Copyright (c) 2026 the National Conference of Bankruptcy Judges
Recharacterizing Contracts: The Sale-versus-Loan Problem of Receivables Financing
by
Steven L. Schwarcz and Isabelle Stewart*
This article addresses a complex and critically important issue that lies at the intersection of contract, property, commercial, and bankruptcy law and is crucial to corporate wealth production: what constitutes the sale of intangible rights to payment, or “receivables.” Courts often recharacterize contracts that purport to sell such rights if, notwithstanding being designated a sale, some of the substantive terms of the transfer are indicative of a loan. The jurisprudence on this sale-versus-loan problem is muddled and inconsistent. The confusion is compounded by the intangibility of receivables, subverting the old adage that “possession is nine-tenths of the law.” About the only well-established legal principle is that a court may sometimes, though it is unclear when, recharacterize a transaction that parties deem a sale to be a secured loan. The resulting uncertainty has serious real-world consequences. A recharacterization means that a purported buyer would not own, but merely would have a security interest in, the receivables and their collections, with the relatively limited rights and remedies associated with that interest. The risk of recharacterization thereby impairs receivables financing as a tool to unlock the growing segment of the world’s money—currently estimated at trillions of dollars—and, in developed countries, the bulk of corporate wealth that is locked up in receivables. To reduce that uncertainty and mitigate its costs, this article seeks to build a rational, consistent, and cost-effective legal framework for resolving the sale-versus-loan problem.
* Schwarcz is the Stanley A. Star Distinguished Professor of Law & Business, Duke University School of Law; Senior Fellow, the Centre for International Governance Innovation (CIGI); and Founding Director, Duke Global Financial Markets Center. Stewart is a J.D. Class of 2026 candidate at Duke University School of Law. This work was made possible by a Fuller-Perdue Grant. The authors thank Kara Bruce, Jens Dammann, Mira Ganor, James Spindler, and participants in the Business Law and Economics Workshop at the University of Texas School of Law and an early-stages faculty workshop at the Duke University School of Law for valuable comments. Although Professor Schwarcz has been an expert witness in a case involving sale-versus-loan recharacterization, the views expressed herein are entirely those of the authors and intended to be impartial.
I. Introduction
This article addresses a complex and critically important issue that lies at the intersection of contract, property, commercial, and bankruptcy law and is crucial to corporate wealth production: what constitutes the sale of intangible rights to payment (hereinafter, “receivables”). Courts often recharacterize contracts that purport to sell such rights if, notwithstanding being designated a sale, some of the substantive terms of the transfer are indicative of a loan.
As a highly simplified example, assume that Party A (the transferor/purported seller) contracts to sell $1,000 of receivables to Party B (the transferee/purported buyer) for $950. If the collections on the receivables are less than $975, or if collections are made later than 180 days (when expected), the contract requires Party A to compensate Party B for the loss or delay. If the collections are more than $985, the contract requires Party B to turn over the surplus collections to Party A.
As a business matter, this sales contract is sensible because it voluntarily and deliberately allocates the transaction’s risk of loss and the time value of money between (typically) sophisticated business parties.[1] Even for this simple example, however, judges struggle whether the recourse of Party B, the transferee, against Party A, the transferor, coupled with the transferor’s right to any surplus collections, permits or even constrains them to recharacterize the contract as creating a loan secured by, as opposed to a sale of, the receivables.[2] Furthermore, most receivables sale contracts are much more complicated.[3]
Absent clear guidelines, judges as well as lawyers face “difficult problems of distinguishing between transactions in which a receivable secures an obligation and those in which the receivable has been sold outright. In many commercial financing transactions the distinction is blurred.”[4] These problems are compounded by the intangibility of receivables, subverting the old adage that “possession is nine-tenths of the law.”[5] About the only well-established legal principle is that a court may sometimes, though it is unclear when, recharacterize a transaction that parties deem a sale to be a secured loan.[6]
A. Uncertainty and Costs
The resulting uncertainty has serious real-world consequences. A recharacterization means that Party B would not own, but merely would have a security interest in, the receivables and their collections, with the relatively limited rights and remedies associated with such an interest.
For example, assume that Party A, needing cash but not wanting to take on more debt, transfers its receivables to Party B and the parties formally document the transfer as a sale. Further assume that Party A subsequently files for bankruptcy. If Party B moves to collect the receivables, Party A (not being estopped[7]) may well argue that, notwithstanding the sale contract, the transaction is in substance a secured loan. If the bankruptcy court concurs—and bankruptcy courts sometimes can favor debtors in arguments about creditor remedies[8]—the receivables and collections thereon would remain the property of Party A notwithstanding the transfer. Party B would then merely have a security interest in that property; accordingly, its rights and remedies would be limited, and any enforcement thereof would be subject to the automatic stay in bankruptcy.[9]
The risk of recharacterization can discourage receivables financing and make it more expensive.[10] This is especially true for securitization, one of the primary modes of receivables financing and a major source of business funding[11]:
Perhaps the most critical issue in a securitization is whether the [transferee’s] investors[12] will continue to be repaid in the event of the [transferor’s] bankruptcy.[13] If the [transferee] owns the [receivables], its investors will continue to be repaid; if not, their rights to be repaid will be suspended and subject to possible impairment. The [transferee] will own the [receivables] only if the transfer of those assets from the [transferor] to the [transferee] constitutes a sale . . . .[14]
There is little doubt that uncertainty can materially increase costs. The National Bureau of Economic Research has found, for example, that “uncertainty has a direct effect on investment” and that “greater uncertainty tends to make investment less desirable”[15] and “exerts a strong negative influence on investment.”[16] Studies have demonstrated that greater legal uncertainty leads to higher interest rates and reduced investment.[17] Similarly, an examination of court outcomes found that in debtor-friendly jurisdictions where recharacterization risk may be higher, interest rates are also higher.[18] That examination concluded that legal uncertainty reduces the size of credit markets, likely because lenders exercise greater caution.[19]
Courts also have expressed concern about uncertainty. The Southern District of New York has observed that uncertainty “would both impair bank financing and increase the costs of obtaining such financing.”[20] The Seventh Circuit likewise has observed that investors influenced by the uncertainty of debt recovery might prefer not “to lend or invest in the future,” causing “the cost of credit [to] rise for all.”[21]
In contrast, scholars have found that in jurisdictions that had adopted anti-recharacterization laws, which reduce legal uncertainty, firms experience improved access to debt financing and engage in less precautionary behavior—thereby mitigating those costs of uncertainty.[22] The same study also showed that strengthening creditor rights through clearer recharacterization rules fosters greater investment in intangible capital and innovation.[23]
By discouraging receivables financing and making it more expensive, the uncertainty caused by recharacterization risk can impair the real economy.[24] Receivables currently represent trillions of dollars of investments in the United States.[25] More broadly, a “growing segment of the world’s money” and in “developed countries, the bulk of corporate wealth” is locked up in receivables.[26] Receivables financing is the tool for unlocking that wealth. Using that tool effectively requires that courts and lawyers can realistically determine if a receivables financing constitutes a sale of, or a loan secured by, the receivables (uncertainty in making that determination hereinafter being the “sale-versus-loan problem”).[27] This has become both a domestic and a worldwide problem.[28]
B. Legal Challenges
To reduce that uncertainty and mitigate its costs, this article seeks to build a rational, consistent, and cost-effective legal framework for resolving the sale-versus-loan problem. Building such a framework faces a host of challenges, including answering fundamental questions about the sale of receivables and other intangible rights.[29] The fact that at least four separate bodies of law—contract, property, commercial, and bankruptcy law—apply to receivables financing adds to the challenges.
