The Law Of Secured Credit: A Trap For The Unwary

Article 9 of the Uniform Commercial Code can be a legal minefield. But debtors and creditors need to know the rules to protect their rights.

Tweet

When a small commuter airline in St. Louis fell behind in its payments for a new Cessna aircraft, the seller (an equipment leasing company) repossessed the plane and sold it at a private auction. The auction price, however, fell short of the amount owed to the seller by about $100,000. In a later lawsuit, the leasing company claimed that it was entitled to a judgment against the airline for the $100,000 shortfall. Under normal circumstances, it should have won easily. However, the seller in this case had neglected to send the airline a notice of the date and place of the resale -- a notice required by Article 9 of the Uniform Commercial Code (UCC). Because of this oversight, the leasing company lost the full $100,000.

When a car dealer in Michigan went bankrupt, the General Motors Acceptance Corp. (GMAC) applied to a court claiming that it had a "security interest" in the dealer's unsold automobiles, and ought, therefore, to be allowed to repossess them. The court found, however, that GMAC had filed a notice of its interest only in the county where the business was located -- not in the debtor's county of residence, as required by Michigan's laws. For this admittedly technical failure, GMAC lost all its special rights to its collateral and became a "general unsecured creditor."

These and literally hundreds of situations like them make up the hard facts of life for creditors operating under one of the most complex statutes in commercial law -- Article 9 of the Uniform Commercial Code. Article 9 is the model upon which the secured credit rules of most states are based, and is designed to assure that creditors will be able to enforce their rights to specified collateral as long as certain legal formalities are satisfied.

Many of the disputes under Article 9 arise when several creditors -- a bank and two suppliers, for example -- seek to claim the same piece of collateral to satisfy a credit obligation by a defaulting or bankrupt debtor. When a repossession takes place, as in the abovecited example, the law also provides some protections for the debtor to assure that his rights are not abused.

WHAT IS A SECURITY INTEREST?

The only commercial transactions covered by Article 9 are those involving security interests. The UCC says that a security interest is any agreement in which personal property such as goods, contract rights, accounts, or fixtures (equipment permanently fixed to land or a building) "secures the payment of an obligation." Loans on inventory, certain equipment leases, and advances on accounts receivable are all examples of security interests.

Article 9 lays out very specific steps that a creditor must take in order to establish a security interest in a particular property. The creditor either receives a signed statement from the debtor agreeing to the arrangement and identifying the collateral, or he is given the collateral itself. Of course, the debtor must have rights to the property that he offers the creditor as collateral: An art gallery owner who displays others' artwork cannot offer that as collateral because he has no present right of ownership.

Finally, no security interest comes into existence until the creditor actually gives something of value (cash or credit) to the debtor in return for the signed agreement. Once all these requirements are fulfilled, the person holding the security interest has the right to claim the collateral from the debtor. His interest is said, by law, to have "attached."

PERFECTION. Article 9 gives the maximum legal protection only to "perfected" security interests. In order for the holder of the security interest to claim rights in the collaterial that will prevail over the claims of other creditors, he must file a written summary of the security interest with an appropriate state official, as designated by state law. This filing -- like the written filing of a property mortgage -- gives other lenders a warning that the property described in the filing is claimed by that particular creditor.

The filing requirements are an especially detailed and complicated aspect of Article 9. Suffice it to say that the lender must get the filing exactly right or he loses his special rights to the collateral.

Most small businessmen are not creditors except insofar as they finance sales to their own customers. You will be relived, therefore, to learn that the UCC does not require these complicated filings for most consumer installment sales (except automobiles) in which the seller advances sufficient credit to enable a customer to buy the product.

Once a security interest is "perfected" -- either automatically or by a filing -- the next question becomes what its "priotiry" is with respect to other security interests held in the same collateral by different creditors.

PRIORITIES. One would think that "perfection," as the word implies, would be enough to secure a creditor's rights in collateral. Unfortunately for creditors, this is not the case. A perfected security interest, like a properly staked out prospecting claim in the Old West, makes good evidence in a court of law, but the court will also want to know if any other claims to the same property were perfected first. There are special rules, the basic one being "first come, first served," that determine the priority to be given conflicting claims to the same collateral.

For example, if you are a small businessman interested in opening up a retail appliance store, you may approach several creditors at once to help you get started. Some of these creditors will want collateral and, surprisingly, you can offer the same collateral to more than one of them. Their rights, however, will line up according to Article 9's rules on priority.

 1 | 2  NEXT