Requirements for Enforcing a Subordination Agreement under the UCC. Caterpillar Financial Svcs. v. Peoples Nat. Bank, 710 F.3d 691 (7th Cir. 2013).
In 2008, Peoples National Bank (“Bank”) lent S Coal $1.8 million, which loan was secured by certain mining equipment (“Equipment”). The Bank was the third lender to secure debt on the Equipment. The first lender, Peabody Energy Corporation (“Peabody”), had secured a $4 million loan against all of S Coal’s assets, which was recorded in a financing statement filed by Peabody in 2005. A second lender, Caterpillar, loaned S Coal $7 million and filed a financing statement in 2006 that specifically referenced the Equipment as the assets encumbered by the loan. In an attempt to gain the first priority position, the Bank entered into a subordination agreement (“Agreement”) with Peabody, giving the Bank’s loan priority over Peabody’s claim. S Coal defaulted on the loan to the Bank and the Bank foreclosed on the Equipment, obtaining the sum of $2.5 million, of which it kept $1.4 million, representing the amount outstanding on its loan to S Coal, and remitting the remaining $1.1 million to Caterpillar. Caterpillar sued the Bank for $2.4 million plus prejudgment interest, asserting that the Bank’s Agreement did not properly give the Bank priority over Caterpillar’s lien because of a deficiency in Peabody’s perfection of its security interest in the Equipment. The Seventh Circuit Court of Appeals (“Court”) upheld the trial court’s ruling and agreed with Caterpillar, finding that the Bank did not produce sufficient evidence that Peabody had a security interest in the Equipment resulting in Peabody losing its priority status with respect to this case. Since Peabody was not found to have a priority claim on the Equipment, the Agreement with the Bank did nothing to change the Bank’s position behind Caterpillar and thus the Bank did not have priority in the Equipment’s sale proceeds.
The Court analyzed the Agreement and the Bank’s priority under four separate theories: (i) did the Agreement create a partial or full subordination; (ii) did Caterpillar’s refinancing of the debt on the Equipment give Caterpillar a purchase money security interest in the Equipment; (iii) did the placing of the Equipment’s title in a special purpose entity defeat the Bank’s claim; and (iv) did the “composite document” rule service to perfect Peabody’s interest in the Equipment and Bank’s claim.
The Court first determined whether the Agreement created a full or partial subordination between Peabody and the Bank. A full subordination is recognized in a minority of jurisdictions and results in (a) the subordinated party’s interest being placed below that of the other party to the agreement and (b) a reordering of the priorities of all claiming parties, even those not party to the agreement. For example, if a first priority party enters into a subordination agreement with a third priority party, the agreement would move the first priority holder below that of the third, which in effect moves the second priority party (i.e. the non‑party) to the first priority position. A partial subordination, which is recognized by a majority of jurisdictions, results in the parties to the subordination agreement switching their respective priority positions. The Court took the majority approach and found that the Agreement swapped the priority position of Peabody with the Bank, moving the Bank to the first priority position and placing Peabody behind Caterpillar.
The Court next considered Caterpillar’s purchase money security interest claim. Caterpillar claimed that its loan using the Equipment as collateral either qualified as a purchase money security interest or as a refinance of the debt owed by S Coal to a leasing company on the Equipment. Under the Uniform Commercial Code (“UCC”) §9‑324(a), if a debt is incurred that enables a debtor to acquire rights in collateral, the creditor is granted a priority security interest, even over earlier security interest in the same property. Further, UCC §9‑103(f)(3) permits a creditor to maintain this priority interest even if it refinances the debt. In the instant case, S Coal was leasing the Equipment from a leasing company. However, Caterpillar claimed that its loan would ultimately enable S Coal to purchase the Equipment and thus gave Caterpillar a purchase money security interest in the Equipment. The Court disagreed, finding that the lease was equivalent of a sales agreement, with the leasing company (not S Coal or Caterpillar) holding a security interest in the Equipment until the full value of the Equipment was paid. Caterpillar further claimed that its refinancing of leasing company’s debt placed Caterpillar in the leasing company’s shoes. The Court again disagreed finding that UCC §9‑103(f)(3) was not available to Caterpillar because the Equipment was not newly purchased using the funds supplied by Caterpillar, but rather was Equipment already owned by S Coal. The Court concluded that the only way that Caterpillar could have stepped into the leasing company’s priority position would be if the leasing company assigned its security interest to Caterpillar, which it did not.
Third, the Court addressed the question of whether the Bank’s interest in the Equipment was adversely affected by the fact that title to the Equipment was no longer held by S Coal, but by an affiliate of Peabody. In an attempt to prevent other creditors from gaining access to the Equipment, Peabody required S Coal to place ownership of the title in an affiliate of Peabody. The transfer of title was done privately and S Coal continued to maintain and use the Equipment on its property. Neither the creation of the affiliate nor the transfer of title was made public. The Court reasoned that if the true owner of property allows a another party to deal as if it is the apparent owner and a third party relies on this appearance of ownership, the true owner is estopped from asserting later that the apparent owner did not have title. The Court found that the lack of public disclosure of the title’s transfer allowed S Coal to hold the Equipment as its own. Since Peabody never informed the Bank of the title arrangement it was estopped from claiming otherwise.
Finally, the Court considered the documents underlying Peabody’s priority claim on the Equipment and their effect on the Agreement. One of the requirements to perfect a security interest under UCC §9‑203(b)(3)(A) is that in addition to filing a financing statement, a debtor must also have authenticated a security agreement that provides a description of the collateral. Peabody never produced an authenticated security agreement. In response to the lack of a security agreement, the Bank attempted to use the “composite document theory” in order to maintain Peabody’s priority claim. The composite document theory allows other documents to be substituted as proof that a security agreement was signed by the debtor. In the instant case, the Bank provided the financing statement and the Agreement, both of which referenced the security agreement as proof that the security agreement and security interest in the Equipment existed. The Court disagreed with the Bank’s use of the financing statement and the Agreement as substitutes for a security agreement. In discussing the financing statement, the Court stated that the financing statement did not provide a specific description of the Equipment, rather it claimed to have an interest in all of S Coal’s equipment. Since there is no requirement that a financing statement’s description match the description of the related security agreement, the Court found that it was unclear whether the missing security agreement would have clearly identified the Equipment; thus, rendering the financing statement an unacceptable substitute. The Court then raised the issue of timing with the Bank’s use of the Agreement as a substitute. It found that the Agreement, signed by S Coal in 2008, was not sufficiently contemporaneous with the filing of Peabody’s financing statement to qualify as proof that a security agreement that covered the Equipment was entered into back when the original financing was filed. Further, the Court found that S Coal’s signature to the Agreement merely indicated that S Coal believed it had created a security interest, not that the interest was actually created. The Court stated that since Peabody and the Bank did not produce a security agreement, nor could they adequately prove the existence of a security agreement using the composite document theory, that Peabody’s priority interest in the Equipment was invalid. This finding affected the Bank’s priority claim under the Agreement. The Court found for Caterpillar, finding that since Peabody was found not to have a priority claim, the Bank’s claim under the Agreement was never superior to Caterpillar’s claim, making the Bank’s sale and retention of the Equipment’s proceeds unlawful.