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advancedbusinesslawandthelegalenvironment_chapter19.pdf
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Chapter 19
Chapter 19 from Advanced Business Law and the Legal Environment was adapted by The Saylor Foundation under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0
license without attribution as requested by the work’s original creator or licensee. © 2014, The Saylor Foundation.
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Secured Transactions and Suretyship
L E A R N I N G O B J E C T I V E S
After reading this chapter, you should understand the following:
1. The basic concepts of secured transactions
2. The property subject to the security interest
3. Creation and perfection of the security interest
4. Priorities for claims on the security interest
5. Rights of creditors on default
6. The basic concepts of suretyship
7. The relationship between surety and principal
8. Rights among cosureties
19.1 Introduction to Secured Transactions
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L E A R N I N G O B J E C T I V E S
1. Recognize, most generally, the two methods by which debtors’ obligations
may be secured.
2. Know the source of law for personal property security.
3. Understand the meaning of security interest and other terminology necessary
to discuss the issues.
4. Know what property is subject to the security interest.
5. Understand how the security interest is created—”attached”—and perfected.
The Problem of Security Creditors want assurances that they will be repaid by the debtor. An oral promise to pay is no security at
all, and—as it is oral—it is difficult to prove. A signature loan is merely a written promise by the debtor
to repay, but the creditor stuck holding a promissory note with a signature loan only—while he may sue a
defaulting debtor—will get nothing if the debtor is insolvent. Again, that’s no security at all. Real security
for the creditor comes in two forms: by agreement with the debtor or by operation of law without an
agreement.
By Agreement with the Debtor
Security obtained through agreement comes in three major types: (1) personal property security (the most
common form of security); (2) suretyship—the willingness of a third party to pay if the primarily obligated
party does not; and (3) mortgage of real estate.
By Operation of Law
Security obtained through operation of law is known as a lien. Derived from the French for “string” or
“tie,” a lien is the legal hold that a creditor has over the property of another in order to secure payment or
discharge an obligation.
In this chapter, we take up security interests in personal property and suretyship. In the next chapter, we
look at mortgages and nonconsensual liens.
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Basics of Secured Transactions The law of secured transactions consists of five principal components: (1) the nature of property that can
be the subject of a security interest; (2) the methods of creating the security interest; (3) the perfection of
the security interest against claims of others; (4) priorities among secured and unsecured creditors—that
is, who will be entitled to the secured property if more than one person asserts a legal right to it; and (5)
the rights of creditors when the debtor defaults. After considering the source of the law and some key
terminology, we examine each of these components in turn.
Here is the simplest (and most common) scenario: Debtor borrows money or obtains credit from Creditor,
signs a note and security agreement putting up collateral, and promises to pay the debt or, upon Debtor’s
default, let Creditor (secured party) take possession of (repossess) the collateral and sell it. Figure 19.1
"The Grasping Hand"illustrates this scenario—the grasping hand is Creditor’s reach for the collateral, but
the hand will not close around the collateral and take it (repossess) unless Debtor defaults.
Figure 19.1 The Grasping Hand
Source of Law and Definitions Source of Law
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Article 9 of the Uniform Commercial Code (UCC) governs security interests in personal property. The
UCC defines the scope of the article (here slightly truncated): [1]
This chapter applies to the following:
1. A transaction, regardless of its form, that creates a security interest in personal property or
fixtures by contract;
2. An agricultural lien;
3. A sale of accounts, chattel paper, payment intangibles, or promissory notes;
4. A consignment…
Definitions
As always, it is necessary to review some definitions so that communication on the topic at hand is
possible. The secured transaction always involves a debtor, a secured party, a security agreement, a
security interest, and collateral.
Article 9 applies to any transaction “that creates a security interest.” The UCC in Section 1-201(35)
defines security interest as “an interest in personal property or fixtures which secures payment or
performance of an obligation.”
Security agreement is “an agreement that creates or provides for a security interest.” It is the contract
that sets up the debtor’s duties and the creditor’s rights in event the debtor defaults. [2]
Collateral “means the property subject to a security interest or agricultural lien.” [3]
Purchase-money security interest (PMSI) is the simplest form of security interest. Section 9-103(a)
of the UCC defines “purchase-money collateral” as “goods or software that secures a purchase-money
obligation with respect to that collateral.” A PMSI arises where the debtor gets credit to buy goods and the
creditor takes a secured interest in those goods. Suppose you want to buy a big hardbound textbook on
credit at your college bookstore. The manager refuses to extend you credit outright but says she will take
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back a PMSI. In other words, she will retain a security interest in the book itself, and if you don’t pay,
you’ll have to return the book; it will be repossessed. Contrast this situation with a counteroffer you might
make: because she tells you not to mark up the book (in the event that she has to repossess it if you
default), you would rather give her some other collateral to hold—for example, your gold college signet
ring. Her security interest in the ring is not a PMSI but a pledge; a PMSI must be an interest in the
particular goods purchased. A PMSI would also be created if you borrowed money to buy the book and
gave the lender a security interest in the book.
Whether a transaction is a lease or a PMSI is an issue that frequently arises. The answer depends on the
facts of each case. However, a security interest is created if (1) the lessee is obligated to continue payments
for the term of the lease; (2) the lessee cannot terminate the obligation; and (3) one of several economic
tests, which are listed in UCC Section 1-201 (37), is met. For example, one of the economic tests is that
“the lessee has an option to become owner of the goods for no additional consideration or nominal
additional consideration upon compliance with the lease agreement.”
The issue of lease versus security interest gets litigated because of the requirements of Article 9 that a
security interest be perfected in certain ways (as we will see). If the transaction turns out to be a security
interest, a lessor who fails to meet these requirements runs the risk of losing his property to a third party.
And consider this example. Ferrous Brothers Iron Works “leases” a $25,000 punch press to Millie’s
Machine Shop. Under the terms of the lease, Millie’s must pay a yearly rental of $5,000 for five years,
after which time Millie’s may take title to the machine outright for the payment of $1. During the period of
the rental, title remains in Ferrous Brothers. Is this “lease” really a security interest? Since ownership
comes at nominal charge when the entire lease is satisfied, the transaction would be construed as one
creating a security interest. What difference does this make? Suppose Millie’s goes bankrupt in the third
year of the lease, and the trustee in bankruptcy wishes to sell the punch press to satisfy debts of the
machine shop. If it were a true lease, Ferrous Brothers would be entitled to reclaim the machine (unless
the trustee assumed the lease). But if the lease is really intended as a device to create a security interest,
then Ferrous Brothers can recover its collateral only if it has otherwise complied with the obligations of
Article 9—for example, by recording its security interest, as we will see.
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Now we return to definitions.
Debtor is “a person (1) having an interest in the collateral other than a security interest or a lien; (2) a
seller of accounts, chattel paper, payment intangibles, or promissory notes; or (3) a consignee.” [4]
Obligor is “a person that, with respect to an obligation secured by a security interest in or an agricultural
lien on the collateral, (i) owes payment or other performance of the obligation, (ii) has provided property
other than the collateral to secure payment or other performance of the obligation, or (iii) is otherwise
accountable in whole or in part for payment or other performance of the obligation.” [5] Here is example 1
from the Official Comment to UCC Section 9-102: “Behnfeldt borrows money and grants a security
interest in her Miata to secure the debt. Behnfeldt is a debtor and an obligor.”
Behnfeldt is a debtor because she has an interest in the car—she owns it. She is an obligor because she
owes payment to the creditor. Usually the debtor is the obligor.
A secondary obligor is “an obligor to the extent that: (A) [the] obligation is secondary; or (b) [the person]
has a right of recourse with respect to an obligation secured by collateral against the debtor, another
obligor, or property of either.” [6] The secondary obligor is a guarantor (surety) of the debt, obligated to
perform if the primary obligor defaults. Consider example 2 from the Official Comment to Section 9-102:
“Behnfeldt borrows money and grants a security interest in her Miata to secure the debt. Bruno cosigns a
negotiable note as maker. As before, Behnfeldt is the debtor and an obligor. As an accommodation party,
Bruno is a secondary obligor. Bruno has this status even if the note states that her obligation is a primary
obligation and that she waives all suretyship defenses.”
Again, usually the debtor is the obligor, but consider example 3 from the same Official Comment:
“Behnfeldt borrows money on an unsecured basis. Bruno cosigns the note and grants a security interest in
her Honda to secure her [Behnfeldt’s] obligation. Inasmuch as Behnfeldt does not have a property interest
in the Honda, Behnfeldt is not a debtor. Having granted the security interest, Bruno is the debtor. Because
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Behnfeldt is a principal obligor, she is not a secondary obligor. Whatever the outcome of enforcement of
the security interest against the Honda or Bruno’s secondary obligation, Bruno will look to Behnfeldt for
her losses. The enforcement will not affect Behnfeldt’s aggregate obligations.”
Secured party is “a person in whose favor a security interest is created or provided for under a security
agreement,” and it includes people to whom accounts, chattel paper, payment intangibles, or promissory
notes have been sold; consignors; and others under Section 9-102(a)(72).
Chattel mortgage means “a debt secured against items of personal property rather than against land,
buildings and fixtures.” [7]
Property Subject to the Security Interest Now we examine what property may be put up as security—collateral. Collateral is—again—property that
is subject to the security interest. It can be divided into four broad categories: goods, intangible property,
indispensable paper, and other types of collateral.
Goods
Tangible property as collateral is goods. Goods means “all things that are movable when a security interest
attaches. The term includes (i) fixtures, (ii) standing timber that is to be cut and removed under a
conveyance or contract for sale, (iii) the unborn young of animals, (iv) crops grown, growing, or to be
grown, even if the crops are produced on trees, vines, or bushes, and (v) manufactured homes. The term
also includes a computer program embedded in goods.” [8] Goods are divided into several subcategories;
six are taken up here.
Consumer Goods These are “goods used or bought primarily for personal, family, or household purposes.” [9]
Inventory
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“Goods, other than farm products, held by a person for sale or lease or consisting of raw materials, works
in progress, or material consumed in a business.” [10]
Farm Products
“Crops, livestock, or other supplies produced or used in farming operations,” including aquatic goods
produced in aquaculture. [11]
Equipment
This is the residual category, defined as “goods other than inventory, farm products, or consumer
goods.” [12]
Fixtures
These are “goods that have become so related to particular real property that an interest in them arises
under real property law.” [13]Examples would be windows, furnaces, central air conditioning, and
plumbing fixtures—items that, if removed, would be a cause for significant reconstruction.
Accession
These are “goods that are physically united with other goods in such a manner that the identity of the
original goods is lost.” [14] A new engine installed in an old automobile is an accession.
Intangible Property
Two types of collateral are neither goods nor indispensible paper: accounts and general intangibles.
Accounts
This type of intangible property includes accounts receivable (the right to payment of money), insurance
policy proceeds, energy provided or to be provided, winnings in a lottery, health-care-insurance
receivables, promissory notes, securities, letters of credit, and interests in business entities. [15] Often there
is something in writing to show the existence of the right—such as a right to receive the proceeds of
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somebody else’s insurance payout—but the writing is merely evidence of the right. The paper itself doesn’t
have to be delivered for the transfer of the right to be effective; that’s done by assignment.
General Intangibles
General intangibles refers to “any personal property, including things in action, other than accounts,
commercial tort claims, deposit accounts, documents, goods, instruments, investment property, letter-of-
credit rights, letters of credit, money, and oil, gas, or other minerals before extraction.” General
intangibles include payment intangibles and software. [16]
Indispensable Paper
This oddly named category is the middle ground between goods—stuff you can touch—and intangible
property. It’s called “indispensable” because although the right to the value—such as a warehouse
receipt—is embodied in a written paper, the paper itself is indispensable for the transferee to access the
value. For example, suppose Deborah Debtor borrows $3,000 from Carl Creditor, and Carl takes a
security interest in four designer chairs Deborah owns that are being stored in a warehouse. If Deborah
defaults, Carl has the right to possession of the warehouse receipt: he takes it to the warehouser and is
entitled to take the chairs and sell them to satisfy the obligation. The warehouser will not let Carl have the
chairs without the warehouse receipt—it’s indispensable paper. There are four kinds of indispensable
paper.
Chattel Paper
Chattel is another word for goods. Chattel paper is a record (paper or electronic) that demonstrates both
“a monetary obligation and a security interest either in certain goods or in a lease on certain
goods.”[17] The paper represents a valuable asset and can itself be used as collateral. For example, Creditor
Car Company sells David Debtor an automobile and takes back a note and security agreement (this is a
purchase-money security agreement; the note and security agreement is chattel paper). The chattel paper
is not yet collateral; the automobile is. Now, though, Creditor Car Company buys a new hydraulic lift from
Lift Co., and grants Lift Co. a security interest in Debtor’s chattel paper to secure Creditor Car’s debt to
Lift Co. The chattel paper is now collateral. Chattel paper can be tangible (actual paper) or electronic.
