Introduction to Security

CHAPTER 42

INTRODUCTION TO SECURITY

Outline

I. Credit

A. Nature of Credit

Credit may be defined as a transaction where one party is obligated to pay consideration for the bargain at some future date.

B. Unsecured Credit

Many transactions are based on an unsecured promise to pay.

C. Secured Credit

In other cases, the creditor requires the debtor to convey a security interest on the debtor's property to secure payment.

II.Suretyship

A.Sureties and Guarantors

A surety is a person who is liable for the payment of another's debt. The surety joins with the person who is primarily liable. A guarantor makes a separate promise agreeing to be liable on the happening of a certain event.

B.Creation of Principal and Surety Relationship

The relationship of principal and surety, or that of principal and guarantor, is created by contract.

C.Defenses of a Surety

A surety can use any defenses against the creditor that the primary debtor has; other defenses include lack of consideration, fraud or duress in inducement of the contract, and breach of contract by the other party.

D.Creditor’s Duties to Surety

The creditor is required to disclose material facts affecting risk to the surety.

Example: Camp v. First Financial Federal Savings and Loan Association: The surety was relieved of his obligation because the bank failed to disclose material facts.

E.Subrogation and Contribution

A surety acquires rights of subrogation upon performance of the principal's obligation; if the surety performs the obligation, the surety has the right to reimbursement from the principal.

III. Liens on Personal Property

A. Security Interests in Personal Property and Fixtures under the Uniform Commercial Code

The security interests a creditor may obtain in the personal property of a debtor is covered by Article 9 of the Code

B.Common Law Liens

Under common law, artisans improving property acquire a lien on the property until paid. Innkeepers and common carriers may claim a lien on property to secure payment.

C.Statutory Liens

Many states today recognize these liens by statute.

D.Characteristics of Liens

Possessory liens permit a lien holder to keep possession of the property until paid.

Example: Swift, Inc. v. Sheffey: The court found that Sheffey did not have a valid mechanic’s lien because Sheffey could not prove that The Swift assented to the dismantling of the engine.

E.Foreclosure of Lien

The right of the lienholder to possess goods does not automatically give the lienholder the right to sell the property.

IV.Security Interests in Real Property

A.Real Estate Mortgage

A mortgage is a security interest in real property given by the mortgagor (owner of property) to a creditor (mortgagee). Foreclosure is the process of terminating rights of the mortgagor in the property.

Example: In Re Foreclosure Cases: If a lienholder transfers their right to real property to a third party, the assignment of rights must be written to be enforceable.

B.Deed of Trust

The purpose of the deed of trust is to make it easy for the security to be liquidated. The borrower deeds to the trustee the right to foreclose if the borrower fails to make a required payment.

C.Land Contracts

The buyer agrees to pay the purchase price over a period of time. The seller agrees to convey title to the property to the buyer when the full price is paid.

Example: Bennett v. Galindo: The court found that even though they defaulted and were in breach, the Galindos are entitled to a six month period to redeem the contract.

D. Mechanic’s and Materialman’s Liens

All states provide for mechanics liens to protect persons who furnish labor or materials to improve real estate.

Example: Mutual Savings Association v. Res/Com Properties, LLC: The court found that mechanic’s liens related to work done after the mortgages were filed take priority over those mortgages under state law that allow mechanic’s liens to relate back to the earliest mechanic’s lien. In this case, the first mechanic’s lien took place prior to the filing of the mortgages.

Learning Objectives

1.You should understand the difference between secured and unsecured credit, and the importance of that difference.

2.You should know different ways a creditor can obtain security in personal or real property.

3.You should be familiar with common law and statutory liens protecting artisans or trade people, innkeepers, and common carriers.

4.You should know what a mechanic's or materialman's lien is and how it protects laborers or suppliers of materials to the property.

5.You should understand the risks that attend unsecured credit, as far as creditors are concerned, and should recognize how difficult it is to recover from an unwilling or destitute debtor.

6.You should be aware of how secured credit minimizes the risks of loss in credit transactions.

7.You should be familiar, in the context of surety and guarantor relationships, with what are personal defenses and what are defenses going to the merits, as well as with the significance of distinguishing between the two.

8.You should understand the duties the creditor owes the surety, along with the rights of the surety.

9.You should understand the mortgage relationship, as well as the rights of the parties upon default.

10.You should understand the importance of recording the mortgage.

11.You should be able to compare and contrast the deed of trust and the mortgage, and should understand why a deed of trust might be employed.

12.You should be able to compare and contrast the land contract and the mortgage, as well as the land contract and the deed of trust.

13.You should have an awareness of real estate financing on the internet.

