An appeals court in Kentucky has issued a reminder to secured lenders of the importance of drawing up control agreements that establish a lender’s interest in a debtor’s assets contained in depository accounts.

In Kentucky Highlands Inv. Corp. v. Bank of Corbin, Inc., No. 2005-CA-000686-MR, (Kty. Ct. App. Sept. 15, 2006), the court was faced with a priority battle between a secured creditor and a depository bank. Kentucky Highlands Investment Corporation (“Highlands”) was a secured creditor to Tri-tech Electronics, LLC (the “Debtor”), with a lien on substantially all of the Debtor’s assets, including the Debtor’s accounts receivable and all proceeds thereof. The Debtor maintained a deposit account at Bank of Corbin, Inc.

In 2002, the Debtor diverted payments from its account debtors for various accounts receivable into the deposit account maintained at the bank. After certain overdrafts and defaults by the Debtor, the bank began to effect set-offs against the deposit account. Highlands asserted that the set-offs amounted to a conversion of the proceeds of accounts receivable, which were subject to Highlands’ lien.

The lower court granted the bank summary judgment, holding that its right of set-off was prior to the interest of Highlands in the proceeds of the accounts receivable. Highlands appealed.

Revised UCC Law

On appeal, the court discussed the priority between a perfected secured creditor and a depository bank in proceeds of accounts receivable deposited into a deposit account. Under former law, the secured creditor’s interest would be prior to the rights of the depository bank to effect a set-off. When Article 9 of the Uniform Commercial Code was amended effective July 1, 2001, the new law resulted in a presumption of priority in favor of the depository bank, unless the perfected secured creditor took some affirmative steps to preserve its security interest vis-à-vis the depository bank.

UCC § 9-340 explicitly provides depository banks the right to exercise set-offs—even against the proceeds of a secured party’s collateral deposited in the deposit account—absent a contractual control agreement to the contrary. This UCC provision subordinates the secured party’s interest in the deposit account (and, by definition, the proceeds of accounts receivable deposited therein) unless and until the secured party is perfected by a control agreement.

In Kentucky Highlands, the court noted that the change in Article 9 shifted the burden from the depository bank (to ascertain the source of funds in the deposit account) to the secured party (to contract with the depository bank to obtain control). Finding that no control agreement was in place in favor of Highlands, the court concluded that the bank’s set-off was prior to the interest of Highlands in the proceeds in the deposit account, and did not constitute a conversion of the funds.

This decision reinforces the common-law right of set-off in favor of a depository bank absent the bank’s agreement to subordinate that right to a perfected secured creditor by entering into a control agreement. The decision illustrates a secured party’s need to negotiate a control agreement with a depository bank, where its borrower maintains its deposits in order to achieve priority.

In practice, most depository banks will not waive the right of set-off even in the face of a control agreement. However, such control agreements do create a way to ensure that the secured creditor will obtain a priority over the interests of a judgment creditor via garnishment or a similar state attachment process.