Chapter 13: LAW OF SECURED TRANSACTIONS

Focus on personal property

Creditor’s right and debtor’s protection; bankruptcy; secured transactions

KEY TERMS

surety a person who has expressly or implicitly agreed to be liable for another’s debts even if the creditor has
not exhausted all remedies for collection
guarantor a person who has expressly or implicitly agreed to be liable for another person’s debts if the
creditor cannot collect directly from the debtor
bankruptcy a legal procedure for settling the debts of individuals or business entities that are unable to pay
debts as they become due. The debtor’s business may be reorganized; a set payment may be arranged, or the
debtor’s nonexempt assets may be liquidated and distributed to creditors. Proper completion of the
bankruptcy procedures leaves the debtor free from liability on some or all of the remaining debts.
secured transaction any transaction involving a security interest, which generally is an interest in the debtor’s
personal property (or fixtures). The security interest is held by the secured party (the creditor) as a means to
ensure payment or performance of the debtor’s obligation.

1. UNSECURED TRANSACTION

HANDSHAKE + PROMISE TO REPAY

Someone lends you money based on their name

Example: Student X agrees to lend Prof. Gardner 20$ because she’s sort of cash. Prof Gardner promises to
pay X back by the end of the month.
-> Unsecured transaction: nothing in hand, except for a promise. If go to court; judge: “Prove it”

2. SECURED TRANSACTION
DEFINITION Agreement whereby Creditor requires Debtor to provide some type of Security
beyond mere promise to repay debt.

A secured transaction is any transaction in which a debtor gives a creditor a security interest in
personal property or fixtures.
A ‘secured transaction’ is where the Grantor/Pledger assigns the Grantee/Pledgee (typically a lender)
a Secured Interest in the collateral
Businesses depend on secured transaction for growth. Getting creditors to provide loans can be
difficult. A security interest provides reassurance to creditors that they will not suffer losses. The
debtor also benefits from a lower interest rate in presence of a collateral.

 Creditor receives additional protection of his/her right to repayment; the creditor requires
that the debtor give a security interest in personal property; if the debtor fails to perform,
the secured creditor can use that personal property (known as collateral) as a substitute for
or a means to collect, the debtor’s performance.

Example: Times are tough. Student Y agrees to lend Prof Gardner 500$ but only if she provides her with some sort of
collateral to serve as a guarantee. Prof Gardner proposes to put up her beautiful pearl necklace as a guarantee (+ certificate
confirming the value of a necklace). Y accepts and lends her the money. Prof Gardner promises to pay her back by the end
of the month, at which point Y promises that she will return the necklace. (if Prof doesn’t pay back; the student is
overcollateralized)
Wise lenders know that there is always a risk of default however strong the credit of the borrower
looks.
At worst, there is a risk that the borrower will become insolvent before he/she performs the personal
repayment obligation.

Advantage of Secured Transaction: as secured creditor you’re in advantage. A Secured Creditor is in

favored position in event of Debtor’s default or insolvency/bankruptcy.

Default = failure to fulfil an obligation under the contract, especially to repay a loan.
*Default: the borrower doesn’t pay you back; either because they are bankrupt, lack of willingness… = failure to make
timely payments on the loan.
There is always the default risk.

Key to Secured Transactions:

A Secured Transaction is not a sale. It is not a gift. Rather, the law of secured transactions governs the
taking of a “security” in personal property (movables) in exchange for a loan.
This creates a “charge” or “lien” against your property, although you are still the legal owner. Your
property is now encumbered. Someone else has a “proprietary right” in your property.
 Purpose of secured transaction: you get to keep using personal property you own but you’ve allowed
there to be a lien on it; you’ve given away one of your sticks; encumbrance on your personal property.
You’re still the legal owner of the property which is now encumbered
 Someone else has a property right in your property.

In bankruptcy, a general creditor (not secured) gets paid back 10 cents on a dollar.

MORTGAGES
Secured Transactions for real property (immovables) are typically referred to as Mortgages
(hypotheek).
All mortgages are recorded in the national land registry where the real property is located.
 Similar to Secured Transaction, a mortgage creates a “charge” or a “lien” against your
property, although you are still the legal owner. Your property is now “encumbered”
although you are able to live in and enjoy your beautiful dream home (so long as you keep
up the payments to your bank)!

Question: What are the legal and practical implications in the event of a default (or worse, an insolvency?)
(practical implication if you’re secured vs. unsecured)
 You have no proof
 Unsecured creditors are left empty-handed; secured creditors have something in hand.

2.1. Security interest

DEFINITION Form of interest in property which provides that the property may be sold on default
in order to satisfy the obligation for which the Security Interest is granted, pursuant
to a Security Agreement.

