Flyover 2 - Default

Welcome back. We now know how a creditor's security interest attaches. Now let's move on to default.

A primary benefit to a creditor of having a security interest in collateral is to be able to extract value from the collateral if the debtor defaults on the accompanying loan. Getting value from the property to pay off the loan due involves sale of the collateral or accepting collateral in lieu of a sale.

As an initial matter, a secured creditor will want to get possession of the collateral. Possession allows the creditor to keep the property safe in advance of sale or retention. Article 9 provides that, after default, the secured party may take possession of its collateral without using any judicial process as long as it does so without breaching the peace. This is called "self-help repossession."

Article 9 does not define what it means to breach the peace. Courts have ruled that if the debtor verbally or physically objects to the repossession, that is a breach of the peace, and the secured creditor must stop trying to repossess the collateral.

If the police or a sheriff helps the secured creditor try to repossess, that also is a breach of the peace. If the secured creditor breaks into the debtor's real property and leaves other property unsafe in the act of repossessing, that also is a breach of the peace.

But if the secured creditor convinces the debtor to turn over possession of the property, or if the secured creditor repossesses at a time when the debtor is not around to object, that self-help repossession is allowed.

Default - Intro

If the debtor defaults, the first step for a secured creditor is to get possession of the collateral. It does that most often through self-help repossession, making sure to not breach the peace. Once the secured creditor possesses the property, it will dispose of it. It can sell the collateral or accept the collateral in lieu of sale. The secured creditor will apply the sale proceeds or the value of the collateral retained against the loan amount due.

Default - Redeem

Before the moment of sale, or when the secured creditor's acceptance is effective, the debtor has the right to redeem. To redeem, the debtor must pay the secured creditor and all other creditors with security interest in the property all amounts that are due.

If so, all the creditors' interests are satisfied. The debtor can keep the property. To recap, if a debtor defaults and the secured creditor threatens to dispose of the collateral to satisfy the debt, before the creditor does so, the debtor can pay off the debt and keep its property.

Default - Sale

Assume the debtor does not redeem. If the secured creditor sells the collateral, Article 9 provides that the sale must proceed in a commercially reasonable manner. Commercially reasonable includes public and private sales. For private sales, reasonableness depends on the type of collateral. For instance, it is commercially reasonable to sell a car at a private automobile auction.

The secured creditor also must notify the debtor and any other creditors with security interest in the collateral of the impending sale at least ten days prior to the sale.

Assume that the secured creditor sells the collateral through a commercially reasonable sale and properly noticed all interested parties. The secured creditor now has a bunch of money, called "proceeds," that it will distribute. The proceeds of the sale first go towards sale costs, then to satisfying the secured creditor, then to any other creditors with subordinate security interests, and then finally to the debtor.

If the secured creditor's security interest is subordinate to another secured creditor's interest, whoever purchases the property through the sale will take the property subject to that other creditor's security interest.

Default - Acceptance

Sale of the collateral is one of two actions that the secured creditor can take to extract value from it to satisfy the debt the creditor is owed. The other action is to accept the collateral in partial or full satisfaction of its debt. To do so, the creditor must notify the debtor and any other creditor with a security interest in the collateral of its intention to accept.

If you encounter a question on the exam about acceptance of collateral, it most likely will focus on the rules about the debtor's reaction to the request to accept. If the debtor consents to the acceptance, the secured creditor may keep the collateral in partial satisfaction of its claim.

This means that if the secured creditor is owed more than the value of the collateral, the debtor still will owe the creditor the difference between the amount due and the value. This is called a "deficiency."

If the debtor does not object, but does not affirmatively consent, the secured creditor may keep the collateral in full satisfaction of its claim. This means that regardless of the relative value of the collateral to the amount outstanding, the debtor will not owe the secured creditor any more money.

So acceptance in partial satisfaction leaves the debtor with a deficiency still owed to the secured creditor. In comparison, acceptance in full satisfaction satisfies the entire debt owed to the secured creditor.

Those are the basic rules about acceptance. One more rule about acceptance: if the collateral is owned by a consumer, meaning an individual person or family using the property for household purposes, the creditor is only allowed to accept the collateral in full satisfaction of its debt.

It may not accept the collateral in partial satisfaction, which means that if a secured creditor retains collateral in a consumer transaction, then the individual's obligation to the secured creditor is satisfied by the acceptance of the collateral.

To recap, this lesson discussed how a secured creditor enforces its security interest. The interest must have attached. If the interest is attached, upon the debtor's default, the secured creditor can repossess the collateral, sell the collateral, or accept the collateral in full or partial satisfaction of its debt.

The next lesson we'll discuss how a secured creditor perfects its security interest.