1. What did the bank do to the debtor’s account?

2. What would happen if banks were permitted to take proceeds deposited by creditors into their accounts?

3. Who has priority in the funds, the bank or GMAC?

General Motors Acceptance Corporation (GMAC) financed the inventory of Donohue Ferrill Motor Company, Inc., which gave GMAC a security interest in its vehicle inventory and all the proceeds of that inventory. The security agreement and financing statements were executed, and GMAC properly filed the financing statements.

Shortly before Donohue Ferrill’s business failed, it sold six trucks and then deposited the proceeds of $124,610.80 from the sale of those trucks into its account at Lincoln National Bank. Lincoln took the deposited funds and applied them to account overdrafts that Donohue Ferrill had. For 38 of the 62 business days of September, October, and November 1991, Donohue Ferrill’s account was overdrawn. Lincoln National honored 133 overdrafts during these three months and charged Donohue Ferrill a total of $1,995 in fees. The total amount of the overdrawn balances for those 38 days was $1,943,306.25.

GMAC objected, saying that it had priority in those funds. The trial court and court of appeals found for the bank and GMAC appealed.

JUDICIAL OPINION

LAMBERT, Chief Justice … The issue presented is whether a bank may apply the cash proceeds of collateral to overdrafts allowed a depositor, thereby defeating established priorities. GMAC based its claim upon KRS 355.9-306(2), which states

Except where this article otherwise provides, a security interest continues in collateral notwithstanding sale, exchange or other disposition thereof unless the disposition was authorized by the secured party in the security agreement or otherwise, and also continues in any identifiable proceeds including collections received by the debtor.

Where cash proceeds are covered into the debtor’s checking account and paid out in the operation of the debtor’s business, recipients of the funds of course take free of any claim which the secured party may have in them as proceeds. What has been said relates to payments and transfers in ordinary course. The law of fraudulent conveyances would no doubt in appropriate cases support recovery of proceeds by a secured party from a transferee out of ordinary course or otherwise in collusion with the debtor to defraud the secured party.

Payment of an overdraft by a bank is of the nature of a loan to the account owner and is premised upon the condition of repayment. Thus, Lincoln National made loans to Donohue Ferrill in the amount of the overdrafts paid. Since the bank had no security for such loans, it was an unsecured creditor of Donohue Ferrill. Thus, as an unsecured creditor, Lincoln National was without any right to take or retain assets of Donohue Ferrill that were subject to the perfected security interest of other secured creditors. The trial court and the Court of Appeals found such an exception in Official Comment 2(c) to the UCC § 9-306 (KRS 355.9-306), holding that the proceeds of the collateral used to cover prior overdrafts were transferred out of Donohue Ferrill’s account in the ordinary course of business. We disagree with this interpretation. Although the commentary provides an exception for proceeds from the debtor’s checking account and paid in the ordinary course of the operation of the debtor’s business, this exception does not apply when a bank seizes funds deposited in a customer’s account and applies such funds to payment of overdrafts or antecedent debts. Such an interpretation would eviscerate the security interest in proceeds of collateral contrary to KRS 355.9-306(2) and permit a bank that had made an unsecured loan to leapfrog secured creditors. ………………..