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THE PUBLICATION FOR February 2006 CREDIT AND FINANCE PROFESSIONALS $7.00

SELECTED Purchase Money Security Interest TOPIC Suppliers Beware: Tracing Collateral Proceeds Is No Sure Thing

Bruce S. Nathan, Esq.

hen a supplier sells product to a financially The Facts Of The Seventh Circuit Case distressed customer and obtains a purchase The debtor was a dealer in agricultural products, money security interest in the product and all including chemicals, fertilizer and limestone. The W proceeds to secure payment of its claim, the debtor had purchased inventory on credit terms from supplier has no assurance that it can recover from the multiple suppliers, including the purchase money sup- Bruce Nathan, Esq. proceeds of its purchase money collateral. The supplier’s plier involved in the case. is a Partner in the security interest continues in all identifiable proceeds law firm of Lowenstein arising from the customer’s sale or other disposition of In 1983, the purchase money supplier and the debtor Sandler PC in New the supplier’s goods. The problem, dear Watson, is in entered into an agreement under which the supplier was York, NY. He is also a identifying such proceeds. granted a security interest in, among other things, the member of NACM and is a Co-Chair of the following assets to secure payment of the supplier’s American Bankruptcy This is frequently at issue after the customer sells the claims against the debtor: Institute Unsecured purchase money supplier’s inventory collateral, and Trade Creditors commingles the proceeds with the proceeds of other “...all inventory [of the Debtor] including, but not Committee. He can be parties’ collateral and/or unencumbered assets. How does limited to, agricultural chemicals, fertilizers and fer- reached via e-mail the supplier determine the proceeds of its collateral? tilizer materials sold to Debtor by [purchase money at bnathan@ supplier] whether now owned or hereafter acquired, lowenstein.com. The purchase money supplier could try to identify the including all replacements, substitutions and addi- proceeds of its collateral through some form of tracing. tions thereto, and the accounts, notes and any other The courts have recognized common law tracing rules proceeds therefrom.” Bruce will be established under state law. Unfor-tunately, these trac- leading the fol- ing rules are often arcane and not necessarily uniform The purchase money supplier had filed the necessary lowing sessions at Credit Congress: among the states. UCC-1 financing statement that described the collateral. As a result, the supplier had a perfected security inter- Industry Day The United States Court of Appeals for the Seventh est in the goods it had sold to the debtor and all pro- Drugs/Cosmetics/ Circuit recently considered the applicability of the pro ceeds, including accounts receivable, arising from the Pharmaceuticals (14025) rata approach to tracing to determine the competing debtor’s sale of such goods, to secure payment of the interests of a purchase money supplier, with a first pri- debtor’s indebtedness to the supplier. Industry Day ority security interest in the goods it had sold to the Metals Group debtor, and a bank that acted as a factor of, and had a In May 1998, the debtor’s bank lender had agreed to (14029) security interest in, all of the debtor’s accounts, inven- make advances to, and entered into a factoring arrange- Bankruptcy Update tory and other assets, in the debtor’s accounts receivable ment with, the debtor under which the bank had pur- One Year Later collections. The court ruled the purchase money suppli- chased the debtor’s accounts receivable. The bank was (14040) er could not trace its purchase money security interest also granted a security interest in all inventory, accounts into any of its customers’ accounts that were factored by Bankruptcy/Creditors’ receivable, general intangibles, and equipment of the Rights Forum: the bank and had no right to recover any collections. The debtor to secure the debtor’s payment of the bank’s You Ask the Speaker! decision raises warning flags for any supplier that seeks claim. To the extent the bank’s collateral included the (14054) to trace its purchase money security interest into pro- purchase money supplier’s inventory, the supplier had a ceeds: this is not an easy task! prior security interest in that inventory. The supplier’s position was complicated by the fact that the debtor lections the bank had received on factored accounts, regardless of had multiple suppliers. The debtor did not (1) segregate inventory when the account was generated or whether the account had been by supplier; (2) track inventory by supplier; and (3) know on any paid directly by an account debtor or by the debtor from its gener- given day how much inventory of any supplier the debtor had on al deposit account. The supplier then claimed the resulting product, hand. In fact, the debtor had conducted its first physical inventory $950,477.55, as the proceeds of its inventory collateral. in April 1999. At that time, the debtor’s records showed an inven- tory of approximately $7 million. However, it turned out that $2.5 The Seventh Circuit rejected this analysis as flawed. The analysis million of the inventory was missing or unaccounted for. omitted the percentages of product supplied by each of the debtor’s suppliers, including the purchase money supplier, on any given day. In June 1999, the debtor defaulted in payment to the purchase The Seventh Circuit refused to buy into the supplier’s assumption money supplier. The supplier then sent a demand letter to the debtor that the portion of the debtor’s inventory attributable to the sup- for full payment of the supplier’s claim. The supplier did not learn of plier’s goods/purchase money collateral on any given day was the the debtor’s factoring arrangement with the bank until July 1999. same as the proportion of the debtor’s inventory purchased from the Prior to this, the bank had been collecting the factored accounts. supplier during the 14-month