Secured Creditor Is Entitled to Recover Fully Repaired Collateral and Insurance Proceeds for Damage to the Collateral
May 16, 2005
Michael Weissman - Chicago
Applying old Article 9 (9-306), the court in In re Tower Air, Inc., 397 F.3d 191 (3rd Cir. 2005) held that a secured creditor may recover not only its fully repaired collateral but also the insurance proceeds generated by damage to the collateral. However, the holding must be considered in the context of this case wherein the secured creditor was able to establish that it was not reaping a windfall since it had other collateral for the debt that had been damaged while in the hands of the debtor.
On May 6, 1996, Tower Air, Inc. (Tower) borrowed $21 million from Finova Capital Corporation (Finova) to finance the purchase of a Boeing 747 and four aircraft engines. At that time, a security agreement, promissory note and mortgage were executed giving Finova a security interest in the plane and the engines. The documents stated that any insurance proceeds were part of Finova’s collateral. And Tower agreed to maintain insurance coverage on the collateral and to get Finova’s approval for any use of the insurance proceeds.
Finova had also financed a number of Tower’s other aircraft purchases and had cross-collateralized all of these loans. Finova perfected its secured position by filing UCC financing statements centrally and locally in New York1 and by filing the mortgage with the Federal Aviation Administration.
On February 29, 2000, Tower filed a Chapter 11 petition and operated as a debtor-in- possession until December 2000 when it converted to Chapter 7 and a trustee was appointed. When Tower went into bankruptcy, it owed Finova $56 million. During the bankruptcy, one engine that had been damaged but was fully repaired by the debtor, was returned to Finova. The total value of all collateral returned to Finova was $36 million leaving it undersecured by $20 million.
The trustee learned that Tower had an accident insurance policy, with a $1 million deductible, on the repaired engine and filed a claim for $1,951,503 which he settled for $951,503 in May of 2001. The bankruptcy court authorized the settlement, but because both Finova and the trustee were claiming the funds, directed that the money be deposited in escrow.
The trustee in bankruptcy argued that Finova was not entitled to the $951,503 because (a) those monies did not constitute proceeds under the UCC and (b) giving Finova both the repaired engine and the insurance proceeds would provide a windfall.
The court had little difficulty in ruling that the insurance money was proceeds in light of Section 9-306 of the UCC stating that “Insurance payable by reason of loss or damage to the collateral is proceeds … .”
The more challenging question was whether granting Finova the insurance money would generate a windfall, the court noting that the UCC comments provide that “The secured party may claim both proceeds and collateral, but may of course have only one satisfaction.” (Section 9-306, comment 3).
In applying the “one satisfaction” rule the court said the difficult case is where the value of the original collateral plus the insurance proceeds exceeds the value of the original collateral but is less than the total amount of the debt. And that, said the court, was the case before it.
Directing attention to the cross-collateralization of the various loans Finova made to Tower, the court said the original value of the Finova’s collateral was not just the disputed aircraft engine but was all of the collateral that secured Finova’s loans. Apparently, much of this collateral had been damaged while in use by Tower. Because the other collateral had been damaged or destroyed, there was no windfall to Finova since the insurance proceeds only partially compensated Finova for the damage to, or destruction of, other items of its collateral. With the overall value of Finova’s collateral still impaired, even after the award of the insurance proceeds, there was no windfall to Finova and only one satisfaction.
Finally, the court said its conclusion was bolstered by the fact that the loan documents gave Finova the right to approve Tower’s application of insurance proceeds and the further fact that it was named as a mortgage payee rather than simply a loss payee in the insurance policy.2
What’s the point?
The court’s decision is correct but is applicable only where the value of the debtor’s original collateral plus the insurance proceeds exceeds the value of the original collateral but is less than the total amount of the debt. It is likely to be applicable where, as in the instant case, there is cross-collateralization of collateral. But is the result different under Revised Article 9 due to the change in the definition of proceeds in Section 9-102 (64)?
For more information, e-mail Michael L. Weissman at
michael.weissman@hklaw.com or call toll free, 1-888-688-8500.
1 The court incorrectly noted that the New York filing was unnecessary overlooking the fact that it perfected Finova’s security interest in the aircraft’s avionics.
2 A mortgage payee is treated as having an independent contract with the insurer whereas a loss payee is merely a party designated to receive the policy proceeds to the extent of any interest it may have if the insured can collect under the policy.