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Documents
This category includes documents of title—bills of lading and warehouse receipts are examples.
Instruments
An “instrument” here is “a negotiable instrument (checks, drafts, notes, certificates of deposit) or any
other writing that evidences a right to the payment of a monetary obligation, is not itself a security
agreement or lease, and is of a type that in the ordinary course of business is transferred by delivery with
any necessary indorsement or assignment.” “Instrument” does not include (i) investment property, (ii)
letters of credit, or (iii) writings that evidence a right to payment arising out of the use of a credit or
charge card or information contained on or for use with the card. [18]
Investment Property
This includes securities (stock, bonds), security accounts, commodity accounts, and commodity
contracts. [19] Securities may be certified (represented by a certificate) or uncertified (not represented by a
certificate). [20]
Other Types of Collateral
Among possible other types of collateral that may be used as security is the floating lien. This is a
security interest in property that was not in the possession of the debtor when the security agreement was
executed. The floating lien creates an interest that floats on the river of present and future collateral and
proceeds held by—most often—the business debtor. It is especially useful in loans to businesses that sell
their collateralized inventory. Without the floating lien, the lender would find its collateral steadily
depleted as the borrowing business sells its products to its customers. Pretty soon, there’d be no security
at all. The floating lien includes the following:
After-acquired property. This is property that the debtor acquires after the original deal was set
up. It allows the secured party to enhance his security as the debtor (obligor) acquires more
property subject to collateralization.
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Sale proceeds. These are proceeds from the disposition of the collateral. Carl Creditor takes a
secured interest in Deborah Debtor’s sailboat. She sells the boat and buys a garden tractor. The
secured interest attaches to the garden tractor.
Future advances. Here the security agreement calls for the collateral to stand for both present
and future advances of credit without any additional paperwork.
Here are examples of future advances:
o Example 1: A debtor enters into a security agreement with a creditor that contains a
future advances clause. The agreement gives the creditor a security interest in a
$700,000 inventory-picking robot to secure repayment of a loan made to the debtor. The
parties contemplate that the debtor will, from time to time, borrow more money, and
when the debtor does, the machine will stand as collateral to secure the further
indebtedness, without new paperwork.
o Example 2: A debtor signs a security agreement with a bank to buy a car. The security
agreement contains a future advances clause. A few years later, the bank sends the debtor
a credit card. Two years go by: the car is paid for, but the credit card is in default. The
bank seizes the car. “Whoa!” says the debtor. “I paid for the car.” “Yes,” says the bank,
“but it was collateral for all future indebtedness you ran up with us. Check out your loan
agreement with us and UCC Section 9-204(c), especially Comment 5.”
See Figure 19.2 "Tangibles and Intangibles as Collateral".
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Figure 19.2 Tangibles and Intangibles as Collateral
Attachment of the Security Interest In General
Attachment is the term used to describe when a security interest becomes enforceable against the debtor
with respect to the collateral. In Figure 19.1 "The Grasping Hand", ”Attachment” is the outreached hand
that is prepared, if the debtor defaults, to grasp the collateral. [21]
Requirements for Attachment
There are three requirements for attachment: (1) the secured party gives value; (2) the debtor has rights in
the collateral or the power to transfer rights in it to the secured party; (3) the parties have a security
agreement “authenticated” (signed) by the debtor, or the creditor has possession of the collateral.
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Creditor Gives Value
The creditor, or secured party, must give “value” for the security interest to attach. The UCC, in Section 1-
204, provides that
a person gives ‘value’ for rights if he acquires them
(1) in return for a binding commitment to extend credit or for the extension of immediately available
credit whether or not drawn upon and whether or not a charge-back is provided for in the event of
difficulties in collection; or
(2) as security for or in total or partial satisfaction of a pre-existing claim; or
(3) by accepting delivery pursuant to a pre-existing contract for purchase; or
(4) generally, in return for any consideration sufficient to support a simple contract.
Suppose Deborah owes Carl $3,000. She cannot repay the sum when due, so she agrees to give Carl a
security interest in her automobile to the extent of $3,000 in return for an extension of the time to pay.
That is sufficient value.
Debtor’s Rights in Collateral
The debtor must have rights in the collateral. Most commonly, the debtor owns the collateral (or has some
ownership interest in it). The rights need not necessarily be the immediate right to possession, but they
must be rights that can be conveyed. [22] A person can’t put up as collateral property she doesn’t own.
Security Agreement (Contract) or Possession of Collateral by Creditor
The debtor most often signs the written security agreement, or contract. The UCC says that “the debtor
[must have] authenticated a security agreement that provides a description of the collateral.…”
“Authenticating” (or “signing,” “adopting,” or “accepting”) means to sign or, in recognition of electronic
commercial transactions, “to execute or otherwise adopt a symbol, or encrypt or similarly process a
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record…with the present intent of the authenticating person to identify the person and adopt or accept a
record.” The “record” is the modern UCC’s substitution for the term “writing.” It includes information
electronically stored or on paper. [23]
The “authenticating record” (the signed security agreement) is notrequired in some cases. It is not
required if the debtor makes a pledgeof the collateral—that is, delivers it to the creditor for the creditor to
possess. For example, upon a creditor’s request of a debtor for collateral to secure a loan of $3,000, the
debtor offers up his stamp collection. The creditor says, “Fine, have it appraised (at your expense) and
show me the appraisal. If it comes in at $3,000 or more, I’ll take your stamp collection and lock it in my
safe until you’ve repaid me. If you don’t repay me, I’ll sell it.” A creditor could take possession of any
goods and various kinds of paper, tangible or intangible. In commercial transactions, it would be common
for the creditor to have possession of—actually or virtually—certified securities, deposit accounts,
electronic chattel paper, investment property, or other such paper or electronic evidence of value. [24]
Again, Figure 19.1 "The Grasping Hand" diagrams the attachment, showing the necessary elements: the
creditor gives value, the debtor has rights in collateral, and there is a security agreement signed
(authenticated) by the debtor. If the debtor defaults, the creditor’s “hand” will grab (repossess) the
collateral.
Perfection of the Security Interest As between the debtor and the creditor, attachment is fine: if the debtor defaults, the creditor will
repossess the goods and—usually—sell them to satisfy the outstanding obligation. But unless an additional
set of steps is taken, the rights of the secured party might be subordinated to the rights of other secured
parties, certain lien creditors, bankruptcy trustees, and buyers who give value and who do not know of the
security interest. Perfection is the secured party’s way of announcing the security interest to the rest of
the world. It is the secured party’s claim on the collateral.
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There are five ways a creditor may perfect a security interest: (1) by filing a financing statement, (2) by
taking or retaining possession of the collateral, (3) by taking control of the collateral, (4) by taking control
temporarily as specified by the UCC, or (5) by taking control automatically.
Perfection by Filing “Except as otherwise provided…a financing statement must be filed to perfect all security agreements.” [25]
The Financing Statement
A financing statement is a simple notice showing the creditor’s general interest in the collateral. It is
what’s filed to establish the creditor’s “dibs.”
Contents of the Financing Statement
It may consist of the security agreement itself, as long as it contains the information required by the UCC,
but most commonly it is much less detailed than the security agreement: it “indicates merely that a person
may have a security interest in the collateral[.]…Further inquiry from the parties concerned will be
necessary to disclose the full state of affairs.” [26] The financing statement must provide the following
information:
The debtor’s name. Financing statements are indexed under the debtor’s name, so getting that
correct is important. Section 9-503 of the UCC describes what is meant by “name of debtor.”
The secured party’s name.
An “indication” of what collateral is covered by the financing statement. [27] It may describe the
collateral or it may “indicate that the financing statement covers all assets or all personal
property” (such generic references are not acceptable in the security agreement but are OK in the
financing statement). [28] If the collateral is real-property-related, covering timber to be cut or
fixtures, it must include a description of the real property to which the collateral is related. [29]
The form of the financing statement may vary from state to state, but see Figure 19.3 "UCC-1 Financing
Statement" for a typical financing statement. Minor errors or omissions on the form will not make it
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ineffective, but the debtor’s signature is required unless the creditor is authorized by the debtor to make
the filing without a signature, which facilitates paperless filing. [30]
Figure 19.3 UCC-1 Financing Statement
Duration of the Financing Statement
Generally, the financing statement is effective for five years; a continuation statement may be filed
within six months before the five-year expiration date, and it is good for another five
years. [31]Manufactured-home filings are good for thirty years. When the debtor’s obligation is satisfied,
the secured party files a termination statement if the collateral was consumer goods; otherwise—upon
demand—the secured party sends the debtor a termination statement. [32]
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Debtor Moves out of State
The UCC also has rules for continued perfection of security interests when the debtor—whether an
individual or an association (corporation)—moves from one state to another. Generally, an interest
remains perfected until the earlier of when the perfection would have expired or for four months after the
debtor moves to a new jurisdiction. [33]
Where to File the Financing Statement
For most real-estate-related filings—ore to be extracted from mines, agricultural collateral, and fixtures—
the place to file is with the local office that files mortgages, typically the county auditor’s office. [34] For
other collateral, the filing place is as duly authorized by the state. In some states, that is the office of the
Secretary of State; in others, it is the Department of Licensing; or it might be a private party that
maintains the state’s filing system. [35] The filing should be made in the state where the debtor has his or
her primary residence for individuals, and in the state where the debtor is organized if it is a registered
organization. [36] The point is, creditors need to know where to look to see if the collateral offered up is
already encumbered. In any event, filing the statement in more than one place can’t hurt. The filing office
will provide instructions on how to file; these are available online, and electronic filing is usually available
for at least some types of collateral.
Exemptions
Some transactions are exempt from the filing provision. The most important category of exempt collateral
is that covered by state certificate of title laws. For example, many states require automobile owners to
obtain a certificate of title from the state motor vehicle office. Most of these states provide that it is not
necessary to file a financing statement in order to perfect a security interest in an automobile. The reason
is that the motor vehicle regulations require any security interests to be stated on the title, so that anyone
attempting to buy a car in which a security interest had been created would be on notice when he took the
actual title certificate. [37]
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Temporary Perfection
The UCC provides that certain types of collateral are automatically perfected but only for a while: “A
security interest in certificated securities, or negotiable documents, or instruments is perfected without
filing or the taking of possession for a period of twenty days from the time it attaches to the extent that it
arises for new value given under an authenticated security agreement.” [38] Similar temporary perfection
covers negotiable documents or goods in possession of a bailee, and when a security certificate or
instrument is delivered to the debtor for sale, exchange, presentation, collection, enforcement, renewal, or
registration. [39] After the twenty-day period, perfection would have to be by one of the other methods
mentioned here.
Perfection by Possession
A secured party may perfect the security interest by possession where the collateral is negotiable
documents, goods, instruments, money, tangible chattel paper, or certified securities. [40] This is a pledge
of assets (mentioned in the example of the stamp collection). No security agreement is required for
perfection by possession.
A variation on the theme of pledge is field warehousing. When the pawnbroker lends money, he takes
possession of the goods—the watch, the ring, the camera. But when large manufacturing concerns wish to
borrow against their inventory, taking physical possession is not necessarily so easy. The bank does not
wish to have shipped to its Wall Street office several tons of copper mined in Colorado. Bank employees
perhaps could go west to the mine and take physical control of the copper, but banks are unlikely to
employ people and equipment necessary to build a warehouse on the spot. Thus this so-called field pledge
is rare.
More common is the field warehouse. The field warehouse can take one of two forms. An independent
company can go to the site and put up a temporary structure—for example, a fence around the copper—
thus establishing physical control of the collateral. Or the independent company can lease the warehouse
facilities of the debtor and post signs indicating that the goods inside are within its sale custody. Either
way, the goods are within the physical possession of the field warehouse service. The field warehouse then
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segregates the goods secured to the particular bank or finance company and issues a warehouse receipt to
the lender for those goods. The lender is thus assured of a security interest in the collateral.
Perfection by Control
“A security interest in investment property, deposit accounts, letter-of-credit rights, or electronic chattel
paper may be perfected by control of the collateral.” [41] “Control” depends on what the collateral is. If it’s a
checking account, for example, the bank with which the deposit account is maintained has “control”: the
bank gets a security interest automatically because, as Official Comment 3 to UCC Section 9-104 puts it,
“all actual and potential creditors of the debtor are always on notice that the bank with which the debtor’s
deposit account is maintained may assert a claim against the deposit account.” “Control” of electronic
chattel paper of investment property, and of letter-of-credit rights is detailed in Sections 9-105, 9-106,
and 9-107. Obtaining “control” means that the creditor has taken whatever steps are necessary, given the
manner in which the items are held, to place itself in a position where it can have the items sold, without
further action by the owner. [42]
Automatic Perfection
The fifth mechanism of perfection is addressed in Section 9-309 of the UCC: there are several
circumstances where a security interest is perfected upon mere attachment. The most important here is
automatic perfection of a purchase-money security interest given in consumer goods. If a seller of
consumer goods takes a PMSI in the goods sold, then perfection of the security interest is automatic. But
the seller may file a financial statement and faces a risk if he fails to file and the consumer debtor sells the
goods. Under Section 9-320(b), a buyer of consumer goods takes free of a security interest, even though
perfected, if he buys without knowledge of the interest, pays value, and uses the goods for his personal,
family, or household purposes—unless the secured party had first filed a financing statement covering the
goods.