For example, contract law applies to receivables financing because the analysis starts with the financing contract itself. As observed, courts sometimes recharacterize these contracts, finding that they merely evidence loans secured by the receivables. This recharacterization directly confronts the principle of freedom of contract.[30]
There are three general limitations to freedom of contract: paternalism, externalities, and statutory policies.[31] In the context of receivables financing, the parties normally are sophisticated businesses, so paternalism generally should not apply.[32] The limitations based on externalities and statutory policies, however, are not well developed, contributing to the uncertainty.[33] Part IV.B of this article examines these limitations.
Property law applies to receivables financing because the ultimate question is whether the purported sale contract effectively transfers ownership of the receivables. As mentioned, the intangibility of receivables complicates the analysis.[34] Part IV.A of this article focuses on property law.
Commercial law also applies because the Uniform Commercial Code (“UCC”) covers both sales of receivables and loans secured by receivables.[35] Although intended to allow UCC Article 9’s notice-filing perfection and priority provisions to protect both types of transfers,[36] that dual coverage muddies the sale analysis by using nomenclature that treats sales of receivables as secured transactions—a treatment that has confused numerous courts, including federal courts of appeal.[37] PEB Commentary No. 14 has now mitigated this confusion, however, by clarifying that “[t]he reason for subjecting both sales and secured transactions to Article 9 was to inform third parties of existing interests in a debtor’s receivables and to provide protection for all types of assignments of receivables.” Moreover, an Official Comment to the UCC now further explains that commercial law should not undermine sale treatment; it directs courts to look to non-commercial law to differentiate sales of, from loans secured by, receivables.[38] Some confusion nonetheless remains.[39]
Bankruptcy law applies to receivables financing because courts most often are asked to recharacterize receivables financing contracts when the purported seller of the receivables (in bankruptcy, the “debtor”) has become subject to bankruptcy.[40] The equitable power of bankruptcy judges then compounds the uncertainty.[41] Although that equitable power is sometimes exercised unpredictably,[42] Part IV.B of this article seeks to provide bankruptcy judges with insights as to how they should apply bankruptcy policies to the sale-versus-loan problem.
Another challenge to characterizing receivables financings is that both sales of receivables and loans secured by receivables superficially look the same. As illustrated below, they both involve the transfer of receivables from one party (Party A) to another party (Party B) and the concurrent transfer, in exchange, of money from Party B to Party A.
That similarity may lead courts to conflate sales and loans involving receivables, creating all the more reason for judges to exercise caution.
A further challenge is the confusion arising from the classic asymmetric information problem of selling property.[43] Because the timing and amount of collections on the receivables cannot always be accurately predicted at the time of the transfer, and the transferor inherently knows more about the receivables than the transferee, the agreement governing the transfer—whether denominated a sale agreement or a loan agreement—normally provides for recourse in the form of an adjustment of payments (as illustrated in this article’s earlier example[44]). That recourse simply reflects the transferor’s assurances about the quality of the receivables being transferred. Courts often view the existence of recourse, however, as inconsistent with a sale.[45]
That view ignores the reality that in order to reduce the information asymmetry, sellers generally make representations and warranties (“R&Ws”) or other assurances about the quality of the property being sold. This recourse helps to solve the “lemons” problem discussed by Nobel-Prize-winning economist George Akerlof, describing how information asymmetry can lead to market inefficiencies.[46] If buyers cannot differentiate between high-quality and low-quality goods, they may be unwilling to pay a premium for quality, resulting in a market dominated by low-quality goods (“lemons”).[47] To address this market failure, sellers typically provide R&Ws, giving buyers assurances about the quality of the goods.[48] This need for sellers to provide recourse to buyers regarding the quality of the property sold is as important for the sale of receivables as for the sale of goods.[49]
The failure to view the sale-versus-loan problem within the larger context of selling property presents yet another challenge. A sale generally is determined by the transfer not only of risks but also of benefits of the transferred property.[50] Due to path dependence, however, courts considering the sale-versus-loan problem have almost completely ignored the transfer of benefits as a sale criterion.[51] Although a sale of property, including receivables, should give the buyer the right to further alienate and otherwise benefit from the property,[52] most sale-versus-loan cases focus almost entirely on the transfer of risks, typically in the form of recourse.[53] Part IV.A of this article analyzes the sale-versus-loan problem in that larger context of selling property.
Finally, a more prosaic challenge is correcting the widespread judicial reliance on a 1991 article by two practitioners (hereinafter, the “1991 article”),[54] which purports to list factors considered by courts in analyzing the sale-versus-loan problem. Although attempting to catalog those factors, that article failed to differentiate their contexts (e.g., bankruptcy, usury, equity of redemption[55]), nor did it critique the relevance or reasonableness of those factors. For example, that article conflated usury-related factors, which focus on excessive interest charged to consumers—a serious social concern that strongly favors recharacterization[56]—with corporate bankruptcy-related factors, which have no relevance to consumers or interest rates.[57] Furthermore, a usury remedy would not stop at recharacterization; it would lead to invalidating the usurious loan.[58]
C. Goals and Direction
This article has mixed normative and positive goals. As mentioned, its normative goals are to derive a rational, consistent, and cost-effective legal framework to resolve the sale-versus-loan problem.[59] To that end, the article seeks to reduce, if not eliminate, the confusion and uncertainty associated with the sale-versus-loan problem, including addressing the challenges discussed in the preceding subpart B. The 1991 article, for example, is problematic[60] and a third of a century old. Since then, there have been major changes in the economy and financing landscape, including significant increases in the volume of receivables financing and the growth of securitization.[61] Judges, lawyers, investors, and scholars alike need a fresh perspective.
To these ends, Part II of this article describes the current jurisprudence, discussing the factors that courts have been considering when addressing the sale-versus-loan problem. Part III of the article critiques that jurisprudence, identifying and discussing its serious flaws. Part IV derives a legal framework for resolving the sale-versus-loan problem. Subpart A of Part IV analyzes what broadly constitutes the sale of property; it shows that the determinants of a sale include not only the intentions of the parties but also the transfer of the risks and benefits of the transferred property. Subpart B applies that analysis to receivables financing, deriving a specific framework for determining what should constitute a sale of receivables. Finally, Part V of the article tests that framework by applying it to hypothetical and actual examples of receivables financings.
