A borrower’s deposit accounts are attractive collateral for lenders. Deposit account funds are essentially cash, and if the lender maintains the account, then the lender can reach the funds without effort. A borrower’s bankruptcy, however, creates a dilemma for deposit account lienholders, and a recent case counsels lenders to obtain adequate protection before turning over deposit account funds to the bankruptcy estate.
A security interest in a deposit account may be perfected by filing the appropriate UCC-1 financing statement or by obtaining “control” of the deposit account. If the lender is the depository of the account, then the lender has “control” of the account.[1] This is important because a security interest perfected by “control” takes priority over one perfected solely by a UCC-1 filing.[2] Thus, a lender’s security interest in deposits at its own bank is automatically perfected and holds priority.[3]
Notwithstanding the strength of a lien held by “control” (often called a “possessory lien”), a possessory lienholder in a deposit account may be required to turn over account funds when the account-holder files for bankruptcy. Under the Bankruptcy Code, once a debtor files for bankruptcy, any entity “in possession, custody, or control” of the debtor’s property must deliver such property to the party managing the debtor’s bankruptcy estate.[4] Usually this turnover provision is of no consequence to lenders because lenders usually do not possess or control the debtor’s property (e.g., real estate, equipment, inventory). Deposit accounts, however, present a special problem: If perfection of a lien in a deposit account relies upon “control” of the account, then does the lienholder lose “control” of the account, and thereby priority of its lien, when it turns over the account funds in bankruptcy?
Answering the question above, the Eighth Circuit Bankruptcy Appellate Panel recently held that a lienholder in deposit account funds lost its possessory lien when it turned the funds over to the bankruptcy trustee without first seeking adequate protection.[5] The court stated that a creditor whose rights in collateral depend upon possession “may withhold turning the collateral over until the bankruptcy court is able to make a determination as to whether, and to what extent, the creditor is entitled to adequate protection” — a procedure “approved by the Supreme Court.”[6] Thus, in response to a demand for turnover, a possessory lienholder in deposit account funds (or a deposit account lienholder whose priority depends on possession) should maintain and freeze the account, then file a motion asking the bankruptcy court to provide for adequate protection. After the lienholder proves the existence and perfection of its lien, a court may enter an order “providing that such lien continue in the proceeds being turned over,” which will make interested parties aware “that the funds … are not available for estate administration and other expenses.”[7]
[1] See U.C.C. § 9-104.
[2] See U.C.C. § 9-327(1).
[3] See U.C.C. § 9-104.
[4] See 11 U.S.C. § 542(a).
[5] See North Am. Banking Co. v. Leonard (In re WEB2B Payment Solutions Inc.), 488 B.R. 387, 394 (B.A.P. 8th Cir. 2013).
[6] Id. at 393 (citing Citizens Bank of Md. v. Strumpf, 516 U.S. 16 (1995), and U.S. v. Whiting Pools Inc., 462 U.S. 198 (1983)).
[7] Id.