Opinion ID: 2971797
Heading Depth: 2
Heading Rank: 2

Heading: Duty to Preserve Collateral

Text: We first consider Johnson’s argument that Bank One violated a duty under Kentucky law to preserve the value of the collateral held in its possession. With respect to the regulation of secured transactions, Kentucky has adopted the Uniform Commercial Code (“U.C.C.”), which states that “a secured party shall use reasonable care in the custody and preservation of collateral in the secured party’s possession. In the case of chattel paper or an instrument, reasonable care includes taking necessary steps to preserve rights against prior parties unless otherwise agreed.” Ky. Rev. Stat. Ann. § 355.9-207. Whether a secured party’s duty to preserve collateral applies to pledged shares is an issue of first impression in Kentucky. Because our jurisdiction in this case is based on a diversity of citizenship among the parties, “[w]e are in effect sitting as a state appellate court in Kentucky, with the obligation to decide the case as we believe the Kentucky Supreme Court would do.” Stalbosky v. Belew, 205 F.3d 890, 893 (6th Cir. 2000). As the district court noted below, although Kentucky courts have not reviewed the matter, several courts around the country have addressed the issue of whether § 9-207 applies to pledged stock. Before analyzing their holdings, however, we begin our analysis with the U.C.C. itself. The comment to § 9-207 states that the provision “imposes a duty of care, similar to that imposed on a pledgee at common law, on a secured party in possession of collateral,” and cites to §§ 17-18 of the Restatement of Security. U.C.C. § 9-207 cmt. 2. Section 17 of the Restatement is essentially identical to the first sentence of § 9-207, and its accompanying explanatory comment states that “[t]he rule of reasonable care expressed in this Section is confined to the physical care of the chattel, whether an object such as a horse or piece of jewelry, or a negotiable instrument or document of title.” Restatement of Security § 17 cmt. a (1941) (emphasis added). Section 18 of the Restatement mirrors the second sentence of § 9-207 and addresses “instruments representing claims of the pledgor against third persons.” Restatement of Security § 18. Though it deals with negotiable instruments rather than equity investments, § 18 sheds light on the topic of preserving collateral value. Specifically, the explanatory comment accompanying the section states “[t]he pledgee is not 6 If the full $2.8 million credit line was used, the market price of the 410,000 shares would need to be approximately $16.89 in order to maintain an LTV ratio of 40%. In July, the shares were sold at an average price of $1.28 over the four-day period. The LTV ratio at the time the collateral was sold was approximately 530%. No. 03-6062 Layne, et al. v. Bank One, Kentucky, et al. Page 5 liable for a decline in the value of pledged instruments, even if timely action could have prevented such decline.” Restatement of Security § 18 cmt. a (1941) (emphasis added). In the context of pledged stock, courts have used this language from the Restatement to hold that “a bank has no duty to its borrower to sell collateral stock of declining value.” Capos v. Mid-Am. Nat’l Bank, 581 F.2d 676, 680 (7th Cir. 1978). See also Tepper v. Chase Manhattan Bank, N.A., 376 So. 2d 35, 36 (Fla. Dist. Ct. App. 1979) (holding that “a pledgee is not liable for a decline in the value of pledged instruments”); Honolulu Fed. Sav. & Loan Ass’n v. Murphy, 753 P.2d 807, 816 (Haw. Ct. App. 1988) (finding that a lender has no duty to preserve the value of pledged securities by financially supporting the issuing company); FDIC v. Air Atl., Inc., 452 N.E.2d 1143, 1147 (Mass. 1983) (finding a lender not liable for the “ruinous” decline in the market value of pledged stock); Marriott Employees’ Fed. Credit Union v. Harris, 897 S.W.2d 723, 728 (Tenn. Ct. App. 1995) (holding that the duty of reasonable care “refers to the physical possession of the stock certificates” and does not impose liability for depreciation in value); Dubman v. N. Shore Bank, 271 N.W.2d 148, 151 (Wisc. Ct. App. 1978) (concluding that “our law does not hold a pledgee responsible for a decline in market value of securities pledged to it as collateral for a loan absent a showing of bad faith or a negligent refusal to sell after demand”). As the Seventh Circuit stated, “[i]t is the borrower who makes the investment decision to purchase stock. A lender in these situations merely accepts the stock as collateral, and does not thereby itself invest in the