The U.S. Court of Appeals for the Eighth Circuit recently held that a secured party's foreclosure did not discharge an otherwise valid security interest in the proceeds of the collateral, nor did it preclude the creditor from pursuing its rights to such proceeds.
A copy of the opinion is available at: Link to Opinion
The borrower settled a lawsuit. Two of the borrower's creditors claimed priority over the settlement funds.
One creditor ("Initial Creditor") made a $2.62 million loan to the borrower on September 13, 2002 which was secured by all fixtures, all chattel paper, equipment, and general intangibles (excluding inventory and accounts receivable), and related proceeds. The security interest was perfected by filing an appropriate financing statement.
On January 21, 2010, final summary judgment was entered against the borrower for its default on the Initial Creditor's loan. Later in 2010, the Initial Creditor foreclosed on its Deed of Trust and security agreement. As of January 2014, more than $3 million remained unpaid on the Initial Creditor's judgment against the borrower.
The other creditor ("Subsequent Creditor") made a $2 million loan to the borrower on February 1, 2006. The borrower defaulted on this loan later in 2006. On June 8, 2007, the borrower executed a written Forbearance Agreement with the Subsequent Creditor under which the Subsequent Creditor agreed to forbear on certain of its contractual, and legal rights and the creditor was given a security interest in the commercial tort claim. This security interest was perfected on June 13, 2007.
In early October 2012, the Initial Creditor applied for Writs of Garnishment in Texas state court and served the writs on the borrower. Then, the borrower filed this interpleader action to allow any entities claiming an interest in the settlement proceeds to assert their claims.
The two creditors filed motions for summary judgment in the interpleader action. The trial court granted the Subsequent Creditor summary judgment and denied the Initial Creditor's motion.
The trial court determined that when the Initial Creditor foreclosed and conducted a foreclosure sale, the security interest was discharged. The Eighth Circuit found this was in error.
As you may recall, Texas UCC § 9.617(a) states "[a] secured party's disposition of collateral after default: (1) transfers to a transferee for value all of the debtor's rights in the collateral; (2) discharges the security interest under which the disposition is made; and (3) discharges any subordinate security interest or other subordinate lien." Texas Business & Commerce Code '9.617.
The trial court read this language broadly to preclude the Initial Creditor from seeking proceeds of its original collateral. However, the Eighth Circuit found that the Initial Creditor, as a secured creditor, had the cumulative right to foreclose on its collateral as well as to enforce its security agreement as to the proceeds of its collateral.
The Eighth Circuit noted that this holding is further supported by the language of the Initial Creditor's security agreement, which stated that collateral includes "sums due from a third party who has damaged or destroyed the Collateral or from that party's insurer."
Accordingly, the Eighth Circuit held that the Initial Creditor's foreclosure did not discharge an otherwise valid security interest in the proceeds of the collateral, nor did it preclude the Initial Creditor from pursuing its rights to such proceeds.
In addition, the Initial Creditor argued that once the commercial tort claim was settled and reduced to a contractual obligation to pay, it became a payment intangible under UCC and Texas law. As you may recall, a payment intangible is a subset of a general intangible "under which the account debtor's principal obligation is a monetary obligation." See id. § 9.102(a) (62).
However, the district court held that the Subsequent Creditor, who had secured an interest in the commercial tort claim perfected in 2007, had the superior claim to settlement proceeds because the Initial Creditor's security interest did not attach until the suit settled in 2012.
The Eighth Circuit concluded that the Initial Creditor did not have an interest in the settlement proceeds from the commercial tort action as a general intangible due to Texas UCC §9.108 (creditors may take a security interest in commercial tort claims as original collateral. See id. §9.109(d) (12).
The Court noted that a commercial tort claim is defined, in relevant part, as "a claim arising in tort with respect to which . . . the claimant is an organization." See id. § 9.102(a) (13)). However, the Court also noted that the UCC imposes heightened identification requirements to encumber commercial tort claims, see id. § 9.108(e) and cmt. 5. The UCC imposes this heightened description requirement "in order to prevent debtors from inadvertently encumbering" commercial tort claims. See id. § 9.108 cmt. 5.
Accordingly, the Eighth Circuit held that the drafters of the UCC intended for the proceeds of a commercial tort claim to be excluded from an after-acquired general intangible clause.
In addition, the Initial Creditor also argued it should still have priority as to the portion of the settlement proceeds that is proceeds of the original collateral. The Eighth Circuit agreed.
Proceeds include "to the extent of the value of collateral, claims arising out of the loss, nonconformity, or interference with the use of, defects or infringement of rights in, or damage to, the collateral." See id. § 9.102(a) (65) (D). The Eighth Circuit held that the Initial Creditor's interest attached to the right of recovery for damage to its original collateral in October 2006.
The Subsequent Creditor argued that the heightened identification requirement applicable to commercial trot claims survives disposition of the claim and extends to proceeds of a commercial tort claim. In re Zych, 379 B.R. 857, 861 (Bankr. D. Minn. 2007). The Zych court ultimately held that the creditor could not claim a security interest in the proceeds of the debtor's commercial tort claim because the security agreement did not identify the commercial tort claim by detailed type and because the commercial tort claim arose after the effective date of the security agreement.
The Eighth Circuit generally agreed with the holding in Zych as applied to proceeds of a commercial tort claim, but held that a superior interest in proceeds of original collateral is not displaced simply because damage to that collateral gives rise to a subsequent commercial tort claim.
Moreover, the Eighth Circuit followed the holding in BMW Financial Services, NA, LLC v. Rio Grande Valley Motors, Inc., No. M-11- 292, 2012 WL 4623198 (S.D. Tex. Oct. 1, 2012). There, the district court held that "[u]nlike the definition of general intangibles, the definition of proceeds does not exclude commercial tort claims" and "a security interest does not cease to attach to collateral merely because the collateral is converted into proceeds." See id. at *10.
The Court held this ruling also conforms to Texas UCC § 9.102, which states that "[a] security interest in a tort claim also may exist under the Article if the claim is proceeds of other collateral." In addition, the Court also noted that "[a] security interest in proceeds is a perfected security interest if the interest in the original collateral was perfected." Texas UCC § 9.315(c).
Thus, the Court ruled that the Initial Creditor held a security interest in the proceeds from the commercial tort claim as a right of recovery with respect to damage to its original collateral.
Ralph T. Wutscher
Maurice Wutscher LLP
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