Secured Transactions and Bankruptcy Professor McKinsey OBE 118, Section 10, Fall 2004 In the real world, few goods are paid for in cash. Most are financed. How does a seller ensure that the buyer will pay? What can the seller do to protect herself if the buyer does not pay?

2 Notes and Instruments Notes and instruments explained how we allow debts and obligations to be easily transferred to parties Obligations to pay someone money or perform services can be a promise in a contract. Sometimes the when an obligation is solely about paying money, it is unconditioned, and it meets certain other requirements, we call it a note.

3 Negotiable Instruments A Note and other instruments such as checks, Certificates of Deposit can often be negotiable meaning they are easily transferred or sold for value. This week we study the world of notes, loans, collateralized loans, purchase agreements, security interests and the like. This is the real world of most personal property acquisition.

4 Security Interest A right another party has in property that allows them take the property and sell it to recover the amount of a debt or obligation Can be in Personal Property or in Fixtures: (We use a different system for Land) A security interest is acquired through a document called a “security agreement”

5 Security Agreements Buyer Seller Security Agreement, $$ Goods This exchange of a security agreement for goods creates a valid security interest in the goods. The goods are “secured property” The Seller is a “secured party” The buyer has less than full rights in the goods

6 Security Interest To have a security interest, the seller must –Obtain a security agreement –Give up value

7 Security Agreement Identification of the property Written* Signed by debtor (authenticated if electronic) Explanation of what the security interest is (description of the financial obligations) Usually the security agreement is a contract that will have a lot more information, promises, terms etc.

8 Oral Security Agreement? Security Agreements should be in writing A secured party can satisfy that requirement if they gain control or possession of the secured property –Control: for intangible things such as accounts. –Possession: for tangible things

9 Security Agreement for Future Property? Sure Can be for after-acquired property (Secured party loans money to debtor). Security interests automatically attach to the proceeds of a sale or disposition of the property.

10 Chattel Paper A special form of a security interest for personal property (chattel) Chattel Paper is the equivalent of a security agreement for a specific piece (or set) of property. Chattel Paper is fairly negotiable: it is often used for other transactions

11 Security Agreements Buyer Seller Security Agreement, $$ Goods This is a security interest in the goods because the seller gave up value Thursday, we examine how this security interest works with third parties

12 Security Interests Buyer Seller Security Agreement, $$ Goods Review: When the above occurs, the seller is said to have a security interest in the goods which are now called secured property.

13 Perfection To protect against claims by other parties, the seller must “perfect” its security interest. “First in time, first in right” is an old adage that often is accurate in the world of property rights. Keep this in mind. Usually, to perfect a claim, the secured party must file a financing statement.

14 Security Agreements Buyer Seller Security Agreement, $$ Goods

15 Perfection by Filing Financing Statement: –Name of debtor –Name of secured party –Identifies the collateral Filed with correct governmental office: –Often county office for most goods – Sometimes state office for special goods –Must look at specific state laws where resident lives or organization has executive office

16 Perfection by Possession It works. Morale? Always physically inspect property you are about use as collateral to loan you are going to make.

17 Security Agreements Buyer Seller Security Agreement, $$ Goods

18 Perfection: Consumer Goods Purchase Money Security Interests (PMSI’s) automatically perfect in consumer goods (no filing required) What does this mean? Morale? Never let consumer goods already held by the consumer be used for collateral when loaning money unless they can show they paid cash for it.

19 Perfected Security Interests Good against all the world (from that point on) except against a buyer who buys the goods from a seller who routinely deals in such goods and who created the security interest. Buyer in Ordinary Course of Business (BIOC)- normally means buying in good faith from a seller who routinely deals in such goods, but good faith drops out for this exception, the buyer can even know of the security interest. Morale? Don’t loan money on inventory either.

20 Perfected Security Interests A security interest allows you to take possession of the collateral from the buyer and dispose of it (except for the inventory exception). A perfected security interest allows you to ignore later claims by other parties and first pay your claims. A perfected security interest allows you to take possession from another, later “owner” of the goods.

21 Priority Book spells it out real well. Perfection trumps over non-perfection First in time…. Review: what causes a security interest to attach? Main answer: when the security agreement is signed and the secured party has given value

22 Bankruptcy Can terminate an otherwise legitimate collectible debt or owed obligation under a contract. Courts do this to allow individuals (people or artificial entities) to start over again by paying a limited price (but painful) to creditors according to a priority list. Different types bankruptcy have different effects

23 Types of Bankruptcy Liquidation (7) versus Reorganization (11 or 13) Voluntary versus Involuntary Individuals versus Business Entities

24 Special Rules Payments to creditors in last 90 days before BK are limited to what creditor would have gotten in BK. Fraudulent transfers in previous year are invalid. Six years required after Chapter 7 or 11 before Chapter 7 allowed. Debtor can reaffirm a debt that would have otherwise have been discharged. Creditors can seek reaffirmation (and should whenever possible)

25 Special Rules – Priority Secured Creditors have highest priority to extend of value of secured property Priority Creditors are paid next Unsecured Creditors get last feeding at the BK trough.

26 Special Rules – Debts not Discharged Student loans Alimony and child support debt Credit Card Cash Advances in last 60 days Fraudulent money acquisitions

27 Three BK Provisions Chapter 7 Chapter 11 Chapter 13

28 Chapter 7- Liquidation Petition –Involuntary - >$10k in unsecured claims, 3 of 12 or 1 of 11 creditors, and not paying debts that are due –Creditors stopped from collecting Debtor- Creditor Meeting Proofs of Claims by Creditors BK Estate Figured Out and Divided Up –Exempt property stays with debtor –The rest is paid out to creditors Secured property first to secured creditors Priority claims paid next Unsecured claims paid last. Debtor is Discharged

29 Chapter 11- Reorganization No Trustee because debtor keeps operating Creditors’ Committee (7 largest creditors) Reorganization plan –How debts will be paid and when, how business will operate –Majority of creditors in each class must vote for it or it must be a “cramdown” by court Discharge –Only some of the debt is discharged. –Some is paid by some of the existing assets –Most debts have new right to a stream of income that will cover remainder

30 Chapter 13- Consumer Reorganization Only consumers with certain debts maximums Only voluntary Consumer’s Payment Plan –Secured and Priority paid in full –Unsecured must do at least as well as under Chapter 7 Discharge –Debts are discharged per plan (only temporarily if debtor violates the plan)