Chapter 11 Secured Transactions and Suretyship

By Agreement with the Debtor

Security obtained through agreement comes in three major types: (1) personal property security (the most common form of security); (2) suretyship—the willingness of a third party to pay if the primarily obligated party does not; and (3) mortgage of real estate.

By Operation of Law

Security obtained through operation of law is known as a lienAn encumbrance upon property to secure payment.. Derived from the French for “string” or “tie,” a lien is the legal hold that a creditor has over the property of another in order to secure payment or discharge an obligation.

In this chapter, we take up security interests in personal property and suretyship. In the next chapter, we look at mortgages and nonconsensual liens.

Source of Law

Article 9 of the Uniform Commercial Code (UCC) governs security interests in personal property. The UCC defines the scope of the article (here slightly truncated):Uniform Commercial Code, Section 9-109.

This chapter applies to the following:

1. A transaction, regardless of its form, that creates a security interest in personal property or fixtures by contract;
2. An agricultural lien;
3. A sale of accounts, chattel paper, payment intangibles, or promissory notes;
4. A consignment…

Definitions

As always, it is necessary to review some definitions so that communication on the topic at hand is possible. The secured transaction always involves a debtor, a secured party, a security agreement, a security interest, and collateral.

Article 9 applies to any transaction “that creates a security interest.” The UCC in Section 1-201(35) defines security interestRight in personal property to secure payment or performance of an obligation. as “an interest in personal property or fixtures which secures payment or performance of an obligation.”

Security agreementAgreement that grants a security interest. is “an agreement that creates or provides for a security interest.” It is the contract that sets up the debtor’s duties and the creditor’s rights in event the debtor defaults.Uniform Commercial Code, Section 9-102(a)(73).

CollateralProperty given as security for a debt. “means the property subject to a security interest or agricultural lien.”Uniform Commercial Code, Section 9-102(12).

Purchase-money security interestThe security interest held by the seller of collateral to secure payment of all or part of the price. (PMSI) is the simplest form of security interest. Section 9-103(a) of the UCC defines “purchase-money collateral” as “goods or software that secures a purchase-money obligation with respect to that collateral.” A PMSI arises where the debtor gets credit to buy goods and the creditor takes a secured interest in those goods. Suppose you want to buy a big hardbound textbook on credit at your college bookstore. The manager refuses to extend you credit outright but says she will take back a PMSI. In other words, she will retain a security interest in the book itself, and if you don’t pay, you’ll have to return the book; it will be repossessed. Contrast this situation with a counteroffer you might make: because she tells you not to mark up the book (in the event that she has to repossess it if you default), you would rather give her some other collateral to hold—for example, your gold college signet ring. Her security interest in the ring is not a PMSI but a pledge; a PMSI must be an interest in the particular goods purchased. A PMSI would also be created if you borrowed money to buy the book and gave the lender a security interest in the book.

Whether a transaction is a lease or a PMSI is an issue that frequently arises. The answer depends on the facts of each case. However, a security interest is created if (1) the lessee is obligated to continue payments for the term of the lease; (2) the lessee cannot terminate the obligation; and (3) one of several economic tests, which are listed in UCC Section 1-201 (37), is met. For example, one of the economic tests is that “the lessee has an option to become owner of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement.”

The issue of lease versus security interest gets litigated because of the requirements of Article 9 that a security interest be perfected in certain ways (as we will see). If the transaction turns out to be a security interest, a lessor who fails to meet these requirements runs the risk of losing his property to a third party. And consider this example. Ferrous Brothers Iron Works “leases” a $25,000 punch press to Millie’s Machine Shop. Under the terms of the lease, Millie’s must pay a yearly rental of $5,000 for five years, after which time Millie’s may take title to the machine outright for the payment of $1. During the period of the rental, title remains in Ferrous Brothers. Is this “lease” really a security interest? Since ownership comes at nominal charge when the entire lease is satisfied, the transaction would be construed as one creating a security interest. What difference does this make? Suppose Millie’s goes bankrupt in the third year of the lease, and the trustee in bankruptcy wishes to sell the punch press to satisfy debts of the machine shop. If it were a true lease, Ferrous Brothers would be entitled to reclaim the machine (unless the trustee assumed the lease). But if the lease is really intended as a device to create a security interest, then Ferrous Brothers can recover its collateral only if it has otherwise complied with the obligations of Article 9—for example, by recording its security interest, as we will see.

Now we return to definitions.

DebtorOne who owes money or a duty of performance to another. is “a person (1) having an interest in the collateral other than a security interest or a lien; (2) a seller of accounts, chattel paper, payment intangibles, or promissory notes; or (3) a consignee.”Uniform Commercial Code, Section 9-102(a)(28).

ObligorOne who owes an obligation. is “a person that, with respect to an obligation secured by a security interest in or an agricultural lien on the collateral, (i) owes payment or other performance of the obligation, (ii) has provided property other than the collateral to secure payment or other performance of the obligation, or (iii) is otherwise accountable in whole or in part for payment or other performance of the obligation.”Uniform Commercial Code, Section 9-102 (59). Here is example 1 from the Official Comment to UCC Section 9-102: “Behnfeldt borrows money and grants a security interest in her Miata to secure the debt. Behnfeldt is a debtor and an obligor.”

Behnfeldt is a debtor because she has an interest in the car—she owns it. She is an obligor because she owes payment to the creditor. Usually the debtor is the obligor.

