Expert’s Corner: Revenue Generated by Collateral Found Not to be Proceeds

December 2, 2013

By Paul Hodnefield, Esq.

A perfected security interest generally extends to proceeds of the original collateral. The term “proceeds” appears broadly defined by UCC Article 9, but there are limits. Exactly where those limits lie, however, is not always clear. The U.S. Court of Appeals for the 6th Circuit recently offered some guidance on the issue in 1st Source Bank v. Wilson Bank & Trust, 2013 U.S. App. LEXIS 22563 (6th Cir. Nov. 7, 2013).

Beginning in late 2004, 1st Source Bank (the “Bank”) entered into a series of secured transactions with two trucking companies (the “Debtors”). The collateral listed in the security agreements included the Debtors’ tractors and/or trailers, accounts, and proceeds from the collateral.

The Bank filed financing statements with the Tennessee Secretary of State to perfect its security interest. The financing statements described the tractors/trailers and “all proceeds thereof,” but omitted any mention of “accounts.”

Shortly after the Bank filed its financing statements, the Debtors entered into secured transactions with three other lenders that would later become defendants in the case (the “Defendants”). The Defendants filed financing statements to perfect their security interests. The financing statements described the collateral to include “all accounts receivable now outstanding or hereafter arising.”

In 2009, the Debtors defaulted on all their loans. As a result, the Bank sought to repossess the collateral described in the security agreements. The Defendants, however, had already taken possession of the accounts receivable described in their financing statements. The Bank objected, claiming that the accounts receivable were the proceeds of its security interest in the tractors and trailers.

The dispute wound up in federal court. The Defendants asserted that the term “proceeds” as described in the Bank’s financing statement did not include accounts receivable. Therefore, the Defendants claimed to have the priority security interest in the accounts receivable and moved for summary judgment in their favor.

The court began by reviewing the sufficiency of the Bank’s collateral descriptions. The financing statements failed to mention either “accounts” or “accounts receivable.” Therefore, the court concluded that the financing statements failed to provide notice to the Defendants of the Bank’s claimed security interest in the Debtor’s accounts receivable.

The Bank, nevertheless, urged the court to rule that the term “all proceeds thereof,” as used in the financing statement collateral description, included the Debtor’s accounts receivable. In support of its position, the Bank relied on the broad Article 9 definition “proceeds,” which includes “whatever is collected on, or distributed on account of, collateral” and “rights arising out of collateral.”

The court agreed that the Article 9 definition of “proceeds” appeared rather broad. However, the court declined to accept the Bank’s interpretation of the term. Doing so would, in effect, expand the definition of the general term “proceeds” in a way that would render the specifically defined category of “accounts” meaningless.

That was not all. The court reviewed prior case law and the official comments to Article 9 to reach the determination that “proceeds” does not refer to income generated from the debtor’s use of the collateral. In order for proceeds to result from rights that arise out of the collateral, they must be obtained from some loss or disposition of the debtor’s interest in the collateral. The court, therefore, found that the term “proceeds” did not include the Debtors’ accounts receivable.

The Bank’s financing statement failed to provide notice of the claimed security interest accounts receivable. Moreover, the accounts were not “proceeds.” Consequently, the court concluded that the Bank’s security interest was subordinate to the Defendants’ perfected superior security interests in the Debtors’ accounts.

The important thing to take away from this case is that the definition of proceeds is broad, but limited to that which results from loss or disposition of the collateral. Proceeds do not arise out of the normal business income generated by the debtor’s use of the collateral. The secured party must be sure that the financing statement fully describes the collateral to perfect a security interest in both the accounts receivable generated by, and the proceeds resulting from disposition of, the collateral.

 

Paul Hodnefield is Associate General Counsel for Corporation Service Company (CSC) and a frequent speaker/writer on UCC due diligence issues. Please feel free to contact him with questions or comments at phodnefi@cscinfo.com or 800-927-9801, ext. 62375.