PRIORITIES

Priorities are determined by the status of the parties involved.

Unsecured Creditor: A creditor who has a personal claim against the debtor and no security interest in the collateral is an unsecured creditor. An unsecured creditor can change his status by getting the debtor to grant a security interest, or he can sue, recover judgment, and create a judicial lien on the collateral.

Judicial Lien Creditor: A creditor who has acquired a lien on the debtor's property by judicial process is a judicial lien creditor. Under Article 9 a lien creditor also includes a trustee appointed in a debtor's bankruptcy, an assignee appointed to represent the debtor's creditors in state liquidation procedures, or a receiver appointed by a court of equity to take over and control the debtor's property 9-301(3). A lien creditor's interest arises at the time of levy. Under the majority, the time of levy is the time that a judicial officer physically seizes the property; under the minority, levy relates back to the time the court clerk issued the writ of execution. A judicial lien is automatically created on all the bankrupt debtor's nonexempt property at the moment the bankruptcy petition is filed. A lien on an assignment for the benefit of creditors arises at the time of appointment of the receiver 9-301(3).

Secured Creditor: If a debtor has agreed to give a security interest in specific collateral to a creditor, and that creditor has taken the steps necessary for the security interest to attach, that creditor becomes a secured creditor 9-203.

Perfected and Secured Creditor: A secured creditor who has taken the steps necessary to protect the security interest from other claimants is a perfected and secured creditor.

Statutory Lien Creditor: A creditor whose lien interest arises automatically by statute or common law is a statutory lien creditor. Statutory liens are granted to taxing authorities, lawyers, innkeepers, landlords, mechanics, and others who have performed services for the debtor. This type of lien attaches to the debtor's property at the time specified by statute.

UNPERFECTED CREDITORS

If there are two conflicting security interests by unperfected creditors in the same collateral, the order of attachment determines priority in the collateral 9-312(5)(b); the first to attach will have priority. Perfected creditors have absolute priority over unperfected creditors; the only exception to this rule is when the creditor knows of the contents of a misfiled financing statement and obtains this knowledge before becoming perfected 9-401(2). An unperfected creditor is junior to a judicial lien creditor who levies before the unperfected creditor perfects his interest. Unperfected creditors are junior to statutory lien holders unless the statutes creating the lien state otherwise 9-310. BFP's are superior to unperfected creditors if the BFP takes without knowledge of the unperfected interest 9-301(1).

PERFECTED CREDITORS

Perfected security interests are superior to unperfected security interests in the same collateral. The priority between perfected creditors is governed by the general rule of priority. The general rule is then modified by the nature of the security interest, the collateral, and the security agreement. The general rule gives the party who files first priority even if a later creditor perfected first. It also gives priority to any interest perfected by a method other than filing over filed interests only if the nonfiling creditor perfected before the other creditor's filing 9-312(5). The general rule is known as the 'first to file or perfect' rule. Note: Knowledge and time of attachment have no bearing on the outcome.

PURCHASE MONEY SECURITY INTERESTS

A purchase money security interest in noninventory takes priority over conflicting security interests in the same collateral if the interest is perfected when the debtor takes possession of the collateral or within 10 days thereafter 9-312(4). Knowledge of prior interests are immaterial. The superiority of the purchase money security interest is limited to the quantum of the cash or credit used in acquisition of the collateral. A purchase money security interest in inventory gets superiority over other creditors only if the purchase money security interest is already perfected at the time the debtor receives possession of the collateral. In addition, the purchase money secured party must give written notice, prior to the date the debtor takes possession of the collateral, to any other security interest holder who has previously filed a financing statement covering inventory of the same type of goods as those that will be covered in the purchase money security interest 9-312(3)(b). The notice must state that the person filing has or expects to acquire a purchase money security interest in the debtor's inventory, and describe the inventory by item or type 9-312(3)(d). The notice lasts five years and may be renewed for continuing five year periods 9-312(3)(c).

TYPES OF COLLATERAL

Fixtures: Purchase money security interests prevail over most existing and future interests in the real estate if the purchase money security interest is perfected by a 'fixture filing' at the time the goods are affixed to the realty or within 10 days thereafter, and if the debtor is the owner or someone in possession of the real estate 9-313(1)(b). A fixture filing requires the normal financing statement and a recital that it is to be filed in the real estate records along with a description of the goods and the real estate. An omission of the statement is not fatal if the papers are actually filed in the proper place. The description of the real estate must provide for constructive notice of the security interest to those examining the real estate records. If the debtor is not the record owner of the real property and is in possession, the financing statement must include the identity of the record owner 9-402(5), 9-403(7).

