Sarah Michaels, Incorporated v. CPC Acquisitions, Incorporated ( 2008 )

In the
United States Court of Appeals
For the Seventh Circuit
Nos. 08-1017, 08-1119
B RENDA P. H ELMS, Trustee,
Plaintiff-Appellant, Cross-Appellee.
v.
C ERTIFIED P ACKAGING C ORPORATION,
Defendant,
and
CPC A CQUISITION, INC.,
Intervenor-Appellee, Cross-Appellant.
Appeals from the United States District Court
for the Northern District of Illinois, Eastern division.
No. 07 C 702—George W. Lindberg, Judge.
A RGUED N OVEMBER 4, 2008—D ECIDED D ECEMBER 30, 2008
Before P OSNER, W OOD , and T INDER, Circuit Judges.
P OSNER, Circuit Judge. Sarah Michaels, Inc., a manufac-
turer of bath products and a customer of a packaging
2 Nos. 08-1017, 08-1119
manufacturer named Certified Packaging Corporation,
declared bankruptcy together with affiliated corporations
unnecessary to discuss separately. The trustee in bank-
ruptcy brought an adversary proceeding against Certified
seeking to avoid transfers that Michaels had made to
that company to pay for packaging. The trustee obtained
a default judgment for some $2 million but in an effort to
collect the judgment collided with LaSalle Bank, which, as
the assignee of a loan to Certified, claimed a security
interest in Certified’s assets. LaSalle in turn assigned its
claim to CPC Acquisition, which is the successor to Certi-
fied and which has intervened in the bankruptcy pro-
ceeding to assert the priority of its lien over the trustee’s
judgment lien. For the sake of simplicity we’ll pretend
that LaSalle was and remains the lender to Certified and
thus the adversary of the trustee in bankruptcy.
In December 2000, after LaSalle had made the loan, a fire
broke out at one of Certified’s plants and damaged equip-
ment in it. The plant was shut down for several weeks, and
the business losses resulting from the shutdown greatly
exceeded the damage to Certified’s property. Certified
brought two lawsuits (both in Illinois state courts) in the
wake of the fire. One was against its insurance broker,
Rothschild, for negligence in having failed to list the plant
on a business-losses insurance policy that Rothschild had
procured for Certified. That suit was settled for $88,000
after deduction of attorneys’ fees. The trustee contends that
the settlement money should belong to the bankrupt estate,
LaSalle that the money should belong to it as proceeds of
the collateral damaged in the fire. The bankruptcy judge
Nos. 08-1017, 08-1119 3
agreed with the trustee but was reversed by the district
judge, and the trustee appeals.
Certified’s other suit was against Commonwealth
Edison and claimed that the fire had been due to Com Ed’s
negligence in maintaining one of its power lines. In that
suit, which is pending, Certified seeks damages of
$2,000,000 for property damage and business losses, the
latter accounting for about 90 percent of the claimed
damages. The bankruptcy judge, seconded by the district
judge, ruled that the business-losses part of Certified’s
claim against Com Ed belongs to the trustee in bank-
ruptcy, not to LaSalle. The cross-appeal challenges that
ruling.
So we must decide whether the negligence claim against
Rothschild for business losses, and the parallel claim
against Certified, or either, or neither, are part of LaSalle’s
security interest. The issues are governed by the Uniform
Commercial Code, as interpreted by the Illinois courts.
The loan agreement between LaSalle and Certified
gave LaSalle a security interest in the equipment
damaged in the fire. If a suit against someone who
steals or damages collateral eventuates in an award
measured by the diminution in the value of the collateral
caused by the defendant’s wrongdoing, so that the
award restores the original value of the collateral, the
award, like an insurance payment for damaged collateral,
constitutes “proceeds” of the collateral and is therefore
covered by the lender’s security interest. UCC §§ 9-
102(a)(64)(D) (proceeds include, “to the extent of the value
of collateral, claims arising out of the loss, nonconformity,
4 Nos. 08-1017, 08-1119
or interference with the use of, defects or infringement of
rights in, or damage to, the collateral”), (E); McGonigle v.
Combs, 968 F.2d 810, 828-29 (9th Cir. 1992); In re Wiersma,
324 B.R. 92, 106 (B.A.P. 9th Cir. 2005), reversed on other
grounds, 483 F.3d 933 (9th Cir. 2007); In re Territo, 32 B.R.
