Post-Petition Security Interests

by John Greco

The Bankruptcy Strategist, Vol. XV, No. 11, Sept. 1998

Secured Creditors Beware: A Post-petition

Security Interest in Cash Proceeds May Be

Wiped Out by U.C.C. Article 9

Under applicable non-bankruptcy law, the commencement of insolvency proceedings may significantly limit a secured creditorís security interest in “cash proceeds” of collateral securing the indebtedness. As an example, under the provisions of the Uniform Commercial Code (“U.C.C.”), a secured creditor’s security interest in cash proceeds in a commingled bank account may be totally wiped out by the filing of a bankruptcy petition. To protect itself from the severe limitations imposed by the application of certain provisions of the U.C.C., the secured creditor should require that proceeds of its collateral be segregated and deposited into a separate account which is established for the purpose of receiving only the proceeds of its collateral.

Introduction

Bankruptcy Code §552(b) provides that perfected security interest in property of the debtor and proceeds received by the debtor before the commencement of the bankruptcy case shall extend to the proceeds of such property acquired after the commencement of the case.

However, the security interest in such after acquired property is only, “to the extent provided by such security agreement and applicable non-bankruptcy law, except to any extent that the court, after notice and hearing and based on the equities of the case, orders otherwise.” Bankruptcy Code §552(b) (emphasis added). Therefore, it is necessary to look to state law to determine the extent to which a security interest in proceeds remains enforceable after the commencement of insolvency proceedings. See Maxl Sales Co. v. Critiques, Inc., 796 F.2d 1293, 1297 (10th Cir. 1986).

The Uniform Commercial Code Provides The Controlling State Law

In most jurisdictions Article 9 of the U.C.C. controls secured transactions. Generally, in a non-bankruptcy context, the U.C.C. provides that a security interest “continues in any identifiable proceeds.” See New York Uniform Commercial Code (ìNYUCCî) §9-306(2)(emphasis added).

“Cash proceeds” are defined by the U.C.C. as “money, checks, deposit accounts and the like” which are received upon the “sale, exchange, collection or other disposition of collateral or proceeds.” NYUCC §9-306(1). Before the commencement of insolvency proceedings, the U.C.C. allows a security interest to continue in “identifiable cash proceeds”. NYUCC §9-306(3)(b). Although the U.C.C. does not define “identifiable cash proceeds”, courts have used the concepts of “tracing funds”, used in trust law, to identify “cash proceeds”. See Maxl Sales Co., 796 F.2d at 1299. Courts have even used tracing concepts to find that “cash proceeds” in commingled accounts may be “identifiable cash proceeds”. See In re: Drexel Burnham Lambert Group, Inc., 142 B.R. 633 (S.D.N.Y. 1992). Thus, prior to the commencement of insolvency proceedings, a secured creditor usually can maintain its security interest in “cash proceeds” so long as they remain “identifiable”, even where they have been commingled with non-proceeds.

Significantly, however, the drafters of the U.C.C. created special provisions for the continuation of security interests after the commencement of insolvency proceedings. See U.C.C. §9-306(4)(a)-(d). With respect to “non-cash proceeds”, the U.C.C. continues non-bankruptcy rules and provides for the continuation of a security interest in “identifiable non-cash proceeds” after the commencement of insolvency proceedings. See NYUCC §9-306(4)(a). Thus, “identifiable non-cash proceeds” are treated in the same manner, whether or not insolvency proceedings have been commenced. See also Bankruptcy Code §552(b).

Similarly, the secured creditorís security interest in cash proceeds which have not been commingled is undisturbed by the commencement of insolvency proceedings. See U.C.C. §9-306(4) (a) – (c). Thus, the U.C.C. allows a secured creditor to retain its security interest in cash proceeds in “separate deposit accounts containing only proceeds”, notwithstanding the commencement of insolvency proceedings. See NYUCC §9-306(4)(a) (emphasis added). A security interest in “cash proceeds” in the form of “money” which has not been commingled with other money nor deposited in a deposit account prior to insolvency proceedings also remains unaltered by the commencement of insolvency proceedings. See NYUCC §9-306(4)(b) (emphasis added). Likewise, a security interest in “cash proceeds in the form of checks and the like” which are not deposited before insolvency proceedings is protected for the benefit of the secured creditor. See NYUCC §9-306(4)(c) (emphasis added).

