Perfection and Priority of Deposit Accounts - International Law Office

Background
Perfection
Establishing Control
Determining Priority
Rights of the Secured Party

Background

In the past, when a lender desired to obtain a cash deposit account as collateral in a secured financing, the Uniform Commercial Code (UCC) did not give guidance on how to perfect a security interest in the deposit account. This forced the secured lender to rely upon state common law principles when making decisions on how to perfect security interests in deposit accounts. Common law principles were often imprecisely articulated in the case law, and it was difficult for secured lenders to become comfortable with the available methods for protection.(1) Perfection under common law generally required that the lender have 'sole dominion and control' over the account, but this broad language did not detail what was truly required.

Revised Article 9 of the UCC, which became effective in most states of the United States on July 1 2001, solved the problems associated with perfection of a security interest in a deposit account. Revised Article 9 makes it cleaner and easier for a lender or other secured party to establish exclusive control over collateral for purposes of perfection of its interests in a deposit account(2) and hence to protect the collateral from the claims of third parties.(3)

Perfection

Revised Article 9 allows for perfection of a security interest in a deposit account as original collateral, except in consumer transactions. In order to obtain a security interest in a deposit account, the security interest must in the first instance attach to the collateral. A security interest attaches to collateral when it becomes enforceable against the debtor with respect to the collateral.(4) A security interest in a deposit account becomes enforceable if:

• value has been given;
• the debtor has rights to the collateral; and
• the secured party has possession or control of the account pursuant to the debtor's security agreement.(5)

Under Revised Article 9, establishment of 'control' is the only way to perfect a security interest in a deposit account.(6)

Establishing Control

There are three basic ways for a secured party to gain and establish control over a deposit account:

• Control is automatically achieved if the secured party is the bank with which the deposit account is maintained.(7) This gives automatic perfection in and control over the deposit account, with no separate agreement needed. This is the simplest way for a depository bank as lender and secured party to ensure that it has fully secured its interest in the deposit account which holds the cash collateral.
• If the depositary bank is not the secured party, control is achieved when the debtor, secured party and bank have agreed in an 'authenticated record' (typically known as a 'deposit account control agreement')(8) stating that the bank will comply with instructions, originated by the secured party, directing disposition of the funds in the account without further consent by the debtor.(9) This is the most typical way of achieving control over a deposit account. Following this procedure, the name of the account can be that of the debtor, but the secured party maintains full control of the account.
• If the depositary bank is not the secured party, control can also be achieved if the secured party becomes the bank's customer with respect to the account.(10) In this case the secured party must put its own name on the deposit account in question.

In cases where the secured party is not the depositary institution, the secured party can enjoy control for perfection purposes even if the secured party authorizes the bank to give the debtor the right to direct the disposition of funds from the deposit account and earn interest on them.(11) In cash collateral accounts, this should not be an issue as the debtor's access to the funds is usually more limited or eliminated entirely in accordance with the terms of the deposit account control agreement.

Determining Priority

Revised Article 9 also creates rules governing priority of competing interests in deposit accounts which hold cash collateral. A security interest in a deposit account perfected by control is superior to a security interest in the deposit account held by a secured party that does not have control.(12) Because perfection is by control, the 'first to control' rule applies and the security interest of the first party with control wins.(13)

However, when the depositary bank and the secured party have competing interests in the account, the situation is trickier. If the cash is maintained in a deposit account at a depositary bank in the depositor's name, and the bank agreed to extend credit to the depositor, the bank is given a security interest in the deposit account. Because a depositary bank automatically is given control, it has a perfected secured interest in the account (without entering into a deposit account control agreement). If the bank, another secured party and depositor then enter into a deposit account control agreement pursuant to which the bank will hold the account on behalf of the other secured party to secure credit extended to the depositor by the other secured party, both the bank and the other secured party will have properly perfected their control over the account. In this situation the depositary bank would have priority over the other secured party even if the other secured party's interests in the deposit account were perfected before the interest of the depositary bank.(14) In this event the bank and the secured party should agree to specific subordination terms.(15) In the alternative, the other secured party can establish control of the deposit account by becoming the bank's customer and opening the applicable account in its own name.(16) This will also operate to subordinate the bank's interests to those of the other secured party.(17)