Any interest in property which secures payment or performance of an obligation.

= security device that does not require transfer of possession
A security interest is a device that allows to keep using collateral and not having to give it over as a
pledge.

Pledge = oldest form of taking a security interest; oldest and simplest type of secured transaction.
The debtor provides the creditor with physical possession of some of the debtor’s property.
This collateral may consist of tangible items, such as jewelry or machinery, or intangible personal
property, such as stocks.
If the debtor defaults, the creditor sells or uses the collateral to satisfy the debt.

 banks don’t want to be warehouses. Idea of lending behind collateral; with security interest the debtor
keeps the collateral in possession (e.g., mortgage; live in house while paying)

Obvious problem with pledges: the debtor frequently will not or cannot turn over possession of his/her
property. In fact, a pledge contradicts the underlying purpose of many credit transactions, that is, to help the
debtor acquire and use property, not merely buy property (on credit) and then pledge away its possession.

2.2. Debtor vs. Secured Party

Debtor: the party who owes payment or performance of the obligation; may also be referred to as
the Promisor, or Pledgor when obligation is of a secured nature

Secured Party: the lender, seller, or any other person in whose favor there is a Security Interest

2.3. Collateral
= property subject to a security interest
 Property which is pledged as satisfaction for debt
 Property that Debtor offers as security:
1) must be legally “owned” by Debtor (have to be able to proof you’re owner of the collateral)
2) in which Debtor has legal interest, and
3) can include both Tangible and Intangible forms of (personal) property
 anything someone is willing to lend against

FORMS OF COLLATERAL
Tangible and Intangible
 Tangibles: All things movable at time the S.I. attaches
Examples: consumer goods, equipment, farm products & livestock, inventory, etc.

 Intangibles: Non-physical property that exists only in connection with something else
Examples: stocks, bonds, certificates of deposit, accounts receivable, contract right payments, patents,
copyright, etc.

Examples of personal property that may be used as Collateral: cars, software, stocks, necklace…; anything that
has a value that you can convince the lender to lend against. (p. 278)
- equipment & inventory (goods including raw materials held by businesses)
- fixtures (items attached to a real property that if removed from it would require extensive
reconstruction)
- vehicles (cars, buses, trucks, etc.)
- stocks & bonds
- personal possession
- documents evincing rights (accounts, promissory notes, insurance policy proceeds, etc.)
- Intangibles (such as software rights; IP
- Proceeds from a Security interest = consideration or sale, exchange or other disposition of collateral
(e.g., rents, interest, sale…) = how any value comes out of original collateral

2.4. Security Agreement

DEFINITION Agreement (contract) that creates or provides for a Security Interest between Debtor
and Secured Party
i.e., an agreement between Debtor and Creditor which grants Creditor (the “secured party”) a S.I.
Debtor’s property
Make sure that it is legal, valid, and binding. (has to possess 4 elements of contract so as to be
enforceable) A security agreement is a contract that covers the loan agreement.
A legally binding document that provides a lender a Security Interest in property or an asset that is
promised as collateral.
It outlines all terms under which debt can be secured and remedies if the debtor defaults while
giving the legal claim to the collateral to the creditor in case of a default by the borrower.

2.5. Creditor’s 2 primary concerns

1) Enforceable Security Interest
In case of default, do I have an enforceable S.I. in Debtor’s property? Can I enforce in the event of
default, bankruptcy…?
2) Priority
If an enforceable S.I. exists, will my S.I. take priority over other S.I.’s & other creditor’s claims? Am I
first?
Especially important bankruptcy!
If value of collateral drops, the debtor has to top up on the collateral, otherwise can ask loan back.

3. BASIS OF THE LAW OF SECURED TRANSACTIONS

At bankruptcy all assets are frozen, the bank appoints a trustee. The trustee is going to give out pieces of
estate, the creditors are not treated equal. Collateralized creditors have priority; general creditors have to share
in the assets.

- Attachment
- Priority through Perfection

ATTACHMENT
DEFINITION The process by which a Security Interest in the property of another becomes
enforceable (you’re rights attached to the collateral)
 S.I. is not enforceable unless the Creditor’s rights have “attached” to the Collateral
 Ensures that the S.I. between Debtor and Security Party is effective/enforceable

“To make the security interest effective between the debtor and creditor, the interest must “attach”
to the secured property (the collateral).”

How exactly does a S.I. “Attach” to collateral?

 Possession (pledge) – Creditor can take Possession of the Collateral
 Physical Transfer of Collateral to Secured Party
Alternatively,
1) If no possession of Collateral, there must be agreement in writing (the Security Agreement)
2) Creditor must give Value to Debtor, and
3) Debtor must maintain Rights in Collateral (not a sale/gift)

Remember, 2 Concerns of all Creditors

1) Do I have an Enforceable S.I.?
Have my rights “attached” to the Collateral?
2) What is my Priority?
How to protect my claim?