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Figure 19.4 Attachment and Perfection
K E Y T A K E A W A Y
A creditor may be secured—allowed to take the debtor’s property upon debtor’s
default—by agreement between the parties or by operation of law. The law
governing agreements for personal property security is Article 9 of the UCC. The
creditor’s first step is to attach the security interest. This is usually accomplished
when the debtor, in return for value (a loan or credit) extended from the creditor,
puts up as collateral some valuable asset in which she has an interest and
authenticates (signs) a security agreement (the contract) giving the creditor a
security interest in collateral and allowing that the creditor may take it if the
debtor defaults. The UCC lists various kinds of assets that can be collateralized,
ranging from tangible property (goods), to assets only able to be manifested by
paper (indispensable paper), to intangible assets (like patent rights). Sometimes
no security agreement is necessary, mostly if the creditor takes possession of the
collateral. After attachment, the prudent creditor will want to perfect the security
interest to make sure no other creditors claim an interest in the collateral.
Perfection is most often accomplished by filing a financing statement in the
appropriate place to put the world on notice of the creditor’s interest. Perfection
can also be achieved by a pledge (possession by the secured creditor) or by
“control” of certain assets (having such control over them as to be able to sell
them if the debtor defaults). Perfection is automatic temporarily for some items
(certified securities, instruments, and negotiable documents) but also upon mere
attachment to purchase-money security interests in consumer goods.
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E X E R C I S E S
1. Why is a creditor ill-advised to be unsecured?
2. Elaine bought a computer for her use as a high school teacher, the school
contributing one-third of its cost. Elaine was compelled to file for bankruptcy.
The computer store claimed it had perfected its interest by mere attachment,
and the bankruptcy trustee claimed the computer as an asset of Elaine’s
bankruptcy estate. Who wins, and why?
3. What is the general rule governing where financing statements should be
filed?
4. If the purpose of perfection is to alert the world to the creditor’s claim in the
collateral, why is perfection accomplishable by possession alone in some
cases?
5. Contractor pawned a power tool and got a $200 loan from Pawnbroker. Has
there been a perfection of a security interest?
[1] Uniform Commercial Code, Section 9-109.
[2] Uniform Commercial Code, Section 9-102(a)(73).
[3] Uniform Commercial Code, Section 9-102(12).
[4] Uniform Commercial Code, Section 9-102(a)(28).
[5] Uniform Commercial Code, Section 9-102 (59).
[6] Uniform Commercial Code, Section 9-102(a)(71).
[7] Commercial Brokers, Inc., “Glossary of Real Estate
Terms,”http://www.cbire.com/index.cfm/fuseaction/terms.list/letter/C/contentid/32302EC3-
81D5-47DF-A9CBA32FAE38B22A.
[8] Uniform Commercial Code, Section 9-102(44).
[9] Uniform Commercial Code, Section 9-102(a)(48).
[10] Uniform Commercial Code, Section 9-102(a)(48).
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[11] Uniform Commercial Code, Section 9-102(a)(34).
[12] Uniform Commercial Code, Section 9-102(a)(33).
[13] Uniform Commercial Code, Section 9-102(a)(41).
[14] Uniform Commercial Code, Section 9-102(a)(1).
[15] Uniform Commercial Code, Section 9-102(a)(2).
[16] Uniform Commercial Code, Section 9-102(42).
[17] Uniform Commercial Code, Section 9-102(11).
[18] Uniform Commercial Code, Section 9-102(a)(47).
[19] Uniform Commercial Code, Section 9-102(a)(49).
[20] Uniform Commercial Code, Section 8-102(a)(4) and (a)(18).
[21] Uniform Commercial Code, Section 9-203(a).
[22] Uniform Commercial Code, Section 9-203(b)(2).
[23] Uniform Commercial Code, Section 9-102, Official Comment 9. Here is a free example of a
security agreement online: Docstoc, “Free Business Templates—Sample Open-Ended Security
Agreement,”http://www.docstoc.com/docs/271920/Free-Business-Templates—-Sample-Open-
Ended-Security-Agreement.
[24] Uniform Commercial Code, Section 9-203(b)(3)(B-D).
[25] Uniform Commercial Code, Section 9-310(a).
[26] Uniform Commercial Code, Section 9-502, Official Comment 2.
[27] Uniform Commercial Code, Section 9-502(a).
[28] Uniform Commercial Code, Section 9-504.
[29] Uniform Commercial Code, Section 9-502(b).
[30] Uniform Commercial Code, Section 9-506; Uniform Commercial Code, Section, 9-502,
Comment 3.
[31] Uniform Commercial Code, Section 9-515.
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[32] Uniform Commercial Code, Section 9-513.
[33] Uniform Commercial Code, Section 9-316.
[34] Uniform Commercial Code, Section 9-501.
[35] Uniform Commercial Code, Section 9-501(a)(2).
[36] Uniform Commercial Code, Section 9-307(b).
[37] Uniform Commercial Code, Section 9-303.
[38] Uniform Commercial Code, Section 9-312(e).
[39] Uniform Commercial Code, Section 9-312(f) and (g).
[40] Uniform Commercial Code, Section 9-313.
[41] Uniform Commercial Code, Section 9-314.
[42] Uniform Commercial Code, Section 8-106, Official Comment 1.
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19.2 Priorities
L E A R N I N G O B J E C T I V E S
1. Understand the general rule regarding who gets priority among competing
secured parties.
2. Know the immediate exceptions to the general rule—all involving PMSIs.
3. Understand the basic ideas behind the other exceptions to the general rule.
Priorities: this is the money question. Who gets what when a debtor defaults? Depending on how the
priorities in the collateral were established, even a secured creditor may walk away with the collateral or
with nothing. Here we take up the general rule and the exceptions.
General Rule The general rule regarding priorities is, to use a quotation attributed to a Southern Civil War general, the
one who wins “gets there firstest with the mostest.” The first to do the best job of perfecting wins. The
Uniform Commercial Code (UCC) creates a race of diligence among competitors.
Application of the Rule
If both parties have perfected, the first to perfect wins. If one has perfected and one attached, the
perfected party wins. If both have attached without perfection, the first to attach wins. If neither has
attached, they are unsecured creditors. Let’s test this general rule against the following situations:
1. Rosemary, without having yet lent money, files a financing statement on February 1 covering
certain collateral owned by Susan—Susan’s fur coat. Under UCC Article 9, a filing may be made
before the security interest attaches. On March 1, Erika files a similar statement, also without
having lent any money. On April 1, Erika loans Susan $1,000, the loan being secured by the fur
coat described in the statement she filed on March 1. On May 1, Rosemary also loans Susan
$1,000, with the same fur coat as security. Who has priority? Rosemary does, since she filed first,
even though Erika actually first extended the loan, which was perfected when made (because she
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had already filed). This result is dictated by the rule even though Rosemary may have known of
Erika’s interest when she subsequently made her loan.
2. Susan cajoles both Rosemary and Erika, each unknown to the other, to loan her $1,000 secured
by the fur coat, which she already owns and which hangs in her coat closet. Erika gives Susan the
money a week after Rosemary, but Rosemary has not perfected and Erika does not either. A week
later, they find out they have each made a loan against the same coat. Who has priority? Whoever
perfects first: the rule creates a race to the filing office or to Susan’s closet. Whoever can submit
the financing statement or actually take possession of the coat first will have priority, and the
outcome does not depend on knowledge or lack of knowledge that someone else is claiming a
security interest in the same collateral. But what of the rule that in the absence of perfection,
whichever security interest first attached has priority? This is “thought to be of merely theoretical
interest,” says the UCC commentary, “since it is hard to imagine a situation where the case would
come into litigation without [either party] having perfected his interest.” And if the debtor filed a
petition in bankruptcy, neither unperfected security interest could prevail against the bankruptcy
trustee.
To rephrase: An attached security interest prevails over other unsecured creditors (unsecured creditors
lose to secured creditors, perfected or unperfected). If both parties are secured (have attached the
interest), the first to perfect wins. [1] If both parties have perfected, the first to have perfected wins. [2]
Exceptions to the General Rule
There are three immediate exceptions to the general rule, and several other exceptions, all of which—
actually—make some straightforward sense even if it sounds a little complicated to explain them.
Immediate Exceptions
We call the following three exceptions “immediate” ones because they allow junior filers immediate
priority to take their collateral before the debtor’s other creditors get it. They all involve purchase-money
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security interests (PMSIs), so if the debtor defaults, the creditor repossesses the very goods the creditor
had sold the debtor.
(1) Purchase-money security interest in goods (other than inventory or livestock). The UCC provides that
“a perfected purchase-money security interest in goods other than inventory or livestock has priority over
a conflicting security interest in the same goods…if the purchase-money security interest is perfected
when debtor receives possession of the collateral or within 20 days thereafter.” [3] The Official Comment to
this UCC section observes that “in most cases, priority will be over a security interest asserted under an
after-acquired property clause.”
Suppose Susan manufactures fur coats. On February 1, Rosemary advances her $10,000 under a security
agreement covering all Susan’s machinery and containing an after-acquired property clause. Rosemary
files a financing statement that same day. On March 1, Susan buys a new machine from Erika for $5,000
and gives her a security interest in the machine; Erika files a financing statement within twenty days of
the time that the machine is delivered to Susan. Who has priority if Susan defaults on her loan payments?
Under the PMSI rule, Erika has priority, because she had a PMSI. Suppose, however, that Susan had not
bought the machine from Erika but had merely given her a security interest in it. Then Rosemary would
have priority, because her filing was prior to Erika’s.
What would happen if this kind of PMSI in noninventory goods (here, equipment) did not get priority
status? A prudent Erika would not extend credit to Susan at all, and if the new machine is necessary for
Susan’s business, she would soon be out of business. That certainly would not inure to the benefit of
Rosemary. It is, mostly, to Rosemary’s advantage that Susan gets the machine: it enhances Susan’s ability
to make money to pay Rosemary.
(2) Purchase-money security interest in inventory. The UCC provides that a perfected PMSI in inventory
has priority over conflicting interests in the same inventory, provided that the PMSI is perfected when the
debtor receives possession of the inventory, the PMSI-secured party sends an authenticated notification
to the holder of the conflicting interest and that person receives the notice within five years before the
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debtor receives possession of the inventory, and the notice states that the person sending it has or expects
to acquire a PMSI in the inventory and describes the inventory. [4] The notice requirement is aimed at
protecting a secured party in the typical situation in which incoming inventory is subject to a prior
agreement to make advances against it. If the original creditor gets notice that new inventory is subject to
a PMSI, he will be forewarned against making an advance on it; if he does not receive notice, he will have
priority. It is usually to the earlier creditor’s advantage that her debtor is able to get credit to “floor”
(provide) inventory, without selling which, of course, the debtor cannot pay back the earlier creditor.
(3) Purchase-money security interest in fixtures. Under UCC Section 9-334(e), a perfected security in
fixtures has priority over a mortgage if the security interest is a PMSI and the security interest is perfected
by a fixture filing before the goods become fixtures or within twenty days after. A mortgagee is usually a
bank (the mortgagor is the owner of the real estate, subject to the mortgagee’s interest). The bank’s
mortgage covers the real estate and fixtures, even fixtures added after the date of the mortgage (after-
acquired property clause). In accord with the general rule, then, the mortgagee/bank would normally have
priority if the mortgage is recorded first, as would a fixture filing if made before the mortgage was
recorded. But with the exception noted, the bank’s interest is subordinate to the fixture-seller’s later-
perfected PMSI. Example: Susan buys a new furnace from Heating Co. to put in her house. Susan gave a
bank a thirty-year mortgage on the house ten years before. Heating Co. takes back a PMSI and files the
appropriate financing statement before or within twenty days of installation. If Susan defaults on her loan
to the bank, Heating Co. would take priority over the bank. And why not? The mortgagee has, in the long
run, benefited from the improvement and modernization of the real estate. (Again, there are further
nuances in Section 9-334 beyond our scope here.) A non-PMSI in fixtures or PMSIs perfected more than
twenty days after goods become a fixture loses out to prior recorded interests in the realty.
Other Exceptions
We have noted the three immediate exceptions to the general rule that “the firstest with the mostest”
prevails. There are some other exceptions.
