Chapter 25: Security Interests and Creditors’ Rights 1
Chapter 25
SecurityInterests
and Creditors’ Rights
Introduction
To study this chapter, students should understand two major concepts. First, they should understand why secured transactions are necessary in business. Nearly every time a retailer makes a significant purchase, a wholesaler buys a large quantity of stock, or a manufacturer buys raw materials necessary for production, secured credit is involved.
Second, students should understand what a security interest is—that it is not a retention of title to goods, but a lien on them. A secured transaction is a borrowing of money for a security interest in goods (the debtor’s property.
Thus, a key to understanding a secured transaction is viewing it from a creditor’s perspective. From this perspective, basic questions are: (1) If a debtor defaults, does the creditor have an enforceable security interest in the debtor’s property? (2) If an enforceable security interest in a debtor’s property exists, will the creditor’s security interest take priority over other security interests and creditors’ claims? The answers to these questions form the basis for the law of secured transactions.
This chapter also concerns various rights and remedies available through statutory and common law other than UCC Article 9 to assist debtors and creditors in resolving their disputes without a debtor’s having to resort to bankruptcy. For students, guaranty and suretyship is the most difficult subject in this chapter.
Chapter Outline
I.Terminology of Secured Transactions
UCC terminology is used in all documents in secured transactions.
•A secured party is a creditor who has a security interest in a debtor’s collateral.
•Adebtor is the party who owes payment or other performance of an obligation.
•Asecurity interest is an interest in a debtor’s collateral that secures payment or performance of an obligation.
•Asecurity agreement is an agreement that creates or provides for a security interest.
•Collateral is the subject of the security agreement.
•Afinancing statement is the instrument normally filed to give public notice to third parties of a secured party’s security interest.
Enhancing Your Lecture—
Article 9 Security Interest
Prior to the drafting of Article 9 of the Uniform Commercial Code and its adoption by the states, secured transactions were governed by a patchwork of security devices. The following summary of these devices will help you to understand the significance and landmark status of Article 9.Security Devices prior to Article 9
The security devices in use prior to the adoption of Article 9 were replete with variations that, according to many, made no logical sense. These devices included chattel mortgages, trust receipts, conditional sales contracts, assignments of accounts, and pledges. Additionally, each device had its own jargon. Depending on the device used, for example, a debtor could be called variously a pledgor, a mortgagor, a conditional vendee, an assignor, or a borrower.
One of the earliest security devices, historically, is the pledge. A pledge is a possessory security interest in which the secured party holds or controls possession of the property involved, called the collateral, to secure the payment or performance of the secured obligation. The pledge has existed since at least the fourth or fifth century. The pledge concept also gave rise to a device for obtaining a security interest in goods that could not be conveniently moved from the debtor’s property. In such a situation, the creditor would have an independent warehouser establish a warehouse on the debtor’s premises to obtain possession of the goods. This was called a field warehouse and dates from about 1900.
Article 9 Streamlined the Law Governing Secured Transactions
The pledge and many other types of security devices were all designed to protect creditors’ interests. Nonetheless, creditors still faced several legal problems. For example, in many states, a security interest could not be taken in inventory or stock in trade, such as cars for a car dealer or chocolate for a candy manufacturer. Sometimes, highly technical limitations were placed on the use of a particular security device. If a court determined that a particular security device was not appropriate for a given transaction, it might void the security interest.
The drafters of Article 9 concluded that two elements were common to all security devices: (1) the objective of conferring on a creditor or secured party priority in certain property (the collateral) against the risk of the debtor’s nonpayment of the debt or the debtor’s insolvency or bankruptcy and (2) a means of notifying other creditors of this prior security interest. With these two elements in mind, the drafters created a new, simplified security device with a single set of terms to cover all situations. What is this security device called? It is called, simply, an Article 9 security interest.
Application to Today’s World
Although the law of secured transactions is still far from simple, it is now—thanks to the drafters of Article 9—far more rational and uniform than it was in the days prior to the UCC. The revised Article 9, which became totally effective in 2001, further streamlined secured transactions law by, among other things, simplifying the filing process and allowing secured transactions documents to be filed electronically with the appropriate government officials.
II.Creating and Perfecting a Security Interest
A.Requirements to Create a Security Interest
When the requirements are met, a creditor’s rights attachto the collateral [UCC 9–203]. To have an enforceable security interest—
•Unless a creditor has possession of the collateral, there must be a written or authenticated security agreement.
•A creditor must give value to the debtor.
•The debtor must have rights in the collateral.
1.Written or Authenticated Security Agreement
A written or authenticated security agreement must describe (reasonably identify) the collateral and be signed or authenticated by the debtor [UCC 9–102(a)(7), 9–203(1), 9–108(c)].