Learning Hints

1.Understanding the nature of a credit transaction is increasingly important for business people. In the event unsecured credit is extended to a debtor, for example, and the debtor fails to pay the debt, the creditor may be unable to recover the debt. For this reason, to minimize credit risk, a creditor can contract for security. In a secured credit situation, if the debtor defaults on the debt, the creditor may be able to foreclose his lien on the real or personal property of the debtor and recover some, if not all, of his loss.

2.There is a difference between a surety and a guarantor, but their rights and liabilities are very similar. A surety joins with the person who is primarily liable in promising to make payment or perform the duty, while a guarantor makes a separate promise agreeing to be liable on the happening of a certain event.

3.The rights and obligations of the surety or guarantor are easy to understand if one remembers that the relationship is basically contractual. Therefore, when the parties materially alter the terms without the surety's consent, one would expect the surety's performance to be excused. This also explains why defenses that go to the merits will excuse performance while the principal's personal defenses will not. Likewise, if the principal and the creditor do anything to increase the surety's risk, the surety's performance should be excused because the contract has been materially altered.

4.Notice that frequently a surety's right of subrogation will make the surety an unsecured creditor of the principal. However, the surety will be a secured creditor if property was also used to secure the original debt or the surety's promise.

5.The greatest weakness of the common law and statutory liens, from the standpoint of the creditor, is that they generally require the creditor to maintain possession of the security. Such a requirement does not necessarily facilitate smooth completion of the vast majority of consumer and commercial transactions that occur today.

6.Remember that foreclosure cannot take place without notice being given to the debtor and to the public before a sale is made. Notice to the debtor is essential in affording the debtor an opportunity to redeem by satisfying the debt. Notice to the public helps ensure that the creditor will receive the highest possible price at the foreclosure sale. The creditor's receiving the highest possible price works in favor of the debtor also because the debtor could still be liable for any deficiency still owed after the foreclosure sale.

7.Recording a mortgage performs the role possession plays in the common law lien context. Third persons would often not be aware of security interests in property and might purchase from the debtor, since possession generally signifies ownership. Thus, in the common law lien situation, the creditor maintains possession in order to avoid the hardships that might arise if an unwitting buyer bought from the debtor. With real property, it is not practical for the creditor to take possession, because doing so would effectively deny the debtor use of the property. The recording statutes were designed to allow prospective buyers and prospective creditors to discover encumbrances on real estate before they purchase it or extend credit in reliance on it.

8.The debtor's right to redeem is his or her last chance to maintain possession of the property securing the debt. In order to redeem and thereby avoid sale of the property, the debtor must pay the debt and any costs or penalties in full.

9.All states have statutes protecting materialmen or mechanics who improve real property. The procedure for obtaining and foreclosing such liens varies from state to state. It is important to note, however, that a valid mechanic's lien may take priority over other lien-holders. No one should purchase real property without making a title search (search of title records) to determine the existence of liens on the property.

10.Even though a land sales contract may not expressly create a security interest in real property, some courts have held that the legal effect of such contracts is to convey equitable title in the property to the purchaser, with the seller retaining a security interest in the property. The practical effect of that holding is to require the seller to foreclose his or her security interest upon default by the purchaser, and to give the buyer rights to redeem the property in certain cases.

True-False

In the blank provided, put "T" if the statement is True or "F" if the statement is False.

_____1.A MasterCard account is an example of a credit account that is unsecured.

_____2.A parent who cosigns on a promissory note for a child is an example of an accommodation surety.

_____3.A surety can utilize the defense of lack of capacity to contract by the principal.

_____4.Al’s Garage does $250 of repairs on Amy’s car. Amy asks Al to bill her for the repairs and drives away. Al has a lien on the car for the amount of the repairs.

_____5.A creditor is not required to disclose any material facts about the risk involved to the surety.

_____6.Tony buys a home by assuming a mortgage. In case of a default, the property is liable for the debt and the property can be sold to satisfy the debt.

_____7.The owner of mortgaged property ordinarily cannot sell the property without the consent of the mortgagee.

_____8.The owner of real estate who sells her property in a land contract maintains title to the property until the buyer pays the full purchase price.

_____9.The creditor has a right to a deficiency under strict foreclosure.

_____10.A surety may use a breach of warranty defense against a creditor of the principal.

Multiple Choice

Circle the best answer.

1. A common law lien is lost:

a.If the debt if paid.

b.If the lien holder gives up possession (unless the debtor regains possession by fraud).

c.Both a and b are correct.

d.If the debtor gains possession by fraud.

2.Alice charged a $5,000 wedding dress on her Visa credit card. If she fails to pay the account:

a.Visa is a secured creditor.

b.Visa has a common law lien on the dress.

c.Visa has no lien because this is an unsecured account.

d.Alice is guilty of violating the state mechanic's lien statute.

