978-1285428222 Chapter 13 Lecture Note Part 2

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Decision: Reversed. Century’s failure to file a lien did not release Glacier from its guaranty. “if

collateral is provided, the creditor cannot diminish or sacrifice it and then demand that a

guarantor meet its obligations to the creditor….While impairment of collateral generally

Surety’s Rights against the Principal. If the debtor does not meet an obligation, and the surety

(guarantor) has to pay, the debtor is obligated to repay the surety. If the debtor could pay the

creditor but refuses to do so, the surety is entitled to exoneration; a court order requiring the

debtor to perform. The surety is also entitled to be subrogated to the rights of the creditor against

the debtor. This generally occurs when the creditor is fully satisfied, but partial payment came

from the surety. The surety may assert any rights the creditor could have asserted against the

borrower had it not paid the creditor in the absence of the surety—including taking any security

interests the creditor obtained from the debtor.

Secured Transactions—The law governing personal property is UCC Article 9. It provides that

property itself may secure the obligation. Called a secured transaction, the lender may obtain a

security interest in the property to help secure payment.

Attachment. To make a security interest enforceable, the creditor must attach and perfect its

interest. For the security agreement to attach, it must be signed by the customer, the lender must

have provided value, and the customer must have conveyable rights in the collateral. If the

customer cannot pay, the creditor has rights superior to unsecured creditors — but not

necessarily superior to other secured creditors.

Perfection. To perfect, the creditor must give notice to others, usually by filing the financing

statement with the Secretary of State. This process need not be followed for consumer goods;

under the UCC a security interest for consumer goods is perfected without a filing. The financing

statement needs the names and addresses of the lender and the customer, a description of the

product, and the customer’s signature. The details of the credit transaction are left to the security

agreement.

Interests in Inventory. As collateral, equipment, inventory and raw materials can be classified as

tangible property—movable goods at the time a security interest attaches. To protect its interests,

the creditor will want to obtain a security interest to give the lender rights against the borrower

that are superior to unsecured and other creditors if the borrower fails to meet its debt

obligations. When extending credit, the lender normally requires that the borrower sign a security

agreement and a financing statement. The security agreement contains major details of the credit

transaction: the amount financed, interest rate, payment schedule, and other financial details. To

establish superior rights if the borrower defaults, the creditor perfects the security interest by

filing the financing statement with the Secretary of State. It contains little more than the names

and addresses of the customer, a description of the product, and the signature of the customer.

A “Floating Lien” for Inventory. Under the UCC, inventory includes goods held for sale, raw

materials, work in process, or materials used. Inventory is constantly turned over, which could

create a problem for a creditor that provides financing with specific inventory as collateral. The

UCC allows a perfected security interest in after-acquired property if the security agreement

between the borrower and the creditor so provides. This permits a valid “floating lien”—a

security interest in any specific item of inventory terminates upon its sale or use but attaches to

new inventory that replenishes the stock.

Default by the Debtor—A security interest protects the interests of the lender if the debtor

defaults. It gives the lender priority to the property over other, unsecured, creditors. The UCC

provides, in case of repossession, “a secured party may proceed without judicial process if this

can be done without breach of peace.” To take possession of consumer goods, the creditor is not

obligated to notify other parties who may also have a security interest; the creditor may keep the

product or resell it. Resale must be in a “commercially reasonable manner” with surplus

proceeds returned to the customer. Repossession can be a delicate matter and creditors often

argue over priority.

CASE: Fordyce Bank and Trust v. Bean Timberland (Sup. Ct., Ark., 2007)—The bank made

loans to Bean so he could buy timber from landowners. He sold the logs to sawmills. The bank

had a perfected security interest in the logs and the sale proceeds were to go to the bank, but

Bean did not pay the money to the bank and went bankrupt. The bank sued the sawmills that

bought the logs, contending it had a priority interest in the timber sale proceeds. The bank

claimed the sawmills failed to exercise good faith by checking to see if a security interest in the

logs existed. The court held for the sawmills; they were not required to perform a security

interest search in the ordinary course of business. Bank appealed.

