Bankruptcy Creditors' Claims

Introduction to Secured Transactions

Creditors want assurances that they will be repaid by the debtor. An oral promise to pay is no security at all, and - as it is oral - it is difficult to prove. A signature loan is merely a written promise by the debtor to repay, but the creditor stuck holding a promissory note with a signature loan only - while he may sue a defaulting debtor - will get nothing if the debtor is insolvent. Again, that's no security at all. Real security for the creditor comes in two forms: by agreement with the debtor or by operation of law without an agreement.

Security obtained through agreement comes in three major types: (1) personal property security (the most common form of security, which we will cover in this chapter); (2) suretyship - the willingness of a third party to pay if the primarily obligated party does not; and (3) mortgage of real estate.

The law of secured transactions consists of five principal components: (1) the nature of property that can be the subject of a security interest; (2) the methods of creating the security interest; (3) the perfection of the security interest against claims of others; (4) priorities among secured and unsecured creditors - that is, who will be entitled to the secured property if more than one person asserts a legal right to it; and (5) the rights of creditors when the debtor defaults. After considering the source of the law and some key terminology, we examine each of these components in turn.

Here is the simplest (and most common) scenario: Debtor borrows money or obtains credit from Creditor, signs a note and security agreement putting up collateral, and promises to pay the debt or, upon Debtor's default, let Creditor (secured party) take possession of (repossess) the collateral and sell it. "The Grasping Hand" Figure illustrates this scenario - the grasping hand is Creditor's reach for the collateral, but the hand will not close around the collateral and take it (repossess) unless Debtor defaults.

Source of Law

Article 9 of the Uniform Commercial Code (UCC) governs security interests in personal property. The UCC defines the scope of the article (here slightly truncated):^[1]

It may be helpful to begin with some definitions. The secured transaction always involves a debtor, a secured party, a security agreement, a security interest, and collateral.

• Article 9 applies to any transaction "that creates a security interest". The UCC in Section 1-201(35) defines security interest as "an interest in personal property or fixtures which secures payment or performance of an obligation".
• Security agreement is "an agreement that creates or provides for a security interest". It is the contract that sets up the debtor's duties and the creditor's rights in event the debtor defaults.
• Collateral "means the property subject to a security interest or agricultural lien".
• Purchase-money security interest (PMSI) is the simplest form of security interest. Section 9-103(a) of the UCC defines "purchase-money collateral" as "goods or software that secures a purchase-money obligation with respect to that collateral". A PMSI arises where the debtor gets credit to buy goods and the creditor takes a secured interest in those goods. Suppose you want to buy a big hardbound textbook on credit at your college bookstore. The manager refuses to extend you credit outright but says she will take back a PMSI. In other words, she will retain a security interest in the book itself, and if you don't pay, you'll have to return the book; it will be repossessed. Contrast this situation with a counteroffer you might make: because she tells you not to mark up the book (in the event that she has to repossess it if you default), you would rather give her some other collateral to hold - for example, your gold college signet ring. Her security interest in the ring is not a PMSI but a pledge; a PMSI must be an interest in the particular goods purchased. A PMSI would also be created if you borrowed money to buy the book and gave the lender a security interest in the book.
• Secured party is "a person in whose favor a security interest is created or provided for under a security agreement," and it includes people to whom accounts, chattel paper, payment intangibles, or promissory notes have been sold; consignors; and others under Section 9-102(a)(72).

Property Subject to the Security Interest

Now we examine what property may be put up as security - collateral. Collateral is - again - property that is subject to the security interest. It can be divided into four broad categories: goods, intangible property, indispensable paper, and other types of collateral. We will consider several in this section.

Goods

Tangible property as collateral is goods. Goods means "all things that are movable when a security interest attaches. The term includes (i) fixtures, (ii) standing timber that is to be cut and removed under a conveyance or contract for sale, (iii) the unborn young of animals, (iv) crops grown, growing, or to be grown, even if the crops are produced on trees, vines, or bushes, and (v) manufactured homes. The term also includes a computer program embedded in goods". Goods are divided into several subcategories; several are taken up here.

