As discussed in Chapter 16, a large portion of business transactions at the wholesale and retail levels is done on a credit basis. Some of these involve unsecured debts, such as transactions paid by credit cards or unsecured personal bank loans (also called signature loans). When large loan amounts are involved, or when dealing with consumers or businesses whose credit histories make them bad risks, sellers often protect themselves by retaining a security interest in the goods sold, or in other personal property belonging to the debtor, as collateral (security) in the event that the debtor defaults on the debt.
Recall that the Uniform Commercial Code (UCC) is divided into articles. Most relevant to the busi- ness environment are Article 2, which covers sales contracts (see Chapter 10); Articles 3 and 4 (see Chapters 12 and 15, respectively), which cover negotiable instruments and banks; and Article 9 (the subject of this chapter), which covers secured transactions. Such transactions are also referred to as Article 9 (or Article IX) transactions.
17.1 Creating a Secured Transaction
Article 9 transactions involve three parties: a creditor, a debtor, and a security interest in col-lateral. Collateral is the personal property used to secure the debt; a security interest refers to the “rights” that a creditor has in the debtor’s collateral so that if the debtor defaults, the creditor can sell the property and recoup some of its losses.
In order for a creditor to obtain an Article 9 security interest in the property of a debtor, three condi- tions must be met:
1. The creditor has to “give value” to the debtor. Usually this means that the creditor makes a loan of money;
2. The debtor must have “rights in the collateral,” meaning that the debtor has ownership in the property he or she is using as the collateral; and
3. The creditor must either take physical possession of the collateral or file a security agree- ment so that others can “see” that the creditor has rights in this particular collateral.
The note represents the debt between the creditor and the debtor. While it does not have to be as formal as a negotiable promissory note (see Chapter 12), it does need to evidence the debt between the parties. Thus, when the debtor signs the note as the maker, the debtor is promising to pay on the debt. In exchange, the creditor gives the debtor value, perhaps a car, boat, house, or loan of cash.
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Section 17.1 Creating a Secured Transaction CHAPTER 17
Value that a debtor receives in exchange for the security interest is usually the extension of credit or the sale of goods to which the security interest attaches. See Figure 17.1 for a diagram of the debtor–creditor relationship.
Note, however, that the value need not relate to the transaction involving the personal property involved in the security interest, as in the following example.
Dawn Debtor is in default on an unsecured loan for her business’s ice cream– making equipment because she missed several monthly payments. She could still offer a security interest in her tangible or intangible personal property (in this case, the title to her various time shares) to her creditors in exchange for the creditor altering the terms of the loan or granting an extension of time to pay it. If they accepted her offer, she would receive “value” for the security interest given to the creditor: the avoidance of a default judgment and the closing of her previously successful ice cream business.
Figure 17.1: Relationship of creditor and debtor in secured and unsecured loans
The requirement that a debtor have rights in the collateral means that debtors may give a security interest only in property that they own or otherwise have the right to possess, and then, only to the extent of their ownership or possessory interest in the property.
The Security Agreement
The security agreement is a written document, formal or informal, that sets out the under- standing between the parties regarding the loan and the creditor’s rights in the collateral that is securing the loan. If the creditor gives value (e.g., loans the money), and the debtor owns the collateral in which he or she is giving a security interest, then a secured transac- tion has taken place. Although it is important that the security agreement identify the
Agreement to repay, evidenced by a note
Loan of money An Unsecured Debt
Agreement to repay, evidenced by a note
Pledge of personal property as collateral for the debt Debtor must have “rights” in property given as collateral
Loan of money/“Giving Value” A Secured Debt
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Section 17.1 Creating a Secured Transaction CHAPTER 17
debt, the agreement does not need to go into detail about the terms of the debt or even repayment. As between the creditor and the debtor only, if the debtor defaults on the loan, then the creditor gains the right to the property.
