Lender's Security Interest in Funds Lost Upon Transfer to Debtor's Counsel

In a decision rendered on December 30, 2016,1 the bankruptcy court for the Southern District of Florida (the "Court") addressed the debtor's counsel's interim application for an award of fees and expenses for services rendered to the debtor and its bankruptcy estate, as well as a secured creditor's objections to the same.[2] The debtor's counsel sought to apply a pre-petition retainer held in her firm's trust account in payment of her fees and expenses.[3] The debtor's lender raised no objection to the amount of the request, but objected to the payment of any court-approved compensation using the retainer on the grounds that the retainer represented the bank's cash collateral in which the bank maintained a superior interest.[4] Therefore, the bank argued, it was entitled to adequate protection for the use of its funds.[5]

The Court quickly identified the flaws in the lender's arguments, noting that more than 5,000 new chapter 11 cases are filed each year; in nearly every one, the debtor's counsel receives a retainer prior to filing the petition for services to be rendered in the case; and bankruptcy cases often involve at least one secured creditor claiming a security interest in all of the debtor's assets, including deposit accounts and cash.[6] The Court asked, "Why, then, is it so difficult to find a reported decision where a secured creditor objected to the use of a pre-petition retainer for payment of approved fees and expenses of the debtor's counsel on the grounds that the retainer is the secured creditor's cash collateral?"[7]

The answer, the Court explained, lay in the simple principle that, absent "extremely unusual circumstances, the secured creditor retains no interest at all in funds paid to debtor's counsel as a prepetition retainer."[8] This is because Section 9-332 of the Uniform Commercial Code provides that a transferee of money or funds from a deposit account takes free of any security interest, "unless the transferee acts in collusion with the debtor in violating the rights of the secured party."[9] There being no suggestion or evidence of collusion in the case,[10] the Court found that the lender had no interest in the retainer held by the debtor's counsel, and that the debtor's counsel could apply the same in payment of her fees and expenses.[11] 

Even if this were not the case, the Court explained that the lender's argument would fail for an independent reason: the engagement agreement executed by the debtor and its counsel constituted a security agreement, and the debtor's counsel's interest in the retainer was perfected by possession.[12] The lender, on the other hand, had never perfected its security interest in the deposit account that was the source of the retainer.[13] Thus, the debtor's counsel had the superior claim.[14]

This case is instructive for lenders with security interests in their borrowers' cash and deposit accounts. In order to validly perfect such interests, one or more of three criteria must be met: (1) the lender must be the bank at which the account is maintained; (2) the lender must have a control agreement with the debtor and the debtor's other bank(s), requiring the bank(s) to comply with the lender's instructions;[15] or (3) the lender must be the other bank's customer with regard to the subject account. Otherwise, absent extraordinary circumstances, the lender will lose any security interest it may possess in the funds held in the borrower's cash and deposit accounts upon the payment of such funds to a third party, including bankruptcy counsel.