issuing firm.”7 Capos, 581 F.2d 680. “Given the volatility of the stock market, a requirement that a secured party sell shares . . . held as collateral, at a particular time, would be to shift the investment risk from the borrower to the lender.” Air Atl., Inc., 452 N.E.2d at 1147. We agree with the reasoning of these courts and believe that the Kentucky Supreme Court would adopt a similar approach with regards to Ky. Rev. Stat. Ann. § 355.9-207. Specifically, we conclude that under Kentucky law a lender has no obligation to sell pledged stock held as collateral merely because of a market decline. If the borrower is concerned with the decline in the share value, it is his responsibility, rather than that of the lender, to take appropriate remedial steps, such as paying off the loan in return for the collateral, substituting the pledged stock with other equally valued assets, or selling the pledged stock himself and paying off the loan.8 7 As noted by the district court, the few courts which have found differently involved cases in which the securities held as collateral were convertible debentures, and the secured party failed to covert them into stock. Reed v. Cent. Nat’l Bank, 421 F.2d 113, 118 (10th Cir. 1970); Grace v. Sterling, Grace & Co., 289 N.Y.S.2d 632, 638 (N.Y. App. Div. 1968). The courts in those cases held that § 9-207 requires the pledgee to take the necessary steps to preserve the value of the securities. As the district court correctly noted, however, “the losses occasioned by the secured creditor’s failure to convert the debentures were clearly foreseeable, because the creditors had specific knowledge of an event that would materially affect the value of the securities.” J.A. at 260-61 n.7 (Dist. Ct. Order). By contrast, where the collateral held by the secured party is stock, “there is no similar, pre-defined event which the creditor knows will impact the value of the stock.” J.A. at 261 n.7 (Dist. Ct. Order). Because the fluctuation in value is not foreseeable, to require a creditor to preserve value of stock is to “foist that role [of investment adviser] upon it.” Capos, 581 F.2d at 680. 8 Johnson argues that these options were not available to him in this case because he did not have other assets to substitute and was unable to sell the stock on his own because of his insider status. Appellant’s Reply Br. at 13-14. Particularized facts of the borrower’s situation, however, are insufficient to alter the law and burden the lender with the responsibility of being an investment adviser. The fact that the borrower adopted a risky investment strategy does not transform the legal obligations of the lender unless explicitly specified in the contract. Moreover, the record does not support Johnson’s contention that he could not avail himself of other options to preserve the value of his collateral. Johnson had other assets which he could have substituted for the collateral stock. In his deposition, Johnson stated that his house in Las Vegas was valued at around $5.0 million and was free of any mortgages and encumbrances. J.A. at 59192 (Johnson Dep.). Discussions were held between Bank One and Johnson during the months of April and May specifically about using the Las Vegas house as additional collateral. Furthermore, despite the fact that he was an insider, Johnson could have sold his restricted stock through a Rule 144 transaction so long as he ensured the sale was No. 03-6062 Layne, et al. v. Bank One, Kentucky, et al. Page 6 In his brief, Johnson attempts to distinguish his case from the several cases outlined above, by arguing that in the situation where a loan is over-secured, the pledgee has a duty to preserve the surplus. Johnson argues that where a loan is over-secured, the amount of collateral greater than the loan value belongs to the borrower and a duty should be imposed on the secured party to protect that surplus because the secured party has no incentive to do so on its own. By contrast, Johnson argues, where a loan is under-secured, the secured party’s incentive is the same as that of the borrower, and thus no statutory duty to preserve the value of the collateral is necessary. In support of his argument, Johnson cites to two district court opinions which distinguish between over-secured and undersecured loans. Unfortunately, his theory is neither supported by these cases nor compelling on its own. Generally, the dual purpose of collateral is to secure financing for the borrower and hedge against credit risk for the lender. Where a lender extends credit solely on the basis of over-secured collateral, it is