Security Interest Can Survive Commingling of Sale Proceeds

If a supplier has a security interest in your inventory, does the supplier’s failure to require you to place the sale proceeds in a separate account weaken the security agreement?

One equipment dealer thought so, as did a Superior Court judge. Unfortunately for the dealer – and to the delight of wholesale suppliers – in September 2004 the Arizona Court of Appeals saw it a different way.

Case Corporation v. Gehrke involved a debt owed by Utility Equipment Company (UEC), a dealer of trenching equipment, backhoes and other construction equipment, to one of its suppliers, Case Corporation. In 1990, UEC’s owner, Duane Gehrke, acting on behalf of UEC, signed and personally guaranteed a wholesale financing and security agreement with Case. The agreement gave Case a security interest in all inventory (existing and future) that Case sold to UEC, as well as the proceeds from sale of the secured inventory. Case was to be paid the amounts due it within seven days of sale. The security agreement also gave Case the right to require UEC to deposit sale proceeds into a separate account to avoid commingling with UEC’s other funds. Case did not exercise that right, leaving UEC free to deposit proceeds from the sale of secured inventory into their general account. Case’s decision not to require the segregation of funds would become central to the eventual dispute between the parties.

In December 2000, ten years after Case and UEC executed the security agreement, UEC defaulted on the agreement by failing to remit full payment for ten pieces of equipment that UEC had sold. Case sought to collect, then terminated the security agreement. A week later, UEC filed for Chapter 11 bankruptcy. In an attempt to skirt the protection of the bankruptcy court, Case sued the Gehrkes personally in June 2002, seeking to recover against Gehrke on his guarantee and alleging that Gehrke had “converted” more than $600,000 in proceeds from the sale of equipment in which Case had a security interest.

Conversion. Conversion is defined as “an act of wrongful dominion or control over personal property in denial of or inconsistent with the rights of another.” To maintain an action for conversion, a plaintiff (in this instance, Case Corp.) must have the right to immediate possession of the personal property when the alleged conversion occurs. (A secured party like Case has the right to immediate possession of all of its collateral upon the dealer’s default, and that collateral is identified by serial number in the transactional documents.) If the dealer defaults but refuses to allow return of the remaining collateral, the secured party has a sufficient possessory interest in that collateral to bring an action for its conversion.

It is relatively difficult to sue for conversion of money. A conversion claim cannot be maintained to collect on an ordinary debt. Money can be the subject of a conversion claim only if a specific fund “can be described, identified or segregated, and an obligation to treat it in a specific manner is established.”

Summary Judgment. Gehrke asked for dismissal of the conversion claim, arguing that, before a conversion action could be brought, the proceeds of sale would have to be placed in a separate, segregated account or otherwise subject to an express trust. Citing two Arizona cases, Autoville v. Friedman and Universal Marketing and Entertainment, Inc. v. Bank One of Arizona, Gehrke contended that, since Case had not required the segregation of sale proceeds and allowed UEC to commingle those funds with the other monies in its general account, Case’s conversion claim should be dismissed.

Case responded that, non-segregation aside, its right to an action for conversion was preserved through its ownership interest in both the equipment and the proceeds of sale.

Siding with Gehrke, the trial court dismissed Case’s conversion claim, finding that “title to the inventory was in [UEC], and all proceeds were deposited to the general corporate account of UEC before any demand was made by Plaintiffs to segregate the funds.”

Reversal. Case appealed the dismissal, and the Arizona Court of Appeals reversed the trial court’s ruling and remanded it for trial.

The Court found that, when a secured party holds a security interest in the proceeds of sale, that security interest is sufficient to identify non-segregated funds and preserve a cause of action for conversion of the money. The Court also ruled that neither of the decisions cited by Gehrke applied to this case:

In Autoville , the plaintiff had no security interest in either the vehicles he provided to the defendant or the proceeds of their sale. The plaintiff’s relationship with the defendant was no more than that of creditor and debtor.

In Universal Marketing , the plaintiff put $50,000 in an individual’s bank account to finance purchase of a business. Before the purchase could be completed, however, the defendant garnished the account and seized the plaintiff’s funds. The plaintiff could not maintain an action for conversion because it did not take appropriate steps to identify and maintain a possessory interest in the funds it transferred.

The Court held that, in contrast, Case had perfected a security interest in both the collateral and the proceeds of sale, and a security interest in specific proceeds allows them to be identified even when they are commingled with other funds:

“Case had a security interest in both the equipment and in the proceeds from any sale of the equipment. The agreement between the parties required that the proceeds from any sale be deposited into UEC’s account and electronically transferred to Case within seven days. On the eighth day after the sale, if the funds were not deposited and transferred, UEC had defaulted on the agreement and Case had the right to immediate possession of the equipment or the proceeds.

“We cannot accept the Gehrkes’ argument that a security interest in proceeds is destroyed when the debtor commingles the proceeds with other funds. Such a decision would give the debtor the ability to unilaterally cancel a creditor’s security interest in the proceeds of sale and would controvert Arizona law. A.R.S. § 47-9315(B)(2) [2003]. (“Proceeds [that are not goods] that are commingled with other property are identifiable proceeds . . . to the extent that the secured party identifies the proceeds by a method of tracing, including application of equitable principles, that is permitted under law[.]”)

Gehrke establishes a precedent for a secured party with a security interest in sale proceeds to sue a business owner individually if that owner fails to see that the company pays the sale proceeds required by the financing or security agreement. This individual right of action is separate from any personal guarantee the owner may have signed, and it cannot be avoided by putting the business into bankruptcy. Every owner of a business that floors vehicles, equipment or any other personal property under a financing agreement should be aware of this potential liability.