Finally, creditors may obtain a security interest only in property that is in their possession. This means that a debtor has either turned the property over to their custody or has pro- vided a description of the property, if it is not in the creditor’s possession. Thus, a debtor may enter into a valid oral security agreement only if he or she turns the property over to the creditor. If the debtor retains the property or otherwise leaves it out of the credi- tor’s control, then the security interest will not arise unless the debtor has authenticated the agreement. The debtor can do so by providing a description of the personal property either in a signed writing or in an electronic form. The electronic version needs to be authenticated by a unique symbol, encryption, or similar process used to identify the per- son in an e-mail or other form of electronic communication, such as a telephone message or a mouse click. In short, the authentication requirement is very broad: It can include many types of actions but does not require a signature.
Up to this point, the creditor may have loaned money, the debtor has given collateral to secure that loan, and the parties have entered into a written security agreement to memori- alize their transaction. It cannot be emphasized enough that while this is indeed a secured transaction, it is only secure as far as the one creditor is concerned. Unfortunately, in many instances, multiple creditors claim an interest in the same collateral. So one must deal with the issue of perfection, or perfecting a security interest, as we will see in the next section.
The Financing Statement
To complicate matters considerably, often competing creditors are vying for the same piece of collateral. Suppose, for example, that you went to purchase an automobile and you financed the purchase through the dealer. The dealer would have a security interest in the car. Now suppose that, in need of money, you borrowed from a friend Jake and gave him a security interest in the same car. In the event that you defaulted on your loan from Jake, two creditors would claim an interest in the same collateral. The question is: Who would prevail? The car dealer or the friend? The answer has to do with perfecting a security interest. Perfection involves a next step after creating the security interest. In it, another form is filled out and filed called a financing statement, more commonly called a UCC-1 form.
There is no way to perfect a security interest other than by filing the UCC-1. Filing a secu- rity agreement, for example, does not lead to perfection. In short, perfection is the legal pro- cess by which creditors with a security interest in personal property protect themselves against claims from other creditors who may also have a security interest in the same property. If a creditor follows the prescribed process and perfects the security interest, that person will have an advantage. His or her right to use the property covered by the secu- rity interest to satisfy the debtor’s debt (in the event of a default) will be superior to that of other creditors with a similar security interest in the property. In addition, perfecting a security interest is intended to give third parties notice of the secured party’s security interest, typically with the local property office and the secretary of state.
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Section 17.2 Other Secured Transaction Issues CHAPTER 17
The financing statement must contain a statement describing the collateral it covers. If the secured interest relates to fixtures (goods permanently attached to realty), the financing statement must be filed in the state office where mortgages on real estate are filed and must include a description of the real estate to which the fixtures are attached.
17.2 Other Secured Transaction Issues
In the previous sections we established the basics of what constitutes a secured trans-action: the note, the security agreement, and the financing statement. In this section, we will examine other concepts that have to do with Article 9 transactions, including further discussion of the concept of perfection.
Purchase Money Security Interests
For some types of personal property, the security interest is perfected automatically with- out requiring the secured party to file a financing statement. One type that is commonly used in business is the purchase money security interest in consumer goods. This is a transaction involving consumer credit where the seller extends credit to the consumer for goods sold and retains a security interest in the goods. For example, if a buyer goes to an automobile dealer and purchases a car on credit, the buyer will sign a note to the seller; the buyer, in turn, will receive the automobile and title to the automobile, even though he or she has not paid any money yet; the seller will file a financing statement evidencing that he or she has a lien on the car that will be reflected on the title. This is a secured transac- tion because if the buyer defaults, the seller can reclaim the car. The seller gave value and the buyer gave collateral in which he or she had “rights,” in this case, ownership. The seller would probably file a financing statement (UCC-1) to evidence his or her rights in the collateral; however, since this is a purchase money security interest, the seller has an automatic perfection. Filing is always preferred, however, as it ensures protection against the debtor as well as other parties who are claiming the same collateral.
Duration of Perfection
A financing statement is generally effective for five years after the date of filing (UCC § 9-515(a)). However, a continuation statement may be filed before the financing state- ment on file lapses. For a continuation statement to be effective, it must be filed within six months of the financing statement’s lapse (e.g., within the last six months of its effec- tive period) and will extend the effectiveness of the security interest for another five years from the date when it would otherwise lapse. Continuations may be filed in suc- cession, effectively extending the coverage of the perfected security interest every five years ad infinitum.
