On March 25, 2013, the US Bankruptcy Appellate Panel of the Eighth Circuit (BAP) held in North American Banking Co. v. Leonard (In re WEB2B Payment Solutions, Inc.) that a creditor relinquished its possessory lien in the debtor's deposit accounts when it turned over the account funds to the Chapter 7 Trustee (Trustee) without first seeking adequate protection. This case serves as a reminder for secured parties about the importance of seeking adequate protection before turning over collateral in which they hold a possessory lien to a trustee.

WEB2B Payment Solutions, Inc. (Debtor) provided check clearing and payment processing services to third parties. Under an agreement with the North American Banking Company (NABC), the Debtor deposited payments received from third parties in its accounts at NABC, which NABC immediately credited. NABC routinely received claims for dishonored checks from third parties. Under the agreement, NABC was entitled to set off the Debtor's obligation to reimburse it for the amount of the dishonored items against the Debtor's accounts at NABC. To further secure the Debtor's obligations, the agreement granted NABC a security interest in its deposit accounts. NABC perfected its security interest in these accounts by possession under the Minnesota Uniform Commercial Code (UCC).

The Debtor had over $933,000 in its accounts with NABC when it filed a Chapter 11 bankruptcy petition on April 4, 2011 in the US Bankruptcy Court for the District of Minnesota. Shortly after, NABC set off $27,180.54 to cover an overdraft and then froze the account. On April 20, 2011, the case was converted to Chapter 7 and the Trustee was appointed. The Trustee requested that NABC turn over the funds in the Debtor's accounts. In response, NABC proposed that it retain $50,000 to cover potential future reclamation requests. The Trustee agreed and NABC turned over the balance. However, NABC did not ask the Bankruptcy Court to order that the Trustee provide adequate protection of its security interest in the released funds. This lack of action suggested that the funds were no longer subject to NABC's lien.

Due to an unanticipated and unprecedented volume and dollar amount of Treasury reclamation claims, NABC soon exhausted the $50,000 it held back from the Trustee. NABC then demanded that the Trustee return to it all of the released funds to satisfy these claims, asserting that they were subject to its first-priority lien. The Trustee refused to comply. Nine months later, NABC sought a declaratory judgment that it had a first-priority lien in the funds it turned over to the Trustee. The Bankruptcy Court held that NABC lost its contractual right to setoff since the funds were no longer in its possession. It also held that NABC lost its possessory lien in the funds, since it failed to first obtain a court order granting adequate protection of its possessory lien before it turned over the funds to the Trustee.

On appeal, NABC conceded that in turning over the funds to the Trustee it lost its contractual right of setoff because the funds were no longer in its possession. However, NABC disputed the Bankruptcy Court's holding that NABC lost its possessory lien in the funds by failing to obtain a court order granting adequate protection of its possessory lien before turning over the funds to the Trustee.

NABC argued that its lien was preserved despite the lack of adequate protection because the turnover requirement in section 542 of the Bankruptcy Code and the automatic stay provisions in section 362 of the Bankruptcy Code forced it to immediately turn over the funds to the Trustee. NABC relied on the US Supreme Court's decision in US v. Whiting Pools, Inc., which held that, in certain contexts, a creditor holding a properly perfected security interest is entitled to adequate protection after it is compelled to turn over collateral in its possession.

The BAP distinguished the case at hand which involved a contractual possessory lien from US v. Whiting Pools, Inc., which involved a statutory tax lien. Under a possessory lien a creditor's rights are dependent on possession, while under a tax lien, the property remains subject to the lien regardless of who actually is in possession of the property. Instead, the BAP relied on the US Supreme Court's decision in Citizens Bank of Maryland v. Strumph, which held that a bank's right to setoff is lost when it relinquishes possession of an account. Explaining that possessory liens are like setoff rights, the BAP ruled that NABC lost its possessory lien in the Debtor's deposit account funds by operation of law when it voluntarily and affirmatively turned over the funds in the accounts to the Trustee without first requesting adequate protection. Furthermore, the BAP reasoned there would have been no need for NABC to hold back any of the funds to cover overdrafts if its possessory lien automatically remained with the funds after it gave up possession.

NABC also argued that section 552(b)(1) of the Bankruptcy Code protected its possessory lien without it needing to seek relief from the stay or adequate protection. Section 552(b)(1) provides that if a creditor's prepetition security interest extends to the "proceeds, products, offspring or profits" of its collateral, then the lien extends to the proceeds, products, offspring and profits received postpetition. The BAP also rejected this argument because the funds in question do not fall under any of these categories.

This case provides a roadmap for creditors whose rights in collateral depend on possession. Courts will not protect creditors that fail to withhold collateral until the bankruptcy court is able to determine their entitlement to adequate protection. In this case, NABC should have asked the Bankruptcy Court for an adequate protection order before turning over the account funds to the Trustee.

Creditors that wish to maintain a security interest in their property should resist and object to the trustee's use of their collateral at every opportunity in the bankruptcy case. In any event, creditors should seek adequate protection under section 361 of the Bankruptcy Code as soon as possible and before any funds are transferred to a trustee.

For more information on adequate protection, see Practice Note, Adequate Protection: Overview.