Trouble Getting Lender Liens Over Reserve Accounts
By Christy Rivera and Philip D. Beaumont
Differences of opinion are cropping up in project financing deals where lenders seek security interests in collateral accounts set up to hold reserves to service debt, satisfy maintenance obligations and so forth. Most lenders and their lawyers are treating these cash collateral accounts as “securities accounts” governed by revised Article 8 under the Uniform Commercial Code, or UCC, but others are questioning the appropriateness of doing this.
How the accounts are treated is important, because it affects how lenders should perfect their security interests in the accounts.
Revisions to Article 8 have been adopted in all but two states (South Carolina and Rhode Island), with effective dates from 1995 to 1998. Prior to the revisions, cash collateral accounts were treated as “deposit accounts,” and lenders in most states had to be sure they had “exclusive dominion and control” over the accounts in order to perfect their security interests. (Perfection is necessary to avoid the risk of losing priority to other creditors of the borrower.)
Even with this control, certainty that perfection had been achieved was not possible in many states, including New York, due to lack of clarity under case law.
The revisions to Article 8 clear up these perfection issues for “securities accounts.” However, whether cash collateral accounts are “securities accounts” is not clear.
Arguments for “Securities Accounts”
Lenders and their lawyers arguing that cash collateral accounts are governed by Article 8 point to the definition of “securities account,” which means an account to which a financial asset “is or may be credited.” They argue, first, that cash can be a financial asset and, second, that even if it is not a financial asset, the account falls within the definition because it “may be” credited with a financial asset in the future.
In the securities account control agreement that is now commonly entered into to set up these accounts as Article 8 “securities accounts,” the parties usually agree that cash is to be treated as a “financial asset,” thus (the argument goes) satisfying the definition of “financial asset,” i.e., “any property” if the institution maintaining the account (called a “securities intermediary”) expressly agrees to treat it as such. The proponents also point to the official comment to section 9-115, which states that “a security interest in a securities account would include credit balances due to the debtor from the securities intermediary, whether or not they are proceeds of a security entitlement.” (Emphasis added.)
Alternatively, as long as the funds in the account “may be” invested in securities, then the account satisfies the definition without regard to whether cash is a financial asset. There is no requirement that securities be credited to the account on day one, i.e., the moment the account is established; all that is needed is documentation that permits this to happen sometime in the future. And because the relevant credit documentation (usually) permits funds in the account to be invested in securities, this does, indeed, satisfy the definition of “securities account.”
Arguments for Something Else
The opposing voices argue that only incidental cash, such as occasional credit balances in an account that otherwise is actively invested in securities, was intended to be covered. Lawyers maintaining this position still insist on “exclusive dominion and control” language to establish a security interest in cash.
This position also has significant merit. The official comments to the UCC state that, in determining whether an account is a “securities account,” what matters most is whether the institution maintaining the account has under-taken to treat the person for whom the account is maintained as entitled to exercise the rights that comprise the “financial assets” credited to the account. When one looks at these rights, they speak in terms of rights associated with holding securities, e.g., obtaining payments and distributions (section 8-505), exercising voting rights (section 8-506), and redeeming and transferring the underlying financial assets (section 8-507). These are not rights associated with holding cash. Furthermore, the definition of financial asset, although it does speak of “property,” was not intended to encompass cash. This strained construction also takes the official comment to section 9-115 out of context. The “credit balances” referred to are only incidental balances in an account otherwise actively invested in securities.
Investing in Time Deposits
The issue may be more important than it appears because, despite a broad array of governmental and corporate securities included in the typical definition of “permitted investments,” in practice many such accounts are invested only in time deposits. Time deposits often are treated under the UCC like a “deposit account” that is expressly excluded from coverage under Article 9 of the UCC in most states and cannot be a financial asset under Article 8. If time deposits are the equivalent of deposit accounts for purposes of Article 8, it may be that many of these accounts never get invested in any financial asset.
Covering All the Alternatives
How, then, should lenders perfect their security interest in these accounts and the underlying mixture of financial assets, cash and time deposits credited to the accounts? Probably the best approach is to cover all the alternatives. In the credit agreement (or in a separate securities account control agreement), the secured parties, the borrower and the securities intermediary would agree that the accounts will be treated as “securities accounts” under Article 8 and that cash and time deposits will be treated as financial assets for purposes of Article 8, but that, to the extent the accounts are not deemed to be securities accounts, or cash or time deposits therein are not deemed to be financial assets, the securities intermediary, as agent for the secured parties, shall have and will exercise exclusive dominion and control over them.
Proposed Article 9 Revisions Will Help
The effect of the distinction between “securities accounts” and “deposit accounts” will become less important after proposed revisions to UCC Article 9 are adopted, hopefully this year. Under the proposed revisions, it will be possible to perfect a security interest in deposit accounts under the UCC. This should eliminate the need to stretch to include cash collateral accounts as “securities accounts” under Article 8, while at the same time eliminating the need to rely on “exclusive dominion and control” concepts to establish security interests.
By Philip D. Beaumont, in Washington