Priorities Among Security Interests - Module 3 of 5

Priorities Among Security Interests - Module 3 of 5


Module 3-Priorities Among Security Interests

 

Introduction

Imagine the following scenario. There’s a widget manufacturing business with a wide array of assets, including manufacturing equipment, a warehouse full of inventory and accounts receivable from customers who pay their invoices after receiving widgets.  One day, the business stops operating after it becomes apparent that its debts exceed its assets and it’s not capable of turning around to make a profit.  The owners lock the doors and freeze the business’ assets.  Now, imagine all of the business’s creditors arriving on the same day to seize what they can.  The rules governing priorities enable the creditors to sort out who gets what, with primacy for the first-place, secured creditors.  Although court intervention is sometimes needed to settle claims among creditors, these rules resolve the vast majority of disputes through application of the UCC.

 

In this module, we will examine issues regarding priority of security interests as well as special rules for certain security interests and types of collateral such as fixtures.

 

Basic Priorities Issues

When examining basic priority issues, the first step is to verify the collateral.  Determining creditor priority is only necessary when two or more creditors are claiming an interest in the same collateral.[1]  For example, if John is a debtor and Bank A has a security interest in some pieces of his business’ equipment and Bank B has a security interest in John’s inventory, there is no dispute.  Each secured party has its own collateral to pursue.  If both Bank A and Bank B have overlapping claims to the same collateral of John’s, then their respective priorities must be resolved.

 

The first rule regarding priority instructs that a secured creditor will beat an unsecured creditor. If Bank A properly attached its security interest in the widget equipment, it will take priority over Bank B and any other creditor who did not take steps to become secured parties and attach a security interest to the collateral at issue.  This is the reward for establishing a security interest and satisfying Article 9’s requirements.  An unsecured creditor must rely on the courts and judicial process to collect on any unpaid debts.

 

The second rule covers multiple creditors,  all of whom have attached security interests in the same collateral.  Since their statuses are essentially equivalent, Article 9 prioritizes the security interest of the secured party that first attaches its security interest to collateral.[2]  All three components of attachment (providing value, ensuring the debtor’s rights in the collateral and obtaining a signed security agreement or possession or control) must be in place before the security interest is established.

 

Analyzing priorities in this scenario is a fact-intensive exercise to determine exactly when each creditor achieved attachment. The third rule rewards a creditor who complies with Article 9 and perfects the security interest. If both Bank A and Bank B have attached security interests in the equipment, but only Bank A has perfected, Bank A will win.[3]

 

The final rule is the one that leads to the most disputes.  If both Bank A and Bank B are attached and perfected, the secured party who first filed a UCC-1 form or otherwise perfected will have top priority.[4]  If a creditor perfects by filing a UCC-1, the analysis is relatively easy.  A state’s central filing office will provide a date stamp when it receives a financing statement for filing, so the date and time will be on the record. 

 

This is where pre-filing of the financing statement is beneficial. A secured party may wait until loan details are finalized, documents are signed, and the security interest is attached prior to spending the time and money to file a UCC-1. Still, if she proactively files the financing statement early, usually during the loan underwriting process, the operative perfection date will be the date of filing of the financing statement, well in advance of loan closing and the actual attachment.

 

The public policy justification for allowing a secured party to stake out her place in line early like this is that advance notice of a lending and security relationship helps to prevent debtors from fraudulently taking out multiple loans secured by the same collateral at the same time, compromising the interests of the affected lenders. If prospective lenders search and file early, it creates a better sequencing of notice, which is what priority is all about.   

 

When a secured party perfects its security interest by possession or control of the collateral, it will have to produce extrinsic evidence documenting when it first exercised that possession or control.  In most cases, it will also have to demonstrate the timeline for all components of attachment to define the exact time the security interest was attached and perfected using possession or control.

 

The best possible position for a creditor is to be secured and perfected and also to be the first creditor to file or perfect. Any subsequent secured party can search the UCC-1 database maintained by the central filing office before deciding to lend against certain collateral. Thus, they can make informed decisions about whether to lend while being in second (or lower) place in priority as to that collateral and thus potentially under-secured.


Purchase-Money Security Interests

Purchase-money security interest lenders are entitled to special rules and priority benefits because of their relationship to the collateral they finance and help the debtor to acquire. 

As the basic rules indicate, sooner is always better for perfecting a security interest.  A grace period of 20 days is provided to permit purchase-money security interest lenders a reasonable opportunity to file their UCC-1’s.[5]  This recognizes that purchase money lending often occurs at the point of sale rather than in a protracted underwriting process as is the case for lines of credit and other commercial financing. 

