Paulman v. Gateway Venture Partners III, L.P. (In re Filtercorp, Inc.)

Citation: 163 F.3d 570Docket: No. 97-35483

Court: Court of Appeals for the Ninth Circuit; December 13, 1998; Federal Appellate Court

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Under Washington law, a security agreement that grants an interest in "inventory" or "accounts receivable" is presumed to include after-acquired property unless there is evidence indicating a contrary intent. The bankruptcy court and Bankruptcy Appellate Panel previously required an explicit after-acquired property clause to secure such interests, but this ruling has been reversed. In the case between Henry Paulman and Filtereorp, Inc., it was determined that Paulman had a security interest in after-acquired accounts receivable, but not in after-acquired inventory, as the security agreement limited inventory collateral by referencing an attached inventory listing that was never provided. Paulman’s additional claims—including arguments regarding the bankruptcy court’s asset sale order, refusal to subordinate other creditors' claims, and denial of adequate discovery—were rejected.

Paulman had provided a series of short-term loans to Filtereorp, Inc., secured by a June 1992 promissory note referencing accounts receivable and inventory. Despite the note indicating a security interest, there was no separate security agreement executed, and a UCC-1 filing identified the collateral without including the promised inventory listing. There was ambiguity regarding the parties' intent about securing future inventory and accounts receivable, with Paulman believing it was meant to cover after-acquired assets, while Filtereorp's president contended that the short loan term did not support an ongoing security interest. Following Filtereorp's default on the note, Paulman successfully litigated for a judgment of $710,572.81 in 1995. Meanwhile, in December 1992, while the litigation was ongoing, Filtereorp transferred its operating assets to a newly formed limited partnership, leaving it with only its limited partnership interest as an asset.

In early 1995, Filtercorp LP secured loans totaling approximately $355,000 from Gateway Venture Lenders III, Charles Brickman, and Donald Eskes, who were insiders of Filtercorp. On February 24, 1995, Filtercorp issued promissory notes for these loans, backdating them, and granted Gateway Lenders a blanket security interest in all its assets, including after-acquired property. Gateway Lenders perfected their security interest by filing a financing statement on March 1, 1995.

In November 1995, after Paulman initiated collection efforts on his judgment against Filtercorp, the company filed for voluntary Chapter 11 bankruptcy and sought court approval to use cash collateral. During bankruptcy proceedings, Filtercorp revealed a pending offer from Gateway Lenders to purchase its assets, which included a credit bid against their secured debt and cash for unsecured assets, along with a provision to escrow proceeds from inventory sales due to competing lien claims with Paulman.

On January 11, 1996, Filtercorp filed an adversary proceeding to address these conflicting claims. Paulman opposed the sale, arguing it was not an arm's-length transaction due to the buyers being insiders, and requested time to evaluate the proposal but did not pursue formal discovery. The court scheduled a hearing for February 27, 1996, to consider the sale and provide Paulman an opportunity to present a competing offer.

At a February 9 hearing, the court noted the company’s assets were potentially wasting and directed parties to file summary judgment motions regarding their competing liens. Ultimately, the bankruptcy court granted summary judgment to Gateway Lenders, concluding that Paulman had no security interest in Filtercorp’s assets, as his liens did not attach to after-acquired property, and none of the remaining assets could be traced back to those existing at the time of his security interest creation. The court found Gateway Lenders’ security interest to be valid and first in priority.

The security interests granted to Gateway Lenders for advances made prior to February 24, 1995, were invalidated as preferential, leaving them with $225,000 in secured debt. Gateway Lenders submitted both a credit and cash bid of $225,000, which was approved by the court, despite Paulman not submitting a revised bid or seeking a stay of the sale order. The sale was completed, transferring assets to Gateway Lenders, who then transferred them to a new corporation, FiberCarb. Actions taken with the sale proceeds included hiring personnel and managing leases. Paulman appealed the sale and the summary judgment, but the Bankruptcy Appellate Panel (BAP) affirmed the bankruptcy court’s decisions, stating that Paulman’s appeal of the sale order was moot due to his failure to obtain a stay, the good faith status of Gateway Lenders, and a lack of due process violation since he did not make formal discovery requests. The BAP also affirmed that express language in a security agreement is necessary for attaching after-acquired property and rejected Paulman's claims regarding the subordination of Gateway Lenders' claims and discovery opportunities. Paulman’s further appeals are under the jurisdiction of 28 U.S.C. 158(d), with the court affirming in part and reversing in part. The standard of review includes de novo for legal conclusions and clear error for factual findings. The mootness of the sale order was upheld, emphasizing that sales to good faith purchasers cannot be modified without a stay during appeal, which Paulman did not obtain. His arguments against the mootness ruling were found to be without merit, as the relief he sought was not applicable to the circumstances of the case.

