Chapter 28 – Introduction to Credit and Secured Transactions
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Chapter 28 – Introduction to Credit and Secured Transactions
- 1. C H A P T E R Introduction to Credit and 28 Secured Transactions Creditors have better memories than debtors. Benjamin Franklin Poor Richard’s Almanac (1758) 28-1
- 2. Learning Objectives • Explain the difference between secured and unsecured credit • Differentiate suretyship from guaranty • Describe the various types of liens on real and personal property • Compare methods for holding a security interest in real property 28-2
- 3. Overview • The term credit has many meanings, but for purposes of this course, credit refers to transactions in which goods are sold, services are rendered, or money is loaned in exchange for a promise to repay the debt at some future date 28-3
- 4. Secured vs. Unsecured Credit • Most transactions are unsecured: a service was rendered or good sold and the consumer-debtor promises to pay for the service or good upon receiving a bill – Maximum risk of loss to the creditor • To minimize risk, a creditor may require the debtor to convey to the creditor a lien (security interest) on the debtor’s property 28-4
- 5. If Consumer Fails to Pay • In unsecured credit transactions, a creditor has recourse against a debtor’s default by sending notices to pay and eventually filing suit against the debtor for payment – Result: collection effort begins • In a secured credit transaction, creditor can go against the security (repossess) to collect debtor’s outstanding obligation 28-5
- 6. Security Devices • A creditor’s or debtor’s rights and liabilities in a secured transaction depends on the particular security device used: surety, guaranty, lien, or mortgage 28-6
- 7. Surety • A surety is a person who is liable for the payment of another person’s debt or for the performance of another person’s duty • The surety joins with the person primarily liable in promising to make the payment or to perform the duty – The classic “co-sign” situation – Generally on the same signature page 28-7
- 8. Surety • A surety is primarily liable for the debtor’s obligation, and the creditor can demand performance from the surety at the time the debt is due rather than sue debtor for payment or performance on the duty 28-8
- 9. Guaranty • A guaranty contract is like a suretyship, but a guarantor does not join the principal debtor in making a promise, but makes a separate promise to be liable only after principle debtor defaults and cannot pay – A surety is primarily liable on the debt, but the guarantor is secondarily liable – Typically, a separate guaranty document that must be in writing to satisfy the statute of frauds 28-9
- 10. Defenses of a Surety • A surety may use defenses to a creditor’s demand for payment that principle debtor would have under the primary contract: – Breach of warranty, lack or failure of consideration, fraudulent inducement, and breach of contract by the creditor party • Courts protect an accommodation surety (e.g., friend, parent) more than a compensated surety (e.g., bonding company) 28-10
- 11. Creditor’s Duties to Surety • Creditor must disclose any material facts about the risk involved to the surety – Failure to do so relieves the surety of liability • See New Jersey Economic Development Authority – Court rejected claim by sureties that creditors violated their duty to the sureties since the creditors did not have any superior knowledge of material facts about risk 28-11
- 12. Surety’s Rights • If a surety performs or pays the principal’s obligation, then the surety acquires all rights creditor had against the principal – Surety’s right of subrogation: judgment rights that creditor had against principal, right to collateral in creditor’s possession, creditor rights in bankruptcy proceedings • Surety may recover costs from principal – Surety’s right to reimbursement 28-12
- 13. Surety’s Rights • If one of two or more co-sureties performs or pays principal’s obligation, the surety who satisfied the obligation has a right to contribution from the co-sureties • A surety or guarantor has a right to exoneration: principal debtor must make good on the commitment to creditor when s/he (1) is able to do so and (2) does not have a valid defense against payment 28-13
- 14. Liens on Personal Property • A lien is a security interest in personal property available to businesses and individuals by statute and common law • Statutes often provide a procedure for foreclosing the lien (foreclosure) 28-14
- 15. Liens on Personal Property • Two essential elements of possessory lien (e.g., artisan, innkeeper, common carrier): – possession by improver/provider of services – a debt created by the improvement to goods or provision of services concerning the goods 28-15
- 16. In re Borden • Facts: – The Bordens granted the Genoa National Bank (Bank) a security interest on all personal property and Bank perfected security interest • Perfected by filing UCC financing statement – Farm machinery required and received repairs by Bellamy’s, which sent bills to Bordens – Bordens couldn’t pay, so Bellamy’s refused to release property to Bordens – Bordens filed for bankruptcy, then took and used machinery without permission from Bellamy’s 28-16
- 17. In re Borden • Procedural History and Legal Reasoning: – Bank filed motion to determine priority of liens – Court found conflicting authority, deciding that Bank had priority over Bellamy’s (artisan) since continuous possession is required to maintain an artisan’s lien; Bellamy’s appealed – Appellate court reasoned that an artisan’s lien is a possessory lien and possessory liens have priority over a creditor’s lien unless artisan voluntarily loses possession 28-17
