Recent Bankruptcy Court Decision Reminds Lenders That Perfection of a Security Interest May Not Be Enough to Protect Funds in a Bank Account
By: Thomas Pinney
Many secured loans, especially real estate loans with a lockbox and cash management arrangement, rely on a security interest in the borrower/debtor’s bank accounts to protect the cash generated from operations from third-party creditors. As a recent decision from the United States Bankruptcy Court for the District of Nevada, Charleston Associates, LLC v. RA Southwest land Company, LLC, et al, (In re Charleston Associates, LLC), Adv. Proc. No. 10-01452-MKN (Bankr. D. NV December 12, 2017) points out, simply establishing a cash management regime over the borrower’s funds may not provide a lender with protection once the funds have left the account.
In Charleston, US Bank, as trustee, was the mortgage lender to New Boca Syndications Group, LLC. As additional security for the loan, US Bank and New Boca entered into a cash management agreement where all operating revenue from New Boca’s shopping center was deposited into a lockbox account at Wells Fargo. The account was solely in New Boca’s name. The lockbox funds were then transferred to a cash collateral account (also solely in New Boca’s name) at Wells Fargo. US Bank was granted a security interest in the accounts, and deposit account control agreements among Wells Fargo, US Bank and New Boca were in place, giving US Bank dominion and control over the account following an event of default and notice to Wells Fargo. As is typical in these arrangements, the funds in the cash collateral account were to be disbursed to pay debt service and operating expenses according to a budget, until an event of default. Following an event of default, US Bank would have sole discretion to administer the funds, and New Boca would no longer have any right to request or control the disbursement of funds.
City National Bank obtained a judgment against New Boca as a result of New Boca’s default under the terms of a confirmed chapter 11 plan through which it obtained, among other things, title to the shopping center. City National then proceeded to execute on the assets of New Boca. Among the assets levied was the cash collateral account at Wells Fargo. Based on City National’s writ of execution approximately $543,000 was seized from the account and paid to City National. It is undisputed that the writ was properly issued and served. US Bank never declared an event of default or notified Wells Fargo that it was exercising its right under the deposit account control agreement to take control of the funds in the cash collateral account prior to the levy.
Unsurprisingly, US Bank objected to the seizure of the funds, and filed an emergency motion to compel City National to return the funds to the account. In support of its motion US Bank argued that it had taken all of the necessary steps required under the Uniform Commercial Code to obtain and maintain a perfected security interest in the funds in the cash collateral account. It was undisputed that US Bank had a properly perfected lien on the funds in the cash collateral account, so this should be an easy win, right? Unfortunately, it wasn’t.
City National countered by arguing that it was a transferee of the funds from a deposit account, and therefore, took the garnished funds free and clear of US Bank’s lien pursuant to Section 9-332 of the UCC. Section 9-332(2) of the UCC provides in relevant part:
(2) A transferee of funds from a deposit account takes the funds free of a security interest in the deposit account unless the transferee acts in collusion with the debtor in violating the rights of the secured party.
The court analyzed the facts in light of the provisions of Section 9-332, and found that as a transferee of funds from the cash collateral account, City National took the funds free of US Bank’s lien, and denied US Bank’s motion. In its analysis, the court reviewed the commentary to Section 9-332, which stated that the reason for Section 9-332 is to provide certainty in free flow of funds in commerce. This makes perfect sense. If New Boca’s creditors, for instance a utility provider (or any creditor of an entity that has granted a security interest in its bank accounts) are at risk that payment from an account is subject to another creditor’s liens, commerce would grind to a halt. Without the protections of Section 9-332, how could the recipient of funds (not to mention its lender) paid by its customers know that it was free to use the funds in the operation of its business?
Given the protections granted by Section 9-332, what should US Bank have done to protect itself? Unfortunately, absent declaring a default (assuming that a $500,000 unstayed judgment against its borrower created an event of default under the loan documents) and terminating New Boca’s rights in the cash collateral account, there is little it could do. As a practical matter, unless a lockbox arrangement provides for full dominion and control of a deposit account by or on behalf of a secured creditor, the secured creditor is not in “control” of the account until it notifies the depository bank that it has terminated the borrower’s rights to the funds in the account.
So what is the moral of this story? Secured lenders need to remember that the grant of a security interest does not guarantee that their lien will survive the transfer of their collateral (this even applies to inventory in most situations). They must remain vigilant and not hesitate to take the additional steps necessary to maintain control over collateral following a default.
US Bank has appealed the decision, we’ll report back once the appeal is decided.