The Security Interests Parties and Creditors Rights Discussion

Debate This: A financing statement that does not have the debtor’s exact name should still be effective because creditors should always be protected when debtors default.

BASE ON THIS INFORMATION AND QUESTIONS

ALSO, I ATTACHED A PDF (WITH THIS CHAPTER) IN CASE YOU NEEDED

Paul Barton owned a small property-management company, doing business as Brighton Homes. In October, Barton went on a spending spree. First, he bought a Bose surround-sound system for his home from KDM Electronics. The next day, he purchased a Wilderness Systems kayak from Outdoor Outfitters, and the day after that he bought a new Toyota 4-Runner financed through Bridgeport Auto. Two weeks later, Barton purchased six new iMac computers for his office, also from KDM Electronics. Barton bought all of these items under installment sales contracts. Six months later, Barton’s property-management business was failing. He could not make the payments due on any of these purchases and thus defaulted on the loans. Using the information presented in the chapter, answer the following questions.

1. For which of Barton’s purchases (the surround-sound system, the kayak, the 4-Runner, and the six iMacs) would the creditor need to file a financing statement to perfect its security interest?
2. Suppose that Barton’s contract for the office computers mentioned only the name, Brighton Homes. What would be the consequences if KDM Electronics filed a financing statement that listed only Brighton Homes as the debtor’s name?
3. Which of these purchases would qualify as a PMSI in consumer goods?
4. Suppose that after KDM Electronics repossesses the surround-sound system, it decides to keep the system rather than sell it. Can KDM do this under Article 9? Why or why not?

Ed Aldridge/Shutterstock.com
Security Interests
and Creditors’ Rights
“I will pay you some,
and, as most debtors
do, promise you
infinitely.”
When buying or leasing goods, debtors frequently pay some
portion of the price now and promise to pay the remainder in the future, as William Shakespeare observed in the
chapter-opening quotation. Logically, sellers and lenders do
not want to risk nonpayment, so they usually will not sell goods
or lend funds unless the payment is somehow guaranteed.
William Shakespeare
Whenever the payment of a debt is guaranteed, or secured,
1564–1616
by personal property owned or held by the debtor, the transac(English dramatist and poet)
tion becomes known as a secured transaction. Indeed, business
as we know it could not exist without laws permitting and
governing secured transactions. When Stone Investments, Ltd., wants to buy a Learjet 70
for executive travel, it borrows funds from Capital Bank. Capital obtains a security interest
in the plane to guarantee that Stone will repay the debt.
Article 9 of the Uniform Commercial Code (UCC) governs secured transactions in
personal property. Personal property includes accounts, agricultural liens, chattel paper
(documents or records evidencing a debt secured by personal property), and fixtures
(certain property that is attached to land). Personal property also includes other types of
intangible property, such as negotiable instruments and patents. Article 9 does not cover
creditor-collection devices such as liens and garnishments.
25–1
Creating and Perfecting a Security Interest
A creditor has two main concerns if the debtor defaults (fails to pay the debt as promised).
The first is whether the debt can be satisfied through the possession and (usually) sale of the
collateral. The second concern is whether the creditor will have priority over any other
25
Learning Objectives
The five Learning Objectives below are
designed to help improve your understanding. After reading this chapter, you should
be able to answer the following questions:
1. What is required to create a
security interest?
2. How can a security interest
extend to a debtor’s newly
acquired inventory?
3. If two parties have perfected
security interests in the
debtor’s collateral, which
party has priority on default?
4. When is a creditor required
to sell or otherwise dispose of
the repossessed collateral?
5. What is a suretyship, and how
does it differ from a guaranty?
Secured Transaction Any transaction
in which the payment of a debt is
guaranteed, or secured, by personal
property owned by the debtor or in
which the debtor has a legal interest.
577
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UNIT THREE: Commercial Transactions
Default Failure to pay a debt when
creditors or buyers who may have rights in the same collateral. These two concerns are met
through the creation and perfection of a security interest.
it is due.
Secured Party A creditor who has
a security interest in the debtor’s
collateral, including a seller, lender,
cosigner, or buyer of accounts or
chattel paper.
Debtor Under Article 9 of the UCC,
any party who owes payment or
performance of a secured obligation.
Security Interest Any interest in
personal property or fixtures that
secures payment or performance of
an obligation.
Security Agreement An
25–1a
Definitions
Before we examine the creation and perfection of security interests, however, you need to
understand the UCC’s terminology, which is uniformly used by every state. The following is
a brief summary of the UCC’s definitions relating to secured transactions.
1. A secured party is any creditor who has a security interest in the debtor’s collateral. This
creditor can be a seller, a lender, a cosigner, or even a buyer of accounts or chattel paper
[UCC 9–102(a)(72)].
2. A debtor is a person who owes payment or other performance of a secured obligation
[UCC 9–102(a)(28)].
3. A security interest is the interest in the collateral (such as personal property or fixtures) that secures
payment or performance of an obligation [UCC 1–201(37)].
agreement that creates or provides
for a security interest between the
debtor and a secured party.
4. A security agreement is an agreement that creates or provides for a security interest [UCC 9–102(a)
(73)]. In other words, it is the contract in which a debtor agrees to give a creditor the right to take his
or her property in the event of default.
Collateral Under Article 9 of
the UCC, the property subject to a
security interest.
5. Collateral is the subject of the security interest [UCC 9–102(a)(12)].
Financing Statement A document
filed by a secured creditor with the
appropriate official to give notice to
the public of the creditor’s security
interest in collateral belonging to the
debtor named in the statement.
Together, these basic definitions form the concept under which a debtor-creditor relationship
becomes a secured transaction relationship (see Exhibit 25–1).
Learning Objective 1
What is required to create
a security interest?
6. A financing statement—referred to as the UCC-1 form—is the instrument normally filed to give public
notice to third parties of the secured party’s security interest [UCC 9–102(a)(39)].
25–1b
Requirements to Create a Security Interest
To become a secured party, a creditor must obtain a security interest in the collateral of the
debtor. Three requirements must be met for a creditor to have an enforceable security interest:
1. Unless the creditor has possession of the collateral, there must be a written or authenticated security
agreement that clearly describes the collateral subject to the security interest and that is signed or
authenticated by the debtor.
2. The secured party must give something of value to the debtor.
3. The debtor must have “rights” in the collateral.
Exhibit 25–1 The Secured Transactions Relationship
In a security agreement, a debtor and a creditor agree that the creditor will have a security interest in collateral in which the debtor
has rights. In essence, the collateral secures the loan and ensures the creditor of payment should the debtor default.
Security
Agreement
Debtor
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Property Rights in
COLLATERAL
Security Interest in
Secured
Party
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CHAPTER 25: Security Interests and Creditors’ Rights
Once these requirements have been met, the creditor’s rights are said to attach to the collateral. Attachment gives the creditor an enforceable security interest in the collateral
[UCC 9–203].1
Example 25.1 To furnish his new office suite, Bryce applies for a credit card at an office
supply store. The application contains a clause stating that the store will retain a security
interest in the goods that he buys with the card until he has paid for them in full. This
application is a written security agreement, which is the first requirement for an enforceable
security interest. The goods that Bryce buys with the card are the something of value from
the secured party (the second requirement). His ownership interest in those goods is the
right that he has in them (the third requirement). Thus, the requirements for an enforceable
security interest are met. When Bryce buys something with the card, the store’s rights attach
to the purchased goods. ■
transaction, the process by which
a secured creditor’s interest
“attaches” to the collateral and the
creditor’s security interest becomes
enforceable.
PeopleImages/Getty Images
Written or Authenticated Security Agreement When the collateral is not in the possession of the secured party, the security agreement must be either written or authenticated.
It must also describe the collateral.
Here, authenticate means to sign, execute, or adopt any symbol on an electronic record
that verifies that the person signing has the intent to adopt or accept the record [UCC
9–102(a)(7)(69)]. Authentication provides for electronic filing (the filing process will be
discussed later). See this chapter’s Adapting the Law to the Online Environment feature for a
discussion of a type of secured transaction that is performed online.
A security agreement must contain a description of the collateral that reasonably identifies
it. Generally, such phrases as “all the debtor’s personal property” or “all the debtor’s assets”
would not constitute a sufficient description [UCC 9–108(c)].
If the debtor signs or otherwise authenticates a security agreement, does he or she also
have to sign an attached list of the collateral to create a valid security interest? That was the
question before the court in the following case.
Attachment In a secured
If you use a store-provided credit
card at that store, does the store
automatically have a security
interest in what you purchase?
Authenticate To sign, execute, or
adopt any symbol on an electronic
record that verifies the intent to adopt
or accept the record.
1. The term attachment has a different meaning in secured transactions than in the context of judicial liens, where it refers to a court-ordered
seizure of property.
Spotlight on Wedding Rings: Case 25.1
Royal Jewelers, Inc. v. Light
Background and Facts Steven Light
bought a $55,050 wedding ring for his wife,
Sherri Light, on credit from Royal Jewelers,
Inc., a store in Fargo, North Dakota. The
receipt granted Royal a security interest in
the ring. Later, Royal assigned its interest to
GRB Financial Corp. Steven and GRB signed a
modification agreement changing the repayment terms. An attached exhibit listed the
ProArtWork/Getty Images
Supreme Court of North Dakota, 2015 ND 44, 859 N.W.2d 921 (2015).
Who retains a security interest in a
wedding ring when the buyer dies?
items pledged as security for the modification,
including the ring. Steven did not separately
sign the exhibit.
A year later, Steven died. Royal and GRB
filed a suit in a North Dakota state court against
Sherri, alleging that GRB had a valid security
interest in the ring. Sherri cited UCC 9–203,
under which there is an enforceable interest
only if “the debtor has authenticated a security
(Continues )
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UNIT THREE: Commercial Transactions
agreement that provides a description of the collateral.” Sherri
argued that the modification agreement did not “properly authenticate” the description of the collateral, including the ring, because
Steven had not signed the attached exhibit. The court issued a
judgment in GRB’s favor. Sherri appealed.
In the Words of the Court
CROTHERS, Justice.
****
Sherri Light * * * claims the * * * modification agreement
signed by Steven Light * * * did not properly authenticate the
agreement describing the collateral under [North Dakota Commercial Code (NDCC)] Section 41–09–13(2)(c)(1) [North Dakota’s
version of UCC 9–203] because he did not separately sign the
exhibit identifying secured collateral, including the ring.
