Don’t Get Caught Unsecured
Let’s not have short memories. In October of 2007, we saw the peak of a market and in March 2009 we saw the trough. The DJIA went from about 14,000 to 7,000 in during that time period. I’m not writing to predict that we will or won’t see that type of economic action for the rest of our lives, but what I am stating is that when things are good is when one needs to prepare for the next economic hiccup.
In general, the downturn was exacerbated by the reduced value of collateral securing debt obligations creating a vicious cycle of downward pressure on the value of that collateral, with no end in sight. What do I mean by this? Most larger loans, as is the case today, were secured by real estate. If the real estate collateral had maintained its value and the lenders could liquidate it to recover the funds lent, there would be no “too big to fail” bailouts, no bank failures, and no mass-consolidation among financial institutions. The collateral class of real estate was simply over-leveraged and high volumes of collateral liquidation caused a reduced demand. Though collateral was losing value, secured lenders were still in a much better position than unsecured creditors.
A flurry of bankruptcies from 2009 to 2013 taught us a very important lesson: secured creditors were recovering a much higher fraction of the money they were owed than unsecured creditors. Forty percent recovery is much better than zero or one percent. The lesson we should have learned from the downturn was when lending money, lend it secured.
This article is intended to provide some basic information to non-bank lenders looking to lend money on a payment plan or lump sum basis for an agreed upon return from the borrower. Warning: When providing personal loans be aware that there are very stringent consumer protection laws whether California or Federal, which create protections for individual borrowers and purchase money loans which are not discussed here, and which may not appear to be common sense.
Securing the money lent with real property, personal property, or personal guanraty(ies) is the way to protect an investment. Though the maintenance of collateral value can’t be guaranteed, some type of recovery can be accounted for when making the loan and determining risk. The process of valuing collateral is part of on-going servicing of a loan.
The following are types of collateral that can secure a loan obligation and a brief description about the pros and cons of each:
Real Property is the most well-known collateral for debt obligations (loans). In general, real estate cycles are long-term and valuation of real property is within the means of the average lender with access to the internet and other resources. Real estate values in general, do not drop. A disadvantage of real property collateral is that if the loan is purchase money and the real property is the borrower’s primary residence, one has no recourse to recover if the property sells at a discount below what the loan was made for. In essence, there is no right to a deficiency judgment against the borrowers.
Personal property includes everything that is not real property. Anything that can be considered personal property can be collateral to a loan. Common types of personal property collateral are equipment, accounts, chattel, and inventory. In general, personal property collateral is provided for purchase money loans for that personal property. Personal property collateral is more difficult to value, and usually requires hiring a professional with specific knowledge as to the value of that type of property to give an appraisal. Personal property collateral can be just as effective as real property collateral.
A borrower’s obligation under a loan can be secured by a personal guarantee. The personal guaranty must not be from the borrower themselves. If the guaranty is from the borrower themselves, then it is considered a sham guaranty and could cause issues with collections should efforts not proceed correctly. If the loan is to a business entity, the guaranty should be from the owner or owners of the company. If the loan is to an individual borrower, the guaranty should be from another person, family member, or company.
The most common way to secure a lien on real property collateral is by having the owner execute a Deed of Trust and record the Deed of Trust in the public records of the county where the particular property is. Recording a properly drafted and executed Deed of Trust perfects the lien, and remains valid until the lien is addressed (either non-judicial foreclosure, judicial foreclosure, or satisfaction). The lender is responsible for lien perfection, and prior to agreeing to take certain real property collateral, it is the lender’s obligation to undertake its due diligence in confirming property value, status of title, and potential lien priority. A purported lien, not properly perfected, risks losing its value as the collateral would not be subject to the lien. Liens on real property are prioritized by first in time, first in right.
There is a database in California currently called UCC Connect and is facilitated by the Secretary of State’s office. This database is essentially the public records for personal property. Anyone can perform a search for a potential borrower’s name and find liens on personal property. Liens include financing liens (purchase money and advances), and judgment liens. lenders taking personal property collateral will file a UCC Financing Statement with the Secretary of State to perfect their lien on the specified property. Filing a UCC Financing Statement perfects the lien. Other times when an individual or company has a judgment in a civil case entered against them, the judgment creditor will record a UCC Notice of Judgment lien with the Secretary of State’s office. This lien then attaches to all personal property that company or individual has. The judgment creditor may then execute on the lien if the debtor does not pay. A lender must be aware that both Financing liens and judgment liens attach to the same property and are entitled to priority based on time. First in time, first in right.
