Secured Transactions

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SECURED TRANSACTIONS

Business dealings that grant a creditor a right in property owned or held by a debtor to assure the payment of a debt or the performance of some obligation.

A secured transaction is a transaction that is founded on a security agreement. A security agreement is a provision in a business transaction in which the obligor, or debtor, in the agreement gives to the creditor the right to own property owned or held by the debtor. This property, called collateral, is then held by either the debtor or the secured party to ensure against loss in the event the debtor cannot fulfill the obligations under the transaction.

The purchase of a car through financing is an example of a secured transaction. The car dealership or some other lender pays for the vehicle in return for a promise from the buyer to repay the loan with interest. The buyer receives the vehicle, but the lender retains the title to the car as security against the risk that the buyer will be unable to make the loan payments. If the buyer defaults on the payments, the lender, called the secured party, may repossess the car to recover losses from the default.

If the same transaction was unsecured, the buyer would receive the title to and possession of the car, and the lender would receive only the buyer's promise to repay the loan. If the buyer defaulted on the payments, the lender could sue the buyer, but the simple remedy of taking the property would not be available.

A security interest may be transferred, or assigned, to a third party. The party receiving the assignment becomes the secured party, and the original secured party no longer holds a claim to the collateral.

The law of secured transactions varies little from state to state because all 50 states plus the District of Columbia and the U.S. Virgin Islands have adopted Article 9, the secured transactions portion of the uniform commercial code (UCC). The UCC is a set of model laws written by lawyers, professors, and other legal professionals in the American Law Institute. In 1999 the institute, in conjunction with the National Conference of Commissioners of Uniform State Laws (NCCUSL), drafted a revised Article 9, which was adopted uniformly on July 1, 2001. The revisions marked the first comprehensive overhaul of Article 9 since 1972. They expand the scope of property and transactions governed by the UCC, clarify existing elements of the article, and provide guidelines for dealing with the growing phenomenon of electronic commerce.

Common Forms of Secured Transactions

Secured transactions come in many forms, but three types are most common for consumers: pledges, chattel mortgages, and conditional sales. A pledge is the delivery of goods to the secured party as security for a debt or the performance of an act. For example, assume that one person has borrowed $500 from another. Assume further that the debtor gives a piece of expensive jewelry to the creditor. If the jewelry is to be returned to the debtor after the debt is repaid, and if the creditor has the right to take full ownership of the jewelry if the debtor does not pay the debt, the arrangement is called a pledge.

A chattel mortgage is like a pledge, but in a chattel mortgage transaction, the debtor is allowed to retain possession of the property that is put up as collateral. If the debtor fails to repay the debt, the creditor may take ownership of the property.

A third type of secured transaction, the conditional sale, uses a purchase money security interest. A purchase money security interest arises when a creditor lends money to a borrower, who uses the money to purchase a particular item. To secure repayment of the loan, the creditor receives a lien on, or claim to, the purchased item. The lien gives the creditor a claim to the property that may be asserted if the borrower does not repay the loan.

Common Forms of Collateral

Any property accepted as security by a creditor can serve as collateral, but generally collateral falls into one of five categories: consumer goods, equipment, farm products, inventory, and property on paper. Consumer goods are items used primarily for personal, family, or household purposes. Equipment consists of items of value used in business or governmental operations. Farm products are items such as crops, livestock, or supplies used or produced in a farming operation. Under the revised Article 9, agricultural liens can also be considered collateral. Inventory consists of goods held for sale or lease or furnished under contracts of service, raw materials, works in process, materials used or consumed in a business, and goods held for sale or lease or furnished under contracts of service.

Paper collateral consists of a writing that serves as evidence of a debtor's rights in personal property. Stocks and bonds are examples of paper collateral. Another common form of paper collateral is chattel paper. Chattel paper is a writing that indicates that the holder is owed money and has a security interest in valuable goods associated with the debt. For example, assume that a car dealership has sold a car on financing to a buyer and has retained the title as security. The dealership may then use the security agreement with the buyer as collateral for a loan of its own from the bank. The revised Article 9 also recognizes "electronic chattel paper." This allows for the validity of so-called electronic signatures, which Article 9 refers to as "authenticated records." The electronic screens in some retail stores that allow customers to sign with a special stylus are thus just as valid as a signature in ink on a paper document.

