A secured loan is only as secure as the quality of its collateral. Every bank has encountered the situation where a debtor defaults and the bank learns that the collateral is not as robust as the bank was led to believe. In these times, this has become a more frequent occurrence.
Every bank has (or should have) procedures in place at the front end and during the life of a secured loan to perfect its security interest in collateral and to evaluate and monitor the quality of the collateral. But what about on the back end of a loan, when the debtor defaults and the collateral proves insufficient? Often, the bank will just liquidate what little collateral remains and swallow the loss. But a shrewd banker will take his or her recovery efforts a step further. This next step starts with an investigation into why the collateral turned out to be of lesser quantity or quality than expected. Frequently, the bank will find that some of its collateral ended up in the hands of a third party—and increasingly, that third party’s rights in the collateral will be subordinate to the bank’s prior perfected security interest. What to do then? As a starting point, comment 2 of Article 9-315 of the Uniform Commercial Code authorizes a secured creditor to commence an action for the tort of conversion against a third party who has taken possession of a bank’s collateral from the bank’s debtor in contravention of the bank’s security interest.
The Powerful Right to Reclaim Converted Collateral
An example from a recent case Davenport Evans handled illustrates how this plays out in the real world. The bank’s debtor, a cattle merchant, bought cattle from a livestock auction barn. The debtor paid the auction barn with a check and took possession of the cattle and moved them to his feedlot. Under the UCC, the Bank’s security interest in all of its debtor’s livestock attached to the cattle in question at the moment the debtor took possession. At that point, the bank’s security interest in the cattle was superior to that of the auction barn—even though it turned out that the debtor’s check bounced.
The auction barn was owned by an S-Corporation, and the two shareholders were less than pleased that the bank’s debtor’s check had bounced. So, they hatched a plan to repossess the cattle from the debtor’s feedlot while he was out of town one weekend. By the time the bank caught wind of this operation, the cattle had been resold and the auction barn refused to remit the proceeds to the bank.
Davenport Evans filed suit against the corporation that owned the auction barn and obtained a judgment against the corporation for conversion. Even though the debtor hadn’t technically paid the auction barn for the cattle, the bank’s prior perfected security interest was superior to the auction barn’s interest as an unpaid seller.
Just before the bank took a judgment against the corporation, it decided to enter into an asset sale agreement to dispose of essentially all of its assets. Unsurprisingly, the proceeds of the sale were quickly funneled out of the corporation to the two shareholders. That wasn’t the end of the story, though. The bank simply took two additional steps available under the law.
First, the bank sued the shareholders of the corporation individually for conversion and obtained a judgment against the shareholder who had orchestrated the repossession operation. The shareholder tried to argue that he could not be personally liable for conversion because he was acting on behalf of the corporation when he seized the cattle from the feedlot. Thus, he reasoned, the corporate form should protect him from individual liability. But that is not how the law of conversion works in South Dakota. Anyone who participates in the taking of property from another—even an individual acting on behalf of a corporation—can be liable for conversion. Accordingly, the bank obtained a judgment against this particular shareholder for conversion in the full amount of the value of the cattle that were taken.
And what of the other shareholder? He received a large portion of the funds from the asset sale that took place on the eve of the bank’s judgment against the corporation. So, the bank sued him under the Uniform Fraudulent Transfers Act, which prohibits preferential transfers to an insider that render a corporation insolvent.
The take home point from all of the foregoing is that it is not necessarily “game over” when a debtor defaults and the collateral for the loan turns out to be insufficient to satisfy the loan balance. The law affords multiple remedies to an aggrieved secured creditor, including those described above, against an interloper who has taken possession of the bank’s collateral without justification. If your bank finds itself in this situation, don’t throw in the towel until you’ve assured yourself that none of your collateral ended up in the wrong hands.
 Sound harsh for the auction barn? Not really. The auction barn could have protected itself by demanding payment in cash or obtaining a perfected purchase money security interest.
Davenport, Evans, Hurwitz & Smith, LLP, located in Sioux Falls, South Dakota, is one of the State’s largest law firms. The firm’s attorneys provide business and litigation counsel to individuals and corporate clients in a variety of practice areas. For more information about Davenport Evans, visit www.DEHS.com.