Section 41–09–13(2)(c)(1) provides:
2. * * * A security interest is enforceable against the debtor and
third parties with respect to the collateral only if:
****
c. One of the following conditions is met:
(1) The debtor has authenticated a security agreement that
provides a description of the collateral * * *.
The plain language of that statute requires a debtor to
authenticate a security agreement providing a description of the
collateral. [Under NDCC Section 41–09–02(1)(g) [North Dakota’s
version of UCC 9–102(1)(g),] “authenticate” means “to sign” or
“to execute or otherwise adopt a symbol, or encrypt or similarly
process a record in whole or in part, with the present intent of the
authenticating person to identify the person and adopt or accept
a record.” NDCC Section 41–09–08(2) [North Dakota’s version of
UCC 9–108(2)] says a description of collateral is sufficient if it
reasonably identifies the collateral and may include a specific
listing or any other method by which the collateral is objectively
determinable.
* * * No authority [requires] a debtor to separately sign an
exhibit attached to and referenced in a signed security agreement
* * * . A security agreement is not unenforceable merely because a
description of collateral in an exhibit was attached to the security
agreement * * * Several documents may be considered together
as a security agreement. [Emphasis added.]
Steven Light signed the * * * modification agreement which
referenced an attached exhibit listing assets pledged as security
for the note. * * * The attached exhibit listing the ring was part
of the * * * agreement signed by Steven Light, and the [lower]
court determined the modification agreement was properly executed by Steven Light. Evidence establishes Steven Light initially
granted a valid security interest in the ring and the ring had not
been fully paid for * * *. GRB Financial received an assignment
of the security interest from Royal Jewelers * * *, and the court
did not err in finding GRB Financial had a valid and enforceable
security interest in the ring.
Decision and Remedy The North Dakota Supreme Court
affirmed the lower court’s judgment. The court stated, “No authority [requires] a debtor to separately sign an exhibit attached to and
referenced in a signed security agreement.”
Critical Thinking
t
Ethical Under the circumstances, is it ethical for GRB to
enforce its security interest in the ring to recover the unpaid
amount of the price? Discuss.
Secured Party Must Give Value The secured party must give something of value to the
debtor. Some examples of value include a binding commitment to extend credit or consideration to support a simple contract [UCC 1–204]. Normally, the value given by a secured
party is in the form of a direct loan or a commitment to sell goods on credit.
Debtor Must Have Rights in the Collateral The debtor must have rights in the
collateral. That means that the debtor must have some ownership interest or right
to obtain possession of the collateral. For instance, a retail seller-debtor can give a
secured party a security interest not only in existing inventory owned by the retailer
but also in future inventory to be acquired by the retailer. (A common misconception
is that the debtor must have title to the collateral to have rights in it, but this is not a
requirement.)
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Adapting the Law to the
Online Environment
Secured Transactions Online
W
hen you buy something online, you
typically must use your credit card,
make an electronic fund transfer, or send a
check before the goods that you bought are
sent to you. If you are buying an expensive
item, such as a car, you are not likely to
send funds without being assured that you
will receive the item in the condition promised. Enter the concept of escrow.
Escrow Accounts
Escrow accounts are commonly used
in real estate transactions, but they are
also useful for smaller transactions, particularly those done on the Internet. An
escrow account involves three parties—
the buyer, the seller, and a trusted third
party that collects, holds, and disperses
25–1c
funds according to instructions
from the buyer and seller. Escrow
services are provided by licensed
and regulated escrow companies. For
instance, if you buy a car on the Internet,
you and the seller will agree on an escrow
company to which you will send the funds.
When you receive the car and are satisfied
with it, the escrow company will release
the funds to the seller. This is a type of
secured transaction.
Escrow.com
One of the best-known online escrow firms
is Escrow.com, which had provided escrow
services for more than $3.5 billion in secured transactions by 2019. All of its escrow
services are offered via its website and
provided independently by Internet Escrow
Services, one of its operating subsidiaries.
Escrow.com is particularly useful for
transactions that involve an international
buyer or seller. It has become the recommended transaction settlement service for
Autotrader, Resale Weekly, Cars.com, eBay
Motors, and Flippa.com.
Critical Thinking
How could online escrow services reduce
Internet fraud?
Perfecting a Security Interest
Perfection by Filing The most common means of perfection is by filing
a financing statement with the office of the appropriate government official.
A financing statement gives public notice to third parties of the secured
party’s security interest. The security agreement itself can also be filed to perfect the security interest. The financing statement must provide the names of
the debtor and the secured party, and must identify the collateral covered by the
financing statement. A uniform financing statement form is now used in all
states [see UCC 9–521].
Communication of the financing statement to the appropriate filing office,
together with the correct filing fee, or the acceptance of the financing statement by the filing officer constitutes a filing [UCC 9–516(a)]. The filing can
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Perfection The legal process
by which secured parties protect
themselves against the claims of
third parties who may wish to have
their debts satisfied out of the same
collateral. It is usually accomplished
by filing a financing statement with
the appropriate government official.
SimplyCreativePhotography/Getty Images
Perfection is the legal process by which secured parties protect themselves against the claims
of third parties who may wish to have their debts satisfied out of the same collateral. Whether
a secured party’s security interest is perfected or unperfected can have serious consequences
for the secured party.
What if a debtor has borrowed from two different creditors, for instance, using the same
property as collateral for both loans? If the debtor defaults on both loans, which of the two
creditors has first rights to the collateral? In this situation, the creditor with a perfected
security interest will prevail.
Perfection usually is accomplished by filing a financing statement. In some
circumstances, however, a security interest becomes perfected even though no
financing statement is filed.
When a bank finances the purchase of a tractor,
how does it normally perfect its security interest
in that tractor?
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UNIT THREE: Commercial Transactions
be accomplished electronically [UCC 9–102(a)(18)]. In fact, most states use electronic filing
systems. A financing statement may be filed even before a security agreement is made or a
security interest attaches [UCC 9–502(d)].
The Debtor’s Name. The UCC requires that a financing statement be filed under the
name of the debtor [UCC 9–502(a)(1)]. Filings are indexed by the name of the debtor so
that they can be located by subsequent searchers. Slight variations in names normally will
not be considered misleading if a search of the filing office’s records, using a standard
computer search engine routinely used by that office, would disclose the filings
[UCC 9–506(c)].2
UCC 9–503 sets out some detailed rules for determining when the debtor’s name as it
appears on a financing statement is sufficient.
1. Corporations. For corporations, which are organizations that have registered with the state, the debtor’s name on the financing statement must be “the name of the debtor indicated on the public record
of the debtor’s jurisdiction of organization” [UCC 9–503(a)(1)].
2. Trusts. If the debtor is a trust or a trustee for property held in trust, the financing statement must
disclose this information and provide the trust’s name as specified in its official documents
[UCC 9–503(a)(3)].
3. Individuals and organizations. For all others, the financing statement must disclose “the individual
or organizational name of the debtor” [UCC 9–503(a)(4)(A)]. The word organization includes
unincorporated associations, such as clubs, churches, joint ventures, and general partnerships.
If an organizational debtor does not have a group name, the names of the individuals in the group
must be listed.
4. Trade names. When the debtor’s trade name is not the legal name of the business, providing only
the trade name in a financing statement is not sufficient for perfection [UCC 9–503(c)]. The financing statement must also include the owner-debtor’s actual name. Example 25.2 Pete Hanson is a
plumber who does business under the name HoneyPot Plumbing. Hanson obtains a loan from North
Bank to purchase some equipment for his business. For North Bank to perfect its security interest
in the equipment, the filed financing statement must include the owner’s name, Pete Hanson, rather
than just his trade name. ■
If the debtor’s name changes, the financing statement remains effective for collateral the
debtor acquired before or within four months after the name change. Unless an amendment to
the financing statement is filed within this four-month period, a security interest in collateral
acquired by the debtor after the four-month period is unperfected [UCC 9–507(b) and (c)].
A one-page uniform financing statement amendment form is available for filing name
changes and for other purposes.
Description of the Collateral. Both the security agreement and the financing statement
must describe the collateral in which the secured party has a security interest. The security
agreement must describe the collateral because no security interest in goods can exist unless
the parties agree on which goods are subject to the security interest.
The financing statement must describe the collateral to provide public notice of the
fact that certain goods of the debtor are subject to a security interest. Other parties who
might later wish to lend funds to the debtor or buy the collateral can thus learn of the
security interest by checking with the office in which a financing statement would be
filed. For land-related security interests, a legal description of the realty is also required
[UCC 9–502(b)].
2. If the name listed in the financing statement is so inaccurate that a search using a standard search engine will not disclose the debtor’s name,
then the financing statement is deemed seriously misleading under UCC 9–506. See also UCC 9–507, which governs the effectiveness of
financing statements found to be seriously misleading.
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583
1. For individual debtors, it is the state of the debtor’s principal residence.
2. For an organization that is registered with the state, such as a corporation or limited
liability company, it is the state in which the organization is registered. Thus, if a debtor
is incorporated in Maryland and has its chief executive office in New York, a secured
party would file the financing statement in Maryland.
3. For all other entities, it is the state in which the business is located or, if the debtor has
more than one office, the place from which the debtor manages its business operations
and affairs.
Tom Cheney The New Yorker Collection/The Cartoon Bank
Sometimes, the descriptions in the two documents vary. The description in the security
agreement must be more precise than the description in the financing statement. The UCC
permits broad, general descriptions in the financing statement, such as “all assets” or “all
personal property,” as long as they are accurate [UCC 9–504].
Example 25.3 A security agreement for a commercial loan to Casey Manufacturing lists all
of Casey’s equipment subject to the loan by serial number. The financing statement for the
equipment simply refers to “all equipment owned or hereafter acquired.” ■ (This chapter’s
Business Law Analysis feature provides an additional illustration.)
Where to File. Normally, a financing statement must be filed centrally in the appropriate
state office, such as the office of the secretary of state, in the state where the debtor is located.
An exception occurs when the collateral consists of timber to be cut, fixtures, or
items to be extracted—such as oil, coal, gas, and minerals [UCC 9–301(3) and
(4), 9–502(b)]. In those circumstances, the financing statement is filed in the
county where the collateral is located.
