On December 26, 2013, the Court of Appeals of Oregon, in Davis v. F.W. Financial Services, Inc., held that a secured creditor's prior perfected security interest in funds owed to a borrower's accounts receivable had priority over a subsequent judgment lien creditor's interest, despite the secured creditor's failure to declare a default and exercise elective remedies before the judgment lien was obtained and the funds were garnished (260 Or. App. 191 (2013)).

On November 21, 2002, F.W. Financial Services, Inc. (FW) and Dryer (Borrower) executed a promissory note and security agreement. The security agreement included:

On March 1, 2004, FW filed a financing statement perfecting its security interest, and subsequently renewed and maintained its perfected security interest. On June 9, 2009, after prior defaults by the Borrower, FW notified the Borrower that it was enforcing the default interest rate on the loan but was not accelerating the maturity of the balance of the loan and was allowing the Borrower to continue its operations. The Borrower represented to FW that it would be able to recover from its financial troubles and make future payments. The Borrower then owed FW $527,264. On February 1, 2010, the parties executed a new note with principal due April 30, 2010.

Simultaneously, the Borrower had been required to contribute to fringe benefit trust funds for the benefit of its workers under a collective bargaining agreement (Benefit Obligation). On February 8, 2010, the Borrower entered into a settlement agreement with Davis, a designated collection agent, for the payment of its Benefit Obligation. The Borrower breached that agreement, and on March 1, 2010, Davis obtained a general judgment upon confession and a money award for $113,221. Between April 8 and May 11, Davis received $67,031 under writs of garnishment that he had issued to the Borrower's accounts receivable debtors.

In August 2010, when it became clear that the Borrower could not repay its loans, FW and the Borrower worked out a consensual liquidation. In October 2010, FW sued the Borrower to foreclose its security interest and was awarded $572,549 in money damages and prejudgement interest of 24% from April 30, 2010. After learning that Davis had garnished payments owed to the Borrower's accounts receivable, on February 15, 2011, FW demanded that Davis return all of the garnished funds and Davis refused.

On April 14, 2011, Davis filed the instant action for declaratory judgement that he had an interest in the collected funds superior to that of FW. Davis argued that because FW failed to accelerate the balance of the debt or demand direct payment from the accounts receivable debtors upon default, FW allowed the Borrower to continue to operate and thereby incur additional obligations to Davis. Because FW allowed the Borrower to incur these obligations, Davis argues, FW waived the Borrower's default and forfeited its priority position in the accounts receivable as a matter of policy and equity. Davis contends that a security interest in intangible accounts receivable is a different creature than a security interest in tangible property and that if FW fails to exercise its right of direct payment, then the accounts receivable proceeds are not traceable to a third party.

FW counterclaimed for conversion, alleging that the failure by Davis to return the funds was conversion as an intentional exercise of control over funds in which FW held a prior perfected security interest. The trial court found that FW's perfected security interest had priority over Davis's judgement lien and that Davis had converted the funds when it refused to return them, but it denied prejudgment interest. Davis appealed and FW cross appealed.

In this case, the key issue before the Court of Appeals of Oregon was whether FW waived its rights as a prior perfected secured party in collected funds by failing to declare a default and exercise elective remedies before the judgement lien was obtained and the funds were garnished.

After noting that the security agreement itself stated that failure to act on its rights was not a waiver, the Court examined whether anything in the Oregon equivalent of the Uniform Commercial Code (UCC) would allow it to invalidate the security interest.

The Court found that the Oregon UCC did not allow FW's failure to exercise its elective remedies to act as a waiver of its prior perfected security interest. The Court examined Oregon's equivalent of Article 9 of the UCC and decided that because Article 9 is part of a uniform law that should be interpreted uniformly, and because this was a matter of first impression in Oregon, the Court could look to case law from other states for guidance. The Court discussed two lines of irreconcilable authority:

The Court elected to adopt the trace and recapture approach. The Court explained that two important commercial practicability considerations exist with regard to the choice of which approach to adopt:

The Court found that the trace and recapture approach better accommodates those considerations consistently with the fundamental framework of UCC Article 9. The Court discussed that FW has priority under Section 9-317 of the UCC because Davis became a judgment lien creditor after FW perfected its security interest. The primacy of a prior perfected secured party's claim to collateral is the touchstone of UCC Article 9 and a secured party's priority may not be lost by the means suggested by Davis and the waiver approach.

This conclusion was supported by the fact that creditors may decline to exercise their remedies after a default for a variety of reasons, including that the Borrower may improve its position, resulting in a greater recovery for all creditors involved. By declining to immediately declare a default and act on its elective remedies, a creditor does not forego its priority. However, that creditor cannot prevent a more junior creditor from acting on its own rights to declare a default and recover collateral. By adopting the trace and recapture method, the Court allows the senior creditor to choose its best course of action, and, if a junior creditor elects to collect the secured collateral, priority is preserved by still allowing the senior creditor to enforce its rights against the collateral.

Here, while FW could have declared a default and directly collected the accounts receivable, it allowed the Borrower to continue in the hopes that its business would improve. The garnishment of the collateral to fulfil the judgment lien was permissible, but upon FW's declaration of the Borrower's default, its priority in the collateral must be recognized and traced to the funds that Davis had garnished. Davis was required to recognize the superior security interest because the funds were identifiable proceeds of the Borrower's accounts receivable collateral.

The Court also held that Davis had converted the garnished funds from the accounts receivable. Conversion, in the context of collateral securing a note, is unauthorized acts of dominion over the property to the exclusion of the creditor's rights. Here, while Davis did not improperly exercise dominion over the garnishments when they occurred, he did exercise improper dominion when he refused to return the funds after FW declared the default and demanded return of its collateral.

Lastly, the Court addressed whether prejudgement interest should be awarded to FW. Despite the fact that the date for demand by FW for return of the funds was included in Davis' original complaint, FW's failure to plead that date in its counterclaim precluded the award of prejudgement interest.

Accordingly, the Court affirmed on the appeal and the cross-appeal.

Secured lenders should take comfort in this decision, knowing that they may step back and decide the best course of action from a business perspective without having to worry that their rights may be deemed to have been waived by failing to act quickly on elective remedies. By adopting the trace and recapture approach, the Court of Appeals of Oregon has given these senior secured creditors leeway in determining their best approach to maximize their recovery while preserving their rights. Junior creditors, acting in their own best interests, may not realize a windfall from the senior creditor's delay.