The Law Of Secured Credit: A Trap For The Unwary

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A local bank will probably want a security interest in the equipment, assets, and/or inventory of your store, as well as in your future accounts receivable, in return for its loan to you. The stove manufacturer who supplies your stoves may want, in return for credit, an interest in the store's proceeds and an assignment to him of any installment sales contracts you receive from customers. Certain tradesmen, however, such as carpenters or electricians who help you set up shop, may not require any collateral but will do their work simply on the basis of your promise to pay them.

You yourself will also be a creditor. When a customer comes in and wants to buy a stove, but lacks the cash to pay for it, he may sign an installment sales agreement that gives you the right to monthly payments and the right to repossess the stove should the consumer default.

Provided the bank and the stove supplier perfect their security interests, (i.e. file their claims correctly), both are secured creditors and take priority over an unsecured creditor such as the electrician who worked on your stove.

Although the usual rule among perfected, secured creditors is that the first to file or perfect his interest takes priority, the bank, in our example, might still lose to the supplier in a battle over inventory collateral.

This is because the supplier's interest is what the UCC calls a "Purchase Money Security Interest," or PMSI. A PMSI is a security interest which finances the purchase of particular equipment or inventory. The PMSI creditor may gain a priority over even a prior-in-time creditor, such as a bank, provided he notifies the bank of his interest and files according to the Article 9 rules.

If the PMSI does not cover inventory (but covers, let's say, equipment) no notification to the bank is required to trigger the exception to the first-in-time rule.

There are two other notable exceptions to the first-in-time rule. The consumer who walks out of your store with a new stove has nothing to fear from the bank that holds a prior perfected security interest in all of your inventory. Even if you default on your obligation to the bank, the law protects the consumer-buyer absolutely.

Finally, purchasers of "chattel paper" (the financing agreement between a retail seller and a consumer) may obtain a priority interest in this paper over a bank or other lender who has a prior-in-time perfected interest in all the proceeds of your sales, so long as the purchaser (usually a finance company) pays cash, actually acquires the paper, and buys without actually knowing you should have passed it on to the other lender.

REPOSSESSION. Once a default occurs, the creditor has a right to repossess the collateral and sell it to satisfy the debtor's obligations. For example, when the purchaser of one of your stoves defaults, you can find and take back the stove he purchased on the installment plan. The same rules apply to any repossession under Article 9.

In general, a secured party has an absolute right to repossess collateral when a debtor defaults. He need not get court approval to take this action, but must only proceed, in the words of Article 9, "without breach of the peace." Of course, where court action is easier than "self-help," the secured party may also get a court judgment and have the state seize the property, conduct a public auction of the collateral, and give you the proceeds.

If the creditor decides to carry out his own repossession and resale, he must notify the debtor of the time and place. This is to allow the debtor a chance to redeem the collateral, drum up outside interest for the sale in hopes of generating a high bid, or just monitor the proceedings to be sure they are fair. Anyone who purchases the collateral at such a sale takes the goods free of all competing security interests.

LEASES. Article 9 does not apply to real estate mortgages (which involve real rather than personal property) or to involuntary obligations such as those created by a court judgment. It may apply, however, to certain leases, although the problem of when a lease comes under Article 9's rules is a hotly contested issue.

In general, Article 9 does not apply to leases. In a lease, the lessor actually owns the property leased -- say a business computer -- so he is fully protected without having to rely on the rules of Article 9. If the lessee goes bankrupt, the lessor simply takes back the leased computer. He need not worry about other parties who may be creditors.

On the other hand, it is often desirable to have the lease ultimately end in a purchase of the leased equipment by the lessee. Thus, the "lease" may finally turn out to have been an installment sales agreement in disguise -- with the lessor being in fact a type of creditor. Unless the lessor has gone to the trouble of complying with Article 9, he could end up having less rights to the equipment in the event of a bankruptcy than other creditors who comply with Article 9.

The best advice to a lessor, therefore, who may eventually want to sell his leased equipment to a lessee, is to make sure he has taken steps to protect himself under Article 9 as well as to protect himself in his lease.

CORRECTION-DATE: July, 1982

CORRECTION:

In the May issue of INC., The Law column on secured credit gave an example stating that Michigan law requires the filing of inventory security interests in both the debtor's county of residence and in the county where the business is located. This is inaccurate. Michigan requires security interests in inventory to be filed only with the secretary of state for the state of Michigan.

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