Exemptions: A lender who finances the construction of a building takes superior priority over all items that become part of the building during construction; this includes superiority over a perfected purchase money security interest in goods becoming fixtures during construction 9-313(6). This real property superior priority may be subordinated in writing 9-313(5)(a).

A nonpurchase money security interest is inferior to prior recorded interests in the realty. However, a nonpurchase money security interest can prevail over subsequent parties (i.e. later real property mortgagees and buyers) by making a fixture filing before the subsequent parties obtain rights in the realty 9-313(4)(b). If the subsequent party is a judicial lien creditor, the fixture financier can perfect the security interest by any method before the judicial lien attaches to the realty 9-313(4)(d).

Accessions: If a security interest precedes installation, it takes priority over a party who has an interest in the whole of the goods 9-314(1). If the security interest attaches subsequent to installation, the secured party takes priority over those who hold interests at the time of installation only to the extent that such parties consent to subordination of their security interest 9-314(2).

Exceptions: The above priority rules are subject to certain exceptions. The following persons will prevail over an unperfected security interest in the accession: a subsequent purchaser for value of the whole; a creditor with a lien on the whole obtained subsequent to affixation or installation; and a creditor with a prior perfected security interest in the whole to the extent that such creditor makes subsequent advances, if they have no knowledge of the unperfected interest when they acquired their interest 9-314(3).

Commingled and Processed Goods: A perfected security interest in goods that have become part of a product transfers to the product if they have been manufactured, assembled, or commingled so that they are no longer identifiable 9-315(1)(a). It is possible to have a virtually unlimited number of transfers depending on the complexity of the product. Under these circumstances, the interests of conflicting parties under this rule are treated as equals 9-315(1)(b).

Proceeds: If a secured party's interest in the original collateral was perfected, that interest normally will continue automatically and permanently in any identifiable proceeds received by the debtor 9-306(2). If the proceeds are the kind of property in which a security interest cannot be perfected by filing, the security interest terminates 10 days after the debtor's receipt of the proceeds unless the security interest is extended by a new perfection; i.e., taking possession 9-306(3)(a). If the place of original filing is not the appropriate place for filing the proceed, the security interest terminates 10 days after receipt unless it is extended by a new perfection 9-306(3)(a). A new perfection made within the 10 day period relates back to the date the original interest was perfected 9-312(6).

The first-to-file-or-perfect rule governs superiority disputes in proceeds except in the following circumstances:

(1) If a security interest exists in the debtor's inventory and a different security interest exists in the debtor's accounts receivable, and the debtor sells the inventory on credit, the accounts receivable creditor will prevails because he was the first to file or perfect as to the accounts 9-312(5).

(2) If a sale of collateral generates promissory notes as proceeds and the notes were transferred to a holder in due course or to a purchaser for new value in the ordinary course of business without knowledge of the interest, the security interest in the instrument would be cut off 9-308, 9-309.

(3) If the purchaser of chattel paper gives new value for it and takes possession in the ordinary course of business, that purchaser has a priority over another security interest in the chattel paper that is claimed merely as proceeds of inventory subject to a security interest even if the purchaser of the chattel paper knows that the paper being bought is subject to the security interest 9-308(b). If the chattel paper is subject to a security interest other than as inventory proceeds, the purchaser of the paper must give new value, and take possession in the ordinary course of business without knowledge of the existing security interest.

Bankruptcy: If bankruptcy is instituted by or against a debtor, a secured party with a perfected security interest in proceeds has a perfected security interest in:

(1) Identifiable noncash proceeds, including separate deposit accounts containing only such proceeds;

(2) Identifiable cash proceeds in the form of money if the proceeds have not been commingled with other money deposited prior to the insolvency proceedings;

(3) Identifiable cash proceeds in the form of checks and similar items that have not been deposited prior to the insolvency proceedings; and

(4) All cash and bank accounts of the debtor in which proceeds have been commingled with other funds, but subject to any right of setoff, and limited to the amount of cash proceeds received by the debtor during the 10 days before insolvency proceedings to which the secured party was entitled but was not paid 9-306(4). A party can setoff only if it had such a right under previous law 9-306(4)(d). Note: These provisions may or may not conflict with Federal Bankruptcy Act Section 545 depending on whether or not 9-306(4)(d) is a statutory lien.

