Wednesday, April 23, 2014

FYI: Cal App Ct Holds Lender's Purported Security Interest in Deposit Accounts Unenforceable

Monday, May 28, 2012

The California Court of Appeal, Second District, recently held that a lender's purported security interest in deposit accounts was unenforceable, because the debtor never had any "rights in the collateral" and never gave value for the security interestso as to allow the lender's security interest to attach to the collateral.
A copy of the opinion is available at: 
As a result of a protracted dispute between developers over a real estate development partnership ("Development Partnership"), defendant developer ("Defendant Developer") bought out Plaintiff's partnership interest pursuant to a partnership sale agreement ("PSA").  The Development Partnership obtained a refinancing loan from a bank ("Claimant Bank"), which took a trust deed and security interest in the Development Partnership's real estate and personal property.
As set forth in the PSA, some of the proceeds from the loan were set aside to pay the Plaintiff for its partnership share and to pay lien claims against the Plaintiff.  The funds set aside were deposited into two separate accounts. According to the PSA, the funds on deposit for Plaintiff's partnership share were to be released to the Plaintiff once Defendant Developer was satisfied that certain conditions had been met.  Plaintiff eventually transferred its partnership interest to the Development Partnership as set forth in the PSA, but Defendant Developer never transferred the funds on deposit to the Plaintiff.
Plaintiff filed an action, seeking a rescission of the PSA and damages, among other things.  The matter was referred to arbitration.  A partial final award found for Plaintiff on the rescission claims, and awarded Plaintiff almost $2 million in restitution plus sole ownership of the Development Partnership property.  The Superior Court confirmed the partial final award. 
While the arbitration was underway, Claimant Bank commenced a judicial foreclosure proceeding on the Development Partnership property, and filed a notice of default specifying that personal property collateral was also being foreclosed.  The trial court appointed a receiver to take possession of the Development Partnership property as well as "all rents, issues, profits, security deposits, royalties, tolls, earnings, income and other benefits payable."  The receiver was ordered not to take any action as to the funds in the two accounts until a determination was made that those funds constituted receivership assets.
In a second round of arbitration, Defendant Developer was found to have engaged in improper conduct, including:  (1) failing to cooperate in the transfer of the Development Partnership property to Plaintiff as previously ordered; (2) permitting the refinancing loan to go into default and foreclosure; (3) failing to release funds in the two accounts to the Plaintiff; and (4) alerting Claimant Bank to the funds in the deposit accounts.   

Accordingly, having concluded that it was no longer possible to restore ownership of the property to Plaintiff, the arbitrator awarded Plaintiff compensatory and punitive damages of around $26 million, as well as the funds on deposit in the two accounts, and attorneys' fees and costs.   The Superior Court confirmed the corrected final award and entered judgment for the Plaintiff.
Plaintiff then intervened in the foreclosure proceeding, claiming that it had superior rights to the funds in the two accounts because the funds were not "rents and profits" belonging to the receiver.  The trial court in the foreclosure action ruled in part that the two accounts were not part of the receivership estate, because "rents and profits" as defined by the deed of trust consisted of income from the property after the date of default.

Claiming to have a security interest in the deposit accounts, however, the Claimant Bank sought to intervene in the Plaintiff's action against Defendant Developer, arguing that the funds on deposit were the proceeds of its loan and were therefore covered by its security interest.  The trial court denied Claimant Bank's motion to intervene and granted the Plaintiff a writ of possession in the two accounts.  The county Sheriff levied the funds several months thereafter.  Claimant Bank, having acquired title to the Development Partnership property in the foreclosure action, pursued a deficiency for the amounts still owing on the loan, asserted a third-party claim to the funds in the deposit accounts and petitioned the court for a hearing on the validity of its claim. 
The trial court denied Claimant Bank's claim, reasoning that had the funds in the accounts been properly disbursed as originally contemplated by the PSA, those funds would not have been available at the time of the foreclosure action. 
Claimant Bank appealed.  The Court of Appeal affirmed, ruling that the Claimant Bank's security interest never attached to the two deposit accounts, because the Development Partnership never had "rights in the collateral" as required by Commercial Code Section 9203.
As you may recall, a security interest is defined as "an interest in personal property or fixtures which secures payment or performance of an obligation."  Com. Code § 1201(b)(35).  In addition, a security interest attaches and becomes enforceable if (1) "value has been given . . . (2) the debtor has rights in the collateral or the power to transfer rights in the collateral to a secured party," and (3) there is some evidence that the debtor intended to create a security interest in the collateral.  Com. Code §9203(b).
Noting that a security interest is enforceable if:  (1) the security interest has attached; (2)  the security interest has been perfected;  and (3) the security interest has priority over a conflicting claim, the Appellate Court examined the threshold question as to whether the security interest had attached to the loan proceeds  that were in the deposit accounts.  In so doing, the Appellate Court noted that a security interest attaches only to those rights which a debtor has in the collateral and that "mere possession of [. . .] collateral by a debtor is not sufficient to constitute 'rights in the collateral' under section 9203." 
Applying this test, the Appellate Court ruled that Claimant Bank's security interest did not include the funds in the two deposit accounts.  In so ruling, the Court noted that the Plaintiff was able to trace the funds in both accounts to the loan proceeds owed to it under the PSA, that the Development Partnership never had any "rights in the collateral," and that there was no evidence that the debtor intended the security interest to attach to funds due to the Plaintiff.
The Appellate Court further ruled that, because the funds were due to Plaintiff as payment for its partnership interest and to pay lien claims, Claimant Bank had given no value for the purported security interest in the deposit accounts and thus had no interest in those accounts.  Noting that Claimant Bank's security agreement and financing statement did not cover the proceeds of the refinancing used to buy out Plaintiff's partnership share,  the Court concluded that the proceeds on deposit were never intended to serve as security for the loan. 

Accordingly, the Appellate Court ruled that, because Claimant Bank's security interest never attached to the deposit accounts, the purported security interest was unenforceable, and the Court did not need to address any issues of perfection or priority to resolve the matter.    

Eric Tsai
McGinnis Wutscher Beiramee LLP
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