II. The Current Jurisprudence
The jurisprudence on the sale-versus-loan problem is muddled and inconsistent. Courts analyzing the problem claim to apply a holistic framework, rather than relying on a single determinative factor. However, they differ in the factors they consider, and the weight given to each.[62] Four factors nonetheless dominate: risk allocation, or “recourse”; rights and obligations regarding surplus and deficiency; control over receivables and collections; and contractual language.
A. Recourse
By far the most significant factor that courts consider is recourse: the extent to which the transferor bears a risk of loss on the transferred receivables.[63] Courts generally recharacterize receivables financings as secured loans if the transferor bears substantial risk.
This risk allocation is clear at the extremes. For example, courts will recharacterize a receivables financing as a secured loan if the transferor bears the entire risk of non-payment of the receivables.[64] Similarly, they will find the financing to be a sale if the transferee assumes the full risk of non-payment.[65]
In between these extremes, there is considerable ambiguity. Courts tend to find a receivables financing to be a loan if the purchase price is retroactively adjusted to address shortfalls in expected collections.[66] Some courts find a receivables financing to be a loan if the transferor is obligated to repurchase defaulted receivables.[67] In contrast, if the transferor’s obligations arise in limited circumstances, a court might find the financing to be a sale.[68]
To complicate matters, courts tend to view a transferee’s right to collect interest after the completion of the transaction as recourse. Absent the transferee’s right to collect interest, some courts find a sale because the risk has been passed to the transferee.[69] But courts tend to find a loan where the transferor is required to pay a fixed amount in interest regardless of whether the accounts were paid, arguing that the transferor has retained much of the risk.[70]
B. Surplus/Deficiency
Courts sometimes consider a transferor’s right to surplus collections or its obligation to cover deficient collections as evidencing a secured loan.[71] Correlatively, absent these rights and obligations, they may find the receivables financing to be a sale.[72]
These rights and obligations are connected to other sale-versus-loan factors discussed in this article. The extent to which a transferor is obligated to cover deficient collections would constitute recourse, as above and subsequently discussed.[73] The extent to which a transferor lacks the right to surplus collections inversely corresponds to the transferee gaining that right, which would constitute the transfer of benefits as later discussed.[74]
Nonetheless, courts do not appear to recognize, or at least acknowledge, those connections. Rather, they tie these rights and obligations to the provisions of commercial law that require a secured lender to return surplus collateral value to the borrower[75] and that obligate the borrower to pay the loan to the extent the collateral is insufficient.[76] The implicit logic is that a receivables financing that has rights and/or obligations that somewhat parallel these commercial law provisions must be a loan.
The problem, however, with resolving the sale-versus-loan problem by looking to commercial law is that the UCC now explicitly directs courts to look to non-commercial law to differentiate sales of, from loans secured by, receivables.[77]
C. Control over Receivables and Collections
Another factor that courts consider is which party has control over the transferred receivables and collections. Control refers to the servicing of the receivables—that is, the right to collect amounts due from the obligors of the receivables—and whether the proceeds, or cash collections, of the receivables are commingled with the transferor’s other property.[78] Control by the transferee would be consistent with a sale, whereas control by the transferor would be more consistent with a loan.[79]
Although some courts rule that it is consistent with a sale for a transferee of the receivables to pay the transferor a fee to service the receivables,[80] others hold that the absence of such a fee would be consistent with a loan.[81] Other courts consider a receivables financing to be a sale where the transferee has the right to collect amounts due from the obligors of the receivables, even if it does not exercise that right.[82] Courts also consider a receivables financing to be a sale where the obligors of the receivables are notified of the transfer.[83]
In general, though, courts are inconsistent in how they view control as a factor.
D. Contractual Language
Courts often begin analyzing the sale-versus-loan problem by examining the express terms used by the contracting parties, including the title of the contract. Ironically, most courts then go on to say that labels and terminology do not matter.[84] In other words, “Simply calling transactions ‘sales’ does not make them so.”[85]
Nonetheless, some courts state that they will respect clear and unambiguous sale language. For example, in Goldstein, the court indicated that if the language clearly expresses an absolute sale, that interpretation should be upheld unless there is compelling, contrary evidence.[86] Nonetheless, most courts tend to disregard labels and to focus on more substantive factors, like the allocation of risk, if there is contradictory terminology or if other factors suggest a loan structure.[87]
III. Critiquing the Current Jurisprudence
The current jurisprudence on the sale-versus-loan problem is seriously flawed as well as inconsistently applied. The inconsistencies alone would be troublesome, inviting forum shopping.[88] Set forth below are critiques of the more serious flaws.
A. Overreliance on Recourse
Perhaps the most serious flaw is the overemphasis on recourse. The transfer of risk, however, is only one of several key factors characterizing a sale. This overemphasis appears to be path-dependent, stemming from the precedent set by the seminal Major’s case.[89]
The question before the Major’s court was which party—the transferor or the transferee of receivables—should be entitled to the so-called equity of redemption, representing the surplus value of collections. Although the receivables financing was evidenced by a “sale” contract, the court found that protecting a borrower’s equity of redemption should override the contract’s formal designation. If the receivables financing was a sale, the transferee (Credit Castle Corporation) would have been entitled to the surplus; if a loan, the transferor (Major’s Furniture Mart) would have been entitled to the surplus.[90] The court examined the substantive terms of the contract and found that the transferor retained virtually all of the risks associated with the transferred receivables.[91] It ruled that the contract created a loan because a sale would have shifted all or a substantial part of those risks to the transferee.[92]
The emphasis of the Major’s court on recourse, however, was fact-specific and should not serve as precedent for resolving the sale-versus-loan problem. Although the broader test of what should constitute the sale of property looks to the transfer not only of risks but also of benefits of the transferred property,[93] the Major’s court could not look to the transfer of benefits as a factor; that would have been circular because the question before the court was which party should be entitled to those benefits. In other words, the court was bound by the facts to look only to the transfer of risks.
B. Failure to Differentiate Types of Recourse
Another flaw in the current jurisprudence on the sale-versus-loan problem is its failure to differentiate the nature of the recourse. As discussed, virtually every sale of property requires the transferor to bear some recourse, often in the form of R&Ws as to the quality of the transferred property, in order to reduce information asymmetry.[94] The Major’s court effectively recognized this distinction: “Guaranties of quality alone, or even guarantees of collectibility alone, might be consistent with a true sale.”[95]
A group of prominent commercial law and bankruptcy scholars further developed this distinction, differentiating recourse for collectibility—essentially the equivalent of R&Ws on the sale of goods—and economic recourse, which more closely represents the type of recourse that should characterize a loan.[96] Full economic recourse would provide the transferee of receivables with a specific guaranteed rate of return regardless of losses or delays in collections. That type of recourse would be inconsistent with a sale because “a true buyer, unlike a lender, cannot adjust its return after the purchase to ensure a market return at all times.”[97]
To date, however, few courts have followed that distinction, possibly reflecting the difficulty of differentiating those forms of recourse.