sample period. This assumption would make sense only where the supplier could determine the amount of The debtor filed bankruptcy on August 23, 1999. The purchase its inventory collateral in the debtor’s possession at the start of the money supplier then demanded that the bank pay the funds it had sample period. Since the debtor lacked any records that would have collected on the factored accounts. The supplier claimed the bank enabled the supplier to show this, it would be impossible to deter- had converted the supplier’s collateral when the bank had collect- mine the supplier’s share of the debtor’s inventory on any day there- ed accounts generated from the sale of the supplier’s goods. after when the debtor was making sales and creating accounts that Unfortunately, this contention was easier to make than to prove! were factored by the bank. Without a starting percentage, the sup- plier could not identify any account receivable arising from the The Purchase Money Supplier’s Inability To Trace debtor’s sale of the supplier’s collateral. Its Purchase Money Security Interest The Seventh Circuit Court of Appeals considered whether the pur- As a result, the Seventh Circuit ruled that the purchase money sup- chase money supplier had proved that the accounts factored by the plier had no prior right to any of the debtor’s accounts receivable bank were proceeds of the goods the supplier had sold to the debtor factored by the bank and the bank won. and in which the supplier had a perfected purchase money security interest with priority over the bank. Article 9 of the Uniform Conclusion Commercial Code governs the resolution of this dispute. Trade creditors obtaining a purchase money security interest in the product they sell to a customer head into treacherous waters when UCC Article 9 defines “proceeds” to include the assets received by they make a claim to proceeds. When the trade creditor is one of the debtor from the sale, exchange, collection or other disposition many suppliers of product to a customer, and has a perfected secu- of its collateral.1 That includes the accounts receivable arising from rity interest in the goods purchased by its customer and all pro- the debtor’s sale of inventory collateral and all cash proceeds col- ceeds, the supplier has the harsh burden of identifying the proceeds lected from such accounts. derived from the debtor’s sale or other disposition of the supplier’s However, UCC Article 9 also limits a creditor’s security interest to collateral. Identification of proceeds requires the creditor to follow identifiable proceeds. Unfortunately, the supplier could not identi- difficult to prove state law tracing principles. fy any account factored with the bank that arose from the debtor’s sale of any of the supplier’s purchase money inventory collateral. Purchase money suppliers that are looking to recover the proceeds of their collateral should consider whether their customers’ records seg- UCC Article 9 does not define the term “identifiable”. Article 9 regate inventory and track sales by supplier of inventory that would requires that the purchase money supplier trace the debtor’s make it easier for the suppliers to trace the debtor’s sale of their col- accounts receivable and collections, as alleged proceeds of the sup- lateral to the debtor’s accounts receivable and other proceeds. plier’s collateral, back to the supplier’s purchase money collateral, Suppliers might also consider expanding their security interest to all the goods it had sold to the debtor. That means proving that the of the customer’s inventory, rather than inventory they had sold to proceeds arose directly from the sale or other disposition of suppli- the customer, in order to more easily identify the proceeds of their er’s purchase money collateral and not from any other source. collateral. Suppliers might also consider negotiating intercreditor agreements with the customer’s lender and other competing secured The debtor’s commingling of the inventory it had purchased from creditors to arrive at a fair arrangement for sharing proceeds. I several suppliers, including the goods purchased from the purchase money supplier (subject to its first priority purchase money security 1. This case involved the former version of UCC Article 9. That version was interest), made it impossible for the supplier to trace its collateral superceded by Revised Article 9 which became effective on July 1, 2001. While the definition of “proceeds” has been expanded under Revised Article into the debtor’s accounts factored by and collections received by 9, it does not appear that would have impacted the court’s decision. the bank. That was due to the debtor’s failure to segregate its inven- tory by supplier and maintain records that tracked sales by supplier. 2. Another state law tracing rule, involving commingled funds in a bank BUSINESS CREDIT account, is the “lowest intermediate balance rule.” This rule, which was not The purchase money supplier attempted to satisfy its tracing bur- at issue in the decision, involves commingled funds in a bank account and presumes that any payment from a commingled fund (which includes 2 den by utilizing the pro rata method of tracing. The supplier calcu- encumbered and unencumbered proceeds) first came from unencumbered lated the percentage of the debtor’s inventory attributable to that funds; then from encumbered funds. If all funds are paid out, the secured supplier’s inventory on any given day by determining the percent- creditor loses its rights to the proceeds. age of the debtor’s purchases from that supplier to the total of all FEBRUARY This is reprinted from Business Credit magazine, a publication of the National of the debtor’s purchases during a 14-month sample period prior to Association of Credit Management. This article may not be forwarded electroni- the bankruptcy. The supplier then multiplied the percentage, which cally or reproduced in any way without written permission from the Editor of turned out to be 18.66 percent, against the $5,095,034.15 of col- Business Credit magazine. 2006 2