Default and Repossession - Module 5 of 5

Default and Repossession

Default

The last substantive title of Article 9, the 9-600’s, governs default.  Article 9 does not define default but does detail the remedies available to a secured party upon a debtor’s default and sets forth the procedure for executing those remedies.

The parties’ security agreement usually outlines the different acts and omissions that may be treated as defaults.  The most obvious form of default is failing to make payments on the debt secured by the collateral.  Some of the less obvious, but also common, means of default include:

·         Failing to maintain casualty insurance to protect tangible collateral

·         Death of a debtor or dissolution of a corporate debtor

·         Death of a guarantor

·         Defaulting on other debts

·         Insolvency of the debtor, including bankruptcy and receivership

·         A business debtor ceasing to operate

·         A business debtor’s loss of license or franchise rights

·         Permitting another security interest or lien to encumber the collateral

Once any contractual default occurs, the secured party may move to enforce its rights and remedies as described in the security agreement or as provided under Article 9.

Repossession

Although one of the primary reasons to attach and perfect a security interest is to have access to self-help remedies without having to involve courts, secured parties are also free to use the courts to pursue debtors and collateral.[1] Judicial process would involve filing a complaint, satisfying service of process requirements and litigating the matter.  Potential causes of action that may be enforced by creditors in this manner include breach of contract, replevin (meaning seizing goods to return them to their owner) or detinue (which means a legal claim to recover wrongfully held goods). The goal of the action may be obtaining possession of tangible collateral or an action for declaratory judgment with regard to intangible collateral.  Litigation for monetary damages may result in a judgment which can be converted into a lien to levy on property of the judgment debtor.  In most cases, such liens are operable as of the date of levy.  However, liens resulting from security interests enjoy earlier effective dates, relating back to the date of perfection or filing of a UCC-1 form.[2]   

Most secured parties choose self-help remedies where possible.  For tangible collateral, self-help means repossession of the collateral.  This usually involves taking physical possession of it, such as by towing a repossessed car.[3]  Sometimes, the collateral is so large or built into place (as in the case of a non-movable trailer or a commercial oven built into a restaurant) that this is not feasible.  In those cases, the secured party may render collateral equipment unusable or leave it in place for disposition.[4]  For example, a secured party might remove the control panel of large industrial equipment or even build a fence around it.  If the collateral is a warehouse full of inventory, the secured party might change the locks and take over the lease and then sell the inventory to others to satisfy the debt.  If the security interest provides for it, the secured party may instruct the debtor to gather the collateral and make it available for pickup.[5]   Debtor cooperation with this requirement is, of course, not always forthcoming.

Breach of Peace

If the secured party chooses to proceed without judicial process, however, it  may not breach the peace.[6]  Breach of the peace is not explicitly defined by the UCC, other than a comment that law enforcement personnel may not be used in any way.[7]  Courts have fashioned a variety of standards to determine breach of peace and there is no bright-line test available because the range of collateral and circumstances of repossession vary so widely.  Instead, some courts use a multi-prong balancing test, typically including consideration of 1) location of repossession; 2) consent from the debtor; express or implied; 3) third party involvement or impact; 4) the kind of premises that needs to be entered; and 5) use of deception, if any.[8]  Other courts simply analyze the facts of each case without a framework.   

A quiet and orderly seizure from a public place or outdoor area is far more likely to pass muster than a tense entry into a residential home.  Threats or actual violence from either side will almost always be deemed a breach of the peace. This is why so many repossessions occur in the dark of night.  In states where deception or trickery is allowed, secured parties might send “warranty notices” to defaulting debtors encouraging them to bring the collateral in to a service center for repair or upgrade, leading the debtors to hand over collateral voluntarily.

