Introduction to Liens and Debtor-Creditor Law
Unpublished Manuscript
Copyright � 1985 and 1989 by Mark S. Scarberry
Here are materials I wrote several years ago as part of a projected multi-volume set on the Uniform Commercial Code. I now use the materials to provide an introduction to liens and to debtor-creditor law. See especially sections 1.08 through 1.11. Note that the citations are to the pre-1999 version of U.C.C. Art. 9. Permission is hereby granted for copying of these materials for classroom use provided that they are copied in their entirety, including this paragraph.
Mark S. Scarberry
Pepperdine Univ. Caruso School of Law
8/27/02
Chapter 1: A
Basic Introduction To Article 9 Secured Transactions
1.01����� Scope
Of Chapter
1.02����� Security
And The Idea Of The Lien
1.03����� Basic
Concepts
1.04� --
Attachment: Enforceability Against The Debtor
1.05� --
Perfection: Rights As Against Third Parties
1.06� --
Priority: Determining Which Claimant Has Superior Rights To
����� ����� The Collateral
1.07� --
Lien Avoidance In Bankruptcy: The Acid Test
1.08� The
Contrast Between The Rights Of Unsecured Creditors And
����� Article
9 Secured Parties
1.09� --
The Unpaid Unsecured Creditor's Rights
1.10� --
The Unpaid Secured Party's Superior Rights
1.11� --
Two Illustrations Of The Superiority Of The Secured Party's
����� ����� Rights
1.12����� Reasons
For Taking Security Under Article 9
1.13����� Reasons
For Giving Security Under Article 9
1.14����� Innovative
Features Central To Article 9
1.15� --
Uniform Applicability To All Security Interests Regardless Of
����� ����� Form Or Characterization By Parties
1.16 --
-- The Lease Intended As Security
1.17
-- -- Coverage
Of Other Security Devices That May Be Created
[Further sections omitted]
_________________
�1.01 Scope Of This Chapter
���� This
chapter is designed to provide an introduction to secured
transactions under Article 9. The important
concepts and innovative
features central to Article 9 are discussed.
The importance of Article
9 security is discussed both in terms of the
superiority of the secured
party's rights over those of an unsecured
creditor and in terms of the
extent of Article 9 secured financing in the
United States economy. The
basic questions of why to take security and
why to give security are
also discussed. This chapter will provide
helpful background
information
for the attorney who does not deal regularly with Article 9.
_________________
�1.02
Security And The Idea Of The Lien
Security in its broad sense includes any
circumstance that makes performance of an obligation more likely. For example,
a third party guarantee of a debt may be considered a form of security, since
it makes the payment of the debt more likely. A creditor who obtains the
guarantee of a credit-worthy third party may decide not to seek other security.
In its narrower sense, security means a right
to look to particular property for payment of an obligation. This property
right is called a "lien." In some sense a creditor who does not have
a lien ‑‑ an unsecured creditor ‑‑ also has a right to
look to the debtor's property (at least the debtor's non‑exempt property)
for repayment of the debt, through the process of enforcement of judgments.
However, the unsecured creditor has no property interest in the debtor's
property until he obtains a judicial lien through the process of enforcement of
judgments; the expense, delay, and uncertainty involved in that process leave
the unsecured creditor in a weak position.1
Liens may be imposed on the debtor's property
without his consent, as in the case of judicial liens,2 common law
and statutory liens,3 and
tax liens.4
Liens may also be created consensually, by
agreement of the debtor. Real property mortgages and deeds of trust create
consensual liens on real property, which are governed by the law of real
property. Article 9 governs consensual liens created in personal property, and
6in some cases in fixtures5; such liens, called "security"
interests,"6 are created by Article 9 "security
agreements,"7 which may take many forms.8 A creditor
who has an Article 9 security interest is called a "secured party."9
__________________
Footnotes
1.����� See
sections 1.09 and 1.11 below.
2. Judicial
liens are those liens obtained by a plaintiff through judicial process in the
course of obtaining and enforcing a money judgment. They include attachment and
execution liens, which are generally obtained by levy on specific property
under a writ of attachment or writ of execution. They also include judgment
liens, which are generally obtained either by recording of the judgment (or an
abstract of it) in the relevant real property records or simply by the
docketing of the judgment; judgment liens extend to all real property owned by
the debtor in the county in which the judgment is recorded or docketed. Cf. the
discussion of remedial equitable liens designed to remedy unjust enrichment at
section ______ below.
3. Common
law and statutory liens are those which arise by operation of law, without
agreement of the parties. They include artisans' liens in favor of those who
furnish services or materials to repair or improve personal property,
materialmen's and mechanics' liens in
favor
of those who furnish materials or services to repair or improve real property,
landlords' liens, and other types of liens.
4.��� See
26 USC �� 6321‑6323 (IRC �� 6321‑6323) (the federal tax lien
����� statutes).
Tax liens are actually a type of statutory lien, but
����� they
are very different from other statutory liens and merit
����� separate
discussion. See R. Jordan and W. Warren, Bankruptcy
537-38 (1985).
5.����� UCC
�� 9‑102(1), 9‑104(j).
6.����� UCC � 1‑201(37).
7.����� UCC � 9‑105(1)(1).
8.����� See UCC � 9‑102(2).
9.����� UCC � 9‑105(1)(m).
___________________
� 1.03 Basic
Concepts
The application of Article 9 to the various
phases of a transaction will be considered in detail in Chapter 2. It will be
helpful, however, to consider initially four basic concepts relevant to Article
9 security interests: attachment, perfection, priority, and lien avoidance in
bankruptcy.
