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Perfection in Proceeds Under Revised Article 9

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As discussed in last issue's column, revised Article 9 greatly expands the definition of "proceeds" so that a security interest in specific collateral will automatically extend to after-acquired property that is derived from the original collateral, even if there is no disposition of the original collateral. Thus, even in the absence of any language in the security agreement, the secured party will automatically get a lien on whatever is received when the original collateral is sold, leased, licensed or disposed of, and on whatever is collected on, or distributed on account of, the collateral. See §§9-315(a)(2) & 9-102(64)(A & B).1 In addition, the lien will extend to any rights arising out of the collateral and claims arising from, or insurance payable as a result of, loss, damage, defects, nonconformity or interference with the use of, or infringement of rights in, the collateral. See §9-102(64)(C, D & E).

This expansion of the reach of the creditor's security interest has implications both in and out of the bankruptcy context. Outside of bankruptcy, it gives the creditor the ability to reach property generated by its collateral, instead of merely property that replaces the original collateral. As a result, it will reduce the amount of unencumbered assets that are available to unsecured creditors. The expanded scope of proceeds will also increase the likelihood of priority disputes where two different secured creditors claim the same property as collateral.

The expanded reach of the secured creditor's lien on proceeds will have a number of implications in bankruptcy. This column will analyze the basic perfection rules for proceeds and the interplay between the new rules and the bankruptcy trustee's "strong-arm" power under §544 of the Bankruptcy Code. Next month's column will focus on the effects of the new proceeds rule on §363 cash-collateral issues and the extent to which the new rule will allow secured creditors to reach property generated post-petition under §552.

The §544 "Strong-arm" Power

Section 544(a)(1) of the Bankruptcy Code gives the trustee or debtor-in-possession the status of a hypothetical judicial lien creditor that obtained its lien at the time of commencement of the bankruptcy case. Under both the current law and revised Article 9, such a judicial lien creditor will have priority over an unperfected security interest. See current §§9-301(1)(b) and 9-317(a)(2).2 Thus, although new §9-315(a)(2) causes the security interest to attach to any identifiable proceeds of the creditor's collateral, the creditor's ability to assert its lien in bankruptcy will depend on whether the proceeds security interest is perfected.

Perfection of Proceeds

Since the proceeds collateral may be of a type different from the original collateral, the steps taken to perfect a security interest in the original collateral may not be the appropriate steps to take in order to perfect a security interest in collateral of the new type. With some revisions, the new act carries forward the current rules that specify the extent to which new steps must be taken in order to maintain perfection in proceeds.

Like current law, if the security interest in the original collateral was perfected, then the proceeds security interest is automatically perfected for a short period of time, giving the creditor an opportunity to take the steps necessary in order to maintain perfection. Compare current §9-306(3) with §9-315(c & d). If the security interest in the original collateral was not properly perfected, then the security interest in proceeds will not be perfected automatically.

The revised act extends the period of automatic perfection from 10 to 20 days. On the 21st day after the security interest attaches to the proceeds, it will become unperfected unless one of three conditions is satisfied. See §9-315(d). Unlike current law, this lapse in perfection is prospective only and apparently does not permit a competing interest that arose while the security interest was perfected to move ahead in priority. See §9-315, cmt. 4.

The three conditions for maintaining perfection are phrased in terms similar to current law. However, other changes in the revised act likely will have the effect of preventing lapses in almost all cases where the original security interest was perfected by filing a financing statement.

The first of the three conditions for continuing perfection after the 20th day is the simplest. If the proper steps for perfecting a security interest in the type of collateral that constitutes proceeds are taken before the 21st day after attachment, then perfection is maintained. See §9-315(d)(3). These steps could be taken during the 20-day grace period, or they could have been taken long before the proceeds were generated. For example, if the creditor has perfected a security interest in the debtor's checking account by "control,"3 and the debtor uses funds from that account to acquire a piece of equipment, the creditor's proceeds security interest in the equipment would be automatically perfected for the first 20 days. If the creditor filed a financing statement listing "equipment" during the 20-day period,4 its security interest in the equipment would remain perfected after the 20th day. Similarly, if the creditor had previously filed a financing statement listing "all assets," then that earlier-filed financing statement would perfect the proceeds security interest in the new equipment immediately upon its acquisition.

If it becomes common practice to file "all-assets" financing statements, as your author expects, then there will be only a few situations where proceeds perfection might lapse in favor of a bankruptcy trustee. This is because of the combination of various features of the revised act. First, an all-assets financing statement filed to perfect the security interest in the original collateral will be sufficient to perfect the proceeds security interest, even though the proceeds constitute a different type of collateral. Second, except for certain real estate-related collateral, all financing statements relating to a particular debtor will be filed in a single office in the debtor's state of incorporation or state of residence.5 Finally, the filing of a financing statement will perfect a security interest against a lien creditor or trustee in bankruptcy with respect to several new types of assets that previously had to be perfected by either possession or control. See §9-312(a) (filing for chattel paper, instruments, negotiable documents and investment property). For example, if a negotiable promissory note is received as proceeds, an all-assets filing will perfect against a trustee in bankruptcy, although it will not provide perfection against a competing purchaser or a secured creditor who takes possession of the note. See §9-330(d). The combined result of these three new rules will be that an all-assets financing statement filed at the outset of the transaction will be sufficient to perfect a security interest in most types of proceeds against a trustee in bankruptcy.

