The US Court of Appeals for the Sixth Circuit has ruled that a lender’s security interest in accounts was not perfected because a reference to “proceeds” in the lender’s UCC financing statement did not expressly refer to “accounts.” The Sixth Circuit surprisingly interpreted the definition of “proceeds”1 in Article 9 of the Uniform Commercial Code to exclude “accounts”2 (despite and without reference to provisions of UCC Article 9 to the contrary). While the Sixth Circuit’s stated basis for this decision is questionable, this decision illustrates the risk of a security interest not being perfected when the collateral description in a UCC filing does not match the collateral description in the related security agreement.3

In 1st Source Bank v. Wilson Bank & Trust et al., 2013 WL 5942056 (No. 13-5088, Nov. 7, 2013), the Sixth Circuit settled a priority dispute between 1st Source and a group of other secured lenders over their respective security interests in accounts receivable of two debtors.

The security agreements in favor of 1st Source granted security interests in, among other things, tractors, trailers and accounts, as well as the proceeds of the agreed-upon collateral. 1st Source’s UCC financing statements filed against the debtors described the collateral, in relevant part, as specific pieces of equipment and several types of collateral, “together with all present and future attachments, accessories, replacement parts, repairs, additions and exchanges thereto and therefore [sic], documents and certificates of title, ownership or origin, with respect to the equipment, and all proceeds thereof, including rental and/or lease receipts.” The UCC financing statement collateral descriptions, however, unlike the security agreements, did not use the terms “accounts,” “accounts receivable” or other similar language.

The other lenders’ UCC financing statements were filed later than 1st Source’s UCC financing statements. However, unlike 1st Source’s UCC financing statements, their UCC financing statements expressly included in their identified collateral “all accounts receivable now outstanding or hereafter arising.”

Applying Tennessee law, the Sixth Circuit ruled that 1st Source did not have perfected security interests in the accounts receivable because accounts receivable were not included in the reference to proceeds in 1st Source’s UCC financing statements against the debtors. Accordingly, 1st Source’s unperfected security interests were junior to the perfected security interests of the other lenders.

1st Source argued that the proceeds referred to in its UCC financing statements included the accounts. The Sixth Circuit rejected that argument, on the basis that the terms are separately defined in UCC Article 9 and that the general term proceeds does not subsume the specific term accounts.

That assertion lacks support in UCC Article 9 itself: “Proceeds” clearly may consist of “accounts.” The priority rules stated in UCC Section 9-324 with respect to inventory collateral and its proceeds make key distinctions depending on whether the proceeds are accounts.4 Moreover, many general UCC Article 9 collateral category terms encompass more specifically defined UCC Article 9 collateral category terms. For example, the term “goods” includes, among other collateral categories, “inventory” and “equipment,”5 the term “instruments” includes “promissory notes”6 and the term “investment property” includes, among other collateral categories, “security,” “security entitlement” and “securities account.”7

We note that the Sixth Circuit approvingly cited in its decision a line of cases that impose a limited reading of the UCC Article 9 definition of proceeds to the effect that it does not include property earned by a debtor from the debtor’s use of collateral that remains in the debtor’s possession (as contrasted with property received by the debtor from the sale, lease or other disposition of collateral by the debtor to another party).8 While such a limited reading is in itself controversial due to the existence of arguments that accounts arising from use of collateral may indeed fit within the definition of proceeds, the Sixth Circuit’s expression of its ruling in this case is more troublesome in suggesting that accounts can never be proceeds of other collateral because the UCC Article 9 definition of “proceeds” does not include accounts.

Unfortunately, because the 1st Source decision was decided by a Federal Circuit Court, and may be followed by other courts, the decision may well need to be dealt with by secured creditors in litigation and otherwise. The UCC definition of “proceeds” has been used by bankruptcy courts in determining under Section 552 of the Bankruptcy Code whether a pre-petition security interest extends to certain property of the debtor arising post-petition, as the Bankruptcy Code does not contain its own definition of proceeds.9 This means that the 1st Source holding may have an impact in bankruptcy cases as well as in cases decided outside of bankruptcy.

As a result, creditors whose interests are secured by property—and their counsel—may wish to consider listing accounts arising from the sale, lease, other disposition or use of such property specifically as original collateral in their security agreements and financing statements.10

For more information about the topics raised in this Legal Update, please contact John F. Lawlor at+1 312 701 7220, Kevin C. McDonald at +1 312 701 7154 or Craig Reimer at +1 312 701 7049.

1 Defined in UCC Section 9-102(a)(64). The definition reads as follows:
“Proceeds”, except as used in Section 9-609(b), means the following property:
(A) whatever is acquired upon the sale, lease, license, exchange, or other disposition of collateral;
(B) whatever is collected on, or distributed on account of, collateral;
(C) rights arising out of collateral;
(D) to the extent of the value of the 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; or
(E) to the extent of the value of collateral and to the extent payable to the debtor or the secured party, insurance payable by reason of the loss or nonconformity of, defects or infringement of rights in, or damage to, the collateral.
2 Defined in UCC Section 9-102(a)(2).
3 But, in certain cases of a security interest covering all personal property of a debtor, mismatched collateral descriptions do not pose that risk where the UCC filing collateral description uses a supergeneric collateral description (such as “all personal property”) as expressly authorized by UCC Section 9-504(2). In contrast, a supergeneric collateral description is not permitted for the collateral description in the granting provision of the security agreement. See UCC Section 9-108(c). (A grant of a security interest in all personal property may, in certain circumstances, be accomplished by listing all UCC Article 9 collateral category terms in the granting provision of the security agreement. See UCC Section 9-108(b).)
4 See Official Comments 8 and 9 to UCC Section 9-324.
5 See UCC Sections 9-102(a)(44), (48) and (33).
6 See UCC Sections 9-102(a)(47) and (65).
7 See UCC Section 9-102(a)(49).
8 See, e.g., In re Gamma Center, Inc., 489 B.R. 688 (Bankr. N.D. Ohio 2013), in which the court held that proceeds of equipment only included proceeds of sale of the equipment instead of proceeds of the use of the equipment, and In re Las Vegas Monorail Co., 429 B.R. 317 (Bankr.D.Nev.2010), in which the court held that rider fees were not proceeds of a monorail franchise.
9 See Collier on Bankruptcy, ¶552.02[1].
10 If the Sixth Circuit had found, to the contrary, that 1st Source did have senior perfected security interests in the accounts, this case would have presented the difficult issue of whether a senior perfected secured party may recover (on the basis of a conversion claim or otherwise) from a junior perfected secured party the proceeds of accounts collected by the junior perfected secured party.