Flyover 5 - Priority

Now that we have covered attachment and perfection, we have arrived at the pinnacle of secured transactions: priority. Priority is about the order in which creditors can take value from a piece of property. It is not useful to think about priority in the abstract. Priority is the conclusion that a particular claim to a particular piece of collateral is better than any other claim.

Creditors have priority against a specific competing claim held by another creditor or other party. To determine priority in a particular piece of property, each pair of parties with interests in the property must be assessed. I think of assessing priority based on each fight over collateral. For instance, as between two creditors given security interests by the debtor, who takes first in the collateral? Or between a creditor given a security interest and a judicial lien creditor, who takes first in the piece of collateral?

Priority depends on the parties that are fighting over a particular piece of property. There are three fights that you may encounter on a secured transactions question: first, judgment lien creditor versus a secured creditor; second, a secured creditor versus a secured creditor; and third, a buyer of collateral from the debtor against a secured creditor.

Three Fights

1. Judgment Lien Creditor vs. Secured Creditor

First, as between a judgment lien creditor and a secured creditor with rights in a piece of property, who has priority? Recall that a judgment lien is a court ruling that gives a creditor the right to take possession of a debtor's property. A judgment lien creditor is a creditor that has levied on the debtor's personal property. When I use the term secured creditor, I am referring to a creditor given a security interest in the property by a debtor.

As between a judgment lien creditor and a secured creditor, the first to establish rights in the collateral wins. There are specific rules for when each type of creditor establishes rights in the collateral. A judgment lien creditor acquires its rights at the moment the sheriff levies on the particular piece of property.

The rule governing when a secured creditor acquires its rights is more complicated. A secured creditor acquires its rights at the earlier of perfection or the filing of a financing statement, and either having an authenticated security agreement with a sufficient collateral description or controlling or possessing the collateral.

Most typically, the secured creditor will have fully perfected its security interest. The security interest will have attached, and the creditor will have filed an effective financing statement or will have possession or control over the collateral. In that scenario, the moment of perfection is when both its security interest is attached and the financing statement has been filed.

However, notice the second alternative, the filing of a financing statement and either having an authenticated security agreement or controlling or possessing the collateral. This means that a secured creditor can file a financing statement and get the debtor to sign a security agreement long before actually extending value.

Once it extends value, its priority as against a lien creditor is determined by the date it filed the financing statement and the debtor signed the security agreement. This could be months before the secured creditor actually makes the loan.

The second most common scenario for a secured creditor that you may see in a secured transactions question is the giving of a loan in return for a purchase-money security interest. Remember that in the case of consumer goods, the purchase-money security interest perfects automatically. This means that the secured creditor's moment of perfection is when the debtor buys the consumer good.

In short, to determine who between a judgment lien creditor and a secured creditor takes first in a piece of property, consider when the judgment lien creditor levied on the property, and when the secured creditor perfected its security interest.

2. Secured Creditor vs. Secured Creditor

A similar rule applies as between two secured creditors. Again, priority is determined by the first creditor to establish rights in the collateral. The primary rule is that the first secured creditor to perfect or file a financing statement has priority to the collateral. Note that a creditor who simply files a financing statement must, at some point, be given an effective security interest, that is, attach an interest to the collateral.

This means that a secured creditor's priority as against another secured creditor is determined by the date it filed the financing statement. This could be months before the creditor actually makes the loan. Implicit in this rule is that all future advances of funds by the creditor made under security agreement and accompanying documents that provide for such advances have priority as of the filing of the financing statement.

Also implicit in this rule is that all after-acquired property that a secured creditor's interest attaches to have priority as of the filing of the financing statement. The exception is for purchase-money security interests. As a reminder, a purchase-money security interest is created when a debtor purchases property with the money loaned by the creditor taking the security interest.

The property most often purchased is goods. For a purchase-money security interest in goods other than inventory, the secured creditor is given 20 days to perfect the security interest after the debtor receives possession of the goods. If the secured creditor does so, that secured creditor has first priority to the goods.

For example, assume the debtor buys equipment with funds extended by the seller of that equipment. Assume also that the debtor already gave a security interest to a bank which extended to after-acquired equipment. That bank would automatically acquire a security interest in the piece of equipment.

