978-0077733711 Chapter 28 Lecture Note

CHAPTER

28

INTRODUCTION TO CREDIT AND SECURED

TRANSACTIONS

I. OBJECTIVES:

The objective of this chapter is to provide some overview and historical perspective on

credit

transactions and then to survey three topics: common law liens, sureties and guarantors, and

.

secured real estate transactions. After reading the chapter and attending class, the student

should

be able

to:

I. Explain the difference between unsecured credit and secured

credit.

2. Recall the definition of a surety, relate how the principal and surety relationship is

created,

and explain the defenses that may be available to a surety as well as the duties that a

creditor

owes to a

surety.

3. Describe common law liens and how they are created, and recall the rights that they

provide

to artisans and others who hold such a

lien.

4. Compare and contrast mortgages, deeds

of trust,

and land contracts as mechanisms

for

holding a security interest in real property.

1

5. List the formalities necessary for the creation of a legally enforceable mortgage, and

explain

what is meant by foreclosure and right of

redemption.

6. Describe

mechanic’s

and

materialmen’s

liens, and explain how they are obtained and

what

rights they give the

lienholder.

II. ANSWER TO

INTRODUCTORY PROBLEM

A. The first question following the hypothetical at the beginning of the chapter asks what

legal

rights and obligations accompany the

“assumption”

of a mortgage. When the purchaser

of

real

property “assumes” a mortgage on the property, the purchaser becomes personally

liable

for the debt and for any deficiency on default and

foreclosure.

B. The second question asks whether the beneficiary of a surety agreement risks losing his

rights

against the surety if he grants the contractor additional time to complete the contract

without

obtaining the surety’s consent to that change. Generally, if the creditor simply allows

the

principal additional time to perform a contract without the surety’s consent, the surety is

not

relieved of responsibility; however, if there is a formal agreement to extend the time,

the

surety’s

consent is

required.

C. The third question asks whether subcontractors and/or companies who provide material to

a

prime contractor and are not paid for their work or material have a right to assert a lien

against the improved property until they are paid. Unless the state statute

specifically

includes sub-materialmen, they normally do not have the right to claim a lien if they are

not

paid.

D. The fourth question asks whether an artisan who repairs equipment can obtain a lien on

the

property until he/she is paid for their work. If the artisan retains the repaired property,

he/she

normally would be entitled to a possessory lien to secure the reasonable value of the

services

they

perform.

Chapter 28 – Introduction to Credit and Secured

Transactions

28-1

©

2016 by McGraw-Hill Education. This

is

proprietary material solely

for

authorized instructor use.

Not

authorized

for

sale

or

distribution in any

manner. This document may

not be

copied, scanned, duplicated, forwarded, distributed,

or

posted

on a

website,

in

whole

or

part.

E. The fifth question asks whether it would be ethical to declare a default in a land

contract

when there has been a very minor default and to reclaim possession with the purchaser

losing

all of the equity he might have built up in the property. Some might argue that the legal

right

to do so was bargained for and the seller has the legal right to do so – and is under no

ethical

obligation to refrain from acting in his own self-interest to maximizing his situation.

Others

might well take the position that one should act toward the buyer as one would like to

be

treated in that situation if the roles were

reversed-and

that the seller should act with

fairness

and equity in he is to be seen to have acted

ethically.

III. SUGGESTIONS FOR LECTURE

PREPARATION:

A.

Credit

1. Generally. Explain that often people and businesses buy merchandise on credit,

merely

promising to pay in the future. Some creditors are unwilling to undertake such a

risk

whe

n

the buyer takes or has possession of the merchandise. Security developed

to

encourage

reluctant sellers and lenders to make sales to credit purchasers and to

make loans

to

persons with poor credit ratings. Since the creditor’s risk is lowered by his

taking

security,

the interest rate he charges on the credit amount will be lower. Note,

therefore,

that

security has a positive effect on our economy, for

it

a. increases the volume of

sales,

b. increases the lending of money for productive uses,

and

c. reduces the cost of

credit.

2. Unsecured Credit. Develop the disadvantages of unsecured

credit.

3. Secured Credit. Point out that people may act as security for another’s debt or

that

property may be security. A surety or guarantor promises to pay the debt in addition

to

the

debtor. The creditor has security for he can collect from the surety or guarantor if

the

debtor fails to pay. A stereo or a house (personal or real property) may be the security

for

a loan or the extension of credit. If the debtor defaults the creditor may

obtain

satisfaction by seizing or selling the property. You might illustrate the operation of

a

credit transaction secured by property by using a string tied to a pencil or a Matchbox

car.