Priorities Among Conflicting Security Interests in the Same Collateral
Generally speaking, “first in time is first in right” when it comes to conflicting per- fected security interests. That is, interests are enforced according to their time of filing or
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Section 17.2 Other Secured Transaction Issues CHAPTER 17
perfection. Further, perfected security interests take priority over unperfected security interests. However, there are exceptions to the general rule. One of these covers perfected purchase money security interests of noninventory purchases of goods. This exception gives preference to these interests over other previously perfected security interests if the purchase money security interest is perfected within 20 days of the debtor taking posses- sion of the collateral (UCC §9-324(a)). Consider the following examples:
Betty Businesswoman gives a general security interest in all present and future business property to Candice Creditor in exchange for a loan. Betty then purchases new fixtures for her business from Frank’s Fixtures, giving Frank a purchase money security interest in the fixtures. Thus, Frank’s security interest will take priority over Candice’s even though hers was perfected first.
When a perfected purchase money security interest in goods that qualify as inventory is involved, such a security interest takes priority over other security interests in the same inventory.
Barb Businesswoman has given Ben Banker a security interest in her inven- tory to secure a line of credit. She then places an order for goods for resale in her store from Sandra Seller, secured by a purchase money security inter- est. Even though it took place later, Sandra’s interest in the goods will take priority over Ben’s.
Article 9 of the UCC does not define what constitutes a default, but it does allow the par- ties to define for themselves what constitutes default by mutual agreement (in any man- ner that is reasonable). When a default occurs, the secured party has several options: to “reduce the claim to judgment” (e.g., sue for default of the underlying note or draft), fore- close, or otherwise enforce the claim, security interest, or agricultural lien by any available judicial procedure. Consider the following scenarios:
• If the collateral consists of documents, the secured party may proceed either as to the documents or as to the goods they cover. For example, if the collateral is a warehouse receipt for goods in the hands of a third party, and the debtor defaults on the debt, the secured party could either • Transfer the negotiable instrument and use the proceeds to settle the debt; or • Use the warehouse receipt to take possession of the goods it covers and then
sell the goods themselves to satisfy the debt. • If the personal property that is the subject of the security interest is insufficient
to cover the full debt, the secured party can obtain a deficiency judgment against the debtor for the difference.
• If the security interest involves property worth more than the debtor’s debt, the debtor is generally entitled to a return of any excess proceeds from the sale or other disposition of the property offset by the reasonable costs related to caring for or disposing of the property .
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Key Terms CHAPTER 17
Article 9 of the UCC The section of the Uniform Commercial Code that governs secured transactions.
Article 9 transactions Another name for secured transactions, governed by Article 9 of the UCC.
authentication Providing a description of the debtor’s personal property either in a signed writing or in an electronic form (by a unique symbol, encryption, or similar process) to complete a security agreement with the creditor.
continuation statement A document that can be filed within six months before a financing statement’s expiration to extend the latter an additional five years.
financing statement (UCC-1 form) More commonly called a UCC-1 form, a record or records composed of an initial financ- ing statement and any filed record relating to the initial financing statement (UCC §9-102(a)(39)); the third step in creating a secured transaction.
foreclose Action taken by a creditor who seeks to enforce the terms of a mortgage by taking possession of a debtor’s home and selling it in order to pay the balance of the debt owed.
note A document that represents the debt between the creditor and the debtor; the first step in creating a security agreement.
perfected security interest or perfection A security interest in personal property that is protected against other creditors who claim the same collateral. Perfection is obtained by filing a financing statement or being in physical possession of the collateral.
purchase money security interests Transactions involving consumer credit where the seller extends credit to the consumer for goods sold and retains a security interest in the goods.
rights in the collateral Requirement of a secured transaction that debtors may give a security interest only in property that they own or otherwise have the right to possess, and only to the extent of their ownership or interest in the property.
