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Insurance Proceeds – Does Article 9 Perfection Protect You?

Lenders routinely describe a security interest in proceeds, “including insurance proceeds” as part of the collateral description in their security agreements, believing that this description plus the filing of a UCC-1 financing statement will perfect their security interest in such insurance proceeds under Article 9 of the UCC. Is this really the case?

A recent opinion out of First Circuit Court of Appeals reminds us it is not this simple. In In re Montreal, Maine & Atlantic Ry, Ltd., 799 F.3d 1, 87 (1st Cir. 2015), the First Circuit addressed the appeal of a case involving the proceeds of a business interruption insurance policy. The facts in Atlantic Ry. were that Montreal, Maine & Atlantic Railway Company (“MMA”) operated a train that had the bad fortune to wreck while traveling through a city in Quebec carrying a load of crude oil. This resulted in a massive explosion that destroyed the train, the train’s cargo, part of the town it was traveling through, and killed 47 people. The net result was MMA’s bankruptcy.

In the ensuing fight over the railroad company’s assets Wheeling and Lake Erie Ry (“Wheeling”), which had advanced a $6.0M secured loan to MMA, sought to recover $3.8M of insurance proceeds from the MMA’s business interruption policy. It was uncontroverted that Wheeling held a properly perfected security interest in all MMA’s accounts, inventory and proceeds “including insurance proceeds”. Wheeling argued this properly perfected Article 9 security interest gave it the prior claim to the proceeds of the insurance policy. The Bankruptcy Trustee disagreed and argued Wheeling’s Article 9 security interest was irrelevant because rights to payment under insurance policies are governed by state law, not Article 9. The Bankruptcy Court and Bankruptcy Appellant panel both agreed with the Trustee and Wheeling appealed the case to the First Circuit.

Wheeling fared no better in the First Circuit which rejected its arguments and affirmed the lower courts. In doing so the First Circuit noted this was a matter of first impression in the Circuits. It then relied upon the insurance exclusion contained in Section 9-109(8) of the UCC which excludes from its scope “a transfer of an interest in or an assignment of a claim of under a policy of insurance” other than certain health care receivables. The First Circuit found this broadly worded exclusion made clear that to obtain rights under an insurance policy, Wheeling was required to comply with state law other than Article 9, and since it had not, it had no enforceable rights under the policy so that the Trustee’s strong arm powers prevailed. Notably, Wheeling apparently did not attempt to argue that this insurance exclusion has a narrow exception through the definition of “proceeds” under section 9-102(a)64, which provides insurance proceeds are proceeds: “to the extent of the value of collateral and to the extent payable by reason of the loss or nonconformity of, defects or infringement of rights in, or damage to, the collateral.” It is unknown if Wheeling could have effectively argued this limited exception in this case, given the scope of its security interest may not have extended to the train or its cargo that was destroyed.

The lesson learned is that for a secured lender to perfect rights under insurance policies they should be sure to comply with both Article 9 and state common law. Generally requiring the borrower and its insurer to name the lender as an additional insured and as a loss payee under its policies of insurance is enough so long as the lender is diligent in seeing this requirement is put and kept in place during the term of the loan.

If you have any questions or would like to discuss how McGrath North’s Financial Services Team can help you navigate this or other potential pitfalls facing secured lenders today, please contact any of the members of our Financial Services Group.