Give the car to a student indicating there has been a purchase. The string indicates

your

lien in the car. Then say, “If you don’t pay for the car, I will pull the string and take

back

the car.” You should then pull the string and retrieve the car. A security interest in

property is another example that property is a bundle of

rights.

4. Development of Security. Discuss the historical security devices. Briefly define

the

pledge, the conditional sale, and other pre-Code security devices. Note the

inadequacies

of

each device and the creditors’ attempts to create secret liens unfair to buyers and

other

creditors, which led to the modernization of the law of secured transactions (which

is

covered in Chapter

29).

B. Suretyship and

Guaranty

1. Sureties and Guarantors. Distinguish between a surety of a debt and a guarantor of a

debt

,

noting that a guaranty relation must be in writing to be enforceable. A good way to

explai

n

the difference is to describe the surety as standing beside the principal debtor, whereas

the

guarantor stands behind the principal debtor. A surety makes the same promise as

the

principal debtor. The surety is liable when the due date arrives without any need for

the

creditor to request payment from the principal debtor. A guarantor promises to pay if

the

principal debtor fails to

pay.

2. Creation of Relationship. Note that the relationship of principal and surety, or that

of

principal and guarantor, is created by

contract.

3. Defenses for a Surety. Explain that personal defenses of the principal debtor may not

be

asserted by the surety. Defenses that go to the merits of the transaction may be

asserted

by the surety. Explain the sensibility of this rule, because often the creditor requires

the

surety to become obligated due to the existence of the principal debtor’s

personal

defenses.

It

should be pointed out that the personal defenses in suretyship law are

roughly

comparable to real defenses in negotiable instrument law. Caution the students not to

be

confused by this dual definition of personal

defenses.

4. Explain why a compensated surety is not released from liability as easily as

an

uncompensated surety when the principal debtor and the creditor modify the

contract.

5. Creditor’s Duties to Surety. Note that a surety will be released from liability to the

extent

the creditor has impaired collateral with respect to which the surety has a right

of

subrogation, and that release of the principal debtor releases the

surety.

Columbia Realty Ventures v. Dang (page 781). This case illustrates the

differences

between a guarantor and a

surety-and

the practical import of those differences.

I

n

this

case where a souse was informed she had to sign a document as

guarantor-but

under

the

terms of the document was in fact a gratuitous surety, the court held that the

“Guaranty”

was unconscionable and unenforceable against the

wife.

Examples: Problem Cases #1 and

#2.

6. Subrogation and Contribution. Explain the concepts of the right to subrogation and

right

to contribution and how they

work.

Example: Problem case #3.

7. Ethics in Action: What is the Ethical Thing To Do? (page 785). A key question to ask

in

this situation is if you were in the shoes of the young woman what would you want

to

know. While it may not be incumbent on you to protect her, you might consider

whether

the preferable thing is to provide her with the information and then let her make a

more

informed decision. The question presents the dilemma of whether you should do

more

tha

n

you are legally required to do since you stand to benefit from another person’s

acting

on less information than you have and in circumstances where it’s clear you’re

not

prepare

d

to go forward in light of that

information.

C. Liens on Personal

Property

1. Common Law Liens. Categorize possessory liens on personal property as automatic

liens,

or liens created by operation of law. Note that there is no agreement to create a lien

between the debtor and the creditor. Instead one is created automatically once

the

element

s

of possession and debt have been met. The debtor, however, must agree to

the

creditor’s

improvement or provisions of services concerning the property. You

might

give several examples

of possessory liens:

a. A trucking company delivers bicycles

cross-country.

b. A repair shop repairs a

stereo.

c. A hotel safeguards in a safe a patron’s

jewels.

Additional Example for Discussion: Problem Case

#4.

2. Characteristics of Liens. Note that surrender of possession extinguishes the lien,

unless

the debtor recovered the goods wrongfully. For

example,

a. A car owner uses his second set of car keys to take his car from the parking lot at

the

mechanic’s garage, because the mechanic had earlier refused to allow the owner

to

take the car without paying the repair

bill.

b. A camera owner gives the camera repair shop a check knowing that he intends to

stop

payment on the check, although he has no legal grounds to refuse payment to

the

camera repair

shop.

