Creditors’ Rights and Secured Transactions

Creditors’ Rights and Secured Transactions

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Terms:


Uniform Commercial Code (UCC): 
A comprehensive set of laws, mostly regarding contracts and sales, which has been adopted, in whole or in part, by almost every state. In addition to issues regarding contracts and sales law, the UCC also deals with a variety of other topics, among them, the rights of creditors in secured transactions. While not fully adopted in all states, the UCC is a good guideline for how a state is likely to proceed in dealing with the creation and payment or discharge of secured transactions. See U.C.C. § 9-102. *

After Acquired Collateral Clause: 
A clause that may appear in contracts, in which a lender takes a security interest in “all property that the debtor acquires after consummation of the loan agreement.” Essentially, such a clause is intended to extend the protection of the creditor to include assets that the debtor purchases or otherwise acquires after the loan or debt is incurred.

* Louisiana has not enacted Articles 2 and 2A of the U.C.C. As a result, Chapter 9 excludes eleven definitions relating to U.C.C. Articles 2 and 2A, and instead includes Louisiana definitions for most of those terms in a new non-uniform Subsection 9-102(d). Louisiana’s Subsection 9-102(d) of Chapter 9 contains nineteen additional non-uniform definitions.

Overview to Creditors’ Rights and Secured Transactions

In the previous sections of this chapter, we briefly touched on the concepts of secured and unsecured lenders. While the concept of a security interest may be familiar to you if you have ever purchased a car, home, or maybe even a computer, the law regulating this area of business is probably as foreign to you as the “rights and responsibilities” statement sent along with your credit cards. Creditors’ rights take up an entire area of the law known as "Secured Transactions." 

While this area of the law is fairly complex, a brief introduction should suffice to acquaint you with the underlying principles. Note, however, that if your work entails consumer protection issues or if you work with small lenders or retailers, you may want to seek additional information or guidance in this area, as the rules can quickly become very daunting.

What are “Secured Transactions"?

EXAMPLE: Joe walked up to his friend Al and asked if he could borrow $500 to purchase a new lawn mower. Joe explained that his grass was over two feet tall, but he was between paychecks and could not afford to buy a mower right then. Al thought about it and remembered that Joe borrowed his wheelbarrow two months previously and had so far failed to return it. Al told Joe that he would not lend him the money. Joe, in response, said “Well, what if I guarantee you the loan with my car as collateral?” Al knew that Joe only had one car, a ’55 Mustang that was valued at over $4,000. Al said he would make Joe the loan as long as Joe returned his wheelbarrow and paid the loan back with 5% interest, compounded each month, for the two months that Joe would have the money. Furthermore, the loan was to be secured by Joe's car so that if Joe failed to repay the loan, Al would be able to foreclose on Joe's car and secure his money in that way. In order to insure that each understood the deal, they put the agreement into writing.

In this single example, it can be illustrated what a secured transaction is and many of the pieces and players involved in a standard secured transaction.

1. The Security Interest – Joe’s Car
A Security Interest is generally a non-possessory (though it may also be possessed by the lender) interest in the property of another. The interest is such that it acts as some sort of security or collateral (the car) - for the loan ($500). Additionally, the security interest is held for the entire term of the loan (2 months) or until alternative arrangements are made between the parties.


2. Lender / Debtor / Secured Party
A party to a secured transaction may be a person or may be any of the business forms that we have encountered in this course. On one side of the transaction is the lender. Upon properly obtaining a security interest, the lender is known as a “secured party” (Al, in our above example). On the other side of the deal is the debtor, who takes the loan and provides the security (Joe, in our example). 


3. The Security Agreement
The security agreement is typically a written agreement between the parties that puts into contract form the respective rights, benefits, and obligations of the parties. While a security agreement need not be in writing in all cases, such a written record of the arrangement is very advisable. In some situations, the UCC will itself indicate the exact type of transactions where security agreements are required and where they are and are not applicable. See U.C.C. § 9-104.

Forming the Security Interest (Attachment)

Not just anyone can give a security interest as to a specific piece of property. In order to have a security interest, all three of the following factors need to be in existence:

  1. The collateral must be in possession or under control of the lender, or there must be a written agreement that discuses the collateral that is signed by the debtor
  2. The secured party must give value – i.e., there must be a transfer from the lender to the debtor (the loan); and
  3. The debtor must have a legal right to own or control the collateral – one can never offer a security interest in property that one does not own

See U.C.C. § 9-203

As we said before, a security interest is generally better handled if it is created in writing. The reason for this is that the writing includes a description of the collateral which is fairly clear and identifies the collateral, and it will be signed by the debtor. This makes absolutely clear that the borrower understands exactly what she is offering as security and the potential consequences of the agreement. 

Additionally, the creditor must give value (virtually anything will do) and the debtor must actually own an identifiable interest in the property. Absent any one of these conditions, the security interest will not be enforceable in a court.

