Priorities Against Other Parties and Proceeds - Module 4 of 5

Module 4: Priorities Against Other Parties and Proceeds

Assume a widget retailer has a wide array of assets, including manufacturing equipment, a warehouse full of inventory and accounts receivable from customers who pay their invoices after receiving widgets. One day, the business stops operating, realizing that its debts exceed its assets and it’s not capable of turning the business around.  The owners lock the doors and freeze the business’ assets.  Imagine now that all of the creditors arrive on the same day to seize what they can. 

The rules governing priorities enable the creditors to sort out who gets what, with priority for the first-place secured creditors.  However, not all of the creditors are governed by the Article 9 priority rules.  Some have bought the debtor’s assets, others have judgments from the courts and some may be unsecured.  If the widget business has formalized its insolvency with a bankruptcy filing, the trustee overseeing the bankruptcy will have a significant presence.  These conflicts present complex priority issues.  Keep in mind that priorities are only relevant when there are multiple interests in the same collateral. 

Buyers in the Ordinary Course  

Inventory is held “by a person for sale or lease or to be furnished under a contract of service.”[1]   When debtors use inventory as collateral, the secured party is (or should be) aware that the debtor seeks to dispose of it by sale.  Indeed, the debtor and secured party depend on these sales to generate cash flow and service the debt or repay the loan.  Consumer confidence would be inhibited if buyers needed to worry about a seller’s secured creditors having a priority interest in their purchases. 

To solve this problem, Article 9 offers an implied release of any security interest in inventory sold to a buyer in a typical transaction for that business.[2]  As long as a buyer of inventory qualifies as a buyer in the ordinary course, they take it free and clear.  A buyer in the ordinary course “means a person that buys goods in good faith, without knowledge that the sale violates the rights of another person in the goods, and in the ordinary course from a person, other than a pawnbroker, in the business of selling goods of that kind.”[3]  In a 1988 case, Daniel v. Bank of Hayward, a Wisconsin court held that a buyer may become a buyer in the ordinary course of business even before taking title or possession of the goods by making a down payment.[4]  However, a subsequent revision to the UCC required that buyers actually take possession or at least have the right to do so to achieve the status of buyer in the ordinary course.[5]

The implied release for sales of inventory in the ordinary course also extends to sales of equipment that look like inventory.  For example, a retail store debtor might treat floor models as equipment but sell them when replaced by new models.  The important factor is that the debtor is in the business of selling “goods of that kind”[6] and the buyer cannot realistically differentiate between inventory and equipment that looks the same.  This rule does not apply to fire sales, those not at arm’s length (such as sales to relatives or friends or part gift, part sales), to insiders or when a third-party is acting as a buyer (known as a straw man) to help the debtor circumvent the security interest.  Additionally, sales of other goods, like equipment used to run the business or the computers used by a plumbing company to track appointments, supplies and bookkeeping are outside of the “goods of that kind” requirement.  

A secured party who has a floating lien in all inventory due to an “after-acquired property clause” is at risk of becoming under-secured if the debtor does not replenish its inventory.  Thus, diligent secured parties may use inventory checkers to monitor and verify inventory levels and respond appropriately to protect their security.  Some of the most interesting Article 9 cases arise from debtors creating very elaborate scams to feign the appearance of high inventory levels to trick secured parties. 

One of the oldest and most famous of these cases is the subject of the book, The Great Salad Oil Swindle,[7] which grew out of a Wall Street Journal investigation.  In that 1963 scheme , the borrower was an experienced commodities trader and fraudster who got involved in selling oil and shortening products through government programs.  His company borrowed from American Express, using its inventory as collateral.  When American Express sent an inventory checker to verify the stock, he had placed thin layers of oil atop large vats of water so that it appeared to be a full supply of salad oil.  The inventory checker was alert enough to insert a long pole to verify the depth of the vats, but the oil floating on top coated its whole length on the way in and out, thus fooling the checker into thinking it was all inventory.[8] 