Swift, Inc. v. Sheffey (page 786). Where an artisan was not able to establish

what

rep[air services had actually been authorized by the owner of a vehicle, the

artisan

was not entitled to an artisan’s lien for the value of the work performed and had

to

surrender the vehicle to the owner when he requested that it be returned to

him.

Points for discussion: What lessons should the artisan learn from this

case?

3. Foreclosure. Note that the creditor is not the owner of the goods and cannot become

the

owner of them. Foreclosure is required for the creditor to be able to satisfy his

claim

against the

goods.

D. Security Interests in Real

Property

1. Begin by explaining that a security interest in real property can arise by the agreement

of

the debtor and creditor (e.g., a mortgage) or it may arise by operating of law (e.g.,

a

mechanic’s lien). Security interests that arise by agreement include the mortgage, deed

of

trust, and the land contract. In these security interests the debtor and the credit

expressly

agree to create a security interest in the real

property.

2. Historical Development of Mortgages. Briefly review the historical evolution of

the

mortgage, and explain the right of redemption and foreclosure procedure. Explain

how

the mortgage is created and explain the mortgage in a common context, the

consumer

purchaser of a home. Usually the consumer purchaser (mortgagor) has title to

the

property. The mortgagee has a right to foreclose upon default. Examine the law of

your

state and discuss

it.

3. Form, Execution and Recording. The need for a writing should be stressed, and

the

importance of public recordation emphasized. Explain that the properly

recorded

mortgage binds the assignees of the

mortgages.

Rights and Liabilities. Note that the owner of property subject to a mortgage can sell

his

interest in the property without the consent of the mortgagee–but that this does not

affect

the mortgagee’s interest in the

property.

In this context discuss the meaning of a purchase “subject to a mortgage” and a

purchaser

who “assumes a

mortgage.”

Example: Problem Case #5. The court held that the purchasers of a home who

assumed

their seller’s obligation under a deed of trust were obligated to the assignees of the

deed

of trust although the purchasers had not signed the note evidencing the deed of trust.

The

court applied third party creditor beneficiary theory to make the purchasers liable to

the

original holder of the deed of trust. This problem case presents a good opportunity

to

explain the difference between a purchaser’s assuming another’s mortgage, deed of

trust,

or

land contract, and a purchaser’s taking property subject to these security

interests.

Note that the properly recorded security interest is enforceable against the property in

either situation. However, the purchaser is obligated to pay the debt only when the

debt

is assumed. Use of examples will clarify this

distinction:

a. Wayne buys on contract a house from Jennifer, and assumes her mortgage with

First

Bank. Wayne fails to pay First Bank on the mortgage. First Bank may

foreclose.

b.

Wayne buys a house from Jennifer. He takes it subject to Jennifer’s mortgage

with

First Bank. Jennifer fails to pay First Ban1c First

Ban1c

may foreclose.

Wayne,

while not a party to the mortgage, may prevent foreclosure by paying

Jennifer’s

obligation to First Ban1c.

5. Foreclosure. Explain the operation of the three common methods of

foreclosure–strict

foreclosure, action and sale, and power of sale. Indicate which methods are permitted

in

your

state.

Example: Problem Case

#5.

In Re foreclosure Cases (page 790). The court held that parties seeking to foreclose

an

interest in real property must be able to demonstrate a clear line of title showing that

they

are indeed the owner of the rights, title and interest in the

mortgage-and

that

their

interests must have been recorded in compliance with Ohio

law.

Points for Discussion: Use this case to discuss the problems inherent in securitization

of

mortgages that contributed to the recent collapse of the market for such

securities.

Example: Problem Case

#6.

6. Right of Redemption. You may wish to explore the trend in mortgage law

providing

greater protection for the mortgagor. The requirement of foreclosure and sale is one

such

procedural protection, as is the right of redemption. These procedures should

be

explaine

d

clearly.

7. Deed of Trust. Explain the relative interests/rights/roles of the three parties to a deed

of

trust. Note that many of the advantages initially envisioned for the deed of trust

device

have been lost as states treat the deed of trust like a

mortgage.