A secondary obligor is “an obligor to the extent that: (A) [the] obligation is secondary; or (b) [the person] has a right of recourse with respect to an obligation secured by collateral against the debtor, another obligor, or property of either.”Uniform Commercial Code, Section 9-102(a)(71). The secondary obligor is a guarantor (surety) of the debt, obligated to perform if the primary obligor defaults. Consider example 2 from the Official Comment to Section 9-102: “Behnfeldt borrows money and grants a security interest in her Miata to secure the debt. Bruno cosigns a negotiable note as maker. As before, Behnfeldt is the debtor and an obligor. As an accommodation party, Bruno is a secondary obligor. Bruno has this status even if the note states that her obligation is a primary obligation and that she waives all suretyship defenses.”

Again, usually the debtor is the obligor, but consider example 3 from the same Official Comment: “Behnfeldt borrows money on an unsecured basis. Bruno cosigns the note and grants a security interest in her Honda to secure her [Behnfeldt’s] obligation. Inasmuch as Behnfeldt does not have a property interest in the Honda, Behnfeldt is not a debtor. Having granted the security interest, Bruno is the debtor. Because Behnfeldt is a principal obligor, she is not a secondary obligor. Whatever the outcome of enforcement of the security interest against the Honda or Bruno’s secondary obligation, Bruno will look to Behnfeldt for her losses. The enforcement will not affect Behnfeldt’s aggregate obligations.”

Secured partyThe creditor who has a security interest in a debtor’s collateral. is “a person in whose favor a security interest is created or provided for under a security agreement,” and it includes people to whom accounts, chattel paper, payment intangibles, or promissory notes have been sold; consignors; and others under Section 9-102(a)(72).

Chattel mortgageA security device by which a mortgagee takes security interest in personal property of the mortgagor; mostly superseded by other security arrangements under UCC Article 9. means “a debt secured against items of personal property rather than against land, buildings and fixtures.”Commercial Brokers, Inc., “Glossary of Real Estate Terms,” http://www.cbire.com/index.cfm/fuseaction/terms.list/letter/C/contentid/32302EC3-81D5-47DF-A9CBA32FAE38B22A.

Goods

Tangible property as collateral is goods. Goods means “all things that are movable when a security interest attaches. The term includes (i) fixtures, (ii) standing timber that is to be cut and removed under a conveyance or contract for sale, (iii) the unborn young of animals, (iv) crops grown, growing, or to be grown, even if the crops are produced on trees, vines, or bushes, and (v) manufactured homes. The term also includes a computer program embedded in goods.”Uniform Commercial Code, Section 9-102(44). Goods are divided into several subcategories; six are taken up here.

Intangible Property

Two types of collateral are neither goods nor indispensible paper: accounts and general intangibles.

Indispensable Paper

This oddly named category is the middle ground between goods—stuff you can touch—and intangible property. It’s called “indispensable” because although the right to the value—such as a warehouse receipt—is embodied in a written paper, the paper itself is indispensable for the transferee to access the value. For example, suppose Deborah Debtor borrows $3,000 from Carl Creditor, and Carl takes a security interest in four designer chairs Deborah owns that are being stored in a warehouse. If Deborah defaults, Carl has the right to possession of the warehouse receipt: he takes it to the warehouser and is entitled to take the chairs and sell them to satisfy the obligation. The warehouser will not let Carl have the chairs without the warehouse receipt—it’s indispensable paper. There are four kinds of indispensable paper.

Other Types of Collateral

Among possible other types of collateral that may be used as security is the floating lienA lien that is expanded to cover any additional property that is acquired by the debtor while the debt is outstanding.. This is a security interest in property that was not in the possession of the debtor when the security agreement was executed. The floating lien creates an interest that floats on the river of present and future collateral and proceeds held by—most often—the business debtor. It is especially useful in loans to businesses that sell their collateralized inventory. Without the floating lien, the lender would find its collateral steadily depleted as the borrowing business sells its products to its customers. Pretty soon, there’d be no security at all. The floating lien includes the following:

• After-acquired property. This is property that the debtor acquires after the original deal was set up. It allows the secured party to enhance his security as the debtor (obligor) acquires more property subject to collateralization.
• Sale proceeds. These are proceeds from the disposition of the collateral. Carl Creditor takes a secured interest in Deborah Debtor’s sailboat. She sells the boat and buys a garden tractor. The secured interest attaches to the garden tractor.

• Future advances. Here the security agreement calls for the collateral to stand for both present and future advances of credit without any additional paperwork.

  Here are examples of future advances:

  • Example 1: A debtor enters into a security agreement with a creditor that contains a future advances clause. The agreement gives the creditor a security interest in a $700,000 inventory-picking robot to secure repayment of a loan made to the debtor. The parties contemplate that the debtor will, from time to time, borrow more money, and when the debtor does, the machine will stand as collateral to secure the further indebtedness, without new paperwork.
  • Example 2: A debtor signs a security agreement with a bank to buy a car. The security agreement contains a future advances clause. A few years later, the bank sends the debtor a credit card. Two years go by: the car is paid for, but the credit card is in default. The bank seizes the car. “Whoa!” says the debtor. “I paid for the car.” “Yes,” says the bank, “but it was collateral for all future indebtedness you ran up with us. Check out your loan agreement with us and UCC Section 9-204(c), especially Comment 5.”

See Figure 11.2 "Tangibles and Intangibles as Collateral".

In General

AttachmentThe process by which a security interest becomes enforceable against the debtor with respect to the collateral. is the term used to describe when a security interest becomes enforceable against the debtor with respect to the collateral. In Figure 11.1 "The Grasping Hand", ”Attachment” is the outreached hand that is prepared, if the debtor defaults, to grasp the collateral.Uniform Commercial Code, Section 9-203(a).

Requirements for Attachment

There are three requirements for attachment: (1) the secured party gives value; (2) the debtor has rights in the collateral or the power to transfer rights in it to the secured party; (3) the parties have a security agreement “authenticated” (signed) by the debtor, or the creditor has possession of the collateral.

