Priority in Foreclosure and Debt Collection
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Overview
This final section of the chapter picks up where we left off in the previous section. Once we have established a secured transaction and the rights of the secured party vis-à-vis the collateral, we must now consider how those rights might be exercised in the event of a default or other failure on the part of the borrower to live up to her end of the bargain.
Priority on Foreclosure
As discussed previously, there are different types of secured, semi-secured, and unsecured creditors. The question becomes: Which of these parties have priority over which other parties when multiple claimants assert claims on the same piece of collateral? The rules regarding priority disputes from foreclosure or other actions against the property are particularly complex and difficult. In addition, the laws of priority vary by state. The following should help guide you through the process. However, it is recommended that you proceed cautiously and with full knowledge of local law when attempting to remedy such a dispute.
In general, distribution of proceeds from a trustee sale in foreclosure priority order:
- Costs and Expenses of sale, including payment of trustee's fees and attorney's fees.
- Purchase-Money Security Interest or Secured Deed or Senior Mortgage.
- Secured Junior Liens or encumbrances in the order of their priority.
- Remainder to Trustor or the Trustor's successor in interest.
1. Secured versus Unsecured
The first and easiest step in the process is that secured creditors will almost always have priority over unsecured creditors. Unsecured creditors’ loans are only satisfied from whatever, if anything, is left over after payment in full to the secured parties.
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 Cash Register company and Fashionable Fashions each have secured interests in Dress’ assets. Thus, they have a secured priority above other creditors who do not have such a security interest.
2. Secured Perfected versus Unperfected
The next dividing line is as between perfected and unperfected secured parties. When two parties hold secured liens on a single piece of property, the rule is that the perfected party will take precedence over the unperfected party.
If, however, there are multiple secured parties on a single piece of property, who have each perfected their interests, then the first party to have perfected will generally take precedence. Conversely, if none of the secured parties has attained perfection, then the first party to have “attached” the security interest would win. “Attachment” is simply the process whereby the security agreement, including the transferring of the loan and the rights in the collateral, is accomplished.
EXAMPLE: Two companies, Fix It, Inc. and Rack’em Up Co. have security interests in all the fixtures at Dress Trough’s many stores. However, only Fix It, Inc. has perfected its security interest by filing a financing statement in the state of incorporation for Dress Trough. As such, in a bankruptcy proceeding, Fix It will have priority over Rack’em.
3. The exception - #1
Notwithstanding the above rules, a “purchase money security interest” (PMSI) holder has “super-priority” over other security interest holders. As explained above, PMSI’s are easy and favored by the law because of their speed, lack of complexity and the fact that they allow the economy to keep moving as purchasers can easily make purchases on readily extended credit while protecting the lender by granting him a PMSI.
This rule of the priority of the PMSI holder is primarily relevant in disputes against an “after-acquired collateral” security interest holders, which we discussed earlier. As long as the property in question is still in the possession of the debtor, the PMSI holder will prevail over a previously secured and perfected after-acquired security interest holder. This rule is designed to encourage loans that are required to allow people to purchase property by assuring the lender that it is his loan that will be paid off first in the event of a default.
4. The exception - #2
A final rule that comes into play on occasion is when the secured property is then resold to a buyer. Essentially, the rule is that a “buyer in the ordinary course of business” – i.e., a buyer who buys from a supplier or retailer – takes precedence over all other parties. The logic behind this is readily apparent in the following example:
EXAMPLE: Mary, a shopper at Dress Trough, purchases a dress from the company. She does not need to worry that a creditor might come and foreclose on her dress. As Mary is a buyer in the ordinary course of business, she has full rights to any dress she buys without needing to worry that she might lose the dress to a creditor of Dress Trough's.
Default and Rights of Repossession
As a final note with regard to secured interests and transactions, there remains unresolved the issue of how exactly a creditor regains possession of the collateral in the event of default. Moreover, what exactly is a default that can trigger a repossession action?
The UCC fails to identify an exact definition for what constitutes a “default” in a universal sense. Thus, it is up to the constituent parties to define in the loan agreement exactly what elements will trigger a default. Typically, parties will include items such as failure to pay the loan – either in full or as payments come due, destruction or other mishandling of the collateral, and/or other such major incursions into the value of either the loan or the collateral itself. In order to determine what the rules are for a given loan, the best place to look is generally to the security agreement itself.
If, after a default is triggered, the secured party wishes to take or retake possession of the collateral, several methods are available. The most effective – but also the most costly and the slowest moving – is through the courts. In many instances, an appeal to the court will result in a decision by the court which requires a local law enforcement agency to repossess or otherwise tag the property (which makes it temporarily unable to be sold), pending the disposition of the dispute. While this method is probably the most efficient, as interference by the debtor of such enforcement can result in criminal penalties, it is also time consuming and expensive.
Alternatively, in a limited number of situations, the lender may choose to use “self-help” to claim the collateral. “Self-help” is legal jargon that essentially means that the lender or his agent physically retakes the property on his own.
While this may sound great to a lender who needs to get the collateral back, there is a strong note of caution required. The general rule is that self-help, while allowed in the case of secured personal property, is seriously discouraged by the law. Self help repossession may never be done in a manner likely to “breach the peace.” See