___________________
� 1.04 --
Attachment: Enforceability Against The Debtor
For a security interest to be enforceable
against the debtor with respect to an item of collateral, it must have attached
to the item.1 If the security interest has attached to the
collateral, the secured party will have the rights discussed below2
to look to the collateral upon the debtor's default. For tangible collateral
this primarily means the right to take possession of the collateral and sell
it.3 For intangible collateral (such as accounts owed to the debtor)
this primarily means the right to make collections from the debtor's debtors4
(called "account debtors"5). If the security interest has
not at attached to the collateral, the would‑be secured party has no such
rights.6
Attachment of the security interest to an
item of collateral occurs when all three of the following requirements are met:
1.� the
debtor has signed a written security agreement that describes the collateral,
or the debtor has made an oral security agreement and the secured party is in
possession of the collateral pursuant to the debtor's agreement;
2.� the secured party has given value; and
���� ����� 3.����� the
debtor has obtained rights in the collateral.7
����� These requirements will be discussed in
detail in Chapter 2. Note however that "value" is defined broadly.8� For example, a creditor who takes a security
interest to secure a pre‑existing debt has given value for the security
interest ("new value" is not required).9 Further, binding
promises or contractual obligations can be value even before the promises or
obligations are carried out.� For
example, a binding commitment to extend credit is value.10 Also note
that if the debtor agrees to give a security interest in collateral which the
debtor plans to acquire, the security interest cannot attach to the collateral
until the debtor acquires the collateral, or at least some rights in it.11� Once a security interest has attached to
collateral it is enforceable against the debtor with respect to that
collateral. If it never attaches to any collateral (because, for example, the
debtor did not sign a written security agreement and the collateral is not in
the secured party's possession), then the creditor is unsecured.12
_________________________
Footnotes
1.�� UCC
� 9‑203(1), (2).
2.�� See
section 1.09 below.
3.�� See
UCC �� 9‑503 and 9‑504.
4.�� See
UCC � 9‑502.
5.�� � 9‑105(1)(a).
6.�� See
UCC � 9‑203, Official Comment 1.
7.� UCC � 9‑203(1).
8.� See UCC � 1‑201(44).
9.� UCC � 1‑201(44)(b).
10. UCC � 1‑201(44)(a), (d).
11.� UCC � 9‑203(1)(c). The point at which a
debtor's interest in the collateral is sufficient to constitute "rights in
the collateral"
���� is discussed below at section
12.� UCC
� 9‑203, Official Comment 5 (rejecting the theory that an oral
agreement creates an equitable lien
enforceable against the debtor
in the absence of a written agreement). But
see 1 Gilmore,
Security Interests In Personal Property
(hereinafter "Gilmore")
�� 345-46
(1965), in which the late Professor Gilmore, one of the
principal drafters
of Article 9, argues that Comment 5, which he wrote, overstates the case
against equitable liens.� See section
___________ below for a further discussion of equitable liens, including the
very different remedial equitable liens imposed by courts of equity to remedy
unjust enrichment.
__________________
� 1.05 --
Perfection: Rights As Against Third Parties
Attachment deals with enforceability against
the debtor; perfection deals with enforceability as against third parties who
have claims to the collateral.1 For example, after giving a security
interest in a piece of equipment ‑‑ say, a lathe ‑‑ to
the secured party, the debtor may sell the lathe to a purchaser who knows
nothing about the security interest. Unless the secured party perfected its
security interest before the sale to the purchaser, the secured party will
probably not have a security interest in the lathe in the hands of the
purchaser.2� Similarly, if a
debtor gives security interests in a drill press to two secured parties, and
only one of the secured parties perfects his security interest, the one who
perfected will have superior rights ("priority") in the drill press.3
Perfection of a security interest in an item
of collateral occurs when:
��� 1.��� the security interest attaches to the item,
and
���������� 2.����� any
further steps required by Article 9 are taken.4
In some cases Article 9 does not require any
further steps, so the
security interest is automatically perfected
when it attaches. For
example, if a seller sells goods (other than
a motor vehicle) to a buyer
for consumer purposes, and the seller retains
a security interest in the
goods to secure the unpaid portion of their
price, the seller's
"purchase money security interest in
consumer goods" will be
automatically perfected.5
Usually, however, Article 9 requires the
secured party to file a financing statement which covers the collateral or take
possession of the collateral to perfect a security interest in that collateral.6
(Depending on the type of collateral involved, the secured party may be able to
use 7 either method, may have to file, or may have to take possession.7)This
requirement reflects the concern, of ancient origin, that enforcement of
"secret liens" is unfair to creditors and other third parties.8
A financing statement usually is a bare‑bones
document that contains only the names and addresses of the debtor and secured
party, a statement indicating the types or describing the items of collateral
covered by the security interest, and the signature of the debtor.9
The security agreement itself does not have to be filed.10
Because the financing statement is filed in a
public officell and is indexed under the debtor's name,12
creditors and other persons who deal with the debtor can determine that a
security interest may exist.� They then
can inquire as to the details of the security agreement.13
Similarly, if the secured party has taken possession of the collateral, the
debtor's lack of possession of it is deemed sufficient to put
creditors
and other person s on notice that the debtor may not own the collateral free
and clear.14
_____________________
Footnotes
1.���� See,
e.g., UCC �� 9-301 and 9-312.
2.� See
UCC � 9-306(2), which provides that a security interest
��� continues
in collateral notwithstanding sale of the collateral,
��� unless
the secured party authorized the sale or unless Article 9
��� otherwise
provides. UCC � 9-301(1)(b) "otherwise provides" by
��� protecting
buyers from unperfected security interests. If the
��� lathe
were part of the debtor's inventory the buyer would likely
��� take
free of even a perfected security ,interest under UCC
��� �
9-307(1) as a buyer in ordinary course.
3.� UCC � 9-312(5). Actually the rule is that the first secured party
to file a financing statement or perfect its security interest has priority.
The example assumes that the unperfected secured party failed to file a
financing statement and failed to take possession of the drill press. If that
secured party filed a financing statement before the other secured party but
still does not have a perfected security interest because its security interest
never attached (e.g., there is no written security agreement), then the
security interest is not even enforceable against the debtor; that secured
party has no enforceable rights that can have any priority at all, and thus the
other secured party's perfected security interest would have priority.
4.����� UCC
� 9‑303(1).
5. ���� UCC
� 9‑302(1)(d).
6.� See UCC �� 9-302 (financing statement must be filed to perfect all
security interests, with certain exceptions), 9-302(1)(a) (providing exception
to filing requirement for security interest perfected by possession), and 9-305
(providing that security interest in certain types of collateral may be
perfected by possession).
7.����� See
section ________ below.
8. ����� See
1 Gilmore 438-39.
9. ����� See
UCC � 9-402(1).
10.����� UCC
� 9-402, Official Comment 2.
11.����� See
UCC � 9-401.
12.����� UCC
� 9-403(4).