Perfection by Filing

“Except as otherwise provided…a financing statement must be filed to perfect all security agreements.”Uniform Commercial Code, Section 9-310(a).

Temporary Perfection

The UCC provides that certain types of collateral are automatically perfected but only for a while: “A security interest in certificated securities, or negotiable documents, or instruments is perfected without filing or the taking of possession for a period of twenty days from the time it attaches to the extent that it arises for new value given under an authenticated security agreement.”Uniform Commercial Code, Section 9-312(e). Similar temporary perfection covers negotiable documents or goods in possession of a bailee, and when a security certificate or instrument is delivered to the debtor for sale, exchange, presentation, collection, enforcement, renewal, or registration.Uniform Commercial Code, Section 9-312(f) and (g). After the twenty-day period, perfection would have to be by one of the other methods mentioned here.

Perfection by Possession

A secured party may perfect the security interest by possession where the collateral is negotiable documents, goods, instruments, money, tangible chattel paper, or certified securities.Uniform Commercial Code, Section 9-313. This is a pledge of assets (mentioned in the example of the stamp collection). No security agreement is required for perfection by possession.

A variation on the theme of pledge is field warehousingMortgage arrangement in which a lender secures its loan with a lien on items stored in a warehouse or at the debtor’s place of business, with access to the items controlled by the lender, who releases goods as they are paid for by the borrower.. When the pawnbroker lends money, he takes possession of the goods—the watch, the ring, the camera. But when large manufacturing concerns wish to borrow against their inventory, taking physical possession is not necessarily so easy. The bank does not wish to have shipped to its Wall Street office several tons of copper mined in Colorado. Bank employees perhaps could go west to the mine and take physical control of the copper, but banks are unlikely to employ people and equipment necessary to build a warehouse on the spot. Thus this so-called field pledge is rare.

More common is the field warehouse. The field warehouse can take one of two forms. An independent company can go to the site and put up a temporary structure—for example, a fence around the copper—thus establishing physical control of the collateral. Or the independent company can lease the warehouse facilities of the debtor and post signs indicating that the goods inside are within its sale custody. Either way, the goods are within the physical possession of the field warehouse service. The field warehouse then segregates the goods secured to the particular bank or finance company and issues a warehouse receipt to the lender for those goods. The lender is thus assured of a security interest in the collateral.

Perfection by Control

“A security interest in investment property, deposit accounts, letter-of-credit rights, or electronic chattel paper may be perfected by control of the collateral.”Uniform Commercial Code, Section 9-314. “Control” depends on what the collateral is. If it’s a checking account, for example, the bank with which the deposit account is maintained has “control”: the bank gets a security interest automatically because, as Official Comment 3 to UCC Section 9-104 puts it, “all actual and potential creditors of the debtor are always on notice that the bank with which the debtor’s deposit account is maintained may assert a claim against the deposit account.” “Control” of electronic chattel paper of investment property, and of letter-of-credit rights is detailed in Sections 9-105, 9-106, and 9-107. Obtaining “control” means that the creditor has taken whatever steps are necessary, given the manner in which the items are held, to place itself in a position where it can have the items sold, without further action by the owner.Uniform Commercial Code, Section 8-106, Official Comment 1.

Automatic Perfection

The fifth mechanism of perfection is addressed in Section 9-309 of the UCC: there are several circumstances where a security interest is perfected upon mere attachment. The most important here is automatic perfectionPerfection by mere attachment. of a purchase-money security interest given in consumer goods. If a seller of consumer goods takes a PMSI in the goods sold, then perfection of the security interest is automatic. But the seller may file a financial statement and faces a risk if he fails to file and the consumer debtor sells the goods. Under Section 9-320(b), a buyer of consumer goods takes free of a security interest, even though perfected, if he buys without knowledge of the interest, pays value, and uses the goods for his personal, family, or household purposes—unless the secured party had first filed a financing statement covering the goods.

Application of the Rule

If both parties have perfected, the first to perfect wins. If one has perfected and one attached, the perfected party wins. If both have attached without perfection, the first to attach wins. If neither has attached, they are unsecured creditors. Let’s test this general rule against the following situations:

1. Rosemary, without having yet lent money, files a financing statement on February 1 covering certain collateral owned by Susan—Susan’s fur coat. Under UCC Article 9, a filing may be made before the security interest attaches. On March 1, Erika files a similar statement, also without having lent any money. On April 1, Erika loans Susan $1,000, the loan being secured by the fur coat described in the statement she filed on March 1. On May 1, Rosemary also loans Susan $1,000, with the same fur coat as security. Who has priority? Rosemary does, since she filed first, even though Erika actually first extended the loan, which was perfected when made (because she had already filed). This result is dictated by the rule even though Rosemary may have known of Erika’s interest when she subsequently made her loan.
2. Susan cajoles both Rosemary and Erika, each unknown to the other, to loan her $1,000 secured by the fur coat, which she already owns and which hangs in her coat closet. Erika gives Susan the money a week after Rosemary, but Rosemary has not perfected and Erika does not either. A week later, they find out they have each made a loan against the same coat. Who has priority? Whoever perfects first: the rule creates a race to the filing office or to Susan’s closet. Whoever can submit the financing statement or actually take possession of the coat first will have priority, and the outcome does not depend on knowledge or lack of knowledge that someone else is claiming a security interest in the same collateral. But what of the rule that in the absence of perfection, whichever security interest first attached has priority? This is “thought to be of merely theoretical interest,” says the UCC commentary, “since it is hard to imagine a situation where the case would come into litigation without [either party] having perfected his interest.” And if the debtor filed a petition in bankruptcy, neither unperfected security interest could prevail against the bankruptcy trustee.

