Priority of Creditors in Secured Transactions
Here is an overview of the Uniform Commercial Code’s extremely complicated rules for creditors and secured transactions.
A secured transaction is a contractual arrangement where a borrower or buyer pledges property as collateral for a loan or purchase. The borrower or buyer is known as the debtor, and the lender or seller is known as the creditor, and more specifically the secured party. Two simple examples of secured transactions are: (1) a bank loaning a business money so it can buy inventory; and (2) a company selling a business equipment on credit. In both examples, to create a secured transaction, the debtor would sign a security agreement. In these examples, the business is the debtor, the bank or the seller is the creditor, and, most likely, the inventory or equipment will be at least part of the collateral.
More complicated situations involve not just one but several creditors or other parties trying to claim the same collateral. The most obvious situation would be if a debtor with multiple creditors declared bankruptcy. The Uniform Commercial Code’s (UCC’s) priority rules for creditors are extremely complicated. In this brief article, we’ll look only at some of the most general elements of those rules. You should consult with a knowledgeable bankruptcy attorney if you have detailed concerns.
The Key Questions
Determining which creditor has priority in a particular situation requires answering several key questions, including:
- what types of creditors are involved
- what types of collateral are involved; and
- is a purchase-money security interest involved.
Different types of creditors have different rights in different situations. Among the potential types of creditors are: secured parties, lien creditors, and buyers. A “secured party” is defined above, and discussed in more detail in other Nolo articles. A “lien creditor” may fall into several categories; among these are creditors that have attached but not perfected an interest in the collateral (see the Nolo article on attachment and perfection) and certain parties that may come into play in bankruptcy proceedings, such as a bankruptcy trustee or a receiver. A “buyer” in this context means someone who has purchased the collateral from the debtor.
There is a very wide range of types of collateral. To name just a few of the more common types: equipment (machinery, vehicles and so on), inventory (items for retail sale, raw materials for manufacturing and so on), instruments (such as promissory notes and other financial instruments), accounts receivable and consumer goods.
A purchase-money security interest (PMSI) generally involves either: (1) a debtor buying an item on credit from a seller, with the seller being the secured party; or (2) a debtor using a loan from a bank directly to buy an item from a seller, with the bank being the secured party. An official comment in the UCC states: “The concept of ‘purchase-money security interest’ requires a close nexus between the acquisition of collateral and the secured obligation. Thus, a security interest does not qualify as a purchase-money security interest if a debtor acquires property on unsecured credit and subsequently creates the security interest to secure the purchase price.” In the two situations just mentioned, a PMSI is created if the security interest is created at the time that the collateral is purchased (most likely by signing a security agreement), but not if the security interest is created at some later time.
A Few Examples
It is not possible to cover all the permutations of creditors, types of collateral, and whether a PMSI is involved. Instead, we’ll just look at three very general scenarios. In each case, we’ll assume that the various parties making claims to the collateral include a first secured party (FSP) that perfected a security interest on October 1, a second secured party (SSP) that perfected a security interest on October 10, a lien creditor (LC) with a lien acquired on October 15, and a buyer who both buys and takes delivery of the collateral on October 20.
No PMSI; collateral is equipment. The FSP has priority over the SSP because the FSP was the first secured creditor to perfect its security interest. The FSP has priority over the LC because the FSP perfected its security interest before the LC acquired its lien. And, the FSP has priority over the buyer because the FSP perfected its security interest before the buyer bought and took delivery of the collateral.
No PMSI; collateral is inventory. The UCC rules for inventory collateral are the same as for equipment collateral with regard to secured parties and lien creditors. Therefore, as with the preceding example, the FSP has priority over the SSP and LC. However, the rules are different with regard to buyers. When it comes to inventory, UCC Section 9-320 states that a buyer of goods who buys “in the ordinary course of business” will take the goods “free of a security interest created by the buyer's seller, even if the security interest is perfected and the buyer knows of its existence.” Thus, a buyer of inventory collateral takes priority even though a secured party has already perfected a security interest—and even if the buyer knowsthat the secured party has perfected a security interest.
PMSI; collateral is equipment. Here we assume that: (a) the FSP is an equipment dealer who has sold equipment to a debtor on credit and retains a purchase-money security interest in the equipment; and (b) that the SSP is a bank that has loaned money to the debtor and, as part of the security for the loan, has taken a non-purchase-money security interest in the equipment. The FSP has priority over the SSP. In fact, the FSP might have priority over the SSP even if the FSP had perfected its PMSI later in time than the SSP perfected its non-PMSI security interest, because the UCC gives a secured party up 20 days after a debtor receives the collateral to perfect a PMSI without the secured party losing priority. The same rules apply with regard to the LC: the FSP has priority over the LC, and in fact could still have priority if it perfects up to 20 days after delivering the collateral to the debtor (which, according to our assumptions above, would be five days after the LC acquired its lien). Finally, essentially the same rules also apply regarding a buyer: the FSP has priority over a buyer, and in fact would still have priority so long as the FSP perfects within 20 days after the debtor takes delivery of the collateral.
Be aware that these three examples provide just the barest sketch of the UCC’s priority rules for secured transactions. However, they should give you a taste of how complex those rules can be.
This article is based on the current version of the model Uniform Commercial Code (UCC). However, not all states have adopted all sections of the current model UCC. Moreover, the model UCC specifically leaves it to individual states to determine the precise wording of certain sections. Therefore, you should always check your own state’s commercial code for the most accurate information.