Debtor-Creditor Relationships
Introduction
Debtor-creditor law governs how debts are created, secured, and collected — and what happens when a debtor cannot pay. The REG exam tests suretyship, secured transactions under UCC Article 9, and federal bankruptcy law extensively. This chapter covers each area in detail.
Suretyship and Guaranty
Definitions
- Surety: A party who is primarily liable for the debtor's obligation alongside the debtor. The creditor may pursue the surety immediately upon default without first demanding payment from the debtor.
- Guarantor: A party who is secondarily liable — the creditor must first attempt to collect from the debtor before pursuing the guarantor (the guarantee is a form of guaranty of collection).
A surety's promise to answer for another's debt must be in writing under the Statute of Frauds unless the surety's main purpose is to benefit themselves (the "main purpose" or "leading object" exception).
Surety's Defenses
A surety may assert certain defenses to avoid liability:
| Defense Available | Defense NOT Available |
|---|---|
| Fraud or duress by the creditor against the surety | Debtor's bankruptcy or insolvency |
| Material modification of the original contract without the surety's consent | Debtor's incapacity (minority, incompetence) |
| Creditor's release of or impairment of collateral | Debtor's fraud against the creditor |
| Statute of limitations | Creditor's failure to pursue the debtor |
| Payment or performance by the debtor |
Co-Sureties
When multiple sureties guarantee the same obligation, they share liability based on their maximum exposure. A co-surety who pays more than their proportionate share has a right of contribution from the other co-sureties.
Example: Gies Co. borrows $120,000 from a bank. Three co-sureties guarantee the loan with maximum exposures of $120,000, $80,000, and $40,000 respectively. The proportionate shares are 50%, 33⅓%, and 16⅔%. If Surety A pays the full $120,000, Surety A may seek contribution of $40,000 from Surety B and $20,000 from Surety C.
Secured Transactions Under UCC Article 9
Key Terminology
| Term | Definition |
|---|---|
| Security interest | An interest in personal property that secures payment of an obligation |
| Debtor | The person who owes the obligation |
| Secured party | The creditor who holds the security interest |
| Collateral | The property subject to the security interest |
| Security agreement | The contract creating the security interest |
| Financing statement (UCC-1) | The document filed to provide public notice of the security interest |
Attachment
A security interest attaches (becomes enforceable against the debtor) when three requirements are met:
- Value has been given by the secured party
- The debtor has rights in the collateral
- The debtor has authenticated a security agreement that describes the collateral (or the secured party has possession or control)
Perfection
Perfection gives the secured party priority over other creditors. Methods of perfection:
| Method | When Used |
|---|---|
| Filing a financing statement | Most common method; used for most types of collateral |
| Possession | Effective for tangible collateral (e.g., goods, instruments, money) |
| Control | Required for deposit accounts; available for investment property |
| Automatic perfection | Purchase money security interest (PMSI) in consumer goods perfects automatically upon attachment |
:::tip Exam Tip
A PMSI in consumer goods perfects automatically — no filing is required. But a PMSI in inventory or equipment must be perfected by filing to receive super-priority.
:::
Priority Rules
When multiple creditors claim the same collateral, priority is determined as follows:
- Perfected PMSI in inventory (if notice given to prior secured party) > other perfected interests
- Perfected PMSI in non-inventory (perfected within 20 days of debtor's possession) > other perfected interests
- Perfected vs. perfected — first to file or perfect wins
- Perfected vs. unperfected — perfected interest wins
- Unperfected vs. unperfected — first to attach wins
- Buyer in the ordinary course of business takes free of a security interest created by the seller
Example: MAS Inc. borrows from Bank A (filed UCC-1 on January 1) and Bank B (filed UCC-1 on March 1), both secured by the same equipment. Bank A has priority because it filed first.