To rephrase: An attached security interest prevails over other unsecured creditors (unsecured creditors lose to secured creditors, perfected or unperfected). If both parties are secured (have attached the interest), the first to perfect wins.Uniform Commercial Code, Section 9-322(a)(2). If both parties have perfected, the first to have perfected wins.Uniform Commercial Code, Section 9-322(a)(1).

Exceptions to the General Rule

There are three immediate exceptions to the general rule, and several other exceptions, all of which—actually—make some straightforward sense even if it sounds a little complicated to explain them.

Resort to Judicial Process

After a debtor’s default (e.g., by missing payments on the debt), the creditor could ignore the security interest and bring suit on the underlying debt. But creditors rarely resort to this remedy because it is time-consuming and costly. Most creditors prefer to repossess the collateral and sell it or retain possession in satisfaction of the debt.

Repossession

Section 9-609 of the Uniform Commercial Code (UCC) permits the secured party to take possession of the collateral on default (unless the agreement specifies otherwise):

(a) After default, a secured party may (1) take possession of the collateral; and (2) without removal, may render equipment unusable and dispose of collateral on a debtor’s premises.

(b) A secured party may proceed under subsection (a): (1) pursuant to judicial process; or (2) without judicial process, if it proceeds without breach of the peace.

This language has given rise to the flourishing business of professional “repo men” (and women). “Repo” companies are firms that specialize in repossession collateral. They have trained car-lock pickers, in-house locksmiths, experienced repossession teams, damage-free towing equipment, and the capacity to deliver repossessed collateral to the client’s desired destination. Some firms advertise that they have 360-degree video cameras that record every aspect of the repossession. They have “skip chasers”—people whose business it is to track down those who skip out on their obligations, and they are trained not to breach the peace.Here is an example of sophisticated online advertising for a repossession firm: SSR, “Southern & Central Coast California Repossession Services,” http://www.simonsrecovery.com/index.htm. See Pantoja-Cahue v. Ford Motor Credit Co., a case discussing repossession, in Section 11.5 "Cases".

The reference in Section 9-609(a)(2) to “render equipment unusable and dispose of collateral on a debtor’s premises” gets to situations involving “heavy equipment [when] the physical removal from the debtor’s plant and the storage of collateral pending disposition may be impractical or unduly expensive.…Of course…all aspects of the disposition must be commercially reasonable.”Uniform Commercial Code, Section 9-609(a)(2), Official Comment 6. Rendering the equipment unusable would mean disassembling some critical part of the machine—letting it sit there until an auction is set up on the premises.

The creditor’s agents—the repo people—charge for their service, of course, and if possible the cost of repossession comes out of the collateral when it’s sold. A debtor would be better off voluntarily delivering the collateral according to the creditor’s instructions, but if that doesn’t happen, “self-help”—repossession—is allowed because, of course, the debtor said it would be allowed in the security agreement, so long as the repossession can be accomplished without breach of peace. “Breach of peace” is language that can cover a wide variety of situations over which courts do not always agree. For example, some courts interpret a creditor’s taking of the collateral despite the debtor’s clear oral protest as a breach of the peace; other courts do not.

Sale

Sale is the usual method of recovering the debt. Section 9-610 of the UCC permits the secured creditor to “sell, lease, license, or otherwise dispose of any or all of the collateral in its present condition or following any commercially reasonable preparation or processing.” The collateral may be sold as a whole or in parcels, at one time or at different times. Two requirements limit the creditor’s power to resell: (1) it must send notice to the debtor and secondary obligor, and (unless consumer goods are sold) to other secured parties; and (2) all aspects of the sale must be “commercially reasonable.”Uniform Commercial Code, Section 9-611; Uniform Commercial Code, Section 9-610. Most frequently the collateral is auctioned off.

Section 9-615 of the UCC describes how the proceeds are applied: first, to the costs of the repossession, including reasonable attorney’s fees and legal expenses as provided for in the security agreement (and it will provide for that!); second, to the satisfaction of the obligation owed; and third, to junior creditors. This again emphasizes the importance of promptly perfecting the security interest: failure to do so frequently subordinates the tardy creditor’s interest to junior status. If there is money left over from disposing of the collateral—a surplus—the debtor gets that back. If there is still money owing—a deficiency—the debtor is liable for that. In Section 9-616, the UCC carefully explains how the surplus or deficiency is calculated; the explanation is required in a consumer goods transaction, and it has to be sent to the debtor after the disposition.

Strict Foreclosure

Because resale can be a bother (or the collateral is appreciating in value), the secured creditor may wish simply to accept the collateral in full satisfaction or partial satisfaction of the debt, as permitted in UCC Section 9-620(a). This is known as strict foreclosureThe creditor takes the collateral, discharges the debtor, and has no right to seek any deficiency.. The debtor must consent to letting the creditor take the collateral without a sale in a “record authenticated after default,” or after default the creditor can send the debtor a proposal for the creditor to accept the collateral, and the proposal is effective if not objected to within twenty days after it’s sent.

The strict foreclosure provisions contain a safety feature for consumer goods debtors. If the debtor has paid at least 60 percent of the debt, then the creditor may not use strict foreclosure—unless the debtor signs a statement after default renouncing his right to bar strict foreclosure and to force a sale.Uniform Commercial Code, 9-620(e); Uniform Commercial Code, Section 9-624. A consumer who refuses to sign such a statement thus forces the secured creditor to sell the collateral under Section 9-610. Should the creditor fail to sell the goods within ninety days after taking possession of the goods, he is liable to the debtor for the value of the goods in a conversion suit or may incur the liabilities set forth in Section 9-625, which provides for minimum damages for the consumer debtor. Recall that the UCC imposes a duty to act in good faith and in a commercially reasonable manner, and in most cases with reasonable notification.Uniform Commercial Code, Section 1-203. See Figure 11.5 "Disposition after Repossession".

