Secured Transactions

Priority of Interests

What Are Secured Creditors?

Secured creditors have priority over other creditors with regard to the property they have a security interest in.

A secured creditor has a specific right to property that the debtor designated as collateral in accordance with a security agreement. If a debtor has offered up certain goods as collateral and the creditor and debtor have a security agreement, then the creditor can seek a lien on those goods. A lien is a security interest granted for an asset or property on behalf of a creditor by a debtor. A secured creditor generally has the right to repossess or sell the collateral if the debtor defaults. For example, a bank is a secured creditor because it has a right to a person’s vehicle in the event that person fails to deliver his end of the bargain, as detailed in the parties' agreement.

These creditors might be oversecured or undersecured. Oversecured is when a secured creditor has an interest in collateral that is worth more than the creditor's claim. For example, suppose First Bank loaned Ben $7,000 for his family vacation but that his car is actually worth $21,000. Here, First Bank is oversecured because its interest in the collateral, Ben's vehicle, is worth more than the loan it gave him. Undersecured is when a secured creditor has an interest in collateral that is worth less than the amount of the creditor's claim. When creditors are undersecured, they have two claims against the debtor: a secured claim against the debtor up to the value of the collateral and an unsecured claim against the debtor for the deficient amount. If Ben's vehicle is only worth $5,000 and First Bank still loaned him $7,000, First Bank is undersecured. In this case, First Bank still has a secured claim against Ben's vehicle for $5,000 but also has an unsecured claim against Ben for the remaining $2,000 (the difference in value between the loan and the collateral, $7,000 – $5,000).

When debtors are insolvent, they typically lack enough assets to pay off all of their creditors. Therefore, creditors strive to be first in line to get paid off. This is called priority. When more than one creditor has a security interest in the same collateral, the priority rules apply. First, creditors with a perfected security interest—one that is protected from the claims of others—take priority over creditors with an unperfected security interest. If both parties perfected their security interests, then the first creditor who filed the security interest with the proper public office gets priority. If neither party perfected their security interest, then the first security interest to attach gets priority.

Priority of Creditors

When a debtor becomes insolvent, creditors have different levels of priority. These levels depend on whether they are secured by collateral, whether the transaction qualifies for a PMSI, and when or if the creditor perfected its security interest.
Generally, once a secured creditor's interest is perfected, it lives on even if the debtor sells, exchanges, or in some way transfers the collateral. An exception to the rule is if a buyer in ordinary course of business purchases the goods. A buyer in ordinary course of business (BIOC) is a person who buys goods in good faith—meaning without the knowledge that the sale violates the rights of another—from a seller who is in the business of selling such goods. A BIOC is not affected by the security interest in the goods. This exception exists to encourage ordinary commerce between the general public and retailers. It would be unreasonable to require the general public to perform a finance check before buying the smallest of items.

What Are Unsecured Creditors?

Unsecured creditors have no priority and are only entitled to take what is left after secured creditors have been satisfied.
An unsecured creditor, often referred to as a general creditor or ordinary creditor, has no claim against specific property of the debtor. They do not have the right to seize any of the debtor's property upon default. Instead, the unsecured creditor must sue the debtor in court for a judgment on its claim. If the unsecured creditor attempts to physically take the debtor's property without pursuing its claim through court, that creditor may be sued or prosecuted.

How an Unsecured Creditor Satisfies a Claim

An unsecured creditor must take five steps through the judicial system to collect a debt from a debtor who is insolvent. Because this process is long, difficult, and expensive, it makes business sense to be a secured creditor whenever possible.
A judicial lien is an official court document that allows a creditor to keep a debtor's property until the debtor pays off a debt. It gives a creditor an interest in specific property owned by the debtor. When an unsecured creditor gets a judicial lien, they become a lien creditor. A lien creditor is an unsecured creditor who won a judgment against the debtor and is allowed to keep specific property of the debtor until a debt is paid.

After a judgment is entered, the lien creditor takes a writ of execution to the sheriff. A writ of execution is a court order to enforce a judgment. The sheriff is instructed to seize the debtor's property and return it to the lien creditor. For example, a foreclosure sale of a home in which the creditor has delinquent mortgage payments.

Other options for creditors include seeking a writ of attachment or a writ of garnishment. A writ of attachment authorizes a sheriff to seize specific property from a debtor because there is a legal action in progress against that debtor. The court holds the property rather than turning it over to the creditor. A judge can issue a writ of garnishment during litigation, which orders a third party to seize the debtor's property and return it to the creditor.

Not all of the debtor's assets are subject to execution, attachment, or garnishment. For example, household goods, medical devices, personal vehicles, and items needed for the debtor to produce income are not subject to execution, attachment, or garnishment. These items are excluded for public policy concerns because these are typically fundamental items a person needs to survive.