Debtor-Creditor & Bankruptcy

Why this topic matters

Taxation and Regulation (REG) Business Law tests three related areas of creditor protection: secured transactions under Article 9 of the Uniform Commercial Code (UCC), suretyship, and federal bankruptcy. Most questions ask who wins when a debtor can't pay everyone.

Secured transactions (UCC Article 9)

Attachment — making the interest enforceable against the debtor

A security interest attaches when all three occur (in any order):

1. The creditor gives value (a loan, credit, or a binding commitment).
2. The debtor has rights in the collateral.
3. There is a security agreement authenticated by the debtor describing the collateral — or the creditor takes possession or control.

Perfection — protecting the interest against third parties

Method	When used
Filing a financing statement (UCC-1)	Most collateral; effective for 5 years; may be filed before attachment
Possession	Goods, negotiable instruments, money (money can be perfected only by possession)
Control	Deposit accounts, investment property, electronic chattel paper
Automatic perfection on attachment	Purchase money security interest (PMSI) in consumer goods (except vehicles with certificates of title)

Priority rules

• Perfected beats unperfected. Between two perfected interests, the first to file or perfect wins. Between two unperfected interests, the first to attach wins.
• A PMSI in inventory has priority over an earlier perfected interest if it is perfected before the debtor receives the inventory and prior secured parties receive written notice.
• A PMSI in non-inventory goods (equipment) has priority if perfected within 20 days after the debtor receives the collateral.
• A buyer in the ordinary course of business takes free of any security interest created by the seller, even if perfected and known.
• A consumer buying from a consumer, for personal use, without knowledge, takes free of an automatically perfected PMSI unless the creditor filed.
• A lien creditor (including a bankruptcy trustee) beats an unperfected security interest.

Default

The secured party may take possession (self-help, without breach of the peace) and sell the collateral in a commercially reasonable manner, then apply proceeds to expenses, the secured debt, and subordinate interests; any surplus goes to the debtor, and the debtor is liable for any deficiency. Strict foreclosure (keeping the collateral in satisfaction) is limited for consumer goods where 60% or more has been paid. The debtor may redeem before disposition.

Suretyship

• A surety is primarily liable with the principal debtor — the creditor can proceed against the surety immediately. A guarantor of collection is secondarily liable (only after the creditor exhausts remedies against the debtor).
• Surety's rights: exoneration (compel the debtor to pay), reimbursement, subrogation (step into the creditor's rights after paying), and contribution from co-sureties (in proportion to the amounts each guaranteed).
• Surety's defenses: the principal's defenses on the underlying debt (fraud or duress by the creditor, breach, material alteration), fraud against the surety, release of the debtor without reserving rights, release or impairment of collateral (to that extent), and a material modification without consent (a compensated surety is released only if harmed).
• Not defenses: the principal debtor's bankruptcy, death, incapacity, or minority — these are the risks the surety agreed to cover.

Bankruptcy

Chapter	Purpose	Key features
Chapter 7	Liquidation	A trustee sells nonexempt assets and distributes proceeds; individual debtors must pass a means test
Chapter 11	Reorganization (mainly businesses)	The debtor usually continues operating as debtor in possession; a plan must be confirmed by the court and creditor classes
Chapter 13	Individual debt adjustment	Individuals with regular income repay under a 3–5 year plan; only voluntary

Filing

• Voluntary petition: by the debtor; insolvency is not required.
• Involuntary petition (Chapters 7 and 11 only): if the debtor has 12 or more creditors, at least 3 must join; with fewer than 12, one creditor may file. Petitioners' unsecured claims must exceed a statutory minimum (indexed). Not available against farmers or charities. The court grants relief if the debtor is generally not paying debts as they come due.
• Filing creates an automatic stay halting most collection actions, foreclosures, and lawsuits (not criminal proceedings or domestic support collection).

The trustee's avoidance powers

• Preferential transfers: a transfer to a creditor, for an antecedent debt, while the debtor was insolvent (presumed in the 90 days before filing), that lets the creditor receive more than in a Chapter 7 liquidation — made within 90 days before filing, or 1 year for insiders (relatives, officers, directors). Exceptions: contemporaneous exchanges for new value, payments in the ordinary course of business, and perfected PMSIs within 30 days.
• Fraudulent transfers: transfers within 2 years before filing made with intent to hinder creditors, or for less than reasonably equivalent value while insolvent.
• Unperfected security interests can be avoided (the trustee is a hypothetical lien creditor).

Distribution order

1. Secured creditors — from their collateral (any shortfall becomes an unsecured claim).
2. Priority unsecured claims, in order: domestic support obligations; administrative expenses of the bankruptcy; involuntary-gap claims; wages and commissions earned within 180 days (up to a limit); employee benefit plan contributions; certain claims of farmers and fishermen; consumer deposits; certain taxes.
3. General unsecured creditors, pro rata.
4. Equity holders.

Discharge

An individual's discharge eliminates most remaining debts. Not dischargeable: most taxes from the last 3 years, domestic support obligations, student loans (unless undue hardship), debts from fraud or willful and malicious injury, fines and penalties, debts not listed, and debts from driving while intoxicated. A discharge may be denied entirely for concealing or destroying assets or records, false oaths, or a prior Chapter 7 discharge within 8 years.

How it is tested

• Determine whether a security interest has attached or been perfected, and rank competing claims.
• Decide whether a surety is released by a given event.
• Identify preferential and fraudulent transfers.
• Rank claims in a Chapter 7 distribution and identify nondischargeable debts.