Among the new areas governed by the revised Article 9 are commercial deposit accounts, promissory notes, and commercial tort claims. healthcare insurance receivables are also covered, which allows doctors and hospitals to include claims against insurance companies for services to their patients as part of the collateral they offer to healthcare lenders.

The Formalities

To be valid, a secured transaction must contain an express agreement between the debtor and the secured party. The agreement must be in writing, must be signed by both parties, must describe the collateral, and must contain language indicating a grant of a security interest to the creditor. Furthermore, something of value must be given by one party to the other party. This can be a binding commitment to extend credit, the satisfaction of an already existing claim, the delivery and acceptance of goods under a contract, or any other exchange of value sufficient to create a contract. Once these formalities have been completed, the security associated with the principal agreement is said to attach. Attachment simply means that the security side of the agreement is complete and legally enforceable.

To completely secure a secured transaction, or perfect the security, the secured party should file a financing statement with the local public records office, secretary of state, or other appropriate government body. Perfecting the security makes the secured party's claim official, puts the rest of the world on notice as to the creditor's rights in the property, and gives the creditor the right to take advantage of special remedies in the event the debtor does not repay the loan. A financing statement is a document that fully describes the secured transaction. The written document that created the agreement may serve as a financing statement, but the law on financing statements varies from state to state. A state may require the secured party to file a financing statement in addition to a copy of the agreement.

In most states financing statements are effective only for a limited duration, such as five years. A secured creditor may extend the length of perfection by filing a continuation statement before the designated time period has expired. If a secured creditor fails to continue the perfection, the security is not lost, but other creditors may claim the property. The secured creditor may file another financing statement, but this would require another signature from the debtor.

Amendments may be made to a financing statement. A secured party may file a statement of release on some of the collateral once the debtor has made payments equal in value to the value of the released collateral. If the amendment adds collateral, the security for the new collateral is effective from the date of the amendment, and not the date of the filing of the original financing statement.

One exception to the filing rule occurs when the secured party has possession of the collateral. In this situation the creditor's security is complete once the parties have agreed to the primary transaction. Another exception is the purchase money security interest in consumer goods other than building fixtures and motor vehicles. The filing of a purchase money security interest for such consumer goods is optional. If a secured party to a conditional sale does not record or file the agreement, however, he may lose the security if the buyer sells the goods to a third party.

Failure to perfect the security may have drastic consequences for the secured party who does not possess the collateral, although such failure does not automatically mean that the security will be lost. If, however, another party later stakes a claim to the collateral and files the proper papers, the secured party may lose his or her claim to the property because claims that have been properly recorded or filed have priority. Thus a secured party is wise to file a financing statement and other required documents to perfect the security and protect against claims by other creditors of the debtor.

Article 9 of the UCC is primarily concerned with protecting the secured party's right to the collateral. Many sections of Article 9 delineate who has the first right to a debtor's property if multiple claims arise. Precisely who has the first right to the debtor's property depends on a number of factors, including whether the security was perfected, who the other claimant is, and the time that the claims arose.

If a security interest has not been perfected, the secured party's claim to the collateral property may be subordinate to any number of creditors. A person who has a lien on the property takes before the secured party, as does a person who has received a court order for attachment of the property. If a person buys the collateral from the debtor and did not know of the security interest, the secured party loses the property if the security was not perfected. This is true only if the buyer purchases the property in the ordinary course of business from a person who is in the business of selling goods of that particular kind. A pawnbroker, for example, is not such a seller because a pawnbroker will sell almost anything if the profit is worth the time and trouble.

The identity of the buyer may influence the outcome of a dispute between a buyer of secured goods and the secured party. Generally, a merchant, or a buyer who purchases property for a business, is held to a higher standard than a person who buys an item for personal use. Merchants are more familiar with markets than are ordinary consumers, and they may be expected to know that a seller was insolvent and that the goods being sold were subject to claims from other parties. In any case, if any buyer knows that another party has a security interest in the property at the time the buyer made the purchase, the secured party retains the first claim to the property and may keep the property out of that buyer's possession until the debt associated with the secured property is fully paid.

If two parties have a security interest in the same property, the party who filed first takes first. If the competing security interests are both unperfected, the party who was first to attach the property as collateral has priority.

