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).