because of perceived heightened risk, and therefore over-collateralization provides the lender with more flexibility. In this case, Bank One agreed to loan Johnson $2.8 million dollars only if he pledged two-and-a-half times that value in PurchasePro stock, or $6.9 million. The underlying rationale was that unless the surplus value was included, the collateral may be insufficient at the time of any default. The LTV ratio was to provide a cushion so that Bank One could either wait for the stock to rebound, restructure the loan, solicit additional collateral, or call the loan with enough time to sell the stock to recoup the value. If accepted, Johnson’s argument would bifurcate the collateral amount between the actual value of the loan and the surplus value, and impose a duty upon the lender to preserve the latter. Requiring preservation of the surplus value, however, leaves only the actual value of the loan to serve as collateral and wipes out any flexibility for the lender. Under Johnson’s theory, Bank One would have had only $2.8 million worth of stock as collateral for the $2.8 million loan and would have been required to preserve the remaining $4.1 million of surplus. On the first day the market value of the stock fell below the LTV requirement, Bank One would have called the loan or risked liability under § 9-207. Imposing automatic liability for the decreased value of the surplus defeats the inherent purpose of requiring over-collateralization in the first place. The two cases Johnson cites for support do not stand for the proposition that overcollateralization necessarily implies a duty of the lender to preserve, but rather suggest that the borrower does have a valid interest in the surplus value and therefore his wishes should not be ignored in over-collateralized situations. In Fidelity Bank & Trust Co. v. Production Metals Corp., 366 F. Supp. 613, 618 (E.D. Pa. 1973), the district court found that “where the value of the collateral exceeds the amount of the debtor’s entire obligation . . . there is no justification for a rule authorizing the pledgee to disregard [the pledgor’s] interest in the collateral and deprive him of the right to control its disposition for the benefit of both parties.” The district court noted that where the pledgee, “upon request of the pledgor” fails to take steps to preserve the value of the collateral, “a question should properly be raised as to whether the pledgee has exercised reasonable care under the circumstances.” Id. (emphasis added). The Fidelity court noted, however, that “where the entire obligation of the pledgor exceeds the value of the collateral held by the pledgee . . . the pledgee’s refusal to sell the collateral upon request of the pledgor would not, as a matter of law, constitute a breach of his duty to preserve its value.” Id. at 619. Similarly, in FDIC v. Caliendo, 802 F. Supp. 575, 583-84 (D.N.H. 1992), the district court, citing Fidelity Bank, ruled that a pledgor could bring a claim under § 9-207, where there is an over-collateralized loan, a default by the pledgor, and “the not a result of any material, non-public information. 17 C.F.R. § 230.144(b). See, e.g., J.A. at 513-16 (Layne’s Stock Selling Plan). Johnson stated in his deposition that he was intending to sell his restricted shares pursuant to a selling plan, the proceeds of which he would use “to pay [Bank One] off one hundred percent.” J.A. at 591 (Johnson Dep.). Unfortunately, the sale of Johnson’s shares under the plan was triggered by the stock reaching a certain price, which it never did. No. 03-6062 Layne, et al. v. Bank One, Kentucky, et al. Page 7 receipt of a reasonable request by the pledgor/borrower to either sell or have the stock redeemed.” These two cases do not provide any support for Johnson’s argument that a duty to preserve collateral arises simply because of an over-collateralized situation; rather, where there is over-collateralization and the pledgor has requested liquidation, the pledgee should respect the pledgor’s interest in the surplus value. These two cases are inapposite to Johnson’s case, because the record is clear that he never made a request to the bank to sell the collateral to preserve his surplus, but rather urged Bank One as late as May 1, 2001, to do the opposite. In sum, we conclude that, under Kentucky law, a lender is not under any duty or obligation to sell collateral in its possession merely because the collateral is declining in value, regardless of whether the loan is over-collateralized. Therefore, the district court’s grant of summary judgment on this issue is affirmed.