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Secured Party Priority in Future Advances to Debtor

34. What is a secured party’s priority in “future advances” of funds to the debtor?

Future advances of funds are funds provided to a debtor based upon an existing lending agreement. This is common when a debtor establishes a line of credit with a lender. The lender will advance funds to the debtor when requested. Generally, a security agreement will provide that the lender is secured by any collateral securing a future advance or new collateral acquired with the advanced funds. The rules for priority in future advances are as follows:

•    Time of Perfection – Generally, the time of perfection of a security interest establishes priority with respect to future advances. That is, if a lender makes an advance of funds based upon a prior agreement, the priority of the lender’s security interest in collateral securing the advance is determined by the time of the filing of the financing statement covering the collateral. If the debtor has secured creditors with priority above that of the lender, these creditors retain priority in the collateral despite the future advance.

⁃    Example: First Bank lends money to Mark and takes a security interest in Mark’s lawn mower. Mark later borrows money from Second Bank that takes a security interest in all of Mark’s assets. As such, First Bank’s security interest in the lawn mower has priority over that of Second Bank. If First Bank makes a future advance to Mark pursuant to the original lending agreement, First Bank will have priority based upon its original security agreement and financing statement. If, however, First Bank’s security agreement does not cover future advances, Second Bank’s security interest in the collateral will have priority over a subsequent security interest filed by First Bank against the collateral to secure payment of the future advance.

•    Priority over Lien Creditors – A secured party that advances additional funds and claims a security interest against the original collateral has priority over a lien creditors of the debtor if:

⁃    The secured party made the advance of new credit within 45 days after the lien attaches, or

⁃    The secured party made the advance of funds more than 45 days after the lien attaches, but without knowledge of the lien or pursuant to a prior agreement entered into without knowledge of the lien.

⁃    Example: First Bank lends money to Katherine and takes a security interest in Katherine’s jewelry. A creditor receives a judgment against Katherine and establishes a lien against her jewelry. First Bank later makes a future advance to Katherine that is secured by her jewelry. If First Bank made the advance within 45 days of the lien creditor establishing its lien, then First Bank will have priority. If First Bank makes the future advance more than 45 days after the lien is established, it will have priority if the future advance was pursuant to the original lending agreement providing for a security interest in the collateral or if First Bank had no knowledge of the other creditor’s lien at the time of the advance.

•    Priority over Buyers of Collateral – A secured party who makes future advances against collateral has priority over a buyer of the collateral in the ordinary course if:

⁃    The secured party’s advance is made within 45 days and without knowledge of the purchase; or

⁃    The advance was made pursuant to a commitment established within 45 days of and without knowledge of the purchase.

⁃    Note: This provision keeps a debtor from selling collateral and then seeking a future advance secured by the collateral.

⁃    Example: First Bank has a security interest in ABC’s inventory. ABC sells an item of inventory to Fanny. Fanny takes the item subject to First Bank’s security interest in the inventory if the advance was made within 45 days of the sale or the advance was made pursuant to a security agreement entered into within 45 days and without knowledge of the sale to Fanny.

•    Discussion: How do you feel about the rules providing for priority for future advances? Do you agree that with the priority rules for future advances above that of lien creditors? Why or why not? Do you agree that with the priority rules for future advances above that of buyers of the collateral in the ordinary course? Why or why not? Can you think of situations where this rule would unduly prejudice lien creditors or buyers in the ordinary course?

•    Practice Question: Luther borrows funds from First Bank. First bank establishes a security agreement and perfects a security interest in Luther’s tractors. Luther later takes out loans from Second Bank and Third Bank. Both banks establish security agreements in all of Luther’s assets. Luther also becomes subject to a lien creditor. Troubled with money issues, Luther sells the tractor without notifying his creditors. Soon thereafter, First Bank makes a future advance to Luther secured by the tractor. Which creditor’s security interest, if any, has priority in the collateral? What additional information do we need to answer this question?

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