Settlement Proceeds: When Does Cash Become Quasi Real Estate?

by Pepper Hamilton LLP
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Farmer v. Citizens Nat’l Bank of Athens (In re Davis), 528 B.R. 757 (Bankr. E.D. Tenn. 2015) –

A chapter 7 trustee sought a court determination that the trustee had a superior claim to settlement proceeds arising from damage to real property.  His argument was that they constituted general intangibles under the Uniform Commercial Code (UCC), and the claim of the mortgagee of the real property was junior because it did not perfect its interest by filing a UCC financing statement.

Prior to bankruptcy the debtors’ real property was damaged by “a catastrophic and now infamous breach of a Tennessee Valley Authority dike filled with coal ash.”  Numerous property owners, including the debtors, sued TVA for damages.  The mortgagee petitioned to intervene, and the court entered an order providing that:

 [A]ll damages, recoveries, proceeds by settlement or otherwise recovered by [the debtors] to the extent of damages to the real property against which [the mortgagee] holds a valid perfected lien are subject to the deed of trust and lien of [the mortgagee], net of attorneys fees and expenses of litigation, and that no disbursement shall be made of those proceeds except as subject to the lien of [the mortgagee].

After the debtors filed a chapter 7 bankruptcy petition, the trustee settled the TVA case.  The question for the bankruptcy court was whether the settlement proceeds were personalty or substitute collateral for the real property.

While acknowledging that the mortgagee’s lien was enforceable against the debtors themselves, the trustee argued that he could assert the “strong arm” powers of a hypothetical judgment lien creditor as of the commencement of the case (under Section 544 of the Bankruptcy Code) or a postpetition creditor (under Section 549).  In either case, he argued that since the mortgagee did not perfect its lien on general intangibles by filing a UCC financing statement, the hypothetical creditors could take the proceeds free and clear of the mortgagee’s interest.

The mortgagee countered that both the mortgagor and mortgagee had causes of action against a third party that damaged the mortgage property.  However, there can be only one recovery, and the mortgagee had the superior claim (except to the extent that the mortgagor had equity in the property).  The trustee responded that the issue was not the relative rights of the debtors and the mortgagee, but rather whether the mortgagee’s rights were superior to those of the “rest of the world.”

The bankruptcy court reviewed several similar cases.  One case involved a tort claim against contractors who built the debtor’s house.  One lender held a perfected lien on the causes of action under the UCC.  A second lender’s lien arose from a deed of trust on the house that predated the UCC interest.  In that case a bankruptcy court concluded that when money is awarded for damage to real property it “takes the place of the reduced value of the land.”  In other words, “to the extent any portion of the settlement allocable to property damage represents a reduction in the value of the [second lender’s] collateral, it is subject to the deed of trust lien, which is superior to [the first lender’s UCC] security interest.”

Similarly another bankruptcy court held that proceeds of an action against a fungicide manufacturer for damage to real estate was subject to the mortgagee’s lien.  That court noted that the property covered by the mortgage included the real estate together with “all rights, interests, easements, hereditaments and appurtenance thereunto belonging, the rents, issues, and profits thereof and revenues and income therefrom,… and all payments at any time owing to Borrower by virtue of any sale, lease, transfer, conveyance, or condemnation of any part thereof or interest therein ….”  It also held that the damages were a substitute for the real estate collateral itself.

In this case, although the deed of trust did not include proceeds, choses in action or general intangibles, the court found it relevant that the deed of trust did include “all… rights… now or hereafter existing in connection with the property or derived therefrom.”  Following a similar path, the court found that the settlement proceeds were substitute collateral for the diminution in value of the real estate, and thus were subject to the mortgagee’s lien under the deed of trust, as opposed to general intangibles under the UCC.  Consequently, the court granted the lender’s motion for summary judgment.

The interface between the UCC and real estate law is often murky and uncertain at best.  (See Mortgage Notes: Those Nasty Assignments.)  Neither UCC lawyers nor real estate lawyers should take it for granted that their respective views of the law will prevail.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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