C. Underreliance on the Transfer of Benefits
As courts are overrelying on the transfer of risk (recourse),[98] they are under-relying on, and often ignoring, the transfer of benefits in analyzing the sale-versus-loan problem. As will be shown, however, determining whether property—whether tangible property or receivables—has been sold turns significantly on whether the benefits associated with the property have sufficiently shifted from the transferor to the transferee.[99]
This analytical gap stems, as discussed, from the very particular and fact-specific opinion in the Major’s case.[100] That court could not look to the transfer of benefits as a sale-versus-loan factor because its inquiry was limited to which party should be entitled to those benefits.[101]
Some courts have considered the right to surplus collections as a type of benefit and its transfer, or lack thereof, as a relevant sale-versus-loan factor. In principle, surplus value is a type of benefit whose transfer should be a relevant factor.[102] Even in those cases, however, many of the courts have tied their analysis to a borrower’s right to the return of surplus collateral value under the UCC. As discussed, the UCC now directs courts to look to non-commercial law to differentiate sales of, from loans secured by, receivables.[103]
D. Dismissing the Parties’ Intentions
The current jurisprudence dismisses, or pays little attention to, the parties’ intentions.[104] As a matter of freedom of contract, those intentions should govern the characterization of a receivables financing absent limitations imposed by externalities or statutory policies. Part IV.B of this article later discusses why those limitations should not apply to the characterization of a receivables financing.
E. Considering Irrelevant Factors
Another serious flaw in the current jurisprudence is that it considers what should be completely irrelevant factors. For example, the 1991 article lists, and some courts follow, that a transferor’s continued servicing of transferred receivables—that is, collecting those receivables and dealing with delinquent and defaulted payments—would be indicative of a loan.[105] This ignores the practical realities of receivables financings. Because transferors, including sellers, typically have longstanding familiarity and expertise in servicing their receivables, transferees, including buyers, often find it efficient to retain the seller as a servicer, typically paying them an arm’s-length fee to do this work.[106]
The 1991 article also states that the lack of an independent credit investigation of the obligors of the receivables may be indicative of a loan. Again, this ignores market practicalities. Making such an independent credit investigation would be extremely expensive and time-consuming.[107] Buyers therefore normally rely on the seller’s R&Ws about the quality of the receivables.[108] This reliance reflects the buyer’s confidence in the seller’s reliability and financial ability to pay for any R&W breaches.[109] Given that confidence, a transferee’s decision whether or not to make such an independent credit investigation should be irrelevant to whether the transfer of the receivables is a sale or a loan.
Some lawyers also have considered the absence of a legal opinion stating that a receivables financing is a sale as supporting recharacterization of the financing as a loan.[110] That again is unrealistic; because a legal opinion is expensive, parties to a receivables financing may decide to forego requiring such an opinion.[111] Furthermore, the presence or absence of a legal opinion would not change the underlying structure or terms of the receivables financing.
Considering these critiques, this article next derives a normative framework for resolving the sale-versus-loan problem.
IV. Deriving a Legal Framework for Resolving the Sale-versus-Loan Problem
A.Analyzing What Should Constitute a Sale of Property
1. Governing Law. State law governs what should constitute a sale of property, even in a bankruptcy case—the typical scenario in which courts are asked to recharacterize receivables financing contracts.[112] In the Butner case,[113] the U.S. Supreme Court held that state law property rights[114] apply in bankruptcy unless “some federal interest requires a different result.”[115] This article later examines whether any federal bankruptcy policies should require a different result than would be applicable under state property law.[116]
2. General Principles. An inquiry into what should constitute the sale of receivables, an intangible form of property, should start with a more general understanding of what constitutes the sale of tangible property under state law. This approach admittedly grafts a normative analysis (what should constitute the sale of receivables) onto a positive observation (what constitutes the sale of tangible property).[117] The scholarly practice of basing normative analyses on positive observations has strong precedent, though.[118] The law should be tethered to reality.[119]
To determine what constitutes the sale of tangible property under state law, the most important factors are the expressed intention of the parties and the transfer of the risks and benefits associated with the property.[120] Assuming the parties intend a sale, ownership of the property is transferred when those risks and benefits sufficiently shift from the transferor to the transferee of the property.[121] This is reasonable, reflecting a substance-over-form approach that focuses on which party bears the economic consequences rather than solely relying on formal documents like title or deeds.[122]
Determining when risks sufficiently shift from the transferor to the transferee of the property usually depends on who would suffer the loss if the property were damaged or destroyed.[123] This can be tricky. For the sale of goods, for example, the law allocates that risk of loss based on commercial realities, such as who would be expected to insure the goods at the time of their loss, not ownership.[124]
In determining when benefits sufficiently shift from the transferor to the transferee of the property, courts look to which party has the right to use, control, or profit from the property, including profiting by reselling (that is, alienating) the property.[125] Alienability is a fundamental aspect of property rights, ensuring that property can be freely exchanged in the market, promoting economic efficiency and stability.[126] These rights are not absolute, however; they can be disaggregated and reorganized. For example, someone may lease or loan their property to another, retaining some ownership rights while temporarily transferring others.[127] This flexibility allows owners to structure transactions to meet their particular needs, providing great autonomy, but it also makes the concept of ownership more complex.
Although documents of title can be important in showing the parties’ intentions,[128] they are not necessarily controlling. In Peoples Bank v. Sanders, the court emphasized that while title “is an important indicator of ownership, it is not the only factor to be considered,” focusing more on authorization to encumber.[129] Similarly, the court in Gingrich v. Unigard Sec. Ins. Co. found other indicia of ownership to be more important than title, including possession, right of control, and the nature of the transaction.[130]
The importance of physically possessing tangible property is still real but diminishing. In Gaass v. Hettinga, for example, the court explained that although “a rebuttable presumption of ownership arises from the possession of property,” “ownership is a collection of rights to use and enjoy property, including the rights to sell and transmit it” and possession is “only one of the incidents of ownership . . . .”[131] Possession may be even less important as an indicator of ownership in the modern business world.[132]
3. Articulating a General Legal Framework for the Sale of Property. A general legal framework for the sale of property under state law thus looks to the expressed intention of the parties and the transfer of the risks and benefits associated with the property as the most important factors. Assuming the parties intend a sale, it occurs when those risks and benefits have sufficiently shifted from the transferor to the transferee of the property. Determining when those risks have sufficiently shifted usually depends on who would suffer the loss if the property were damaged or destroyed. Determining when those benefits have sufficiently shifted depends on which party has the right to use, control, or profit from the property (including by reselling the property). Because state law allows these rights to be disaggregated and reorganized to provide flexibility, it may not always be obvious whether the benefits have sufficiently shifted.[133] Subpart B next derives a legal framework for the sale of receivables by applying this general framework to receivables financing.
B. Applying that Analysis to Derive a Legal Framework for Selling Receivables
1. Intention of the Parties. The threshold question for determining whether a transfer of receivables constitutes a sale therefore should be whether the parties intend a sale. This could be evidenced, for example, by how the parties label their contract. A contract labeled a receivables sale agreement—especially one that includes language expressing a sale of the receivables by the transferor and a purchase thereof by the transferee—should be sufficient.
