Guide to creditor-debtor relationships in business
Debtor-creditor laws govern situations where an obligor is unable to pay a monetary obligation to a creditor. There are three types of relationships between
creditors and obligors.
- First are those who acquire a lien through statute, agreement between the parties, or judicial proceedings against a particular piece of property. This property (or proceeds from its sale) must be used to satisfy the debt to the lien-creditor before it can be used to satisfy debts to other creditors. Once a lien has been created state statutory law governs how the lien is executed against the debtor’s property. The sale of property subject to a lien to satisfy the debt is also governed by state statutory law. The type of property that may be used to satisfy a debt is governed by state and federal legislation, such as the Consumer Credit Protection Act.
- Secondly, a creditor may have a priority interest. A priority arises through statutory law. If a creditor has a priority his debt must be paid ahead of other creditors when the debtor becomes insolvent.
- The third type of creditor is one who has neither a lien against the debtor’s property or holds a statutory priority. Many collection matters fall within this third category.
Non-bankruptcy debtor-creditor law is governed mainly by state statutory and common law. Harassment, defamation, and/or other unfair practices in attempts at debt collection may be curbed by tort claims in state court. States also regulate debt collection through statute. Congress enacted the Fair Debt Collection Practices Act to regulate some debt collectors, in some creditor-debtor relationships. These laws do not apply to commercial obligations and were drafted to protect obligors in personal debt matters, check with your local legal authorities to be sure about laws in your domicile.
Creditors use judicial and statutory processes to have debts satisfied; albeit these legal maneuvers, termed ‘motion practice’ are time consuming and may extend for years and in some cases decades. Attachment is a limited statutory remedy whereby a creditor has the property of a debtor seized to sell the same to satisfy all or part of a debt. In many states personal property such as a ‘homestead’ (the obligor’s home) is exempt from such seizure. Florida is a ‘homestead’ state with laws designed to prevent a creditor from seizing an obligor’s home under any circumstances. Garnishment (typically from an obligor’s pay check or other income) allows a creditor to collect part of a debt up to a certain percentage and depending on prior obligations already being deducted from the said wages
or income to satisfy an obligation.
Replevin allows a creditor to seize goods, such as a security interest, that he or she has a property interest in, to satisfy the debt. The best way to ensure that a creditor is protected under the law to be able to seize property in the event of a default is to file UCC1 forms.
Creditors can be unsecured or secured. An unsecured, or general, creditor has a general claim against a debtor, which is not secured by any particular asset of the debtor. An unsecured creditor has the weakest claim, which may go unpaid. However, an unsecured creditor may become a secured creditor after a lawsuit and judgment.
A secured creditor, who has a claim on a particular asset, can use the court system to seize the asset and to satisfy the debt. This clearly presents a significant risk for the business owner. How does a creditor become a secured creditor and obtain an interest in a debtor’s property? These interests are referred to as liens against the property in question.
Receivership involves the appointing of a third party by a court to dispose of the debtor’s property in order to satisfy the debt in the event
of a bankruptcy. A debtor may attempt to fraudulently convey a piece of property to keep it out of the creditors’ hands. State laws seek to prevent this type of property transfer. Many states have adopted the Uniform Fraudulent Conveyances Act or its successor, the Uniform Fraudulent Transfer Act.
Certain liens are powerful in helping creditors get at the obligor’s assets. In order to know if assets are accessible, it is imperative that you have an understanding of the different types of liens available to secure your business’ interests. Here are liens you may utilize as a business owner:
- Consensual
- Purchase-Money Security Liens
- Non-Purchase-Money Security Liens
- Statutory
- Mechanic’s Liens
- Tax Liens
- Judgment
Consensual Liens
Of the different types of liens, these are liens to which you voluntarily consent, as a result of a loan or other advance of credit. A homebuyer consents to a bank taking a security interest in the home when a mortgage is obtained. A security interest also is created when a car dealer arranges for financing for a car buyer. The property purchased secures the buyer’s obligation to pay for the property.
Consensual liens include:
Purchase-Money Security Interest Liens. Here, the creditor extends credit to the debtor specifically for the purchase of the property that secures the debt. Examples include a first mortgage on a home, a car loan, and situations in which the seller finances the purchase of property, such as furniture, through a credit agreement.
Non-Purchase-Money Security Interest Liens. Here, the debtor puts up property he or she already owns as collateral for a loan. The loan proceeds are then used to pay expenses (or perhaps to buy other property). Examples include a second mortgage (or refinancing of a mortgage) on a home or a loan used to pay operating expenses with previously owned office equipment put up as collateral.