13.� See
UCC � 9‑402, Official Comment 2.
14.� See
J. White and R. Summers, Handbook Of The Law Under The Uniform
Commercial Code (hereinafter White and
Summers) 933-34 (2nd Ed 1980).
_________________
� 1.06
‑‑ Priority: Determining Which
Claimant Has
Superior Rights To The Collateral
As illustrated in Section 1.05, two or more
parties other than the debtor may assert claims to the collateral. The question
then is which claimant has "priority," meaning the superior rights,
and which claimant is subordinate. As stated in Section 1.05, the secured party
usually must perfect its security interest to have priority over other
claimants.
However, eventual perfection of the security
interest is not a guarantee that the secured party will have priority. For
example, a perfected security interest will be subordinate to a judicial lien
which arose in the collateral before the security interest was perfected,1
or to the interest of an innocent buyer who bought the collateral from the
debtor before the security interest was perfected.2� Thus the timing of perfection is often
crucial.
Further, in many cases two secured parties
each have a perfected security interest in the collateral. If both have
perfected security interests it might seem reasonable to give priority to the
one who perfected first. However, Article 9 gives priority to the first one who
either perfects its security interest in the collateral or files a financing
statement that covers the collateral.3� Recall that a security interest cannot be perfected until it
attaches.4� Article 9 permits
the secured party to file a financing statement before the security interest
attaches to the collateral;5 such a pre‑attachment filing
cannot perfect the security interest, but it can establish priority as against
other secured parties. The "first to file or perfect" rule gives the
secured party an incentive to file as early as possible.6
Special rules apply to purchase money
security interests under Article 9. A credit seller who takes a security
interest in the collateral to secure part or all of its price has a purchase
money security interest.7 A lender who lends money to the debtor to
acquire the collateral, and who takes a security interest in the collateral to
secure that loan, has a purchase money security interest, if the debtor in fact
uses the loan proceeds to acquire the collateral.8� A purchase money security interest in
collateral other than the debtor's inventory has priority over all other
security interests and almost all judicial liens if it is perfected within ten
days after the debtor receives the collateral.9� For reasons to be discussed below, there are
stricter requirements for a purchase money security interest in the debtor's
inventory to qualify for special purchase money priority as against other
secured parties.10
There are other priority rules which govern
the rights of secured parties as against purchasers of collateral (such as the
favored buyer in ordinary course"11 ), holders of statutory or
common law liens,12 and other parties. Chapter 2 discusses all of
the priority rules in detail.
_____________
Footnotes
1. ����� UCC
� 9‑301(1)(b) and Official Comment 3 thereto. Section
���� 9‑301(1)(b)
could be interpreted as subordinating only security
���� interests
which are in existence (attached) and unperfected as of
���� the
time the judicial lien arises. However, it is actually
���� interpreted
to mean that any security interest which is perfected
���� after
the judicial lien arises (or which is never perfected) is
���� subordinate.
Thus, any security interest that attaches to
���� collateral
after a judicial lien has arisen in the collateral will
���� be
subordinate, even if it is perfected the instant it attaches.
2.����� UCC
� 9-301(1)(c).
3.����� UCC
� 9-312(5).
4.����� See
section 1.05 above.
5.�� UCC � 9-303(1) and Official Comment 1
thereto; UCC � 9-402(1) and Official Comment 2 to � 9-402.
6.�� See section �� ��below for a description of the circumstances
under which a secured party would "pre-file."
7.����� UCC
� 9-107(a).
8.����� UCC
� 9-107(b).
9.����� UCC
� 9-312(4).
10.����� See
UCC � 9-312(3) and section ����� �below.
11.����� See
UCC � 9-307(1).
12.����� See
UCC � 9‑310.
__________________
�1.07 ‑‑
Lien Avoidance In Bankruptcy: The Acid Test
When the debtor enters a bankruptcy
proceeding, the debtor's trustee in bankruptcy (or the debtor-in-possession in
a Chapter 11 reorganization) has powers which he can use to try to avoid liens,
including security interests. If the trustee succeeds, he will have saved more
of the debtor's assets for distribution to the general unsecured creditors whom
he represents. The secured party whose security interest is avoided then
becomes one of those unsecured creditors, at least if she has no other
security. Since unsecured creditors typically receive very little in
bankruptcy, the secured party is vitally concerned with whether the security
interest will be avoided
in bankruptcy. This has been termed the
"acid test" for security
interests.1
����� The
trustee in bankruptcy has two major powers to attack security
interests. They are the "hypothetical
lien creditor" power2 and the
power to avoid preferences.3 The
former power permits the trustee to
avoid most security interests that are
unperfected when the petition in
bankruptcy is filed.4 The latter
power permits the trustee in many
cases to avoid security interests which are
either acquired by the
secured party to secure a pre-existing debt5
_or which are perfected more than ten days after they attach.6
The possibility of a security
interest being avoided in the debtor's
bankruptcy proceeding makes it
extremely hazardous for the secured party to
delay in perfecting its
security interest. The prudent secured party
will therefore make sure
that the security interest is perfected as
soon as it attaches, or, if
that is not possible, that it is perfected
within ten days after
attachment.
����� The
debtor also has an avoiding power in bankruptcy. The debtor
can avoid non-possessory, non-purchase money
security interests in
certain property (such as household goods)
that the debtor could
otherwise exempt.7� Secured parties who take possession of the
collateral (e.g., pawnbrokers), and secured
parties who are careful to
obtain and maintain8 purchase
money status are not affected.
_____________________
Footnotes
1.��� White
and Summers 993.
2.��� See
Bankruptcy Code � 544(a)(1).
3.��� See
Bankruptcy Code � 547.
4.��� Section
544(a)(1) gives the trustee the state law rights of a
hypothetical lien creditor who obtained a
judicial lien in all of
��� the
debtor's property as of the time the bankruptcy proceeding
commenced, that is, when the petition in
bankruptcy was filed.
��� Such
a lien creditor would have priority over any security interest
��� that
was not perfected at the time the petition in bankruptcy was
��� filed
(except for certain purchase money security interests).
Therefore the trustee's rights are superior to
such a security
interest (again with the purchase money
exception). However, the
secured party is not merely subordinated in
some way; the secured
��� party
entirely loses its security interest. See section ________
below.
