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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
© 2013
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).
)
