A federal appeals panel recently affirmed a district court’s judgment awarding $2.4 million in damages to Caterpillar’s financing arm, Caterpillar Financial Services Corp. The case revolved around both entities claiming a priority interest in funds of the debtor.
Caterpillar essentially accused Peoples National Bank of having converted proceeds from the sale of a bankrupt debtor’s mining equipment. According to the appeals court’s 14-page opinion written opinion, S Coal, a southern Illinois coal company, borrowed about $7 million from Caterpillar in 2006 and took out a $1.8 million loan two years later from the bank, both of which were secured by the same mining equipment.
S Coal was already indebted to Peabody Energy Corporation for an earlier loan, and at Peabody’s request, S Coal had transferred title to the same mining equipment to an affiliate of Peabody. (The appeals court found the affiliate to be a “special purpose” entity with the intention of trying to prevent creditors other than Peabody from seizing the equipment.)
When the bank loaned the company money in 2008, it discovered that S Coal had given Peabody a security interest in all of its assets. The bank negotiated a subordination agreement with Peabody for the purpose of gaining priority over Peabody’s earlier security interest in the mining equipment.
When the debtor defaulted on the loans, Caterpillar and the bank squared off, each claiming priority above the other in the mining equipment. The bank beat Caterpillar to the punch by gaining possession of the equipment and eventually selling it for $2.5 million. Caterpillar did not object to the sale, but reserved the right to sue the bank for the proceeds.
The bank then sold the equipment for $2.5 million and sent Caterpillar a $1.1 million check, keeping the balance to cover what the S Coal owed the bank. Caterpillar didn’t cash or return the check. Instead, it brought an action asserting seniority to recover the balance of the proceeds from the bank.
The bank defended its actions, claiming the subordination agreement with Peabody allowed the bank to step into Peabody’s shoes, giving it priority over Caterpillar, since Peabody had an earlier security interest than either the bank or Caterpillar.
Writing for the appeals panel, Judge Posner noted a disagreement among courts on how subordination agreements affect priority when the issue is not specifically set out in the agreements. Some cases, opting for what is called “complete subordination,” drop the subordinating creditor to the bottom of the priority ladder. (See, e.g., AmSouth Bank, N.A. v. J & D Financial Corp., 679 So.2d 695 (Ala. 1996) (per curiam).
The majority approach to subordination agreements, which goes by the name “partial subordination,” simply swaps the priorities of the parties to the subordination agreement—a swap that would make the order in this case the bank, Caterpillar, Peabody—thus leaving nonparties unaffected by it.
But, that was not the final analysis in this case.
Finding for Caterpillar, the court’s decision came down to a basic rule of law in secured transactions, as written by Judge Posner:
So far we have seen Caterpillar’s arguments for priority over the bank falling like ninepins. But the bank’s argument for priority encounters a greater obstacle—in fact an insurmountable one. If Peabody had a security agreement with S Coal, it hasn’t surfaced in this litigation. Peabody did not produce any such agreement in response to the bank’s subpoena, and the bank dropped the matter; for example it made no effort to obtain a copy from S Coal.
It is of course possible, and in fact very likely, that Peabody had such an agreement with S Coal; its financing statement says so. But remember that a security interest is not enforceable unless “the debtor has authenticated a security agreement that provides a description of the collateral.” UCC § 9-203(b)(3)(A).
The bank can’t prove that S Coal, the debtor, did that for Peabody. And even if there was a security agreement, we can’t assume that the collateral it described, if it did describe collateral, included the specific equipment that the bank took possession of in 2009 to satisfy its loan.
So, because of the missing security agreement between S Coal and Peabody, Caterpillar’s security interest in the equipment was prior to the bank’s, which was derivative from Peabody’s. And Caterpillar’s security interest, with its priority, continued into the proceeds when the bank sold the equipment.
The moral of the story: Don’t forget the security agreement is essential to authenticating a security interest, and ultimately, a right to priority in collateral. Make sure every essential piece of evidence is discovered and presented to a court in support of your claim.
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