Case Synopsis—Case 25.1: Royal Jewelers Inc. v. Light
Steven Light bought a $55,050 wedding ring for his fiancé Sherri Light on credit from Royal Jewelers, Inc., a store in Fargo, North Dakota. The receipt granted Royal a security interest in the ring. Later, Royal assigned its interest toGRB Financial Corp. Steven and GRB signed a modification agreement changing the repayment terms. An attached exhibit listed the items pledged as security for the modification, including the ring. Steven did not separately sign the exhibit. After Steven’s death, Royal and GRB filed a suit in a North Dakota state court against Sherri, alleging that GRB had a valid security interest in the ring. Sherri cited UCC 9–203, under which there is an enforceable interest only if “the debtor has authenticated a security agreement that provides a description of the collateral.” Sherri argued that the modification agreement did not “properly authenticate” the description of the collateral, including the ring, because Steven did not sign the attached exhibit. The court issued a judgment in GRB’s favor. Sherri appealed.
The North Dakota Supreme Court affirmed. “No authority [requires] a debtor to separately sign an exhibit attached to and referenced in a signed security agreement.”
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Notes and Questions
Can the description of the collateral in the security agreement and the financing statement be the same? Yes. A security agreement’s description may be repeated in a financing statement. In fact, a security agreement may be filed as the financing statement (if it meets the criteria); or, when permitted, a combination security agreement–financing statement form may be filed.
What is the effect of a financing statement that fails to perfect a creditor’s interest? Whether a party’s interest in a debtor’s collateral is perfected can have serious consequences for the creditor. A creditor with a perfected security interest will prevail over any unsecured creditors. If an interest is not perfected and the debtor defaults, the creditor with the unperfected interest will not have first rights to the collateral.
How do the documents that comprise a security agreement function as a “Statute of Frauds”? A signedwriting serves as a “Statute of Frauds” to prevent enforcement of claims based on wholly oral representations.
What sort of description in a written security agreement might be insufficient to create a security interest? Descriptions that have been held to be insufficient included an attempted security interest in “all of the debtor’s personal property now owned and hereafter acquired.” Why would this description be considered insufficient to create a security interest? It is too general to put third parties on notice of the possible claim of the creditor.
Under what circumstances might a financing statement not be considered effective even if it does not identify the debtor correctly? (Hint: When will a computer’s search engine find a debtor’s name even when it is listed incorrectly?) There is a safe harbor under UCC 9–506(c).. If a search of the filing office's records under the debtor's correct name, using the filing office's standard search logic, if any, would nevertheless disclose that financing statement, the name provided does not make the financing statement seriously misleading.
2.Secured Party Must Give Value
Value is any consideration that supports a simple contract [UCC 1–201(44)]. Value can be security given for a preexisting (antecedent) obligation or any binding commitment to extend credit.
3.Debtor Must Have Rights in the Collateral
The debtor’s rights can represent a current or future interest. Title is not a requirement.
B.Perfectinga Security Interest
Perfection protects a security interest against some claims of third parties who may wish to have their debts satisfied out of the same collateral. Collateral is generally considered either tangible or intangible. The text lists the types of property that fall into each category and the methods for perfecting security interests in them.
1.Perfection by Filing
The most common method of perfecting a security interest under Article 9 is to file a financing statement with the appropriate public office. This may be done electronically [UCC 9–102(a)(18)]. A financing statement must (1) be signed by the debtor, (2) contain the addresses of debtor and creditor, and (3) describe collateral by type or item [UCC 9–502, 9–504].
a.The Debtor’s Name
A security agreement must be filed under the name of the debtor. Slight variations are not misleading if a name can be found by the filing office’s search methods. Other potential problems with this requirement discussed in the text include—
•Corporations—A corporate debtor’s name on the financing statement must match its name in the “public records” [UCC 9–503(a).
•Trusts—A trust’s name must be as specified in official documents. Financing statements for other organizations—unincorporated associations, joint ventures, churches, clubs, etc.—must be filed under their organizational names.
•Individuals and organizations—Financing statements for other organizations—unincorporated associations, joint ventures, churches, clubs, etc.—must be filed under the names of their organizations or the names of their members.
•Trade names—A debtor’s trade name alone is not sufficient [UCC 9–503(c)].
A financing statement remains effective for collateral acquired before or within four months after a name change [UCC 9–507(b), (c)]. To perfect an interest in collateral acquired later, an amendment to the financing statement must be filed.
b.Description of the Collateral
A security agreement’s description may be repeated in a financing statement; a security agreement may be filed as the financing statement (if it meets the criteria); or, when permitted, a combination security agreement–financing statement form may be filed.
c.Where to File
Depending on the classification of the collateral, a financing statement is filed in the appropriate state office of the state in which the debtor is located, or locally with a county official when the collateral consists of timber to be cut, fixtures, or collateral to be extracted (oil, coal, gas, and minerals) [UCC 9–301(3), (4); 9–502(b)]. The location of the debtor is—
•For individual debtors, the state of the debtor’s principal residence.
•For an organization registered with a state, the state of the registration.
•For others, the state in which the business is located or, if more than one, the state in which the chief executive office is.
d.Consequences of an Improper Filing
The secured party’s claim, in bankruptcy, is reduced to that of an unsecured creditor.