Returned goods: The original security interest in the goods continues if the goods are returned 9-306(5)(a). If the sale of the goods has created chattel paper or an account receivable, the purchaser of the chattel paper or account has a security interest in the returned goods 9-306(5)(b),(c) that must be perfected against creditors of the transferor and purchasers of the returned or repossessed goods. If an inventory financier under subsection 9-306(5)(a) and a purchaser of chattel paper under subsection 9-306(5)(b) have conflicting claims, they are subject to 9-308; the security interest of the purchaser of chattel paper has priority over that of the inventory financier if the purchaser of the chattel paper gave value and took it in the ordinary course of business 9-306(5)(b). If a conflict between an inventory financier and the assignee of an account is created when goods are returned, the interest of the account transferee is subordinate to that of the inventory financier 9-306(5)(c).

SECURITY AGREEMENT

Future Loans A security agreement can create security interests in the collateral and cover the current loan and future loans by the same creditor. The filed financing statement will then perfect the security interest both to the current loan and to any new advances. If a creditor fails to make a security agreement that covers future loans to the debtor, he will prevail over advances pursuant to any later security agreement as long as he had priority over later creditors by filing or possession 9-312(7). Temporary perfection is not valid under this section.

Cross Collaterization: Sometimes a security agreement provides that the collateral will act as security for repayment of a current loan and for any other future debts owed by the debtor to the creditor. Courts have refused to enforce these clauses when the new debt is completely unrelated to the original transaction. Some states do not allow these clauses in consumer loans.

Consent Clauses: Many security agreements have provisions that prohibit the debtor from selling collateral without written consent. If the creditor discovers the unauthorized sale and takes no action, some courts hold that this results in a common law waiver of the security interest in the particular property sold. Other courts refuse to find a waiver and allow the security interest to continue in the proceeds. Other jurisdictions make the alleged waiver of the security interest ineffective if the debtor fails to comply with the implied condition in the agreement that the proceeds be used to repay the debt to the creditor. There is no real direct support for any of these positions under Article 2 or 9.

PRIORITY AMONG SECURED CREDITORS

Buyers of Collateral: If property is subject to an unperfected security interest, a buyer of that property generally acquires the property free of all creditor's rights. A buyer who purchases goods in the ordinary course of business from a dealer's inventory takes free of perfected security interests 9-307(1). A 'buyer in the ordinary course of business' buys goods out of inventory in a transaction that is common to that business, gives new value, and does not know that the sale is in violation of a security agreement (Note: The security interest in the item sold must have been created by the seller). Bulk sales are not covered and if the goods are not in inventory the security interest of the creditor is still valid 9-306(2). Note: Federal statutes govern the sale of farm products subject to secured interests under 7 USC 163.

A purchaser of noninventory takes free of increases in a security interest due to future advances unless the advances are made by the creditor within 45 days following the sale and are made either without knowledge of the sale or pursuant to a commitment that was entered into without such knowledge 9-307(3).

Consumer to Consumer Transactions: A consumer buying consumer goods from another consumer for value takes free of a perfected security interest in the goods unless the buying consumer knows of the security interest, or a financing statement covering them has been filed 9-307(2). This provision has not been adopted in some states.

Quasi-tangible Collateral Chattel Paper: Holders in due course of negotiable instruments, holders to whom a negotiable document of title has been duly negotiated, and bona fide purchasers of investment securities are all protected from perfected security interests. If a purchaser of chattel paper gives new value and takes possession of the collateral in the ordinary course of business, he takes free of any security interest he does not know about at the time of purchase if the security interest is only temporarily perfected under 9-304 or 9-306. The purchaser of the chattel paper prevails even if he knows of the prior inventory security interest 9-308.

Statutory Lien Holders: A person who acquires a line on goods in his possession prevails over a prior perfected security interest in those goods regardless of how the lien arose (common law or statutory law) unless the statute makes the lien inferior to prior secured interests. Only possessory statutory liens are covered by 9-310. Priority between nonpossessory statutory liens is covered by state law.

Federal Tax Lien: Federal tax liens arise at the moment of assessment by the IRS. A federal tax lien's validity against secured interests depends on when the secured interest was perfected. The federal lien takes priority over an unperfected creditor. The federal lien does not prevail over a perfected Article 9 interest until it is filed. The federal lien is inferior to a perfected purchase money security interest in property acquired by the taxpayer even after the tax lien is filed. Floating liens on after-acquired security interests in inventory, chattel paper, instruments, and accounts, which come into existence within the 45 days after the tax lien is filed are superior to the tax lien. After 45 days they are inferior. A perfected security interest covering future advances takes priority over a tax lien to the extent to which it is enlarged by a future advance if the advance was made without knowledge of the tax lien and within 45 days after the tax lien if filed.

Judicial Lien Creditors: A judicial lien creditor is superior to a security interest that is unperfected at the time of the lien creditor's levy and is inferior to a perfected security interest in the collateral 9-301(1)(b). Future advances retain priority if made within 45 days after the judicial lien is acquired or after the 45 days if the creditor either has no knowledge of the judicial lien or the advance is made pursuant to a commitment which was entered into without knowledge of the lien 9-105(1)(k).

