Opinion ID: 790467
Heading Depth: 2
Heading Rank: 2

Heading: GECC's Security Interest in the Funds UPB Received

Text: 21
22 GECC, however, did not object to the deposit of these funds. Its conversion claim rests on UPB's sweeps. So GECC had the burden of proving that the funds UPB swept were traceable to the funds deposited—funds in which it had a security interest. See Bell, 85 S.W.3d at 54. But proving that link is quite difficult, if not impossible, when funds from numerous sources are deposited and credited to a single account, from which the depositor makes withdrawals and orders payments. Equitable tracing principles ease this difficulty. The question how such tracing works in this case is addressed below. But because equitable tracing principles cannot be used unless equity calls for it, and because there are good commercial reasons for not using such principles to impose liability, we must initially determine when [a court] should trace proceeds through a commingled account. Harley-Davidson Motor Co. v. Bank of New England, 897 F.2d 611, 622 (1st Cir.1990). 23 One UCC provision has been used to delineate when a debtor's payee will be deemed a recipient of encumbered proceeds through the use of equitable tracing principles. That provision provides the following: 24 Where cash proceeds are covered into the debtor's checking account and paid out in the operation of the debtor's business, recipients of the funds of course take free of any claim which the secured party may have in them as proceeds. What has been said relates to payments and transfers in ordinary course. The law of fraudulent conveyances would no doubt in appropriate cases support recovery of proceeds by a secured party from a transferee out of ordinary course or otherwise in collusion with the debtor to defraud the secured party. 25 Mo. Ann. Stat. § 400.9-306, cmt. 2(c). 26 We agree with the district court that Missouri, like most other states confronted with this issue, would recognize this official comment as law. The current version of Missouri's Uniform Commercial Code supports this result. See Mo. Ann. Stat. § 400.9-332(b) (West 2003) (ending a security interest in a deposit account upon the transfer of funds unless the transferee acts in collusion with the debtor in violating the rights of the secured party). And we agree with those courts that have held that this comment effectively delineates those circumstances when tracing is appropriate: when the payee receives funds out of ordinary course or otherwise in collusion with the debtor. See, e.g., Harley-Davidson Motor Co., 897 F.2d at 622. Here, the district court held that the subordination agreement meant that UPB, as a matter of law, did not receive the funds swept from the parent account in the ordinary course of Machinery's business. We disagree. 27 In Orix Credit Alliance, Inc. v. Sovran Bank, 4 F.3d 1262 (4th Cir.1993), the court was faced with a factually similar situation. The depository bank and the debtor/depositor had set up a cash collateral account in which all of the debtor's customers' payments were deposited. Routinely, and pursuant to an agreement, the balance of that account was applied to the depositor's line of credit with the depository bank. The transaction that gave rise to the lawsuit involved the depository bank's application of the balance of the deposit account to reduce the balance on the outstanding line of credit just after the proceeds of a crane had been deposited in the debtor's cash collateral account. Both the plaintiff—another lender—and the depository bank had a security interest in the crane and the generated proceeds that were deposited. The depository bank had subordinated its interest in the crane to the competing lender's interest in the crane. And the court assumed that the bank knew the proceeds of the crane had been deposited in the account. Id. at 1264-66 & n. 7. 28 The court in Orix held that the depository bank took the funds free of the plaintiff's superior security interest under Official Comment 2(c). Id. at 1267-69. As to the plaintiff's claim that the depository bank knew that encumbered proceeds had been deposited, the court said, [A] transferee's knowledge of a prior security interest in proceeds does not, by itself, indicate that the transfer of these proceeds occurred outside the ordinary course of the debtor's business. Id. at 1267. We agree with that statement and, like the court in Orix, we conclude that the phrase in the ordinary course, means that the plaintiff must establish more than a defendant's knowledge of a superior security interest: It must establish either a lack of good faith or that the payee knows ... that the [payment] is in violation of some term in the security agreement not waived by the words or conduct of the secured party. Mo. Ann. Stat. § 400.9-307, cmt. 2; accord Orix, 4 F.3d at 1266-67; ITT Commercial Fin. Corp. v. Bank of the West, 166 F.3d 295, 307-08 (5th Cir.1999) (collecting and discussing authorities). 