Secured Transactions: Fall 2009
Chapter 1: Creating a Security Interest
Why Secured Credit?
i. Credit is a good thing (businesses using leverage)
ii. Allowing lenders to take security interests in property reduces the risk of not being repaid and expands the volume of credit
iii. Advantage over unsecured creditors during insolvency
iv. As an aside, covenants in unsecured credit agreements may be structured to have the same effect as a secured interest
Rights of Unsecured Creditor
i. Historical argument: “before judgment an unsecured creditor has no rights at law or in equity in the property of his debtor.”
ii. Seller v. Creditor:
1. creditor must sue, obtain judgment, and then whatever is required under state law to authorize the sheriff to seize/levy on the debtor’s assets (becoming a judicial lien and the seller becomes a “lien creditor”)
iii. Seller v. Other Creditors and Trustee in Bankruptcy:
1. creditor becomes at risk of losing preference to other creditors should the debtor fall on hard times; “race to the courthouse”
a. who ever wins the race gets all of the proceeds until the debt is satisfied
2. a judicial lien will become a secured interest under bankruptcy proceedings
1. the first impulse would be to suggest that the seller should receive the barrels back; of course, this isn’t a legal remedy; only the action on the promissory note remains
a. Once the sale has been complete, the buyer owns the wine barrels. The seller has a cause of action against the buyer on the promissory note.
2. the process for an unsecured creditor is stupidly hard
a. This is a race to the courthouse situation
Rights of Secured Creditor
i. Seller v. Creditor
1. Seller gains a security interest by executing a security agreement under Article 9 (could be in writing or electronic correspondence)
ii. Seller v. Other Creditors and Trustee in Bankruptcy:
1. UCC 9-201(a): “except as otherwise provided, a security agreement is effective according to its terms between the parties, against purchasers of the collateral, and against creditors.”
a. Basically, secured claims will trump unsecured claims
2. What does “otherwise” entail?
a. Unless an interest is “perfected” there is a risk of it being primed by a lien creditor in bankruptcy
b. UCC § 9-317(a)(2)(A)
1. What goes into a security agreement?
a. Written agreement with description of the collateral that the debtor signs or acknowledges
b. See § 9-203(b)
2. If you default, the seller would be entitled to immediate possession to the collateral (through self-help or an accelerated judicial process)
a. The seller could then sell the collateral and apply the proceeds to the debt
b. Avoids the cumbersome process of gaining a judgment
3. Two documents that are important:
a. Security agreement: contract between the debtor and the secured party that creates or provides for the security interest; when it’s enforceable, we say that it’s “attached”
i. The terms of the security agreement are enforceable against 3rd parties unless UCC otherwise provides (and it never provides for unsecured creditors)
ii. How do you sort out priority though?
1. See 9-201
iii. The acid test of a security agreement is to determine if it’s recognized as valid during the debtor’s bankruptcy
i. Some sort of public notice that the seller has a security interest in the collateral
ii. The most common method is to file a financing statement (referred to as a UCC 1)
1. has the names of the debtor, secured party, addresses, description of the collateral covered by the security agreement, and other random info, and is filed in a public office (usually the Secretary of State)
2. financing statement is unsigned document, but must be authorized to file (authorization implied by executed SA)
iii. Does perfection ensure priority?
1. not necessarily
c. Juncture of the UCC and the Bankruptcy Code (§ 544)
i. If the interest is valid then the seller has the power to avoid pre-petition transfers
ii. 544(a) (the strong-arm clause/ hypothetical lien creditor)
1. allows the trustee to avoid transfers that were valid between the parties under state law
2. the trustee is given the status of a creditor that has become a lien creditor
iii. how does this impact the seller though?
1. see definitions first (§ 101(54) & (37))
iv. the real question is how do secured parties fare against lien creditors
1. § 9-317(a)(2)(A)
a. Says unperfected security interests are subordinate to lien creditors if the person became a lien creditor before the security interest was perfected (trustee, placed in the position of a lien creditor, wins over unperfected security interest)
b. If the seller’s interest was unperfected on the day of bankruptcy then the trustee can avoid it under § 544(a)
4. What is the scope of Article 9?
a. Suppose you have a Ford dealer, who then needs to buy cars from Ford Motor Company; the dealer goes to a bank for financing; the bank will make advances for the benefit of the dealership each time the dealer makes a purchase of a car (e.g. dealer gives the invoice to the bank and the bank pays FMC); the bank will always take a security interest in the car to secure the dealer’s obligation to repay the advance
b. This is called floor plan financing
i. Under such a method, the dealer will sell the new car to a buyer but retain a security interest in it as well (while promising to pay for the car in installments)à if the buyer fails to pay the dealer, the dealer can exercise its rights under Article 9
ii. This is great but there’s a problem; the bank wants their money within 5 days after the sale of the car (and the dealer only gets the money over 60 months or so); the dealer only has a conditional sales contract (termed chattel paper)
iii. How is the chattel paper turned into cash?
1. typically another company, lets say Ford Credit, will buy the contracts from the dealers; this cash will then be used to pay the inventory loan
2. sales of revenue streams (such as chattel paper) are Article 9 events; see § 9-109(a)(3)
3. So Ford Credit has a sweet security interest in the car; they also have similar interests in thousands of other cars, but how do they get the billions of dollars to pay the dealers?
i. They also note the Duggan case from Colorado:
e. The court does note that those cases are a bit different b/c they involved perishable items and the actions were necessary
f. The Q then becomes: what does it take to establish a claim for restitution?
i. Basically fraud
a. Just b/c the secured creditor has been enriched by the actions of the unsecured creditor, that doesn’t give rise to a right of restitution
b. For restitution to be proper, you need something provided by the unsecured creditor that was necessary to preserve the value of the collateral (such as harvesting crops)
c. In addition, they also look at the conduct of the secured creditor; the court specifically doesn’t like the idea that acquiescence can give rise to liability; you need something more like inducement or fraud
6. In this case, there was no expenditure necessary to preserve the collateral (the addition of barrels just increased the amount of collateral); in addition, Phoenix had nothing to do with luring Knox into an unsecured transaction with Domaine b/c the deal was already in place
a. It could be argued that Phoenix’s payment of the first shipment could have induced the second shipment – the best we have is acquiescence and that’s dubious
7. Is it proper to allow Phoenix to come into a situation where Domaine was having financial issues and suddenly jump ahead of all the unsecured creditors (establish priority)?
a. Some would say that this is bad policy and unfair
8. What did the court have to say about the injustice to Knox?
a. They said he put himself in his own injustice (he could have protected himself in a number of ways by demanding cash before releasing the barrels; perfected a purchase money security interest; checked to see if a security interest was out there, obtained a secured creditor’s agreement to subordinate its priority according to 9-312)
b. Purchase money security interest: an interest that the seller retains for the price of the goods sold
i. If Knox had done this, he would have had priority
c. Basically, Knox was commercially negligent; secured parties are entitled to a rebuttable preference for payment
a. 1-103 is out there and will be used to shirk Article 9; courts aren’t too likely to be receptive to this argument (although, some are more responsive than others)
i. Comment 2 to 1-103 seems to narrow the door to equity
ii. The court notes that the idea of a floating lien and notice filing seem promote the idea that recognizing claims of this type are against the policies of Article 9