Secured Claims

• Author: Gregory Germain
• Pages: 19-41

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Chapter 2: Secured Claims

2.1. Liens and Priority

In Chapter 1, we looked at the process for collecting unsecured claims and noted that

creditors have two basic options – (1) obtain voluntary payment from the debtor, or (2) use the

judicial process for obtaining and enforcing a judgment. The judicial process is slow and

expensive, and fraught with the risk that other creditors will win the race to the courthouse, and

thus render the judicial effort fruitless.

There are three kinds of liens. We have already looked at judicial liens obtained when a

judgment creditor causes a levy on the debtor’s property. In this chapter, we will look at two other

types of liens: (1) consensual liens, and (2) statutory liens.

We will also look at the priority between lienholders. Priority is the most important

question in the process for it determines the order in which lienholders get paid from the sale of

the property that is subject to the lien, which we call the “collateral.” Under the absolute priority

rule, creditors with higher priority get paid in full before creditors with lower priority get anything

from the proceeds of sale.

The first step is the process of creating a lien, known as attachment. Once the lien is

created, or attaches, it is enforceable between the debtor and the creditor, but it does not necessarily

protect the creditor from later creditors or buyers who also obtain liens against the collateral or

purchase the collateral.

The second step, known as perfection, is normally the process of giving constructive

notice of the existence of the lien to the world in the hope of preserving the lienholder’s priority

against later lien creditors or buyers. However, some liens are perfected without giving notice.

Given the number of exceptions to the general concept, it is difficult to define the concept of

perfection in a coherent way. Maybe the best way to think about perfection is as the point where

the lienholder has done all that the lienholder can do under the statute to obtain priority over later

creditors and buyers, but it does not necessarily determine that the lienholder will have priority

over later lienholders or buyers.

The final step, priority, is the conclusion about which secured creditors or lienholders gets

paid first out of the proceeds from the sale of the collateral. Priority is the key to getting paid out

of the collateral.

2.2. Attachment of Consensual Liens

Consensual liens are an alternative to unsecured credit. A consensual lienholder obtains a

property interest (a lien) in the debtor’s collateral to secure repayment of the debt.

It is always important to remember that a lien is a property interest, but it does not entitle

the lienholder to ownership of the property. The debtor retains the right to redeem the property

from the lien by paying the debt in full (until the debtor’s right of redemption is foreclosed).

Different documents are used to create consensual liens on real property and personal

property (everything other than real property).

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2.3. Attachment of Consensual Liens on Real Property.

Consensual liens on real property are created when the debtor transfers a lien in the

debtor’s property to the creditor by way of a written mortgage or deed of trust. In some states,

called “title states,” the instrument transfers legal title to the property to the creditor who holds

title to the property subject to an obligation to re-convey title to the debtor when the debt is paid.

In other states, called “lien states,” only a lien interest in the property rather than title to the

property is transferred by the debtor to the creditor, and the lien is terminated upon repayment. In

practice the distinction between title and lien states is one of form rather than substance, but will

affect the language used in the instrument of transfer (the mortgage or deed of trust).

A mortgage is a two party instrument under which the owner of the property transfers title

(subject to re-conveyance) or a lien (subject to termination) to the creditor as security for the loan

or other credit. A deed of trust is a three party instrument under which title or a lien is transferred

to a trustee to hold for the benefit of the creditor if the loan or other credit is not repaid. Once

again, in practice the dist inction between a mortgage and deed of trust is one of form rather than

substance and is not very important. It is important for a lawyer (or other party) documenting a

transaction to use a proper form for the jurisdiction in which the property is located.

2.4. Attachment of Consensual Liens on Personal Property

Consensual liens on personal property (everything other than real property) can be

created with a pledge or with a written security agreement. A pledge is a physical delivery of the

collateral to the creditor to hold until payment is made. A security agreement is a written document

by which the debtor (or owner of the property) conveys a lien, called a security interest, in the

property to the creditor.

Consensual liens on personal property are governed by Article 9 of the Uniform

Commercial Code (“UCC”), which has been enacted as law in every state (although some states

have non-standard provisions). Article 9 is one of the most uniform provisions of the UCC. It has

been enacted in every state with only minor variations between states. New York’s version of UCC

Article 9 is reprinted in Appendix G. For your convenience, the Article 9 code sections in this

book are linked – if you are reading an electronic copy of this book you may click on the links to

jump to the full code sections.

There are exceptions to the application of Article 9 for special kinds of property under state

or federal law, such as personal use automobiles that are registered with the motor vehicles

department, and aircraft that are registered in a special federal filing office in Oklahoma City. In

most states, a security interest in a personal use automobile must be noted on the vehicle’s official

title document to be perfected. However, vehicles held by a dealer in inventory for sale or rental

are generally governed by the Article 9.

A security interest (or lien) does not exist under Article 9 of the UCC until the requirements

for attachment of the lien have occurred. Attachment is a key concept under the UCC, and should

not be confused with the provisional remedy of prejudgment attachment in a law suit discussed

above.