Even if "effective relief" were a valid exception to mootness, it is unfeasible in this case due to the adverse effects on non-parties. The physical assets have been transferred to a new corporation, with leases signed, employees hired, and new liabilities incurred based on the sale's finality. Marketing rights and inventory have been sold to third parties. Paulman claims that equitable relief could be achieved through Gateway Lenders' escrow plan proposed during the asset sale approval; however, this is no longer viable since no escrow was created for the inventory proceeds after the bankruptcy court's ruling on priority. The court found Gateway Lenders to be a good faith purchaser under 11 U.S.C. 363(m), and this determination is not clearly erroneous. Good faith buyers act without fraud or collusion, and Paulman's unsupported allegations of bad faith lack evidence. He was provided with a receivables report and had the opportunity to submit a bid, though his priority was denied due to the summary judgment ruling. Gateway Lenders’ revised bid of approximately $450,000 was deemed to be for value, given that Filtercorp's assets were valued between $400,000 and $600,000. Paulman's due process claim regarding inadequate discovery is undermined by his failure to serve discovery requests or seek a continuance under relevant procedural rules. As the sale was not stayed, Paulman’s challenge is moot.

Regarding the summary judgment appeal from the bankruptcy court, it is moot if the appealing party did not obtain a stay, unless effective relief can be fashioned. Filtercorp and Gateway Lenders contend that the summary judgment ruling on security interest priority is intertwined with the sale order and thus should be subject to mootness. However, the BAP found potential for effective relief without undoing the sale, as approximately $107,000 remains in the bankruptcy estate. If Paulman were recognized as the first secured creditor, partial relief could be available from those funds without affecting the sale. Consequently, the appeal from the summary judgment is not moot. Paulman contests the summary judgment ruling that he did not secure an interest in after-acquired property, rendering him an unsecured creditor of Filtercorp.

On appeal, the court must assess whether any genuine issues of material fact exist and if the bankruptcy court applied the relevant law correctly, viewing evidence favorably for the nonmoving party. The creation of a lien on specific assets via a security agreement is determined by state law. Washington law has not been clearly defined regarding whether a security agreement that includes "inventory" or "accounts receivable" also applies to after-acquired property. The federal court's role is to predict how the Washington Supreme Court would rule on this matter.

The court acknowledges a division among jurisdictions concerning whether security interests in inventory or receivables inherently include after-acquired property in the absence of explicit language. While some jurisdictions require clear intent expressed in the agreement, the majority position supports the view that such interests presumptively encompass after-acquired property unless proven otherwise by the parties' intent. The court aligns with the majority perspective, indicating that a security interest in "inventory" and "accounts receivable" generally includes after-acquired interests, consistent with Uniform Commercial Code provisions.

Inventory and accounts receivable are characterized as "cyclically depleted and replenished assets," leading to the presumption of a floating lien due to their constantly changing nature. These assets are viewed collectively rather than as individual items, meaning no creditor would accept a security interest in collateral that could quickly diminish. A security interest on such collateral inherently covers after-acquired property without needing an explicit clause in the security agreement. The Uniform Commercial Code (U.C.C.) supports this view, allowing for a flexible approach to describing collateral as long as it reasonably identifies the assets involved. The presumption of floating liens aligns with the U.C.C.'s intent to liberalize rules regarding after-acquired property clauses. While some courts have rejected this presumption based on specific language in security agreements, the majority opinion holds that the cyclical nature of inventory and accounts receivable justifies the presumption, even in the absence of explicit language indicating the intent to cover all collateral types. This interpretation is reinforced by case law, including American Employers Ins. Co. v. American Sec. Bank, which supports the notion that the cyclical characteristics of the assets themselves underpin the presumption of a floating lien.

The American Employers court recognized inventory and accounts receivable as unique collateral types, often viewed as a single entity due to their constant turnover. The court asserted that describing collateral as "accounts receivable" sufficiently alerts potential creditors to the likelihood that the security agreement encompasses both present and future accounts receivable. The addition of "future" to the terminology was deemed unnecessary for clarity. The court held that security agreements granting interests in all inventory or receivables inherently include after-acquired assets, supported by a presumption favoring such inclusion. This presumption is generally upheld in jurisdictions following the American Employers interpretation, which suggests that a reasonable person would infer the intention to secure after-acquired assets despite the absence of explicit clauses.

