Building windows

The Significance of a Security Interest in Proceeds

In equipment leasing (and other secured transactions), the Security Agreement and financing statement (UCC-1) typically include at the end of the description of collateral a reference to the “proceeds” of the collateral securing the lease payments or loan payments.  What are proceeds?  Under what circumstances is the security interest in the original collateral lost because it changed into something that was not “proceeds” and what can secured parties do to protect themselves?  To what extent can lessors and those providing financing to equipment lessors sidestep the proceeds issue altogether by broadening their security interest in the original collateral?

What are Proceeds?

“Proceeds” is defined as whatever is acquired on the sale, lease, or other disposition of property, whatever is collected on or distributed on account of collateral, rights arising out of collateral, and certain claims arising out of the collateral.[1]  The definition of “collateral” includes “proceeds” to which a security interest attaches, however, as the qualification indicates, not all proceeds are collateral.  Therefore, in taking a security interest in the original collateral, the lessor also receives a security interest in the proceeds of that collateral.[2]  Most importantly, a security interest in proceeds is perfected, at least for 20 days, if the security interest in the original collateral was perfected[13] and the timing of filing or perfection as to the security interest in the underlying collateral is also deemed the time of filing or perfection as to the proceeds of that collateral.[4]  A security interest in proceeds ceases to be perfected 21 days after the proceeds arise unless one of several conditions is met.  The most common of these are (i) that the security interest in the original collateral was perfected by filing and the proceeds are “identifiable” cash proceeds (including checks and deposit accounts),[5] and (ii) that the proceeds are of a type covered by a filed financing statement, the proceeds are collateral in which a security interest may be perfected by filing in the same office, and the proceeds were not acquired with cash collateral.[6] For purposes of exception (i), “identifiable” does not necessarily mean “segregated,” so equitable tracing principles can be used for commingled cash (e.g. cash proceeds are identifiable in a commingled account so long as the balance in the bank account into which the funds are deposited does not drop below the amount of cash proceeds initially deposited).[7]  Exception (ii) covers situations where a person could predict from the original filing that the proceeds are covered; for example, if a secured party has a perfected security interest in inventory, which is sold generating an account receivable (the proceeds), exception (ii) would provide for continuous perfection in the account receivable.

The cash proceeds of collateral are distributed first to expenses of sale, second to the secured creditor’s claim, and third to interests subordinate to the secured creditor’s claim.[8]  To illustrate, if a secured creditor takes a senior security interest in certain office equipment, which the debtor subsequently sells and deposits the cash in an account, the secured creditor would automatically have a perfected security interest in the identifiable cash proceeds of the office equipment relating back to the time of the filing in the underlying collateral, and therefore, on sale, the cash proceeds would be distributed first to the expenses of sale, and second to the secured creditor up to the amount of its secured claim.

What are the Limits on the Definition of Proceeds?

Assume that a finance company finances the inventory of an equipment lessor and perfects its security interest in the inventory, and the equipment lessor leases the inventory to its customer on a short term lease.  If the equipment lessor defaults on its loan to the finance company, can the finance company claim a security interest in the rent from the lessor’s customer as “proceeds” of the equipment?  While some courts view proceeds as arising only from a permanent disposition and therefore rent would not qualify, the better answer is nevertheless yes.  Under the plain language of the statute, “proceeds” is whatever is acquired on the sale, lease, or disposition of property[9], and the lease represents a disposition in the sense that the lease causes an erosion in the value of the goods leased in return for rent (even for a short-term lease).  There are limits, however, in how far the definition of proceeds can be stretched.  Accounts receivable generated from the use of equipment will generally not be considered proceeds.  In a recent case, where a trucking company pledged equipment to a secured party, and the trucking company used the equipment to move goods for its customers generating an account receivable from the customers to the trucking company, the accounts receivable were not considered proceeds of the equipment since the equipment was not being leased to a third party but only being used by the company itself.[10]  In other words, cash arising from disposition of collateral is proceeds, but not from the mere use of collateral by the debtor itself.

Practice Pointer – Broaden the Original Security Interest

Disputes as to whether a security interest in a particular asset is proceeds of the original collateral, and if so, its priority, can be averted by broadening the original collateral description.  For example, finance companies should where possible avoid relying on just the security interest in the rent as proceeds of inventory, but rather take an original security interest in the lease (as chattel paper) and in accounts receivable, and perfect the security interest by filing[11] and by taking possession of the original chattel paper.[12]  This would avoid the risk of a court holding that rent is not proceeds of inventory or potentially losing priority in the rents to another creditor.  For example, a subsequent purchaser of chattel paper in good faith may have priority over a security interest in rent claimed as proceeds of inventory (which could have been avoided if the original secured party had possession of the chattel paper).[13]

Practice Pointer – Monitor the Disposition of Collateral

Secured parties should carefully monitor the status of the collateral so as not to inadvertently lose their security interest because of the conversion of cash proceeds from the original collateral to other assets.  For example, if cash proceeds were collected from the original collateral and used to buy new equipment, the security interest in the new equipment (as proceeds) would not be perfected beyond the 20-day period without filing an amended financing statement that expressly covers the new equipment unless the original security interest were in all equipment.[14]

[1] UCC §9-102(a)(64).

[2] UCC §9-102(a)(12).

[3] UCC §9-315(c).

[4] UCC §9-322(b)(1).

[5] UCC §9-315(d)(2).

[6] UCC §9-315(d)(1).

[7] UCC §9-315(b)(2), Uniform Commercial Code Comment 3.

[8] UCC §9-615(a).

[9] UCC §9-102(a)(64).

[10] 1st Source Bank v. Wilson Bank and Trust, 735 F.3d 500 (6th Cir. 2013).

[11]  UCC § 9312(a).

[12]  UCC § 9313(a).

[13]  UCC § 9330.

[14] UCC §9-315(e).