Assignment 3
Attachment of the Security
Interest: Proceeds of Collateral
Reference: Understanding Secured
Transactions §§ 2.03
Sale/Exchange of Collateral
• Property subject to valid SI can
still be transferred by debtor
– Creation of a SI doesn’t legally
prevent debtor from transferring
the collateral
• When such a transfer takes
place, how are the rights of the
secured party affected?
§ 9-401. Alienability of Debtor’s Rights.
(a) [Other law governs alienability; exceptions.]
Except as otherwise provided in subsection (b) and
Sections 9-406, 9-407, 9-408, and 9-409, whether a
debtor’s rights in collateral may be voluntarily or
involuntarily transferred is governed by law other than
this article.
(b) [Agreement does not prevent transfer.] An
agreement between the debtor and secured party which
prohibits a transfer of the debtor’s rights in collateral or
makes the transfer a default does not prevent the transfer
from taking effect.
Problem 1
• Winter borrowed $15,000 from Neighborly
Finance (NF), which took/perfected a SI in all of
Winter’s business equipment, including afteracquired business equipment
• Winter sold his table saw to Johnson for $3,000,
payable in 10 installments of $300 each
– Johnson didn’t know about NF’s security interest
• How did this transaction affect NF’s rights?
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§ 9-203(f). The attachment of a security interest in
collateral gives the secured party the right to proceeds
provided by Section 9-315 ....
§ 9-315(a). Except as otherwise provided in this
article and in Section 2-403(2):
(1) a security interest or agricultural lien
continues in collateral notwithstanding sale, lease,
license, exchange or other disposition thereof unless
the secured party authorized the disposition free of the
security interest or agricultural lien; and
(2) a security interest attaches to any identifiable
proceeds of collateral.
• Now that Winter has defaulted, NF can
repossess the table saw from Johnson
– General rule [§ 9-315(a)(1)]: SI follows the
collateral, unless another provision of Article 9
says otherwise (derivative title principle)
– No other Article 9 provision applies here to permit
Johnson to take saw “free and clear” of NF’s SI
• Likewise, NF could repossess the lathe (sold to
Dave’s Custom Furniture) and the tool drawer
(traded in to Ace Hardware)
§ 9-102(a)(64). Proceeds ... means the following property:
(A) whatever is acquired upon the sale, lease, license,
exchange or other disposition of collateral;
(B) whatever is collected on, or distributed on account of,
collateral;
(C) rights arising out of collateral;
(D) to the extent of the value of collateral, claims arising out of
the loss, nonconformity, or interference with the use of,
defects or infringement of rights in, or damage to, the
collateral; or
(E) to the extent of the value of collateral and to the extent
payable to the debtor or the secured party, insurance payable
by reason of the loss or nonconformity of, defects or
infringement of rights in, or damage to, the collateral.
Problem 1
• Winter’s right to collect installment payments
owed by Johnson is an “account” [§ 9-102(a)(2)]
• Although NF’s security agreement did not create
a direct SI in Winter’s accounts, the account is
identifable “proceeds” of the table saw [§ 9102(a)(64)(A)]
• Thus, NF also has a SI in this account, too [§§ 9315(a)(2)]
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• Why should Article 9 gives NF a SI in both the
table saw (the original collateral) and the right to
collect payment from Johnson (proceeds)? Does
that unjustly enrich Neighborly Finance?
– Presumption: parties would intend for SI to extend to
“proceeds,” unless K says otherwise
– Presumption: parties would also intend for SI to follow
the collateral, unless K (or positive law) is to the
contrary
• Note: NF is entitled to only one recovery of the
debt (proceeds rule can expand the collateral, not
the debt itself), so it is not unjustly enriched
• Why provide proceeds
coverage as a default rule?
– Secured Party’s real interest is in
the economic value of collateral;
when collateral is disposed of,
“proceeds” are a substitute
– Sale/exchange by Debtor may
make it harder for Secured Party
to enforce its SI in the original
collateral (e.g., Secured Party
may be unable to find the buyer)
Proceeds Coverage
• In many cases, secured party cannot proceed against
the original collateral (despite derivative title)
• E.g., buyer of collateral in ordinary course of business
– If X buys a dishwasher at Downtown Appliance (DA), X
would take it free of any SI that DA had granted to Bank in
its inventory [§ 9-320(a)] (“buyer in ordinary course” rule)
– But, SI in dishwasher as inventory would attach to the cash
proceeds of the dishwasher (otherwise, Bank would have no
collateral once DA sold the inventory!)
