Control Agreements — Avoiding a Potential Pitfall

In the wake of the recent financial crisis, it has become apparent that in many respects cash is indeed king, particularly as a form of collateral. Thus, secured parties would be wise to ensure that they have a properly perfected security interest in a debtor’s deposit accounts. In that regard, secured parties should consider adding language to their control agreements to avoid a potential pitfall. By William V. Jacobsen, Jr. and Richard M. Newman
Although a security interest in a deposit account can be perfected as “proceeds” of other collateral (e.g., collections on accounts receivable) as long as the proceeds are “identifiable,” pursuant to the Uniform Commercial Code (UCC), the only way to perfect a security interest in a deposit account as primary collateral (and to have priority over a competing security interest based on a claim of proceeds) is to have “control” of the deposit account. The filing of a UCC financing statement is wholly ineffective for such purpose.

If the secured party is also the bank at which the deposit account is maintained, the UCC provides that the secured party automatically has “control” over the account. When the account is maintained at a bank that is not the secured party, a secured party may obtain “control” of such account by having the account in its own name (i.e., it is the secured party’s account maintained at the depositary bank) for the benefit of the debtor or, more commonly, by entering into a “control agreement” whereby the depositary bank agrees that it will comply with instructions it receives from the secured party regarding the funds in the account without any further consent of the debtor.

The general rule under the UCC is that perfection, the effect of perfection or non-perfection, and the priority of a security interest are all governed by the local laws of the jurisdiction where the debtor is located. However, pursuant to UCC §9-304(a), the local law of a depositary bank’s jurisdiction governs perfection, the effect of perfection or non-perfection, and the priority of a security interest in a deposit account maintained with the depositary bank.

UCC §9-304(b) provides a “waterfall” of methods for determining a depositary bank’s jurisdiction for purposes of the UCC. UCC §9-304(b)(1) states, “If an agreement between the bank and its customer governing the deposit account expressly provides that a particular jurisdiction is the bank’s jurisdiction for purposes of [the UCC], that jurisdiction is the bank’s jurisdiction.” UCC §9-304(b)(2) states, “If paragraph (1) does not apply and an agreement between the bank and its customer governing the deposit account expressly provides that the agreement is governed by the law of a particular jurisdiction, that jurisdiction is the bank’s jurisdiction.”

A problem could arise if the control agreement and the “customer agreement” entered into between the depositary bank and the debtor as its customer in connection with the opening of the account each expressly provides for a particular, but different, jurisdiction to be the bank’s jurisdiction for purposes of the UCC, as each agreement would be “an agreement between the bank and its customer governing the deposit account.” The same problem could arise if neither the control agreement nor the customer agreement expressly provides for the bank’s jurisdiction, but each such agreement provides that it is governed by the law of a particular, but different, jurisdiction. To avoid such problems, all secured parties should 1.) cause their control agreements to expressly state that a particular jurisdiction is the bank’s jurisdiction for purposes of the UCC and 2.) consider adding the following provision (or words to such effect) to their control agreements:

This agreement is “an agreement between the bank and its customer governing the deposit account” within the meaning of UCC §9-304(b). The designation of the bank’s jurisdiction for purposes of the Uniform Commercial Code in this agreement shall be controlling in the event of any conflict between this agreement and any other agreement between the bank and its customer governing [the account].

Including such language could avoid the risks and uncertainty that would arise if the application of the provisions of UCC §9-304(b) would result in two separate jurisdictions being identified under two separate agreements.
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Reprinted with permission from Mayer Brown. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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