Appellate panel affirms that creditor’s failure to seek adequate protection before turning collateral over to trustee terminates possessory lien.

On March 25, 2013, the Eighth Circuit Bankruptcy Appellate Panel affirmed the bankruptcy court’s order in In re WEB2B Payment Solutions, Inc., holding that a creditor loses its possessory lien when it turns collateral over to the bankruptcy trustee without first seeking adequate protection from the bankruptcy court.

FACTS

Prior to filing bankruptcy, the debtor was in the business of providing check clearing and payment processing services under contracts with third parties. The debtor and North American Banking Co. (“NABC”) entered into a remote deposit capture service agreement in which the debtor submitted to NABC electronic deposits of funds captured from checks received by the debtor and its affiliates. NABC would then process these transactions on the debtor’s behalf and would credit the debtor’s account. Throughout the term of the agreement, NABC periodically received claims from third parties for checks that were rejected. If a check was returned, the agreement gave NABC the right to set off against the debtor’s funds any of the debtor’s obligations to NABC. The agreement also gave NABC a possessory security interest in the debtors’ funds deposited with NABC.1

When the debtor filed bankruptcy, it had over $933,000 on deposit in its accounts with NABC. After the case was converted, the Chapter 7 trustee requested that NABC turn over the funds and agreed to NABC’s proposal that it retain $50,000 to cover future claims for returned checks. NABC estimated this amount would be sufficient based on the debtor’s history. When these funds proved insufficient, NABC requested the trustee return the forwarded funds immediately, contending that it held a first-priority security interest in the funds. After the trustee refused to return the funds, NABC sought a court determination as to whether it had a lien on the funds turned over to the trustee. The bankruptcy court held that NABC lost its possessory lien since it failed to first obtain a court order granting adequate protection of its lien.

DECISION

On appeal, the panel affirmed the court’s decision, holding that NABC lost its possessory lien when it turned over the debtor’s account funds to the trustee without first seeking adequate protection from the court. The panel noted that, although the Bankruptcy Code obligates a creditor to turn over collateral upon demand by the trustee, a creditor in NABC’s position – where turnover will destroy the creditors’ possessory lien – may withhold turnover until the bankruptcy court is able to make a determination as to whether, and to what extent, the creditor is entitled to adequate protection. Thus, NABC lost its possessory lien when it turned over possession of the funds without first seeking adequate protection from the court.

IMPLICATIONS

The panel’s holding clarifies that creditors holding possessory liens in collateral can both protect their lien rights and simultaneously comply with the Bankruptcy Code’s turnover requirement by seeking adequate protection before turning over funds to the trustee.

The panel’s holding clarifies that creditors holding possessory liens in collateral can both protect their lien rights and simultaneously comply with the Bankruptcy Code’s turnover requirement by seeking adequate protection before turning over funds to the trustee.

Upon the filing of a bankruptcy petition, creditors with liquidated or contingent pre-petition claims against the debtor that can be setoff against the debtor’s assets held by the creditor2 should immediately do the following:

  1. administratively freeze the account3,
  2. file a secured claim asserting a security interest in the debtor’s assets4, and
  3. file a motion for stay relief or, alternatively, adequate protection.

The creditor should oppose a trustee’s efforts to use the collateral and withhold turnover until the court has ruled on the motion.