The Bottom Line
Adequate protection compensates secured creditors for the debtor’s use of their collateral in bankruptcy. This protection is not automatic and a recent decision by the Bankruptcy Appellate Panel of the Eighth Circuit (the “Appellate Panel”) underscores the importance of affirmatively asking for adequate protection or forfeiting a possessory security interest in funds turned over to the debtor. In In re WEB2B Payment Solutions, Inc., 488 B.R. 387 (8th Cir. B.A.P. 2013), the Appellate Panel held that the creditor lost its possessory lien in certain funds when it turned them over to a Chapter 7 trustee without requesting adequate protection. Unlike other liens that can only be released upon a filing of a release or termination statement, a possessory lien is, by definition, released when possession of the collateral is relinquished. For the creditor to preserve its possessory lien in property that is the subject of a turnover in bankruptcy, the burden is on the creditor to ask the court to adequately protect its (no longer possessory) lien in the property being turned over. Absent such request, the Appellate Panel held that the possessory lien was relinquished.
The debtor, WEB2B Payment Solutions, Inc. (“WEB2B”), provided check clearing and payment processing services to third parties. Under an agreement with North American Banking Company (“NABC”), WEB2B deposited third-parties’ checks it received with NABC, who in turn processed the check transactions on WEB2B’s behalf and immediately credited WEB2B’s account. NABC routinely received reclamation claims from third parties related to WEB2B’s check cashing transactions (”Reclamation Claims”). The Reclamation Claims often stemmed from check cashing transactions that had been rejected for different reasons, such as chargeback claims that were made by the United States Treasury for fraudulent, counterfeit, or forged Treasury checks. Pursuant to the agreement between WEB2B and NABC, when an item was rejected, NABC was entitled to recover the relevant funds from WEB2B’s accounts at NABC. To secure NABC’s right to recover such funds from WEB2B’s accounts, WEB2B had assigned to NABC all its deposit accounts with NABC, and authorized NABC to offset and debit these accounts in order to obtain payment of WEB2B’s obligations under the agreement.
At the time that WEB2B filed its Chapter 11 petition, it had over $933,000 in its accounts with NABC. Shortly thereafter, the case was converted to Chapter 7, and the Chapter 7 trustee (the “Trustee”) demanded that NABC turn over the funds in WEB2B’s accounts. NABC responded by proposing that it retain $50,000 of the funds (the “Holdback Funds”) to cover potential future Reclamation Claims (based on historic numbers). The Trustee agreed to NABC’s proposal, and, after retaining the Holdback Funds (plus an additional small amount that was set off against an overdraft in another of WEB2B’s accounts with NABC), NABC turned over the remaining sum to the Trustee. Key to this blog, NABC never requested adequate protection for its possessory security interest in the funds in WEB2B’s accounts.
Within a few months, the Holdback Funds had been depleted as a result of an unanticipated and unprecedented volume of Reclamation Claims. NABC demanded that the Trustee immediately return to NABC the full amount of its collateralized funds that had been previously turned over. After the Trustee refused, NABC filed an adversary proceeding against the Trustee, asserting that it had a possessory lien in those funds. The bankruptcy court held that NABC lost its possessory lien in the funds, since it failed to obtain court-ordered adequate protection of its possessory lien before turning the funds over to the Trustee. NABC filed an appeal from the bankruptcy court’s decision with the Appellate Panel.
On appeal, the Appellate Panel first observed that it was undisputed that, as of the petition date, NABC had a contractual security interest in the account that was perfected by its possessory lien, which survived the bankruptcy filing. However, it was no longer perfected and its possessory lien was lost once NABC turned over the funds. In U.S. v. Whiting Pools, Inc., 462 U.S. 198 (1983), the Supreme Court held that while a secured creditor can be compelled to turn over collateral in its possession to a trustee, such creditor is entitled to adequate protection for its properly perfected security interest in the property. NABC asserted that under Whiting Pools “its right to adequate protection – i.e., a continuing lien in the money turned over – automatically replaced its possessory lien.” 488 B.R. at 392. The Appellate Panel explained, however, that Whiting Pools involved a statutory tax lien which attaches to property when the tax is assessed, regardless of whether the creditor possesses the collateral. Whiting Pools was distinguishable and does not apply to the case at bar, in which NABC’s status as a lien-holder was dependent upon its ongoing possession of the collateral.
In Citizens Bank of Maryland v. Strumpf, 516 U.S. 16 (1995), the Supreme Court recognized that a bank’s right to setoff is lost when it relinquishes possession of an account, but held that a creditor does not violate the automatic stay by temporarily freezing the debtor’s account while it seeks a determination of its rights to the funds (either by a motion to lift the automatic stay or by a motion for adequate protection). The Appellate Panel found that this procedure is equally applicable here, where relinquishment of possession itself destroys the creditor’s security interest. To assure itself that the lien was not lost, the creditor bears the burden of seeking adequate protection for its possessory lien (by seeking an order that its lien continues in the proceeds being turned over). Here, NABC never sought adequate protection before turnover, compounded by the fact that it waited more than nine months before it requested that its possessory lien remain in effect after turnover.
Why the Case Is Interesting
The decision underscores two basic requirements for secured creditors. First, keep track of your method of perfection and do not assume that compliance with other provisions of the Bankruptcy Code (e.g., turn over demand) preserves perfection. Second, adequate protection is not automatic protection. It must be requested. Combining these two concepts, the Appellate Panel recognized that the status of perfection can be forfeited absent affirmatively requesting adequate protection for the use of the collateralized funds by the trustee or debtor in bankruptcy.