Many investors, angels or VCs, will make secured loans to
portfolio companies - or to companies that they intend to become portfolio
companies. The priority of their security interest is a key
consideration. This article explains where perfected security interests
in deposit accounts can fail, courtesy of Richard Newman,
Senior Counsel in DLA Piper's New York office.
When a secured party's collateral includes a perfected
security interest in a deposit account maintained for the debtor by a bank that
is not the secured party, there are three situations in which its
perfected security interest in the deposit account can be defeated.
A secured party has an automatically perfected security
interest in a deposit account as "proceeds" to the extent the funds credited to
deposit account represent identifiable proceeds of the secured party's
"primary" collateral (e.g., collections of accounts
receivable). In addition, a secured party can perfect its security
interest in a deposit account as "primary" collateral by having
"control" of the deposit account by (A) having a three-party control agreement
among the debtor, the secured party and the depositary bank pursuant to which
the depositary bank agrees to follow the secured party's directions regarding
distribution of funds in the account without the further consent of the debtor
or (B) being the "customer" of the depositary bank with respect to
the deposit account (i.e., the deposit account is the secured party's
account rather than the debtor's account).
Notwithstanding a secured party's perfected security
interest, UCC §9-332(b) provides that a transferee of funds from a deposit
account takes the funds free of a perfected security interest unless the
transferee acts in collusion with the debtor. In Orix Financial
Services, Inc. v. Kovacs, 167 Cal.App.4th 242 (2008) the
court held that an unsecured creditor who garnishes a deposit account
and receives payment from the depositary bank is a "transferee" entitled
to the benefit of this UCC provision. Although a perfected security
interest would have priority over a subsequent judgment lien creditor (see
UCC §9-317(a)(2)), where the creditor enforces its judgment through a writ of
garnishment and receives payment from the depositary bank, the judgment
creditor will take free of the perfected security interest. Although the
secured party's security interest was only perfected as "proceeds" in the cited
case, based on the court's reasoning the result would be the same even if the
secured party were perfected in the deposit account by "control".
A second situation arises in the case where the
depositary bank has been granted a security interest in the deposit
account. Pursuant to UCC §§9-327(3) and (4), where the deposit account
is "owned" by the debtor (i.e., the debtor is the depositary bank's
customer with respect to the account), the depositary bank's security interest
will have priority over the secured party's security interest. The
depositary bank's security interest will have priority even if arose subsequent
to the time the secured party perfected its security interest by "control".
The third situation in which the secured creditor
can be defeated is by a setoff or recoupment exercised by the
depositary bank.[1]
UCC §9-340(a) and (c), when read together, provide that, if the deposit
account is "owned" by the debtor (i.e., the debtor is the depositary bank's
customer with respect to the account), the depositary bank's right of setoff
against the deposit account to satisfy a claim against the debtor will have
priority over the secured party's perfected security interest in the deposit
account. See Kentucky Highlands Inv. Corp. v. Bank of Corbin
217 S.W.3d 851 (Ky. Ct. App. 2006).
Tips to Ensure Your Security Interest is Good
1. If perfecting a security interest by means of a
control agreement include a waiver or subordination by the depositary bank
of any security interest it might have in or right of setoff or recoupment it
might have against the deposit account (except, perhaps, for unpaid fees,
returned items and the like).
2. Require the debtor to notify the secured
party of any money judgments against the debtor that could result in a
garnishment action, and require the depositary bank to give the secured party
notice of the receipt of any garnishments and give the secured party sufficient
time to seek an injunction or otherwise take steps to stop the payment being
made to the garnishing creditor.
[1]
Note that a right of setoff or recoupment is not a security interest. See UCC
§9-109(d)(10).
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