It’s difficult if not impossible for a debtor to create a trust giving a subsequent lender priority over a prior-perfected security interest, for reasons explained in a March 21 opinion by District Judge James Wesley Hendrix of Abilene, Texas.
A debtor obtained a loan from a lender in 2013 secured by a perfected security interest in accounts receivable. The lender filed the required continuation statements.
Five years later, the debtor obtained bonds from a bonding company. To secure the debtor’s obligation to indemnify the bonding company, the agreement called for the bonding company to have a security interest in accounts receivable. The bonding company did not perfect the security interest by filing financing statements until years later, on the eve of the debtor’s bankruptcy.
Doubtless because there was already a perfected security interest in accounts receivable, the agreement between the debtor and the bonding company purported to create a trust in favor of the bonding company. The trust would include accounts receivable arising from projects where the bonding company issued bonds.
To create the trust, the debtor declared in a provision in the agreement
that all monies due and to become due [on any project] covered by Bonds . . . are trust funds, whether in the possession of [the debtor] or otherwise, for the benefit of and for payment of all obligations for which [the bonding company] would be liable under any of said Bonds, and this Agreement shall constitute notice of such trust. Said trust also inures to the benefit of [the bonding company] for any liability or loss it may have or sustain under any of said Bonds, and this Agreement shall constitute notice of such trust.
The debtor defaulted on the loan agreement. Exercising its rights under the 2013 security agreement, the lender swept several million dollars from the debtor’s bank account. The bonding company protested, claiming that most of the swept funds were in trust for its benefit.
The debtor ended up in chapter 7. The bonding company sued the lender in state court. The lender removed the suit to the bankruptcy court, where the bankruptcy judge recommended that the district court withdraw the reference.
After the district court withdrew the reference, both parties made cross motions for summary judgment. The lender claimed that it had a prior, perfected security interest, while the bonding company claimed that the accounts receivable proceeds were in trust where the security interest could not attach.
Judge Hendrix granted the lender’s summary judgment motion.
The outcome turned on the validity of the trust. In Texas, “the settlor must show an intent to create a trust,” Judge Hendrix said.
Judge Hendrix cited cases where the Fifth Circuit “repeatedly warned against concluding that a trust exists based on mere talismanic language or labels.” Simply saying that property is held in trust is not sufficient to establish an express trust, the circuit court said.
In a virtually identical case in the Northern District of Texas, the court “decline[d] to allow the parties to circumvent the priority schemes . . . by mere recitation of the words ‘trust funds.’” Pineda REO, LLC v. Weir Bros, Inc., No. 3:18-CV-1660-N, 2020 WL 1236548, at *7–8 (N.D. Tex. Mar. 12, 2020).
Judge Hendrix ticked off the reasons why the agreement did not create a trust. To begin with, the words “beneficiary” or “grantor” do not appear in the agreement. Likewise, there was no prohibition regarding the comingling of funds.
Judge Hendrix said that the agreement had the “hallmarks” of a security agreement and that “the talismanic language ‘trust funds’ and ‘trust’ appears to be used to allow [the bonding company] to circumvent [the lender’s] superior security interest in [the debtor’s] accounts receivable.”
Holding that the agreement did not create an express trust, Judge Hendrix granted the lender’s motion for summary judgment. Quoting the Fifth Circuit, he said that the agreement’s reference to a trust was “nothing more than a draftsman’s ineffectual effort to ‘bootstrap’ a bit of additional leverage” for the surety given the lender’s prior, perfected interest. In re Sakowitz, 949 F.2d 178, 183 (5th Cir. 1991).
Observations
Let’s imagine a tougher case. Assume the agreement used all the right words and required the segregation of proceeds from accounts receivable. Who wins? Can a secret trust defeat a prior, perfected security interest?
We’re willing to bet that a court would still construe the agreement as creating a subordinate security interest. Otherwise, a subordinate lender could easily defeat a perfected security interest, leaving the lender with little ability to determine whether there was a secret trust.
Here’s another angle: The senior lender could sue the beneficiary of the trust, alleging that creation of the secret trust was an actual fraud to hinder or delay creditors. Remember, actual fraud does not require insolvency.
It’s difficult if not impossible for a debtor to create a trust giving a subsequent lender priority over a prior-perfected security interest, for reasons explained in a March 21 opinion by District Judge James Wesley Hendrix of Abilene, Texas.
A debtor obtained a loan from a lender in 2013 secured by a perfected security interest in accounts receivable. The lender filed the required continuation statements.
Five years later, the debtor obtained bonds from a bonding company. To secure the debtor’s obligation to indemnify the bonding company, the agreement called for the bonding company to have a security interest in accounts receivable. The bonding company did not perfect the security interest by filing financing statements until years later, on the eve of the debtor’s bankruptcy.