Proceeds in Bankruptcy Under Revised Article 9

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Mar 2001

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As explained in the last two columns, 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, assets
derived from the original collateral, such as license fees, rental fees and stock
dividends, will be subject to the creditor's security interest automatically and, in
most instances, will be perfected automatically. See §§9-315(a)(2) and
9-102(a)(64).<a href="#1" name="1a">1</a>

Two sets of UCC rules must be considered when dealing with after-acquired property.
First, both current law and revised Article 9 broadly validate "after-acquired
property" clauses. See current §§9-204(1) and 9-204(a). Thus, if proper
language is included in the security agreement, the security interest will extend to
property acquired by the debtor in the future, even if that future property is not
derived from or in any way related to the creditor's original collateral. If,
however, the future property qualifies as "proceeds," then the security interest
automatically attaches to the future property without the need for any language in the
security agreement.

It is difficult to predict the bankruptcy impact of the changes in the UCC
proceeds rules. Since these rules extend the reach of the secured creditor's security
interest, one likely effect of these and other changes in the UCC will be that the
secured creditor's lien will cover more assets at the time bankruptcy is filed.
However, as noted above, a similar result can be achieved under both the current
law and revised Article 9 by including an "after-acquired property" clause in the
security agreement. Thus, sophisticated lenders probably already obtain security interests
in most types of after-acquired property that are now included in the expanded
"proceeds" definition.

<h3>Cash Collateral</h3>

The Article 9 revision is likely to have a significant impact on cash-collateral
issues. With the exception of a few non-uniform states, current Article 9 excludes
deposit accounts (bank accounts) from its scope. See current §9-104(l). Thus,
under current law, it is not possible to take an Article 9 security interest in
the debtor's bank accounts as "original collateral."<a href="#2" name="2a">2</a> A secured creditor can,
however, obtain a lien on the funds in the deposit account, but only if those funds
are proceeds of some other collateral. Thus, currently cash collateral issues under
§363 of the Bankruptcy Code involve primarily proceeds collateral.

Since the revised act permits creditors to take security interests in deposit accounts
as original collateral,<a href="#3" name="3a">3</a> such accounts will likely be subject to liens even when the
funds in the accounts are not proceeds of some other collateral. This may make it
difficult for the debtor to provide adequate protection, which is required as a
pre-condition to the use of cash collateral under §363 of the Bankruptcy Code.

Currently, if the cash collateral is the proceeds of some other item of the same
creditor's collateral, it may be possible to provide adequate protection by agreeing to
use the cash collateral to enhance or maintain the value of the non-cash collateral.
For example, rents can be used to operate and maintain the real estate collateral,
or the cash proceeds of inventory can be used to purchase new inventory. However,
if the first priority lien on the deposit account is held by a creditor that does
not have other collateral, the debtor may be not be able to use the funds in the
account to operate the business unless it can provide some other form of adequate
protection.

This problem will be exacerbated by the new priority rules for deposit accounts.
These rules increase the likelihood that the creditor with the first priority lien in
the deposit account will not be the creditor who also holds a lien on the debtor's
inventory or other productive assets.

Under current law, when proceeds are deposited into a bank account, the
perfected-proceeds lender has priority over the depositary bank's right of set-off.<a href="#4" name="4a">4</a>
Further, since deposit accounts cannot be original collateral under current law, there
is rarely a competing non-proceeds creditor with a valid lien on the account.
However, under revised Article 9, the depository bank's rights of set-off and
recoupment generally will have priority over the proceeds security interest. See
§9-340(a). Further, if a competing creditor has obtained a security interest
in the bank account as original collateral and has perfected by control, its security
interest will also be superior to the proceeds security interest. See §9-327(1).
Finally, even if the proceeds creditor foresees the problem and obtains and perfects
an Article 9 security interest in the account as original collateral, its perfected
security interest generally will be subordinate to an Article 9 security interest held
by the depository bank. See §9-327(3) and (4).

In addition to the new deposit account rules, the changes in the proceeds rule
will have two significant effects in the cash-collateral area. First, since the
proceeds rule now extends to a wider range of income generated by the original
collateral, the likelihood that the funds in the debtor's bank account constitute "cash
collateral" will be much greater. For example, if rental fees, license fees or stock
dividends have been deposited into the debtor's bank account pre-petition, the funds
in the account will now be the "cash collateral" of the creditor holding a security
interest in the asset that generated those fees. Thus, the debtor-in-possession must
seek a cash collateral order under §363 before using those funds.

The second change deals with cash proceeds that have been commingled. Under current
law, a special rule applies when the debtor becomes involved in an insolvency
proceeding. Current §9-306(4)(d) limits the creditor's proceeds security interest
in funds that have been deposited into a commingled bank account to the amount of any
cash proceeds received by the debtor within 10 days before the institution of the
insolvency proceeding. This provision has generated conflicting case law<a href="#5" name="5a">5</a> and could have
the drastic effect of cutting off the proceeds claim if no funds were received during
the 10-day period.<a href="#6" name="6a">6</a>

The revised act eliminates the special insolvency proceeds rule. As a result, the
proceeds claim will no longer be artificially limited by the 10-day rule. In
addition, the revised act expressly authorizes use of equitable tracing principles, such
as the "lowest intermediate balance rule," to establish that commingled funds on deposit
are the identifiable proceeds of the creditor's original collateral. See
§9-315(b)(2), cmt. 3. The combined effect of these changes will be to
enhance the secured creditor's ability to assert cash collateral claims against funds in
the debtor's bank accounts.

