In re WEB2B Payment Solutions, Inc., 2013 WL 1188041 (8th Cir. BAP, Mar. 26, 2013)
The bank, which held a possessory lien in the deposit account of the debtor, lost its lien when it turned over the funds in the account to the trustee upon his turnover demand, because the bank failed to seek adequate protection prior to turning over the funds.
Debtor WEB2B Payment Solutions was in the business of providing check clearing and payment processing services to third parties. WEB2B entered into an agreement with North American Banking Company under which WEB2B submitted checks for processing by NABC, which would immediately deposit funds into WEB2B’s deposit account. Where such checks were subject to chargeback because they were, for example, counterfeit or forged, NABC exercised its possessory lien rights and its contractual security rights in the deposit account by withdrawing funds from this account in the amount of the chargeback.
At the time of the debtor’s chapter 11 petition, it had more than $900,000 on deposit with NABC. The case was converted to chapter 7, and the trustee demanded that NABC turnover the deposit account funds to the trustee pursuant to section 542. NABC complied with the turnover demand, but, with the trustee’s consent, held back $50,000 in the deposit account to cover the potential future reclamation requests. This amount was based on NABC’s review of the debtor’s history of reclamation and its prediction regarding future potential chargebacks. Unfortunately, NABC vastly underestimated the amount of chargebacks, which quickly exceeded $500,000.
NABC demanded that the trustee return the full $880,000 that NABC had initially turned over to the trustee. The trustee refused, and NABC filed an adversary proceeding against the trustee, seeking a determination that NABC held a first-priority lien in the turned-over funds. The parties filed cross-motions for summary judgment, and the bankruptcy court granted the trustee’s motion and denied NABC’s motion. NABC appealed.
At the outset of its discussion, the court stated that it was "undisputed" that NABC’s lien was perfected by possession of the funds as of the petition date, and that its lien survived the bankruptcy filing itself. The dispute revolved around the "effect of the turnover [of funds] on NABC’s possessory lien."
NABC argued that by virtue of the Bankruptcy Code’s section 542 turnover requirement and section 362’s automatic stay provisions, it was required to turn over the funds, but that under the U.S. Supreme Court’s holding in U.S. v. Whiting Pools, Inc., its lien was preserved notwithstanding the turnover. In Whiting Pools, the Court held that a secured creditor may be compelled under section 542 to turn over collateral in its possession, but that if the creditor has a properly perfected security interest, the creditor is entitled to adequate protection for its interest. NABC argued that, therefore, it could only seek adequate protection after it turned over the funds. NABC also argued that, under Whiting Pools, its right to adequate protection, i.e., a continuing lien in the money turned over, automatically replaced its possessory lien.
The court rejected these arguments. Whiting Pools involved a statutory tax lien, not a possessory lien. The court held that whereas tax liens and recorded UCC-1 liens may survive turnover because the creditor does not expressly release its lien interest in those instances, this was not the case for possessory liens. The court held that this is "a critical distinction because, as opposed to a lien perfected by filing or recording – which is released only upon another affirmative act such as the filing of a release – a possessory lien is, by definition, released when possession of the collateral is relinquished. Thus … NABC did voluntarily and affirmatively release its lien by operation of law when it relinquished possession."
The court analogized the case to Citizens Bank of Maryland v. Strumpf, a case in which the U.S. Supreme Court addressed the issue of the creditor’s rights dependent on a possessory lien. There, the Court, recognizing that a bank’s right to setoff is lost when possession of the account is relinquished, held that a creditor does not violate the automatic stay by temporarily freezing the account and seeking court determination of the parties’ relative rights to the funds, by filing a motion for relief from stay or for adequate protection.
The court opined that "Taken together, Whiting Pools and Strumpf provide a roadmap for creditors whose rights in collateral will be relinquished with possession." In such a scenario, a creditor holding a possessory lien but facing a turnover demand is entitled to seek adequate protection from the bankruptcy court (e.g., an order that the creditor’s liens survive turnover and that the funds are not subject to distribution by the trustee) prior to turning over possession. The court also wryly noted that had NABC truly believed its lien survived turnover, it would not have held back the $50,000 it estimated would cover future chargebacks.
The court affirmed the bankruptcy court’s decision.
Banks holding possessory liens over deposit accounts must be vigilant in protecting their liens. When faced with a turnover demand, a bank should immediately seek adequate protection of the bankruptcy court before doing so. Quick action is the key, since a bank can expect to be threatened with liability by the trustee for waiting too long to comply with a turnover demand. In the face of such threats, a bank should not allow itself to be coerced by the trustee into giving up its secured status, but should instead immediately seek the protection of the bankruptcy court.