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6 Credit Introduction to Credit and Secured Transactions P A R T Credit Introduction to Credit and Secured Transactions Security Interests in Personal Property Bankruptcy

Introduction to Credit and Secured Transactions 28 C H A P T E R Introduction to Credit and Secured Transactions Creditors have better memories than debtors. Benjamin Franklin Poor Richard’s Almanac (1758)

Learning Objectives Explain the difference between secured and unsecured credit Differentiate suretyship from guaranty Describe the various types of liens on real and personal property Compare methods for holding a security interest in real property

Secured vs. Unsecured Credit Most transactions are unsecured: a service was rendered or good sold and the consumer-debtor promises to pay for the service or good upon receiving a bill Maximum risk of loss to the creditor To minimize risk, a creditor may require the debtor to convey to the creditor a lien (security interest) on the debtor’s property Examples of unsecured credit: store charge accounts, medical services to be billed, repair services later billed, inventory shipped and invoiced for later billing, etc. Examples of secured credit: appliances sold on an installment plan, a mortgage for real property, a lien on restaurant equipment, a lien on agricultural products or machinery, etc.

If Consumer Fails to Pay In unsecured credit transactions, a creditor has recourse against a debtor’s default by sending notices to pay and eventually filing suit against the debtor for payment Result: collection effort begins In a secured credit transaction, creditor can go against the security (repossess) to collect debtor’s outstanding obligation The collection effort includes having a sheriff “execute” a judgment and/or (depending on state law) garnishing debtor’s wages – a very long process in and of itself.

Surety A surety is a person who is liable for the payment of another person’s debt or for the performance of another person’s duty The surety joins with the person primarily liable in promising to make the payment or to perform the duty The classic “co-sign” situation Generally on the same signature page A surety is primarily liable for the debtor’s obligation, and the creditor can demand performance from the surety at the time the debt is due rather than sue debtor for payment or performance on the duty

Guaranty A guaranty contract is like a suretyship, but a guarantor does not join the principal debtor in making a promise, but makes a separate promise to be liable only after principle debtor defaults and cannot pay A surety is primarily liable on the debt, but the guarantor is secondarily liable Typically, a separate guaranty document that must be in writing to satisfy the statute of frauds

Creditor’s Duties to Surety Creditor must disclose any material facts about the risk involved to the surety Failure to do so relieves the surety of liability See New Jersey Economic Development Authority v. Pavonia Restaurant, Inc. Court rejected claim by sureties that creditors violated their duty to the sureties since the creditors did not have any superior knowledge of material facts about risk The hyperlink is to the opinion on the Findlaw.com website. Note that the New Jersey Economic Development Authority v. Pavonia Restaurant, Inc. case may confuse students!!! The investors who secured the transaction signed under a separate agreement: “The guarantors executed a Personal Guaranty Agreement under which they each agreed individually to guarantee repayment of the loan to EDA and the Bank.” The court referred to the investors as guarantors. However, the discussion about how the NJEDA and bank pursued repayment equally from the restaurant company and the guarantor investors (and granted a forbearance), and later sued both the principle debtor and the guarantors jointly, indicates the investors actually were sureties, primarily liable in conjunction with the principle debtor restaurant rather than secondarily liable. Oddly, the court even quotes a statement from Section 124 from the Restatement of Security – Suretyship that discusses the duty to a surety. Just be aware that the distinction between a surety and a guaranty is a fine line and that a guaranty is almost more of a subset of the broader “surety” classification than a separate classification.

Surety’s Rights and Defenses If surety performs or pays obligation of principal, then surety acquires all rights creditor had against the principal and: Right of subrogation Right to reimbursement Right to contribution Right to exoneration Surety may use defenses to creditor’s demand that principle debtor would have Surety’s right of subrogation: right to collateral in creditor’s possession, judgment rights creditor had against principal, and creditor rights in bankruptcy proceedings Surety’s right to reimbursement: Surety may recover costs from the principal If one of two or more co-sureties performs or pays principal’s obligation, the surety who satisfied the obligation has a right to contribution from the co-sureties A surety or guarantor has a right to exoneration: principal debtor must make good on the commitment to creditor when s/he (1) is able to do so and (2) does not have a valid defense against payment A surety may use defenses to a creditor’s demand for payment that principle debtor would have under the primary contract: Breach of warranty, lack or failure of consideration, fraudulent inducement, and breach of contract by the creditor party Courts protect accommodation sureties (e.g., friend, parent) more than compensated sureties (e.g., bonding company)

