Part II Article 9 in a Nutshell
Chapter 3 The Nature of Secured Credit under Article 9
An appropriate starting place is to ask the following question: Why bother with an Article 9 security interest? The answer to this question is central to understanding Article 9 law and practice.
Consider the following problem.
Problem 3.1 (interactive)
Last February, John Smith sold his portable basketball hoop, net and standard to Jane Jones, his neighbor, for $250. John spent a year in law school so he knew he should get something in writing. Jane signed the following piece of paper:
The undersigned, John Smith, hereinafter "Seller," sells to Jane Jones, hereinafter "Buyer," one used portable basketball set, consisting of a hoop, a net and a standard, for the price of $250. Buyer promises to pay Seller $50 on delivery and the remaining $200 over the next six months.
___________________
John Smith, Seller
___________________
Jane Jones, Buyer
Dated: 2-5-[year]
Jane paid John $50 and took delivery in February. It is now August of the year of sale. The portable basketball set is sitting in Jane's driveway and Jane shoots baskets almost every day. However, Jane has not paid John anything further towards what she owes John.
What are John's rights? What is the source of these rights?
Could John simply go over to Jane's house and take the portable basketball hoop back?
If not, why not?
What must John do to collect his $200? Explain your answers.
The major point of Problem 3.1 is that the breach of contract for sale of the basketball hoop alone does not give John an interest in any particular property of Jane, not even the basketball hoop, out of which to satisfy the claim for breach of contract. Even if John obtained a judgment against Jane for breach of contract, without more (see below), John would not be able to go after the basketball hoop to satisfy the debt owed by Jane. See W. Boyd & C. Smith, Debtor Creditor Law in Arizona, Ch. 6 (Banks-Baldwin/West 1993). Later references to this work will be abbreviated "B & S."
If John had a lien the situation would be quite different. A "lien" is an interest in particular property to secure a debt. See BRA § 101(37) (defining "lien"). A lien is a "security interest" under Article 1, section 1-201(b)(35) when it is an interest in personal property to secure payment or performance of an obligation. Although the statute does not say so in so many words, it is understood that a security interest in personal property that arises out of an agreement (i.e., the lien is "consensual") is an "Article 9 security interest." See Official Comment 2 to new 9-109. Compare BRA § 101(51).
A holder of an Article 9 security interest not only has an interest in particular property to secure a debt but, subject to limitations explored in Part VII, has certain rights of "self help" regarding the property securing the debt, meaning that the holder of the security interest need not seek the assistance of a court in trying to satisfy a debt out of the property in which the holder has a security interest.
Consider the next problem.
Problem 3.2 (interactive)
Assume the facts of Problem 3.1. Assume further, however, that the writing that Jane signed contained the following provision:
" Buyer grants to Seller an interest in the portable basketball hoop to secure its unpaid price."
What does such a provision give to John that he does not otherwise have?
Does John have an "Article 9 security interest"?
Could John simply go and get the basketball hoop?
Check out new section 9-609 before you answer. (Don't fret the details of this section of Article 9, or other sections referred to in the remainder of this chapter, as they will be considered in depth in later chapters.)
If the provision in the agreement is enforceable and John can take back the basketball hoop when Jane fails to pay, what can John do with the basketball hoop after retaking it? See new 9-610 and new 9-620.
The basic points should be clear. In Problem 3.1 John is simply an unsecured creditor with no rights in the basketball hoop. In Problem 3.2 John has a lien on the basketball hoop. The lien is an Article 9 security interest and under Article 9 John has special rights with regard to the basketball hoop, including certain rights of self help.
The special rights enjoyed by a secured party as contrasted with an unsecured creditor do much to explain why getting an Article 9 security interest is worth the bother. If John has an Article 9 security interest in the basketball hoop he also likely is better off should Jane file bankruptcy. The explanation is as follows. If John has a security interest (or other lien) on the basketball hoop then he may also be a "secured claim holder " within the meaning of Bankruptcy Reform Act (BRA) § 506(a) under which a creditor is secured claimholder to the extent of the value of property on which the creditor has a lien (security interest) up to the amount of the debt secured by the lien.