29 GECC's claim is weaker than the plaintiff's claim in Orix. In Orix, the balance of the cash collateral account was applied only to the line of credit and there was some evidence that the depository bank knew that the deposit at issue contained proceeds. Thus, there was at least an inference (albeit an insufficient inference for liability purposes) of the depository bank's knowledge that proceeds of a secured party's collateral had been deposited, and there was no question that the account balance was created by such funds. Here, there is no evidence that UPB knew that proceeds of GECC-financed inventory had been deposited. And, more importantly, there is no evidence that UPB knew that the account balance after all other expenses had been paid was created by such deposits. Even GECC's trial evidence shows that only about four or five percent of Machinery's $4 million in total deposits were proceeds of GECC-financed inventory, while UPB swept an amount that equaled 37.6% of the total deposits. UPB should not be charged with knowing that the remaining account balance was created by the small portion of proceeds of GECC-financed inventory that had been deposited. 30 If UPB did not know that the remaining account balance was traceable to the encumbered deposits, then as a matter of law it did not know that its sweeps violated the terms of GECC's security agreement with Machinery because it did not know GECC's interests were implicated. And even if UPB knew that proceeds of GECC-financed inventory had been deposited in the account and that the remaining balance had been created by the deposits, as in Orix, that knowledge is not enough. Given Machinery's apparent ability to deposit those funds and use the account to pay creditors, UPB surely did not know, and should not be expected to know, that its sweeps would violate a term in Machinery and GECC's security agreement that GECC had not waived. 31 The district court concluded that the subordination agreement unlock[ed] the mystery to this case, holding UPB could not avoid liability by claiming it did not know that the funds it swept were encumbered by GECC's security interest. UPB argued that GECC should have required Machinery to segregate the lease payments on GECC-financed inventory from Machinery's other revenue, and that without such segregation, there was no way for UPB to know that it was being paid with proceeds of GECC-financed inventory. The court responded: When ... [UPB] gave up its rights to whatever [GECC] had, it should have been the party responsible for making sure that it did not violate its contractual obligations. GECC takes this to mean that the district court held that the subordination agreement imposed upon UPB an implicit contractual duty to find and segregate any funds that were deposited in which GECC may claim a security interest, and that in the face of that duty, UPB could not claim a lack of knowledge. If that is what the district court meant, it erred. First, as explained below, UPB did not give up all of its rights. Second, we will not imply a duty to segregate a debtor's deposits. Sophisticated lenders like GECC and UPB are fully able to bargain for such duties, and they know the risks associated with allowing debtors to commingle funds in a single account that is used to pay various creditors in the ordinary course of the debtor's business. 32 Apparently, the district court concluded that the subordination agreement meant that UPB agreed that it would not accept payment from Machinery if the funds Machinery used were produced by leasing GECC-financed inventory. The terms of the subordination agreement, however, are not that broad. UPB claimed that the sweeps from the cash management system were the conduit through which Machinery paid UPB on the line of credit. GECC did not present any evidence to the contrary, and Machinery does not appear to have paid UPB on the line of credit in any other way. Thus, UPB sufficiently established that the sweeps were payments. 