Foreclosure on Intangible Collateral

A secured party’s repossession of inventory or equipment can disrupt or even close a debtor’s business. However, when the collateral is intangible—such as accounts receivable, general intangibles, chattel paper, or instruments—collection by a secured party after the debtor’s default may proceed without interrupting the business. Section 9-607 of the UCC provides that on default, the secured party is entitled to notify the third party—for example, a person who owes money on an account—that payment should be made to him. The secured party is accountable to the debtor for any surplus, and the debtor is liable for any deficiency unless the parties have agreed otherwise.

As always in parsing the UCC here, some of the details and nuances are necessarily omitted because of lack of space or because a more detailed analysis is beyond this book’s scope.

Definition

Suretyship is the second of the three major types of consensual security arrangements noted at the beginning of this chapter (personal property security, suretyship, real property security)—and a common one. Creditors frequently ask the owners of small, closely held companies to guarantee their loans to the company, and parent corporations also frequently are guarantors of their subsidiaries’ debts. The earliest sureties were friends or relatives of the principal debtor who agreed—for free—to lend their guarantee. Today most sureties in commercial transaction are insurance companies (but insurance is not the same as suretyship).

A suretyOne who promises to act or pay upon the default of another: a guarantor. is one who promises to pay or perform an obligation owed by the principal debtorThe person whose debt is guaranteed by a surety., and, strictly speaking, the surety is primarily liable on the debt: the creditor can demand payment from the surety when the debt is due. The creditor is the person to whom the principal debtor (and the surety, strictly speaking) owes an obligation. Very frequently, the creditor requires first that the debtor put up collateral to secure indebtedness, and—in addition—that the debtor engage a surety to make extra certain the creditor is paid or performance is made. For example, David Debtor wants Bank to loan his corporation, David Debtor, Inc., $100,000. Bank says, “Okay, Mr. Debtor, we’ll loan the corporation money, but we want its computer equipment as security, and we want you personally to guarantee the debt if the corporation can’t pay.” Sometimes, though, the surety and the principal debtor may have no agreement between each other; the surety might have struck a deal with the creditor to act as surety without the consent or knowledge of the principal debtor.

A guarantorOne who promises to pay or perform a contract obligation upon the default of another; a surety. also is one who guarantees an obligation of another, and for practical purposes, therefore, guarantor is usually synonymous with surety—the terms are used pretty much interchangeably. But here’s the technical difference: a surety is usually a party to the original contract and signs her (or his, or its) name to the original agreement along with the surety; the consideration for the principal’s contract is the same as the surety’s consideration—she is bound on the contract from the very start, and she is also expected to know of the principal debtor’s default so that the creditor’s failure to inform her of it does not discharge her of any liability. On the other hand, a guarantor usually does not make his agreement with the creditor at the same time the principal debtor does: it’s a separate contract requiring separate consideration, and if the guarantor is not informed of the principal debtor’s default, the guarantor can claim discharge on the obligation to the extent any failure to inform him prejudices him. But, again, as the terms are mostly synonymous, surety is used here to encompass both.

Types of Suretyship

Where there is an interest, public or private, that requires protection from the possibility of a default, sureties are engaged. For example, a landlord might require that a commercial tenant not only put up a security deposit but also show evidence that it has a surety on line ready to stand for three months’ rent if the tenant defaults. Often, a municipal government will want its road contractor to show it has a surety available in case, for some reason, the contractor cannot complete the project. Many states require general contractors to have bonds, purchased from insurance companies, as a condition of getting a contractor’s license; the insurance company is the surety—it will pay out if the contractor fails to complete work on the client’s house. These are types of a performance bondA surety bond that ensures a property owner (as a developer or municipality) of the completion of a construction contract or payment of actual damages to the extent of the bond in the event that the contractor fails to complete it.. A judge will often require that a criminal defendant put up a bond guaranteeing his appearance in court—that’s a type of suretyship where the bail-bonder is the surety—or that a plaintiff put up a bond indemnifying the defendant for the costs of delays caused by the lawsuit—a judicial bondA bond filed with the court as a guarantee. For example, a party to a court action may post a judicial bond to guarantee payment of a verdict while an appeal is being considered.. A bank will take out a bond on its employees in case they steal money from the bank—the bank teller, in this case, is the principal debtor (a fidelity bondAn assurance, generally purchased by an employer, to cover employees who are entrusted with valuable property or funds.). However, as we will see, sureties do not anticipate financial loss like insurance companies do: the surety expects, mostly, to be repaid if it has to perform. The principal debtor goes to an insurance company and buys the bond—the suretyship policy. The cost of the premium depends on the surety company, the type of bond applied for, and the applicant’s financial history. A sound estimate of premium costs is 1 percent to 4 percent, but if a surety company classifies an applicant as high risk, the premium falls between 5 percent and 20 percent of the bond amount. When the purchaser of real estate agrees to assume the seller’s mortgage (promises to pay the mortgage debt), the seller then becomes a surety: unless the mortgagee releases the seller (not likely), the seller has to pay if the buyer defaults.

Creation of the Suretyship

Suretyship can arise only through contract. The general principles of contract law apply to suretyship. Thus a person with the general capacity to contract has the power to become a surety. Consideration is required for a suretyship contract: if Debtor asks a friend to act as a surety to induce Creditor to make Debtor a loan, the consideration Debtor gives Creditor also acts as the consideration Friend gives. Where the suretyship arises after Creditor has already extended credit, new consideration would be required (absent application of the doctrine of promissory estoppelAmerican Druggists’ Ins. Co. v. Shoppe, 448 N.W.2d 103, Minn. App. (1989).). You may recall from the chapters on contracts that the promise by one person to pay or perform for the debts or defaults of another must be evidenced by a writing under the statute of frauds (subject to the “main purpose” exception).