<h3>Post-petition Effect of Security Interest</h3>

The revisions to the proceeds rule may significantly expand the ability of secured
creditors to assert security interests in property generated post-petition. As noted
above, an after-acquired property clause is effective outside of bankruptcy and will
cause the security interest to attach automatically to the after-acquired property of
the debtor. In bankruptcy, however, §552(a) of the Bankruptcy Code cuts off
the after-acquired property clause and prevents it from creating a security interest in
property acquired after the commencement of the case.

Section 552(b)(1) then creates an exception to the general rule for
post-petition property that constitutes proceeds, product, offspring or profits of the
original collateral. Under the §552(b)(1) exception, a pre-petition security
interest will create a lien on property acquired by the estate post-petition if the
debtor entered into a pre-petition security agreement that extends both to property
acquired before bankruptcy and to "proceeds, product, offspring or profits" of that
property. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §552(b)(1)</a>.

What effect will the expanded Article 9 definition of "proceeds" have on
§552(b)(1)? First, since an Article 9 security interest automatically extends
to proceeds, the expanded-proceeds definition will cause a security agreement that lacks
an after-acquired property clause to create a more extensive security interest in
after-acquired property than is the case under current law. As a result, the
§552(b)(1) requirement that the pre-petition security agreement extend to the
post-petition assets will be more easily satisfied in cases of poorly drafted security
agreements.

The more difficult question is whether the expansion of the Article 9 definition
of "proceeds" will automatically expand the meaning of the term "proceeds" under
§552(b)(1). Currently, the courts are split as to the proper interpretation
of the term "proceeds" as used in §552(b)(1). Some courts use a restrictive
federal bankruptcy law definition that emphasizes the rehabilitative purpose of bankruptcy
law, others apply the current Article 9 definition, and some rely on the
legislative history of §552 to create a definition that is more liberal than the
current Article 9 definition.<a href="#7" name="7a">7</a>

If courts defer to the Article 9 definition, the expanded-proceeds definition
will enhance the secured creditor's ability to reach post-petition assets. For
example, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. FDIC, 2 F.3d 1042, 1045 (10th Cir.
1993)</a>, relied on the then-current Article 9 definition of proceeds to hold
that ordinary cash dividends were not proceeds of stock because they did not result
from a disposition of the stock. Since the revised act includes dividends in the
definition of proceeds, deference to the Article 9 definition would reverse the
Hastie result. See §9-102(a)(64)(B). Similarly, secured creditors may
now be able to assert §552(b)(1) secured claims to post-petition rental fees,
moneys generated by coin-operated devices, and license fees.<a href="#8" name="8a">8</a>

However, even if the Article 9 change does expand the reach of the secured
creditor's §552(b)(1) claim on post-petition assets, the net effect may be
minimal. Although §552(b)(1) recognizes the secured creditor's lien on
post-petition assets as an initial matter, it also provides the bankruptcy court with
wide discretion to limit the lien "based on the equities of the case." See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
U.S.C. §552(b)(1)</a>. Thus, while revised Article 9 extends the reach of
the proceeds security interest to property generated by the original collateral, the
bankruptcy court might find that the equities do not support recognizing the lien on
those proceeds.

<h3>Enactment Update</h3>

As of early February, only 28 states plus the District of Columbia had
adopted revised Article 9. With only a few months left before the July 1,
2001, effective date, there will be a major effort to push the revision through
the remaining state legislatures. Revision bills have already been reintroduced in 12
states plus the U.S. Virgin Islands.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> 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." <a href="#1a">Return to article</a>

<a name="2">2</a> See, generally, Warner, G. Ray, "Deposit Accounts as Collateral Under Revised Article 9," 19 ABI Journal 18
(July/August 2000). <a href="#2a">Return to article</a>

<a name="3">3</a> Id. <a href="#3a">Return to article</a>

<a name="4">4</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…, Barkley, The Law of Secured Transactions Under the Uniform Commercial Code, Para. 3.11, p. 3-190.2 (Rev.
ed. 2000)</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> Compare <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Gibson Products of Arizona, 543 F.2d 652, 656 (9th Cir. 1976), cert. denied, 430 U.S.
946 (1977)</a> (gives creditor a security interest in all funds in account even if only $10 is traceable), with <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Philco
Finance Corp., 491 F.2d 1288, 1291-92 (7th Cir. 1974)</a> (limits security interest to traceable proceeds received within
10 days); see, also, Dunne, Gerald, "Commingled Proceeds—Clarification, Please!" <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Banking L.J. 3 (1987)</a>. <a href="#5a">Return to article</a>

<a name="6">6</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Sales Co. v. Critiques Inc., 796 F.2d 1293, 1301 (10th Cir. 1986)</a>. <a href="#6a">Return to article</a>

<a name="7">7</a> See 5 Collier on Bankruptcy, Para. 552.02[2], pp. 552-7 and 552-8 (15th ed. rev. 2000). <a href="#7a">Return to article</a>

<a name="8">8</a> See §9-102(64)(A), (B) and (C); compare, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Cleary Bros. Construction Co., 9 B.R. 40, 41
(Bankr. S.D. Fla. 1980)</a> (rental of equipment does not produce proceeds); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re S&J Holding Corp., 42 B.R. 249,
250 (Bankr. S.D. Fla. 1984)</a> (coins not proceeds of video games); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Value-Added Communications Inc., 139 F.3d
543, 546 (5th Cir. 1998)</a> (coins not proceeds of pay telephones). <a href="#8a">Return to article</a>

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Journal Authors

G. Ray Warner

Journal Date

Thursday, March 1, 2001 - 12:00

Bankruptcy Rule

2001