33 Therefore, the question becomes whether the subordination agreement barred UPB from accepting such payments in the ordinary course of business if they were traceable to funds in which GECC could have claimed an interest. It did not. While UPB limited its ability to look to its security to satisfy Machinery's indebtedness by subordinating its security interest to GECC's, it did not promise to forego Machinery's payment of the substantial debt that Machinery owed. The cases GECC cites do not support a contrary conclusion. In the Orix dissent, 4 F.3d at 1269-72, Chief Judge Ervin based his analysis on the bank's express subordination of any interest, id. at 1271, it had in the crane and its proceeds, not simply the bank's subordination of its security interest. In Safeco Credit Co. v. U.S. Bancorp Leasing & Fin., Inc., 833 F.Supp. 833 (D.Or.1993), the court based its conclusion on the bank's express subordination of any security interest, lien, claim or right, now or hereafter asserted ... with respect to the [loader] or the cash or non-cash proceeds of the [loader]. Id. at 834 (second and third alteration in original). And in HCC Credit Corp. v. Springs Valley Bank & Trust, 712 N.E.2d 952, 958 (Ind. 1999), the court was describing a situation in which a secondary lender subordinates its debt to the secured party or otherwise excludes the debtor's obligations to the secured lender in computing the debtor's borrowing base. All are inapposite. 34 At most, the subordination agreement in this case ensured that UPB was a junior secured creditor 4 and firmly established that UPB knew of GECC's security interest in some of Machinery's inventory and its proceeds. But even a junior secured creditor that knows of its junior status can be paid in the ordinary course of business. GECC had to show more. See, e.g., Anderson, Clayton & Co. v. First Am. Bank of Erick, 614 P.2d 1091, 1095 (Okla.1980) (holding that notice of the superior security interest provided by subordination agreement, depository bank's knowledge of proceeds deposits, and depository bank's demand for payment on a note that was not yet due took the payment outside of the ordinary course). 35 We conclude the district court erred in holding that the payments from Machinery to UPB were not in the ordinary course of Machinery's business. We decline, however, to direct the district court to enter summary judgment in UPB's favor. The district court based its conclusion on the subordination agreement, and we have concluded that agreement does not carry the day. And while we have strong doubts as to whether any other evidence establishes the requisite wrongdoing for January and February, March is a closer question. In March, Machinery was in default on its obligation to UPB, GECC contacted UPB and demanded that UPB turn over all proceeds of GECC-financed inventory (albeit without mentioning the amount or any way of identifying particular proceeds), and UPB had taken a much more active role in Machinery's operations, requiring Machinery to justify its expenses to UPB and sweeping a larger percentage of deposited funds in that month than in either of the two preceding months. See Barber-Greene Co. v. Nat'l Bank of Minneapolis, 816 F.2d 1267, 1272 (8th Cir. 1987) (concluding that a depository bank's total control over the account from which payment was made took the transfer out of the ordinary-course language of Official Comment 2(c)). Because GECC may be able to prevail at trial, at least for the March sweeps, we vacate the district court's grant of summary judgment and remand the case for further proceedings.
36 As indicated, GECC may be able to establish that some of UPB's sweeps occurred outside of the ordinary course of business, enabling it to use equitable tracing principles to establish that the funds UPB received were identifiable proceeds of GECC-financed inventory. Because the district court ruled on how GECC may trace deposited funds to UPB's sweeps, and because the parties have briefed the issue, we address the matter. 37 When funds from multiple sources are deposited to the same account and subsequent payments are made from the account, it becomes difficult, if not impossible, to determine whether the subsequent payments are traceable to the initial deposits. Equity, though, can serve as a means of attributing rights in such a commingled account by tracing the subsequent payments to particular deposits. And, as the district court held, Missouri law recognizes the use of equitable tracing principles to identify a secured party's interest in a commingled deposit account. 38 As an initial matter, we reject GECC's attempt to characterize the use of equitable tracing principles as a way of measuring damages. The measure of damages in a conversion action is generally the fair market value of the property at the time and place of the conversion. Bell, 85 S.W.3d at 54. Equitable tracing, on the other hand, allows a plaintiff to establish that the credit created by the deposit of encumbered funds was used to make a payment or a withdrawal. While tracing is a tool to permit the calculation of damages at the time of conversion, Meyer v. Norwest Bank Iowa, 112 F.3d 946, 951 (8th Cir.1997), it is not a measure of damages. It is the primary means of demonstrating the plaintiff's rights, and therefore the defendant's liability, in cases involving commingled accounts. This case illustrates that premise. Without equitable tracing, GECC cannot make out a claim for conversion because it cannot establish that the funds allegedly converted were identifiable proceeds in which it had a security interest. 