377, 379-80 (Bkrtcy. E.D.N.Y. 1983); Richard F. Duncan et
al., The Law and Practice of Secured Transactions: Working with
Article 9 § 2.05[3], pp. 2-57 to 2-58 (2008); R. Davis Rice,
“McCullough v. Goodrich & Pennington Mortgage Fund, Inc.:
Are Secured Creditors Really ‘Secure’ from Third Party
Impairment of Collateral?,” 59 S. Car. L. Rev. 455, 467-70
(2008); Lynn M. LoPucki & Elizabeth Warren, Secured
Credit: A Systems Approach 205-06 (2d ed. 1998).
If Certified’s suit against Com Ed succeeds, it will be
as if Com Ed had converted some $200,000 of the col-
lateral for LaSalle’s loan and was therefore obliged
to repay it; and “an action for conversion is a proper
remedy for a secured party to bring against a third
party when its collateral has been disposed of by the
debtor.” Taylor Rental Corp. v. J.I. Case Co., 749 F.2d 1526,
1529 (11th Cir. 1985); see also UCC § 9-315, comment 2;
Bartlett Milling Co., L.P. v. Walnut Grove Auction & Realty
Co., 665 S.E.2d 478, 488-89 (N. Car. App. 2008); Farmers
State Bank v. Easton Farmers Elevator, 457 N.W.2d 763,
766 (Minn. App. 1990). And so the judgment obtained
in that suit would constitute proceeds of the collateral
up to its value. That is why LaSalle’s entitlement to
the property-damage component of Certified’s claim
against Com Ed is unchallenged, and it is why if
Rothschild, the insurance broker, had failed to obtain
insurance coverage for damage to the physical assets that
Nos. 08-1017, 08-1119 5
secured LaSalle’s loan, the claim against the broker rather
than for loss of business would be a claim to proceeds of
the collateral.
But the claim against Rothschild was for failure to obtain
business-loss insurance, and w e d o n ot see
how compensation for that failure can be considered
proceeds of collateral. The usual proceeds of collateral
are the money obtained from selling it. By a modest
extension, as we have just seen, they are money
obtained in compensation for a diminution in the value of
the collateral. But replacing a business loss is not restoring
the value of damaged collateral. There is no necessary
relation between the value of collateral and a business loss
that results from its being destroyed or damaged—as this
case illustrates: the business losses exceeded the impair-
ment of the value of the collateral ninefold. The claim of a
secured creditor to the proceeds of collateral cannot exceed
the value of the collateral. UCC § 9-102(a)(64)(D), (E); In re
Tower Air, Inc., 397 F.3d 191, 199 and n. 10 (3d Cir. 2005); In
re Stevens, 130 F.3d 1027, 1030 (11th Cir. 1997). Recall the
qualification in the definition of proceeds in UCC § 9-
102(a)(64)(D): “to the extent of the value of collateral.”
The district judge was therefore wrong to treat the
$88,000 settlement of Certified’s claim against Rothschild
for failing to procure business-loss coverage as proceeds of
damaged collateral. But LaSalle has another ground for
claiming a security interest in Certified’s business-loss
claim against Rothschild, as well as against Common-
wealth Edison. A provision in LaSalle’s loan agreement
with Certified says that the collateral for the loan includes
6 Nos. 08-1017, 08-1119
“Commercial Tort Claims listed on Schedule B” of the
agreement. Certified’s claims against both Rothschild and
Com Ed are commercial tort claims. UCC § 9-102(a)(13)(A).
So if, as LaSalle contends, the loan agreement gave it a
security interest in any tort claim filed by Certified, it is
entitled to enforce that interest against the settlement that
Certified made with Rothschild and against any judgment
or settlement that Certified may obtain from Com Ed.
But Schedule B is a blank piece of paper except for its
title (“SCHEDULE B: Commercial Tort Claims”). The
agreement was amended after the fire yet states that
Certified “has no Commercial Tort Claims pending other
than those set forth on Schedule B hereto as Schedule B
may be amended from time to time. [Certified] shall notify
[LaSalle] promptly upon becoming aware of any Com-
mercial Tort Claims of [Certified] which may arise, which
notice shall constitute [Certified’s] authorization to
amend Schedule B to add such Commercial Tort Claim.”
Schedule B was never amended to add any claims.
No matter, argues LaSalle. Its UCC financing statement
claimed collateral in all of Certified’s assets, expressly
including “Commercial Tort Claims,” and anyway the
purpose of providing notice of liens is to protect subse-
quent creditors, and there were none. “[T]he purpose of
the financing statement is to put third parties on notice
that the secured party who filed it may have a perfected
security interest in the collateral described, and that
further inquiry into the extent of the security interest is
prudent.” Magna First National Bank & Trust Co. v. Bank of
Illinois, 553 N.E.2d 64, 66 (Ill. App. 1990); see also GP Credit
Nos. 08-1017, 08-1119 7
Co., LLC v. Orlando Residence, Ltd., 349 F.3d 976, 982-83 (7th
Cir. 2003). “The financing statement is an abbreviation
of the security agreement. It is a streamlined paper to be
filed for the purpose of giving notice to third parties of the
essential contents of the security agreement.” 1 Eldon H.
