An October 2011 decision from the United States District Court for the Northern District of New York highlights the importance of correctly taking all of the steps necessary to obtain a security interest in commercial tort claims under the U.C.C.
In Algonquin Power Income Fund v. Christine Falls of New York, Inc., 2011 WL 6178802 (N.D.N.Y. 2011), Trafalgar Power, Inc. and Christine Falls of New York, Inc. (collectively, “Trafalgar”) borrowed $22.5 million in secured financing from an insurance company to develop six power plants. Approximately one year later, Trafalgar brought suit against the engineering firm that designed the power plants and one of its engineers for miscalculations that resulted in an estimate of energy production and thus income which far exceeded what the power plants were able to attain. After the loan was restructured, Algonquin Power Income Fund and its affiliates (collectively, “Algonquin”) purchased two notes that secured the loan.
The jury eventually ruled in Trafalgar’s favor in connection with the malpractice case and the parties later stipulated to a judgment amount of $11.1 million. After obtaining a settlement, Trafalgar assigned its interest in the malpractice judgment to one if its affiliates. Trafalgar and its affiliates then filed for Chapter 11 bankruptcy protection.
Algonquin, wanting to collect on the settlement proceeds, sought legal relief in bankruptcy court, claiming a security interest in the malpractice claim and the proceeds of the claim. The bankruptcy court held in favor of Trafalgar and on appeal, the district court affirmed the bankruptcy court’s decision on collateral estoppels grounds, without reaching the merits. This affirmance was deemed error by the Second Circuit, which vacated the decision and remanded to the district court for consideration of the merits of Algonquin’s claim of a security interest in the malpractice claim and its proceeds.
On remand, the district court first determined whether or not a security interest could be granted under Connecticut law in a malpractice suit. The court decided that a malpractice action is not assignable under Connecticut law and that, although the security agreement described the collateral as “any interest in any kind of property or asset, whether real, personal or mixed, and whether tangible or intangible,” this description was not sufficiently particular under state common law to cover the malpractice claim.
Likewise, had Revised Article 9 of the U.C.C. applied, the court would have reached the same decision because Section 9-108(e)(1) requires heightened specificity when describing commercial tort claims in security agreements. A description of collateral as “all commercial tort claims” is insufficient to meet the requirement for attachment, as is the general description in Algonquin’s security agreement.
The court then addressed Algonquin’s claim that even if a security interest never attached to the malpractice claim, it did obtain a security interest when the claim was “transformed to a judgment, bond claim, contract claim, and interest in an escrow account.” The security agreement granted Algonquin a security interest in contract rights, general intangibles and all accounts and other receivables, and although the court found support in Algonquin’s proposition that a contingent right to an escrow fund is a general intangible, it ultimately rejected Algonquin’s transformation argument. According to the district court, Algonquin failed to present any case law suggesting that that a security interest arose upon the malpractice claim (in which Algonquin did not have a security interest) transforming into a contract right. Affirming the bankruptcy court’s decision, it held that “[i]f the security agreement does not expressly grant a security interest in the underlying tort claim or its proceeds, no subsequent transformation will magically result in an automatic attachment of those proceeds.”
The final decision on these issues remains to be determined, as Algonquin appealed the decision of the district court. Regardless, practitioners and their clients would be best served by describing with specificity any commercial tort claims in which they wish to obtain a security interest.