Note that the state in which a financing statement should be filed usually
depends on the debtor’s location, not the location of the collateral (but not for the
exception just mentioned) [UCC 9–301]. The debtor’s location is determined as
follows [UCC 9–307]:
Perfecting a Security Interest
T
homas Tille owned M.A.T.T. Equipment
Company. To operate the business, Tille
borrowed funds from Union Bank. For each
loan, Union filed a financing statement
that included Tille’s signature and address,
the bank’s address, and a description of the
collateral.
The first loan covered all of Tille’s
equipment, including “any after-acquired
property.” The second loan covered a truck
crane “whether owned now or acquired
later.” The third loan covered a “Bobcat
mini-excavator.” Did these financing statements perfect Union’s security interests?
Analysis: In most situations, perfec-
tion is accomplished by filing a financing
30301_ch25_hr_577-606.indd 583
statement with the appropriate official.
To effectively perfect a security interest, a financing statement must contain
(1) the debtor’s signature, (2) the debtor’s
and creditor’s addresses, and (3) a description of the collateral by type or item. Under
the UCC, the financing statement can
contain broad, general descriptions of the
collateral, whereas the security agreement
must be more precise.
Result and Reasoning: All of Union
Bank’s financing statements were sufficient to perfect its security interests in
Tille’s equipment. They each provided the
name and address of the debtor (Tille), and
the name and address of the secured party
Business Law
Analysis
(Union Bank). They also included a description of the collateral covered by the financing statement. For one loan, it was all of
Tille’s equipment, including after-acquired
property; for another, the truck crane; and
for the third, a Bobcat mini-excavator. These
descriptions were clearly sufficient to put a
prospective creditor on notice that the collateral was the subject of a security interest.
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“People may live as
much retired from the
world as they like, but
sooner or later, they
find themselves debtor
or creditor to some one.”
Consequences of an Improper Filing. Improper filing renders the security interest unperfected and reduces the secured party’s claim in bankruptcy to that of an unsecured creditor. For
instance, if the debtor’s name on the financing statement is seriously misleading or if the collateral is not sufficiently described in the financing statement, the filing may not be effective.
Example 25.4 Arthur Mendez Juarez, a strawberry farmer, leases farmland from Morona
Fruits, Inc., and borrows funds from Morona for payroll and production expenses. The
sublease and other documents set out Juarez’s full name, but Juarez generally goes by
the name “Mendez” and signs the sublease “Arthur Mendez.” To perfect its interests, Morona
files financing statements that identify the debtor as “Arthur Mendez.”
Then Juarez contracts to sell strawberries to Frozun Foods, Inc., which also advances
him funds secured by a financing statement that identifies the debtor as “Arthur Juarez.” By
the following year, Juarez is unable to pay his debts and owes Morona more than $200,000
and Frozun nearly $50,000. Both Morona and Frozun file a suit against Juarez claiming to
have priority under a perfected security interest. In this situation, a properly filed financing
statement would identify the debtor’s true name (Arthur Juarez). Because a debtor name
search for “Arthur Juarez” would not disclose a financing statement in the name of “Arthur
Mendez,” Morona’s financing statement is seriously misleading. Therefore, Frozun’s security
interest would have priority because its financing statement was recorded properly. ■
Johann Wolfgang von Goethe
1749–1832
(German writer)
Perfection without Filing A few types of security interests can be perfected without
Pledge A security device in which
personal property is transferred into
the possession of the creditor as
security for the payment of a debt and
retained by the creditor until the debt
is paid.
Purchase-Money Security
Interest (PMSI) A security interest
that arises when a seller or lender
extends credit for part or all of the
price of goods purchased by a buyer.
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filing a financing statement. One occurs when the collateral is transferred into the possession of the secured party. A second occurs when the security interest can be perfected
on attachment (without a filing and without having to possess the goods) [UCC 9–309].
The phrase perfected on attachment means that these security interests are automatically perfected at the time of their creation. Two of the more common security interests
that are perfected on attachment are a purchase-money security interest in consumer goods
(discussed shortly) and an assignment of a beneficial interest in a decedent’s estate [UCC
9–309(1), (13)].
Perfection by Possession. In the past, one of the most common means of obtaining
financing was to pledge certain collateral as security for the debt and transfer the collateral
into the creditor’s possession. When the debt was paid, the collateral was returned to
the debtor. Article 9 of the UCC retained the common law pledge and the principle that the
security agreement need not be in writing to be enforceable if the collateral is transferred to
the secured party [UCC 9–310, 9–312(b), 9–313].
Certain items, such as stocks, bonds, negotiable instruments, and jewelry, are commonly transferred into the creditor’s possession when they are used as collateral for loans.
Example 25.5 Sheila needs cash to pay for a medical procedure. She obtains a loan for $4,000
from Trent. As security for the loan, she gives him a promissory note on which she is the
payee. Even though the agreement to hold the note as collateral was oral, Trent has a perfected security interest and does not need to file a financing statement. No other creditor of
Sheila’s can attempt to recover the promissory note from Trent in payment for other debts. ■
For most collateral, however, possession by the secured party is impractical because it
denies the debtor the right to use or derive income from the property to pay off the debt.
Example 25.6 Jeb, a farmer, takes out a loan to finance the purchase of a large corn harvester
and uses the equipment as collateral. Clearly, the purpose of the purchase would be defeated
if Jeb transferred the collateral into the creditor’s possession, because he would not be able
to use the equipment to harvest his corn. ■
Perfection by Attachment—The Purchase-Money Security Interest in Consumer Goods.
Under the UCC, fourteen types of security interests are perfected automatically at the
time they are created [UCC 9–309]. The most common is the purchase-money security interest
(PMSI) in consumer goods (items bought primarily for personal, family, or household purposes). A PMSI in consumer goods is created when a person buys goods on credit. The entity
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CHAPTER 25: Security Interests and Creditors’ Rights
585
that extends the credit and obtains the PMSI can be either the seller (a store, for instance)
or a financial institution that lends the buyer the funds with which to purchase the goods
[UCC 9–102(a)(2)].
Exceptions to the Rule of Automatic Perfection. There are two exceptions
to the rule of automatic perfection for PMSIs:
.shock/iStock/Getty Images
Automatic Perfection. A PMSI in consumer goods is perfected automatically at the
time of a credit sale—that is, at the time the PMSI is created. The seller in this situation
does not need to do anything more to perfect her or his interest. Example 25.7 Jami purchases
an LG washer and dryer from West Coast Appliance for $2,500. Unable to pay the entire
amount in cash, Jami signs a purchase agreement to pay $1,000 down and
$100 per month until the balance, plus interest, is fully paid. West Coast
Appliance is to retain a security interest in the appliances until full payment
has been made. Because the security interest was created as part of a purchase
agreement with a consumer, it is a PMSI, and West Coast Appliance’s security
interest is automatically perfected. ■
1. Certain types of security interests that are subject to other federal or state laws may
require additional steps to be perfected [UCC 9–311]. Many jurisdictions, for instance,
have certificate-of-title statutes that establish perfection requirements for security
interests in certain goods, including automobiles, trailers, boats, mobile homes, and
If this couple buys a 4K UHD television on credit,
is a PMSI automatically perfected?
farm tractors.
Example 25.8 Martin Sedek purchases a boat at a Florida dealership. Florida
has a certificate-of-title statute. Sedek obtains financing for his purchase through General Credit
Corporation. General Credit Corporation will need to file a certificate of title with the appropriate state
official to perfect the PMSI. ■
2. PMSIs in nonconsumer goods, such as a business’s inventory or livestock, are not automatically
perfected [UCC 9–324]. These types of PMSIs will be discussed later in this chapter in the context
of priorities.
Perfection and the Classification of Collateral Where or how to perfect a security
interest sometimes depends on the classification or definition of the collateral. Collateral
is generally divided into two classifications: tangible collateral (collateral that can be seen,
felt, and touched) and intangible collateral (collateral that consists of or generates rights).
Exhibit 25–2 summarizes the various classifications of collateral and the methods of perfecting a security interest in collateral falling within each of those classifications.3
Effective Time Duration of Perfection A financing statement is effective for five years
from the date of filing [UCC 9–515]. If a continuation statement is filed within six months
prior to the expiration date, the effectiveness of the original statement is continued for
another five years, starting with the expiration date of the first five-year period
[UCC 9–515(d), (e)]. The effectiveness of the statement can be continued in the same
manner indefinitely. Any attempt to file a continuation statement outside the six-month
window will render the continuation ineffective, however, and the perfection will lapse at
the end of the five-year period.
If a financing statement lapses, the security interest that had been perfected by the filing
becomes unperfected. A purchaser for value can acquire the collateral as if the security interest had never been perfected [UCC 9–515(c)].
Continuation Statement A
statement that, if filed within six
months prior to the expiration date
of the original financing statement,
continues the perfection of the
security interest for another five years.
3. There are additional classifications, such as agricultural liens, commercial tort claims, and investment property. For definitions of these types of
collateral, see UCC 9–102(a)(5), (a)(13), and (a)(49).
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Exhibit 25–2 Selected Types of Collateral and Their Methods of Perfection
TANGIBLE COLLATERAL
METHOD OF PERFECTION
All things that are movable at the time the security interest attaches or that are
attached to land, including timber to be cut and growing crops.
1. Consumer Goods
[UCC 9–301, 9–303,
9–309(1), 9–310(a),
9–313(a)]
Goods used or bought primarily for personal, family, or
household purposes—for example, household furniture [UCC 9–102(a)(23)].
2. Equipment
[UCC 9–301,
9–310(a), 9–313(a)]
Goods bought for or used primarily in business (and
Filing or (rarely) possession by secured party.
not part of inventory or farm products)—for example, a
delivery truck [UCC 9–102(a)(33)].
3. Farm Products
[UCC 9–301,
9–310(a), 9–313(a)]
Crops (including aquatic goods), livestock, or supplies
produced in a farming operation—for example, ginned
cotton, milk, eggs, and maple syrup [UCC 9–102(a)(34)].
4. Inventory
[UCC 9–301,
9–310(a), 9–313(a)]
Goods held by a person for sale or under a contract of Filing or (rarely) possession by secured party.
service or lease; raw materials held for production and
work in progress [UCC 9–102(a)(48)].