If the basketball hoop is worth $250, then John has a secured claim of $200 because the amount of the debt is the upper limit. If the hoop is worth only $150, then John has a secured claim of $150 (and is unsecured as to the remaining $50).
Using the Chapter 7, or liquidation, proceeding as the paradigm, the distribution of assets in bankruptcy is relatively easily described. The trustee gathers all the property of the bankruptcy estate not timely taken out of the estate by the debtor as being exempt and satisfies out of these assets, in the following order, the claims of secured parties, priority unsecured claims, and general unsecured claims and equity interests.
Under this scheme a secured creditor takes essentially dollar-for-dollar while an unsecured creditor shares pro rata with other unsecured creditors after secured and priority claims are settled. This distribution scheme is captured in the following formula:
Another important advantage enjoyed by a secured creditor in bankruptcy is that secured claims are not subject to a discharge. Under BRA § 524(a), a discharge affects only personal liability, i.e., unsecured debts. For a quick primer on bankruptcy law from an Article 9 practitioner's perspective, see B & S (cited above), Ch. 6.
Much will be made in later chapters of the fact that a security interest must be perfected if a secured party is to be protected against third parties who also have a claim to the collateral. Perfection generally requires notice of the existence of a security interest so as to protect third parties against "secret liens." Perfection most commonly is achieved by filing a document or record called a financing statement, but perfection also may be accomplished in other ways. See Part V.
A security interest that is not perfected is at risk of being avoided in bankruptcy, leaving the creditor unsecured. In Problem 3.2, for example, if John had failed to perfect its security interest in the basketball hoop then John could end up being unsecured in the bankruptcy proceeding.
Consider the next Problem.
Problem 3.3 (interactive)
Suppose Jane in Problem 3.2 files bankruptcy. Jane owes unsecured creditors a total of $10,000. There are priority claims of $100. The basketball hoop is worth $200. Jane has a total of non-exempt assets, including the basketball hoop worth $1300.
If John has an enforceable Article 9 security interest John how much will John take out of a liquidation bankruptcy? Would it matter whether or not John had perfected his security interest at the time of bankruptcy? If John is unsecured how much will he take out of a liquidation bankruptcy? What do other unsecured creditors take out of such a bankruptcy?
Why a secured creditor should be better off in and out of bankruptcy than an unsecured creditor is a nice question that has long been debated, most recently in connection with the adoption of new Article 9. See Symposium, 9 American Bankruptcy Institute Law Review, Number 1 (Spring 2001).
For completeness you should be aware that John in Problem 3.1 could get a lien on the basketball hoop after-the-fact. That is, John could start out unsecured and later become secured. One way for John to do so is for John to obtain an Article 9 security interest from Jane. However, as explained above, doing so would require Jane's consent and Jane is not all that likely to enter into the necessary agreement when she already has the basketball hoop. John also may become a secured creditor without getting Jane's consent. This route to becoming secured (getting a lien) after starting out unsecured can be messy. The following commentary from B & S (cited above), will give you the general idea:
A holder of a money judgment is referred to as a ``judgment creditor,' and the party against whom the judgment is entered is the ``judgment debtor.' * * * As will be seen in [subsequent chapters], persons who have not recovered a judgment, such as those who have obtained a provisional remedy or who are the beneficiaries of a support order, are considered ``judgment creditors' for purposes of garnishment.
A money judgment is of little value unless the plaintiff can realize the amount awarded. Various Arizona statutes set out procedures for collecting money judgments. The Rules of Civil Procedure expressly authorize the use of these procedures. Under the Federal Rules of Civil Procedure and a local federal court rule for the District of Arizona, the clerk of the federal district court may issue a writ of attachment or garnishment in the circumstances and in the manner under which these remedies are permitted by the laws of the State of Arizona.
