Monday, April 1, 2013

FYI: 7th Cir Recognizes, But Limits, "Composite Document" Theory in Article 9 Priority Dispute Involving Missing Security Agreement

The U.S. Court of Appeals for the Seventh Circuit recently rejected a bank's argument that it had, through a subordination agreement with a third-party secured creditor, positioned itself into a superior position over a finance company, because the bank was unable to produce the security agreement between the third-party and the borrower, as required by the Uniform Commercial Code, to provide an accurate description of the specific collateral to which multiple claims were made.


In so doing, the Court also ruled that the bank could not invoke the "composite document theory" to support its reliance on a recorded financing statement that merely referred to the collateral and the security agreement generally, as the security agreement was needed to confirm the extent of the security interest that was subordinated to the bank's interest.  A copy of the opinion is attached.


Plaintiff finance company ("Finance Company") extended a loan of about $7 million to a coal mining company ("Mining Company") that was secured by Mining Company's coal mining equipment.  Finance Company filed a financing statement.  At the time, however, Mining Company was already in debt to an energy financing company ("Energy Firm").  Mining Company then transferred title to the same mining equipment, subject to Finance Company's security interest in the equipment, to a "special purpose" affiliate of Energy Firm that served as a means of protecting the equipment from seizure by other creditors. 


Two years later, defendant bank ("Bank") extended a loan to Mining Company of almost $2 million that was also secured by the same equipment that secured the loans from Energy Firm and Financing Company.  Prior to lending Mining Company the money, Bank discovered a recorded financing statement indicating that Mining Company had given Energy Firm a security interest in all of Mining Company's assets.  Bank filed its own financing statement covering its collateral, but also, to ensure that its security interest had priority over that of Energy Firm, entered into an agreement with Energy Firm whereby Energy Firm agreed to subordinate its interest in the collateral to Bank's security interest.  Bank, however, failed to obtain a copy of the security agreement between Mining Company and Energy Firm regarding Energy Firm's prior loan to Mining Company. 


Mining Company eventually defaulted on all the loans, and Bank and Finance Company each sought to enforce their respective security interests in the same collateral.  In so doing, Bank, having taken possession of the assets, eventually sold the assets for $2.5 million, but kept $1.4 million to cover Mining Company's debt to it, and sent a check to Finance Company for the remaining $1.1 million. Finance Company never returned or cashed the check, fearing that cashing the check would constitute a waiver of any objection to Bank's claim of a superior security interest.


Financing Company filed suit, alleging that bank converted the proceeds of the sale of the collateral to which Finance Company had a superior secured claim.  The lower court, following a bench trial, granted judgment for Financing Company and awarded it damages of $2.4 million plus pre-judgment interest.  Bank appealed.


The Seventh Circuit affirmed, ruling that Bank had converted the $2.4 million in proceeds, and that because of the missing security agreement between Mining Company and Energy Firm, Finance Company's security interest was superior to Bank's.


As you may recall, when two or more secured creditors claim conflicting security interests in the same collateral, the creditor who filed his financing statement earlier typically has the senior claim.  See Uniform Commercial Code §9-322(a)(1).  In addition, a security interest is not enforceable unless "the debtor has authenticated a security agreement that provides a description of the collateral."  Uniform Commercial Code § 9-203(b)(3)(A).


In rendering its ruling, the Seventh Circuit took particular note of the following:  (1) Bank's claim of priority derived from its dealings with the Energy Firm, because Mining Company and Energy Firm had a pre-existing loan agreement; (2) Energy Firm had transferred its secured interest in the equipment to Bank through the subordination agreement; (3) originally, Energy Firm's security interest was prior and thus superior to Finance Company's secured interest; and (4) but for the subordination agreement, Energy Firm's security interest would have had first priority, Finance Company would have second priority, and Bank would have had third priority. 


Moreover, in noting the different priority positions resulting from "complete subordination" and "partial subordination," the Court rejected Finance Company's various arguments that: (1) Finance Company's security interest in Mining Company's equipment was a purchase money security interest that gave it priority over earlier security interests in the same property; and (2) Bank could not have obtained a security interest in Mining Company's assets because the assets no longer belonged to Mining Company but instead to the special purpose affiliate of Energy Firm. 


Nevertheless, the Seventh Circuit ultimately concluded that Bank could not satisfy the requirement to produce the security agreement between Mining Company and Energy Firm showing a description of the collateral to which Bank claimed a priority security interest in order to enforce its security interest.   Without that security agreement, the Seventh Circuit emphasized, Bank could not prove:  (a) that Mining Company had a security agreement with Energy Firm that was eventually subordinated to Bank;  (b) the exact nature of the collateral covered by that agreement; or,  (c) whether the collateral included the equipment that Bank took possession of to satisfy its loan. 


Although the Seventh Circuit recognized the validity of the so-called "composite document theory" generally, it reasoned that it was inapplicable here, because Bank's recorded financing statement vaguely referred to "all equipment" of Mining Company, but left unclear whether the missing security agreement, required under the UCC, provided a similarly general description of the collateral or whether it itemized the equipment in which Energy Firm had acquired a security interest.   See In re Numeric Corp., 485 F.2d 1328, 1331 (1st Cir. 1973)(allowing substitution for a missing security agreement a financing statement and a signed board of directors' resolution that, together, satisfied the requirements of UCC section 9-203(b)). 


Accordingly, noting that financing statements do not create security interests, the Seventh Circuit rejected Bank's attempted use of the composite document theory, reasoning that if Energy Firm's financing statement listed any equipment not specified in the missing security agreement, Energy Firm had no security interest in that equipment that it could subordinate to the Bank's security interest.


Thus, the Seventh Circuit ruled that, without the missing security agreement between Mining Company and Energy Firm, Finance Company's security interest in the equipment was prior and superior to Bank's.  Further, the Court ruled that, because Finance Company's security interest extended to any proceeds Bank obtained when it sold the equipment, Bank had converted the proceeds, and that Finance Company was thus entitled to the $2.4 million in damages plus prejudgment interest from Bank.  Accordingly, the Seventh Circuit affirmed the lower court's ruling.




Ralph T. Wutscher
McGinnis Wutscher Beiramee LLP
The Loop Center Building
105 W. Madison Street, 18th Floor
Chicago, Illinois 60602
Direct: (312) 551-9320
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