• E.g., destruction of collateral
– In Problem 1, Johnson’s drill press was destroyed (no longer
has any value); insurance monies that Johnson received are a
substitute for the original collateral [§ 9-102(a)(64)(E)]
• The “proceeds” in which Neighborly Finance
could claim a SI in Problem 1 include:
– The account owed by Johnson (right to payment
due on sale of table saw) [§ 9-102(a)(64)(A)]
– The mower (received by Winter in exchange for
tool drawer) [§ 9-102(a)(64)(A)]
– The flat screen TV (bought by Winter with cash
proceeds) [§ 9-102(a)(64)(A)]
– Insurance monies for damaged drill press [§ 9102(a)(64)(E)]
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Problem 1 and Cash Proceeds
Cash Proceeds
• Winter sold lathe (NF’s collateral) for $5,000 cash
• Suppose that Winter took the $3,000 of remaining
cash from the sale of lathe and put it in his bank
account (along with his $500 tax refund)
• At this point, he’s mixed the $3,000 cash from
sale of the lathe (proceeds) with other money (the
other $500, which was not “proceeds”)
• Is the $3,000 still sufficiently “identifiable” for
Neighborly Finance to claim a SI in it?
– That $5,000 was “identifiable proceeds” of lathe and
thus NF had a SI in the cash [§ 9-315(a)(2)]
• Winter then took the $5,000 cash and bought a flat
screen TV (assume he paid $2,000 for it)
– The TV is “identifiable proceeds” of the cash (which
was collateral) and thus NF has SI in the TV, too
– NF would also still have a SI in the remaining $3,000
cash from sale of the lathe
$3,500
“Commingling” and Tracing
• Grant Gilmore (drafter of original
Article 9) thought a SI in cash
proceeds was lost if the cash proceeds
were “commingled” with other cash
• Courts rejected this view, and allow
secured parties to use “tracing rules”
such as the lowest intermediate
balance rule [Understanding, p. 88]
– Rationale: SP shouldn’t lose its SI
due to a unilateral act by debtor that
SP can’t readily prevent
“Tracing” Using
Lowest
Intermediate
Balance Rule
$500
Prof. Grant
Gilmore
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$3,500
Problem 1
• Assume Winter’s deposit account has $3,500 in it
($3,000 proceeds of lathe, $500 from tax refund)
• Winter then pays $2,000 to Smith (salary), leaving
$1,500 in the deposit account
– Under “lowest intermediate balance rule,” the first $500
of the salary payment came from the non-proceeds
– The next $1,500 came from NF’s proceeds
– Deposit account is now comprised of $1,500 (all of
which is “proceeds” of the lathe
Handling of Cash Proceeds
• In this variation of Problem 1,
$1,500 of the money used to pay
Smith’s salary was cash
proceeds of NF’s collateral
• Can NF recover that money
from Smith (i.e., does NF’s SI
“follow the money” under
derivative title rule)?
“Tracing” Using
Lowest
Intermediate
Balance Rule
$500
$2,000 payment
Sums disbursed from account are taken from nonproceeds,
to the extent of nonproceeds remaining in account
Transferees of Cash
• Neighborly Finance probably cannot enforce its SI
against Smith (even though the money had been
“proceeds” of NF’s collateral in which it had a SI)
– “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.” [§ 9-332(b)]
– This codifies the common law principle of the
negotiability of money
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Handling Cash Proceeds: Lockbox
• Lenders who have a SI in all of a Debtor’s
inventory and accounts often require use of a
“lockbox” to protect their SI in cash proceeds
– Debtor’s customers are told: “pay your bill at this
address”
– Payments go into a deposit account controlled by
the secured party (no commingling)
– Debtor’s access to funds in the account can be
controlled by lender’s security agreement
• A few priority concepts are key to understanding
this situation
• The basic priority rule governing conflicting SIs is
“first to file or perfect” [§ 9-322(a)(2)]
– Under this rule, Bank’s SI in the hogs has priority over
Farmer’s Co-op’s SI in the hogs (Bank was first to file)
• But, a purchase money security interest (PMSI) can
take priority over a conflicting SI that arises under
an “after-acquired” clause [§ 9-324(a)]
– Even though Bank has SI in the feed (as after-acquired
farm products) and was first to file, Farmer’s Co-op has
a PMSI (and thus qualifies for first priority in the feed)
Farmers Co-op v. Union State Bank
• Cockrum (hog farmer) had credit line at Bank
– Collateral = “all farm products including …
livestock” (and including after-acquired)
• Cockrum bought feed on credit from Farmer’s
Co-op. Cockrum granted Farmer’s Co-op:
– A purchase money SI in the feed, and
– A nonpurchase money SI in his hogs
• Bank, Farmer’s Co-op now each claim a SI in
the hogs, and each claims first priority
Farmers Co-op v. Union State Bank
• Farmer’s Co-op argues:
– Our PMSI in the feed was entitled to priority over
Bank’s SI in the feed [§ 9-324(a)]
– The hogs are “proceeds” of the feed, so we have a
SI in the hogs [§ 9-315(a)(2)]
– We get the same priority as to the proceeds (hogs)
as we had for original collateral (feed) [§ 9-324(a)]
– Thus, we have first priority as to the hogs
• Should this argument be correct?