 

The 20 day-clock starts ticking as soon as the collateral is delivered to the debtor.[6]  We must keep in mind that purchase-money security interests in consumer goods are automatically perfected upon attachment, so there is no required timeline.[7]

 

The 20 day-grace period enables the purchase money lender to take priority over another secured party who may claim an interest in the financed collateral between attachment and perfection.  In essence, the purchase money provider’s priority date relates back to attachment so long as it is perfected with a UCC-1 within 20 days.  On the 21st day after delivery, the lender who has not yet perfected falls in line with the general rules we discussed before.

 

To qualify for the special priority treatment that section 9-324 provides, a lender must ensure that its security interest meets the definitional requirements of a purchase-money security interest.[8]  Under Article 9, a “‘purchase-money obligation’ means an obligation of an obligor incurred as all or part of the price of the collateral or for value given to enable the debtor to acquire the rights in or the use of the collateral if the value is, in fact, so used.”[9]  This definition presents two different kinds of purchase money lenders. 

 

Types of Purchase Money Financing

The first, more common type, is third party lender financing.  This means the “value given to enable the debtor to acquire” the collateral.[10]  Sellers rarely finance all sales “in-house” and instead partner with banks and other lending institutions to offer loans to buyers.  For example, when a person buys a new car and finances it, a bank or affiliated lender, such as the Ford Motor Credit Company, pays the dealership in full for the car, and the purchaser repays the Ford Motor Credit Company over time with interest. Often, retailers set up lender affiliations so that they can secure credit approval for the buyer at the point of sale, allowing the sale to be completed in one seamless transaction.  The purchaser, who is also the debtor, may not even know that a third party is involved unless she examines the forms and payment address closely.  These transactions often generate chattel paper and are used for all kinds of tangible collateral.

 

A third-party lender must be careful to ensure that the value it gives “is in fact so used” to acquire the collateral.[11]  If the debtor diverts the funds to another purpose, or even commingles them inappropriately, the purchase money status of the loan and security interest may fail. So, if the bank writes a car loan check to the purchaser, and the purchaser uses some of that money to buy other items, the loan may not attain that stature of a purchase money security interest, thus negating the perfection grace period and other benefits. That’s why, in most cases, the third-party lender will simply pay the seller of the collateral directly to ensure the funds are used as intended – to buy the collateral.  Releasing the funds to the debtor is too risky.

 

The second, less common and more old-fashioned type of purchase money security interest lender is descriptively referred to as a “seller take-back.”  This is how buyers financed purchases before bank lending and is defined by Article 9 as the “obligation . . . incurred as all or part of the price of the collateral.”[12]  The seller advances the goods and the buyer makes payments over time.  If the buyer fails to pay, the seller takes back the collateral. Rather than paying for the car, the lender, in this scenario, buys the car and finances it to the seller. Occasionally, a small used car dealer will offer in-house financing this way. 

 

Maintaining the Purchase Money Security Interest Priority

When a debtor has used both a third-party lender and a seller take-back lender to purchase and finance the same collateral (such as one loan for the down payment and the other for the balance), and they both perfect within 20 days as required, they wind up tied for priority.  Article 9 resolves this tie by declaring the seller take-back lender the winner, ahead of the third-party lender.[13]  The policy rationale supporting this outcome is that sellers are not in the business of lending money.  Third-party lenders, usually banks and other finance companies, are structured to sustain occasional losses. Thus, priority is given to the party that’s usually not the professional bank or finance company.

 

In commercial financing, there is also a process for re-arranging priorities when purchase money security interests come into the picture.  The scenario occurs when a commercial debtor has already granted a security interest with an after acquired property clause, known as a floating lien, in its inventory, equipment or both.  The debtor may have exhausted its line of credit, may have cash flow difficulties or may just want to use advantageous lending terms that lenders are willing to extend in exchange for an “after acquired collateral” security interest. This pre-existing perfected security interest means that new lenders will be subordinated to the lender with the after acquired property security interest. 

 

Still, UCC Section 9-324 provides a mechanism whereby certain purchase money security interest lenders who finance equipment purchases can gain priority even over such a prior, perfected lender. If the purchase money security interest lender perfects by filing a UCC-1 that covers the specific equipment financed within 20 days of delivery of that equipment to the debtor, the lender had priority even over a previously perfected security interest that applies to all acquitted collateral by the borrower.[14]  Because this opportunity to jump ahead is so valuable, the purchase money lender should ensure that it pays the seller of the equipment directly so that the transaction truly qualifies as a purchase money security interest.

