Enforcing a Security Interest in Promissory Notes Evidencing Tort Settlements
If a borrower or guarantor gives a security interest in a promissory note to a lender, the lender's main concern is probably whether the obligor on that note will pay up. Understanding the underlying transaction giving rise to the note is not always a high priority. As a consequence, lenders can be misled about the enforceability of their security interest in a promissory note executed to evidence settlement of a tort claim if they are not knowledgeable about applicable law.
A few months ago, a savvy guarantor challenged the enforceability of my lender client's security interest in a promissory note by alleging that the note pledged as collateral evidenced a structured settlement of a tort claim. The guarantor argued that the note evidenced the settlement of a discrimination lawsuit and pointed to some language in the applicable statute which at first certainly seemed to support the guarantor's position. On closer examination, however, it became clear that while clever, the exclusion relied upon by the borrower was in fact much narrower than suggested by the guarantor.
Direct Pay Letter? Now to the casual dabbler in secured transactions law, it might seem that the best way to realize upon a promissory note evidencing a tort lawsuit settlement which has been pledged as collateral for a now delinquent obligation would be to send one of those “direct pay” letters. Ohio Rev. Code §1309.406(A) – (I am sooooo glad Ohio finally got with the program and doesn’t have weird numbering any more for the UCC, at least for UCC Article 9) -- provides:
an account debtor on an account, chattel paper, or payment intangible may discharge its obligation by paying the assignor until, but not after, the account debtor receives a notification, authenticated by the assignor or the assignee, that the amount due or to become due has been assigned and that payment is to be made to the assignee. After receipt of the notification, the account debtor may discharge its obligation by paying the assignee and may not discharge the obligation by paying the assignor
And this is what my lender client proceeded to do. Seems pretty straightforward, right? However, the obligor on the note pledged as collateral balked at honoring the direct pay letter on the grounds that the guarantor had convinced them that a garnishment proceeding was necessary due to a statutory exception for "structured settlement payments".
Special Structured Settlement Provisions. The guarantor had argued that Ohio Rev. Code §1309.406(K) carved out a giant exception to the application of UCC Article 9 which required additional action before my lender client could realize upon its collateral. That statute provides “[n]othing in this section shall supersede the provisions of sections 2323.58 to 2323.587 of the Revised Code.”
So now we go to the “killer” rule. Ohio Rev. Code §2323.581 adds additional requirements that must be met for a transfer -- which pursuant of Ohio Rev. Code 2323.58 includes an assignment, pledge, or grant of a valid security interest -- in “structured settlement payment rights” to be effective. It provides that no “direct or indirect transfer of structured settlement rights” is effective and no obligor on such an obligation is required to make payments to the “transferee” unless
- the “transferee” has provided the payee/borrower “and other interested parties” with certain detailed required disclosures detailed in Ohio Rev. Code 2323.582 BEFORE the payee “becomes obligated under a transfer agreement” AND
- the transfer has been approved in advance by the Court.
A "structured settlement" is defined by Ohio Rev. Code 2323.58(L) as "periodic payments of damages for injury to a person that is established by a settlement or a court judgment in resolution of a tort claim." Thus, the unwary lender might come to believe its security interest has serious enforceability issues. That would be wrong.
Remember the Definition of "Payee". Iin this case, as in many others, you gotta read the small print. The definition of "payee" -- upon which the exception of Ohio Rev. Code 1309.406(K) relies -- narrows the scope considerably of those structured settlement payments potentially excluded from the reach of a direct pay letter. Pursuant to Ohio Rev. Code 2323.58(G), "payee" is an "individual" receiving payments "excludable from the individual's gross income under federal income taxation laws applicable to that individual". According to the IRS, these payments arise from tort claims involving physical injuries or physical sickness and workers compensation claims. 26 USC 104.
Thus, while superficially perhaps a matter of concern for a lender, in reality, the language of Ohio Rev. Code 1309.406(K) only applies to payments related to personal injury claims. So, happily for my lender client, we were eventually able to convince the note obligor to honor the direct pay letter. The lessons to be learned? First, make sure you follow a clever borrower's argument ALL the way to the end. And, second, remember that promissory notes evidecing personalnjury settlements may be vulnerable to enforceability challengs.