2. Transfer of Risks. The next question for determining whether a transfer of receivables constitutes a sale should be whether the risks associated with the receivables have sufficiently shifted from the transferor to the transferee. The test for the risk transfer of tangible property, who would suffer the loss if the property were damaged or destroyed, does not apply to receivables, which are intangible property. Rather, the risk of loss associated with receivables is that they will not be paid (default risk) or that they will be paid later than agreed (delinquency risk).
Default and delinquency risks depend on the quality of the receivables. As discussed, sellers of tangible property normally assume some portion of the quality risk associated with the property being sold, typically in the form of R&Ws, in order to reduce the information asymmetry between them and the buyers.[134] R&Ws or other forms of recourse serving this function for the sale of receivables—such as R&Ws protecting against default risk and delinquency risk due to misrepresentations about the quality of the receivables[135]—should be consistent with sale characterization. Part V of this article later examines, pragmatically, how lawyers and judges could distinguish that retention of risk as part of a broader inquiry into whether the risks associated with the receivables have sufficiently shifted from the transferor to the transferee to constitute a sale of the receivables.
3. Transfer of Benefits. Finally, consider whether the benefits associated with the receivables have sufficiently shifted from the transferor to the transferee to constitute a sale. Those benefits could include the monetary collections of the receivables as well as alienability—the transferee’s right to resell the receivables.
In a pristine sale, the transferee would have the right to all of the monetary collections of the receivables.[136] Realistically, though, few if any receivables financings commercially provide that because transferees typically require significant overcollateralization to protect themselves.[137] Transferors and transferees customarily bargain over how surplus collections from the overcollateralization, or surplus value, will be divided between them.[138] That is sensible as a business matter because it voluntarily and deliberately allocates those collections between the parties.[139] Such a bargained-for allocation of benefits also is consistent with state law, which allows the benefits to be disaggregated and reorganized to provide flexibility.[140]
An arm’s length bargain over how surplus value will be divided therefore generally should be consistent with a sale, notwithstanding that some courts have held that the transferor’s right to receive surplus value suggests a loan.[141] Nonetheless, allocating the surplus value to the transferor could be inconsistent with a sale if that allocation coupled with the recourse[142] creates full economic recourse.[143]
A contractual restriction on alienability would be inconsistent with a sale, whereas a provision specifically contemplating alienability would suggest a sale. Silence, which tends to be the default in contracts for receivables financings,[144] would appear to be neutral. Parties wishing to more clearly document their transaction as a sale could consider inserting a provision into their contract specifically authorizing alienability of the transferred receivables. To be effective in evidencing a sale, any such provision would have to clearly provide that it applies to alienability of ownership of the transferred receivables, not merely to alienability of whatever lesser rights (e.g., secured transaction rights) the transferee has received in those receivables.[145]
4. Articulating a Tentative Framework. Based on the foregoing analysis, a receivables financing that satisfies these criteria should be characterized as a sale:
(i) The contract evidencing the financing is labeled a sale or it includes explicit language expressing a sale of the receivables by the transferor and a purchase thereof by the transferee; and the contract does not otherwise state that it is primarily intended[146] to create a secured loan rather than a sale.
(ii) The recourse is expressed through R&Ws or other provisions assuring the quality of the receivables, in order to reduce information asymmetry. R&Ws limited to the quality of the transferred receivables at the time of their transfer should conclusively be deemed to be consistent with sale characterization.[147]
(iii) The contract may freely allocate surplus value of the receivables between the transferor and the transferee, provided that allocation coupled with the recourse does not create full economic recourse.
(iv) The contract either gives the transferee the right to further transfer or sell the receivables or is silent on alienability restrictions.
5. Taking into Account Externalities and Statutory Policies. The analysis next stresses the foregoing tentative framework by taking into account externalities and statutory policies, which could limit freedom of contract.[148] First consider externalities, then statutory policies.[149]
(i) Externalities should not limit the characterization of a receivables financing. The only third parties who potentially might be harmed by the financing would be the transferor’s unsecured creditors.[150] Fundamentally, a receivables financing, whether characterized as a sale or a secured loan, transfers $(X+Δ) of receivables in exchange for $X of money. The $Δ represents what is customarily called overcollateralization—an excess of receivables value over the amount of money transferred.[151] The overcollateralization takes into account the risk of loss on the receivables and, because the receivables will be paid in the future, the time value of money.[152]
The amount of overcollateralization in an arm’s length receivables financing—or at least the portion thereof that the transferee has the right to retain[153]—should be reasonable, otherwise sophisticated business parties[154] would not voluntarily bargain to exchange the relevant receivables and money. From the standpoint of the transferor, therefore, the $X of money received should represent a fair exchange for the $(X+Δ) of receivables transferred.[155] Unsecured creditors of the transferor thus should have no compelling reason to oppose the receivables financing.
Empirical observations confirm this supposition, though with an interesting twist. Covenants restricting the sale of receivables are relatively rare in financing agreements, while covenants that restrict loans secured by receivables are much more prevalent.[156] In other words, to the extent a transferor’s creditors oppose receivables financing, they are likely to oppose a loan secured by receivables and not a sale of receivables. This at least suggests that unsecured creditors do not generally see the sale of receivables as creating externalities.
(ii) Next stress the foregoing tentative framework by taking into account statutory policies that could limit freedom of contract. Theoretically, this limitation could apply in two contexts. First, it could constitute a generic state law limitation based on statutory policies as a limit to freedom of contracting.[157] Second, it could constitute a specific conflict-of-law limitation based on the Supreme Court’s jurisprudence as to when the policies of federal bankruptcy law should override state law.[158]
For the receivables financings discussed in this article, however, these contexts merge. The only statutory policies that could limit freedom of contract are bankruptcy policies because, as discussed, courts adjudicate receivables financing recharacterization cases almost exclusively when a transferor becomes bankrupt and is advancing a recharacterization argument.[159] Furthermore, the only bankruptcy policies are federal bankruptcy policies because bankruptcy is governed by federal law.[160] The other potentially applicable statutory policies that could limit receivables financing contracts—usury and equity of redemption[161]—do not apply here. As previously explained, usury focuses on excessive interest charged to consumers, which has no relevance to business-related receivables financings.[162] And equity-of-redemption issues arise only in specific limited circumstances.[163]
The relevant inquiry, therefore, is whether bankruptcy policies should limit freedom of contract in order to sometimes justify recharacterization of a receivables financing contract.[164] The primary bankruptcy policies are equal treatment for creditors and debtor rehabilitation.[165] In another context, one of the authors of this article and others concluded that neither of those policies would be sufficiently “threatened by the concept of a true sale with recourse for collectibility as to require courts to create federal common law and ignore state law rights.”[166] The more specific question for this article, though, is whether either of those policies should require or allow a court to recharacterize as a secured loan a receivables financing that, contractually, purports to be a sale.
Logically, a bankruptcy policy should require or allow that recharacterization only if the contractual characterization as a sale violates that policy. Contractually characterizing a receivables financing as a sale would not violate the policy of equal treatment for unsecured creditors. Although the transferee of the receivables would have greater rights to the receivables and their collections in a sale than in a secured loan,[167] both a sale and a secured loan would give the transferee rights therein that are superior to those of the transferor’s unsecured creditors.[168] Therefore, the characterization of a receivables financing as a sale or a secured loan would be irrelevant to equal treatment of those creditors.
