cAPITAL Editor: Kate Glaze 2014 Issue Two

Perfecting A Security Interest In Proceeds

By Laura Hebert 214.855.3109 | [email protected]

In practically any case where personal property secures a loan, a claim to proceeds of the collateral will be extremely valuable to the lender. Under the Texas Uniform Commercial Code (UCC), a lender will in many instances have an automatic security interest in proceeds of collateral, but not always. This article describes some of the points a lender should keep in mind to ensure a claim to proceeds. The Texas Uniform Commercial Code (UCC), Section 9.102(a)(65) generally defines proceeds as the following property:

(A) whatever is acquired upon the sale, lease, license, exchange, or other disposition of collateral;

(B) whatever is collected on, or distributed on account of, collateral; [or]

(C) rights arising out of collateral; as well as claims and insurance payments arising out of loss or damage to the collateral. A security interest in inventory provides a good example of why a claim to proceeds is so valuable. When the borrower sells inventory, proceeds from the sale will typically replace the inventory as collateral. If a lender’s perfected security interest in inventory did not extend to proceeds, the lender’s security interest would, at any given time, only cover inventory on hand at that time. Under Section 9.315(a)(2) of the UCC, a security interest automatically attaches to “any identifiable proceeds of collateral.”

The automatic extension of a security interest to proceeds that occurs in many cases, together with the broad definition of proceeds quoted above, provide a large measure of protection to the secured lender, but certain steps must be taken to ensure that the interest in proceeds is properly protected. The first step is to make sure that the security interest in the underlying collateral is properly perfected. An example comes from a recent case in which a lender to a trucking company took a first lien security interest in the borrower’s tractor- trailers and accounts receivable, but inadvertently omitted accounts receivable from the description of collateral in the financing statement. Subsequent lenders took junior lien security interests in the same collateral, but included accounts receivable on their financing statements. When the borrower defaulted, the junior lenders claimed the accounts receivable owed by the company’s trucking customers on the basis that the senior lender had not perfected its security interest in the accounts because it had not included accounts receivable on its financing statement. In the ensuing lawsuit, the senior lender argued that the accounts were proceeds of the tractor- trailers, in which it had a perfected first lien security interest, either because the accounts represented amounts collected on account of the collateral, or because wear and tear on the collateral resulting from use in service to the company’s customers would result in a decline in value constituting a “disposition” of the collateral. The court did not buy either argument and the accounts went to the junior lender.

As demonstrated by the trucking case, an initial requirement for perfecting a security interest in proceeds is proper perfection of the security interest in the underlying collateral. Even if perfection in the underlying collateral is properly obtained, the interest in proceeds may be of only limited value if additional steps are not taken because the automatic perfection as to proceeds lasts for only 20 days unless one of three conditions is met. In many cases, one of the conditions will be met with no further action on the part of the secured lender because UCC Section 9.322(b)(1) provides that the time of filing or perfection as to a security interest in collateral is also the time of filing or perfection of proceeds of that collateral. Therefore, if a security interest in underlying collateral was perfected by filing a financing statement, as would be the case, for example, with inventory or equipment, and the proceeds are of a type that would also be perfected by filing a financing statement in the same office, such as accounts receivable, the security interest in the proceeds would be continuously perfected with no further action by the lender as long as the filed financing statement does not lapse.

If, on the other hand, security interests in the underlying collateral and the proceeds would require different methods of perfection, the interest in the proceeds will lapse after the 20-day grace period if not properly perfected. For example, if a bank has a security interest

Carrington, Coleman, Sloman & Blumenthal, L.L.P. • 901 Main Street, Suite 5500 • Dallas, Texas 75202 • www.ccsb.com Capital - 2014 Issue Two

in a farmer’s equipment, which is perfected by filing a financing statement, and the farmer trades a piece of equipment for a truck, in which a security interest must be perfected by being recorded on the certificate of title, the bank’s security interest in the truck will only be perfected for 20 days unless the bank perfects by complying with the state’s certificate-of-title law.

Perfection will also automatically continue past the 20-day grace period if the proceeds are identifiable cash proceeds. Cash proceeds are defined in the UCC as “money, checks, deposit accounts, or the like.” If, for example, a bank has a security interest in a debtor’s accounts and the debtor receives payment on an account in the form of a check, the bank will be perfected as to the check because the check is cash proceeds. Furthermore, under the UCC, proceeds of proceeds qualify as proceeds. Therefore, the lender’s security interest in proceeds of the check will be perfected, including the debtor’s right to collect from its bank, which qualifies as a deposit account and thus also constitutes cash proceeds. As long as the proceeds are some form of cash proceeds, the security interest will not lapse.

Despite the UCC’s broad protections of security interests in cash proceeds, exercising claims on cash proceeds is often difficult. The problem with cash proceeds is that they can be easily dissipated and difficult to identify. If, for example, cash proceeds in a deposit account are commingled with other funds in the account, the cash proceeds may not be identifiable and the security interest will lapse. Additionally, under UCC rules, a transferee of a check may in many instances take the check free of a perfected security interest. Finally, a transferee of funds from a deposit account will take the funds free of a perfected security interest as long as the transferee has not colluded with the debtor to violate the secured party’s rights.

To summarize, a valid and properly perfected security interest in proceeds of collateral can be of great value to a secured lender. UCC rules are intended to permit the creation and perfection of interests in proceeds without too much difficulty, but lenders must be aware of those rules and the steps required to ensure their interests in proceeds.

Page 2 Carrington, Coleman, Sloman & Blumenthal, L.L.P. • 901 Main Street, Suite 5500 • Dallas, Texas 75202 • www.ccsb.com