Decision: Affirmed. Under 9-320 a buyer in the ordinary course of business takes free of a

security interest, even if perfected and even if the buyer knows of it. The sawmills had no duty to

Questions: 1. The high court affirmed that the buyers of the timber had no duty to do a search for

a lien on the timber, so were not liable to the bank which lost its potential collateral. What is the

logic of not having buyers in the ordinary course of business not do a lien search?

It would be very costly if every buyer in the ordinary course of business had to search for liens

2. What could the bank have done to protect itself against this sort of outcome?

Pretty hard other than to monitor Bean more closely and perhaps require him to sell all timber to

one or two mills, which were notified that they were to send proceeds to the bank, and agreed to

Add. Case: Peerless Packing v. Malone & Hyde (Sup. Ct., W.Va., 1988)–Kizer managed a

grocery store owned by M&H. He bought the store; M&H held the note on it. Unable to make a

go of it, Kizer, broke, turned the store back over to M&H and went to work as its manager again.

M&H refused to pay for the food delivered to the store while Kizer was the owner. The food was

sold on open account credit; there were no secured interests. The food sellers sued M&H on the

theory of unjust enrichment, as the food was sold from the store. Court held for M&H; plaintiffs

appealed.

Decision: Affirmed. While the rule seems harsh, the creditors could have protected themselves

by demanding cash or by taking a purchase money security interest in the goods they delivered.

Add. Case: HCC Credit v. Springs Valley Bank & Trust (Ct. App., Ind., 1996)–Lindsey

Tractor sold farm equipment in French Lick, Indiana (home of Larry Bird). Lindsey bought

equipment from suppliers on credit supplied by HCC, which had a perfected security interest that

stated that sale proceeds would be paid to HCC. Before bankruptcy, Lindsey deposited about

$200,000 from a sale to a customer to its checking account at Springs Valley Bank and paid a

debt owed the bank, which was unaware of HCC’s interest. HCC sued the bank to recover the

money it received from Lindsey. Trial court held for the bank; HCC appealed.

Decision: Affirmed. Ordinarily the perfected security interest would have insured the money was

HCC’s. However, under 9-306, proceeds to checking accounts in the normal course of business

Add. Case: Valentino v. Glendale Nissan (App. Ct., Ill., 2000)–Valentino bought a car from

Glendale and signed an installment agreement to finance it. The agreement was assigned to First

Bank, which perfected its security interest. Valentino later claimed that Glendale violated the

Illinois law regarding consumer fraud and ceased payments. The bank repossessed the car.

Valentino sued for return of the car, claiming consumer fraud. The bank moved to dismiss her

suit, claiming she was in default under the contract and it had the right to repossess since it has

a security interest superior to the interests of Valentino. The court dismissed the suit. Valentino

appealed.

Decision: Affirmed. A creditor’s perfected purchase-money security interest in a vehicle has

priority over the vehicle buyer’s UCC-based security interest, which is a possessory interest. The

Add. Case: Turbinator v. U.S. Windtricity (Ct. App., Cal., 1995)–Turbinator sold wind

turbines to a customer on credit. The collateral was turbines given as security for promissory

notes executed by the buyer of the turbines. The buyer then sold the turbines to Windtricity,

which knew of the debt attached to the turbines. Under Article 9 “perfection is accomplished by

filing a financing statement in the office of the county recorder in the county of the debtor’s

residence. However, such a filing lapses after five years, unless a ‘continuation statement’ is

filed.” Turbinator allowed the filing to lapse after five years. Windtricity tried to sell the

turbines; Turbinator moved to take possession. Court held for Windtricity; Turbinator appealed.

Decision: Reversed. Creditor Turbinator, whose security interest had lapsed, retained priority

rights against subsequent purchasers (Windtricity) since it acquired interests in the collateral

(turbines) with knowledge of the creditor’s interest. Once the security interest lapsed, the interest

was unperfected; it is not void or ineffective. “The failure to perfect a security interest does not

Add. Info: Security Interests in the Event of Default—In default, the security agreement and

UCC provisions govern the rights of the parties. Generally, the party that holds a security

interest in an asset of the debtor as collateral may seek judicial relief or begin foreclosure

proceedings. The secured party may take possession of the collateral upon default without going

through a judicial procedure—if possession can be had without breach of the peace. The UCC

provides that collateral may be disposed of at a sale that is “commercially reasonable.” Unless

the collateral could decline rapidly in value, the secured party must give notice of the sale to the

debtor. The collateral may be sold as found upon repossession or after refurbished by reasonable

preparation. The secured party may keep the collateral to satisfy the debt, unless the debtor

objects (which it likely do if it expects a sale to generate a surplus). The borrower may redeem

the collateral by paying the debt at any time prior to the sale of the collateral by the secured

party.

