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28-1 Introduction to Credit and Secured Transactions P A E T R H C 28 Creditors have better memories than debtors. Benjamin Franklin Poor Richard’s Almanac (1758)
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Chapter 28 – Introduction to Credit and Secured Transactions

Oct 20, 2014

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Page 1: Chapter 28 – Introduction to Credit and Secured Transactions

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Introduction to Credit and Secured Transactions

PA ET RHC 28

Creditors have better memories than debtors.

Benjamin FranklinPoor Richard’s Almanac(1758)

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Learning Objectives

• Explain the difference between secured and unsecured credit

• Differentiate suretyship from guaranty

• Describe the various types of liens on real and personal property

• Compare methods for holding a security interest in real property

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• The term credit has many meanings, but for purposes of this course, credit refers to transactions in which goods are sold, services are rendered, or money is loaned in exchange for a promise to repay the debt at some future date

Overview

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• Most transactions are unsecured: a service was rendered or good sold and the consumer-debtor promises to pay for the service or good upon receiving a bill– Maximum risk of loss to the creditor

• To minimize risk, a creditor may require the debtor to convey to the creditor a lien (security interest) on the debtor’s property

Secured vs. Unsecured Credit

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• In unsecured credit transactions, a creditor has recourse against a debtor’s default by sending notices to pay and eventually filing suit against the debtor for payment– Result: collection effort begins

• In a secured credit transaction, creditor can go against the security (repossess) to collect debtor’s outstanding obligation

If Consumer Fails to Pay

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• A creditor’s or debtor’s rights and liabilities in a secured transaction depends on the particular security device used: surety, guaranty, lien, or mortgage

Security Devices

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• A surety is a person who is liable for the payment of another person’s debt or for the performance of another person’s duty

• The surety joins with the person primarily liable in promising to make the payment or to perform the duty– The classic “co-sign” situation– Generally on the same signature page

Surety

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• A surety is primarily liable for the debtor’s obligation, and the creditor can demand performance from the surety at the time the debt is due rather than sue debtor for payment or performance on the duty

Surety

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• A guaranty contract is like a suretyship, but a guarantor does not join the principal debtor in making a promise, but makes a separate promise to be liable only after principle debtor defaults and cannot pay– A surety is primarily liable on the debt, but

the guarantor is secondarily liable– Typically, a separate guaranty document that

must be in writing to satisfy the statute of frauds

Guaranty

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• A surety may use defenses to a creditor’s demand for payment that principle debtor would have under the primary contract:– Breach of warranty, lack or failure of

consideration, fraudulent inducement, and breach of contract by the creditor party

• Courts protect an accommodation surety (e.g., friend, parent) more than a compensated surety (e.g., bonding company)

Defenses of a Surety

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• Creditor must disclose any material facts about the risk involved to the surety– Failure to do so relieves the surety of liability

• See New Jersey Economic Development Authority v. Pavonia Restaurant, Inc.– Court rejected claim by sureties that creditors

violated their duty to the sureties since the creditors did not have any superior knowledge of material facts about risk

Creditor’s Duties to Surety

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• If a surety performs or pays the principal’s obligation, then the surety acquires all rights creditor had against the principal– Surety’s right of subrogation: judgment

rights that creditor had against principal, right to collateral in creditor’s possession, creditor rights in bankruptcy proceedings

• Surety may recover costs from principal– Surety’s right to reimbursement

Surety’s Rights

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• If one of two or more co-sureties performs or pays principal’s obligation, the surety who satisfied the obligation has a right to contribution from the co-sureties

• A surety or guarantor has a right to exoneration: principal debtor must make good on the commitment to creditor when s/he (1) is able to do so and (2) does not have a valid defense against payment

Surety’s Rights

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• A lien is a security interest in personal property available to businesses and individuals by statute and common law

• Statutes often provide a procedure for foreclosing the lien (foreclosure)

Liens on Personal Property

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• Two essential elements of possessory lien (e.g., artisan, innkeeper, common carrier): – possession by improver/provider of services – a debt created by the improvement to goods or

provision of services concerning the goods

Liens on Personal Property

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In re Borden

• Facts: – The Bordens granted the Genoa National Bank

(Bank) a security interest on all personal property and Bank perfected security interest• Perfected by filing UCC financing statement

– Farm machinery required and received repairs by Bellamy’s, which sent bills to Bordens

– Bordens couldn’t pay, so Bellamy’s refused to release property to Bordens

– Bordens filed for bankruptcy, then took and used machinery without permission from Bellamy’s

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• Procedural History and Legal Reasoning: – Bank filed motion to determine priority of liens– Court found conflicting authority, deciding that

Bank had priority over Bellamy’s (artisan) since continuous possession is required to maintain an artisan’s lien; Bellamy’s appealed

– Appellate court reasoned that an artisan’s lien is a possessory lien and possessory liens have priority over a creditor’s lien unless artisan voluntarily loses possession

In re Borden

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• Eighth Circuit Bankruptcy Appellate Panel: – “Artisan did not lose its artisan’s lien…when Debtor

took the Equipment without the Artisan’s knowledge or consent…Reverse the bankruptcy court’s order” determining priority.