2.Perfection without Filing
a.Perfection by Possession
Perfection by possession may be impractical because it denies a debtor the right to use, sell, or derive income from property to pay off the debt. Security interests in some types of collateral (negotiable instruments, nonnegotiable transferable instruments, stocks, bonds) can only be perfected by possession.
b.Perfection by Attachment—Purchase Money Security Interest in Consumer Goods
A purchase-money security interest (PMSI) can be perfected automatically when it is created under a written security agreement.
c.Automatic Perfection
A PMSI can be perfected automatically when it is created under a written security agreement. The seller does not need to do more to perfect.
d.Exceptions to the Rule of Automatic Perfection
Exceptions include—
•Security interests that are subject to other federal or state laws.
•Sales to businesses or other entities that do not qualify as consumers [UCC 9–311, 9–324].
Enhancing Your Lecture—
How Do You Perfect a Security Interest?
The importance of perfecting your security interest cannot be overemphasized, particularly when the debt is large and you wish to maximize the priority of your security interest in the debtor’s collateral. Failure to perfect or to perfect properly may result in your becoming the equivalent of an unsecured creditor.Perfection by Filing
The filing of a financing statement in the appropriate location, as discussed in this chapter, is the most common method of perfection. Generally, the moment the filing takes place, your priority is established over the other creditors—as well as over some purchasers of the collateral and a subsequent trustee in bankruptcy.
When you create a security agreement, describe the collateral in terms that are specific enough to put third parties on notice of your security interest in that collateral. If your description is insufficient or misleading, your security interest will not be perfected.
Transactions outside Normal Business Relationships
Sometimes, credit transactions occur outside normal business relationships. You may be asked, for example, to aid an associate, a relative, or a friend. At that moment, you should reflect on your need for security for any debt that will be owed to you.
If there is a need for security, then you should perfect your security interest, even if you believe this action is unnecessary because the debtor is a friend or a relative. That particular friendship or blood relationship is irrelevant should he or she ever enter into bankruptcy proceedings. Bankruptcy law does not allow friends or relatives to be paid ahead of nonfriends or nonrelatives. You will end up standing in line with the other unsecured creditors if you have not perfected your security interest in the collateral. The best way to protect your security interest by perfection is to have your friend, relative, or associate transfer to your possession the collateral—stocks, bonds, jewelry, or whatever. By possessing such collateral, you can keep the transaction private but still have security for the loan.
Checklist for Perfecting Your Security Interest
1.File a financing statement promptly.
2.Describe the collateral sufficiently—sometimes, it is better to err by giving too much detail than by giving too little.
3.Even with friends, relatives, or associates, be sure to perfect your security interest, perhaps by having the debtor transfer the collateral to your possession.
3.Perfection and the Classification of Collateral
The classification (tangible or intangible) or definition of collateral can determine where or how to perfect a security interest (summarized in the text).
4.Effective Time Duration of Perfection
A financing statement is effective for five years from the date of filing [UCC 9–515]. A continuation statement filed within six months before the expiration date continues the effectiveness for five more years [UCC 9–515(d), (e)].
Additional Background—What Happens When Collateral Is Moved to Another State?
Generally, a properly perfected security interest in collateral moved into a new state continues to be perfected in the new state for a period of up to four months from the date it was moved or for the period remaining under the perfection in the original state, whichever expires first [UCC 9–103(1)(d), 9–103(3)(e)]. (Thus, for instance, if there is a properly perfected interest in harvesting equipment that a debtor takes into a neighboring state, the interest remains effective for up to four months.) Collateral moved from county to county within a state when local filing is required may not have a four-month limitation, and the original filing may have continuous priority [see UCC 9–403(3)].
As for automobiles, perfection of a security interest in a motor vehicle varies according to state law, but typically occurs only when a notation of the interest appears on the vehicle’s certificate of title. If a state does not require a certificate of title as part of its perfection process, perfection automatically ends four months after a car is moved into another state. When a security interest exists in a car in a state in which title registration is required, and the interest is noted on the certificate, perfection of the interest continues after the car is moved to another state requiring a certificate until the car is registered in the new state [UCC 9–103(2)]. Because each title state requires that the old certificate be surrendered to obtain a new one, and because a secured party typically holds the certificate, the party can usually ensure that his or her interest is noted on the new certificate.
III.Scope of a Security Interest
A.Proceeds
A secured party has an automatically perfected interest in proceeds from the sale, exchange, or other disposal of collateral [UCC 9–315]. The interest remains perfected for twenty days after the debtor’s receipt of the proceeds. When collateral is of a type that is likely to be sold, a security agreement typically provides for extended coverage.
B.After-Acquired Property
This is property acquired after the execution of a security agreement [UCC 9–204(a)].
C.Future Advances
Future advances against a line of credit are subject to a security interest in the same collateral without filling out and perfecting new security agreements [UCC 9–204(c)].
D.The Floating-Lien Concept
Altogether, this is described as a floating lien (a lien that changes over time).