Exempt Property—Business owners often pledge personal assets as security for the debts of the

business. If the debt is not paid, the creditor may have the pledged assets seized and sold. If the

debt is not fully paid by the sale, the creditor may sue the owners for the rest of the debt. To

protect its interests before a judgment, the creditor may ask the court for an attachment. After

judgment has been rendered, if the owner is unable (or unwilling) to pay, the creditor may ask

the court for a writ of execution; that is, the creditor moves against the owner’s nonexempt

property. Most states exempt certain real and personal property. To ensure that a debtor has

housing, states provide a homestead exemption. Statutes provide limited exemptions for, among

other things, furniture, clothing, cars, and tools used in the debtor’s trade or business.

Real Estate Financing—The real estate itself is used to secure a loan to buy it and will be

evidenced by a mortgage. The mortgage is a lien, giving the holder the right to sell the property

and repay the debt from proceeds in the event the debtor defaults. Such transactions are governed

by state common law and real estate statutes since the UCC does not apply to real estate

mortgages.

The Mortgage—According to the Statute of Frauds, a mortgage must be in writing. In most

states, a simple and concise form is recognized. The mortgage normally contains a description of

the property, sets forth any warranties to it, states the debt, the mortgagor’s duties concerning

taxes, insurance, and repairs, and other relevant information. To protect the mortgagee’s rights

against other creditors, mortgages are recorded.

Default by the Mortgagor—If the borrower is unable to pay, the mortgagee may foreclose on the

property. If sale proceeds cover the costs of foreclosure and the debt, any surplus is returned. If

the proceeds are not sufficient, the mortgagee can obtain a deficiency judgment, obtained in a

separate action after the foreclosure. In about half of the states, the borrower would have the

right to redeem the property by paying the debt within the statutory redemption period—

normally from six months to a year after the default.

Liens—Security obtained by a lender by operation of law is called a lien. Since it is obtained

without the agreement of the customer, it may be called a nonconsensual lien. Lien is from

French, meaning “tie” or “string.” It is the legal hold the creditor has over the property of the

customer to secure payment for that product or for services, such as repairs, to that property.

Procedures for liens are determined by state law (common and statutory). A creditor may obtain a

lien without the consumer’s consent by following statutory procedures. An additional remedy is

garnishment, a statutory procedure under which the creditor gets the right to attach up to 25% of

the customer’s net wages to apply to debt.

Issue Spotter: Lean on a Lien?

Business is never risk free. If the builder is a large, stable, experienced mall developer, then the

risk of loss if probably low. Assuming the paperwork is normal, so that you could sue the

developer should the primary contractor fail to pay you, then other the problem of having to

carry the debt until the matter is resolved, it is probably not high risk. Is the mall actually owned

by the primary developer, or is it in its own corporation so that it must stand on its own? If so,

the risk is higher. Real estate tends to take huge swings and large projects can sit unfinished for

years, in which case you would be finished. Subcontractors usually get paid, but it may take a

long time and be only a portion of the debt, should the economy sour.

Mechanic’s Lien—The most common nonconsensual lien on real property. In most states, the

party that has furnished material, labor, or services for construction or repair of real property can

place a lien on the property for unpaid amounts. The creditor must take all required legal steps

within the time specified in the statute. Upon filing the lien, the creditor obtains security for the

debt. If the property owner does not pay the lien, the creditor forces the sale of the property to

satisfy the debt. In some states, such a sale must take place within 12 months of the original

filing. If no action is taken within the stated time, the lien expires and cannot be revived.

