UCC Expert’s Corner: Court Finds Security Interest in Inventory and Proceeds Not Perfected by Real Estate Law

UCC Expert’s Corner: Court Finds Security Interest in Inventory and Proceeds Not Perfected by Real Estate Law

February 3, 2016

A real estate instrument can serve as a security agreement with respect to the debtor’s tangible personal property and proceeds. However, recording that same instrument may not perfect that security interest, even if the personal property collateral is physically located on the related real property. As a secured party learned in the recent case In re: Shree Meldikrupa, Inc., 2016 WL 235205 (Bankr. S.D. Ga. Jan. 15, 2016), perfection of such a security interest in personal property and proceeds normally requires compliance with UCC Article 9.

Shree Meldikurpa, Inc. (the “Debtor”) operated a gas station and convenience store. In 2013, the Debtor obtained financing from Cornerstone Bank (the “Bank”). To secure the loan, the Debtor executed a Deed to Secure Debt and Security Agreement (“Security Deed”) in favor of the Bank.

The Security Deed granted the Bank a security interest in the real property where the Debtor conducted its business. In addition, the Security Deed granted the Bank a security interest in personal property “in any way connected with the use and enjoyment” of the property. The description of the personal property collateral was broad enough to encompass the Debtor’s inventory and all proceeds of the sale of inventory.

As additional security, the Debtor also executed an Assignment of Leases and Rents whereby it assigned to the Bank all of its right, title, and interest in all rents, issues, and profits from leases, rental agreements, and any other profits from the property. The Bank duly recorded the Security Deed and Assignment of Leases and Rents in the county real property records. However, the Bank never filed a UCC financing statement.

Unfortunately, the Debtor later ran into financial difficulties. In August 2015, the Debtor filed a Chapter 11 bankruptcy petition. The Bank filed a proof of claim in the amount of $220,116, claiming a second priority lien on the real property and a security interest in the Debtor’s personal property.

A month later, the Debtor filed a motion seeking an order for the use of cash collateral (which arose from the sale if its inventory). The Bank objected to the Debtor’s motion and filed a motion to prohibit the Debtor’s use of cash collateral.

The Bank claimed that its security interest extended to the cash collateral. The Debtor, however, argued that the Bank failed to perfect its security interest and was therefore not entitled to enforce its security interest. The court, therefore, had to decide whether the Bank had an enforceable interest in the cash collateral.

As a threshold issue, the court determined that the Bank must have a properly perfected security interest in the Debtor’s inventory and its proceeds before it could claim an interest in the cash collateral. The Bank contended that its security interest was perfected when it filed its Security Deed and Assignment of Leases and Rents in the county real property records because the proceeds of the inventory were a product of the Debtor’s use of the property.

The court, however, found that the Debtor did not receive any revenue from the real property interest, which would have been secured by the Assignment of Leases and Rents. Instead, the revenue came solely from the sale of inventory. Inventory constitutes personal property. Perfection of a security interest in personal property requires the secured party to comply with Article 9. The Bank failed to file a financing statement or otherwise perfect under Article 9. The court concluded that the Bank did not have a perfected security interest in the inventory or its proceeds. Therefore, the court granted the Debtor’s motion to use its cash collateral.

The important thing to take away from this case is that personal property collateral generally cannot be perfected by filing or recording under real estate law. There are exceptions for certain types of collateral, such as fixtures, where interests also arise under real estate law. For other types of personal property, however, perfection should be done in compliance with UCC Article 9 or the secured party may be unable to enforce its security interest.

 

Paul Hodnefield is associate general counsel for Corporation Service Company® and a frequent speaker/writer on UCC due diligence issues. Please feel free to contact him with questions or comments at paul.hodnefield@cscglobal.com or 800-927-9801, ext. 61730.