Chapter 26 Secured Party Versus Lien Creditor; Future Advances; Bankruptcy
A. Non-Purchase Money Security Interest Versus Lien Creditor
1. Generally
Among the possible competitors to collateral is a "lien creditor." We will see in subpart D below that there is a critical interaction between the Article 9 rules governing lien creditor disputes and federal bankruptcy. However, it is desirable to start with the non-bankruptcy setting.
2. The Meaning of "Lien Creditor"
As was true under former Article 9, under new section 9-102(a)(52) a "lien creditor " is a creditor who obtains a lien by litigation, especially through execution. As noted in Chapter 3 (The Nature of Secured Credit under Article 9), the most common lien making a person a lien creditor is a lien arising by a levy pursuant to a writ of execution.
In many states, including Arizona, a judicial lien arises, and hence a person becomes a lien creditor, at the time of the levy. A levy as to personal property generally requires that the sheriff seize (or otherwise take possession of) the property.
Under new section 9-102(a)(52)(C), a trustee in bankruptcy is a lien creditor from the date a bankruptcy petition is filed. The interaction between federal bankruptcy law and the new Article 9 rules governing disputes between secured parties and lien creditors is considered in subpart D below.
3. The Basic Priority Rule
As noted in Chapter 25 (The How and Why of Priority), new Article 9, new section 9-201(a), retains the "general rule" of former section 9-201, under which a secured party prevailed against a debtor and third parties "except as otherwise provided." An important "except as otherwise provided" is found in new section 9-317(a)(2)(A).
Under new section 9-317(a)(2)(A), a lien creditor who obtains a lien before a non-purchase money security interest is perfected subordinates the security interest. Conversely, if a non-purchase money security interest is perfected before a levy then the security interest has priority (is not subordinated) under the general priority rule of new section 9-201(a). New sections 9-317(a)(2)(A) and new 9-201(a) together preserve the simple first-in-time of perfection or levy priority rule that existed under former Article 9. However, new Article 9 qualifies the foregoing basic first-in-time priority rule for lien creditors and non-purchase money secured parties and increases the protection given non-purchase money secured parties against lien creditors by former Article 9.
Under new section 9-317(a)(2)(B) subject to new section 9-323(b), as discussed below, if a secured party has filed a financing statement and one of the requirements of new section 9-203(b)(3) for enforceability of a security interest (essentially that the debtor has authenticated a security agreement or the secured party has taken possession pursuant to agreement -- see Chapter 8 (The Specifics of Enforceability -- A Security Agreement Authenticated by the Debtor or Its Equivalent)) -- has been satisfied then the secured party has priority even if value necessary to attachment and perfection of the security interest technically has not yet been given.
Thus, a non-purchase money security interest is protected against a judicial lien obtained prior to perfection of the security interest provided that the secured party has filed a financing statement and the debtor has authenticated a security agreement (or the secured party has taken possession of the collateral) before the lien was obtained (before the levy).
The change made by new section 9-317(a)(2)(B) is not quite as dramatic as might first appear because, as noted above, new section 9-323(b) may operate to limit the protection given a non-purchase money party. Under new section 9-323(b) a discretionary advance would be at risk even if the secured party has filed and satisfied one of the conditions of new section 9-203(b)(3) unless the advance is made within 45 days of the levy or the secured party does not know of the levy. New section 9-323(b) is explained more fully in subpart C.
New section 9-317(a)(2)(B) changes the rule of former Article 9 in a less obvious way. Under former Article 9, if a non-purchase money security interest became enforceable and, hence, attached to collateral after a levy had been made and a lien had arisen, the security interest attached to property already subject to a lien and was subordinate to the lien under the nemo dat concept. See Official Comment 4 to new 9-317.
Because under new section 9-317(a)(2)(B) a non-purchase money party whose security interest has not attached at the time of the levy has priority if the secured party has filed at the time of the levy and one of the conditions of enforceability in new section 9-203(b)(3) has been met, a non-purchase money party is not subordinated by a lien obtained before attachment of the security interest if the secured party has filed a financing statement and the debtor has authenticated a security agreement or the secured party has taken possession of the collateral (and the secured party has given value in a timely fashion as required by new section 9-323(b)).
As will be discussed in Chapter 28 (Secured Party Versus Secured Party), the change in the priority rule also eliminates what was viewed as an anomalous outcome under former Article 9, namely, that a secured party could be ahead of another secured party under the first-to-file priority rule but be subordinate to a lien creditor under the first to levy or perfect rule.
