In a case of first impression, the United States Court of Appeals for the Third Circuit has held that a secured creditor could collect insurance proceeds from an aircraft engine that had been damaged, even though the creditor already possessed the repaired engine.
The decision contains several caveats, but is advantageous to creditors and confirms a number of key steps creditors should take to draft effective security agreements for large-ticket pieces of equipment.
In Stanziale v. FINOVA Capital Corporation (In Re: Tower Air, Inc.), No. 03-3101 (3d Cir. Feb. 10, 2005), the court qualified its holding that the secured creditor could recover insurance proceeds for the engine in question by noting that even after gaining possession of the repaired engine, the creditor still was undersecured in its total loan amount to the debtor.
The court was careful to distinguish this case from circumstances in which recovery of insurance proceeds plus the underlying collateral would equal an amount greater than the debt owed.
Debtor Tower was an airline that purchased a Boeing 747 and four aircraft engines in 1996, obtaining $21 million in financing from FINOVA. Tower entered into a security agreement and executed both a promissory note and mortgage, giving FINOVA a security interest in the financed collateral including the engine at issue. The agreement stated that insurance proceeds of the engines were part of FINOVA’s collateral. Tower covenanted to maintain insurance on the aircraft, and submit any plans for use of insurance proceeds to FINOVA for approval.
Finova had financed other purchases by Tower, and executed cross-collateralization agreements on all loans by Tower. Finova perfected its security interest by filing UCC financing statements with the State of New York, with Queens County and by filing the mortgage with the FAA.
A little more than a year after the financing, the aircraft engine at issue was damaged in an in-flight accident. Tower repaired the engine without collecting insurance proceeds.
In 2000, Tower filed a voluntary Chapter 11 petition in the Bankruptcy Court for the District of Delaware, which was converted to Chapter 7. Finova claimed Tower owed it $56 million at the time of the bankruptcy filing. The engine in question was returned to Finova; however, the creditor alleged that other collateral was destroyed or impaired by Tower. Finova claimed the total value of returned collateral was $36 million, leaving it undersecured by approximately $20 million.
The bankruptcy trustee for Tower discovered the insurance policy on the engine that had been damaged, and made a claim that resulted in a payment of $951,503.26. Finova moved to claim the proceeds. The Bankruptcy Court awarded the proceeds to Finova, and the trustee appealed the award.
Under the parties’ security agreement, their dispute was governed by the Arizona UCC, which establishes a default rule that a security interest in property includes an interest in the proceeds of that property. The parties reinforced this default rule by specifically granting FINOVA a security interest in proceeds from the mortgage.
The trustee argued, however, that FINOVA should not be allowed to collect the insurance money after obtaining possession of the aircraft engine because this would amount to double recovery, which is forbidden by the UCC.
The Third Circuit acknowledged the UCC only allows “one satisfaction,” but noted that in this case, the value of the original collateral plus the proceeds still was less than the amount of the debt. The fact that FINOVA’s loans were cross-collateralized “is important,” the court stated, “because it eliminates any concern we might have about giving FINOVA a windfall.”
The court noted its conclusion was bolstered by the language of FINOVA’s agreement with Tower, which afforded FINOVA the “sole discretion” to decide to apply the insurance proceeds to the satisfaction of Tower’s debt, rather than repairing the engine.
In addition, FINOVA was designated as a mortgagee payee in the insurance policy covering the engine. A loss payee is “a mere appointee” whose rights to receive insurance proceeds are derivative to, and limited by, the rights of the insured. A mortgagee payee, however, has an independent agreement with the insurer.
The decision creates a road map for creditors to secure rights to insurance proceeds. They can do so by cross-collateralizing loans, specifically contracting to receive insurance proceeds, and by ensuring the insurance policy contains a “standard” or “union” clause, which confers upon the creditor the status of mortgage payee, as opposed to a “simple” clause, which only designates a party as a loss payee.