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Think about how these other exceptions might arise: who might want to take property subject to a security
agreement (not including thieves)? That is, Debtor gives Creditor a security interest in, say, goods, while
retaining possession. First, buyers of various sorts might want the goods if they paid for them; they
usually win. Second, lien creditors might want the goods (a lien creditor is one whose claim is based on
operation of law—involuntarily against Debtor, and including a trustee in bankruptcy—as opposed to one
whose claim is based on agreement); lien creditors may be statutory (landlords, mechanics, bailees) or
judicial. Third, a bankruptcy trustee representing Debtor’s creditors (independent of the trustee’s role as
a lien creditor) might want to take the goods to sell and satisfy Debtor’s obligations to the creditors.
Fourth, unsecured creditors; fifth, secured creditors; and sixth, secured and perfected creditors. We will
examine some of the possible permutations but are compelled to observe that this area of law has many
fine nuances, not all of which can be taken up here.
First we look at buyers who take priority over, or free of, unperfected security interests. Buyers who take
delivery of many types of collateral covered by an unperfected security interest win out over the hapless
secured party who failed to perfect if they give value and don’t know of the security interest or agricultural
lien. [5] A buyer who doesn’t give value or who knows of the security interest will not win out, nor will a
buyer prevail if the seller’s creditor files a financing statement before or within twenty days after the
debtor receives delivery of the collateral.
Now we look at buyers who take priority over perfected security interests. Sometimes people who buy
things even covered by a perfected security interest win out (the perfected secured party loses).
Buyers in the ordinary course of business. “A buyer in the ordinary course of business, other than
[one buying farm products from somebody engaged in farming] takes free of a security interest
created by the buyer’s seller, even if the security interest is perfected and the buyer knows
[it].” [6] Here the buyer is usually purchasing inventory collateral, and it’s OK if he knows the
inventory is covered by a security interest, but it’s not OK if he knows “that the sale violates a term
in an agreement with the secured party.” [7] It would not be conducive to faith in commercial
transactions if buyers of inventory generally had to worry whether their seller’s creditors were
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going to repossess the things the buyers had purchased in good faith. For example (based on
example 1 to the same comment, UCC 9-320, Official Comment 3), Manufacturer makes
appliances and owns manufacturing equipment covered by a perfected security agreement in
favor of Lender. Manufacturer sells the equipment to Dealer, whose business is buying and selling
used equipment; Dealer, in turn, sells the stuff to Buyer, a buyer in the ordinary course. Does
Buyer take free of the security interest? No, because Dealer didn’t create it; Manufacturer did.
Buyers of consumer goods purchased for personal, family, or household use take free of security
interests, even if perfected, so long as they buy without knowledge of the security interest, for
value, for their own consumer uses, and before the filing of a financing statement covering the
goods. This—again—is the rub when a seller of consumer goods perfects by “mere attachment”
(automatic perfection) and the buyer of the goods turns around and sells them. For example, Tom
buys a new refrigerator from Sears, which perfects by mere attachment. Tom has cash flow
problems and sells the fridge to Ned, his neighbor. Ned doesn’t know about Sears’s security
interest and pays a reasonable amount for it. He puts it in his kitchen for home use. Sears cannot
repossess the fridge from Ned. If it wanted to protect itself fully, Sears would have filed a
financing statement; then Ned would be out the fridge when the repo men came. [8] The “value”
issue is interestingly presented in the Nicolosi case (Section 19.5 "Cases").
Buyers of farm products. The UCC itself does not protect buyers of farm products from security
interests created by “the person engaged in farming operations who is in the business of selling
farm products,” and the result was that sometimes the buyer had to pay twice: once to the farmer
and again to the lender whom the farmer didn’t pay. As a result, Congress included in its 1985
Farm Security Act, 7 USC 1631, Section 1324, this language: “A buyer who in the ordinary course
of business buys a farm product from a seller engaged in farming operations shall take free of a
security interest created by the seller, even though the security interest is perfected; and the buyer
knows of the existence of such interest.”
There are some other exceptions, beyond our scope here.
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Lien Creditors
Persons (including bankruptcy trustees) who become lien creditorsbefore the security interest is perfected
win out—the unperfected security interest is subordinate to lien creditors. Persons who become lien
creditors after the security interest is perfected lose (subject to some nuances in situations where the lien
arises between attachment by the creditor and the filing, and depending upon the type of security interest
and the type of collateral). [9] More straightforwardly, perhaps, a lien securing payment or performance of
an obligation for services or materials furnished with respect to goods by a person in the ordinary course
of business has priority over other security interests (unless a statute provides otherwise). [10] This is the
bailee or “material man” (one who supplies materials, as to build a house) with a lien situation. Garage
Mechanic repairs a car in which Owner has previously given a perfected security interest to Bank. Owner
doesn’t pay Bank. Bank seeks to repossess the car from Mechanic. It will have to pay the Mechanic first.
And why not? If the car was not running, Bank would have to have it repaired anyway.
Bankruptcy Trustee
To what extent can the bankruptcy trustee take property previously encumbered by a security interest? It
depends. If the security interest was not perfected at the time of filing for bankruptcy, the trustee can take
the collateral. [11] If it was perfected, the trustee can’t take it, subject to rules on preferential transfers: the
Bankruptcy Act provides that the trustee can avoid a transfer of an interest of the debtor in property—
including a security interest—(1) to or for the benefit of a creditor, (2) on or account of an antecedent debt,
(3) made while the debtor was insolvent, (4) within ninety days of the bankruptcy petition date (or one
year, for “insiders”—like relatives or business partners), (5) which enables the creditor to receive more
than it would have in the bankruptcy. [12] There are further bankruptcy details beyond our scope here, but
the short of it is that sometimes creditors who think they have a valid, enforceable security interest find
out that the bankruptcy trustee has snatched the collateral away from them.
Deposit accounts perfected by control. A security interest in a deposit account (checking account, savings
account, money-market account, certificate of deposit) takes priority over security interests in the account
perfected by other means, and under UCC Section 9-327(3), a bank with which the deposit is made takes
priority over all other conflicting security agreements. [13] For example, a debtor enters into a security
agreement with his sailboat as collateral. The creditor perfects. The debtor sells the sailboat and deposits
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the proceeds in his account with a bank; normally, the creditor’s interest would attach to the proceeds.
The debtor next borrows money from the bank, and the bank takes a security interest in the debtor’s
account by control. The debtor defaults. Who gets the money representing the sailboat’s proceeds? The
bank does. The rationale: “this…enables banks to extend credit to their depositors without the need to
examine [records] to determine whether another party might have a security interest in the deposit
account.” [14]
K E Y T A K E A W A Y
Who among competing creditors gets the collateral if the debtor defaults? The
general rule on priorities is that the first to secure most completely wins: if all
competitors have perfected, the first to do so wins. If one has perfected and the
others have not, the one who perfects wins. If all have attached, the first to attach
wins. If none have attached, they’re all unsecured creditors. To this general rule
there are a number of exceptions. Purchase-money security interests in goods and
inventory prevail over previously perfected secured parties in the same goods and
inventory (subject to some requirements); fixture financers who file properly have
priority over previously perfected mortgagees. Buyers in the ordinary course of
business take free of a security interest created by their seller, so long as they
don’t know their purchase violates a security agreement. Buyers of consumer
goods perfected by mere attachment win out over the creditor who declined to
file. Buyers in the ordinary course of business of farm products prevail over the
farmer’s creditors (under federal law, not the UCC). Lien creditors who become
such before perfection win out; those who become such after perfection usually
lose. Bailees in possession and material men have priority over previous perfected
claimants. Bankruptcy trustees win out over unperfected security interests and
over perfected ones if they are considered voidable transfers from the debtor to
the secured party. Deposit accounts perfected by control prevail over previously
perfected secured parties in the same deposit accounts.
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E X E R C I S E S
1. What is the general rule regarding priorities for the right to repossess goods
encumbered by a security interest when there are competing creditors
clamoring for that right?
2. Why does it make good sense to allow purchase-money security creditors in
(1) inventory, (2) equipment, and (3) fixtures priority over creditors who
perfected before the PMSI was perfected?
3. A buyer in the ordinary course of business is usually one buying inventory.
Why does it make sense that such a buyer should take free of a security
interest created by his seller?
[1] Uniform Commercial Code, Section 9-322(a)(2).
[2] Uniform Commercial Code, Section 9-322(a)(1).
[3] Uniform Commercial Code, Section 9-324(a).
[4] Uniform Commercial Code, Section 9-324(b).
[5] Uniform Commercial Code, Section 9-317(b).
[6] Uniform Commercial Code, Section 9-320(a).
[7] Uniform Commercial Code, Section 9-320, Comment 3.
[8] Uniform Commercial Code, Section 9-320(b).
[9] Uniform Commercial Code, Section 9-317(a)(2)(B) and 9-317(e).
[10] Uniform Commercial Code, Section 9-333.
[11] 11 United States Code, Section 544 (Bankruptcy Act).
[12] United States Code, Section 547.
[13] Uniform Commercial Code, Section 9-327(1).
[14] Uniform Commercial Code, Section 9-328, Official Comment 3 and 4.
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19.3 Rights of Creditor on Default and Disposition after Repossession
L E A R N I N G O B J E C T I V E S
1. Understand that the creditor may sue to collect the debt.
2. Recognize that more commonly the creditor will realize on the collateral—
repossess it.
3. Know how collateral may be disposed of upon repossession: by sale or by
strict foreclosure.
Rights of Creditor on Default Upon default, the creditor must make an election: to sue, or to repossess.
Resort to Judicial Process
After a debtor’s default (e.g., by missing payments on the debt), the creditor could ignore the security
interest and bring suit on the underlying debt. But creditors rarely resort to this remedy because it is time-
consuming and costly. Most creditors prefer to repossess the collateral and sell it or retain possession in
satisfaction of the debt.
Repossession
Section 9-609 of the Uniform Commercial Code (UCC) permits the secured party to take possession of the
collateral on default (unless the agreement specifies otherwise):
(a) After default, a secured party may (1) take possession of the collateral; and (2) without removal, may
render equipment unusable and dispose of collateral on a debtor’s premises.
(b) A secured party may proceed under subsection (a): (1) pursuant to judicial process; or (2) without
judicial process, if it proceeds without breach of the peace.
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This language has given rise to the flourishing business of professional “repo men” (and women). “Repo”
companies are firms that specialize in repossession collateral. They have trained car-lock pickers, in-
house locksmiths, experienced repossession teams, damage-free towing equipment, and the capacity to
deliver repossessed collateral to the client’s desired destination. Some firms advertise that they have 360-
degree video cameras that record every aspect of the repossession. They have “skip chasers”—people
whose business it is to track down those who skip out on their obligations, and they are trained not to
breach the peace. [1] See Pantoja-Cahue v. Ford Motor Credit Co., a case discussing repossession,
in Section 19.5 "Cases".
The reference in Section 9-609(a)(2) to “render equipment unusable and dispose of collateral on a
debtor’s premises” gets to situations involving “heavy equipment [when] the physical removal from the
debtor’s plant and the storage of collateral pending disposition may be impractical or unduly
expensive.…Of course…all aspects of the disposition must be commercially reasonable.” [2] Rendering the
equipment unusable would mean disassembling some critical part of the machine—letting it sit there until
an auction is set up on the premises.
The creditor’s agents—the repo people—charge for their service, of course, and if possible the cost of
repossession comes out of the collateral when it’s sold. A debtor would be better off voluntarily delivering
the collateral according to the creditor’s instructions, but if that doesn’t happen, “self-help”—
repossession—is allowed because, of course, the debtor said it would be allowed in the security agreement,
so long as the repossession can be accomplished without breach of peace. “Breach of peace” is language
that can cover a wide variety of situations over which courts do not always agree. For example, some
courts interpret a creditor’s taking of the collateral despite the debtor’s clear oral protest as a breach of the
peace; other courts do not.
Disposition after Repossession After repossession, the creditor has two options: sell the collateral or accept it in satisfaction of the debt
(see Figure 19.5 "Disposition after Repossession").
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Figure 19.5 Disposition after Repossession
Sale
Sale is the usual method of recovering the debt. Section 9-610 of the UCC permits the secured creditor to
“sell, lease, license, or otherwise dispose of any or all of the collateral in its present condition or following
any commercially reasonable preparation or processing.” The collateral may be sold as a whole or in
parcels, at one time or at different times. Two requirements limit the creditor’s power to resell: (1) it must
send notice to the debtor and secondary obligor, and (unless consumer goods are sold) to other secured
parties; and (2) all aspects of the sale must be “commercially reasonable.” [3] Most frequently the collateral
is auctioned off.
Section 9-615 of the UCC describes how the proceeds are applied: first, to the costs of the repossession,
including reasonable attorney’s fees and legal expenses as provided for in the security agreement (and it
will provide for that!); second, to the satisfaction of the obligation owed; and third, to junior creditors.
This again emphasizes the importance of promptly perfecting the security interest: failure to do so
frequently subordinates the tardy creditor’s interest to junior status. If there is money left over from
disposing of the collateral—a surplus—the debtor gets that back. If there is still money owing—a
deficiency—the debtor is liable for that. In Section 9-616, the UCC carefully explains how the surplus or
deficiency is calculated; the explanation is required in a consumer goods transaction, and it has to be sent
to the debtor after the disposition.