In re Borden

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• Three basic contract devices for using real estate as security for an obligation: (1) the real estate mortgage, (2) the deed of trust, and (3) the land contract.

• Also, state statutes give mechanics and materialmen a right to a lien on real property into which their labor or materials have been incorporated

Security for Real Property

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• A mortgage is a security interest in (or deed to) real property given by the owner (mortgagor) as security for a debt owed to the creditor (mortgagee)– A lien on land rather than

conveyance of title – Must be executed with

the formality of a deed

The Mortgage

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• A mortgagor (owner) can sell the property interest without consent of mortgagee, but sale does not affect the mortgagee’s property interest or claim against mortgagor– A purchaser of mortgaged property may buy

it and assume (take over) the mortgage– If a mortgage contains a due on sale clause,

any remaining balance becomes promptly due and payable when the property is sold

The Mortgage & Sale of Interest

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• Foreclosure: rights of the mortgagor or current property owner are cut off

• Foreclosure proceedings are regulated by state statutes using three methods: – strict foreclosure– action and sale– power of sale

Foreclosing The Mortgage

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• A mortgagor or an assignee of mortgagor has an equity of redemption in the real estate within a specified redemption period and by full discharge of the mortgage debt– Title to property restored free and clear

Mortgage Redemption

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• Pooling of home loans into securities has been long-standing practice– Practice makes working out troubled loans

difficult for homeowners

• 2007: Federal Court judge dismissed 14 foreclosures filed by Deutsche-Bank – Bank was trustee for investment pool, but

did not own or hold the mortgage loan when the lawsuits were filed

– Lesson: have your paperwork in order!

In re Foreclosure Cases

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• A deed of trust is another mechanism for a security interest in real property– Generally, treated like a mortgage

• Three parties to a deed of trust: property owner who borrows money (debtor), trustee who holds legal title to property put up as security, and lender and the beneficiary of the trust

Deed of Trust

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• Land contract secures the balance due seller for the purchase of real estate– An installment contract for a land purchase

• Seller agrees to convey property title to buyer when full price paid, but buyer takes possession of, pays taxes on, insures, and assumes other obligations for the property

Land Contract

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• Two statutory systems permit one who furnishes labor or materials to improve real estate to claim a lien until they are paid– Simple sale of goods does not entitle

seller to a lien on real property • A general contractor contracts with owner

to build, remodel, or improve real property• A subcontractor contracts with general

contractor to perform a particular job

Mechanic’s & Materialman’s Liens

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• New York system: subcontractors or materialmen cannot recover more than is owed to the contractor at the time they file a lien or give notice of lien to owner

• Pennsylvania system: subcontractors or materialmen have direct liens and are entitled to liens for the value of labor and materials furnished, irrespective of amount due from owner to contractor

Mechanic’s & Materialman’s Liens

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• Statutes generally require filing of a notice of lien with a county official

• Most statutes grant priority to mechanic’s lien over all liens attaching after first work performed or first materials are furnished– Priority: order of payment

Mechanic’s & Materialman’s Liens

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Test Your Knowledge

• True=A, False = B– A guarantor is primarily liable for debtor’s

obligation, and the creditor can demand performance from the guarantor at the time the debt is due.

– Since a surety is not the principle debtor, it has no defenses available in response to a creditor’s demand for payment.

– A bond company is a compensated surety.

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• True=A, False = B– A creditor must disclose to a surety all

information about the risk involved in a particular debtor, including whether the debtor business is likely to be successful

– Foreclosure means that the mortgagor’s rights to the property are terminated.

– A mortgage is a security interest in (or deed to) personal property.

Test Your Knowledge

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• Multiple Choice– Bob Builder contracted with Joe Homes to

build a house. Bob hired Ken Carpenter, who built the kitchen cabinets, but Bob refused to pay Ken. What should Ken do? a) Ken may file a lien on Joe’s real propertyb) Ken may file a mortgage on Joe’s propertyc) Ken may sue Bob and Joe for redemptiond) Ken may foreclose on Bob for payment

Test Your Knowledge

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• Multiple Choice– Which two statutory systems permit one

who furnishes labor or materials to improve real estate to claim a lien until they are paid? a) The Torrens and Priority systemsb) The Pennsylvania and New York systemsc) The New York and New Jersey systemsd) None of the above

Test Your Knowledge

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Thought Questions

• What are the advantages and disadvantages of credit?

• How does credit affect your life?

• Do you have any secured credit?