Bankruptcy
Filing a Petition
| Type | Who Files | Requirements |
|---|---|---|
| Voluntary | The debtor | Available under any chapter; no insolvency required |
| Involuntary | Creditors | Available only under Chapters 7 and 11; debtor must generally not be paying debts as they become due |
For an involuntary petition:
- If the debtor has 12 or more unsecured creditors, at least 3 must join, with aggregate claims of at least $18,600 (adjusted periodically)
- If the debtor has fewer than 12 unsecured creditors, 1 creditor with at least $18,600 in claims may file
Automatic Stay
Upon filing, an automatic stay immediately halts most collection actions, including:
- Lawsuits against the debtor
- Foreclosures and repossessions
- Wage garnishments
- Telephone calls and letters demanding payment
The automatic stay does not stop criminal proceedings, certain tax proceedings, or domestic support obligations (alimony and child support).
Chapter 7 — Liquidation
- A trustee is appointed to collect and liquidate the debtor's nonexempt assets
- Proceeds are distributed to creditors according to statutory priority
- The debtor receives a discharge of most remaining debts
Exempt property (varies by state but includes a homestead exemption, personal property, tools of the trade, etc.) is not available to creditors.
Chapter 11 — Reorganization
- Typically used by businesses to restructure debts while continuing operations
- The debtor usually remains in possession as debtor-in-possession (DIP)
- A plan of reorganization must be proposed and confirmed by the court
Chapter 13 — Individual Debt Adjustment
- Available only to individuals with regular income
- Debtor proposes a 3- to 5-year repayment plan
- Debt limits apply (secured debts under $1,257,850; unsecured debts under $419,275 — adjusted periodically)
Priority of Claims in Bankruptcy
Claims are paid in the following order:
| Priority | Claim Type |
|---|---|
| 1 | Secured claims (to the extent of collateral value) |
| 2 | Domestic support obligations (alimony, child support) |
| 3 | Administrative expenses (trustee fees, professional fees) |
| 4 | Gap claims (in involuntary cases, claims arising in the ordinary course between filing and the order for relief) |
| 5 | Wages and salaries earned within 180 days before filing (up to $15,150 per employee) |
| 6 | Employee benefit plan contributions |
| 7 | Certain consumer deposits (up to $3,350 per individual) |
| 8 | Tax claims (income, property, employment taxes) |
| 9 | General unsecured claims |
Nondischargeable Debts
Certain debts survive bankruptcy and are not discharged:
- Student loans (unless undue hardship is proven)
- Taxes owed within 3 years of filing
- Debts obtained by fraud or false pretenses
- Domestic support obligations (alimony, child support)
- Fines and penalties owed to governmental units
- Debts from willful and malicious injury to another
- Debts not listed on the bankruptcy schedules
Preferences and Fraudulent Transfers
- Preference: A payment made to a creditor within 90 days before filing (or one year for insiders) that gives the creditor more than it would receive in a Chapter 7 liquidation. The trustee may avoid such transfers.
- Fraudulent transfer: A transfer made within 2 years before filing with the intent to hinder, delay, or defraud creditors — or made for less than reasonably equivalent value while the debtor was insolvent.
Example: Illini Entertainment pays a $50,000 unsecured debt to Kingfisher Industries (an insider) 10 months before filing for bankruptcy. This payment may be avoided as a preferential transfer because it was made to an insider within the one-year look-back period.
Summary
| Topic | Key Rule |
|---|---|
| Surety | Primarily liable; may assert own defenses but not debtor's personal defenses |
| Attachment | Value + rights in collateral + security agreement |
| Perfection | Filing, possession, control, or automatic (PMSI consumer goods) |
| Priority | First to file or perfect generally wins; PMSI has super-priority |
| Automatic stay | Halts most collection actions upon filing |
| Chapter 7 | Liquidation; trustee sells nonexempt assets |
| Chapter 11 | Reorganization; debtor usually stays in possession |
| Nondischargeable | Student loans, recent taxes, fraud, domestic support |
| Preferences | Avoidable if within 90 days (1 year for insiders) |