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Financial Services FLASHPOINTS March 2021

Michael L. Weissman, Levin Ginsburg, Chicago
312-368-0100 | E-mail Michael L. Weissman

Secured Creditor Can Collect from Account Debtors of Defaulted Borrower

The Supreme Court of Nebraska, in First State Bank Nebraska v. MP Nexlevel, LLC, 307 Neb. 198, 948 N.W.2d 708 (2020), had to decide whether a bank, having been granted a security interest in the accounts of a borrower, could collect from the account debtors of the borrower even though the borrower claimed it was not in default. The court said it could.

The bank’s borrower, Husker Underground Utilities & Construction, LLC, received loans from the bank in May and June 2016. The loans were secured by a grant to the bank of a security interest in virtually all of Husker’s assets, including its accounts and accounts receivable. The bank filed UCC1 financing statements with the Nebraska Secretary of State.

In January 2018, Husker was hired by MP Nexlevel, LLC, to perform certain construction services as a subcontractor. While performing these services during 2018, Husker billed MP.

Sometime in 2018, Husker ceased making payments to the bank and, when its promissory note matured, failed to pay the fully matured indebtedness. In August 2018, the bank sued Husker, and on January 23, 2019, judgment was entered against Husker. While this litigation was going on during 2018, the bank sent three separate notices to MP, advising that it had been granted a security interest in Husker’s accounts, that Husker had assigned its rights to payment to the bank, and that failure to pay the bank would have adverse consequences. Attached to the notices sent in May, July, and August 2018 were copies of the UCC1 financing statement the bank had filed.

When MP communicated with Husker, Husker demanded that MP continue to make payment as it had in the past, i.e., to Husker. MP complied, making payments aggregating $412,302.59 to Husker after receipt of the May 2018 notice.

When the case reached the Supreme Court of Nebraska, MP defended its position by arguing that when it made payments to Husker in 2018, Husker was not in default and that an assignment of an account is not the grant of a security interest. Construing the applicable provisions of the Uniform Commercial Code, the court ruled in favor of the bank.

To begin, the court declared that, under the UCC, a “secured party” includes a person to whom payments rights have been sold, that a “debtor” includes a seller of payment rights, and that an “account debtor” includes a person obligated on an account who is subject to the payment rights that have been sold or granted. It also said that when payment rights have been granted and the debtor is in default, the secured party may exercise the rights of the borrower against the party obligated to make payment. Additionally, the court stated that the account debtor, having been given notice of the assignment of the payment rights, can discharge its obligations only by paying the secured party.

The court found that a “security interest” includes an assignment of rights to payment as security, so the only remaining issue was whether the notices that the bank sent to MP were sufficient to impose a “duty on MP Nexlevel to discharge its obligations under its agreement with Husker Underground by paying directly to First State.” 948 N.W.2d at 725.

The court found the notices adequate, specifically noting, “First State authenticated the security interest by attaching a copy of a UCC financing statement identifying the security interest.” 948 N.W.2d at 722.

Addressing MP’s assertion that Husker was not in default when the bank sent its notices, the court said, quite correctly, that the UCC does not define what amounts to a default. It is left to the parties to flesh that out. As the court phrased it, “default is whatever the security agreement says it is.” 948 N.W.2d at 723.

The security agreement at issue stated that default occurs when the borrower fails to make the required payments to the bank when they are due. Payments were past due when the bank sent its notices to MP. That created a default. The court also pointed out that “the date of default does not change simply because Husker Underground . . . challenged it.” 948 N.W.2d at 724.

What’s the point? If a borrower has assigned its accounts as security for a debt to a financial institution, if the debt is in default by the terms of the underlying loan agreements, the financial institution may demand payment from the borrower’s account debtors and, if they refuse to pay, may collect the amounts due from the account debtors regardless of whether have already paid the borrower.