Contractually characterizing a receivables financing as a sale could impact debtor rehabilitation, however. As observed, a sale means that the transferee owns the receivables and collections, whereas a loan means that the transferor-debtor continues to own the receivables and collections and the transferee merely has a security interest therein.[169] Significantly for debtor rehabilitation, bankruptcy law would then allow the transferor-debtor to use the cash collections of the receivables for reorganization purposes if it provides the transferee with adequate protection of its security interest.[170]
Should that debtor-rehabilitation advantage, created by recharacterizing a receivables sale as a secured loan, be significant enough to “require[] a different result”[171] than what the parties contracted for? We think not because sale characterization would enable the transferor to obtain lower cost financing,[172] which should help it avoid bankruptcy in the first place. Bankruptcy law favors transfers that could help a firm try to avoid bankruptcy, even though the transfer could impair the firm’s ability to reorganize if it subsequently enters bankruptcy. For example, bankruptcy law permits a financially distressed firm to grant a security interest in its assets as a quid pro quo to obtain default waivers that could help the firm avoid bankruptcy.[173] This grant of collateral, which could impede the firm’s ability to reorganize in bankruptcy,[174] would remain valid even if those waivers ultimately fail to enable the firm to avoid bankruptcy.[175] Furthermore, although recharacterization would allow the firm to use the cash collections of the receivables for reorganization purposes,[176] bankruptcy law already separately enables firms to obtain reorganization financing.[177]
On balance, therefore, bankruptcy policies should not justify recharacterization of a receivables financing contract.
6. Articulating the Derived Framework. As shown above, neither externalities nor statutory policies should limit the contractual freedom of sophisticated business parties to designate their receivables financing as a sale. Accordingly, this article proposes that the tentative framework[178] be the final derived framework (the “framework”) for finding that a receivables financing constitutes a sale, namely that the following criteria are met:
(i) The contract evidencing the financing is labeled a sale or it includes explicit language expressing a sale of the receivables by the transferor and a purchase thereof by the transferee; and the contract does not otherwise state that it is primarily intended to create a secured loan rather than a sale.
(ii) The recourse is expressed through R&Ws or other provisions assuring the quality of the receivables, in order to reduce information asymmetry. R&Ws limited to the quality of the transferred receivables at the time of their transfer should conclusively be deemed to be consistent with sale characterization.
(iii) The contract may freely allocate surplus value of the receivables between the transferor and the transferee, provided that allocation coupled with the recourse does create full economic recourse.[179]
(iv) The contract either gives the transferee the right to further transfer or sell the receivables or is silent on alienability restrictions.
If all four of these criteria are met, the receivables financing should definitively be found to constitute a sale. In applying the framework, Part V will also consider how meeting certain criteria should be balanced with failing others.
V. Testing the Framework
The foregoing framework may appear sensible, but its raison d’être is to provide clear and pragmatic guidelines for judges, lawyers, and investors, thereby reducing uncertainty and cost and discouraging forum shopping. This Part V tests the framework by applying it to the simplified example in the Introduction and to other hypothetical and actual examples of receivables financings. These applications show that the framework should achieve those goals.
A. Application to Simplified Example
The simplified example in the Introduction[180] assumes that Party A (the transferor/purported seller) contracts to sell $1,000 of receivables to Party B (the transferee/purported buyer) for $950. If the collections on the receivables are less than $975, or if collections are made later than expected (180 days), the contract requires Party A to compensate Party B for the loss or delay. If those collections are more than $985, the contract requires Party B to turn over the surplus collections to Party A.
Subject to the discussion below,[181] that contract should constitute a sale of the receivables. Criterion (i) of the framework is met because the “contracts to sell” language explicitly expresses a sale of the receivables by the transferor and a purchase thereof by the transferee. The example does not suggest, and we therefore assume, that the contract does not otherwise state that it is primarily intended to create a secured loan rather than a sale.
Although less clear, criterion (ii) of the framework should be met. The contract requires Party A to compensate Party B if the collections on the receivables are less than $975 or if collections are made later than expected. These recourse provisions help to assure Party B about the quality of the receivables, thereby reducing the information asymmetry.
Criterion (iii) of the framework should be met because the contract allocates surplus value of the receivables between the transferor and the transferee; Party B retains any surplus value up to and including $985, and Party A is entitled to any surplus value exceeding that number.[182] That allocation of surplus value coupled with the recourse would not create full economic recourse—defined as providing Party B, the transferee of receivables, with a specific guaranteed rate of return regardless of losses or delays in collections.[183]
The allocation of recourse and surplus value in the contract nonetheless provides Party B with a degree of economic recourse by assuring investment protection within a range of possible outcomes. In principle, that should be consistent with a sale; an arm’s length sophisticated business party would not voluntarily make an investment, such as buying receivables for a specified purchase price, unless it reasonably expects its investment to be repaid with (or close to) a market rate of return.[184] For the simplified example, assume that receipt by Party B, the buyer, of $980 of collections of the receivables in 180 days would achieve a market rate of return on its $950 investment. The simplified example provides a degree of economic recourse because Party A, the seller, must compensate Party B if collections are less than $975 or if those collections are delayed beyond 180 days. Therefore, Party A contractually assures Party B that it will receive at least something close to a market rate of return. Party B’s rate of return could be higher if it receives collections exceeding $980, but even that has an upper limit because Party A is entitled to any surplus value exceeding $985.[185]
The contract thus provides Party B with investment protection within a range of possible outcomes that are negotiated at arm’s length at the time of the receivables transfer. Technically, that should not be full economic recourse because it does not guarantee a specific rate of return, as would be the case with a loan that bears an agreed interest rate.[186] Furthermore, it shifts at least some of the risk (up to $5 of risk if collections are between $975 and $980) and benefit (up to $5 of benefit if collections are between $980 and $985) from the transferor to the transferee.[187]
Even so, at what point should a court find that a contract has so narrowed the range of possible outcomes to create the de facto equivalent of a specific rate of return (and thus create full economic recourse)? Although the answer is not unequivocal, a reasonable response might be that a material range of variation for both risks and benefits should obviate a finding of full economic recourse. The rule of thumb for materiality is 5%.[188] The range of variation in the above simplified example for both risks and benefits exceeds 5%.[189] That range of variation should not create full economic recourse.
Finally, criterion (iv) of the framework would be met because the example does not suggest, and we therefore assume the contract does not impose (and hence is silent about), alienability restrictions. Because all the framework’s criteria are met, the contract in the simplified example should create a sale of receivables.
B. Application to other Hypothetical Examples
The following applications stress the key variables in the framework.