Article 2 Claimants: An Article 2 claimant who has possession of goods has a number of rights dependent on whether he is a buyer or a seller. A buyer can reject defective goods or revoke acceptance. By doing so, he obtains a possessory security interest in the goods to secure the return of the price paid for them and other incidental damages 2-602, 2-608, 2-711(3). A seller can stop goods in transit and resell goods 2-706. These Article 2 rights are perfected upon possession. The UCC is silent on the resolution of priorities between Article 2 claimants and Article 9 creditors.

Insolvent buyer: Under 2-702 a seller can make a demand for goods sold on credit to a buyer if he discovers the buyer's insolvency within 10 days after delivery. The time is extended to 90 days if a written fraud was involved. However, 2-702 rights are subject to a good faith purchaser. Under Article 9, a good faith purchaser is defined as a secured creditor. The rights of the secured creditor are superior to those granted to the seller under 2-702.

BANKRUPTCY

Collateral that is subject to any kind of lien or security interest that the trustee determines to be valid at the moment of filing the petition is generally released by the trustee to the lien creditor. Any remaining property is sold, and the proceeds are distributed to special creditors to pay for bankruptcy proceedings, wages and retirement benefits owed to employees of the bankrupt petitioner, certain creditor expenses, and certain tax debts. If any property is left, it is distributed pro rata among the general (unsecured) creditors. The trustee is given an automatic judicial lien on all property of the bankrupt petitioner. He also has all the powers that could have been exercised by a creditor with an execution writ or a creditor with a line on all the property of the petitioner 544(a) of the Bankruptcy Act. This section is called the 'strong arm clause'. The trustee will prevail against any claims, liens, or interests that are not fully perfected at the time of bankruptcy.

Secured Creditors: The filing of a bankruptcy petition creates an automatic stay against any creditor collection activity. The Bankruptcy Act enables the trustee to invalidate security interests that would be completely secure outside of bankruptcy. If a security interest is made by an insolvent petitioner for less than fair value, it is presumed to be fraudulent. Fraud under the Bankruptcy Act encompasses all transactions that limit a creditor's remedies in an unlawful manner and which are made with an intent to defraud other creditors of the petitioner.

Preferences

A preference is defined under Bankruptcy Act 547(b), (c)(7) as (1) A transfer of any property of the debtor, (2) Made to or for the benefit of a creditor, (3) On account of an antecedent debt; (4) Made by the debtor while insolvent and within 90 days before the filing of the bankruptcy petition; (5) The effect of which transfer is to allow the creditor to obtain a greater percentage of the debt than the creditor could otherwise have received in the bankruptcy proceeding; (6) And, in a consumer case only, the aggregate value of all affected property is greater than $600.

If a transaction can be defined as a preference, it is voidable by the trustee in bankruptcy. A secured interest could lose that status and become an unsecured creditor, or a preferred creditor may be forced to repay money to the trustee. Payments for value and payments made to a fully secured creditor are not preferences even if the payments were made on the eve of bankruptcy. A trustee may not find a preference if: (1) The parties intended a contemporaneous exchange or the transfer was substantially contemporaneous; or (2) The payments were made in the ordinary course of the debtor's business or financial affairs.

Insider: An insider is someone who has a close relationship to the petitioner. If the preferred creditor was an insider who received a preferential transfer in the period between 90 days and one year before the filing of the petition, the trustee can recover a transfer if the insider had reasonable cause to believe that the debtor was insolvent at the time of transfer.

Transfers: The time of transfer is critical in finding a preference. A transfer of personal property is complete when a general creditor of the bankrupt could no longer have secured a superior lien to the property by suing the debtor on the debt and levying an attachment on the collateral. For real property, the test is whether a bona fide purchaser of the property could have obtained rights superior to those of the secured party. This argument is a hypothetical one: i.e., if a hypothetical general creditor or BFP could have achieved a higher priority within 90 days of bankruptcy. The lien must be a judicial lien; statutory liens are not included.

Exceptions: No preference will occur when a purchase money security interest perfects within 10 days after the debtor takes possession of the property even if the creditor gave value prior to the debtor's possession. The Bankruptcy Act gives all creditors a 10 day grace period to perfect from the time of transfer. If perfection is created within that period, the transfer is judged at the moment it became effective between the parties (attachment).

AFTER-ACQUIRED PROPERTY

Accounts receivable or inventory falling under a perfected creditor's floating lien are not preferential even if first acquired in the 90 days (one year for insiders) prior to the petition Bankruptcy Act 547(c)(5).

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