5.
This is a classic preference, received shortly (within 90 days) before
bankruptcy on account of antecedent debt. See section __________ below.
6.� In this case the Bankruptcy Code performs sleight-of-hand by
deeming the delay in perfection to be a delay in creation of the security
interest. Thus, artificially, the security interest is
deemed to have been given after the
debt arose, even though in reality it may have been given contemporaneously.
Thus it is deemed to be for antecedent debt. If the delayed perfection occurs
within 90 days before the petition is filed, the security interest
will likely be
avoided as a preference. See section ��� �below.
7.� See Bankruptcy Code � 522(f). Also see the
unfair trade practice regulation cited in note 4 to section 1.10 below.
8.
See section �below, discussing how a secured party can
ensure
��� that
its security interest is a purchase money security interest,
��� and
section ______ below, discussing perils to purchase money
��� status
from cross‑collateralization clauses, future advance
��� clauses,
and refinancing arrangements.
___________________
�1.08
The Contrast Between the Rights of Unsecured
Creditors
And Article 9 Secured Parties
The value of an Article 9
security interest is best shown by contrasting the rights of unsecured
creditors and Article 9 secured parties. The Article 9 secured party has
substantial advantages over an unsecured creditor in obtaining payment. As
discussed in � 1.12 below, in most cases the primary reason for taking security
is that the existence of the security interest creates strong pressure on the
debtor to pay voluntarily. Those pressures are created by the prospect of the
secured party exercising its rights in the event the debtor does not
voluntarily pay. Those rights are far superior to the rights of an unpaid
unsecured creditor.
____________________
�
1.09 -- The Unpaid Unsecured Creditor's Rights
If the debtor is unable to or
adamantly refuses to pay, an unsecured creditor must sue the debtor, obtain a
judgment, and obtain a lien on particular property of the debtor through the local
procedures for enforcing judgments. Only then, after the unsecured creditor has
become a secured judicial lien creditor, does the creditor obtain payment, by
foreclosing on the lien at an execution sale.1
Several obstacles may confront
the unsecured creditor en route to the essential judicial lien. First, although
most collection actions result in default judgments, some are defended by the
debtor. Even a meritless defense causes expense and delay. A colorable defense
that can survive summary judgment may cause a delay of years. In some cases the
creditor may be able to obtain a pre-judgment attachment lien but, even if so,
the lien cannot be foreclosed until after a judgment is obtained.
Second, the creditor who
obtains a judgment may have difficulty in locating sufficient property of the
debtor. During the time spent obtaining a judgment, property can be hidden or
dissipated, even if sufficient property existed previously. In the case of an
individual
debtor, most or all of the property that can
be located may be exempt
from being
used to satisfy the judgment.2
Third,
even if property can be found and a judicial lien is
obtained,
the property may already be subject to other liens, including
Article 9
security interests. The judicial lien will be subordinate to
an Article
9 security interest unless the judicial lien arises before
the
security interest is perfected.3
The potential judicial lien
creditor
cannot count on any secured parties having been foolish enough
not to
perfect their security interests. Further, other creditors of
the debtor
may have already obtained judicial liens on the property
which will
have priority over the new judicial lien because they were
"first
in time."4� That means
that the new judicial lien creditor will
receive
payment out of proceeds of sale of the property only if there is
money left
over after the proceeds are used to pay off the debts held by
the prior
lien holders, including any secured parties. In most cases
there will
be no money left over, if there is a prior lien.
Fourth, if the debtor enters bankruptcy proceedings within 90 days
after the
new judicial lien creditor obtained its lien, the lien will
probably
be avoided -- eliminated -- as a preference.5� That will return
the
judicial lien creditor to its previous status as an unsecured
creditor;
as such the creditor will likely receive very little in the
bankruptcy
proceeding.
����� Thus the unsecured creditor's attempt to
obtain payment is an
expensive,
time-consuming, and uncertain venture.
____________________
Footnotes
1.� On the topic of enforcement of judgments, see
generally 9 Debtor-Creditor Law ��( 37.01-37.07 (T. Eisenberg ed.-in-chief
1985). Note that at � 37.07 [B] it is stated that an execution lien created by
levy on personal property relates back to the date the writ of execution was
delivered to the sheriff. A substantial number of jurisdictions follow that
rule, but the majority rule is that the lien is created at the time of levy
with no relation back. See S. Riesenfeld, Cases And Materials On Creditors'
Remedies And Debtors' Protection (hereinafter "Riesenfeld") 154-57,
160-61 (3rd Ed 1979).
2.� See
9 Debtor-Creditor Law �( 37.03 (T. Eisenberg ed.-in-chief 1985).
3.��� See
UCC � 9-301(1)(b) and Official Comment 3 thereto.
4.� See, e.g., Cal. Civ. Code � 2897 ("Other
things being equal, different liens upon the same property have priority
according to the time of their creation . . ."); N.Y. Civ. Proc. R. � 5234
(b) (multiple execution liens have priority based on time of levy, except that
liens arising from levies made by the same officer have priority based on the
order in which the writs of execution were delivered to the officer -- thus
preventing the officer from favoring one creditor over another).
5. Bankruptcy Code � 547; see, e.g., In re
Lassiter, 42 Bankr. 631
(Bankr. ED Mo. 1984).
________________
�
1.10 -- The Unpaid Secured Party's Superior Rights
By contrast to the weak
position of an unsecured creditor, an Article 9 secured party is entitled to
immediate possession of the collateral when the debtor defaults.1� If possession can be obtained without
breaching the peace, then the secured party can take possession of tangible
collateral by "self-help" without going to court.2� The secured party can then sell the
collateral and apply the proceeds to its debt, again without going to court.3� If the collateral consists of debts owed to
the debtor (such as accounts), the secured party (without going to court) can
notify the account debtors (the debtor's debtors) to pay the secured party
directly, and they are then obligated to do so.4� The debtor generally cannot claim any
exemption for the collateral; exemption statutes do not prevent a debtor from
voluntarily transferring a security interest in exempt property.5� If the secured party followed the proper
steps in creating its security interest and perfecting it (usually by filing a
financing statement in a public office6), the security interest will
usually have priority over other liens.7
Even in bankruptcy, a secured party with a
properly perfected
security interest will usually be protected.
