Contributed by Andrea Saavedra
A recent decision out of the United States Bankruptcy Court for the Eastern District of New York, In re Milton Abeles, reminds secured creditors that when it comes to cash, perfection of a security interest turns on control. And sometimes (particularly when tracing is not available), certain things are simply outside of one’s control.
In Milton Abeles, the debtor’s chapter 7 trustee filed a motion seeking to reclassify a bank’s $1.1 million secured claim as unsecured, asserting that the bank did not have a secured interest in the $100,000 proceeds of the chapter 7 trustee’s settlement of a fraudulent transfer action. The bank countered that by virtue of its prepetition perfected security interest in the debtor’s deposit account, any funds transferred out of that deposit account (as these fraudulently conveyed funds were) remained subject to its continuously perfected security interest as proceeds of its collateral. The court examined both applicable New York state and federal bankruptcy law to address the bank’s assertion.
First turning to section 9-312(b)(1) of New York’s Uniform Commercial Code (UCC), the court noted that a security interest in a deposit account can only be perfected by “control.” While the bank had a perfected security interest in the deposit account, once the funds left the deposit account and were transferred to a third party, it no longer had any “control” of those funds and its interests became unperfected. With respect to the secured creditor’s argument that settlement funds were perfected as proceeds of the secured creditor’s collateral (i.e., the debtor’s deposit account), the court noted that under UCC section 9-315, a security interest only attaches to “identifiable proceeds,” and if proceeds that are not goods are commingled with other property, they can only be identifiable through a tracing methodology. Given the amount of time that had passed between the transfer and the litigation, the bank could not identify the proceeds of the deposit account, and thus the court found that the bank did not, as of the petition date, have a prior perfected secured interest in the settlement funds.
Turning to federal law, the court noted that while section 552 of the Bankruptcy Code usually preserves, on a postpetition basis, a secured creditor’s prepetition, perfected secured interest in the debtor’s property and related “proceeds, product, offspring, or profits of such property,” in this case, its ambit was unavailing to the bank because it did not have such a prepetition, perfected security interest in the settlement funds for the reasons discussed earlier. Accordingly, the court reclassified the bank’s claim as unsecured. The court suggested, however, that the result might be different in the case of a fraudulent transfer settlement resulting from the transfer of property in which a secured creditor had an interest other than deposit funds.
Interestingly, almost two years prior to the debtor’s petition date, the bank had not only recovered a $4.3 million judgment against the debtor and its affiliate, but had also initiated its own state law action against the third party transferee to recover the contested funds, asserting that it was the proper plaintiff under state law. Shortly after the debtor filed for bankruptcy, the bank asked the bankruptcy court to compel the chapter 7 trustee to abandon any claim against the third party transferee, as the bank asserted that it was the proper party to pursue such claims. The court denied the bank’s efforts at that time, but without prejudice to its assertion of a secured interest in any funds recovered.
The $100,000 ultimately recovered was the sole asset of the debtor’s estates. Therefore, although the numbers were relatively low, the stakes were high for the bank as it found itself being forced to share in bankruptcy what, under state law, it perceived it had the sole right to recover. In any event, the decision serves as a reminder that, when it comes to cash, once it is out of the debtor’s accounts – and out of a secured creditor’s control – recovery of such lost cash via a fraudulent conveyance action (particularly in the absence of any tracing analysis) does not inure to the sole benefit of the secured creditor, but is for the benefit of the estate and the entirety of its creditors.