Although some secured parties have tried it in the past, the current UCC does not permit debtors to waive the prohibition on breaches of the peace as a matter of public policy.[9] So, a provision in a loan agreement allowing repossessions that breach the peace would be invalid. Moreover, secured parties may not delegate their obligations to carry out repossessions peaceably. So, while most secured parties, such as banks, use third party recovery agents as independent contractors to physically repossess collateral, if an independent contractor commits a breach of the peace, the secured party will be liable.[10]

For intangible collateral, self-help looks a little different.  Section 9-607 provides a series of options for different types, provided the security agreement includes a matching provision.  For example, a secured party with an interest in accounts receivable, payment intangibles or instruments may direct the debtor’s customers or payors, described as account debtors, to make payment directly to the secured party.[11]  For a deposit account subject to control by the secured party, the balance of the account is simply frozen, withdrawn and applied to the debt.[12]  Proceeds from the disposition of collateral are likewise collectible.[13]  The secured party is entitled to reimburse its costs of collection before applying the funds to the debt and figuring in any surplus or deficiency that may apply.[14]  

When the collateral is or includes fixtures or overlaps with real property, the connection to real property complicates repossession. In many cases, a secured party who has an interest in related real property may proceed under the rules for foreclosure  and the personal property in improvements on the real property follows along.[15]  For fixtures, repossessions may still occur, but the secured party is obligated to repair or cover the cost of repair when damage occurs in the repossession process if someone other than the debtor has an interest in the real estate.[16] 

Whether the secured party uses judicial process or self-help remedies, a bankruptcy filing by the debtor can bring all enforcement and collection activity to an immediate halt.  Once a bankruptcy petition is filed, an automatic stay takes effect and forces all creditors, including secured parties, to pursue their claims within the bankruptcy proceedings.  Self-help repossession can proceed only on order of the bankruptcy court following a motion for relief from the stay.  Lawsuits may be carried out as adversarial proceedings within the bankruptcy courts rather than traditional civil courts.  Perfected secured parties do have the highest level of standing to recover from bankruptcy estates, so the risk of an automatic stay should encourage creditors to attach and perfect security interests.

Post-Repossession

There is no requirement for secured parties to provide notice of their intent to repossess collateral.  Such an obligation would ruin the element of surprise that usually enables recovery agents to quickly and quietly seize the goods, as defaulting debtors might otherwise hide the collateral or keep watch and attempt to create a breach of the peace to thwart the process. Post-repossession processes, however, center on the provision of statutorily defined notices.

Usually, the secured party will want to sell tangible collateral and put the proceeds toward the debt.[17]  The UCC permits public and private sales, [18] but prefers public sales, which usually means an auction.  Public sales ensure that the price is set by the current market and not made artificially low.  Private sales are more relevant for specialized goods with smaller potential markets.  In all cases, the sale must be commercially reasonable in its price and terms.[19]  The secured party or its representative may also purchase by bid at a public sale or at a private sale.[20]

Prior to any sale, the secured party must send notice outlining its plans for disposing of the collateral.  A form is included in UCC section 9-613(5).  The best approach is to use the form, adding additional information as needed.  A sufficient form must:

-       describe the debtor and secured party,

-       describe the collateral to be disposed of,

-       identify the method of disposition,

-       indicate that the debtor is entitled to an accounting, and

-       state the time and place of disposition.[21]   

The notification must be sent after the debtor defaults, but at least ten days before the intended sale.[22]  A slightly different form for consumer debtors, with simpler language, is also provided.[23]   

Copies of the required notification should be sent to the debtors, all other obligors on the debt and every other party with interests in the collateral.[24]  The secured party should conduct a UCC search to identify all required addressees.[25]  The best practice is to send these notices by certified mail to be able to prove delivery.  The debtor and any other obligor may waive its right to receive this notification only after default, but not as part of the original loan agreement or loan application.[26]