To simplify a complicated
subject, the secured party is likely to
obtain ether the collateral or
its value in the debtor's bankruptcy
proceeding.8� There may be
substantial delays,9 and there are
some risks for the secured party,10
but the position of the secured party is much
preferable to that of the
unsecured creditor in bankruptcy.
It is true that the secured
party is subject to certain general risks inside or outside of bankruptcy. The
collateral may have been over-valued and may sell for less than the amount of
the debt, especially in a liquidation. The collateral may have disappeared or
may have been destroyed or damaged. The debtor may have committed fraud the
collateral (or some part of it) may not even have ever existed.11� However, the secured party has practical
ways to minimize these risks,12 and, to the extent that the debt
remains unpaid -- to the extent that there is a deficiency -- the secured party
has the same rights as an unsecured creditor to sue the debtor.13
__________________
Footnotes
1. UCC � 9-503 (first sentence).
2. UCC � 9-503 (second sentence).
3. UCC � 9-504(1).� If necessary the secured party can obtain
possession by judicial process (replevin or
claim and delivery) and
then sell the collateral itself, or the
secured party can choose to proceed entirely by judicial action in which a
court officer conducts the sale of the collateral. UCC � 9-503, 9-501(1), (5).
4.�� UCC �� 9-502(1) (right to notify account debtors on default of debtor),
9-318(3) (account debtor's right to pay assignor/debtor ceases when
notification to pay assignee is given).
5.�� See State v. Avco Financial Service of New York, 50 N.Y. 2d 383,
429 NYS 2d 181, 406 NE 2d 1075 (1980), and cases cited therein. However,
Bankruptcy Code � 522(f) permits a debtor in bankruptcy to avoid
non-possessory, non-purchase money security interests in certain property that
would otherwise be exempt, such as household goods. Further, a Federal Trade
Commission unfair trade practice regulation prohibits lenders and retail
installment sellers from taking a non-possessory, non-purchase money security
interest in household goods. 16 CFR � 444.2(a).
6.����� UCC �� 9‑302(1), 9-401.
7.�� See UCC �� 9-312(5) (secured party who is
first to either perfect a
���� security interest in the collateral or file
a financing statement
���� has priority over other secured parties);
9-301(1)(b) and Official
���� Comment 3 thereto (security interest has
priority over judicial
���� lien unless judicial lien arises before
security interest is
���� perfected). However, the security interest
may still be junior to
���� common law or statutory liens and may be
junior to a purchase money
���� security interest in the collateral. See
UCC � 9-310 and 2 Gilmore
���� 886-89 concerning common law and statutory
liens, and UCC �
���� 9-312(3), (4) concerning purchase money
priority. There are also
���� other residual risks of non‑priority.
See sections � �below.
8.����� See section ����� �below.
9.����� See section ����� �below.
10.� See section �� �below. Also see
section 1.07 above and note 4
���� to this section 1.10.
11.����� See section ����� �below.
12.� See S. Krause, H. Kripke, and J. Seidman, Business Frauds, Their
Perpetration Detection And Redress, 20 Bus. Law. 83, 93-101, 104-12 (1964).
13.����� See UCC � 9-504(2).
__________________
� 1.11 �- Two Illustrations Of The Superiority Of The
The Secured Party's Rights
Two final points illustrate the superiority
of the secured party's rights over those of an unsecured creditor. First,
consider an
unsecured creditor who searches the public
records, finds no financing statements filed against the debtor, and then
extends credit to the debtor, whose assets consist of equipment and inventory.
How will that unsecured creditor fare against a secured party who obtained a
security interest in the equipment and inventory at some time before the
unsecured creditor's record search but who failed to file until sometime later
(or failed to file at all)?
Some states' pre-Code law would
have protected such an unsecured creditor who lent in the "gap"
period when a secured party was unreasonably delaying to file.1� Article 9 does not. Under Article 9, the
unsecured creditor, as unsecured creditor, cannot complain when collateral is
taken by a secured party to pay secured debts whether the security interest is
perfected or unperfected.2
Only when the unsecured creditor obtains a judicial lien does the
unsecured creditor obtain any rights in the property, and unless that judicial
lien is obtained before the security interest is perfected, the security
interest will have priority.3 The unsecured creditor may complain
that it was misled into extending credit by the secured party's delay in
perfecting. However, even under pre-Code law the debtor could grant perfectly
valid security interests after the unsecured creditor made the record
search and extended credit; the unsecured creditor should not therefore have
been misled by the absence of any filings into thinking that the assets would
be available to it.
The point is that a creditor
who desires to be sure that some or all of the debtor's personal property will
be available for satisfaction of the debt must take an Article 9
security interest in the property. An unsecured creditor cannot safely rely on
the absence or apparent absence of security interests.
The second point that illustrates the
superiority of the secured party's rights involves the rights of an unpaid
credit seller of goods. An unpaid credit seller of goods that have been
delivered generally has no more right to the goods than does any, other
unsecured creditor, such as the telephone company, unless the seller has
obtained a signed agreement from the buyer creating a security interest in the
goods to secure their price. The goods belong to the buyer, and all that the
seller owns is an unsecured debt.4 �Even in the very limited situations in which an unpaid credit
seller has a right to reclaim the goods,5 the seller will often find
that a secured creditor of the buyer has a security interest in the goods which
is superior to the seller's reclamation rights.6
On the other hand, a credit seller of goods
who obtains a security interest in the goods to secure payment of the purchase
price can repossess the goods if the buyer fails to pay.7� Further, assuming the goods are not
inventory in the hands of the buyer, the seller's "purchase money security
interest" will have priority over all other security interests and all
judicial liens, if the seller perfects the security interest within ten days
after the buyer receives the goods.8 This is very generous protection
and of course is far superior to the rights of the unsecured credit seller of
goods.
_________________
Footnote
1.���� Gilmore
485‑88.
2.� UCC
� 9-301, Official Comment 3. Of course, if the debtor enters
��� bankruptcy
proceedings, the trustee in bankruptcy can avoid
��� unperfected
security interests (and even perfected security
��� interests
in some cases if the secured party delayed in
��� perfecting).
See section 1.07 above and section � �below.
3.���� UCC
� 9-301(1)(b) and Official Comment 3 thereto.
4.���� See
White and Summers 292, 1025-29.