CASE: Summers Group v. Tempe Mechanical (Ct. App., AZ, 2013)—Summers (dba Rexel)

sold electrical materials used in construction on property owned by Metro. When the real estate

bust hit, Metro could not pay and Rexel filed a mechanic’s lien on Metro property as did other

unpaid parties. After non-payment, Rexel sued Metro and all other lienholders. Some lienholders

did not respond so had default judgments entered against them. Tempe, which also had a lien,

responded. Metro was in bankruptcy under control of trustee ML Manager, which argued that it

should receive payment first and that Rexel should pay attorney fees. Trial court agreed; Rexel

appealed.

Decision: Reversed. The lien statute must be followed in terms of priority for payment. Revenue

Questions: 1. A number of contractors that had liens against Metro Lofts did not respond to the

filing of this action to settle lien claims. Why would you think they failed to respond, since they

lose all rights to collect?

The contractors provided assorted labor in the project—electrical work, drywall, etc. Such firms

are often small. When the real estate crash hit in 2008, work in construction evaporated,

2. We will look at bankruptcy law next, but why would you think the bankruptcy trustee can

impose payment of all attorney fees on claimants?

Bankruptcy trustees must have some assurance of costs of their work being covered, so making

Add. Case: National Lumber v. LeFrancois Const. (Sup. Ct., Mass., 2000)–LeFrancois

contracted with National to supply materials for building a house. National recorded a notice of

the contract in the county registry of deeds, identifying LeFrancois as owner of the property.

Later, National recorded in the registry a sworn statement of claim that $26,104 had not been

paid for materials supplied to LeFrancois. Four days before that lien was filed, LeFrancois sold

the property to the Schwartzes. Two months later, National sued LeFrancois and the Schwartzes

to enforce the lien. The Schwartzes filed a motion to dismiss, contending that the lien was not

good against them. The court refused to dismiss them from the suit; the Schwartzes appealed.

Decision: Affirmed. The purpose of the mechanic’s lien statute is to provide security to

contractors and suppliers for value of their services and goods provided for improving the real

estate and to ensure that a person searching land records in the registry of deeds can determine

Add. Case: Stunkel v. Gazebo Landscaping (Sup. Ct., Fla., 1995)–Stunkel contracted with a

contractor to build a home on their property. The contractor orally contracted with Gazebo, a

subcontractor, to plant trees selected by Stunkel. He selected and tagged several trees at a

nursery to be delivered and planted, which Gazebo did. Gazebo, unable to contact Stunkel,

posted a notice of a lien on the gate of his property. A year later Gazebo sued to foreclose its

claim of lien. Court dismissed; the court of appeals certified a question to the state supreme

court to clarify the law.

Decision: Remanded. For there to be a lien, there must be a contract. For a mechanics lien, “a

sub-contractor begins to furnish services or materials for the purpose of giving notice to the

owner under [Florida law concerning mechanic’s lien] when the services or materials are

delivered to the job site. … mechanic’s lien law serves at least two purposes. First, mechanic’s

Possessory Lien—The possessory or artisan’s lien is the most common form of nonconsensual

lien on personal property. It provide a security interest for lenders that provide credit for labor,

value added, or the care of personal property. The lender has the right to hold goods on which

work has been done or materials supplied until the customer pays. The lien stays as long as the

creditor retains possession— unless the lien is filed according to the state’s lien and recording

statutes. That way, the creditor provides notice of the lien to others and protects its interests. If

the customer does not pay, the creditor can force the sale of the property to satisfy the debt. As

with the mechanic’s lien, the lender must give the customer prior notice of the sale.

Add. Case: Kesco, Inc. v. Brand Banking Co. (Ct. App., Ga., 2004)–Brand loaned $1.5 million

to Tumlin for a real estate development. Tumlin hired Kesco for services. When Tumlin fell

$89,000 behind in paying Kesco, Kesco filed a lien on the property, as did other subcontractors.

Brand stepped in to try to salvage the place. Its superior lien would have eliminated all the

subcontractors’ liens, so Brand suggested the let Tumlin sell some lots without liens on them to

raise cash to keep things going. Kesco and others removed their liens and Kesco got $18,000

before Tumlin gave up and the bank foreclosed. Kesco sued Brand, contending it breached a

promise not to foreclose the property. Court held for Brand. Kesco appealed.

