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.

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.