Rick Antonoff, Partner, Blank Rome LLP
Rick Antonoff, Partner, Blank Rome LLP

Two recent rulings on secured creditor interests address matters of human error, leading to outcomes that were indisputably inconsistent with the parties’ intent. In both cases, erroneous UCC filings prevailed over the parties’ clear intent, to the detriment of the secured creditors. Other recent rulings involve interpretation of UCC provisions that narrowed the scope of security interests, which could have been avoided with careful drafting.

The ABF Journal addressed in its March issue the most notorious court ruling in which the U.S. Court of Appeals for the Second Circuit deprived JPMorgan Chase (JPMC) of securing a $1.5 billion claim against General Motors after JPMC mistakenly filed a UCC termination statement as an attachment to other UCC termination statements it had intended to file. JPMC petitioned the Second Circuit for a hearing en banc, but the active court members denied the request this spring, and most commentators agree that further review by the U.S. Supreme Court is unlikely. Below are examples of other cases in which secured creditors were caught offguard by similar unfavorable rulings.


In Duckworth, an error in writing the date of a promissory note in a security agreement resulted in thesecured party having no security interest in farm crops and equipment, even though the date was just two days off and the borrower agreed that it was a mistake. The problem for the secured party was that the borrower filed for bankruptcy under Chapter 7 of the Bankruptcy Code, and evidence that would have been admissible against the borrower to prove the validity of the security interest was ruled inadmissible against the Chapter 7 bankruptcy trustee, on the basis that the trustee was not a party to the original transaction.

The borrower was a farmer who took a $1.1 million loan from State Bank of Toulon, and signed a promissory note dated December 15, 2008. Two days before signing the promissory note and taking the loan, the borrower granted the bank a security interest in his crops and his equipment as security for repayment of the loan, and executed an Agricultural Security Agreement. Presumably, because the security agreement was signed two days before the loan, it identifies the secured obligation as being a promissory note dated December 13, 2008. In 2010, the borrower filed Chapter 7 in the U.S. Bankruptcy Court for the Central District of IL, and the bankruptcy trustee sold the borrower’s crops and equipment, but did not pay any of the sale proceeds over to the bank. The bank brought an adversary proceeding against the trustee to recover proceeds of the sale as proceeds of the bank’s collateral. On cross-motions for summary judgment, the bankruptcy court held that the mistaken date in the security agreement did not defeat the bank’s security interest. That decision was affirmed by the district court on appeal, and the bankruptcy trustee then appealed to the U.S. Circuit
Court of Appeals for the Seventh Circuit, which reversed.

The Circuit Court framed the issue as, “whether the mistaken date in the security agreement defeats the bank’s asserted security interest in the crops and equipment.” The borrower gave testimony that the date in the security agreement was a mistake, and that the parties intended the security agreement to identify the December 15, 2008 promissory note. The court stated that this evidence would be enough to correct the mistake if the dispute arose between the bank and the borrower, but not when the dispute is with a bankruptcy trustee:

“We conclude that although the evidence could have supported reformation of the security agreement as between the original parties, the evidence cannot be used against the bankruptcy trustee to reform the security agreement or otherwise to correct the mistaken identification of the debt to be secured.”

There is a question left open from the court’s reasoning in Duckworth. Much of the court’s opinion is devoted to how a bankruptcy trustee is in a “different position” from the debtor, due to the additional powers a trustee has under the Bankruptcy Code — the so-called “strong-arm” powers — by which a trustee is “deemed to be in the privileged position” of a good faith purchaser or a hypothetical judicial lien creditor, and may thereby avoid transactions such as security interests that are not properly perfected or are otherwise defective. The court held that, because evidence of the parties’ actual intent would not be sufficient to overcome the mistake and enforce a security interest against a hypothetical lien creditor, it is likewise insufficient against a bankruptcy trustee. Although the court states that the evidence of intent and mistake could be used to prove the validity of the security interest against the borrower if there was no trustee, the court does not address section 1107 of the Bankruptcy Code, which provides that, in a Chapter 11 case, the borrower, a debtor-in-possession, generally has all the rights and powers of a trustee and can assert strong-arm powers against creditors. While it is true that Duckworth is a Chapter 7, case, it begs the question of how the Seventh Circuit’s reasoning squares with the rights and powers of a debtor-in-possession under Chapter 11. By the way, farmer Duckworth waived indictment and pleaded guilty to money laundering and bankruptcy fraud.

Brooke Capital

Brooke Capital involves the scope of automatic perfection under Section 310(c) of the Uniform Commercial Code when participations are recharacterized as loans. In 2007, Brooke Capital Advisors (BCA) made a $12.38 million loan (BCA Loan) to its parent company, Brooke Capital Corporation (BCC), secured by stock BCC owned in another subsidiary called First Life America Corporation (FLAC). At the same time, BCC also obtained a $9 million loan from Citizens Bank & Trust Company, secured by a pledge of stock in another BCC subsidiary.