Suretyship contracts are affected to some extent by government regulation. Under a 1985 Federal Trade Commission Credit Practices Rule, creditors are prohibited from misrepresenting a surety’s liability. Creditors must also give the surety a notice that explains the nature of the obligation and the potential liability that can arise if a person cosigns on another’s debt.Here is an example of the required notice: Federal Trade Commission, “Facts for Consumers: The Credit Practices Rule,” http://www.ftc.gov/bcp/edu/pubs/consumer/credit/cre12.shtm.

Duties of the Surety

Upon the principal debtor’s default, the surety is contractually obligated to perform unless the principal herself or someone on her behalf discharges the obligation. When the surety performs, it must do so in good faith. Because the principal debtor’s defenses are generally limited, and because—as will be noted—the surety has the right to be reimbursed by the debtor, debtors not infrequently claim the surety acted in bad faith by doing things like failing to make an adequate investigation (to determine if the debtor really defaulted), overpaying claims, interfering with the contact between the surety and the debtor, and making unreasonable refusals to let the debtor complete the project. The case Fidelity and Deposit Co. of Maryland v. Douglas Asphalt Co., in Section 11.5 "Cases", is typical.

Rights of the Surety

The surety has four main rights stemming from its obligation to answer for the debt or default of the principal debtor.

Defenses of the Parties

The principal and the surety may have defenses to paying.

Preliminary Statement and Issues

This matter is before the court upon a petition by the trustee to sell a diamond ring in his possession free of liens.…Even though no pleadings were filed by Rike-Kumler Company, the issue from the briefs is whether or not a valid security interest was perfected in this chattel as consumer goods, superior to the statutory title and lien of the trustee in bankruptcy.

Findings of Fact

The [debtor] purchased from the Rike-Kumler Company, on July 7, 1964, the diamond ring in question, for $1237.35 [about $8,500 in 2010 dollars], as an engagement ring for his fiancée. He executed a purchase money security agreement, which was not filed. Also, no financing statement was filed. The chattel was adequately described in the security agreement.

The controversy is between the trustee in bankruptcy and the party claiming a perfected security interest in the property. The recipient of the property has terminated her relationship with the [debtor], and delivered the property to the trustee.

Conclusion of Law, Decision, and Order

If the diamond ring, purchased as an engagement ring by the bankrupt, cannot be categorized as consumer goods, and therefore exempted from the notice filing requirements of the Uniform Commercial Code as adopted in Ohio, a perfected security interest does not exist.

No judicial precedents have been cited in the briefs.

Under the commercial code, collateral is divided into tangible, intangible, and documentary categories. Certainly, a diamond ring falls into the tangible category. The classes of tangible goods are distinguished by the primary use intended. Under [the UCC] the four classes [include] “consumer goods,” “equipment,” “farm products” and “inventory.”

The difficulty is that the code provisions use terms arising in commercial circles which have different semantical values from legal precedents. Does the fact that the purchaser bought the goods as a special gift to another person signify that it was not for his own “personal, family or household purposes”? The trustee urges that these special facts control under the express provisions of the commercial code.

By a process of exclusion, a diamond engagement ring purchased for one’s fiancée is not “equipment” bought or used in business, “farm products” used in farming operations, or “inventory” held for sale, lease or service contracts. When the [debtor] purchased the ring, therefore, it could only have been “consumer goods” bought “primarily for personal use.” There could be no judicial purpose to create a special class of property in derogation of the statutory principles.

Another problem is implicit, although not covered by the briefs.

By the foregoing summary analysis, it is apparent that the diamond ring, when the interest of the debtor attached, was consumer goods since it could have been no other class of goods. Unless the fiancée had a special status under the code provision protecting a bona fide buyer, without knowledge, for value, of consumer goods, the failure to file a financing statement is not crucial. No evidence has been adduced pertinent to the scienter question.

Is a promise, as valid contractual consideration, included under the term “value”? In other words, was the ring given to his betrothed in consideration of marriage (promise for a promise)? If so, and “value” has been given, the transferee is a “buyer” under traditional concepts.

The Uniform Commercial Code definition of “value”…very definitely covers a promise for a promise. The definition reads that “a person gives ‘value’ for rights if he acquires them…generally in return for any consideration sufficient to support a simple contract.”

It would seem unrealistic, nevertheless, to apply contract law concepts historically developed into the law of marriage relations in the context of new concepts developed for uniform commercial practices. They are not, in reality, the same juristic manifold. The purpose of uniformity of the code should not be defeated by the obsessions of the code drafters to be all inclusive for secured creditors.

Even if the trustee, in behalf of the unsecured creditors, would feel inclined to insert love, romance and morals into commercial law, he is appearing in the wrong era, and possibly the wrong court.

Ordered, that the Rike-Kumler Company holds a perfected security interest in the diamond engagement ring, and the security interest attached to the proceeds realized from the sale of the goods by the trustee in bankruptcy.

Uniform Commercial Code Section 2A-525(3)

In count I, plaintiff alleged “a breach of the peace occurred as [Ford]’s repossession agent broke into Plaintiff’s locked garage in order to take the vehicle” and Ford’s agent “repossessed the subject vehicle by, among other things, breaking into Plaintiff’s locked garage and causing substantial damage to Plaintiff’s personal property in violation of [section 2A-525(3)]”:

“After a default by the lessee under the lease contract * * * or, if agreed, after other default by the lessee, the lessor has the right to take possession of the goods. * * *

The lessor may proceed under subsection (2) without judicial process if it can be done without breach of the peace or the lessor may proceed by action.” [emphasis added.]