3. Which of the following is a possible remedy for an unsecured creditor in the event of default by the debtor?

a.Repossession of the property.

b. Lawsuit against the debtor.

c.Garnishment.

d.Both b and c.

4.Which of the following defenses could not be used by a surety?

a.Minority of principal party.

b.Lack of consideration.

c.Breach of contract by the dealer.

d.Breach of warranty by the dealer.

5.Brenda signs a note as surety for Carla. Carla defaults on the instrument and Brenda pays the bank for the amount of the note plus interest. Brenda now as the right to pursue any remedies against Carla that the bank would have had. This is called the:

a.Right to reimbursement.

b.Right of contribution.

c.Right of subrogation.

d.Right of foreclosure.

6.Alf and Biff were co-sureties of their friend, Chloe, on a certain obligation on which Chloe was the principal. When Chloe defaulted, Biff paid the entire obligation. After having done so, Biff:

a.Was automatically relieved from any liability for any other obligations on which he was a surety and Chloe was the principal.

b.Acquired all rights the creditor had against Chloe.

c.Acquired the right to call upon Alf to reimburse him for Alf's share of the obligation.

d.Acquired the rights referred to in answers b and c.

7.Ernie and Ethel Ray buy a new home. The Rays go to Friendly Bank and borrow the money to purchase the home. The Rays sign an agreement promising to pay the debt plus interest each month for the next 30 years. This security device is called a:

a.Land contract.

b.Mortgage.

c.Deed of trust.

d.Possessory lien.

8.Which of the following situations does not create a possessory lien?

a. Rob takes his car to Ed for repairs. Ed does the work and demands payment.

b. Stella drops her watch off at Diamond Jewelers for repairs. Diamond does the agreed work on the watch.

c. Tom goes to Kathy’s house and fixes her television set.

d. John takes Paula’s computer to his shop for repairs and does the work.

9.Which real estate security device has a third party who holds legal title to the property so that the security can be more easily liquidated in the event of default?

a.Deed of trust.

b.Mortgage.

c.Land contract.

d.Mechanic’s lien on real estate.

10.Which of the following is not true concerning mortgages?

a.A mortgage should be properly recorded to protect the mortgagee’s rights.

b.If foreclosed property sells for more than the amount of the debt, the debtor is generally entitled to the surplus.

cA purchaser who buys subject to the mortgage is personally liable for any deficiency.

d. An owner may be able to redeem the property up to six months after foreclosure.

Short Essay

1. Nancy buys a house from Ginger. Nancy will pay Ginger monthly payments and she will also pay the taxes and insurance on the house. Describe this situation. Who has title to the house?

2.Lowes sells replacement windows for Bates’ house on credit. The total cost of the windows is $20,000. What rights does Lowes have against Bates?

3.Bart purchased a home for $99,000. He paid $10,000 down and financed the rest through Solvent Savings & Loan, which obtained a mortgage on the property to secure payment of the debt. Because of a Solvent employee's error, Solvent failed to record its mortgage interest. Several years later, Bart sold the house to Seretha, who paid him $118,000. At the time of the sale to Seretha, Bart still owed Solvent $81,000. When Bart failed to make his monthly payment for the second consecutive month, Solvent discovered the sale to Seretha. After learning that Bart had squandered the $118,000 in Las Vegas, Solvent instituted proceedings to gain possession of the property from Seretha. Seretha defended on the ground that she was not aware of the prior security interest and was therefore the sole owner of the home. Discuss the strength, or lack of strength, of Solvent's position.

4.Rhonda is a loan officer at a bank. Darla is a customer who has had some problems paying back a loan. Glen is a surety on Darla’s current loan at the bank. Darla approaches Rhonda about an extension of her loan. Discuss the impact of a formal extension of time on Glen’s obligation as a surety. What will the impact be on Glen if Rhonda just tells Darla she can have another ten days to make a payment?

5.Greg assumes Todd’s mortgage and buys Todd’s house. Discuss the impact of an assumption on Todd’s potential liability for the debt.

6.EZ Credit Union is considering making an unsecured loan to Kara. EZ is also considering making a car loan to Brent. Discuss the credit union’s recourse on both of these loans in the event of a default. Also discuss the risks involved in each loan and which loan the credit union would like charge the higher interest rate.

7.Some states use a subrogation rule regarding the payment of contractors for liens owed to subcontractors. Under those rules, if the general contractor is paid, but fails to pay the subcontractors, the property owner has a defense in having paid the contractor, i.e., the subcontractor’s remedies are to go against only the general contractor. Most states do not follow this rule. What can you do to assure yourself that the general contractor has paid his/her subcontractors?

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