Both types of consensual liens are usually non-possessory, meaning the debtor takes, or retains, possession of the property. However, it’s possible for either type of consensual lien to be possessory. In that case, the creditor takes possession of the collateral. A loan from a pawnbroker, for example, usually would create a possessory, non-purchase-money security interest lien in the collateral.
While this seems very straightforward, the type of debt can have a large impact on the creditor’s rights if a debtor defaults. The rules vary from state to state, but characteristics of a debt are critical to understand if assets are to be protected. Issues include:
Who is holding the property that secures the debt: the debtor or the creditor? In a car loan, the debtor has possession of the property. When a loan is obtained from a pawnshop, the creditor has possession of the property securing the loan.
Was the debt incurred to purchase property or not? For example, a first mortgage loan is a purchase money loan since the proceeds were used to purchase a residence. In contrast, a refinancing loan is not a purchase money loan. The homeowner already owned the property.
What are the characteristics of the property purchased? This is often the essential inquiry when it comes to asset protection. The states, as well as the federal government, have a wide variety of laws relating to what assets are protected from creditors and how they are protected. The primary mechanism for protecting selected
assets is a concept called exemptions. In essence, the law may declare that certain property simply cannot be seized by a creditor.
For many people, the most important exemption is the homestead exemption. This protects part or all of the value of a residence from creditors other than lenders holding mortgages. Each state has its own rules. Some protect the residence fully; others provide little or no protection. Other types of property that might be
protected are personal items and business tools of the trade (for more details, discuss this with your attorney or accountant).
Statutory Liens
There are many different types of liens that creditors can use to get at your assets to satisfy a debt. In certain circumstances, creditors obtain security interests by the operation of state (or federal) laws. These liens include:
Mechanic’s Liens. This type of lien arises when a contractor or mechanic performs work on property and is not paid. Examples include a contractor who installs a furnace in a home, or an auto mechanic who performs repairs to a car. This lien is a security interest in the property. If the owner tries to sell the property, the debtor will have a secured interest in the portion of the proceeds needed to pay the debt.
Tax Liens. This type of lien is placed against property by the local, state or federal government, as authorized by statute, for delinquent taxes, including property, income and estate taxes.
Judgments are the Most Powerful forms of Liens
Of the three types of liens, this is the most dangerous form, but one which the informed business owner may be able to eliminate. A judicial lien is created when a court grants a creditor an interest in the debtor’s property, after a court judgment.
These can arise in a wide variety of circumstances. For example, if a driver negligently injures someone in an accident, the injured person is likely to sue for damages. To the extent that insurance doesn’t cover the judgment, a judicial lien may be placed against the negligent driver’s property to secure payment of the claim to the injured party.
A plaintiff who obtains a monetary judgment is termed a “judgment creditor.” The defendant becomes a “judgment debtor.” The judgment in the lawsuit provides the basis for the lien.
If the debt is not paid, the judgment creditor can then seek to enforce (or execute) the judgment. This can be accomplished by garnishing wages, seizing a bank account, or placing a lien against the debtor’s property. The lien is the first step by the judgment creditor in a process that will culminate in a sale of the attached property, to satisfy the judgment debt.
Any lien placed on the defendant’s assets as a result of a court judgment is known as a judgment lien. If a lien were placed on a home, the judgment creditor would then seek to foreclose on the property, in the same way a mortgage holder such as a bank would foreclose if it were not paid.
In this section, the term “judgment lien” is used in its strictest sense: a lien attributed to a court judgment, where the court judgment itself is the basis for the lien. An example would be a plaintiff who is awarded a monetary judgment against a defendant in a lawsuit based on negligence, and who then is granted an order of attachment against the debtor’s property.
In contrast, this definition excludes a judgment based on a pre-existing lien (i.e., a prior consensual lien or statutory lien). Thus, for example, this definition would exclude a judgment in a mortgage foreclosure. This distinction is critically important in discerning what types of liens against exempt property can be eliminated.
Call or write us for more information on how to execute and enforce your liens. Credit Resolution can also help you put liens in place by working with our national network of firms that specialize in lien placement to protect you and your business’ assets.
Disclaimer: The information contained here is not to be construed as legal advice. You need to consult an attorney and accountant to be sure of what is best for you and your business. Do not take this recommendation lightly it can have a severe impact on your business and your income. Get their advice. There are a lot of filings in many municipalities and States that can be done by you as a business person — still get professional advice!