Reiley, Security Interests in Personal Property § 7:3, pp. 7-3 to
7-4 (3d ed. 1999).
Because the loan agreement authorized LaSalle to
amend Schedule B to add any commercial tort claims
that it might acquire, its failure to do so after Certified
had notified LaSalle of both commercial tort claims was,
LaSalle argues, an innocent mistake that harmed no one,
and such mistakes, even when unilateral (that is, made
by only one of the parties to the contract), are forgivable;
that at least is the standard response of contract law.
Donovan v. RRL Corp., 27 P.3d 702 (Cal. 2001); In re UAL
Corp., 411 F.3d 818, 823-24 (7th Cir. 2005); Midwest Com-
merce Banking Co. v. Elkhart City Centre, 4 F.3d 521, 525 (7th
Cir. 1993); Market Street Associates Limited Partnership v.
Frey, 941 F.2d 588, 594 (7th Cir. 1991); Restatement (Second)
of Contracts § 153, illustration 1 (1981); E. Allan Farnsworth,
Contracts § 9.4, p. 615 (4th ed. 2004). Anyone contem-
plating lending money to Certified would have seen
“Commercial Tort Claims” in the financing statement
(filed in the pertinent UCC registry) and, LaSalle argues,
would have called LaSalle to ask whether there were any
such claims and would have learned about the two law-
suits. And while the fact that no creditor relied on the
failure to amend Schedule B to add the tort claims against
Rothschild and Com Ed is irrelevant because a trustee
in bankruptcy has the rights of a hypothetical secured
8 Nos. 08-1017, 08-1119
creditor, In re Vic Supply Co., 227 F.3d 928, 931 (7th Cir.
2000), LaSalle argues that any creditor would have been
put on notice by the financing agreement and, thus
warned, would quickly have discovered the claims.
Well, that is not true. A prudent potential creditor
would have requested a copy of the security agreement
because that, and not what an existing creditor’s employee
might tell the potential creditor over the phone, is the
security interest that the parties to the security agreement
had agreed to create. The prudent potential creditor would
have read the relevant portion of the agreement, seen that
Schedule B was blank, and concluded—and would have
been reasonable in concluding—that LaSalle had no
security interest in Certified’s tort claims.
Furthermore, section 9-203(b)(3)(A) of the UCC provides
that a security interest is enforceable against a subsequent
creditor (or, as in this case, a trustee in bankruptcy ac-
corded the status of a hypothetical secured creditor) only
if “the debtor has authenticated a security agreement that
provides a description of the collateral” (emphasis added). The
purpose of the financing statement is to place would-be
subsequent creditors on notice that a creditor has a
security interest in the debtor’s property; it is the security
agreement, which in this case is the part of the loan
contract that contains the grant to the lender of a security
interest, that defines that interest and by defining limits
it. UCC § 9-102(a)(73); Signal Capital Corp. v. Lake Shore
National Bank, 652 N.E.2d 1364, 1371 (Ill. App. 1995); Allis-
Chalmers Corp. v. Staggs, 453 N.E.2d 145, 148-49 (Ill. App.
1983); In re Martin Grinding & Machine Works, Inc., 793
Nos. 08-1017, 08-1119 9
F.2d 592, 594-95 (7th Cir. 1986) (Illinois law); Northwest
Acceptance Corp. v. Lynnwood Equipment, Inc., 841 F.2d 918,
922 (9th Cir. 1988); In re Macronet Group, Ltd., 2004 WL
2958447, at *3-4 (Bkrtcy. N.D. Ill. 2004). Hence less detail
is required in the financing statement. UCC § 9-504;
Richard F. Duncan et al., supra, § 2.02[5][d], pp. 2-22.2 to
p. 2-24; cf. 4 James J. White & Robert S. Summers, Uniform
Commercial Code § 31-3, pp. 107-09 (5th ed. 2004).