Consumer Goods

These are "goods used or bought primarily for personal, family, or household purposes".

Inventory

"Goods, other than farm products, held by a person for sale or lease or consisting of raw materials, works in progress, or material consumed in a business".

Farm Products

"Crops, livestock, or other supplies produced or used in farming operations," including aquatic goods produced in aquaculture.

Equipment

This is the residual category, defined as "goods other than inventory, farm products, or consumer goods".

Accounts

This type of intangible property includes accounts receivable (the right to payment of money), insurance policy proceeds, energy provided or to be provided, winnings in a lottery, health-care-insurance receivables, promissory notes, securities, letters of credit, and interests in business entities. Often there is something in writing to show the existence of the right - such as a right to receive the proceeds of somebody else's insurance payout - but the writing is merely evidence of the right. The paper itself doesn't have to be delivered for the transfer of the right to be effective; that's done by assignment.

Other Types of Collateral

Among possible other types of collateral that may be used as security is the floating lien. This is a security interest in property that was not in the possession of the debtor when the security agreement was executed. The floating lien creates an interest that floats on the river of present and future collateral and proceeds held by - most often - the business debtor. It is especially useful in loans to businesses that sell their collateralized inventory. Without the floating lien, the lender would find its collateral steadily depleted as the borrowing business sells its products to its customers. Pretty soon, there'd be no security at all. The floating lien includes the following:

• After-acquired property. This is property that the debtor acquires after the original deal was set up. It allows the secured party to enhance his security as the debtor (obligor) acquires more property subject to collateralization.
• Sale proceeds. These are proceeds from the disposition of the collateral. Carl Creditor takes a secured interest in Deborah Debtor's sailboat. She sells the boat and buys a garden tractor. The secured interest attaches to the garden tractor.

Attachment of a Security Interest

Attachment is the term used to describe when a security interest becomes enforceable against the debtor with respect to the collateral. In the "The Grasping Hand" figure above, "Attachment" is the outreached hand that is prepared, if the debtor defaults, to grasp the collateral.

There are three requirements for attachment: (1) the secured party gives value; (2) the debtor has rights in the collateral or the power to transfer rights in it to the secured party; (3) the parties have a security agreement "authenticated" (signed) by the debtor, or the creditor has possession of the collateral.

The creditor, or secured party, must give "value" for the security interest to attach. Typically this is extending credit to the debtor. The debtor must have rights in the collateral. Most commonly, the debtor owns the collateral (or has some ownership interest in it). The rights need not necessarily be the immediate right to possession, but they must be rights that can be conveyed.^[10] A person can't put up as collateral property she doesn't own.

The debtor most often signs the written security agreement, or contract. The UCC says that "the debtor [must have] authenticated a security agreement that provides a description of the collateral.…" "Authenticating" (or "signing," "adopting," or "accepting") means to sign or, in recognition of electronic commercial transactions, "to execute or otherwise adopt a symbol, or encrypt or similarly process a record…with the present intent of the authenticating person to identify the person and adopt or accept a record". The "record" is the modern UCC's substitution for the term "writing". It includes information electronically stored or on paper. The "authenticating record" (the signed security agreement) is not required in some cases. It is not required if the debtor makes a pledge of the collateral - that is, delivers it to the creditor for the creditor to possess.

Perfection of a Security Interest

As between the debtor and the creditor, attachment is fine: if the debtor defaults, the creditor will repossess the goods and - usually - sell them to satisfy the outstanding obligation. But unless an additional set of steps is taken, the rights of the secured party might be subordinated to the rights of other secured parties, certain lien creditors, bankruptcy trustees, and buyers who give value and who do not know of the security interest. Perfection is the secured party's way of announcing the security interest to the rest of the world. It is the secured party's claim on the collateral.

There are five ways a creditor may perfect a security interest: (1) by filing a financing statement, (2) by taking or retaining possession of the collateral, (3) by taking control of the collateral, (4) by taking control temporarily as specified by the UCC, or (5) by taking control automatically.

"Except as otherwise provided…a financing statement must be filed to perfect all security agreements". A financing statement is a simple notice showing the creditor's general interest in the collateral. It is what's filed to establish the creditor's "dibs".