However, in certain instances, the non-bankruptcy general rule that a security interest continues in “identifiable proceeds” is modified upon the filing of insolvency proceedings. In particular, the rules contained in U.C.C. §9-306(4) limit the secured creditorís ability to continue its security interest in commingled cash proceeds, even if the cash proceeds are “identifiable.”

Security Interests in Commingled Cash Proceeds Are Severely Limited

Upon the commencement of insolvency proceedings, U.C.C. § 9-306(4)(d) significantly alters the secured creditors’ interest in cash proceeds which have been commingled. See NYUCC §9-306(4)(d). Prior to the commencement of insolvency proceedings, a secured creditor may have a security interest in “identifiable cash proceeds”, even if they are found in a commingled account. See NYUCC §9-306(2). However, upon the commencement of insolvency proceedings, the secured creditor no longer may use “tracing rules” to identify “cash proceeds” in a commingled account, and instead, the secured creditor is limited to the formula set forth in U.C.C. § 9-306(4)(d). See Maxl Sales Co., 796 F.2d at 1300; In re Oriental Rug Warehouse Club, Inc., 205 B.R. 407 (Bankr.D.Minn. 1997).

U.C.C. §9-306(4)(d) limits a secured creditor’s security interest in cash and deposit accounts in which proceeds have been commingled with other funds. The security interest allowed under §9-306(4)(d) is:

(i) subject to any right of setoff; and

(ii) limited to an amount not greater than the amount of any cash proceeds received by the debtor within ten days before the institution of the insolvency proceedings less the sum of (I) the payments made to the secured party on account of cash proceeds received by the debtor during such period and (II) the cash proceeds received by the debtor during such period to which secured party is entitled under paragraphs (a) – (c) of this subsection (4).

NYUCC §9-306(4)(d).

The initial restriction imposed by NYUCC § 9-306(4)(d) on the secured creditor’s interest in cash proceeds limits such interest to an amount not to exceed the amount of cash proceeds received by the debtor during the ten (10) days preceding the bankruptcy. Standing alone, this restriction creates a severe limitation on the secured creditor’s rights. However, U.C.C. §9-306(4)(d) does not stop there!

Instead, U.C.C. § 9-306(4)(d) places two further restrictions on the secured creditorís interest in commingled cash proceeds. The first additional restriction is that the security interest is reduced by the amount of payments made to the secured party on account of cash proceeds during the ten (10) day period preceding the bankruptcy filing. The other restriction on the secured creditor’s interest is that the security interest is reduced by the amount of “other” cash proceeds received by the debtor to which the secured party is entitled under U.C.C. §9-306(4)(a) – (c).

Thus, the secured creditor’s interest in commingled funds first, will be capped at an amount equal to the cash proceeds received by the debtor during the ten (10) days preceding the bankruptcy. That “ceiling” amount then will be reduced by the following:

(i) the amount of payments made to the secured creditor on account of cash proceeds during the ten (10) days preceding the

filing;

(ii) the amount the secured creditor is entitled to receive from:

(a) cash proceeds in separate deposit accounts containing only proceeds,

(b) identifiable cash proceeds in the

form of money which is neither commingled with other money nor deposited into a

deposit account, and

(c) identifiable cash proceeds in the form of checks and the like which are not deposited in a deposit account prior to insolvency proceedings.

The hypothetical example accompanying this article demonstrates how the foregoing provisions affect a secured creditor’s security interest in cash proceeds of collateral.

Security Interests in Cash Proceeds in Non-Commingled Deposit Accounts Have Been Subjected to the Same Restrictions as Commingled Deposit Accounts

Under U.C.C. §9-306(4)(a), a secured creditor may maintain its security interest “in separate deposit accounts containing only proceeds”. As previously discussed, a security interest in a deposit account in which cash proceeds have been commingled with other funds is subject to the restrictions contained in U.C.C. §9-306(4)(d). However, the U.C.C. does not address the situation where, although the debtor’s bank account may not be commingled and contains only proceeds, the account is the debtor’s general operating account, was not set up as a “separate deposit account” for depositing only proceeds and may have been commingled at some earlier time. In this situation, although the account is not commingled, the secured creditorís security interest still may end up being limited by the restrictions imposed by U.C.C. §9-306(4)(d).