INTANGIBLE COLLATERAL
For purchase-money security interest, attachment
(that is, the creation of a security interest) is sufficient.
For boats, motor vehicles, and trailers, filing or compliance with a certificate-of-title statute is required.
For other consumer goods, general rules of filing or
possession apply.
Filing or (rarely) possession by secured party.
METHOD OF PERFECTION
Nonphysical property that exists only in connection with something else.
1. Chattel Paper
[UCC 9–301,
9–310(a), 9–312(a),
9–313(a), 9–314(a)]
A writing or electronic record that evidences both a
monetary obligation and a security interest in goods
and software used in goods—for example, a security
agreement [UCC 9–102(a)(11), (a)(31), and (a)(78)].
Filing or possession or control by secured party.
2. Instruments
[UCC 9–301,
9–309(4), 9–310(a),
9–312(a) and (e),
9–313(a)]
A negotiable instrument, such as a check, note, certificate of deposit, draft, or other writing that evidences
a right to the payment of money and is not a security
agreement or lease, but rather a type that can ordinarily be transferred (after indorsement, if necessary)
by delivery [UCC 9–102(a)(47)].
Normally filing or possession. For the sale of
promissory notes, perfection can be by attachment
(automatically on the creation of the security interest).
3. Accounts
Any right to receive payment for property (real or
[UCC 9–301, 9–309(2) personal), including intellectual licensed property,
and (5), 9–310(a)]
services, insurance policies, and certain other receivables [UCC 9–102(a)(2) and (a)(46)].
Filing required except for certain assignments that
can be perfected by attachment (automatically on the
creation of the security interest).
4. Deposit Accounts
[UCC 9–104, 9–304,
9–312(b), 9–314(a)]
Any demand, time, savings, passbook, or similar
account maintained with a bank [UCC 9–102(a)(29)].
25–2
Perfection by control, such as when the secured party
is the bank in which the account is maintained or when
the parties have agreed that the secured party can
direct the disposition of funds in a particular account.
Scope of a Security Interest
A security interest can cover property in which the debtor has either present or future ownership or possessory rights. Therefore, security agreements can cover not only collateral in
the present possession or control of the debtor but also proceeds from the sale of collateral,
after-acquired property, and future advances, as discussed next.
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25–2a
587
Proceeds
Proceeds are whatever cash or property is received when collateral is sold or disposed of in
some other way [UCC 9–102(a)(64)]. A security interest in the collateral gives the secured
party a security interest in the proceeds acquired from the sale of that collateral.
A security interest in proceeds perfects automatically on the perfection of the secured
party’s security interest in the original collateral. It remains perfected for twenty days after
the debtor receives the proceeds. The parties can agree to extend the twenty-day automatic
perfection period in their original security agreement [UCC 9–315(c), (d)]. This is typically
done when the collateral is the type that is likely to be sold, such as a retailer’s inventory of
tablets or smartphones. The UCC also permits a security interest in identifiable cash proceeds
to remain perfected after twenty days [UCC 9–315(d)(2)].
The dispute in the following case focused on proceeds. The court was asked to decide
whether the actions taken by the debtor and another creditor had stripped a secured creditor
of its interest in certain proceeds.
Proceeds Under Article 9 of the
UCC, whatever is received when
collateral is sold or disposed of in
some other way.
Case 25.2
In re Tusa–Expo Holdings, Inc.
United States Court of Appeals, Fifth Circuit, 811 F.3d 786 (2016).
Background and Facts Tusa Office Solutions, Inc., a sub-
sidiary of Tusa–Expo Holdings, Inc., was the largest retail dealer
in new furniture made by Knoll, Inc. A customer placed an order
for Knoll furniture from Tusa Office, which, in turn, ordered the
furniture from Knoll, who delivered it to the customer. The customer paid Tusa Office, which then paid Knoll. Knoll set a limit
on the amount of the payments that could be outstanding before
it would stop filling new orders. As part of the deal, Tusa Office
granted Knoll a first-priority security interest in specified accounts
receivable.
Meanwhile, Tusa Office obtained a loan from Textron Financial,
Inc. Knoll and Textron agreed separately that Textron would have a
first-priority security interest in all of Tusa Office’s assets, except
for Knoll’s collateral (the furniture).
The terms of the loan required Tusa Office to establish a bank
account—called the lockbox—into which its customers made
payments directly. Textron could withdraw funds from the lockbox and use them to increase the credit available to Tusa Office
on its loan. Tusa Office used the increased credit to pay Knoll.
By paying Knoll, Tusa Office kept its debt to Knoll below the furniture maker’s limit, which enabled Tusa Office to fill new orders
for its customers.
Ultimately, Tusa Office filed a bankruptcy petition in a federal
bankruptcy court. Marilyn Garner, the bankruptcy trustee, sought
to recapture some of the funds that Knoll had received through the
lockbox.a To do this, Garner had to prove that Knoll had received
more by these transfers than it would receive on Tusa Office’s
bankruptcy. The court issued a ruling against the trustee, who
appealed.
In the Words of the Court
WIENER, Circuit Judge:
****
* * * A creditor who merely recovers its own collateral receives
no more * * * than it would have received anyway. [Emphasis
added.]
The Trustee asserts that the transfers from Tusa Office to Knoll
were not made from the proceeds of Knoll’s collateral.
****
The Trustee does not dispute that the payments Tusa Office’s
customers deposited into the lockbox were proceeds of Tusa
Office’s accounts receivable. She argues * * * that * * * Knoll’s
first-priority security interest in the payments was stripped
by operation of [Texas Business and Commerce Code] Section
9.332(a) [Texas’s version of UCC 9–332(a)]: “A transferee of money
takes the money free of a security interest * * * .” Section 9.332(a)
a. A debtor files a petition in a federal bankruptcy court to liquidate its assets, pay its creditors
with the proceeds, and obtain a discharge of any remaining debt. It is the job of the bankruptcy trustee to collect those assets and distribute them fairly among the debtor’s creditors.
(Continues )
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UNIT THREE: Commercial Transactions
does not apply if such a transfer of money was made to the debtor.
The Trustee therefore insists that Textron, not Tusa Office, was the
transferee. In so doing, the Trustee contends that the lockbox was
“owned * * * by Textron.”
****
* * * The Loan Agreement is clear. It specifies that * * *
“Tusa Office shall have established a * * * lockbox * * * for its
collections and the transfer thereof to Textron * * *.” The Loan
Agreement also states that “Tusa Office shall have possession of
Textron’s Collateral.”
Because Tusa Office, not Textron, owned the lockbox, Section
9.332(a) does not apply. Therefore, Knoll’s first-priority security
interest in the proceeds of Tusa Office’s accounts receivable survived the deposit into the lockbox.
****
The Trustee next contends that Section 9.332(b) [Texas’s version of UCC 9–332(b)] stripped Knoll’s first-priority security interest when they were transferred from the lockbox to Textron.
****
The plain language of Section 9.332(b) states that a “transferee
of funds from a deposit account takes the funds free of a security
interest in the deposit account.”
****
25–2b
After-Acquired Property Property
that is acquired by the debtor
after the execution of a security
agreement.
Learning Objective 2
How can a security interest
extend to a debtor’s newly
acquired inventory?
The plain language of Section 9.332(b) is unambiguous. Knoll’s
first-priority security interest in the proceeds of Tusa Office’s
accounts receivable survived the transfer from the lockbox to
Textron. Not only is this consistent with Section 9.332(b), but it
is also consistent with the * * * Agreement between Knoll and
Textron.
Decision and Remedy The U.S. Court of Appeals for the
Fifth Circuit affirmed the ruling of the lower court. The trustee
could not recover the funds that were transferred to Knoll from
Tusa Office through the lockbox because those funds were the
proceeds of Knoll’s own collateral.
Critical Thinking
t
Legal Environment Why does the UCC permit transferees
to take funds “free of a security interest”? How did this provision
work to protect the parties in this case?
t
Ethical Office Expo, Inc., a dealer in used furniture, was, like
Tusa Office, a subsidiary of Tusa–Expo Holdings. Tusa Office operated profitably, but Office Expo did not. To bolster Office Expo,
funds were transferred from Tusa Office to Office Expo on a regular basis, which caused problems for Tusa Office. Were these
transfers unethical? Discuss.
After-Acquired Property
After-acquired property is property that the debtor acquired after the execution of the security
agreement. The security agreement may provide for a security interest in after-acquired
property, such as a debtor’s inventory [UCC 9–204(1)]. Generally, the debtor will purchase
new inventory to replace the inventory sold. The secured party wants this newly acquired
inventory to be subject to the original security interest. Thus, the after-acquired property
clause continues the secured party’s claim to any inventory acquired thereafter. (This is not
to say that the original security interest will always take priority over the rights of all other
creditors with regard to this after-acquired inventory, as will be discussed later.)
Example 25.9 Amato buys factory equipment from Bronson on credit, giving as security an
interest in all of her equipment—both what she is buying and what she already owns. The
security interest with Bronson contains an after-acquired property clause. Six months later,
Amato pays cash to another seller of factory equipment for more equipment. Six months
after that, Amato goes out of business before she has paid off her debt to Bronson. Bronson
has a security interest in all of Amato’s equipment, even the equipment bought from the
other seller. ■
25–2c
Future Advances
Often, a debtor will arrange with a bank to have a continuing line of credit under which the
debtor can borrow funds intermittently. Advances against lines of credit can be subject to a
properly perfected security interest in certain collateral.
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25–2d
The Floating-Lien Concept
A security agreement that provides for a security interest in proceeds, in
after-acquired property, or in collateral subject to future advances by the
secured party (or in all three) is often characterized as a floating lien. This
type of security interest continues in the collateral or proceeds even if
the collateral is sold, exchanged, or disposed of in some other way.
Cross-Collateralization The use
of an asset that is not the subject of a
loan to collateralize that loan.
Baranozdemir/Getty Images
The security agreement may provide that any future advances made against that line of
credit are also subject to the security interest in that collateral [UCC 9–204(c)]. Future
advances do not have to be of the same type or otherwise related to the original advance to
benefit from this type of cross-collateralization.4 Cross-collateralization occurs when an asset
that is not the subject of a loan is used to secure that loan.
