Bank's Pre-Bankruptcy Security Interest In Funds In Bank Account Was Not Terminated By Delivery OF Funds To Trustee

The Bankruptcy Appellate Panel for the Sixth Circuit has issued an opinion protecting and preserving a bank’s security interest in funds in the debtor’s bank account notwithstanding the fact that the bank released those funds to the trustee. In re Cumberland Molded Products, LLC, No. 09-8049 (6th Cir. B.A.P. June 23, 2010).

In Cumberland, the bank held a perfected security interest in all of the debtor’s tangible personal property, its accounts receivable and its general intangibles, as well as proceeds. The proceeds from the debtor’s accounts receivable were deposited into debtor’s checking account maintained with the bank. As of the petition date, the account had a balance of over $450,000. After the petition date, the trustee instructed the debtor to turn over all the funds in the account and the debtor delivered a check for the balance to the trustee. The trustee deposited the check into her account and the bank posted the check, effectively transferring the funds to the trustee. Later, the bank asserted a security interest in the funds and filed a motion for return of the funds.

One of the arguments made by the trustee was that the payment of the funds to the trustee by the bank ended the perfection of the bank’s security interest based on possession of the funds. The trustee asserted that transfer to the trustee caused the security interest to become unperfected. The BAP held otherwise, saying that the post-petition delivery of the check “did nothing more than deliver to the Trustee property that was already property of the Debtor’s estate.” The Court added that “while compliance with a turnover request or the release to the trustee by a creditor holding a secured claim may result in a waiver of the ability to setoff pursuant to § 553 or § 542(b), it is not a waiver of the underlying claim nor an avoidance of the underlying security interest.” Because the interests of the parties were “frozen” at the instant of the filing of the bankruptcy, the transfer did not affect the bank’s security interest. The Court did acknowledge that better practice by the bank might have been a freeze of the account, followed by an action to permit retention or setoff of the balance. However, there is no requirement of a freeze to protect the bank’s security interest.

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Categories: Bankruptcy & Banking Law