- 18. In re Borden • Eighth Circuit Bankruptcy Appellate Panel: – “Artisan did not lose its artisan’s lien…when Debtor took the Equipment without the Artisan’s knowledge or consent…Reverse the bankruptcy court’s order” determining priority. 28-18
- 19. Security for Real Property • Three basic contract devices for using real estate as security for an obligation: (1) the real estate mortgage, (2) the deed of trust, and (3) the land contract. • Also, state statutes give mechanics and materialmen a right to a lien on real property into which their labor or materials have been incorporated 28-19
- 20. The Mortgage • A mortgage is a security interest in (or deed to) real property given by the owner (mortgagor) as security for a debt owed to the creditor (mortgagee) – A lien on land rather than conveyance of title – Must be executed with the formality of a deed 28-20
- 21. The Mortgage & Sale of Interest • A mortgagor (owner) can sell the property interest without consent of mortgagee, but sale does not affect the mortgagee’s property interest or claim against mortgagor – A purchaser of mortgaged property may buy it and assume (take over) the mortgage – If a mortgage contains a due on sale clause, any remaining balance becomes promptly due and payable when the property is sold 28-21
- 22. Foreclosing The Mortgage • Foreclosure: rights of the mortgagor or current property owner are cut off • Foreclosure proceedings are regulated by state statutes using three methods: – strict foreclosure – action and sale – power of sale 28-22
- 23. Mortgage Redemption • A mortgagor or an assignee of mortgagor has an equity of redemption in the real estate within a specified redemption period and by full discharge of the mortgage debt – Title to property restored free and clear 28-23
- 24. In re Foreclosure Cases • Pooling of home loans into securities has been long-standing practice – Practice makes working out troubled loans difficult for homeowners • 2007: Federal Court judge dismissed 14 foreclosures filed by Deutsche-Bank – Bank was trustee for investment pool, but did not own or hold the mortgage loan when the lawsuits were filed – Lesson: have your paperwork in order! 28-24
- 25. Deed of Trust • A deed of trust is another mechanism for a security interest in real property – Generally, treated like a mortgage • Three parties to a deed of trust: property owner who borrows money (debtor), trustee who holds legal title to property put up as security, and lender and the beneficiary of the trust 28-25
- 26. Land Contract • Land contract secures the balance due seller for the purchase of real estate – An installment contract for a land purchase • Seller agrees to convey property title to buyer when full price paid, but buyer takes possession of, pays taxes on, insures, and assumes other obligations for the property 28-26
- 27. Mechanic’s & Materialman’s Liens • Two statutory systems permit one who furnishes labor or materials to improve real estate to claim a lien until they are paid – Simple sale of goods does not entitle seller to a lien on real property • A general contractor contracts with owner to build, remodel, or improve real property • A subcontractor contracts with general contractor to perform a particular job 28-27
- 28. Mechanic’s & Materialman’s Liens • New York system: subcontractors or materialmen cannot recover more than is owed to the contractor at the time they file a lien or give notice of lien to owner • Pennsylvania system: subcontractors or materialmen have direct liens and are entitled to liens for the value of labor and materials furnished, irrespective of amount due from owner to contractor 28-28
- 29. Mechanic’s & Materialman’s Liens • Statutes generally require filing of a notice of lien with a county official • Most statutes grant priority to mechanic’s lien over all liens attaching after first work performed or first materials are furnished – Priority: order of payment 28-29
- 30. Test Your Knowledge • True=A, False = B – A guarantor is primarily liable for debtor’s obligation, and the creditor can demand performance from the guarantor at the time the debt is due. – Since a surety is not the principle debtor, it has no defenses available in response to a creditor’s demand for payment. – A bond company is a compensated surety. 28-30
- 31. Test Your Knowledge • True=A, False = B – A creditor must disclose to a surety all information about the risk involved in a particular debtor, including whether the debtor business is likely to be successful – Foreclosure means that the mortgagor’s rights to the property are terminated. – A mortgage is a security interest in (or deed to) personal property. 28-31
- 32. Test Your Knowledge • Multiple Choice – Bob Builder contracted with Joe Homes to build a house. Bob hired Ken Carpenter, who built the kitchen cabinets, but Bob refused to pay Ken. What should Ken do? a) Ken may file a lien on Joe’s real property b) Ken may file a mortgage on Joe’s property c) Ken may sue Bob and Joe for redemption d) Ken may foreclose on Bob for payment 28-32
- 33. Test Your Knowledge • Multiple Choice – Which two statutory systems permit one who furnishes labor or materials to improve real estate to claim a lien until they are paid? a) The Torrens and Priority systems b) The Pennsylvania and New York systems c) The New York and New Jersey systems d) None of the above 28-33
- 34. Thought Questions • What are the advantages and disadvantages of credit? • How does credit affect your life? • Do you have any secured credit? 28-34
Editor's Notes
- Examples of unsecured credit: store charge accounts, medical services to be billed, repair services later billed, inventory shipped and invoiced for later billing, etc. Examples of secured credit: appliances sold on an installment plan, a mortgage for real property, a lien on restaurant equipment, a lien on agricultural products or machinery, etc.