1. Stressing the Framing of the Contract. This could be stressed by including inconsistent framing language. For example, assume the contract is titled “Receivables Sale Agreement” but contains a provision stating “this Agreement is intended to provide [Transferee] with security for the obligations of [Transferor] hereunder.” A court reasonably could find that this specific secured loan language expresses the primary intention of the parties, thereby outweighing the title itself. In contrast, many receivables financing agreements state that “if a court rules that it does not create a sale, this Agreement shall be deemed to provide [Transferee] with security for the obligations of [Transferor] hereunder.” Such a backstop security interest would not contradict the primary intention of the parties, to create a sale, and therefore should be consistent with a sale.
2. Stressing the Recourse. This could be stressed by providing for full recourse that goes beyond assuring the quality of the transferred receivables. For example, assume the contract states that “if any receivable fails to be paid in full within 60 [or some other specified number of] days, [Transferor] shall promptly pay [Transferee] the amount of such payment deficiency.” Although this type of full recourse for collectibility would be more consistent with a loan than a sale, a court should be able to find that the contract creates a sale if the framework’s other criteria are met.[190]
3. Stressing the Allocation of Surplus Value. This could be stressed by allocating the surplus value to the transferee to the extent such allocation provides the transferee with a return of its investment plus an agreed rate of return. That alone would not provide full economic recourse—and thus it should be consistent with a sale—because the amount of the surplus could be insufficient to provide that rate of return. However, if that return of surplus were coupled with full recourse for collectibility, thereby guaranteeing that the transferee receives (either through collections or through the recourse) a return of its investment plus a specific rate of return, there would be full economic recourse, which would be inconsistent with a sale. A court therefore could recharacterize the contract as a secured loan, subject to the contract giving the transferee full alienability of the receivables.[191]
4. Stressing Alienability. This could be stressed by restricting alienability of the transferred receivables. For example, assume the contract states that “[Transferee] shall have no right to sell, assign, or otherwise transfer the transferred receivables.” That suggests that the transferee does not actually own those receivables but merely has a security interest therein. In contrast, a contractual provision giving the transferee the right to further sell the receivables and keep all the sale proceeds not only should be consistent with a sale but also, assuming the contract is framed as a sale, should outweigh the existence of full economic recourse. The rationale for this view is twofold: that full alienability (i) transfers all the benefits of the property and (ii) goes directly to the substance of property rights whereas recourse goes only to the economics of the transaction, and where the two conflict the former should govern ownership.[192]
C. Application to Actual Examples
1. Examples where Courts Recharacterized a Receivables Financing to be a Secured Loan but where the Framework would justify a Sale. Although there are certainly more examples, the following cases exemplify scenarios where courts recharacterized receivables financings to be secured loans but, under this article’s framework, would be classified as sales.
(a) In In re Shoot the Moon,[193] the court recharacterized a receivables financing labeled as a “Merchant Agreement” to be a secured loan. Citing the 1991 article, the Shoot the Moon court said that it would follow “a holistic, multipart framework to examine a [receivables financing] transaction on the way to classifying it as a sale or a loan.”[194] The court initially observed that the fact that the transferor of the receivables gave a “broad” security interest in its assets to the transferee, to secure the transferor’s obligations under the contract, “is indicative of a loan, not a sale.”[195] That observation, however, should be irrelevant to both the transfer of receivables and this article’s framework. The security interest merely backed whatever obligations the transferor had; it is the nature and extent of those obligations (the recourse), not the transferor’s creditworthiness to perform them, which should be relevant to sale-versus-loan characterization. Similarly, the court stated that the guaranty of the transferor’s obligations by the principal of the transferor “weighs heavily in favor of characterizing the transactions as loans.”[196] Again, a backing of the transferor’s creditworthiness should be irrelevant to sale-versus-loan characterization.[197]
The court next observed that the UCC-1 “financing statements contain another revealing indicator that they relate to secured loans: they identify [the transferor] as a ‘debtor.’”[198] This observation should be of no import because it conflates the UCC’s application to both sales and secured loans, treating both as secured transactions for perfection and priority purposes,[199] with a substantive sale-versus-loan determination for bankruptcy law purposes. The model form of UCC-1 financing statement, which transferors of receivables must file for perfection and priority purposes, even officially identifies the transferor—whether a seller or a collateral debtor—as a “DEBTOR.”[200]
Finally, the court applied certain other factors included in the 1991 article to its analysis, noting that
three [such factors] weigh heavily in favor of classifying the transactions as loans. First, as contemplated in the first factor, [the transferee] retained a definite right of recourse against the [transferor] . . . . Second, as the second factor contemplates, the Shoot the Moon entities commingled funds from the [receivables] with other funds and specifically those used to operate the restaurants, with [the transferee’s] approval to boot. Finally, as contemplated by the eighth factor, the language contained in the agreements and the conduct of the parties reveal an apparent debtor-creditor, rather than seller-buyer, relationship. Considered in conjunction with the overall economic substance and risk allocation that connects the factors, the court concludes that the transactions are substantially similar to a loan.[201]
The first such factor, recourse, goes to criterion (ii) of this article’s framework. Although the court does not describe the recourse in detail, it mentions “the absence of any provisions allowing the [transferee] . . . to alter the pricing terms.”[202] This appears to indicate that the recourse was intended to assure the quality of the receivables, consistent with criterion (ii), and certainly not to create full economic recourse.[203] The second factor, commingling of proceeds, is not part of the framework not only because courts are inconsistent in how they view control over receivables collections as relevant to sale-versus-loan characterization[204] but also because sellers normally service the receivables.[205] The third factor, “the language contained in the agreements and the conduct of the parties,” should be irrelevant. The “language contained in the agreements” should be irrelevant because the court only references that language in the financing statements which, as discussed above,[206] conflates the UCC’s application to both sales and secured loans with a substantive sale-versus-loan determination. The “conduct of the parties” should be irrelevant because such conduct was limited to “business actors often discuss[ing] the transactions in vernacular reserved for debtor-creditor relationships.”[207] The legal nature of a contract should not turn on the discussion of non-lawyers.[208]
Applying the other criteria of this article’s framework, criterion (i) would be met because the contract contained “lengthy provisions regarding how the central transaction ‘is not intended to be, nor shall it be construed as a loan’.”[209] Criterion (iii) would be met because the contract does not allocate surplus value.[210] Criterion (iv) would be met because the court does not observe any restrictions on, and thus we assume the contract was silent about, alienability. Shoot the Moon therefore exemplifies a case where the court recharacterized a receivables financing to be a secured loan but where this article’s framework would classify the financing as a sale.
(b) The case of CF Motor Freight v. Schwartz (In re De-Pen Line)[211]exemplifies another scenario in which a court recharacterized a receivables financing to be a secured loan, whereas this article’s framework would classify the financing as a sale. The contract was labeled a “Factoring Agreement,” and the invoices evidencing the receivables were stamped with a statement that they have been “sold and assigned.”[212] The court recognized that factoring involves “the purchase of accounts receivable . . . .”[213] The transferee advanced 86% of the face amount of each receivable at the time of its transfer, with an additional 10% if and when the receivable collected.[214] If a receivable failed to collect within 60 days, the transferee had recourse for repayment of the amount advanced.[215] As a result of this recourse, the court found “that the risks which are characteristic of a true sale are not accepted by [the transferee] in the Agreement.”[216]
Applying this article’s framework, criterion (i) would be met because the contract clearly purported to create a sale of the receivables.[217] On balance, criterion (ii) should be met. Although full recourse for collectibility would be more consistent with a loan than a sale, a court should be able to find that the contract creates a sale if the framework’s other criteria are met.[218] Criterion (iii) would be met because the contract does not allocate surplus value. Criterion (iv) would be met because the court does not observe any restrictions on, and thus we assume the contract was silent about, alienability. CF Motor Freight therefore again exemplifies a case where the court recharacterized a receivables financing to be a secured loan but where this article’s framework would classify the financing as a sale.