Example 25.10 Stroh is the owner of a small manufacturing plant with equipment valued
at $1 million. He has an immediate need for $50,000 of working capital, so he obtains a
loan from Midwestern Bank and signs a security agreement, putting up all of his equipment as security. The bank properly perfects its security interest. The security
agreement provides that Stroh can borrow up to $500,000 in the future, using
the same equipment as collateral for any future advances. In this situation,
Midwestern Bank does not have to execute a new security agreement and perfect a security interest in the collateral each time an advance is made, up to a
cumulative total of $500,000. For priority purposes, each advance is perfected
as of the date of the original perfection. ■
Can equipment be used as collateral for future
advances?
A Floating Lien in Inventory Floating liens commonly arise in the financing of inventories. A creditor is not interested in specific pieces of inventory, which are constantly changing, so the lien “floats” from one item to another as the inventory changes.
Example 25.11 Cascade Sports, Inc., an Oregon corporation, operates as a cross-country
ski dealer and has a line of credit with Portland First Bank to finance its inventory of
cross-country skis. Cascade and Portland First enter into a security agreement that provides
for coverage of proceeds, after-acquired inventory, present inventory, and future advances.
Portland First perfects its security interest in the inventory by filing centrally with the office
of the secretary of state in Oregon.
One day, Cascade sells a new pair of the latest cross-country skis and receives a used pair
in trade. That same day, Cascade purchases two new pairs of cross-country skis from a local
manufacturer for cash. Later that day, to meet its payroll, Cascade borrows $8,000 from
Portland First Bank under the security agreement.
Portland First gets a perfected security interest in the used pair of skis under the proceeds
clause and a perfected security interest in the two new pairs of skis under the after-acquired
property clause. This collateral, as well as other inventory, secures the new funds advanced
to Cascade under the future-advances clause. All of this is accomplished under the original
perfected security interest. The various items in the inventory have changed, but Portland
First still has a perfected security interest in Cascade’s inventory. Hence, it has a floating lien
in the inventory. ■
A Floating Lien in a Shifting Stock of Goods The concept of the floating lien can also
apply to a shifting stock of goods. The lien can start with raw materials, follow them as they
become finished goods and inventories, and continue as the goods are sold and are turned
into accounts receivable, chattel paper, or cash.
Floating Lien A security interest in
proceeds, after-acquired property, or
collateral subject to future advances
by the secured party (or all three).
The security interest is retained
even when the collateral changes in
character, classification, or location.
Know This
Secured creditors—
perfected or not—have
priority over unsecured
creditors.
4. See official Comment 5 to UCC 9–204.
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25–3
Priorities, Rights, and Duties
When more than one party claims an interest in the same collateral, which has priority? The
UCC sets out detailed rules to answer this question. Although in many situations the party
who has a perfected security interest will have priority, there are exceptions. The UCC also
provides certain rights and duties to debtors and secured parties.
25–3a
General Rules of Priority
The basic rule is that when more than one security interest has been perfected in the same
collateral, the first security interest to be perfected (or filed) has priority over any security
interests that are perfected later. If only one of the conflicting security interests has been
perfected, then that security interest has priority. If none of the security interests have
been perfected, then the first security interest that attaches has priority.
The UCC’s rules of priority can be summarized as follows:
Learning Objective 3
2. Conflicting perfected security interests. When two or more secured parties have perfected security
interests in the same collateral, the first to perfect (by filing or taking possession of the collateral)
generally has priority [UCC 9–322(a)(1)].
3. Conflicting unperfected security interests. When two conflicting security interests are unperfected, the
first to attach (be created) has priority [UCC 9–322(a)(3)]. This is sometimes called the “first-in-time” rule.
MaxyM/Shutterstock.com
If two parties have perfected
security interests in the
debtor’s collateral, which
party has priority on default?
1. Perfected security interest versus unsecured creditors and unperfected security interests. When two
or more parties have claims to the same collateral, a perfected secured party’s interest has priority
over the interests of most other parties [UCC 9–322(a)(2)]. This includes priority to the proceeds from
a sale of collateral resulting from a bankruptcy (giving the perfected secured party rights superior to
that of a bankruptcy trustee).
A family dairy farm operation is sold and a dispute arises
over who has priority to part of the proceeds. What are
three rules of priority the court will follow?
25–3b
Example 25.12 Rick Morales and his wife and son own a dairy farm
called Lost Creek Heifers (LCH) that has received multiple loans
through Ag Services, Inc. To obtain the loans, Morales executes a
$800,000 promissory note and security agreement in favor of Ag Services. The note lists all of LCH’s accounts, equipment, farm products,
inventory, livestock, and proceeds as collateral. A year later, Morales
and his wife separate, and he signs a separation agreement giving her
some cash and land.
The following year, Morales buys out his son’s interest in LCH by
giving him a promissory note for $100,000. The note lists all of LCH’s
equipment, inventory, livestock, and proceeds as collateral. Morales
also sells a herd of dairy cows for $500,000 and gives his former wife a
check for $240,000. LCH files for bankruptcy shortly thereafter. A dispute arises over which party (Ag Services, Morales’s son, or Morales’s
former wife) is entitled to the proceeds from the sale of the cows. In
this situation, a court will likely find that because Ag Services’ security
interest in the proceeds was the first in time to attach, Ag Services has
first priority to the proceeds. ■
Exceptions to the General Priority Rules
Under some circumstances, on the debtor’s default, the perfection of a security interest will
not protect a secured party against certain other third parties having claims to the collateral. For instance, the UCC provides that in some situations a PMSI, properly perfected,5
5. Recall that, with some exceptions (such as motor vehicles), a PMSI in consumer goods is automatically perfected—no filing is necessary. A
PMSI that is not in consumer goods must still be perfected, however.
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will prevail over another security interest in after-acquired collateral, even though the
other was perfected first. We discuss some significant exceptions to the general rules of
priority next.
Buyers in the Ordinary Course of Business Under the UCC, a person who buys “in
the ordinary course of business” takes the goods free from any security interest created
by the seller even if the security interest is perfected and the buyer knows of its existence
[UCC 9–320(a)]. A buyer in the ordinary course of business is a person who in good faith,
and without knowledge that the sale violates the rights of another in the goods, buys goods
in the ordinary course from a person in the business of selling goods of that kind
[UCC 1–201(9)].6 The rationale for this rule is obvious. If buyers could not obtain the
goods free and clear of any security interest the merchant had created—for instance, in
inventory—the free flow of goods in the marketplace would be hindered.
Example 25.13 Dubbs Auto grants a security interest in its inventory to Heartland Bank for a
$300,000 line of credit. Heartland perfects its security interest by filing financing statements
with the appropriate state offices. Dubbs uses $9,000 of its credit to buy two used trucks and
delivers the certificates of title, which designate Dubbs as the owner, to Heartland.
Later, Dubbs sells one of the trucks to Shea Murdoch and another to Michael Laxton.
National City Bank finances both purchases. New certificates of title are issued in the buyers’
names, but Heartland receives none of the funds from the sales.
If Heartland sues National City, claiming that its security interest in the vehicles takes
priority, it will lose. Because Murdoch and Laxton are buyers in the ordinary course of business, Heartland’s security interest in the motor vehicles was extinguished when the vehicles
were sold to them. (Dubbs still owes Heartland the $9,000, of course.) ■
“A man who pays his
bills on time is soon
forgotten.”
Oscar Wilde
1854–1900
(Irish author, playwright, and poet)
PMSI in Inventory Another important exception to the first-in-time rule has to do with
security interests in inventory. (Remember that a PMSI that is not in consumer goods must
be perfected.) A perfected PMSI in inventory has priority over a conflicting security interest
in the same inventory. To maintain this priority, the holder of the PMSI must notify the
holder of the conflicting security interest on or before the time the debtor takes possession
of the inventory [UCC 9–324(b)].
Buyers of the Collateral The UCC recognizes that there are certain types of buyers
whose interests in purchased goods could conflict with those of a perfected secured party
on the debtor’s default. These include not only buyers in the ordinary course of business (as
just discussed), but also buyers of farm products, chattel paper, instruments, documents, or
securities. The UCC sets down special rules of priority for these types of buyers.
25–3c
Rights and Duties of Debtors and Creditors
The security agreement itself determines most of the rights and duties of the debtor and the
secured party. The UCC, however, imposes some rights and duties that are applicable unless
the security agreement states otherwise.
Information Requests At the time of filing, a secured party can furnish a copy of the
financing statement and request that the filing officer note the file number, date, and hour
of the original filing on the copy [UCC 9–523(a)]. The filing officer must send this copy to
the person designated by the secured party.
The filing officer must also give information to a person who is contemplating obtaining
a security interest from a prospective debtor [UCC 9–523(c), (d)]. If requested, the filing
officer must issue a certificate (for a fee) that provides information on possible perfected
financing statements with respect to the named debtor.
6. Note that even though a buyer may know about the existence of a perfected security interest, he or she must not know that buying the goods
violates the rights of any third party.
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Release, Assignment, and Amendment A secured party can release all or part of any
collateral described in the financing statement, thereby terminating its security interest in
that collateral. The release is recorded by filing a uniform amendment form [UCC 9–512,
9–521(b)].
A secured party can also assign all or part of the security interest to a third party (the
assignee). The assignee becomes the secured party of record if the assignment is filed by use
of a uniform amendment form [UCC 9–514, 9–521(a)].
If the debtor and the secured party agree, they can amend the filing—to add or substitute new collateral, for example—by filing a uniform amendment form that indicates the
file number of the initial financing statement [UCC 9–512(a)]. The amendment does not
extend the time period of perfection, but if new collateral is added, the perfection date
(for priority purposes) for the new collateral begins on the date the amendment is filed
[UCC 9–512(b), (c)].
Confirmation or Accounting Request by Debtor The debtor may believe that
the amount of the unpaid debt or the list of collateral subject to the security interest is
inaccurate. The debtor has the right to request a confirmation of the unpaid debt or list
of collateral [UCC 9–210]. The debtor is entitled to one request without charge every
six months.
The secured party must comply with the debtor’s confirmation request by authenticating
and sending to the debtor an accounting within fourteen days after the request is received.
Otherwise, the secured party will be held liable for any loss suffered by the debtor, plus $500
[UCC 9–210, 9–625(f)].
Termination Statement When the debtor has fully paid the debt, if the secured party perfected the security interest by filing, the debtor is entitled to have a termination statement
filed. Such a statement demonstrates to the public that the filed perfected security interest
has been terminated [UCC 9–513].