Strict Foreclosure
Because resale can be a bother (or the collateral is appreciating in value), the secured creditor may wish
simply to accept the collateral in full satisfaction or partial satisfaction of the debt, as permitted in UCC
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Section 9-620(a). This is known as strict foreclosure. The debtor must consent to letting the creditor
take the collateral without a sale in a “record authenticated after default,” or after default the creditor can
send the debtor a proposal for the creditor to accept the collateral, and the proposal is effective if not
objected to within twenty days after it’s sent.
The strict foreclosure provisions contain a safety feature for consumer goods debtors. If the debtor has
paid at least 60 percent of the debt, then the creditor may not use strict foreclosure—unless the debtor
signs a statement after default renouncing his right to bar strict foreclosure and to force a sale. [4] A
consumer who refuses to sign such a statement thus forces the secured creditor to sell the collateral under
Section 9-610. Should the creditor fail to sell the goods within ninety days after taking possession of the
goods, he is liable to the debtor for the value of the goods in a conversion suit or may incur the liabilities
set forth in Section 9-625, which provides for minimum damages for the consumer debtor. Recall that the
UCC imposes a duty to act in good faith and in a commercially reasonable manner, and in most cases with
reasonable notification. [5] See Figure 19.5 "Disposition after Repossession".
Foreclosure on Intangible Collateral
A secured party’s repossession of inventory or equipment can disrupt or even close a debtor’s business.
However, when the collateral is intangible—such as accounts receivable, general intangibles, chattel
paper, or instruments—collection by a secured party after the debtor’s default may proceed without
interrupting the business. Section 9-607 of the UCC provides that on default, the secured party is entitled
to notify the third party—for example, a person who owes money on an account—that payment should be
made to him. The secured party is accountable to the debtor for any surplus, and the debtor is liable for
any deficiency unless the parties have agreed otherwise.
As always in parsing the UCC here, some of the details and nuances are necessarily omitted because of
lack of space or because a more detailed analysis is beyond this book’s scope.
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K E Y T A K E A W A Y
Upon default, the creditor may bring a lawsuit against the debtor to collect a
judgment. But the whole purpose of secured transactions is to avoid this costly
and time-consuming litigation. The more typical situation is that the creditor
repossesses the collateral and then either auctions it off (sale) or keeps it in
satisfaction of the debt (strict foreclosure). In the former situation, the creditor
may then proceed against the debtor for the deficiency. In consumer cases, the
creditor cannot use strict foreclosure if 60 percent of the purchase price has been
paid.
E X E R C I S E S
1. Although a creditor could sue the debtor, get a judgment against it, and
collect on the judgment, usually the creditor repossesses the collateral. Why is
repossession the preferred method of realizing on the security?
2. Why is repossession allowed so long as it can be done without a breach of the
peace?
3. Under what circumstances is strict foreclosure not allowed?
[1] Here is an example of sophisticated online advertising for a repossession firm: SSR,
“Southern & Central Coast California Repossession
Services,”http://www.simonsrecovery.com/index.htm.
[2] Uniform Commercial Code, Section 9-609(a)(2), Official Comment 6.
[3] Uniform Commercial Code, Section 9-611; Uniform Commercial Code, Section 9-610.
[4] Uniform Commercial Code, 9-620(e); Uniform Commercial Code, Section 9-624.
[5] Uniform Commercial Code, Section 1-203.
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19.4 Suretyship
L E A R N I N G O B J E C T I V E S
1. Understand what a surety is and why sureties are used in commercial
transactions.
2. Know how suretyships are created.
3. Recognize the general duty owed by the surety to the creditor, and the
surety’s defenses.
4. Recognize the principal obligor’s duty to the surety, and the surety’s rights
against the surety.
5. Understand the rights among cosureties.
Definition, Types of Sureties, and Creation of the Suretyship Definition
Suretyship is the second of the three major types of consensual security arrangements noted at the
beginning of this chapter (personal property security, suretyship, real property security)—and a common
one. Creditors frequently ask the owners of small, closely held companies to guarantee their loans to the
company, and parent corporations also frequently are guarantors of their subsidiaries’ debts. The earliest
sureties were friends or relatives of the principal debtor who agreed—for free—to lend their guarantee.
Today most sureties in commercial transaction are insurance companies (but insurance is not the same as
suretyship).
A surety is one who promises to pay or perform an obligation owed by the principal debtor, and,
strictly speaking, the surety is primarily liable on the debt: the creditor can demand payment from the
surety when the debt is due. The creditor is the person to whom the principal debtor (and the surety,
strictly speaking) owes an obligation. Very frequently, the creditor requires first that the debtor put up
collateral to secure indebtedness, and—in addition—that the debtor engage a surety to make extra certain
the creditor is paid or performance is made. For example, David Debtor wants Bank to loan his
corporation, David Debtor, Inc., $100,000. Bank says, “Okay, Mr. Debtor, we’ll loan the corporation
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money, but we want its computer equipment as security, and we want you personally to guarantee the
debt if the corporation can’t pay.” Sometimes, though, the surety and the principal debtor may have no
agreement between each other; the surety might have struck a deal with the creditor to act as surety
without the consent or knowledge of the principal debtor.
A guarantor also is one who guarantees an obligation of another, and for practical purposes,
therefore, guarantor is usually synonymous with surety—the terms are used pretty much
interchangeably. But here’s the technical difference: a surety is usually a party to the original contract and
signs her (or his, or its) name to the original agreement along with the surety; the consideration for the
principal’s contract is the same as the surety’s consideration—she is bound on the contract from the very
start, and she is also expected to know of the principal debtor’s default so that the creditor’s failure to
inform her of it does not discharge her of any liability. On the other hand, a guarantor usually does not
make his agreement with the creditor at the same time the principal debtor does: it’s a separate contract
requiring separate consideration, and if the guarantor is not informed of the principal debtor’s default, the
guarantor can claim discharge on the obligation to the extent any failure to inform him prejudices him.
But, again, as the terms are mostly synonymous, surety is used here to encompass both.
Figure 19.6 Defenses of Principal Debtor and Surety
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Types of Suretyship
Where there is an interest, public or private, that requires protection from the possibility of a default,
sureties are engaged. For example, a landlord might require that a commercial tenant not only put up a
security deposit but also show evidence that it has a surety on line ready to stand for three months’ rent if
the tenant defaults. Often, a municipal government will want its road contractor to show it has a surety
available in case, for some reason, the contractor cannot complete the project. Many states require general
contractors to have bonds, purchased from insurance companies, as a condition of getting a contractor’s
license; the insurance company is the surety—it will pay out if the contractor fails to complete work on the
client’s house. These are types of a performance bond. A judge will often require that a criminal
defendant put up a bond guaranteeing his appearance in court—that’s a type of suretyship where the bail-
bonder is the surety—or that a plaintiff put up a bond indemnifying the defendant for the costs of delays
caused by the lawsuit—a judicial bond. A bank will take out a bond on its employees in case they steal
money from the bank—the bank teller, in this case, is the principal debtor (a fidelity bond). However, as
we will see, sureties do not anticipate financial loss like insurance companies do: the surety expects,
mostly, to be repaid if it has to perform. The principal debtor goes to an insurance company and buys the
bond—the suretyship policy. The cost of the premium depends on the surety company, the type of bond
applied for, and the applicant’s financial history. A sound estimate of premium costs is 1 percent to 4
percent, but if a surety company classifies an applicant as high risk, the premium falls between 5 percent
and 20 percent of the bond amount. When the purchaser of real estate agrees to assume the seller’s
mortgage (promises to pay the mortgage debt), the seller then becomes a surety: unless the mortgagee
releases the seller (not likely), the seller has to pay if the buyer defaults.
Creation of the Suretyship
Suretyship can arise only through contract. The general principles of contract law apply to suretyship.
Thus a person with the general capacity to contract has the power to become a surety. Consideration is
required for a suretyship contract: if Debtor asks a friend to act as a surety to induce Creditor to make
Debtor a loan, the consideration Debtor gives Creditor also acts as the consideration Friend gives. Where
the suretyship arises after Creditor has already extended credit, new consideration would be required
(absent application of the doctrine of promissory estoppel [1]). You may recall from the chapters on
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contracts that the promise by one person to pay or perform for the debts or defaults of another must be
evidenced by a writing under the statute of frauds (subject to the “main purpose” exception).
Suretyship contracts are affected to some extent by government regulation. Under a 1985 Federal Trade
Commission Credit Practices Rule, creditors are prohibited from misrepresenting a surety’s liability.
Creditors must also give the surety a notice that explains the nature of the obligation and the potential
liability that can arise if a person cosigns on another’s debt. [2]
Duties and Rights of the Surety Duties of the Surety
Upon the principal debtor’s default, the surety is contractually obligated to perform unless the principal
herself or someone on her behalf discharges the obligation. When the surety performs, it must do so in
good faith. Because the principal debtor’s defenses are generally limited, and because—as will be noted—
the surety has the right to be reimbursed by the debtor, debtors not infrequently claim the surety acted in
bad faith by doing things like failing to make an adequate investigation (to determine if the debtor really
defaulted), overpaying claims, interfering with the contact between the surety and the debtor, and making
unreasonable refusals to let the debtor complete the project. The case Fidelity and Deposit Co. of
Maryland v. Douglas Asphalt Co., in Section 19.5 "Cases", is typical.
Rights of the Surety
The surety has four main rights stemming from its obligation to answer for the debt or default of the
principal debtor.
Exoneration
If, at the time a surety’s obligation has matured, the principal can satisfy the obligation but refuses to do
so, the surety is entitled to exoneration—a court order requiring the principal to perform. It would be
inequitable to force the surety to perform and then to have to seek reimbursement from the principal if
all along the principal is able to perform.
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Reimbursement
If the surety must pay the creditor because the principal has defaulted, the principal is obligated to
reimburse the surety. The amount required to be reimbursed includes the surety’s reasonable, good-faith
outlays, including interest and legal fees.
Subrogation
Suppose the principal’s duty to the creditor is fully satisfied and that the surety has contributed to this
satisfaction. Then the surety is entitled to be subrogated to the rights of the creditor against the principal.
In other words, the surety stands in the creditor’s shoes and may assert against the principal whatever
rights the creditor could have asserted had the duty not been discharged. The right of
subrogation includes the right to take secured interests that the creditor obtained from the principal to
cover the duty. Sarah’s Pizzeria owes Martha $5,000, and Martha has taken a security interest in Sarah’s
Chevrolet. Eva is surety for the debt. Sarah defaults, and Eva pays Martha the $5,000. Eva is entitled to
have the security interest in the car transferred to her.
Contribution
Two or more sureties who are bound to answer for the principal’s default and who should share between
them the loss caused by the default are known as cosureties. A surety who in performing its own
obligation to the creditor winds up paying more than its proportionate share is entitled
to contribution from the cosureties.
Defenses of the Parties
The principal and the surety may have defenses to paying.
Defenses of the Principal
The principal debtor may avail itself of any standard contract defenses as against the creditor, including
impossibility, illegality, incapacity, fraud, duress, insolvency, or bankruptcy discharge. However, the
surety may contract with the creditor to be liable despite the principal’s defenses, and a surety who has
undertaken the suretyship with knowledge of the creditor’s fraud or duress remains obligated, even
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though the principal debtor will be discharged. When the surety turns to the principal debtor and
demands reimbursement, the latter may have defenses against the surety—as noted—for acting in bad
faith.
One of the main reasons creditors want the promise of a surety is to avoid the risk that the principal
debtor will go bankrupt: the debtor’s bankruptcy is a defense to the debtor’s liability, certainly, but that
defense cannot be used by the surety. The same is true of the debtor’s incapacity: it is a defense available
to the principal debtor but not to the surety.
Defenses of the Surety
Generally, the surety may exercise defenses on a contract that would have been available to the principal
debtor (e.g., creditor’s breach; impossibility or illegality of performance; fraud, duress, or
misrepresentation by creditor; statute of limitations; refusal of creditor to accept tender or performance
from either debtor or surety.) Beyond that, the surety has some defenses of its own. Common defenses
raised by sureties include the following:
Release of the principal. Whenever a creditor releases the principal, the surety is discharged,
unless the surety consents to remain liable or the creditor expressly reserves her rights against the
surety. The creditor’s release of the surety, though, does not release the principal debtor because
the debtor is liable without regard to the surety’s liability.
Modification of the contract. If the creditor alters the instrument sufficiently to discharge the
principal, the surety is discharged as well. Likewise, when the creditor and principal modify their
contract, a surety who has not consented to the modification is discharged if the surety’s risk is
materially increased (but not if it is decreased). Modifications include extension of the time of
payment, release of collateral (this releases the surety to the extent of the impairment), change in
principal debtor’s duties, and assignment or delegation of the debtor’s obligations to a third party.