One class of proceeds that generally cannot be perfected by filing is "cash proceeds." This group includes money, which must be perfected by possession, and deposit accounts, which must be perfected by control. See §§9-102(9) and 9-312(b)(1 & 3). However, here the second condition allows perfection to be maintained for as long as the cash proceeds are traceable. Section 9-315(d)(2) provides that a security interest in "identifiable cash proceeds" remains perfected after the 20th day. Since the cash proceeds likely will have been commingled with other funds, the critical issue under this provision will be whether the cash proceeds remain "identifiable." The act expressly provides that cash proceeds are identifiable "to the extent that the secured party identifies the proceeds by a method of tracing, including application of equitable principles..." See §9-315(b)(2). The comment to that provision specifically mentions the "lowest intermediate balance rule" as one such equitable tracing principle that may be applied. See §9-315, cmt. 3.

The third condition is the "same-office" rule. This rule applies to maintain perfection if (1) a filed financing statement covers the original collateral, (2) the proceeds are collateral that could be perfected by filing a financing statement in the same filing office as the original statement, and (3) the proceeds were not acquired with cash proceeds. For example, if the original financing statement described the collateral as "inventory," the proceeds security interest in the accounts generated when inventory is sold would be perfected as long as the proper office for filing an "accounts" financing statement is the same office where the "inventory" financing statement is on file. Thus, a financing statement listing only inventory can perfect a proceeds security interest in accounts, and the secured creditor has no duty to amend its filing to reflect that accounts also are covered. This rule does not apply if there are intervening cash proceeds. A two-part example illustrates this point. If the debtor trades some inventory for a piece of equipment, the "inventory" financing statement will perfect the proceeds security interest in the equipment (assuming that the equipment could have been perfected by filing an "equipment" financing statement in the same filing office). If, on the other hand, the debtor sells the inventory for cash and then uses the cash to purchase the equipment, the proceeds security interest in the equipment would not be perfected by the inventory financing statement.

While collateral descriptions are critically important under current law, extensive use of all-assets financing statements under the revised act (as discussed above) should limit the need to rely on the same-office rule. However, in those cases where a narrowly worded collateral description is used in the original financing statement, the "same office" rule will provide far greater protection than it does under current law. The revised act expands the reach of the "same office" rule in two ways. First, under current law, financing statements for tangible collateral (like inventory) are filed in the state where the collateral is located, while those covering intangibles (like accounts) are filed in the state where the debtor's chief executive office is located. See current §9-103. Thus, if the inventory and the chief executive office are located in different states, the same-office rule does not maintain perfection of the proceeds security interest in the accounts. Since the revised act centralizes filing and requires that almost all financing statements relating to a debtor be filed in the debtor's state of incorporation or residence, there will rarely be a case where the proceeds filing would need to be in a different office. Second, since filing can now be used to perfect instruments and investment property against a trustee in bankruptcy, the rule will apply in situations where it previously did not apply. For example, the same-office rule will now cause the "inventory" financing statement to perfect a security interest in a negotiable promissory note received as proceeds.

The net effect of these rules will be to enhance the secured creditor's position in bankruptcy. The expanded "proceeds" definition will significantly extend the reach of a secured creditor's proceeds claim, while the new perfection rules will reduce the opportunities for a bankruptcy trustee or debtor-in-possession to avoid a proceeds security interest claim under §544.

Enactment Update

The revised act's effective date of July 1 is now only five months away. However, even with the recent addition of Michigan to the list of adopting states, only 28 states plus the District of Columbia had adopted revised Article 9 as of early January. As state legislatures reconvene, expect to see a flurry of enactment activity in the coming months.


Footnotes

1 All citations are to the revised 1999 version of Article 9 of the Uniform Commercial Code, unless otherwise indicated. Citations to the currently applicable 1972 version of Article 9 are indicated by the term "current." Return to article

2 Note that the revised act slightly modifies current law to increase the protection afforded secured creditors. Under current law, the security interest must be "perfected" before a judicial lien attaches in order to have priority over it. Since "perfection" requires attachment, and attachment requires that value be given and that the debtor have rights in collateral, the secured creditor's priority does not date from the filing of its financing statement. The revision modifies this rule by giving the secured creditor priority over lien creditors from the date of filing in cases where the parties have entered into a security agreement. Return to article

3 For a discussion of security interests in bank accounts, see Warner, G. Ray, "Deposit Accounts as Collateral Under Revised Article 9," 19 ABI Journal 18 (No. 6, July/August 2000). Return to article

4 Note that the debtor's signature is no longer needed on a financing statement, so the creditor would not need the assistance of the debtor in order to maintain perfection. Return to article

5 See Warner, G. Ray, "New Filing Rules Follow the Debtor," 19 ABI Journal 16 (No. 2, March 2000). Return to article

Journal Date: 
Thursday, February 1, 2001

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