Whenever consumer goods are involved, the secured party must file a termination
statement (or, alternatively, a release). The statement must be filed within one month of
the final payment or within twenty days of receiving the debtor’s demand, whichever is
earlier [UCC 9–513(b)]. When the collateral is not consumer goods, the secured party
is not required to file or to send a termination statement unless the debtor demands one
[UCC 9–513(c)].
25–4
Default
Article 9 defines the rights, duties, and remedies of the secured party and of the debtor on
the debtor’s default. If the secured party fails to comply with his or her duties, the debtor is
afforded particular rights and remedies under the UCC.
25–4a
What Constitutes Default?
What constitutes default is not always clear. In fact, Article 9 does not define the term.
Instead, the UCC encourages parties to include in their security agreements the standards
under which their rights and duties will be measured [UCC 9–601, 9–603]. In so doing,
parties can stipulate the conditions that will constitute a default. Often, these critical terms
are shaped by creditors in an attempt to provide themselves with the maximum protection
possible. The terms may not, however, run counter to the UCC’s provisions regarding good
faith and unconscionability.
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Any breach of the terms of the security agreement can constitute default. Nevertheless,
default occurs most commonly when the debtor fails to meet the scheduled payments or
becomes bankrupt.
25–4b
Basic Remedies
UCC 9–601(a) and (b) set out rights and remedies for secured parties, and these rights and
remedies are cumulative [UCC 9–601(c)]. Therefore, if a creditor is unsuccessful in enforcing
rights by one method, he or she can pursue another method. Generally, a secured party’s
remedies can be divided into the two basic categories discussed next.
Repossession of the Collateral—The Self-Help Remedy On the debtor’s default, a
secured party can take peaceful possession of the collateral without the use of judicial process
[UCC 9–609(b)]. This provision is often referred to as the “self-help” provision of Article 9.
The UCC does not define peaceful possession. The general rule is that the collateral has
been taken peacefully if the secured party can take possession without trespassing, assaulting, or breaking and entering.
On taking possession, the secured party may either retain the collateral for satisfaction of the
debt [UCC 9–620] or resell the goods and apply the proceeds toward the debt [UCC 9–610].
Judicial Remedies Alternatively, a secured party can relinquish the security interest and
25–4c
Disposition of Collateral
Once default has occurred and the secured party has obtained possession of the collateral,
the secured party can:
1. Retain the collateral in full or partial satisfaction of the debt (subject to limitations, discussed next).
2. Sell, lease, license, or otherwise dispose of the collateral in any commercially reasonable manner,
and apply the proceeds toward satisfaction of the debt [UCC 9–602(7), 9–603, 9–610(a), 9–613, 9–620].
Any sale is always subject to procedures established by state law.
Retention of Collateral by the Secured Party Parties are sometimes better off if they
do not sell the collateral. Therefore, the UCC generally allows secured parties to choose
not to sell. A secured party may retain the collateral unless it consists of consumer goods
and the debtor has paid 60 percent or more of the purchase price or loan amount (see the
discussion of consumer goods for specifics). This general right to retain the collateral is
subject to several limitations.
Notice Requirements. The secured party must notify the debtor of its proposal to retain
the collateral. Notice is required unless the debtor has signed a statement renouncing or
modifying her or his rights after default [UCC 9–620(a), 9–621].
If the collateral is consumer goods, the secured party does not need to give any other
notice. In all other situations, the secured party must also send notice to any other secured
party from whom the secured party has received notice of a claim of interest in the collateral.
Objections. The debtor or other party notified of the retention has the right to object. If,
within twenty days after the notice is sent, the secured party receives a written objection,
the secured party must sell or otherwise dispose of the collateral. If no written objection is
received, the secured party may retain the collateral in full or partial satisfaction of the
debtor’s obligation [UCC 9–620(a), 9–621].
30301_ch25_hr_577-606.indd 593
©Haveseen/Shutterstock.com
use any judicial remedy available, such as obtaining a judgment on the underlying debt,
followed by execution and levy [UCC 9–601(a)]. (Execution is the implementation of a
court’s decree or judgment. Levy is the legal process of obtaining funds through the seizure
and sale of nonexempt property, usually done after a writ of execution has been issued.)
This man is not stealing this car.
What UCC remedy might he be
exercising instead?
Execution The implementation of a
court’s decree or judgment.
Levy The legal process of obtaining
funds through the seizure and sale
of nonexempt property, usually done
after a writ of execution has been
issued.
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Learning Objective 4
When is a creditor required
to sell or otherwise dispose of the repossessed
collateral?
UNIT THREE: Commercial Transactions
Consumer Goods When the collateral is consumer goods and the debtor has paid
60 percent of the purchase price on a PMSI or loan amount on a non-PMSI, the secured
party cannot retain the goods. Instead, the secured party is required to sell or otherwise dispose of the repossessed collateral within ninety days [UCC 9–620(e), (f)]. Failure to comply
opens the secured party to an action for conversion or other liability under UCC 9–625(b)
and (c). A secured party will not be liable, however, if the consumer-debtor signed a written
statement after default renouncing or modifying the right to demand the sale of the goods
[UCC 9–624].
Disposition Procedures A secured party who does not choose to retain the collateral
Cameron Spencer/Getty Images
or who is required to sell it must follow the disposition procedures prescribed in the UCC.
The sale can be public or private. The collateral can be disposed of in its present condition
or following any commercially reasonable preparation or processing [UCC 9–610(a)].
Notice Requirement. The secured party must notify the debtor and
other specified parties in writing ahead of time about the sale or disposition of the collateral. If the collateral is consumer goods, the notice
must specify the method of intended disposition. Notification is not
required if the collateral is perishable, will decline rapidly in value, or
is a type customarily sold on a recognized market [UCC 9–611(b), (c)].
Commercially Reasonable Manner. Every aspect of the disposition’s method, manner, time, and place must be commercially reasonable [UCC 9–610(b)]. If the secured party does not dispose of the
collateral in a commercially reasonable manner, the price paid for
the collateral at the sale may be negatively affected. In that situation,
a court can reduce the amount of any deficiency that the debtor owes
to the secured party [UCC 9–626(a)(3)].
Is the sale of collateral at auction a reasonable means of
The issue in the following case was whether the creditor’s disposidisposing of that collateral?
tion of the collateral was commercially reasonable.
Case 25.3
SunTrust Bank v. Monroe
Court of Appeals of Texas, Fort Worth, 2018 WL 651198 (2018).
Background and Facts Liberty Redevelopment Group, LLC,
financed the purchase of an Aston Martin for $233,305.46 with a
loan from the dealer, Aston Martin of Dallas. Mark Monroe, a Liberty
officer and the owner and operator of Delta Bail Bonds, co-signed for
the loan. The dealer assigned the loan to SunTrust Bank. Seven
months later, Liberty defaulted on the payments. SunTrust repossessed the car and sold it at auction for $115,000.
The bank filed a suit in a Texas state court against Monroe
to recover the deficiency between the auction price and the balance of the loan, plus $38,000 in repossession expenses. Monroe
responded that the sale was not made in a commercially reasonable manner. A jury agreed with Monroe and found that he owed
SunTrust nothing. The bank appealed.
30301_ch25_hr_577-606.indd 594
In the Words of the Court
Bonnie SUDDERTH, Chief Justice
****
“Commercial reasonableness” at its core is a fact-based inquiry
that requires a balance of Article 9’s two competing policies—
protecting debtors against creditor dishonesty and minimizing
interference in honest dispositions. Courts have considered a
number of non-exclusive factors when addressing the term “commercial reasonableness,” such as (1) whether the secured party
endeavored to obtain the best price possible; (2) whether the collateral was sold in bulk or piecemeal; (3) whether it was sold via
private or public sale; (4) whether it was available for inspection before sale; (5) whether it was sold at a propitious time;
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CHAPTER 25: Security Interests and Creditors’ Rights
(6) whether the expenses incurred during the sale were reasonable
and necessary; (7) whether the sale was advertised; (8) whether
multiple bids were received; (9) what state the collateral was in;
and (10) where the sale was conducted. The inquiry’s ultimate purpose is to ensure the creditor realizes a satisfactory price, which is
not necessarily the highest price, and it is recognized that secured
creditors frequently sell in the low end of the wholesale markets.
[Emphasis added.]
****
* * * SunTrust presented little evidence to support its contention that the collateral’s sale was made in a commercially reasonable manner. Monroe testified that he had not received anything
from SunTrust to tell him the time, date, place, or anything else
about the sale or to show SunTrust’s other attempts to sell the
vehicle; that he had not seen any documents about the actual
sale; that he had looked at Kelly Blue Book’s retail value and
NADA Black Book’s wholesale value, as well as online research,
to reach his own valuation of $165,000 to $175,000; and that he
was astounded that the vehicle had been sold for $115,000. As
to the $38,000 in repossession expenses, Monroe testified that
in his experience as a bail bondsman, this was higher than any
repossession fee he had ever seen.
****
* * * [Given] the lack of any evidence for the jury’s fact-based
inquiry to determine whether SunTrust endeavored to obtain the
best price possible for the vehicle, * * * and the lack of evidence
with regard to the state of the collateral and whether the expenses
incurred in the sale were reasonable and necessary, we conclude
that the jury could have reasonably determined that SunTrust did
not dispose of the collateral in a commercially reasonable manner.
Decision and Remedy A state intermediate appellate court
affirmed the lower court’s judgment. “Because the jury found that
SunTrust did not dispose of the collateral in a commercially reasonable manner, Monroe’s liability for a deficiency was limited. . . .
The trial court entered a take-nothing judgment. . . . We affirm.”
Critical Thinking
t
Legal Environment Is a low price sufficient to establish that
a sale of collateral was not made in a commercially reasonable
manner? Explain.
t
Economic A jury has broad discretion to identify the value
of collateral in a commercially reasonable transaction. What evidence might provide a rational basis for this determination?
Distribution of Proceeds from the Disposition Proceeds from the disposition of
collateral after default on the underlying debt are distributed in the following order:
1. Reasonable expenses incurred by the secured party in repossessing, storing, and reselling the
collateral are paid first.