5.� See
UCC � 2-702(2), which permits the credit seller in some cases
��� to
reclaim delivered goods when he discovers that the buyer is
��� insolvent.
See also White and Summers 1025-29; Bankruptcy Code
��� �
546(c) (recognizing to some extent the seller's UCC � 2-702(2)
��� reclamation
right in bankruptcy, provided the seller demands return
��� of
the goods in writing within ten days after delivery). See
��� section
� �above [in the volume on Article 2] for a discussion
��� of
the reclamation right and of its very limited assistance to most
��� unpaid
sellers.
6.� See, e.g., In re Samuels and Co., 510 F2d
139, 154, 16 UCC Rep Serv 577, 596 (dissenting opinion of Judge Godbold), revd,
526 F2d 1238, 18 UCC Rep Serv 545 (CAS, 1976) (adopting Judge Godbold's dissenting
opinion), cert. denied 429 U.S. 834. Contra: Lavonia Mfg. Co. v. Emery Corp.
(In re Emery Corp.), 38 Bankr 489 (Bankr ED Pa 1984), which was incorrectly
decided. See B. Smith, UCC Survey: Secured Transactions, 40 Bus Law 1487 1510‑11
(1985). [Lavonia was later reversed, as it should have been. 52 Bankr.
944 (1985 Ed Pa)].
7.���� UCC
� 9-503.
8.���� UCC
�� 9-12(4), 9-301(2).
____________________
�1.12
Reasons For Taking Security Under Article 9
As sections 1.08 through 1.11
suggest, there are several reasons why a creditor may desire to take a security
interest.
Although the secured party's
rights on default are far superior to an unsecured creditor's rights, most
reasonable creditors are much more interested in having the debtor voluntarily
pay the debt than in exercising even the best rights on default. There are
costs and inconveniences that accompany enforcement of rights against a debtor,
not all of which can be quantified or recovered. Thus the primary purpose in
most cases for taking security is the strong pressure it puts on the debtor to
repay the debt voluntarily, so as not to lose the collateral.
The prospect of being sued by
an unsecured creditor is not a happy one, but it lacks the impact and immediacy
that the secured party's rights carry. On default the secured party can take
possession of tangible collateral immediately, usually without going to court;1
this
prospect is fearsome, both to
the consumer who faces the humiliation and inconvenience of losing his
automobile or furniture, and to the business entity which faces an immediate
shutdown if its inventory or vital equipment is taken. If the collateral is
intangible, the secured party, if it is not already making collections, can
notify the account debtors and collect the intangibles; this cuts off the
debtor's source of funds.2
Thus the existence of the security interest creates strong pressure on
the debtor to pay voluntarily.
���� Of course, the advantages on default of
having security if the
debtor does not
pay voluntarily are also important reasons for taking
security. Those
advantages are catalogued in sections 1.08 through
1.11. Taking a
security interest will help to avoid delay and expense
and will
increase the likelihood of repayment, inside or outside of
bankruptcy.2� There are even transactions, generally
pledges, in which
the enforcement
of the security interest is so easy and risk-free that
the likelihood
of voluntary repayment and the general credit-worthiness
of the debtor
become relatively unimportant. These transactions include
some���� securities margin loans and all pawnbroker
transactions.
���� Finally, in some transactions the request
for security tests the
sincerity of the
debtor and may force the debtor to face reality. An
extreme
non-Article 9 example is the request by a bank for a mortgage on
the debtor's
home to secure a business loan. The homestead exemption,
which is
generous in many states, is in effect waived by the giving of
the mortgage.3� The sincerity of the debtor's expressed
optimism about
the success of
the business venture is tested by such a request, and it
may also cause
honest reappraisal of the venture by the debtor. Large
dollar-exemptions
are less likely to be found in regard to property
covered by
Article 9 (except perhaps mobile homes), but to some extent a
request for
security under Article 9 has a similar effect, especially in
light of its
effect on any Chapter 11 reorganization.4
_______________________
Footnotes
1.��� See
UCC � 9-503.
2.� See
UCC � 9-502(1). Further, under � 9-502(1) the secured party
��� has
the right to take from the debtor any collections the debtor
��� has
made if they can still be identified as proceeds of the
��� intangible
collateral (although that will probably require judicial
��� action).
See section � �below. If the secured party is already
��� collecting
the intangibles before default, the secured party can
��� continue
to do so. The secured party can also cut off the debtor's
��� source
of funds by refusing to make new advances. See section _____
��� below.
3. Texas, however, restricts the enforceability of
non-purchase money mortgages on homesteads.
4.���� See
section ���� �below.
_______________________
�
1.13 Reasons For Giving Security Under Article 9
Article 9 security interests
are given voluntarily by agreement of the debtor. In the absence of good reasons
for doing so, no debtor should agree to grant a security interest. As discussed
in the previous sections, a security interest gives the secured party
substantial leverage to force the debtor to repay the obligation, exposes the
debtor to swift and often devastating action if payment is not made, and
prevents the debtor in most cases from claiming the collateral as exempt. It
permits the secured party to receive the collateral or its value in bankruptcy,
thus probably reducing the value of assets which an individual debtor (or a
corporate debtor's stockholders) can retain in bankruptcy, and makes
reorganization of a business in a Chapter 11 bankruptcy proceeding more
difficult.1
Counsel for a debtor should
therefore be sure that the debtor understands the effects of the granting of a
security interest and has considered other possible options. However, if credit
is desired, it will often be necessary, or even advantageous, to grant security
interests.
A theoretical dispute rages
over why debtors incur secured debt. Although some of the theorists deny that
it is so (or at least deny that it ought to be so), desired credit often cannot
be obtained on an unsecured basis.2
The discussion in the previous sections should make clear why a lender
often refuses to accept the weak position of unsecured creditor when the
debtor's credit‑worthiness is less than stellar. Thus the primary reason
for granting security is to obtain credit that is not available on an unsecured
basis.
A secondary reason is that if
unsecured credit of the amount desired could be obtained, the time for
repayment, the interest rate, and other terms might be unacceptable to the
debtor. For example, automobile loans to consumers payable over 48 months are
common; unsecured personal loans to consumers, if available, must usually be
paid off in a much shorter time, and at a much higher interest rate.