Unsecured Creditor’s Unjust Enrichment Claim Against Bank Fails

In GlobalTranz Enterprises, Inc. v. PNC Bank, N.A., C.A. No. N19C-09-144 MAA, 2020 WL 3469114 (Del. June 25, 2020), the court applied California law and dismissed a lawsuit brought by GlobalTranz Enterprises against PNC based on unjust enrichment. Breaking from states like Delaware and Illinois, California has recognized a cause of action for unjust enrichment in which an unsecured creditor can sue a secured creditor based on the contention that the secured creditor has received a benefit and has been unjustly benefited at the expense of an unsecured creditor. It is a crack in the absolute priority normally enjoyed by a properly secured creditor.

The case arose on a motion to dismiss, which simply challenged the allegations made by the unsecured creditor; it was not an adjudication on the merits. It simply meant the unsecured creditor had not pleaded enough to show it was entitled to a day in court.

The factual situation was as follows: Kraco Enterprises, LLC, was an automobile accessory company based in California. In December 2015, it hired GlobalTranz, a freight brokerage company, to contract with freight carriers to deliver Kraco products to Kraco distributors. GlobalTranz paid the freight carriers for their services and then billed Kraco.

Kraco experienced financial difficulties during 2018. GlobalTranz provided freight-forwarding services totaling about $800,000 from January 1, 2018, to May 2, 2018. 2020 WL 3469114 at *1. Kraco failed to pay GlobalTranz for those services because it was going through a liquidation in early 2018.

During this same period, Kraco was indebted to PNC, and PNC had a security interest in Kraco’s accounts receivable, including amounts due from Kraco distributors for products they had purchased. PNC was successful in obtaining the proceeds from those sales by directing that payment be made to it. It also obtained the proceeds from the liquidation of Kraco’s assets. At no point did GlobalTranz challenge PNC’s security interest. GlobalTranz’s attack on PNC came from a different angle.

GlobalTranz argued that PNC spearheaded the liquidation of Kraco in early 2018, that PNC acquiesced in GlobalTranz continuing to provide services to Kraco and/or encouraged Kraco to obtain services from GlobalTranz without disclosing Kraco’s deteriorating financial condition, and that PNC “knowingly accepted the benefit of GlobalTranz’s services and [was] obligated to pay for those services in order to ‘avoid injustice.’ ” 2020 WL 3469114 at *2.

Despite acknowledging that California had created an exception to the UCC rules governing priority, the court ruled against GlobalTranz. It began by saying, “In order to overcome California’s Article 9 priority scheme, a plaintiff must show ‘something more’ than gain to the secured creditor.” 2020 WL 3469114 at *4. It said that the “something more” had to be overreaching by the secured creditor or an unusual contribution by the unsecured creditor such as the preservation of perishable food products.

The court stated, “GlobalTranz has failed to state a claim for unjust enrichment under California law.” 2020 WL 3469114 at *8. On the issue of PNC’s acquiescence in GlobalTranz’s providing services to Kraco, the court made a significant observation: imposing liability on a secured creditor for simply acquiescing in the conduct of an unsecured creditor “would upend [A]rticle 9’s interlocking notice-filing and priority provisions, [and] cannot be accepted.” Id.

The court also said, “GlobalTranz did not provide goods or services that were necessary to preserve the collateral.” 2020 WL 3469114 at *9. The court observed that GlobalTranz had other options to protect its interests that it did not pursue, such as perfecting a purchase money security interest, performing a UCC search, or obtaining a subordination agreement from a prior perfected secured creditor.

What’s the point? Although California, unlike most states, has been willing to open the door a crack on the UCC priority rules under the doctrine of unjust enrichment, the burden it imposes on an unsecured creditor is heavy, and California courts do not seem to countenance the deviation from the customary UCC rules on priority lightly.

For more information about financial services, see COMMERCIAL AND INDUSTRIAL LOAN DOCUMENTATION (IICLE®, 2018). Online Library subscribers can view it for free by clicking here. If you don’t currently subscribe to the Online Library, visit www.iicle.com/subscriptions.

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