Certain traditional collection remedies available to judgment creditors have general application. They are (1) writs of execution; (2) writs of garnishment; (3) writs of attachment; (4) judgment liens; and (5) supplemental proceedings.
Execution, which involves a forced sale of the debtor's nonexempt assets, probably is the most readily available and most widely used process to enforce a money judgment. Execution can lead to the creation of a judicial lien or be used to enforce preexisting liens, including consensual liens. Writs of execution are considered in Text Chapter 8 and execution sales in Text Chapter 9.
* * * *
Execution is a postjudgment collection remedy. It is most often used as a device for satisfying a money judgment, but it also may be needed in conjunction with another collection remedy, such as garnishment, and it may be used in connection with an action to foreclose a lien that arose independently of the execution, a real estate mortgage or a judgment lien. Execution may be general or it may be special. A writ of general execution commands the officer to whom it is directed to satisfy a judgment out of the debtor's property without specifying particular property. A writ of special execution directs that specific property be sold or be delivered as provided for in a judgment.
B&S 4.01, 4.02, 7.01 and 8.01.
So, if John sued Jane and got a judgment against Jane and then got a writ of execution and the sheriff levied on (took possession of) Jane's nonexempt property then John would have a judicial lien on that property. The basketball hoop very likely would be nonexempt and John would have a lien on the basketball hoop when it was levied upon by the sheriff and John would be secured. However, John would have a judicial lien, a lien obtained by litigation, not a lien by agreement (a security interest).
As you may have surmised, judicial liens are created outside Article 9. However, as we will discover later, a holder of a judicial lien is a "lien creditor" under Article 9 and lien creditors can come into conflict with Article 9 secured parties. The resolution of these conflicts is a "priority" matter and is the subject of Chapter 26 (Secured Party Versus Lien Creditor; Future Advances; Bankruptcy) and, more generally, Part VI.
In a manner that requires much fuller explanation, trustees in bankruptcy exercise the rights of lien creditors if a debtor files bankruptcy. This explanation also is best deferred to Chapter 26 (Secured Party Versus Lien Creditor; Future Advances; Bankruptcy).
To test your general understanding of judicial liens, consider the following problem.
Problem 3.4 (interactive)
We saw in Problem 3.1 that to collect the $200 from Jane, John would have to sue Jane for breach of contract. As the CANINE materials point out, even if John obtained a judgment against Jane, John would have only an unsecured debt. But, as is also explained in the CANINE text, John can become secured after-the-fact and by doing so can obtain a lien that facilitates collection of the debt.
How does John obtain a lien after-the-fact?
Problem 3.5 (interactive)
Complete the following statements by filling in the blanks:
(a) On the facts of Problem 3.1, John is an _______ creditor, even if John gets a judgment against Jane based upon a breach of contract.
(b) On the facts of Problem 3.2, John has a _____.
(c) On the facts of Problem 3.2, John has an Article 9 security interest because the security interest arises by _______.
(d) As the holder of an Article 9 security interest, John has certain rights of _____ _____, including the right to take back the basketball hoop without seeking judicial assistance.
(e) If Jane files a liquidation bankruptcy when Jane owes John $200 and the basketball hoop is worth $250 and John has a perfected security interest in the basketball hoop then John is a secured claimholder and will take $ ____ out of the bankruptcy.
(f) On the facts of Problem 3.1, John is an unsecured creditor but may become a secured creditor by obtaining a ____ ____.
(g) If Jane files bankruptcy and John has only an unsecured claim against Jane (for example, because John does not have an Article 9 security interest or has failed to perfect the security interest and John does not have a judicial lien), then the claim is subject to _____.
CASE COMMENTARY
In re Yates, 332 B.R. 1 (10th Cir. BAP 2005)
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2011-08-22 update