This is not to say that secured
credit is always inexpensive. Depending on the type of collateral involved and
on the amount of trust the secured party has for the debtor, the secured
creditor may incur substantial costs monitoring or "policing" the
collateral. The interest rate charged by the secured party will reflect these
costs. Such costs tend to be high when the debtor's credit‑worthiness is
not excellent and when the collateral changes rapidly, as with a "floating
lien" security interest that covers a business's accounts. The secured
party may demand daily reports on the accounts and daily turnover of
collections.3 Collateral such as equipment which the debtor is
expected to keep and which will ordinarily have a life of several years does
not need to be monitored so closely, and policing costs should be low. Thus a
debtor who can obtain sufficient unsecured credit would seldom choose to borrow
against accounts, but might choose to buy new equipment on secured credit so as
to get a lower interest rate than on an unsecured loan.
An additional reason for giving
security arises in cases in which a creditor demands security for a previously
unsecured debt which is payable on demand or which could otherwise be
accelerated. In such a case if the debtor gives security it may win at least a
90 day respite from vigorous collection activities by the creditor; if the
creditor pushes the debtor into filing a petition in bankruptcy within 90 days
after the security interest was granted, the
security interest will be avoided as a preference, since it was given to secure
an antecedent debt.4 On the other hand, if the debtor grants such a
security interest it is almost an invitation to the debtor's remaining
unsecured creditors to file an involuntary petition in bankruptcy against the
debtor within that 90 day period.5
______________________
Footnotes
1.
See section ��� �below.
2.� See J. White, Efficiency Justification For
Personal Property Security, 37 Vand. L. Rev. 473, 473-75, 491-94, 508 (1984).
Professor White considers and attempts to refute the recent theoretical
arguments that the existence of security is not economically efficient and does
not lead to increased availability of credit to debtors. See also 1 Asset Based
Financing: A Transactional Guide �1.04[1] (H. Ruda Ed-in-Chief 1985)
("there is a recognition that the smaller or starting or undercapitalized
business can get credit only via secured borrowings.")
3.� See
3 Asset Based Financing: A Transactional Guide �26.01[3][d]
(H. Ruda Ed-in-Chief 1985).
4.� See
Bankruptcy Code � 547 and section below. Further, the
��� newly
secured creditor may choose to grant additional financing to
��� the
debtor. To the extent that the newly secured party does make
��� further
advances to the debtor after granting of the security
��� interest,
the security interest will not be avoidable under � 547.
��� See
Bankruptcy Code � 547(c)(4), and section �below.
5.� If the 90 day period passes without the filing
of a petition in bankruptcy, the security interest will no longer be avoidable
as a preference, assuming the creditor is not an "insider." See
Bankruptcy Code � 547(b)(4). If the unsecured creditors permit the security interest
to become unavoidable they decrease further the small dividend they would
receive in any eventual bankruptcy proceeding.
______________________
�1.14
Innovative Features Central to Article 9
Article 9 was drafted at a time
when the law of personal property security had become complex, arcane, and
unclear. Many different types of agreements were used to create personal
property security, and each type had its own set of complex rules. It was
usually (though not always) possible to create the security interests that
commercial needs demanded, but the procedures were often expensive and complex,
and a relatively high degree of uncertainty as to priorities and other matters
existed.1
The concept of the drafters was
that Article 9 would remedy these unfortunate attributes of personal property
security through incorporation of certain basic features that were to a greater
or lesser extent innovative.
Under Article 9, all security
interests (with narrow exceptions) are governed by one law -- Article 9 --
regardless of how the parties characterize or label the transaction.2� Only functionally important
differences between transactions, such as differences between types of
collateral,3 cause transactions to be treated differently by the
law.
Outright sales of certain intangibles
(accounts and chattel paper) are also governed by Article 9.4 That
usually allows avoidance of the often difficult question of whether a
transaction is an outright assignment, or an assignment for security;5
it also makes the UCC filing records more helpful to potential assignees of
such intangibles, because both outright assignments and security assignments
must be perfected to be valid as against subsequent assignees.6
Article 9 expands the range of
permitted security practices, and the procedures for those practices are
simplified and made less expensive, as compared to pre-Code law. In particular,
the use as collateral of property acquired by the debtor after signing of the
security agreement ("after-acquired property") is much easier under Article
9,7 as is the securing of credit extended after signing of the
agreement ("future advances").8� Article 9 also eliminates the legal requirement that the secured
party engage in costly policing of the collateral.9
Finally,
Article 9 instituted a system of notice filing that permits the filing of a
simple, bare-bones document called a "financing statement rather than
requiring filing of the security agreement itself.10� The financing statement can be filed prior
to execution of the security agreement11 prior to the debtor's
acquisition of some or all of the collateral,12 and prior to the
extension of some or all of the credit.13� This permits near certainty that the security interest has
priority over other security interests,14 ease of use of after-acquired
property as collateral,15 and ease of use of revolving loans in
which further advances are made at regular intervals.16� The new filing system is especially
beneficial to secured parties making revolving loans against rapidly changing
accounts or inventory, since only one financing statement needs to be filed.17
Each of these basic features is
described in more detail in the following sections.
____________________
Footnotes
1.����� See Official Comment 1 to UCC � 9-101. See
generally 1 Gilmore
����� 1-286 for a thorough treatment of pre-Code
security devices.
2.����� See section 1.15 below.
3.��� See
section 1.18 below.����� Other significant
functional differences are (1) whether the secured party has possession of the
collateral not (see section ____ below), and (2) whether the security
interest is a purchase money security interest or not (see section _____
below).
4.��� UCC � 9-102(1)(b). See section ����� �below.
5. ����� See section ����� �below.
6.����� See section ����� �below.
7.����� See section ����� �below.
8.����� See section ����� �below.
9.����� See section ����� �below.
10.����� See section ����� �below.
11.����� See section ����� �below.
12.����� See section ����� �below.
13.����� See section ����� �below.
14.����� See section ����� �below.
15.����� See section ����� �below.
16.����� See section ����� �below.
17.����� See section ����� �below.
