Optimizing English and American security interests.

AuthorLoPucki, Lynn M.
PositionIntroduction through III. Fixed Charges Compared with Security Interests B. Encumbrance of Collateral, p. 1785-1823

INTRODUCTION

Security is a relationship between collateral and monetary obligations. The essence of the relationship is that if the obligations are not paid, the collateral may be sold and the sale proceeds applied to pay the obligations. The security concept is embodied in mortgages, security interests, and liens.

Security enjoys a highly privileged position in American law. A simple-sentence grant of a security interest, (1) combined with the filing of notice in an obscure set of public records, will give the secured creditor's claim priority over employees' wage claims, (2) child support obligations, (3) tax claims, (4) civil damage judgments, (5) criminal fines and forfeitures, (6) claims for unjust enrichment, (7) and just about any other kind of debt imaginable. (8)

Scholars have attempted to justify security on both contract and property theories. On the American side, Dean David Leebron best articulated the contract argument:

The priority claim of a secured creditor rests almost entirely on principles of contract and notice. A persuasive theory of secured credit financing has been elusive, but the priority of a secured creditor over other financial creditors can be justified on the grounds that non-secured creditors grant a loan knowing that some assets are subject to security interests or could be subjected to security interests without their permission. If particular creditors will not tolerate other creditors having security interests in the borrower's assets, they can refuse to make a loan or make it only if the borrower agrees not to subject its assets to any security interests. (9) Contract cannot, however, justify security because security agreements "[are] effective according to [their] terms ... against purchasers of the collateral, and against creditors." (10) That includes purchasers and creditors who did not consent to the security agreement, had no way of knowing of its existence, or never chose to become creditors at all. (11) Agreement is the essence of contract, but the affected purchasers and creditors have not agreed. As Professors Lynn LoPucki and Elizabeth Warren put it, "[s]ecurity is an agreement between A and B that C take nothing." (12)

Other scholars attempt to justify security on property theories. For example, Professors Stephen Harris and Charles Mooney argued:

It seems clear enough that security interests, under Article 9 and real estate law alike, are interests in property. The legal regime for security interests reflects property law functionally as well as doctrinally. We believe it follows that the law should honor the transfer or retention of security interests on the same normative grounds on which it respects the alienation of property generally. (13) The property theory begins from the generally accepted premise that a building owner can, by conveying the building in an otherwise unobjectionable transaction, cut off the rights of the debtor's creditors to the building. By analogy, the property theory holds that by conveying the first $100,000 of the value of the building in return for a $100,000 loan, the owner should be able to cut off the rights of the debtor's other creditors to the first $100,000 of the value of the building. Frequent American literature references to security interests as "property" (14) and English literature references to charges as "proprietary" (15) are invocations of this theory.

A necessary implication of the property conveyance theory is that encumbered property has multiple owners. The secured creditor owns the value of the collateral up to the full amount of the debt. The debtor owns the value of the collateral in excess of the amount of the debt, the right to redeem the property by paying the debt, (16) and the right to use the property in the interim.

The principal policy objections to security are that it is deceptive (17) (the "Deception Problem") and that it distorts incentives for the management of property (the "Incentives Problem"). The essence of the Deception Problem is that debtors who have granted security interests appear to have wealth, but do not. The effect is to deceive third parties who extend credit without knowledge of the pre-existing security. The problem is generally referred to as "ostensible ownership" in the United States (18) and as "false wealth" in England. (19)

The Incentives Problem is most egregious and easiest to see when the amount of the secured debt equals or exceeds the value of the collateral. Consider, for example, a business that operates with one billion dollars in assets encumbered by one billion dollars in secured debt. As the property's owner, the debtor has the right to control its use. The debtor can engage in business activities that risk inflicting billions of dollars in damages on third parties. (20) Those third parties have no remedy against the debtor, because the debtor owns no part of the value of its own assets. (21) They have no remedy against the secured party because the secured party--switching its metaphorical role from "owner" to "creditor"--has priority over them. (22) By shielding the debtor's property from the valid claims of third parties, security renders both "owners" judgment-proof (23) and encourages the irresponsible management of wealthy. (24)

Through a functional comparison of English and American security interests, this Article identifies potential practical solutions to the Deception and Incentives Problems. The proof that these solutions can potentially work in one country is that they appear already to be working, in similar circumstances, in the other.

The challenge was to distinguish these potential solutions from the hundreds of differences that exist in legal doctrines and concepts between English and American security interests. We accomplished that by conducting our comparison at the functional rather than the doctrinal level. Put simply, we focused on the resolutions of particular problems in the two systems. We treated the systems as the same if they reach the same resolutions--what LoPucki and Weyrauch have referred to as "delivered law"--regardless of the paths by which they arrived at them. (25) To the extent that terminology differed between the two systems, we posed the problems and resolutions in a neutral language, which we constructed as needed. This method is well-recognized in the field of comparative law. (26)

Functional comparison dramatically reduces the apparent level of difference between two legal systems. (27) The explanation for this previously recognized phenomenon is beyond the scope of this Article. In our comparison of English and American security interests, the effect was to demonstrate that the systems are operating almost identically.

The few functional differences that remain are each true policy alternatives. We know that each is likely capable of transplant to the other system, because each is already operating in an otherwise almost-identical system.

Of the seven functional differences we identify, the most important addresses the Incentives Problem. In the American system, security interests have priority over virtually all competitors. In the English system, a "carve-out" gives administrative expenses, preferential creditors, and an unsecured creditor "prescribed share" priority over security interests.

Three other differences address the Deception Problem. Both the English and American systems generate secret liens, but they do so in different ways and with respect to different collateral. The English system is company-based while the American system is name-based. The English system supplies more information, and to a wider audience. The three remaining differences are of only minor importance.

We do not claim to have shown that the devices identified solve the underlying problems, even in the countries in which they are currently in use. Our claim is that they are potential solutions because they are purported to have mitigated those problems.

We also make two other claims. First, our comparison is the most extensive point-by-point comparison of the English and American law governing secured transactions to date. (28) Second, the extraordinary level of similarity we observed at the functional level suggests that law-making is in most instances better described as a search for the only solution that will work, than as a process of choosing among alternative policy solutions.

Both the English and American security systems recognize a wide variety of security devices. (29) To render our subject manageable, we confine consideration in this Article to the principal forms of security granted by companies. In the American system, that is the Uniform Commercial Code Article 9 security interest with respect to personal property and the mortgage with respect to real property. In the English system, that is the fixed and floating charge, either of which can--in theory at least--extend to both real and personal property.

This Article proceeds in four parts. Part I compares the English and American systems with respect to attachment, perfection, and enforcement of security interests. Part II explains the distinction between fixed and floating charges under English law. Part III compares American security interests with English fixed charges by comparing the outcomes in prototypical cases. Part IV compares American floating liens with English floating charges in the same manner. The final Part concludes that the Americans should consider adopting the English Carve-out, the English should consider adopting the American cramdown, and both should consider improvements to their security interest registration systems.

  1. SYSTEMS COMPARED GENERALLY

    English fixed and floating charges are created, perfected, prioritized, and enforced in essentially the same manner as American security interests.

    1. Attachment

      In both the English and American systems, debtors and creditors create security interests by contract. In both, the...

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