did not get the Plaintiff around its own statutory prohibitions. In the end, the Court simply was not going to “leave the [creditors] in the lurch and [grant the Plaintiff] all of the notes’ benefits.” Interestingly, the courts protected the prior lienholders in the tissue mill, even though it appears that those creditors were not parties to the case.
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