Decision: Affirmed. Brand had a superior lien on the property. There was a good faith effort to

salvage the deal so Kesco and others could get paid; they got something by removing their liens,

Add. Case: Holly Lake Assn. v. Federal Natl. Mtg. Assn. (Sup. Ct., Fla., 1995)–When Holly

Lake, a mobile home development homeowner’s association, was formed in 1974 it recorded

covenants on real property in the development. Residents were required to pay monthly

maintenance fees. If they did not, a lien would be imposed on their property. McKesson bought a

home site and made a mortgage to FNMA that was recorded in 1983. In 1991, McKesson failed

to pay monthly fees and Holly filed a lien against his property. FNMA foreclosed on McKesson

for failure to make mortgage payments. Holly claimed its lien was superior to FNMA’s mortgage

because the covenants dated to 1974. The Florida S. Ct. was asked to clarify the law.

Decision: The Holly covenant was written in 1974 but Holly did not file a lien until 1991; which

Add. Case: Midland Savings Bank v. Stewart Group (Sup.Ct., Iowa, 1995)–Stewart, a

developer, borrowed money from Midland for new home construction. Stewart defaulted on a

mortgage held by Midland, and on debts to suppliers, whose interests were perfected by

mechanics’ liens. The money from Midland was used to buy lots and to finance construction. The

question is who stood first in line for the funds available.

Decision: “Construction mortgage liens shall be preferred to all mechanics’ liens of claimants

who commenced their particular work or improvement subsequent to the date of the recording of

the construction mortgage lien. …a lien is a ‘construction mortgage lien’ to the extent that it

secures loans or advancements made to directly finance work or improvements upon the real

estate which secures the lien.” “Iowa Code … clearly limits the definition of a construction

Court-Decreed Liens. After a debt has become past due, the creditor may sue the customer.

Creditors prefer alternatives to litigation because of the time and expense involved. In the event

of suit, the lender will find attachment and judgment liens at its disposal as judicial means for

protecting its interests. An attachment lien is a court-ordered seizure of the property to prevent

the debtor from disposing of it. Under state statute, the requirements imposed on the lender are

specific and limited. The lender needs to show that the debtor is likely to dispose of the product.

If the court concurs, it issues a writ of attachment directing the sheriff to seize the good.

If a creditor is successful in its action against a debtor, the court awards a judgment lien. No lien

is created simply by the rendering of a judgment by the court. The creditor must obtain an

abstract of judgment. When it is prepared, recorded and indexed, it creates a lien in the county

against the debtor’s real property and provides notice to subsequent purchasers. A judgment lien

is not enforceable against exempt real property of the customer (discussed below). No lien will

attach without compliance with the relevant statutory terms. Normally, the lien holds for 10

years. If the debtor does not pay the judgment, the court may issue a writ of execution. Issued by

the clerk of the court, it directs the sheriff to seize and sell the debtor’s nonexempt real or

personal property within the court’s jurisdiction.

Add. Case: Hensley v. Harbin (6th Cir., 1999)–Hensley won a $780,000 judgment against

Harbin and attached his property to satisfy the award. On appeal, judgment was reversed and

remanded on damages. Parties then settled for $400,000. Before settlement had been reached,

the U.S. filed a tax lien against Harbin’s property. Hensley then sued Harbin and the U.S. to

establish priority of Hensley’s judgment lien and to force foreclosure of Harbin’s property. The

question before the court was which lien was perfected first.

Decision: “Where a federal tax lien is involved, the relative priority of competing liens is

governed by federal law.” The federal rule is “the first in time is the first in right.” Once the

BANKRUPTCY—The framers of the Constitution thought that bankruptcy was so important

they specifically made it a matter of federal law. The Bankruptcy Reform Act of 1978, called the

Bankruptcy Code, is the key statute governing procedure. There was a major revision in 2005 to

make it more difficult to file. Key parts are Chapter 7 (providing for liquidation and fair

distribution of the debtor’s assets for creditors), Chapter 11 (allowing businesses to reorganize

rather than being liquidated), and Chapter 13 (personal bankruptcy for individuals).