[U]pon a lessee’s default, a lessor has the right to repossess the leased goods in one of two ways: by using the judicial process or, if repossession could be accomplished without a breach of the peace, by self-help [UCC Section 2A-525(3)]. “If a breach of the peace is likely, a properly instituted civil action is the appropriate remedy.” [Citation] (interpreting the term “breach of the peace” in the context of section 9-503 of the Code, which provides for the same self-help repossession as section 2A-525 but for secured creditors rather than lessors).

Taking plaintiff’s well-pleaded allegations as true, Ford resorted to self-help, by employing an agent to repossess the car and Ford’s agent broke into plaintiff’s locked garage to effectuate the repossession. Although plaintiff’s count I allegations are minimal, they are sufficient to plead a cause of action for a violation of section 2A-525(3) if breaking into a garage to repossess a car is, as plaintiff alleged, a breach of the peace. Accordingly, the question here is whether breaking into a locked garage to effectuate a repossession is a breach of the peace in violation of section 2A-525(3).

There are no Illinois cases analyzing the meaning of the term “breach of the peace” as used in the lessor repossession context in section 2A-525(3). However, there are a few Illinois cases analyzing the term as used in section 9-503 of the Code, which contains a similar provision providing that a secured creditor may, upon default by a debtor, repossess its collateral either “(1) pursuant to judicial process; or (2) without judicial process, if it proceeds without breach of the peace.” The seminal case, and the only one of any use in resolving the issue, is Chrysler Credit Corp. v. Koontz, 277 Ill.App.3d 1078, 214 Ill.Dec. 726, 661 N.E.2d 1171 (1996).

In Koontz, Chrysler, the defendant creditor, sent repossession agents to repossess the plaintiff’s car after the plaintiff defaulted on his payments. The car was parked in the plaintiff’s front yard. The plaintiff heard the repossession in progress and ran outside in his underwear shouting “Don’t take it” to the agents. The agents did not respond and proceeded to take the car. The plaintiff argued the repossession breached the peace and he was entitled to the statutory remedy for violation of section 9-503, denial of a deficiency judgment to the secured party, Chrysler.…

After a thorough analysis of the term “breach of the peace,” the court concluded the term “connotes conduct which incites or is likely to incite immediate public turbulence, or which leads to or is likely to lead to an immediate loss of public order and tranquility. Violent conduct is not a necessary element. The probability of violence at the time of or immediately prior to the repossession is sufficient.”…[The Koontz court] held the circumstances of the repossession did not amount to a breach the peace.

The court then considered the plaintiff’s argument that Chrysler breached the peace by repossessing the car under circumstances constituting criminal trespass to property. Looking to cases in other jurisdictions, the court determined that, “in general, a mere trespass, standing alone, does not automatically constitute a breach of the peace.” [Citation] (taking possession of car from private driveway does not, without more, constitute breach of the peace), [Citation] (no breach of the peace occurred where car repossessed from debtor’s driveway without entering “any gates, doors, or other barricades to reach” car), [Citation] (no breach of the peace occurred where car was parked partially under carport and undisputed that no door, “not even one to a garage,” on the debtor’s premises was opened, much less broken, to repossess the car), [Citation] (although secured party may not break into or enter homes or buildings or enclosed spaces to effectuate a repossession, repossession of vehicle from parking lot of debtor’s apartment building was not breach of the peace), [Citation] (repossession of car from debtor’s driveway without entering any gates, doors or other barricades was accomplished without breach of the peace).…

Although the evidence showed the plaintiff notified Chrysler prior to the repossession that it was not permitted onto his property, the court held Chrysler’s entry onto the property to take the car did not constitute a breach of the peace because there was no evidence Chrysler entered through a barricade or did anything other than drive the car away. [Citation] “Chrysler enjoyed a limited privilege to enter [the plaintiff’s] property for the sole and exclusive purpose of effectuating the repossession. So long as the entry was limited in purpose (repossession), and so long as no gates, barricades, doors, enclosures, buildings, or chains were breached or cut, no breach of the peace occurred by virtue of the entry onto his property.”

…[W]e come to essentially the same conclusion: where a repossession is effectuated by an actual breaking into the lessee/debtor’s premises or breaching or cutting of chains, gates, barricades, doors or other barriers designed to exclude trespassers, the likelihood that a breach of the peace occurred is high.

Davenport v. Chrysler Credit Corp., [Citation] (Tenn.App.1991), a case analyzing Tennessee’s version of section 9-503 is particularly helpful, holding that “‘[a] breach of the peace is almost certain to be found if the repossession is accompanied by the unauthorized entry into a closed or locked garage.’”…This is so because “public policy favors peaceful, non-trespassory repossessions when the secured party has a free right of entry” and “forced entries onto the debtor’s property or into the debtor’s premises are viewed as seriously detrimental to the ordinary conduct of human affairs.” Davenport held that the creditor’s repossession of a car by entering a closed garage and cutting a chain that would have prevented it from removing the car amounted to a breach of the peace, “[d]espite the absence of violence or physical confrontation” (because the debtor was not at home when the repossession occurred). Davenport recognized that the secured creditors’ legitimate interest in obtaining possession of collateral without having to resort to expensive and cumbersome judicial procedures must be balanced against the debtors’ legitimate interest in being free from unwarranted invasions of their property and privacy interests.

“Repossession is a harsh procedure and is, essentially, a delegation of the State’s exclusive prerogative to resolve disputes. Accordingly, the statutes governing the repossession of collateral should be construed in a way that prevents abuse and discourages illegal conduct which might otherwise go unchallenged because of the debtor’s lack of knowledge of legally proper repossession techniques” [Citation].

We agree with [this] analysis of the term “breach of the peace” in the context of repossession and hold, with regard to section 2A-525(3) of the Code, that breaking into a locked garage to effectuate a repossession may constitute a breach of the peace.

