24. What is “priority” of a security interest?
The priority of a secured party regards the party’s right to payment in the event of default by a debtor. If a debtor defaults, a secured party with a security interest in collateral will have a claim of ownership in the collateral. As such, she can repossess the collateral, sell it, and use the proceeds to satisfy the debt. Many issues arise, however, when there are multiple creditors of the debtor. The situations gets more complicated when there are multiple secured parties claiming an interest in the subject collateral. This is when the concept of priority is most important.
• Priority – Priority establishes the order of who has the highest claim to assets or the proceeds from the sale of those assets. A secured party with the highest priority in collateral will receive payment of her claim before any other creditors receive payment. Subordinate secured creditors will only receive payment once the highest priority secured creditor is paid in full. Once the highest priority creditor is paid, the next highest priority creditor is paid, and so on.
⁃ Note: The secured party with the highest priority faces the lowest risk of nonpayment. The terms of secured-party lending reflects the risk associated with the borrower’s priority.
• Risk and Creditor Status – The lower the priority of a creditor, the greater the risk that she will not receive any money from the sale of the collateral in the event of default. If a creditor’s claim is not paid in full, she becomes an unsecured creditor of the debtor. Unsecured creditors generally have the highest risk of non-payment. This is particularly troublesome if the debtor files for bankruptcy protection. In the event of debtor bankruptcy, unsecured creditors generally receive a fraction, if anything, of their claim amount. Secured creditors, on the other hand, must either be paid in full or they can force the sale or surrender of the collateral securing the obligation.
⁃ Note: A debt to an unsecured creditor that is not paid in full from the debtor’s bankruptcy estate is discharged. This means the debtor cannot later seek payment from the debtor and must accept the loss.
• Discussion: How do you feel about the priority system for establishing which creditors are paid first in the event of sale of the collateral or bankruptcy of the debtor? Is this system fair? Why or why not?
• Practice Question: Devon purchase equipment from Julia, who takes a security interest in the equipment. Devon has outstanding loans to Gerard and Fred. Devon defaults on all of his loans. What information do you need to determine who has priority in the collateral or proceeds from sale of the collateral?