The surety may consent to modifications.
Creditor’s failure to perfect. A creditor who fails to file a financing statement or record a
mortgage risks losing the security for the loan and might also inadvertently release a surety, but
the failure of the creditor to resort first to collateral is no defense.
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Statute of frauds. Suretyship contracts are among those required to be evidenced by some writing
under the statute of frauds, and failure to do so may discharge the surety from liability.
Creditor’s failure to inform surety of material facts within creditor’s knowledge affecting
debtor’s ability to perform (e.g., that debtor has defaulted several times before).
General contract defenses. The surety may raise common defenses like incapacity (infancy), lack
of consideration (unless promissory estoppel can be substituted or unless no separate
consideration is necessary because the surety’s and debtor’s obligations arise at the same time),
and creditor’s fraud or duress on surety. However, fraud by the principal debtor on the surety to
induce the suretyship will not release the surety if the creditor extended credit in good faith; if the
creditor knows of the fraud perpetrated by the debtor on the surety, the surety may avoid liability.
See Figure 19.6 "Defenses of Principal Debtor and Surety".
The following are defenses of principal debtor only:
Death or incapacity of principal debtor
Bankruptcy of principal debtor
Principal debtor’s setoffs against creditor
The following are defenses of both principal debtor and surety:
Material breach by creditor
Lack of mutual assent, failure of consideration
Creditor’s fraud, duress, or misrepresentation of debtor
Impossibility or illegality of performance
Material and fraudulent alteration of the contract
Statute of limitations
The following are defenses of surety only:
Fraud or duress by creditor on surety
o Illegality of suretyship contract
o Surety’s incapacity
o Failure of consideration for surety contract (unless excused)
o Statute of frauds
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o Acts of creditor or debtor materially affecting surety’s obligations:
Refusal by creditor to accept tender of performance
Release of principal debtor without surety’s consent
Release of surety
Release, surrender, destruction, or impairment of collateral
Extension of time on principal debtor’s obligation
Modification of debtor’s duties, place, amount, or manner of debtor’s obligations
K E Y T A K E A W A Y
Creditors often require not only the security of collateral from the debtor but also
that the debtor engage a surety. A contract of suretyship is a type of insurance
policy, where the surety (insurance company) promises the creditor that if the
principal debtor fails to perform, the surety will undertake good-faith performance
instead. A difference between insurance and suretyship, though, is that the surety
is entitled to reimbursement by the principal debtor if the surety pays out. The
surety is also entitled, where appropriate, to exoneration, subrogation, and
contribution. The principal debtor and the surety both have some defenses
available: some are personal to the debtor, some are joint defenses, and some are
personal to the surety.
E X E R C I S E S
1. Why isn’t collateral put up by the debtor sufficient security for the creditor—
why is a surety often required?
2. How can it be said that sureties do not anticipate financial losses like
insurance companies do? What’s the difference, and how does the surety
avoid losses?
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3. Why does the creditor’s failure to perfect a security interest discharge the
surety from liability? Why doesn’t failure of the creditor to resort first to
perfected collateral discharge the surety?
4. What is the difference between a guarantor and a surety?
[1] American Druggists’ Ins. Co. v. Shoppe, 448 N.W.2d 103, Minn. App. (1989).
[2] Here is an example of the required notice: Federal Trade Commission, “Facts for Consumers:
The Credit Practices Rule,”http://www.ftc.gov/bcp/edu/pubs/consumer/credit/cre12.shtm.
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19.5 Cases
Perfection by Mere Attachment; Priorities In re NICOLOSI
4 UCC Rep. 111 (Ohio 1966)
Preliminary Statement and Issues
This matter is before the court upon a petition by the trustee to sell a diamond ring in his possession free
of liens.…Even though no pleadings were filed by Rike-Kumler Company, the issue from the briefs is
whether or not a valid security interest was perfected in this chattel as consumer goods, superior to the
statutory title and lien of the trustee in bankruptcy.
Findings of Fact
The [debtor] purchased from the Rike-Kumler Company, on July 7, 1964, the diamond ring in question,
for $1237.35 [about $8,500 in 2010 dollars], as an engagement ring for his fiancée. He executed a
purchase money security agreement, which was not filed. Also, no financing statement was filed. The
chattel was adequately described in the security agreement.
The controversy is between the trustee in bankruptcy and the party claiming a perfected security interest
in the property. The recipient of the property has terminated her relationship with the [debtor], and
delivered the property to the trustee.
Conclusion of Law, Decision, and Order
If the diamond ring, purchased as an engagement ring by the bankrupt, cannot be categorized as
consumer goods, and therefore exempted from the notice filing requirements of the Uniform Commercial
Code as adopted in Ohio, a perfected security interest does not exist.
No judicial precedents have been cited in the briefs.
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Under the commercial code, collateral is divided into tangible, intangible, and documentary categories.
Certainly, a diamond ring falls into the tangible category. The classes of tangible goods are distinguished
by the primary use intended. Under [the UCC] the four classes [include] “consumer goods,” “equipment,”
“farm products” and “inventory.”
The difficulty is that the code provisions use terms arising in commercial circles which have different
semantical values from legal precedents. Does the fact that the purchaser bought the goods as a special
gift to another person signify that it was not for his own “personal, family or household purposes”? The
trustee urges that these special facts control under the express provisions of the commercial code.
By a process of exclusion, a diamond engagement ring purchased for one’s fiancée is not “equipment”
bought or used in business, “farm products” used in farming operations, or “inventory” held for sale, lease
or service contracts. When the [debtor] purchased the ring, therefore, it could only have been “consumer
goods” bought “primarily for personal use.” There could be no judicial purpose to create a special class of
property in derogation of the statutory principles.
Another problem is implicit, although not covered by the briefs.
By the foregoing summary analysis, it is apparent that the diamond ring, when the interest of the debtor
attached, was consumer goods since it could have been no other class of goods. Unless the fiancée had a
special status under the code provision protecting a bona fide buyer, without knowledge, for value, of
consumer goods, the failure to file a financing statement is not crucial. No evidence has been adduced
pertinent to the scienter question.
Is a promise, as valid contractual consideration, included under the term “value”? In other words, was the
ring given to his betrothed in consideration of marriage (promise for a promise)? If so, and “value” has
been given, the transferee is a “buyer” under traditional concepts.
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The Uniform Commercial Code definition of “value”…very definitely covers a promise for a promise. The
definition reads that “a person gives ‘value’ for rights if he acquires them…generally in return for any
consideration sufficient to support a simple contract.”
It would seem unrealistic, nevertheless, to apply contract law concepts historically developed into the law
of marriage relations in the context of new concepts developed for uniform commercial practices. They
are not, in reality, the same juristic manifold. The purpose of uniformity of the code should not be
defeated by the obsessions of the code drafters to be all inclusive for secured creditors.
Even if the trustee, in behalf of the unsecured creditors, would feel inclined to insert love, romance and
morals into commercial law, he is appearing in the wrong era, and possibly the wrong court.
Ordered, that the Rike-Kumler Company holds a perfected security interest in the diamond engagement
ring, and the security interest attached to the proceeds realized from the sale of the goods by the trustee in
bankruptcy.
C A S E Q U E S T I O N S
1. Why didn’t the jewelry store, Rike-Kumler, file a financing statement to
protect its security interest in the ring?
2. How did the bankruptcy trustee get the ring?
3. What argument did the trustee make as to why he should be able to take the
ring as an asset belonging to the estate of the debtor? What did the court
determine on this issue?
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Repossession and Breach of the Peace Pantoja-Cahue v. Ford Motor Credit Co.
872 N.E.2d 1039 (Ill. App. 2007)
Plaintiff Mario Pantoja-Cahue filed a six-count complaint seeking damages from defendant Ford Motor
Credit Company for Ford’s alleged breach of the peace and “illegal activities” in repossessing plaintiff’s
automobile from his locked garage.…
In August 2000, plaintiff purchased a 2000 Ford Explorer from auto dealer Webb Ford. Plaintiff, a native
Spanish speaker, negotiated the purchase with a Spanish-speaking salesperson at Webb. Plaintiff signed
what he thought was a contract for the purchase and financing of the vehicle, with monthly installment
payments to be made to Ford. The contract was in English. Some years later, plaintiff discovered the
contract was actually a lease, not a purchase agreement. Plaintiff brought suit against Ford and Webb on
August 22, 2003, alleging fraud. Ford brought a replevin action against plaintiff asserting plaintiff was in
default on his obligations under the lease. In the late night/early morning hours of March 11–12, 2004,
repossession agents [from Doe Repossession Services] entered plaintiff’s locked garage and removed the
car…
Plaintiff sought damages for Ford and Doe’s “unlawful activities surrounding the wrongful repossession of
Plaintiff’s vehicle.” He alleged Ford and Doe’s breaking into plaintiff’s locked garage to effectuate the
repossession and Ford’s repossession of the vehicle knowing that title to the car was the subject of
ongoing litigation variously violated section 2A-525(3) of the [Uniform Commercial] Code (count I against
Ford), the [federal] Fair Debt Collection Practices Act (count II against Doe),…Ford’s contract with
plaintiff (count V against Ford) and section 2A-108 of the Code (count VI against Ford and Doe).…
Uniform Commercial Code Section 2A-525(3)
In count I, plaintiff alleged “a breach of the peace occurred as [Ford]’s repossession agent broke into
Plaintiff’s locked garage in order to take the vehicle” and Ford’s agent “repossessed the subject vehicle by,
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among other things, breaking into Plaintiff’s locked garage and causing substantial damage to Plaintiff’s
personal property in violation of [section 2A-525(3)]”:
“After a default by the lessee under the lease contract * * * or, if agreed, after other default by the lessee,
the lessor has the right to take possession of the goods. * * *
The lessor may proceed under subsection (2) without judicial process if it can be done without breach of
the peace or the lessor may proceed by action.” [emphasis added.]
[U]pon a lessee’s default, a lessor has the right to repossess the leased goods in one of two ways: by using
the judicial process or, if repossession could be accomplished without a breach of the peace, by self-help
[UCC Section 2A-525(3)]. “If a breach of the peace is likely, a properly instituted civil action is the
appropriate remedy.” [Citation] (interpreting the term “breach of the peace” in the context of section 9-
503 of the Code, which provides for the same self-help repossession as section 2A-525 but for secured
creditors rather than lessors).
Taking plaintiff’s well-pleaded allegations as true, Ford resorted to self-help, by employing an agent to
repossess the car and Ford’s agent broke into plaintiff’s locked garage to effectuate the repossession.
Although plaintiff’s count I allegations are minimal, they are sufficient to plead a cause of action for a
violation of section 2A-525(3) if breaking into a garage to repossess a car is, as plaintiff alleged, a breach
of the peace. Accordingly, the question here is whether breaking into a locked garage to effectuate a
repossession is a breach of the peace in violation of section 2A-525(3).
There are no Illinois cases analyzing the meaning of the term “breach of the peace” as used in the lessor
repossession context in section 2A-525(3). However, there are a few Illinois cases analyzing the term as
used in section 9-503 of the Code, which contains a similar provision providing that a secured creditor
may, upon default by a debtor, repossess its collateral either “(1) pursuant to judicial process; or (2)
without judicial process, if it proceeds without breach of the peace.” The seminal case, and the only one of
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any use in resolving the issue, isChrysler Credit Corp. v. Koontz, 277 Ill.App.3d 1078, 214 Ill.Dec. 726, 661
N.E.2d 1171 (1996).
In Koontz, Chrysler, the defendant creditor, sent repossession agents to repossess the plaintiff’s car after
the plaintiff defaulted on his payments. The car was parked in the plaintiff’s front yard. The plaintiff heard
the repossession in progress and ran outside in his underwear shouting “Don’t take it” to the agents. The
agents did not respond and proceeded to take the car. The plaintiff argued the repossession breached the
peace and he was entitled to the statutory remedy for violation of section 9-503, denial of a deficiency
judgment to the secured party, Chrysler.…
After a thorough analysis of the term “breach of the peace,” the court concluded the term “connotes
conduct which incites or is likely to incite immediate public turbulence, or which leads to or is likely to
lead to an immediate loss of public order and tranquility. Violent conduct is not a necessary element. The
probability of violence at the time of or immediately prior to the repossession is
sufficient.”…[The Koontzcourt] held the circumstances of the repossession did not amount to a breach the
peace.