Here, plaintiff alleges more than simply a trespass. He alleges Ford, through Doe, broke into his garage to repossess the car. Given our determination that breaking into a locked garage to repossess a car may constitute a breach of the peace, plaintiff’s allegation is sufficient to state a cause of action under section 2A-525(3) of the Code. The court erred in dismissing count I of plaintiff’s second amended complaint and we remand for further proceedings.

Uniform Commercial Code Section 2A-108

In count VI, plaintiff alleged the lease agreement was unconscionable because it was formed in violation of [the Illinois Consumer Fraud Statute, requiring that the customer verify that the negotiations were conducted in the consumer’s native language and that the document was translated so the customer understood it.]…Plaintiff does not quote [this] or explain how the agreement violates [it]. Instead, he quotes UCC section 2A-108 of the Code, as follows:

“With respect to a consumer lease, if the court as a matter of law finds that a lease contract or any clause of a lease contract has been induced by unconscionable conduct or that unconscionable conduct has occurred in the collection of a claim arising from a lease contract, the court may grant appropriate relief.

Before making a finding of unconscionability under subsection (1) or (2), the court, on its own motion or that of a party, shall afford the parties a reasonable opportunity to present evidence as to the setting, purpose, and effect of the lease contract or clause thereof, or of the conduct.”

He then, in “violation one” under count VI, alleges the lease was made in violation of [the Illinois Consumer Fraud Statute] because it was negotiated in Spanish but he was only given a copy of the contract in English; he could not read the contract and, as a result, Webb Ford was able to trick him into signing a lease, rather than a purchase agreement; such contract was induced by unconscionable conduct; and, because it was illegal, the contract was unenforceable.

This allegation is insufficient to state a cause of action against Ford under section 2A-108.…First, Ford is an entirely different entity than Webb Ford and plaintiff does not assert otherwise. Nor does plaintiff assert that Webb Ford was acting as Ford’s agent in inducing plaintiff to sign the lease. Plaintiff asserts no basis on which Ford can be found liable for something Webb Ford did. Second, there is no allegation as to how the contract violates [the statute], merely the legal conclusion that it does, as well as the unsupported legal conclusion that a violation of [it] is necessarily unconscionable.…[Further discussion omitted.]

For the reasons stated above, we affirm the trial court’s dismissal of counts IV, V and VI of plaintiff’s second amended complaint. We reverse the court’s dismissal of count I and remand for further proceedings. Affirmed in part and reversed in part; cause remanded.

Per Curium:Latin for “by the court.” A decision of an appeals court as a whole in which no judge is identified as the specific author.

The Georgia Department of Transportation (“GDOT”) contracted with Douglas Asphalt Company to perform work on an interstate highway. After Douglas Asphalt allegedly failed to pay its suppliers and subcontractors and failed to perform under the contract, GDOT defaulted and terminated Douglas Asphalt. Fidelity and Deposit Company of Maryland and Zurich American Insurance Company had executed payment and performance bonds in connection with Douglas Asphalt’s work on the interstate, and after Douglas Asphalt’s default, Fidelity and Zurich spent $15,424,798 remedying the default.

Fidelity and Zurich, seeking to recover their losses related to their remedy of the default, brought this suit against Douglas Asphalt, Joel Spivey, and Ronnie Spivey. The Spiveys and Douglas Asphalt had executed a General Indemnity Agreement in favor of Fidelity and Zurich.They promised to reimburse the surety for its expenses and hold it harmless for further liability.

After a bench trial, the district court entered judgment in favor of Fidelity and Zurich for $16,524,798. Douglas Asphalt and the Spiveys now appeal.

Douglas Asphalt and the Spiveys argue that the district court erred in entering judgment in favor of Fidelity and Zurich because Fidelity and Zurich acted in bad faith in three ways.

First, Douglas Asphalt and the Spiveys argue that the district court erred in not finding that Fidelity and Zurich acted in bad faith because they claimed excessive costs to remedy the default. Specifically, Douglas Asphalt and the Spiveys argue that they introduced evidence that the interstate project was 98% complete, and that only approximately $3.6 million was needed to remedy any default. But, the district court found that the interstate project was only 90%–92% complete and that approximately $2 million needed to be spent to correct defective work already done by Douglas Asphalt. Douglas Asphalt and the Spiveys have not shown that the district court’s finding was clearly erroneous, and accordingly, their argument that Fidelity and Zurich showed bad faith in claiming that the project was only 90% complete and therefore required over $15 million to remedy the default fails.

Second, Douglas Asphalt and the Spiveys argue that Fidelity and Zurich acted in bad faith by failing to contest the default. However, the district court concluded that the indemnity agreement required Douglas Asphalt and the Spiveys to request a contest of the default, and to post collateral security to pay any judgment rendered in the course of contesting the default. The court’s finding that Douglas Asphalt and the Spiveys made no such request and posted no collateral security was not clearly erroneous, and the sureties had no independent duty to investigate a default. Accordingly, Fidelity and Zurich’s failure to contest the default does not show bad faith.

Finally, Douglas Asphalt and the Spiveys argue that Fidelity and Zurich’s refusal to permit them to remain involved with the interstate project, either as a contractor or consultant, was evidence of bad faith. Yet, Douglas Asphalt and the Spiveys did not direct the district court or this court to any case law that holds that the refusal to permit a defaulting contractor to continue working on a project is bad faith. As the district court concluded, Fidelity and Zurich had a contractual right to take possession of all the work under the contract and arrange for its completion. Fidelity and Zurich exercised that contractual right, and, as the district court noted, the exercise of a contractual right is not evidence of bad faith.

Finding no error, we affirm the judgment of the district court.