2. The balance of the debt owed to the secured party is then paid.
3. Other lienholders who have made written or authenticated demands are paid.
4. Any surplus goes to the debtor, unless the collateral consists of accounts, payment intangibles,
promissory notes, or chattel paper [UCC 9–608(a); 9–615(a), (e)].
“If you think nobody
cares if you’re alive, try
missing a couple of car
payments.”
Earl Wilson
1907–1987
(American journalist)
Noncash Proceeds Sometimes the secured party receives noncash proceeds from
the disposition of collateral after default. Whenever that occurs, the secured party must
make a value determination and apply this value in a commercially reasonable manner
[UCC 9–608(a)(3), 9–615(c)].
Deficiency Judgment Often, after proper disposition of the collateral, the secured party
has not collected all that the debtor still owes. Unless otherwise agreed, the debtor normally
is liable for any deficiency, and the creditor can obtain a deficiency judgment from a court to
collect this amount. Practically speaking, though, debtors who have defaulted on a loan
rarely have the cash to pay any deficiency.
Note that if the underlying transaction was a sale of accounts, chattel paper, or promissory notes, the debtor is not liable for any deficiency. The debtor normally is entitled to any
surplus from the disposition of these types of collateral, however [UCC 9–615(e)].
30301_ch25_hr_577-606.indd 595
Deficiency Judgment A judgment
against a debtor for the amount of
a debt remaining unpaid after the
collateral has been repossessed
and sold.
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UNIT THREE: Commercial Transactions
Redemption Rights The debtor or any other secured party can exercise the right of
redemption of the collateral. Redemption may occur at any time before the secured party
disposes of the collateral, enters into a contract for its disposition, or discharges the debtor’s obligation by retaining the collateral. The debtor or other secured party exercises the
redemption right by tendering performance of all obligations secured by the collateral and
by paying the expenses reasonably incurred by the secured party in retaking and maintaining the collateral [UCC 9–623].
Ethical Issue
How long should a secured party have to seek a deficiency
judgment? Because of depreciation, the amount received from the
sale of collateral is frequently less than the amount the debtor owes to the secured party. In this
situation, the secured party can file a suit against the debtor in an attempt to collect the balance
due. UCC Article 9 does not contain a statute of limitations provision, though, so it is not clear how
long a secured party has after default to file a deficiency suit against a debtor. If the secured party
waits until the debtor becomes solvent again, though, the court may not allow the suit. When
creditors have sued debtors for deficiencies owed on repossessed cars, for instance, courts have
sometimes applied the four-year limitation period specified in UCC Article 2 because the transaction
was a sale of goods, even though a security interest was involved.7 Is this fair?
25–5
Other Laws Assisting Creditors
Both the common law and statutory laws other than Article 9 of the Uniform Commercial
Code create rights and remedies for creditors. These remedies are available regardless of
whether a creditor is secured or unsecured. Here, we discuss some of these rights and remedies.
25–5a
Liens
A lien is an encumbrance on (claim against) property to satisfy a debt or protect a claim for
the payment of a debt. Creditors’ liens may arise under the common law or under statutory
law. Statutory liens include mechanic’s liens, whereas artisan’s liens were recognized by common law. Judicial liens arise when a creditor attempts to collect on a debt before or after a
judgment is entered by a court.
Liens can be useful because a lien creditor generally has priority over an unperfected
secured party. In other words, if a creditor obtains a lien before another party perfects a
security interest in the same property, the lienholder has priority. If the lien is obtained after
another’s security interest in the property is perfected, the perfected security interest has
priority. Mechanic’s and artisan’s liens are exceptions to this rule. They normally take priority
even over perfected security interests, unless a statute provides otherwise.
Mechanic’s Lien A nonpossessory,
filed lien on an owner’s real estate for
labor, services, or materials furnished
for making improvements on the
realty.
Mechanic’s Lien Sometimes, a person who has contracted for labor, services, or materials
to be furnished for making improvements on real property does not immediately pay for the
improvements. When that happens, the creditor can place a mechanic’s lien on the property.
A mechanic’s lien creates a special type of debtor-creditor relationship in which the real
estate itself becomes security for the debt. If the property owner fails to pay the debt, the
lienholder is technically entitled to foreclose on the real estate and sell it. (Foreclosure is
7. See, for example, Price Automotive II, LLC v. Mass Management, LLC, 2015 WL 300418 (W.D.Va. 2015).
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597
the process by which a creditor legally takes a debtor’s property to satisfy a debt.) The sale
proceeds are then used to pay the debt and the costs of the legal proceedings. The surplus,
if any, is paid to the former owner.
In the real world, however, small-amount mechanic’s liens are rarely the basis of foreclosure. Rather, these liens simply remain on the books of the state until the property is sold.
At closing (when the sale is finalized), the seller agrees to pay all mechanic’s liens out of the
proceeds of the sale before the seller receives any of the funds. In contrast, mechanic’s liens
for significant amounts, such as when a contractor is owed millions for building an apartment complex, sometimes do lead to foreclosure.8
State law governs the procedures that must be followed to create a mechanic’s lien.
Generally, the lienholder must file a written notice of lien within a specific time period
(usually 60 to 120 days) from the last date that labor or materials were provided.
Artisan’s Lien When a debtor fails to pay for labor and materials furnished for the repair
MaxyM/Shutterstock.com
or improvement of personal property, a creditor can recover payment through an artisan’s lien. Artisan’s Lien A possessory
held by a party who has made
Lienholder Must Retain Possession. Unlike a mechanic’s lien, an artisan’s lien is lien
improvements and added value to the
possessory. The lienholder ordinarily must have retained possession of the property and personal property of another party
expressly or impliedly agreed to provide the services on a cash, not a credit, basis. The lien as security for payment for services
remains in existence as long as the lienholder maintains possession of the property, and the performed.
lien is terminated once possession is voluntarily surrendered, unless the surrender is only
temporary.
Case Example 25.14 Carrollton Exempted Village School District (in Ohio) hired Clean
Vehicle Solutions America, LLC (CVSA, based in New York), to convert ten school buses
from diesel to compressed natural gas. The contract price was $660,000. The district paid
a $400,000 deposit and agreed to pay installments of $26,000 to CVSA after the delivery of
each converted bus. After the first two buses were delivered, the district refused to continue
the contract, claiming that the conversion made the two buses unsafe to drive.
Both parties filed breach of contract lawsuits. CVSA also asserted
an artisan’s lien over two other buses that it still had in its possession
because it had started converting them to natural gas and had spent
$65,000 doing so. CVSA has an artisan’s lien that gives it a priority
claim to those two buses as long as they remain in its possession. The
buses act as security for the district’s payment of the amount that
CVSA has spent converting them to natural gas.9 ■
Foreclosure on Personal Property. Modern statutes permit the
holder of an artisan’s lien to foreclose and sell the property subject
to the lien to satisfy payment of the debt. As with a mechanic’s lien,
the holder of an artisan’s lien must give notice to the owner of the
property prior to foreclosure and sale. The sale proceeds are used to
pay the debt and the costs of the legal proceedings, and the surplus,
A dispute over payment arose in a contract to convert
if any, is paid to the former owner.
Judicial Lien When a debt is past due, a creditor can bring a legal
school buses to natural gas. For the lien on the buses to
remain in effect, what must the lienholder do?
action against the debtor to collect the debt. If the creditor is successful, the court awards the creditor a judgment against the debtor (usually for the amount
of the debt plus any interest and legal costs incurred). Frequently, however, the creditor is
unable to collect the awarded amount.
To ensure that a judgment will be collectible, the creditor can request that certain nonexempt property of the debtor be seized to satisfy the debt. (Under state or federal statutes,
8. See, for example, Picerne Construction Corp. v. Villas, 244 Cal.App.4th 1201, 199 Cal.Rptr.3d 257 (2016).
9. Clean Vehicle Solutions America, LLC v. Carrollton Exempted Village School District Board of Education, 2015 WL 5459852 (S.D.N.Y. 2015).
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UNIT THREE: Commercial Transactions
certain property is exempt from attachment by creditors.) A court’s order to seize the debtor’s
property is known as a writ of attachment if it is issued before a judgment. If the order is
issued after a judgment, it is referred to as a writ of execution.
Writ of Attachment. In the context of judicial liens, attachment is a court-ordered seizure
of property before a judgment is secured for a past-due debt. Attachment rights are created
by state statutes. Because attachment is a prejudgment remedy, it occurs at the time a lawsuit
is filed or immediately afterward. The due process clause of the Fourteenth Amendment to
the U.S. Constitution requires that the debtor be given notice and an opportunity to be heard
before property can be seized.
To use attachment, a creditor must comply with the specific state’s statutory restrictions
and requirements. The creditor must have an enforceable right to payment of the debt under
law and must follow certain procedures. Otherwise, the creditor may be liable for damages
for wrongful attachment. The typical procedures for attachment are as follows:
1. The creditor files with the court an affidavit (a written statement, made under oath) stating that the
debtor has failed to pay. The affidavit must indicate the statutory grounds for seeking attachment.
2. The creditor must post a bond to cover at least the court costs, the value of the property attached,
and the value of the loss of use of that property suffered by the debtor.
Writ of Attachment A court
order to seize a debtor’s nonexempt
property prior to a court’s final
determination of a creditor’s rights to
the property.
Writ of Execution A court order
directing the sheriff to seize (levy)
and sell a debtor’s nonexempt real or
personal property to satisfy a court’s
judgment in the creditor’s favor.
Garnishment A legal process
3. When the court is satisfied that all the requirements have been met, it issues a writ of attachment.
The writ directs the sheriff or other officer to seize the debtor’s nonexempt property. If the creditor
prevails at trial, the seized property can be sold to satisfy the judgment.
Writ of Execution. If the creditor wins a judgment against a debtor and the debtor will
not or cannot pay the amount due, the creditor can request a writ of execution. A writ of execution is an order that directs the sheriff to seize (levy) and sell any of the debtor’s nonexempt
real or personal property. The writ applies only to property that is within the court’s geographic jurisdiction (usually the county in which the courthouse is located).
The proceeds of the sale are used to pay off the judgment, accrued interest, and the costs
of the sale. Any excess is paid to the debtor. The debtor can pay the judgment and redeem
the nonexempt property any time before the sale takes place. (Because of exemption laws
and bankruptcy laws, however, many judgments are uncollectible.)