It is important to be aware that knowledge or the absence thereof and reliance or the lack thereof were not relevant in applying the priority rule of former Article 9 and the same is true under new section 9-317(a)(2). Judgment creditors do not check the public records before directing the sheriff to levy and the absence or existence of a filing that provides constructive notice is not relevant. Actual knowledge of a security interest is similarly immaterial.
4. The meaning of "subordinate to"
Some of the priority rules that we have yet to examine speak in terms of "taking free of" a security interest. For reasons that are explored later, a person who takes free of a security interest takes title that is not subject to the security interest and can transfer the property to others free of the security interest.
The priority rule of new section 9-317(a) for lien creditors is different. New section 9-317(a) provides that under the conditions spelled out in new section 9-317(a)(2), as just discussed, a security interest is "subordinate to" the rights of a lien creditor. Former section 9-301(1)(b) likewise provided for subordination.
Subordination essentially means the lien creditor has the first crack at the property to satisfy the lien. To oversimplify somewhat, if property worth $1,000 is levied upon to satisfy a $300 judgment before a security interest in the property securing a $1,000 debt was perfected, then the lien creditor gets $300 and the secured party is able to reach only the $700 of "equity" left in the property. In practice, the resolution of conflicts between lien creditors and secured parties is anything but mathematically precise and determining how and what a secured party actually will realize on its security interest if it is subordinate to a lien creditor can be difficult at best.
The primary source of the uncertainty is that lien creditors dispose of property that has been levied upon through execution sales under circumstances that are likely to be less than optimal with respect to getting the most value out of the property. Cf. Official Comment 6 to new 9-401 and Part VII.
Even if a security interest is not subordinate in priority terms a levying creditor may still cause problems for a secured party. It is one thing to have priority and another to be able to effectively exercise one's rights against collateral. As noted above, when property is levied upon the sheriff seizes that property. To get at the collateral the secured party has to retake the property from the sheriff and the sheriff and the lien creditor likely will not be eager to relinquish possession without resistance. The details of this practical and legal reality are best left to Part VII, but it is useful to be aware of it early on.
You may test your understanding of the treatment of disputes between holders of non-purchase money security interests and lien creditors under new Article 9 in the next problem.
Problem 26.1 (INTERACTIVE)
Lisa Lender and Donna Debtor enter into negotiations about a $10,000 loan to be secured by an interest in Donna's equipment, existing and after-acquired. Lisa files a financing statement covering Donna's equipment. Without Lisa's knowledge the Sheriff levies on all of Donna's equipment, worth $10,000, to satisfy a $10,000 judgment awarded earlier to Leon Lien Creditor. Lisa then lends the $10,000 to Donna who signs a security agreement describing the collateral as all of Debtor's equipment, existing and after-acquired.
Who has first claim to the equipment?
Would your answer to the question posed in Problem 26.1 change if Lisa could prove that Leon knew of Lisa's negotiations with Donna?
Suppose that Lisa had closed the loan and filed before the levy. Who would have first claim to the equipment now?
Suppose that at the time of the levy Donna had signed a security agreement creating a security interest in Lisa's favor, but Lisa had not yet lent Donna the $10,000. Who would have priority now if Lisa made the loan within 45 days of the levy?
B. Lien Creditor Versus Purchase Money Security Interest
To this point we have been discussing conflicts between lien creditors and non-purchase money security interests. As was also true under former Article 9, new Article 9 gives special protection to a purchase money security interest against lien creditors.
Under new section 9-317(e) a purchase-money secured party has priority over a lien creditor whose lien was obtained prior to perfection so long as the security interest was perfected by filing before or within twenty days (previously ten days) after the debtor receives possession of the collateral. Of course, if the secured party does not file within the twenty-day period then the lien creditor will be able to subordinate the security interest under new section 9-317(a)(2).
As discussed in Chapter 18 (Perfection by Doing Nothing -- Automatic Perfection), a security interest is a purchase money security interest under new section 9-103(b) essentially when the goods are purchase-money collateral with respect to the security interest (i.e., when the obligation secured was incurred to enable the debtor to acquire rights in the collateral).
You may explore the operation of the purchase money exception in new section 9-317(e) to the rule for non-purchase money cases in new section 9-317(a)(2) in the next problem.
Problem 26.2 (INTERACTIVE)
Selma Seller sells a drill press to Donald Debtor for use in Donald's business. Selma takes a security interest in the drill press to secure its unpaid price. The next day Selma delivers the drill press to Donald.
If later that same day the sheriff levies on the drill press pursuant to a writ of execution obtained by Leon Lien Creditor, who has first claim to the drill press under new section 9-317(a)(2)?