Liens on Personal Property A lien is a security interest in personal property available to businesses and individuals by statute and common law Statutes often provide a procedure for foreclosing the lien (foreclosure) Two essential elements of possessory lien (e.g., artisan, innkeeper, common carrier): possession by improver/provider of services a debt created by the improvement to goods or provision of services concerning the goods Pronunciation of “lien” varies in the U.S. from “lēn” (like lean) to “lē-ən” (like Lee-en) In foreclosure, property owner’s rights are cut off so the lienholder can realize the security interest. A lien (secured interest) typically is associated with the purchase of appliances or expensive items of personal property.

Security for Real Property Three basic contract devices for using real estate as security for an obligation: (1) the real estate mortgage, (2) the deed of trust, and (3) the land contract. Also, state statutes give mechanics and materialmen a right to a lien on real property into which their labor or materials have been incorporated Mechanics: plumbers, carpenters, electricians, cabinetmakers, drywallers… Materialmen: lumberyards, flooring companies, landscape supply…

The Mortgage A mortgage is a security interest in (or deed to) real property given by the owner (mortgagor) as security for a debt owed to the creditor (mortgagee) A lien on land rather than conveyance of title Must be executed with the formality of a deed

Foreclosing The Mortgage Foreclosure: rights of the mortgagor or current property owner are cut off Regulated by state statutes using three methods: strict foreclosure, action and sale, power of sale A mortgagor or an assignee of mortgagor has an equity of redemption in the real estate within a specified redemption period and by full discharge of the mortgage debt Title to property restored free and clear Strict foreclosure. Creditor keeps property in satisfaction of debt, and owner’s rights cut off. Creditor has no right to a deficiency and debtor has no right to any surplus. Foreclosure by action and sale, is permitted in all states and the only method of foreclosure permitted in some states. Although state statutes not uniform, they are alike in their basic requirements: suit is brought in a court having jurisdiction, any party with a property interest that would be cut off by the foreclosure must be made a defendant, if any such party has a defense s/he must enter his appearance and set up the defense, after trial a judgment is entered and the property is sold, proceeds of sale are applied to payment of the mortgage debt, any surplus is paid to mortgagor and any deficiency is entered as a judgment against mortgagor and such other persons as are liable on the debt. Right to foreclose under a power of sale must be expressly conferred on the mortgagee by the terms of the mortgage. If the procedure for the exercise of the power is set out in the mortgage, that procedure must be followed. Several states have enacted statutes that set out the procedure to be followed in the exercise of a power of sale. No court action is required.

Deed of Trust A deed of trust is another mechanism for a security interest in real property Generally, treated like a mortgage Three parties to a deed of trust: property owner who borrows money (debtor), trustee who holds legal title to property put up as security, and lender and the beneficiary of the trust

Mechanic’s & Materialman’s Liens Two statutory systems permit one who furnishes labor or materials to improve real estate to claim a lien until they are paid Simple sale of goods does not entitle seller to a lien on real property A general contractor contracts with owner to build, remodel, or improve real property A subcontractor contracts with general contractor to perform a particular job New York system: subcontractors or materialmen cannot recover more than is owed to the contractor at the time they file a lien or give notice of lien to owner Pennsylvania system: subcontractors or materialmen have direct liens and are entitled to liens for the value of labor and materials furnished, irrespective of amount due from owner to contractor Statutes generally require filing of a notice of lien with a county official Most statutes grant priority to mechanic’s lien over all liens attaching after first work performed or first materials are furnished Priority: order of payment Mutual Savings Association v. Res/Com Properties, L.L.C., on page 734 of the text, illustrates a situation where subcontractors were able to obtain a preferred position through compliance with a state lien statute.

Thought Questions What are the advantages and disadvantages of credit? How does credit affect your life? Do you have any secured credit? Opportunity to discuss the impact of credit on society as well as individuals.