Use Careful Consideration When Drafting Collateral Descriptions

by Kenneth P. Weinberg & Jennifer L. Howard Jan/Feb 2015

In part two of this two-part series, Kenneth P. Weinberg and Jennifer L. Howard continue their discussion of collateral descriptions in security agreements. Touching on limiting verbiage, timing considerations and collateral type changes, they recommend careful review to make sure you come up smelling like a rose when your lien is challenged.

Kenneth P. Weinberg,
Shareholder,
Donelson, Bearman, Caldwell & Berkowitz, P.C.

Jennifer L. Howard,
Of Counsel,
Donelson, Bearman, Caldwell & Berkowitz, P.C.

The last edition of Dispatches from the Trenches discussed the importance of collateral descriptions in security agreements and financing statements as well as the use of collateral types versus more specific descriptions. This edition focuses further on helpful techniques and considerations when preparing collateral descriptions. If a collateral description is tested in court, a rose by any other name would not necessarily smell as sweet.

All Equipment & Fixtures, Including but not Limited to Rose Bushes

The order of terms used in a collateral description can be important. It is best to start broadly with the types of collateral and then use an “including, but not limited to” precursor before providing specifics. For example, in Flores de N.M., Inc. v Banda Negra Int’l, Inc., 151 BR 571 (Bankr. D. NM 1993), the court analyzed whether a collateral description referring to “miscellaneous equipment” was sufficient to put third parties on inquiry notice that the lender claimed a security interest in approximately 60,000 rose bushes belonging to the debtor, who was a rose producer.

Although the secured party’s failure to file a fixture filing in the real property records caused the court to analyze whether the rose bushes constituted fixtures, the secondary analysis conducted by the court regarding the sufficiency of the description of the “equipment” is more useful. The collateral description never specifically mentioned rose bushes, despite the fact that the description used by the secured party relied primarily on an item-by-item description rather than a description by collateral type. In particular, the collateral description included “various motors, tanks, pumps, generators, carts, loaders, hand tools, and miscellaneous equipment and supplies.” The court held that even if the rose bushes constituted “equipment” under Article 9, since they were not held for sale or lease but rather were used merely to grow the roses that were sold separately, the foregoing description was not sufficient to put third parties on notice of any interest by the secured party in the rose bushes.

Avoid Limiting Phrases: “All Roses, Buds. . . That are Yellow”

Secured parties should also be careful not to insert unduly limiting language in collateral descriptions. For example, in the case of In re Dickerson, 31 UCC Rep. 367 (Bankr. D. Colo. 1981), the financing statement identified the collateral as “all accounts receivable of the assignor including those presently existing and all future accounts which shall come into existence during the term of the obligation which this assignment secures.” The court found that the last phrase, “which shall come into existence during the term of the obligation which this assignment secures” temporally limited the security interest, and an account was not part of the collateral where it came into existence after the term ended for the specific obligation referenced in the description.

Even if the limitation is intentional, a secured party must be careful that the methodology it contemplates is viable. For example, in the case In re Inofin, Inc., 455 B.R. 19 (Bankr. D. Mass. 2011), the court narrowly construed a collateral description of “motor vehicle installment contracts financed with proceeds of its loans,” holding that certain installment sales contracts were not collateral because the secured party could not trace loan proceeds to those particular contracts.

Timing Considerations: A Rose Bush Will Bloom Again

Another common issue is how to describe the collateral when the parties intend the security interest to include property that was not in the debtor’s possession at the time the security interest arose but that may come into the debtor’s possession at a later time. To include such collateral, secured parties commonly include an after-acquired property clause in the security agreement such as “now owned or hereafter acquired,” “now existing or hereafter arising,” or “owned by the borrower now or in the future.”

Because some types of collateral, such as inventory or accounts, inherently suggest they include after-acquired property, some courts have found the after-acquired property clause is not needed to create a security interest in such types of collateral. However, other courts have refused to recognize security interests in after-acquired inventory and accounts where an after-acquired property clause was not used in the security agreement’s collateral description. Therefore, the safer practice is to use such a clause any time after-acquired property is part of the collateral, even for inventory and accounts. The official comment to §9-502 states that an after-acquired property clause is not required for financing statements, but many practitioners believe the best practice is still to include one.

Collateral that Changes Type: Roses That Become Potpourri

In the event the debtor sells or leases the leased or financed equipment without authorization, it is good practice to include a reference to “proceeds” of the other types of collateral. Although Article 9 automatically includes proceeds within the scope of the security interest (see §9-315), the Bankruptcy Code does not. An express reference to proceeds is advisable under Bankruptcy Code §552, which provides, “if the debtor and an entity entered into a security agreement . . . and if the security interest . . . extends to property of the debtor acquired before the commencement of the case and to proceeds . . . of such property, then such security interest extends to such proceeds” unless the court orders otherwise.

In addition, it is generally preferable for a secured party to be able to claim property as part of its original collateral rather than merely as proceeds of its original collateral. Prudent lessors and lenders in the equipment leasing and finance industry therefore frequently take a security interest not only in the leased or financed equipment but also in chattel paper, instruments, accounts, proceeds of insurance or any other property resulting from the sale, lease or other disposition of such equipment. This approach has the benefit of mitigating the risk of court interpretation as to the scope of the collateral category referred to in Article 9 as “proceeds.”

Consider, for example, the case of 1st Source Bank v. Wilson Bank & Trust, 735 F.3d 500 (6th Cir. 2013). There, the primary secured party (SP-1) provided financing to the debtors for the sale or lease of tractors and trailers. The security agreements granted the creditor a security interest in the debtors’ tractors and trailers, accounts, and proceeds from the collateral. However, the financing statements identified the collateral only as the specified tractors and trailers, and “all proceeds thereof, including rental and/or lease receipts.”

Another creditor (SP-2) had subsequently filed against all accounts now existing and hereafter acquired or arising, and began collecting on accounts generated by the lease of the tractors and trailers. In litigation, an issue arises as to whether such accounts were covered by the SP-1’s financing statement. The court, quoting Comment No. 8 issued by the Permanent Editorial Board for the Uniform Commercial Code, stated that “proceeds” does not refer to “income generated from the debtor’s own use and possession of goods” or to situations where there was “no disposition of the goods” and held that SP-1 was unperfected in the accounts. The lesson is clear: Leave as little room as possible for court analysis.

Conclusion

Collateral descriptions and indications are obviously a very thorny topic. The foregoing discussion and examples are intended primarily to encourage readers to think carefully about the way the collateral is described in both security agreements and financing statements. Careful consideration of such issues may be necessary for a secured party whose lien is challenged to come up smelling like a rose.

Kenneth P. Weinberg is a shareholder at Baker, Donelson, Bearman, Caldwell & Berkowitz, P.C., and practices in the area of commercial finance, focusing on equipment leasing, equipment finance and renewable energy project finance. He has penned Dispatches from the Trenches since 2002.

Jennifer L. Howard is of counsel at Baker, Donelson, Bearman, Caldwell & Berkowitz, P.C., and practices in the areas of equipment leasing, equipment finance and renewable energy project finance.

Part 1: Drafting Collateral Descriptions that Pass the Sniff Test

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