It may consist of the security agreement itself, as long as it contains the information required by the UCC, but most commonly it is much less detailed than the security agreement: it "indicates merely that a person may have a security interest in the collateral[.]…Further inquiry from the parties concerned will be necessary to disclose the full state of affairs". The financing statement must provide the following information:

• The debtor's name. Financing statements are indexed under the debtor's name, so getting that correct is important. Section 9-503 of the UCC describes what is meant by "name of debtor".
• The secured party's name.
• An "indication" of what collateral is covered by the financing statement. It may describe the collateral or it may "indicate that the financing statement covers all assets or all personal property" (such generic references are not acceptable in the security agreement but are OK in the financing statement). If the collateral is real-property-related, covering timber to be cut or fixtures, it must include a description of the real property to which the collateral is related.

The form of the financing statement may vary from state to state, but see the "UCC-1 Financing Statement" Figure for a typical financing statement. Minor errors or omissions on the form will not make it ineffective, but the debtor's signature is required unless the creditor is authorized by the debtor to make the filing without a signature, which facilitates paperless filing.

Generally, the financing statement is effective for five years; a continuation statement may be filed within six months before the five-year expiration date, and it is good for another five years. The UCC also has rules for continued perfection of security interests when the debtor - whether an individual or an association (corporation) - moves from one state to another. Generally, an interest remains perfected until the earlier of when the perfection would have expired or for four months after the debtor moves to a new jurisdiction. For most real-estate-related filings - ore to be extracted from mines, agricultural collateral, and fixtures - the place to file is with the local office that files mortgages, typically the county auditor's office. For other collateral, the filing place is as duly authorized by the state. In some states, that is the office of the Secretary of State; in others, it is the Department of Licensing; or it might be a private party that maintains the state's filing system. The filing should be made in the state where the debtor has his or her primary residence for individuals, and in the state where the debtor is organized if it is a registered organization. The point is, creditors need to know where to look to see if the collateral offered up is already encumbered. In any event, filing the statement in more than one place can't hurt. The filing office will provide instructions on how to file; these are available online, and electronic filing is usually available for at least some types of collateral.

Exemptions

Some transactions are exempt from the filing provision. The most important category of exempt collateral is that covered by state certificate of title laws. For example, many states require automobile owners to obtain a certificate of title from the state motor vehicle office. Most of these states provide that it is not necessary to file a financing statement in order to perfect a security interest in an automobile. The reason is that the motor vehicle regulations require any security interests to be stated on the title, so that anyone attempting to buy a car in which a security interest had been created would be on notice when he took the actual title certificate.

Temporary Perfection

The UCC provides that certain types of collateral are automatically perfected but only for a while: "A security interest in certificated securities, or negotiable documents, or instruments is perfected without filing or the taking of possession for a period of twenty days from the time it attaches to the extent that it arises for new value given under an authenticated security agreement". Similar temporary perfection covers negotiable documents or goods in possession of a bailee, and when a security certificate or instrument is delivered to the debtor for sale, exchange, presentation, collection, enforcement, renewal, or registration. After the twenty-day period, perfection would have to be by one of the other methods mentioned here.

Perfection by Possession

A secured party may perfect the security interest by possession where the collateral is negotiable documents, goods, instruments, money, tangible chattel paper, or certified securities. This is a pledge of assets (mentioned in the example of the stamp collection). No security agreement is required for perfection by possession.

Automatic Perfection

The fifth mechanism of perfection is addressed in Section 9-309 of the UCC: there are several circumstances where a security interest is perfected upon mere attachment. The most important here is automatic perfection of a purchase-money security interest given in consumer goods. If a seller of consumer goods takes a PMSI in the goods sold, then perfection of the security interest is automatic. But the seller may file a financial statement and faces a risk if he fails to file and the consumer debtor sells the goods. Under Section 9-320(b), a buyer of consumer goods takes free of a security interest, even though perfected, if he buys without knowledge of the interest, pays value, and uses the goods for his personal, family, or household purposes - unless the secured party had first filed a financing statement covering the goods.