Following any sale or disposition, the secured party prepares an accounting of the proceeds realized.  First, the expenses are deducted.  These include the costs of collecting and storing the collateral as well as preparing it for and conducting the sale,[27] and reasonable attorney’s fees.[28]  The remaining funds are used toward the secured debt, including all interest and fees properly chargeable.[29]  If anything remains, it is used to satisfy subordinate secured parties and lienholders in descending order of priority.[30]  Once all creditors and costs are paid in full, any surplus must be returned to the debtor.[31]  That does not happen very often.  More likely, there will be a deficiency and the proceeds of disposition will not be enough to even satisfy the secured debt.[32]  The secured party memorializes this accounting in a written explanation that illustrates how the surplus or deficiency was calculated.[33]

A purchaser of collateral from a secured party in this type of disposition is usually entitled to take the property free and clear of all encumbrances as long as they acted in good faith, even if the secured party erred in some way.[34]  Because of the secured party’s disconnected relationship with the goods sold, it is entitled to disclaim warranties, making the sale “buyer beware” and “as is.”[35]  The secured party should complete the sale by preparing a record that reflects the nature of the sale and enables the purchaser to take title to the former collateral.[36]

Less commonly, a secured party may wish to keep the collateral and cancel part or all of the debt in exchange.  This is called strict foreclosure and is more carefully regulated to ensure that it is done fairly, since market forces cannot be relied on to set the fair price.[37]  This process is allowed only if several requirements are met.  First, the debtor must consent to the strict foreclosure after default and, if a consumer, not be in possession of the collateral at the time of consent.[38]  Next, the secured party must send proposals outlining the arrangement to subordinate secured parties and anyone else with an interest in the collateral[39] and not receive a timely objection.[40]    

Finally, a strict foreclosure can only be carried out if a consumer debtor has paid less than 60% of the total debt secured by that collateral.[41]  The debtor and any other obligor may waive the 60% requirement only after default.[42]  Once a strict foreclosure is complete, the debtor’s obligation to the secured party is discharged to the extent agreed and all subordinate interests are extinguished.[43]  Because the secured party is fixing the value of the collateral in its proposal, strict foreclosures are more suspect when done for only a partial discharge of the debt and when other subordinate interests are affected.

A debtor who does not want to lose the collateral can seek to redeem it.  Other obligors and subordinate secured parties and lienholders may also seek to redeem the collateral.[44]   Redemption requires more than just catching up the overdue payments.  The redeeming party must tender the entire amount of the debt and all expenses and reasonable attorney’s fees incurred by the secured party.[45]  Redemption must occur before the collateral is disposed of.[46]  Alternatively, if the secured party has noticed an intent to sell the collateral at a public sale, the debtor is free to bid at the public sale and try to buy it back.

Penalties for Non-Compliance

When a secured party commits a breach of the peace or otherwise errs in the repossession and disposition process, penalties are imposed under the UCC.  Without these provisions, there would be no useful enforcement mechanism as defaulting debtors are rarely in a financial position to sue to enforce their rights in separate proceedings.  Since secured parties usually draft security agreements, they never include penalties for repossession wrongdoing.

In general, the applicable standard for conducting a repossession, disposition and accounting is “commercially reasonable,” which is a flexible standard that recognizes the realities of selling goods outside of the ordinary course of business.[47]

While the repossession and disposition is ongoing, a debtor, obligor or subordinate lienholder may petition a court for an order enforcing appropriate conditions on the secured party.[48]  The debtor may also raise non-compliance with the governing provisions in a proceeding to recover a deficiency following disposition.[49]  In such a proceeding, a secured party who acted wrongfully may be forced to forfeit its right to a deficiency or pay a surplus that would have been realized if it had complied.[50]  Aggrieved consumer debtors are entitled to recover liquidated damages in the amount of the total interest or financing charges plus 10% of the principal amount financed.[51]

Conclusion

            Thank you for participating in LawShelf’s video-course in secured transactions. Together, we’ve surveyed some of the most important rules of UCC Article 9 governing secured transactions, collateral and repossessions. We hope you’ve gained the knowledge and skills to better handle secured transactions and we encourage you to take advantage of our other courses in the areas of contracts and sales. Best of luck and please let us know if you have any questions or feedback.