A recent decision of the Bankruptcy Appellate Panel of the First Circuit, Wheeling & Lake Erie Railway Company v. Keach,[1] ruled that a lender (Wheeling) did not have a perfected security interest in a business interruption insurance policy or its proceeds.  The decision in Wheeling is inconsistent with a prior court decision that dealt with business interruption insurance as proceeds of collateral and was more favorable to secured creditors, and therefore should be of concern to lenders.

Background

In 2009, Wheeling extended a line of credit to Montreal, Maine & Atlantic Railway Ltd. (the “Debtor”), the Debtor’s Canadian subsidiary and certain of their affiliates.  To secure their obligations, the borrowers granted Wheeling a security interest in certain collateral, including accounts, payment intangibles and inventory.[2]  Wheeling perfected its security interest by filing a financing statement under the Uniform Commercial Code.

In April 2013, Travelers issued a commercial property insurance policy insuring certain of the borrowers; this policy included coverage for loss of business income following certain insured events.

In July 2013, a train operated by the Debtor containing 72 tank cars filled with crude oil derailed in Quebec, causing several massive explosions.  As a result of this incident, 47 people died and there was substantial damage to property.  The Debtor filed bankruptcy one month after the derailment.  The Debtor made a claim under the Travelers policy for casualty losses and for loss of business income.  Travelers, the bankruptcy trustee and the Canadian subsidiary eventually reached a settlement whereby Travelers agreed to pay $3.8 million to the Debtor and the Canadian subsidiary.  Wheeling objected to the settlement.

The bankruptcy court ruled that Wheeling did not have a security interest in the settlement payment.  Wheeling appealed.  The Bankruptcy Appellate Panel of the First Circuit affirmed.

Analysis

The principal issue in the Wheeling case is whether it was possible for the lender to obtain a perfected security interest in the business interruption insurance policy or the settlement payment by virtue of its UCC filing.  The lender apparently took no other steps to perfect its security interest.

Section 9-109(d)(8) of the UCC excludes from the scope of Article 9 of the UCC “a transfer of an interest in or an assignment of a claim under a policy of insurance . . . but sections 9–315 and 9–322 apply with respect to proceeds and priorities in proceeds.”  The definition of “proceeds” in Article 9 includes insurance proceeds to the extent of the value of the original collateral (see UCC §9-102(64)(E)).  To the extent that a creditor wishes to takes a security interest in a policy of insurance that is outside the scope of Article 9, it must comply with non-UCC law in order to do so.  In many states, this involves taking a collateral assignment of the insurance policy and recording the same with the insurer.

For collateral consisting of tangible personal property that is covered by a policy of casualty insurance, the way the Section 9-104 insurance exclusion works can be straightforward.  For example, if a lender has a perfected security interest in a particular piece of equipment that is insured under a casualty insurance policy, and the equipment suffers an insured loss under the policy, then (A) the lender does not have a perfected security interest under the UCC in the insurance policy, but (B) the lender has a perfected security interest[3] under the UCC in any insurance payment arising from the loss to the extent of the value of the insured equipment.

At the other end of the conceptual spectrum from this example is the payment of a death benefit under a policy of key man life insurance.  Since the event giving rise to the insurance payment (death of the insured) would not involve the loss of property in which the lender had a security interest under Article 9 of the UCC, the payment of the death benefit would not constitute “proceeds” of original collateral for purposes of Article 9, and thus would not fall within the scope of the insurance proceeds that are excepted from the general exclusion of insurance policies in Section 9-104(d)(8).  A creditor would be required to perfect its lien in the life insurance policy under applicable non-UCC law, and would not have an Article 9 security interest in the proceeds of the policy.

Very few court cases have examined whether business interruption insurance proceeds can be the subject of a security interest under Article 9 of the UCC.  A 1992 U.S. District Court case, MNC Commercial Corp. v. Rouse,[4] held that a secured party that had a perfected security interest in the debtor’s accounts, general intangibles, contract rights, documents, instruments, chattel paper and inventory also had a perfected security interest in proceeds of the debtor’s business interruption insurance policy following a suspension of the debtor’s operations caused by a fire.  The court stated that “[t]he purpose of the business interruption insurance proceeds was to compensate [the debtor] for lost business income that would have been generated but for the fire.  Business income normally takes the form of cash, accounts receivable or a chose in action—all of which [the secured party] had a security interest in . . . .”  The court also stated that it was important to its analysis that the secured party had a perfected security interest in the “tangible income producing property of the business, which was [the debtor’s] inventory and raw materials,” and which were damaged in the fire.  The MNC Commercial court stated that “[t]here is no real distinction between business income generated from normal operations and insurance proceeds paid to replace lost business income under a Business Interruption Policy.”

To our knowledge, until the bankruptcy court rendered its decision in Wheeling, there had not been another published court decision since MNC Commercial that examined whether a secured party could have a security interest under Article 9 of the UCC in the proceeds of business interruption insurance.

For some reason, the lender in Wheeling did not argue that the business interruption insurance claim was proceeds of its collateral, but rather argued that the payments under the business interruption policy were included in its original collateral consisting of accounts.  As the court in Wheeling noted, this argument brought the insurance payment squarely within the insurance exclusion in Section 9-104(d)(8).

The Wheeling court then went on to attempt to distinguish MNC Commercial and to criticize it.  It purported to distinguish MNC Commercial by arguing that the secured party in Wheeling did not have a security interest in certain of the debtor’s income-producing assets, such as railroad tracks and real estate, unlike the case of the secured party in MNC Commercial.  The Wheeling court also took the position that “the [MNC Commercial] court did not adequately distinguish between proceeds of an ‘account,’ which is conventionally within the scope of Article 9, and proceeds payable under a business interruption insurance policy which, essentially, insures against the temporal absence of accounts and their proceeds” (emphasis in original).

Observations

The Wheeling court’s criticism of the MNC Commercial holding may be fairly described as dicta, because it was unnecessary to the court’s holding since the lender did not assert that the business interruption insurance was proceeds of its original collateral.  Nonetheless, lenders should be concerned by such criticism.  Lenders and their counsel may wish to consider taking steps under non-UCC state law to perfect their interests in such policies in jurisdictions where MNC Commercial may not be followed.

Wheeling also purported to distinguish MNC Commercial on the grounds that, in MNC Commercial, the income-producing tangible assets that suffered the damage which led to the business interruption loss were the lender’s collateral, whereas in Wheeling this may not have been the case.  This could mean that a creditor’s ability to claim that a business interruption insurance payment was proceeds of its collateral might depend on the nature of the assets that suffered the loss.  If a creditor were secured by all assets that would have generated the lost revenue stream, it might have an easier time.

The Wheeling court also took the position that, although the lender’s collateral included accounts and payment intangibles, the business interruption insurance “did not provide coverage against loss, damage or destruction to some other collateral specifically identified in the security agreement . . . .”[5]  This is contrary to the reasoning of MNC Commercial, in which the court held that the business interruption insurance covered lost business income that fell within the scope of the lender’s security interest.

The definition of “proceeds” in Article 9 is not limited to insurance payable for damages to collateral, but also includes all insurance payable by reason of the loss of the collateral.[6]  Consistent with the holding in MNC Commercial, if a lender has a security interest in all of the debtor’s revenue, and in the assets necessary to produce such revenue, any insurance compensation for the loss of such revenue would fit within the Article 9 definition of “proceeds.”

The holding in MNC Commercial has been cited with approval over the years by several legal commentators.[7]  MNC Commercial viewed the proceeds of business interruption insurance as a replacement for the lost income stream (in which the secured party had a perfected security interest)[8] that would have been generated by damaged assets (in which the secured party also had a perfected security interest), and for that reason concluded that the insurance proceeds were “proceeds” for Article 9 purposes.  The Wheeling court seemed to reject this line of reasoning, in positing that the business interruption insurance related to the “absence” of a revenue stream that might otherwise have been created, and not the proceeds of actual receivables.  The court seemed to suggest that receivables that were “absent”—that did not actually exist—could not be the subject of a loss that would generate Article 9 proceeds.  If the Wheeling court were correct, this would mean that the proceeds exception to the insurance exclusion in Section 9-104 would effectively be limited to proceeds of casualty insurance on tangible collateral.[9]  This would make the proceeds exception inapplicable to not only business interruption insurance, but also to other types of insurance that are not tied to damage to tangible collateral, such as political risk insurance.[10]