Authored by: David Simonds and Edward McNeilly (both of Hogan Lovells)
New Mexico Bankruptcy Court Holds That Lender’s Security Interest Does Not Extend to Proceeds of Commercial Tort Claim Settlement
In In re S-Tek 1, LLC, 2021 WL 6101680 (Bankr. D. N.M. Dec. 23, 2021), the United States Bankruptcy Court for the District of New Mexico (the “Bankruptcy Court”) was asked to determine the scope of a creditor’s security interest in a chapter 11 debtor’s property. The Bankruptcy Court held the debtor had unambiguously granted the creditor a security interest in after-acquired accounts receivable, but that the creditor did not have a security interest in the debtor’s commercial tort claim or in funds payable or paid in settlement of the commercial tort claim.
S-Tek 1, LLC (the “Debtor”) is a limited liability company that provided commercial and residential land surveying and platting services in New Mexico. In 2018, the Debtor entered into an agreement to purchase the surveying business from a company named Surv-Tek. In connection with the purchase, the Debtor executed a promissory note payable to the order of Surv-Tek, and Surv-Tek and the Debtor executed a security agreement (the “Security Agreement”) in which the Debtor granted a security interest to Surv-Tek in certain property.
In July 2019, the Debtor filed an action against, among others, Surv-Tek and the transaction broker, Dennis Smiegel (“Smiegel”), alleging tortious conduct related to the Debtor’s purchase of Surv-Tek’s surveying business. In November 2020, the Debtor and Smiegel entered into a settlement agreement pursuant to which Smiegel agreed to pay the Debtor $30,000 (the “Settlement Funds”) in exchange for a release of all claims against him arising from the sale. Smiegel paid the Settlement Funds to the Debtor, which thereafter filed for relief under chapter 11 of the Bankruptcy Code. The Debtor subsequently filed a motion seeking to determine the scope of Surv-Tek’s security interest in the Debtor’s property.
The Debtor first argued that it did not grant Surv-Tek a security interest in after-acquired receivables. However, the Bankruptcy Court found that argument to be meritless, as the Security Agreement, while imperfectly drafted, specifically granted a security interest in property “hereafter acquired.” However, the Bankruptcy Court agreed with the Debtor that Surv-Tek did not have a security interest in the Settlement Funds. First, Surv-Tek did not have a security interest in the Debtor’s commercial tort claims against Smiegel because the Security Agreement did not comply with the Uniform Commercial Code’s strict requirements for granting and perfecting a security interest in commercial tort claims, which require commercial torts claims to be specifically described (not merely as a general collateral type) and render a generic after-acquired property clause ineffective to create a security interest in commercial tort claims. As the Security Agreement did not mention commercial tort claims, much less describe with specificity the claim against Smiegel, Surv-Tek did not have a security interest in the Debtor’s commercial tort claims against Smiegel as after-acquired property.
Second, the Bankruptcy Court held that Surv-Tek did not have a security interest in the Debtor’s right to funds payable or paid in settlement of the commercial tort claims against Smiegel. The Bankruptcy Court acknowledged that one line of cases held that a creditor may have a security interest in the proceeds of a commercial tort claim pursuant to broader lien grant clauses incorporating proceeds as a category of the collateral. These cases, including In re Wiersma, 324 B.R. 92, 107 (B.A.P. 9th Cir. 2005), held that, once a commercial tort claim has settled, it is a payment intangible and not subject to the requirements that apply with respect to perfecting commercial tort claims. However, the Bankruptcy Court chose to follow the other line of cases, led by the Eighth Circuit Court of Appeal’s decision in Bayer CropScience, LLC v. Stearns Bank Nat’l Ass’n, 873 F.3d 811 (8th Cir. 2016), that a secured party cannot have a security interest in the proceeds of a commercial tort claim if it was not properly perfected in the underlying commercial tort claim.
The Bankruptcy Court held that to grant Surv-Tek a security interest in the Settlement Funds would be an end-run around the UCC limitations on a debtor granting a security interest in a commercial tort claim. Moreover, as the Debtor settled commercial tort claims against Smiegel arising out of alleged tortious conduct by Surv-Tek and Smiegel, it would violate public policy for Surv-Tek to benefit from the settlement with Surv-Tek’s own alleged co-tortfeasor. It appears that the Bankruptcy Court was swayed to follow the line of cases it followed in no small measure due to the facts of this case.
While the dollar amounts in this case were small, it provides a useful reminder of the need to describe collateral with specificity in a security agreement and to take any other steps mandated under the UCC or other applicable law in order for a security interest to properly attach and in order to achieve perfection. Also, while it has become common for borrowers to categorically exclude or significantly limit certain “special” collateral from their security grants, including assets such as commercial tort claims, if possible, lenders should ensure that their loan documents and security agreements explicitly require the borrower to periodically report on the existence of assets that are not perfected by filing of a generic UCC financing statement, such as commercial tort claims, and provide a process for amendments to the disclosures of the security agreement to address such updates.
 The Federal Rules of Bankruptcy Procedure require an adversary proceeding be filed to determine the validity, extent or priority of a lien. F.R.B.P. 7001(2). However, the parties here agreed to proceed by contested matter and without a hearing.