If secured inventory is sold to someone without “buyer in the ordinary course” status, the security interest in collateral persists even after the sale.[9]  So, a buyer who purchases something that the debtor is not in the business of selling will take possession subject to any pre-existing security interests and is susceptible to the secured party exercising its rights to repossess.  When purchasing used equipment, buyers should search for any applicable security interests through a UCC search and then obtain a written release from any secured parties to sever the encumbrance, if necessary.  If a debtor subject to an after-acquired property clause returns inventory to its supplier, the security interest may have already attached while the inventory was collateral such that it stays attached even after being sent back to the supplier.[10]

Though not buyers in the ordinary course, consumers are afforded an extra layer of protection from existing security interests when making informal purchases from one another.  This special exception arises often in the yard or garage sale context, including using online message boards and marketplaces.  These situations arise when a consumer buys goods- like furniture, electronics or jewelry- on credit and grants the lender a security interest but then resells the goods before paying off the loan. 

There are 4 requirements before a resale purchaser is free from the security interest.[11]  First, the purchaser must have completed the sale without knowledge that the goods were encumbered.  Second, the purchaser must act in good faith.  For example, offering brand new consumer goods at pennies on the dollar raises a red flag that they might be stolen or otherwise subject to a third party’s claim. Ignoring such red flags means that the purchase was in bad faith.  Third, the purchaser buys “primarily for the buyer’s personal, family, or household purposes” (not to re-sell). Finally, the resale must occur before the secured party files a UCC-1 financing statement covering the relevant goods.[12] If all 4 of these requirements are satisfied, the secured party loses its interest and cannot repossess from the resale purchaser.

Lien Creditors

Section 9-317 offers a framework for organizing priorities between Article 9 secured parties and other types of creditors, referred to collectively as lien creditors.  It is written from the perspective of when an Article 9 secured party will lose to another kind of creditor.[13]    

The most common lien creditor considered here is one who has obtained a writ of levy to seize assets belonging to the debtor.[14]  Goods are typically levied by a sheriff or equivalent law enforcement officer, pursuant to a judgment against the debtor to levy and seize identified personal or real property.  Unsecured creditors use this process to access the debtor’s assets since they do not have a security interest.  It requires filing a lawsuit, serving the debtor with process, litigating the matter, obtaining a judgment, contending with any appeals and then searching to identify the debtor’s unencumbered assets to request writs of levy. Avoiding this long, expensive collections path is a significant motivation for creditors to become secured and perfected.  

When a judgment creditor tries to seize already secured property, the party with the pre-existing security interest prevails if it is already perfected or it has filed a UCC-1 financing statement and obtained a signed security agreement, possession or control from the debtor before the lien creditor attached the collateral through a levy.  In other words, if the secured party’s paperwork is done, it has priority over the judgment creditor.[15]  Prior perfection is the best option and easiest to prove.  This priority-but-not-yet-perfected scenario often arises when the funding of the loan lags behind the paperwork.  The filed financing statement is key to this priority determination because a UCC search should reveal the security interest to a judgment creditor, enabling other parties to avoid the encumbered property.

The 20-day grace period for perfecting a purchase money security interest also applies to benefit purchase money secured parties against lien creditors.  If the security interest is perfected within 20 days of delivery of the collateral to the debtor, the secured party has priority over an intervening lien creditor who attempts to levy the purchase money collateral during that grace period.  However, if the secured party misses the window, the lien creditor will take first place and the secured party will remain subordinated.      

Also under section 9-317, lessees of goods and licensees of intangible collateral are not subject to security interests, so a car renter would not be subject to repossession during the period of the rental.  This assumes that the lessee gave value, did not have knowledge of the encumbrance and leased or licensed before perfection.  This is comparable to the “buyer in the ordinary” course rule.

Bankruptcy Trustee

Section 9-317 also controls the priority between an Article 9 secured party and a bankruptcy trustee, who is defined as a lien creditor.[16]  When a person or entity files for bankruptcy protection, the trustee’s job is to marshal all of the remaining assets- known as the estate- as well as to evaluate the creditors’ claims.  When a secured party has perfected well in advance of the bankruptcy filing, it will generally be able to recover its collateral in due course through the bankruptcy proceedings.  Creditors who have lesser statuses, including secured but unperfected or unsecured, will often not fare as well.  Unsecured creditors rarely receive much, if anything, in bankruptcy proceedings and may expend time and effort preserving claims that are wholly discharged.

