Security Interest Survives Crazy Collateral Transfers

Bank’s Security Interest Survives Crazy Collateral Transfers; UCC Filing for the Win

It’s a great day to read about a UCC success story! The secured creditor’s UCC filing allowed it to maintain its secured position, despite the collateral being transferred from the debtor’s company to a related company owned by the same debtor. I’ll forewarn you; this case is a little crazy and convoluted, but the takeaway is strong. A security interest, via UCC filing, survives if you properly perfect it.

The Case: IN RE K&L TRAILER LEASING, INC., Bankr. Court, ED TN 2021

I mentioned this case is a bit convoluted. Before we dive in, let’s map out the key players and facts.

  • The Secured Creditor: Greeneville Federal Bank (GFB)
  • The Collateral for the Security Interest: Certain Trailers and Lease and Sales Proceeds
  • The Debtor: K&L Sales & Leasing, Inc. (Sales)
  • The Debtor’s Other ½ of a Company: K&L Trailer Leasing, Inc. (Leasing)
  • Other Creditors: other parties who claim a security interest in the transferred inventory and have filed claims in the Debtors’ bankruptcy cases. (This includes defendant FirstBank, a creditor of Leasing.)

OK, let me explain the debtor’s ½ company. K&L Sales & Leasing, Inc. (Sales) is GFB’s debtor, and is owned 100% by Kris Fellhoelter. Kris also has 50% ownership in K&L Trailer Leasing, Inc. (Leasing); the other 50% is owned by Kris’ parents (Marvin and Linda). Kris is the president of both companies, and according to the court summary, both companies “share other officers, and employees, some of whose salaries were paid by Sales.”

It Started with a $2.5M Loan, Secured by a UCC

GFB loaned Sales $2.5M and GFB perfected its security interest by filing a blanket UCC with the Tennessee Secretary of State. As mentioned above, the collateral included “certain trailers and lease and sale proceeds.” As necessary, GFB continued its security interest by filing Continuations. “At all pertinent times, Sales was engaged in the sale of ‘big rig trailers’ so that GFB’s filing of the UCC-1 perfected its blanket inventory lien on all used trailers owned by Sales.”

Cash Disappeared and Things Got a Bit Questionable

In theory, and in albeit questionable business practices, Leasing would buy trailers from Sales to lease to its customers. “The transfers of trailers from Sales to Leasing ‘ordinarily occurred only after [Leasing] had a potential third party willing to lease that trailer.’” One of the first, but minor-ish, questionable business practices was Kris insisting on being the one to enter these sales transactions in the records for both companies – despite having a CFO that manages the books.

The real questionable behaviors started just before Sales and Leasing both filed for bankruptcy. Here’s a snippet from the court opinion:

“During May 2020, the month before Sales and Leasing filed their bankruptcy petitions, Sales transferred trailers that were subject to GFB’s inventory lien to Kris and Marvin at a rate that was more than twenty times the historical average monthly volume of such transfers, with such transfers in May 2020 exceeding $2 million in value. Transfers by Sales to Leasing, Kris, and Marvin in June (at the end of which the bankruptcy petitions were filed) also far exceeded the previous monthly average for such transfers. Sales’ records for ‘virtually all of the transfers’ from Sales to Leasing or Marvin reflect that Kris was the salesperson. For many of the trailers transferred from Sales to Leasing, Kris, and Marvin in May and June of 2020, the CFO ‘could find no evidence of any funding.’”

So, just before Sales files for bankruptcy protection, it transfers collateral (secured by GFB’s UCC!) to Leasing, and unsurprisingly Sales doesn’t pay GFB.

Know what this sounds like? Well, I’ll tell you what it doesn’t sound like: transfers to a buyer in the ordinary course of business.

Bankruptcy Trustee Tries to Avoid GFB’s Security Interest

GFB argued it was owed the proceeds from these transfers because the transfers didn’t occur in the ordinary course of business and remained protected by its UCC. The Bankruptcy Trustee (Trustee) claimed GFB’s “security interest was interrupted” when Sales transferred goods to Leasing, and that these transfers happened in the ordinary course of business.

Why does that matter?

Well, if the transfers occurred during the ordinary course of business, the Bankruptcy Trustee could avoid GFB’s security interest. In addition to the Trustee’s efforts to avoid GFB’s lien, FirstBank (a creditor of Leasing) joined the fight for funds. FirstBank argued GFB’s security interest was subordinate to FirstBank’s because GFB’s interest ended once goods transferred from Sales to Leasing.

Ultimately, the Trustee and FirstBank arguments relied on these transfers occurring during the ordinary course of business. It was up to GFB to prove the transfers happened outside the ordinary course of business.

GFB Proves It and Wins It; The Security Interest Survives

First, GFB defeated FirstBank’s argument. The court determined, if FirstBank had done its due diligence and run a UCC search, it would have uncovered GFB’s security interest in the trailers in Leasing’s possession.

“Had such would-be creditor of Leasing inquired into how Leasing came into ownership of the trailers, the creditor would have discovered that the trailers were transferred from Sales. That knowledge would then have led the creditor to search the UCC filing office in Tennessee for liens against Sales’ inventory, only to discover the inventory lien of GFB. The discovery of GFB’s lien against Sales’ inventory then would have led to an inquiry into whether the transfer by Sales to Leasing was either (a) approved by GFB or (h) a sale in the ordinary course under section 47-2-403(2) because those are the only two ways that GFB’s perfected security interest in the inventory of Sales could have been lost by Sales’ transfer to Leasing of the inventory on which GFB had a perfected security interest.”

Next, GFB defeated the Trustee. When relying on “ordinary course of business” failed the first time, the Trustee claimed it was within its “strong arm power” (see Bankruptcy Code 11 U.S.C. § 544(a)(3)) to avoid GFB’s security interest. And that’s where the argument failed a second time.

“…under Tennessee law as discussed above, unless the trailers at issue were transferred by Sales to Leasing as a buyer in the ordinary course or with GFB’s permission, GFB’s perfected security interest in those trailers continued in the hands of Leasing, and nothing about § 544(a)(1) or (2) allows the Trustee to overcome GFB’s prior perfected security interest.”

GFB’s security interest survives and its secured creditor status remains in tact.

Never underestimate the power of a properly perfected security interest. Your UCC filing is the leverage and protection you need to ensure recovery of your receivable.

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