In our last post, we addressed the importance of concisely breaking down dry and esoteric commercial litigation issues in a way that is easy to follow. In this appeal, we did that by beginning our Brief with a hypothetical.
Let’s dive into the legal issues. Those legal issues include:
- Whether the Bank obtained and perfected a security interest in the accounts receivable of three debtors, in accordance with R.C. 1309.108.
- Whether the Bank adequately “traced” the proceeds of the allegedly converted property (accounts receivable of the three debtors) as required by R.C. 1309.315(B).
- Whether UCC § 9-332(B), codified in Ohio as R.C. 1309.332(B), stripped any security interest the Bank had in funds transferred to our client from a deposit account.
- Several issues related to damages.
The § 332(B) issue is one of first impression in the First District and Supreme Court of Ohio. That statute provides:
A transferee of funds from a deposit account takes the funds free of a security interest in the deposit account unless the transferee acts in collusion with the debtor in violating the rights of the secured party.
Official Comments to § 332(B) explain the policies underlying the statute: finality of payments and the free flow of funds. But for § 332(B), a bank with a security interest could potentially sue to claw back any payment made to anyone by a debtor in default—payroll, Netflix, college tuition, any payment whatsoever. Imagine the chaos this would cause.
§ 332(B) was created in response to the increasing prevalence of electronic payments and was adopted by Ohio in 2001. Balancing the need for finality with protecting secured creditors, the collusion exception protects the secured party where there is malfeasance.
Because our client was paid entirely via ACH transfers from a deposit account, we argued that R.C. 1309.332(B) stripped any security interest, precluding a claim for conversion. The Eleventh District Court of Appeals decided this issue in our client’s favor in Cortland Savs. & Banking Co. v. Platinum Rapid Funding Group, Ltd., 2021-Ohio-461, 182 N.E.3d 1259 (11th Dist.), another Bank v. MCA case.
We urged the First District to follow Cortland and its progeny, while the bank advocated for the Court to instead follow In re Tusa-Expo Holdings, Inc. v. Knoll, Inc., 811 F.3d 786 (5th Cir.2016), a case arising in the Bankruptcy context.
Cortland held that the MCA company took the funds transferred from the deposit account free of the bank’s security interest, unless the bank could prove “collusion” between the MCA company and its debtor (collusion was not alleged in our case). Cortland rejected the holding in Tusa, concluding that it was decided based on the incorrect premise that a deposit account “contains funds,” as opposed to representing a “right to payment from a bank of the money that was deposited by the customer.”
The fact pattern in Tusa is extremely convoluted, almost absurdly so. Grab some popcorn and read this excerpt:
…Tusa Office was the largest retail dealer in new furniture manufactured by Knoll. Tusa Office and Knoll’s relationship was embodied in several contractual arrangements, only one of which is relevant here. Under it, (1) a customer would order furniture from Tusa Office, (2) Tusa Office would then order that furniture from Knoll, (3) Knoll would deliver the furniture to Tusa Office, (4) Tusa Office would deliver the furniture to the customer and install it, (5) Tusa Office would invoice the customer, (6) the customer would pay Tusa Office, and (7) Tusa Office would pay Knoll. This arrangement was initially governed by an April 30, 2002, Payment Agreement between Tusa Office and Knoll. Under that agreement, Tusa Office granted Knoll a first-priority security interest in, among other things, all of its present and after-acquired assets, including its accounts receivable.
In 2005, Tusa Office acquired Office Expo, Incorporated (“Office Expo”), a dealer in used furniture. After a reorganization, Tusa Office and Office Expo became wholly-owned subsidiaries of Tusa–Expo Holdings, Incorporated. Although Tusa Office continued to operate profitably, Office Expo did not. To bolster Office Expo’s flagging performance, Tusa Office began to transfer funds to Office Expo regularly, which caused Tusa Office problems of its own.
Tusa Office and Knoll eventually entered into an Amended Payment Agreement (the “APA”) in June 2008, which restructured Tusa Office’s debt to Knoll. Under the APA, Tusa Office’s current indebtedness to Knoll (that is, the part of its debt that was more than 90 days old) could not exceed $3.1 million until its past-due indebtedness (that is, the part of its debt that was more than 90 days old) was less than $1.9 million. The APA again granted Knoll a first-priority security interest in substantially all of Tusa Office’s present and after-acquired assets, including its accounts receivable. When Tusa Office and Knoll entered into the APA, Tusa Office’s current indebtedness to Knoll was $2,863,898.60 and its past-due indebtedness was $2,703,955.29.23.
In addition to restructuring its debt to Knoll, Tusa Office obtained financing from Textron Financial, Incorporated (“Textron”). Specifically, Tusa Office and Textron entered into an agreement (the “Loan Agreement”) in July 2009, under which Textron provided Tusa Office with a $6.5 million revolving loan in exchange for a first-priority security interest in all of Tusa Office’s current and after-acquired assets, including Knoll’s collateral. The Loan Agreement also required Tusa Office to have its customers make payments directly to a bank deposit account (the “lockbox”) that was controlled by Textron.
As a condition precedent to the Loan Agreement, Textron and Knoll entered a separate Subordination Agreement, under which Knoll retained a first-priority security interest in specified accounts receivable of Tusa Office and a second-priority security interest in all other current and after-acquired assets of Tusa Office. With the exception of those specified accounts receivable, Textron received a first-priority security interest in all remaining current and after-acquired assets of Tusa Office. Textron and Knoll subsequently entered an Amended Subordination Agreement.
Under these several agreements, Tusa Office’s accounts receivable were paid directly into the lockbox by its customers. Having control of the lockbox, Textron withdrew the deposited funds daily and applied them to increase the available credit to Tusa Office on its revolving loan. On request, Textron would advance new revolving loan funds to Tusa Office’s operating account. Tusa Office used those funds to, among other things, pay Knoll. By paying Knoll, Tusa Office reduced its indebtedness under the APA, allowing it to fill new orders from its customers.
Pretty simple, no? Just kidding—I probably read this passage ten times and made multiple flowcharts before making sense of it.
This was a challenging but fun issue to argue. In the next post, we will break down the oral argument.
