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What are the general “priority rules” for security interests?
The following are the general priority rules for security interests:
• Perfected vs Unperfected Security Interests – A perfected security interest has priority over an unperfected security interest. This is true even if the unperfected security interest was established well before the perfected security interest.
⁃ Note: This fact can give rise to issues when a party’s security interest has temporary automatic perfection.
• Unperfected vs Unperfected Security Interests – Unperfected security interests have priority based upon the order of attachment of the security interest. In this case, the earlier party to establish the security interest has priority over those coming later.
⁃ Note: A later unsecured party may establish priority by filing her security interest (or otherwise perfecting) before the other secured parties.
• Multiple Perfected Security Interests – The first secured party to file or perfect is entitled to priority over secured parties later acquiring or perfecting their interest in the subject collateral. This situation also brings up an issue for temporary automatic perfection. If a party takes the steps necessary to continue the temporary automatic perfection, her perfection date is retroactive back to the date and time that the security interest attached. This becomes and issue when the collateral is also subject to an “after-acquired collateral” clause. If she fails to take the steps necessary to continue the security interest, any third party may establish a security interest in the collateral and gain priority over her unperfected security interest.
⁃ Note: An issue arises for collateral that is used to secure “future advances”.
These are default rules. Any of these rules can be changed pursuant to agreement between the parties. That is, a party can agree to subordinate her security interest to the security interests of others. This is important when new lenders require priority of a security interest before extending new credit to a debtor.
• Discussion: How do you feel about the above-stated priority rules applicable to security interests? Is it fair that a party can establish priority over an earlier security interest by being the first to file? Why or why not? Can you think of any situations where the automatic temporary perfection rules could cause an issue?
• Practice Question: Heidi purchases a piece of equipment from Indira. Indira finances the purchase and attaches a security interest. Heidi has a loan outstanding to Jan that has an after-acquired property clause in the security agreement. After the purchase of the equipment, Heidi borrows money from Kyle, who takes a security interest in all of Heidi’s assets. If Heidi defaults on all of her debts, who has priority of payment from the sale of the equipment? What other information do we need to know to answer this question?