Personal Bankruptcy—Under the 2005 version of the code, before one may file bankruptcy, a

person must complete pre-bankruptcy counseling to discuss alternatives to bankruptcy (easily

done); see the DoJ website for the U.S. Trustee Program. If the debtor files, then there must be

debtor education. There must be records of these events.

Income and Means Testing—When a person filed, an income (means) test is used to see if the

person filed under Chapter 7 (liquidation) or Chapter 13 (reorganization). If income is above

state median income, it is more likely that Chapter 13 will be required. More people will be

forced into Chapter 13 than was usually the case before.

Chapter 7—Chapter 7 was the most popular alternative, but since 2005, many debtors are not

allowed this option. It means liquidation and fair distribution of the debtor’s assets for the

creditors. While Chapter 7 may be used by businesses and by individuals, only individuals can

use it to obtain discharge. Most Chapter 7s are filed voluntarily by the debtor. A petition is filed

with the bankruptcy court, which may be the federal district court or a federal bankruptcy court.

The petition includes:

1. Statement of the financial affairs of the debtor (assets and liabilities)

2. List of all creditors, addresses, and debts owed to each

3. List of properties owned by the debtor

4. Statement of current income and expenses of debtor.

Filing means there is a freeze against all actions by creditors against the debtor. A trustee is

appointed to administer the debtor’s estate; to call of meeting of the creditors; to review the

accuracy of the debtor’s information. In an involuntary bankruptcy, three creditors file a petition

with the court, forcing the declaration of bankruptcy and the beginning of proceedings.

Chapter 13—Chapter 13 allows for the reorganization of debts of individuals, which includes

sole proprietorships. The debtor submits a Confirmation Plan which is essentially an installment

payment plan that requests the debtor be allowed to extend payment obligations. The debtor

remains in possession of the property but shares administration with a court appointed trustee.

The trustee collects money from the debtor and makes payments to the creditors according to the

plan. The trustee does not manage the affairs of the bankrupt but sees that payments are made

and to approve any changes in the financial position of the debtor. The debts of the bankrupt are

not discharged. Normally, repayment must take place within three-years, but no more than five

years. Long-term debts (such as mortgages) are treated differently. If the plan fails to work, the

debtor may shift to Chapter 7.

CASE: In re Darby (5th Cir., 2006)—Darby had filed for Chapter 13. Time Warner refused him

cable service. He filed a motion in bankruptcy court to compel the provision of service if he

promised payment. The court held that cable service is not a utility that is a necessity, so he had

no right to it. He appealed.

Decision: Affirmed. Utility means electricity and gas; cable service is not a necessity and cable

Questions: 1. The appeals court affirmed that a cable television company need not provide cable

service to a person in bankruptcy. Would you think Internet service and television service is a

necessity?

Most people treat it that way, but not so under the code. Cell phones are also not necessities.

2. How could Time Warner assure itself of payment from Darby?

It cannot, which is why it wanted to be rid of him. No doubt the company has had bad

Add. Case: In re Lamanna (1st Cir., 1998)–Lamanna sought relief from $15,000 in consumer

debt by filing for Chapter 7. Based on finding that Lamanna had sufficient income to pay his

debts under a Chapter 13 payment schedule, the bankruptcy court dismissed the filing as an

abuse of Chapter 7. The Bankruptcy Appellate Panel agreed with that finding. Lamanna

appealed.

Decision: Affirmed. The court joins other circuits in adopting the “totality of the circumstances”

test as the measure of abuse under the Bankruptcy Code. This is a flexible standard in the code

Add. Case: In re Pond (2nd Cir., 2001)–The Ponds filed for Chapter 13. Their house was valued

at $69,000. The order of liens on the property was: 1) $1,505 for property taxes; 2) $49,000 for

a first mortgage; 3) $20,000 for another mortgage; and 4) $10,630 for another mortgage held

by Farm Specialist. The Ponds requested the court to void Farm’s lien. The Bankruptcy Court

refused to void the junior mortgage held by Farm. The district court reversed in favor of the

Ponds. Farm appealed.