Some of the other bankruptcy rules are also of importance to secured parties.  As soon as a bankruptcy filing is made in the Bankruptcy Court where the debtor resides or operates, an automatic stay takes effect.  This means that all creditors, secured and unsecured, must cease all collection activity on debts that arose prior to the filing. Collection activity broadly covers repossessions and lawsuits as well as collection letters and phone calls and even efforts to perfect.  The trustee manages the process entirely and individual creditors are not permitted to exercise their legal and contractual rights without seeking relief from the stay, which is a court order permitting them to proceed with a particular collection activity (and is not easily available).

There is also a window of time called the preference period.  It usually covers the 90 days immediately preceding the bankruptcy filing and gives a retroactive window in which the trustee can scrutinize the debtor’s transactions.  The window is even longer for “insider” transactions involving principals and affiliates of the debtor.  If the trustee finds that the debtor showed favoritism, or demonstrated a preference, toward one or more of its creditors without a good reason to do so, the trustee can undo the relevant transactions.  Secured parties who attached or perfected during the preference period may be susceptible to the trustee reversing those efforts, thereby subordinating their statuses.

Proceeds

The disposition of collateral often results in proceeds, which means the money received from the sale of the collateral.  Proceeds are “whatever is acquired upon the sale, lease, license, exchange, or other disposition of collateral” as well as insurance payments arising from any casualty loss of encumbered property.[17]  These concepts have been construed broadly by the courts, covering even settlements that included, in one case, punitive damages and labor expenses for injuries to cows who were electrocuted when the cows were collateral farm products.[18] 

Security interests in collateral immediately attach to identifiable proceeds generated by its sale.   A visual way of approaching this idea is that a security interest is a single line or track from the time it is created.  Upon sale of the collateral, it breaks into two, with the security interest following both the collateral and the sale proceeds.  Even if the interest in the collateral itself is severed (such as if the buyer is a buyer in the ordinary course), the security interest in the proceeds of the sale keeps running.[19] However, the proceeds must be “identifiable” as being from the sale, thus placing a burden on the secured party to keep track of its collateral’s fate and movement and the debtor’s business.   

Historically, secured parties used physical lock boxes to secure the cash realized on sales of inventory collateral.  Armored cars would collect the funds and ensure that they were properly deposited to service the debt and subject to the security interest.  As transactions have moved away from cash and toward checks and then credit cards and other electronic payments, actual lock boxes have evolved into the maintenance of deposit accounts under the control of secured parties.

Proceeds are at risk of losing their “identifiable” nature when they are commingled with non-proceeds.  Proceeds that are goods can sometimes be tracked, especially if they are unique.[20]  But cash and cash-equivalents like checks and bank deposits, referred to collectively as cash proceeds,[21] require the application of funds tracing principles, which vary from state to state.[22]  Funds tracing can get very complicated and may require the expertise of a forensic accountant.   

For retail sales debtors, proceeds may take the form of promissory notes or chattel paper generated when extending credit to purchasers.  Like cash, negotiable instruments need to be possessed for proper perfection,[23] so a secured party should monitor the receipt of such proceeds and take prompt possession or put other controls in place.

As proceeds are deemed automatically attached, they are likewise deemed automatically perfected so long as there was a properly filed financing statement covering the original collateral.[24]  However, that perfection may last only 20 days and obligates the secured party to file a new UCC-1 identifying the proceeds in certain circumstances, as when cash proceeds are used to acquire different, non-cash proceeds.[25]  Proceeds that remain cash and are identifiable need not be re-perfected.[26]   Commonly referred to as the “same office rule,” a security interest in proceeds need not be re-perfected if the filing would be in the same office as the original financing statement already filed.[27]  When a UCC-1 lapses, it lapses as to both the original collateral and any proceeds.[28]

In our final module, we’ll look at remedies available for secured creditors in the event of default, including repossession.