In First Nat. Bank of Amarillo v. Martin, 48 B.R. 317 (N.D.Tx. 1985), the Court directly addressed this issue and stated:

Surely the framers understood that a general deposit account could, on occasion, by application of common law tracing rules, be found to contain only proceeds despite its previously commingled character. Nevertheless, the authors of the Code, as has already been stated, chose to reject the tracing approach in favor of the application of the subsection (d)(4) formula when dealing with deposit accounts which have been commingled. . . . Accepting that the use of the word “separate” within the language of subsection (d)(1) was intended to limit the kinds of deposit accounts to which subsection (d)(1) applies, this Court should follow the approach of the court in In re Cooper, 2 B.R. 188 (Bkrtcy – S.D.Tx.1980), wherein the Court suggested that the application of §9-306(d)(1) be limited to those accounts specifically created and used for the deposit of proceeds of secured collateral.

Id. at 321. Instead of determining whether the account was commingled or whether it contained only proceeds, the Court in First Nat. Bank of Amarillo simply applied the U.C.C. subsection for accounts “in which proceeds have been commingled with other funds,” Texas U.C.C. §9-306(d)(4) (the equivalent of NYUCC §9-306(4)(d)).

Similarly, in In re Barsotti Brothers Bakery, Inc., 80 B.R. 745 (Bankr. W.D.Pa. 1987), the Court stated: “[t]he application of this section [Pennsylvaniaís U.C.C. §9-306(d)(1) (which is equivalent to NYUCC §9-306(4)(a))] is limited to those accounts which are specifically created and used for the deposit of proceeds of secured collateral.” 80 B.R. at 747. Based upon the foregoing, the Court in Barsotti did not apply Pennsylvania U.C.C. §9-306(d)(1) (applicable to non-commingled proceeds in a segregated account) and, instead, applied the limitations contained in Pennsylvania U.C.C. §9-306(d)(4)(applicable to proceeds in a commingled account; equivalent to NYUCC §9-306(4)(d)).

Thus, it appears that even if cash proceeds are in a general operating account that is not commingled, U.C.C. §9-306(4)(d) may be applied to severely limit the secured creditorís security interest in the cash proceeds in that account.

In contrast, In re Collated Products, Corp., 121 B.R. 195, 205 (D.Del. 1990), affíd without opinion, 937 F.2d 596 (3d Cir. 1991), the United States District Court applied 12A:9-306(4)(a) of the New Jersey Code and held that the Bank continued to enjoy a security interest in proceeds of its collateral, even though such proceeds were contained in the debtor’s operating account, since such proceeds were not commingled with non-proceeds.

Bankruptcy Code §552(b) May Provide Equitable Relief from the Harsh Results of U.C.C. §9-306(4)(d)

In In re Trans-Texas Petroleum Corporation, 33 B.R. 67 (Bankr. N.D.Tx. 1983), although the Court found that §9-306(d)(4) of the Texas U.C.C. applied, the Court exercised its equitable powers under §552(b) of the Bankruptcy Code to prevent what it deemed to be the harsh results of Texas U.C.C. §9-306(d)(4). In In re Trans-Texas Petroleum Corporation, the Court stated that in light of the fact “that the proceeds were commingled with other funds only to the extent of $1,403.63 and in consideration of the hardship that would be imposed on [the secured creditor] if its security interest in the cash post-petition proceeds were reduced to a de minimis amount by operation of §9-306(d)(4) . . . I hold that the equities of the case require [the Debtor’s] post-petition cash proceeds be treated as if they were non-commingled and identifiable under §9-306(d)(1).” Id. at 70. Thus, on equitable grounds the court refused to apply the harsh restrictions of Texas U.C.C. §9-306(d)(4). But see In re Cross Baking Co., Inc., 818 F.2d 1027, 1033 (1st Cir. 1987).

Although it is obvious that a secured creditor does not want to rely upon the mercy of the Court, in some instances the Court’s equitable powers under §552(b) of the Bankruptcy Code may be the secured creditor’s only “safe harbor” from the severe limitations that can result from the application of the provisions of U.C.C. §9-306(4)(d).

Conclusion

In an effort to protect itself from the harsh restrictions discussed above, the secured creditor is advised to require that: (i) a separate account be established for the deposit of only proceeds of its collateral; and (ii) proceeds of its collateral be segregated and deposited only into that account.

If the debtor complies with the foregoing requirements, the secured creditor should be protected by U.C.C. §9-306(4)(a), (b) and (c). In addition, to the extent that the debtor fails to comply with its obligation to segregate proceeds, the secured creditor will have a stronger argument when requesting that the Court exercise its equitable powers under §552(b) of the Bankruptcy Code.