The court then considered the plaintiff’s argument that Chrysler breached the peace by repossessing the
car under circumstances constituting criminal trespass to property. Looking to cases in other
jurisdictions, the court determined that, “in general, a mere trespass, standing alone, does not
automatically constitute a breach of the peace.” [Citation] (taking possession of car from private driveway
does not, without more, constitute breach of the peace), [Citation] (no breach of the peace occurred where
car repossessed from debtor’s driveway without entering “any gates, doors, or other barricades to reach”
car), [Citation] (no breach of the peace occurred where car was parked partially under carport and
undisputed that no door, “not even one to a garage,” on the debtor’s premises was opened, much less
broken, to repossess the car), [Citation] (although secured party may not break into or enter homes or
buildings or enclosed spaces to effectuate a repossession, repossession of vehicle from parking lot of
debtor’s apartment building was not breach of the peace), [Citation] (repossession of car from debtor’s
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driveway without entering any gates, doors or other barricades was accomplished without breach of the
peace).…
Although the evidence showed the plaintiff notified Chrysler prior to the repossession that it was not
permitted onto his property, the court held Chrysler’s entry onto the property to take the car did not
constitute a breach of the peace because there was no evidence Chrysler entered through a barricade or
did anything other than drive the car away. [Citation] “Chrysler enjoyed a limited privilege to enter [the
plaintiff’s] property for the sole and exclusive purpose of effectuating the repossession. So long as the
entry was limited in purpose (repossession), and so long as no gates, barricades, doors, enclosures,
buildings, or chains were breached or cut, no breach of the peace occurred by virtue of the entry onto his
property.”
…[W]e come to essentially the same conclusion: where a repossession is effectuated by an actual breaking
into the lessee/debtor’s premises or breaching or cutting of chains, gates, barricades, doors or other
barriers designed to exclude trespassers, the likelihood that a breach of the peace occurred is high.
Davenport v. Chrysler Credit Corp., [Citation] (Tenn.App.1991), a case analyzing Tennessee’s version of
section 9-503 is particularly helpful, holding that “‘[a] breach of the peace is almost certain to be found if
the repossession is accompanied by the unauthorized entry into a closed or locked garage.’”…This is so
because “public policy favors peaceful, non-trespassory repossessions when the secured party has a free
right of entry” and “forced entries onto the debtor’s property or into the debtor’s premises are viewed as
seriously detrimental to the ordinary conduct of human affairs.” Davenport held that the creditor’s
repossession of a car by entering a closed garage and cutting a chain that would have prevented it from
removing the car amounted to a breach of the peace, “[d]espite the absence of violence or physical
confrontation” (because the debtor was not at home when the repossession
occurred). Davenport recognized that the secured creditors’ legitimate interest in obtaining possession of
collateral without having to resort to expensive and cumbersome judicial procedures must be balanced
against the debtors’ legitimate interest in being free from unwarranted invasions of their property and
privacy interests.
Saylor URL: http://www.saylor.org/books Saylor.org 930
“Repossession is a harsh procedure and is, essentially, a delegation of the State’s exclusive prerogative to
resolve disputes. Accordingly, the statutes governing the repossession of collateral should be construed in
a way that prevents abuse and discourages illegal conduct which might otherwise go unchallenged
because of the debtor’s lack of knowledge of legally proper repossession techniques” [Citation].
We agree with [this] analysis of the term “breach of the peace” in the context of repossession and hold,
with regard to section 2A-525(3) of the Code, that breaking into a locked garage to effectuate a
repossession may constitute a breach of the peace.
Here, plaintiff alleges more than simply a trespass. He alleges Ford, through Doe, broke into his garage to
repossess the car. Given our determination that breaking into a locked garage to repossess a car may
constitute a breach of the peace, plaintiff’s allegation is sufficient to state a cause of action under section
2A-525(3) of the Code. The court erred in dismissing count I of plaintiff’s second amended complaint and
we remand for further proceedings.
Uniform Commercial Code Section 2A-108
In count VI, plaintiff alleged the lease agreement was unconscionable because it was formed in violation
of [the Illinois Consumer Fraud Statute, requiring that the customer verify that the negotiations were
conducted in the consumer’s native language and that the document was translated so the customer
understood it.]…Plaintiff does not quote [this] or explain how the agreement violates [it]. Instead, he
quotes UCC section 2A-108 of the Code, as follows:
“With respect to a consumer lease, if the court as a matter of law finds that a lease contract or any clause
of a lease contract has been induced by unconscionable conduct or that unconscionable conduct has
occurred in the collection of a claim arising from a lease contract, the court may grant appropriate relief.
Before making a finding of unconscionability under subsection (1) or (2), the court, on its own motion or
that of a party, shall afford the parties a reasonable opportunity to present evidence as to the setting,
purpose, and effect of the lease contract or clause thereof, or of the conduct.”
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He then, in “violation one” under count VI, alleges the lease was made in violation of [the Illinois
Consumer Fraud Statute] because it was negotiated in Spanish but he was only given a copy of the
contract in English; he could not read the contract and, as a result, Webb Ford was able to trick him into
signing a lease, rather than a purchase agreement; such contract was induced by unconscionable conduct;
and, because it was illegal, the contract was unenforceable.
This allegation is insufficient to state a cause of action against Ford under section 2A-108.…First, Ford is
an entirely different entity than Webb Ford and plaintiff does not assert otherwise. Nor does plaintiff
assert that Webb Ford was acting as Ford’s agent in inducing plaintiff to sign the lease. Plaintiff asserts no
basis on which Ford can be found liable for something Webb Ford did. Second, there is no allegation as to
how the contract violates [the statute], merely the legal conclusion that it does, as well as the unsupported
legal conclusion that a violation of [it] is necessarily unconscionable.…[Further discussion omitted.]
For the reasons stated above, we affirm the trial court’s dismissal of counts IV, V and VI of plaintiff’s
second amended complaint. We reverse the court’s dismissal of count I and remand for further
proceedings. Affirmed in part and reversed in part; cause remanded.
C A S E Q U E S T I O N S
1. Under what circumstances, if any, would breaking into a locked garage to
repossess a car not be considered a breach of the peace?
2. The court did not decide that a breach of the peace had occurred. What would
determine that such a breach had occurred?
3. Why did the court dismiss the plaintiff’s claim (under UCC Article 2A) that it
was unconscionable of Ford to trick him into signing a lease when he thought
he was signing a purchase contract? Would that section of Article 2A make
breaking into his garage unconscionable?
4. What alternatives had Ford besides taking the car from the plaintiff’s locked
garage?
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5. If it was determined on remand that a breach of the peace had occurred, what
happens to Ford?
Defenses of the Principal Debtor as against Reimbursement to Surety Fidelity and Deposit Co. of Maryland v. Douglas Asphalt Co.
338 Fed.Appx. 886, 11th Cir. Ct. (2009)
Per Curium: [1]
The Georgia Department of Transportation (“GDOT”) contracted with Douglas Asphalt Company to
perform work on an interstate highway. After Douglas Asphalt allegedly failed to pay its suppliers and
subcontractors and failed to perform under the contract, GDOT defaulted and terminated Douglas
Asphalt. Fidelity and Deposit Company of Maryland and Zurich American Insurance Company had
executed payment and performance bonds in connection with Douglas Asphalt’s work on the interstate,
and after Douglas Asphalt’s default, Fidelity and Zurich spent $15,424,798 remedying the default.
Fidelity and Zurich, seeking to recover their losses related to their remedy of the default, brought this suit
against Douglas Asphalt, Joel Spivey, and Ronnie Spivey. The Spiveys and Douglas Asphalt had executed
a General Indemnity Agreement in favor of Fidelity and Zurich. [2]
After a bench trial, the district court entered judgment in favor of Fidelity and Zurich for $16,524,798.
Douglas Asphalt and the Spiveys now appeal.
Douglas Asphalt and the Spiveys argue that the district court erred in entering judgment in favor of
Fidelity and Zurich because Fidelity and Zurich acted in bad faith in three ways.
First, Douglas Asphalt and the Spiveys argue that the district court erred in not finding that Fidelity and
Zurich acted in bad faith because they claimed excessive costs to remedy the default. Specifically, Douglas
Asphalt and the Spiveys argue that they introduced evidence that the interstate project was 98% complete,
and that only approximately $3.6 million was needed to remedy any default. But, the district court found
Saylor URL: http://www.saylor.org/books Saylor.org 933
that the interstate project was only 90%–92% complete and that approximately $2 million needed to be
spent to correct defective work already done by Douglas Asphalt. Douglas Asphalt and the Spiveys have
not shown that the district court’s finding was clearly erroneous, and accordingly, their argument that
Fidelity and Zurich showed bad faith in claiming that the project was only 90% complete and therefore
required over $15 million to remedy the default fails.
Second, Douglas Asphalt and the Spiveys argue that Fidelity and Zurich acted in bad faith by failing to
contest the default. However, the district court concluded that the indemnity agreement required Douglas
Asphalt and the Spiveys to request a contest of the default, and to post collateral security to pay any
judgment rendered in the course of contesting the default. The court’s finding that Douglas Asphalt and
the Spiveys made no such request and posted no collateral security was not clearly erroneous, and the
sureties had no independent duty to investigate a default. Accordingly, Fidelity and Zurich’s failure to
contest the default does not show bad faith.
Finally, Douglas Asphalt and the Spiveys argue that Fidelity and Zurich’s refusal to permit them to remain
involved with the interstate project, either as a contractor or consultant, was evidence of bad faith. Yet,
Douglas Asphalt and the Spiveys did not direct the district court or this court to any case law that holds
that the refusal to permit a defaulting contractor to continue working on a project is bad faith. As the
district court concluded, Fidelity and Zurich had a contractual right to take possession of all the work
under the contract and arrange for its completion. Fidelity and Zurich exercised that contractual right,
and, as the district court noted, the exercise of a contractual right is not evidence of bad faith.
Finding no error, we affirm the judgment of the district court.
Saylor URL: http://www.saylor.org/books Saylor.org 934
C A S E Q U E S T I O N S
1. Why were Douglas Asphalt and the Spiveys supposed to pay the sureties
nearly $15.5 million?
2. What did the plaintiffs claim the defendant sureties did wrong as relates to
how much money they spent to cure the default?
3. What is a “contest of the default”?
4. Why would the sureties probably not want the principal involved in the
project?
[1] Latin for “by the court.” A decision of an appeals court as a whole in which no judge is
identified as the specific author.
[2] They promised to reimburse the surety for its expenses and hold it harmless for further
liability.
Saylor URL: http://www.saylor.org/books Saylor.org 935
19.6 Summary and Exercises
Summary The law governing security interests in personal property is Article 9 of the UCC, which defines a security
interest as an interest in personal property or fixtures that secures payment or performance of an
obligation. Article 9 lumps together all the former types of security devices, including the pledge, chattel
mortgage, and conditional sale.
Five types of tangible property may serve as collateral: (1) consumer goods, (2) equipment, (3) farm
products, (4) inventory, and (5) fixtures. Five types of intangibles may serve as collateral: (1) accounts, (2)
general intangibles (e.g., patents), (3) documents of title, (4) chattel paper, and (5) instruments. Article 9
expressly permits the debtor to give a security interest in after-acquired collateral.
To create an enforceable security interest, the lender and borrower must enter into an agreement
establishing the interest, and the lender must follow steps to ensure that the security interest first attaches
and then is perfected. There are three general requirements for attachment: (1) there must be an
authenticated agreement (or the collateral must physically be in the lender’s possession), (2) the lender
must have given value, and (3) the debtor must have some rights in the collateral. Once the interest
attaches, the lender has rights in the collateral superior to those of unsecured creditors. But others may
defeat his interest unless he perfects the security interest. The three common ways of doing so are (1)
filing a financing statement, (2) pledging collateral, and (3) taking a purchase-money security interest
(PMSI) in consumer goods.
A financing statement is a simple notice, showing the parties’ names and addresses, the signature of the
debtor, and an adequate description of the collateral. The financing statement, effective for five years,
must be filed in a public office; the location of the office varies among the states.
Security interests in instruments and negotiable documents can be perfected only by the secured party’s
taking possession, with twenty-one-day grace periods applicable under certain circumstances. Goods may
Saylor URL: http://www.saylor.org/books Saylor.org 936
also be secured through pledging, which is often done through field warehousing. If a seller of consumer
goods takes a PMSI in the goods sold, then perfection is automatic and no filing is required, although the
lender may file and probably should, to avoid losing seniority to a bona fide purchaser of consumer goods
without knowledge of the security interest, if the goods are used for personal, family, or household
purposes.
The general priority rule is “first in time, first in right.” Priority dates from the earlier of two events: (1)
filing a financing statement covering the collateral or (2) other perfection of the security interest. Several
exceptions to this rule arise when creditors take a PMSI, among them, when a buyer in the ordinary
course of business takes free of a security interest created by the seller.
On default, a creditor may repossess the collateral. For the most part, self-help private repossession
continues to be lawful but risky. After repossession, the lender may sell the collateral or accept it in
satisfaction of the debt. Any excess in the selling price above the debt amount must go to the debtor.
Suretyship is a legal relationship that is created when one person contracts to be responsible for the
proper fulfillment of another’s obligation, in case the latter (the principal debtor) fails to fulfill it. The
surety may avail itself of the principal’s contract defenses, but under various circumstances, defenses may
be available to the one that are not available to the other. One general defense often raised by sureties is
alteration of the contract. If the surety is required to perform, it has rights for reimbursement against the
principal, including interest and legal fees; and if there is more than one surety, each standing for part of
the obligation, one who pays a disproportionate part may seek contribution from the others.