Soon after these loans, BCA sold fractional interests in the BCA loan, denominated as “Participation Certificates,” to three buyers (i.e., the “participants”), each of which owed a pre-existing debt to yet another BCC affiliate, Aleritas Capital. Under the terms of the participation certificates, if BCC or BCA defaulted, the amount of the participant’s participation in the BCA loan could be deducted from the amount the participant owed to Aleritas. In addition, BCA had an obligation to repurchase the participation after six months. In the participation certificates, BCA assigned and sold to the participants the security interest in the FLAC stock pledged under the BCA loan, and provided that BCA held the FLAC stock for the benefit of the participants. The participation certificate also prohibited BCA from releasing or substituting the FLAC stock as security for repayment of the BCA Loan.

BCA then sold a fourth participation in the BCA Loan under slightly different terms to Bank of Kansas (BoK). Unlike the participants, BoK did not have a debt to Aleritas or any other BCC affiliates (thus no setoff), BCA was not obligated to repurchase the BoK participation, and BoK was entitled to a share of borrower fees paid to BCA under the BCA loan, as well as expenses of servicing the loan. Similar to the Participants, BCA also assigned and sold to BoK a security interest in the FLAC stock pledged under the BCA Loan.

In May 2008, BCC began to have financial difficulties and entered into restructuring negotiations with Citizens. In the course of negotiations, BCC disclosed the BCA loan and pledge of FLAC stock, but did not disclose the participation interests in the BCA loan sold to the participants and BoK. The parties reached a restructuring agreement, in which BCA agreed to release its security interest in the FLAC stock so it could be pledged to Citizens, at such time as: (1) the FLAC stock was sold, (2) Citizens released its security interest in the other affiliate’s stock, and (3) the other affiliate’s stock was pledged to BCA as collateral under the BCA Loan. BCC, BCA and Citizens entered into a restructuring agreement (i.e., the “payment agreement”) providing — among other things — that if the FLAC stock was sold, and BCC or BCA was entitled to receive proceeds of such sale, they would immediately pay such proceeds to Citizens to satisfy amounts due under the Citizens loan. The parties also entered into a security agreement in which BCC granted Citizens a security interest in all BCC’s personal property, which included its interest in the FLAC stock. Citizens promptly filed a financing statement. Moreover, at Citizens’s request, BCC placed the FLAC stock in escrow, to perfect both security interests under an agreement identifying BCA as the first lien lender and Citizens as the second lien lender.

BCC soon became embroiled in litigation, resulting in the appointment of a special master who took control of BCC and filed Chapter 11 in the U.S. Bankruptcy Court for the District of Kansas, which was later converted to a Chapter 7 case. In the bankruptcy case, the special master, now acting as Chapter 7 trustee, filed a motion to sell the FLAC stock. Citizens commenced an adversary proceeding seeking a declaratory judgment to determine the priority rights in the sale proceeds of the FLAC stock. After a three-day trial, the bankruptcy court ruled that Citizens had a superior claim to the FLAC stock proceeds, finding that the payment agreement effectively subordinated BCA’s interest. The Bankruptcy Court further ruled that Citizens also had a superior claim to the participants, after finding that the participations should be recharacterized as disguised loans and that the participants held unperfected security interests. However, the court held that the participation sold to BoK was a true participation, and that BCA was not authorized to subordinate BoK’s interest in the FLAC stock under the payment agreement. Therefore, BoK’s security interest in the FLAC stock under its participation agreement was superior to Citizens’s interest.

The participants appealed the ruling to the U.S. District Court, which reversed — finding that the participants held perfected security interests in the FLAC stock superior to Citizens’s interest. The district court based its decision on Section 9-310(c) of the Uniform Commercial Code, which provides automatic perfection to an assignee of a perfected security interest.

“Assignment of perfected security interests. If a secured party assigns a perfected security interest … a filing under this article is not required to continue the perfected status of the security interest against creditors of and transferees from the original debtor. UCC §9-310(c).”

The district court, therefore, ruled that the participants were not required to take any additional steps to perfect their security interest in the FLAC stock, and rejected Citizens’ argument that recharacterization of the participations as disguised loans makes Section 9-310(c) inapplicable. Citizens appealed the district court’s decision to the U.S. Court of Appeals for the Tenth Circuit, which reversed the district court and reinstated the bankruptcy court’s decision, finding that the participations should be recharacterized as loans. As such, the participants were creditors of BCA that could not rely on automatic perfection under UCC 9-310(c), and had to perfect their security interests in a different way, depending on what those interests were. As creditors of BCA, the participants could only take a security interest in property owned by BCA, and not, for example, the FLAC stock, which was not owned by BCC, but merely pledged to BCA under the BCA loan. The Circuit Court concluded that what BCA owned and could grant as a security interest to the participants was: (1) the right to receive payment from BCC under the BCA loan (a payment intangible), and (2) BCA’s security interest in the FLAC stock (i.e., a security interest in a security interest, which is a general intangible).