- The collection effort includes having a sheriff “execute” a judgment and/or (depending on state law) garnishing debtor’s wages – a very long process in and of itself.
- Students probably had their parents co-sign for their first car or for students loans.
- The hyperlink is to the opinion on the Findlaw.com website. Note that the New Jersey Economic Development Authority v. Pavonia Restaurant, Inc. case may confuse students!!! The investors who secured the transaction signed under a separate agreement: “ The guarantors executed a Personal Guaranty Agreement under which they each agreed individually to guarantee repayment of the loan to EDA and the Bank.” The court referred to the investors as guarantors. However, the discussion about how the NJEDA and bank pursued repayment equally from the restaurant company and the guarantor investors (and granted a forbearance), and later sued both the principle debtor and the guarantors jointly, indicates the investors actually were sureties, primarily liable in conjunction with the principle debtor restaurant rather than secondarily liable. Oddly, the court even quotes a statement from Section 124 from the Restatement of Security – Suretyship that discusses the duty to a surety. Just be aware that the distinction between a surety and a guaranty is a fine line and that a guaranty is almost more of a subset of the broader “surety” classification than a separate classification.
- Pronunciation of “lien” varies in the U.S. from “lēn” (like lean ) to “lē-ən” (like Lee-en ) In foreclosure , property owner’s rights are cut off so the lienholder can realize the security interest. A lien (secured interest) typically is associated with the purchase of appliances or expensive items of personal property.
- The hyperlink is to the Eighth Circuit Bankruptcy Appellate Panel’s decision On June 25, 2002, Michael Borden and his wife granted the Genoa National Bank a blanket security interest on all of their personal property, including machinery and equipment then owned and thereafter acquired. The lender perfected its security interest by filing a UCC financing statement with the Nebraska Secretary of State on June 26, 2002. [These concepts are covered in the next chapter, Chapter 29, Security Interests in Personal Property.] On separate occasions in late 2004, Borden took a cornhead and a tractor to Bellamy’s, Inc., for repairs. Bellamy’s performed the repairs and in February 2005 sent the Bordens a bill in the amount of $3,811.46 for the work performed on the cornhead and in March 2005 sent a bill in the amount of $1,281.34 for the work performed on the tractor. Borden did not have the money to pay for the repairs and Bellamy’s refused to release the tractor and cornhead to Borden without payment, so they remained in Bellamy’s possession. On April 1, Borden and his wife filed a voluntary petition for relief under Chapter 12 of the Bankruptcy Code. [Bankruptcy is discussed in Chapter 30 of this textbook]. On this date the tractor and cornhead were in Bellamy’s possession. In June 2005, Borden took the tractor from Bellamy’s lot without permission and used it in connection with his farming operation. Bellamy’s discovered the tractor was missing and contacted Borden to inquire if he had it in his possession. Borden admitted he had taken the tractor, explained that he needed it for his farming operation, and agreed to return it to Bellamy’s as soon as he was finished using it. The tractor broke down while he was using it, and he returned it to Bellamy’s in the fall of 2005. Borden later took the cornhead without permission, used it, and returned it.
- In 2006, Genoa National Bank filed a motion with the bankruptcy court to determine the priority of the respective liens claimed by it and by Bellamy’s. The bankruptcy court determined that no controlling authority existed in Nebraska concerning the situation of competing liens where an artisan loses possession of the personal property through action of the property owner. The bankruptcy court looked to other jurisdictions for guidance and found that other courts faced with the issue had reached conflicting results. The bankruptcy court decided that Genoa National Bank’s lien had priority over the lien asserted by the artisan, Bellamy’s. In reaching its decision, the bankruptcy court concluded that continuous possession is required to maintain an artisan’s lien. Bellamy’s appealed. Court: “An artisan’s lien falls within this definition of possessory lien under Nebraska law. A possessory lien on goods, such as an artisan’s lien, has priority over a security interest in the goods unless the possessory lien is treated by a statute that expressly provides otherwise. The artisan’s lien statute does not provide otherwise; accordingly, an artisan’s lien has priority over a previously perfected security interest in the same goods…. Possession is generally required for a possessory lien. If an artisan surrenders possession, the artisan no longer has a possessory lien with priority over pre-existing security interests…. Where the artisan loses possession involuntarily, the artisan does not necessarily lose the artisan’s lien.”