8. Land Contracts. Give special attention to the land contract, which is a major

financing

device. Note that the land contract historically was more nearly a rental device than

a

sale device. Hence as the land contract has become a more significant tool for

home

buyers, the law has moved away from allowing strict foreclosure in all circumstances

and

moved toward requiring foreclosure and sale. Under strict foreclosure upon default

the

seller was permitted to retain all past payments, to consider them as rent, and to

repossess

the property. Under foreclosure and sale upon default the seller is entitled to

receive

from the proceeds of the sale only the unpaid portion of the

debt.

Additional Example: Problem Case

#7.

9. Ethics in Action: What is the Right Thing to Do? (page 792): This problem raises

the

question of whether there are circumstances that should cause you to do less than

exercise

legal rights you have, and in particular whether you should consider the situation of

the

party with whom you are dealing. Do fairness and compassion enter in? Again, a

key

question may be to put yourself in the shoes of the other party and ask how you

would

want

to be–or would expect to be treated–in this

situation.

E. Mechanic’s and Materialman’s

Liens

1. Introduction. Note that these liens are created by operation of law and

arise

automatically to protect the valid interests of contractors, subcontractors,

and

materialmen. This occurs when the landowner and the provider of labor or

materials

agree that the work should be done, the work is done, and the provider files a lien

with

the proper recording office. Some states require notice to the owner also. There is

no

need to agree to the creation of a

lien.

2. Rights of Subcontractors and Materialmen. Distinguish general contractors

from

subcontractors. Explain the difference between the Pennsylvania and New

York

approaches to these

liens.

3. Basis for Mechanic’s or Materialman’s

Lien/Requirements

for Obtaining a Lien.

Examine

your state’s law on mechanic’s and materialman’s liens and use them as a basis to

explain

the operation of these liens. List the elements necessary to create the lien. Note that

the

properly filed mechanic’s lien binds the assignees of the debtor’s

property.

Examples: Problem Cases #7 and

8.

Mutual Savings Association v. Res/Com Properties, L.L.C. (page 794). Where

one

subcontractor performed some on site work, including staking of boundary corners,

and

staking of preliminary layouts for utilities and streets, the liens for work done by

other

contractors and subcontractors subsequent to the filing of a mortgage on the property

all

related back and were entitled to priority based on the time of the first

lien.

Points for Discussion: Ask whether they think the result in this case is fair to the

bank?

Why or why not? What should have put the bank on notice of possible

materialmen’s

liens? Why should all subsequent contractor lienors be entitled to get the benefit of

the

earliest filed unsatisfied

lien?

4. Priorities and Foreclosure. Explain how mechanics and materialman’s liens relate

to

other interests in the property, including other security interests. Briefly describe

the

process used in foreclosing on such a line, focusing particularly on the process used

in

your

state.

5. Waiver of Lien. Explain the various ways a property owner can seek to protect

himself

concerning liens when he contracts for work on his property and makes payments for

that

work.

Can there be a mechanic’s lien in the following

situations:

a. Fred paints Jane’s house without asking her whether he may. No

lien.

b. When Joe is not home Hannah delivers gravel to Joe’s house. Joe had

earlier

requested the gravel be delivered when he was home.

Lien.

c. Mary delivers maple flooring to Sam’s house. Sam had contracted with Alex

to

install maple floors. Alex contracted with Mary to supply the flooring.

Lien.

28-6

by McGraw-Hill Education. This

is

proprietary material solely

for

authorized instructor use. Not authorized for

sale or

distribution

in

any

mam1er. This document may

not be

copied, scanned, duplicated, forwarded, distributed,

or

posted

on a

website,

in

whole

or

part.

N.

RECOMMENDED

REFERENCES:

A. Restatement

of the

Law

of Security

( 1

81

with 1996 Supp., American Law Institute

Publishers,

The most comprehensive source of the law of possessory liens, this restatement

also covers

the

law of suretyship and guaranty and the pre-Code law of

pledges.

B. Lawrence P. Simpson, Handbook

on

the

Law

of

Suretyship, West Publishing Co., 1950.

This

is another of the West hornbooks that comprehensively cover the law in an easily

accessible

form. Although quite old, it is the best single source on suretyship

law.

C. John W. Bruce, Real

Estate

Finance

in

a

Nutshell, West Publishing Co., 2008. An

excellent

exposition of the law of real estate finance including illustrations that may be useful for

class

discussion and

exams.

D. Grant Nelson, Real Estate Transfer, Finance and Development, American Casebook,

2009.

E. D. Barlow Burke, et. al, Real

Estate

Transactions:

Examples

&

Explanations

(

4

111

edition

)

(2006).

)