In other words, “The security agreement embodies
the intention of the parties and is the document which
creates the security interest. ‘It is the primary source to
which a creditor’s or potential creditor’s inquiry is
directed and must be reasonably specific.’ In re Laminated
Veneers Co., 471 F.2d 1124, 1125 (2d Cir. 1973). The financ-
ing statement on the other hand need not particularize in
detail the collateral secured under the security agreement
because in accordance with the ‘notice filing’ concept
adopted under the Uniform Commercial Code a financing
statement serves to give notice that the secured party who
filed may have a security interest in the collateral and that
further inquiry with respect to the security agreement will
be necessary to disclose the complete state of affairs. Thus,
while the financing statement may be adequate, it is the
security agreement which must resolve the question as to
adequacy of the description of the collateral.” In re Fagan,
1979 WL 30029, p. 2 (S.D.N.Y. June 19, 1979) (citation
omitted). So the prudent creditor need look no further than
the security agreement. In re Martin Grinding & Machine
Works, Inc., supra, 793 F.2d at 596-97; In re Laminated Veneers
Co., supra, 471 F.2d at 1125.
10 Nos. 08-1017, 08-1119
For many kinds of collateral, the description in the
security agreement need only name the type of collateral.
See UCC § 9-108(b)(3); Reiley, supra, §§ 10:14, 10:18, pp. 10-
17, 10-20 to 10-21, such as accounts, equipment, and
negotiable instruments, UCC §§ 9-102(a)(2), (33), (47). But
that is not true of commercial tort claims. Id., § 9-108(e).
Had the security agreement between LaSalle and Certified
been amended to define the collateral as including “all
commercial tort claims relating to the fire at Certified’s
facility,” that would have sufficed, § 9-108, for all that the
section requires is that the description of a commercial
tort claim “contain[] a descriptive component beyond the
‘type’ alone,” id., comment 5, such as: “All of debtor’s
rights to damages or compensation, including insurance
proceeds, arising out of destruction of business property
located at ____ [and/or which claims are currently
pending as Cause No. 123 in the Superior Court of ____
County, State of ____.] or Debtor’s claim for [identify tort]
against [identify defendant].” Reiley, supra, § 10.18, pp. 10-
25 to 10-26. But nowhere in the loan agreement is there
even an allusion to Certified’s two tort claims. The agree-
ment does not mention them and while it purports to grant
LaSalle a security interest in after-acquired property, such
a grant is ineffective when the property is a commercial
tort claim. UCC § 9-204 and comment 4. That is a corollary
of the requirement that such claims be described with
greater than usual specificity; a claim that has not yet come
into being when the security agreement is drafted cannot
be described at all.
LaSalle’s reliance on In re Vic Supply Co., supra, is unavail-
ing, despite the superficial resemblance of that case to
Nos. 08-1017, 08-1119 11
this one. By what was obviously just an oversight the
lender had failed to sign the loan agreement, though he
continued to extend credit to the borrower in accordance
with the agreement’s terms. A subsequent lender wanted
to knock out the previous lender’s security interest on the
basis of the defect. We ruled that he could not do that. The
agreement adequately described the collateral and was
signed by the borrower. It was thus in full compliance with
what section 9-203(b)(3)(A) now requires for a security
interest to trump a subsequent creditor, In re Vic Supply Co.,
supra, 227 F.3d at 931-32; Sears v. Conry, 748 N.E.2d 1248,
1249-50 (Ill. App. 2001); Duncan et al., supra, § 2.02[2], p. 2-
7, and what section 9-203(1)(a) required when Vic Supply
was decided, the only relevant difference being that the
current provision permits electronic authentication in lieu
of the debtor’s signature.
LaSalle invokes the “composite document” line of cases,
see, e.g., Gibson County Farm Bureau Co-Operative Ass’n v.
Greer, 643 N.E.2d 313 (Ind. 1994); In re Bollinger Corp., 614
F.2d 924 (3d Cir. 1980); In re Numeric Corp., 485 F.2d 1328
(1st Cir. 1973), which hold that “a writing or writings,
regardless of label, which adequately describes the collat-
eral, carries the signature of the debtor, and establishes
that in fact a security interest was agreed upon, would
satisfy both the formal requirements of the statute [for
a valid security agreement] and the policies behind it.” Id.
at 1331; see also 4 White & Summers, supra, § 31-3, pp. 103-
06. But the issue in this case is not (as in Vic Supply)
whether there was a valid security agreement, as there
obviously was, but whether the agreement adequately
described the collateral in contention, which obviously it
12 Nos. 08-1017, 08-1119
did not. A hypothetical lien creditor reading the financing
statement, the security agreement, and Schedule B to the
security agreement wouldn’t have had a clue that LaSalle
had a security interest in Certified’s tort claims against
Rothschild and Com Ed.
The district court’s decision is affirmed insofar as the
claim against Com Ed that seeks damages in excess of the
damaged collateral is concerned, but is reversed with
respect to the $88,000 claim against Rothschild. In
short, the decision of the bankruptcy court, denying all
business-loss relief to LaSalle’s successor, CPC Acquisition,
is reinstated.
12-30-08