Provided that the seller of the equipment perfected its security interest in that piece of equipment within 20 days of the debtor receiving possession of it, the seller, which also is a lender, will take first in that piece of equipment before the bank. The exception to this exception is for purchase-money security interests in inventory.

For inventory, the purchase-money security interest creditor must give advance notice to creditors already secured by the inventory. If the creditor does so, the purchase-money security interest creditor has first priority in the inventory, provided it perfects its security interest by the time the debtor receives possession of the inventory. In reality, almost all lenders secured by inventory will not allow the debtor to buy inventory on a purchase-money basis.

If you encounter a question about priority between secured creditors, consider if the relevant piece of property is a good, and whether one of the creditors extended the debtor the money to purchase that good. If so, the creditor holds a purchase-money security interest and most likely has priority in that particular good. If not, recall the primary rule is that the first secured creditor to perfect or file a financing statement has priority to the collateral.

3. Buyer vs. Secured Creditor

The final priority fight that you may encounter on a secured transactions question is between a buyer of collateral from the debtor and the secured creditor that has a security interest in the piece of collateral that the debtor sold to the buyer.

The question here is what rights do secured creditors have to access collateral that the debtor sold to third parties, who are called buyers? Article 9 provides that a security agreement is effective against a purchaser of the collateral and that a security interest continues in collateral notwithstanding the sale, unless the secured creditor authorizes the disposition to be free of the security interest.

You might find that a shocking rule, particularly now that you may have realized that almost every piece of inventory you have ever purchased at a store probably had a security interest attached to it. You will be relieved that there are three important exceptions to this primary rule. Most importantly, if the purchaser is a buyer in the ordinary course of business, it takes free of the security interest created by the seller.

A buyer in the ordinary course of business is based on the seller's business. If you buy sparkling water from Target, you are a buyer in the ordinary course of business. Target, in part, is a grocery store. If you buy a coffee mug from Starbucks, you are a buyer in the ordinary course of business. Starbucks sells coffee and coffee-related items.

But if you buy light fixtures from a location of Starbucks that is going out of business, you are not a buyer in the ordinary course of business. In this scenario, you will need to assure yourself that Starbucks' secured creditor has authorized the sale of the light fixture free of the security interest.

In short, even though almost every piece of inventory you ever purchased at a store probably had a security interest attached to it. Because you most likely were a buyer in the ordinary course of business for all those transactions, you, as the buyer, took the personal property free of any security interests.

The second exception to the primary rule is termed the " consumer-to-consumer exception." A buyer of goods from a person who used the goods primarily for consumer purposes takes free of a security interest, even if perfected, if the buyer buys without knowing about the security interest and tends to use the property for consumer purposes and before a financing statement covering the property is filed.

Remember that purchase-money security interests in consumer goods perfect automatically. Most people purchase goods that they might then sell with funds lent by their secured creditor, and thus, most secured creditors lending to consumers do not file financing statements.

This means that if you go to a garage sale and purchase something that has a security interest attached to it, you can rest assured that you will take that property free of the security interest. To do so, however, you must actually pay for the property. If someone gives you property that has a security interest attached to it and you pay nothing for it, the consumer-to-consumer exception does not apply. The security interest travels with the property, and the secured creditor could repossess it from you if the person who gifted you the property fails to pay the underlying loan.

The final exception to the primary rule that a security interest continues in collateral notwithstanding the sale involves unperfected security interest. An unperfected security interest has still attached, but the secured creditor failed to give notice properly to the world. It is unperfected. The buyer takes free of an unperfected security interest if it does not know about the security interest.

To recap, priority is about the order in which creditors can take value from a piece of property. To determine priority in a particular piece of collateral, each pair of parties with interests in that collateral must be assessed.

Judgment lien creditors' and secured creditors' priority is assessed primarily by first in time, first in right. There are different specific rules for each type of creditor's exact timing for gaining rights in the collateral. Buyers of collateral will take the property they purchased subject to a secured creditor's interest unless they are buyers in the ordinary course, they're buying in a consumer-to-consumer transaction, or the security interest is unperfected.

We have reached the end of the material about secured transactions. Thank you for coming with me on the journey from attachment through perfection and, finally, to priority. Once you feel confident with the material, you can test your knowledge on a secured transactions question from a recent MEE.