After an exhaustive analysis of the UCC exceptions to the need for filing a financing statement (i.e., automatic perfection), the court found that the participants were required to file a financing statement to perfect their security interests in payment intangibles and general intangibles, and having failed to do so, “the underlying transactions granted the Participants only unperfected security interests” and therefore are junior to Citizens’s perfected security interest in the FLAC stock and the sale proceeds. The apparent lesson of the Brooke Capital decision is that purchasers of participations in loans who take assignments of the seller’s security interest should file protective financing statements in the event the participation is recharacterized as a loan.

Montreal, Maine & Atlantic Railway

This case addresses the extent to which a debtor may grant a security interest in proceeds of insurance policies, and whether a security interest in “accounts” and “payment intangibles” includes a settlement payment owed to the debtor under business interruption insurance. In 2009, the secured lender (Wheeling) provided credit to Montreal, Maine & Atlantic Railway (MM&A) secured by other collateral:

“All accounts and other rights to payment (including Payment Intangibles), whether or not earned by performance, including but not limited to, payment of property or services sold, leased, rented, licensed, or assigned. This includes any rights and interests (including all liens) that Debtor may have by law or agreement against any account debtor or obligor of Debtor.”

In 2013, a train operated by MM&A and carrying oil derailed, killing several people and causing structural and environmental damage. MM&A submitted a claim for $7.5 million under insurance policies issued by Travelers Property Casualty Company, based on the damages, losses resulting from business interruption and related expenses. Travelers denied coverage, arguing that the policy did not cover business interruption. While the dispute ensued, MM&A filed for bankruptcy in the U.S. Bankruptcy Court for the District of Maine under Chapter 11 of the Bankruptcy Code and a Chapter 11 bankruptcy trustee was appointed. The company also filed bankruptcy in Canada.

Travelers sought relief from the automatic stay in order to file a declaratory judgment action in the U.S. District Court on the scope of coverage under the policy. The trustee opposed the motion, and the bankruptcy court denied the motion. Travelers appealed, but the parties reached a settlement whereby Travelers agreed to pay $3.8 million, and the trustee sought bankruptcy court approval of the settlement. Wheeling objected to the settlement, claiming that its valid, perfected, first priority security interest in MM&A’s inven 2015tory, accounts and payment intangibles included the right to payment under the Travelers policy, and the settlement. The bankruptcy court approved the settlement, but directed the payment to be held in escrow pending resolution of Wheeling’s claim.

Wheeling made two arguments: First, it argued that its security interest in accounts and payment intangibles included insurance policy proceeds, particularly after the UCC amendments in 2000 included payment intangibles as “a general intangible under which the account debtor’s principal obligation is a monetary obligation.” Wheeling argued that, since Travelers’ principal obligation to MM&A was payment of the settlement amount, it should fall within the scope of a payment intangible. Second, Wheeling argued that, even if proceeds of an insurance policy are excluded under UCC 9-109(d)(8), Wheeling had a perfected security interest under Maine common law, by virtue of having filed a financing statement.

MM&A argued that Wheeling’s security interest cannot include proceeds of an insurance settlement, because UCC 9-109(d)(8) specifically excludes “an interest in or an assignment of a claim under a policy of insurance,” and under Maine common law, filing a financing statement is not sufficient to perfect.

The bankruptcy court approved the settlement, ruling that Wheeling’s security interest in accounts and payment intangibles did not include proceeds of business interruption insurance, because: 1) UCC 9-109(d)(h) expressly excludes insurance policies, and 2) The addition of payment intangibles in the UCC did not supersede the exclusion. The bankruptcy court further held that perfection under Maine common law requires possession of the collateral, which Wheeling did not have.

On appeal, the First Circuit Bankruptcy Appellate Panel (BAP) agreed with the bankruptcy court’s conclusion that accounts and payment intangibles do not include proceeds of insurance policies. The BAP noted that the definition of “accounts”:

“… does include some insurance-related rights but that those rights refer to the insurer’s right to receive premiums from its insured (which rights could be an important source of collateral for financing the insurer’s business) or to an agent’s right to be paid a commission on the issuance of a policy…Thus, the inclusion of “a right to payment…for a policy of insurance issued or to be issued” is designed to facilitate financing by insurers or insurance agents, which has nothing to do with an insured’s right to receive payment under a policy. If we were to read the statute as broadly as Wheeling argues, the revised definition of “accounts” would eviscerate the insurance exclusion…”

As to Maine common law, the BAP said that, while it is not clear what is required to perfect a security interest in the proceeds payable under an insurance policy, “it is clear that Maine law requires something more than the filing of a UCC-1 financing statement.” As examples, the BAP cited notifying the insurer and becoming a loss payee under the policy. Since Wheeling did neither of these, nor anything else, its security interest in the settlement payment was deemed unperfected.

Precautionary Tales

Each of these recent circuit court rulings could have come out the other way if the secured parties had taken greater care in filing documents to perfect or properly terminate their security interests, or had taken protective measures to account for recharacterization or narrow interpretation of their security interests. They serve as a cautionary tale for creditors to take nothing for granted.