Perfection

When it comes to the secured party making the security interest stick – what is known as “perfecting” the security interest - things begin to get more complex.

Perfection of a security interest requires that the lender "announce" to the public that the security interest exists. Essentially, in performing the act of perfection, the lender is putting the world – and in particular, other potential creditors – on notice that she got there first and secured her loan against the property as security. The necessity to perfect debts lies in the fact that when the debtor does default on his or her loans, there may well be more than one creditor scrambling for ownership of a single piece of property. If one creditor has “perfected” her security interest and another has failed to do so, the perfected party will prevail over the unperfected party in vying for the right to take the secured property.

1. Perfection by Filing
As the requirement for perfection is one of providing notice to other potential creditors, the easiest and most common method used to perfect a security interest is to file a notice of that interest with the appropriate authority. In that way, any perspective lender will be able to go to that same authority, reference the borrower and the piece of property, and discover whether or not other perfected lenders already exist with respect to that property. See U.C.C. § 9-304.

A Financing Statement, as described in the UCC, is the single most common way of perfecting a security interest. The information required of a financing statement is:

  1. The debtor’s signature
  2. Name and address of creditor and debtor
  3. Description of the collateral

See U.C.C. § 9-502.

The UCC further makes it apparent that even a very general description of the property involved, such as “all the debtor’s property” or “all the debtor’s automobiles” will generally suffice. 

As for the required filing location, the rules generally vary from state to state. Typically, it is safe to assume that filings with regard to real property should be made locally, probably with the county or city clerk, in the area where the property is located. Moveable personal property will typically require filing either at the location of the debtor’s primary residence or with the Secretary of State in the state of the debtor’s residence. However, it is important, whenever dealing with such a situation, to consult the local laws of where the debtor is located, where the property is located, and perhaps even the location of where the property was purchased. The reason for this is that variations in the law exist from state-to-state, and that failing to file properly may reduce a secured party to the status of an unsecured party in a bankruptcy filing, thereby nullifying all the work done in acquiring the security interest in the first place.


2. Other Means of Perfection
Apart from filing a financing statement, perfection may be achieved via several other means:

a. Possession
There is a saying that goes, “Possession is nine-tenths of the law.” When it comes to secured transactions, that statement is accurate. If the secured party takes possession of the collateral by physically taking it (in the case of personal property) or by occupation (in the case of real property), then the security interest is perfected. Such a situation is typical when the item purchased is an instrument, such as a security (e.g., stocks, bonds, notes, etc.) that can easily be retained by the lender to create perfection of the lender’s security interest. See U.C.C. § 9-305

EXAMPLE: Hank required some cash to purchase a new car, but because he only needed a few hundred dollars, he asked his neighbor Ed if he could borrow the money from him. Ed was willing to lend the money to Hank because they were friends, but Ed was a little concerned because he knew that Hank had a reputation for not always paying off his loans. As such, Ed required that Hank give him his lawnmower, which he (Ed) would keep, until Hank had completed repayment for the loan.


b. Purchase-Money Security Interest
Another easy example of perfection is when a lender provides the money for the debtor to effect the purchase of specific property. Consider the following example:

EXAMPLE: Sue wants to buy a new TV but is a bit short on funds. Electro-World extends her a temporary line of credit in the exact amount of the cost of the TV that she wants, in order for Sue to buy the TV. Electro-World keeps a security interest in the TV.

In the above example, Electro-World has created a strong security interest in the TV and has automatically perfected its interest in the TV by virtue of the fact that it extended the funds for the purchase. This situation is known as a “purchase-money security interest” (PMSI) and this interest is very favored by the law because of it its ease of management.

After Acquired Property

One important additional note involves the “after-acquired collateral” clause in a security agreement. Oftentimes, lenders will request a degree of protection in their security agreement that exceeds the scope of a single purchase. Thus, they include in their security agreements an “after-acquired collateral clause," which extends the lender’s security interest to the property that the borrower has now and that which he or she may acquire in the future. 

Such clauses are almost always enforceable. The problem with them, however, is that they may create dispute when future lenders secure against property that is already otherwise covered in an “after-acquired” clause. 

EXAMPLE: Dress Trough, Inc. is a company in the business of selling a large number of dresses at retail outlets across the country. Dress has many creditors including the companies that make the dresses that it sells, the places where it leases space in malls, and other companies such as those that sell it fixtures, cash registers, and other tools necessary for running the business. In one such agreement – the deal with the cash register company - Dress signed a deal that said that the cash register company was entitled to a security right in all of Dress’s “after acquired property.” A similar deal, with the same “after acquired” clause, was also struck with Fashionable Fashions – the company that supplied Dress Trough with most of its inventory.

The concluding section of this chapter discusses this scenario. However, we will note at the outset that holders of “purchase money security interests” will generally prevail over creditors who have an interest in that same item via an “after acquired collateral” security interest clause.