_______________________
�1.15 -- Uniform Applicability To All
Security Interests
��� ��� Regardless Of Form Or Characterization By
Parties
A key feature of Article 9 is
that, with narrow exceptions, ante transaction which creates a security
interest in personal property is governed by Article 9.1� The transaction may be in any conceivable
form -- conditional sale, chattel mortgage, trust receipt, pledge,2
etc. -- but it is governed by Article 9 if it is intended to create a security
interest.3 "Security interest" in turn is broadly defined to
mean "an interest in personal property or fixtures which secures payment
or performance of an obligation."4� Try as he might, a creditor cannot obtain a consensual lien on
personal property without it being governed by Article 9, unless one of Article
9's narrow exclusions applies.5
This ensures the integrity of the Article 9 filing system and ensures
that debtors obtain the protections provided in Article 9.
The all-inclusive functional
scope of Article 9 responds to the history of security in personal property.
The proliferation of security devices before Article 9's adoption was due in
part to the ingenuity of
creditors' lawyers in creating a new device
whenever the law governing old devices seemed too restrictive. Article 9 is
designed to prevent that from happening.6
_________________________
Footnotes
1. See UCC �� 9-102(1), 9-104.
2. See UCC � 9-102(2).
3. UCC � 9-102(1).
4. UCC � 1-201(37).
5. See UCC � 9-102(1), Official Comment 1.See
also 1 Gilmore 296.
6. As Professor Gilmore explained:
The long history of the proliferation of
independent security devices . . . is brought to an end. Whatever else counsel
confronted by a novel situation may do, he may not, under Article 9, invent a
new device which, if eventually it wins judicial recognition, will develop its
own set of rules, its own metaphysical structure, and, in time, its own filing
system. However counsel may solve this novel situation, whatever name he may
give to the documents he drafts, he will end up, if the "transaction"
is one "intended to create a security interest," with an Article 9
security interest, subject to the Article 9 rules, the Article 9 metaphysics,
and most importantly, the Article 9 filing system.
1 Gilmore 296.
_________________
�1.16
-- -- The Lease Intended As Security
One device that creditors (and debtors) often
use to attempt to avoid various consequences of a secured credit transaction is
the lease. When the substance of a transaction is a secured sale or a secured
purchase money loan, the parties may use a lease form for the transaction, for
tax and financial accounting reasons.1� The Code expressly deals with the case of leases that are
actually secured transactions and includes them within the scope of Article 9.2� If, for the example, the "lessee"
has an option at the end of the "lease" to become the owner free or
for a nominal sum, the "lease" is a security agreement and the
"lessor's" interest is a security interest.3� Of course, few cases are so clear cut, and
the question of whether a "lease" is a true lease or one intended as
security has generated much litigation.4
Consider the impact of a
finding that a "lease" of goods is a secured transaction rather than
a true lease. If the "lessor" did not file a financing statement, the
"lessor" will usually find that it only has an unperfected security
interest. If the "lessee" is in bankruptcy,
that unperfected
security interest will be avoided, leaving the "lessor"
as a mere
unsecured creditor. Even outside of bankruptcy, there may be
(1) another
secured party whose perfected security interest in the goods
has priority over
the "lessor's" unperfected security interest, (2) a
judicial lien
creditor who has priority over the unperfected security
interest, (2) a
tax lien claimant who has priority, or (3) even a buyer
who bought the
goods from the "lessee" thinking the "lessee" owned them
and who takes the
goods free of the "lessor's" interest. Even if no
competing
interests have priority, the "lessor" will be limited by
Article 9's
default provisions if the "lease" is not a true lease; thus,
for example, the
"lessor" cannot simply cancel the "lease" and take back
the machine as
its own if the "lessee" defaults. Rather, the "lessor"
will have to sell
or otherwise dispose of the goods and account to the
debtor for any
surplus obtained above the amount of the debt.5
����� The impact on the "lessor" may
seem harsh, but it is necessary. If
simply calling a
transaction a "lease" (or something else) could exempt
it from Article
9's coverage (and thus excuse the failure to file a
financing
statement), secured creditors could not rely on the Article 9
filing system to
be complete,6 creditors could evade the debtor
protection
provisions of Article 9, and the law would shortly return to
the chaotic,
balkanized state that preceded adoption of Article 9.
______________________
Footnotes
1.
See section ��� �below.
2.� UCC � 1-201(37) (second paragraph). When Article 2A (covering true
leases) was added to the UCC in 1987, section 1-201(37) was expanded to provide
more guidance as to when a "lease" is actually a disguised security
interest.
3.��� UCC
� 1-201(37) (second paragraph).
4.��� See
section ��� �below.
5. ��� See
section ��� �below.
6.� It
should be noted, however, that the Article 9 filing system is ��� already incomplete in that no filing is
required with respect to a ��� true lease.
The new Article 2A of the UCC does not require any ��� filing or other public notice, despite vigorous arguments that it
��� should. See section � �below. For this and other reasons (e.g., ��� the void title doctrine with regard to stolen goods), a prudent ��� secured party will generally check the
debtor's title to the ��� collateral
before extending credit. See section � �below.
______________________
�1.17
-- -- Coverage Of Other Security Devices That May Be Created
The Code expressly deals with
leases, but other new devices that might be "cooked up" are subject
to the same analysis. Suppose an equipment seller sold equipment to a buyer
under a credit contract which provided that only a "defeasible fee"
in the equipment would be
transferred to the buyer. On failure of the
buyer to make any required payment, title would revert to the seller. The Code
does not deal with this specifically. The Code does provide that conditional
sales contracts in which the seller purports to retain title give the seller a
security interest,1 and the buyer obtains title,2 but the
Code does not mention title reversion agreements. However, the seller's
"possibility of reverter"3 is an interest in personal
property "which secures payment or performance of an obligation."
Thus it is simply a security interest, and the transaction which creates it is
subject to Article 9, as a "transaction (regardless of its form) which is
intended to create a security interest."4
Thus Article 9 is designed to
prevent creative lawyers, even ones much more creative than the authors, from
creating personal property security devices that are not covered by Article 9.5
___________________
Footnotes
1. UCC � 1-201(37) (second sentence).
2. UCC �� 1-201(37) and 2-401(1).
3. See Restatement, Property �� 153(1) and
154, under which the
seller's interest would be classified as a
possibility of reverter.
4. See UCC �� 1-201(37) and 9-102(1).
5. UCC � 9-102, Official Comment 1. See also
note 6 to section 1.15
above.