Saylor URL: http://www.saylor.org/books Saylor.org 937
E X E R C I S E S
1. Kathy Knittle borrowed $20,000 from Bank to buy inventory to sell in her knit shop
and signed a security agreement listing as collateral the entire present and future
inventory in the shop, including proceeds from the sale of inventory. Bank filed no
financing statement. A month later, Knittle borrowed $5,000 from Creditor, who
was aware of Bank’s security interest. Knittle then declared bankruptcy. Who has
priority, Bank or Creditor?
2. Assume the same facts as in Exercise 1, except Creditor—again, aware of Bank’s
security interest—filed a financing statement to perfect its interest. Who has
priority, Bank or Creditor?
3. Harold and Wilma are married. First Bank has a mortgage on their house, and it
covers after-acquired property. Because Harold has a new job requiring travel to
neighboring cities, they purchase a second car for Wilma’s normal household use,
financed by Second Bank. They sign a security agreement; Second Bank files
nothing. If they were to default on their house payments, First Bank could
repossess the house; could it repossess the car, too?
4.
a. Kathy Knittle borrowed $20,000 from Bank to buy inventory to sell
in her knit shop and signed a security agreement listing her
collateral—present and future—as security for the loan. Carlene
Customer bought yarn and a tabletop loom from Knittle. Shortly
thereafter, Knittle declared bankruptcy. Can Bank get the loom
from Customer?
b. Assume that the facts are similar to those in Exercise 4a, except
that the loom that Knittle sold had been purchased from Larry
Loomaker, who had himself given a secured interest in it (and the
other looms he manufactured) from Fine Lumber Company (FLC) to
finance the purchase of the lumber to make the looms. Customer
bought the loom from Knittle (unaware of Loomaker’s situation);
Saylor URL: http://www.saylor.org/books Saylor.org 938
Loomaker failed to pay FLC. Why can FLC repossess the loom from
Customer?
c. What recourse does Customer have now?
Creditor loaned Debtor $30,000 with the provision that the loan was callable
by Creditor with sixty days’ notice to Debtor. Debtor, having been called for
repayment, asked for a ninety-day extension, which Creditor assented to, provided
that Debtor would put up a surety to secure repayment. Surety agreed to serve as
surety. When Debtor defaulted, Creditor turned to Surety for payment. Surety
asserted that Creditor had given no consideration for Surety’s promise, and
therefore Surety was not bound. Is Surety correct?
a. Mrs. Ace said to University Bookstore: “Sell the books to my
daughter. I’ll pay for them.” When University Bookstore presented
Mrs. Ace a statement for $900, she refused to pay, denying she’d
ever promised to do so, and she raised the statute of frauds as a
defense. Is this a good defense?
b. Defendant ran a stop sign and crashed into Plaintiff’s car, causing
$8,000 damage. Plaintiff’s attorney orally negotiated with
Defendant’s insurance company, Goodhands Insurance, to settle
the case. Subsequently, Goodhands denied liability and refused to
pay, and it raised the statute of frauds as a defense, asserting that
any promise by it to pay for its insured’s negligence would have to
be in writing to be enforceable under the statute’s suretyship
clause. Is Goodhands’s defense valid?
a. First Bank has a security interest in equipment owned by Kathy
Knittle in her Knit Shop. If Kathy defaults on her loan and First Bank
lawfully repossesses, what are the bank’s options? Explain.
Saylor URL: http://www.saylor.org/books Saylor.org 939
b. Suppose, instead, that First Bank had a security interest in Kathy’s
home knitting machine, worth $10,000. She paid $6,200 on the
machine and then defaulted. Now what are the bank’s options?
S E L F - T E S T Q U E S T I O N S
1. Creditors may obtain security
a. by agreement with the debtor
b. through operation of law
c. through both of the above
d. through neither of the above
Under UCC Article 9, when the debtor has pledged collateral to the
creditor, what other condition is required for attachment of the security
interest?
a. A written security agreement must be authenticated by the
debtor.
b. There must be a financing statement filed by or for the creditor.
c. The secured party received consideration.
d. The debtor must have rights in the collateral.
To perfect a security interest, one may
a. file a financing statement
b. pledge collateral
c. take a purchase-money security interest in consumer goods
d. do any of the above
Saylor URL: http://www.saylor.org/books Saylor.org 940
Perfection benefits the secured party by
a. keeping the collateral out of the debtor’s reach
b. preventing another creditor from getting a secured interest in the
collateral
c. obviating the need to file a financing statement
d. establishing who gets priority if the debtor defaults
Creditor filed a security interest in inventory on June 1, 2012. Creditor’s
interest takes priority over which of the following?
a. a purchaser in the ordinary course of business who bought on
June 5
b. mechanic’s lien filed on May 10
c. purchase-money security interest in after-acquired property who
filed on May 15
d. judgment lien creditor who filed the judgment on June 10 S E L F - T E S T A N S W E R S
1. c
2. d
3. d
4. d
5. d
Saylor URL: http://www.saylor.org/books Saylor.org 941
19.7 Summary and Exercises
Summary The law governing security interests in personal property is Article 9 of the UCC, which
defines a security interest as an interest in personal property or fixtures which secures
payment or performance of an obligation. Article 9 lumps together all the former types
of security devices, including the pledge, chattel mortgage, and conditional sale.
Five types of tangible property may serve as collateral: (1) consumer goods, (2)
equipment, (3) farm products, (4) inventory, and (5) fixtures. Five types of intangibles
may serve as collateral: (1) accounts, (2) general intangibles (for example, patents), (3)
documents of title, (4) chattel paper, and (5) instruments. Article 9 expressly permits
the debtor to give a security interest in after-acquired collateral.
To create an enforceable security interest, the lender and borrower must enter into an
agreement establishing the interest, and the lender must follow steps to ensure that the
security interest first attaches and then is perfected. There are three general
requirements for attachment: (1) there must be an authenticated agreement (or the
collateral must physically be in the lender’s possession), (2) the lender must have given
value, and (3) the debtor must have some rights in the collateral. Once the interest
attaches, the lender has rights in the collateral superior to those of unsecured creditors.
But others may defeat his interest unless he perfects the security interest. The three
common ways of doing so are (1) filing a financing statement, (2) pledging collateral,
and (3) taking a purchase money security interest (PMSI) in consumer goods.
A financing statement is a simple notice, showing the parties’ names and addresses, the
signature of the debtor, and an adequate description of the collateral. The financing
statement, effective for five years, must be filed in a public office; the location of the
office varies among the states.
Saylor URL: http://www.saylor.org/books Saylor.org 942
Security interests in instruments and negotiable documents can be perfected only by the
secured party’s raking possession, with twenty-one-day grace periods applicable under
certain circumstances. Goods may also be secured through pledging, which is often done
through field warehousing. If a seller of consumer goods takes a purchase money
security interest in the goods sold, then perfection is automatic and no filing is required,
although the lender may file and probably should to avoid losing seniority to a bona fide
purchaser of consumer goods without knowledge of the security interest, if the goods are
used for personal, family, or household purposes.
The general priority rule is “first in time, first in right.” Priority dates from the earlier of
two events: (1) filing a financing statement covering the collateral, or (2) other
perfection of the security interest. Several exceptions to this rule arise when creditors
take a purchase money security interest, among them: a buyer in the ordinary course of
business takes free of a security interest created by the seller.
On default, a creditor may repossess the collateral. For the most part, self-help private
repossession continues to be lawful but risky. After repossession, the lender may sell the
collateral or accept it in satisfaction of the debt. Any excess in the selling price above the
debt amount must go to the debtor.
Suretyship is a legal relationship that is created when one person contracts to be
responsible for the proper fulfillment of another’s obligation, in case the latter (the
principal debtor) fails to fulfill it. The surety may avail itself of the principal’s contract
defenses, but under various circumstances, defenses may be available to the one that are
not available to the other. One general defense often raised by sureties is alteration of
the contract. If the surety is required to perform, it has rights for reimbursement against
the principal, including interest and legal fees, and if there is more than one surety, each
standing for part of the obligation, one who pays a disproportionate part may seek
contribution from the others.
Saylor URL: http://www.saylor.org/books Saylor.org 943
E X E R C I S E S
1. Creditors may obtain security:
a. by agreement with the debtor
b. through operation of law
c. through both of these
d. through neither of the above
Under UCC Article 9, when the debtor has pledged collateral to the
creditor, what other condition is required for attachment of the security
interest?
a. A written security agreement must be authenticated by the
debtor.
b. There must be a financing statement filed by or for the creditor.
c. The secured party received consideration.
d. The debtor must have rights in the collateral.
To perfect a security interest, one may:
a. file a financing statement
b. pledge collateral
c. take a purchase money security interest in consumer goods
d. do any of the above
Perfection benefits the secured party by:
a. keeping the collateral out of the debtor’s reach
b. preventing another creditor from getting a secured interest in the
collateral
c. obviating the need to file a financing statement
d. establishing who gets priority if the debtor defaults
Saylor URL: http://www.saylor.org/books Saylor.org 944
Creditor filed a security interest in inventory on June 1, 2012. Creditor’s
interest takes priority over which of the following?
a. A purchaser in the ordinary course of business who bought on June
5
b. Mechanic’s lien filed on May 10
c. Purchase-money security interest in after-acquired property who
filed May 15
d. Judgment lien creditor who filed the judgment on June 10
Kathy Knittle borrowed $20,000 from Bank to buy inventory to sell in her knit
shop and signed a security agreement listing as collateral the entire present and
future inventory in the shop, including proceeds from the sale of inventory. Bank
filed no financing statement. A month later Knittle borrowed $5000 from Creditor,
who was aware of Bank’s security interest. Knittle then declared bankruptcy. Who
has priority, Bank or Creditor?
Same facts as above, except Creditor—again aware of Bank’s security
interest—filed a financing statement to perfect its interest. Who has priority, Bank
or Creditor?
Harold and Wilma are married. First Bank has a mortgage on their house and
it covers after-acquired property. Because Harold has a new job requiring travel to
neighboring cities, they purchase a second car for Wilma’s normal household use,
financed by Second Bank. They sign a security agreement; Second Bank files
nothing. If they were to default on their house payments, First Bank could
repossess the house: could it repossess the car, too?
a. Kathy Knittle borrowed $20,000 from Bank to buy inventory to sell
in her knit shop and signed a security agreement listing her
Saylor URL: http://www.saylor.org/books Saylor.org 945
collateral—present and future—as security for the loan. Carlene
Customer bought yarn and a tabletop loom from Knittle. Shortly
thereafter Knittle declared bankruptcy. Can Bank get the loom
from Customer?
b. Similar to facts as above, except the loom that Knittle sold had
been purchased from Larry Loomaker, who had himself given a
secured interest in it (and the other looms he manufactured) from
Fine Lumber Company (FLC) to finance the purchase of the lumber
to make the looms. Customer bought the loom from Knittle
(unaware of Loomaker’s situation); Loomaker failed to pay FLC.
Why can FLC repossess the loom from Customer?
c. What recourse does Customer have now?
Creditor loaned Debtor $30,000 with the provision that the loan was callable
by Creditor with sixty days’ notice to Debtor. Debtor, having been called for
repayment, asked for a ninety-day extension, which Creditor assented to, provided
Debtor would put up a surety to secure repayment; Surety agreed to serve as
surety. When Debtor defaulted, Creditor turned to Surety for payment. Surety
asserted that Creditor had given no consideration for Surety’s promise and
therefore Surety was not bound. Is Surety correct?
a. Mrs. Ace said to University Bookstore: “Sell the books to my
daughter. I’ll pay for them.” When Bookstore presented Mrs. Ace a
statement for $900, she refused to pay, denying she’d ever
promised to do so, and she raised the statute of frauds as a
defense. Is this a good defense?
b. Defendant ran a stop sign and crashed into Plaintiff’s car, causing
$8,000 damage. Plaintiff’s attorney orally negotiated with
Defendant’s insurance company, Goodhands Insurance, to settle
Saylor URL: http://www.saylor.org/books Saylor.org 946
the case. Subsequently, Goodhands denied liability and refused to
pay, and it raised the statute of frauds as a defense, asserting that
any promise by it to pay for its insured’s negligence would have to
be in writing to be enforceable under the statute’s suretyship
clause. Is Goodhand’s defense valid?
a. First Bank has a security interest in equipment owned by Kathy
Knittle in her Knit Shop. If Kathy defaults on her loan and First Bank
lawfully repossesses, what are the bank’s options? Explain.
b. Suppose instead First Bank had a security interest in Kathy’s home
knitting machine, worth $10,000. She paid $6,200 on the machine
and then defaulted. Now what are the bank’s options?
Answers 1. c
2. d
3. d
4. d
5. d