HOW TO PROTECT YOUR CLAIM?

Danger of 3rd Party Creditors:
Although S.I. has attached and is enforceable, sometimes the Secured Party must ensure that
additional steps have been taken in order to protect his claim to the Collateral over other claims
(brought by 3rd parties).
PERFECTION of Security Interest
DEFINITION The legal process by which Secured Parties protect themselves against the claims of
third parties who may wish to have their debts satisfied out of the same Collateral.

“To make the security interest effective against third parties, it must be “perfected.” Perfection
gives the secured party priority over other parties seeking to attach or otherwise use the collateral.”

- Usually accomplished by the filing of a Financing Statement with the appropriate

government officials (=form filled out by lender saying: “Who is the lender, who is the
borrower, what is the amount of loan, what is the collateral” => public!: perfected 
important to keep priority (putting the world on notice that you have rights in collateral; if
you don’t perfect in common law countries, you may not have priority
- Know Local Rules!

“Failure to perfect” (not file financing statement)

NO PRIORITY + NOT OPOSSABLE TO 3RD PARTIES = UNSECIRED CREDITOR
*General rule: priority by first in time (line)
Risk in collateral: you don’t know if it has been pledged to someone else

HOW TO PERFECT?
1) Possession – “Possession is Perfection”
2) Public filing in Common Law Countries
Public notice of the S.I.: Puts the World on Notice
i) UK - Filing of Financing Statement at Companies House ii) U.S. - UCC 1 Form at Secretary of State
iii) Other Common Law Jurisdictions – check local rules
See, especially:
Debtor’s jurisdiction + location of Collateral + governing law of Security Agreement

CHART book!! “Who wins?”

A perfected security holder vs. perfected security holder => the first to perfect
Perfected security holders vs. unperfected security holder => perfected security holder regardless of whose
security interest arose first
Unperfected security holder vs. unperfected security holder => first one who has security interest attached
(date)
Unperfected security holder vs. unsecured creditor => unperfected security holder

The order in which creditors are paid follows an established system of priorities, in which the first to
perfect a security interest usually takes precedence.

3.1. Financing statement

DEFINITION A document prepared by Secured Creditor and filed with the appropriate
government official to give notice to the public that the Secured Creditor claims an
interest in Collateral belonging to the Debtor named in the statement.
1) Signed by Debtor
2) Contains names & addresses of both Debtor & Secured Party
3) Provides description of Collateral

Do not confuse the financing statement with the security agreement. The former cannot replace the latter.
Indeed, the financing statement simply furnishes the minimal information needed to put other parties on notice
of a security interest. (In some cases, the security agreement itself may be filed as the financing statement.)
FILING ISSUES (perfection issues)
1) Collateral has been moved to another jurisdiction
2) Expiry of Filing Statement (if you don’t rely, you’re unperfected; 2nd in line moves to 1st place)
3) Amendments – change of name, corporate form, etc.
4) Debtor’s often reluctant to file (especially from Civil Law countries)
5) Beware of vague descriptions of Collateral!

HOMEWORK: A closer look at Security Interests – THE PROBLEM WITH PROCEEDS - …

What is the problem with proceeds?
What happens if collateral changes form?

The legal system protects creditors by making it possible for a creditor to have a security interest in the collateral as
well as interest in the proceeds from the sale of the collateral.
Example: security interest/collateral = flower -> turned into bread; the flower no longer exists, the bread does, so the
security interest persists in the bread.
Important: “traceable proceeds” (ex. hog food); the hog feed disappears => court said: animal didn’t change

Example: collateral: car -> damaged: the “proceeds” consist of the insurance payment made to the debtor.
Problem of “disappearing” proceeds leaves perfected security interests creditors empty-handed.

Insurance

<- car: collateral

The creditor thinks; there will be insurance proceeds to the debtor for
the crashed car.
The insurance company says; our Debtor Creditor relationship is only with the debtor.
Why didn’t creditor go to the debtor firsthand?
The money is going to disappear; don’t trust debtor (has already defaulted) => result case: creditor left empty-
handed; the creditor only had S.I. in car not in proceeds
 Any creditor will have a proceeds clause
 Always have proceeds clause as a lender because collateral can change; otherwise may be left empty-
handed

Question: “Why would someone agreed to be second?” (even though they are also perfected)
The collateral will cover it; if you’re sure your credit will be covered. Necklace is worth 550$; first
creditor should receive 50, second 80, so you’ll recover your loan of 50.