Loans by the depositary bank to the depositor are not the only issue to be considered. The rights of the depository bank against the secured party must also be considered. Generally, a bank with which a deposit account is maintained may exercise any right of recoupment or set-off against a secured party that holds a security interest in the deposit account.(18) In this situation, the secured party's interest is effectively subordinated to the bank's interest. In this event the secured party can protect itself from the bank's set-off claims arising from a claim against the debtor by: (i) obtaining a subordination agreement from the bank, where the bank agrees to be subordinated, or (ii) placing the account in its own name (thus becoming a secured party that acquires the rights of a customer under Article 4). In these situations the bank would no longer have set-off rights, but only recoupment rights.(19)

Rights of the Secured Party

Because the old Article 9 gave little guidance on perfection of an interest in a deposit account, the secured party often would have to go to court in order to gain access to funds in a deposit account. Under Revised Article 9, once the lender has perfected its interest in a deposit account through control, it is given certain rights as a secured party. If the secured party is the depositary bank, which perfected its interest by control, it can apply the balance of the cash in the deposit account to the obligation secured by the deposit account upon the occurrence of an event of default of the underlying obligations of the debtor.(20) A secured party who is not the depositary bank, and who holds an interest in a deposit account, perfected by control (through a deposit account control agreement or by becoming the bank's customer), may, upon the occurrence of an event of default, instruct the depositary bank to pay the balance of the cash in the deposit account to the secured party.(21) If the lender fails to gain control of the security interest, Revised Article 9 provides the lender with no protection against the claims of the depositary bank or any third parties. A bank has no duty to pay out the funds to secured parties where there is an unperfected security interest in a deposit account.(22) Therefore, it is of great importance that the secured party perfect its interest in a cash collateral account as required by Revised Article 9.

For further information on this topic please contact Timothy Lynes at Katten Muchin Zavus Rosenman by telephone (+1 202 625 3500) or by fax (+1 202 298 7570) or by email (timothy.lynes@kmzr.com).

Endnotes

(1) See, for example, Cibro Petroleum Products v Fowler Finishing Co, 400 NYS2d 322 (Sup Ct 1977).

(2) A 'deposit account' is defined under Revised Article 9 as a "demand, time, savings, passbook or similar account maintained with a bank". Revised Article 9, § 9-102(a)(29).

(3) Revised Article 9, §§ 9-104, 9-327(1), 9-327(4), 9-340(c).

(4) Revised Article 9, § 9-203(a).

(5) Revised Article 9, § 9-203(b).

(6) Revised Article 9, § 9-312(b)(1), 9-314; Official Comment 4(d) to § 9-101.

(7) Revised Article 9, § 9-104(a)(1).

(8) The control agreement has one primary objective - to establish control sufficient to satisfy Section 9-104 - but the control agreement should also govern the relationship between secured party and bank, ensuring that the bank's interest is subordinated. Control agreements often also include: (i) provisions ensuring that the depositary bank sends deposit account statements to debtor and secured party for monitoring; (ii) provisions ensuring that the bank comply with instructions regarding disposition of funds; and (iii) provisions indemnifying the bank. Ben Carpenter, "Security Interests in Deposit Accounts Under Revised UCC Article 9", Compliance Headquarters, at http://www.complianceheadquarters.com/Deposit_Ops/Deposit_Articles/security_interests_in_deposit_.html (January 2002).

(9) Revised Article 9, § 9-104(a)(2), Official Comment 3 to § 9-104.

(10) Revised Article 9, § 9-104(a)(3); Article 4, §§ 4-104(a)(5).

(11) Revised Article 9, § 9-104(b).

(12) Revised Article 9, § 9-327(1), Official Comment 3 to § 9-327.

(13) Revised Article 9, § 9-317(a)(2).

(14) Revised Article 9 § 9-327(3).

(15) Revised Article 9, § 9-339; Official Comment 4 to § 9-327.

(16) Revised Article 9, § 9-104(a)(3), Official Comment 3 to § 9-104.

(17) Revised Article 9, § 9-327(4); Official Comment 4 to § 9-327.

(18) Revised Article 9, § 9-340(a).

(19) Revised Article 9, § 9-340(c), Official Comment 2 to § 9-340.

(20) Revised Article 9, § 9-607(a)(4).

(21) Revised Article 9, § 9-607(a)(5).

(22) Revised Article 9, § 9-341.