(c) The decision in Nickey Gregory Co. v. AgriCap LLC[219]further exemplifies a case—notably, by a federal court of appeals—in which the court recharacterized a receivables financing to be a secured loan whereas this article’s framework would classify the financing as a sale. The contract was labeled a “Factoring Agreement,”[220] which traditionally evidences a sale of receivables.[221] The transferor, Robison Farms, granted the transferee, AgriCap, a security interest in all of Robison Farms’ assets to secure its obligations and also subordinated the claims of third parties to any future recourse claims of the transferee.[222] The president and owner of Robison Farms also personally guaranteed payment of any such future recourse claims.[223] The transferee had recourse against Robison Farms for receivables remaining unpaid past a specified period unless the obligor on the unpaid receivables had become bankrupt or insolvent.[224] The transferee also had recourse against Robison Farms for any unpaid receivables for which there was a R&W breach or an unsettled dispute.[225] Additionally, the filed UCC–1 financing statement referred to Robison Farms as “the Debtor.”[226] As a result of the recourse, the credit support, and the UCC-1 financing statement, the court found the financing to be a secured loan.[227]
Applying this article’s framework, criterion (i) would be met because the contract, a factoring agreement, purported to create a sale of the receivables. Criterion (ii) should be met because the recourse was limited and certainly did not constitute full economic recourse. The recourse resulting from R&W breaches simply assured the transferee/buyer about the quality of the receivables being sold.[228] The recourse for receivables that were subject to disputes was also quality-related because it related to the quality of the goods that were being sold to generate the receivables. The remaining recourse had an exception for unpaid receivables for which the obligor had become bankrupt or insolvent, the most likely reason generally for non-payment.[229] The court’s observation that the “Factoring Agreement ensured that AgriCap had almost total recourse against Robison Farms if a receivable went unpaid”[230] was therefore unfounded—possibly because the court was influenced by the district court’s “finding that the agreement between the parties in this case effectively insulated AgriCap from loss and was therefore a loan rather than a factoring sale.”[231]
Criterion (iii) of this article’s framework would be met because the contract allocated surplus value without creating full economic recourse. Criterion (iv) would be met because the court did not observe any restrictions on, and thus we assume the contract was silent about, alienability. Finally, the court’s reliance on the existence of the credit support for Robison Farms’ recourse obligations should be irrelevant because, as previously discussed,[232] it is the nature and extent of the recourse obligations, not the transferor’s creditworthiness to perform them, which should be relevant to sale-versus-loan characterization. Similarly, the court’s observation that the UCC-1 financing statement referred to Robison Farms as “the Debtor” should be irrelevant because, as previously discussed,[233] it conflated the UCC’s application to both sales and secured loans with a substantive sale-versus-loan determination. This case yet again, therefore, exemplifies a court recharacterizing a receivables financing to be a secured loan where this article’s framework would classify the financing as a sale.[234]
2. Example where Court found a Receivables Financing to be a Sale and where the Framework would Concur. In Dryden Advisory,[235] the court concluded that a receivables financing labeled as a “factoring agreement” constituted a sale. The framework would similarly recognize a sale. Consistent with criterion (i) of the framework, the agreement used language throughout expressing a sale, including “sale of accounts,” “accounts purchased by,” and “accounts offered for sale.” Nothing in the agreement indicated that the financing was intended to create a secured loan. Consistent with criterion (ii), the recourse related to the quality of the receivables, and even that quality-related recourse was limited.[236] Consistent with criterion (iii), the contract did not allocate surplus value of the receivables. Finally, consistent with criterion (iv), the agreement was silent on alienability restrictions.
3. Example where Court Recharacterized a Receivables Financing to be a Secured Loan and where the Framework does not provide a Clear Resolution. In the Lange case,[237] the court recharacterized the receivables financing to be a secured loan. The contract was labeled an “Invoice Purchase Agreement.” Under criterion (i), that labeling could be consistent with a sale,[238] but more information about the transfer language would be desirable. The contract was stated as being “full recourse,” requiring the transferor to repurchase receivables if their full amount was not paid within a set number of days. Under criterion (ii), that full recourse could be consistent with a secured loan if, coupled with criterion (iii), the surplus, it constituted full economic recourse. The contract, however, appeared to be silent about surplus value. The contract also appeared to be silent about criterion (iv), alienability, which could be consistent with a sale. The factual background is therefore insufficient to enable the framework to provide a clear resolution. A court applying the framework to this case therefore would have to review the facts de novo to try to reach a clear outcome.
VI. Conclusion
Courts often recharacterize contracts that purport to sell receivables—intangible rights to payment—if some of the substantive terms of the transfer are indicative of a loan. The jurisprudence on recharacterizing these contracts is muddled and inconsistent. This uncertainty impairs receivables financing as a tool to unlock the trillions of dollars (and growing) segment of the world’s wealth that is locked up in receivables.
This article builds a legal framework for reducing that uncertainty and mitigating its costs. This framework should give judges, lawyers, investors, and scholars a fresh perspective by correcting decades of judicial confusion, some of which stems from an outdated law journal article that was imprecise even when originally published.[239] The framework also should give contract-drafting guidance to lawyers, which could help to facilitate their clients’ objectives and minimize the ambiguity and litigation relating to receivables financing.
Notwithstanding this article’s framework, we caution that judicial confusion is not uncommon in inherently complex business, bankruptcy, financial, and other “commercial” cases. In another context, one of the authors studied erroneous court decisions involving the payment of checks, the honoring of letters of credit, the enforcement of assignment and anti-assignment clauses, and the sales of accounts.[240] That study suggested a possible way to improve the lawmaking process: to further develop, and then to steer relevant complex commercial cases to, business (sometimes called commercial) courts. In principle, these types of specialized courts—which generally operate either with specialized dockets that focus on commercial disputes, as separate divisions within existing court structures, or as separate courts entirely[241]—should be able to deal with the adjudication of complex commercial cases better than general jurisdiction courts.[242]
Although there has been an increased worldwide trend towards creating business courts,[243] there are no conclusive data on whether such courts are actually justified on a cost-benefit basis.[244] It also is unclear whether there are more cost-effective alternatives to a formal business-court regime, such as arbitration or a requirement for litigants to retain specialized business-law counsel[245] in complex commercial cases.[246] As the complexity of those cases increases,[247] it will become progressively important to consider how these and other ways to improve the lawmaking process could enhance the adjudication of commercial disputes, including disputes involving the sale-versus-loan problem.