25–5b
Garnishment
An order for garnishment permits a creditor to collect a debt by seizing property of the debtor
that is being held by a third party. As a result of a garnishment proceeding, for instance, a
debtor’s employer may be ordered by the court to turn over a portion of the debtor’s wages
to pay the debt. Many other types of property can be garnished as well,
including funds in a bank account, tax refunds, pensions, and trust
funds. It is only necessary that the property not be exempt from garnishment and be in the possession of a third party.
Case Example 25.15 When Edward G. Tinsley divorced Michelle
Townsend, they entered into a marital settlement contract. They agreed
to sell the marital home and split the proceeds evenly. But Tinsley
refused to cooperate with the sale. A court therefore appointed a trustee
to sell the house for them and ordered the sheriff to evict Tinsley.
Tinsley then conveyed the house to a trust established in his name.
Although the sheriff evicted Tinsley from the house and changed the
locks, Tinsley managed to move back in and change the locks again.
Tinsley was arrested for trespassing and charged with contempt of
When can property—such as proceeds from a house
court (for disobeying court orders). In the meantime, Tinsley secretly
sale—be garnished from a trust?
sold the home for $150,000 and deposited the proceeds into a bank
Artazum/Shutterstock.com
whereby a creditor collects a debt by
seizing property of the debtor that is
in the hands of a third party.
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CHAPTER 25: Security Interests and Creditors’ Rights
599
account held in the name of Edward G. Tinsley Living Trust at SunTrust Bank. After learning
of the sale, the court-appointed trustee obtained a writ of garnishment on all of Tinsley’s and
his trust’s accounts at SunTrust Bank. Despite Tinsley’s objections, SunTrust Bank eventually
complied with the garnishment order and sent all the funds to the trustee.10 ■
Procedures Garnishment can be a prejudgment remedy, requiring a hearing before a
court, but it is most often a postjudgment remedy. State law governs garnishment, so the
procedure varies.
In some states, the creditor needs to obtain only one order of garnishment, which will then
apply continuously to the debtor’s wages until the entire debt is paid. In other states, the judgment creditor must go back to court for a separate order of garnishment for each pay period.
Limitations Both federal and state laws limit the amount that can be taken through garnishment proceedings.11 Federal law provides a framework to protect debtors from suffering
unduly when paying judgment debts by setting limits on how much can be garnished per
pay period.12 State laws also provide dollar exemptions, and these amounts are often larger
than those provided by federal law. In addition, under federal law, an employer cannot
dismiss an employee because his or her wages are being garnished.
25–5c
Creditors’ Composition Agreements
Creditors may contract with a debtor for discharge of the debtor’s liquidated debts (debts
that are definite, or fixed, in amount) on payment of a sum less than that owed. These agreements are called creditors’ composition agreements, or simply composition agreements, and usually are held to be enforceable.
25–5d
Suretyship and Guaranty
When a third person promises to pay a debt owed by another in the event that the debtor
does not pay, either a suretyship or a guaranty relationship is created. Exhibit 25–3 illustrates these relationships. The third person’s income and assets become the security for the
debt owed.
Creditors’ Composition
Agreement A contract between
a debtor and his or her creditors
in which the creditors agree to
discharge the debts on the debtor’s
payment of a sum less than the
amount actually owed.
Learning Objective 5
What is a suretyship, and how
does it differ from a guaranty?
10. Tinsley v. SunTrust Bank, 2016 WL 687545 (Md.App. 2016).
11. Some states (for example, Texas) do not permit garnishment of wages by private parties except under a child-support order.
12. For instance, the federal Consumer Credit Protection Act, 15 U.S.C. Sections 1601–1693r, provides that a debtor can retain either 75 percent of
disposable earnings per week or a sum equivalent to thirty hours of work paid at federal minimum-wage rates, whichever is greater.
Exhibit 25–3 Suretyship and Guaranty Relationships
Principal
Debtor
Surety
or
Guarantor
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Creditor
Primary Liability to Creditor
or
Secondary Liability to Creditor
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600
UNIT THREE: Commercial Transactions
Suretyship and guaranty provide creditors with the right to seek payment from the third
party if the primary debtor defaults on her or his obligations. At common law, there were
significant differences in the liability of a surety and a guarantor, as discussed in the following
subsections. Today, however, the distinctions outlined here have been abolished in some states.
Suretyship A promise made by a
third party to be responsible for a
debtor’s obligation.
Surety A third party who agrees to
be primarily responsible for the debt
of another.
Surety A contract of strict suretyship is a promise made by a third person to be responsible
for the debtor’s obligation. It is an express contract between the surety (the third party) and
the creditor. The surety in the strictest sense is primarily liable for the debt of the principal.
The creditor need not exhaust all legal remedies against the principal debtor before holding the surety responsible for payment. The creditor can demand payment from the surety
from the moment the debt is due.
Example 25.16 Roberto Delmar wants to borrow from the bank to buy a used car. Because
Roberto is still in college, the bank will not lend him the funds unless his father, José Delmar,
who has dealt with the bank before, will cosign the note (add his signature to the note,
thereby becoming a surety and thus jointly liable for payment of the debt). When José
cosigns the note, he becomes primarily liable to the bank. On the note’s due date, the bank
can seek payment from either Roberto or José, or both jointly. ■
Guaranty With a suretyship arrangement, the surety is primarily liable for the debtor’s obliGuarantor A third party who agrees
to be secondarily liable for the debt
of another (the debtor) only after the
principal debtor defaults.
gation. With a guaranty arrangement, the guarantor—the third person making the guaranty—
is secondarily liable. The guarantor can be required to pay the obligation only after the principal
debtor defaults, and default usually takes place only after the creditor has made an attempt to
collect from the debtor.
Case Example 25.17 To finance a development project in Delaware, Brandywine Partners,
LLC, borrowed $15.9 million from HSBC Realty Credit Corp. (USA). As part of the deal, Brian
O’Neill, an executive at Brandywine, signed a guaranty on the loan. The guaranty expressly
stated that O’Neill was familiar with the value of the property and that he was not relying on
it as an inducement to sign. Brandywine defaulted, and HSBC filed a suit in a federal district
court against O’Neill to recover. O’Neill tried to claim that he had been fraudulently induced
into signing the guaranty, but the court found that argument unconvincing given the language
of the guaranty. Therefore, the guaranty was enforceable, and O’Neill had to pay HSBC.13 ■
Blend_Images/DigitalVision/Getty Images
Actions That Release the Surety and Guarantor Basically, the same actions will
release a surety or a guarantor from an obligation. In general, the following rules apply to
both sureties and guarantors, but for simplicity, we refer just to sureties:
Many parents are sureties for their children’s
student loans. If the student loan is materially
modified without the parents’ knowledge, why
can the loan be completely discharged?
1. Material modification. Making any material modification to the terms of the original
contract without the surety’s consent will discharge the surety’s obligation.
The extent to which the surety is discharged depends on whether he or she was
compensated and the amount of the loss suffered as a result of the modification.
For instance, a father who receives no consideration in return for acting as a
surety on his daughter’s loan will be completely discharged if the loan contract is
modified without his consent.
2. Surrender of property. If a creditor surrenders the collateral to the debtor or impairs
the collateral without the surety’s consent, these acts can reduce the obligation
of the surety. If the creditor’s actions reduce the value of the property used as collateral, the surety is released to the extent of any loss suffered.
3. Payment or tender of payment. Naturally, any payment of the principal obligation
by the debtor or by another person on the debtor’s behalf will discharge the surety
from the obligation. Even if the creditor refused to accept payment of the principal
debt when it was tendered, the obligation of the surety can be discharged.
13. HSBC Realty Credit Corp. (USA) v. O’Neill, 745 F.3d 564 (1st Cir. 2014).
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Defenses of the Surety and the Guarantor Generally, the surety (or guarantor) can
also assert any of the defenses available to the principal debtor to avoid liability on the
obligation to the creditor. A few exceptions do exist, however. The surety cannot assert
the principal debtor’s incapacity or bankruptcy as a defense. Nor can the surety assert the
statute of limitations as a defense.
Obviously, a surety (or guarantor) may also have her or his own defenses. For instance,
the surety can assert her or his own incapacity or bankruptcy as a defense. Furthermore,
if the creditor fraudulently induced the surety to guarantee the debt of the debtor, the surety
can assert fraud as a defense. In most states, the creditor has a legal duty to inform the surety,
before the formation of the suretyship contract, of material facts known by the creditor that
would substantially increase the surety’s risk. Failure to so inform may constitute fraud and
render the suretyship obligation voidable.
Rights of the Surety and the Guarantor Usually, when the surety (or guarantor) pays
the debt owed to the creditor, the surety (or guarantor) is entitled to certain rights.
The Right of Subrogation. The surety has the legal right of subrogation, which means that
any right the creditor had against the debtor now becomes the right of the surety. Included
are creditor rights in bankruptcy, rights to collateral possessed by the creditor, and rights to
judgments secured by the creditor. In short, the surety stands in the shoes of the creditor
and may pursue any remedies that were available to the creditor against the debtor.
The Right of Reimbursement. The surety has a right of reimbursement from the debtor. Basically, the surety is entitled to receive from the debtor all outlays made on behalf of the suretyship arrangement. Such outlays can include expenses incurred as well as the actual amount
of the debt paid to the creditor.
The Right of Contribution. Two or more sureties are called co-sureties. When one co-surety
pays more than her or his proportionate share on a debtor’s default, she or he is entitled
to recover from the other co-sureties the amount paid above her or his obligation. This is
the right of contribution. Generally, a co-surety’s liability either is determined by agreement
between the co-sureties or, in the absence of an agreement, is specified in the suretyship
contract itself.
Example 25.18 Two co-sureties—Yasser and Itzhak—are obligated under a suretyship contract to guarantee the debt of Jules. Itzhak’s maximum liability is $15,000, and Yasser’s is
$10,000. Jules owes $10,000 and is in default. Itzhak pays the creditor the entire $10,000.
In the absence of an agreement to the contrary, Itzhak can recover $4,000 from Yasser.
The amount of the debt that Yasser agreed to cover is divided by the total amount that Itzhak
and Yasser together agreed to cover. The result is multiplied by the amount of the default,
yielding the amount that Yasser owes: ($10,000 4 $25,000)3 $10,000 5 $4,000. ■
Right of Subrogation The right of a
party to stand in the place of another,
givi…