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§ 9-102(a)(64). Proceeds ... means the following property:
(A) whatever is acquired upon the sale, lease, license,
exchange or other disposition of collateral;
(B) whatever is collected on, or distributed on account of,
collateral;
(C) rights arising out of collateral;
(D) to the extent of the value of collateral, claims arising out of
the loss, nonconformity, or interference with the use of,
defects or infringement of rights in, or damage to, the
collateral; or
(E) to the extent of the value of collateral and to the extent
payable to the debtor or the secured party, insurance payable
by reason of the loss or nonconformity of, defects or
infringement of rights in, or damage to, the collateral.
• But, Cockrum did “dispose” of the feed in practical
terms (it’s gone/eaten); plus, hogs are bigger/more
valuable, so there’s been an “exchange” of sorts
(though not a “market” exchange)
• So why not treat the now-larger hogs as “proceeds”
of the feed?
– Concern: bigger and more valuable hogs aren’t just
attributable solely to the feed, but to other inputs as
well (water, labor, medicines) in which Farmers Co-op
did NOT have a security interest
– “Proceeds” have to be identifiable to the original
collateral for a SI to extend to them [§ 9-315(a)(2)]
Farmers Co-op v. Union State Bank
• Court: hogs are not “proceeds” of the feed
– Feeding hogs isn’t a “disposition” of the feed [p. 4]
• Is this a sensible result?
– Court reasons that “Sale, lease, exchange, license,
or other disposition” encompasses some type of
exchange transaction
– Here, there was no such transaction; the feed was
just fed to the hogs (which the debtor already
owned to begin with)
Problem 3
• Putnam County Bank has a
SI in all of the pinball and
video games located at
Goober’s Games
– Debtor is in default
• Bank wants to repossess the
machines before Debtor
empties the coins
• Good idea or bad idea?
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• Are the coins “identifiable
proceeds” of the machines?
If so, Bank has a SI in the
coins, too [§ 9-315(a)(2)]
– If not, Bank can repossess the
machines, but not coins (unless
security agreement gives Bank
a direct SI in the coins)
• How would you argue the
case for Bank?
• Contrary view
– Is the ability to play a video game really a license of the
machine itself? [Maybe??]
– Coins are not just attributable to the games, but to other
inputs (electricity, the real estate on which the games sit)
• Coins arguably fit within § 9-102(a)(64)(B)
(“collected on account of” the machines), but ...
• Bank can avoid the whole “is it proceeds?” mess by
making it explicit, in the security agreement, that its SI
also covers money generated by the machines
– If Bank had also taken a “direct” SI in the money
generated by the machines, it wouldn’t matter whether the
money was “proceeds” of the machines
• Bank might argue:
– (1) Proceeds includes any property received upon the
“license” of collateral [§ 9-102(a)(64)(A)]; customers had
“license” to use machines, so coins are “proceeds”
– (2) Proceeds also includes whatever is “collected” on
account of collateral [§ 9-102(a)(64)(B)]; money was
“collected” from machines
• Note: “collection” often refers to enforcement of an
“account” or other right to payment [e.g., § 9-607]
• But, courts: stock dividends are “collected” on account
of stock and are “proceeds” of stock [Hastie]
Problem 2
• If goods that are collateral are
commingled into a
product/mass, SI in original
goods continues into the
product/mass [§ 9-336(c)]
• So why not treat the cattle as a
“product/mass” in which the
feed supplier has a SI?
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Commingled Goods
• § 9-336(a): “commingled goods” are ones
physically united with each other in such a
manner that their identity is lost
– E.g., flour and eggs baked into a cake
• Cattle are being “united” with the feed, but not
in a manner that the identity of the cattle are
lost
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