You find a nice model boat, talk to the builder and come to terms, and plunk down five-figure money to get the process started. Two months later the builder has used your money to buy a hull and an engine, and he’s well along on the process of building your dream.
Then you open your mail and find an official notice that the builder is filing Chapter 7 bankruptcy: All his assets will be sold to satisfy creditors.
But you’re ok, right? I mean, the guy used your money to buy the hull and engine. You can get those back, right?
When a debtor files bankruptcy all collection efforts of any type must immediately cease, by federal law. The bankrupt's "estate" then comes under the control of the U.S. Bankruptcy Court, acting through an appointed trustee. The trustee collects the assets, identifies claims against the estate (trade creditors, the brother in-law who lent ten thousand dollars to the debtor, etc.), ensures genuine claims are paid correctly, contests dubious claims and sues those who may owe the estate money.
There are fundamentally two types of bankruptcy. In a Chapter 11 "reorganization", the debtor (usually a business, sometimes an individual with a lot of assets) tries to keep the business going, using the court’s powers as leverage to negotiate better terms with lenders and other creditors. A Chapter 13 bankruptcy is a lot like a Chapter 11, except it's for wage-earning individuals who want to try to pay their debts on a stretched-out schedule. A Chapter 12 bankruptcy is like a Chapter 13, except it’s for farmers and fisherman, and it offers a few advantages for those who toil on the sea or till the soil.
A Chapter 7 bankruptcy, in contrast, is a yard sale. Everything must be sold to pay creditors, except some home residence value (varies by state; in Maine, up to $47,500.00, generally), some value in tools of the trade, some value in a vehicle, and a few other "bankruptcy exemptions". Both individuals and businesses can file Chapter 7, and the result is discharge of most debts. Some debts cannot be discharged, such as student loan debt, most taxes, debts stemming from the debtor’s fraud, and some others.
It is common for a Chapter 11 plan of reorganization to fail or a Chapter 13 plan to fail, when the debtor is unable to perform the plan. When that happens the bankruptcy often converts to a Chapter 7 liquidation.
In any bankruptcy creditors are paid according to their statutory priority. The first priority is administrative claims, which are the costs of getting the bankruptcy done. The IRS and the state generally come next, with their tax claims. Next are secured creditors: the bank that loaned money secured by a mortgage on the house or on the boat, for example. Last in line are the pitiful "unsecureds", who may be lucky to get a few pennies on the dollar and very often get zip.
The take away is this: Unless you have a "security interest" – like a mortgage – in the hull and engine your money bought, you will probably be deemed a mere unsecured creditor, standing in line with the guy that sold the yard its copy paper. Ouch.
There’s a better way. It involves small money for lawyers, but it is the way to go.
First, tell the yard that you will need a security interest in the components as the yard buys them and in the boat as it comes into being. The creation of a security interest will require the yard to sign a simple document granting the interest and identifying the components, by make and model and hull identification number and engine serial number. Any component which is expensive and bought for the project ought to be specifically identified: hull, engines and generators, but also electronics, steering gear, bow thruster, watermaker etc., adding the catch-all "And, other materials and components of said yacht, wherever situated."
Then the security agreement is "perfected" by recording it with the UCC Division of the Secretary of State. This is lawyer work, or bank work, but is pretty cheap or should be.
Don’t be dissuaded by the yard’s protest that no one has ever asked for this before. It’s standard procedure at the bigger yards, and you will be bringing your builder's business practices up to speed by your request.
But here's a hitch. The yard’s bank almost surely already has a security interest in everything the yard has. Yet you certainly don't want to be "behind" the bank if the yard goes under. The solution is simple and routine. The bank will sign a "partial release" of its security interest, releasing only the interest it has (or may have – doesn’t matter) in the components your security agreement describes and in the boat as it comes along.
The bank will be happy to do this because it understands the need and because it knows that the request means its borrower is busy building boats. But if the bank is reluctant, watch out. When a borrower is on the ropes banks are very leery of relinquishing any security. The bank will not tell you its borrower is having a hard time paying the bank, but its actions in refusing to give a partial release may speak volumes. Don’t jump to conclusions, and please confirm that the bank officer understands the request before assuming the refusal has real significance, but be aware. Please don't take a grant of security in your boat if the bank is ahead of you and won't give you a partial release.
When you take delivery of the boat you will get a builder's certificate and a bill of sale from the yard, and you'll use that to either document the boat with the Coast Guard or register it with the state. There is no need for any action relating to the security agreement.
Two final notes. First, a survey should be performed even of a new built boat. It is rare that the survey won't turn up something that was overlooked or that might have been done better, and it could be something vital. Second, course of construction insurance (sometimes called "Builder’s Risk") protects the owner from loss of or damage to the hull and the components of a vessel during construction. This insurance attaches from the time construction commences, and covers subsequent launching, sea trials and delivery. In the event of a catastrophe at the yard you would be indemnified. Talk to a marine insurance broker about such coverage.
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