Other creditors of a debtor may have the first claim on secured property. However, the federal government has priority in some instances for collection of federal tax liens. Most states have artisan's lien statutes, which give servicers of property the right to hold the property in their possession as security for payment of the service bill. If the bill remains unpaid, the servicer has priority even over a secured party who has perfected his or her interest. Once a servicer or repairperson is paid for his services, he must release the goods to either their owner or the party with the security interest in the goods.

If the debtor to a secured party defaults, the secured party who has failed to perfect the security interest may lose first claim to the secured property to a receiver or an assignee for the benefit of creditors. A receiver is a party who is appointed by the bankruptcy court to manage the finances of the debtor for the benefit of the debtor's creditors. An assignee for the benefit of creditors is a person chosen by the debtor to manage all or substantially all of the debtor's property and to distribute it to creditors. A secured party who has perfected the security interest has priority over an assignee or a receiver, but even a secured party who has perfected may not receive all of the debt owed under a security agreement by a bankrupt debtor. Federal bankruptcy laws are designed to distribute the assets of an insolvent debtor in a fair and ratable manner among all of the debtor's creditors.

Satisfaction of the Secured Debt

Once a secured debt is repaid in full, the secured party must, upon written request by the debtor, send a termination statement to the debtor and file a termination statement with all offices that hold the financing statement. A termination statement serves as evidence that the debt has been paid in full. If the debtor makes a written request for the termination statement, the creditor must send the statement within ten days of the date of the request. Even if the debtor does not so request, the secured party must send a termination statement to offices that hold the financing statement within 30 days of the satisfaction of the debt.

Default

If a debtor defaults on his obligations under a secured transaction, the secured party may foreclose on the security interest. Foreclosure can be accomplished in different ways. The secured party may calculate the amount of the debt owed and sue the debtor without taking possession of the property. Alternatively, unless the parties have agreed otherwise, the secured party may take possession of the collateral property and either keep it or sell it. In either case, if the value received by the secured party does not fully satisfy the debt, the secured party may sue the debtor for the deficiency.

In most states a secured party may take possession of the collateral without judicial involvement if this can be accomplished without a breach of the peace. For example, the secured party may repossess a vehicle if it is parked outdoors. If, however, the agent of the secured party must break into a garage to repossess the vehicle, such action would be a breach of the peace because it would require breaking and entering, a criminal offense.

If a consumer has defaulted on a secured transaction but has paid 60 percent or more on the debt, most states prohibit a secured party from taking the security and keeping the windfall. In such cases the secured party may either sue in court for the money outstanding or take the property and return part of the money. In other situations a secured party may be entitled to any excess value or income that results from the debtor's default.

The retention of collateral by a secured party after the debtor's default is called strict foreclosure. If a secured party decides to keep collateral in satisfaction of a debt, the secured party must send written notice to the debtor. In transactions involving collateral other than consumer goods, a secured party may be obliged to send notice of the strict foreclosure to any other parties who have security in the collateral property. If a party objects to the strict foreclosure, the secured party must sell or otherwise dispose of the collateral. If no other party objects to the strict foreclosure, the secured party may keep the collateral.

A secured party who sells or leases collateral after a debtor defaults may charge the debtor for reasonable expenses incurred in the sale or lease. This can include attorneys' fees and court costs. The money made from a sale of collateral rarely satisfies a debt because such sales do not bring favorable prices. If there is a surplus of money after the collateral is sold, all expenses are accounted for, and the sale or lease is applied to the debt, other parties holding a security interest in the collateral must be paid with the surplus money.

Unless the parties have agreed otherwise, a debtor who is in possession of the collateral and who has defaulted on the obligations in a secured transaction has the right to redeem the collateral before the secured party takes action. To avoid foreclosure of the security interest by the secured party, the debtor may pay the unpaid balance of the debt secured by the collateral, as well as any reasonable expenses incurred by the secured party in taking, holding, and preparing the foreclosure. This does not mean the debtor must pay the entire amount of the debt; rather, the debtor must make those payments that are in default. Some security agreements have an acceleration clause that makes all payments due immediately upon default, but a court may hold that such a clause should not be enforced if the debtor has brought the payments up to date before the secured party has acted on the delinquency. A secured party who violates default provisions may be liable to the debtor for losses resulting from that conduct.