Example:

Assumed Facts

A secured creditor (“SC”) had a security interest in all of the debtor’s (“D”) inventory and accounts receivables (“Collateral”) to secure an indebtedness of $1,000,000. D filed for bankruptcy on February 1, 1998. On the petition date D had: (i) a general operating account (ìOperating Acctî) containing $400,000, and (ii) a separate account opened for the purpose of depositing proceeds of Collateral (“Collateral Acct”) containing $200,000. As of the petition date D also had: (i) $25,000 in undeposited checks received in payment of accounts receivable; and (ii) $10,000 in money. Of the $400,000 in the Operating Acct, $399,000 would be considered identifiable cash proceeds of the Collateral if SC could use tracing rules.

During the ten days prior to filing the bankruptcy, D received $200,000 in cash proceeds of Collateral and paid $50,000 to SC. Of the $200,000 received, as of the petition date: (i) $50,000 of it had been deposited into the Collateral Acct; (ii) $120,000 of it had been deposited into the Operating Acct; (iii) $25,000 of it was held by D in undeposited checks; and (iv) $5,000 of it was held by D in money which had been commingled with non-proceed money.

Application of NYUCC 9-306(4):

Under the provisions of NYUCC §9-306(4), SC would have a security interest in the cash proceeds as follows: (i) in entire $200,000 in the Collateral Acct since that amount was in a separate deposit account set up to receive proceeds of the Collateral and since that account contained only proceeds of the Collateral, pursuant to NYUCC §9-306(4)(a); (ii) in the $25,000 in undeposited checks pursuant to NYUCC §9-306(4)(c); and (iii) in $75,000 of the commingled cash proceeds in Operating Acct and money as more fully described below.

Pursuant to NYUCC §9-306(4)(d), SC’s security interest in the $400,000 remaining in the Operating Acct and the $5,000 in commingled cash would be subject to setoff (it is assumed that no right of set-off exists) and have a maximum cap of $200,000 (the amount of proceeds received by D during the ten days prior to the filing). However, the $200,000 cap would be reduced as follows:

Maximum Allowable Security Interest in Commingled Cash Proceeds

$200,000.00

– Amount of proceeds paid to SC during the ten days prior to the filing

$50,000.00

– Amount of cash proceeds in the Collateral Acct received

by the Debtor during the ten days before the bankruptcy

which SC is entitled to receive under NYUCC §9-306(4)(a)

$50,000.00

– Amount of money SC is entitled to receive under NYUCC §9-306(4)(b)

$0.00

– Undeposited checks SC is entitled to receive under NYUCC §9-306(4)(c)

$25,000.00

Total Security Interest in Commingled Cash Proceeds

$75,000.00

In this example, based upon the limitations imposed by NYUCC 9-306(4)(d), SC would have a security interest in only $75,000 of the total $405,000 in commingled cash proceeds contained in the Operating Acct and money.

Similarly, out of total available cash (including undeposited checks) in the amount of $665,000, under the limitations imposed by NYUCC §9-306(4), SC would have a total security interest in cash proceeds of its Collateral in the amount of only $300,000, as follows:

Total Security Interest in

Commingled Cash Proceeds

$75,000.00

+ Amount of cash proceeds in the Collateral Acct NYUCC §9-306(4)(a)-

$200,000.00

+ Undeposited checks SC is entitled to receive under NYUCC §9-306(4)(c)

$25,000.00

Total Security Interest in Cash Proceeds

$300,000.00

In contrast, if D had not filed for bankruptcy and the general non-bankruptcy provisions of NYUCC §9-306(2) were used to determine SC’s security interest in cash proceeds of its collateral, SC would have the ability to use rules of tracing and could have a security interest in each of the following:

Collateral AccountTotal$200,000.00

Undeposited Checks$25,000.00

Traceable Commingled Cash Proceeds in Money$5,000.00

Traceable Commingled Cash Proceeds in Operating Acct$399,000.00

Total Pre-Petition Security Interest in Cash Proceeds$629,000.00

In the above example, absent a bankruptcy filing by D, SC would have had a total security interest in cash proceeds of its Collateral held by D in the amount of $629,000. Thus, simply by virtue of D’s bankruptcy filing, the restrictions contained in NYUCC §9-306(4)(d) acted to reduce SC’s security interest by $329,000 or approximately 50%.