- The photo is of a combine with corn header on the front of the machine and tractor with trailer. A corn header is used to remove kernels from the cobs. Corn stover – the stalks, cobs, and leaves – is left. Eighth Circuit Bankruptcy Appellate Panel: “We conclude that the Artisan did not lose its artisan’s lien in the Equipment when the Debtor took the Equipment without the Artisan’s knowledge or consent. Such involuntary loss of possession does not defeat the Artisan’s lien. Furthermore, even if the Artisan’s failure to take action to regain possession of the Equipment can be deemed consent to the Debtor’s prior wrongful taking of the Equipment, such after-the-fact consent could not have been more than a conditional consent to the Debtor’s temporary use of the Equipment with an agreement to return it to the Artisan. A conditional consent to a prior wrongful taking likewise does not defeat the Artisan’s lien…. An artisan’s lien does not require registration with any entity…Courts and legislatures generally recognize that a party who provides labor and materials to property enhances the value of the property. Therefore, the principles of natural justice and commercial necessity dictate that the entity who enhances the value of property should be entitled to payment for such services and may retain the property until receipt of payment therefore.” Conclusion: “The Artisan had an artisan’s lien in the Equipment on the date the Debtor filed bankruptcy which had priority over the Lender’s security interest under Nebraska law. The Artisan did not lose its artisan’s lien nor its priority over the Lender’s security interest when the Debtor took the Equipment from the Artisan’s possession postpetition without authority. Accordingly, under these circumstances we REVERSE the bankruptcy court’s order determining that the Lender’s security interest in the Equipment takes priority over the Artisan’s lien therein.” … . Judgment awarding damages to ARS reversed and remanded.”
- Mechanics: plumbers, carpenters, electricians, cabinetmakers, drywallers… Materialmen: lumberyards, flooring companies, landscape supply…
- Strict foreclosure. Creditor keeps property in satisfaction of debt, and owner’s rights cut off. Creditor has no right to a deficiency and debtor has no right to any surplus. Foreclosure by action and sale , is permitted in all states and the only method of foreclosure permitted in some states. Although state statutes not uniform, they are alike in their basic requirements: suit is brought in a court having jurisdiction, any party with a property interest that would be cut off by the foreclosure must be made a defendant, if any such party has a defense s/he must enter his appearance and set up the defense, after trial a judgment is entered and the property is sold, proceeds of sale are applied to payment of the mortgage debt, any surplus is paid to mortgagor and any deficiency is entered as a judgment against mortgagor and such other persons as are liable on the debt. Right to foreclose under a power of sale must be expressly conferred on the mortgagee by the terms of the mortgage. If the procedure for the exercise of the power is set out in the mortgage, that procedure must be followed. Several states have enacted statutes that set out the procedure to be followed in the exercise of a power of sale. No court action is required.
- The hyperlink is to the opinion on the consumerwarningnetwork.com website. The opinion by Judge Boyko, Eastern Ohio United States District Court, in In re Foreclosure Cases (pg. 754 of text) generated a lot of attention in the media and in the financial and legal communities when it was issued in October 2007. Judge Boyko dismissed 14 Deutsche Bank-filed foreclosures, basing the decision on lack of standing for not owning and/or holding the mortgage loan at the time the lawsuits were filed. The opinion served as a warning to would-be foreclosers that they needed to have their paperwork in order before they sought to put a homeowner out of his house.
- Depending on state statute, seller may have right to declare forfeiture and take possession if buyer defaults
- Mutual Savings Association v. Res/Com Properties, L.L.C., on page 758 of the text, illustrates a situation where subcontractors were able to obtain a preferred position through compliance with a state lien statute.
- False. A surety is primarily liable for the debtor’s obligation, and creditor can demand performance from the surety at the time the debt is due . A guarantor is secondarily liable for the debt. However, note that even courts frequently treat these two security devices equally. False. A surety may use defenses to a creditor’s demand for payment. True.
- False. A creditor only has the duty to disclose material information, but information equally available to a surety (such as an opinion of success) need not be disclosed. This is the lesson of the New Jersey Economic Development Authority v. Pavonia Restaurant, Inc case. True. False. A mortgage is a security interest in real property.
- The correct answer is (a).
- The correct answer is (b). New York system : subcontractors or materialmen cannot recover more than is owed to the contractor at the time they file a lien or give notice of lien to owner. Pennsylvania system : subcontractors or materialmen have direct liens and are entitled to liens for the value of labor and materials furnished, irrespective of amount due from owner to contractor.
- Opportunity to discuss the impact of credit on society as well as individuals.