However, this presumption can be rebutted if the agreement explicitly limits collateral to specified property, if clear evidence of intent to limit is presented, or if the business context indicates that the collateral does not regularly turn over. It is anticipated that, were this matter to be considered by the Washington Supreme Court, it would align with the prevailing view that after-acquired collateral is presumptively included in agreements referencing "inventory" or "accounts receivable," promoting uniformity in commercial transactions as per the Uniform Commercial Code.

In the specific case of the security agreement between Paulman and Filtercorp, the presumption for after-acquired accounts receivable remains intact, but is rebutted regarding inventory due to an attached inventory listing. The bankruptcy court found the parties' conflicting declarations regarding their intent inconclusive, a determination not deemed clearly erroneous, with no additional evidence of intent presented.

Paulman possesses a perfected security interest in Filtercorp's after-acquired accounts receivable, established by filing a UCC-1 financing statement prior to other creditors and before Filtercorp's bankruptcy. However, regarding the security interest in inventory, the note referred to an "attached inventory listing" that was never submitted with the note or financing statement. Paulman argues he did not attach the listing based on an agreement with Filtercorp's President, Bernard, to create a general security interest, including after-acquired inventory. Conversely, Bernard claims that after-acquired inventory was not discussed and he did not intend to include it due to the loans' short-term nature. The bankruptcy court found the conflicting evidence inconclusive, which is not clearly erroneous. The note's language suggests an intent to limit the collateral, indicating that after-acquired inventory is not included. Consequently, Paulman's ambiguity regarding the inventory security interest is construed against him, leading to the conclusion that he lacks a security interest in Filtercorp's after-acquired inventory. The judgment is reversed concerning the lien on accounts receivable and affirmed regarding the lien on inventory.

Paulman's request for equitable subordination or avoidance of Gateway Lenders' claims is denied. The bankruptcy court's decision is reviewed for abuse of discretion and found none. Equitable subordination requires evidence of inequitable conduct causing injury to other claimants or providing an unfair advantage, which Paulman failed to demonstrate. He alleged Gateway Lenders engaged in inequitable conduct by lending to Filtercorp while it was insolvent and backdating security agreements. However, insolvency alone does not warrant subordination, and the court requires more than mere undercapitalization to establish inequitable conduct. The case cited by Paulman is distinguishable from the current situation.

Insider creditors in the Herby’s Foods case did not contribute capital to the debtor corporation and executed a security agreement nearly a year after the loans. In contrast, Gateway Lenders provided $1.7 million to Filtercorp LP before issuing a loan of $355,000 and executed the relevant security agreement within two months of the initial loans, coinciding with the final loan. The bankruptcy court and the Bankruptcy Appellate Panel (BAP) found Gateway Lenders’ claim of a continuous loan transaction credible. However, the bankruptcy court deemed all security interests as preferential transfers, except for the one that became effective on February 24, 1995, making the backdating of other agreements irrelevant. Paulman’s argument that the February 24 security interest should be considered a preferential transfer also failed. Although Gateway Lenders filed its financing statement five days after creating the security interest, the bankruptcy court ruled it constituted a contemporaneous exchange for new value under 11 U.S.C. 547(c)(1)(A). Paulman argued that he was denied adequate discovery opportunities before the summary judgment; however, he never formally requested discovery or sought a continuance, and the court noted that Filtercorp’s assets were diminishing. The bankruptcy court was found not to have abused its discretion in this matter. The appellate court reversed in part and affirmed in part, remanding for further proceedings. It also clarified that the analysis for security agreements differs from that for financing statements and that a financing statement does not need to explicitly mention after-acquired property for an interest in such property to be perfected.

A security agreement can stipulate that obligations are secured by after-acquired collateral. However, under an after-acquired property clause, a security interest does not attach to consumer goods, except for accessions, unless the debtor obtains rights in them within ten days after the secured party provides value. The Official Comment to the UCC highlights the acceptance of a "continuing general lien," while rejecting historical biases against floating charges that sought to prevent borrowers from encumbering all their present and future assets for the protection of creditors. Importantly, a financing statement can secure after-acquired property even if it does not explicitly reference it. In this case, Paulman lacks interest in after-acquired inventory, and the bankruptcy estate does not include original inventory or traceable assets, preventing him from recovering from the estate based on his security interest in Filtercorp's inventory. Consequently, it is unnecessary to address whether the original description of the security agreement was flawed or whether discrepancies regarding his interest limit his security interest.