39 In its summary-judgment order, the district court held that the lowest intermediate balance rule could be applied to Machinery's parent account. But at the damages trial, it concluded that a pro-rata methodology based on the total deposits, withdrawals, and sweeps over the relevant period was more appropriate because the lowest intermediate balance rule yielded a result of zero. Under its pro-rata rationale, the district court concluded that GECC could recover 37.6% of the total GECC proceeds deposited because UPB swept 37.6% of the total deposits. 40 The parties have cited no Missouri cases utilizing a pro-rata tracing methodology like that employed in this case, and we have found none. 5 Thus, we conclude that the lowest intermediate balance rule is the only tracing method available in this litigation. 41 But the district court erred in concluding that a proper application of the lowest intermediate balance rule yielded a result of zero. Because UPB received the funds at different times over the course of the three months, and GECC's conversion claim is based on UPB's sweeps, the analysis must look to those transactions. Under the lowest intermediate balance rule, it is assumed the traced proceeds are the last funds withdrawn from a contested account. Once the traced proceeds are withdrawn, however, they are treated as lost, even though subsequent deposits are made into the account. Id. at 951 (citation omitted). The district court concluded that because the account was zeroed out by UPB sweeps and other payments, the traced proceeds were therefore gone. That conclusion would be appropriate if GECC's claim were based on the account balance after UPB swept the account. But GECC's claim is based on UPB's sweeps. Thus, Machinery's account balance at the time UPB swept it is the relevant account balance. By the very occurrence of the sweep, we know the balance of the account was not zero at that time. An appropriate application of the lowest intermediate balance rule would therefore focus on attributing the account balance at that time to preceding deposits of GECC proceeds. 42 Of course, a zero balance in the parent account after a deposit of GECC proceeds but before a UPB sweep would mean all of the credit that resulted from the deposit of GECC proceeds had been exhausted and, thus, lost. So the time frame the court must look to ends with a UPB sweep and begins with the immediately preceding zero balance. If GECC proceeds were deposited after the immediately preceding zero balance, they may be traced to UPB's sweep through an ordinary application of the lowest intermediate balance rule. Thus, the funds UPB swept on a given day will be deemed identifiable proceeds of GECC-encumbered deposits to the extent post-deposit withdrawals that precede the sweep didn't reduce the account balance below the amount of those encumbered deposits. 43 A hypothetical explains this proposition. If UPB swept the account on March 16 and received $20,000, then the court should look back to the immediately preceding zero balance. If that event occurred on March 15 (either through a transfer to the operating accounts or a previous UPB sweep), the court begins its application of the lowest intermediate balance rule there. After the preceding zero balance, assume that (1) $10,000 in GECC proceeds were deposited, (2) then $50,000 of other funds were deposited, (3) then $55,000 were transferred to the operating accounts to cover expenses, and (4) then $15,000 of other funds were deposited. The following chart represents the deposits, withdrawals, and account balances during the relevant time frame. 44 ---------------------------------------------- GECC Proceeds Other Account Deposits Deposits Withdrawals Balance ---------------------------------------------- $10,000 $10,000 ---------------------------------------------- $50,000 $60,000 ---------------------------------------------- ($55,000) $ 5,000 ---------------------------------------------- $15,000 $20,000 ---------------------------------------------- 45 On these facts, GECC would be able to trace $5,000 of deposited proceeds in which it had a security interest, through the account, to the funds UPB received. Its other $5,000 interest in the account would be lost because after the $10,000 of GECC proceeds were deposited, the account balance dropped to $5,000 when $55,000 were transferred to the operating accounts. The subsequent deposit of $15,000 did not replenish GECC's interest in the account. 46 We recognize that the facts upon which this analysis must proceed could be difficult to establish. But that problem does not entitle a plaintiff to recover on a conversion claim without establishing what property was converted.