Massachusetts: Transfer of funds to court-ordered escrow does not extinguish security interest

Contributed by Kevin Braun of Bingham McCutchen LLP:

Lender’s perfected security interest in funds held by debtor was not extinguished, under Article 9 of the Massachusetts UCC, upon transfer of the funds from a bank deposit account to a court-ordered escrow account.  Zimmerling v. Affinity Fin. Corp., 14 N.E.3d 325 (Mass. App. Ct. 2014).

In 2008, BHC (the “Lender”) loaned $13.5 million to Affinity Financial Corporation (the “Borrower”), executing loan documents and security agreements in connection therewith (the “Loan”).  The Lender perfected its security interest in the covered assets, after-acquired assets, and proceeds of assets of the Borrower. 

By March of 2010, the Borrower had defaulted on the Loan.  Additionally, the Borrower owed approximately $370,930 to William Zimmerling (the “Employee”) per an arbitration award for breach of an employment contract, confirmed in the United States District for the District of Colorado.  The Employee brought action to enforce the judgment in Massachusetts, his suit constituting a “reach and apply” action against AARP (the “Borrower’s Debtor”), which owed sums to the Borrower under a separate arbitration judgment.  The Massachusetts Superior Court ordered the Borrower’s Debtor to establish an escrow account as prejudgment security for the Employee.  Learning of this development, the Lender intervened in the reach and apply action, at which time the judge issued an amended order requiring $500,000 to remain in the escrow account until resolution of all claims against the Borrower, including the Lender’s.

The Employee, in claiming entitlement to the funds, did not dispute that Lender had properly perfected its security interests.  Instead, the Employee contended that, under Section 9-332(b) of the Uniform Commercial Code as enacted in Massachusetts (the “Massachusetts UCC”), the wire transfer from the deposit account of the Borrower’s Debtor to the escrow account extinguished Lender’s security interests in the funds.  The Employee cited Section 9-332(b) of the Massachusetts UCC for this proposition, which states:  “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.” 

Nonetheless, the court sided with the Lender by ruling that the transfer to the escrow account did not extinguish Lender’s perfected security interest in the funds since there was neither a transfer of legal title nor a transfer of equitable title to satisfy the language of Section 9-332(b) of the Massachusetts UCC.

The court began by noting that the funds were in fact transferred to the escrow account.  However, it ruled that the plain language of Section 9-332(b) of the Massachusetts UCC contemplates an “actual transfer” of funds (including all interest and control thereof), not a transfer of contingent or conditional interests in those funds.  For examples of actual transfers, the court cited commentary to Section 9-332(b) of the Massachusetts UCC, which references actions that result in a complete transfer of all interest and control over funds, e.g. transfer by check or cashier’s check.   In contrast, the transfer of equitable title to the funds in this case was contingent on the judge establishing the Employee’s right to the funds; a condition that was still outstanding.  Further, the court noted that Section 9-332(b) is unlike other statutes that do recognize transfers of conditional equitable interests, such as the Federal Bankruptcy Code (“transfer means . . . each mode, direct or indirect, absolute or conditional . . . of disposing of . . . property[] or an interest in property”). 

The court further held that the Employee never obtained legal title to the funds because legal title would transfer only after the escrow conditions were fulfilled, i.e. when the judge determines who receives the funds.  Until such occurrence, the Borrower’s Debtor retained legal title to the funds.

The court concluded its analysis by detailing the policy implications of its decision.  It stated that a ruling in favor of the employee would “render inoperable the use of escrow agreements in commercial transactions involving secured parties” because it could result in the odd situation where a secured party’s perfected security interest is irretrievably extinguished but the party seeking the escrow is deemed to have no right in the property.