secured party Any creditor who has a security interest in the debtor’s collateral, including a person who holds an agricul- tural lien, a consignor, or the purchaser of chattel paper, payment intangibles, or promissory notes (UCC §9-102(a)(72)).
security agreement An agreement that creates or provides for a security interest (UCC §9-102(a)(73)).
security interest The rights a creditor has in the debtor’s collateral; if the debtor defaults, the creditor can sell the property and recoup some of its losses.
signature loan An unsecured personal bank loan without collateral to guarantee payment.
value In a secured transaction, what the debtor receives from the creditor in exchange for the promise to pay on the debt, e.g., a car, boat, house, or loan of cash; also could be an intangible benefit, e.g., the avoidance of a default judgment.
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Critical Thinking and Discussion Questions CHAPTER 17
Critical Thinking and Discussion Questions
1. What types of property are covered by Article 9 of the UCC? 2. In order for a creditor to obtain a security interest in the property of a debtor,
what three conditions must exist? 3. What is the purpose of perfecting a security interest, and how is it generally
accomplished? 4. Your supervisor asks you to file a UCC-1 on a piece of collateral. Find a UCC-1
form online and then determine where (in your location as a student) the form would be properly filed.
5. Why do you think the UCC set up a system that allows creditors to obtain a security interest in a debtor’s collateral? Suppose such a system did not exist. What would be the ramifications of no system in existence to allow for secured transactions?
6. How is it possible that more than one creditor has a claim in the same collateral as other creditors? Can you think of any ways to prevent this from happening?
7. Harry Homeowner needs to buy a new boiler for his home to upgrade his heat- ing system. The total cost would be $7,500, which includes $5,000 for the cost of a new high-efficiency furnace and $2,500 for labor, transportation, and taxes. He wants to purchase the unit on credit from Penelope, a licensed HVAC contractor, who is willing to finance the purchase and installation in exchange for a security interest in the boiler for $7,500.
a. A month after the boiler is installed, Harry loses his job and is unable to make the second monthly payment to Penelope. If he offers to give a security interest to Penelope in his entire art collection (worth $100,000) in exchange for Penelope giving him a three-month grace period on making further pay- ments on the boiler and Penelope accepts, may she perfect a security interest in the artwork as well as in the boiler?
b. Assuming that the security interest in the artwork may be given by Harry to Penelope, what must Penelope do to perfect her interest in the artwork?
c. If Harry fails to make payments after the grace period ends because he has been unable to find another job, what are Penelope’s legal options?
8. Bernard wants to buy a 50-inch plasma high-definition television from his local appliance store. The store, which caters to low-income clientele and offers elec- tronics and other household goods at highly inflated prices and at the highest interest rate that the law allows in his state, agrees to sell the set to him at a price of $5,000 financed over a six-year period at a 25% rate of interest. The financing agreement makes it clear that the store retains a purchase money security interest in the television set. As part of the deal, Bernard also executes a second security agreement covering his $5,000 synthesizer (he is a professional musician) and a $2,000 diamond ring that he inherited from his dad. He turns the ring over to the appliance store as security in a verbal agreement, but it is agreed that he will be allowed to keep the synthesizer as long as he makes timely payments, and he pro- vides a written, signed copy of an agreement to this effect to the appliance store. The store promptly perfects its interest in the synthesizer by forwarding a financ- ing statement to his state’s secretary of state with the appropriate fee and in the form required by local law but does not send financing statements covering the television set or ring to the secretary of state.
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Critical Thinking and Discussion Questions CHAPTER 17
Two years later, Bernard stops making payments on the television set because he realizes that he made a bad bargain when agreeing to buy the set.
a. Has the store perfected its security interest with regard to the ring under the facts given?
b. May the store enforce the security agreement against the synthesizer if the outstanding loan amount at the time of Bernard’s default is $4,000 and the actual value of the television set at the time is $500?
c. If the value of the synthesizer at the time of the debtor’s default is $3,000 and the market value of the television set is $500, what are the creditor’s rights with regard to the secured property? Discuss fully.
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