A personal guaranty is a document signed at the time the loan is made. Best practices dictate that all transaction documents in a secured transaction relate and reference each other. If the documents don’t reference each other, there may be some disagreement that a certain guaranty actually secures a certain promissory note or loan obligation. Personal guaranties in California require certain disclosures pursuant to CA law, however, this depends on the type of loan involved. Once a guaranty is properly drafted and executed, the individual signatory is personally liable for the obligation.
Collection Efforts on Secured Loans
If the lender’s Deed of Trust includes a “power of sale” clause, the lender may commence a non-judicial foreclosure. This is typically the most efficient and cost effective recovery for a secured lender. In general, a foreclosure processing company assists the lender in with the process and acts as the trustee. The non-judicial foreclosure process includes notice to certain parties, recording of a Notice of Default (NOD), publishing a sale date, and crying the sale. Once a Notice of Default is recorded, the borrower has 90-days to redeem the loan by paying all the amounts owed in arrears plus some reasonable fees associated with commencement of the foreclosure. Once the 90-day period has ended, the lender may then set and publish the trustee’s sale date set no earlier than 21 days from the date of publishing. This means, the absolute fastest a non-judicial foreclosure can be completed is 111 days after the NOD is recorded. In general, a lender foreclosing in this manner has no right to a deficiency judgment should the collateral sell at the trustee’s sale for less than what the lender is owed.
Real Property may be recovered through a judicial foreclosure. This involves the filing of a lawsuit. It usually includes obtaining a court order to sell the property at auction, and obtaining a deficiency judgment for any amounts owed to the lender that are not paid after credit is given for the proceeds from the sale. This process usually requires an attorney and careful adherence to California law. A secured commercial lender with a perfected lien on collateral that has lost value, it is generally recommended to commence a judicial foreclosure and obtain a deficiency judgment.
The document evidencing pledge of personal property collateral on a debt obligation is a security agreement (also commonly known as a commercial security agreement). This agreement provides for the rights of the parties. If the security agreement contains non-judicial foreclosure rights granted to the lender, the lender may choose to pursue that option. If the security agreement doesn’t include those rights, then the lender must sue for breach of contract and judicial foreclosure of the personal property. This process is the same as stated above for real property.
Collections efforts against personal guarantors take the form of a lawsuit for breach of contract against the guarantor(s).
Risk of Debtor Bankruptcy
Bankruptcy is a real risk for creditors when suing to collect a debt. The automatic stay goes into effect the minute a debtor files for bankruptcy, whether their petition is complete or not. The debtor has a certain amount of time to complete all the filings before their case would be dismissed and collections actions continue.
When the petition is filed, creditors are noticed and each makes its respective creditor’s claim. The claims are classified between priority, secured and unsecured. Different chapters of bankruptcy (Ch 7, Ch 11, Ch 12, Ch 13) treat creditor classes differently. In general, if one is a secured creditor, the claim remains secured by the collateral property even after discharge. Under certain circumstances, if the lender had commenced a collection lawsuit, and the property is not necessary for the bankruptcy estate, the lender can ask the bankruptcy court for relief from the automatic stay and continue the lawsuit. The lender’s relief is usually limited to the value of the collateral after a bankruptcy.
Bankruptcy should be a real consideration for lender in determining what types of collections actions to take, and a well-secured lender is much better prepared than an unsecured lender. An unsecured creditor, upon bankruptcy discharge, is often left with no-pay back or very little.
Disclosure & Other Important Law Not Discussed or Considered in this Article
California Code of Civil Procedure §726 et seq. provides a creditor but one form of action. This means that if a debtor has defaulted on a debt obligation, the lender has one way of recovery. Note of caution to lenders, this doesn’t necessarily mean one lawsuit. A simple set-off of an account would be considered the one-action, and any liens in personal or real property WOULD BE WAIVED.
California Code of Civil Procedure §580 et seq. provides the legal framework for obtaining deficiency judgments. The substance of this section is much more than could be covered in this article.
Nothing in this article should be relied upon as legal advice, construed as providing legal advice or creating an attorney-client relationship.
Zahbihi & Watkins Law Firm, APC is the premier boutique business law firm in the Sacramento Valley region of California and specializes in commercial secured transactions and litigation. Please contact Zahbihi & Watkins Law Firm, APC if you would like to discuss your specific situation.