May Selma avoid being subordinated to the lien under new Article 9?
If so, what action must Selma take to prevent Leon from having priority?
New section 9-317(e) also deals with certain other priority disputes, namely, those between purchase money secured parties and buyers, lessees and licensees. Priority disputes involving buyers are considered in Chapter 27 (Secured Party Versus Buyers). As to lessees priority is conditioned upon delivery without knowledge of the security interest (such as is the rule under Article 2A). The inclusion of licensees is intended to make clear that the Article 9 rules cover transferees of intangibles as well as tangibles. Priorities as to intangibles and in consignment situations are dealt with in later chapters.
Recall from Chapter 17 (Perfection as to Goods Subject to Certificate of Title Legislation) that under new section 9-311(b), perfection by compliance with a certificate of title law or federal law is the equivalent of filing a financing statement. Therefore, perfection of a purchase money security interest by compliance with a certificate of title law or federal law within the twenty-day period would prevent a lien creditor who obtained the lien before perfection from subordinating the security interest.
C. Future Advances and "Non-Advances"
1. Future Advances
In Chapter 9 (The Specifics of Enforceability -- After-Acquired Property, Proceeds and Future Advances) we saw that a security interest can cover "future advances." At times "future advance" has meant an advance made pursuant to a clause in a security agreement by which collateral secures an advance made contemporaneously with the execution of the security agreement and any later advances as well.
This would seem to be the preferred meaning of the concept of a future advance. However, "future advance" has also referred to any advances made subsequent to the execution of the security agreement, including any initial but delayed advance and advances made pursuant to a new security agreement.
Additionally, recall that an advance made subsequent to the time a security agreement is executed may be optional, that is, at the discretion of the secured party, or it may be obligatory, meaning, in Article 9 terms, "pursuant to commitment." See new 9-102(a)(68). As explained below, the exact nature of the advance, including the purpose for which it is made, can impact priority.
Under former Article 9 a discretionary advance made within 45 days of a levy or such an advance made at any time without knowledge of a levy was protected against a lien obtained between the time a secured party perfected a security interest and the time the discretionary advance was made. This protection was given even though, technically speaking, the lien was obtained prior to perfection as to the advance (because value is not given as to a discretionary advance until the advance is made).
New Article 9 preserves the basic scheme of former Article 9 but under new section 9-323(b) it is not necessary that the security interest have been perfected prior to the time the lien is obtained. This change was made to accommodate the expansion of the protection given to holders of non-purchase money security interests in new section 9-317(a)(2) as explored in subpart A above.
Thus, a discretionary advance made within 45 days of a levy or such an advance made at any time without knowledge of a levy is protected so long as the secured party has filed a financing statement and the debtor has authenticated a security agreement or the secured party has possession of the collateral even if value was not been given prior to the advance (in which case there was no perfection prior to the advance in question).
The principal impact of the change is to protect a discretionary advance that is the first advance made by the secured party, for example, where the secured party and debtor agree that if a loan is made then the loan will be secured and the secured party files and the debtor authenticates a security agreement and before the advance is made a creditor obtains a lien on the collateral. However, a discretionary first advance is protected under new section 9-323(b) only if it is made without knowledge of a levy or within 45 days of the levy.
Note that a discretionary advance that is made more than 45 days after a levy is obtained and with knowledge of the levy is subordinated by the lien whether or not the secured party had a perfected security interest prior to the levy or was relying on the expanded protection given by new section 9-317(a)(2)(B). In this sense, as Official Comment 4 to new section 9-323 observes, "subsection (b) does not elevate the priority of a security interest that is subordinate to the rights of a lien creditor under new section 9-317(a)(2); it only subordinates."
You may consider new Article 9's treatment of future advance disputes between secured parties and lien creditors in the next problem.
Problem 26.3 (INTERACTIVE)
Lisa Lender lends $10,000 to Donald Debtor. Donald signs a security agreement giving Lisa a security interest in Donald's computer system, worth about $15,000 and used in Donald's business. Lisa immediately files properly. Subsequently, the sheriff levies on the computer system pursuant to a writ of execution obtained by Leon Lien Creditor to satisfy a judgment against Donald for $5,000. Lisa learns of the levy and threatens to foreclose. Donald advises Lisa that if she lends him another $5,000 then he will be able to get out of his current financial difficulties and Donald and Lisa can continue a business relationship that has been mutually beneficial for some time. Lisa makes the $5,000 loan. Which of the following statements are correct? Note that more than one choice may be correct.