Arizona Commercial Mortgage Lenders Association

Articles -

May 2001

Legal Update for ACMLA Members

A Closer Look at the UCC Article 9 Revisions

New rules expand bank setoff rights in proceeds held in deposit accounts

By Joseph Wm. Kruchek

The last issue of this newsletter discussed very generally the revisions to Arizona’s Uniform Commercial Code (the "UCC") Article 9. This newsletter "drills down" a bit deeper into a couple of issues which may impact certain aspects of real estate financing transactions.

Changes in a Bank’s Rights of Setoff

Currently, in Arizona and most other states, a creditor cannot obtain a security interest in a deposit account. (California is one of the few exceptions to this rule). Under the revisions, this rule is amended to provide that creditors may obtain perfected security interests in deposit accounts. Further, currently in Arizona, a bank which holds a deposit account has a right of setoff against the funds in the account for debts owed by the debtor to the bank. However, the bank’s right of setoff is subordinate to the perfected security interest of a lender in funds deposited into the bank account which are proceeds of the lender’s original collateral (i.e., money received from a sale or other disposition of the original collateral). The revisions materially change the rules related to a bank’s right of setoff.

Under the revisions, the bank or another creditor which has the depositary relationship with the debtor, may obtain a first priority perfected security interest in the deposit account and may perfect by having control of the account. Under these circumstances, the bank or any other creditor with an interest in a deposit account may have priority over the lender who claims a first priority security interest in the funds in the account held as proceeds. Further, the revisions provide that the bank’s rights of setoff and recoupment generally are superior to the security interest of a lender in proceeds, even if the lender with the security interest in the proceeds has perfected a security interest in the deposit account as original collateral.

These issues will be of material concern in real estate financing transactions involving owner-occupied properties where the lender obtains a lien on the real property and a security interest in the owner’s business assets and operations located on the property and properties like hotels and motels.

Expanded Definition of "Proceeds"

The revisions materially expand the definition of "proceeds."

The impact in connection with deposit accounts is that, perhaps, on a more frequent basis than previously, two secured creditors may claim funds in the same account as collateral as a result of each of the secured creditors’ security interests in different sets of proceeds, for instance, receipts from certain hotel operations and license fees. Further, the revisions provide that a security interest in proceeds which are cash remain perfected without further action only if such proceeds are identifiable cash proceeds. Thus, due to the potential increase in proceeds claims resulting from the expanded definition of proceeds, the ability to trace cash proceeds will be more critical than ever in order to establish that the creditor’s cash proceeds are identifiable cash proceeds.

Perfection in Deposit Accounts by Control

Because lenders will be able to obtain security interests in deposit accounts pursuant to the revisions of the UCC, lenders involved in financing income-producing properties should consider taking the deposit accounts into which rents and other income from the real property will be deposited as additional collateral. In order to do so, a lender must obtain control as defined in the revisions of the UCC. Essentially, to have control effective to perfect the security interest in the deposit account, the lender must have the agreement of the bank that it will recognize the lender’s instructions to direct the disposition of the funds in the deposit account without any further instructions or consent required from the borrower, or the lender must become the customer with the bank for the deposit account.

Implications of the Revisions

One of the implications of the revisions outlined above, which will be in effect in 28 states as of this writing (including Arizona on July 1, 2001), is that non-bank lenders whose collateral includes cash proceeds deposited in accounts with banks with which the borrowers have other loans, may be subject to bank setoff rights. Thus, the revisions make it even more important than before for non-bank lenders to assure that the depositary institutions selected for deposits of proceeds are with banks other than banks with whom the borrowers may have some other lending relationship. Another implication, to this author, is that the changes may make more prevalent the use of "lock-box" type arrangements to assure that proceeds are not deposited or controlled by borrowers, but rather are deposited with the lenders who then issue funds to borrowers for payment of specific expenses. This author has already seen a "lock-box" arrangement in a transaction. Yet another possible implication of the revisions is that lenders, both bank and non-bank, will want to assure that borrowers are required to use only one account for the deposit of proceeds, such as rent, to assure that issues regarding possible commingling are eliminated.

If I can be of service in connection with the issues raised in this newsletter, any other issues related to the impending effectiveness of the revisions to Article 9 of the Arizona Uniform Commercial Code, or issues related to real property transactions or financing, please let me know. I will be pleased to be of service.

This update is intended for general information purposes only. You are urged to consult an attorney concerning your situation and any specific legal questions you may have. For further information about these contents, please contact the author,