 

When the financing is of inventory rather than equipment, the process is a bit more complicated.  For the purchase money security interest lender-financed inventory, the lender must perfect its security interest before the debtor receives the financed inventory; the 20-day grace period does not apply.[15]  Next, the lender must notify the prior, perfected secured party in writing.[16]  This party can be identified through a search of the UCC-1 records and a delivery method with tracking and confirmation-like certified mail with a return receipt- should be used.  Additionally, the notice must be sent and received before the debtor gets its new inventory and must be renewed every 5 years if the inventory lending is ongoing.[17] Finally, the notice must indicate that the lender is obtaining a purchase money security interest and describe the affected inventory collateral.[18]


Fixtures

Fixtures on real property, such as installed kitchen appliances, chandeliers and the like, present an interesting problem because the real property they become affixed to may be subject to other interests and encumbrances.  If the debtor is a renter or lessee, the landlord or lessor has interests in the land.  If the debtor owns the real estate but has subjected it to a mortgage or other lien, the lender has a security interest in the land and improvements on it. Only where the debtor owns the real property free and clear do security interests in fixtures function the same as others in terms of priority.

 

A fixture lender should act to perfect its security interest within 20 days of the goods being installed.[19]  Perfection of fixtures is accomplished by filing a UCC-1 in the land records office where the relevant real property is located. This provides notice to potential purchasers and mortgagees that this lien exists. Satisfying these criteria puts the fixture lender in first place in terms of getting paid at the time of sale or foreclosure of the underlying real property.[20]  This is a special priority because it enables a perfected fixture lender to jump ahead of a pre-existing mortgage lender. The rationale for this is that the mortgage lender’s interest in the real property benefits from the fixture also.

 

A debtor who finances fixtures isn’t always an owner.  Lessees of all kinds, including retail stores and restaurants, often borrow money to fund the installation of fixtures to open or renovate their businesses.  This creates a conflict with the owner of the property - the landlord.  If the landlord has a mortgage, then there are at least three parties with interests in the real property now subject to a security interest in the fixture. Because of the other interests in the real property, a fixture lender does not have as much freedom to act on its collateral as if the collateral were still tangible and movable goods or intangible assets.  Indeed, repossession of the fixture may be impractical because removing a fixture could cause substantial damage and impair a landlord or mortgage lender’s interests in the real property. 

 

A good example is a commercial oven.  In a restaurant’s or bakery’s kitchen, the oven may be mounted to the wall, even bricked in, and likely has a gas line connected to it.  Haphazardly ripping out the oven could easily cause damage to the walls and floors of the kitchen as well as to other nearby installations.  If a professional plumber or pipefitter is not utilized to safely cap the gas line, it could leak and lead to a fire or explosion.  Therefore, the fixture lender must repossess fixtures carefully and mend any damage to the surrounding structure, improvements and other fixtures.[21]  For this reason, fixtures are rarely actually repossessed. Fixture filings remain common, however, because of the priority benefits, ensuring payoff when the property is sold, refinanced or foreclosed.  If, however, the fixture debtor owns the real property outright with no mortgages or liens, the fixture lender is free to repossess without regard to damage caused.

 

In our fourth module on Secured Transactions, we’ll learn about priorities against other parties and the rules of priority, and we’ll also look at liens, priorities and repossessions in cases of bankruptcy.



[2] Unif. Comm. Code § 9-322(a)(3).

[3] Unif. Comm. Code § 9-322(a)(2).

[4] Unif. Comm. Code § 9-322(a)(1).

[6] Unif. Comm. Code § 9-324(a).

[8] Unif. Comm. Code § 9-324.

[10] Unif. Comm. Code § 9-103(a)(2).

[11] Unif. Comm. Code § 9-103(a)(2).

[12] Unif. Comm. Code § 9-103(a)(2).

[13] Unif. Comm. Code § 9-324(g)(1).

[14] Unif. Comm. Code § 9-324(a).

[15] Unif. Comm. Code § 9-324(b)(1).

[16] Unif. Comm. Code § 9-324(b)(2).

[17] Unif. Comm. Code § 9-324(b)(3).

[18] Unif. Comm. Code § 9-324(b)(4).

[20] Unif. Comm. Code § 9-334(d).

 

See Also: