The Challenge of Enforcing a Security Interest in Funds Once They Have Left a Debtor's Deposit Account

A 2024 Ohio Court of Appeals case presents an striking follow-up to our previous article about security interests in cash and deposit accounts. The case, First Financial Bank v. Tailored Fund Cap, LLC underscores some of the challenges that arise when secured creditors do not take care to establish sufficient control over collateralized deposit accounts and the slipperiness that arises when trying to subsequently attach to funds from a deposit account.

Background of the Underlying Credit Transactions

The underlying commercial dispute in First Financial Bank arose from a familiar tension between two types of creditors in the small and medium sized business credit ecosystem: banks and merchant cash advance (MCA) providers. Three entities affiliated with a businessman, Harold Sosna – who was ultimately convicted of check-kiting – entered into loans with a predecessor-in-interest to First Financial Bank (FFB). 

These entities secured their borrowing obligations by granting FFB a security interest in, among other things, cash collateral accounts, one of which lay at the heart of the legal dispute. Subsequent to the FFB loans being made, eighteen entities affiliated with Sosna, including the ones that received funding from FFB, entered into MCA arrangements with Tailored Fund Cap (TFC) under which they sold a portion of their future receivables in exchange for upfront lump sum payments.

When the check-kiting schemes came to light, FFB called an event of default against the entities it lent to, seeking to collect the outstanding balances due on the loans. When FFB became aware of the MCA arrangements with TFC, FFB demanded that TFC return over $3 million of “wrongfully received” payments that TFC had withdrawn from one of the accounts. TFC refused, which prompted FFB to file suit against TFC for conversion – essentially, a claim that TFC took property that rightfully belonged to FFB.

The Application of UCC 9-332 and the UCC’s Policy Goal of Transaction Finality

At trial, FFB contended that its UCC financing statements gave TFC actual or constructive knowledge of FFB’s first priority security interests in FFB’s borrowers’ accounts. TFC, for its part, argued that it received the funds free and clear under Ohio’s statute adopting UCC 9-332, which allows a transferee of money to receive funds free and clear “if the transferee receives the funds without acting in collusion with the debtor in violating the rights of the secured party.” The trial court granted summary judgment in favor of FFB, holding that conversion had taken place, and, when awarding damages to FFB, held that TFC had converted about $3.6 million from the account in question.

On appeal, TFC argued that the Ohio statute adopting UCC 9-332 barred FFB from clawing back funds that had previously been distributed from the subject bank account. In interpreting UCC 9-332, the appeals court noted that the Code section represents an “attempt by policymakers to strike a balance between the competing interests of financial institutions on the one hand and clients who utilize their services to execute commercial transactions on the other.” 

The appeals court opinion is a real treat for attorneys and credit practitioners that specialize in UCC Article 9 matters. In interpreting the application of UCC 9-332 to the case, the court carried out a thorough review of UCC 9-332’s drafting history. Prior to the drafting of 9-332, Comment 2(c) to UCC 9-306 (which lacks the legal authority of an actual Code section) provided that recipients of cash proceeds “paid out in the operation of the debtor's business” took such funds free of secured party’s claims on them. Prior to the drafting of UCC 9-332, a split in authority existed between courts as to whether transferees of funds were immune from clawbacks from secured creditors even when the funds were traceable back to funds in which the secured creditor held a security interest. Citing Keybank Nat. Ass'n v. Ruiz Food Products, Inc., a federal district court decision that discussed at length the drafting history of UCC-9-332 as adopted under Idaho law, the First Financial Bank appeals court concluded it was “reasonably likely” that UCC 9-332 was intended to “entrench the majority view that transferees of funds from a deposit account take free of a security interest, even if that interest was in collateral to which the funds can be traced.”

On appeal, TFC and FFB advanced competing public policy arguments, each of which was backed by supporting legal precedent. TFC argued that “claw-back lawsuits like [FFB’s] undermine the free flow of commerce, upset the preference for finality in commercial transactions, and wrongfully punish third parties who stop short of colluding with debtors.” In contrast, FFB underscored as a matter of public policy, the “importance of protecting perfected first-priority security interests from transferees who take collateral proceeds out of a deposit account on notice of their subservient position.”

The First Financial Bank court turned to a prior Ohio appellate court decision, Cortland Savings and Banking Company v. Platinum Rapid Funding Group, Ltd., for guidance in resolving these two conflicting positions under Ohio law. Critically in its analysis, the court relied on Cortland’s conclusion that “a security interest in a deposit account cannot be divorced from a security interest in the obligation to pay funds from the account.” Because UCC Article 9 defines a “deposit account” as “an obligation to pay funds from the account…a security interest in a deposit account is merely a security interest in a right to payment from the account, i.e., the funds deposited in the account.” On that basis, the court held, absent collusion between the transferee and the account debtor (which FFB never alleged at trial), a secured party’s interest in a deposit account (i.e., a right to receive payment from the account) is “extinguishe[d]” under UCC 9-332 when payment is made from an account to the transferee. In other words, TFC took the funds it debited from the subject account free and clear, with the legal result being that the trial court’s judgment was reversed and remanded.

Considerations for Secured Creditors 

It is worth underscoring that First Financial is an intermediate appellate court decision in Ohio, and the actual reach of its legal authority should be considered in that context. Nevertheless, the case emphasizes how hard it can be for a secured creditor to enforce its rights over funds in a deposit account once the funds have left the account.

As discussed in our previous article, deposit account control agreements (DACAs) provide a useful mechanism for secured creditors to establish not only “control” under UCC 9-104 over a deposit account (and super priority over the account under UCC 9-327), but also operational oversight. It is not clear from the appeals court in First Financial Bank whether the deposit account in question was held at FFB (in which case FFB would have enjoyed control under UCC 9-104(a)(1)) or the deposit account was maintained at a different depositary bank (in which case FFB would have needed to enter into a DACA under UCC 9-104(a)(2)). In either event, operational control over the account, with restrictions such as those found in a blocked Deposit Account Control Agreement, might well have helped to avoid the funds being withdrawn from the account and FFB’s security interest being extinguished.

Of course, establishing the appropriate level of “control” for UCC Article 9 purposes and practical operational oversight over a deposit account is ultimately a compromise that must be struck between secured creditors and debtors. Restricting the deposit account too much runs the risk of creating significant operational impediments to a debtor’s day-to-day business, and requiring such restrictions when entering into a secured financing runs the risk of jeopardizing the debtor’s willingness to close. On the other hand, as the First Financial Bank appeals court noted, the “legislative preference for transactional finality over the preservation of security interests when it comes to funds moving through deposit accounts” in UCC 9-332 creates significant collection risk to secured creditors over funds that leave pledged deposit accounts.

If nothing else, First Financial Bank serves as a stark reminder to secured creditors to remain vigilant over transaction activity in their debtor’s bank accounts. For nonbank secured creditors, even if a blocked DACA proves too blunt of an instrument for a debtor to accept, periodic and persistent review of monthly account statements or ongoing view access through software solutions can help avoid the loss of bargained-for security interests in deposit accounts. The UCC represents an immensely valuable legal regime for commercial counterparties to transact under, but its policy goal of finality does not always result in a happy ending for secured creditors.